Download Concepts of Equity Method

Concepts of Equity Method. - 1
ACCOUNTING FOR VARIOUS INVESTMENTS
Classification
Investment in
Debt Securities
Investment in
Equity Securities
Control-greater than 50%
ownership of voting stock
Not applicable
Consolidation
Significant influence - 20% to
50% ownership of voting stock
Not applicable
Equity method
Debt securities classified as held
to maturity, and equity securities
for which fair value is not readily
determinable
Amortized cost method
Cost method
Debt and equity securities
classified as trading securities
Fair value method, with unrealized holding gain or loss
included in earnings
Debt and equity securities
classified as available for sale
Fair value method, with unrealized holding gain or loss
included as a component of comprehensive income/
stockholders’ equity
Concepts of Equity Method. - 2
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Size (of the Investment) Matters!!!
Investor Ownership of the
Investee’s Shares
Outstanding
0%
{
Fair
Value
Equity
Method
20%
Consolidated Financial
Statements
50%
100%
In some cases, influence or control may
exist with less than 20% ownership.
Concepts of Equity Method. - 3
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The Significance of the Size of the
Investment
Investor Ownership of the
Investee’s Shares
Outstanding
0%
Equity
Method
20%
{
Fair
Value
Consolidated Financial
Statements
50%
Significant influence is generally
assumed with 20% to 50%
ownership.
100%
Concepts of Equity Method. - 4
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The Significance of the Size of the
Investment
Investor Ownership of the
Investee’s Shares
Outstanding
0%
Equity
Method
20%
Consolidated Financial
Statements
50%
{
Fair
Value
Financial Statements of all related
companies must be consolidated.
100%
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Concepts of Equity Method. - 5
Criteria for Determining Whether There is
“Significant” Influence
(APB Opinion 18)
Representation on the investee’s Board of
Directors
Participation in the investee’s policymaking process
Material intercompany transactions.
Interchange of managerial personnel.
Technological dependency.
Extent of ownership in relationship to
other investor ownership percentages.
Concepts of Equity Method. - 6
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Equity Method
 Requires that the investor has the
potential for “significant”
influence.
 Generally used when ownership is
between 20% and 50%.
– Significant Influence might be
present with much smaller
ownership percentages. (The
accountant must consider the
particulars!!!)
Concepts of Equity Method. - 7
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Remember:
 The ability to exert significant influence
is the determining factor in applying the
equity method
 No actual influence need have been
applied!!
Concepts of Equity Method. - 8
EQUITY METHOD
Evidence against Significant Influence
 Investee opposition
 Investor/investee agreement
 Closely held majority
stockholder
 Lack of information
 Lack of board representation
Concepts of Equity Method. - 9
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Equity Method
Step 1: The investor records its investment
in the investee at cost.
Journal entry:
Debit – Investment in Investee
Credit – Cash (or other Assets/Stock)
Cost can be defined by cash paid or the Fair
Market Value of Stock or Assets given up.
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Concepts of Equity Method. - 10
Equity Method
Step 2: The investor recognizes its
proportionate (pro rata) share of the
investee’s net income (or net loss) for
the period.
Journal entry at end of period:
Debit – Investment in Investee
Credit – Equity in Investee Income
This will appear as a separate
line-item on the investor’s
income statement.
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Concepts of Equity Method. - 11
Equity Method
Step 3: The investor reduces the
investment account by the amount of
cash dividends received from the
investee.
Journal entry when cash dividends received:
Debit – Cash
Credit – Investment in Investee
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Concepts of Equity Method. - 12
Excess of Cost Over BV Acquired
When Cost > BV acquired, the difference
must be identified and accounted for.
Source of the Difference
Assets that are
undervalued on the
investee's books
Goodwill
Accounting
Amortize the difference over the
remaining useful life of the associated
asset.
In accordance with SFAS No. 142, for
fiscal years beginning Dec. 15, 2001, and
after, Goodwill will be carried forward
without adjustment until the investment
is sold or a permanent decline in value
occurs.
Concepts of Equity Method. - 13
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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.
GENERAL JOURNAL
Date
Year
End
Description
Equity in Investee Income
Investment in Investee
Page
Debit
##
Credit
$$$$
$$$$
Concepts of Equity Method. - 14
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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 the
sale of an equity
investment.
Reporting
investee
losses.
Concepts of Equity Method. - 15
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Reporting a Change to the Equity
Method. (Retroactive Adjustment)
 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
. . . all accounts are restated so that the
significant influence is established . . .
investor’s financial statements appear as if the
equity method had been applied from the date
of the first [original] acquisition. - - APB
Opinion 18
?
Concepts of Equity Method. - 16
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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 reduction
of the investment
account to the fair
value.
A
temporary
decline is
ignored!!!
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Concepts of Equity Method. - 17
Possible Criticisms:
 Over-emphasis on possession of 2050% voting stock in deciding on
“significant influence” vs. “control”
 Possibility of “off-balance sheet
financing”
 Potential manipulation of performance
ratios