Chapter 1: The Equity Method of Accounting for Investments

How is the fair value method recorded?

Recorded at cost and adjusted to fair value

Equity Method Reporting Effects: [Part II- Example] -Investmor Co. CONSIDERING 25% equity investment in Marco, Inc., that WILL provide a significant level of influence -Marco projects an annual income of $300,000 for the near future -Marco's book value is $450,000; w/unrecorded newly developed technology appraised at $200,000 w/est. useful life of 10 yrs [*Step 1: Project Equity Earnings* and *Step 2: Determine the max price to meet the first-year rate of return requirement (20% for Investmor Co.*]

Step 1: *Project Equity Earnings* [when considering offer prices] Projected Income (25% x $300,000) $75,000 Excess unpatented technology amortization [(25% x 200,000) / 10 yrs] (5,000) *Annual expected equity in Marco earnings* $70,000 Step 2: *Determine the maximum price to meet the first-year rate of return requirement.* *Investmor's required first-year rate of return (before tax) on these types of investments is 20%, THEREFORE, to meet the first year rate of return requirement involves a *maximum price of $350,000* ($70,000 / 20% = $350,000)

Consolidated net income

The parent Co.'s personal net income plus the parent Co.'s proportionate share of the net income or loss of its subsidiary companies

According to FASB, what is the objective of the fair-value option?

to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently w/out having to apply complex hedge accounting provisions

What does the Equity Method affect?

(1) timing of income recognition AND (2) the carrying amount of the investment

Why does the equity method record dividends from an investee as a reduction in the investment account, not as dividend income?

*1st Tier Answer: Avoid Double Booking Income 2nd Tier Answer: *When the investee declares a cash dividend, its owners' equity decreases*. The *investor mirrors this change by recording a reduction in the carrying amount of the investment rather than recognizing the dividend as revenue* **If Investor elects to use the fair value method* to measure and report an investment that otherwise would be accounted for using the equity method, the investor *DOES recognize its share of the investee's cash dividends paid*. Those *cash dividends are considered income* for the period to the investor.

*Equity Method [Chapter 1]

*20-50% *Key Factor: although control is NOT achieved, the degree of ownership (20-50%) indicates the ability of the investor to exercise SIGNIFICANT INFLUENCE over the investee *Investor's share of Income/Profit (Loss) of the investee is recognised in the investor's profit or loss; recognized/accrued as it is earned by the investee *Dividends Declared: recognized as a decrease in the investment account, NOT as income [they need to treat it just as the subsidiary would treat dividends declared] *Investment is INITIALLY recognized at cost and the carrying amount is increased or decreased to recognize the investor's share of the profit or loss of the investee after the date of acquisition

Equity Method- Significant Influence *Several conditions that indicate the presence of this degree of influence:

*20-50% ownership interest ^[Objective factor- but don't put too much weight on it] - Investor representation on the board of directors - Investor participation in the policy-making process of the investee - Material intra-entity transactions [upstream/downstream of inventory, etc.] - Interchange of managerial personnel - Technological dependency - Extent of ownership by the investor in relation to the size and concentration of other ownership interests in the investee [20-50% of ownership] *All are evaluated together to determine the presence or absence of the sole criterion: the ability to exercise significant influence over the investee

How is significant influence determined?

*All of the 'degree of influence' factors are evaluated together to determine the presence or absence of the sole criterion: the ability to exercise significant influence over the investee

EXTENSIONS OF EQUITY METHOD APPLICABILITY: Examples where the use of the Equity Method would be deemed APPROPRIATE:

*Conditions exist where the equity method is appropriate despite a MAJORITY ownership interest (over 50%) [OPPOSITE OF PREVIOUS CARD] *Sometimes, rights granted to non-controlling shareholders restrict the powers of the majority shareholder ^Such Rights Include: -approval over compensation, hiring, and termination -approval over other critical operating and capital spending decisions of an entity *If the non-controlling rights are so restrictive as to call into question whether control rests with the majority owner, the equity method is employed for financial reporting rather than consolidation

LIMITATIONS OF EQUITY METHOD APPLICABILITY: Variable Interest Entity

*Consolidation, NOT Equity Method* *Situations in which financial *control exists absent majority ownership interest* *Even though there is LESS THAN 50% controlling interest, *CONTROL is achieved through contractual and other arrangements called VARIABLE INTERESTS* ^specifies decision-making power and the distribution of profits and losses

The Amortization Process [General]

*Even though the actual dollar amounts are recorded within the investment account, a definite historical cost can be attributed to the undervalued assets *Only Assets w/useful lives are applicable to amortization *Amortization = Expense; Expense = Reduction to NI; Reduction to NI = Reduction in Investment*

T/F: Under the Consolidation Method for investments w/ control, the direction of the sale b/w the investor and investee (upstream or downstream) has no effect on the final amounts reported in the FS(s).

