CHAPTER 8
Investments in Equity Securities
SYNOPSIS
In this chapter, the author discusses investments in equity securities. The discussion is divided
into equity securities classified as current and long-term investments. The specific topics
associated with investments in equity securities are (1) the criteria for equity investments to be
classified as current; (2) accounting for investments in trading and available-for-sale securities,
including the mark-to-market rule; and (3) selected economic and theoretical issues. The
specific topics associated with long-term equity investments are (1) accounting for long-term
equity investments under the cost method, the mark-to-market method, the equity method,
consolidations, goodwill, special purpose entities, and (2) the economic consequences
associated with the different methods. The author provides a discussion of the detailed
accounting procedures for consolidating financial statements in Appendix 8A.
The ethics vignette examines the liberal accounting rules for recognition and amortization of
goodwill in countries outside the United States. It then considers whether it is ethical for the
government or standard-setting body in a particular country to set accounting standards that are
designed to provide international economic advantages enjoyed solely by the companies and
capital markets in that country.
The Internet research exercise examines Cisco System’s strategy of growth through
acquisitions.
The following key points are emphasized in Chapter 8:
1.
Criteria that must be met before a security can be listed in the current assets section of the
balance sheet.
2.
Trading and available-for-sale securities and how the mark-to-market rule is used to
account for them.
3.
Why companies make long-term investments in equity securities.
4.
The mark-to-market method, the cost method, and the equity method of accounting for
long-term equity investments, and the conditions under which each method is used.
5.
Consolidated financial statements, when they are prepared, and how they differ from
financial statements that account for equity investments using the equity method.
LECTURE/TEXT OUTLINE
Investments in equity securities.
I. Equity investments are an investment in the equity securities of other companies. These
investments are made (1) to earn investment income through dividends and stock
appreciation, and (2) to exert influence or control over the board of directors and
management of the investee company.
II.
Equity securities classified as current.
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A.
Short-term investments in equity securities are reported as current assets.
B.
Criteria to be classified as current.
1.
The securities must be readily marketable. This criterion implies that the
security can be sold and converted into cash at will.
2.
Management must intend to convert the investment to cash within the time
period of current assets.
3.
a)
Management's incentives to "window dress" current assets through the
classification of equity securities.
b)
Auditors can examine the company's past practices and the nature and
size of the investment to determine management's intentions.
If neither criterion is met, the investment must be included in the long-term
investment section.
III. Trading and available-for-sale securities.
A.
Accounting for readily marketable equity securities is governed by SFAS No. 115,
"Accounting for Certain Investments in Debt and Equity Securities."
B.
Investments in readily marketable equity securities are classified into one of two
categories.
1.
Trading securities—securities bought and held principally for the purpose of
selling them in the near future with the objective of generating profit on shortterm price changes. These securities are always listed in the current section
of the balance sheet.
2.
Available-for-sale securities—those investments not classified as trading
securities. These securities are listed on the balance sheet as current or longterm, depending on management’s intention.
C. Events related to accounting for trading and available-for-sale securities.
1.
2.
Purchase of securities.
a)
Equity securities are always recorded at cost when they are acquired.
b)
Cost includes any incidental acquisition costs such as brokerage
commissions and taxes.
Declaration and receipt of cash dividends.
a)
On the date the dividend is declared, dividend income and the
corresponding dividend receivable are recorded.
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b)
3.
4.
When the cash from the dividend is received, Cash is debited and
Dividend Receivable is credited. Receiving the dividend is simply an
exchange of assets.
Sale of securities.
a)
The balance sheet value of the securities is removed from the books.
b)
The difference between the balance sheet value of the securities and the
proceeds of the sale is recognized as either a realized gain or a realized
loss.
Price changes of securities.
a)
The FASB mandated in SFAS No. 115 that readily marketable equity
securities be carried on the balance sheet at current market value.
b)
The mark-to-market rule gives rise to unrealized (or holding) gains or
losses.
c)
End of period adjustments to reflect current market values differ for
trading securities and available-for-sale securities.
(1) For trading securities, holding gains or losses are considered
temporary accounts. They appear in the income statement and
are reflected in retained earnings.
(2) For available-for-sale securities, the unrealized price changes are
considered permanent accounts and are carried in the
shareholders' equity section of the balance sheet.
