Chapter One

The Equity Method of

Accounting for Investments

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Learning Objective 1-1

Describe in general the various methods of accounting for an investment in equity shares of another company.

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Accounting for Investments in Corporate Equity Securities

GAAP recognizes three ways to report investments in other companies:

Fair-Value Method

Consolidation of Financial Statements

Equity Method

The method selected depends upon the degree of influence the investor has over the investee.

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Fair Value Method

Use when:investor holds a small percentage (usually less

than 20%) of equity securities of investee

Investor cannot significantly affect investee’s operations

Investment is made in anticipationof dividends or market appreciation.

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Fair Value Method

Investments classified as Trading Securities: Held for sale in the short term. Unrealized holding gains and losses are included in earnings.

Investments in equity securities, when neither significant influence or control is present, are recorded at cost and subsequently adjusted to fair value, if determinable, otherwise they remain at cost.

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Fair Value Method

Equity securities not classified as trading securities are classified as available-for-sale securities and reported at fair value.

Unrealized holding gains and losses are excluded from earnings and reported in a separate component of shareholders’ equity as part of other comprehensive income.

Dividends received are recognized as income for both trading and available-for-sale securities.

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Fair Value Method

FASB ASC Topic 825, Financial Instruments, allows a special fair-value reporting option for available-for-sale securities.

Although the balance sheet amounts for the investments remain at fair value under this option, changes in fair values over time are recognized in the income statement (as opposed to other comprehensive income) as they occur.

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Consolidation of Financial Statements

Required when: Investor’s ownership exceeds 50% of an organization’s outstanding voting stock

except when control does not rest with the majority investor

One set of financial statements prepared to consolidate all accounts of the parent company and all of its controlled subsidiaries as a single entity.

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FASB ASC section 810-10-05, Variable Interest Entities

Includes entities controlled through special contractual arrangements (not through voting stock interests)

Intended to combat misuse of SPE’s (Special Purpose Entities) to keep large amounts of assets and liabilities off the balance sheet known as “off balance sheet financing”

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Equity Method

Use when: Investor has the ability to exercise significant influence on investee operations (whether influence is applied or not) Generally used when ownership is between 20% and 50%. Significant Influence might be present with much lower ownership percentages. Under the equity method, investor’s share of investee dividends declared are recorded as decreases in the investment account, not income.

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International Standard 28 Investment in Associates

The International Accounting Standards Board (IASB), similar to FASB, defines “significant influence” as the power to participate in the financial and operating policy decisions of the investee, but it is not control or joint control over those policies.

If investor has 20% or more ownership, it is presumed to have significant influence, unless it is demonstrated not to be the case.

If investor holds less than 20% ownership, it is presumed it does not have significant influence, unless influence can be clearly demonstrated.

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Learning Objective 1-2

Identify the sole criterion for applying the Equity Method of accounting and guidance in assessing whether the criterion is met.

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Sole Criterion for Utilizing the Equity Method

Significant Influence (FASB ASC Topic 323) Representation on the investee’s Board of Directors

Participation in the investee’s policy-making process

Material intra-entity transactions

Interchange of managerial personnel

Technological dependency

Other investee ownership percentages

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Limitations of Equity Method Applicability

The equity method is not appropriate for investments that demonstrate any of the following characteristics regardless of the investor’s degree of ownership:

• An agreement exists between investor and investee by which the investor surrenders significant rights as a shareholder.

• A concentration of ownership operates the investee without regard for the views of the investor.

• The investor attempts but fails to obtain representation on the investee’s board of directors.

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Extensions of Equity Method Applicability

For some investments that either fall short of or exceed 20 to 50 percent ownership, the equity method is appropriately used for financial reporting.

Conditions can exist where the equity method is appropriate despite a majority ownership interest.

If the non-controlling rights are so restrictive as to call into question whether control rests with the majority owner, the equity method is employed for financial reporting rather than consolidation.

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Summary of Accounting Methods

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Accounting for an Investment - Equity Method

The investor increases the investment account as the investee earns and reports income. The investor uses the accrual method to record investment income —recognizing it in the same time period as the investee earns it.

The investor decreases its investment account’s carrying value for its share of investee cash dividends. When the investee declares a cash dividend, its owners’ equity decreases.

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Fair-Value Vs. Equity Method

*Equity in investee income is 20 percent of the current year income reported by Little Company. † The carrying amount of an investment under the equity method is the original cost plus income recognized less dividends. For 2014, as an example, the $230,000 reported balance is the $200,000 cost plus $40,000 equity income less $10,000 in dividends.

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Learning Objective 1-3

Prepare basic equity method journal entries for an investor and describe the financial reporting for equity method investments.

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Equity Method Example

Assume that Big Company owns a 20% interest in Little Company purchased on January 1, 2014, for $200,000.

Little then reports net income of $200,000, $300,000, and $400,000, respectively, in the next three years while declaring dividends of $50,000, $100,000, and $200,000.

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Equity Method Example

Big Company records the following journal entries toapply the equity method for 2014:

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Learning Objective 1-4

Allocate the cost of an equity method investment and compute amortization expense to match revenues recognized from the investment to the excess of investor cost over investee book value.

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Excess of Investment Cost Over Book Value Acquired

Fair values of specific investee assets and liabilities can differ from their book values. Excess payment can be identified directly with those accounts.

If purchase price exceeds fair value, future benefits are expected to accrue from the investment due to estimated profitability of the investee or the relationship established between the two companies. The additional payment is attributed to an intangible asset referred to as goodwill rather than to any specific investee asset or liability.

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Excess of Investment Cost Over Book Value Acquired

Assume Grande Company is negotiating the acquisition of30 percent of the outstanding shares of Chico Company. Chico’s balance sheet reports assets of $500,000 and liabilities of $300,000 for a net book value of $200,000. After investigation, Grande determines that Chico’s equipment is undervalued in the company’s financial records by $60,000. One of its patents is also undervalued, but only by $40,000.

