Chapter One

The Equity
Method of
Accounting
for
Investments

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All

rights reserved.
 Reporting Investments in
-2

Corporate Equity Securities

GAAP allows 3 approaches to
reporting investments:

These 3 approaches are not interchangeable.

(The appropriate method depends upon the
characteristics of the particular investment)
-3

Fair Value Method

Details
Detailsin inSFAS
SFAS No.
No. 115
115::
 Initial

Initial Investments
Investmentsare are recorded
recorded atat
cost.
cost. (Subsequently
(Subsequently adjusted
adjusted toto
fair
fairvalue
value only
onlyifif readily
readily
determinable)
determinable)
 Dividends

Dividendsreceived
receivedarearerecognized
recognized
as
asincome.
income.
 Investments

Investmentsin in equities
equitiesof of other
other
companies
companiesare areclassified
classified either
either as
as
Trading
Tradingor or Available-for-Sale
Available-for-Sale
Securities
Securities..
-4

Fair Value Method (continued)

 Trading

Tradingsecurities
securitiesare
areheld
heldfor
forthe
the
purpose
purposeofofre-sale
re-saleininthe
theshort
shortterm.
term.
Unrealized
Unrealizedholding
holdinggains
gainsand
andlosses
losses
are
areincluded
includedininearnings
earnings..
 Available-for-sale

Available-for-salesecurities
securitiesare
are
those
thosenot
notclassified
classifiedas astrading.
trading.
Unrealized
Unrealizedholding
holdinggains
gainsand
andlosses
losses
are
arereported
reportedininshareholders’
shareholders’equity
equity
as
asother
othercomprehensive
comprehensiveincome.
income.
(They
(Theyare
are not
notincluded
includedin inearnings.)
earnings.)
 Consolidation of Financial
-5

Statements
 Required when investor’s ownership
exceeds 50% of investee, except
“where control does not actually rest
with the majority shareholders”
 Legal reorganizations
 Bankruptcies
 Foreign government restrictions

 A single set of financial statements is

produced, recording the consolidated
assets, liabilities, equities, revenues,
and expenses for the parent company
and all controlled subsidiary
companies.
-6

WARNING!!!! WARNING!!!

 FASB Interpretation No. 46-R,

Consolidation of Variable Interest Rate
Entities [FIN 46] expands the use of
consolidated financial statements:
 Includes entities controlled through
“special contractual arrangements”
 Intended to combat misuse of SPE’s
(special purpose entities) by firms like
Enron
 Part of the accounting defense against
“off balance sheet financing”
-7

Equity Method

 Requires

Requiresthat
that the
theinvestor
investor has
has
the
thepotential
potential for
for “significant”
“significant”
influence.
influence.
 Generally

Generally used
used when
whenownership
ownership
is
is between
between 20%
20% andand50%.
50%.
 Significant

SignificantInfluence
Influencemight
mightbe
be
present
presentwith
withmuch
muchsmaller
smaller
ownership
ownershippercentages.
percentages.(The
(The
accountant
accountantmust
mustconsider
considerthe
the
particulars!!!)
particulars!!!)
-8 Criteria for Determining Whether There
is “Significant” Influence
(APB Opinion 18)

Representation
Representationon
onthe
theinvestee’s
investee’sBoard
Board of
of
Directors
Directors
Participation
Participationin
inthe
theinvestee’s
investee’s policy-
policy-
making
makingprocess
process
Material
Material inter-company
inter-companytransactions.
transactions.
Interchange
Interchange of
of managerial
managerial personnel.
personnel.
Technological
Technological dependency.
dependency.
Extent
Extent of
of ownership
ownershipin
inrelationship
relationshipto
to
other
other investor
investor ownership
ownership percentages.
percentages.
-9

Size (of the Investment) Matters!!!

Investor Ownership of the

Investee’s Shares
Outstanding

Fair Equity Consolidated Financial

Value Method Statements
{

0% 20% 50% 100%

In
Insome
somecases,
cases,influence
influenceor
orcontrol
controlmay
may
exist
existwith
withless
lessthan
than20%
20%ownership.
ownership.
 The Significance of the Size of the
-10

Investment

Investor Ownership of the

Investee’s Shares
Outstanding

Fair Equity Consolidated Financial

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

Significant
Significantinfluence
influenceis
isgenerally
generally
assumed
assumedwith with20%
20%toto50%
50%
ownership.
ownership.
 The Significance of the Size of the
-11

Investment

Investor Ownership of the

Investee’s Shares
Outstanding

Fair Equity Consolidated Financial

Value Method Statements

{
0% 20% 50% 100%

Financial
FinancialStatements
Statementsof
ofall
allrelated
related
companies
companiesmust
mustbe
beconsolidated.
consolidated.
-12

Remember:

 The ability to exert significant

influence is the determining factor in
applying the equity method

 No actual influence need have been

applied!!
-13

Equity Method

Step 1: The investor records its investment

in the investee at cost.

