Slide

1-1

Chapter One

The Equity
Method of
Accounting
for
Investments

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

 Reporting Investments in
Slide
1-2

Corporate Equity Securities

GAAP allows 3 approaches to
reporting investments.

Note: These 3 approaches are not

interchangeable. The characteristics of each
investment will dictate the appropriate
accounting approach.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004
Slide
1-3

Fair Value Method

Details
Details inin SFAS
SFAS No. No. 115
115
 Initial
Initial Investment
Investment is is recorded
recorded
at
at cost.
cost.
 Investments
Investments in in equities
equities of
of
other
other companies
companies are are
classified
classified as as either
either Trading
Trading
Securities
Securities or or Available-for-
Available-for-
Sale
Sale Securities
Securities..
 Income
Income is is only
only realized
realized to
to the
the
extent
extent of of dividends
dividends received.
received.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

 Consolidation of Financial
Slide
1-4

Statements
 Governed by ARB No. 51, SFAS
No. 141, and SFAS No. 142.
 Required when investor’s
ownership exceeds 50% of
investee.
 A single set of financial
statements including the assets,
liabilities, equities, revenues,
and expenses for the parent
company and all controlled
subsidiary companies.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

Slide
1-5

Equity Method

 Defined
Defined by
by APB
APB Opinion
Opinion 18
18
and
and SFAS
SFAS No.
No. 142.
142.
 Requires
Requires that
that the
the investment
investment
is
is sufficient
sufficient to
to insure
insure
significant
significant influence.
influence.
 Generally
Generally used
used when
when
ownership
ownership is is between
between 20%
20% &
&
50%.
50%.
Influence
 Influencecan
canbe
bepresent
presentwith
with
much
muchsmaller
smallerownership
ownership
percentages.
percentages.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

 Criteria for Determining Whether
Slide
1-6

There is Influence

Representation
Representationon
onthe
theinvestee’s
investee’sBoard
Boardof
of
Directors
Directors
Participation
Participationin
inthe
theinvestee’s
investee’s policy-
policy-
making
makingprocess
process
Material
Materialintercompany
intercompanytransactions.
transactions.
Interchange
Interchangeof
of managerial
managerialpersonnel.
personnel.
Technological
Technological dependency.
dependency.
Extent
Extent of
of ownership
ownershipin
inrelationship
relationshipto
to
other
other ownership
ownershippercentages.
percentages.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

 The Significance of the Size of the
Slide
1-7

Investment
Investor Ownership of
Investee Shares
Outstanding
Fair Equity Consolidated Financial
Value Method Statements

{
{
{

0% 20% 50% 100%

Significant
Significantinfluence
influenceis
is Financial
FinancialStatements
Statementsof
ofall
all
generally
generallyassumed
assumedwith
with related
relatedcompanies
companiesmust
mustbebe
20%
20%to
to50%
50%ownership.
ownership. consolidated.
consolidated.

In
Insome
somecases,
cases,influence
influenceor
orcontrol
controlmay
mayexist
existwith
with
less
lessthan
than20%
20%ownership.
ownership.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004
Slide
1-8

Equity Method

Step 1: The investor records its

investment in the investee at cost.
Cost
Cost can
can be
bedefined
defined by
by cash
cash paid
paidor
orFair
Fair Market
Market
Value
Valueof
ofStock
Stockor
orother
other assets
assetsgiven
givenup.
up.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

Slide
1-9

Equity Method

Step 2: The investor recognizes its

proportionate share of the investee’s
net income (or net loss) for the period.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

Slide
1-10

Equity Method

Step 2: The investor recognizes its

proportionate share of the investee’s
net income (or net loss) for the period.

