2 - 1 ©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Stock Investments – Investor Accounting Chapter 2

2 - 2 ©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Learning Objective 1 Recognize investors’ varying levels of influence or control based on the level of stock ownership.

2 - 3 ©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Accounting for Stock Investment GAAP for recording common stock acquisitions require that the investor record the investment at its cost. GAAP for recording common stock acquisitions require that the investor record the investment at its cost. Fair value/cost methodEquity method

2 - 4 ©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Concept Underlying Fair Value/Cost and Equity Methods Under the fair value/cost method investments in common stock are recorded at cost. Under the fair value/cost method investments in common stock are recorded at cost. Dividends from subsequent earnings are reported as dividend income. Dividends from subsequent earnings are reported as dividend income.

2 - 5 ©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Concept Underlying Fair Value/Cost and Equity Methods The equity method of accounting is essentially accrual accounting for equity investments. The equity method of accounting is essentially accrual accounting for equity investments. Investments are recorded at cost and adjusted for earnings, losses, and dividends. Investments are recorded at cost and adjusted for earnings, losses, and dividends.

2 - 6 ©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Learning Objective 2 Anticipate how accounting adjusts to reflect the economics underlying varying levels of investor influence.

2 - 7 ©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Economic Consequences of Using Fair Value/Cost and Equity Methods The different methods of accounting result in different investment amounts in the balance sheet of the investor corporation and different income amounts in the income statement.

2 - 8 ©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Economic Consequences of Using Fair Value/Cost and Equity Methods Investor can significantly influence or control the operations of the investee. Fair value/cost method is unacceptable.

2 - 9 ©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Economic Consequences of Using Fair Value/Cost and Equity Methods The equity method is not a substitute for consolidation, the income reported is generally the same as the income reported in consolidated financial statements.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Learning Objective 3 Apply the fair value/cost and equity methods of accounting for stock investments.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Accounting Procedures Under the Fair Value/Cost and Equity Methods July 1: Pilzner acquires 2,000 of the 10,000 outstanding shares of Sud at $50 per share. $50 per share equals the book value and fair value of Sud’s net assets. Sud net income for the year is $50,000. Dividends of $20,000 are paid on November 1.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Fair Value/Cost Method July 1 Investment in Sud100,000 Cash100,000 November 1 Cash 4,000 Dividend income 4,000 December 31 No entry Net marketable stock or market price = $50

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Fair Value/Cost Method Assume that Sud’s net income had been $30,000. What is Pilzner’s share? $30,000 × ½ × 20% = $3,000 December 31 Dividend Income1,000 Investment in Sud1,000

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Equity Method July 1 Investment in Sud100,000 Cash100,000 November 1 Cash 4,000 Investment in Sud 4,000

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Equity Method December 31 Investment in Sud5,000 Income from Sud5,000 $50,000 × ½ × 20% = $5,000

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Learning Objective 4 Identify factors beyond stock ownership that affect an investor’s ability to exert influence or control.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Influence or Control An investment of 20% or more of the voting stock of an investee should lead to a presumption that an investor has the ability to exercise significant influence over an investee.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Influence or Control The equity method should be followed by an investor whose investment in voting stock gives it the ability to exercise significant influence over operating and financial policies on an investee even though the investor does not control the investee.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Influence or Control An investor may be able to exert significant influence over its investee with an investment interest of less then 20%. The equity method should not be applied if the investor’s ability to exert significant influence is temporary or if the investees are foreign companies operating under severe exchange restrictions or controls.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Learning Objective 5 Apply the equity method to purchase price allocations.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Equity Method: A One-Line Consolidation Investment is reported in a single amount on one line of the investor company’s balance sheet Investment income is reported in a single amount on one line of the investor’s income statement.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Equity Investments at Acquisition PJ, Inc., purchases 30% of SR outstanding voting common stock on January 1 from existing stockholders. ($2,000,000 cash plus 200,000 shares of PJ $10 par common with a market value of $15 per share)

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Additional direct costs SEC fees:$ 50,000 Consulting and advisory fees:$100,000 How are these transactions recorded? Equity Investments at Acquisition

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Investment in SR5,000,000 Common Stock, $10 par2,000,000 Additional Paid-in Capital1,000,000 Cash2,000,000 To record acquisition of a 30% equity investment in SR Equity Investments at Acquisition

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Investment in SR100,000 Additional Paid-in Capital 50,000 Cash150,000 To record additional direct costs of purchasing a 30% equity interest in SR Equity Investments at Acquisition

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Illustration of a Purchase Combination Book Value Assets Cash$ 1,500$ 1,500 Net receivables 2,200 2,200 Inventories 3,000 4,000 Other current assets 3,300 3,100 Equipment, net 5,000 8,000 Total assets$15,000$18,800 Fair Value

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Illustration of a Purchase Combination Book Value Liabilities Accounts payable$ 1,000$ 1,000 Note payable 2,000 1,800 Common stock 10,000 Retained earnings 2,000 Total liabilities and stockholders’ equity$15,000 Fair Value $15,000 – 3,000 = $12,000$12,000 × 30% = $3,600