*FALSE

Fair-Value Reporting for Equity Method Investments

*Financial reporting standards allow a fair-value option which an entity may irrevocably elect fair value as the initial and subsequent measurement attribute for CERTAIN financial A and L (i.e. investments otherwise accounted for under the Equity Method) *Under the F-V option, report: 1. INVESTMENT's fair value AS an ASSET 2. CHANGEs in the fair value of the elected financial items AS EARNINGS 3. DIVIDENDS from an investee are included in EARNINGS [because dividends typically reduce an investment's fair value, an incraese in earnings from investee dividends would be offset by a decrease in earngings from the decline in an investment's fair value] *Firms neither compute excess cost amortizations nor adjust earnings for intra-entity profits **Firms have been reluctant to elect this option [SEE JE]

Goodwill arising from a Business Combination vs. Goodwill arising from Equity Method Investments

*Goodwill arising from a Business Combination: *subject to annual impairment reviews*, whereas goodwill implicit in equity method investments is not **Goodwill arising from Equity Method Investments: *tested in their entirety for PERMANENT declines in value*

International Accounting Standard 28- Investments in Associates *Presumptions regarding Significant Influences:

*If an investor holds, directly or indirectly (e.g., through subsidiaries), 20% or MORE of the voting power of the investee, it is presumed that the investor DOES have significant influence, UNLESS it can be clearly demonstrated that this is not the case *If the investor holds, directly or indirectly (e.g., through subsidiaries), LESS THAN 20% of the voting power of the investee, it is presumed that the investor does NOT have significant influence, UNLESS such influence can be clearly demonstrated

3 Criticisms of the Equity Method: [Equity Method vs. Consolidation] *2. Allowing off-balance-sheet financing

*If equity method is used, the investee's A and L are NOT combined w/the investor's amounts. Instead, the investor's B/S reports a single amount for the investment, and the I/S reports a single amount for its equity in the earnings of the investee *If consolidated, the A, L, R, and E of the investee are combined and reported in the body of the investor's F/S(s) ^^Investor's F/S(s) w/ Investee #s combined and reported *ISSUE: By keeping its ownership below 50%, a co. can technically meet the rules for applying the equity method for its investments and at the same time report investee A and L "off balance sheet" *CONSEQUENTLY: They report smaller values for A and L. Consequently, higher rates of return for its assets and sales, as well as lower debt-to-equity ratios

1. Reporting a change to the equity method

*In many instances, an investor's ability to significantly influence an investee is not achieved through a single stock acquisition ^^this new change could come about from intentionally increased degree of influence, reduction of investee's outstanding stock, etc. *Prior to accomplishing significant influence, any investment would have been reported by either the fair value method or, if the investment fair value is not readily determinable, the cost method. *PROSPECTIVE Approach: If an investment increases enough to qualify for use of the equity method..., the investor shall add the cost of acquiring the additional interest in the investee (if any) to the current basis of the investor's previously held interest and adopt the equity method of accounting as of the date the investment becomes qualified for equity method accounting

EXCESS of Investment Cost over Book Value Acquired **Why* is finding the source of the excess *important*? *Explain the additional cost incurred by the investor [*2 Reasons for Excess Payment*]

*Income recognition requires *matching the income generated from the investment with its cost*. ^^*Excess costs allocated to fixed assets will likely be expensed over longer periods than costs allocated to inventory* 1. *Undervalued Assets:* Specifically identifiable investee assets and liabilities can have fair values that differ from their present book values. The excess payment can be identified directly with individual accounts such as inventory, equipment, franchise rights, and so on 2. *Goodwill:* There is an expectation of future benefits to accrue from the investment, which cannot be attributed to any specifically identifiable investee asset or liability. ^i.e. *expected synergies*

Under what circumstance would differentiating b/w downstream and upstream sales be relevant?

