FINAL EXAM: Chapter 1: The Equity Method of Accounting for Investments AND Chapter 2: Consolidation of Financial Information

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

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

*Contingent Consideration*

*An *additional element of consideration transferred:* acquisition agreements often contain *provisions to pay former owners* (tyipcally cash or additional shares of the acquirer's stock) *upon achievement of specified future performance measures* *Can be useful in negotiation when two parties disagree w/each other's estimates of future cash flows for the target firm or when valuation uncertainty is high *Walt Disney Co.: "subsequent changes in the estimated fair value, if any, will be recognized in earnings"

Morgan Co. acquires all of the outstanding shares of Jennings, Inc., for cash. Morgan transfers consideration more than the fair value of the company's net assets. How should the *payment in excess of fair value* be accounted for in the consolidation process?

*Any excess of the fair value of the consideration transferred over the net amount assigned to the individual assets acquired and liabilities assumed is recognized by the acquirer as goodwill

Catron Corporation is having liquidity problems, and as a result, it sells all of its outstanding stock to Lambert, Inc., for cash. Because of Catron's problems, Lambert is able to acquire this stock at less than the fair value of the company's net assets. How is the *reduction in price* accounted for within the consolidation process?

*Any excess of the net amount assigned to the individual assets acquired and liabilities assumed over the fair value of the consideration transferred is recognized by the acquirer as a *"gain on bargain purchase"* Reported in current income of the combined entity

When does an accounting consolidation occur for a combination when *all companies retain incorporation* [neither company dissolves?

*Because the companies preserve their legal identities, each continues to maintain its own independent accounting records *Thus, *NO permanent consolidation of the account balances is ever made* *^Rather, *the consolidation process must be carried out ANEW EACH TIME the reporting entity prepares F/S(s) for external reporting purposes*

Additional Issues: Intangibles Two essential Criteria in determining whether to recognize an intangible asset ina busines com

*Intangible assets often comprise the largest proportion of an acquired firm

Acquisition-Date Fair-Value Allocations: Additional Issues In determining whether to recognize an intangible asset in a business combination two specific criteria are essential

1. *Contractual/Legal Criterion:* Does the intangible asset arise from contractual or other legal rights? 2. *Separability Criterion:* Is the tangible asset capable of being sold or otherwise separated from the acquired enterprise? ^*The acquirer is not required to have the intention to sell, license, or otherwise exchange the intangible in order to meet ^this criterion

T/F : Consolidation Worksheet Entry "S" takes on fair value adjustments and is the final step to eliminating the investment account [for the SIMULATED consolidation]

FALSE; "S": S/E Equity "A": F.V. Adjustments

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*

What is often the *best source* of the *fair value of consideration transferred* in a business combination? (if available)

Market Values (i.e. stock prices)

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

TRUE pg. 24

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

"Subsidiary Dissolved" means

a *permanent one time* consolidation

*REGARDLESS OF the *elements that constitute the consideration transferred*, WHAT *comprises the valuation basis for the acquired firm* in consolidated financial reports?

the combined fair values of the parent's considerations transferred and the non-controlling interest

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.

What is the *accounting valuation basis* for consolidating *assets and liabilities* in a business combination?

• Acquisition Method: Acquisition-date Fair Value for recording all combinations ^Replaces the purchase method/cost method/original book values

Sloan, Inc., issues 25,000 shares *of its own common stock in exchange* for all of the outstanding shares of Benjamin Company. Benjamin will remain a separately incorporated operation. How does Sloane *record the issuance of these shares*?

• Shares issued are *recorded at fair value as if the stock had been sold and the money obtained used to acquire the subsidiary*. • The Common Stock account is *recorded at the par value* of these shares with any *excess amount attributed to additional paid-in capital* DR Investment in Benjamin Co. CR Common Stock (Par Value) CR AIP- Excess of Par

Jones Co. obtains all the common stock of Hudson, Inc., by issuing 50,000 shares of its own stock. Under these circumstances, *why might the determination of a fair value for the consideration transferred be difficult*?

• The shares may be *newly issued* (if Jones has just been created) so that *no accurate value has yet been established* • Jones may be a *closely held corporation* [few people- usually family owned) so that *no fair value is available* for its shares • The *number of newly issued shares* (especially if the amount is *large in comparison to the quantity of previously outstanding shares*) may *cause the price of the stock to fluctuate* widely so that no accurate fair value can be determined during a reasonable period of time • Jones' stock may have *historically experienced drastic swings in price*. Thus, a quoted figure at any specific point in time may not be an adequate representative value for long-term accounting purposes

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.

If the goal of business activity is to maximize the firm's value, in what ways do business combinations help achieve that goal?

*Business combinations- a strategy for growth and competitiveness: 1. Size and scale are becoming critical as firms compete in today's markets 2. Valuable *synergies* 3. If large firms can be more efficient in delivering goods and services, they gain a competitive advantage and become more profitable for the owners 4. Increases in scale can produce larger profits from enhanced sales volume despite smaller (more competitive) profit margins 5. Cost effective- not only share expenses [elimination of duplicate efforts] but also improve each other's business (i.e. delivery reach/time, coordination of raw material purchases, etc.) can lead to substantial savings *continuous expansion of their organizations into diversified areas (branch out with you subsidiaries)

[still Step 5] A One-Time Permanent Consolidation vs. The FIRST of many Periodic Consolidations

*By increasing the subsidiary's book value to fair value, the reported balances are the same as in other examples where dissolution occurred. *The use of a worksheet does NOT alter the consolidated figures but only the method of deriving those numbers*

*IF* separate incorporation is *maintained*

*Companies that form a business combination will often retain their separate legal identities as well as their individual accounting systems. o ^In such cases, internal financial data continues to be accumulated by each organization. o *Separate financial reports may be required for outside shareholders (a noncontrolling interest), the government, debt holders, etc. o This information may also be utilized in corporate evaluations and other decision making.

