Chapter One

The Equity The Equity Method of Method of

Accounting Accounting for for

InvestmentsInvestments

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Reporting Investments in Corporate Equity Securities

GAAP recognizes 3 ways to report investments in other companies:

Fair-Value MethodConsolidationEquity Method

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The method is selected based upon the degree of influence the investor has over the investee.

Fair Value Method1-3

Used when the investor holds a small percentage of the investee’s outstanding stock, and is not able to significantly affect the investee’s operations.Investment is made in anticipationof dividends and/or market appreciation.Investments will be classified as either Trading Securities or Available-for-Sale Securities.

Fair Value Method (Trading vs Available-for-Sale)

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Trading Securities Held for sale in the short term. Unrealized holding gains and losses are included in earnings (net income).

Available-for-Sale Securities Any Securities not classified as Trading.Unrealized holding gains and losses are reported in shareholders’ equity as other comprehensive income (ie, not included in net income).

Consolidation of Financial Statements Required when the investor’s ownership exceeds 50% of investee,

except where control does not actually rest with the majority investor

Contractual agreementsBankruptciesGovernment restrictions

One set of financial statementsis prepared which consolidates all accounts of the parent company and all of its controlled subsidiary companies, as though they were a single entity.

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Equity Method

Used when the investor has the ability to exercise significant influence on theinvestee operations

Generally used when ownership is between 20% and 50%.Significant Influence might be

present with much lower ownership percentages. (The accountant must consider the particulars!!!)

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What is “Significant” Influence?? (FASB ASC Section 323)

Representation on the investee’s Board of Directors

Participation in the investee’s policy-making processMaterial intercompany transactionsInterchange of managerial personnelTechnological dependencyExtent of ownership in

relation to other investor ownership percentages

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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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Reporting a Change to the Equity Method An investment that is too small to

have significant influence is recorded using the fair-value method, but…

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 FASB ASC (para. 323-10-35-33)

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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 investor’s income statement.

Examples include: Discontinued operations Extraordinary items Prior period adjustments

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Reporting Investee Losses

A permanent decline in the investee’s 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 the Sale of an Equity InvestmentIf 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, a proportionate amount of the Investment account is removed.

If significant influence is lost, NO RETROACTIVE ADJUSTMENT is recorded, but the equity method is no longer applied.

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Excess of Cost Over BV Acquired

When Cost > BV acquired, the difference must be identified.

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Downstream Sale

Upstream Sale

Unrealized Gains in Inventory

Sometimes affiliated companies sell or buy inventory from each other.

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