Concepts of Equity Method' 1

1
ACCOUNTING FOR VARIOUS INVESTMENTS
Investment in Debt Securities
Investment in Equity Securities
Classification
Control-greater than 50 ownership of voting stock
Not applicable
Consolidation
Significant influence - 20 to 50 ownership of
voting stock
Not applicable
Equity method
Debt securities classified as held to maturity,
and equity securities for which fair value is not
readily determinable
Amortized cost method
Cost method
Debt and equity securities classified as trading
securities
Fair value method, with unrealized holding gain
or loss included in earnings
Debt and equity securities classified as
available for sale
Fair value method, with unrealized holding gain
or loss included as a component of comprehensive
income/ stockholders equity
2
Size (of the Investment) Matters!!!
1-2
Fair Value
Equity Method
Consolidated Financial Statements

0
20
50
100
In some cases, influence or control may exist
with less than 20 ownership.
3
The Significance of the Size of the Investment
1-3
Fair Value
Equity Method
Consolidated Financial Statements

0
20
50
100
Significant influence is generally assumed with
20 to 50 ownership.
4
The Significance of the Size of the Investment
1-4
Fair Value
Equity Method
Consolidated Financial Statements

0
20
50
100
Financial Statements of all related companies
must be consolidated.
5
Criteria for Determining Whether There is
Significant Influence (APB Opinion 18)
1-5
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
investor ownership percentages.
6
Equity Method
1-6

• Requires that the investor has the potential for
  significant influence.
• Generally used when ownership is between 20 and
  50.
• Significant Influence might be present with much
  smaller ownership percentages. (The accountant
  must consider the particulars!!!)

7
Remember
1-7

• The ability to exert significant influence is the
  determining factor in applying the equity method
• No actual influence need have been applied!!

8
EQUITY METHODEvidence against Significant
Influence

• Investee opposition
• Investor/investee agreement
• Closely held majority
• stockholder
• Lack of information
• Lack of board representation

9
Equity Method
1-9

• Step 1 The investor records its investment in
  the investee at cost.
• Journal entry
• Debit Investment in Investee
• Credit Cash (or other Assets/Stock)

Cost can be defined by cash paid or the Fair
Market Value of Stock or Assets given up.
10
Equity Method
1-10

• Step 2 The investor recognizes its
  proportionate (pro rata) share of the investees
  net income (or net loss) for the period.
• Journal entry at end of period
• Debit Investment in Investee
• Credit Equity in Investee Income

This will appear as a separate line-item on the
investors income statement.
11
Equity Method
1-11

• Step 3 The investor reduces the investment
  account by the amount of cash dividends received
  from the investee.
• Journal entry when cash dividends received
• Debit Cash
• Credit Investment in Investee

12
Excess of Cost Over BV Acquired
1-12

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

When Cost gt BV acquired, the difference must be
identified and accounted for.
13
Excess of Cost Over BV Acquired
1-13
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.
14
Special Procedures for Special Situations
1-14
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.
15
Reporting a Change to the Equity Method.
(Retroactive Adjustment)
1-15

• 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
18
?
16
Reporting Investee Losses
1-16

• A permanent decline in the investees fair
  market value is recorded as an impairment loss
  and the reduction of the investment account to
  the fair value.

A temporary decline is ignored!!!
17
Possible Criticisms
1-17

• Over-emphasis on possession of 20-50 voting
  stock in deciding on significant influence vs.
  control
• Possibility of off-balance sheet financing
• Potential manipulation of performance ratios