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

The Acquisition Method When *Separate Incorporation is Maintained*

*Fair value remains the basis for initially consolidating the subsidiary's A and L *DIFFERENCES in accounting for combinations in which each co. remains a legally incorporated separate entity: -*the consolidation of the financial information is *only simulated; the acquiring co. does not physically record the acquired A and L *A worksheet and consolidating entries are employed using data gathered from these separate companies *When the *subsidiary remains separate*, the *parent establishes an investment account* that *initially reflects* the acquired firm's acquisition-date fair value

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*

Preexisting Goodwill on Subsidiary's Books

*How should a parent treat this preexisting goodwill? *The *new owner simply excludes* the carrying amount of any *preexisting goodwill from the subsidiary's acquisition-date book value* *^realloacting any preexisting subsidiary goodwill via a CR in Consolidation Worksheet Entry "A" [^This worksheet CR to the subsidiary's goodwill balance is then offset by worksheet entries to identifiable A and L, followed by a DR to the new goodwill from the combination] *The logic of ^this being that the total business fair value is first allocated to the identified A and L; ONLY IF an *excess amount remains* after recognizing the fair values fo the net identified A *is any goodwill recognized*

Consolidation Values and related Acquisition Accounting: (1) Consideration transferred *equals* the fair values of net identified assets acquired

*Identified A acquired and L assumed are recorded *at their fair values*

Consolidation Values and related Acquisition Accounting: (3) Considerations transferred is *less than* the fair values of net identified A acquired. The total of the indiv. fair values of the net identified As acquired effetively becomes the acquired busienss fair value

*Identified A acquired and L assumed are recorded *at their fair values* *The *excess amount of net identified A fair value* over the consideration transferred is recorded as a *gain on bargain purchase*

Consolidation Values and related Acquisition Accounting: (2) Considerations transferred is *greater than* the fair values of net identified A acquired

*Identified A acquired and L assumed are recorded *at their fair values* *The *excess consideration transferred* over the net identified asset fair value is recorded as *goodwill*

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

When does the net amount of fair values for the A acquired and L assumed serve as the acquired firm's valuation basis?

*In a BP, the net asset fair value effectively replaces the consideration transferred as the acquired firm's valuation basis

Fair-Value Reporting for Equity Method [JE] [Continued...]

*In its December 31, 2018, Balance Sheet, Westwind thus reports its Investment in Armco account at $748,000, equal to 40% of Armco's total fair value (or $722,000 initial cost adjusted for 2017-2018 fair value changes of $38,000 less $12,000)

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

Business Combinations: Managerial Income

*Managers of successful firms also receive substantial benefits in salaries, especially if their compensation contracts are partly based on stock market performance of the firm's shares

*Conglomerates*

*Many firms seek the continuous expansion of their organizations, often into diversified areas. ^They do so by managing a vast network of different businesses (in varying areas), known as conglomerates. *Entry into new industries is immediately available to the parent w/out having to construct facilities, develop products, train mgmt, or create market recognition

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

[Step 6] Subtract consolidated expenses from revenues to arrive at a net income

*NOTE: because this is an *acquisition-date worksheet*, we consolidate no amounts for Smallport's revenues and expenses ^*Having just been acquired, Smallport has nto yet earned any income for BigNet owners. Subsequent to acquisition, the Smallport's R and E accounts will be consolidated w/BigNet's

To obtain all of the stock of Molly, Inc., Harrison Corporation issues its own common stock*. Harrison had to pay $98,000 to lawyers, accountants, and a stock brokerage firm in connection with services rendered during the creation of this business combination. In addition, Harrison paid $56,000 in costs associated with the stock issuance. *How will these two costs be recorded?*

*The *direct combination costs of $98,000* are *allocated to expense* in the period in which they occur. DR Professional Services Expenses 98,000 CR Cash 98,000 *To record as expenses of the current period any direct combination costs. **Stock issue costs of $56,000* are treated as a *reduction of APIC* [Additional Paid-In Capital] (*to reduce the value assigned to the fair value of the securities issued*). DR Additional Paid-In Capital 56,000 CR Cash 56,000 *To record costs to register and issues stock in connection with Molly, Inc. acquisition

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

Wilson Co. acquired 40% of Andrew Co. at a bargain price because of losses expected to result from Andrew's failure in marketing several new products. Wilson paid only $100,000, although Andrew's corresponding book value was much higher. In the first year after acquisition, Andrews lost $300,000. *In applying equity method, how should Wilson account for this loss?*

*The investment was initially recorded at cost ($100,000) which means that the Andre Investment Account balance is currently only $100,000. DR Investment in Andrew Co. 100,000 CR Cash 100,000 *The loss of $300,000 would cause a $200,000 investment deficit if it were to be recorded in full, so INSTEAD, Wilson Co. will *reduce the Investment account to a ZERO BALANCE* DR *Investment Loss* 100,000 CR *Investment in Andrew Co.* 100,000 *Wilson Co. should *discontinue using the Equity Method rather than establish a negative balance* *^Once the original cost of the investment has been eliminated, no additional losses can accrue to the investor **The Investment retains a ZERO balance until subsequent investee profits eliminate all unrecognized losses* (the remaining $20,000)

*Convergence b/w U.S. and International Accounting Standards* (for business combinations and consolidation): Why is this a *remarkable accomplishment*?

*The joint project on business combinations represents *one of the first successful implementations of the agreement b/w the two standard-setting groups to coordinate efforts on future work with the goal of developing high-quality comparable standards for both domestic and cross-border financial accounting

Which valuation technique employed for assets acquired and liabilities assumed is often useful for acquired in-process research and development?

*The multi-period Income Approach

How should a parent consolidate its subsidiary's *revenues and expenses*?