*It has definite consequences when financial CONTROL requires the CONSOLIDATION of FS(s) *The direction of intra-entity sales does NOT affect reported equity method balances for investments when significant influence exists

Consolidation of Financial Statements (overview)

*More than 50% of an organization's outstanding voting stock [or for entities that are financially controlled through special contractual arrangements] *rather than simply influencing the investee's decisions, the investor often can direct the entire decision-making process *Investor-Investee relationship is so closely connected that the two corporations are viewed as a single entity for reporting purposes *^Thus, a single set of F/S(s) is created for external reporting purposes with all assets, liabilities, revenues, and expenses brought together

Prior to 2017, the FASB required what approach with regards to reporting a change (from F.V. or Cost method) to the Equity Method?

*Retrospective adjustment to an investor's previous ownership shares upon achieving significant influence over an investee

What is the TRUE sole criterion for determining whether the investor should apply the equity method of accounting to her investment?

*SIGNIFICANT INFLUENCE [rather than control] *the ability to exercise significant influence needs to be present *Red Herring: between 20-50% ownership ^If 20-50%, thEn ASSUME significant influence exists and equity method is applied

3 Criticisms of the Equity Method: [Equity Method vs. Consolidation] *3. Potentially biasing performance ratios

*Some companies have CONTRACTUAL PROVISIONS (e.g., debt covenants, managerial compensation agreements) based on ratios in the main body of the FS(s) *Meeting ^these provisions of such contracts could provide managers strong incentives to maintain technical eligibility to use the equity method rather than full consolidation

4. Reporting the Sale of an Equity Investment

*The equity method continues to be applied until the transaction date, thus establishing an appropriate carrying amount for the investment ^*The investor then reduces ^^this balance by the % of shares sold *Should Top Company's holding be reduced from 40% to 15%, the equity method might no longer be appropriate after the sale ^The remaining shares held by the investor are reported according to the fair-value method with the remaining book value becoming the new COST figure for the investment RATHER THAN the amount originally paid [assuming Top Co.'s significant influence was based solely on it's 40% ownership and no other (strong) factors] *NO retrospective adjustment is necessary *SEE JE

2. Reporting Investee Losses

*The investor *recognizes the appropriate % of each loss* and reduces the carrying amount of the investment account [Carrying amount = Book Value] 1. *Losses reported by the investee* create *corresponding losses for the investor* 2. A *permanent decline in the fair value* of an investee's stock should be recognized *immediately* by the investor as an *impairment loss* 3. *Investee losses* can possibly *reduce the carrying value of the investment account to a zero balance*. At that point, the equity method ceases to be applicable and the fair-value method is subsequently used Two Concerns: 1. Impairments of Equity Method Investments 2. Investment Reduced to Zero

Equity Method: *4 Types of Changes to the Investment Account

*The investor adjusts the investment account to reflect all changes in the equity of the investee company *ESTABLISHING THE INVESTMENT ACCOUNT*: Record the *cost of the acquisition* [and Future changes in ownership levels] 1. *Income* recognized and reported increases as the investment *^Emphasizes the connection between the two companies; as the owners' equity of the investee increases through the earnings process, the investment account also increases *If loss, then reduction to investment account 2. *Dividends declared* by the investee create a reduction in the carrying amount of the Investment account. ^[*NOT treated as income*, but *RATHER* its considered a *return on investment* reducing the listed value of owned shares] This book assumes all investee dividends are declared and paid in the same reporting period. 3. *Amortization* - Amortization of book value in excess of cost (i.e., on amounts allocated to write down nonfinancial assets) OR - *Amortization of cost in excess of book value (i.e., on amounts allocated to identifiable assets, but not Goodwill)* 4. *Deferred Intra-Entity Gross Profits*- Inventory ^The investor's share of gross profits remaining in ending inventory (of an arm's reach transaction) is deferred until the items are used or sold to unrelated parties -The investor's own inventory account contains the deferred gross profit -A JE defers recognition of this profit by decreasing Major's investment account in Minor RATHER THAN the inventory balance

