Stock Investments – Investor Accounting

1. Stock Investments –Investor Accounting Chapter 2

2. Learning Objective 1 Recognize investors’ varying levels of influence or control based on the level of stock ownership.

3. Accounting for Stock Investment GAAP for recording common stock acquisitions require that the investor record the investment at its cost. Fair value/cost method Equity method

4. Concept Underlying Fair Value/Costand Equity Methods Under the fair value/cost method investments in common stock are recorded at cost. Dividends from subsequent earnings are reported as dividend income.

5. Concept Underlying Fair Value/Costand Equity Methods The equity method of accounting is essentially accrual accounting for equity investments. Investments are recorded at cost and adjusted for earnings, losses, and dividends.

6. Learning Objective 2 Anticipate how accounting adjusts to reflect the economics underlying varying levels of investor influence.

7. Economic Consequences of UsingFair Value/Cost and Equity Methods The different methods of accounting result in different investment amounts in the balance sheet of the investor corporation and different income amounts in the income statement.

8. Economic Consequences of UsingFair Value/Cost and Equity Methods When Investor can significantly influence or control the operations of the investee. Fair value/cost method is unacceptable.

9. Economic Consequences of UsingFair Value/Cost and Equity Methods Although The equity method is not a substitute for consolidation, the income reported is generally the same as the income reported in consolidated financial statements.

10. Learning Objective 3 Apply the fair value/cost and equity methods of accounting for stock investments.

11. Accounting Procedures Under theFair Value/Cost and Equity Methods July 1: Pilzner acquires 2,000 of the 10,000 outstanding shares of Sud at $50 per share. $50 per share equals the book value and fair value of Sud’s net assets. Sud net income for the year is $50,000. Dividends of $20,000 are paid on November 1.

12. Fair Value/Cost Method July 1 Investment in Sud 100,000 Cash 100,000 November 1 Cash 4,000 Dividend income 4,000 December 31 No entry Net marketable stock or market price = $50

13. Fair Value/Cost Method Assume that Sud’s net income had been $30,000. What is Pilzner’s share? $30,000 ×½× 20% = $3,000 December 31 Dividend Income 1,000 Investment in Sud 1,000

14. Equity Method July 1 Investment in Sud 100,000 Cash 100,000 November 1 Cash 4,000 Investment in Sud 4,000

15. Equity Method December 31 Investment in Sud 5,000 Income from Sud 5,000 $50,000 ×½× 20% = $5,000

16. Learning Objective 4 Identify factors beyond stock ownership that affect an investor’s ability to exert influence or control.

17. Influence or Control An investment of 20% or more of the voting stock of an investee should lead to a presumption that an investor has the ability to exercise significant influence over an investee.

18. Influence or Control The equity method should be followed by an investor whose investment in voting stock gives it the ability to exercise significant influence over operating and financial policies on an investee even though the investor does not control the investee.

19. Influence or Control An investor may be able to exert significant influence over its investee with an investment interest of less then 20%. The equity method should not be applied if the investor’s ability to exert significant influence is temporary or if the investees are foreign companies operating under severe exchange restrictions or controls.

20. Learning Objective 5 Apply the equity method to purchase price allocations.

21. Equity Method:A One-Line Consolidation Investment is reported in a single amount on one line of the investor company’s balance sheet Investment income is reported in a single amount on one line of the investor’s income statement.

22. Equity Investments at Acquisition PJ, Inc., purchases 30% of SR outstanding voting common stock on January 1 from existing stockholders. ($2,000,000 cash plus 200,000 shares of PJ $10 par common with a market value of $15 per share)

23. Equity Investments at Acquisition Additional direct costs SEC fees: $ 50,000 Consulting and advisory fees: $100,000 How are these transactions recorded?

24. Equity Investments at Acquisition Investment in SR 5,000,000 Common Stock, $10 par 2,000,000 Additional Paid-in Capital 1,000,000 Cash 2,000,000 To record acquisition of a 30% equity investment in SR

25. Equity Investments at Acquisition Investment in SR 100,000 Additional Paid-in Capital 50,000 Cash 150,000 To record additional direct costs of purchasing a 30% equity interest in SR

26. Illustration of a PurchaseCombination Book Value Fair Value Assets Cash $ 1,500 $ 1,500 Net receivables 2,200 2,200 Inventories 3,000 4,000 Other current assets 3,300 3,100 Equipment, net 5,000 8,000 Total assets $15,000 $18,800

27. Illustration of a PurchaseCombination Book Value Fair Value Liabilities Accounts payable $ 1,000 $ 1,000 Note payable 2,000 1,800 Common stock 10,000 Retained earnings 2,000 Total liabilities and stockholders’ equity $15,000 $15,000 – 3,000 = $12,000 $12,000 × 30% = $3,600

