Chapter One

The Equity
Method of
Accounting for
Investments

Copyright 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Learning Objective 1-1

Describe in general the various

methods of accounting for an
investment in equity shares of
another company.

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Accounting for Investments in

Corporate Equity Securities
GAAP recognizes three ways to report investments in
other companies:
Fair-Value Method
Consolidation of Financial Statements
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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Fair Value Method

Investments in equity securities, when neither significant
influence or control is present, are recorded at cost and
subsequently adjusted to fair value, if determinable,
otherwise they remain at cost.

Investments classified as Trading Securities:

Held for sale in the short term.
Unrealized holding gains and losses are
included in earnings.
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Fair Value Method

Equity securities not classified as trading securities are
classified as available-for-sale securities and reported at
fair value.
Unrealized holding gains and losses are excluded from
earnings and reported in a separate component of
shareholders equity as part of other comprehensive
income.
Dividends received are recognized as income for both
trading and available-for-sale securities.
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Fair Value Method

FASB ASC Topic 825, Financial Instruments, allows a
special fair-value reporting option for available-for-sale
securities.
Although the balance sheet amounts for the investments
remain at fair value under this option, changes in fair
values over time are recognized in the income statement
(as opposed to other comprehensive income) as they occur.

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Consolidation of
Financial Statements
Required when:
Investors ownership exceeds 50% of
an organizations outstanding voting stock

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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FASB ASC section 810-10-05,

Variable Interest Entities
Includes entities controlled through special
contractual arrangements (not through voting
stock interests)
Intended to combat misuse of SPEs (Special
Purpose Entities) to keep large amounts of assets
and liabilities off the balance sheet known as off
balance sheet financing

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Equity Method
Use when:
Investor has the ability to exercise significant
influence on 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.
Under the equity method, investors share of
investee dividends declared are recorded as
decreases in the investment account, not income.
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International Standard 28 Investment

in Associates
The International Accounting Standards Board (IASB),
similar to FASB, defines significant influence as the
power to participate in the financial and operating policy
decisions of the investee, but it is not control or joint control
over those policies.
If investor has 20% or more ownership, it is presumed to
have significant influence, unless it is demonstrated not to
be the case.
If investor holds less than 20% ownership, it is presumed it
does not have significant influence, unless influence can be
clearly demonstrated.
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Learning Objective 1-2

Identify the sole criterion for

applying the Equity Method of
accounting and guidance in assessing
whether the criterion is met.

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Sole Criterion for Utilizing the Equity Method

Significant Influence (FASB ASC Topic 323)
Representation on the investees Board of Directors
Participation in the investees policy-making process
Material intra-entity transactions
Interchange of managerial personnel
Technological dependency
Other investee ownership percentages

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Limitations of Equity Method Applicability

The equity method is not appropriate for investments
that demonstrate any of the following characteristics
regardless of the investors degree of ownership:
An agreement exists between investor and investee
by which the investor surrenders significant rights as
a shareholder.
A concentration of ownership operates the investee
without regard for the views of the investor.
The investor attempts but fails to obtain
representation on the investees board of directors.
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Extensions of Equity Method Applicability

For some investments that either fall short of or
exceed 20 to 50 percent ownership, the equity
method is appropriately used for financial
reporting.
Conditions can exist where the equity method is
appropriate despite a majority ownership interest.
If the non-controlling rights are so restrictive as to
call into question whether control rests with the
majority owner, the equity method is employed
for financial reporting rather than consolidation.
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Summary of Accounting Methods

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Accounting for an Investment - Equity Method

The investor increases the investment account as the

investee earns and reports income. The investor uses
the accrual method to record investment income
recognizing it in the same time period as the investee
earns it.
The investor decreases its investment accounts
carrying value for its share of investee cash dividends.
When the investee declares a cash dividend, its owners
equity decreases.

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Fair-Value Vs. Equity Method

*Equity in investee income is 20 percent of the current year income reported by

Little Company. The carrying amount of an investment under the equity method
is the original cost plus income recognized less dividends. For 2014, as an
example, the $230,000 reported balance is the $200,000 cost plus $40,000 equity
income less $10,000 in dividends.
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Learning Objective 1-3

Prepare basic equity method journal

entries for an investor and describe
the financial reporting for equity
method investments.

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Equity Method Example

Assume that Big Company owns a 20%
interest in Little Company purchased on
January 1, 2014, for $200,000.
Little then reports net income of $200,000,
$300,000, and $400,000, respectively, in the
next three years while declaring dividends of
$50,000, $100,000, and $200,000.

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Equity Method Example

Big Company records the following journal entries to
apply the equity method for 2014:

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Learning Objective 1-4

Allocate the cost of an equity method

investment and compute amortization
expense to match revenues recognized
from the investment to the excess of
investor cost over investee book value.