This
Thiswill
will appear
appearas
asaaseparate
separate
line-item
line-itemononthe
theinvestor’s
investor’s
income
incomestatement.
statement.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004
Slide
1-11

Equity Method

Step 3: The investor reduces the

investment account by the amount of
dividends received from the investee.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

Slide
1-12

Equity Method Example – Step 1

On January 1, 2005, Big Corp. buys 20%

of Small Inc. for $2,000,000 cash.
Record Big’s journal entry.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

Slide
1-13

Equity Method Example – Step 2

On December 31, 2005, Small reports net

income for the year of $300,000.
Record Big’s journal entry.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

Slide
1-14

Equity Method Example – Step 2

Big owns 20% of Small and gets credit

for 20% of Small’s income.
20% × $300,000 = $60,000

60,000
60,000

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

Slide
1-15

Equity Method Example – Step 3

On December 31, 2003, Big received a

$25,000 dividend check from Small.
Record Big’s journal entry.

25,000
60,000 25,000

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

 Special Procedures for Special
Slide
1-16

Situations

Reporting
Reporting aa
change Reporting
Reporting the
the
change toto
the sale
sale of
of an
an equity
equity
the equity
equity
method. investment.
investment.
method.

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

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

 Reporting a Change to the Equity
Slide
1-17

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
all accounts
accounts are
arerestated
restated so
so that
that the
the
investor’s
investor’s financial
financial statements
statements appear
appear as as ifif the
the
equity
equity method
method had had been
been applied
applied from
from the
the date
?
date
of
of the
the first
first [original]
[original] acquisition.
acquisition. -- -- APB
APB
Opinion
Opinion 1818

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

Slide
1-18

Restatement - Example
Assume
AssumethatthatExxo
Exxo Company
Companyacquires
acquires 5%
5%ofof
LipGloss
LipGlossInc.
Inc. on
onJanuary
January1, 1,2004
2004for
for$2,000,000.
$2,000,000.
There
Thereis isno
nosignificant
significantinfluence.
influence. TheTheinvestment
investmentis is
recorded
recorded atatthe
the time
timeasasanan Available-for-Sale
Available-for-Sale
Investment.
Investment.
In
In2004,
2004,LipGloss
LipGlosshadhad net
net income
incomeof of $300,000,
$300,000,and
and
paid
paiddividends
dividendsof of $140,000.
$140,000. Exxo Exxowould
wouldreport
report the
the
investment
investment as asindicated
indicatedin inthe
thetable
tablebelow:
below:

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

Slide
1-19

Restatement - Example
On
On January
January1, 1, 2005,
2005, Exxo
Exxo buys
buysan
anadditional
additional 15%
15%
interest
interest in
inLipGloss,
LipGloss,raising
raisingthe
thetotal
totalinvestment
investment toto
20%.
20%. The
Thefirstfirstthing
thingthat
that Exxo
Exxomust
mustdodois
is restate
restate
the
the12/31/04
12/31/04numbers
numbersby byapplying
applying the
theequity
equitymethod
method
to
tothe
the5% 5%investment
investmentin inLipGloss.
LipGloss.
We
We have
haveto to RESTATE
RESTATEthe theInvestment
Investment account,
account,put
put aa
balance
balancein in Equity
Equityin inInvestee
InvesteeIncome,
Income, and
andeliminate
eliminate
the
theDividend
DividendRevenue
Revenue balance.
balance.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

Slide
1-20

Restatement - Example
An
Anadjustment
adjustment is
isrecorded
recordedto
tothe
theInvestment
Investment
account
accountand
andto
toRetained
Retained Earnings
Earnings (since
(sinceDividend
Dividend
Revenue
Revenuehas
has already
alreadybeen
been closed
closed out).
out).

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

 Reporting Investee Income from
Slide
1-21

Other Sources
 When net income
includes elements other
than Operating Income,
those elements should
be separately reported
on the investor’s income
statement.
 Examples include:
 Extraordinary items
 Discontinued operations
 Prior period adjustments

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

 Reporting Investee Income from
Slide
1-22

Other Sources

Big
Big owns
owns 30%
30% ofof Little.
Little. Little
Little reports
reports net
net income
income
for
for 2005
2005 ofof $120,000.
$120,000. Little’s
Little’s Income
Income includes
includes
operating
operating income
income of of $135,000
$135,000 and
and anan
extraordinary
extraordinary loss
loss of
of $15,000.
$15,000.
Big’s
Big’s equity
equity method
method entry
entry atat year-end
year-end is:
is:

