Chapter 2 Stock Investments Investor Accounting and Reporting

Chapter 2: Stock Investments – Investor Accounting and Reporting by Jeanne M. David, Ph. D. , Univ. of Detroit Mercy to accompany Advanced Accounting, 10 th edition by Floyd A. Beams, Robin P. Clement, Joseph H. Anthony, and Suzanne Lowensohn © Pearson Education, Inc. publishing as Prentice Hall 2 -

Stock Investments: Objectives 1. Recognize investors' varying levels of influence or control, based on the level of stock ownership. 2. Anticipate how accounting adjusts to reflect the economics underlying varying levels of investor influence. 3. Apply the fair value/cost and equity methods of accounting for stock investments. 4. Identify factors beyond stock ownership that affect an investor's ability to exert influence or control. © Pearson Education, Inc. publishing as Prentice Hall 2 -

Objectives (continued) 5. Apply the equity method to purchase price allocations. 6. Learn how to test goodwill for impairment. © Pearson Education, Inc. publishing as Prentice Hall 2 -

Stock Investments – Investor Accounting and Reporting 1: Levels of Influence or Control © Pearson Education, Inc. publishing as Prentice Hall 2 -

Levels of Influence • <20% – presumes lack of significant influence – fair value (cost) method • 20% to 50% – presumes significant influence – equity method • >50% – presumes control – consolidated financial statements © Pearson Education, Inc. publishing as Prentice Hall Consolidated financial statements Fair value (cost) method Equity method 2 -

Stock Investments – Investor Accounting and Reporting 2: Accounting Reflects Economics © Pearson Education, Inc. publishing as Prentice Hall 2 -

Accounting for the Investment Degree of influence Investment's carrying value Investment income Lack of significant influence Fair value (cost, if nonmarketable) Dividends declared Significant influence Original cost adjusted to reflect periodic earnings and dividends, e. g. , a proportionate share of investee's net assets Proportionate share of investee's periodic earnings* * If income were measured as dividends declared, by influencing or controlling dividend decisions, the investor could manipulate its own investment income. © Pearson Education, Inc. publishing as Prentice Hall 2 -7

Stock Investments – Investor Accounting and Reporting 3 a: Fair Value/Cost Method © Pearson Education, Inc. publishing as Prentice Hall 2 -8

Fair Value (Cost) Method FASB Statement No. 115 • At acquisition: Pilzner buys 2, 000 shares of Sud for $100, 000. Investment in Sud Cash 100, 000 • Pilzner receives $4, 000 in dividends from Sud. Cash Dividend income © Pearson Education, Inc. publishing as Prentice Hall 4, 000 2 -9

Fair Value Method, at Year-end • Reduce dividend income recognized, if needed Dividend income 1, 000 Investment in Sud 1, 000 If Pilzner determines that cumulative dividends exceed its cumulative share of income by $1, 000. • Adjust investment to fair value Allowance to adjust available-for 21, 000 sale securities to fair value Other comprehensive income 21, 000 If fair value of increases to $120, 000 and the Investment in Sud account balance is $99, 000. © Pearson Education, Inc. publishing as Prentice Hall 2 -10

Stock Investments – Investor Accounting and Reporting 3 b: Equity Method © Pearson Education, Inc. publishing as Prentice Hall 2 -11

Equity Method APB Opinion No. 18 • At acquisition: Pilzner buys 2, 000 shares of Sud for $100, 000. Investment in Sud Cash 100, 000 • Pilzner receives $4, 000 in dividends from Sud. Cash Investment in Sud © Pearson Education, Inc. publishing as Prentice Hall 4, 000 2 -12

Equity Method, at Year-end • Pilzner determines that its share of Sud's income is $5, 000. Cash 4, 000 Investment in Sud 4, 000 • The ending balance in the Investment in Sud is: $100, 000 cost - $4, 000 dividends + $5, 000 income = $101, 000. © Pearson Education, Inc. publishing as Prentice Hall 2 -13

Stock Investments – Investor Accounting and Reporting 4: Ability to Influence or Control © Pearson Education, Inc. publishing as Prentice Hall 2 -14

