Chapter 8: Investments in Equity Securities

Investment in Marketable Equity Securities -Overview Equity investments represent ownership of another company’s outstanding common stock. Marketable equity investments are actively traded on a public stock exchange. There are different accounting rules for: (1) less than 20 percent ownership. (2) between 20 and 50 percent ownership. (3) greater than 50 percent ownership.

(1) Less than 20 % ownership. If marketable securities, use the mark-to market method (carry securities on balance sheet at market value). Revalue 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.

(a) Trading Securities Trading securities held for the short term, with purpose of selling securities for profit. At purchase: Dr. Investment xx Cr. Cash xx During the period - record declaration of cash dividends: Dividends Receivable xx Dividend Income xx

(a) Trading Securities At the end of the accounting period - revalue to market value Dr. Investment xx Cr. Unrealized Gain (I/S) xx OR Dr. Unrealized Loss (I/S) xx Cr. Investment xx When sold - recognize “Gain/Loss on Sale” for any balance since the last revaluation. Dr. Cash xx Dr./Cr. Realized Gain/Loss (I/S) xx Cr. Investment xx

(b) Available-for-sale Securities Available-for-sale (AFS) securities may be held for the short term or for long term, depending on management’s intentions. At purchase: Dr. Investment xx Cr. Cash xx During the period - record declaration of cash dividends: Dividends Receivable xx Dividend Income xx

(b) Available-for-sale Securities 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 Shareholders’ Equity). Dr. Investment xx Cr. Unrealized Gain/Loss (B/S-SE) xx OR Dr. Unrealized Gain/Loss (B/S-SE) xx Cr. Investment xx When sold - recognize “Gain/Loss on Sale” on Income Statement for total difference between original cost and selling price. Dr. Cash xx Dr./Cr. Unrealized Gain/Loss (B/S-SE) xx Cr. Investment xx Cr. Realized Gain (I/S) xx

(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. The equity method increases the investment account and recognizes investor’s portion of income as investee earns it (reports income to investor). The equity method decreases the investment account as investee declares dividends to the investor.

Equity Method Journal Entries On investor’s books: 1. When investment is purchased: L.T. Investment xx Cash, etc. xx 2. When dividends are declared to investor: Dividends Receivable xx 3. When income is reported by investee to investor: Income from Investment xx Note: the Investment account contains any implied goodwill in the purchase. Goodwill is not explicitly reported until the ownership is sufficient to consolidate the investment.

Illustration - Equity Method Company P purchases 30% of the outstanding common stock of Company S on January 2, 2007 for $400,000 cash. At the time of acquisition, Company S had total net assets of $1,000,000 fair value (and book value). Note that net assets = assets - liabilities = equity. During 2007, Company S reported net income of $300,000 to its shareholders, and declared $100,000 dividends to its shareholders.

Illustration - Equity Method Required: 1. Prepare all journal entries necessary (on Company P’s books) to record this investment using the equity method of accounting. 2. Calculate (a) the value that would be reported in Company P’s 12/31/07 balance sheet for its L.T. Investment in Company S, and (b) the Income from Company S reported on P’s income statement for 2007.

Requirement 1. Journal Entries on P’s Books: 1. Acquisition: Note: the $400,000 investment includes $100,000 goodwill, calculated as: Cash paid: $400,000 - Fair market value acquired: 1,000,000 x 30% -300,000 Difference = goodwill = $100,000 L.T. Investment 400,000 Cash 400,000

Requirement 1. Journal Entries on P’s Books: 2. Dividends declared (100,000 x 30%) 3. Income reported (300,000 x 30%) Div. Receivable 30,000 L.T. Investment 30,000 L. T. Investment 90,000 Income from S 90,000

Requirement 2 - Calculate balances: The L.T. Investment account = $400,000 (DR) Invest. - 30,000 (CR) Dividends from S + 90,000 (DR) Income from S $460,000 (DR) balance at 12/31/07 The Income from S account = 90,000 (CR) Income from S for 2007

Equity Investment (T-account) Retained Earnings 400,000 90,000 Income 90,000 Dividends 30,000 460,000 Dividend Receivable 30,000

Cautions Regarding Equity Method This method will give rise to a difference between reported net income (loss) and cash flow from operations. It ignores market price. 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 (more in appendix). Issues are more complex than illustrated in this chapter.

(3)Greater than 50% Investment Mergers One company acquires all of the assets and liabilities of another company, and the acquired company is dissolved Journal entry on acquiring company’s books: Dr. Assets xx Cr. Liabilities xx Cr. Cash, etc. Xx Acquisitions One company acquires at least 50% of the common stock of another company; both companies continue to operate as separate legal entities, and maintain separate sets of books. This is called a parent/subsidiary relationship. Dr. Investment in Subsidiary xx Cr. Cash, etc. xx

a. Purchase Accounting The journal entry to record the acquisition as a purchase might take the following forms: for cash: Dr. Investment in Sub xx fair mkt. value Cr. Cash xx fair mkt. value with the issue of common stock: Dr. Investment in Sub xx fair mkt. value Cr. Common Stock xx par value Cr. APIC xx excess (The credit to CS and APIC is the same as if the CS had been issued for cash.)

a. Purchase Accounting Note that the investment account contains the following information: fair value of the net assets of the sub. goodwill recognized on acquisition of the sub. Alternatively, the investment account contains the following information: book value of the net assets of the sub. revaluation of the net assets of the sub.

b. Consolidation of Purchased Subsidiaries The parent uses the equity method of accounting to record income from the investment during the year. The investment account is replaced by the assets and liabilities of the subsidiary, and goodwill is recognized explicitly in the consolidation process. Any goodwill is subsequently written down if the related assets are impaired. If the subsidiary is greater than 50% but less than 100% owned, the parent still adds all of the subs assets and liabilities, and all of the subs revenues and expenses in the consolidation. The parent must then recognize that part of the subsidiary belongs to a “Minority Interest” when reporting the results to the parent’s shareholders. Foreign subsidiaries often operate with accounting standards that are different from US GAAP, and the financials must be converted to US GAAP before they can be consolidated. Once the financials are converted to US GAAP and US dollars, the rest of the consolidation is the same.

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