*The revenues and expenses (both current and past) of the PARENT are INCLUDED within reported figures. *HOWEVER, the revenues and expenses of the SUBSIDIARY are consolidated *from the date of the acquisition forward* within the worksheet consolidation process. ^The operations of the subsidiary are only applicable to the business combination if earned *subsequent to its creation*. ^^Revenues, Expenses, Net Income, Retained Earnings, Dividends Declared of the subsidiary are *NOT reported on the parent's consolidated FS(s)* *STEP 3 of the Consolidation process is *Consolidation Entry "S"* which *eliminates the subsidiary's stockholder's equity accounts* DR *Common Stock* (Subsidiary Co.) DR *Additional Paid-In Capital* (Subsidiary Co.) DR *Retained Earnings* (Subsidiary Co.) CR *Investment in Subsidiary Co.*

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

*Related Costs of Business Combinations:* - BigNet pays an additional $100,000 in accounting and attorney fees - Internal secretarial and administrative costs of $75,000 are *indirectly attributable* to BigNet's combination w/Smallport - Costs to register and issue BigNet's securities issued in the combination total $20,000

*To be recorded by BigNet *REGARDLESS of whether dissolution occurs or separate incorporation is maintained*: DR Professional Services Expense 100,000 CR Cash 100,000 * To record as expenses of the current period any *direct combination costs*. DR Salaries and Administrative Expenses 75,000 CR Accounts Payable (or Cash) 75,000 * To record as expenses of the current period any *indirect combination costs* DR Additional Paid-in Capital 20,000 CR Cash 20,000 * To record *costs to register and issue stock in connection with the Smallport acquisition*

Acquisition Method- Equity and Income Accounts

*Under the acquisition method, *ONLY* the subsidiary's revenues, expenses, dividends, and equity *transactions that occur SUBSEQUENT to the takeover affect the business combination*

Goodwill: An Indefinite Life

*Unlike other A, we consider goodwill as unidentifiable because we presume it emerges from several other assets acting together to produce an expectation of enhanced profitability

3 Valuation Techniques Employed for Assets Acquired and Liabilities Assumed: [ADDITIONAL INFORMATION] *Cost Approach vs. Used Assets

*Used assets can present a particular valuation challenge if active markets only exist for newer versions of the asset (i.e. certain technology/products become outdated- overtime or very quickly, like Blockbuster vs. Netflix) *^Thus, the cost to replace a particular asset reflects both its *estimated replacement cost* and the *effects of obsolescence*

When are consolidated financial reports to be prepared?

*Whenever one firm has a controlling financial interest in another *Although ownership of a majority voting interest is the usual condition for a controlling financial interest, *the power to control may also exist w/a lesser % of ownership through governance contracts, leases, or agreements w/other stockholders* *IF,* "controlling financial interest" exists *THEN,* prepare consolidated financial reports

What is a *business combination*?

*a transaction (i.e. acquisition of controlling voting stock) or other events (i.e. contractual agreements) in which an acquirer obtains control over one or more businesses *can be part of an overall managerial strategy to maximize shareholder value ^Managers may be hired to direct resources so that the firm's value grows over time [in this way, owners receive a return on their investment]

What is the fundamental principle of the acquisition method?

*an acquirer must identify the assets acquired and the liabilities assumed in the business combination [to be measured at their acquisition-date fair values, *with only a few exceptions*]

Define *Goodwill* [in a business combination]

*an asset representing the *future economic benefit* arising in a business combination that are *NOT* individually identified and separately recognized *Goodwill often embodies the expected synergies* as well as non-recognized intangibles of the acquired firm such as employee expertise

Worksheets:

*are a part of neither company's accounting records nor the resulting F/S(s), yet serves as a *catalyst* to bring together the two independent sets of financial information *are an efficient structure for organizing and adjusting the information used to prepare externally reported consolidated statements *On the worksheet, the investment account is effectively replaced w/the acquisition-date fair values of Smallport's A and L along w/(potentially) goodwill created by the combination

How does the Acquisition Method treat contingent obligations?

*as a negotiated component of the fair value of the consideration transferred ^*According to this view, contingencies have value to those who receive the consideration and represent measurable obligations of the acquirer Listed in Consdieration Transferred calculation as "Fair Value of contingent performance liabilitiy"

Worksheet Entries

*either adjust or eliminate various account balances of the parent and subsidiary *Because no actual union occurs, neither company ever records consolidation worksheet entries in its journals

[Step 3] Consolidation Entry "S"

*eliminates Smallport's stockholder's equity accounts *"S" is a reference to beginning subsidiary stockholder's equity *a worksheet entry and accordingly does not affect the financial records of either co. *This entry also eliminates a large component of the investment account that equates to the book value of the subsidiary's NA *This portion of the parent's Investment in Smallport Co. account balance is eliminated and replaced by the specific subsidiary A and L that are already listed in teh second column of the worksheet

"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)

[Step 5] All accounts are extended into the Consolidated Totals column

*for some assets such as "Current Assets," this process simply adds Smallport and BigNet book values *BUT, when applicable, this extension also include any allocations to establish the acquisition-date fair value of Smallport's A and L [worksheet JEs]

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

*Obsolescence*

*meant to capture *economic declines in value* including both *technological obsolescence* and *physical deterioration* *relates to the treatment of used assets under the Cost Approach of valuing assets acquired and liabilities assumed

[Step 4] Consolidation Entry "A"

*removes the excess payment in the Investment in Smallport Co. and assigns it to the specific accounts indicated by the fair-value allocation schedule *"A" indicates the allocation made in connection with Smallport's acquisition-date fair value *Consolidation Entry "A" *completes the* [simulated] *elimination of the Investment* in Smallport Co. account balance. [*the investment remains on BigNet's book*, but it does not appear on the consolidated B/S. Instead the *investment account is replaced on the worksheet w/Smallport's actual As and Ls* as shown in Step 5

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 a *worksheet needed*?

*the business combination must periodically produce consolidated financial statements encompassing all of the companies within the single economic entity. ^*HOWEVER*, the financial information must be brought together periodically *W/OUT disturbing the accounting systems of the indiv. companies*

What is the *starting point* in *valuing and recording a business combination*?

