Chapter One The Equity Method of Accounting for Investments Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Accounting for Investments in Corporate Equity Securities GAAP recognizes three ways to report investments in Equity Securities:  Fair-Value Method through Net Income  Consolidation of Financial Statements  Equity Method The method selected depends upon the degree of influence the investor has over the investee. 1-2

Fair Value Method Use when:  investor holds a small percentage (usually less than 20%) of equity securities of investee  Investor cannot significantly affect investee’s operations (insignificant influence)  Investment are made for dividends or market appreciation. 1-3

Fair Value Method Unrealized holding gains and losses are included in earnings. Investments in equity securities, when neither significant influence or control is present, are initially recorded at historical cost and subsequently adjusted to fair value through net income, if determinable, otherwise they remain at cost. 1-4

Consolidation of Financial Statements Required when:  Investor’s ownership exceeds 50% of an organization’s outstanding voting stock (unless there is evidence otherwise)  Except when control does not rest with the majority investor  One set of financial statements prepared to consolidate all accounts of the parent company and all of its controlled subsidiaries as a single entity. 1-5

Equity Method Use when:  Investor has the ability to exercise significant influence on investee operations (whether influence is applied or not)  Generally used when ownership is between 20% and 50%.  Significant Influence must be present with lower ownership percentages.  Under the equity method, investor’s share of investee dividends declared are recorded as decreases in the investment account. (Non-cash income) 1-6

Indicators for the Equity Method Significant Influence (FASB ASC Topic 323)  Representation on the investee’s Board of Directors  Participation in the investee’s policy-making process  Material intra-entity transactions  Interchange of managerial personnel  Technological dependency  Other investee ownership percentages 1-7

Summary of Accounting Methods 1-8

Accounting for an Investment - Equity Method The investor increases the investment account as the investee earns and reports income. The investor uses the accrual method to record investment income — recognizing it in the same time period as the investee earns it. The investor decreases its investment account’s carrying value for its share of investee cash dividends. When the investee declares a cash dividend, its owners’ equity also decreases. 1-9

Fair-Value Vs. Equity Method *Equity in investee income is 20 percent of the current year income reported by Little Company. The carrying amount of an investment under the equity method is the original cost plus income recognized less dividends. For 2014, as an example, the $230,000 reported balance is the $200,000 cost plus $40,000 equity income less $10,000 in dividends. 1-10

Learning Objective 1 Prepare basic equity method journal entries for an investor and describe the financial reporting for equity method investments. 1-11

Equity Method Example Assume that Big Company owns a 20% interest in Little Company purchased on January 1, 2014, for $200,000. Little then reports net income of $200,000, $300,000, and $400,000, respectively, in the next three years while declaring dividends of $50,000, $100,000, and $200,

Equity Method Example Big Company records the following journal entries to apply the equity method for 2014: 1-13

Learning Objective 2 Allocate the cost of an equity method investment and compute amortization expense to match revenues recognized from the investment to the excess of investor cost over investee book value. 1-14

Excess of Investment Cost Over Book Value Acquired (no longer required) Fair values of specific investee assets and liabilities can differ from their book values. Excess payment can be identified directly with those accounts. If purchase price exceeds fair value, future benefits are expected to accrue from the investment due to estimated profitability of the investee or the relationship established between the two companies. The additional payment is attributed to an intangible asset referred to as goodwill rather than to any specific investee asset or liability. 1-15

Excess of Investment Cost Over Book Value Acquired Assume Grande Company is negotiating the acquisition of 30 percent of the outstanding shares of Chico Company for $125,000. Chico’s balance sheet reports assets of $500,000 and liabilities of $300,000 for a net book value of $200,000. After investigation, Grande determines that Chico’s equipment is undervalued in the company’s financial records by $60,000. One of its patents is also undervalued, but only by $40,000. By adding these valuation adjustments to Chico’s book value, Grande arrives at an estimated $300,000 worth (200, , ,000) for the company’s net assets, excluding goodwill. 1-16

Excess of Cost Over Book Value of Acquired Investment When Purchase Price > Book Value of an investment acquired, the difference must be identified. Assets may be undervalued on the investee’s books because: 1.The fair values (FV) of some assets and liabilities are different than their book values (BV). 2.The investor may be willing to pay extra because future benefits are expected to accrue from the investment (goodwill). 1-17

Excess of Investment Cost Over Book Value Acquired Any extra payment that cannot be attributed to a specific asset or liability is assigned to the intangible asset goodwill. The actual purchase price can be computed by different techniques or simply as a result from negotiations. 1-18

