Chapter 1 - Equity Method

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Application of Equity Method

- Investee Recognizes income, Investor recognizes proportionate share of income - Investee Declares dividends, Investor's share of investee dividends reduce the investment account

Criticisms of equity method

-Emphasizing the 20-50 percent of voting stock in determining significant influence versus control -Allowing off-balance-sheet financing -Potentially biasing performance ratios

In applying the equity method, the cause of such an excess payment can be divided into two general categories

1. 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. The investor may pay an extra amount because it expects future benefits to accrue from the investment. Such benefits could be anticipated as the result of factors such as the estimated profitability of the investee or the expected relationship between the two companies

TheF FASB ASC provides the following definition on loss in value

A loss in value of an investment which is other than a temporary decline shall be recognized. Evidence of a loss in value might include, but would not necessarily be limited to, absence of an ability to recover the carrying amount of the investment or inability of the investee to sustain an earnings capacity that would justify the carrying amount of the investment

AOCI

Accumulated Other Comprehensive Income

Assume that Grande Company is negotiating the acquisition of 30 percent of the outstanding shares of Chico Company. Chico's balance sheet reports assets of $500,000 and liabilities of $300,000 for a net book value of $200,000. Grande determines that Chico's equipment is undervalued in the company's financial records by $60,000. One of it's patents is also undervalued in the financial records by $40,000. By adding these valuation adjustments, to Chico's book value, Grande arrives at an estimated $300,000 worth for the company's net assets. Based on this, Grande offers $90,000 for a 30 percent share of the investee's outstanding stock

Assume Chico rejects 90k, wants 125K instead. Payment by investor 125K percentage of book value acquired 60K payment in excess of book value 65K Equipment undervalue 18k patent undervalue 12k total 30k Excess payment not identified with specific assets - goodwill 65k - 30k = $35,000

Who are the highest authority in the management of a corporation?

Boards of directors

Book value of Chico Company (Assets minus liabilities) = $200,000 Undervaluation of equipment = $60,000 Undervaluation of patent = $40,000 Value of net assets = $300,000 Percentage acquired 30% Purchase Price = $90,000

If there is control through variable interests (governance documents, contracts), and ownership is of primary beneficiary status, what method should you use?

Consolidated Financial Statements

If there is control through voting interests, and ownership is more than 50%, what method should you use?

Consolidated Financial Statements

Little Company reported a net income of $200,000 during 2020 and declared and paid cash dividends of $50,000. These figures indicate that Little's net assets have increased by $150,000 during the year. Therefore, in its financial records, Big Company records the following journal entries to apply the equity method

DR Investment in Little Company 40,000 CR Equity in Investee Income 40,000 -To accrue earnings of a 20 percent owned investee ($200,000 x 20%)- DR Dividend Receivable 10,000 CR Investment in Little Company 10,000 -To record a dividend declaration by Little Company ($50,000 x 20%) DR Cash 10,000 CR Dividend Receivable 10,000 -To record collection of the cash dividend-

Accounting for both the profit deferral and subsequent recognition takes place through adjustments to the

Equity in Investee Income, Investment accounts

If there is an ability to significantly influence, and ownership is between 20-50%, what method should you use?

Equity method or fair value

Differences between IAS and FASB definition of significant influence

FASB allows a fair value reporting option for investments that otherwise are accounted for under the equity method. IAS, however, does not provide for a fair value option. Also, if the investee employs accounting policies that differ from those of the investor, IAS requires the financial statements of the investee to be adjusted to reflect the investor's accounting policies for the purpose of applying the equity method

Generally accepted accounting principles recognize four different approaches to the financial reporting of investments in corporate equity securities

Fair value method, cost method for equity securities without readily determinable fair values, consolidation of financial statements, and the equity method

If there is an inability to significantly influence, and the ownership level is less than 20%, what method should you use?

