Advanced Accounting 11ed Chapter 1 PowerPoints

Accounting for Investments in Corporate Equity SecuritiesGAAP recognizes 3 ways to report investments in other companies: Fair-Value MethodConsolidationEquity MethodThe method selected depends upon the degree of influence the investor has over the investee.LO 11-*

2

At present, generally accepted accounting principles (GAAP) recognize three different approaches to the financial reporting of investments in corporate equity securities: The fair-value method. The consolidation of financial statements. The equity method.The financial statement reporting for a particular investment depends primarily on the degree of influence that the investor (stockholder) has over the investee, a factor typically indicated by the relative size of ownership.1 Because voting power typically accompanies ownership of equity shares, influence increases with the relative size of ownership. The resulting influence can be very little, a significant amount, or, in some cases, complete control.

Fair Value MethodUse when:investor holds a small percentage (usually less than 20%) of equity securities of investee

Investor cannot significantly affect investees operations

Investment is made in anticipation

of dividends or market appreciation.1-*

3

In many instances, an investor possesses only a small percentage (usually less than 20%) of an investee companys outstanding stock, perhaps only a few shares. Because of the limited level of ownership, the investor cannot expect to significantly affect the investees operations or decision making. Theseshares are bought in anticipation of cash dividends or in appreciation of stock market values.Such investments are recorded at cost and periodically adjusted to fair value according to theFinancial Accounting Standards Board (FASB) Accounting Standards Codification (ASC)Topic 320, InvestmentsDebt and Equity Securities.

Consolidation of Financial StatementsRequired when: Investors ownership exceeds 50% of

investee

except when control does not rest with

the majority investor

One set of financial statements prepared

to consolidate all accounts of the parent company and all of its controlled subsidiaries AS A SINGLE ENTITY.

1-*1-*

4

Consolidation of Financial Statements is required when Investors ownership exceeds 50% of investee except when control does not rest with the majority investor. One set of financial statements is prepared to consolidate all accounts of the parent company and all of its controlled subsidiaries AS A SINGLE ENTITY.

Equity MethodUse when: Investor has the ability to exercise

significant influence on the investee operations (whether influence is applied or not)

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

Significant Influence might be present

with much lower ownership percentages. 1-*LO 21-*

5

The equity method is used when the investor has the ability to exercise significant influence on the investee operations (whether influence is applied or not). It is generally used when ownership is between 20% and 50%. Significant Influence might be present with much lower ownership percentages.

What is Significant Influence? (FASB ASC Topic 323)Representation on the investees Board of Directors

Participation in the investees policy-making process

Material intra-entity transactions

Interchange of managerial personnel

Technological dependency

Other investor ownership percentages

1-*1-*

6

FASB ASC Topic 323 provides guidance to the accountant by listing several conditions that indicate the presence of this degree of influence: Investor representation on the board of directors of the investee. Investor participation in the policymaking process of the investee. Material intercompany transactions. Interchange of managerial personnel. Technological dependency. Extent of ownership by the investor in relation to the size and concentration of other ownershipinterests in the investee.No single one of these guides should be used.

0%20%50%100%Fair ValueEquity MethodConsolidated Financial StatementsGeneral Ownership GuidelinesSignificant influence generally assumed (20% to 50% ownership).Usually lack of control or significant influence.Financial statements of all related companies must be consolidated.1-*

8

The Fair Value or Cost method is used to account for the investment with less than 20% ownership, and the investor lacks the ability to significantly influence the investee. With the ability to significantly influence, 20%50% ownership, the equity method is used.

With control, more than 50% ownership, the investor prepares Consolidated financial statements.

Fair ValueEquity MethodConsolidated Financial StatementsGeneral Reporting Guidelines1: Same as Fair Value2: Investor recognizes its share (% of owner-ship) of investees net income (net loss) as an increase (decrease) in the investment account and 3. Records dividends as a decrease.1. Investor records investment at cost. 2. Investor recognizes cash dividends from investee as income.One set of financial statements are prepared to combine accounts of the investor and all of its investees AS A SINGLE ENTITY. LO 31-*

8



Equity Method AppliedStep 1 Investment in Investee XXXX Cash (or other Assets/Stock) XXXX Step 2 Debit CreditInvestment in InvesteeXXXXEquity in Investee Income XXXX

If net loss: Debit CreditEquity in Investee IncomeXXXX Investment in Investee XXXX1-*1-*

11

To record net income, debit the Investment in Investee account, and credit the Equity in Investee Income for the investors share of the investees income. To record a net loss, debit the Equity in Investee Income account, and credit the Investment in Investee account for the investors share of the investees net loss. Record as a separate line-item on investors income statement.

