Chapter 2: Reporting Intercorporate

Interests

Objectives
1. Describe the cost method of reporting, determine
in which settings it should be used and prepare
appropriate journal entries given a set of
circumstances.
2. Describe the equity method of reporting,
determine in which settings it should be used and
prepare appropriate journal entries given a set of
circumstances.
3. Prepare appropriate journal entries given a)
additional investment in common stock during
the year and b) a change from cost to equity
method of reporting.

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The Cost Method
Used for reporting investments in marketable and
non-marketable securities when both
consolidation and equity-method reporting are
inappropriate. When securities are marketable, the
investment is adjusted to market value under
FASB 115.

Basic Example (Investor JE’s)

1. Investor Company purchases 20% of Investee
Company’s common stock for $100,000 at the
beginning of 20X1. Influence is determined not to
be significant.

Investment in Investee Stock 100,000

Cash 100,000

2. During the year, Investee Company has net income

of $50,000 and pays dividends of $20,000.

Cash (20% of $20,000) 4,000

Dividend Income 4,000

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Cost Method, continued

Liquidating Dividends

Investor holds common stock in a company that

declares dividends in excess of the income it has earned
since stock was acquired by Investor.

e.g.,

a. On January 2, 20X1, Investor Company purchases

10% of Investee Company’s common stock.
Investee Company’s net income is $100,000 and
dividends paid total $70,000.

Cash (10% of $70,000) 7,000

Dividend Income 7,000

b. 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.

Cash (10% of $120,000) 12,000

Dividend Income 12,000

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Cost Method, continued

Liquidating Dividend example, continued

c. 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.

Cash (10% x $120,000) 12,000

Investment in Investee 1,000
[($310,000-300,000)x10%]*
Dividend Income 11,000

*$10,000 of the 20X3 Dividend represents return of

capital.

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The Equity Method

APB Opinion No. 18 requires that the equity

method be used for reporting investments, other
than temporary in common stock, of the
following:

1) Corporate joint ventures

2) Companies in which the investor’s voting
stock interest gives the investor the “ability
to exercise significant influence over
operating and financial policies” of that
company.

What is significant influence?

“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.”

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 Equity Method, continued

Basic Example (Investor JE’s)

1. Investor Company acquires significant influence over
Investee Company by purchasing 20% of the common
stock of Investee at the beginning of the year. Investee
reports net income of $60,000 (20% x $60,000 =
$12,000).

Investment in Investee Company $12,000

Income from Investee Company $12,000
Equity accrual

2. Investee Company declares and pays a $20,000

dividend (20% X $20,000 = $4,000)

Cash $4,000
Investment in Investee Company $4,000

What is the carrying value of the investment at year-

end?

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Equity Method Continued,
Interim Acquisition

Investor Company acquires 20% of Investee

Company’s common stock on October 1 for
$109,000. Investee Company reports income of
$60,000 and pays dividends of $20,000. What is
carrying value of the investment at year-end?

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Equity Method, continued

Cost Exceeds Fair Value

Investor Company purchases 40% of the common

stock of Investee Company on January 1, 20X1, for
$200,000. Investee has net assets with a book value
of $400,000 and a fair value of $465,000.

Cost of investment to Investor $200,000

Book value of investee net assets $160,000
(40% x $400,000)
Difference (Excess cost over BV) $ 40,000

Cost of investment to Investor $200,000

Fair value of investee net assets $186,000
(40% x $465,000)
Difference (Excess cost over FV) $ 14,000

Excess of FV over BV of net assets $ 26,000

(Given: $6,000 assigned to land and $20,000
to equipment which showed increase in FV;
Remainder of $14,000 goes to Goodwill)

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Equity method, continued
(Cost exceeds BV, continued: Investor books)

1. Investee reports net income of $80,000 in

20X1 (40% X $80,000) and declares and
pays a dividend of $20,000 (40% X
$20,000).

Investment in investee $32,000

Income from investee $32,000

Cash $ 8,000
Investment in investee $ 8,000

2. Amortization of excess: land and goodwill

not amortized but $20,000 of equipment is
($20,000/5 = $4,000 per year).

Income from investee $4,000

Investment in investee $4,000

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Equity method, continued

Above example, continued

Disposal of differential related assets

Investee sells the land in 20X2 for $125,000
(original cost is $75,000) for a gain of $50,000.
Investor portion of gain is $20,000 (40% X
$50,000). The above noted differential ($6,000)
related to the land needs to be removed in the
process of recognizing the gain on Investor books.

Entry after recording income for year:

Income from Investee $6,000

Investment in Investee $6,000

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Equity method, continued

Above example, continued

Purchase additional shares: Even though the new
and old shares are combined for financial reporting
purposes, income accruing to the new shares can be
recognized by the investor only from the date of
acquisition forward.

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Equity method, continued

Change to the Equity Method, i.e., investment was

previously carried at cost and additional shares give
ability to significantly influence.

The investment account and retained earnings of

the Investor are restated as if the equity method
had been applied from the date of the original
acquisition.

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Overview: Figure 2-2 compares cost and equity
method.

Additional Issues: Read for overview (not covered on

exam or in class).

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