Slide
1-1
Chapter One
The Equity
Method of
Accounting
for
Investments
McGraw-Hill/Irwin
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Slide
1-2
Reporting Investments in
Corporate Equity Securities
GAAP allows 3 approaches to
reporting investments.
Note: These 3 approaches are not
interchangeable. The characteristics of each
investment will dictate the appropriate
accounting approach.
McGraw-Hill/Irwin
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Slide
1-3
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-forSale Securities.
 Income is only realized to the
extent of dividends received.
McGraw-Hill/Irwin
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Slide
1-4
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.
McGraw-Hill/Irwin
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Slide
1-5
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.
McGraw-Hill/Irwin
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Slide
1-6
Criteria for Determining Whether
There is Influence
Representation on the investee’s Board of
Directors
Participation in the investee’s policymaking process
Material intercompany transactions.
Interchange of managerial personnel.
Technological dependency.
Extent of ownership in relationship to
other ownership percentages.
McGraw-Hill/Irwin
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Slide
1-7
The Significance of the Size of the
Investment
Investor Ownership of
Investee Shares
Outstanding
0%
{
Fair
Value
Equity
Method
20%
Consolidated Financial
Statements
50%
100%
In some cases, influence or control may
exist with less than 20% ownership.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2004
Slide
1-8
The Significance of the Size of the
Investment
Investor Ownership of
Investee Shares
Outstanding
0%
Equity
Method
20%
{
Fair
Value
Consolidated Financial
Statements
50%
100%
Significant influence is generally
assumed with 20% to 50%
ownership.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2004
Slide
1-9
The Significance of the Size of the
Investment
Investor Ownership of
Investee Shares
Outstanding
0%
Equity
Method
20%
Consolidated Financial
Statements
50%
{
Fair
Value
100%
Financial Statements of all related
companies must be consolidated.
McGraw-Hill/Irwin
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Slide
1-10
Equity Method
Step 1: The investor records its
investment in the investee at cost.
Cost can be defined by cash paid or Fair Market
Value of Stock or other assets given up.
GENERAL JOURNAL
Date
Description
Investment in Investee
Cash
McGraw-Hill/Irwin
Page
Debit
##
Credit
$$$$
$$$$
© The McGraw-Hill Companies, Inc., 2004
Slide
1-11
Equity Method
Step 2: The investor recognizes its
proportionate share of the investee’s
net income (or net loss) for the period.
GENERAL JOURNAL
Date
Description
Year
End
Investment in Investee
Equity in Investee Income
McGraw-Hill/Irwin
Page
Debit
##
Credit
$$$$
$$$$
© The McGraw-Hill Companies, Inc., 2004
Slide
1-12
Equity Method
Step 2: The investor recognizes its
proportionate share of the investee’s
net income (or net loss) for the period.
GENERAL JOURNAL
Date
Description
Year
End
Investment in Investee
Equity in Investee Income
Page
Debit
##
Credit
$$$$
$$$$
This will appear as a separate
line-item on the investor’s
income statement.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2004
Slide
1-13
Equity Method
Step 3: The investor reduces the
investment account by the amount of
dividends received from the investee.
GENERAL JOURNAL
Date
Year
End
Description
Cash
Investment in Investee
McGraw-Hill/Irwin
Page
Debit
##
Credit
$$$$
$$$$
© The McGraw-Hill Companies, Inc., 2004
Slide
1-14
Let’s do an
equity method
example.
McGraw-Hill/Irwin
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Slide
1-15
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.
GENERAL JOURNAL
Date
Description
1-Jan Investment in Small
Cash
Cash
2,000,000
McGraw-Hill/Irwin
Page 25
Debit
Credit
2,000,000
2,000,000
Investment in Small
2,000,000
© The McGraw-Hill Companies, Inc., 2004
Slide
1-16
Equity Method Example – Step 2
On December 31, 2005, Small reports net
income for the year of $300,000.
Record Big’s journal entry.
GENERAL JOURNAL
Date
Description
Investment in Small
2,000,000
McGraw-Hill/Irwin
Page 180
Debit
Credit
Equity in Small's NI
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Slide
1-17
Equity Method Example – Step 2
Big owns 20% of Small and gets credit
for 20% of Small’s income.
20% × $300,000 = $60,000
GENERAL JOURNAL
Date
Description
31-Dec Investment in Small
Equity in Small's Income
Investment in Small
2,000,000
Page 180
Debit
Credit
60,000
60,000
Equity in Small's NI
60,000
60,000
McGraw-Hill/Irwin
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Slide
1-18
Equity Method Example – Step 3
On December 31, 2003, Big received a
$25,000 dividend check from Small.
Record Big’s journal entry.
GENERAL JOURNAL
Date
Description
31-Dec Cash
Investment in Small
Investment in Small
2,000,000
60,000
McGraw-Hill/Irwin
Page 180
Debit
Credit
25,000
25,000
Cash
25,000
25,000
© The McGraw-Hill Companies, Inc., 2004
Slide
1-19
Special Procedures for Special
Situations
Reporting a
change to
the equity
method.