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Assignment of Excess Cost Over Underlying Equity BV $3,600 FMV $4,800 Cost $5,100

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Assignment of Excess Cost Over Underlying Equity Investment in SR$5,100,000 Book value of the interest acquired–3,600,000 Excess cost over book value$1,500,000 Fair value – Book value × 30% =$1,200,000 Amount assigned Remainder assigned to goodwill$ 300,000

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Assignment of Excess Cost Over Underlying Equity Inventories$ 300,000 Other current assets (60,000) Equipment 900,000 Note payable 60,000 Total$1,200,000

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Accounting for Excess of Investment Cost Over Book Value What are PJ’s journal entries? Assume SR pays dividends of $1,000,000 on July 1, and reports net income of $3,000,000 for the year.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Accounting for Excess of Investment Cost Over Book Value July 1 Cash 300,000 Investment in SR 300,000 To record additional dividends received from SR at 30% equity interest in SR

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Accounting for Excess of Investment Cost Over Book Value December 31 Investment in SR900,000 Income from SR900,000 To record equity in income of SR December 31 Income from SR300,000 Investment in SR300,000 To write off excess allocated to inventory

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Accounting for Excess of Investment Cost Over Book Value December 31 Investment in SR60,000 Income from SR60,000 To record income credit for overvalued other current assets disposed of

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Accounting for Excess of Investment Cost Over Book Value December 31 Income from SR45,000 Investment in SR45,000 To record depreciation on excess allocated to undervalued equipment with a 20-year remaining useful life ($900,000 ÷ 20)

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Accounting for Excess of Investment Cost Over Book Value December 31 Income from SR12,000 Investment in SR12,000 To amortize the excess allocated to the overvalued note payable over the remaining life of the note ($60,000 ÷ 5)

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Accounting for Excess of Investment Cost Over Book Value Investment 5,100,000300, ,000300,000 60,000 45,000 12,000 Income from SR 300,000900,000 45,000 60,000 12,000

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Excess of Book Value Acquired Over Investment Cost Post Corporation purchases 50% of the outstanding voting common stock of Taylor on January 1 for $40,000. Taylor’s stockholders’ equity Jan 1:$100,000 Add: Income 20,000 Deduct: Dividends paid 7/1 – 5,000 Stockholders’ equity 12/31$115,000

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Assignment of Excess Cost over Underlying Equity BV $50,000 FMV + Cost $40,000

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Excess of Book Value Acquired Over Investment Cost $100,000 × 50% – $40,000 = $10,000 This is the excess book value over cost. The excess is assigned to: Inventories $(1,000) Equipment $(9,000)

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Negative Goodwill Post acquires a 25% interest in Saxon for $110,000 Saxon net income and dividends for the year are $60,000 and $40,000

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Illustration of a Purchase Combination Book Value Assets Inventories$240,000$260,000 Other current assets 100, ,000 Equipment, net 50,000 50,000 Building, net 140, ,000 Total assets$530,000$610,000 Liabilities 130, ,000 Net assets$400,000$480,000 Fair Value Saxon’s net assets

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Assignment of Excess Cost over Underlying Equity BV $100,000 FMV $120,000 Cost $110,000

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Negative Goodwill $110,000 – $120,000 = – $10,000 This is the excess of FMV over cost.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Interim Acquisitions of an Investment Interest Accounting for equity investments becomes more specific when the firm makes acquisitions within an accounting period.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Investment in a Step-by-Step Acquisition An investor may acquire the ability to exercise significant influence over the operating and financial policies of an investee in a series of stock acquisitions, rather than in a single purchase.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Sale of an Equity Interest When an investor sells a portion of an equity investment that reduces its interest at 20% or less than the level necessary to exercise significant influence the equity method is no longer appropriate.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Stock Purchases Directly from the Investee Karl Corporation purchases 20,000 of previously unissued common stock from Master Co. for $450,000 on January 1, Shares outstanding after new shares are issued: December 31, ,000 Issued to Karl 20,000 Total 40,000

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Stock Purchases Directly from the Investee Master’s stockholders’ equity before issuance ($200,000 capital stock + $150,000 retained earnings)$350,000 Sale to Karl 450,000 Master’s stockholder after issuance$800,000 Book value acquired by Karl$400,000

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Investee Corporation with Preferred Stock Some adjustments are necessary when an investee has preferred as well as common stock outstanding.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Extraordinary Items, Cumulative- Effect-Type, and Other Considerations Ordinary Extraordinary Cumulative-effect

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Disclosures for Equity Investees Name of each investee and percentage of ownership. Accounting policies of the investor with respect to investments in common stock. Difference between the carried amount of investment and the amount of underlying equity in net assets.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn Related Party Transactions These transactions arise when one of the transacting parties has the ability to influence significantly the operations of the other.

©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn End of Chapter 2