Module 7: Intercorporate Investments

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Module 7Intercorporate Investments

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Investment in Marketable Equity Securities -
Overview

• Equity investments represent ownership of another
  companys outstanding common stock.
• Marketable equity investments are actively traded
  on a public stock exchange.
• By owning shares of common stock, the investor
  owns a part of the company, represented by the
  percentage ownership.
• There are different accounting rules for
• (1) less than 20 percent ownership (passive).
• (2) between 20 and 50 percent ownership
• (significant influence).
• (3) greater than 50 percent ownership (control).

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(1) Less than 20 ownership.

• If marketable securities, use the mark-to market
  method.
• Carries securities on balance sheet at market
  value.
• Revaluation at the end of each period based on
  new market price
• Unrealized gains (or losses) are recognized as
  the investment is valued up (or down).
• Treatment of the Unrealized G/L depends on
  classification of security
• (a) Trading securities.
• (b) Available-for-sale securities.

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(a) Trading Securities

• Trading securities held for the short term, with
  purpose of selling securities for profit.
• At purchase - record at cost to acquire.
• Activity during the year - record declaration of
  cash dividends, and recognize Dividend Income
  on the Income Statement
• Dividends Receivable xx
• Dividend Income xx

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(a) Trading Securities

• For securities on hand at the end of the
  accounting period - revalue to market value and
  record Unrealized Gain/Loss on Income
  Statement.
• When sold - recognize Gain/Loss on Sale on
  Income Statement for any balance since the last
  revaluation.

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(b) Available-for-sale Securities

• Available-for-sale (AFS) securities may be held
  for the short term or for long term, depending on
  managements intentions.
• At purchase - record at cost to acquire.
• Activity during the year - record declaration of
  cash dividends, and recognize Dividend Income
  on the Income Statement
• Dividends Receivable xx
• Dividend Income xx

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(b) Available-for-sale Securities

• For securities on hand at the end of the
  accounting period - revalue to market value and
  record Unrealized Gain/Loss on Balance Sheet
  (as part of Other Comprehensive Income in
  Stockholders Equity).
• When sold - recognize Gain/Loss on Sale on
  Income Statement for total difference between
  original cost and selling price.

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(2) From 20 to 50 Investment

• Because investment represents significant
  influence of investor, we cannot account for
  investments the same way as Trading or AFS.
• Specifically, we cannot recognize Dividend
  Income as dividends are declared, because the
  investor can control dividend payout, and
  therefore control the creation of income.

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(2) From 20 to 50 Investment

• The equity method increases the investment
  account and recognizes investors portion of
  income as investee earns it (as investee reports
  income to investor).
• The equity method decreases the investment
  account as investee declares dividends to the
  investor.
• Note additional complications from equity method
  from cost exceeding fair value of investment
  (e.g., goodwill) are not addressed here for
  unconsolidated investments.

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Basic Equity Method Journal Entries

• On investors books
• 1. When investment purchased
• L.T. Investment xx
• Cash, etc. xx
• 2. When dividends declared to investor
• Dividends Receivable xx
• L.T. Investment xx
• 3. When income reported by investee to investor
  (from investees I/S)
• L.T. Investment xx
• Income from Investment xx

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Illustration - Equity Method

• Company P purchases 30 of the outstanding
  common stock of Company S on January 2, 2009 for
  400,000 cash. During 2009, Company S reported
  net income of 300,000 to its shareholders, and
  declared 100,000 dividends to its shareholders.
• Required
• Prepare all journal entries necessary (on
  Company Ps books) to record this investment
  using the equity method of accounting.

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Journal Entries on Ps Books

• 1. Acquisition
• 2. Dividends declared (100,000 x 30)
• 3. Income reported (300,000 x 30)

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Effects of Equity method

• If the company had used the cost method and
  recognized dividend income, the amount of income
  would have been 30,000.
• Under the equity method, Company P recognized
  90,000 income.
• The equity method often yields higher income, but
  the amount is less subject to manipulation.
• The IRS recognizes income as the cash is received
  (dividend income). This creates a differential
  basis between tax and financial accounting (more
  in Chapter 5, Part 2).

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Other Cautions Regarding Equity Method

• The equity ignores market value for the
  investment account. Instead the investment
  account fluctuates as the investees equity
  fluctuates (income in excess of dividends).
• 20-50 percent is not always a valid indication of
  significant influence.
• It generates off-balance sheet financing - one
  line on the balance sheet may actually represent
  a percentage ownership in a number of assets and
  liabilities. (Consolidated investments show all
  the detail of assets and liabilities, where
  unconsolidated investments show only a net asset
  amount.

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(3)Greater than 50 Investment

• If an investor has majority control, the
  investment is recorded using the equity method,
  and a parent/subsidiary relationship is
  established.
• At the end of the period, the financials of the
  parent and subsidiary must be combined, or
  consolidated, for external financial reporting.
• Goodwill is recognized as a separate asset in the
  consolidation.

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Comprehensive Problem

• Prepare the following journal entries for Jackson
  Company for 2013. Assume there were no other
  investments prior to the following activities.
• Feb. 17 - Purchased 500 shares of Medical
  Company common stock for 20 per share
  (classified as trading securities)
• March 31 - Received a 1.20 per share dividend on
  Medical Company stock

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Comprehensive Problem

• April 1 - Purchased 30,000 of the 100,000
  outstanding shares of Olde Company common stock
  at 10 per share.
• Classification of Investment?
• June 28 - Received a 1.00 share dividend on the
  Olde Company stock

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Comprehensive Problem

• Oct. 1 - Purchased 2,000 of Alpha Company common
  stock for 15 per share.
• These shares are classified as available-for-sale.
  
• Dec. 31 - Olde Company reported annual earnings
  of 80,000 to its investors

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Comprehensive Problem

• Dec. 31 AJEs - At the end of the year, the
  following market prices per share were reported
• Medical Co. (trading) 25 per share
• Alpha Co. (AFS) 12 per share
• Olde Co. (equity) 11 per share
• AJE for Medical?
• AJE for Alpha?
• AJE for Olde?

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Comprehensive Problem

• What total effect would the previous transactions
  have on the income statement for 2013?
• What effect would the previous transactions have
  on other comprehensive income for 2013?