Chapter One

The Equity
Method of
Accounting for
Investments

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Learning Objective 1-1
Accounting for Investments in
Corporate Equity Securities
Describe in general the various methods of accounting for
an investment in equity shares of another company.
GAAP recognizes three ways:

Fair-Value Method
Consolidation of Financial Statements
Equity Method

The method selected depends upon the degree of

influence the investor has over the investee.
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Consolidation of
Financial Statements
Required when:
Investors ownership exceeds 50% of
an organizations outstanding voting stock
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.

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International Standard 28 Investment
in Associates
The International Accounting Standards Board (IASB),
similar to FASB, defines significant influence as the
power to participate in the financial and operating policy
decisions of the investee, but it is not control or joint control
over those policies.

If investor has 20% or more ownership, it is presumed to

have significant influence, unless it is demonstrated not to
be the case.
If investor holds less than 20% ownership, it is presumed it
does not have significant influence, unless influence can be
clearly demonstrated.
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Learning Objective 1-2
Sole Criterion for Utilizing the Equity Method
Identify the sole criterion for applying the Equity Method
of accounting and guidance in assessing whether it is met.

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 investee ownership percentages
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Summary of Accounting Methods

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Learning Objective 1-3
Equity Method Example
Prepare basic equity method journal entries for an
investor and describe the financial reporting for equity
method investments.
Assume Big Company owns 20% interest in Little
Company purchased on January 1, 2014, for $200,000.
Little reports net income of $200,000, $300,000, and
$400,000, respectively, in the next three years while
declaring dividends of $50,000, $100,000, and $200,000.

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 Equity Method Example
Bigs investment in Little, as determined by market prices,
was $235,000, $255,000, and $320,000 at the end of 2014,
2015, and 2016, respectively. Big Company records these
journal entries to apply the equity method:

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Learning Objective 1-4
Excess Cost Over Book Value
Allocate the cost of an equity method investment and
compute amortization expense to match revenues
recognized from the investment to the excess of investor
cost over investee book value.
Fair values of specific investee assets and liabilities can
differ from their book values. Excess payment can be
identified directly with those accounts.
If purchase price exceeds fair value, future benefits are
expected to accrue from the investment due to estimated
profitability of the investee or the relationship established
between the two companies
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Excess of Cost Over Book Value
of Acquired Investment
When Purchase Price>Book Value of an investment
acquired, the difference must be identified.
The additional payment is attributed to an intangible asset
referred to as goodwill rather than to a specific investee
asset or liability.
Assets may be undervalued on the investees books because:
1. The fair values (FV) of some assets and liabilities are
different than their book values (BV).
2. The investor may be willing to pay extra because future
benefits are expected to accrue from the investment.

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Learning Objective 1-5a
Change to the Equity Method
Report 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)

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 Learning Objective 1-5b
Investee Other Comprehensive Income

OCI is defined as revenues, expenses, gains, and losses that

under GAAP are included in comprehensive income but
excluded from net income.
Accumulated Other Comprehensive Income (AOCI)
includes unrealized holding gains and losses on
available-for-sale securities, foreign currency translation
adjustments, and certain pension adjustments.
OCI is accumulated and reported in stockholders equity
and represents a source of change in investee company
net assets that is recognized under the equity method.

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Investee Other Comprehensive Income

Other equity method recognition issues arise for

irregular items traditionally included within net
income. An investor must report its share of the
following items reported in investees current
income:
Discontinued operations
Extraordinary items
Other comprehensive income

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 Learning Objective 1-5c
Reporting Investee Losses
A permanent decline in the investees fair market value is
recorded as an impairment loss and the investment account
is reduced to the fair value.
When accumulated losses incurred and dividends paid by
the investee reduce the investment account to $-0-, no
further loss can be accrued.
Investor discontinues using the equity method rather than
record a negative balance. Balance remains at $-0-, until
subsequent profits eliminate all UNRECOGNIZED losses.
A temporary decline is ignored!

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Learning Objective 1-5d
Reporting Sale of Equity Investment
Record the sale of an equity investment and identify the
accounting method to be applied to any remaining shares
that are subsequently held.
If part of an investment is sold during the period, the
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.

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Learning Objective 1-6
Deferral of Unrealized Profits in Inventory
Describe the rationale and computations to defer unrealized
gross profits on intra-entity inventory transfers until the
goods are either consumed or sold to outside parties.

Equity acquisitions establish ties between companies to

facilitate the direct purchase and sale of inventory items. Such
intra-entity transactions can occur regularly or sporadically.

INVESTOR INVESTOR

Downstream Upstream
Sale Sale
INVESTEE INVESTEE
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Learning Objective 1-7
Fair Value Reporting Option
Explain the rationale and reporting implications of the
value accounting for investments otherwise accounted for
by the equity method.
An entity may irrevocably elect fair value as the initial and
subsequent measurement for certain financial assets and
financial liabilities including investments accounted for
under the equity method.
Under the fair-value option, changes in the fair value of the
elected financial items are included in earnings.

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