Welcome to Financial Accounting

Chapter 8

Investing in Other
Entities

@Cambridge Business Publishers, 2013
1
Why Companies Buy Shares of Other Entities
 Reasons often correlate to the percentage
of outstanding stock acquired
 Less than 20 percent acquisition
 Indicates an expectation that the investment
will provide an acceptable rate of return for idle
funds, and
 Investor-company does not intend to take an
active role in management of investee
 From 20 to 100 percent acquisitions
 Investor company desires to exercise an active
role in investee’s business
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Which Investment Accounting Method to Apply?
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Marketable Securities
 Can be either debt or equity securities
 Shareholding percentage is relatively small
 Less than 20 percent
 Mark-to-market accounting is used
 If a ready market exists for trading the
securities
 Marketable securities are written up or down to
the current market value
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Market adjustments are justified because a
ready resale market exists making the
investment’s current value reliably ascertained.
Trading Securities
 Consist of marketable debt and equity
securities that may be sold at any time to
take advantage of price changes
 Valued at market value on the balance sheet
 Unrealized gain or loss included in the
investor’s net income
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Unrealized gain or loss – Change in market
value for an asset not yet sold
Realized gain or loss – Profit or loss on the
sale of an asset
Trading Securities Example
On Dec. 1, 2013, Cup A Jo invested in $20,000 of
Dell stock, with the intent to hold for the short-term.
Dividends received were $400. The market value at
Dec. 31, 2013 was $19,900.

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1. Less than 20% ownership
2. Intent to hold short-term
Trading Securities
Investment
Implies
Market value
adjustment
Available-for-Sale Securities
 Investments in debt or equity securities that
management intends to hold for the long-
term
 Management might liquidate under the right
circumstances
 Valued on the balance sheet at market value
 Unrealized gain or loss is included as part of
Other Comprehensive Income
 Represents wealth increases and decreases that
have not yet been realized
 Disclosed in the shareholders’ equity section of
the balance sheet


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Available-for-Sale Securities Example
On June 1, 2013, Cup A Jo invested in $50,000 of JCPenney
stock, with the intent to hold for the long-term. Dividends
received were $800. The market value at Dec. 31, 2013 was
$51,300.

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1. Less than 20% ownership
2. Intent to hold long-term
3. Liquidation under right
circumstances
Available-for-
Sale Security
Implies
Adjust to market value
Held-to-Maturity Debt Securities
 Investments in debt securities that
management intends to hold until they
mature
 Valued on the balance sheet at amortized
cost
 The original purchase price of the debt plus or
minus the amortization of any purchase discount
or premium

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Held-to-Maturity Debt Securities Example
On January 1, 2013, Cup A Jo invested in $80,000 of The
Gap’s 8% notes, with the intent to hold to maturity in 2016.
The notes’ market value at December 31, 2013 was
$78,000.

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No market value
adjustments are made
to held-to-maturity
investments.
1. Debt security
2. Intent to hold to maturity
Held-to-Maturity
Debt Security
Implies
Trading, Available-for-Sale, and Held-to-
Maturity at Year End
Assets
Investments
Trading equity securities $19,900
Available-for-sale equity securities 51,300
Held-to-maturity securities 80,000
Shareholders' Equity
Retained earnings 7,500
Other Comprehensive income
Unrealized gain on available-for-sale securities 1,300
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Interest income $6,400
Dividend income 1,200
Non-operating expenses
Unrealized loss on trading equity securities (100)
Inconsistent Accounting
for Unrealized Gains and Losses
 Treatment coincides with the expected
length of the holding period
 Trading securities
 Relative short holding period
 Available-for-sale securities
 Uncertain holding period
 Including in income could create distortion
of current period performance
 Due to unexpected swings in market values
 Uncontrollable by management
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Profit Manipulation
 Keep the best, sell the rest
 Selectively selling securities to include
realized gains but not losses in current
earnings
 Also known as cherry picking

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Equity Method Securities
 Consists of investments in equity securities
 Investor is able to exercise significant
influence over an investee’s operating
policies
 Ownership is not large enough to have voting
control
 Generally from 20 up to 50 percent
ownership
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Reporting Equity Method Securities
 Investment account on the balance sheet
equals
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Original cost
+ Proportionate share of net income/loss
– Proportionate share of dividends
 Proportionate share of net income/loss
 Reported as Equity in the Earnings(loss) of
an Unconsolidated Affiliate
Equity Method Example
On January 1, 2013, Cup A Jo purchased 25% of
the outstanding shares of Beans Direct stock for a
total cost of $250,000. The market value at the
date of purchase equals the book value of
$1,000,000. Beans Direct reported the following
for 2013:
Net income $90,000
Dividends paid 28,000
© Cambridge Business Publishers, 2013
More than 20% ownership
implies the ability to
exercise significant influence
but not control
Equity Method
Security
Implies
Equity Method Example continued
Proportional earnings recognition:
25% × $90,000 = $22,500
Cup A Jo’s investment in equity affiliate account
increases by 25% of the net earnings amount by
which Beans Direct’s shareholders’ equity
increases
Proportional dividends recognition:
25% × $28,000 = $7,000
Cup A Jo’s investment in equity affiliate account
decreases by 25% of the dividends amount by
which Beans Direct’s shareholders’ equity
decreases