By adding these valuation adjustments to Chico’s book value, Grande arrives at an estimated $300,000 worth for the company’s net assets. Based on this computation, Grande pays $125,000 for a 30 percent share of the investee’s outstanding stock.

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Excess of Cost Over Book Value of Acquired Investment

When Purchase Price > Book Value of an investment acquired, the difference must be identified.

Assets may be undervalued on the investee’s books because:

1. The fair values (FV) of some assets and liabilities are different than their book values (BV).

2. The investor may be willing to pay extra because future benefits are expected to accrue from the investment.

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Excess of Investment Cost Over Book Value Acquired

Any extra payment that cannot be attributed to a specific assetor liability is assigned to the intangible asset goodwill. The actual purchase price can be computed by different techniques or simply as a result from negotiations.

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The Amortization Process

Payment relating to each asset (except land, goodwill, and other indefinite life intangibles) should be amortized over an appropriate time period.

Goodwill associated with equity method investments, for the most part, is measured in the same manner as goodwill arising from a business combination, tested for declines in value and impairment. Goodwill, implicit in equity investments, is not.

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Learning Objective 1-5

Understand the financial reporting consequences for: a. A change to the equity method. b. Investee other comprehensive income.

c. Investee losses. d. Sales of equity method investments.

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Learning Objective 1-5aReporting a Change to the Equity Method

Report a change to the equity method if: An investment that was recorded using the fair-value

method reaches the point where significant influence is established.

All accounts are restated retroactively so the investor’s financial statements appear as if the equity method had been applied from the date of the first acquisition. (FASB ASC para. 323-10-35-33)

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Reporting a Change to the Equity Method (Retroactive Adjustment)

Giant Company acquires a 10% ownership in Small Company on January 1, 2014.

Giant company does not have the ability to exert significant influence over Small.

Giant properly records the investment using the fair-value method as an available-for-sale security.

On January 1, 2016, Giant purchases another 30% of Small’s outstanding stock, thereby achieving the ability to significantly influence Small’s decisions.

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Reporting a Change to the Equity Method (Retroactive Adjustment)

After changing to the equity method on January 1, 2016, Giant must restate the prior years to present the investment as if the equity method had always been applied. The income restatement for these earlier years can be computed as follows:

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Journal Entries to Report Change to Equity Method

Giant’s reported earnings for 2014 will increase by $5,000 with a $7,000 increment needed for 2015. To bring about this retrospective change to the equity method, Giant prepares the following journal entry on Jan.1, 2016:

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Learning Objective 1-5bInvestee Other Comprehensive

OCI is defined as revenues, expenses, gains, and losses that under GAAP are included in comprehensive income but excluded from net income.

Accumulated Other Comprehensive Income (AOCI) includes unrealized holding gains and losses on available-for-sale securities, foreign currency translation adjustments, and certain pension adjustments.

OCI is accumulated and reported in stockholders’ equity and represents a source of change in investee company net assets that is recognized under the equity method.

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Reporting Investee Other Comprehensive Income and Irregular Items

Other equity method recognition issues arise for irregular items traditionally included within net income. An investor must report its share of the following items reported in investee’s current income: Discontinued operationsExtraordinary itemsOther comprehensive income

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Learning Objective 1-5cReporting Investee Losses

A permanent decline in the investee’s fair market value is recorded as an impairment loss and the investment account is reduced to the fair value.

When accumulated losses incurred and dividends paid by the investee reduce the investment account to $-0-, no further loss can be accrued.

Investor discontinues using the equity method rather than record a negative balance. Balance remains at $-0-, until subsequent profits eliminate all unrecognized losses. A temporary decline is ignored!

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Learning Objective 1-5dReporting Sale of Equity Investment

The equity method continues to be applied up to the date of the transaction.

At the transaction date, the Investment account balance is reduced by the percentage of shares sold.

If significant influence is lost, NO RETROACTIVE ADJUSTMENT is recorded, but the equity method is no longer applied.

If part of an investment is sold during the period:

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Learning Objective 1-6

Describe the rationale and computations to defer unrealized gross profits onintra-entity inventory transfers until thegoods are either consumed or sold to outside parties.

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INVESTORINVESTOR

INVESTEEINVESTEE

INVESTORINVESTOR

INVESTEEINVESTEE

Downstream Sale

Upstream Sale

Deferral of Unrealized Profits in Inventory

Many equity acquisitions establish ties between companies to facilitate the direct purchase and sale of inventory items. Such intra-entity transactions can occur either on a regular basis or only sporadically.

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Deferral of Unrealized Profits in Inventory

The seller of the goods retains a partial stake in the inventory for as long as the buyer holds it.

The earning process is not considered complete at the time of the original sale.

Reporting the profit is delayed until the inventory is consumed within operations or resold to an unrelated party.

At the disposition of the inventory, the original sale is culminated and gross profit is recognized.

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Financial Reporting Effects

Measurements of financial performance often affect the following: The firm’s ability to raise capital. Managerial compensation. The ability to meet debt covenants and future

interest rates. Managers’ reputations.

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Criticisms of the Equity Method

Over-emphasis on possession of 20-50% voting stock in deciding on significant influence vs. control

Allowing off-balance sheet financing

Potential manipulation of performance ratios

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Learning Objective 1-7

Explain the rationale and reporting implications of the value accounting for investments otherwise accounted for by the equity method.

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Fair Value Reporting Option

An entity may irrevocably elect fair value as the initial and subsequent measurement for certain financial assets and financial liabilities including investments accounted for under the equity method.

Under the fair-value option, changes in the fair value of the elected financial items are included in earnings.

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