Slide 1 1 Chapter One The Equity Method

Slide 1 -1 Chapter One The Equity Method of Accounting for Investments Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -2 Reporting Investments in Corporate Equity Securities GAAP allows 3 approaches to reporting investments. Note: These 3 approaches are not interchangeable. The characteristics of each investment will dictate the appropriate accounting approach. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -3 Fair Value Method Details in SFAS No. 115 l Initial Investment is recorded at cost. l Investments in equities of other companies are classified as either Trading Securities or Available-for. Sale Securities. l Income is only realized to the extent of dividends received. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -4 Equity Method Defined by APB Opinion 18 and SFAS No. 142. l Requires that the investment is sufficient to insure significant influence. l Generally used when ownership is between 20% & 50%. l v Influence can be present with much smaller ownership percentages. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -5 Consolidation of Financial Statements Governed by ARB No. 51, SFAS No. 141, and SFAS No. 142. l Required when investor’s ownership exceeds 50% of investee. l A single set of financial statements including the assets, liabilities, equities, revenues, and expenses for the parent company and all controlled subsidiary companies. l Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -6 Criteria for Determining Whether There is Influence 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 ownership percentages. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

The Significance of the Size of the Investment Slide 1 -7 Investor Ownership of Investee Shares Outstanding { Fair Value 0% Equity Method 20% Consolidated Financial Statements 50% 100% In some cases, influence or control may exist with less than 20% ownership. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -8 The Significance of the Size of the Investment Investor Ownership of Investee Shares Outstanding 0% Equity Method { Fair Value 20% Consolidated Financial Statements 50% 100% Significant influence is generally assumed with 20% to 50% ownership. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -9 The Significance of the Size of the Investment Investor Ownership of Investee Shares Outstanding 0% Equity Method 20% Consolidated Financial Statements 50% { Fair Value 100% Financial Statements of all related companies must be consolidated. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -10 Fair Value Method (Revisited) – using Available for Sale (AFS) securities l Purchase v Dr Investment in AFS v Cr Cash l XXXXX Dividend Income v Dr Cash v Cr Dividend Income l XXXXX Change in Value of Security (Increase)1 v Dr Market Value Adj. – AFS v Cr Unrealised inc/dec in AFS 2 XXXXX 1 - The reverse is true for a decrease 2 – This account appears in stock holders equity. If it were a “Held for Trading” security the gain would have appeared in the income statement as an “Unrealized loss on Trading Securities” Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -11 Equity Method Step 1: The investor records its investment in the investee at cost. Cost can be defined by cash paid or Fair Market Value of Stock or other assets given up. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -12 Equity Method Step 2: The investor recognizes its proportionate share of the investee’s net income (or net loss) for the period. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -13 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. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -14 Equity Method Step 3: The investor reduces the investment account by the amount of dividends received from the investee. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -15 Let’s do an equity method example. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -16 Equity Method Example – Step 1 On January 1, 2005, Big Corp. buys 20% of Small Inc. for $2, 000 cash. Record Big’s journal entry. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -17 Equity Method Example – Step 2 On December 31, 2005, Small reports net income for the year of $300, 000. Record Big’s journal entry. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -18 Equity Method Example – Step 2 Big owns 20% of Small and gets credit for 20% of Small’s income. 20% × $300, 000 = $60, 000 Mc. Graw-Hill/Irwin 60, 000 © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -19 Equity Method Example – Step 3 On December 31, 2003, Big received a $25, 000 dividend check from Small. Record Big’s journal entry. 60, 000 Mc. Graw-Hill/Irwin 25, 000 © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -20 Special Procedures for Special Situations Reporting a change to the equity method. Reporting investee income from sources other than continuing operations. Mc. Graw-Hill/Irwin Reporting the sale of an equity investment. Reporting investee losses. © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -21 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. l When ownership grows to the point where significant influence is established. . . l . . . 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 ? Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -22 Restatement - Example Assume that Exxo Company acquires 5% of Lip. Gloss Inc. on January 1, 2004 for $2, 000. There is no significant influence. The investment is recorded at the time as an Available-for-Sale Investment. In 2004, Lip. Gloss had net income of $300, 000, and paid dividends of $140, 000. Exxo would report the investment as indicated in the table below: Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -23 Fair Market Value entry l The entries for adjustment to FMV would also have been required. E. g. Assume that the FMV @ 31/12/2004 was $2, 400, 000. Then the following entry would have been made (as per SFAS 115): Dr Market Value Adjustment - AFS 400, 000 Cr Unrealized inc/dec in value of AFS 400, 000 Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -24 Restatement - Example On January 1, 2005, Exxo buys an additional 15% interest in Lip. Gloss, raising the total investment to 20%. The first thing that Exxo must do is restate the 12/31/04 numbers by applying the equity method to the 5% investment in Lip. Gloss. We have to RESTATE the Investment account, put a balance in Equity in Investee Income, and eliminate the Dividend Revenue balance. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -25 Restatement - Example An adjustment is recorded to the Investment account and to Retained Earnings (since Dividend Revenue has already been closed out). Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -26 Removal of Fair Market Value related accounts l The FMV related accounts would also have to be removed. i. e. : Dr Unrealized inc/dec in value of AFS 400, 000 Cr Market Value Adjustment - AFS 400, 000 Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -27 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. l Examples include: l v Extraordinary items v Discontinued operations v Prior period adjustments Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -28 Reporting Investee Income from Other Sources Big owns 30% of Little reports net income for 2005 of $120, 000. Little’s Income includes operating income of $135, 000 and an extraordinary loss of $15, 000. Big’s equity method entry at year-end is: Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -29 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. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -30 Reporting Investee Losses Investment Reduced to Zero l 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. l The balance remains at $0, until subsequent profits eliminate all UNRECORDED losses. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -31 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. (as is the case when switching from FV to Equity method) Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -32 Reporting the Sale of an Equity Investment Alice Co. 30% (300, 000 shares) of Sam, Inc. . The balance in Alice’s Investment account at March 31, 2005, is $268, 000. If Alice Co. sells 10% of its shares (30, 000 shares) on April 1, 2005 for $100, 000, what entry should Alice make on April 1, 2005? $268, 000 ×. 10% = $26, 800 This brings the Investment account to a balance of $241, 200 © The Mc. Graw-Hill Companies, Inc. , 2004 Mc. Graw-Hill/Irwin