Fair value or cost method

Two fundamental motivations for such investments

Firms may temporarily invest in another firm's equity shares to earn a return on idle cash. Also, equity shares can provide a powerful business tool to investors

After a sale of investment, if the percent ownership is still above 20%, the equity method still applies in terms of valuing the investment

However, if the sale had dropped ownership below 20%, the equity method would cease to be applicable. The value of the investment would be 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

At any time, the investor can choose to sell part or all of its holdings in the investee company

If a sale occurs, 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 percentage of shares sold

Basics of the equity method in International Accounting Standard

If an investor holds, directly or indirectly, 20 percent or more of the voting power of the investee, it is presumed that the investor has significant influence, unless it can be clearly demonstrated that this is not the case. Conversely, if the investor holds, directly or indirectly, less than 20 per cent 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. A substantial or majority ownership by another investor does not necessarily preclude an investor from having significant influence

Although the entry to show the increase in investment income from the investee, and the entry to show amortization on the assets, are shown as separate lines and entries

In reality, these may be combined to show one increase/decrease in investment

Upstream Sale

Investee sells item to the investor

FASB provides guidance to the accountant by listing conditions that indicate influence

Investor representation on the board of directors of the investee, investor participation in the policy making process of the investee, material intra entity transactions, interchange of managerial personnel, technological dependency, and extent of ownership by the investor in relation to the size and concentration of other ownership interests in the investee

Downstream Sale

Investor sells item to investee

OCI

Other Comprehensive Income

Payment by investor = 90,000 Percentage of book value acquired = 60,000 (200,000 x 30%) Payment in excess of book value = 30,000 Excess payment identified with specific assets: - Equipment (60,000 undervalued x 30%) 18,000 - Patent (40,000 undervalued x 30%) 12,000 18+12 = 30,000 Excess payment not identified with specific assets - goodwill = $0

after recording the cost of the acquisition, two equity method entries periodically record the investment's impact:

The investor's investment account increases as the investee recognizes and reports income. The investor decreases its investment account for its share of investee cash dividends

Because of the limited level of ownership, the investor cannot expect to significantly affect the investee's operations or decision making

These shares are bought in anticipation of cash dividends or appreciation of stock market values

Control generally requires the consolidation of the accounting information produced by individual companies.

Thus, a single set of financial statements is created for external reporting purposes with all assets, liabilities, revenues, and expenses brought together

Intra entity sales require special accounting to ensure proper timing for profit recognition. An entity cannot recognize profits through activities with itself

Thus, in the presence of significant influence, the amount of profit deferred is limited to the investor's ownership share of the investee

FASB ASC (para. 323-10-35-4)

Under the equity method, an investor shall recognize its share of the earnings or losses of an investee in the periods for which they are reported by the investee in its financial statements rather than in the period in which an investee declares a dividend

Sometimes, an investment can be reduced to a zero balance, which can happen if a purchase was made at a low, bargain price

When an investment account is reduced to zero, the investor should discontinue using the equity method rather than establish a negative balance

Cost Method

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

The financial statement reporting for a particular investment depends primarily on the degree of influence that the investor has over the investee

a factor most often indicated by the relative size of ownership

Intra-Entity

a term used to describe sales between an investor and its equity method investee; the influence relationship creates its own entity that works to achieve business objectives

Included in AOCI are items such as

accumulated derivative net gains and losses, foreign currency translation adjustments, and certain pension adjustments

Certain intangibles such as goodwill are considered to have indefinite lives and thus are not subject to

amortization

When is equity method not appropriate?

an agreement exists between investor and investee where the investor surrenders significant rights as a shareholder, a concentration of ownership operates the investee without regard for the views of the investor, or the investors attempts but fails to obtain representation on the investee's board of directors

the rationale behind the equity method

an investor begins to gain the ability to influence the decision making process of an investee as the level of ownership rises

Conversely, an investment of less than 20 percent of the voting stock of an investee shall lead to a presumption that

an investor does not have the ability to exercise significant influence unless such ability can be demonstrated

upward adjustments in the asset balance are recorded as soon as the investee makes a profit

and if the investee reports a loss, the investor reduces the account balance

Changes in the fair values of equity securities during a reporting period

are recognized as income

Dividends declared on the equity securities

are recognized as income

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

Investments in equity securities that employ the cost method often continue to be reported

at their original cost over time

If an entity can exercise control over its investee, regardless of ownership level

consolidation rather than the equity method is appropriate

GAAP allows for two fair value assessments that may affect cost method amounts reported on the balance sheet and the income statement

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. Also, ASC allows for recognition of observable price changes in orderly transactions for the identical or a similar investment of the same issuer

First year return on beginning investment balance

defined as equity earnings / beginning investment balance

Fair Value

defined by the ASC as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date

Corporate investors frequently acquire ownership shares of both

domestic and foreign businesses

Because the investor recognizes income when the investee recognizes it

double counting would occur if the investor also recorded its share of subsequent investee dividends as revenue

the equity method

employs the accrual basis for recognizing the investor's share of investee income; the investor recognizes income as it is earned by the investee