Journal entry:
Debit – Investment in Investee
Credit – Cash (or other Assets/Stock)

Cost
Cost can
canbebedefined
defined by
bycash
cash paid
paidor
orthe
theFair
Fair
Market
Market Value
Value of
of Stock
Stock or
or Assets
Assetsgiven
given up.
up.
-14

Equity Method

Step 2: The investor recognizes its

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

Journal entry at end of period:

Debit – Investment in Investee
Credit – Equity in Investee Income

This
This will
will appear
appear as
asaa separate
separate
line-item
line-itemononthe
the investor’s
investor’s
income
incomestatement.
statement.
-15

Equity Method

Step 3: The investor reduces the

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

Journal entry when cash dividends received:

Debit – Cash
Credit – Investment in Investee
-16

Equity Method Example

 Little Company reported a net income of

$200,000 during 2008 and paid cash
dividends of $50,000. These figures
indicate that Little’s net assets have
increased by $150,000 during the year.

Investment in Little Company. . 40,000

Equity in Investee Income .. . . . . . . . . . 40,000
To accrue earnings of a 20 percent owned investee
($200,000 20%).
-17

Equity Method Example

Cash . . . . . . . . . . . . .. . . . . . 10,000
Investment in Little Company . .. . . . 10,000
To record receipt of cash dividend from
Little Company ($50,000 20%).
 Special Procedures for Special
-18

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.
 Reporting a Change to the Equity
-19

Method. (Retroactive Adjustment)

 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
are restated
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
 Restatement (Retroactive
-20

Adjustment) - Example
Giant
GiantCompany
Companyacquires
acquiresaa1010percent
percentownership
ownershipin in
Small
SmallCompany
Companyon onJanuary
January1,1,2008.
2008.Officials
Officialsof
ofGiant
Giant
do
donot
notbelieve
believethat
thattheir
theircompany
companyhashasgained
gainedthe
theability
ability
to
toexert
exertsignificant
significantinfluence
influenceover
overSmall.
Small.Giant
Giantproperly
properly
records
recordsthe
theinvestment
investmentby byusing
usingthe
thefair-value
fair-valuemethod
methodas as
an
anavailable-for-sale
available-for-salesecurity.
security.Subsequently,
Subsequently,on onJanuary
January
1,1,2010,
2010,Giant
Giantpurchases
purchasesananadditional
additional3030percent
percentof ofthe
the
Small’s
Small’soutstanding
outstandingvoting
votingstock,
stock,thereby
therebyachieving
achievingthe the
ability
abilityto
tosignificantly
significantlyinfluence
influencethe
theinvestee’s
investee’sdecision
decision
making.
making. TheThereadjustment
readjustmentfollows
followsononthe
thenext
nextslide.
slide.
 Restatement (Retroactive
-21

Adjustment) - Example
 Reporting Investee Income from
-22

Other Sources
 When net income includes
elements other than
Operating Income, these
elements should be
presented separately on the
investor’s income statement.

 Examples include:
 Discontinued operations
 Extraordinary items
 Prior period adjustments
 Reporting Investee Income from
-23

Other Sources

 Large
LargeCompany
Companyowns owns4040percent
percentof ofthe
thevoting
votingstock
stockof
of
Tiny
TinyCompany
Companyand andaccounts
accountsforforthis
thisinvestment
investmentby bymeans
means
of
ofthe
theequity
equitymethod.
method.InIn2008,
2008,Tiny
Tinyreports
reportsnet
netincome
incomeof of
$200,000,
$200,000,aafigure
figurecomposed
composedof of$250,000
$250,000ininincome
incomefrom
from
continuing
continuingoperations
operationsandandaa$50,000
$50,000extraordinary
extraordinaryloss.
loss.
Large
LargeCompany
Companyaccrues
accruesearnings
earningsof of$80,000
$80,000based
basedonon4040
percent
percentofofthe
the$200,000
$200,000net
netfigure.
figure.
Larges
Largesequity
equitymethod
methodentry
entryatatyear-end
year-endis:is:
-24

Reporting Investee Losses

A
A permanent
permanent
decline
decline in
in the
the
investee’s
investee’s fair
fair
market
market value
value isis
recorded
recorded as as an
an
impairment
impairment loss loss
and
and the
the reduction
reduction
of
of the
the investment
investment
account A
account to to the
the fair
fair temporary
value.
value. decline is
ignored!!!
-25

