Slide

1-1

Chapter One

The Equity
Method of
Accounting
for
Investments
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Slide
1-2

Reporting Investments in
Corporate Equity Securities
GAAP allows 3 approaches to
reporting investments.

Note: These 3 approaches are not

interchangeable. The characteristics of each
investment will dictate the appropriate
accounting approach.
McGraw-Hill/Irwin

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Slide
1-3

Fair Value Method

Details
Details in
in SFAS
SFAS No.
No. 115
115

Initial
Initial Investment
Investment is
is recorded
recorded
at
at cost.
cost.

Investments
Investments in
in equities
equities of
of
other
other companies
companies are
are
classified
classified as
as either
either Trading
Trading
Securities
Securities or
or Available-forAvailable-forSale
Sale Securities
Securities..

Income
Income is
is only
only realized
realized to
to the
the
extent
extent of
of dividends
dividends received.
received.

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Slide
1-4

Equity Method

Defined
Defined by
byAPB
APB Opinion
Opinion 18
18

and
and SFAS
SFAS No.
No. 142.
142.

Requires
Requires that
that the
the investment
investment
is
is sufficient
sufficient to
to insure
insure
significant
significant influence.
influence.

Generally
Generally used
used when
when
ownership
ownership is
is between
between 20%
20% &
&
50%.
50%.

Influence
Influencecan
can be
be present
presentwith
with

much
much smaller
smaller ownership
ownership
percentages.
percentages.

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Slide
1-5

Consolidation of Financial
Statements
Governed

by ARB No. 51, SFAS

No. 141, and SFAS No. 142.
Required when investors
ownership exceeds 50% of
investee.
A single set of financial
statements including the assets,
liabilities, equities, revenues,
and expenses for the parent
company and all controlled
subsidiary companies.
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Slide
1-6

Criteria for Determining Whether

There is Influence
Representation
Representation on
on the
theinvestees
investeesBoard
Board of
of
Directors
Directors
Participation
Participationin
in the
theinvestees
investeespolicypolicymaking
makingprocess
process
Material
Materialintercompany
intercompanytransactions.
transactions.
Interchange
Interchange of
of managerial
managerialpersonnel.
personnel.
Technological
Technologicaldependency.
dependency.
Extent
Extent of
ofownership
ownership in
in relationship
relationshipto
to
other
other ownership
ownershippercentages.
percentages.

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Slide
1-7

The Significance of the Size of the

Investment
Investor Ownership of
Investee Shares
Outstanding

Fair
Value
0%

Equity
Method
20%

Consolidated Financial
Statements
50%

100%

In
Insome
somecases,
cases,influence
influenceor
orcontrol
controlmay
may
exist
existwith
withless
lessthan
than20%
20%ownership.
ownership.
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Slide
1-8

The Significance of the Size of the

Investment
Investor Ownership of
Investee Shares
Outstanding

0%

Equity
Method

Fair
Value
20%

Consolidated Financial
Statements
50%

100%

Significant
Significantinfluence
influenceis
isgenerally
generally
assumed
assumedwith
with20%
20%to
to50%
50%
ownership.
ownership.
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Slide
1-9

The Significance of the Size of the

Investment
Investor Ownership of
Investee Shares
Outstanding

0%

Equity
Method
20%

Consolidated Financial
Statements
50%

Fair
Value

100%

Financial
FinancialStatements
Statementsof
ofall
allrelated
related
companies
companiesmust
mustbe
beconsolidated.
consolidated.
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Slide
1-10

Fair Value Method (Revisited) using

Available for Sale (AFS) securities

Purchase
Dr Investment in AFS
Cr Cash

XXXXX

Dividend Income
Dr Cash
Cr Dividend Income

XXXXX

XXXXX
XXXXX

Change in Value of Security (Increase)1

Dr Market Value Adj. AFS
Cr Unrealised inc/dec in AFS2

XXXXX
XXXXX

1 - The reverse is true for a decrease

2 This account appears in stock holders equity. If it were a
Held for Trading security the gain would have appeared in
the income statement as an Unrealized loss on Trading
Securities
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Slide
1-11

Equity Method
Step 1: The investor records its
investment in the investee at cost.
Cost
Cost can
canbe
bedefined
defined by
bycash
cash paid
paid or
or Fair
Fair Market
Market
Value
Valueof
ofStock
Stockor
or other
other assets
assetsgiven
given up.
up.

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Slide
1-12

Equity Method
Step 2: The investor recognizes its
proportionate share of the investees
net income (or net loss) for the period.

