1. Advanced Accounting Autumn 2015
Chapter 2
Stock Investments – Investor Accounting and Reporting
Bill Myer – Autumn 2015

2. Agenda
Homework
Chapter 2: Stock Investments – Investor Accounting and Reporting
Bill Myer – Autumn 2015

3. Homework You should have already read chapters 1 and 2
You should have already completed Exercises and Problems assigned for chapter 1
Be prepared for a quiz on chapter 1
Also, please complete:
Chapter 2, Exercises E2-1 (5); E2-2 (1, 3, 4, 5); E2-5; E2-15
Bill Myer – Autumn 2015

4. Vocabulary – Important Vocabulary for Chapter 2
Cost method
Book value / carrying value
Fair value method
Liquidating dividend
Equity method
T-account
Investor
Treasury stock
Investee
Step acquisition (or step-by-step acquisition)
Nonmarketable
Accounting Standards Codification (ASC)
Available-for-sale securities
Trading securities
Reporting unit
Held-to-maturity securities
Implied fair value
Unrealized gain
Impairment loss
Other comprehensive income
Bill Myer – Autumn 2015

5. Agenda
Homework 
Chapter 2: Stock Investments – Investor Accounting and Reporting
Bill Myer – Autumn 2015

6. Investor Accounting – Focus Questions
How do levels of influence affect accounting for investments?
How do you account for investments when you lack significant influence?
How do you account for investments when you have significant influence?
What is a differential?
How do you account for changes in influence, and for sales of investments?
How do you test goodwill for impairment?
Bill Myer – Autumn 2015

7. 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 over an investee
Learn how to test goodwill for impairment
Bill Myer – Autumn 2015

8. Levels of Influence
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9. 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*
* The investor could manipulate its own investment income if income is measured by dividends.
Bill Myer – Autumn 2015

10. The Cost Method Investments are classified as: Trading Securities
Available-for-Sale Securities
Held to maturity
Held for sale in the short term
Unrealized holding gains and losses are included in earnings (net income)
Any securities not classified as Trading
Unrealized holding gains and losses are reported in shareholders’ equity as other comprehensive income (i.e., not included in net income)
Bill Myer – Autumn 2015

11. The Cost Method
At the time of purchase, the investor records its investment in common stock at the total cost incurred in making the purchase
The investment account is adjusted to fair-market value (if readily determinable at report date) until the time of sale
Debit – Investment
Credit – Unrealized Gain on Investment**
** This will appear on the income statement for Trading Securities, or in Other Comprehensive Income for those classified as Available-for-Sale
Income from the investment is recognized as dividends are declared by the investee (see important exception next slide)
Bill Myer – Autumn 2015

12. Cost method – liquidating dividends
Declaration of dividends in excess of earnings since acquisition
Liquidating dividends – Dividends declared by the investee in excess of its earnings since acquisition by the investor from the investor’s viewpoint
The investor’s share of these liquidating dividends is treated as a return of capital, and the investment account balance is reduced by that amount
These dividends usually are not liquidating dividends from the investee’s point of view
Bill Myer – Autumn 2015

13. Fair Value (Cost) Method
FASB Statement No. 115
Pal buys 2,000 shares of Sid for $50,000 and does not have significant influence over Sid
Pal receives $4,000 in dividends from Sid
Investment in Sid (+A)
50,000
Cash (-A)
Cash (+A)
4,000
Dividend income (R, +SE)
Bill Myer – Autumn 2015

14. Fair Value (Cost) Method, at Year-end
Reduce dividend income recognized, if needed
Adjust investment to fair value
Dividend income (-R, -SE)
500
Investment in Sid (-A)
If Pal determines that cumulative dividends exceed its cumulative share of income by $500.
Allowance to adjust available-for-sale securities to market value (+A)
10,500
Unrealized gain on available-for-sale securities (+SE)
If fair value of the stock increases to $60,000 and the Investment in Sid account balance is $49,500.
Bill Myer – Autumn 2015

15. Equity Method At acquisition: Pal buys 2,000 shares of Sid for $50,000
Pal receives $4,000 in dividends from Sid
Investment in Sid (+A)
50,000
Cash (-A)
Cash (+A)
4,000
Investment in Sid (-A)
Bill Myer – Autumn 2015

16. Equity Method, at Year-end
Pal determines that its share of Sid's income is $2,500
The ending balance in the Investment in Sid is:
$50,000 cost
- $4,000 dividends
+ $2,500 income
= $48,500
Investment in Sid (+A)
2,500
Income from Sid (R, +SE)
Bill Myer – Autumn 2015

17. Review questions
When are investments in common stock accounted for using (a) the equity method and (b) the cost method?
How is the receipt of a dividend accounted for under the cost method?
How is an increase in fair value of an investment accounted for under the cost method?
How is an increase in fair value of an investment accounted for under the equity method?
What is a liquidating dividend?
Bill Myer – Autumn 2015

