Chapter One

The Equity Method

of Accounting for
Investments

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the prior written consent of McGraw Hill.
 Learning Objective 1-1

Describe motivations for a firm to gain

significant influence over another firm.

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 Why do firms buy common stock of
other firms?
• Temporary investment to earn a return on
idle cash.
• Gain voting privileges to influence how a
firm operates.

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 Learning Objective 1-2

Describe in general the various methods of

accounting for an investment in equity shares
of another company.

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 The Reporting of Investments in
Corporate Equity Securities
GAAP recognizes four methods to report
investments in other companies:
• Fair-value method.
• Cost method for equity securities without
readily
determinable fair values.
• Consolidation of financial statements.
• Equity method.
The method selected depends upon the degree of
influence the investor (stockholder) has over the
investee.
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 International Accounting Standard
28—Investments in Associates
• The International Accounting Standards Board
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 percent 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 percent ownership, it is
presumed it does not have significant influence,
unless influence can be clearly demonstrated.

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 The Degree of Influence

• <20% – presumes lack of significant Fair value

influence – fair value (cost) method (cost)
• 20% to 50% – presumes significant method
influence – equity method Consolidated
financial
• >50% – presumes control – consolidated statements Equity
financial statements
method

© McGraw Hill 1-7

 Fair-Value Method

Use when:
• Investor holds a small percentage of equity
securities of investee.
• Investor cannot significantly affect investee’s
operations.
• Investment is made in anticipation of
dividends or market appreciation.

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 Recording Fair-Value Method
Initial investments in equity securities when
significant influence and control are not present are:
Recorded at cost.
• Adjusted to fair value if fair value is determinable.
• If fair value is not determinable, remains at cost.

- Changes in fair values are recognized as income.

- Dividends declared on the securities are recognized
as income.
- As of December 15, 2017, available-for-sale category
with fair value changes recorded in other
comprehensive income will no longer be available.
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 Fair-Value Method and
Impairment Assessment
GAAP allows for two fair value assessments that
may affect cost method amounts reported on the
financial statements:
1. Periodic assessment for impairment to
determine if the fair value of the investment is
less than its carrying amount.
2. Recognition of “observable price changes in
orderly transactions for the identical or a similar
investment of the same issuer” as unrealized
holding gains (or losses).

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 Consolidation of
Financial Statements
• Required when investor’s ownership exceeds
50 percent of an organization’s outstanding
voting stock.
• When a majority of voting stock is held, the
investor-investee relationship is so closely
connected that the two corporations are
viewed as a single entity.
• 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.
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 Variable Interest Entities

• Includes 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 financing.”

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 Equity Method

Use when:
• Investor has the ability to exercise significant
influence on investee operations (whether
applied or not).
• Ownership is between 20 percent and 50
percent.
Significant influence might be present with much
lower ownership percentages. 
Under the equity method, investor’s share of investee
dividends declared are recorded as decreases in the
investment account, not income.
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 Learning Objective 1-3

Identify the sole criterion for applying the

equity method of accounting and know the
guidelines to assess whether the criterion is
met.

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 Criteria for Utilizing
the Equity Method
Significant Influence :
• Representation on the investee’s board of
directors.
• Participation in the investee’s policy-making
process.
• Material intra-entity transactions.
• Interchange of managerial personnel.
• Technological dependency.
• Other investee ownership percentages.

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 Limitations of Equity Method
Applicability
Regardless of investor’s degree of ownership, the equity
method is not appropriate if investments demonstrate:
• An agreement exists between investor and investee by
which the investor surrenders significant rights as a
shareholder.
• A concentration of ownership operates the investee
without regard for the views of the investor.
• The investor attempts but fails to obtain representation
on the investee’s board of directors.

If an entity can exercise control over investee, regardless of

ownership level, consolidation is required.

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 Extensions of Equity Method
Applicability
For some investments that fall short of or exceed
20 to 50 percent ownership, the equity method is
appropriately used for financial reporting.
Conditions can exist where the equity method is
appropriate despite a majority ownership interest.
• For example, if the noncontrolling rights are so
restrictive as to call into question whether control
rests with the majority owner, the equity method is
employed for financial reporting rather than
consolidation.

