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Chapter One

Chapter One. The Equity Method of Accounting for Investments. Reporting Investments in Corporate Equity Securities. GAAP allows 3 approaches to reporting investments. Fair Value Method. Equity Method. Consolidation.

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Chapter One

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  1. Chapter One The Equity Method of Accounting for Investments

  2. Reporting Investments in Corporate Equity Securities GAAP allows 3 approaches to reporting investments. Fair Value Method Equity Method Consolidation Note: These 3 approaches are not interchangeable. The characteristics of each investment will dictate the appropriate accounting approach.

  3. Fair Value Method Details in SFAS No. 115 • Initial Investment is recorded at cost. • Investments in equities of other companies are classified as either Trading Securities or Available-for-Sale Securities. • Income is only realized to the extent of dividends received.

  4. Consolidation of Financial Statements • Governed by ARB No. 51, SFAS No. 141, and SFAS No. 142. • Required when investor’s ownership exceeds 50% of investee. • A single set of financial statements including the assets, liabilities, equities, revenues, and expenses for the parent company and all controlled subsidiary companies.

  5. Equity Method • Defined by APB Opinion 18 and SFAS No. 142. • Requires that the investment is sufficient to insure significant influence. • Generally used when ownership is between 20% & 50%. • Influence can be present with much smaller ownership percentages.

  6. Criteria for Determining Whether There is Influence Representation on the investee’s Board of Directors Participation in the investee’s policy-making process Material intercompany transactions. Interchange of managerial personnel. Technological dependency. Extent of ownership in relationship to other ownership percentages.

  7. The Significance of the Size of the Investment Investor Ownership of Investee Shares Outstanding Fair Value Equity Method Consolidated Financial Statements { 0% 20% 50% 100% In some cases, influence or control may exist with less than 20% ownership.

  8. The Significance of the Size of the Investment Investor Ownership of Investee Shares Outstanding Fair Value Equity Method Consolidated Financial Statements { 0% 20% 50% 100% Significant influence is generally assumed with 20% to 50% ownership.

  9. The Significance of the Size of the Investment Investor Ownership of Investee Shares Outstanding Fair Value Equity Method Consolidated Financial Statements { 0% 20% 50% 100% Financial Statements of all related companies must be consolidated.

  10. Equity Method Step 1: The investor records its investment in the investee at cost. Cost can be defined by cash paid or Fair Market Value of Stock or other assets given up.

  11. Equity Method Step 2: The investor recognizes its proportionate share of the investee’s net income (or net loss) for the period.

  12. Equity Method Step 2: The investor recognizes its proportionate share of the investee’s net income (or net loss) for the period. This will appear as a separate line-item on the investor’s income statement.

  13. Equity Method Step 3: The investor reduces the investment account by the amount of dividends received from the investee.

  14. Let’s do an equity method example.

  15. Equity Method Example – Step 1 On January 1, 2005, Big Corp. buys 20% of Small Inc. for $2,000,000 cash. Record Big’s journal entry.

  16. Equity Method Example – Step 2 On December 31, 2005, Small reports net income for the year of $300,000. Record Big’s journal entry.

  17. Equity Method Example – Step 2 Big owns 20% of Small and gets credit for 20% of Small’s income. 20% × $300,000 = $60,000 60,000 60,000

  18. Equity Method Example – Step 3 On December 31, 2003, Big received a $25,000 dividend check from Small. Record Big’s journal entry. 25,000 60,000 25,000

  19. Special Procedures for Special Situations Reporting a change to the equity method. Reporting the sale of an equity investment. Reporting investee income from sources other than continuing operations. Reporting investee losses.

  20. Reporting a Change to the Equity Method. • An investment that is too small to have significant influence is accounted for using the fair-value method. • When ownership grows to the point where significant influence is established . . . . . . all accounts are restated so that the investor’s financial statements appear as if the equity method had been applied from the date of the first [original] acquisition. - - APB Opinion 18 ?

  21. Restatement - Example Assume that Exxo Company acquires 5% of LipGloss Inc. on January 1, 2004 for $2,000,000. There is no significant influence. The investment is recorded at the time as an Available-for-Sale Investment. In 2004, LipGloss had net income of $300,000, and paid dividends of $140,000. Exxo would report the investment as indicated in the table below:

  22. Restatement - Example On January 1, 2005, Exxo buys an additional 15% interest in LipGloss, raising the total investment to 20%. The first thing that Exxo must do is restate the 12/31/04 numbers by applying the equity method to the 5% investment in LipGloss. We have to RESTATE the Investment account, put a balance in Equity in Investee Income, and eliminate the Dividend Revenue balance.