Investment Reduced to Zero

*This condition is most likely to occur if the investee has suffered extreme losses OR if the original purchase was made at a low, bargain price *DISCONTINUE using the equity method rather than establish a negative balance *The investment retains a zero balance until subsequent investee profits eliminate all unrecognized losses (remaining loss balance) *Once the original cost of the investment has been eliminated, no additional losses can accrue to the investor (since the entire cost has been written off) FS(s) Notes Excerpt: "Future equity income will be offset by these losses prior to recording equity income in our results" *SEE JE

2. Reporting Investee's Other Comprehensive Income (OCI)

*When an investee company's activities require recognition of OCI, its owners' equity (and net assets) will reflect changes not captured in its reported NI. ^^*Intended to mirror the close relationship b/w the two companies* *OCI* - an increase in Investment account; represents a source of change in investee co. net assets that are recognized under the equity method *Items of other comprehensive income* that might change equity would include: a. Unrealized gains/losses on available-for-sale securities; b. Foreign currency items; c. Pension and post retirement benefit items not recognized in period cost *DR Investment in Bostic Company* *CR Equity in Investee Income* (REGULAR INCOME-keep separate) *CR Other Comprehensive Income of Investee* (OCI-keep separate) *To accrue the investee's operating income and other comprehensive income from equity investment *SEE JE

What accounting treatments are appropriate for investments in equity securities without readily determinable fair values?

*When the fair value of an investment in equity securities is not readily determinable, and the investment provides neither significant influence nor control, the investment may be measured at COST *Cost Method = what you paid for it *The investment REMAINS at cost UNLESS 1) A demonstrable impairment occurs for the investment, or OR 2) An observable price change occurs for identical or similar investments of the same issuer

Impairment Loss

*a PERMANENT decline in the F.V. of an investee's stock should be recognized IMMEDIATELY by the investor as an impairment loss, so as to NOT OVERSTATE on the B/S [Remain Conservative] *Usually: (STEP 1): The investor recognizes the appropriate % of each loss and (STEP 2) reduces the carrying amount of the investment account (asset). ^*Accounting for losses incurred by the investee is handled in a similar manner as profits

What is considered Goodwill under the Equity Method?

*any extra payment that cannot be attributed to a specific asset or liability is assigned to the intangible asset goodwill *anticipated benefits *Because goodwill is an indefinite-lived asset, it is NOT amortized

"Special Purpose Entities" (SPE)

*entities that own little or no voting stock interests but is otherwise controlled through special contracts *Prior to the accounting requirements for variable interest entities, these entities provided vehicles for some firms to keep large amounts of assets and liabilities off their consolidated FS(s)

3 Criticisms of the Equity Method: [Equity Method vs. Consolidation] *1. Emphasizing the 20-50% of voting stock in determining significant influence versus control

*guidelines for the equity method suggest that a 20-50% ownership of voting share indicates significant influence that FALLS SHORT of control HOWEVER, firms have learned ways to control other firms despite owning less than 50% of voting shares (i.e. control is exerted through a variety of CONTRACTUAL ARRANGEMENTS)

Financial Reporting Effects of the Equity Method

*managers frequently are very interested in how FS(s) report the effects of their decisions

Deferral of Intra-Entity Gross Profits in Inventory

*many equity acquisitions establish ties b/w companies to facilitate the direct purchase and sale of inventory items *Work to ensure proper timing for profit recognition Ex: when an investor company sells inventory to its 40% owned investee at a profit, 40% of this intra-entity sale effectively is with itself. ^^Consequently, when inventory sales occur b/w investor and investee, because of their ownership affiliation, the investor delays gross profit recognition until the inventory is sold to an independent party or is consumed. *Downstream Vs. Upstream Inventory Sales [*more relevant in Ch. 2: Consolidated FS(s)]

Rationale underlying the Equity Method:

*that an investor begins to gain the *ABILITY* to influence the decision-making process of an investee as the level of ownership rises *One only needs the ABILITY to exercise significant influence, they are not required to act on it for it to still be considered present

Why is it that the price an investor pays for equity securities often differs significantly from the investee's underlying book value?

*the historical cost based accounting model does not keep track of changes in a firm's fair value

Intra-Entity

*used to describe sales b/w an investor and its equity method investee

Reporting companies *MUST DISCLOSE* what certain information about *related-party transactions*?

-*nature of the relationship* -a *description* of the transactions -the *dollar amounts* of the transactions -*amounts due to or from* any related parties *at year-end* *readers of the FS(s) need to be made aware of the inclusion of intra-entity gross profits amount in the I/S

What are the other Equity Method recognition issues that arise for irregular items traditionally included w/in NI?

