Chapter One

The Equity Method of Accounting for Investments

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

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Reporting Investments in Corporate Equity Securities

GAAP recognizes 3 ways to report investments in other companies:

Fair-Value Method
Consolidation
Equity Method
The method is selected based upon the degree of influence the investor has over the investee.

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Fair Value Method

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

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

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).

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Consolidation of Financial Statements

Required when the investors ownership exceeds 50% of investee, except where control does not actually rest with the majority investor Contractual agreements Bankruptcies Government restrictions One set of financial statements is 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 the investee 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 investees Board of Directors Participation in the investees policy-making process Material intercompany transactions Interchange of managerial personnel Technological dependency Extent 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 losses.

Reporting investee income from sources other than continuing operations.

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 investors 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 investors income statement. Examples include:
Discontinued operations Extraordinary items

Prior period adjustments

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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.

A temporary decline is ignored!!!

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Reporting the Sale of an 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, 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.

Source of the Difference Accounting

Assets that are undervalued on the investee's books Goodwill

Amortize the difference over the remaining useful life of the associated asset. For fiscal years beginning on or after Dec. 15, 2001, Goodwill will be carried forward without adjustment until the investment is sold or a permanent decline in value occurs.

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Unrealized Gains in Inventory

Sometimes affiliated companies sell or buy inventory from each other.

INVESTOR
Downstream Sale

INVESTOR
Upstream Sale

INVESTEE

INVESTEE