The Amortization Process Payment relating to each asset (except land, goodwill, and other indefinite life intangibles) should be amortized over an appropriate time period. Goodwill associated with equity method investments, for the most part, is measured in the same manner as goodwill arising from a business combination, tested for impairment. 1-19

Learning Objective 3 Understand the financial reporting consequences for: a. A change to the equity method. b. Investee other comprehensive income. c. Investee losses. d. Sales of equity method investments. 1-20

Learning Objective 3A Reporting a Change to the Equity Method Report a change to the equity method if:  An investment that was recorded using the fair-value method reaches the point where significant influence is established.  All accounts are restated retroactively so the investor’s financial statements appear as if the equity method had been applied from the date of the first acquisition. (FASB ASC para ) 1-21

Reporting a Change to the Equity Method (Retroactive Adjustment)  Giant Company acquires a 10% ownership in Small Company on January 1,  Giant company does not have the ability to exert significant influence over Small.  Giant properly records the investment using the fair-value method (Ignore any unrealized holding gain/loss).  On January 1, 2016, Giant purchases another 30% of Small’s outstanding stock, thereby achieving the ability to significantly influence Small’s decisions. (Year 3) 1-22

Reporting a Change to the Equity Method (Retroactive Adjustment) After changing to the equity method on January 1, 2016, Giant must restate the prior years (Year’s 1 & 2) to present the investment as if the equity method had always been applied. The income restatement for these earlier years can be computed as follows: 1-23

Journal Entries to Report Change to Equity Method Giant’s reported earnings for 2014 will increase by $5,000 with a $7,000 increment needed for To bring about this retrospective change to the equity method, Giant prepares the following journal entry on Jan.1, 2016 (Year 3): 1-24

Learning Objective 3b Investee Other Comprehensive  OCI is defined as revenues, expenses, gains, and losses that under GAAP are included in comprehensive income but excluded from net income.  Accumulated Other Comprehensive Income (AOCI) includes unrealized holding gains and losses on available-for-sale securities (debt), foreign currency translation adjustments, certain pension adjustments, and certain derivatives.  OCI is accumulated and reported in stockholders’ equity and represents a source of change in investee company net assets that is recognized under the equity method. 1-25

Reporting Investee Other Comprehensive Income and Irregular Items  Other equity method recognition issues arise for irregular items traditionally included within net income. An investor must report its share of the following items reported in investee’s current income:  Discontinued operations  Other comprehensive income 1-26

Learning Objective 3c Reporting Investee Losses A permanent decline in the investee’s fair market value is recorded as an impairment loss and the investment account is reduced to the fair value. When accumulated losses incurred and dividends paid by the investee reduce the investment account to $-0-, no further loss can be accrued. Investor discontinues using the equity method rather than record a negative balance. Balance remains at $- 0-, until subsequent profits eliminate all unrecognized losses. A temporary decline is ignored! 1-27

Learning Objective 3d Reporting Sale of Equity Investment The equity method continues to be applied up to the date of the transaction. At the transaction date, the Investment account balance is reduced by the percentage of shares sold. If significant influence is lost, NO RETROACTIVE ADJUSTMENT is recorded, but the equity method is no longer applied. If part or all of an investment is sold during the period: 1-28

Learning Objective 4 Describe the rationale and computations to defer unrealized gross profits on intra-entity inventory transfers until the goods are either consumed or sold to outside parties. 1-29

INVESTORINVESTOR INVESTEEINVESTEE INVESTORINVESTOR INVESTEEINVESTEE Downstream Sale Upstream Sale Deferral of Unrealized Profits in Inventory Many equity acquisitions establish ties between companies to facilitate the direct purchase and sale of inventory. Such intra-entity transactions can occur either on a regular basis or only sporadically. 1-30

Deferral of Unrealized Profits in Inventory The seller of the goods retains a partial stake in the inventory for as long as the buyer holds it. The earning process is not considered complete at the time of the original sale. Reporting the profit is delayed until the inventory is consumed within operations or resold to an unrelated party. At the disposition of the inventory, the original sale is culminated and gross profit is recognized. 1-31

Fair Value Reporting Option – Equity Method An entity may irrevocably elect fair value as the initial and subsequent measurement for certain financial assets and financial liabilities including investments accounted for under the equity method. Under the fair-value option, changes in the fair value of the elected financial items are included in earnings. 1-32