Many firms will buy sufficient voting shares to

enable the election of their representatives to another firm's board of directors

Investments can suffer permanent losses in fair value that are not evident through

equity method accounting

Achieving the ability to exercise significant influence over operating and financial policies of an investee

even thought the investor holds 50 percent or less of the common stock

Income is recognized both from changes in

fair value, and upon receipt of dividends

In contract to the equity method, the fair value method reports investments at

fair value, if it is readily determinable

Because the investor can influence their timing, investee dividends cannot objectively measure income

generated from the investment

When the additional payment cannot be attributed to any specifically identifiable investee asset or liability, the investor recognizes an intangible asset called

goodwill

How to address the issue of an investment in common stock that becomes qualified for use of the equity method

if an investment qualifies for use of the equity method, the investor shall add the cost of acquiring the additional interest in the investee 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

The FASB provides a general ownership test

if an investor holds between 20 and 50 percent of the voting stock of the investee, significant influence is normally assumed, and the equity method is applied

an investment of 20 percent or more of the voting stock of an investee shall lead to a presumption that

in the absence of predominant evidence to the contrary an investor has the ability to exercise significant influence over an investee

The ability to vote for directors can be a powerful tool to

influence the decisions of an investee corporation

In recording the annual amortization expense, Grande reduces the investment balance in the same way

it would amortize the cost of any other asset that had a limited life. The expense is recognized by decreasing the investor's equity income accruing from the investee company

Equity method accounting requires that the investor record its share of investee OCI, which is then included in

its balance sheet as Accumulated other comprehensive income

When an investee declares a cash dividend

its owners' equity decreases

If an investment is acquired at a price in excess of the investee's book value

logical reasons should explain the additional cost incurred by the investor

How are permanent losses in fair value caused?

loss of major customers, changes in economic conditions, loss of a significant patent or other legal right, damage to the company's reputation, and the like

Income recognition requires

matching the income generated from the investment with its cost

Initial investments in equity securities are recorded at cost and subsequently adjusted to fair value if fair value is readily determinable;

otherwise the investment remains at cost

Unless the investor acquires its ownership at the time of the investee's conception

paying an amount equal to book value is rare

For most investments in equity securities,

quoted stock market prices represent fair values

Additional equity method issues include

reporting a change to the equity method, reporting investee income from sources other than continuing operations, reporting investee losses, and reporting the sale of an equity investment

With a cost to the investor as well as a specified life, the payment relating to each asset (Except land, goodwill, and other indefinite life intangibles)

should be amortized over an appropriate time period

If an investor holds between 20 and 50 percent of the voting stock of the investee

significant influence is normally assumed and the equity method is applied

Many corporate investors acquire enough shares to gain actual control over an investees operation

such control may be achieved when a stockholder accumulates more than 50 percent of an organization's outstanding voting stock

In many investments, the degree of ownership indicates

the ability of the investor to exercise significant influence over the investee

OCI thus represents a source of change in investee company net assets that is recognized under

the equity method

for Some investments that either fall short of or exceed 20 to 50 percent ownership

the equity method is used for financial reporting

As the owner's equity of the investee increases through the earnings process

the investment account also increases

Under the equity method

the investment in an associate 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

When a permanent decline in an equity method investment's value occurs

the investor must recognize an impairment loss and reduce the asset to fair value

Although most of the previous illustrations are based on the recoding of profits, accounting for losses incurred by the investee is handled in a similar manner

the investor recognizes the appropriate percentage of each loss and reduces the carrying amount of the investment account

Under the equity method

the investor records its share of investee dividends declared as a decrease in the investment account, not as income

In applying the equity method in intra equity transactions

the investor therefore defers only its share of the profit from the sale until the buyer's ultimate disposition of the goods

Income from cost method equity investments usually consists of

the investor's share of dividends declared by the investee

The IASB defines significant influence 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

In addition to your initial investment, add your payment for additional investment percentage

then compare to the fair value of Bailey that relates to Your percentage. Compare that to your investment, and see if youre over or under. The excess will be used in calculating the excess fair value amortization schedule

The equity method affects both the

timing of income recognition and the carrying amount of the investment account

In applying the equity method, the accounting objective is

to report the investment and investment income to reflect the close relationship between the investor and investee

When financial controls exists absent of majority ownership interest, control is achieved through contractual and other arrangements called

variable interests

Application of the equity method thus causes the investment account on the investor's balance to

Chapter 1 - Equity Method

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