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.

Learning Objective 1-1 Accounting for Investments in Corporate Equity Securities 1-2  Fair-Value Method  Consolidation of Financial Statements  Equity Method The method selected depends upon the degree of influence the investor has over the investee. Describe in general the various methods of accounting for an investment in equity shares of another company. GAAP recognizes three ways:

Consolidation of Financial Statements Required when:  Investor’s ownership exceeds 50% of an organization’s outstanding voting stock  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. 1-3

International Standard 28 Investment in Associates The International Accounting Standards Board (IASB), similar to FASB, defines “significant influence” as the power to participate in the financial and operating policy decisions of the investee, but it is not control or joint control over those policies. If investor has 20% or more ownership, it is presumed to have significant influence, unless it is demonstrated not to be the case. If investor holds less than 20% ownership, it is presumed it does not have significant influence, unless influence can be clearly demonstrated. 1-4

Learning Objective 1-2 Sole Criterion for Utilizing the Equity Method 1-5 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 Identify the sole criterion for applying the Equity Method of accounting and guidance in assessing whether it is met.

Summary of Accounting Methods 1-6

Learning Objective 1-3 Equity Method Example Prepare basic equity method journal entries for an investor and describe the financial reporting for equity method investments. Assume Big Company owns 20% interest in Little Company purchased on January 1, 2014, for $200,000. Little 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 1-8 Big’s investment in Little, as determined by market prices, was $235,000, $255,000, and $320,000 at the end of 2014, 2015, and 2016, respectively. Big Company records these journal entries to apply the equity method:

Learning Objective 1-4 Excess Cost Over Book Value 1-9 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 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.

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. The additional payment is attributed to an intangible asset referred to as goodwill rather than to a specific investee asset or liability.

Learning Objective 1-5a 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 ) 1-11

Learning Objective 1-5b Investee Other Comprehensive Income 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, foreign currency translation adjustments, and certain pension adjustments.  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. 1-12

Investee Other Comprehensive Income  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  Extraordinary items  Other comprehensive income 1-13

Learning Objective 1-5c Reporting Investee Losses 1-14 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. A temporary decline is ignored! 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.

Learning Objective 1-5d Reporting Sale of 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, 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 Record the sale of an equity investment and identify the accounting method to be applied to any remaining shares that are subsequently held.

INVESTORINVESTOR INVESTEEINVESTEE INVESTORINVESTOR INVESTEEINVESTEE Downstream Sale Upstream Sale Learning Objective 1-6 Deferral of Unrealized Profits in Inventory Equity acquisitions establish ties between companies to facilitate the direct purchase and sale of inventory items. Such intra-entity transactions can occur regularly or sporadically 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.

Learning Objective 1-7 Fair Value Reporting Option Explain the rationale and reporting implications of the value accounting for investments otherwise accounted for by the 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. 1-17