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

2. Lon Term Investments What are investments? Why do companies invest?
What is equity?
Where are investments recorded?
What methods can be used to record one company’s investment in the stock of another company ?

3. Financial Assets and Investments
Debt investments include: “investments in government debt, corporate bonds, convertible debt, commercial paper, and securitized debt instruments”
Equity instruments represent ownership interests in companies (e.g., common stock, preferred stock)
Motivations for investments include: to obtain short-term returns or long-term returns on investments, and for corporate strategy

4. Fair Value Issues
Recent changes require that investments are to be recognized at their fair value at acquisition (usually = the purchase price)
Also, many investments are revalued to fair value at the balance sheet date
Unrealized holding gains or losses occur when a financial instrument is revalued at its fair value

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

6. Size (of the Investment) Matters!!!
1-6
Investor Ownership of the Investee’s Shares Outstanding
Fair Value
Equity Method
Consolidated Financial Statements { 0%
20%
50%
100%
In some cases, influence or control may exist with less than 20% ownership. 8

7. Fair Value Method Details in SFAS No. 115:
1-7
Details in SFAS No. 115:
Initial Investments are recorded at cost. (Subsequently adjusted to fair value only if readily determinable)
Dividends received are recognized as income.
Investments in equities of other companies are classified either as Trading or Available-for-Sale Securities. 3

8. Fair Value Method (continued)
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Trading securities are held for the purpose of re-sale in the short term. Unrealized holding gains and losses are 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.) 3

9. Equity Investments: Common Shares
As common shares carry voting rights, extent of influence becomes a factor in determining the appropriate accounting treatment
There are three levels of influence, each with its own accounting treatment:
Little or no influence
Significant influence
Control

10. Equity Method
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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!!!) 5

11. Criteria for Determining Whether There is “Significant” Influence (APB Opinion 18)
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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. 6

12. Consolidation of Financial Statements
1-12
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, recording the consolidated assets, liabilities, equities, revenues, and expenses for the parent company and all controlled subsidiary companies. 4

13. The Significance of the Size of the Investment
1-13
Investor Ownership of the Investee’s Shares Outstanding
Fair Value
Equity Method
Consolidated Financial Statements { 0%
20%
50%
100%
Significant influence is generally assumed with 20% to 50% ownership. 9

14. The Significance of the Size of the Investment
1-14
Investor Ownership of the Investee’s Shares Outstanding
Fair Value
Equity Method
Consolidated Financial Statements { 0%
20%
50%
100%
Financial Statements of all related companies must be consolidated. 9

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

16. Accounting and Reporting for Equity Investments
Line-by-line consolidation
Not recognized
Consolidation
3. Control: Subsidiary
Investment income equal to investor’s share of investee’s net income reported (adjusted)
Equity
2. Significant Influence
Dividends as received or receivable
Recognized in net income
Fair value
Held-for-Trading
Dividends as received or receivable; gains/losses from sale or impairment
Recognize in “OCI” and as separate component of shareholders’ equity
Available-for-sale
1. No significant influence:
Other Income Statement Effects
Unrealized Holding Gains or Losses
Valuation
Category

17. Step 1: The investor records its investment in the investee at cost.
Equity Method
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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. 10

18. Equity Method
1-18
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. 11

19. Equity Method
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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 13

20. Equity Method Example
1-20
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, %). 17

21. Equity Method Example Cash . . . . . . . . . . . . .. . . . . . 10,000
1-21
Cash ,000
Investment in Little Company ,000
To record receipt of cash dividend from Little Company ($50, %). 19

22. Special Procedures for Special Situations
1-22
Reporting a change to the equity method.
Reporting the sale of an equity investment.
Reporting investee income from sources other than continuing operations.
Reporting investee losses.

23. Reporting a Change to the Equity Method. (Retroactive Adjustment)
1-23
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 18 ?

24. Restatement (Retroactive Adjustment) - Example
Assume that Exxo Company acquires 5% of LipGloss Inc. on January 1, 2007 for $2,000,000. There is no significant influence. The investment is recorded at the time as an Available-for-Sale Investment.
In 2007, LipGloss had net income of $300,000, and paid dividends of $140,000. Exxo would report the investment as indicated in the table below:

25. Restatement (Retroactive Adjustment) – Example (continued)
On January 1, 2008, Exxo buys an additional 15% interest in LipGloss, raising the total investment to 20%. The first thing that Exxo must do is restate the 12/31/07 numbers by applying the equity method to the 5% investment in LipGloss.
We have to RESTATE the Investment account, put a balance in Equity in Investee Income, and eliminate the Dividend Revenue balance.