Slide 1 -33 Excess of Cost Over BV Acquired When Cost > BV acquired, the difference must be identified and accounted for. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -34 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. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -35 Excess of Cost Over BV Example On January 1, 2005, Big Corp. acquired 20% of Small Inc. for $2, 000 cash. l 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. l Allocate the cost to fair market value adjustments and Goodwill acquired by Big. l Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -36 Excess of Cost Over BV Example Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -37 Excess of Cost Over BV Example The Building has a remaining useful life of 10 years. Goodwill is never amortized. Compute the amortization expense for Big at 12/31/05. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -38 Amortization of Cost Over BV Example Big’s equity method entry will include an adjustment to the investment account of $4, 000. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -39 Amortization of Cost Over BV Example Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -40 Mc. Graw-Hill/Irwin Let’s look at some intercompany transactions. © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -41 Unrealized Gains in Inventory Sometimes affiliated companies sell or buy inventory from each other. INVESTOR Downstream Sale INVESTEE Mc. Graw-Hill/Irwin INVESTOR Upstream Sale INVESTEE © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -42 Unrealized Gains in Inventory Let’s look at an Investor that has 200 units of inventory with a cost of $1, 000. INVESTOR sells 200 units of inventory with a total cost of $1, 000. Mc. Graw-Hill/Irwin Let us assume that the Investor sells the inventory to a 20% owned Investee for $1, 250. © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -43 Unrealized Gains in Inventory Let’s look at anof. Investor that has 200 Note that there is $250 intercompany profit. At units of itinventory with. UNREALIZED. a cost of $1, 000. this point is considered INVESTOR sells 200 units of inventory with a total cost of $1, 000. 20% ownership Intercompany Sale of 200 units INVESTEE buys 200 units of inventory and pays a total of $1, 250. If all 200 units are not sold to an outside party during the period, we will need have unrealized, intercompany profit that must be deferred. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -44 Unrealized Gains in Inventory 60 of the original 200 units (30%) are still “unsold” to a 3 rd party. We must defer our share (20%) of the original $250 of intercompany profit that is unrealized (30%). INVESTOR sells 200 units of inventory with a total cost of $1, 000. 20% ownership Intercompany Sale of 200 units Outside Party Mc. Graw-Hill/Irwin INVESTEE buys 200 units of inventory and pays a total of $1, 250. Investee sells only 140 units to a 3 rd party © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -45 Unrealized Gains in Inventory Mc. Graw-Hill/Irwin l Compute the deferral by multiplying: l The required journal (for both upstream and downstream) is: $250 × 30% × 20% = $15 © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -46 Unrealized Gains in Inventory In the period following the period of the transfer, the remaining inventory is often sold. l When that happens, the original entry is reversed. . . l The reversal takes place in the period that the inventory is sold to an outside party. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004

Slide 1 -47 End of Chapter 1 And this is only the FIRST chapter? ! Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2004