Equity Method Applied(Continued)Step 3: Investor reduces the investment account by the amount of cash dividends received from the investee.

Debit CreditCashXXXXInvestment in Investee XXXX1-*1-*

13

Investor reduces the investment account by the amount of cash dividends received from the investee. Debit the Cash account, and credit the Investment in Investee account.

Reporting a Change to the Equity MethodReport a change to the equity method if:An investment that was recorded using the fair-value method reaches the point where significant influence is established.

All accounts are restated retroactively so the investors financial statements appear as if the equity method had been applied from the date of the first acquisition. (FASB ASC para. 323-10-35-33)

1-*1-*

An investment that is too small to have significant influence is recorded using the fair-value method, until ownership reaches the point where significant influence is established, then all accounts are restated retroactively so the investors financial statements appear as if the equity method had been applied from the date of the first acquisition. (FASB ASC para. 323-10-35-33)

Reporting a Change to the Equity Method (Retroactive Adjustment)Giant Company acquires a 10% ownership in Small Company on January 1, 2012.

Giant company does not have the ability to exert significant influence over Small.

Giant properly records the investment using the fair-value method as an available-for-sale security.

On January 1, 2014, Giant purchases another 30% of Smalls outstanding stock, thereby achieving the ability to significantly influence Smalls decisions.

1-*1-*

Giant Company acquires a 10% ownership in Small Company on January 1, 2012. Giant company does not have the ability to exert significant influence over Small. Giant properly records the investment using the fair-value method as an available-for-sale security. On January 1, 2014, Giant purchases another 30% of Smalls outstanding stock, thereby achieving the ability to significantly influence Smalls decisions.

Reporting a Change to the Equity Method (Retroactive Adjustment)1-*The income restatement for these earlier years can be computed as follows:Would have reported under the equity methodDid report under the fair-market value method1-*

YearEquity in Investee Income (10%)Income Reported from DividendsRetrospective Adjustment2012$7,000$2,000$5,000201311,0004,0007,000Total Adjustment to Retained Earnings:$12,000

The income restatement for these earlier years can be computed as follows:

Equity in Investee Income Reported Retrospective Income (10%) from Dividends Adjustment2012 $7,000 $2,000 $5,000 11,000 4,000 7,000

Total Adjustment to Retained Earnings: $12,000

Journal Entries to Report Change to Equity Method Debit CreditInvestment in Small Company . . . . . . . . . . . . . . . . . 12,000 Retained Earnings - Prior Period Adjustment- Equity in Investee Income . . . . . . . . . . . . . . . . . . . . . . . 12,000 To adjust 2012 and 2013 records so that investment is accounted for using the equity method in a consistent manner.

Unrealized Holding Gain-Shareholders Equity. . . . .13,000 Fair Value Adjustment (Available-for-Sale). . . . . . . . .13,000 To remove the investors percentage of the increase in fair value (10% $130,000) from stockholders equity and the available-for-sale portfolio valuation account.1-*

Journal Entries to Report Change to Equity Method:

Debit CreditInvestment in Small Company . . . . . . . . . . . . . . . . . 12,000 Retained Earnings - Prior Period Adjustment- Equity in Investee Income . . . . . . . . . . . . . . . . . . . . . . . 12,000To adjust 2012 and 2013 records so that investment is accounted for using the equity method in a consistent manner.

Unrealized Holding Gain-Shareholders Equity. . . . . . . . 13,000 Fair Value Adjustment (Available-for-Sale). . . . . . . . . . . . .13,000 To remove the investors percentage of the increase in fair value (10% $130,000) from stockholders equity and the available-for-sale portfolio valuation account.

