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Chapter 2: Stock Investments – Investor Accounting and Reporting

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1 Chapter 2: Stock Investments – Investor Accounting and Reporting
Beams, Advanced Accounting 10e, Ch. 2 4/28/2017 Chapter 2: Stock Investments – Investor Accounting and Reporting 2-1 Pearson Education, Inc., publishing as Prentice Hall 1

2 Stock Investments: Objectives
Recognize investors' varying levels of influence or control, based on the level of stock ownership. Anticipate how accounting adjusts to reflect the economics underlying varying levels of investor influence. Apply the fair value/cost and equity methods of accounting for stock investments. Identify factors beyond stock ownership that affect an investor's ability to exert influence or control. Apply the equity method to purchase price allocations. Learn how to test goodwill for impairment. 2-2

3 1: Levels of Influence or Control
Stock Investments – Investor Accounting and Reporting 1: Levels of Influence or Control 2-3

4 Fair value (cost) method Consolidated financial statements
Levels of Influence <20% – presumes lack of significant influence – fair value (cost) method 20% to 50% – presumes significant influence – equity method >50% – presumes control – consolidated financial statements Fair value (cost) method Consolidated financial statements Equity method 2-4

5 2: Accounting Reflects Economics
Stock Investments – Investor Accounting and Reporting 2: Accounting Reflects Economics 2-5

6 Accounting for the Investment
Degree of influence Investment's carrying value Investment income Lack of significant influence Fair value (cost, if nonmarketable) Dividends declared Significant influence Original cost adjusted to reflect periodic earnings and dividends, e.g., a proportionate share of investee's net assets Proportionate share of investee's periodic earnings* * If income were measured as dividends declared, by influencing or controlling dividend decisions, the investor could manipulate its own investment income. 2-6

7 3a: Fair Value/Cost Method
Stock Investments – Investor Accounting and Reporting 3a: Fair Value/Cost Method 2-7

8 Example Assume that Pil Company acquires 2,000 of the 10,000 outstanding shares of Sud Corporation at $50 per share on July 1. Assume the book value and fair value of Sud’s assets and liabilities are equal. Further, the cash paid equals 20 percent of the fair value of Sud’s net assets. Sud’s net income for the fiscal year ending December 31 is $50,000, and dividends of $20,000 are paid on November 1. 2-8

9 Fair Value (Cost) Method
FASB Statement No. 115 At acquisition: Pilzner buys 2,000 shares of Sud for $100,000. Pilzner receives $4,000 in dividends from Sud. Investment in Sud 100,000 Cash Cash 4,000 Dividend income 2-9

10 Fair Value Method, at Year-end
Reduce dividend income recognized, if needed Adjust investment to fair value Dividend income 1,000 Investment in Sud If Pilzner determines that cumulative dividends exceed its cumulative share of income by $1,000. Allowance to adjust available-for-sale securities to fair value 21,000 Other comprehensive income If fair value of increases to $120,000 and the Investment in Sud account balance is $99,000. 2-10

11 Stock Investments – Investor Accounting and Reporting
3b: Equity Method 2-11

12 Equity Method APB Opinion No. 18
At acquisition: Pilzner buys 2,000 shares of Sud for $100,000. Pilzner receives $4,000 in dividends from Sud. Investment in Sud 100,000 Cash Cash 4,000 Investment in Sud 2-12

13 Equity Method, at Year-end
Pilzner determines that its share of Sud's income is $5,000. The ending balance in the Investment in Sud is: $100,000 cost - $4,000 dividends + $5,000 income = $101,000. Cash 4,000 Investment in Sud 2-13

14 4: Ability to Influence or Control
Stock Investments – Investor Accounting and Reporting 4: Ability to Influence or Control 2-14

15 Significant Influence
20% to 50% voting stock ownership is a presumption of significant influence. Use the equity method. Don't use equity method if there is a lack of significant influence Opposition by investee, Surrender of significant shareholder rights, Concentration of majority ownership, Lack of information for equity method, and Failure to obtain board representation. 2-15

16 Control More than 50% voting stock ownership is presumptive evidence of control. Prepare consolidated financial statements. Don't consolidate if control is temporary or if the parent lacks control Legal reorganization or bankruptcy Severe foreign restrictions. 2-16

17 5: Applying the Equity Method
Stock Investments – Investor Accounting and Reporting 5: Applying the Equity Method 2-17

18 Acquisition Cost > FV net assets FV net assets > BV net assets
Payne acquires 30% of Sloan for $5,000. Sloan's identifiable net assets (assets less liabilities) are: Fair value: A – L = $18,800 - $2,800 = $16,000. Book value: A – L = E = $15,000 - $3,000 = $12,000 The $4,000 difference ($16,000 - $12,000) is due to: $1,000 undervalued inventories sold this year, $200 overvalued other current assets used this year, $3,000 undervalued equipment with a life of 20 years, and $200 overvalued notes payable due in 5 years. $5,000 > 30%(16,000) > 30%(12,000) $5,000 > $4,800 > $3,600 2-18

19 Acquisition of Sloan Stock
At acquisition, Payne pays $2,000 cash and issues common stock with a fair value of $3,000 and par value of $2,000. Payne also pays $50 to register the securities and $100 in consulting fees. Investment in Sloan 5,000 Cash 2,000 Common stock, at par Additional paid in capital 1,000 50 Investment expense 100 150 2-19