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Slide
1-13

Equity Method
Step 2: The investor recognizes its
proportionate share of the investees
net income (or net loss) for the period.

This
Thiswill
willappear
appear as
asaa separate
separate
line-item
line-itemon
onthe
theinvestors
investors
income
incomestatement.
statement.
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Slide
1-14

Equity Method
Step 3: The investor reduces the
investment account by the amount of
dividends received from the investee.

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Slide
1-15

Lets do an
equity method
example.

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Slide
1-16

Equity Method Example Step 1

On January 1, 2005, Big Corp. buys 20%
of Small Inc. for $2,000,000 cash.
Record Bigs journal entry.

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Slide
1-17

Equity Method Example Step 2

On December 31, 2005, Small reports net
income for the year of $300,000.
Record Bigs journal entry.

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Slide
1-18

Equity Method Example Step 2

Big owns 20% of Small and gets credit
for 20% of Smalls income.
20% $300,000 = $60,000

60,000
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Slide
1-19

Equity Method Example Step 3

On December 31, 2003, Big received a
$25,000 dividend check from Small.
Record Bigs journal entry.

60,000
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25,000

25,000

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Slide
1-20

Special Procedures for Special

Situations
Reporting
Reporting aa
change
change to
to
the
the equity
equity
method.
method.

Reporting
Reporting investee
investee
income
income from
from sources
sources
other
other than
than continuing
continuing
operations.
operations.
McGraw-Hill/Irwin

Reporting
Reporting the
the
sale
sale of
of an
an equity
equity
investment.
investment.

Reporting
Reporting
investee
investee
losses.
losses.

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Slide
1-21

Reporting a Change to the Equity

Method.

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
all accounts
accounts are
arerestated
restated so
so that
that the
the
investors
investorsfinancial
financial statements
statements appear
appear as
as ifif the
the
equity
equity method
method had
had been
been applied
applied from
from the
thedate
date
of
of the
the first
first [original]
[original] acquisition.
acquisition. -- --APB
APB
Opinion
Opinion 18
18

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Slide
1-22

Restatement - Example
Assume
Assumethat
thatExxo
ExxoCompany
Companyacquires
acquires5%
5%of
of
LipGloss
LipGlossInc.
Inc.on
onJanuary
January1,
1, 2004
2004for
for$2,000,000.
$2,000,000.
There
Thereis
isno
no significant
significantinfluence.
influence. The
Theinvestment
investment is
is
recorded
recordedat
at the
thetime
timeas
asan
anAvailable-for-Sale
Available-for-Sale
Investment.
Investment.
In
In2004,
2004,LipGloss
LipGlosshad
had net
net income
incomeof
of $300,000,
$300,000,and
and
paid
paiddividends
dividendsof
of $140,000.
$140,000. Exxo
Exxo would
would report
report the
the
investment
investment as
asindicated
indicatedin
inthe
thetable
tablebelow:
below:

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Slide
1-23

Fair Market Value entry

The

entries for adjustment to FMV

would also have been required. E.g.
Assume that the FMV @ 31/12/2004
was $2,400,000. Then the following
entry would have been made (as per
SFAS115):
Dr Market Value Adjustment - AFS
400,000
Cr Unrealized inc/dec in value of AFS 400,000

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Slide
1-24

Restatement - Example
On
OnJanuary
January1,
1,2005,
2005, Exxo
Exxobuys
buysan
anadditional
additional15%
15%
interest
interest in
inLipGloss,
LipGloss,raising
raisingthe
thetotal
totalinvestment
investment to
to
20%.
20%. The
Thefirst
first thing
thingthat
thatExxo
Exxo must
must do
do is
isrestate
restate the
the
12/31/04
12/31/04numbers
numbersby
byapplying
applying the
theequity
equitymethod
methodto
to
the
the5%
5%investment
investment in
in LipGloss.
LipGloss.
We
Wehave
haveto
toRESTATE
RESTATEthe
theInvestment
Investment account,
account,put
putaa
balance
balancein
inEquity
Equityin
inInvestee
InvesteeIncome,
Income,and
andeliminate
eliminate
the
theDividend
DividendRevenue
Revenue balance.
balance.

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Slide
1-25

Restatement - Example
An
Anadjustment
adjustmentis
isrecorded
recordedto
tothe
theInvestment
Investment
account
accountand
andto
to Retained
Retained Earnings
Earnings (since
(sinceDividend
Dividend
Revenue
Revenuehas
has already
alreadybeen
been closed
closed out).
out).