Reporting Investee Income from Sources other than OperationsWhen net income includes elements other than Operating Income, these elements should be presented separately on the investors income statement.

Examples include:Discontinued operationsExtraordinary itemsOther comprehensive income

1-*1-*

When net income includes elements other than Operating Income, these elements should be presented separately on the investors income statement.


Reporting Investee Income from Other Sources Large Company owns 40% of the voting stock of Tiny Company and accounts for this investment using the equity method. In 2012, Tiny reports net income of $200,000, resulting from $250,000 in income from continuing operations and a $50,000 extraordinary loss. Large Company increases the value of its investment by $80,000, based on 40% of the $200,000 net figure.

Larges Equity Method entry at year-end is:1-* Debit CreditInvestment in Tiny Company . . . . . . . . . . . 80,000Extraordinary Loss of Investee. . . . . . . . . . .20,000Equity in Investee Income . . . . . . . . . . . . . . . . . . . . . . .100,000To accrue operating income and extraordinary loss from equity investment.1-*

Large Company owns 40% of the voting stock of Tiny Company and accounts for this investment using the equity method. In 2012, Tiny reports net income of $200,000, resulting from $250,000 in income from continuing operations and a $50,000 extraordinary loss. Large Company increases the value of its investment by $80,000, based on 40% of the $200,000 net figure.

Larges Equity Method entry at year-end is: Debit CreditInvestment in Tiny Company . . . . . . . . . . . 80,000Extraordinary Loss of Investee. . . . . . . . . . . 20,000 Equity in Investee Income . . . . . . . . . . . . . . . . . . .100,000To accrue operating income and extraordinary loss from equity investment.

Reporting Investee LossesA permanent decline in the investees fair market value is recorded as an impairment loss and the investment account is reduced to the fair value.A temporary decline is ignored!!!1-*

When a permanent decline in an equity method investments value occurs, the investormust recognize an impairment loss and reduce the asset to fair value. However, this lossmust be permanent before such recognition becomes necessary. Under the equity method, a temporary drop in the fair value of an investment is simply ignored.

Reporting Investee Losses(Continued)Investment Reduced to ZeroWhen accumulated losses incurred and dividends paid by the investee reduce the investment account to $-0-, NO ADDITIONAL LOSSES are accrued (unless a further commitment has been made).

Balance remains at $-0-, until subsequent profits eliminate all UNREALIZED losses.

Investor discontinues using the equity method rather than record a negative balance.1-*1-*

When an investment account is reduced to zero, the investor should discontinue using the equity method rather than establish a negative balance. The investment retains a zero balance until subsequent investee profits eliminate all unrealized losses. Once the original cost of the investment has been eliminated, no additional losses can accrue to the investor (since the entire cost has been written off ) unless some further commitment has been made on behalf of the investee.

Excess of Cost Over Book Value of Acquired InvestmentWhen Cost > Book Value of an investment acquired, the difference must be identified.1-*LO 4 Assets may be undervalued on the investees books because:

The fair values (FV) of some assets and liabilities are different than their book values (BV).

The investor may be willing to pay extra because future benefits are expected to accrue from the investment.

1-*

21

When Cost > Book Value of asset acquired, the difference must be identified.Assets may be undervalued on the investees books because:The fair values (FV) of specific assets and liabilities are different than their book values (BV).The investor may be willing to pay extra because future benefits are expected to accrue from the investment.

When Cost > BV of asset acquired, the difference must be identified and accounted for correctly in the accounting records.1-*Source of difference:Assets undervalued on the investees book

Goodwill

Accounting method:Amortize the difference (FV BV) over the remaining useful life of the associated asset.Goodwill is carried forward without adjustment until the investment is sold or a permanent decline in value of the investment occurs.Excess of Cost Over Book Value (Continued)1-*

21

When Cost > BV of asset acquired, the difference must be identified and accounted for correctly in the accounting records. For undervalued assets on the investees books, the investor will amortize the difference (FV BV) over the remaining useful life of the assets. The excess of FV over BV, after assigning FV to the assets, will be assigned to an intangible asset, Goodwill. Goodwill is carried forward without adjustment until the investment is sold or a permanent decline in the value of the investment occurs.