-an investee may report income (loss) from discontinued operations as components of its current net income ^The equity method would require the investor to record and report its share of these items in recognizing equity earnings of the investee

Impairment indicators

-assessments of earnings performance -economic environment going-concern ability, etc [losing a major customer may call into question the future of the co. if they were too dependent on that customer]

Under the Equity Method, the investor... [Misc.]

...enters total cost in a single investment account regardless of the allocation of any excess purchase price [i.e. to A, L, Goodwill, or Gain on Bargain Purchase] The entire $125,000 (includes the amount by which assets are undervalued as well as goodwill) was paid to acquire this investment, and its is recorded as such

Deferral of Intra-Entity Gross Profits in Inventory *In the presence of significant influence, the amount of profit deferred is...

...limited to the investor's ownership share of the investee *Equity method: Investor *defers ONLY its SHARE of the PROFIT* from the intra-entity sales until the buyer's ultimate disposition of the goods. ^^Ex: 40% ownership would mean that the investor only needs to defer 40% of the profits from the i-e sale *Whether upstream or downstream, the investor's sales and purchases are still reported as if the transactions were conducted with outside parties *^^Only the investor's share of the gross profit is deferred, and that amount is adjusted solely through the equity income account

Fair Value Method

0-20% ownership *Possesses neither significant influence nor control *recorded at cost and periodically adjusted to fair value *Dividends declared: recognized as income *Income: changes in the fair values of the equity securities during a reporting period are recognized as income *these shares are bought in anticipation of cash dividends or in appreciation of stock market values *If F.V. is NOT readily determinable, then the investment is to remain at cost [Cost Method]

Under the Cost Method: *The *investment REMAINS at cost UNLESS*:

1) A demonstrable *impairment* occurs for the investment, or OR 2) An *observable price change* occurs for identical or similar investments of the same issuer [*Fair Value becomes available*]

2. Reporting Investee Losses: What are the *Two Concerns*:

1. *Impairments* of Equity Method Investments 2. Investment Reduced to *Zero*

Reasons for a difference b/w the Book Value of a Co. and its Fair Value as reflected by the price of its stock:

1. A co.'s fair value at any time is based on a multitude of factors such as company profitability, the introduction of a new product, expected dividend payments, projected operating results, and general economic conditions 2. Stock prices are based, at least partially, on the perceived worth of a company's net assets, amounts that often vary dramatically from underlying book values ^B/S tends to measure historical costs rather than current value 3. ^^These figures are also affected by the specific accounting methods adopted by a company (i.e. LIFO, FIFO, or the various depreciation methods)

LIMITATIONS OF EQUITY METHOD APPLICABILITY: Examples where the use of the Equity Method would be deemed INappropriate:

1. An agreement exists b/w investor and investee by which the investor surrenders significant rights as a shareholder 2. A concentration of ownership operates the investee without regard for the views of the investor 3. The investor attempts but fails to obtain representation on the investee's board of directors *In each of the situations, because the investor is unable to exercise significant influence over its investee, the equity method is not applied [4.] • *Co. A may have other variable interests (through contractual and other arrangements) that result in control over the Co. B.

Despite its emphasis on cost measurements, GAAP allows for TWO Fair Value Assessments:

1. Cost method equity investments periodically must be assessed for impairment to determine if the fair value of the investment is less than its carrying amount Because the F.V. of a cost method equity investment is not readily available (by definition), if an impairment is deemed likely, an entity must estimate a fair value for the investment to measure the amount (if any) of the impairment loss *A qualitative assessment determines if impairment is likely. If the qualitative assessment does not indicate impairment, no further testing is required 2. Allows for recognition of "observable price changes in orderly transaction for the identical or a similar investment of the same issuer." Any unrealized holding gains (or losses) from these observable price changes are included in earnings with a corresponding adjustment to the investment account

3 Criticisms of the Equity Method [Equity Method vs. Consolidation]

1. Emphasizing the 20-50% of voting stock in determining significant influence versus control 2. Allowing off-balance-sheet financing 3. Potentially biasing performance ratios

Four Methods used to account for an investment in equity securities

1. Fair Value Method 2. Cost Method 3. Consolidation 4. Equity Method [See Index Card]

What are the two motivations for allowing a Fair-Value Option?