*the fair value of the *consideration transferred* to acquire a business from its former owners

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

Bargain Purchases:

*typically considered anomalous [businesses generally do not sell assets or businesses at prices below their fair values] *Usually in forced or distressed sales *The acquisition method records the identified A acquired and L assumed at their individual Fair Values *^In a BP situation, ^this net asset fair value effectively replaces the consideration transferred as the acquired firm's valuation basis for financial reporting *The acquirer recognizes this gain on its I/S in the period the acquisition takes place

Intra-Entity

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

When does an accounting consolidation occur for a *statutory merger* or a *statutory consolidation*?

*when the acquired co. (or companies) is (are) legally dissolved, only one [PERMANENT] accounting consolidation ever occurs *Date of Acquisition: the surviving co. simply *records the various account balances from each of the dissolving companies* *after the balances have been transferred to the survivor, the financial records of the acquired companies are closed out as part of the dissolution

(1) Acquisition Method when *Dissolution* takes place

*when the acquired firm's legal status is dissolved in a business combination, the *continuing firm takes direct ownership of the former firm's assets and assumes its liabilities*: Thus, *the continuing firm records the following JEs:* 1. The fair value of the *consideration transferred* by the acquiring firm to the former owners of the acquiree, and 2. The identified *assets acquired and liabilities assumed* at their indiv. fair values

*Items* of Consideration Transferred for the Acquired Business

- *cash* - *securities* (either stocks or debt/liabilities/NP) - *contingent performance liability* - *other* property or obligations

Acquired *In-Process research and Development* General Info

- IPR&D asset is *initially considered an indefinite-lived intangible asset* [and is *NOT* subject to *amortization*] UNTIL the *project is completed or abandoned* [i.e. until its useful life is determined to be no longer indefinite] - IPR&D is then *tested for impairment annually or more frequently* if events or changes in circumstances indicate that the asset might be impaired - Similar to costs that result in goodwill and other internally generated intangibles (e.g., customer lists, trade names, etc.), *IPR&D costs are expensed as incurred in ongoing business activities* ^*For a business combination:* *R&D expenditures incurred subsequent to the date of acquisition will continue to be expensed *SEE JE* *Acquired IPR&D assets initially

Acquired *In-Process research and Development* Requires *significant estimates and assumptions* including but not limited to:

- Projecting regulatory approvals - Estimating future cash flows from product sales resulting from completed products and in-process projects - Developing appropriate discount rates and probability rates by project

Applying the acquisition method *involves recognizing and measuring:*

- The *consideration transferred* for the acquired business and any non-controlling interest - The separately identified *assets acquired and liabilities assumed* - *Goodwill*, or a *gain from a bargain purchase*

Business Combination Profitability Characteristics

- Vertical integration of one firm's output and another firm's distribution or further processing - Cost savings through elimination of duplicate facilities and staff [share expenses] - Quick entry for new and existing products into domestic and foreign markets - Economics of scale allowing greater efficiency and negotiating power - The ability to access financing at more attractive rates. As firm size increases, negotiating power w/financial institutions can increase also - Diversification of business risk

*WHEN does the consolidation take place?*

-*IF dissolution takes place*, a *permanent consolidation occurs* at the date of the combination -*IF separate incorporation is maintained*, the consolidation process is carried out *at regular intervals* [PERIODICALLY] whenever F/S(s) are to be prepared

*WHAT is to be consolidated?*

-*IF dissolution takes place*, appropriate account balances are physically consolidated in the surviving co.'s financial records [*booked on the actual records*] -*IF separate incorporation is maintained*, only the financial statement information [*NOT the actual records*] is consolidated

*HOW are the accounting records affected?*

-*IF dissolution takes place*, the surviving co.'s *accounts are adjusted to include appropriate balances of the dissolved co.* The dissolved co.'s *records are closed out*. -*IF separate incorporation is maintained*, each co. *continues to retain its own records*. *Using worksheets* facilitates the periodic consolidation process *w/out disturbing the indiv. accounting systems*

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

*Bargain Purchase of a Separately Incorporate Subsidiary*- Prob. 28 [OG]

-If the consideration transferred is less than the fair value of a newly acquired subsidiary's identifiable NA, then the *parent records a bargain purchase gain on its books as part of the investment acquisition journal entry* ^A.k.a. the first *prerequisite JE* prepared

Within the consolidation process, what is the *PURPOSE* of a *worksheet*?

-The purpose of a worksheet is *to organize and structure the process of simulating a consolidation b/w two companies that maintain their separate identities to be carried out on a regular, periodic basis without affecting the financial records* of the various component companies*. *Worksheets are a part of neither company's accounting records nor the resulting FS(s) *Entries either adjust or eliminate various account balances of the parent and subsidiary* *The worksheet entries serve as a *catalyst* to bring together the two independent sets of financial information

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]

T/F: FASB ASC Presumption that consoidated FS(s) are...

...more meaningful than separate F/S(s) and that they are usually necessary for fair presentation when one of the entities in the consolidated group directly or indirectly has a controlling financial interest in the other entities

3 Additional Categories of Costs typically accompany business combinations, regardless of whether dissolution takes palce:

1) *Direct Combination Costs* (e.g., accounting, legal, investment banking, appraisal fees, etc.) 2) *Indirect Combination Costs* (e.g., internal costs such as allocated secretarial or managerial time) 3) *Stock Issuance Costs* (e.g., Amounts incurred to register and issue securities *SEE JE

3 Valuation Techniques Employed for Assets Acquired and Liabilities Assumed:

1. *Market Approach [PRESENT]*- Estimates fair values *using other market transactions involving similar A or L* ^^*OFTEN USED FOR: *maretable securities* and *some tangible assets who have established markets* that can provide comparable market values for estimating fair values 2. *Income Approach [FUTURE]*- Relies on multi-period estimates of future cash flows projected to be generated by an asset ^These projected CFs are then *discounted at a required rate of return* that reflects the time value of money and the risk associated w/realizing the future estimated CFs ^^*OFTEN USED FOR: obtaining fair value estimates of *intangible assets* and *acquired in-process research and development* 3. *Cost Approach [PAST]*- Estimates fair values by reference to the current cost of replacing an asset with another of comparable economic utility ^SEE Card: Cost Approach vs. Used assets ^^*OFTEN USED FOR: many *tangible assets* acquired such as property, plant, and equipment

Describe the *different types of legal arrangements* that can take place to create a business combination.

