Advanced Accounting by Hoyle et al, 6th Edition
Chapter OneThe Equity Method of Accounting for Investments
Copyright 2015 McGraw-Hill Education. All rights reserved. No
reproduction or distribution without the prior written consent of
McGraw-Hill Education.Reporting Investments in Corporate Equity
SecuritiesGAAP recognizes 3 ways to report investments in other
companies: Fair-Value MethodConsolidationEquity Method
The method is selected based upon the degree of influence the
investor has over the investee.
2Fair Value MethodUsed when the investor holds a small
percentage of the investees outstanding stock, and is not able to
significantly affect the investees operations.Investment is made in
anticipationof dividends and/or market appreciation.Investments
will be classified as either Trading Securities or
Available-for-Sale Securities.3Fair Value Method (Trading vs
Available-for-Sale)Trading Securities Held for sale in the short
term. Unrealized holding gains and losses are included in earnings
(net income).Available-for-Sale Securities Any Securities not
classified as Trading.Unrealized holding gains and losses are
reported in shareholders equity as other comprehensive income (ie,
not included in net income).3Consolidation of Financial
StatementsRequired when the investors ownership exceeds 50% of
investee, except where control does not actually rest with the
majority investorContractual agreementsBankruptciesGovernment
restrictionsOne set of financial statements is prepared which
consolidates all accounts of the parent company and all of its
controlled subsidiary companies, as though they were a single
entity.4Consolidation SPECIAL!!!! FASB ASC Subsection 810-10-65,
Variable Interest Entities, expands the use of consolidated
financial statements: includes entities that are controlled through
special contractual arrangements (rather than through voting stock
interests). Intended to combat misuse of SPEs (Special Purpose
Entities) by firms like EnronPart of the accounting defense against
off balance sheet financingEquity MethodUsed when the investor has
the ability to exercise significant influence on theinvestee
operationsGenerally used when ownership is between 20% and
50%.Significant Influence might be present with much lower
ownership percentages. (The accountant must consider the
particulars!!!)5What is Significant Influence?? (FASB ASC Section
323)Representation on the investees Board of DirectorsParticipation
in the investees policy-making processMaterial intercompany
transactionsInterchange of managerial personnelTechnological
dependencyExtent of ownership inrelation to other investor
ownership percentages1-86CategoryValuationUnrealized HoldingOther
IncomeGains and LossesEffects BV acquired, the difference must be
identified.
21Excess of Cost Over BV Acquired(Continued)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.
1-3522Excess of Cost Over BV - ExampleBig Company is negotiating
the acquisition of 30% of the outstanding shares of Little Company.
Littles balance sheet reports assets of $500,000 and liabilities of
$300,000 for a net book value of $200,000. Upon review, Big
determines that Littles equipment is undervalued in the financial
records by $60,000, and of its patents is also undervalued, but
only by $40,000.
How much should Big offer Little??23Investment NBV Equipment
Patent Acq. Cost 200,000 +60,000 +40,000 = 300,000 *0.3 60,000
+18,000 + 12,000 = 90,000Excess of Cost Over BV - Example
SolutionBy adding these valuation adjustments to Littles book
value, Big arrives at an estimated $300,000 worth for the companys
net assets. Based on this computation, Big should offer $90,000 for
a 30% share of the investees outstanding stock.23Excess of Cost
Over BV Example AmortizationPayment by investor . . . . . . . . . .
. . . . . . . . . $90,000Percentage of book value acquired
($200,000 30%) . . . . . . . . . . . . . . 60,000Payment in excess
of book value . . . . . . . . . . . 30,000
Excess payment identified with specific assets:Equipment (30% of
$60,000 undervalued). . .$18,000Patent (30% of $40,000 undervalued)
. . . . . . . 12,000 30,000Excess payment not identified with
specific assetsgoodwill . . . . . . . . . . . . . . 01-3824
Amortization of Cost Over BV Example Amortization
(Continued)
1-39At the end, Equity in Investee Income balance is Investees
NI*% -4,200. Investment in Investee is Beg. Balance + Equty in
Investee Income Investees Dividend*%26Amortization of Cost Over BV
Example Amortization (Continued)Note, that any ADDITIONAL amount
paid in excess of the book value of $90,000 would be the cost of
the goodwill purchased and would not be amortized like the other
assets.
1-4026INVESTORINVESTEEINVESTORINVESTEEDownstream SaleUpstream
SaleUnrealized Gains in InventorySometimes affiliated companies
sell or buy inventory from each other.28Unrealized Gains in
InventoryExampleLets look at an Investor that has 200 units of
inventory with a cost of $1,000.Let us assume that the Investor
sells the inventory to a 20% owned Investee for $1,250. Note that
there is $250 of intercompany profit. At this point it is
considered UNREALIZED because we are reporting as a
SINGLE-ENTITY.We will DEFER this profit in the financial reports
until the goods are sold to an OUTSIDE PARTY.