  23. Restatement - Example An adjustment is recorded to the Investment account and to Retained Earnings (since Dividend Revenue has already been closed out).

  24. Reporting Investee Income from Other Sources • When net income includes elements other than Operating Income, those elements should be separately reported on the investor’s income statement. • Examples include: • Extraordinary items • Discontinued operations • Prior period adjustments

  25. Reporting Investee Income from Other Sources Big owns 30% of Little. Little reports net income for 2005 of $120,000. Little’s Income includes operating income of $135,000 and an extraordinary loss of $15,000. Big’s equity method entry at year-end is:

  26. Reporting Investee Losses Permanent Losses in Value A permanent decline in the investee’s market value is recorded as a reduction of the investment account.

  27. Reporting Investee Losses Investment Reduced to Zero • When the accumulated losses incurred by the investee and dividends paid by the investee reduce the investment account to zero, NO ADDITIONAL LOSSES are accrued. • The balance remains at $0, until subsequent profits eliminate all UNRECORDED losses.

  28. Reporting the Sale of an Equity Investment If part of an investment is sold during the period . . . • The equity method continues to be applied up to the date of the transaction. • At the transaction date, a proportionate amount of the Investment account is removed. • If significant influence is lost, NO RETROACTIVE ADJUSTMENT is recorded.

  29. Reporting the Sale of an Equity Investment Alice Co. 30% (300,000 shares) of Sam, Inc.. The balance in Alice’s Investment account at March 31, 2005, is $268,000. If Alice Co. sells 10% of its shares (30,000 shares) on April 1, 200 for $100,000, what entry should Alice make on April 1, 2005? $268,000 × .10% = $26,800 This brings the Investment account to a balance of $241,200

  30. Excess of Cost Over BV Acquired When Cost > BV acquired, the difference must be identified and accounted for.

  31. Excess of Cost Over BV Acquired The amortization of the difference associated with the undervalued assets is recorded as a reduction of both the Investment account and the Equity in Investee Income account.

  32. Excess of Cost Over BVExample • On January 1, 2005, Big Corp. acquired 20% of Small Inc. for $2,000,000 cash. • Assume that Small’s assets had BV on January 1 of $8,500,000. Small owns a building with a BV of $500,000, and a FMV of $700,000, and a remaining useful life of 10 years. All other assets had BV = FMV. • Allocate the cost to fair market value adjustments and Goodwill acquired by Big.

  33. Excess of Cost Over BVExample

  34. Excess of Cost Over BVExample The Building has a remaining useful life of 10 years. Goodwill is never amortized. Compute the amortization expense for Big at 12/31/05.

  35. Amortization of Cost Over BV Example Big’s equity method entry will include an adjustment to the investment account of $4,000.

  36. Amortization of Cost Over BV Example

  37. Let’s look at some intercompany transactions.

  38. Unrealized Gains in Inventory INVESTOR INVESTOR INVESTEE INVESTEE Sometimes affiliated companies sell or buy inventory from each other. Downstream Sale Upstream Sale

  39. Let’s look at an Investor that has 200 units of inventory with a cost of $1,000. Unrealized Gains in Inventory Let us assume that the Investor sells the inventory to a 20% owned Investee for $1,250. INVESTORsells 200 units of inventory with a total cost of $1,000.

  40. Unrealized Gains in Inventory 20% ownership Intercompany Sale of 200 units Note that there is $250 of intercompany profit. At this point it is considered UNREALIZED. Let’s look at an Investor that has 200 units of inventory with a cost of $1,000. INVESTORsells 200 units of inventory with a total cost of $1,000. INVESTEEbuys 200 units of inventory and pays a total of $1,250. If all 200 units are not sold to an outside party during the period, we will need have unrealized, intercompany profit that must be deferred.

  41. Unrealized Gains in Inventory 20% ownership Intercompany Sale of 200 units Investee sells only 140 units to a 3rd party Outside Party 60 of the original 200 units (30%) are still “unsold” to a 3rd party. We must defer our share (20%) of the original $250 of intercompany profit that is unrealized (30%). INVESTORsells 200 units of inventory with a total cost of $1,000. INVESTEEbuys 200 units of inventory and pays a total of $1,250.

  42. Unrealized Gains in Inventory • Compute the deferral by multiplying: • The required journal is: $250 × 30% × 20% = $15

  43. Unrealized Gains in Inventory • In the period following the period of the transfer, the remaining inventory is often sold. • When that happens, the original entry is reversed . . . The reversal takes place in the period that the inventory is sold to an outside party.

  44. End of Chapter 1 And this is only the FIRST chapter?!

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