FISCHER | TAYLOR | CHENG Accounting for Influential Investments

Influence: Practically: an investment of 20% or more but no more than 50% U.S. GAAP: an investment enables the investor to influence the operating or financial decisions of the investee COPYRIGHT © 2012 South-Western/Cengage Learning 2

Influential Investments: Investor Investment Income Amortization of any excess is adjusted to investee’s net income Recognition of intercompany gains/losses deferred until confirmed by transaction between the affiliated group and unrelated parties Investor net income under the sophisticated equity method is the same as it would be under consolidation procedures (“one-line- consolidation”) COPYRIGHT © 2012 South-Western/Cengage Learning 3

Influential Investments: Example COPYRIGHT © 2012 South-Western/Cengage Learning 4 D&D of Excess Schedule Price paid$250,000 Equity (25%  $800,000)200,000 Excess of cost over book value 50,000 Attributable to 5-year equipment that is undervalued by $80,000 (80,000×25%)(20,000) Goodwill$30,000

Influential Investments: Investor Investment Income Investee reports net income of $60,000 Investor’s entry to record: COPYRIGHT © 2012 South-Western/Cengage Learning 5 Investment in Investee Co11,000 Investment Income11,000 Investee’s reported net income$60,000 Investor’s interest × 25% 15,000 Less amortization of excess ($20,000 ÷ 5 yr)(4,000) $11,000

Influential Investments: Intercompany Transactions by Investee Investee profits are adjusted via the IDS. Defer the investor’s share of intercompany profits Example: Investee (Flag) results of operations: –Year 2011 $60,000 net income –Year 2012 $70,000 net income; $10,000 dividends Investor (Excel) holds mdse purchased from Flag: –12/31/2011 inventory$30,000(Investee gross profit 40%) –12/31/2010 inventory40,000(Investee gross profit 45%) Flag sells equipment to Excel on 1/1/2011: –4-year equipment sold for $20,000; a gain of $4,000 COPYRIGHT © 2012 South-Western/Cengage Learning 6

Influential Investments: Investee Income Distribution Schedule COPYRIGHT © 2012 South-Western/Cengage Learning 7

Influential Investment: Tax Effects of Equity Method 20% of the dividends are includable in taxable income Provision for tax is based on the equity income –Amortizations of excess are not deductible –Tax allocation applies to the includable 20% portion A deferred tax liability is created for undistributed investment income COPYRIGHT © 2012 South-Western/Cengage Learning 8

Influential Investment: Tax Effects of Equity Method 9 COPYRIGHT © 2012 South- Western/Cengage Learning

Influential Investment: Unusual Equity Adjustments Investee with preferred stock –investor's equity adjustment is based on the portion of investee income available for common stockholders Investee stock transactions –Compare investor's ownership interest before and after the investee stock transaction; recognize gain or loss given change in investor's interest Write-down to market value –To record a permanent decline is value; no subsequent write-up COPYRIGHT © 2012 South-Western/Cengage Learning 10

Influential Investment: Unusual Equity Adjustments Zero investment balance –Investment account cannot be equity-adjusted to a credit balance –Memo entries track unrecorded losses –Future income not recognized until it exceeds unrecorded losses Intercompany asset transactions by investor –Defers gain/loss in proportion to investor’s interest COPYRIGHT © 2012 South-Western/Cengage Learning 11

Influential Investment: Unusual Equity Adjustments Intercompany bond transactions by investor –No adjustments to income Gain or loss of influence –Achieve influence with subsequent purchases: retroactive conversion to sophisticated equity –Loose influence: stop using sophisticated equity, no retroactive adjustment COPYRIGHT © 2012 South-Western/Cengage Learning 12

Influential Investments: Fair Value Option Elect to record investment using fair value at each recording date Election is made on date of purchase –The investment is recorded at the price paid. –At the end of each accounting period, the investment is adjusted to fair value and the adjustment is recorded as income. –Dividends are recorded as income when declared by the investee. Election cannot be revoked. COPYRIGHT © 2012 South-Western/Cengage Learning 13