1. In support of the increasing emphasis on fair values in financial reporting *2. Perceived need for consistency across various B/S items. *^In particular, the fair-value option is designed to limit volatility in earnings that occurs when some financial items are measured using cost-based attributes and others at fair value

Equity Method- Additional Issues More specifically, special procedures are required in accounting for each of the following:

1. Reporting a change to the equity method 2. Reporting investee income from sources other than continuing operations 3. Reporting investee losses 4. Reporting the sale of an equity investment

What are the *5* conditions that indicate the *presence of significant influence*?

1. Representation on Board of Directors 2. Participation in the policy-making process 3. Material intra-entity transactions (Involving both companies) 4. Interchange of managerial personnel 5. Technological dependency

Equity Method Reporting Effects: [Part I] *Attention to financial reporting effects of business decisions arises because measurements of financial performance often affect the following:* Alternate Wording: What are a manager's concerns over financial reporting effects? [specifically, effects of the equity method]

1. The firm's *ability to raise capital* 2. Managerial *compensation* 3. The *ability to meet debt covenants and future interest rates* 4. Managers' *reputations* *Managers are also keenly aware that measures of earnings per share can strongly affect *investors' perceptions* of the underlying value of their firms' publicly traded stock *5 Step Decision-Making Process would encourage management to fully consider the potential effects of their options/decisions (regarding the list above) *^Such analyses of prospective reported income effects can influence firms regarding the degree of influence they wish to have, or even on the decision of whether to invest ^^Ex: *Managers could have a required projected rate of return on an initial investment. In such cases, an analysis of projected income will be made to assist in setting an offer price* [See Part II]

How are dividends recorded under the fair value method vs the equity method?

Fair Value Method - Dividends are recognized as income Equity Method - Dividends reduce the investment account

Fair-Value Method vs. Equity Method [pg. 8] Big Co. now controls Little Co. [*Almost wasn't studied]

Fair-Value Method: carries the investment at its market values, (if readily available, if NOT, then use cost method) ^Income is recognized both through changes in Little's Fair Value and as Little declares dividends Equity Method: Big recognizes income as it is recorded by Little ^Equity method reflects the accrual method: The investor recognizes income as it is recognized by the investee, not when the investee declares a cash dividend *See Chart on Page 8

Impairments of Equity Method Investments

In This Case: *The investor must (1) recognize an impairment loss [IMMEDIATELY upon realization that the loss is permanent so as not to overstate the B/S] and (2) reduce the asset to fair value *There is an impairment of the equity method present- this investment is suffering from a permanent loss in fair value that is not evident through equity method accounting. ^^i.e. loss of major customers, changes in economic conditions, loss of a significant patent or other legal right, damage to the company's reputations, and the like

Joint Venture

Investment in which two or more companies form a new enterprise to carry out a specified operating purpose *Investors do *NOT possess absolute control* because they *hold less than a majority of the voting stock*. Thus, the preparation of *consolidated F/S(s) is inappropriate*

APPLICATION OF EQUITY METHOD: Investee Event: 1. Income is recognized 2. Dividends are declared *What corresponding investor accounting would take place?

Investor Accounting: 1. Proportionate share of income is recognized 2. Investor's share of investee dividends reduce the investment account

Profits (Losses) and Dividends under the Equity Method (Misc.)

Profits: *The investor initially records the acquisition at cost, then records upward adjustments in the asset balance as soon as the investee makes a profit Dividends: *When the investee declares a cash dividend, its owners' equity decreases. The investor mirrors this change by recording a reduction in the carrying amount of the investment rather than recognizing the dividend as revenue

Change from Fair-Value Method to Equity Method: What approach does FASB require?

Prospective approach- adopt the equity method of accounting as of the date the investment becomes qualified for equity method accounting *2 yrs ago it was the retrospective approach

Prospective Approach

SITUATION- reporting a change (from the fair value method) to the equity method WHEN- when the ability to significantly influence an investee is achieved through a series of acquisitions TO DO- 1. Initial purchase(s) - fair value method (or at cost) until the ABILITY to significantly influence is attained *EVENT: a series of acquisitions occur; the ability to exercise significant influence occurs 2. The investor applies the equity method prospectively. The total fair value at the date significant influence is attained is compared to the investee's book value to determine future excess fair value amortization *2 yrs ago it was the retrospective approach

T/F: Consideration transferred equates a contractual promise.