18. Cost method – practice problem
ABC Company acquires 20 percent of XYZ Company’s common stock for $100,000 at the beginning of the year but does not gain significant influence over XYZ. During the year, XYZ has net income of $60,000 and pays dividends of $20,000.
What are the journal entries to record the purchase of XYZ?
What are the journal entries to recognize income from XYZ?
What would be the entries if the dividend were $60,000 and net income were $20,000?
What would be the entries if ABC has significance influence over XYZ?
Bill Myer – Autumn 2015

19. Exercises E2-1, question 5 (page 50) E2-2, question 1 E2-2, question 3
Additional practice:
E2-7, question 1
E2-7, question 3
Bill Myer – Autumn 2015

20. Significant Influence
20% to 50% voting stock ownership is a presumption of significant influence. Generally 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 or
Failure to obtain board representation
Bill Myer – Autumn 2015

21. Control
More than 50% voting stock ownership is presumptive evidence of control. Generally prepare consolidated financial statements
Don't consolidate if the parent lacks control
Legal reorganization or bankruptcy
Severe foreign restrictions
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22. Applying the Equity Method
Investor’s equity in the investee
The investor records its investment at the original cost
This amount is adjusted periodically:
Bill Myer – Autumn 2015

23. Review questions When is the equity method used?
When could an investor own less than 20% but still exert significant influence?
When could an investor own 20% or more and not be able to exert significant influence?
What is the effect of a dividend declaration by an investee under (a) the cost method and (b) the equity method?
Bill Myer – Autumn 2015

24. The equity method - illustration
ABC Company acquires significant influence over XYZ Company by purchasing 20 percent of the common stock of the XYZ Company for $100,000, XYZ earns income of $60,000 and pays dividends of $20,000.
How is income recognized?
What is the effect of the dividend?
What is the carrying amount of the investment at the end of the period?
Bill Myer – Autumn 2015

25. Applying the equity method – differential
The difference between the cost of the investment to the investor and the book value of the investor’s proportionate share of the investee’s net assets
Example: River Corporation acquires 30% of the common stock of Rock Company for $100,000. Rock Company has net assets on the acquisition date with a book value of $250,000 and a fair value of $300,000. What is the amount of the differential?
Bill Myer – Autumn 2015

26. Applying the equity method – differential
Reasons for the differential
Investee’s assets worth more than their book values
Existence of unrecorded goodwill
Ascertain the portion of the differential pertaining to each asset of the investee, including goodwill
The portion of the differential pertaining to limited-life assets, including identifiable intangibles, must be amortized over their remaining economic lives
Any portion of the differential that represents goodwill is not amortized or written off because of impairment
Bill Myer – Autumn 2015

27. Applying the equity method – differential
Amortizing the differential
Reduce the income recognized by the investor from the investee and the balance of the investment account:
Bill Myer – Autumn 2015

28. Applying the equity method – differential
Ajax Corporation acquires 40% of the common stock of Barclay on January 1, 20X1 for $200,000. Barclay has net assets on that date with a book value of $400,000 and fair value of $465,000. The $65,000 excess consists of a $15,000 increase in the value of Barclay’s land and a $50,000 increase in the value of equipment. The equipment is amortized over its remaining life of five years (land has an unlimited economic life). Barclay declares dividends of $20,000 during 20X1 and at year-end reports net income of $80,000 for the year.
What are the entries to record the purchase of Barclay in 20X1?
What are the entries to recognize Ajax’s share of Barclay’s 20X1 net income?
What are Ajax’s entries to recognize the dividend paid by Barclay?
How much is the differential?
What are Ajax’s entries to amortize the differential?
Bill Myer – Autumn 2015

29. Applying the Equity Method
Acquisition Cost > FV net assets, and FV net assets > BV net assets
Payne acquires 30% of Sloan for $5,000. Sloan's identifiable net assets (assets less liabilities) are (in thousands):
Fair value: A – L = $18,800 - $2,800 = $16,000
Book value: A – L = E = $15,000 - $3,000 = $12,000
$5,000 > 30%(16,000) > 30%(12,000)
$5,000 > $4,800 > $3,600
Bill Myer – Autumn 2015

30. Differences between FV and BV
Fair value: $16,000
Book value: $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
Bill Myer – Autumn 2015

31. 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 (+A)
5,000
Cash (-A)
2,000
Common stock, at par (+SE)
Additional paid in capital (+SE)
1,000
Additional paid in capital (-SE) 50
Investment expense (E, -SE)
100
150
Bill Myer – Autumn 2015

32. Cost/Book Value Assignment
Investment in Sloan
$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
Bill Myer – Autumn 2015