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Excess of Investment Cost Over Book

Value Acquired
Fair values of specific investee assets and liabilities
can differ from their book values. Excess payment
can be identified directly with those accounts.
If purchase price exceeds fair value, future benefits are
expected to accrue from the investment due to estimated
profitability of the investee or the relationship established
between the two companies. The additional payment is
attributed to an intangible asset referred to as goodwill
rather than to any specific investee asset or liability.

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Excess of Investment Cost Over Book

Value Acquired
Assume Grande Company is negotiating the acquisition of
30 percent 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 companys financial records by $60,000.
One of its patents is also undervalued, but only by $40,000.
By adding these valuation adjustments to Chicos book value,
Grande arrives at an estimated $300,000 worth for the
companys net assets. Based on this computation, Grande pays
$125,000 for a 30 percent share of the investees outstanding
stock.
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Excess of Cost Over Book Value

of Acquired Investment
When Purchase Price > 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 Investment Cost Over Book

Value Acquired

Any extra payment that cannot be attributed to a specific asset

or liability is assigned to the intangible asset goodwill. The actual
purchase price can be computed by different techniques or simply
as a result from negotiations.
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The Amortization Process

Payment relating to each asset (except land, goodwill, and
other indefinite life intangibles) should be amortized over an
appropriate time period.

Goodwill associated with equity method investments, for the

most part, is measured in the same manner as goodwill arising
from a business combination, tested for declines in value and
impairment. Goodwill, implicit in equity investments, is not.
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Learning Objective 1-5

Understand the financial reporting
consequences for:
a. A change to the equity method.
b. Investee other comprehensive income.
c.
d.

Investee losses.
Sales of equity method investments.
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Learning Objective 1-5a

Reporting a Change to the Equity Method
Report a change to the equity method if:
An investment that was recorded using the fair-value
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. 323-10-35-33)

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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, 2014.
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, 2016, 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)
After changing to the equity method on January 1,
2016, Giant must restate the prior years to present
the investment as if the equity method had always
been applied. The income restatement for these
earlier years can be computed as follows:

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Journal Entries to Report Change

to Equity Method
Giants reported earnings for 2014 will increase by $5,000 with a
$7,000 increment needed for 2015. To bring about this retrospective
change to the equity method, Giant prepares the following journal
entry on Jan.1, 2016:

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Learning Objective 1-5b

Investee Other Comprehensive
OCI is defined as revenues, expenses, gains, and losses
that under GAAP are included in comprehensive income
but excluded from net income.
Accumulated Other Comprehensive Income (AOCI)
includes unrealized holding gains and losses on
available-for-sale securities, foreign currency translation
adjustments, and certain pension adjustments.
OCI is accumulated and reported in stockholders equity
and represents a source of change in investee company
net assets that is recognized under the equity method.

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Reporting Investee Other Comprehensive

Income and Irregular Items

Other equity method recognition issues arise for

irregular items traditionally included within net
income. An investor must report its share of the
following items reported in investees current
income:
Discontinued operations
Extraordinary items
Other comprehensive income

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Learning Objective 1-5c

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.
When accumulated losses incurred and dividends paid
by the investee reduce the investment account to $-0-,
no further loss can be accrued.
Investor discontinues using the equity method rather
than record a negative balance. Balance remains at $0-, until subsequent profits eliminate all unrecognized
losses. A temporary decline is ignored!
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Learning Objective 1-5d

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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Learning Objective 1-6

Describe the rationale and computations

to defer unrealized gross profits on
intra-entity inventory transfers until the
goods are either consumed or sold to
outside parties.

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Deferral of Unrealized Profits

in Inventory
Many equity acquisitions establish ties between companies
to facilitate the direct purchase and sale of inventory items.
Such intra-entity transactions can occur either on a regular
basis or only sporadically.

INVESTOR
INVESTOR
Downstream
Sale

INVESTEE
INVESTEE

INVESTOR
INVESTOR
Upstream
Sale

INVESTEE
INVESTEE
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Deferral of 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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Financial Reporting Effects

Measurements of financial performance often affect
the following:
The firms ability to raise capital.
Managerial compensation.
The ability to meet debt covenants and future
interest rates.
Managers reputations.

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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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Learning Objective 1-7

Explain the rationale and reporting

implications of the value accounting for
investments otherwise accounted for by
the equity method.

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Fair Value Reporting Option

An entity may irrevocably elect fair value as the
initial and subsequent measurement for certain
financial assets and financial liabilities including
investments accounted for under the equity
method.
Under the fair-value option, changes in the fair
value of the elected financial items are included in
earnings.

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