TRUE

T/F: Supplementary Information could be available under the Equity Method that would NOT be separately identified in consolidation.

TRUE *The Equity Method requires summarized information as to A, L, and results of operations of the investee to be presented in the notes or in separate statements

T/F: The fair-value option is designed to match asset valuation with fair value reporting requirements for many liabilties

TRUE pg. 24

T/F: Under the Equity Method for investments w/Significant Influence, the direction of the sale b/w the investor and investee (upstream or downstream) has no effect on the final amounts reported in the FS(s).

TRUE, *Unlike consolidated FS(s), the equity method reports upstream sales of inventory in the same manner as downstream sales

T/F: In regards to Prob. #28 (and other's like it) our concern lies in Tucker's fair value not book value

TRUE; Acquisition Method= *Acquisition-Date Fair Value*

What is the key factor in assessing one company's degree of influence over another?

The relative size of ownership (i.e. 0-20% vs. 20-50% vs. over 50% ownership) *However, other factors (e.g., contractual relationships b/w firms) can also provide influence or control over firms regardless of the % of shares owned

Traditional vs. Alternative Treatment for deferring gross profits [Equity Method]

Traditional Treatment: -The investor's own inventory account contains the deferred gross profit -A JE defers recognition of this profit by decreasing Major's investment account in Minor RATHER THAN the inventory balance Alternative Treatment: -Direct reduction of the investor's inventory balance as a means of accounting fo rthis deferred amount *Although this alternative treatment is acceptable, decreasing the investment account remains the TRADITIONAL APPROACH for deferring gross profits, even for upstream sales

Cost Method

[Investments in Equity Securities w/out Readily Determinable Fair Values] *The investment REMAINS at cost UNLESS 1) A demonstrable impairment occurs for the investment, or OR 2) An observable price change occurs for identical or similar investments of the same issuer Income: Share of dividends declared by the investee *Such investments sometimes can be found in ownership share of firms that are not publicly traded or experience only infrequent trades *Despite its emphasis on cost measurements, GAAP allows for two fair value assessments that may affect cost method amounts reported on the B/S and the I/S

Upstream Sales of Inventory [Equity Method]

[SEE JE] 1. "Upstream" refers to transfers made by the investee to the investor 2. Unlike consolidated FS(s), under the equity method, the deferral process for intra-entity gross profits identical for upstream and downstream transfers ^Hence, the investor's share of gross profits remaining in ending inventory is deferred until the items are used or sold to unrelated parties *Two Treatments for Upstream Sales [SEE next card]

Downstream Sales of Inventory [Equity Method]

[SEE JE] 1. "Downstream" refers to transfers made by the *investor to the investee* 2. Intra-entity gross profits from sales are *initially deferred under the equity method* and *then recognized as income* at the time of the inventory'es eventual disposal 3. Amount of Gross Profit to be Deferred = *the Investor's Ownership % X Est. GP on the Merchandise Remaining at the EOY* *Est. GP is usually based on the GP % obtained in the sale of the other (already sold and accounted for) inventory*

T/F: FASB has always expanded the use of consolidated F/S(s) to include entities that are financially controlled through *special contractual arrangements rather than through voting stock interest*

[a Sherwin question] *FALSE*; *Only Siths deal in absolutes [the hypocricy of this statements highlights the fact that there may be a T/F question with an absolute like "all" or "only" that may be true. Just try to get a feel for how aggressive the absolute is and whether it feels right by instinct and base knowledge if necessary

*Items of other comprehensive income* that might change equity would include:

a. *Unrealized gains/losses* on available-for-sale securities; b. *Foreign currency items*; c. *Pension and post retirement benefit items* not recognized in period cost

*What information does the Equity method convey? [*Almost wasn't studied]

information that describes the relationship created by the investor's ability to significantly influence the investee

IASB defines significant influences as:

the power to participate in the financial and operating policy decisions of the investee, but it is not control or joint control over those policies.

Define Fair Value

the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction b/w market participants at the measurement date *Usually the quoted stock market prices represent fair values

In applying the equity method, what is the accounting objective?

to *report the investment and investment income* in a way that *reflects the close relationship b/w the investor and investee*