33. Dividends and Income Cash (+A) 300 Investment in Sloan (-A)
Payne receives $300 dividends from Sloan
Sloan reports net income of $3,000
Payne will recognize its share (30%) of Sloan's income ($900), but will adjust it for amortization of the differences between book and fair values
Cash (+A)
300
Investment in Sloan (-A)
Bill Myer – Autumn 2015

34. Amortization and Investment Income
Cost/book value differences:
Initial amount
1st year amort.
Unamortized excess at year-end
Inventories
$300
($300) $0
Other current 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
Bill Myer – Autumn 2015

35. Cost – dividends + investment income
Year-End Entry & Balance
Record the investment income (single entry)
The ending balance in the investment account is:
5,000 –
= 5,303
Investment in Sloan (+A)
603
Income from Sloan (R, +SE)
Cost – dividends + investment income
Bill Myer – Autumn 2015

36. Exercises
E2-5 (page 52)
P2-3
Bill Myer – Autumn 2015

37. 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
Bill Myer – Autumn 2015

38. 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
Bill Myer – Autumn 2015

39. 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
Bill Myer – Autumn 2015

40. Other considerations There are other special considerations when:
The investment is purchased at an interim date
Acquisition is done in stages
Equity interest is sold
Treasury stock transactions / stock purchased from investee
Investee with preferred stock
Investee reports discontinued operations or extraordinary items
Investment balance goes to zero
We will only cover acquisition done in stages and sale of equity interest
Bill Myer – Autumn 2015

41. Acquisition in Stages Investment in XYZ (+A) XXX
Also called a step-by-step acquisition
Fair value (cost) method equity method
Restate prior-period statements
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 investee’s retained earnings – amortization, if any
Investment in XYZ (+A)
XXX
Retained earnings (+SE)
Bill Myer – Autumn 2015

42. Sale of Equity Interest
Sale of investment that results in a lack of significant influence over the investee
Equity method fair value (cost) method
Prospective treatment
1. For the sale
Reduce the investment account for a proportionate share of the stock sold
Record a gain or loss on the sale
2. Apply the fair value (cost) method to remaining investment
Bill Myer – Autumn 2015

43. Review questions What is the accounting treatment…
…If a company sells part of an equity method investment that results in a lack of significant influence over the investee?
…If a company buys additional shares in a cost method investment that results in significant influence over the investee?
Bill Myer – Autumn 2015

44. 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 assets, liabilities, results of operations
Related party disclosures
FASB ASC
Bill Myer – Autumn 2015

45. Disclosures – example (1 of 2)
Source: BGCP 10-K, year ending 12/31/2014
Bill Myer – Autumn 2015

46. Disclosures – example (2 of 2)
Source: BGCP 10-K, year ending 12/31/2014
Bill Myer – Autumn 2015

47. Goodwill Impairment
Test annually, and if significant events occur, two-step process [FASB ASC ]
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
Bill Myer – Autumn 2015

48. 2011 Amendment by FASB
Gives companies an option of making a qualitative evaluation to determine if the first step is needed
If it is more likely than not that FMV < carrying amount, the company need not perform the two-step test
Bill Myer – Autumn 2015

49. Impairment of Equity Investments
Goodwill implied in equity investments is not tested for impairment
The investment itself is tested for impairment
Example: Sam has a 30% interest in Lake, Investment in Lake, with a carrying value of $4,200; this includes implied goodwill of $350
The $350 implied goodwill is not tested for impairment
If Sam’s interest has a fair value of less than $4,200, an impairment loss on the Investment in Lake is recorded
Bill Myer – Autumn 2015

50. Goodwill impairment – example
Paul owns 80% of Surly Corporation
Paul carries $5 million of goodwill related to Surly
Paul estimates that Surly has a total fair value of $36.25 million if he purchased Surly today
The fair value of Surly’s total net assets are $31.25 million
What is the implied fair value of goodwill?
Paul’s 80% investment would have a total fair value of $29 M
Paul’s 80% interest in net assets is $25 M
Therefore, the implied FV of goodwill is $4 M
Paul must record a $1 M impairment loss
Bill Myer – Autumn 2015

51. Exercises
E2-15
Additional Practice:
E2-16
Bill Myer – Autumn 2015

52. New Equity Method Guidance
In June 2015, FASB issued a proposal to simplify the equity method of accounting
The proposal would eliminate the requirement that the investor identify and account for the difference between its cost basis of an investment and its proportional interest in the equity of the investee
The proposal would also eliminate the requirement that an investor account for an equity method investment retrospectively when it increases its ownership to a level that qualifies for the equity method
However, this is still only a proposal
Bill Myer – Autumn 2015

53. Investor Accounting – Review Questions
How do levels of influence affect accounting for investments?
How do you account for investments when you lack significant influence?
How do you account for investments when you have significant influence?
What is a differential?
How do you account for changes in influence, and for sales of investments?
How do you test goodwill for impairment?
Bill Myer – Autumn 2015