1. *Statutory merger*: only one of the original companies remains in business as a legally incorporated enterprise. [Co. 2 Dissolves] - *Assets and Liabilities* can be acquired w/the seller then dissolving itself as a corporation - *All of the capital stock* of a company can be acquired with the assets and liabilities then transferred to the buyer followed by the seller's dissolution Combination: *Facebook and WhatsApp* 2. *Statutory consolidation* - assets or capital stock of two or more companies are transferred to a newly formed corporation - *BOTH original companies DISSOLVE, ONLY the NEW now exists *WESTROCK Ex.* 3. Acquisition by one co. of a *controlling interest in the voting stock* of a second. - Dissolution does NOT take place; both parties retain their separate legal incorporation - Each co. maintains an independent accounting system - *to reflect the combination, the acquiring company enters the takeover transaction into its own records by *establishing a single investment asset account* - *Marshal and Tucker Prob. #28 4. *Control* of a Variable Interest Entity (VIE) - *control is exercised through contractual arrangements with a sponsoring firm that, although it technically may not own the VIE, becomes its "primary beneficiary" with rights to its residual profits - Ex: contracts in the form of leases, participation rights guarantees, or other interests -PAST CONCERN: off-balance sheet financing/reporting was being accomplished by the formerly applicable equity method

2 Forms of Consolidation

1. Acquisition method when *dissolution* takes place 2. Acquisition method when *separate incorporation is maintained*

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.

Potential Reasons for Goodwill For reference: BigNet (acquirer) Smallport (acquiree)

1. BigNet may expect its A to act in concert w/those of Smallport, thus creating *SYNERGIES* what will produce profits beyond the total expected for the individual companies 2. Smallport's history of *profitability* 3. S's *reputation* 4. S's *quality of personnel* 5. The *current economic condition of the industry* in which Smallport operates

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

*3* recent business combination examples of *distinct motivations to combine*:

1. Facebook and WhatsApp 2. AT&T and DirecTV 3. Rock-Tenn and Meadwest Vaco [Read Straight From TB]

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]

*Benefits* of keeping both entities alive and *w/sperate legal identities* (specifically the acquired co.)

Better utilization of such factors as: - licenses - trade names - employee loyalty - company reputation

Acquisition Method- One of the *first steps regardless of the acquired firms dissolution status*:

Compare *consideration transferred* to the *fair value of the net identifiable* assets acquired and liabilities assumed to determine if *GOODWILL or a GAIN on BARGAIN PURCHASE* should be recorded

The Acquisition Method- STEP 1: Calculate Consideration Transferred for the Acquired Business

Consideration Transferred = *Sum of*: 1. the *acquisition date fair values of the assets* transferred by the acquirer [Cash or Common Stock used to purchase controlling interest] + 2. the *liabilities incurred* by the *acquirer to former owners of the acquiree*, and + 3. the equity interest issued by the acquirer* [Amortization of undervalued assets]

What is the journal entry to record a dividend declaration?

DR Dividend Receivable CR Investment

What is the journal entry to record the investment income at the end of the year?

DR Investment CR Equity in Investment Income *(Net Income x % interest owned)

Acquired *In-Process research and Development* EX: Consideration transferred $2,300,000 Receivables $ 55,000 Patents 220,000 *In-process research and development 1,900,000* Accounts payable (175,000) Fair value of identified net assets acquired 2,000,000 *Goodwill $ 300,000*

DR Receivables 55,000 DR Patents 220,000 *DR Research and Development Asset 1,900,000* DR Goodwill 300,000 CR Accounts Payable 175,000 CR Cash 2,300,000 *R&D *expenditures incurred subsequent* to the date of acquisition will continue *to be expensed*

T/F: The acquisition method only applies to business combinations where the acquired firm maintains its separate incorporation.

FALSE, *Regardless of whether the acquired firm maintains its separate incorporation *or dissolution takes place*, current standards require the acquisition method to account for business combinations

T/F: Both the parent and subsidiary would record the following event: Psych, Inc. achieves legal control over Monk Co. by acquiring a majority of voting stock.

FALSE, *to reflect the combination, the acquiring company enters the takeover transaction into its own records by *establishing a single investment asset account* *However*, the newly acquired subsidiary *OMITS* any recording of this event; its stock is simply transferred to the parent from the subsidiary's shareholders ^THUS, *the subsidiary's financial records are NOT directly affected by a takeover*

Business Combinations using the Acquisition Method embrace a *fair-value* measurement attribute. Adoption of this attribute reflects what?

FASB's change of emphasis from Cost Principle [purchase price] to Fair Value Measurement

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

To recognize an asset (*Goodwill*) or to recognize a gain (*Gain on Bargain Purchase*)

Goodwill: Excess of *consideration transferred* over the *acquisition-date net amount of the identified assets acquired and the liabilities assumed* *[CT *>* A-D NA] Gain on Bargain Purchase: Excess of *collective fair value of the net identified assets acquired and liabilities assumed* over the *consideration transferred* *[CT *<* A-D NA] ^*The *fair value of the net assets acquired replaces the consideration transferred as the valuation basis* for the acquired firm ^^*Can be a result of various distress sales ^^^Before recognizing a gain on bargain purchase, the acquirer *must reassess whether it has correctly identified and measured all of the acquired A and L*

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

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

When does the consideration transferred serve as the acquired firm's valuation basis?

Only if the consideration EQUALS or EXCEEDS the net amount of fair values for the A acquired and L assumed

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

How is the fair value method recorded?