26. Restatement (Retroactive Adjustment) – Example (continued)
An adjustment is recorded to the Investment account and to Retained Earnings (since Dividend Revenue has already been closed out).

27. Restatement (Retroactive Adjustment) - Example
1-27
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.

28. Restatement (Retroactive Adjustment) - Example
1-28

29. Reporting Investee Income from Other Sources
1-29
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

30. Reporting Investee Income from Other Sources
1-30
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:

31. Reporting Investee Losses
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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!!!

32. Reporting Investee Losses
1-32
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.

33. Reporting the Sale of an Equity Investment
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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.

34. Reporting the Sale of an Equity Investment
Alice Co. holds 30% (300,000 shares) of Sam, Inc.. The balance in Alice’s Investment account at March 31, 2008, is $268,000.
If Alice Co. sells 10% of its shares (30,000 shares) on April 1, 2008 for $100,000, what entry should Alice make on April 1, 2008?
$268,000 × .10% = $26,800
This brings the Investment account to a balance of $241,200

35. Reporting the Sale of an Equity Investment
1-35
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 $30,000.

36. Excess of Cost Over BV Acquired
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When Cost > BV acquired, the difference must be identified and accounted for. 21

37. Excess of Cost Over BV Acquired
1-37
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. 22

38. Excess of Cost Over BV Example
1-38
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 is undervalued in the company’s financial records by $60,000. One of its patents 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. 23

39. Excess of Cost Over BV Example
1-39
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 $ 90,000 24

40. Amortization of Cost Over BV Example
1-40
Payment by investor ……………..…… $90,000
Percentage of book value acquired ($200, %) …………….…… ,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
Excess payment not identified with specific assets—goodwill –0– 24

41. Excess of Cost Over BV Example
On January 1, 2008, Big Corp. acquired 20% of Small Inc. for $2,000,000 cash.
Assume that Small’s assets had BV on January 1 of $8,500,000. Small owns a building with a BV of $500,000, and a FMV of $700,000 with a remaining useful life of 10 years. All other assets had BV = FMV.
Allocate the cost to fair market value adjustments and Goodwill acquired by Big. 23

42. Excess of Cost Over BV Example24

43. Excess of Cost Over BV Example
The Building has a remaining useful life of 10 years. Goodwill is not amortized. Compute the amortization expense for Big at 12/31/08. 24

44. Amortization of Cost Over BV Example
Big’s equity method entry will include an adjustment to the investment account of $4,000. 24

45. Amortization of Cost Over BV Example26

46. Unrealized Gains in Inventory
1-46
Sometimes affiliated companies sell or buy inventory from each other.
INVESTOR
INVESTEE
INVESTOR
INVESTEE
Downstream Sale
Upstream Sale 28

47. Unrealized Gains in Inventory
1-47
Let’s look at an Investor that has 200 units of inventory with a cost of $1,000.
Let us assume that the Investor sells the inventory to a 20% owned Investee for $1,250.
INVESTOR sells 200 units of inventory with a total cost of $1,000. 29

48. Unrealized Gains in Inventory
1-48
Note that there is $250 of intercompany profit. At this point it is considered UNREALIZED.
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.
INVESTEE buys 200 units of inventory and pays a total of $1,250.
Intercompany Sale of 200 units
20% ownership
If all 200 units are not sold to an outside party during the period, we will have unrealized, intercompany profit that must be deferred. 29

49. Unrealized Gains in Inventory
1-49
60 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%).
INVESTOR sells 200 units of inventory with a total cost of $1,000.
INVESTEE buys 200 units of inventory and pays a total of $1,250.
Intercompany Sale of 200 units
20% ownership
Investee sells only 140 units to a 3rd party
Outside Party 29

50. Unrealized Gains in Inventory
1-50
Compute the deferral by multiplying:
The required journal entry is:
$250 × 30% × 20% = $15 33

51. Unrealized Gains in Inventory
1-51
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. 33

52. Summary
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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.

53. Possible Criticisms: WHAT DO YOU THINK?????
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Over-emphasis on possession of 20-50% voting stock in deciding on “significant influence” vs. “control”
Possibility of “off-balance sheet financing”
Potential manipulation of performance ratios
WHAT DO YOU THINK?????