Chapter 2

Stock
Investments
Investor
Accounting and
Reporting

Stock Investments: Objectives

1. Recognize investors' varying levels of
influence or control, based on the level of
stock ownership.
2. Anticipate how accounting adjusts to reflect
the economics underlying varying levels of
investor influence.
3. Apply the fair value/cost and equity
methods of accounting for stock
investments.

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Objectives (continued)
4. Identify factors beyond stock ownership
that affect an investor's ability to exert
influence or control over an investee.
5. Apply the equity method to stock
investments.
6. Learn how to test goodwill for impairment.

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Stock Investments Investor Accounting and Reporting

1: LEVELS OF INFLUENCE
OR CONTROL

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Levels of Influence
Percent Ownership of Voting Stock
<20% presumes lack of
significant influence fair
value (cost) method
20% to 50% presumes
significant influence equity
method
>50% presumes control
consolidated financial
statements

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>50%

<20%

Fair
value
(cost)
method

Consolidated
financial
statements
Equity
method

20-50%

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Stock Investments Investor Accounting and Reporting

2: ACCOUNTING REFLECTS
ECONOMICS

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Accounting for the Investment

Degree of
influence

Investment's carrying
value

Investment
income

Lack of
significant
influence

Fair value (cost, if

nonmarketable)

Dividends
declared

Significant
influence

Original cost adjusted to

reflect periodic earnings
and dividends, e.g., a
proportionate share of
investee's net assets

Proportionate
share of investee's
periodic earnings*

* The investor could manipulate its own investment

income if income is measured by dividends.
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Stock Investments Investor Accounting and Reporting

3A: FAIR VALUE/COST

METHOD

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Fair Value (Cost) Method

FASB Statement No. 115
Pal buys 2,000 shares of Sud for $50,000 and does not have
significant influence over Sid.
Investment in Sid (+A)

50,000

Cash (-A)

50,000

Pil receives $4,000 in dividends from Sid.

Cash (+A)
Dividend income (R, +SE)

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2,000
2,000

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Fair Value (Cost) Method, at Year-end

Reduce dividend income recognized, if needed
Dividend income (-R, -SE)

500

Investment in Sid (-A)

500

If Pal determines that cumulative dividends exceed its cumulative share of

income by $500.

Adjust investment to fair value

Allowance to adjust available-for-sale
securities to market value (+A)
Unrealized gain on available-for-sale
securities (+SE)

10,500
10,500

If fair value of the stock increases to $60,000 and the Investment in

Sid account balance is $49,500.
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Stock Investments Investor Accounting and Reporting

3B: EQUITY METHOD

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Equity Method
At acquisition: Pal buys 2,000 shares of Sid for
$50,000.
Investment in Sid (+A)

50,000

Cash (-A)

50,000

Pal receives $4,000 in dividends from Sid.

Cash (+A)
Investment in Sid (-A)

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2,000
2,000

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Equity Method, at Year-end

Pal determines that its share of Sud's income is $2,500.
Investment in Sid (+A)

2,500

Income from Sid (R, +SE)

2,500

The ending balance in the Investment in Sud is:

$50,000 cost
- $2,000 dividends
+ $2,500 income
= $50,500

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Stock Investments Investor Accounting and Reporting

4: ABILITY TO INFLUENCE
OR CONTROL

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Significant Influence
20% to 50% voting stock ownership is a
presumption of significant influence. Use the
equity method.
Don't use equity method if there is a lack of
significant influence.

Opposition by investee,
Surrender of significant shareholder rights,
Concentration of majority ownership,
Lack of information for equity method, and
Failure to obtain board representation

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Control
More than 50% voting stock ownership is
presumptive evidence of control. Prepare
consolidated financial statements.
Don't consolidate if the parent lacks control
Legal reorganization or bankruptcy
Severe foreign restrictions

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Stock Investments Investor Accounting and Reporting

5: APPLYING THE EQUITY

METHOD

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Acquisition Cost > FV net assets, and

FV net assets > BV net assets
Payne acquires 30% of Sloan for $5,000.
Sloan's identifiable net assets (assets less
liabilities) are (in thousands):
Fair value: A L = $18,800 - $2,800 = $16,000
Book value: A L = E = $15,000 - $3,000 = $12,000

$5,000 > 30%(16,000) > 30%(12,000)

$5,000 > $4,800 > $3,600

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Differences between FV and BV

Fair value: $16,000
Book value: $12,000
The $4,000 difference ($16,000 - $12,000) is
due to:
$1,000 undervalued inventories sold this year,
$200 overvalued other current assets used this
year,
$3,000 undervalued equipment with a life of 20
years, and
$200 overvalued notes payable due in 5 years
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Acquisition of Sloan Stock

At acquisition, Payne pays $2,000 cash and issues
common stock with a fair value of $3,000 and par
value of $2,000. Payne also pays $50 to register the
securities and $100 in consulting fees.
Investment in Sloan (+A)

5,000

Cash (-A)

2,000

Common stock, at par (+SE)

2,000

Additional paid in capital (+SE)

1,000

Additional paid in capital (-SE)

Investment expense (E, -SE)
Cash (-A)

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50
100
150

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Cost/Book Value Assignment

Investment in Sloan

$5,000

Less 30% book value = 30%(12,000)

3,600

Excess of cost over book value

Assigned to:
Inventories 30%(+1,000)
Other curr. assets 30%(-200)
Equipment 30%(+3,000)
Note payable 30%(+200)
Goodwill (to balance)
Total

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$1,400
Amount

Amortization

$300

1st year

(60)

1st year

900

20 years

60
200

5 years
None

$1,400

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Dividends and Income

Payne receives $300 dividends from Sloan.
Cash (+A)
Investment in Sloan (-A)

300
300

Sloan reports net income of $900.