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Slide
1-26

Removal of Fair Market Value

related accounts
The

FMV related accounts would also

have to be removed. i.e. :
Dr Unrealized inc/dec in value of AFS 400,000
Cr Market Value Adjustment - AFS
400,000

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Slide
1-27

Reporting Investee Income from

Other Sources
When

net income
includes elements other
than Operating Income,
those elements should
be separately reported
on the investors income
statement.
Examples include:
Extraordinary items
Discontinued operations
Prior period adjustments

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Slide
1-28

Reporting Investee Income from

Other Sources

Big
Big owns
owns 30%
30% of
of Little.
Little. Little
Little reports
reports net
net income
income
for
for 2005
2005 of
of $120,000.
$120,000. Littles
Littles Income
Income includes
includes
operating
operating income
income of
of $135,000
$135,000 and
and an
an
extraordinary
extraordinary loss
loss of
of $15,000.
$15,000.
Bigs
Bigs equity
equity method
method entry
entry at
at year-end
year-end is:
is:

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Slide
1-29

Reporting Investee Losses

Permanent
Permanent
Losses
Losses in
in Value
Value
A
Apermanent
permanent
decline
decline in
in the
the
investees
investees market
market
value
value is
is recorded
recorded
as
as aa reduction
reduction of
of
the
the investment
investment
account.
account.

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Slide
1-30

Reporting Investee Losses

Investment
Investment Reduced
Reduced to
to Zero
Zero

When
When the
the accumulated
accumulated losses
losses
incurred
incurred by
by the
the investee
investee and
and
dividends
dividends paid
paid by
by the
the investee
investee
reduce
reduce the
the investment
investment
account
account to
to zero,
zero, NO
NO
ADDITIONAL
ADDITIONAL LOSSES
LOSSES are
are
accrued.
accrued.

The
The balance
balance remains
remains at
at $0,
$0,
until
until subsequent
subsequent profits
profits
eliminate
eliminate all
all UNRECORDED
UNRECORDED
losses.
losses.

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Slide
1-31

Reporting the Sale of an Equity

Investment
If part of an investment is sold during
the period . . .

The
Theequity
equitymethod
methodcontinues
continues to
tobe
be

applied
appliedup
upto
to the
the date
dateof
of the
the
transaction.
transaction.

At
At the
thetransaction
transaction date,
date,aa
proportionate
proportionateamount
amount of
of the
the
Investment
Investment account
account is
isremoved.
removed.

IfIf significant
significantinfluence
influenceis
islost,
lost, NO
NO
RETROACTIVE
RETROACTIVEADJUSTMENT
ADJUSTMENT is
is
recorded.
recorded. (as
(asis
isthe
the case
casewhen
when
switching
switchingfrom
from FV
FVto
to Equity
Equity
method)
method)
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Slide
1-32

Reporting the Sale of an Equity

Investment

Alice
AliceCo.
Co.30%
30%(300,000
(300,000shares)
shares)of
ofSam,
Sam,Inc..
Inc.. The
Thebalance
balance
in
inAlices
AlicesInvestment
Investmentaccount
accountat
atMarch
March31,
31,2005,
2005,is
is
$268,000.
$268,000.
IfIfAlice
AliceCo.
Co.sells
sells10%
10%of
ofits
itsshares
shares(30,000
(30,000shares)
shares)on
on
April
April1,
1,2005
2005 for
for$100,000,
$100,000,what
whatentry
entryshould
shouldAlice
Alice
make
makeon
onApril
April1,
1,2005?
2005?

$268,000 .10% = $26,800

This brings the Investment account to a
balance of $241,200
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Slide
1-33

Excess of Cost Over BV Acquired

When Cost > BV acquired, the difference
must be identified and accounted for.

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Slide
1-34

Excess of Cost Over BV Acquired

The
The amortization
amortization of
of the
the difference
difference associated
associated
with
with the
the undervalued
undervalued assets
assets is
is recorded
recorded as
as aa
reduction
reduction of
of both
both the
the Investment
Investment account
account
and
and the
the Equity
Equity in
in Investee
Investee Income
Income account.
account.

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Slide
1-35

Excess of Cost Over BV

Example

On
OnJanuary
January1,
1,2005,
2005, Big
BigCorp.
Corp.

acquired
acquired 20%
20%of
ofSmall
Small Inc.
Inc. for
for
$2,000,000
$2,000,000cash.
cash.

Assume
Assumethat
thatSmalls
Smallsassets
assets
had
hadBV
BVon
on January
January11of
of
$8,500,000.
$8,500,000. Small
Small owns
ownsaa
building
building with
with aaBV
BVof
of $500,000,
$500,000,
and
andaaFMV
FMVof
of $700,000,
$700,000, and
and aa
remaining
remaininguseful
useful life
life of
of 10
10
years.
years. All
All other
other assets
assets had
had BV
BV
== FMV.
FMV.

