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LO 1

Accounting for Investments in


Corporate Equity Securities
GAAP recognizes 3 ways to report
investments in other companies:

Fair-Value Method
Consolidation
Equity Method
The method selected depends upon the degree
of influence the investor has over the investee.
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Fair Value Method


Use when:
investor holds a small percentage
(usually less than 20%) of equity
securities of investee
Investor cannot

significantly affect
investees operations
Investment

is made in anticipation
of dividends or market appreciation.
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Consolidation of
Financial Statements
Required when:
Investors ownership exceeds 50% of
investee

except when control does not rest with


the majority investor
One set of financial statements prepared
to consolidate all accounts of the parent
company and all of its controlled subsidiaries
AS A SINGLE ENTITY.
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LO 2

Equity Method
Use when:
Investor has the ability to exercise
significant influence on the
investee operations (whether influence is
applied or not)

Generally used when ownership is


between 20% and 50%.
Significant Influence might be present
with much lower ownership percentages.
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What is Significant Influence?


(FASB ASC Topic 323)
Representation
Participation

on the investees Board of Directors

in the investees policy-making

process
Material

intra-entity transactions

Interchange

of managerial personnel

Technological

dependency

Other investor ownership

percentages

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General Ownership Guidelines


Investor Ownership of the Investees Shares
Outstanding
Fair
Value
0%

Equity
Method
20%

Usually lack
of control
or
significant
influence.

Consolidated Financial
Statements
50%

Significant
influence
generally assumed
(20% to 50%
ownership).

100%
Financial
statements of all
related
companies must
be consolidated.
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LO 3

General Reporting Guidelines


Fair
Value

Equity
Method

1. Investor
records
investment at
cost.

1: Same as Fair
Value
2: Investor recognizes
its share (% of
owner-ship)
of investees net
income (net loss)
as an increase
(decrease) in the
investment
account and
3. Records dividends
as a decrease.

2. Investor
recognizes cash
dividends from
investee as
income.

Consolidated
Financial
Statements
One set of
financial
statements are
prepared to
combine accounts
of the investor and
all of its investees
AS A SINGLE
ENTITY.

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Equity Method Applied


Step 1
Investment in Investee
Cash (or other Assets/Stock)

XXXX

XXXX

Step 2

Debit Credit
Investment in Investee
Equity in Investee Income

XXXX

If net loss:
Equity in Investee Income
Investment in Investee

Debit Credit
XXXX
XXXX

XXXX

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Equity Method Applied


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

XXXX
XXXX

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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 fairvalue method reaches the point where
significant influence is established.

All accounts are restated retroactively so the


investors financial statements appear as if the
equity method had been applied from the date
of the first acquisition. (FASB ASC para. 32310-35-33)

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Reporting a Change to the Equity


Method (Retroactive Adjustment)
Giant Company acquires a 10% ownership in
Small Company on January 1, 2012.
Giant company does not have the ability to exert
significant influence over Small.
Giant properly records the investment using the
fair-value method as an available-for-sale
security.
On January 1, 2014, Giant purchases another
30% of Smalls outstanding stock, thereby
achieving the ability to significantly influence
Smalls decisions.
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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:
Year

Equity in Investee
Income (10%)

Income Reported from


Dividends

Retrospective
Adjustment

2012

$7,000

$2,000

$5,000

2013

11,000

4,000

7,000

Total Adjustment to
Retained Earnings:

$12,000

Would have reported under


the equity method

Did report under the fairmarket value method


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Journal Entries to Report


Change to Equity Method
Debit Credit
Investment in Small Company . . . . . . . . . . . . . . . . . 12,000
Retained Earnings - Prior Period AdjustmentEquity in Investee Income . . . . . . . . . . . . . . . . . . . . . . . 12,000
To adjust 2012 and 2013 records so that investment is
accounted for using the equity method in a consistent manner.
Unrealized Holding Gain-Shareholders Equity. . . . .13,000
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 the availablefor-sale portfolio valuation account.