Excess of Cost Over Book Value (Continued)

1-*ADDITIONAL amount paid in excess of book value not allocated to undervalued assets is attributed to an intangible future value and recorded as GOODWILL Equity method goodwill accounts are not separable from the investment, and are not separately tested for impairment. 1-*

26

ADDITIONAL amounts paid in excess of book value not allocated to undervalued assets is attributed to an intangible future value and recorded as Goodwill. Equity method goodwill accounts are not separable from the investment, and are not separately tested for impairment.

Reporting Sale of Equity InvestmentThe equity method continues to be applied up to the date of the transaction.

At the transaction date, the Investment account balance is reduced by the percentage of shares sold.

If significant influence is lost, NO RETROACTIVE ADJUSTMENT is recorded, but the equity method is no longer applied. If part of an investment is sold during the period: LO 51-*

At any time, the investor can choose to sell part or all of its holdings in the investee company. If a sale occurs, the equity method continues to be applied until the transaction date, thus establishing an appropriate carrying value for the investment. The investor then reduces this balance by the percentage of shares being sold. After the sale is completed, the investor continues to apply the equity method to this investment based on the new percentage of ownership. However, if the sale had been of sufficientmagnitude to cause the investor to lose its ability to exercise significant influence over the investee, the equity method ceases to be applicable. ADD : No retroactive adjustment is recorded

Reporting the Sale of an Equity Investment (Continued)Top Company owns 40% of the 100,000 outstanding shares of Bottom Co., and accounts for it using the equity method.

The 40,000 shares were acquired for $200,000, and under the equity method, the asset balance increased to $320,000 as of January 1, 2012.

Bottom Company reported income of $70,000 during the first six months of 2012 and distributed cash dividends of $30,000.

1-*1-*

Top Company owns 40% of the 100,000 outstanding shares of Bottom Co., and accounts for it using the equity method. The 40,000 shares were acquired for $200,000, and under the equity method, the asset balance increased to $320,000 as of January 1, 2012. Bottom Company reported income of $70,000 during the first six months of 2012 and distributed cash dividends of $30,000.

Reporting the Sale of an Equity Investment (Continued)On July 1, 2012, Top sells 10,000 of the shares (1/4 of its investment) for $110,000 in cash, reducing ownership in Bottom from 40% to 30%.

1-* Debit CreditCash . . . . . . . . . . . . . . . . . . . . . . . . . . 110,000 Investment in Bottom Company . . . . . . . . .84,000 Gain on Sale of Investment. . . . . . . . . . . . . .26,000To record the sale of of the investment. (14 X $336,000 = $84,000).1-*

On July 1, 2012, Top sells 10,000 of the shares (1/4 of its investment) for $110,000 in cash, reducing ownership in Bottom from 40% to 30%. The investor debits the cash account for $110,000 and credits a gain on the sale of investment for $26,000, credits the investment in Bottom Company for $84,000 to record the sale of of the investment.

Downstream SaleUpstream SaleUnrealized Profits in InventorySometimes affiliated companies sell or buy inventory from each other in intra-entity transactions that necessitate special accounting procedures.1-*LO 61-*

28

Sometimes affiliated companies sell or buy inventory from each other in intra-entity transactions that necessitate special accounting procedures. When the investor sells to the investee, it is called a downstream sale. When the investee sells to the investor, it is called an upstream sale.

Unrealized Profits in InventoryThe seller of the goods retains a partial stake in the inventory for as long as the buyer holds it.

The earning process is not considered complete at the time of the original sale.

Reporting the profit is delayed until the inventory is consumed within operations or resold to an unrelated party.

At the disposition of the inventory, the original sale is culminated and gross profit is recognized.1-*1-*

29

The seller of the goods retains a partial stake in the inventory for as long as the buyer holds it. The earning process is not considered complete at the time of the original sale. Reporting the profit is delayed until the inventory is consumed within operations or resold to an unrelated party. At the disposition of the inventory, the original sale is culminated and gross profit is recognized.

