Chapter One

The Equity
Method of
Accounting
for
Investments
Reporting Investments in 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.
 Fair Value Method
Details in SFAS No. 115:
•Initial Investments are recorded at cost.
(Subsequently adjusted to fair value only if
readily determinable)

•Dividends received are recognized as income.

•Investments in equities of other companies are
classified either as Trading or Available-for-Sale
Securities
 Cont…
• Trading securities are held for the purpose
of re-sale in the short term. Unrealized
holding gains and losses are included in
reported earnings.
• Available-for-sale securities are those not
classified as trading. Unrealized holding
gains and losses are reported in
shareholders’ equity as other comprehensive
income. (They are not included in earnings.)
 Equity Method
• Required when an investor has the
ability to “significantly influence” the
investee.
• Generally used when ownership is
between 20% to 50%.
• ™
Significant Influence might be present
with much smaller ownership
percentages. (The accountant must
consider the particulars!!!
• IAS 28 applies to all investments in which an
investor has significant influence but not
control or joint control except for investments
held by a venture capital organisation, mutual
fund, unit trust, and similar entity that are
designated under IAS 39 to be at fair value
with fair value changes recognised in profit or
loss. [IAS 28.1]
 Key definitions IAS 28.2
• Associate: an entity in which an investor has
significant influence but not control or joint control.
• Significant influence: power to participate in the
financial and operating policy decisions but not
control them.
• Equity method: a method of accounting by which an
equity investment is initially recorded at cost and
subsequently adjusted to reflect the investor's share of
the net assets of the associate (investee).
• Identification of associates
• A holding of 20% or more of the voting power
(directly or through subsidiaries) will indicate
significant influence unless it can be clearly
demonstrated otherwise. If the holding is less
than 20%, the investor will be presumed not to
have significant influence unless such influence
can be clearly demonstrated. [IAS 28.6]
• What are exceptional circumstances? Read
IAS28.13a-c
Consolidation of Financial Statements
• Governed SFAS No. 141, and SFAS No.
142.(IFRS 10)
• 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.
• IFRS 10 Consolidated Financial Statements
• outlines the requirements for the preparation
and presentation of consolidated financial
statements, requiring entities to consolidate
entities it controls. Control requires exposure or
rights to variable returns and the ability to
affect those returns through power over an
investee.
An investor controls an investee if and only if the
investor has all of the following elements: [IFRS
10:7]
• power over the investee, i.e. the investor has existing
rights that give it the ability to direct the relevant
activities (the activities that significantly affect the
investee's returns)
• exposure, or rights, to variable returns from its
involvement with the investee
• the ability to use its power over the investee to
affect the amount of the investor's returns.
Criteria for Determining Whether
There is Influence
Representation on the investee’s Board of Directors

Participation in the investee’s policy-making process

Material intercompany transactions.

Interchange of managerial personnel.
Technological dependency.

Extent of ownership in relationship to other

ownership percentages.
 The Significance of the Size of the
Investment
Investor Ownership of
Investee Shares
Outstanding

Fair Equity Consolidated Financial

Value Method Statements
{

0% 20% 50% 100%

In some cases, influence or control may

exist with less than 20% ownership.
 The Significance of the Size of the
Investment
Investor Ownership of
Investee Shares
Outstanding

Fair Equity Consolidated Financial

Value Method Statements
{
0% 20% 50% 100%

Significant influence is generally

assumed with 20% to 50%
ownership.
 The Significance of the Size of the
Investment
Investor Ownership of
Investee Shares
Outstanding

Fair Equity Consolidated Financial

Value Method Statements

{
0% 20% 50% 100%

Financial Statements of all related

companies must be consolidated.
 Fair Value Method (Revisited) – using
Available for Sale (AFS) securities
• Purchase
– Dr Investment in AFS XXXXX
– Cr Cash XXXXX

• Dividend Income
– Dr Cash XXXXX
– Cr Dividend Income XXXXX

• Change in Value of Security (Increase)1

– Dr Market Value Adj. – AFS XXXXX
– Cr Unrealized inc/dec in AFS2 XXXXX

1 - The reverse is true for a decrease

2 – This account appears in stock holders equity. If it were a “Held for Trading”
security the gain would have appeared in the income statement as an
“Unrealized loss on Trading Securities”
 Equity Method
Step 1: The investor records its
investment in the investee at cost.

Cost can be defined by cash paid or Fair Market

Value of Stock or other assets given up.