Reporting Investee Losses

Investment
Investment Reduced
Reducedto toZero
Zero
 When

When the
theaccumulated
accumulatedlosseslosses
incurred
incurred by
by the
theinvestee
investeeand and
dividends
dividends paid
paid byby the
theinvestee
investee
reduce
reducethe
theinvestment
investment account
account to to
zero,
zero, NO
NO ADDITIONAL
ADDITIONALLOSSES LOSSESare are
accrued
accrued(unless
(unlessaa further
further
commitment
commitment has hasbeen
beenmade)
made)
 The

Thebalance
balanceremains
remains atat$0,
$0, until
until
subsequent
subsequentprofits
profitseliminate
eliminateallall
UNREALIZED
UNREALIZED losses.
losses.
 Reporting the Sale of an Equity
-26

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

 The

Theequity
equitymethod
method continues
continuesto
to be
be
applied
appliedup upto
tothe
the date
dateofof the
the
transaction.
transaction.
 At

Atthethe transaction
transaction date,
date, aa
proportionate
proportionateamountamount ofof the
the
Investment
Investment account
account isisremoved.
removed.
 IfIf significant

significantinfluence
influenceis is lost,
lost, NO
NO
RETROACTIVE
RETROACTIVE ADJUSTMENT
ADJUSTMENTis is
recorded,
recorded, but butthe
theequity
equitymethod
method is is
no
no longer
longer applied.
applied.
 Reporting the Sale of an Equity
-27

Investment

 Top
TopCompany
Companyowns owns40 40percent
percentofofthe
the100,000
100,000outstanding
outstanding
shares
sharesofofBottom
BottomCompany,
Company,an aninvestment
investmentaccounted
accountedfor forby
bythe
the
equity
equitymethod.
method.Although
Althoughthese
these40,000
40,000shares
shareswere
wereacquired
acquired
some
someyears
yearsago
agofor for$200,000,
$200,000,application
applicationofofthe
theequity
equitymethod
method
has
hasincreased
increasedthe theasset
assetbalance
balanceto to$320,000
$320,000as asofofJanuary
January1,1,
2008.
2008.On
OnJuly
July1,1,2008,
2008,Top
Topelects
electsto tosell
sell10,000
10,000ofofthese
theseshares
shares
(one-fourth
(one-fourthofofits
itsinvestment)
investment)forfor$110,000
$110,000inincash,
cash,thereby
thereby
reducing
reducingownership
ownershipininBottom
Bottomfrom
from40 40percent
percentto
to3030percent.
percent.
Bottom
BottomCompany
Companyreportsreportsincome
incomeofof$70,000
$70,000during
duringthe
thefirst
firstsix
six
months
monthsofof2008
2008andanddistributes
distributescash
cashdividends
dividendsofof$30,000.
$30,000.
-28

Excess of Cost Over BV Acquired

When Cost > BV acquired, the difference

must be identified and accounted for.
-29

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 of of both
both the
the
Investment
Investment account
account andand the
the Equity
Equity in
in
Investee
Investee Income
Income account.
account.
 Excess of Cost Over BV
-30

Example

 Big
BigCompany
Companyisisnegotiating
negotiatingthe theacquisition
acquisition
of
of 30 percent of the outstanding sharesof
30 percent of the outstanding shares of
Little
LittleCompany.
Company.
 Little’s

Little’sbalance
balancesheet
sheetreports
reportsassets
assetsof of
$500,000
$500,000and andliabilities
liabilitiesof
of$300,000
$300,000for foraa
net
netbook
bookvalue
valueof of$200,000.
$200,000.
 After

Afterinvestigation,
investigation,Big Bigdetermines
determinesthat that
Little’s
Little’s equipment is undervalued inthe
equipment is undervalued in the
company’s financial records by
company’s financial records by $60,000.$60,000.
One
Oneof ofits
itspatents
patentsisisalso
alsoundervalued,
undervalued,but but
only
onlybyby$40,000.
$40,000.
 By

Byadding
addingthese
thesevaluation
valuationadjustments
adjustmentsto to
Little’s book value, Big arrives
Little’s book value, Big arrives at anat an
estimated
estimated$300,000
$300,000worth worthfor
forthe
the
company’s
company’s net assets. Based onthis
net assets. Based on this
computation,
computation, Big offers $90,000 foraa30
Big offers $90,000 for 30
percent
percentshare
shareof ofthe
theinvestee’s
investee’soutstanding
outstanding
stock.
stock.
 Excess of Cost Over BV
-31