Recorded at cost and adjusted to fair value

T/F: Business Combinations- Even though the various companies may retain their legal identities as separate corporations, the resulting information is more meaningful to outside parties when consolidated into a single set of F/S(s)

TRUE

T/F: Consideration transferred equates a contractual promise.

TRUE

T/F: In all business combinations, only goodwill reflected in the current acquisition is brought forward in the consolidated entity's financial reports.

TRUE

T/F: The *specific format* is a *critical factor* in the subsequent consolidation of financial information

TRUE

T/F: Current accounting standards require that acquired In-Process Research and Development (IPR&D) be measured at acquisition-date fair value and recognized in consolidated F/S(s) as an A

TRUE; *Past Standards:* required immediate expense treatment for acquired IPR&D *Arguments about the future economic benefits of IPR&D ultimately persuaded FASB to require asset recognition *Uses the *income approach* to valuating assets and liabilities

T/F: In a bargain purchase, the fair values of the A received and all L assumed in a business combination are considered more relevant for asset valuation than the consideration transferred

TRUE; *In a BP situation, ^this net asset fair value effectively replaces the consideration transferred as the acquired firm's valuation basis for financial reporting

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*

T/F: Our concern lies in the fair values of ONLY the A and L of the acquired; the capital stock, retained earnings, dividend, revenue, and expense accounts represent historical measurements rather than any type of future values

TRUE; Although these *equity and income accounts* can give some indication of the organization's overall worth, they are NOT property and thus *are NOT transferred in the combination*

T/F: The FASB ASC Topics "Business Combinations" (805) and "Consolidation"(810) represent outcomes of a joint project b/w the FASB and the IASB.

TRUE; OBJECTIVE: - domestic and cross-border financial reporting - a common set of principles and related guidance that produces decision-useful information and minimizes exceptions to those principles - *to improve the completeness, relevance, and comparability of financial information about business combinations*

T/F: Although it remains on BigNet's books, the Investment in Smallport account is eliminated entirely in consolidation

TRUE; Through Consolidation Entries "S" and "A"

T/F: One of the first steps in the consolidation process is to close Smallport's R, E, and Dividend accounts into its RE account.

TRUE; [Step 2] *These activities occurred before Smallport was acquired; thus, the new owner should NOT include any pre-combination subsidiary revenues or expenses in the consolidated statements

T/F: The acquisition method does not consider the related costs of business combinations as part of the fair value received by the acquirer

TRUE; pg. 55

ASC's definition of *control*

The *direct or indirect ability to determine the direction of mgmt and policies through ownership, contract, or otherwise* [The *power to control* may also exist with a lesser % of ownership, for example, by contract, lease, agreement w/other stockholders, or by court decree]

What schedule effectively serves as a convenient supporting schedule for the consolidation worksheet and is routinely prepared for every consolidation?

The Acquisition-Date Fair-Value Allocation Schedule [Step 1]

Legacy Effects

[Appendices- NOT on Exam] We're still recent enough that the prior use of the purchase method (cost principle) over the fair value measurement

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

Determining the fair value of contingent future payments typically involves:

probability and risk assessments based on circumstances existing on the acquisition date

What is a consequence of implementing a fair-value concept to acquisition accounting?

the recognition of an unrealized gain on the bargain purchase

In producing F/S(s) for external distribution,...

the reporting entity *transcends the boundaries of incorporation to encompass (i.e. consolidate) all companies for which control is present*

Consolidation Objective and Overview

• When FS(s) represent more than one corporation • *OBJECTIVE* of Consolidation: to report the financial position, results of operations, and cash flows for the combined entity *Reciprocal accounts [Investment Account] and intra-entity transactions [arms-reach transactions/sales, usually inventory] must be adjusted or eliminated to ensure that all reported balances truly represent the single entity • *IF* the acquired company is *legally dissolved*, *a permanent consolidation* is produced on the *date of acquisition* by entering all account balances *into* the financial records of the *surviving company*. • *IF* separate incorporation is *maintained*, consolidation is *periodically simulated* whenever FS(s) are to be prepared. This process is carried out through the *use of worksheets and consolidation entries*. Consolidation worksheet entries are used to *adjust and eliminate subsidiary company accounts*. *Entry "S" eliminates* the *equity accounts of the subsidiary*. *Entry "A"* *allocates excess payment* amounts to identifiable assets and liabilities based on the fair value of the subsidiary accounts. [SEE pg. 57 Consolidation Entries] *(Consolidation journal entries are NEVEER recorded in the books of either company, they are worksheet entries only.)

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

the investor enters total cost in a single investment account regardless of the allocation of any excess purchase price 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

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

The Amortization Process [pg. 12] *Investor's portion of Assets are undervalued by : Equipment ($60,000 undervaluation x 30%) $ 18,000 Patent ($40,000 undervaluation x 30%) 12,000 *Previously Determined: *Goodwill of $35,000 *Equipment (RUL)- 10 yrs *Patent (RUL)- 5 yrs *Goodwill (RUL)- INDEFINITE

Account Cost Assigned Remaining Useful Life Annual Amortization Equipment $18,000 10 years $ 1,800 Patent 12,000 5 years 2,400 Goodwill 35,000 Indefinite -0- Annual Expense (for 5 yrs until patent cost is completely amortized) *$ 4,200* *recording this annual expense REDUCES the investment balance IN THE SAME WAY it would amortize the cost of any other asset that had a limited life. JE: DR Equity in Investee Income 4,200 CR Investment in Chico Co. 4,200 *To record amortization of excess payment allocated to equipment and patent *Because this amortization relates to investee assets, the investor does not establish a specific expense account ^Instead, the expense is recognized by decreasing the investor's equity income accruing from the investee company

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*

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

When does the consolidation of financial information into a single set of statements become necessary?

