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Updated Sixth Edition

CHAPTER

1
The Equity Method of Accounting for Investments

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Reporting Investments in Corporate Reporting Investments in Corporate Equity Securities Equity Securities
Three basic approaches Three basic approaches are allowed by GAAP: are allowed by GAAP: The Fair Value Method The Fair Value Method The Equity Method The Equity Method The Consolidation of The Consolidation of Financial Statements Financial Statements
Note: These 3 approaches are not interchangeable. The characteristics of each investment will dictate the appropriate accounting approach.

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Fair Value Method Fair Value Method

Used when influence is negligible. Used when influence is negligible. Initial Investment is recorded at Initial Investment is recorded at

cost. cost. Income is only realized to the extent Income is only realized to the extent of dividends received. of dividends received. Both Trading Securities and Both Trading Securities and Available-for-Sale Securities are Available-for-Sale Securities are carried at market value. carried at market value. SFAS No. 115 provides more SFAS No. 115 provides more details. details.

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Consolidation of Financial Consolidation of Financial Statements Statements

Governed by ARB No. 51 Governed by ARB No. 51

and APB Opinion 16. and APB Opinion 16. Required when investors Required when investors ownership exceeds 50% of ownership exceeds 50% of investee. investee. Control is presumed to Control is presumed to exist. exist. Covered later in the text. Covered later in the text.

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Equity Method Equity Method

The Equity Method is defined by The Equity Method is defined by

APB Opinion 18. APB Opinion 18. Requires that the investment is Requires that the investment is sufficient to insure significant sufficient to insure significant influence. influence. Generally used when ownership Generally used when ownership is between 20% & 50%. is between 20% & 50%.
smaller ownership percentages. smaller ownership percentages.

Influence can be present with much Influence can be present with much

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Criteria for Determining Whether Criteria for Determining Whether There is Influence There is Influence
Representation on the investees Board of Representation on the investees Board of Directors Directors Participation in the investees policyParticipation in the investees policymaking process making process Material intercompany transactions. Material intercompany transactions. Interchange of managerial personnel. Interchange of managerial personnel. Technological dependency. Technological dependency. Extent of ownership in relationship to Extent of ownership in relationship to other ownership percentages. other ownership percentages.

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The Significance of the Size of the The Significance of the Size of the Investment Investment
Investor Ownership of Investee Shares Outstanding Fair Value Equity Method 20% Consolidated Financial Statements 50% 100%

0%

In some cases, influence or control may In some cases, influence or control may exist with less than 20% ownership. exist with less than 20% ownership.

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The Significance of the Size of the The Significance of the Size of the Investment Investment
Investor Ownership of Investee Shares Outstanding Fair Value 0% 20% Equity Method Consolidated Financial Statements 50% 100%

Significant influence is generally Significant influence is generally assumed with 20% to 50% assumed with 20% to 50% ownership. ownership.

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Equity Method Equity Method

Step 1: The investor records its investment in the investee at cost.

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Equity Method 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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Equity Method Equity Method

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

This will appear as a separate This will appear as a separate line-item on the investors line-item on the investors income statement. income statement.

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Equity Method Equity Method

Step 3: The investor reduces its investment account for its proportionate share of the investees dividends.

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Lets do an equity method example.

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Equity Method Example Equity Method Example

On January 1, 2003, Big Corp. buys 20% of Small Inc. for $2,000,000 cash. Record Bigs journal entry.

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Equity Method Example Equity Method Example

On December 31, 2003, Small reports net income for the year of $300,000. Record Bigs journal entry.

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Equity Method Example Equity Method Example

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

60,000

60,000

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Equity Method Example Equity Method Example

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

60,000

25,000

25,000

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Special Procedures for Special Special Procedures for Special Situations Situations
Reporting a Reporting a change to change to the equity the equity method. method. Reporting the sale Reporting the sale of an equity of an equity investment. investment.

Reporting investee Reporting investee income from sources income from sources other than continuing other than continuing operations. operations.

Reporting Reporting investee investee losses. losses.

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Reporting a change to the equity Reporting a change to the equity method. 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 accounts are restated so that the investors all accounts are restated so that the investors financial statements appear as if the equity method financial statements appear as if the equity method had been applied from the date of the first [original] had been applied from the date of the first [original] acquisition. ----APB Opinion 18 acquisition. APB Opinion 18

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Reporting Investee Income from Reporting Investee Income from Other Sources 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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Reporting Investee Income from Reporting Investee Income from Other Sources Other Sources
Big owns 30% of Little. Little reports net income Big owns 30% of Little. Little reports net income for 2003 of $40,000. That includes Operating for 2003 of $40,000. That includes Operating income of $45,000 and an extraordinary loss of income of $45,000 and an extraordinary loss of $5,000. $5,000. Bigs equity method entry at year-end is: Bigs equity method entry at year-end is:

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Reporting Investee Losses Reporting Investee Losses

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

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Reporting Investee Losses Reporting Investee Losses

Investment Reduced to Zero Investment Reduced to Zero
When the accumulated losses When the accumulated losses

incurred by the investee and incurred by the investee and dividends paid by the investee dividends paid by the investee reduce the investment account to reduce the investment account to zero, NO ADDITIONAL LOSSES zero, NO ADDITIONAL LOSSES are accrued. are accrued. The balance remains at $0, until The balance remains at $0, until subsequent profits eliminate all subsequent profits eliminate all UNRECORDED losses. UNRECORDED losses.

