Chapter One The Equity Method of Accounting for Investments McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Reporting Investments in Corporate Equity Securities These 3 approaches are not interchangeable. (The appropriate method depends upon the characteristics of the particular investment) GAAP allows 3 approaches to reporting investments: Fair Value Method Equity Method Consolidation 1-2

Fair Value Method Initial Investments are recorded at cost. (Subsequently adjusted to fair value only if readily determinable) Initial Investments are recorded at cost. (Subsequently adjusted to fair value only if readily determinable) Dividends received are recognized as income. Dividends received are recognized as income. Investments in equities of other companies are classified either as Trading or Available-for-Sale Securities. Investments in equities of other companies are classified either as Trading or Available-for-Sale Securities. Initial Investments are recorded at cost. (Subsequently adjusted to fair value only if readily determinable) Initial Investments are recorded at cost. (Subsequently adjusted to fair value only if readily determinable) Dividends received are recognized as income. Dividends received are recognized as income. Investments in equities of other companies are classified either as Trading or Available-for-Sale Securities. Investments in equities of other companies are classified either as Trading or Available-for-Sale Securities. 1-3

Fair Value Method (continued) Trading securities are held for the purpose of re-sale in the short term. Unrealized holding gains and losses are included in reported earnings. Trading securities are held for the purpose of re-sale in the short term. Unrealized holding gains and losses are included in reported earnings. Available-for-sale securities are those not classified as trading. Unrealized holding gains and losses are reported in shareholders’ equity as other comprehensive income. (They are not included in earnings.) Available-for-sale securities are those not classified as trading. Unrealized holding gains and losses are reported in shareholders’ equity as other comprehensive income. (They are not included in earnings.) Trading securities are held for the purpose of re-sale in the short term. Unrealized holding gains and losses are included in reported earnings. Trading securities are held for the purpose of re-sale in the short term. Unrealized holding gains and losses are included in reported earnings. Available-for-sale securities are those not classified as trading. Unrealized holding gains and losses are reported in shareholders’ equity as other comprehensive income. (They are not included in earnings.) Available-for-sale securities are those not classified as trading. Unrealized holding gains and losses are reported in shareholders’ equity as other comprehensive income. (They are not included in earnings.) 1-4

Consolidation of Financial Statements Required when investor’s ownership exceeds 50% of investee, except “where control does not actually rest with the majority shareholders”  Legal reorganizations  Bankruptcies  Foreign government restrictions A single set of financial statements is produced, reporting the consolidated assets, liabilities, equities, revenues, and expenses for the parent company and all controlled subsidiary companies. 1-5

WARNING!!!! WARNING!!! FASB Interpretation No. 46-R, Consolidation of Variable Interest Entities [FIN 46] expands the use of consolidated financial statements:  Includes entities controlled through “special contractual arrangements”  Intended to combat misuse of SPE’s (special purpose entities) by firms like Enron  Part of the accounting defense against “off balance sheet financing” 1-6

Equity Method Required when an investor has the ability to “significantly influence” the investee. 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!!!) Required when an investor has the ability to “significantly influence” the investee. 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!!!) 1-7

Criteria for Determining Whether There is “Significant” Influence 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. 1-8

{ 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!!! 1-9

{ 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 1-10

{ 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 1-11

Remember: The ability to exert significant influence is the determining factor in applying the equity method No actual influence need have been applied!! 1-12

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 value of stock or other assets given up. Cost can be defined by cash paid or the fair value of stock or other assets given up. 1-13

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. 1-14

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 1-15

Equity Method Example Little Company reported a net income of $200,000 during 2008 and paid cash dividends of $50,000. These figures indicate that Little’s net assets have increased by $150,000 during the year. Investment in Little Company.. 40,000 Equity in Investee Income ,000 To accrue earnings of a 20 percent owned investee ($200,000 × 20%). 1-16

Equity Method Example Cash ,000 Investment in Little Company ,000 To record receipt of cash dividend from Little Company ($50,000 × 20%). 1-17