*When the business combination of two or more companies creates a single economic entity

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)]

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

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

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*

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

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

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

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*

*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

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

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

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

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

Downstream Sale of Inventory [PART I-Prep] -Major Co. owns 40% share of Minor Co. -Employs Equity Method -In 2018, Major sells inventory to Minor for $50,000 ^Includes: gross profit of 30% [of the sale price], or $15,000 -By the EOY 2018, Minor has sold $40,000 of these goods to outside parties while retaining $10,000 in inventory for sale during the subsequent year

[PART I-Prep] *Recognition of the related profit must be delayed until the buyer disposes of these goods *The $40,000 that has been resold to outsiders is justified in being reported as normal profits now *The remaining $10,000 still in the investee's inventory, the investor delays gross profit recognition *The GP of on the OG intra-entity sale was 30% of the sale price; therefore, Major's profit associated w/these remaining items is $3,000 ($10,000 x 30%) ^^However, because only 40% of the investee's stock is held, just $1,200 ($3,000 x 40%) of this profit is deferred

Fair-Value Reporting for Equity Method [JE] On January 1, 2017, Westwind Co. pays $722,000 in exchange for 40,000 common shares of Armco, Inc., which has 100,000 common shares outstanding, the majority of which continue to trade on the NYSE. During the next 2 years, Armco report the following information: Common Shares Total Fair Value Year Net Income Cash Dividends at December 31 2017 $158,000 $25,000 $1,900,000 2018 125,000 25,000 1,870,000

JEs: 1) DR Investment in Armco, Inc. 722,000 CR Cash 722,000 *To record Westwind's initial 40% investment in Armco, Inc. 2) DR Dividend Receivable 10,000 CR Cash 10,000 DR Cash 10,000 CR Dividend receivable 10,000 *To recognize 2017 dividends received (40%) as investment income [EXTENDED JE] 3) DR Investment in Armco, Inc. 38,000 CR Investment Income 38,000 *To recognize Westwind's 40% of the 2017 change in Armco's fair value [($1,900,000 x 40%) - $722,000] 4) DR Cash 10,000 CR Dividend Income 10,000 *To recognize 2018 dividends received (40%) as investment income [SIMPLIFIED JE- assumes dividend declaration and payment occur at the same time] 5) DR Investment Loss 12,000 CR Investment in Armco, Inc. 12,000 *To recognize Westwind's 40% of the 2018 change in Armco's fair value [40% x ($1,870,000 - $1,900,000)

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)

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: 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 does the Equity Method affect?

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

*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

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]

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*

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

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

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

Riggins Co. accounts for its investment in Bostic Co. using the equity method. During the past fiscal year, Bostic reported other comprehensive income from translation adjustments related to its foreign investments. How would this other comprehensive income affect the investor's financial records?

*When an investee company's activities require recognition of other comprehensive income (OCI), its owner's equity (and net assets) will reflect changes not captured in its reported net income Step 1: Riggins Co. would record an increase to its own other comprehensive income [Shown on the B/S as Accumulated Other Comprehensive Income (AOCI) equal to its percentage investment in the Bostic Co. multiplied by Bostic Co.'s reported OCI] *OCI - an increase in Investment account; represents a source of change in investee co. net assets that are recognized under the equity method DR Investment in Bostic Company CR Equity in Investee Income [REGULAR INCOME-keep seperate] CR Other Comprehensive Income of Investee [OCI-keep separate] *To accrue the investee's operating income and other comprehensive income from equity investment

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

Change from Fair-Value Method to Equity Method: Because of the acquisition of additional investee shares, an investor will now change from the fair-value method to equity method. Which procedures are applied to accomplish this accounting change?

1. *To record an additional 30% investment in Isles Company [Rizzoli's books] DR Investment in Isles Company CR Cash 2. Prepare an Investment Allocation Schedule: to determine the proper amount of excess fair value amortization required in applying the equity method. Investment Fair Value Allocation Schedule Investment in Isles Company January 1, 2018 Current fair value of initial 10% ownership of Isles $ 89,000 Payment for additional 30% investment in Isles 267,000 TOTAL fair value of 40% investment in Isles $356,000 Rizzoli's share of Isles' book value (40% x $715,000) 286,000 Investment fair value in excess of Isles' book value $ 70,000 Excess fair value attributable to Isles' patent (40% x $175,000) 70,000 -0- 3. Recognize and Report Investor's portion of Investee Income based on ownership interest % 4. Record Declared Dividends as increases to dividends receivable and reductions to Investment 5. Record Collection of Dividends

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)

EXCESS of Investment Cost over Book Value Acquired -Grande Co. acquires 30% of the outstanding shares of Chico Co. -Chico's B/S: A of $500,000 - L of $300,000 = Net Book Value of $200,000 -*Undervalued Assets: Equipment by $60,000 and Patent by $40,000 **NEW Net Assets Calculation w/properly valued assets = $300,000 *1. Calculate Purchase Price [revaluing specifically identifiable investee assets and liabilities] *2. Determine Goodwill, assuming that Chico refuses the $99,000 intitial offer and they agree on $125,000.

1. Calculate Purchase Price: Book value of Chico Co. [A-L(or SE)] $200,000 Undervaluation of equipment 60,000 Undervaluation of patent 40,000 Value of Net Assets $300,000 Percentage Acquired X 30% Purchase Price *$ 90,000* 2. Determine Goodwill: Payment by investor $ 125,000 Percentage of book value acquired ($200,000 x 30%) 60,000 Payment in excess of book value 65,000 Excess payment identified with specific assets: Equipment ($60,000 undervaluation x 30%) $ 18,000 Patent ($40,000 undervaluation x 30%) 12,000 30,000 *Excess Payment not identified with specific assets -- goodwill $ 35,000

Reporting Investee's Other Comprehensive Income (OCI)

1. Charles Co. accrues earnings of $150,000 based on 30% of the $500,000 net figure *2. Charles MUST recognize an INCREASE in its Investment in Norris account for its 30% share of its investee's OCI DR Investment in Norris Company 174,000 CR Equity in Investee Income 150,000 CR Other Comprehensive Income of Investee 24,000 *To accrue the investee's operating income and other comprehensive income from equity investment ^^[Intended to mirror the close relationship b/w the two companies]