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 Summary of Accounting Methods
Accounting Methods Applicable in Various Stock
Ownership Levels
Normal Ownership Applicable Accounting
Criterion Level Method
Inability to significantly Less than 20% Fair value or cost method
influence
Ability to significantly 20% to 50% Equity method or fair value
influence
Control through voting More than 50% Consolidated financial
interests statements
Control through variable Primary beneficiary Consolidated financial
interests (governance status (no ownership statements
documents, contracts) required)

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 Learning Objective 1-4

Describe the financial reporting for equity

method investments and prepare basic equity
method journal entries for an investor.

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 Accounting for Increases in an
Investment—The Equity Method
• The investor increases the investment
account as the investee earns and reports
income. The investor uses the accrual
method to record investment income—
recognizing it in the same time period as the
investee earns it.
• The asset balance is increased as the
investee makes a profit. The investor
reduces the investment account if the
investee reports a loss.

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 Accounting for Decreases in an
Investment—The Equity Method
• The investor decreases its investment
account’s carrying value for its share of
investee cash dividends. When the investee
declares a cash dividend, its owners’ equity
decreases.
• The investor shall recognize its share of the
earnings or losses of an investee in the
periods for which they are reported by the
investee in its financial statements.

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 Equity Method Example

Big Company owns a 20 percent interest in Little

Company purchased on January 1, 2020, for
$210,000. 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.
The fair values of Big’s investment in Little, as
determined by market prices, were $245,000,
$282,000, and $325,000 at the end of 2020, 2021,
and 2022, respectively.

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 Fair-Value versus Equity Method
EXHIBIT 1.1 Comparison of Fair-Value Method and Equity Method

Accounting by Accounting
Big Company by Big
When Company
Accounting by Influence Is When
Big Company Accounting by Big Not Influence Is
When Influence Company When Significant Accounting by Big Significant
Is Not Influence Is Not (fair-value Company When (equity
Dividends Significant (fair- Significant (fair- method): Influence Is method):
Income of Declared by value method): value method): Fair- Carrying Significant (equity Carrying
Little Little Dividend Value Change to Amount of method): Equity in Amount of
Year Company Company Income Income Investment Investee Income* Investment†
2020 $200,000 $ 50,000 $ 10,000 (210k-245k) $ 35,000 $245,000 $ 40,000 $240,000
2021 300,000 100,000 20,000 (245k-282k) 37,000 282,000 60,000 280,000
2022 400,000 200,000 40,000 (282k- 325k) 43,000 325,000 80,000 320,000
Total income $ 70,000 $115,000 $180,000
recognized

*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 2020, as an example, the $240,000 reported
balance is the $210,000 cost plus $50,000 equity income less $10,000 in dividends.
© McGraw Hill 1-23
 Equity Method Example—Journal
Entries
Big Company records the following journal entries to apply the equity
method for its investment in Little Company for 2020:

Investment in Little Company 40,000

Equity in Investee Income 40,000
To accrue earnings of a 20 percent owned investee ($200,000
×20%)
Dividend Receivable 10,000
Investment in Little Company 10,000
To record a dividend declaration by Little Company ($50,000 × 20%)
Cash 10,000
Dividend Receivable 10,000
To record collection of the cash dividend.
1st entry: Big accrues income based on the investee’s reported earnings.
2nd entry: Big records dividend declaration and reduction in Little’s net
assets.
3rd entry: Big reports the collection of cash dividends.
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 Learning Objective 1-5

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.

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 Excess of Investment Cost over Book
Value Acquired 1

Differences may exist between a company’s book

value and fair value because:
• Fair value is based on multiple factors, including
but not limited to profitability, new products,
expected dividend payments, projected
operating results, and general economic
conditions.
• Stock prices are based, partially, on the
perceived worth of a company’s net assets,
amounts that often vary from underlying book
values.

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 Excess of Investment Cost over Book
Value Acquired 2

Asset and liability accounts on the balance

sheet tend to measure historical costs rather
than current value.
Reported figures are affected by the
accounting methods selected and lead to
different book values; for example:
• Inventory costing methods (WA, L I F O and F I F O).
• Acceptable depreciation methods (straight-
line, units of production).

