1. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-1 Reporting Intercorporate Investments in Common Stock http://www.mhe.com./business/accounting/bakerhttp://www.mhe.com./business/accounting/baker5e Baker / Lembke / King 2 Electronic Presentation by Douglas Cloud Pepperdine University

2. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-2 0%20%50%100% Level of Common Stock Ownership Influence not significant Significant influence Control Cost Method Equity Method Consolidation

3. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-3 The Cost Method Investor Company purchases 15 percent of Investee Company’s common stock for $100,000 at the beginning of 20X1. Influence is determined to be not significant. Investment in XYZ Company Stock100,000 Cash100,000 Record purchase of XYZ Company stock

4. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-4 The Cost Method During the year, XYZ has net income of $50,000 and pays dividends of $20,000. 15% of $20,000 Cash3,000 Dividend Income3,000 Record dividend income from XYZ Company. Note that ABC records only its share of the distributed earnings of XYZ.

5. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-5 On January 2, 20X1, Investor Company purchases 10 percent of Investee Company’s common stock. Investee Company’s net income is $100,000 and dividends paid total $70,000. Liquidating Dividends Illustrated Cash7,000 Dividend Income7,000 Record receipt of 20X1 dividend from Investee Company. 10% of $70,000

6. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-6 On January 2, 20X2, Investee Company’s net income is $100,000 and dividends paid total $120,000. Thus, Investee had cumulative net income of $200,000 and paid cumulative dividends of $190,000. Liquidating Dividends Illustrated Cash12,000 Dividend Income12,000 Record receipt of 20X1 dividend from Investee Company. 10% of $120,000

7. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-7 For 20X3, Investee’s net income is $100,000 and $120,000 in dividends are declared and paid. Cumulative net income is now $300,000 and cumulative dividends paid total $310,000. Liquidating Dividends Illustrated Cash12,000 Investment in Investee Company Stock1,000 Dividend Income11,000 Record receipt of 20X3 dividend from Investee Company. ($310,000 - $300,000) x 10% 10% x ($120,000 - $10,000) 10% of $120,000

8. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-8 Equity Method What is significant influence?

9. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-9 Equity Method APB 18 states, “An investment (direct or indirect) of 20% or more of the voting stock of an investee should lead to the presumption that in the absence of evidence to the contrary an investor has the ability to exercise significant influence over an investee.”

10. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-10 Equity Method--Recognition of Income 1. ABC Company acquires significant influence over XYZ Company by purchasing 20 percent of the common stock of XYZ at the beginning of the year, at cost $ 300.000. 1. ABC Company acquires significant influence over XYZ Company by purchasing 20 percent of the common stock of XYZ at the beginning of the year, at cost $ 300.000. Investment in XYZ Common Stock300,000 Cash 300.000

11. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-11 Equity Method--Recognition of Dividends XYZ declares and pays a $20,000 dividend. Cash4,000 Investment in XYZ Company Stock4,000 Record receipt of dividend from XYZ. 20% x $20,000

12. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-12 Equity Method--Recognition of Income XYZ reports net income of $60,000. Investment in XYZ Common Stock12,000 Income from Investee12,000 Record income from investment in XYZ Co. 20% x $60,000

13. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-13 Equity Method--Carrying Amount Investment in XYZ Common Stock Original cost100,000 Equity accrual ($60,000 x.20) 12,000 Ending balance108,000 Dividends ($20,000 x.20) 4,000

14. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-14 Equity Method--Interim Acquisitions Investment in XYZ Common Stock Original cost109,000 Equity accrual ($60,000 x 1/4 x.20) 3,000 Ending balance108,000 Dividends ($20,000 x.20) 4,000 ABC Company acquires 20 percent of XYZ’s common stock on October 1 for $109,000. XYZ earns income of $60,000 and pays dividends of $20,000. ABC Company acquires 20 percent of XYZ’s common stock on October 1 for $109,000. XYZ earns income of $60,000 and pays dividends of $20,000.

15. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-15 Equity Method--Cost Exceeds Book Value Ajax Corporation purchases 40 percent of the common stock of Barclay Company on January 1, 20X1, for $200,000. Barclay has net assets with a book value of $400,000 and a fair value of $465,000. Ajax Corporation purchases 40 percent of the common stock of Barclay Company on January 1, 20X1, for $200,000. Barclay has net assets with a book value of $400,000 and a fair value of $465,000. Cost of investment to Ajax$200,000 Book value of Ajax’s share of Barclay’s net assets (.40 x $400,000)(160,000) Differential$ 40,000

16. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-16 Cost of Investment $200,000 Fair value of net identifiable assets ( 40% x $465,000) $186,000 Total differential $40,000 Excess of cost over fair value of net identifiable assets $14,000 Excess of fair value over book value of net identifiable assets $26,000 Book value of net identifiable assets ( 40% x $400,000) $160,000 Equity Method--Cost Exceeds Book Value

17. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-17 Equity Method--Cost Exceeds Book Value Barclay reports net income of $80,000 in 20X1. Investment in Barclay Stock32,000 Income from Investee32,000 Record equity-method income.

18. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-18 Equity Method--Cost Exceeds Book Value Barclay declares and pays a dividend of $20,000 in 20X1. 40% x $20,000 Barclay reports net income of $80,000 in 20X1. Investment in Barclay Stock32,000 Income from Investee32,000 Record equity-method income. Cash8,000 Investment in Barclay Stock8,000 Record dividend from Barclay.

19. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-19 Equity Method--Cost Exceeds Book Value The $40,000 excess paid by Ajax is assigned to Land, $6,000, Equipment, $20,000, and Goodwill, $14,000. Equipment is amortized, but land and goodwill are not. Equipment ($20,000 ÷ 5 years)$4,000 Income from Investee4,000 Investment in Barclay Stock4,000 Amortize differential.

20. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-20 Equity Method--Disposal of Assets If Barclay had purchased the land in 20X0 for $75,000 and sells the land in 20X2 for $125,000. Barclay recognizes a gain on the sale of $50,000, and Ajax’s share is $20,000 (40%). Ajax’s share of Barclay's reported gain $20,000 Portion of Ajax’s differential related to land (6,000) Gain to be recognized by Ajax $14,000 Income from Investee6,000 Investment in Barclay Stock6,000 Remove differential related to Barclay’s land sold.

21. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-21 Equity Method--Purchase Additional Shares ABC Company purchases 20 percent of XYZ’s common stock on January 2, 20X1, and another 10 percent on July 1, 20X1, and the stock purchases are at book value. Income, January 2 to June 30: $20,000 x.20$ 4,000 Income, July 1 to December 31: $30,000 x.30 9,000 Income from Investment, 20X1$13,000 Investment in XYZ Stock13,000 Income from Investee13,000

22. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-22 Equity Method--Purchase Additional Shares XYZ declares and pays a $10,000 dividend on January 15 and again on July 15. January 15 dividend: $10,000 x.20$2,000 July 15 dividend: $10,000 x.30 3,000 Reduction in Investment, 20X1$5,000 Cash2,000 Investment in XYZ Stock2,000 January 15, 20X1 Cash3,000 Investment in XYZ Stock3,000 July 15, 20X1

23. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-23 Equity Method--Change to Equity Method Aron Corporation purchases 15 percent of Zenon Company’s common stock on January 2, 20X1 and another 10 percent on January 2, 20X4. Aron switches to the equity method on January 2, 20X4. Originally under Restated under Year Net Income Dividends Cost Equity Zenon Investment Income Reported by Aron 20X1$15,000$10,000$1,500$2,250 20X218,00010,0001,5002,700 20X322,00010,0001,5003,300 $55,000$30,000$4,500$8,250

24. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-24 The investment account and retained earnings of Aaron are restated as if the equity method had been applied from the date of the original acquisition. Investment in Zenon Common Stock3,750 Retained Earnings3,750 Restate investment account from cost to equity method. $8,250 - $4,500 Equity Method--Change to Equity Method

25. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-25 Cost and Equity Methods Compared Recorded amount of investment at date of acquisition. Cost Method Original cost

26. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-26 Cost and Equity Methods Compared Recorded amount of investment at date of acquisition. Equity Method Original cost

27. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-27 Cost and Equity Methods Compared Usual carrying amount of investment subsequent to acquisition Original cost Cost Method

28. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-28 Cost and Equity Methods Compared Original cost increased (decreased) by investor’s share of investee's income (loss) and decreased by investor’s share of investee’s dividends and by amortization or write-off of the differential. Equity Method Usual carrying amount of investment subsequent to acquisition

29. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-29 Cost and Equity Methods Compared Not amortized or written-off Cost Method Differential

30. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-30 Cost and Equity Methods Compared Differential Amortized or written down if related to limited- life assets of investee or assets disposed of. Equity Method

31. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-31 Cost and Equity Methods Compared Income recognized by investor Investor’s share of investee’s dividends declared from earnings since acquisition Cost Method

32. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-32 Cost and Equity Methods Compared Investor’s share of investee’s earnings since acquisition, whether distributed or not, reduced by any amortization or write-off of the differential. Equity Method Income recognized by investor

33. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-33 Cost and Equity Methods Compared Investee dividends from earnings since acquisition by investor Income Cost Method

34. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-34 Cost and Equity Methods Compared Investee dividends from earnings since acquisition by investor Reduction of investment Equity Method

35. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-35 Cost and Equity Methods Compared Investee dividends in excess of earnings since acquisition by investor Reduction of investment Cost Method

36. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-36 Investee dividends in excess of earnings since acquisition by investor Reduction of investment Equity Method Cost and Equity Methods Compared

37. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-37 APB 18--What is Significant Influence? An investor owning less than 20 percent can still have significant influence. APB 18 stated a number of factors that could indicate such influence. 1.Representation on board of directors. 2.Participation in policy-making. 3.Material intercompany transactions. 4.Interchange of managerial personnel. 5.Technological dependency. 6.Size of investment in relation to concentration of other shareholdings.

38. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-38 FASB InterpretationNo. 35 FASB Interpretation No. 35 Evidence that an investor is unable to exercise significant influence over an investee: 1.Opposition by the investee. 2.The investor and investee sign an agreement in which the investor surrenders significant rights as a shareholder. 3.Majority ownership of the investee is concentrated among a small group of shareholders who operate the investee without regard to the views of the investor. 4.The investor, desiring more information than is available to the investee’s other shareholders, tries to obtain that information, and fails. 5.The investor tries and fails to obtain representation on the investee’s board of directors.

39. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-39 Chapter Two The End

40. McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 2-40