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Reporting Investee Income from


Sources other than Operations

When net income includes elements other


than Operating Income, these elements
should be presented separately on the
investors income statement.

Examples include:
Discontinued operations
Extraordinary items
Other comprehensive income

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Reporting Investee Income


from Other Sources
Large Company owns 40% of the voting stock of Tiny Company
and accounts for this investment using the equity method. In 2012,
Tiny reports net income of $200,000, resulting from $250,000 in
income from continuing operations and a $50,000 extraordinary
loss.
Large Company increases the value of its investment by $80,000,
based on 40% of the $200,000 net figure.
Larges Equity Method entry at year-end is:

Debit
Credit
Investment in Tiny Company . . . . . . . . . . . 80,000
Extraordinary Loss of Investee. . . . . . . . . . .20,000
Equity in Investee Income . . . . . . . . . . . . . . . . . . . . . . .100,000
To accrue operating income and extraordinary loss 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)
Investment Reduced to Zero
When accumulated losses incurred and dividends
paid by the investee reduce the investment account
to $-0-, NO ADDITIONAL LOSSES are accrued
(unless a further commitment has been made).
Balance remains at $-0-, until subsequent profits
eliminate all UNREALIZED losses.
Investor discontinues using the equity method
rather than record a negative balance.

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LO 4

Excess of Cost Over Book Value


of Acquired Investment
When Cost > Book Value of an investment
acquired, the difference must be identified.
Assets may be undervalued on the investees books
because:
1.The

fair values (FV) of some assets and liabilities


are different than their book values (BV).

2.The

investor may be willing to pay extra because


future benefits are expected to accrue from the
investment.
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Excess of Cost Over Book Value


(Continued)

When Cost > BV of asset acquired, the difference must


be identified and accounted for correctly in the
accounting records.
Accounting method:
Source of difference:
Amortize the difference (FV
Assets undervalued on BV) over the remaining
the investees book
useful life of the associated
asset.
Goodwill is carried forward
Goodwill
without adjustment until the
investment is sold or a
permanent decline in value
of the investment occurs.
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Excess of Cost Over Book Value


(Continued)

ADDITIONAL amount paid in excess of book


value not allocated to undervalued assets is
attributed to an intangible future value and
recorded as

GOODWILL
Equity method goodwill accounts are not
separable from the investment, and are not
separately tested for impairment.
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LO 5

Reporting Sale of 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, the Investment account
balance is reduced by the percentage of shares
sold.
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 Co., and accounts for
it using the equity method.
The 40,000 shares were acquired for $200,000, and
under the equity method, the asset balance
increased to $320,000 as of January 1, 2012.
Bottom Company reported income of $70,000
during the first six months of 2012 and distributed
cash dividends of $30,000.

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Reporting the Sale of an Equity


Investment (Continued)
On July 1, 2012, Top sells 10,000 of the shares (1/4
of its investment) for $110,000 in cash, reducing
ownership in Bottom from 40% to 30%.
Debit
Credit
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 110,000
Investment in Bottom Company . . . . . . . . .84,000
Gain on Sale of Investment. . . . . . . . . . . . . .26,000
To record the sale of of the investment.
(14 X $336,000 = $84,000).

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LO 6

Unrealized Profits in Inventory


Sometimes affiliated companies sell or buy
inventory from each other in intra-entity
transactions that necessitate special
accounting procedures.

Downstream
Sale

Upstream
Sale

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Unrealized Profits in Inventory


The seller of the goods retains a partial stake in
the inventory for as long as the buyer holds it.
The earning process is not considered complete at
the time of the original sale.
Reporting the profit is delayed until the inventory
is consumed within operations or resold to an
unrelated party.
At the disposition of the inventory, the original
sale is culminated and gross profit is recognized.
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Criticisms of the Equity Method

Over-emphasis on possession of 20-50%


voting stock in deciding on significant
influence vs. control

Allowing off-balance sheet financing

Potential manipulation of performance


ratios

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