Significant Influence • 20% to 50% voting stock ownership is a presumption of significant influence. Use the equity method. • Don't use equity method if there is a lack of significant influence 1. Opposition by investee, 2. Surrender of significant shareholder rights, 3. Concentration of majority ownership, 4. Lack of information for equity method, and 5. Failure to obtain board representation. © Pearson Education, Inc. publishing as Prentice Hall 2 -15

Control • More than 50% voting stock ownership is presumptive evidence of control. Prepare consolidated financial statements. • Don't consolidate – if control is temporary or – if the parent lacks control 1. Legal reorganization or bankruptcy 2. Severe foreign restrictions. © Pearson Education, Inc. publishing as Prentice Hall 2 -16

Stock Investments – Investor Accounting and Reporting 5: Applying the Equity Method © Pearson Education, Inc. publishing as Prentice Hall 2 -17

Acquisition Cost > FV net assets > BV net assets Payne acquires 30% of Sloan for $5, 000. Sloan's identifiable net assets (assets less liabilities) are: Fair value: A – L = $18, 800 - $2, 800 = $16, 000. Book value: A – L = E = $15, 000 - $3, 000 = $12, 000 The $4, 000 difference ($16, 000 - $12, 000) is due to: • $1, 000 undervalued inventories sold this year, • $200 overvalued other current assets used this year, • $3, 000 undervalued equipment with a life of 20 years, and • $200 overvalued notes payable due in 5 years. $5, 000 > 30%(16, 000) > 30%(12, 000) $5, 000 > $4, 800 > $3, 600 © Pearson Education, Inc. publishing as Prentice Hall 2 -18

Acquisition of Sloan Stock At acquisition, Payne pays $2, 000 cash and issues common stock with a fair value of $3, 000 and par value of $2, 000. Payne also pays $50 to register the securities and $100 in consulting fees. Investment in Sloan 5, 000 Cash 2, 000 Common stock, at par 2, 000 Additional paid in capital 1, 000 Additional paid in capital Investment expense Cash © Pearson Education, Inc. publishing as Prentice Hall 50 100 150 2 -19

Cost/Book Value Assignment Cost of acquisition Less 30% book value = 30%(12, 000) Excess of cost over book value Assigned to: Inventories 30%(+1, 000) Other curr. assets 30%(-200) Equipment 30%(+3, 000) Note payable 30%(+200) Goodwill (to balance) Total Amount $300 (60) 900 60 200 $1, 400 © Pearson Education, Inc. publishing as Prentice Hall $5, 000 3, 600 $1, 400 Amortization 1 st year 20 years 5 years None 2 -20

Dividends and Income Payne receives $300 dividends from Sloan. Cash 300 Investment in Sloan 300 Sloan reports net income of $900. Payne will recognize its share (30%) of Sloan's income, but will adjust it for amortization of the differences between book and fair values. © Pearson Education, Inc. publishing as Prentice Hall 2 -21

Amortization and Investment Income Cost/book value differences: Inventories Other curr. Assets Equipment Note payable Initial amount 1 st year amort. Unamortized excess at year-end $300 (60) ($300) 60 $0 0 900 (45) 855 60 (12) 48 Goodwill 200 0 200 Total $1, 400 ($297) $1, 103 Investment income is 30% of Sloan's net income – amortization 30%($3, 000) – $297 = $603. © Pearson Education, Inc. publishing as Prentice Hall 2 -22

Year-end Entry & Balance Record the investment income Investment in Sloan 603 Income from Sloan 603 The ending balance in the investment account is: Cost – dividends + investment income 5, 000 – 300 + 603 = 5, 303. © Pearson Education, Inc. publishing as Prentice Hall 2 -23

More on Cost/Book Value Assignment • On acquisition date, compare: – Cost of acquisition, – Book value of net assets, and – Fair value of identifiable net assets • Cost of the investment includes cash paid, fair value of securities issued, and debt assumed. • The book value of the investee's net assets = assets – liabilities, or = stockholders' equity © Pearson Education, Inc. publishing as Prentice Hall 2 -24

