Chapter One

The Equity Method of Accounting for Investments

McGraw-Hill/Irwin Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

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Reporting Investments in Corporate Equity Securities

GAAP recognizes 3 ways to report investments in other companies:

Fair-Value Method
Consolidation
Equity Method
The method is selected based upon the degree of influence the investor has over the investee.

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Fair Value Method

Used when the investor holds a small percentage of the investees outstanding stock, and is not able to significantly affect the investees operations. Investment is made in anticipation of dividends and/or market appreciation. Investments will be classified as either Trading Securities or Available-for-Sale Securities.

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Fair Value Method (Trading vs Available-for-Sale)

Trading Securities
Held for sale in the short term. Unrealized holding gains and losses are included in earnings (net income).

Available-for-Sale Securities
Any Securities not classified as Trading. Unrealized holding gains and losses are reported in shareholders equity as other comprehensive income (ie, not included in net income).

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Consolidation of Financial Statements

Required when the investors ownership exceeds 50% of investee, except where control does not actually rest with the majority investor Contractual agreements Bankruptcies Government restrictions One set of financial statements is prepared which consolidates all accounts of the parent company and all of its controlled subsidiary companies, as though they were a single entity.

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Consolidation SPECIAL!!!!

FASB ASC Subsection 810-10-65, Variable Interest Entities, expands the use of consolidated financial statements: includes entities that are controlled through special contractual arrangements (rather than through voting stock interests). Intended to combat misuse of SPEs (Special Purpose Entities) by firms like Enron Part of the accounting defense against off balance sheet financing

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Equity Method

Used when the investor has the ability to exercise significant influence on the investee operations Generally used when ownership is between 20% and 50%. Significant Influence might be present with much lower ownership percentages. (The accountant must consider the particulars!!!)

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What is Significant Influence?? (FASB ASC Section 323)

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 relation to other investor ownership percentages

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Size (of the Investment) Matters!!!

Investor Ownership of the Investees 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.

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The Significance of the Size of the Investment

Investor Ownership of the Investees Shares Outstanding 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

Investor Ownership of the Investees Shares Outstanding Fair Value Equity Method 20% Consolidated Financial Statements 50%

0%

100%

Financial Statements of all related companies must be consolidated.

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Remember:
The

ability to exert significant influence is the determining factor in applying the equity method

No

actual influence need have been applied!!

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Fair-Value Method Applied (SFAS No. 115)

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

Cost can be defined as cash paid or the Fair Market Value of other assets given up.

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Fair-Value Method Applied (continued)

Step 2: Investor recognizes dividend income for the amount of cash dividends received from investee
Journal entry: Debit Cash Credit Income from Investment

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Fair-Value Method Applied (continued)

Step 3: Investor adjusts the investment account to fair-market value (if readily determinable at report date) If FMV is higher than current carrying balance in account
Journal entry: Debit Investment Credit Unrealized Gain on Investment** ** This will appear on the income statement for Trading Securities, or in Other Comprehensive Income for those classified as Available-for-Sale.

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Equity Method - Applied

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

Cost can be defined as cash paid or the Fair Market Value of other assets given up.

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Equity Method Applied (Continued)

Step 2: The investor recognizes its proportionate (pro rata) share of the investees net income (or net loss) for the period.
Journal entry: Debit Investment in Investee Credit Equity in Investee Income
This will appear as a separate line-item on the investors income statement.

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Equity Method Applied (Continued)

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

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Equity Method Example

Little Company reported net income of $200,000 during 2010 and paid cash dividends of $50,000. These figures indicate that Littles net assets have increased by $150,000 during the year. Big owns 20% of Little and records the following entries using the equity method. Investment in Little Company. . 40,000 Equity in Investee Income .. . . . . . . . . . 40,000 To accrue earnings of a 20 percent owned investee. Cash . . . . . . . . . . . . .. . . . . . 10,000 Investment in Little Company . .. . . . 10,000 To record receipt of cash dividend from investee.