Example

Book value of Little Company (assets minus

liabilities [or stockholders’ equity]). . . . $200,000
Undervaluation of equipment .. . . . . . . . . . 60,000
Undervaluation of patent .. . . . . . . . . . . . . 40,000
Value of net assets . . . . . . . . . . . . . . . . . $300,000
Portion being acquired . .. . . . . . . . . . . . . . . . 30%
Acquisition price .. . . . . . . . . . . . . . . . . . . $ 90,000
 Amortization of Cost Over BV
-32

Example

Payment
Paymentby byinvestor.
investor.. .. .. .……………..……..
……………..……... .. .. .. .. .. .$90,000 $90,000
Percentage
Percentageofofbook
bookvalue
value
acquired
acquired($200,000
($200,000 30%)
30%). .. . . .…………….……...
…………….…….... .. .60,000 60,000
Payment
Paymentininexcess
excessof
ofbook
bookvaluevalue…………………..…30,000
…………………..…30,000
Excess
Excesspayment
paymentidentified
identifiedwith withspecific
specificassets:
assets:
Equipment
Equipment($60,000
($60,000undervaluation
undervaluation 30%). 30%).. .$18,000 $18,000
Patent
Patent($40,000
($40,000undervaluation
undervaluation 30%) 30%). .. .. .. .. .. .12,000
12,000 30,000
30,000
Excess
Excesspayment
paymentnot
notidentified
identified
with
withspecific
specificassets—goodwill
assets—goodwill. .. .. .. .–0– –0–
 Amortization of Cost Over BV
-33

Example
-34

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
-35

Unrealized Gains in Inventory

Let’s look at an Investor that has 200

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

INVESTOR Let us assume

INVESTOR
sells that the Investor
sells200
200 units
units
of
ofinventory
inventory sells the
with
with aatotal
total inventory to a
cost
cost of
of$1,000.
$1,000. 20% owned
Investee for
$1,250.
-36

Unrealized Gains in Inventory

Note
Let’s look at an Investor that has 200
Notethat
that there
thereis is $250
$250of
of inter-company
inter-companyprofit.
profit. At
At
this units of inventory with a cost of
this point
point ititis
isconsidered
consideredUNREALIZED.
UNREALIZED.
$1,000.

INVESTOR
INVESTOR INVESTEE
INVESTEE
sells 20% ownership
sells200
200units
units buys
buys200
200 units
units
of
of inventory
inventory of
ofinventory
inventoryandand
with inter-company
with aatotal
total Sale of 200 units
pays
paysaa total
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, we
wewill
willhave
haveunrealized,
unrealized,inter-
inter-
company
company profit
profitthat
that must
must bebedeferred.
deferred.
-37

Unrealized Gains in Inventory

60 of the original 200 units (30%) remain

“unsold” to an “outside” party. We must defer
our share (20%) of the original $250 of inter-
company profit that is unrealized (30%).

INVESTOR
INVESTOR INVESTEE
INVESTEE
sells 20% ownership
sells200
200units
units buys
buys200
200 units
units
of
of inventory
inventory of
ofinventory
inventoryandand
with inter-company
with aatotal
total Sale of 200 units
pays
paysaa total
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
-38

Unrealized Gains in Inventory

 Compute the deferral by multiplying:

 The required journal entry is:

$250 × 30% × 20% = $15

-39

Unrealized Gains in Inventory

 In

In the
theperiod
periodfollowing
followingthe
the period
period of
of the
the
transfer,
transfer, the
theremaining
remaining inventory
inventoryisis often
often
sold.
sold.
 When

When that
that happens,
happens, the
theoriginal
original entry
entryisis
reversed
reversed.. .. ..

The reversal takes place during the period that

the inventory is sold to an outside party.
-40

Summary
 The equity method is applied to an investment
whenever significant influence appears to exist.
 Significant influence is presumed whenever
ownership is between 20 and 50% (however, each
situation must be examined separately.)
 Investee income proportionately increases the
investment, while dividends decrease it.
 The equity method is applied retroactively once
significant influence is apparent.
 Excess payments of acquisition are assigned either to
specific assets and liabilities or to goodwill.
Assigned costs (other than to land or goodwill after
2001) are systematically amortized. This is applied
until the date of disposal
 inter-company markups on transferred assets are
deferred until the items are consumed or sold to
outside parties.
-41

Possible Criticisms:

 Over-emphasis on possession of 20-

50% voting stock in deciding on
“significant influence” vs. “control”
 Possibility of “off-balance sheet
financing”
 Potential manipulation of performance
ratios

WHAT DO YOU THINK?????