Fair Values Used in Assignment • Identifiable net assets include all the investee's assets and liabilities, whether recorded or not – Fair value of research in progress – Fair value of contingent liabilities – Fair value of unrecorded patents • Exception: use book value for pensions and deferred taxes. • If cost > fair value, goodwill exists. • If cost < fair value, a bargain purchase exists. © Pearson Education, Inc. publishing as Prentice Hall 2 -25

Bargain Purchase When the acquisition cost is less than the fair value of the identifiable net assets, a gain is recognized on the acquisition. The investment is recorded at the fair value of the identifiable net assets Investment in ABC Cash, CS, APIC Gain on bargain purchase © Pearson Education, Inc. publishing as Prentice Hall xxx xxx 2 -26

Interim Acquisitions Book value of net assets = BV equity. If equity is given as beginning of year, add current earnings and deduct dividends to date. Amortization for first, partial, year: – Take full amortization for inventory and other current assets disposed of by year-end. – Take partial year's amortization for equipment, buildings, and debt to be written off over multiple years. Record dividends if after the acquisition date. © Pearson Education, Inc. publishing as Prentice Hall 2 -27

Acquisition in Stages • Also called a step-by-step acquisition. • Fair value (cost) method equity method – Retroactive adjustment • Investee's growth in retained earnings is – Excess of income over dividends declared • Investment account desired balance using equity method = original cost + share of growth in retained earnings – amortization, if any Investment in XYZ Retained earnings © Pearson Education, Inc. publishing as Prentice Hall xxx 2 -28

Sale of Equity Investment • Sale of investment that results in a lack of significant influence over the investee • Equity method fair value (cost) method – Prospective treatment • For the sale – Reduce the investment account for a proportionate share of the stock sold – Record a gain or loss on the sale • Apply the fair value (cost) method to remaining investment © Pearson Education, Inc. publishing as Prentice Hall 2 -29

Stock Purchased from Investee If stock is purchased from old shareholders, the percentage ownership is based on the shares outstanding and the investee's equity is not changed. • If acquired directly from the investee: • Percentage acquired = shares acquired / (shares acquired + previously outstanding shares) • Investee's new stockholders' equity = Previous equity + value received for new shares © Pearson Education, Inc. publishing as Prentice Hall 2 -30

Investee with Preferred Stock • Compare cost of acquisition to the book value of the common stock. = Total equity – book value of preferred stock* * BV of PS = call value + dividends in arrears • Dividends received will be a portion of the dividends to common shareholders = total dividends – current PS dividends • Investment income is based on income available to common shareholders = investee net income – PS dividends** ** Pref. Div. = current dividend if cumulative, or dividends declared if noncumulative. © Pearson Education, Inc. publishing as Prentice Hall 2 -31

Special Reporting Issues • If material, the investor continues separate reporting of extraordinary items and/or discontinued operations of the investee – Income from Investee is based on income before discontinued operations or extraordinary items • Optionally, the investor may report its equity investments at fair market value, FASB Statement Nos. 159 and 157 © Pearson Education, Inc. publishing as Prentice Hall 2 -32

Disclosures • For significant equity investees – Name, percent ownership – Accounting policy – Difference between investment carrying value and underlying equity in net assets – Aggregate market value – Summarized asset, liability, operations • Related party disclosures FASB Statement No. 57 © Pearson Education, Inc. publishing as Prentice Hall 2 -33

Stock Investments – Investor Accounting and Reporting 6: Impairment of Goodwill © Pearson Education, Inc. publishing as Prentice Hall 2 -34

Impairment of Goodwill • Test annually, and if significant events occur (e. g. , adverse legal factors or loss of key personnel) • FASB Statement No. 142: Two step process 1. If the fair value of the whole reporting unit < the carrying value of the reporting unit including its goodwill, there might be impairment. – If no implied impairment, step 2 is not needed. – Use quoted market prices of reporting unit, or valuation techniques applied to similar groups of assets and liabilities. 2. If the implied fair value of the goodwill < the carrying value of the goodwill, record an impairment loss for the difference. © Pearson Education, Inc. publishing as Prentice Hall 2 -35

Impairment of Equity Investments • Goodwill implied in equity investments is not tested for impairment. • The investment itself is tested for impairment. • APB Opinion No. 18 © Pearson Education, Inc. publishing as Prentice Hall 2 -36

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