Chapter One

The Equity Method of Accounting for Investments

McGraw-Hill/Irwin

Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

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

Investments in equity securities are recorded at cost and subsequently adjusted to fair value. Investments classified as Trading Securities: Held for sale in the short term. Unrealized holding gains and losses are included in earnings (net income). Investments classified as Available-for-Sale Securities: Any Securities not classified as Trading. Unrealized holding gains and losses are reported in shareholders equity as other comprehensive income (i. e., not included in net income).
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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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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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General Ownership Guidelines

Investor Ownership of the Investees Shares Outstanding Fair Value Equity Method Consolidated Financial Statements

0%

20%

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

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

Usually lack of control or significant influence.

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LO 3

General Reporting Guidelines

Fair Value
1. Investor records investment at cost. 2. Investor recognizes cash dividends from investee as income.

Equity Method
1: Same as Fair Value
2: Investor recognizes its share (% of ownership) of investees net income (net loss) as an increase (decrease) in the investment account and dividends as a decrease.

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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Special Procedures for Special Situations

Reporting a change to the equity method. Reporting investee income from sources other than continuing operations.

Reporting investee losses.

Reporting the sale of an equity investment.

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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 because: 1.Fair values (FV) of some assets and liabilities on investees books are different than book values (BV). 2.Investor is willing to pay extra expecting future benefits to accrue from the investment. 3.Additional amount paid in excess of book value not allocated to undervalued assets is attributed to an intangible future value and recorded as Goodwill.

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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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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.

INVESTOR
Downstream Sale

INVESTOR
Upstream Sale

INVESTEE

INVESTEE
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LO 7

Fair Value Reporting Option

In 2007, FASB introduced a fair-value 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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Fair Value Option

Investment that can otherwise be accounted for under the equity method

Investment in nonmarketable equity securities

After 2007, under the Fair-value Option, changes in the fair value of these assets are reported in earnings.
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