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Equity Method Example continued
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Assets
Investments
Investment in equity affiliate $265,500
Shareholders' Equity
Retained earnings 22,500
Revenue $ xx
Expenses xx
Operating income xx
Equity in the earnings of unconsolidated affiliate 22,500
Equity Method and Off-Balance-Sheet Debt
 Less than 50% ownership allows a parent-
company to report its investment in the
affiliate without disclosing the affiliate’s
liabilities
 Referred to as off-balance-sheet financing
 U.S. GAAP requires disclosure of
 Aggregate assets, liabilities, revenue and
expenses of equity affiliates in the parent-
company footnotes
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Consolidation Accounting
 Investments in equity securities in which an
investor-company establishes voting control
over an affiliate
 Voting control is over 50%
 Operating results are combined with those
of the investor
 A single set of financial statements is
created for the combined companies
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Investor Company
Subsidiary
Consolidation Accounting Example
On January 1, 2013, Cup A Jo purchased 90% of
the outstanding shares of Beans Direct stock for a
total cost of $900,000. The market value of Beans
Direct at the date of purchase equals the book
value of $1,000,000. Cup A Jo reported net
income of $110,000 for 2010. Beans Direct
reported the following for 2013:
Net income $90,000
Dividends paid 28,000
© Cambridge Business Publishers, 2013
More than 50% ownership
implies the ability to
exercise significant influence
and an intent to control
Consolidation
Accounting
Investment
Implies
Consolidation Accounting Example continued
Balance sheets of Cup A Jo and Beans Direct
prior to the consolidation on January 1, 2013:

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Cup A Jo Beans Direct
Assets
Cash $3,200,000 $1,000,000
Other assets 6,000,000 1,300,000
Total assets $9,200,000 $2,300,000
Long-term debt

$1,600,000

$1,300,000
Common stock 3,500,000 200,000
Retained earnings 4,100,000 800,000
Total liabilities & shareholders' equity $9,200,000 $2,300,000
Consolidation Accounting Example continued
Beans Direct records it current year income
totaling $90,000 and dividends totaling $28,000
for 2013:

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Before Net
Income and
Dividends
2013 Income
and Dividends
After Net
Income and
Dividends
Assets
Cash $1,000,000 $62,000 $1,062,000
Other assets 1,300,000 1,300,000
Total assets $2,300,000 $2,362,000
Long-term debt 1,300,000

$1,300,000
Common stock 200,000 200,000
Retained earnings 800,000 62,000 862,000
Total liabilities & shareholders' equity $2,300,000 $2,362,000
Consolidation Accounting Example continued
Percentage ownership: 7,200/8,000 = 90%
Proportional earnings recognition:
90% × $90,000 = $81,000
Proportional dividends recognition:
90% × $28,000 = $25,200
© Cambridge Business Publishers, 2013
Same
approach as
equity
method
Cup A Jo
Before
Elimination
Entries
Elimination Entries
 Necessary to avoid double counting certain
amounts which may overstate financials
 Amounts to eliminate
 Reduce the Investment account by the current balance
 Reduce the common stock and retained earnings accounts
by 90% of the balances for Cup A Jo’s investment, and
10% for the noncontrolling investment
 Transfer 10% balances in common stock and retained
earnings to noncontrolling interest