Payne will recognize its share (30%) of
Sloan's income, but will adjust it for
amortization of the differences between book
and fair values.

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Amortization and Investment

Income
Cost/book value
differences:
Inventories

Initial
amount

1st year Unamortized excess at

amort.
year-end

$300

($300)

$0

Other current assets

(60)

60

Equipment

900

(45)

855

60

(12)

48

200

200

$1,400

($297)

$1,103

Note payable
Goodwill
Total

Investment income is 30% of Sloan's net income

amortization
30%($3,000) $297 = $603.
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Year-End Entry & Balance

Record the investment income (single entry)
Investment in Sloan (+A)
Income from Sloan (R, +SE)

603
603

The ending balance in the investment account

is:
Cost dividends + investment income

5,000 300 + 603

= 5,303
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More on Cost/Book Value

Assignment
On acquisition date, compare:
Cost of acquisition,
Book value of net assets, and
Fair value of identifiable net assets

Cost of the investment includes cash paid, fair

value of securities issued, and debt assumed.
The book value of the investee's net assets
= assets liabilities, or
= stockholders' equity

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Fair Values Used in Assignment

Identifiable net assets include all the
investee's assets and liabilities, whether
recorded or not
Fair value of research in progress
Fair value of contingent liabilities
Fair value of unrecorded patents

Exception: use book value for pensions and

deferred taxes.
If cost > fair value, goodwill exists.
If cost < fair value, a bargain purchase exists.
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Bargain Purchase
When the acquisition cost is less than the fair
value of the identifiable net assets, a gain is
recognized on the acquisition.
The investment is recorded at the fair value of
the identifiable net assets
Investment in ABC

XXX

Cash, CS, APIC

XXX

Gain on bargain purchase

XXX

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Interim Acquisitions
Book value of net assets = BV equity.
If equity is given as beginning of year, add
current earnings and deduct dividends to date.
Amortization for first, partial, year:
Take full amortization for inventory and other
current assets disposed of by year-end.
Take partial year's amortization for equipment,
buildings, and debt to be written off over multiple
years.

Record dividends if after the acquisition date.

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Acquisition in Stages
Also called a step-by-step acquisition.
Fair value (cost) method
equity method
Restate prior-period statements

Investee's growth in retained earnings is

Excess of income over dividends declared

Investment account desired balance using equity

method = original cost + share of growth in investees
retained earnings amortization, if any
Investment in XYZ (+A)
Retained earnings (+SE)
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XXX
XXX
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Sale of Equity Interest

Sale of investment that results in a lack of significant
influence over the investee
Equity method
fair value (cost) method
Prospective treatment

1. For the sale

Reduce the investment account for a proportionate share
of the stock sold
Record a gain or loss on the sale

2. Apply the fair value (cost) method to remaining

investment

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Stock Purchased from Investee

If stock is purchased from old shareholders,
the percentage ownership is based on the
shares outstanding and the investee's equity
is not changed.
If acquired directly from the investee:
Percentage acquired = shares acquired / (shares
acquired + previously outstanding shares)
Investee's new stockholders' equity = Previous
equity + value received for new shares

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Investee with Preferred Stock

Compare cost of acquisition to the book value of
the common stock
= Total equity book value of preferred stock*
* BV of PS = call value + dividends in arrears

Dividends received will be a portion of the dividends

to common shareholders
= total dividends current PS dividends

Investment income is based on income available to

common shareholders
= investee net income PS dividends**
** PS Div. = current dividend if cumulative, or
dividends declared if noncumulative

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Special Reporting Issues

If material, the investor continues separate
reporting of extraordinary items and/or
discontinued operations of the investee
Income from Investee is based on income before
discontinued operations or extraordinary items

Optionally, the investor may report its equity

investments at fair market value, [FASB ASC
825-10-25]

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Disclosures
For significant equity investees
Name, percent ownership
Accounting policy
Difference between investment carrying value
and underlying equity in net assets
Aggregate market value
Summarized assets, liabilities, results of
operations

Related party disclosures

FASB ASC 850-10-50-5
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Stock Investments Investor Accounting and Reporting

6: GOODWILL
IMPAIRMENT

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Goodwill Impairment
Test annually, and if significant events occur, two-step
process [FASB ASC 350-20-35]
1. If the fair value of the whole reporting unit < the
carrying value of the reporting unit including its
goodwill, there might be impairment.
If no implied impairment, step 2 is not needed.
Use quoted market prices of reporting unit, or
valuation techniques applied to similar groups of
assets and liabilities.
2. If the implied fair value of the goodwill < the
carrying value of the goodwill, record an
impairment loss for the difference.
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2011 Amendment by FASB:

Gives companies an option of making a
qualitative evaluation to determine if the
first step is needed
If it is more likely than not that FMV <
carrying amount, the company need not
perform the two-step test

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Impairment of Equity Investments

Goodwill implied in equity investments is not
tested for impairment.
The investment itself is tested for impairment.

Sam has a 30% interest in Lake, Investment

in Lake, with a carrying value of $4,200; this
includes implied goodwill of $350.
The $350 implied goodwill is not tested for
impairment.
If Sams interest has a fair value of less than
$4,200, an impairment loss on the Investment in
Lake is recorded.
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