Criticisms of the Equity MethodOver-emphasis on possession of 20-50% voting stock in deciding on significant influence vs. control

Allowing off-balance sheet financing

Potential manipulation of performance ratios

1-*1-*

Over the past several decades, thousands of business firms have accounted for their investments using the equity method. Recently, however, the equity method has come under criticism for the following: Emphasizing the 2050 percent of voting stock in determining significant influence versus control. Allowing off-balance sheet financing. Potentially biasing performance ratios.

2

At present, generally accepted accounting principles (GAAP) recognize three different approaches to the financial reporting of investments in corporate equity securities: The fair-value method. The consolidation of financial statements. The equity method.The financial statement reporting for a particular investment depends primarily on the degree of influence that the investor (stockholder) has over the investee, a factor typically indicated by the relative size of ownership.1 Because voting power typically accompanies ownership of equity shares, influence increases with the relative size of ownership. The resulting influence can be very little, a significant amount, or, in some cases, complete control.

3

In many instances, an investor possesses only a small percentage (usually less than 20%) of an investee companys outstanding stock, perhaps only a few shares. Because of the limited level of ownership, the investor cannot expect to significantly affect the investees operations or decision making. Theseshares are bought in anticipation of cash dividends or in appreciation of stock market values.Such investments are recorded at cost and periodically adjusted to fair value according to theFinancial Accounting Standards Board (FASB) Accounting Standards Codification (ASC)Topic 320, InvestmentsDebt and Equity Securities.

4

Consolidation of Financial Statements is required when Investors ownership exceeds 50% of investee except when control does not rest with the majority investor. One set of financial statements is prepared to consolidate all accounts of the parent company and all of its controlled subsidiaries AS A SINGLE ENTITY.

5

The equity method is used when the investor has the ability to exercise significant influence on the investee operations (whether influence is applied or not). It is generally used when ownership is between 20% and 50%. Significant Influence might be present with much lower ownership percentages.

6

FASB ASC Topic 323 provides guidance to the accountant by listing several conditions that indicate the presence of this degree of influence: Investor representation on the board of directors of the investee. Investor participation in the policymaking process of the investee. Material intercompany transactions. Interchange of managerial personnel. Technological dependency. Extent of ownership by the investor in relation to the size and concentration of other ownershipinterests in the investee.No single one of these guides should be used.

8



8



11

To record net income, debit the Investment in Investee account, and credit the Equity in Investee Income for the investors share of the investees income. To record a net loss, debit the Equity in Investee Income account, and credit the Investment in Investee account for the investors share of the investees net loss. Record as a separate line-item on investors income statement.

13

Investor reduces the investment account by the amount of cash dividends received from the investee. Debit the Cash account, and credit the Investment in Investee account. An investment that is too small to have significant influence is recorded using the fair-value method, until ownership reaches the point where significant influence is established, then all accounts are restated retroactively so the investors financial statements appear as if the equity method had been applied from the date of the first acquisition. (FASB ASC para. 323-10-35-33)

Giant Company acquires a 10% ownership in Small Company on January 1, 2012. Giant company does not have the ability to exert significant influence over Small. Giant properly records the investment using the fair-value method as an available-for-sale security. On January 1, 2014, Giant purchases another 30% of Smalls outstanding stock, thereby achieving the ability to significantly influence Smalls decisions.The income restatement for these earlier years can be computed as follows:

Equity in Investee Income Reported Retrospective Income (10%) from Dividends Adjustment2012 $7,000 $2,000 $5,000 11,000 4,000 7,000

Total Adjustment to Retained Earnings: $12,000Journal Entries to Report Change to Equity Method:

Debit CreditInvestment in Small Company . . . . . . . . . . . . . . . . . 12,000 Retained Earnings - Prior Period Adjustment- Equity in Investee Income . . . . . . . . . . . . . . . . . . . . . . . 12,000To adjust 2012 and 2013 records so that investment is accounted for using the equity method in a consistent manner.

Unrealized Holding Gain-Shareholders Equity. . . . . . . . 13,000 Fair Value Adjustment (Available-for-Sale). . . . . . . . . . . . .13,000 To remove the investors percentage of the increase in fair value (10% $130,000) from stockholders equity and the available-for-sale portfolio valuation account.When net income includes elements other than Operating Income, these elements should be presented separately on the investors income statement.