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Investment account reduction: $955,800
Noncontrolling interest:
10% of [$200,000 + $862,000] = $106,200
Results of Consolidation Process After
Elimination Entries
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Assets Cup A Jo Beans Direct Adjustments Consolidated
Cash $2,435,200 $1,062,000 $3,497,200
Other assets 6,000,000 1,300,000 7,300,000
Investment in affiliate 955,800 (955,800)
Total assets $9,391,000 $2,362,000 $(955,800) $10,797,200
Long-term debt $1,600,000 $1,300,000 $2,900,000
Noncontrolling interest 106,200 106,200
Common stock 3,500,000 200,000 (200,000) 3,500,000
Retained earnings 4,291,000 862,000 (862,000) 4,291,000
Total liabilities & shareholders' equity $9,391,000 $2,362,000 $(955,800) $10,797,200
Cup A Jo prepares a
consolidated balance
sheet reflecting the
consolidated totals.
Cup A Jo’s income statement will reflect:
Cup A Jo’s operations: $110,000
+ 90% of Beans Direct operations $81,000
Total net income for 2008 $191,000
Consolidation Accounting Considerations
 What if the fair market value of the net
assets of the affiliate differs from the book
value of the net assets of the affiliate?
 Goodwill is present
 Goodwill is the excess of the purchase price of
an investment over the fair market value of the
purchased identifiable net assets
 Parent-company must adjust asset and liability
values to the respective fair market values before
the consolidated balance sheet is prepared
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Consolidation Accounting Example
Fair Market Value Differs from Book Value
On January 1, 2013, Cup A Jo purchased 100% of
the outstanding shares of Beans Direct stock, for a
total cost of $1,180,000. The market value of the
other assets at the date of purchase is $30,000
more than the book value. Cup A Jo reported net
income of $110,000 for 2010. Beans Direct
reported the following for 2010:
Net income $90,000
Dividends paid 28,000
© Cambridge Business Publishers, 2013
More than 50% ownership
implies the ability to
exercise significant influence
and an intent to control
Consolidation
Accounting
Investment
Implies
Consolidation Accounting Example
Fair Market Value Differs from Book Value
Using the previous example, we begin with the
balance sheets of Cup A Jo and Beans Direct
prior to the consolidation on January 1, 2013:

© Cambridge Business Publishers, 2013
Cup A Jo Beans Direct
Assets
Cash $3,200,000 $1,000,000
Other assets 6,000,000 1,300,000
Total assets $9,200,000 $2,300,000
Long-term debt

$1,600,000

$1,300,000
Common stock 3,500,000 200,000
Retained earnings 4,100,000 800,000
Total liabilities & shareholders' equity $9,200,000 $2,300,000
Consolidation Accounting Example with
Fair Market Value Differs from Book Value con’t.
Beans Direct records it current year income
totaling $90,000 and dividends totaling $28,000
for 2013 in the same manner:

© Cambridge Business Publishers, 2013
Before Net
Income and
Dividends
2013 Income
and Dividends
After Net
Income and
Dividends
Assets
Cash $1,000,000 $62,000 $1,062,000
Other assets 1,300,000 1,300,000
Total assets $2,300,000 $2,362,000
Long-term debt 1,300,000

$1,300,000
Common stock 200,000 200,000
Retained earnings 800,000 62,000 862,000
Total liabilities & shareholders' equity $2,300,000 $2,362,000
Consolidation Accounting Example continued
Cup A Jo recognizes the purchase price of
$1,180,000 and 100% of Beans Direct’s
net income and dividends in its investment
account. Cup A Jo also recognizes its own
current year net income.
© Cambridge Business Publishers, 2013
Same
approach
as equity
method
Goodwill and Asset Adjustments
Goodwill is determined at the purchase date:

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Goodwill is an intangible asset
• Never amortized
• Tested for impairment in value at year end and written
down if necessary
Purchase price to acquire Beans Direct $ 1,180,000
Less book value of Beans Direct at January 1:
Cash $ 1,000,000
Other assets 1,300,000
Less long-term debt (1,300,000)
Book value of net assets (1,000,000)
Less fair value adjustment of Other Assets (30,000)
Goodwill $ 150,000
Consolidation Accounting Example continued
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Consolidation Adjustments for Cup A Jo:
1. Decrease the investment in affiliate account
for its balance of $1,242,000.
2. Decrease the equity accounts for the amount
of the affiliate balances:
Common stock, $200,000
Retained earnings, $862,000
3. Recognize the increase in the fair value of
‘Other assets’ for $30,000.
4. Recognize an intangible asset for goodwill,
$150,000.
Consolidation Accounting Example continued
Cup A Jo Beans Direct Adjustments Consolidated
Assets
Cash $2,158,000 $1,062,000 $3,220,000
Other assets 6,000,000 1,300,000 30,000 7,330,000
Investment in affiliate 1,242,000 (1,242,000)
Goodwill 150,000 150,000
Total assets $ 9,400,000 $2,362,000 $(1,062,000) $10,700,000
Long-term debt $ 1,600,000 $1,300,000 $2,900,000
Common stock 3,500,000 200,000 (200,000) 3,500,000
Retained earnings 4,300,000 862,000 (862,000) 4,300,000
Total liabilities &
shareholders' equity $9,400,000 $2,362,000 $(1,062,000) $10,700,000
© Cambridge Business Publishers, 2013
Because there are no minority shareholders, there is
no minority interest recognized.
Elimination Entries
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35
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END OF CHAPTER 8