GENERAL JOURNAL Page ##

Date Description Debit Credit
Investment in Investee $$$$
Cash(other asset/stock) $$$$
 Equity Method

Step 2: The investor recognizes its

proportionate share of the investee’s net
income (or net loss) for the period.
GENERAL JOURNAL Page ##
Date Description Debit Credit
Year Investment in Investee $$$$
End Equity in Investee Income $$$$
 Equity Method

Step 2: The investor recognizes its

proportionate share of the investee’s net
income (or net loss) for the period.
GENERAL JOURNAL Page ##
Date Description Debit Credit
Year Investment in Investee $$$$
End Equity in Investee Income $$$$

This will appear as a separate

line-item on the investor’s
income statement.
 Equity Method

Step 3: The investor reduces the investment

account by the amount of dividends
received from the investee.
GENERAL JOURNAL Page ##
Date Description Debit Credit
Year Cash $$$$
End Investment in Investee $$$$
 Equity Method Example Step1
On January 1, 2005, Big Corp. buys 20% of
Small Inc. for $2,000,000 cash.
Record Big’s journal entry.
GENERAL JOURNAL Page 25
Date Description Debit Credit
1-Jan Investment in Small 2,000,000
Cash 2,000,000

Cash Investment in Small

2,000,000 2,000,000
 Equity Method Example Step 2
On December 31, 2005, Small reports net
income for the year of $300,000.
Record Big’s journal entry.
GENERAL JOURNAL Page 180
Date Description Debit Credit

Investment in Small Equity in Small's NI

2,000,000
 Equity Method Example Step2
Big owns 20% of Small and gets credit for
20% of Small’s income.
20% × $300,000 = $60,000
GENERAL JOURNAL Page 180
Date Description Debit Credit
31-Dec Investment in Small 60,000
Equity in Small's Income 60,000

Investment in Small Equity in Small's NI

2,000,000 60,000
60,000
 Equity Method Example Step 3
On December 31, 2003, Big received a
$25,000 dividend check from Small.
Record Big’s journal entry.
GENERAL JOURNAL Page 180
Date Description Debit Credit
31-Dec Cash 25,000
Investment in Small 25,000

Investment in Small Cash

2,000,000 25,000
60,000 25,000
 Special Procedures for Special
Situations
Reporting a
change to Reporting the
the equity sale of an equity
method. investment.

Reporting investee
income from sources Reporting
other than continuing investee
operations. losses.
 Reporting a Change to the Equity
Method(Retroactive adjustments).
• 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 accounts are restated so that the

investor’s financial statements appear as if the
equity method had been applied from the date

?
of the first [original] acquisition. - - APB
Opinion 18
 Restatement - Example
Assume that Exxo Company acquires 5% of
LipGloss Inc. on January 1, 2004 for $2,000,000.
There is no significant influence. The investment is
recorded at the time as an Available-for-Sale
Investment.
In 2004, LipGloss had net income of $300,000, and
paid dividends of $140,000. Exxo would report the
investment as indicated in the table below:
Equity in
Investee Dividend
Date Investment Income Revenue
12/31/04 $ 2,000,000 $ - $ 7,000
 Fair Market Value entry

• The entries for adjustment to FMV would

also have been required. E.g. Assume that
the FMV @ 31/12/2004 was $2,400,000.
Then the following entry would have been
made (as per SFAS115):
Dr Market Value Adjustment - AFS 400,000
Cr Unrealized inc/dec in value of AFS 400,000
 Restatement - Example
On January 1, 2005, Exxo buys an additional 15%
interest in LipGloss, raising the total investment to
20%. The first thing that Exxo must do is restate the
12/31/04 numbers by applying the equity method to
the 5% investment in LipGloss.
We have to RESTATE the Investment account, put a
balance in Equity in Investee Income, and eliminate
the Dividend Revenue balance.
Equity in
Investee Dividend
Date Investment Income Revenue
12/31/04 $ 2,000,000 $ - $ 7,000
Adjusted $ 2,008,000 $ 15,000 $ -
 Restatement - Example
An adjustment is recorded to the Investment
account and to Retained Earnings (since Dividend
Revenue has already been closed out).
GENERAL JOURNAL Page 180
Date Description Debit Credit
1/1/05 Investment In LipGloss 8,000
R/E - Prior Period Adjustment, Equity in
LipGloss Earnings 8,000

Equity in
Investee Dividend
Date Investment Income Revenue
12/31/04 $ 2,000,000 $ - $ 7,000
Adjusted $ 2,008,000 $ 15,000 $ -
 Removal of Fair Market Value
related accounts
• The FMV related accounts would also have
to be removed. i.e. :
Dr Unrealized inc/dec in value of AFS 400,000
Cr Market Value Adjustment - AFS 400,000
 Reporting Investee Income from
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
 Reporting Investee Income from
Other Sources
Big owns 30% of Little. Little reports net income
for 2005 of $120,000. Little’s Income includes
operating income of $135,000 and an
extraordinary loss of $15,000.
Big’s equity method entry at year-end is:

GENERAL JOURNAL Page ##

Date Description Debit Credit
31-Dec Investment in Little 36,000
Extraordinary Loss of Little 4,500
Equity in Little's Income 40,500
 Reporting Investee Losses

Permanent Losses in Value

A permanent decline in the investee’s
market value is recorded as a reduction of
the investment account.
 Reporting Investee Losses
Investment Reduced to Zero
• When the accumulated losses incurred
by the investee and dividends paid by
the investee reduce the investment
account to zero, NO ADDITIONAL
LOSSES are accrued.
• The balance remains at $0, until
subsequent profits eliminate all
UNRECORDED losses.
 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. (as is the case when
switching from FV to Equity method)
 Reporting the Sale of an Equity Investment
Alice Co. 30% (300,000 shares) of Sam, Inc.. The balance
in Alice’s Investment account at March 31, 2005, is
$268,000.
If Alice Co. sells 10% of its shares (30,000 shares) on
April 1, 2005 for $100,000, what entry should Alice
make on April 1, 2005?