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

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

Reporting the Sale of an Equity Investment -Top Co. owns 40% of the 100,000 outstanding shares of Bottom Co. -Over the years asset balance as increased from $200,000 to $320,000 as of January 1, 2018 -On July 1, 2018, Top elects to sell 10,000 of these shares (1/4 of its investment) for $110,000 in cash [thereby reducing ownership in Bottom from 40% to 30%] -Bottom Co. reports NI of $70,000 during first 6 months of 2018 and declares and pays cash dividends of $30,000

1. July 1, 2018 JEs to accrue the proper income and establish the correct investment balance: DR Investment in Bottom Company 28,000 CR Equity in Investee Income 28,000 *To accrue equity income for first six months of 2018 ($70,000 x 40%) DR Dividend Receivable 12,000 CR Investment in Bottom Company 12,000 *To record a cash dividend declaration by Bottom Company ($30,000 x 40%) DR Cash 12,000 CR Dividend Receivable 12,000 *To record collection of the cash dividend ^These two entries INCREASE the carrying amount of Top's investment by $16,000, creating a balance of $336,000 as of July 1, 2018 2. July 1, 2018 Top sells 1/4 of its shares in Bottom DR Cash 110,000 CR Investment in Bottom Company 84,000 CR Gain on Sale of Investment 26,000 *To record sale of one-fourth of investment in Bottom Company (1/4 X $336,000 = $84,000)

Investment Account Reduced to Zero Balance Scenario: [simplified example] Loss to be absorbed: $200,000 Investment in Andrew Co. Current Balance: $100,000

1. Reduce the Investment account to a ZERO BALANCE DR Investment Loss 100,000 CR Investment in Andrew Co. 100,000 *Wilson Co. should discontinue using the Equity Method rather than establish a negative balance [*NOW use Fair-Value Method] 2. Once the original cost of the investment has been eliminated, no additional losses can accrue to the investor **The Investment retains a ZERO balance until subsequent investee profits eliminate all unrecognized losses (the remaining $20,000)

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

Generally, there are 2 periodic transactions under the Equity Method Little Co.: NI $200,000; Declared and Paid Cash Div. $50,000 ^These figures indicate that Little's net assets have increased by $150,000 during the year

The investor accrues its % of the earnings reported by the investee each period: DR Investment in Little Co. 40,000 CR Equity in Investee Income 40,000 Investee dividend declarations reduce the investment balance according to % to reflect the decrease in the investee's book value: DR Dividend Receivable 10,000 CR Investment in Little Co. 10,000 DR Cash 10,000 CR Dividend Receivable 10,000 *The $30,000 net increment recorded here in Big's investment account ($40,000 - $10,000) represents 20% of the $150,000 increase in Little's book value that occurred during the year

Upstream Sales of Inventory -Major Co. owns 40% share of Minor Co. -Employs Equity Method -In 2018, Minor sells inventory costing $40,000 to Major for $60,000 -By the EOY 2018, Minor still retains $15,000 of these goods -Minor reports NI of $120,000 for the year

[PART II-JEs] INITIAL STEP: Major records an Income Accrual JE at EOY 2018 (to reflect the basic accrual of the investee's earnings) DR Investment in Minor Company 48,000 CR Equity in Investee Income 48,000 *To accrue income from 40% owned investee ($120,000 x 40%) STEP 1: The amount of the deferred intra-entity gross profit remaining at year-end is computed using 33 1/3% gross profit percentage of the sales price ($20,000/$60,000) Remaining Gross Gross Profit Investor Deferred Ending Profit in Ending Ownership Intra-Entity Inventory Percentage Inventory Percentage Gross Profit $ 15,000 33 1/3% $5,000 40% $ 2,000 *^Once again, a deferral of the gross profit created by the intra-entity sale is necessary for proper timing of income recognition Step 2: Intra-Entity Gross Profit Deferral JE DR Equity in Investee Income 2,000 CR Investment in Minor Company 2,000 *To DEFER recognition of intra-equity gross profit until inventory is used or sold to unrelated parties *After ^this adjustment, Major, the investor, reports earnings from this equity investment of $46,000 ($48,000 -$2,000) Step 3: Subsequent Recognition of Intra-Entity Gross Profit [NEXT YEAR's JE] *By merely reversing the preceding deferral entry, the accountant succeeds in moving the investor's profit into the appropriate time period DR Investment in Minor Company 2,000 CR Equity in Investee Income 2,000 *To RECOGNIZE income on intra-entity sale that now can be recognized after sales to outsiders

Downstream Sale of Inventory [PART II-JEs] -Major Co. owns 40% share of Minor Co. -Employs Equity Method -In 2018, Major sells inventory to Minor for $50,000 ^Includes: gross profit of 30% [of the sale price], or $15,000 -By the EOY 2018, Minor has sold $40,000 of these goods to outside parties while retaining $10,000 in inventory for sale during the subsequent year

[PART II-JEs] Step 1: Determine Deferred Intra-Entity Gross Profit Amount Remaining Gross Gross Profit Investor Deferred Ending Profit in Ending Ownership Intra-Entity Inventory Percentage Inventory Percentage Gross Profit $ 10,000 30% $3,000 40% $1,200 Step 2: Intra-Entity Gross Profit Deferral JE *the investor decreases current equity income by $1,200 to reflect the deferred portion of the intra-entity profit ^^This procedure temporarily removes this portion of the profit from the investor's books in 2018 until the investee disposes of the inventory in 2019 DR Equity in Investee Income 1,200 CR Investment in Minor Company 1,200 *To DEFER gross profit on sale of inventory to Minor Company Step 3: Subsequent Recognition of Intra-Entity Gross Profit [NEXT YEAR's JE] *By merely reversing the preceding deferral entry, the accountant succeeds in moving the investor's profit into the appropriate time period DR Investment in Minor Company 1,200 CR Equity in Investee Income 1,200 *To RECOGNIZE income on intra-entity sale that now can be recognized after sales to outsiders