Reporting investee
income from sources
other than continuing
operations.
McGraw-Hill/Irwin
Reporting the
sale of an equity
investment.
Reporting
investee
losses.
© The McGraw-Hill Companies, Inc., 2004
Slide
1-20
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 . . .
. . . all accounts are restated so that the
investor’s financial statements appear as if the
equity method had been applied from the date
of the first [original] acquisition. - - APB
Opinion 18
?
McGraw-Hill/Irwin
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Slide
1-21
Restatement - Example
Assume that Exxo Company acquires 5% of
LipGloss Inc. on January 1, 2004 for $2,000,000.
There is no significant influence. The investment is
recorded at the time as an Available-for-Sale
Investment.
In 2004, LipGloss had net income of $300,000, and
paid dividends of $140,000. Exxo would report the
investment as indicated in the table below:
Date
12/31/04
McGraw-Hill/Irwin
Investment
$ 2,000,000
Equity in
Investee
Income
$
-
Dividend
Revenue
$
7,000
© The McGraw-Hill Companies, Inc., 2004
Slide
1-22
Restatement - Example
On January 1, 2005, Exxo buys an additional 15%
interest in LipGloss, raising the total investment to
20%. The first thing that Exxo must do is restate the
12/31/04 numbers by applying the equity method to
the 5% investment in LipGloss.
We have to RESTATE the Investment account, put a
balance in Equity in Investee Income, and eliminate
the Dividend Revenue balance.
Date
Investment
12/31/04 $ 2,000,000
Adjusted $ 2,008,000
McGraw-Hill/Irwin
Equity in
Investee
Income
$
$
15,000
Dividend
Revenue
$
7,000
$
-
© The McGraw-Hill Companies, Inc., 2004
Slide
1-23
Restatement - Example
An adjustment is recorded to the Investment
account and to Retained Earnings (since Dividend
Revenue has already been closed out).
GENERAL JOURNAL
Date
Page 180
Description
Debit
1/1/05 Investment In LipGloss
R/E - Prior Period Adjustment, Equity in
LipGloss Earnings
Date
Investment
12/31/04 $ 2,000,000
Adjusted $ 2,008,000
McGraw-Hill/Irwin
Equity in
Investee
Income
$
$
15,000
Credit
8,000
8,000
Dividend
Revenue
$
7,000
$
-
© The McGraw-Hill Companies, Inc., 2004
Slide
1-24
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
McGraw-Hill/Irwin
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Slide
1-25
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:
GENERAL JOURNAL
Date
Description
31-Dec Investment in Little
Extraordinary Loss of Little
Equity in Little's Income
McGraw-Hill/Irwin
Page
Debit
##
Credit
36,000
4,500
40,500
© The McGraw-Hill Companies, Inc., 2004
Slide
1-26
Reporting Investee Losses
Permanent
Losses in Value
A permanent
decline in the
investee’s market
value is recorded
as a reduction of
the investment
account.
McGraw-Hill/Irwin
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Slide
1-27
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.
McGraw-Hill/Irwin
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Slide
1-28
Reporting the Sale of an Equity
Investment
If part of an investment is
sold during the period . . .
 The equity method continues to be
applied up to the date of the
transaction.
 At the transaction date, a
proportionate amount of the
Investment account is removed.
 If significant influence is lost, NO
RETROACTIVE ADJUSTMENT is
recorded.
McGraw-Hill/Irwin
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Slide
1-29
Reporting the Sale of an Equity
Investment
Alice Co. 30% (300,000 shares) of Sam, Inc.. The balance
in Alice’s Investment account at March 31, 2005, is
$268,000.
If Alice Co. sells 10% of its shares (30,000 shares) on
April 1, 200 for $100,000, what entry should Alice make
on April 1, 2005?
GENERAL JOURNAL
Date
Description
1-Apr Cash
Gain on Sale of Investment
Investment in Sam, Inc.
Page
Debit
##
Credit
100,000
73,200
26,800
$268,000 × .10% = $26,800
This brings the Investment account to a
balance of $241,200
© The McGraw-Hill Companies, Inc., 2004
McGraw-Hill/Irwin
Slide
1-30
Excess of Cost Over BV Acquired
When Cost > BV acquired, the difference
must be identified and accounted for.
Source of the Difference
Assets that are
undervalued on the
investee's books
Goodwill
McGraw-Hill/Irwin
Accounting
Amortize the difference over the
remaining useful life of the associated
asset.
In accordance with SFAS No. 142, for
fiscal years beginning after Dec. 15,
2001, Goodwill will be carried forward
without adjustment until the investment
is sold or a permanent decline in value
occurs.
© The McGraw-Hill Companies, Inc., 2004
Slide
1-31
Excess of Cost Over BV Acquired
The amortization of the difference associated
with the undervalued assets is recorded as a
reduction of both the Investment account
and the Equity in Investee Income account.