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

Slide
1-23

Reporting Investee Losses

Permanent
Permanent
Losses
Losses in in Value
Value
AA permanent
permanent
decline
decline in in the
the
investee’s
investee’s market
market
value
value is is recorded
recorded
as
as aa reduction
reduction of of
the
the investment
investment
account.
account.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

Slide
1-24

Reporting Investee Losses

Investment
Investment Reduced
Reduced to to Zero
Zero
 When
When the
the accumulated
accumulated losseslosses
incurred
incurred by
by the
the investee
investee andand
dividends
dividends paid
paid by
by the
the investee
investee
reduce
reduce the
the investment
investment
account
account to
to zero,
zero, NO
NO
ADDITIONAL
ADDITIONAL LOSSES
LOSSES are are
accrued.
accrued.
 The
The balance
balance remains
remains atat $0,
$0,
until
until subsequent
subsequent profits
profits
eliminate
eliminate all
all UNRECORDED
UNRECORDED
losses.
losses.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004
 Reporting the Sale of an Equity
Slide
1-25

Investment
If part of an investment is
sold during the period . . .

 The
 The equity
equitymethod
methodcontinues
continuesto
tobe
be
applied
appliedup upto
to the
thedate
dateof
ofthe
the
transaction.
transaction.
 At
 At the
thetransaction
transactiondate,
date,aa
proportionate
proportionateamountamountof
ofthe
the
Investment
Investment account
accountisisremoved.
removed.
 IfIf significant
 significantinfluence
influenceisislost,
lost, NO
NO
RETROACTIVE
RETROACTIVEADJUSTMENT
ADJUSTMENT is is
recorded.
recorded.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

 Reporting the Sale of an Equity
Slide
1-26

Investment
Alice
AliceCo. Co.30%30%(300,000
(300,000shares)
shares) ofof Sam,
Sam, Inc..
Inc.. The
Thebalance
balance
in
inAlice’s
Alice’sInvestment
Investmentaccount
accountatatMarch
March31,
31,2005,
2005,is
is
$268,000.
$268,000.
IfIf Alice
AliceCo.Co.sells
sells10%
10% of
of its
itsshares
shares (30,000
(30,000shares)
shares) on
on
April
April1, 1, 200
200for
for$100,000,
$100,000,whatwhat entry
entryshould
shouldAlice
Alicemake
make
on
onApril
April1,1,2005?
2005?

$268,000 × .10% = $26,800

This brings the Investment account to a
McGraw-Hill/Irwin
balance of $241,200 © The McGraw-Hill Companies, Inc., 2004
Slide
1-27

Excess of Cost Over BV Acquired

When Cost > BV acquired, the difference

must be identified and accounted for.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

Slide
1-28

Excess of Cost Over BV Acquired

The
The amortization
amortization of of the
the difference
difference associated
associated
with
with the
the undervalued
undervalued assets
assets is is recorded
recorded as
as aa
reduction
reduction ofof both
both thethe Investment
Investment account
account
and
and the
the Equity
Equity in
in Investee
Investee Income
Income account.
account.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

 Excess of Cost Over BV
Slide
1-29

Example
 On
OnJanuary
January1,1,2005,
2005,BigBigCorp.
Corp.
acquired
acquired 20%
20% ofof Small
SmallInc.Inc.for
for
$2,000,000
$2,000,000cash.
cash.
 Assume
Assumethat
thatSmall’s
Small’sassets
assets
had
hadBVBVon
onJanuary
January11of of
$8,500,000.
$8,500,000. Small
Small owns
ownsaa
building
buildingwith
withaaBVBVof of$500,000,
$500,000,
and
andaaFMV
FMVof of $700,000,
$700,000,and and aa
remaining
remaininguseful
useful life
lifeof
of 10
10
years.
years. All
Allother
other assets
assetshad had BV
BV
== FMV.
FMV.
 Allocate
Allocatethe
thecost
cost to
tofair
fairmarket
market
value
valueadjustments
adjustmentsand and
Goodwill
Goodwillacquired
acquiredby byBig.
Big.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004
 Excess of Cost Over BV
Slide
1-30