1-4229INVESTEE buys inventory and pays a total of $1,250 to
investor.20% ownershipUnrealized Gains in InventoryExample
(Continued)INVESTOR sells 200 units of inventory with original cost
of $1,000.If 60 of the original 200 units (30%) remain unsold to an
outside party, we must defer our share (20%) of the original $250
of intercompany profit that is unrealized (30%).Investee sells only
140 units to an outside party
Outside Party1-4329
Unrealized Gains in InventoryExample (Continued)Compute the
deferral by multiplying:
The required journal entry is:$250 30% 20% = $15
At the end, Equity in Investee Income balance is Investees NI*%
-15. Investment in Investee is Beg. Balance + Equty in Investee
Income Investees Dividend*%33Unrealized Gains in InventoryExample
(Continued)In the period following the period of the transfer, the
remaining inventory is often sold.When that happens, the original
entry is reversed . . . The reversal takes place during the period
that the inventory is sold to an outside party.
At the end, Equity in Investee Income balance is Investees NI*%
+15. Investment in Investee is Beg. Balance + Equty in Investee
Income Investees Dividend*%33FASB ASC section 810-10-05, Variable
Interest EntitiesIncludes entities controlled through special
contractual arrangements (not through voting stock interests)
Intended to combat misuse of SPEs (Special Purpose Entities) to
keep large amounts of assets and liabilities off the balance sheet
known as off balance sheet financing1-46The FASB ASC Section
810-10-05 on variable interest entities expands the use of
consolidated financial statements to include entities that are
financially controlled through special contractual arrangements
rather than through voting stock interests. Prior to the accounting
requirements for variable interest entities, many firms (e.g.,
Enron) avoided consolidation of entities in which they owned little
or no voting stock but otherwise were controlled through special
contracts. These entities were frequently referred to as special
purpose entities (SPEs) and provided vehicles for some firms to
keep large amounts of assets and liabilities off their consolidated
financial statements.Fair-Value Vs. Equity Method *Equity in
investee income is 20 percent of the current year income reported
by Little Company. The carrying amount of an investment under the
equity method is the original cost plus income recognized less
dividends. For 2014, as an example, the $230,000 reported balance
is the $200,000 cost plus $40,000 equity income less $10,000 in
dividends.
1-476*Equity in investee income is 20 percent of the current
year income reported by Little Company. The carrying amount of an
investment under the equity method is the original cost plus income
recognized less dividends. For 2014, as an example, the $230,000
reported balanceis the $200,000 cost plus $40,000 equity income
less $10,000 in dividends.Learning Objective 1-5aReporting 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)1-48An 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, 2014.
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, 2016, Giant purchases another 30% of Smalls
outstanding stock, thereby achieving the ability to significantly
influence Smalls decisions.
1-49Giant Company acquires a 10% ownership in Small Company on
January 1, 2014. 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, 2016, 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)After changing to the equity method on January 1, 2016,
Giant must restate the prior years to present the investment as if
the equity method had always been applied. The income restatement
for these earlier years can be computed as follows:
1-50After changing to the equity method on January 1, 2016,
Giant must restate the prior years to present the investment as if
the equity method had always been applied. The income restatement
for these earlier years can be computed as follows:
Equity in Investee Income Reported Retrospective Income (10%)
from Dividends Adjustment2014 $7,000 $2,000 $5,0002015 11,000 4,000
7,000Total Adjustment to Retained Earnings: $12,000
Sheet1GENERAL JOURNALPage##DateDescriptionDebitCredit
&APage &P
Sheet1GENERAL
JOURNALPage##DateDescriptionDebitCredit31-DecInvestment in Tiny
Company$80,000Extraordinary Loss of investee$20,000Equity in
Investee's Income$100,000
&APage &P
Sheet1GENERAL
JOURNALPage##DateDescriptionDebitCreditCash$110,000Gain on Sale of
Investment$26,000Investment in Minor, Inc.$84,000
&APage &P
Sheet1Source of the DifferenceAccountingAssets that are
undervalued on the investee's booksAmortize the difference over the
remaining useful life of the associated asset.GoodwillFor fiscal
years beginning on or after Dec. 15, 2001, Goodwill will be carried
forward without adjustment until the investment is sold or a
permanent decline in value occurs.
Sheet2
Sheet3
Sheet1GENERAL JOURNALPage##DateDescriptionDebitCreditYearEquity
in Investee Income$$$$EndInvestment in Investee$$$$
&APage &P
Sheet1GENERAL
JOURNALPage##DateDescriptionDebitCredit31-DecEquity in Investee
Income$4,200Investment in Investee$4,200
&APage &P
Sheet1AssetFMV AdjustmentLife
remainingAmortizationEquipment$18,00010 years1,800Patent$12,0005
years$2,400GoodwillIndefinite0.0Annual expense years 1-5$4,200
&APage &P
Sheet1GENERAL JOURNALPage##DateDescriptionDebitCreditYearEquity
in Investee Income$15EndInvestment in Investee$15
&APage &P
Sheet1Intercompany Profitx% unsoldx% owned by investor
Sheet1GENERAL
JOURNALPage##DateDescriptionDebitCreditYearInvestment in
Investee$15EndEquity in Investee Income$15
&APage &P