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 Excess of Investment Cost over Book
Value Acquired 3

When purchase price exceeds book value of an

investment acquired, the difference must be identified.
Assets may be undervalued on the investee’s books
because:
• The fair values (FV) of some assets and liabilities are
different from their book values (BV).
• The investor may be willing to pay extra because
future benefits are expected to accrue from the
investment.
• Extra payment that cannot be attributed to a specific
asset or liability is assigned to the intangible asset
goodwill.
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 Excess of Investment Cost over Book
Value Acquired Example
Grande Company is negotiating the acquisition of 30
percent of the outstanding shares of Chico Company.
Chico’s balance sheet reports assets of $500,000 and
liabilities of $300,000 for a net book value of $200,000.
Grande determines that Chico’s equipment is
undervalued in the company’s financial records by
$60,000. One of its patents is also undervalued, but
only by $40,000.
Adding these valuation adjustments to Chico’s book
value indicates that the company’s net assets are
estimated to be valued at $300,000. Therefore, Grande
offers $90,000 for a 30 percent share of the investee’s
outstanding stock.
© McGraw Hill 1-29
 Excess of Investment Cost over Book
Value Acquired—Valuations
Grande’s purchase price is in excess of the proportionate
share of Chico’s book value, which can be attributed to two
specific accounts: Equipment and Patents.
No part of the extra payment is traceable to any other
projected future benefit. The cost of Grande’s investment is
allocated as follows:
Payment by investor $ 90,000

Percentage of book value acquired ($200,000 × 30%) 60,000

Payment in excess of book value 30,000

Excess payment identified with specific assets:

Equipment ($60,000 undervaluation × 30%) $ 18,000
Patent ($40,000 undervaluation × 30%) 12,000 30,000

Excess payment not identified with specific assets—goodwill $ –0–

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 The Amortization Process
Payment relating to each asset (except land, goodwill, and other
indefinite life intangibles) should be amortized over an
appropriate time period.
Remaining
Account Cost Assigned Useful Life Annual Amortization
Equipment $ 18,000 10 years $ 1,800
Patent 12,000 5 years 2,400
Goodwill 35,000 Indefinite –0–
Annual expense (for five years $ 4,200
until patent cost is completely
amortized)

Goodwill associated with equity method investments and a

business combination, for the most part, is measured in the same
manner. Except business combinations are tested for declines in
value and impairment. Equity method investments are tested in
their entirety for permanent declines in value.
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 The Amortization Process—Journal
Entries
To record the annual expense, Grande reduces the
investment balance in the same way it would
amortize the cost of any other asset that had a
limited life. At the end of the first year of holding
the investment, the investor records the following
journal entry under the equity method.

Equity in Investee Income 4,200

Investment in Chico Company 4,200
To record amortization of excess payment allocated to
equipment and patent.

© McGraw Hill 1-32

 Learning Objective 1-6:
Equity Method—Additional Issues
Understand the financial reporting
consequences for:
• A change to the equity method.
• Investee’s other comprehensive income.
• Investee losses.
• Sale of equity method investments.

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 Learning Objective 1-6a

Understand the financial reporting

consequences for a change to the equity
method.

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 Reporting a Change to the Equity
Method
Report a change to the equity method if:
• An investment that was recorded using the cost
or fair-value method reaches the point where
significant influence is established.
• When an investment qualifies for use of the
equity method, the investor adds the cost of
acquiring additional interest in the investee to
the current basis and adopts the equity method
of accounting [(FASB ASC (para. 323-10-35-33)].
• This prospective approach avoids the
complexity of restating prior period amounts.
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 Reporting a Change to the
Equity Method Example
• Alpha Company acquires a 10 percent
ownership in Bailey Company on January 1,
2020, for $84,000.
• Alpha company does not have the ability to
exert significant influence over Bailey.
• Alpha properly records the investment using
the fair-value method and recognizes in net
income its 10 percent ownership share of
changes in Bailey’s fair value.