Allocate
Allocatethe
thecost
cost to
to fair
fairmarket
market
value
valueadjustments
adjustmentsand
and
Goodwill
Goodwillacquired
acquiredby
byBig.
Big.
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Slide
1-36

Excess of Cost Over BV

Example

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Slide
1-37

Excess of Cost Over BV

Example

The
The Building
Building has
has aa
remaining
remaininguseful
usefullife
life
of
of10
10years.
years. Goodwill
Goodwill
is
isnever
neveramortized.
amortized.
Compute
Computethe
the
amortization
amortization expense
expense
for
for Big
Big at
at12/31/05.
12/31/05.

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Slide
1-38

Amortization of Cost Over BV

Example

Bigs
Bigsequity
equitymethod
method
entry
entrywill
will include
includean
an
adjustment
adjustment to
tothe
the
investment
investmentaccount
account
of
of$4,000.
$4,000.

McGraw-Hill/Irwin

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Slide
1-39

Amortization of Cost Over BV

Example

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Slide
1-40

McGraw-Hill/Irwin

Lets look at
some
intercompany
transactions.

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Slide
1-41

Unrealized Gains in Inventory

Sometimes affiliated companies sell or
buy inventory from each other.

INVESTOR
INVESTOR
Downstream
Sale

INVESTEE
INVESTEE
McGraw-Hill/Irwin

INVESTOR
INVESTOR
Upstream
Sale

INVESTEE
INVESTEE

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Slide
1-42

Unrealized Gains in Inventory

Lets look at an Investor that has 200
units of inventory with a cost of $1,000.

INVESTOR
INVESTOR

sells
sells200
200units
units
of
of inventory
inventory
with
withaatotal
total
cost
cost of
of $1,000.
$1,000.

McGraw-Hill/Irwin

Let us assume
that the Investor
sells the
inventory to a
20% owned
Investee for
$1,250.

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Slide
1-43

Unrealized Gains in Inventory

Lets
look
at anofInvestor
that has
200
Note
that
there
is
$250
intercompany
profit.
Note that there is $250 of intercompany profit. At
At
units of
inventory UNREALIZED.
with a cost of
this
thispoint
pointitit is
isconsidered
considered UNREALIZED.
$1,000.

INVESTOR
INVESTOR

sells
sells200
200units
units
of
of inventory
inventory
with
withaatotal
total
cost
cost of
of $1,000.
$1,000.

20% ownership
Intercompany
Sale of 200 units

INVESTEE
INVESTEE

buys
buys200
200units
units
of
ofinventory
inventoryand
and
pays
paysaa total
totalof
of
$1,250.
$1,250.

IfIf all
all200
200units
unitsare
arenot
not sold
soldto
toan
anoutside
outsideparty
party
during
duringthe
theperiod,
period,we
wewill
will need
need have
haveunrealized,
unrealized,
intercompany
intercompanyprofit
profit that
thatmust
mustbe
bedeferred.
deferred.
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Slide
1-44

Unrealized Gains in Inventory

60 of the original 200 units (30%) are still
unsold to a 3rd party. We must defer our
share (20%) of the original $250 of
intercompany profit that is unrealized (30%).

INVESTOR
INVESTOR

sells
sells200
200units
units
of
of inventory
inventory
with
withaatotal
total
cost
cost of
of $1,000.
$1,000.

20% ownership
Intercompany
Sale of 200 units

Outside Party
McGraw-Hill/Irwin

INVESTEE
INVESTEE

buys
buys200
200units
units
of
ofinventory
inventoryand
and
pays
paysaa total
totalof
of
$1,250.
$1,250.

Investee sells only

140 units to a 3rd
party

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Slide
1-45

Unrealized Gains in Inventory

Compute

the deferral by multiplying:

The

required journal (for both

upstream and downstream) is:

$250 30% 20% = $15

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Slide
1-46

Unrealized Gains in Inventory

In
Inthe
theperiod
periodfollowing
followingthe
theperiod
periodof
ofthe
the

transfer,
transfer,the
theremaining
remaininginventory
inventoryis
isoften
often
sold.
sold.

When
Whenthat
thathappens,
happens,the
theoriginal
originalentry
entryis
is
reversed
reversed......

The reversal takes place in the period that the

inventory is sold to an outside party.
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Slide
1-47

End of Chapter 1
And this is
only the
FIRST
chapter?!

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