Concepts of Equity Method. - 1 ACCOUNTING FOR VARIOUS INVESTMENTS Classification Investment in Debt Securities Investment in Equity Securities Control-greater than 50% ownership of voting stock Not applicableConsolidation Significant influence - 20% to 50% ownership of voting stock Not applicableEquity method Debt securities classified as held to maturity, and equity securities for which fair value is not readily determinable Amortized cost methodCost method Debt and equity securities classified as trading securities Fair value method, with unrealized holding gain or loss included in earnings Debt and equity securities classified as available for sale Fair value method, with unrealized holding gain or loss included as a component of comprehensive income/ stockholders’ equity

Concepts of Equity Method. - 2 { In some cases, influence or control may exist with less than 20% ownership. Investor Ownership of the Investee’s Shares Outstanding 0%20%50%100% Fair Value Equity Method Consolidated Financial Statements Size (of the Investment) Matters!!! 1-2

Concepts of Equity Method. - 3 { Significant influence is generally assumed with 20% to 50% ownership. Investor Ownership of the Investee’s Shares Outstanding The Significance of the Size of the Investment 0%20%50%100% Fair Value Equity Method Consolidated Financial Statements 1-3

Concepts of Equity Method. - 4 { Financial Statements of all related companies must be consolidated. Investor Ownership of the Investee’s Shares Outstanding The Significance of the Size of the Investment 0%20%50%100% Fair Value Equity Method Consolidated Financial Statements 1-4

Concepts of Equity Method. - 5 Criteria for Determining Whether There is “Significant” Influence (APB Opinion 18) Representation on the investee’s Board of Directors Participation in the investee’s policy- making process Material intercompany transactions. Interchange of managerial personnel. Technological dependency. Extent of ownership in relationship to other investor ownership percentages. 1-5

Concepts of Equity Method. - 6 Equity Method  Requires that the investor has the potential for “significant” influence.  Generally used when ownership is between 20% and 50%. –Significant Influence might be present with much smaller ownership percentages. (The accountant must consider the particulars!!!)  Requires that the investor has the potential for “significant” influence.  Generally used when ownership is between 20% and 50%. –Significant Influence might be present with much smaller ownership percentages. (The accountant must consider the particulars!!!) 1-6

Concepts of Equity Method. - 7 Remember:  The ability to exert significant influence is the determining factor in applying the equity method  No actual influence need have been applied!! 1-7

Concepts of Equity Method. - 8 EQUITY METHOD Evidence against Significant Influence  Investee opposition  Investor/investee agreement  Closely held majority stockholder  Lack of information  Lack of board representation

Concepts of Equity Method. - 9 Equity Method Step 1: The investor records its investment in the investee at cost. Journal entry: Debit – Investment in Investee Credit – Cash (or other Assets/Stock) Cost can be defined by cash paid or the Fair Market Value of Stock or Assets given up. 1-9

Concepts of Equity Method Equity Method Step 2: The investor recognizes its proportionate (pro rata) share of the investee’s net income (or net loss) for the period. Journal entry at end of period: Debit – Investment in Investee Credit – Equity in Investee Income This will appear as a separate line-item on the investor’s income statement. 1-10

Concepts of Equity Method Equity Method Step 3: The investor reduces the investment account by the amount of cash dividends received from the investee. Journal entry when cash dividends received: Debit – Cash Credit – Investment in Investee 1-11

Concepts of Equity Method Excess of Cost Over BV Acquired When Cost > BV acquired, the difference must be identified and accounted for When Cost > BV acquired, the difference must be identified and accounted for.

Concepts of Equity Method Excess of Cost Over BV Acquired 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. 1-13

Concepts of Equity Method Special Procedures for Special Situations Reporting a change to the equity method. Reporting investee income from sources other than continuing operations. Reporting investee losses. Reporting the sale of an equity investment. 1-14

Concepts of Equity Method ? Reporting a Change to the Equity Method. (Retroactive Adjustment)  An investment that is too small to have significant influence is accounted for using the fair-value method.  When ownership grows to the point where significant influence is established all accounts are restated so that the investor’s financial statements appear as if the equity method had been applied from the date of the first [original] acquisition. - - APB Opinion

Concepts of Equity Method Reporting Investee Losses A permanent decline in the investee’s fair market value is recorded as an impairment loss and the reduction of the investment account to the fair value. A temporary decline is ignored!!! 1-16

Concepts of Equity Method Possible Criticisms:  Over-emphasis on possession of % voting stock in deciding on “significant influence” vs. “control”  Possibility of “off-balance sheet financing”  Potential manipulation of performance ratios 1-17