Example

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 Excess of Cost Over BV
Slide
1-31

Example

The
TheBuilding
Buildinghas
hasaa
remaining
remaininguseful
usefullife
life
of
of1010years.
years. Goodwill
Goodwill
is
isnever
neveramortized.
amortized.
Compute
Computethethe
amortization
amortization expense
expense
for
forBig
Bigat
at12/31/05.
12/31/05.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

 Amortization of Cost Over BV
Slide
1-32

Example

Big’s
Big’sequity
equitymethod
method
entry
entrywill
willinclude
includeanan
adjustment
adjustment to tothe
the
investment
investmentaccount
account
of
of$4,000.
$4,000.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

 Amortization of Cost Over BV
Slide
1-33

Example

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

Slide
1-34 Let’s look at some intercompany
transactions.
Unrealized Gains in Inventory
Sometimes affiliated companies sell or
buy inventory from each other.

INVESTOR
INVESTOR INVESTOR
INVESTOR
Downstream Upstream
Sale Sale

INVESTEE
INVESTEE INVESTEE
INVESTEE

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

Slide
1-35

Unrealized Gains in Inventory

Let’s look at an Investor that has 200

units of inventory with a cost of $1,000.

Let us assume
INVESTOR
INVESTOR
sells
that the Investor
sells200
200units
units
of
of inventory
inventory
sells the
with
with aatotal
total inventory to a
cost
cost ofof $1,000.
$1,000. 20% owned
Investee for
$1,250.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

Slide
1-36

Unrealized Gains in Inventory

Note
Let’s look at an Investor that has 200
Note that
thatthere
there
units
is
is
of
$250
$250 of
of intercompany
intercompany
inventory with a
profit.
profit.
cost of
At
At
this
thispoint
point ititis
isconsidered
consideredUNREALIZED.
UNREALIZED.
$1,000.

INVESTOR
INVESTOR INVESTEE
INVESTEE
sells 20% ownership
sells200
200units
units buys
buys200
200units
units
of
of inventory
inventory of
ofinventory
inventoryand
and
with Intercompany
with aatotal
total Sale of 200 units
pays
paysaatotal
total of
of
cost
cost ofof $1,000.
$1,000. $1,250.
$1,250.

IfIfall
all 200
200units
units are
are not
notsold
sold to
to an
an outside
outsideparty
party
during
during the theperiod,
period,wewewill
willneed
need have
have unrealized,
unrealized,
intercompany
intercompanyprofit
profit that
thatmust
mustbe bedeferred.
deferred.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004
Slide
1-37

Unrealized Gains in Inventory

60 of the original 200 units (30%) are still

“unsold” to a 3rd party. We must defer our
share (20%) of the original $250 of
intercompany profit that is unrealized (30%).

INVESTOR
INVESTOR INVESTEE
INVESTEE
sells 20% ownership
sells200
200units
units buys
buys200
200units
units
of
of inventory
inventory of
ofinventory
inventoryand
and
with Intercompany
with aatotal
total Sale of 200 units
pays
paysaatotal
total of
of
cost
cost ofof $1,000.
$1,000. $1,250.
$1,250.

Investee sells only

140 units to a 3rd
party
Outside Party
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004
Slide
1-38

Unrealized Gains in Inventory

 Compute the deferral by multiplying:

 The required journal is:

$250 × 30% × 20% = $15

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004
Slide
1-39

Unrealized Gains in Inventory

 In
Inthe
theperiod
periodfollowing
followingthe
theperiod
periodof
of the
the
transfer,
transfer,the
theremaining
remaining inventory
inventoryis
isoften
often
sold.
sold.
 When
When that
thathappens,
happens, the theoriginal
originalentry
entryis is
reversed
reversed.. ....

The reversal takes place in the period that the

inventory is sold to an outside party.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004
Slide
1-40

End of Chapter 1

And this is
only the
FIRST
chapter?!

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004