Chapter 2: Stock Investments Investor Accounting and Reporting

by Jeanne M. David, Ph.D., Univ. of Detroit Mercy to accompany Advanced Accounting, 10th edition by Floyd A. Beams, Robin P. Clement, Joseph H. Anthony, and Suzanne Lowensohn

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Stock Investments: Objectives

1. Recognize investors' varying levels of influence or control, based on the level of stock ownership. 2. Anticipate how accounting adjusts to reflect the economics underlying varying levels of investor influence. 3. Apply the fair value/cost and equity methods of accounting for stock investments. 4. Identify factors beyond stock ownership that affect an investor's ability to exert influence or control.
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Objectives (continued)
5. Apply the equity method to purchase price allocations. 6. Learn how to test goodwill for impairment.

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Stock Investments Investor Accounting and Reporting

1: Levels of Influence or Control

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Levels of Influence
Percent Ownership of Voting Stock
<20% presumes lack of significant influence fair value (cost) method 20% to 50% presumes significant influence equity method >50% presumes control consolidated financial statements
<20% >50%
Consolidated financial statements
Fair value (cost) method Equity method

20-50%

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Stock Investments Investor Accounting and Reporting

2: Accounting Reflects Economics

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Accounting for the Investment

Degree of influence Lack of significant influence Significant influence Investment's carrying value Fair value (cost, if nonmarketable) Original cost adjusted to reflect periodic earnings and dividends, e.g., a proportionate share of investee's net assets Investment income Dividends declared

Proportionate share of investee's periodic earnings*

* If income were measured as dividends declared, by influencing or controlling dividend decisions, the investor could manipulate its own investment income.
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Stock Investments Investor Accounting and Reporting

3a: Fair Value/Cost Method

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Fair Value (Cost) Method

FASB Statement No. 115 At acquisition: Pilzner buys 2,000 shares of Sud for $100,000.

Investment in Sud Cash

100,000 100,000

Pilzner receives $4,000 in dividends from Sud. Cash Dividend income

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4,000 4,000
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Fair Value Method, at Year-end

Reduce dividend income recognized, if needed

Dividend income 1,000 Investment in Sud 1,000 If Pilzner determines that cumulative dividends exceed its cumulative share of income by $1,000.
Adjust investment to fair value Allowance to adjust available-forsale securities to fair value 21,000

Other comprehensive income 21,000 If fair value of increases to $120,000 and the Investment in Sud account balance is $99,000.
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Stock Investments Investor Accounting and Reporting

3b: Equity Method

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Equity Method
APB Opinion No. 18 At acquisition: Pilzner buys 2,000 shares of Sud for $100,000.

Investment in Sud Cash

Cash Investment in Sud
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100,000 100,000
4,000 4,000
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Pilzner receives $4,000 in dividends from Sud.

Equity Method, at Year-end

Pilzner determines that its share of Sud's income is $5,000. Cash 4,000 Investment in Sud 4,000
The ending balance in the Investment in Sud is:

$100,000 cost - $4,000 dividends + $5,000 income = $101,000.

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Stock Investments Investor Accounting and Reporting

4: Ability to Influence or Control

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Significant Influence
20% to 50% voting stock ownership is a presumption of significant influence. Use the equity method. Don't use equity method if there is a lack of significant influence 1. Opposition by investee, 2. Surrender of significant shareholder rights, 3. Concentration of majority ownership, 4. Lack of information for equity method, and 5. Failure to obtain board representation.
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Control
More than 50% voting stock ownership is presumptive evidence of control. Prepare consolidated financial statements. Don't consolidate if control is temporary or if the parent lacks control 1. Legal reorganization or bankruptcy 2. Severe foreign restrictions.

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Stock Investments Investor Accounting and Reporting

5: Applying the Equity Method

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Acquisition Cost > FV net assets FV net assets > BV net assets
Payne acquires 30% of Sloan for $5,000. Sloan's identifiable net assets (assets less liabilities) are: Fair value: A L = $18,800 - $2,800 = $16,000. Book value: A L = E = $15,000 - $3,000 = $12,000

The $4,000 difference ($16,000 - $12,000) is due to: $1,000 undervalued inventories sold this year, $200 overvalued other current assets used this year, $3,000 undervalued equipment with a life of 20 years, and $200 overvalued notes payable due in 5 years.

