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C H A P T E R

C H A P T E R. 1. Updated Sixth Edition. The Equity Method of Accounting for Investments. Reporting Investments in Corporate Equity Securities. Three basic approaches are allowed by GAAP: The Fair Value Method The Equity Method The Consolidation of Financial Statements.

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C H A P T E R

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  1. C H A P T E R 1 Updated Sixth Edition The Equity Method of Accounting for Investments

  2. Reporting Investments in Corporate Equity Securities Three basic approaches are allowed by GAAP: • The Fair Value Method • The Equity Method • The Consolidation of Financial Statements Note: These 3 approaches are not interchangeable. The characteristics of each investment will dictate the appropriate accounting approach.

  3. Fair Value Method • Used when influence is negligible. • Initial Investment is recorded at cost. • Income is only realized to the extent of dividends received. • Both Trading Securities and Available-for-Sale Securities are carried at market value. • SFAS No. 115 provides more details.

  4. Consolidation of Financial Statements • Governed by ARB No. 51 and APB Opinion 16. • Required when investor’s ownership exceeds 50% of investee. • Control is presumed to exist. • Covered later in the text.

  5. Equity Method • The Equity Method is defined by APB Opinion 18. • Requires that the investment is sufficient to insure significant influence. • Generally used when ownership is between 20% & 50%. • Influence can be present with much smaller ownership percentages.

  6. 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.

  7. Investor Ownership of Investee Shares Outstanding The Significance of the Size of the Investment Fair Value Equity Method Consolidated Financial Statements { 0% 20% 50% 100% In some cases, influence or control may exist with less than 20% ownership.

  8. Investor Ownership of Investee Shares Outstanding Fair Value Equity Method Consolidated Financial Statements 0% 20% 50% 100% The Significance of the Size of the Investment { Significant influence is generally assumed with 20% to 50% ownership.

  9. Equity Method Step 1: The investor records its investment in the investee at cost.

  10. Equity Method Step 2: The investor recognizes its proportionate share of the investee’s net income (or net loss) for the period.

  11. Equity Method Step 2: The investor recognizes its proportionate share of the investee’s net income (or net loss) for the period. This will appear as a separate line-item on the investor’s income statement.

  12. Equity Method Step 3: The investor reduces its investment account for its proportionate share of the investee’s dividends.

  13. Let’s do an equity method example.

  14. Equity Method Example On January 1, 2003, Big Corp. buys 20% of Small Inc. for $2,000,000 cash. Record Big’s journal entry.

  15. Equity Method Example On December 31, 2003, Small reports net income for the year of $300,000. Record Big’s journal entry.

  16. Equity Method Example Big owns 20% of Small and gets credit for 20% of Small’s income. 20% × $300,000 = $60,000 60,000 60,000

  17. Equity Method Example On December 31, 2003, Big received a $25,000 dividend check from Small. Record Big’s journal entry. 25,000 60,000 25,000

  18. Special Procedures for Special Situations Reporting a change to the equity method. Reporting the sale of an equity investment. Reporting investee income from sources other than continuing operations. Reporting investee losses.

  19. Reporting a change to the equity method. • 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 ?

  20. 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

  21. Reporting Investee Income from Other Sources Big owns 30% of Little. Little reports net income for 2003 of $40,000. That includes Operating income of $45,000 and an extraordinary loss of $5,000. Big’s equity method entry at year-end is:

  22. 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.

  23. 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.

  24. Reporting the Sale of an Equity Investment • 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. If part of an investment is sold during the period . . .

  25. Reporting the Sale of an Equity Investment Big owns 30% (300,000 shares) of Little. As of December 31, 2002, the Investment account is at $250,000. Little reports net income for the first quarter of 2003 of $60,000. What is Big’s entry at 3/31/03? $60,000 × 30% = $18,000 This brings the Investment account to a balance of $268,000

  26. Reporting the Sale of an Equity Investment Big sells 30,000 shares (10% of their investment) on April 1, 2003 for $100,000. What is Big’s entry at 4/1/03? $268,000 × .10% = $26,800 This brings the Investment account to a balance of $241,200

  27. Excess of Cost Over BV Acquired When Cost > BV acquired, the difference must be identified and accounted for.

  28. 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.

  29. Excess of Cost Over BVExample • Recall, on January 1, 2003, 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. • Compute the Goodwill acquired by Big.

  30. Excess of Cost Over BVExample

  31. Excess of Cost Over BVExample Big’s equity method entry will include an adjustment to the investment account of $4,000.

  32. Amortization of Cost Over BV Example

  33. Let’s look at some intercompany transactions.

  34. INVESTOR INVESTOR INVESTEE INVESTEE Unrealized Gains in Inventory Sometimes affiliated companies sell or buy inventory from each other. Downstream Sale Upstream Sale

  35. 20% ownership Intercompany Sale of 200 units Investee sells 200 units for $1,500. Outside Party Unrealized Gains in Inventory If all the inventory is sold to an outside party during the period, all of the profit is “real”. INVESTORsells 200 units of inventory with a total cost of $1,000. INVESTEEbuys 200 units of inventory and pays a total of $1,250.

  36. Unrealized Gains in Inventory • If any of the inventory is still unsold at the end of the period, some of the intercompany profits, or unrealized gains, are still on the books. • These unrealized gains must be pro-rated based on the investor’s ownership percentage and eliminated from the consolidated books.

  37. 20% ownership Intercompany Sale of 200 units Investee sells only 160 units for $1,200 Outside Party Unrealized Gains in Inventory INVESTORsells 200 units of inventory with a total cost of $1,000. INVESTEEbuys 200 units of inventory and pays a total of $1,250.

  38. 30% ownership Intercompany Sale of 200 units Unrealized Gains in Inventory INVESTORsells 200 units of inventory with a total cost of $1,000. INVESTEEbuys 200 units of inventory and pays a total of $1,250. X 20% of the original units are still “unsold” to an outside party. Therefore, 20% of the original $250 of intercompany profit is still unrealized at the end of the period (i.e. sold to an outside party. There are still 40 units (20%) in the Investee’s inventory!

  39. Unrealized Gains in Inventory • We must defer our share (20%) of the $50 in unrealized intercompany profit. • The required journal is: $50 × .20% = $10

  40. 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 . . . This entry will be reversed in the period that the inventory is sold to an outside party.

  41. End of Chapter 1 And this is only the FIRST chapter?!

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