Large Company owns 40% of the voting stock of Tiny Company and accounts for this investment using the equity method. In 2012, Tiny reports net income of $200,000, resulting from $250,000 in income from continuing operations and a $50,000 extraordinary loss. Large Company increases the value of its investment by $80,000, based on 40% of the $200,000 net figure.

Larges Equity Method entry at year-end is: Debit CreditInvestment in Tiny Company . . . . . . . . . . . 80,000Extraordinary Loss of Investee. . . . . . . . . . . 20,000 Equity in Investee Income . . . . . . . . . . . . . . . . . . .100,000To accrue operating income and extraordinary loss from equity investment.When a permanent decline in an equity method investments value occurs, the investormust recognize an impairment loss and reduce the asset to fair value. However, this lossmust be permanent before such recognition becomes necessary. Under the equity method, a temporary drop in the fair value of an investment is simply ignored.When an investment account is reduced to zero, the investor should discontinue using the equity method rather than establish a negative balance. The investment retains a zero balance until subsequent investee profits eliminate all unrealized losses. Once the original cost of the investment has been eliminated, no additional losses can accrue to the investor (since the entire cost has been written off ) unless some further commitment has been made on behalf of the investee.

21

When Cost > Book Value of asset acquired, the difference must be identified.Assets may be undervalued on the investees books because:The fair values (FV) of specific assets and liabilities are different than their book values (BV).The investor may be willing to pay extra because future benefits are expected to accrue from the investment.

21

When Cost > BV of asset acquired, the difference must be identified and accounted for correctly in the accounting records. For undervalued assets on the investees books, the investor will amortize the difference (FV BV) over the remaining useful life of the assets. The excess of FV over BV, after assigning FV to the assets, will be assigned to an intangible asset, Goodwill. Goodwill is carried forward without adjustment until the investment is sold or a permanent decline in the value of the investment occurs.

26

ADDITIONAL amounts paid in excess of book value not allocated to undervalued assets is attributed to an intangible future value and recorded as Goodwill. Equity method goodwill accounts are not separable from the investment, and are not separately tested for impairment. At any time, the investor can choose to sell part or all of its holdings in the investee company. If a sale occurs, the equity method continues to be applied until the transaction date, thus establishing an appropriate carrying value for the investment. The investor then reduces this balance by the percentage of shares being sold. After the sale is completed, the investor continues to apply the equity method to this investment based on the new percentage of ownership. However, if the sale had been of sufficientmagnitude to cause the investor to lose its ability to exercise significant influence over the investee, the equity method ceases to be applicable. ADD : No retroactive adjustment is recordedTop Company owns 40% of the 100,000 outstanding shares of Bottom Co., and accounts for it using the equity method. The 40,000 shares were acquired for $200,000, and under the equity method, the asset balance increased to $320,000 as of January 1, 2012. Bottom Company reported income of $70,000 during the first six months of 2012 and distributed cash dividends of $30,000.

On July 1, 2012, Top sells 10,000 of the shares (1/4 of its investment) for $110,000 in cash, reducing ownership in Bottom from 40% to 30%. The investor debits the cash account for $110,000 and credits a gain on the sale of investment for $26,000, credits the investment in Bottom Company for $84,000 to record the sale of of the investment.

28

Sometimes affiliated companies sell or buy inventory from each other in intra-entity transactions that necessitate special accounting procedures. When the investor sells to the investee, it is called a downstream sale. When the investee sells to the investor, it is called an upstream sale.

29

The seller of the goods retains a partial stake in the inventory for as long as the buyer holds it. The earning process is not considered complete at the time of the original sale. Reporting the profit is delayed until the inventory is consumed within operations or resold to an unrelated party. At the disposition of the inventory, the original sale is culminated and gross profit is recognized.Over the past several decades, thousands of business firms have accounted for their investments using the equity method. Recently, however, the equity method has come under criticism for the following: Emphasizing the 2050 percent of voting stock in determining significant influence versus control. Allowing off-balance sheet financing. Potentially biasing performance ratios.

Documents

Advanced Accounting 11ed Chapter 1 PowerPoints