GENERAL JOURNAL
Date
Year
End
McGraw-Hill/Irwin
Description
Equity in Investee Income
Investment in Investee
Page
Debit
##
Credit
$$$$
$$$$
© The McGraw-Hill Companies, Inc., 2004
Slide
1-32
Excess of Cost Over BV
Example



McGraw-Hill/Irwin
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.
© The McGraw-Hill Companies, Inc., 2004
Slide
1-33
Excess of Cost Over BV
Example
Big's %
Small's
Amounts
Big's
Share
$ 2,000,000
Big's Cost
Small's BV
20% $ 8,500,000
1,700,000
Difference
Asset FMV Adj.
Building
Goodwill
McGraw-Hill/Irwin
300,000
20%
200,000
40,000
$
260,000
© The McGraw-Hill Companies, Inc., 2004
Slide
1-34
Excess of Cost Over BV
Example
Big's %
Big's Cost
Small's
Amounts
The Building has a
remaining useful life
Small's BV
20% $ 8,500,000
of 10 years. Goodwill
is never amortized.
Difference
Compute the
Asset FMV Adj. amortization expense
Building
200,000
for20%
Big at 12/31/05.
Goodwill
McGraw-Hill/Irwin
Big's
Share
$ 2,000,000
1,700,000
300,000
40,000
$
260,000
© The McGraw-Hill Companies, Inc., 2004
Slide
1-35
Amortization of Cost Over BV
Example
Big's Cost
Big's
Share
$ 2,000,000
Small's BV
1,700,000
Difference
300,000
Asset FMV Adj.
Building
Goodwill
McGraw-Hill/Irwin
Big’s equity method
entry will include an
adjustment to the
investment account
of $4,000.
40,000 ÷ 10 = $4,000
$
260,000 Goodwill is NOT amortized
© The McGraw-Hill Companies, Inc., 2004
Slide
1-36
Amortization of Cost Over BV
Example
Big's
Share
Date
Description
31-Dec
Equity in Investee
Income
Big's
Cost
$ 2,000,000
GENERAL JOURNAL
Page
Debit
1,700,000
Difference
300,000
Asset FMV Adj.
Building
Goodwill
McGraw-Hill/Irwin
Credit
4,000
Investment in Investee
Small's BV
##
4,000
40,000 ÷ 10 = $4,000
$
260,000 Goodwill is NOT amortized
© The McGraw-Hill Companies, Inc., 2004
Slide
1-37
McGraw-Hill/Irwin
Let’s look at
some
intercompany
transactions.
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Slide
1-38
Unrealized Gains in Inventory
Sometimes affiliated companies sell or
buy inventory from each other.
INVESTOR
Downstream
Sale
INVESTEE
McGraw-Hill/Irwin
INVESTOR
Upstream
Sale
INVESTEE
© The McGraw-Hill Companies, Inc., 2004
Slide
1-39
Unrealized Gains in Inventory
Let’s look at an Investor that has 200
units of inventory with a cost of
$1,000.
INVESTOR
sells 200 units
of inventory
with a total cost
of $1,000.
McGraw-Hill/Irwin
Let us assume
that the Investor
sells the
inventory to a
20% owned
Investee for
$1,250.
© The McGraw-Hill Companies, Inc., 2004
Slide
1-40
Unrealized Gains in Inventory
Let’s look at an Investor that has 200
Note that there is $250 of intercompany profit. At
unitsit is
ofconsidered
inventoryUNREALIZED.
with a cost of
this point
$1,000.
INVESTOR
sells 200 units
of inventory
with a total cost
of $1,000.
INVESTEE
20% ownership
Intercompany
Sale of 200 units
buys 200 units
of inventory and
pays a total of
$1,250.
If all 200 units are not sold to an outside party
during the period, we will need have unrealized,
intercompany profit that must be deferred.
McGraw-Hill/Irwin
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Slide
1-41
Unrealized Gains in Inventory
60 of the original 200 units (30%) are still
“unsold” to a 3rd party. We must defer our
share (20%) of the original $250 of
intercompany profit that is unrealized (30%).
INVESTOR
sells 200 units
of inventory
with a total cost
of $1,000.
INVESTEE
20% ownership
Intercompany
Sale of 200 units
Outside Party
McGraw-Hill/Irwin
buys 200 units
of inventory and
pays a total of
$1,250.
Investee sells only
140 units to a 3rd
party
© The McGraw-Hill Companies, Inc., 2004
Slide
1-42
Unrealized Gains in Inventory

Compute the deferral by multiplying:
Intercompany
Profit

%
% owned by
x
x
unsold
investor
The required journal is:
GENERAL JOURNAL
Date
Year
End
Description
Equity in Investee Income
Investment in Investee
Page
Debit
##
Credit
15
15
$250 × 30% × 20% = $15
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2004
Slide
1-43
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 . . .
GENERAL JOURNAL
Date
Year
End
Description
Investment in Investee
Equity in Investee Income
Page
Debit
##
Credit
15
15
The reversal takes place in the period that the
inventory is sold to an outside party.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2004
Slide
1-44
End of Chapter 1
And this is
only the
FIRST
chapter?!
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2004