Chapter One
Reporting Investments in Corporate Equity Securities
Fair Value Method
Details in SFAS No. 115
Initial Investment is recorded at cost.
Investments in equities of other companies are classified as either Trading Securities or Available-for-Sale Securities.
Income is only realized to the extent of dividends received.
Equity Method
Defined by APB Opinion 18 and SFAS No. 142.
Requires that the investment is sufficient to insure significant influence.
Generally used when ownership is between 20% & 50%.
Influence can be present with much smaller ownership percentages.
Consolidation of Financial Statements
Governed by ARB No. 51, SFAS No. 141, and SFAS No. 142.
Required when investor’s ownership exceeds 50% of investee.
A single set of financial statements including the assets, liabilities, equities, revenues, and expenses for the parent company and all controlled subsidiary companies.
Criteria for Determining Whether There is Influence
The Significance of the Size of the Investment
The Significance of the Size of the Investment
The Significance of the Size of the Investment
Fair Value Method (Revisited) – using Available for Sale (AFS) securities
Purchase
Dr Investment in AFS XXXXX
Cr Cash XXXXX
Dividend Income
Dr Cash XXXXX
Cr Dividend Income XXXXX
Change in Value of Security (Increase)1
Dr Market Value Adj. – AFS XXXXX
Cr Unrealised inc/dec in AFS2 XXXXX
1 - The reverse is true for a decrease
2 – This account appears in stock holders equity. If it were a “Held for Trading” security the gain would have appeared in the income statement as an “Unrealized loss on Trading Securities”
Equity Method
Step 1: The investor records its investment in the investee at cost.
Equity Method
Step 2: The investor recognizes its proportionate share of the investee’s net income (or net loss) for the period.
Equity Method
Step 2: The investor recognizes its proportionate share of the investee’s net income (or net loss) for the period.
Equity Method
Step 3: The investor reduces the investment account by the amount of dividends received from the investee.
Equity Method Example – Step 1
On January 1, 2005, Big Corp. buys 20% of Small Inc. for $2,000,000 cash.
Record Big’s journal entry.
Equity Method Example – Step 2
On December 31, 2005, Small reports net income for the year of $300,000.
Record Big’s journal entry.
Equity Method Example – Step 2
Big owns 20% of Small and gets credit for 20% of Small’s income.
20% × $300,000 = $60,000
Equity Method Example – Step 3
On December 31, 2003, Big received a $25,000 dividend check from Small.
Record Big’s journal entry.
Special Procedures for Special Situations
Reporting a Change to the Equity Method.
An investment that is too small to have significant influence is accounted for using the fair-value method.
When ownership grows to the point where significant influence is established . . .
Restatement - Example
Fair Market Value entry
The entries for adjustment to FMV would also have been required. E.g. Assume that the FMV @ 31/12/2004 was $2,400,000. Then the following entry would have been made (as per SFAS115):
Dr Market Value Adjustment - AFS 400,000
Cr Unrealized inc/dec in value of AFS 400,000
Restatement - Example
Restatement - Example
Removal of Fair Market Value related accounts
The FMV related accounts would also have to be removed. i.e. :
Dr Unrealized inc/dec in value of AFS 400,000
Cr Market Value Adjustment - AFS 400,000
Reporting Investee Income from Other Sources
When net income includes elements other than Operating Income, those elements should be separately reported on the investor’s income statement.
Examples include:
Extraordinary items
Discontinued operations
Prior period adjustments
Reporting Investee Income from Other Sources
Big owns 30% of Little. Little reports net income for 2005 of $120,000. Little’s Income includes operating income of $135,000 and an extraordinary loss of $15,000.
Big’s equity method entry at year-end is:
Reporting Investee Losses
Reporting Investee Losses
Investment Reduced to Zero
When the accumulated losses incurred by the investee and dividends paid by the investee reduce the investment account to zero, NO ADDITIONAL LOSSES are accrued.
The balance remains at $0, until subsequent profits eliminate all UNRECORDED losses.
Reporting the Sale of an Equity Investment
ΠThe equity method continues to be applied up to the date of the transaction.
At the transaction date, a proportionate amount of the Investmentaccount is removed.
Ž If significant influence is lost, NO RETROACTIVE ADJUSTMENT is recorded. (as is the case when switching from FV to Equity method)
Reporting the Sale of an Equity Investment
Excess of Cost Over BV Acquired
When Cost > BV acquired, the difference must be identified and accounted for.
Excess of Cost Over BV Acquired
Excess of Cost Over BV
Example
Example
On January 1, 2005, Big Corp. acquired 20% of Small Inc. for $2,000,000 cash.
Assume that Small’s assets had BV on January 1 of $8,500,000. Small owns a building with a BV of $500,000, and a FMV of $700,000, and a remaining useful life of 10 years. All other assets had BV = FMV.
Allocate the cost to fair market value adjustments and Goodwill acquired by Big.
Excess of Cost Over BV
Example
Example
Excess of Cost Over BV
Example
Example
Amortization of Cost Over BV
Example
Example
Amortization of Cost Over BV
Example
Example
Unrealized Gains in Inventory
Sometimes affiliated companies sell or buy inventory from each other.
Unrealized Gains in Inventory
Let’s look at an Investor that has 200 units of inventory with a cost of $1,000.
Unrealized Gains in Inventory
Unrealized Gains in Inventory
Unrealized Gains in Inventory
Compute the deferral by multiplying:
The required journal (for both upstream and downstream) is:
Unrealized Gains in Inventory
In the period following the period of the transfer, the remaining inventory is often sold.
When that happens, the original entry is reversed . . .
End of Chapter 1
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