Chapter 1

The Equity Method of

Accounting for Investments

Reporting Investments in
Corporate Equity Securities

GAAP recognizes 3 ways to report investments

in other companies:
Fair-Value Method (No significant
influence or control)

Consolidation (Control)

Equity Method (Significant influence)

Depends primarily on the degree of influence.

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Fair Value Method

Used when significant influence or control is
absent.
Ownership is normally between 0 and 20%.
Such investments are recorded at cost and
periodically adjusted to fair value.
Trading securities and available-for-sale
securities.

Consolidation of Financial
Statements
Required

when investor controls the

investee.
Normally the ownership is bigger than
50%.
One set of financial statements
is prepared which consolidates
all accounts of the parent company
and of its controlled subsidiary
companies, as though they were a
single entity.

Equity Method
Used

when the investor has the ability to exercise

significant influence on the investee.
Normally ownership is between 20% and 50%.
Criteria

to establish significant influence

Representation on the investees Board of Directors

Participation in the investees policy-making process
Material intercompany transactions
Interchange of managerial personnel
Technological dependency
Extent of ownership in relation to other investor ownership
percentages

Equity Method - Applied

Step 1: Investor records investment in the

investee at cost.
Journal entry:
Debit Investment in Investee
Credit Cash (or other Assets/Stock)
Cost can be defined as cash paid or the Fair
Market Value of other assets given up.

Equity Method Applied

(Continued)
Step 2: The investor recognizes its
proportionate (pro rata) share of the
investees net income (or net loss) for the
period.
Journal entry:
Debit Investment in Investee
Credit Equity in Investee Income
This will appear as a separate line-item
on the investors income statement.

Equity Method Applied

(Continued)
Step 3: The investor reduces the
investment account by the amount of cash
dividends received from the investee.
Journal entry:
Debit Cash
Credit Investment in Investee

Equity Method Example

Little Company reported net income of $200,000

during 2014 and declared and paid cash dividends of
$50,000. Net assets have increased by $150,000
during the year.
Big owns 20% of Little and records the following
entries using the equity method.
Investment in Little Company40,000
Equity in Investee Income.40,000
(To accrue earnings of a 20 percent owned investee)
Dividend Receivable ..10,000
Investment in Little Company .10,000
(To record a dividend declaration by Little Company)
Cash..10,000
Dividend Receivable .10,000
(To record collection of the cash dividend)
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Excess of Cost Over BV Acquired

When Investment Cost > BV acquired,
the difference must be identified.

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Excess of Cost Over BV Example

Grande Company is negotiating the acquisition of
30% of the outstanding shares of Chico Company.
Chicos balance sheet reports assets of $500,000
and liabilities of $300,000 for a net book value of
$200,000.
After investigation, Grande determines that
Chicos equipment is undervalued in the financial
records by $60,000, and one of its patents is also
undervalued, but only by $40,000.
Based on this computation, Grande should offer
$90,000 for a 30% share of the investees
outstanding stock.

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Excess of Cost Over BV

Example (Continued)

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 (30% of $60,000 undervalued). . .$18,000
Patent (30% of $40,000 undervalued) . . . . . . .12,000
30,000
Excess payment not identified with specific
assetsgoodwill . . . . . . . . . . . . . . .. 0

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Amortization of Cost Over BVExample

Journal entry of Grande Company:

Equity in Investee Income.4,200
Investment in Chico Company.4,200
(To record amortization of excess payment allocated to
equipment and patent)

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Amortization of Cost Over BVExample (Continued)

Goodwill: Any ADDITIONAL amount paid in excess

of $90,000 would be the cost of the goodwill
purchased and would not be amortized like the
other assets.
What if Grande Company paid $125,000?

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Special Procedures
Reporting a
change to
the equity
method.
Reporting
investee
losses.

Reporting investee other

comprehensive income
and irregular items.

Reporting the
sale of an equity
investment.
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Reporting a Change to the Equity

Method
Before the investor achieves significant
influence, the investment should be
reported by the fair-value method.
When ownership grows to the point where
significant influence is established . . .

. . . all accounts are restated so that 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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Reporting a Change to the Equity

Method

Giant Company acquires 10% ownership in Small Company

on January 1, 2014 and records the investment using the
fair-value method as an available-for-sale security.
On January 1, 2016, Giant purchases another 30% of
Smalls outstanding stock, thereby achieving the ability to
significantly influence Smalls decisions.
Small Company
Year

Net Income

Cash Dividends

Fair Value at
January 1

2014

$70,000

$20,000

$800,000

2015

110,000

40,000

840,000

2016

130,000

50,000

930,000

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Reporting a Change to the Equity

Method (Retroactive Adjustment)

The income restatement for these earlier years

can
be computed as follows:
Yea
r

Equity in
Investee
Income (10%)

Income Reported
from Dividends

Retrospective
Adjustment

2014

$7,000

$2,000

$5,000

2015

11,000

4,000

7,000

Total Adjustment
to Retained
Earnings:

$12,000

Would have
reported under
the equity
method

Did report under

the fair-market
value method
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Reporting a Change to the Equity

Method

Journal entries on January 1, 2016.

Investment in Small Company12,000
Retained Earnings- Prior Period Adjustment-Equity in
Investee Income..12,000
(To adjust 2014 and 2015 records)

Unrealized Holding Gain- Shareholders Equity13,000

Fair Value Adjustment (Available-for-sale)13,000
(To remove the investors percentage of the increase in
fair value 10%*$130, 000 from stockholders equity
and
available-for-sale securities account)

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Reporting Investee Other Comprehensive

Income and Irregular Items

Equity method accounting requires that the

investor record its share of investee OCI
which is included in its balance sheet as
Accumulated Other Comprehensive Income
(AOCI).
Items included in AOCI:

Unrealized holding gains/losses

Foreign currency translation adjustments
Certain pension adjustments

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Reporting Investee Other Comprehensive

Income and Irregular Items-Example

Charles company owns 30% of the voting stock of Norris

Company (Equity Method).
In 2014, Norris reports net income of $500,000, and $80,000
in OCI from pension and other postretirement adjustments.
Journal entry of Charles Company:
Investment in Norris Company174,000
Equity in Investee Income150,000
Other Comprehensive Income..24,000
(To accrue operating income and other comprehensive income from
equity investment)

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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.
A temporary decline is ignored!!!

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Reporting Investee Losses

(Continued)
When an investment account is reduced to
zero due to the recognition of reported
losses as well as permanent drops in fair
value, the investor normally should
discontinue using the equity method.
The investment retains a zero balance until
subsequent investee profits eliminate all
unrecognized losses.

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Reporting the Sale of an Equity

Investment
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, a proportionate amount
of the Investment account is removed.
If significant influence is lost, NO RETROACTIVE
ADJUSTMENT is recorded, but the equity method
is no longer applied.

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Reporting the Sale of an Equity

Investment (Continued)

Top company owns 40% of the 100,000 outstanding shares of

Bottom Company (Equity method).
The 40,000 shares were acquired several years ago for $200,000,
and the asset balance has increased to $320,000 as of January 1,
2015. On July 1, 2015, Top elects to sell 10,000 shares for $110,000
in cash, thereby reducing ownership in Bottom from 40% to 30%.
Bottom Company reports income of $70,000 during the first six
months of 2015 and distributes cash dividends of $30,000.
Journal entry of Top Company on July 1, 2015:

Cash.110,000
Investment in Bottom Company84,000
Gain on Sale of Investment.26,000
(To record sale of one-fourth of investment in Bottom
company *$336,000=$84,000)

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