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 Reporting a Change to the Equity
Method without Significant Influence
• Alpha Company recognizes the increase in
its 10 percent ownership in Bailey Company
at the end of 2020 and increases its
investment account to $89,000.
• Because the fair-value method is used to
account for the investment, Bailey’s $670,000
book value balance at January 1, 2020 does
not affect Alpha’s accounting.
• On January 1, 2021, Alpha purchases an
additional 30 percent of Bailey’s outstanding
voting stock for $267,000.
© McGraw Hill 1-37
 Reporting a Change to the Equity
Method with Significant Influence
• On January 1, 2021, Alpha achieves the
ability to exercise significant influence over
Bailey, and will now apply the equity method
to account for its investment in Bailey.
• On January 1, 2021, Bailey’s carrying
amounts for its assets and liabilities equaled
their fair values except for a patent, which
was undervalued by $175,000 and had a 10-
year remaining useful life.
• The fair value of Alpha’s total (40 percent)
investment serves as the valuation basis.
© McGraw Hill 1-38
 Recording a Change to the Equity
Method 1

Alpha prepares the following journal entry on January 1, 2021, to

bring about prospective change to the equity method:
Investment in Bailey Company 267,000
Cash 267,000
To record an additional 30 percent investment in Bailey Company.

Investment Allocation Schedule

Investment in Bailey Company January 1, 2021
Current fair value of initial 10 percent ownership of Bailey $ 89,000
Payment for additional 30 percent investment in Bailey 267,000
Total fair value of 40 percent investment in Bailey $356,000
Alpha’s share of Bailey’s book value (40% × $715,000*) 286,000
Investment fair value in excess of Bailey’s book value $ 70,000
Excess fair value attributable to Bailey’s patent (40% × $175,000) $ 70,000
-0-
*Bailey’s book value 2021 = (267,000 /30%)= 890,000, 890,000 -175,000 = 715,00
© McGraw Hill 1-39
 Recording a Change to the Equity
Method 2

Bailey reports net income of $130,000 and declares

and pays a $50,000 dividend at the end of 2021. Alpha
records the following journal entries:
Investment in Bailey Company 45,000
Equity in Investee Income 45,000
To accrue 40 percent of the year 2021 income reported by
Bailey Company ($130,000 × 40%) – $7,000 excess patent
amortization (70,000 over 10-year remaining life).
Dividend Receivable 20,000
Investment in Bailey Company 20,000
To record the 2021 dividend declaration by Bailey
Company ($50,000 × 40%).
Cash 20,000
Dividend Receivable 20,000
To record collection of the cash dividend.

© McGraw Hill 1-40

 Learning Objective 1-6b

Understand the financial reporting

consequences for investee’s other
comprehensive income.

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 Other Comprehensive Income (OCI)

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

that under GAAP are included in comprehensive income
but excluded from net income.
• Items included in AOCI (Accumulated Other
Comprehensive Income) on the balance sheet are
accumulated derivative net gains and losses, foreign
currency translation adjustments, and certain pension
adjustments.
• Equity method accounting requires that the investor record
its share of investee OCI and irregular items traditionally
found in net income.
• AOCI is reported in stockholders’ equity and represents a
source of change in investee company net assets that is
recognized under the equity method.
© McGraw Hill 1-42
 Learning Objective 1-6c

Understand the financial reporting

consequences for investee losses.

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 Reporting Investee Losses
• Declines in investment value can result due to a loss
of major customers, changes in economic
conditions, loss of a significant patent or other legal
right, damage to the company’s reputation, etc. A
temporary drop in the fair value of an investment is
simply ignored.
• FASB ASC (para. 323-10-35-32) requires that a loss
in value of an investment which is other than a
temporary decline shall be recognized.
• A permanent decline in the investee’s fair market
value is recorded as an impairment loss and the
investment account is reduced to the fair value.

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 Investment Reduced to Zero

• When accumulated losses incurred and

dividends paid by the investee reduce the
investment account to $-0-, no further loss
can be accrued. A temporary decline is
ignored!
• Once the original cost of the investment has
been eliminated, no additional losses can
accrue to the investor.
• Future equity income will be offset by these
losses prior to recording equity income in
our results.
© McGraw Hill 1-45
 Learning Objective 1-6d

Understand the financial reporting

consequences for sales of equity method
investments.

© McGraw Hill 1-46

 Reporting the Sale of an Equity
Investment
If part of an investment is sold during the period:
• The equity method is applied up to the transaction
date.
• 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 if the investor is required
to change FROM the equity method to the fair-value
method.
• Note: A change TO the equity method is also treated
prospectively.

© McGraw Hill 1-47

 Learning Objective 1-7

Describe the rationale and computations to

defer the investor’s share of gross profits on
intra-entity inventory sales until the goods are
either consumed by the owner or sold to
outside parties.

