Stock Investments –
Investor Accounting
Chapter 2
©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn
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Learning Objective 1
Recognize investors’ varying
levels of influence or control
based on the level of
stock ownership.
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Accounting for Stock Investment
GAAP for recording common stock
acquisitions require that the investor
record the investment at its cost.
Fair value/cost method
Equity method
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Concept Underlying Fair Value/Cost
and Equity Methods
Under the fair value/cost method
investments in common stock
are recorded at cost.
Dividends from subsequent earnings
are reported as dividend income.
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Concept Underlying Fair Value/Cost
and Equity Methods
The equity method of accounting
is essentially accrual accounting
for equity investments.
Investments are recorded at cost
and adjusted for earnings,
losses, and dividends.
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Learning Objective 2
Anticipate how accounting adjusts
to reflect the economics underlying
varying levels of investor influence.
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Economic Consequences of Using
Fair Value/Cost and Equity Methods
The different methods of accounting result in
different investment amounts in the balance
sheet of the investor corporation and different
income amounts in the income statement.
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Economic Consequences of Using
Fair Value/Cost and Equity Methods
Investor can significantly influence or
control the operations of the investee.
Fair value/cost method is unacceptable.
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Economic Consequences of Using
Fair Value/Cost and Equity Methods
The equity method is not a substitute for
consolidation, the income reported is
generally the same as the income reported
in consolidated financial statements.
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Learning Objective 3
Apply the fair value/cost and
equity methods of accounting
for stock investments.
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Accounting Procedures Under the
Fair Value/Cost and Equity Methods
July 1: Pilzner acquires 2,000 of the 10,000
outstanding shares of Sud at $50 per share.
$50 per share equals the book value
and fair value of Sud’s net assets.
Sud net income for the year is $50,000.
Dividends of $20,000 are paid on November 1.
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Fair Value/Cost Method
July 1
Investment in Sud
100,000
Cash
100,000
November 1
Cash
4,000
Dividend income
4,000
December 31 No entry
Net marketable stock or market price = $50
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Fair Value/Cost Method
Assume that Sud’s net income had been $30,000.
What is Pilzner’s share?
$30,000 × ½ × 20% = $3,000
December 31
Dividend Income
Investment in Sud
1,000
1,000
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Equity Method
July 1
Investment in Sud
Cash
November 1
Cash
Investment in Sud
100,000
100,000
4,000
4,000
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Equity Method
December 31
Investment in Sud
5,000
Income from Sud
5,000
$50,000 × ½ × 20% = $5,000
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Learning Objective 4
Identify factors beyond stock
ownership that affect an
investor’s ability to
exert influence or control.
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Influence or Control
An investment of 20% or more of the
voting stock of an investee should
lead to a presumption that an investor
has the ability to exercise significant
influence over an investee.
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Influence or Control
The equity method should be followed
by an investor whose investment in
voting stock gives it the ability to
exercise significant influence over
operating and financial policies on
an investee even though the investor
does not control the investee.
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Influence or Control
An investor may be able to exert significant
influence over its investee with an
investment interest of less then 20%.
The equity method should not be applied if
the investor’s ability to exert significant
influence is temporary or if the investees
are foreign companies operating under
severe exchange restrictions or controls.
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Learning Objective 5
Apply the equity method to
purchase price allocations.
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Equity Method:
A One-Line Consolidation
Investment is reported in a single
amount on one line of the investor
company’s balance sheet
Investment income is reported in
a single amount on one line of the
investor’s income statement.
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Equity Investments at Acquisition
PJ, Inc., purchases 30% of SR outstanding
voting common stock on January 1
from existing stockholders.
($2,000,000 cash plus 200,000 shares
of PJ $10 par common with a market
value of $15 per share)
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Equity Investments at Acquisition
Additional direct costs
SEC fees:
$ 50,000
Consulting and advisory fees: $100,000
How are these transactions recorded?
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Equity Investments at Acquisition
Investment in SR
5,000,000
Common Stock, $10 par
2,000,000
Additional Paid-in Capital
1,000,000
Cash
2,000,000
To record acquisition of a 30% equity investment
in SR
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Equity Investments at Acquisition
Investment in SR
100,000
Additional Paid-in Capital 50,000
Cash
150,000
To record additional direct costs of purchasing
a 30% equity interest in SR
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Illustration of a Purchase
Combination
Assets
Cash
Net receivables
Inventories
Other current assets
Equipment, net
Total assets
Book
Value
Fair
Value
$ 1,500
2,200
3,000
3,300
5,000
$15,000
$ 1,500
2,200
4,000
3,100
8,000
$18,800
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Illustration of a Purchase
Combination
Liabilities
Accounts payable
Note payable
Common stock
Retained earnings
Total liabilities and
stockholders’ equity
Book
Value
Fair
Value
$ 1,000
2,000
10,000
2,000
$ 1,000
1,800
$15,000
$15,000 – 3,000 = $12,000 $12,000 × 30% = $3,600
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Assignment of Excess Cost
Over Underlying Equity
BV
$3,600
FMV
$4,800
Cost
$5,100
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Assignment of Excess Cost
Over Underlying Equity
Investment in SR
Book value of the interest acquired
Excess cost over book value
Fair value – Book value × 30% =
Amount assigned
Remainder assigned to goodwill
$5,100,000
–3,600,000
$1,500,000
$1,200,000
$ 300,000
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Assignment of Excess Cost
Over Underlying Equity
Inventories
Other current assets
Equipment
Note payable
Total
$ 300,000
(60,000)
900,000
60,000
$1,200,000
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Accounting for Excess of Investment
Cost Over Book Value
Assume SR pays dividends of $1,000,000
on July 1, and reports net income of
$3,000,000 for the year.