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. 1-18

? 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

Restatement (Retroactive Adjustment) - Example Giant Company acquires a 10 percent ownership in Small Company on January 1, Officials of Giant do not believe that their company has gained the ability to exert significant influence over Small. Giant properly records the investment by using the fair-value method as an available-for- sale security. Subsequently, on January 1, 2010, Giant purchases an additional 30 percent of the Small’s outstanding voting stock, thereby achieving the ability to significantly influence the investee’s decision making. The readjustment follows on the next slide. Giant Company acquires a 10 percent ownership in Small Company on January 1, Officials of Giant do not believe that their company has gained the ability to exert significant influence over Small. Giant properly records the investment by using the fair-value method as an available-for- sale security. Subsequently, on January 1, 2010, Giant purchases an additional 30 percent of the Small’s outstanding voting stock, thereby achieving the ability to significantly influence the investee’s decision making. The readjustment follows on the next slide. 1-20

Restatement (Retroactive Adjustment) - Example 1-21

Reporting Investee Income from Other Sources When net income includes elements other than Operating Income, these elements should be presented separately on the investor’s income statement. Examples include:  Discontinued operations  Extraordinary items  Prior period adjustments 1-22

Reporting Investee Income from Other Sources Large Company owns 40 percent of the voting stock of Tiny Company and accounts for this investment by means of the equity method. In 2008, Tinyreports net income of $200,000, a figure composed of $250,000 in income from continuing operations and a $50,000 extraordinary loss. Large Company accrues earnings of $80,000 based on 40 percent of the $200,000 net figure. Larges equity method entry at year-end is: 1-23

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!!! 1-24

Reporting Investee Losses Investment Reduced to Zero When the accumulated losses incurred by the investee and dividends paid by the investee reduce the investment account to zero, NO ADDITIONAL LOSSES are accrued (unless a further commitment has been made) The balance remains at $0, until subsequent profits eliminate all UNREALIZED losses. Investment Reduced to Zero When the accumulated losses incurred by the investee and dividends paid by the investee reduce the investment account to zero, NO ADDITIONAL LOSSES are accrued (unless a further commitment has been made) The balance remains at $0, until subsequent profits eliminate all UNREALIZED losses. 1-25

Reporting the Sale of an Equity Investment If part of an investment is sold during the period...  The equity method continues to be applied up to the date of the transaction.  At the transaction date, a proportionate amount of the Investment account is removed.  If significant influence is lost, NO RETROACTIVE ADJUSTMENT is recorded, but the equity method is no longer applied.  The equity method continues to be applied up to the date of the transaction.  At the transaction date, a proportionate amount of the Investment account is removed.  If significant influence is lost, NO RETROACTIVE ADJUSTMENT is recorded, but the equity method is no longer applied. 1-26

Reporting the Sale of an Equity Investment Top Company owns 40 percent of the 100,000 outstanding shares of Bottom Company, an investment accounted for by the equity method. Although these 40,000 shares were acquired some years ago for $200,000, application of the equity method has increased the asset balance to $320,000 as of January 1, On July 1, 2008, Top elects to sell 10,000 of these shares (one-fourth of its investment) for $110,000 in cash, thereby reducing ownership in Bottom from 40 percent to 30 percent. Bottom Company reports income of $70,000 during the first six months of 2008 and distributes cash dividends of $30,

Excess of Cost Over BV Acquired When Cost > BV acquired, the difference must be identified and accounted for. 1-28

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. 1-29

Big Company is negotiating the acquisition of 30 percent of the outstanding shares of Little Company. Little’s balance sheet reports assets of $500,000 and liabilities of $300,000 for a net book value of $200,000. After investigation, Big determines that Little’s equipment (5 year remaining life) is undervalued in the company’s financial records by $60,000. One of its patents (10 year remaining life) is also undervalued, but only by $40,000. By adding these valuation adjustments to Little’s book value, Big arrives at an estimated $300,000 worth for the company’s net assets. Based on this computation, Big offers $90,000 for a 30 percent share of the investee’s outstanding stock. Big Company is negotiating the acquisition of 30 percent of the outstanding shares of Little Company. Little’s balance sheet reports assets of $500,000 and liabilities of $300,000 for a net book value of $200,000. After investigation, Big determines that Little’s equipment (5 year remaining life) is undervalued in the company’s financial records by $60,000. One of its patents (10 year remaining life) is also undervalued, but only by $40,000. By adding these valuation adjustments to Little’s book value, Big arrives at an estimated $300,000 worth for the company’s net assets. Based on this computation, Big offers $90,000 for a 30 percent share of the investee’s outstanding stock. Excess of Cost Over BV Example 1-30