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Special Procedures for Special Situations

Reporting a change to the equity method.

Reporting investee losses.

Reporting investee income from sources other than continuing operations.

Reporting the sale of an equity investment.

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Reporting a Change to the Equity Method

An investment that is too small to have significant influence is recorded using the fair-value method, but 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 FASB ASC (para. 323-10-35-33)

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Reporting a Change to the Equity Method (Retroactive Adjustment)

Giant Company acquires a 10% ownership in Small Company on January 1, 2010. Giant does not believe that their company has gained the ability to exert significant influence over Small. Giant properly records the investment using the fair-value method as an available-for-sale security. On January 1, 2012, Giant purchases another 30% of Smalls outstanding stock, thereby achieving the ability to significantly influence Smalls decisions.

How should this additional acquisition be recorded?

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Reporting a Change to the Equity Method (Retroactive Adjustment)

The income restatement for these earlier years can be computed as follows:
Equity in Investee Year Income (10%)
2010 2011 $7,000 11,000

Income Reported from Dividends

$2,000 4,000 Total Adjustment to Retained Earnings:

Retrospective Adjustment
$5,000 7,000 $12,000

Would have reported under the equity method

Did report under the fair-market value method

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Reporting Investee Income from Sources other than Operations

When net income includes elements other than Operating Income, these elements should be presented separately on the investors income statement. Examples include:
Discontinued operations Extraordinary items

Prior period adjustments

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Reporting Investee Income from Other Sources

Large Company owns 40% of the voting stock of Tiny Company and accounts for this investment using the equity method. In 2010, Tiny reports net income of $200,000, resulting from $250,000 in income from continuing operations and a $50,000 extraordinary loss. Large Company increases the value of its investment by $80,000, based on 40% of the $200,000 net figure. Larges Equity Method entry at year-end is:

GENERAL JOURNAL
Date Date

GENERAL JOURNAL Description Description

Page
Debit Debit

Page

##

Credit Credit

##

31-Dec Investment in Tiny Company Extraordinary Loss of investee Equity in Investee's Income

80,000 20,000 100,000

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Reporting Investee Losses

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

A temporary decline is ignored!!!

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Reporting Investee Losses (Continued)

Investment Reduced to Zero When the accumulated losses incurred by the investee, and dividends paid by the investee, reduce the investment account to $-0-, NO ADDITIONAL LOSSES are accrued (unless a further commitment has been made) The balance remains at $-0-, until subsequent profits eliminate all UNREALIZED 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, but the equity method is no longer applied.

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Reporting the Sale of an Equity Investment (Continued)

Top Company owns 40% of the 100,000 outstanding shares of Bottom Co., and properly accounts for it using the equity method. The 40,000 shares were acquired several years ago for $200,000, and under the equity method, the asset balance has increased to $320,000 as of January 1, 2010. On July 1, 2010, Top elects to sell 10,000 of these shares (1/4 of its investment) for $110,000 in cash, thereby reducing ownership in Bottom from 40% to 30%. Bottom Company reports income of $70,000 during the first six months of 2010 and distributes cash dividends of $30,000.

GENERAL JOURNAL
Date Description

Page
Debit

##
Credit

Cash Gain on Sale of Investment Investment in Minor, Inc.

110,000 26,000 84,000

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Excess of Cost Over BV Acquired

When Cost > BV acquired, the difference must be identified.

Source of the Difference Accounting

Assets that are undervalued on the investee's books Goodwill

Amortize the difference over the remaining useful life of the associated asset. For fiscal years beginning on or after Dec. 15, 2001, Goodwill will be carried forward without adjustment until the investment is sold or a permanent decline in value occurs.