GENERAL JOURNAL Page ##

Date Description Debit Credit
1-Apr Cash 100,000
Gain on Sale of Investment 73,200
Investment in Sam, Inc. 26,800

$268,000 × .10% = $26,800

This brings the Investment account to a
balance of $241,200
 Excess of Cost Over BV Acquired
When Cost > BV acquired, the difference must
be identified and accounted for.

Source of the Difference Accounting

Assets that are Amortize the difference over the
undervalued on the remaining useful life of the associated
investee's books asset.
Goodwill In accordance with SFAS No. 142, for
fiscal years beginning after Dec. 15,
2001, Goodwill will be carried forward
without adjustment until the investment
is sold or a permanent decline in value
occurs.
 Excess of Cost Over BV Acquired

The amortization of the difference associated

with the undervalued assets is recorded as a
reduction of both the Investment account
and the Equity in Investee Income account.

GENERAL JOURNAL Page ##

Date Description Debit Credit
Year Equity in Investee Income $$$$
End Investment in Investee $$$$
Excess of Cost Over BV Example
• On January 1, 2005, Big Corp. acquired 20% of Small
Inc. for $2,000,000 cash.
• Assume that Small’s assets had BV on January 1 of
$8,500,000. Small owns a building with a BV of
$500,000, and a FMV of $700,000, and a remaining
useful life of 10 years. All other assets had BV = FMV.
• Allocate the cost to fair market value adjustments and
Goodwill acquired by Big.
 Excess of Cost Over BV
Example
Small's Big's
Big's % Amounts Share
Big's Cost $ 2,000,000
Small's BV 20% $ 8,500,000 1,700,000
Difference 300,000
Asset FMV Adj.
Building 20% 200,000 40,000
Goodwill $ 260,000
 Excess of Cost Over BV
Example
Small's Big's
Big's % Amounts Share
Big's Cost The Building has a $ 2,000,000
remaining useful life
Small's BV 20% $ 8,500,000 1,700,000
of 10 years. Goodwill
Difference is never amortized. 300,000
Compute the
Asset FMV Adj. amortization expense
Building for20% 200,000
Big at 12/31/05. 40,000
Goodwill $ 260,000
 Amortization of Cost Over BV
Example
Big's
Share Big’s equity method
Big's Cost $ 2,000,000 entry will include an
adjustment to the
Small's BV 1,700,000 investment account
Difference 300,000 of $4,000.

Asset FMV Adj.

Building 40,000 ÷ 10 = $4,000
Goodwill $ 260,000 Goodwill is NOT amortized
 Amortization of Cost Over BV
Example
Big's
GENERAL JOURNAL Page ##
Date Share
Description Debit Credit
31-Dec
Big's Equity in Investee
Cost Income
$ 2,000,000 4,000
Investment in Investee 4,000
Small's BV 1,700,000
Difference 300,000
Asset FMV Adj.
Building 40,000 ÷ 10 = $4,000
Goodwill $ 260,000 Goodwill is NOT amortized
Intercompany Transactions.
 Unrealized Gains in Inventory

Sometimes affiliated companies sell or buy

inventory from each other.

INVESTOR INVESTOR
Downstream Upstream
Sale Sale

INVESTEE INVESTEE
 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
sells 200 units
that the Investor
of inventory sells the
with a total cost inventory to a
of $1,000. 20% owned
Investee for
$1,250.
 Unrealized Gains in Inventory
Let’s look at an Investor that has 200
Note that there is $250 of intercompany profit. At
unitsit is
this point ofconsidered
inventoryUNREALIZED.
with a cost of
$1,000.

INVESTOR INVESTEE
sells 200 units 20% ownership buys 200 units
of inventory of inventory and
with a total cost Intercompany pays a total of
Sale of 200 units
of $1,000. $1,250.

If all 200 units are not sold to an outside party

during the period, we will need have unrealized,
intercompany profit that must be deferred.
 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 INVESTEE
sells 200 units 20% ownership buys 200 units
of inventory of inventory and
with a total cost Intercompany pays a total of
Sale of 200 units
of $1,000. $1,250.

Investee sells only

140 units to a 3rd
party
Outside Party
 Unrealized Gains in Inventory
• Compute the deferral by multiplying:

Intercompany % % owned by
x x
Profit unsold investor
• The required journal (for both upstream
and downstream) is:
GENERAL JOURNAL Page ##
Date Description Debit Credit
Year Equity in Investee Income 15
End Investment in Investee 15

$250 × 30% × 20% = $15

Unrealized Gains in Inventory
• In the period following the period of the transfer,
the remaining inventory is often sold.
• When that happens, the original entry is reversed
...

GENERAL JOURNAL Page ##

Date Description Debit Credit
Year Investment in Investee 15
End Equity in Investee Income 15

The reversal takes place in the period that the

inventory is sold to an outside party.
End of Chapter 1