Excess of Cost Over BV Example Book value of Little Company (assets minus liabilities [or stockholders’ equity]) $200,000 Undervaluation of equipment ,000 Undervaluation of patent ,000 Value of net assets $300,000 Portion being acquired % Acquisition price $ 90,

Amortization of Cost Over BV Example Payment by investor.... ……………..…… ,000 Percentage of book value acquired ($200,000 × 30%).. …………….…… ,000 Payment in excess of book value …………………..…30,000 Excess payment identified with specific assets: Equipment ($60,000 undervaluation × 30%). 18,000 Patent ($40,000 undervaluation × 30%) ,000 30,000 Excess payment not identified with specific assets—goodwill.. –0– Payment by investor.... ……………..…… ,000 Percentage of book value acquired ($200,000 × 30%).. …………….…… ,000 Payment in excess of book value …………………..…30,000 Excess payment identified with specific assets: Equipment ($60,000 undervaluation × 30%). 18,000 Patent ($40,000 undervaluation × 30%) ,000 30,000 Excess payment not identified with specific assets—goodwill.. –0– 1-32

Amortization of Cost Over BV 1-33

INVESTORINVESTOR INVESTEEINVESTEE INVESTORINVESTOR INVESTEEINVESTEE Downstream Sale Upstream Sale Unrealized Gains in Inventory Sometimes affiliated companies sell or buy inventory from each other. 1-34

Unrealized Gains in Inventory Let’s look at an Investor that has 200 units of inventory with a cost of $1,000. INVESTOR sells 200 units of inventory with a total cost of $1,000. Let us assume that the Investor sells the inventory to a 20% owned Investee for $1,

INVESTEE buys 200 units of inventory and pays a total of $1,250. Intercompany Sale of 200 units 20% ownership Unrealized Gains in Inventory INVESTOR sells 200 units of inventory with a total cost of $1,000. Let’s look at an Investor that has 200 units of inventory with a cost of $1,000. Note that there is $250 of intercompany profit. At this point it is considered UNREALIZED. If all 200 units are not sold to an outside party during the period, we will have unrealized, intercompany profit that must be deferred. 1-36

INVESTEE buys 200 units of inventory and pays a total of $1,250. Intercompany Sale of 200 units 20% ownership Unrealized Gains in Inventory INVESTOR sells 200 units of inventory with a total cost of $1, of the original 200 units (30%) remain “unsold” to an “outside” party. We must defer our share (20%) of the original $250 of intercompany profit that is unrealized (30%). Investee sells only 140 units to a 3 rd party Outside Party 1-37

Unrealized Gains in Inventory Compute the deferral by multiplying: The required journal entry is: $250 × 30% × 20% = $

Unrealized Gains in Inventory In the period following the period of the transfer, the remaining inventory is often sold. When that happens, the original entry is reversed... In the period following the period of the transfer, the remaining inventory is often sold. When that happens, the original entry is reversed... The reversal takes place during the period that the inventory is sold to an outside party. 1-39

Summary The equity method is applied to an investment whenever significant influence appears to exist. Significant influence is presumed whenever ownership is between 20 and 50% (however, each situation must be examined separately.) Investee income proportionately increases the investment, while dividends decrease it. The equity method is applied retroactively once significant influence is apparent. Excess payments of acquisition are assigned either to specific assets and liabilities or to goodwill. Assigned costs (other than to land or goodwill after 2001) are systematically amortized. This is applied until the date of disposal Intercompany markups on transferred assets are deferred until the items are consumed or sold to outside parties. 1-40

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 WHAT DO YOU THINK????? 1-41

Homework P1.12, P1.14, P1.16, P1.17 P1.22, P1.25