Chapter One

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Chapter One
The Equity Method of Accounting for Investments
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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.
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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.

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Consolidation of Financial Statements

• Governed by ARB No. 51, SFAS No. 141, and SFAS
  No. 142.
• Required when investors 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.

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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.

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Criteria for Determining Whether There is
Influence
Representation on the investees Board of
Directors
Participation in the investees policy-making
process
Material intercompany transactions.
Interchange of managerial personnel.
Technological dependency.
Extent of ownership in relationship to other
ownership percentages.
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The Significance of the Size of the Investment
Fair Value
Equity Method
Consolidated Financial Statements

0
20
50
100
In some cases, influence or control may exist
with less than 20 ownership.
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The Significance of the Size of the Investment
Fair Value
Equity Method
Consolidated Financial Statements

0
20
50
100
Significant influence is generally assumed with
20 to 50 ownership.
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The Significance of the Size of the Investment
Fair Value
Equity Method
Consolidated Financial Statements

0
20
50
100
Financial Statements of all related companies
must be consolidated.
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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.
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Equity Method

• Step 2 The investor recognizes its
  proportionate share of the investees net income
  (or net loss) for the period.

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Equity Method

• Step 2 The investor recognizes its
  proportionate share of the investees net income
  (or net loss) for the period.

This will appear as a separate line-item on the
investors income statement.
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Equity Method

• Step 3 The investor reduces the investment
  account by the amount of dividends received from
  the investee.

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Lets do an equity method example.
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Equity Method Example Step 1

• On January 1, 2005, Big Corp. buys 20 of Small
  Inc. for 2,000,000 cash.
• Record Bigs journal entry.

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Equity Method Example Step 2

• On December 31, 2005, Small reports net income
  for the year of 300,000.
• Record Bigs journal entry.

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Equity Method Example Step 2

• Big owns 20 of Small and gets credit for 20 of
  Smalls income.
• 20 300,000 60,000

60,000
60,000
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Equity Method Example Step 3

• On December 31, 2003, Big received a 25,000
  dividend check from Small.
• Record Bigs journal entry.

25,000
60,000
25,000
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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.
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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
investors financial statements appear as if the
equity method had been applied from the date of
the first original acquisition. - - APB Opinion
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?
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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
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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.
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Restatement - Example
An adjustment is recorded to the Investment
account and to Retained Earnings (since Dividend
Revenue has already been closed out).
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Reporting Investee Income from Other Sources

• When net income includes elements other than
  Operating Income, those elements should be
  separately reported on the investors income
  statement.
• Examples include
• Extraordinary items
• Discontinued operations
• Prior period adjustments

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Reporting Investee Income from Other Sources

• Big owns 30 of Little. Little reports net
  income for 2005 of 120,000. Littles Income
  includes operating income of 135,000 and an
  extraordinary loss of 15,000.
• Bigs equity method entry at year-end is

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Reporting Investee Losses

• Permanent Losses in Value
• A permanent decline in the investees market
  value is recorded as a reduction of the
  investment account.

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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.

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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.

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Reporting the Sale of an Equity Investment
Alice Co. 30 (300,000 shares) of Sam, Inc.. The
balance in Alices 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
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Excess of Cost Over BV Acquired

• When Cost gt BV acquired, the difference must be
  identified and accounted for.

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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.
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Excess of Cost Over BVExample

• On January 1, 2005, Big Corp. acquired 20 of
  Small Inc. for 2,000,000 cash.
• Assume that Smalls 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.

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Excess of Cost Over BVExample
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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.
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Amortization of Cost Over BV Example
Bigs equity method entry will include an
adjustment to the investment account of 4,000.
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Amortization of Cost Over BV Example
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Lets look at some intercompany transactions.
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Unrealized Gains in Inventory

• Sometimes affiliated companies sell or buy
  inventory from each other.

Downstream Sale
Upstream Sale
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Unrealized Gains in Inventory

• Lets look at an Investor that has 200 units of
  inventory with a cost of 1,000.

Let us assume that the Investor sells the
inventory to a 20 owned Investee for 1,250.
INVESTOR sells 200 units of inventory with a
total cost of 1,000.
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Unrealized Gains in Inventory
Note that there is 250 of intercompany profit.
At this point it is considered UNREALIZED.
Lets look at an Investor that has 200 units of
inventory with a cost of 1,000.
INVESTEE buys 200 units of inventory and pays a
total of 1,250.
INVESTOR sells 200 units of inventory with a
total cost of 1,000.
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.
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Unrealized Gains in Inventory
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).
INVESTEE buys 200 units of inventory and pays a
total of 1,250.
INVESTOR sells 200 units of inventory with a
total cost of 1,000.
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Unrealized Gains in Inventory

• Compute the deferral by multiplying
• The required journal is

250 30 20 15
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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.
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End of Chapter 1
And this is only the FIRST chapter?!