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 Deferral of Intra-Entity Gross Profits
in Inventory
Many equity acquisitions establish ties between
companies to facilitate the direct purchase and sale of
inventory items. Such intra-entity transactions can
occur either on a regular basis or sporadically.
EXHIBIT 1.2 Downstream and Upstream Sales

Access the text alternative for slide images.

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 Downstream Sales of Inventory—
Investor Sales to Investee
• Profit recognition is delayed until buyer disposes of the
goods.
• Investor decreases current equity income to reflect the
deferred portion of the intra-entity profit.
• When this inventory is eventually consumed or sold to
unrelated parties, the deferral is no longer needed.
• The investor should recognize the deferred intra-entity
gross profit. Recognition shifts from the year of inventory
transfer to the year in which the sale to unrelated
customers occurred.
• An alternative treatment would be the direct reduction of
the investor’s inventory balance as a means of
accounting for this deferred amount.
© McGraw Hill 1-50
 Downstream Sales of Inventory—Investor
Sales to Investee Journal Entries
If gross profit on an original intra-entity sale is 30 percent of $10,000 in
sales, investor profit associated with the sale is $3,000. If 40 percent of
investee’s stock is held, just $1,200 of the profit is deferred.
Current equity income decreases by $1,200 to defer the intra-entity profit
and temporarily remove 30 percent of the profit from the investor’s
books in 2018 until the investee disposes of the inventory in 2019.
Intra-Entity Gross Profit Deferral
Equity in Investee Income 1,200
Investment in Minor Company 1,200
To defer gross profit on sale of inventory to Minor Company.

Reverse the preceding deferral entry to move the profit into the year of
sale to outside customers.
Subsequent Recognition of Intra-Entity Gross Profit
Investment in Minor Company 1,200
Equity in Investee Income 1,200
To recognize income on intra-entity sale that now can be recognized
after sales to outsiders.
© McGraw Hill 1-51
 Upstream Sales of Inventory—Investee
Sales to Investor
• Upstream sales of inventory are reported in the
same manner as downstream sales.
• Profit recognition is delayed until buyer disposes of
the goods.
• Investor decreases current equity income to reflect
the deferred portion of the intra-entity profit.
• The investor’s own inventory account contains the
deferred gross profit. Recognition of profit is
deferred by decreasing the investment account
rather than the inventory balance.
• When this inventory is eventually consumed or sold
to unrelated parties, the deferral is reversed.
© McGraw Hill 1-52
 Upstream Sales of Inventory—Investee
Sales to Investor Journal Entries
Suppose the investee sells merchandise costing $40,000 to the investor
for $60,000, and at year’s end, the investor still retains $15,000 of the
goods. The investee reports net income of $120,000 for the year. The
investor records a journal entry to reflect the basic accrual of the
investee’s earnings.
Income Accrual
Investment in Minor Company 48,000
Equity in Investee Income 48,000
To accrue income from 40 percent owned investee ($120,000 × 40%).

A second entry is required of the investor at year-end. Income accrual is

reduced, and the investor defers its portion of the intra-entity gross
profit.
Intra-Entity Gross Profit Deferral
Equity in Investee Income 2,000
Investment in Minor Company 2,000
To defer recognition of intra-entity gross profit until inventory is
used or sold to unrelated parties.
© McGraw Hill 1-53
 Financial Reporting Effects

Measurements of financial performance often

affect the following:
• The firm’s ability to raise capital.
• Managerial compensation.
• The ability to meet debt covenants and future
interest rates.
• Managers’ reputations.

© McGraw Hill 1-54

 Criticisms of the Equity Method

• Emphasizing the 20 to 50 percent of voting

stock in determining significant influence
versus control.
• Allowing off-balance-sheet financing.
• Potentially biasing performance ratios.

© McGraw Hill 1-55

 Learning Objective 1-8

Explain the rationale and reporting

implications of fair-value accounting for
investments otherwise accounted for by the
equity method.

© McGraw Hill 1-56

 Fair-Value Reporting Option 1

• 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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 Fair-Value Reporting Option 2

• The fair-value option improves financial

reporting. It provides entities with the
opportunity to mitigate volatility in reported
earnings caused by measuring related
assets and liabilities differently without
having to apply complex hedge accounting
provisions.
• The fair-value option matches asset
valuation with fair-value reporting
requirements for many liabilities.

© McGraw Hill 1-58