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Reporting the Sale of an Equity Reporting the Sale of an Equity Investment Investment
If part of an investment is sold during the period . . .
The equity method continues to be applied The equity method continues to be applied

up to the date of the transaction. up to the date of the transaction. At the transaction date, a proportionate At the transaction date, a proportionate amount of the Investment account is amount of the Investment account is removed. removed. If significant influence is lost, NO If significant influence is lost, NO RETROACTIVE ADJUSTMENT is recorded. RETROACTIVE ADJUSTMENT is recorded.

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Reporting the Sale of an Equity Reporting the Sale of an Equity Investment Investment
Big owns 30% (300,000 shares) of Little. As of December Big owns 30% (300,000 shares) of Little. As of December 31, 2002, the Investment account is at $250,000. Little 31, 2002, the Investment account is at $250,000. Little reports net income for the first quarter of 2003 of reports net income for the first quarter of 2003 of $60,000. $60,000. What is Bigs entry at 3/31/03? What is Bigs entry at 3/31/03?

$60,000 30% = $18,000

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Reporting the Sale of an Equity Reporting the Sale of an Equity Investment Investment
Big sells 30,000 shares (10% of their investment) on April Big sells 30,000 shares (10% of their investment) on April 1, 2003 for $100,000. 1, 2003 for $100,000. What is Bigs entry at 4/1/03? What is Bigs entry at 4/1/03?

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

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Excess of Cost Over BV Acquired Excess of Cost Over BV Acquired

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

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Excess of Cost Over BV Acquired Excess of Cost Over BV Acquired

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.

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Excess of Cost Over BV Excess of Cost Over BV Example Example

Recall, on January 1, 2003, Big Corp. Recall, on January 1, 2003, Big Corp.

acquired 20% of Small Inc. for acquired 20% of Small Inc. for $2,000,000 cash. $2,000,000 cash. Assume that Smalls assets had BV Assume that Smalls assets had BV on January 1 of $8,500,000. Small on January 1 of $8,500,000. Small owns a building with a BV of $500,000, owns a building with a BV of $500,000, and a FMV of $700,000, and a and a FMV of $700,000, and a remaining useful life of 10 years. All remaining useful life of 10 years. All other assets had BV = FMV. other assets had BV = FMV. Compute the Goodwill acquired by Compute the Goodwill acquired by Big. Big.

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Excess of Cost Over BV Excess of Cost Over BV Example Example

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Excess of Cost Over BV Excess of Cost Over BV Example Example

Bigs equity Bigs equity method entry will method entry will include an include an adjustment to the adjustment to the investment investment account of $4,000. account of $4,000.

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Amortization of Cost Over BV Amortization of Cost Over BV Example Example

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Lets look at some intercompany transactions.

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Unrealized Gains in Inventory Unrealized Gains in Inventory

Sometimes affiliated companies sell or buy inventory from each other.

INVESTOR INVESTOR
Downstream Sale

INVESTOR INVESTOR
Upstream Sale

INVESTEE INVESTEE

INVESTEE INVESTEE

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Unrealized Gains in Inventory Unrealized Gains in Inventory

If all the inventory is sold to an outside party during the period, all of the profit is real.
sells 200 units sells 200 units of inventory of inventory with a total cost with a total cost of $1,000. of $1,000.

INVESTOR INVESTOR

20% ownership Intercompany Sale of 200 units

buys 200 units buys 200 units of inventory and of inventory and pays a total of pays a total of $1,250. $1,250.

INVESTEE INVESTEE

Investee sells 200 units for $1,500.

Outside Party

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Unrealized Gains in Inventory Unrealized Gains in Inventory

If any of the inventory is still unsold If any of the inventory is still unsold

at the end of the period, some of the at the end of the period, some of the intercompany profits, or unrealized intercompany profits, or unrealized gains, are still on the books. gains, are still on the books. These unrealized gains must be pro These unrealized gains must be prorated based on the investors rated based on the investors ownership percentage and ownership percentage and eliminated from the consolidated eliminated from the consolidated books. books.

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Unrealized Gains in Inventory Unrealized Gains in Inventory

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

INVESTOR INVESTOR

20% ownership Intercompany Sale of 200 units

buys 200 units buys 200 units of inventory and of inventory and pays a total of pays a total of $1,250. $1,250.

INVESTEE INVESTEE

Investee sells only 160 units for $1,200

Outside Party

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Unrealized Gains in Inventory Unrealized Gains in Inventory

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

INVESTOR INVESTOR

30% ownership Intercompany Sale of 200 units

buys 200 units buys 200 units X of inventory and of inventory and pays a total of pays a total of $1,250. $1,250.

INVESTEE INVESTEE

20% of the original units are still 20% of the original units are still unsold to an outside party. unsold to an outside party. Therefore, 20% of the original $250 Therefore, 20% of the original $250 of intercompany profit is still of intercompany profit is still unrealized at the end of the period unrealized at the end of the period (i.e. sold to an outside party. (i.e. sold to an outside party.

There are still 40 There are still 40 units (20%) in the units (20%) in the Investees Investees inventory! inventory!

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Unrealized Gains in Inventory Unrealized Gains in Inventory

We

must defer our share (20%) of the $50 in unrealized intercompany profit. The required journal is:

$50 .20% = $10

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Unrealized Gains in Inventory Unrealized Gains in Inventory

In the period following the period of the In the period following the period of the

transfer, the remaining inventory is often sold. transfer, the remaining inventory is often sold. When that happens, the original entry is When that happens, the original entry is reversed .. .. .. reversed

This entry will be reversed in the period that the inventory is sold to an outside party.

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End of Chapter 1 End of Chapter 1

And this is only the FIRST chapter?!

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