What are PJ’s journal entries?
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Accounting for Excess of Investment
Cost Over Book Value
July 1
Cash
300,000
Investment in SR
300,000
To record additional dividends received
from SR at 30% equity interest in SR
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Accounting for Excess of Investment
Cost Over Book Value
December 31
Investment in SR
900,000
Income from SR
900,000
To record equity in income of SR
December 31
Income from SR
300,000
Investment in SR
300,000
To write off excess allocated to inventory
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Accounting for Excess of Investment
Cost Over Book Value
December 31
Investment in SR
60,000
Income from SR
60,000
To record income credit for overvalued
other current assets disposed of
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Accounting for Excess of Investment
Cost Over Book Value
December 31
Income from SR
45,000
Investment in SR
45,000
To record depreciation on excess allocated
to undervalued equipment with a 20-year
remaining useful life ($900,000 ÷ 20)
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Accounting for Excess of Investment
Cost Over Book Value
December 31
Income from SR
12,000
Investment in SR
12,000
To amortize the excess allocated to the
overvalued note payable over the remaining
life of the note ($60,000 ÷ 5)
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Accounting for Excess of Investment
Cost Over Book Value
Investment
5,100,000 300,000
900,000 300,000
60,000 45,000
12,000
Income from SR
300,000 900,000
45,000 60,000
12,000
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Excess of Book Value Acquired
Over Investment Cost
Post Corporation purchases 50% of the
outstanding voting common stock of
Taylor on January 1 for $40,000.
Taylor’s stockholders’ equity Jan 1: $100,000
Add: Income
20,000
Deduct: Dividends paid 7/1
– 5,000
Stockholders’ equity 12/31
$115,000
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Assignment of Excess Cost
over Underlying Equity
BV
$50,000
FMV
+
Cost
$40,000
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Excess of Book Value Acquired
Over Investment Cost
$100,000 × 50% – $40,000 = $10,000
This is the excess book value over cost.
The excess is assigned to:
Inventories $(1,000)
Equipment $(9,000)
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Negative Goodwill
Post acquires a 25% interest in
Saxon for $110,000
Saxon net income and dividends for
the year are $60,000 and $40,000
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Illustration of a Purchase
Combination
Saxon’s net assets
Assets
Inventories
Other current assets
Equipment, net
Building, net
Total assets
Liabilities
Net assets
Book
Value
Fair
Value
$240,000
100,000
50,000
140,000
$530,000
130,000
$400,000
$260,000
100,000
50,000
200,000
$610,000
130,000
$480,000
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Assignment of Excess Cost
over Underlying Equity
BV
$100,000
FMV
$120,000
Cost
$110,000
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Negative Goodwill
$110,000 – $120,000 = – $10,000
This is the excess of FMV over cost.
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Interim Acquisitions of an
Investment Interest
Accounting for equity investments
becomes more specific when the
firm makes acquisitions within
an accounting period.
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Investment in a Step-by-Step
Acquisition
An investor may acquire the ability to exercise
significant influence over the operating and
financial policies of an investee in a series of
stock acquisitions, rather than in a single purchase.
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Sale of an Equity Interest
When an investor sells a portion of an equity
investment that reduces its interest at 20%
or less than the level necessary to exercise
significant influence the equity method
is no longer appropriate.
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Stock Purchases Directly
from the Investee
Karl Corporation purchases 20,000 of previously
unissued common stock from Master Co. for
$450,000 on January 1, 2004.
Shares outstanding after new shares are issued:
December 31, 2003 20,000
Issued to Karl
20,000
Total
40,000
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Stock Purchases Directly
from the Investee
Master’s stockholders’ equity before issuance
($200,000 capital stock
+ $150,000 retained earnings)
$350,000
Sale to Karl
450,000
Master’s stockholder after issuance $800,000
Book value acquired by Karl
$400,000
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Investee Corporation with
Preferred Stock
Some adjustments are necessary when
an investee has preferred as well as
common stock outstanding.
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Extraordinary Items, CumulativeEffect-Type, and Other Considerations
Ordinary
Extraordinary
Cumulative-effect
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Disclosures for Equity Investees
Name of each investee and percentage of ownership.
Accounting policies of the investor with respect
to investments in common stock.
Difference between the carried amount of investment
and the amount of underlying equity in net assets.
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Related Party Transactions
These transactions arise when one of the
transacting parties has the ability to influence
significantly the operations of the other.
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End of Chapter 2
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