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Chapter One
The EquityMethod of
Accountingfor
Investments
McGraw-Hill/Irwin Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
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Reporting Investments inCorporate Equity Securities
GAAP recognizes 3 ways to reportinvestments in other companies:
Fair-Value MethodConsolidation
Equity Method
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The method is selected based uponthe degree of influence the investor
has over the investee.
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Fair Value Method1-3
Used when the investor holds a smallpercentage of the investees outstanding
stock, and is not able to significantly
affect the investees operations.Investment is made in anticipation
of dividends and/or
market appreciation.Investments will be classified
as eitherTrading Securities or
Available-for-Sale Securities.
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Fair Value Method(Trading vs Available-for-Sale)
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Trading SecuritiesHeld for sale in the short term.
Unrealized holding gains and losses are
included in earnings (net income).
Available-for-Sale SecuritiesAny Securities not classified as
Trading.Unrealized holding gains and losses
are reported in shareholders equity
as other comprehensive income (ie,
not included in net income).
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Consolidation of FinancialStatements
Required when the investorsownership exceeds 50% of investee,except where control does not actuallyrest with the majority investor
Contractual agreementsBankruptcies
Government restrictions One set of financial statements
is prepared which consolidatesall accounts of the parent company andall of its controlled subsidiarycompanies, as though they were asingle entity.
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Equity Method
Used when the investor has
the ability to exercise
significant influence on the
investee operations Generally used when
ownership is between 20% and 50%.
Significant Influence might bepresent with much lower ownershippercentages. (The accountant mustconsider the particulars!!!)
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What is Significant Influence??(FASB ASC Section 323)
Representation on theinvestees Board of Directors
Participation in the investees
policy-making processMaterial intercompany transactions
Interchange of managerialpersonnel
Technological dependencyExtent of ownership in
relation to other investorownership percentages
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Special Proceduresfor Special Situations
Reporting achange tothe equitymethod. Reporting investee
income from sourcesother than continuing
operations.Reportinginvestee
losses.Reporting the
sale of an equityinvestment.
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Reporting a Changeto the Equity Method
An investment that is too small tohave significant influence is recordedusing the fair-value method, but
When ownership grows to the point
where significant influence isestablished . . .
. . . all accounts are restated so that the
investors financial statements appearas if theequity method had been applied from the date
of the first [original] acquisition. - - APB
FASB ASC (para. 323-10-35-33)
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Reporting Investee Income fromSources other than Operations
When net income includeselements other thanOperating Income, theseelements should be
presented separately on theinvestors income statement.
Examples include:
Discontinued operations Extraordinary items
Prior period adjustments
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Reporting Investee Losses
A permanentdecline in theinvestees fair
market value isrecorded as an
impairment loss andthe investment
account is reducedto the fair value.
A temporarydecline isignored!!!
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Reporting the Sale ofan Equity Investment
If part of an investment issold during the period . . .
The equity method continues to be
applied up to the date of thetransaction.At the transaction date, a proportionate
amount of the Investmentaccount isremoved.
If significant influence is lost, NORETROACTIVE ADJUSTMENT isrecorded, but the equity method is nolonger applied.
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INVESTOR
INVESTEE
INVESTOR
INVESTEE
DownstreamSale
UpstreamSale
Unrealized Gains in Inventory
Sometimes affiliated companies sell orbuy inventory from each other.
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