28. Assignment of Excess CostOver Underlying Equity Cost $5,100 FMV $4,800 BV $3,600

29. Assignment of Excess CostOver Underlying Equity Investment in SR $5,100,000 Book value of the interest acquired –3,600,000 Excess cost over book value $1,500,000 Fair value – Book value × 30% = $1,200,000 Amount assigned Remainder assigned to goodwill $ 300,000

30. Assignment of Excess CostOver Underlying Equity Amount Assigned Inventories $ 300,000 Other current assets (60,000) Equipment 900,000 Note payable 60,000 Total $1,200,000

31. Accounting for Excess of InvestmentCost Over Book Value Assume SR pays dividends of $1,000,000 on July 1, and reports net income of $3,000,000 for the year. What are PJ’s journal entries?

32. Accounting for Excess of InvestmentCost Over Book Value July 1 Cash 300,000 Investment in SR 300,000 To record additional dividends received from SR at 30% equity interest in SR

33. Accounting for Excess of InvestmentCost Over Book Value December 31 Investment in SR 900,000 Income from SR 900,000 To record equity in income of SR December 31 Income from SR 300,000 Investment in SR 300,000 To write off excess allocated to inventory

34. Accounting for Excess of InvestmentCost Over Book Value December 31 Investment in SR 60,000 Income from SR 60,000 To record income credit for overvalued other current assets disposed of

35. Accounting for Excess of InvestmentCost Over Book Value December 31 Income from SR 45,000 Investment in SR 45,000 To record depreciation on excess allocated to undervalued equipment with a 20-year remaining useful life ($900,000 ÷ 20)

36. Accounting for Excess of InvestmentCost Over Book Value December 31 Income from SR 12,000 Investment in SR 12,000 To amortize the excess allocated to the overvalued note payable over the remaining life of the note ($60,000 ÷ 5)

37. Accounting for Excess of InvestmentCost Over Book Value Income from SR 300,000 900,000 45,000 60,000 12,000 Investment 5,100,000 300,000 900,000 300,000 60,000 45,000 12,000

38. Excess of Book Value AcquiredOver Investment Cost Post Corporation purchases 50% of the outstanding voting common stock of Taylor on January 1 for $40,000. Taylor’s stockholders’ equity Jan 1: $100,000 Add: Income 20,000 Deduct: Dividends paid 7/1 – 5,000 Stockholders’ equity 12/31 $115,000

39. Assignment of Excess Costover Underlying Equity BV $50,000 FMV + Cost $40,000

40. Excess of Book Value AcquiredOver Investment Cost $100,000 × 50% – $40,000 = $10,000 This is the excess book value over cost. The excess is assigned to: Inventories $(1,000) Equipment $(9,000)

41. Negative Goodwill Post acquires a 25% interest in Saxon for $110,000 Saxon net income and dividends for the year are $60,000 and $40,000

42. Illustration of a PurchaseCombination Saxon’s net assets Book Value Fair Value Assets Inventories $240,000 $260,000 Other current assets 100,000 100,000 Equipment, net 50,000 50,000 Building, net 140,000 200,000 Total assets $530,000 $610,000 Liabilities 130,000 130,000 Net assets $400,000 $480,000

43. Assignment of Excess Costover Underlying Equity FMV $120,000 Cost $110,000 BV $100,000

44. Negative Goodwill $110,000– $120,000 = – $10,000 This is the excess of FMV over cost.

45. Interim Acquisitions of anInvestment Interest Accounting for equity investments becomes more specific when the firm makes acquisitions within an accounting period.

46. Investment in a Step-by-StepAcquisition An investor may acquire the ability to exercise significant influence over the operating and financial policies of an investee in a series of stock acquisitions, rather than in a single purchase.

47. Sale of an Equity Interest When an investor sells a portion of an equity investment that reduces its interest at 20% or less than the level necessary to exercise significant influence the equity method is no longer appropriate.

48. Stock Purchases Directlyfrom the Investee Karl Corporation purchases 20,000 of previously unissued common stock from Master Co. for $450,000 on January 1, 2004. Shares outstanding after new shares are issued: December 31, 2003 20,000 Issued to Karl 20,000 Total 40,000

49. Stock Purchases Directlyfrom the Investee Master’s stockholders’ equity before issuance ($200,000 capital stock + $150,000 retained earnings) $350,000 Sale to Karl 450,000 Master’s stockholder after issuance $800,000 Book value acquired by Karl $400,000

50. Investee Corporation withPreferred Stock Some adjustments are necessary when an investee has preferred as well as common stock outstanding. APB Opinion No. 18.