$5,000 > 30%(16,000) > 30%(12,000) $5,000 > $4,800 > $3,600
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Acquisition of Sloan Stock

At acquisition, Payne pays $2,000 cash and issues common stock with a fair value of $3,000 and par value of $2,000. Payne also pays $50 to register the securities and $100 in consulting fees. Investment in Sloan 5,000 Cash Common stock, at par Additional paid in capital 2,000 2,000 1,000

Additional paid in capital Investment expense Cash

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50 100
150
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Cost/Book Value Assignment

Cost of acquisition Less 30% book value = 30%(12,000) Excess of cost over book value Assigned to: Inventories 30%(+1,000) Other curr. assets 30%(-200) Equipment 30%(+3,000) Note payable 30%(+200) Goodwill (to balance) Total Amount $300 (60) 900 60 200 $1,400 $5,000 3,600 $1,400 Amortization 1st year 1st year 20 years 5 years None

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Dividends and Income

Payne receives $300 dividends from Sloan.
Cash 300 Investment in Sloan 300 Sloan reports net income of $900. Payne will recognize its share (30%) of Sloan's income, but will adjust it for amortization of the differences between book and fair values.

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Amortization and Investment Income

Cost/book value differences: Inventories Other curr. Assets Equipment Note payable Initial amount $300 (60) 900 60 1st year amort. ($300) 60 (45) (12) Unamortized excess at year-end $0 0 855 48

Goodwill 200 0 200 Total $1,400 ($297) $1,103 Investment income is 30% of Sloan's net income amortization 30%($3,000) $297 = $603.
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Year-end Entry & Balance

Record the investment income
Investment in Sloan 603 Income from Sloan 603 The ending balance in the investment account is: Cost dividends + investment income

5,000 300 + 603 = 5,303.

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More on Cost/Book Value Assignment

On acquisition date, compare: Cost of acquisition, Book value of net assets, and Fair value of identifiable net assets Cost of the investment includes cash paid, fair value of securities issued, and debt assumed. The book value of the investee's net assets = assets liabilities, or = stockholders' equity
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Fair Values Used in Assignment

Identifiable net assets include all the investee's assets and liabilities, whether recorded or not Fair value of research in progress Fair value of contingent liabilities Fair value of unrecorded patents Exception: use book value for pensions and deferred taxes. If cost > fair value, goodwill exists. If cost < fair value, a bargain purchase exists.
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Bargain Purchase
When the acquisition cost is less than the fair value of the identifiable net assets, a gain is recognized on the acquisition. The investment is recorded at the fair value of the identifiable net assets
Investment in ABC Cash, CS, APIC Gain on bargain purchase
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Interim Acquisitions
Book value of net assets = BV equity. If equity is given as beginning of year, add current earnings and deduct dividends to date. Amortization for first, partial, year: Take full amortization for inventory and other current assets disposed of by year-end. Take partial year's amortization for equipment, buildings, and debt to be written off over multiple years. Record dividends if after the acquisition date.
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Acquisition in Stages
Also called a step-by-step acquisition. Fair value (cost) method equity method Retroactive adjustment Investee's growth in retained earnings is Excess of income over dividends declared Investment account desired balance using equity method = original cost + share of growth in retained earnings amortization, if any Investment in XYZ Retained earnings
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Sale of Equity Investment

Sale of investment that results in a lack of significant influence over the investee Equity method fair value (cost) method Prospective treatment For the sale Reduce the investment account for a proportionate share of the stock sold Record a gain or loss on the sale Apply the fair value (cost) method to remaining investment
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Stock Purchased from Investee

If stock is purchased from old shareholders, the percentage ownership is based on the shares outstanding and the investee's equity is not changed. If acquired directly from the investee: Percentage acquired = shares acquired / (shares acquired + previously outstanding shares) Investee's new stockholders' equity = Previous equity + value received for new shares
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Investee with Preferred Stock

Compare cost of acquisition to the book value of the common stock. = Total equity book value of preferred stock* * BV of PS = call value + dividends in arrears Dividends received will be a portion of the dividends to common shareholders = total dividends current PS dividends Investment income is based on income available to common shareholders = investee net income PS dividends** ** Pref. Div. = current dividend if cumulative, or dividends declared if noncumulative.
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Special Reporting Issues

If material, the investor continues separate reporting of extraordinary items and/or discontinued operations of the investee Income from Investee is based on income before discontinued operations or extraordinary items Optionally, the investor may report its equity investments at fair market value, FASB Statement Nos. 159 and 157
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Disclosures
For significant equity investees Name, percent ownership Accounting policy Difference between investment carrying value and underlying equity in net assets Aggregate market value Summarized asset, liability, operations Related party disclosures FASB Statement No. 57

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Stock Investments Investor Accounting and Reporting

6: Impairment of Goodwill

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Impairment of Goodwill
Test annually, and if significant events occur (e.g., adverse legal factors or loss of key personnel) FASB Statement No. 142: Two step process 1. If the fair value of the whole reporting unit < the carrying value of the reporting unit including its goodwill, there might be impairment. If no implied impairment, step 2 is not needed. Use quoted market prices of reporting unit, or valuation techniques applied to similar groups of assets and liabilities. 2. If the implied fair value of the goodwill < the carrying value of the goodwill, record an impairment loss for the difference.
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Impairment of Equity Investments

Goodwill implied in equity investments is not tested for impairment. The investment itself is tested for impairment. APB Opinion No. 18

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