20 Fair Value Information for Sloan Company at January 1
2-20

21 2-21

22 Cost/Book Value Assignment
Cost of acquisition $5,000 Less 30% book value = 30%(12,000) 3,600 Excess of cost over book value $1,400 Assigned to: Amount Amortization Inventories 30%(+1,000) $300 1st year Other curr. assets 30%(-200) (60) Equipment 30%(+3,000) 900 20 years Note payable 30%(+200) 60 5 years Goodwill (to balance) 200 None Total $1,400 2-22

23 Dividends and Income Payne receives $300 dividends from Sloan.
Sloan reports net income of $900. Payne will recognize its share (30%) of Sloan's income, but will adjust it for amortization of the differences between book and fair values. Cash 300 Investment in Sloan 2-23

24 Amortization and Investment Income
Cost/book value differences: Initial amount 1st year amort. Unamortized excess at year-end Inventories $300 ($300) $0 Other curr. Assets (60) 60 Equipment 900 (45) 855 Note payable (12) 48 Goodwill 200 Total $1,400 ($297) $1,103 Investment income is 30% of Sloan's net income – amortization 30%($3,000) – $297 = $603. 2-24

25 Year-end Entry & Balance
Record the investment income The ending balance in the investment account is: 5,000 – = 5,303. Investment in Sloan 603 Income from Sloan Cost – dividends + investment income 2-25

26 More on Cost/Book Value Assignment
On acquisition date, compare: Cost of acquisition, Book value of net assets, and Fair value of identifiable net assets Cost of the investment includes cash paid, fair value of securities issued, and debt assumed. The book value of the investee's net assets = assets – liabilities, or = stockholders' equity 2-26

27 Fair Values Used in Assignment
Identifiable net assets include all the investee's assets and liabilities, whether recorded or not Fair value of research in progress Fair value of contingent liabilities Fair value of unrecorded patents Exception: use book value for pensions and deferred taxes. If cost > fair value, goodwill exists. If cost < fair value, a bargain purchase exists. 2-27

28 Bargain Purchase When the acquisition cost is less than the fair value of the identifiable net assets, a gain is recognized on the acquisition. The investment is recorded at the fair value of the identifiable net assets Investment in ABC xxx Cash, CS, APIC Gain on bargain purchase 2-28

29 Interim Acquisitions Book value of net assets = BV equity.
If equity is given as beginning of year, add current earnings and deduct dividends to date. Amortization for first, partial, year: Take full amortization for inventory and other current assets disposed of by year-end. Take partial year's amortization for equipment, buildings, and debt to be written off over multiple years. Record dividends if after the acquisition date. 2-29

30 Acquisition in Stages Also called a step-by-step acquisition.
Fair value (cost) method equity method Retroactive adjustment Investee's growth in retained earnings is Excess of income over dividends declared Investment account desired balance using equity method = original cost + share of growth in retained earnings – amortization, if any Investment in XYZ xxx Retained earnings 2-30

31 Sale of Equity Investment
Sale of investment that results in a lack of significant influence over the investee Equity method fair value (cost) method Prospective treatment For the sale Reduce the investment account for a proportionate share of the stock sold Record a gain or loss on the sale Apply the fair value (cost) method to remaining investment 2-31

32 Stock Purchased from Investee
If stock is purchased from old shareholders, the percentage ownership is based on the shares outstanding and the investee's equity is not changed. If acquired directly from the investee: Percentage acquired = shares acquired / (shares acquired + previously outstanding shares) Investee's new stockholders' equity = Previous equity + value received for new shares 2-32

33 Investee with Preferred Stock
Compare cost of acquisition to the book value of the common stock. = Total equity – book value of preferred stock* * BV of PS = call value + dividends in arrears Dividends received will be a portion of the dividends to common shareholders = total dividends – current PS dividends Investment income is based on income available to common shareholders = investee net income – PS dividends** ** Pref. Div. = current dividend if cumulative, or dividends declared if noncumulative. 2-33

34 Special Reporting Issues
If material, the investor continues separate reporting of extraordinary items and/or discontinued operations of the investee Income from Investee is based on income before discontinued operations or extraordinary items Optionally, the investor may report its equity investments at fair market value, FASB Statement Nos. 159 and 157 2-34

35 Disclosures For significant equity investees Name, percent ownership
Accounting policy Difference between investment carrying value and underlying equity in net assets Aggregate market value Summarized asset, liability, operations Related party disclosures FASB Statement No. 57 2-35

36 6: Impairment of Goodwill
Stock Investments – Investor Accounting and Reporting 6: Impairment of Goodwill 2-36

37 Impairment of Goodwill
Test annually, and if significant events occur (e.g., adverse legal factors or loss of key personnel) FASB Statement No. 142: Two step process If the fair value of the whole reporting unit < the carrying value of the reporting unit including its goodwill, there might be impairment. If no implied impairment, step 2 is not needed. Use quoted market prices of reporting unit, or valuation techniques applied to similar groups of assets and liabilities. If the implied fair value of the goodwill < the carrying value of the goodwill, record an impairment loss for the difference. 2-37

38 Impairment of Equity Investments
Goodwill implied in equity investments is not tested for impairment. The investment itself is tested for impairment. APB Opinion No. 18 2-38


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