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Excess of Cost Over BV Acquired (Continued)

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.
GENERAL JOURNAL
Date Description

Page
Debit

##
Credit

Year Equity in Investee Income End Investment in Investee

$$$$ $$$$

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Excess of Cost Over BV Example

Big Company is negotiating the acquisition of 30% of the outstanding shares of Little Company. Littles balance sheet reports assets of $500,000 and liabilities of $300,000 for a net book value of $200,000. Upon review, Big determines that Littles equipment is undervalued in the financial records by $60,000, and of its patents is also undervalued, but only by $40,000.

How much should Big offer Little??

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Excess of Cost Over BV Example Solution

By

adding these valuation adjustments to Littles book value, Big arrives at an estimated $300,000 worth for the companys net assets. Based on this computation, Big should offer $90,000 for a 30% share of the investees outstanding stock.

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Excess of Cost Over BV Example Amortization

Payment by investor . . . . . . . . . . . . . . . . . . . $90,000 Percentage of book value acquired ($200,000 30%) . . . . . . . . . . . . . . 60,000 Payment in excess of book value . . . . . . . . . . . 30,000

Excess payment identified with specific assets: Equipment (30% of $60,000 undervalued). . .$18,000 Patent (30% of $40,000 undervalued) . . . . . . . 12,000 30,000 Excess payment not identified with specific assetsgoodwill . . . . . . . . . . . . . . 0

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Amortization of Cost Over BV Example Amortization (Continued)

Asset FMV Adjustment Life remaining Amortization

Equipment Patent Goodwill

10 years 5 years Indefinite Annual expense years 1-5

18,000 12,000

1,800 2,400 4,200

GENERAL JOURNAL
Date Description

Page
Debit

##
Credit

31-Dec Equity in Investee Income Investment in Investee

4,200 4,200

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Amortization of Cost Over BV Example Amortization (Continued)

Note, that any ADDITIONAL amount paid in excess of the book value of $90,000 would be the cost of the goodwill purchased and would not be amortized like the other assets.

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Unrealized Gains in Inventory

Sometimes affiliated companies sell or buy inventory from each other.

INVESTOR
Downstream Sale

INVESTOR
Upstream Sale

INVESTEE

INVESTEE

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Unrealized Gains in Inventory Example

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. Note that there is $250 of intercompany profit. At this point it is considered UNREALIZED because we are reporting as a SINGLE-ENTITY. We will DEFER this profit in the financial reports until the goods are sold to an OUTSIDE PARTY.

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Unrealized Gains in Inventory Example (Continued)

If 60 of the original 200 units (30%) remain unsold to an outside party, we must defer our share (20%) of the original $250 of intercompany profit that is unrealized (30%).

INVESTOR
sells 200 units of inventory with original cost of $1,000.
20% ownership

INVESTEE
buys inventory and pays a total of $1,250 to investor.

Outside Party

Investee sells only 140 units to an outside party

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Unrealized Gains in Inventory Example (Continued)

Compute the deferral by multiplying:

% % owned by x x unsold investor

Intercompany Profit

The required journal entry is:

GENERAL JOURNAL
Page
Debit

##
Credit

Date

Description

Year End

Equity in Investee Income Investment in Investee

15 15

$250 30% 20% = $15

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Unrealized Gains in Inventory Example (Continued)

In the period following the period of the transfer, the remaining inventory is often sold. When that happens, the original entry is reversed . . .
GENERAL JOURNAL
Page
Debit

##
Credit

Date

Description

Year End

Investment in Investee Equity in Investee Income

15 15

The reversal takes place during the period that the inventory is sold to an outside party.

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Summary

There are three methods to account for an investment in another company, depending on the size of the investment and level of influence the investor is able to exercise over the investee. If the investor pays more than the Book Value of the investee, the excess payment is assigned to specific assets and liabilities, or to goodwill. Intercompany profits on transferred assets are deferred until the items are consumed or sold to outside parties.

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Possible Criticisms:

Over-emphasis on possession of 2050% voting stock in deciding on significant influence vs. control Possibility of off-balance sheet financing Potential manipulation of performance ratios

WHAT DO YOU THINK?????