5.
6.
Reclassifications and permanent market value declines.
a)
When management changes the classification of investments from
trading to available-for-sale, or vice versa, unrealized holding gains or
losses should be recognized immediately in the income statement.
b)
When permanent market value declines (i.e., the price declines and is not
expected to recover) the security should be written down to its market
value and a realized loss should be recognized immediately.
Mark-to-market accounting and comprehensive income.
a)
While unrealized price changes in available-for-sale securities are not
reflected in net income, the FASB requires that such changes be
reported on a statement of comprehensive income.
b)
No specific form is required, but the statement of comprehensive income
must be displayed with the same prominence as the other financial
statements.
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c)
7.
Comprehensive income provides the statement user with an estimate of
the overall change in a company's wealth during the period.
Practical and theoretical issues associated with the mark-to-market rule.
a)
Current market values provide more useful information about the wealth
of the firm.
b)
Market value accounting, in general, is criticized because market values
are subjective and can result in large fluctuations from period to period
(which are not necessarily relevant). Mark-to-market accounting for
investments in equity securities avoids these criticisms.
(1) The rule applies only to readily marketable equity securities, i.e.,
those that have readily determinable and objective market prices.
(2) Market value changes of only those securities that are intended to
be sold in the very near future (trading securities) are reflected in
current income. Unrealized price changes related to securities
classified as available-for-sale are not included in the income
statement.
c)
IV.
Management's subjective judgment may influence the reported dollar
amount of net income because the classification of securities as trading
or available-for-sale depends heavily on management's intention.
Long-term equity investments.
A.
The accounting treatment used for long-term equity investments depends upon the
investor's potential to influence the investee company.
1.
Mark to market or cost method: If the investor has little potential to influence
the investee company (defined as owning less than 20 percent of the
investee's outstanding stock), then the marketability of the investee's stock
determines the appropriate accounting treatment.
a)
If the investee's stock is not readily marketable, then the cost method is
used to account for the equity investment.
(1) The investment is initially recorded at cost, which includes any
incidental costs like brokerage fees.
(2) Dividends declared by the investee are recognized as revenue.
(3) The investment is carried on the books at cost until it is sold or until
it suffers a permanent impairment in value.
b)
If the investee's stock is readily marketable, then the securities are
classified as available-for-sale and the mark-to-market rule is applied.
The investment is accounted for as outlined in [II.–C.] above.
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2.
Equity method: If the investor can exert significant influence over the investee
company (defined as owning between 20 percent and 50 percent of the
investee's outstanding stock), then the investment, regardless of whether the
investee's stock is marketable, should be accounted for using the equity
method.
a)
The investment is initially recorded at cost, which includes any incidental
costs like brokerage fees.
b)
The amount reported for the investment is adjusted for changes in the
investor's proportionate share of the investee's net assets.
(1) The carrying value of the investment is adjusted for the investor's
proportionate share of the investee's net income or loss.
(a) Net income increases the investment, and the investor's share
of the investee's net income flows through to the investor's
income statement. That is, the investment account is debited,
and an investment income account is credited for the investor's
proportionate share of the investee's net income.
(b) Net loss decreases the investment, and the investor's share of
the investee's net loss flows through to the investor's income
statement. That is, the investment account is credited, and an
investment loss account is debited for the investor's
proportionate share of the investee's net loss.
(2) The carrying value of the investment is adjusted for the investor's
proportionate share of dividends declared by the investee.
(a) Dividends declared by the investee decrease the investor's
investment and do not flow through to the investor's income
statement. That is, Cash is debited and the investment account
is credited for the investor's proportionate share of dividends
declared by the investee.
(b) Dividends declared by the investee are simply an exchange of
one asset (the investment) for another asset (cash).
c)
Some cautions to financial statement users about the equity method.
3.
The fair market value option: disclosures are required relating to the basis for
the market value estimate when market values are used.
4.
Consolidated financial statements: used when more than 50% of an entity is
controlled. The assets and liabilities of the acquired company (subsidiary) are
added to those of the parent corporation. The acquired company’s revenues
and expenses are included in the income statement of the parent. See
appendix 8A for further details.
5.
Goodwill.
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a)
Asset on the balance sheet that arises when there is a business
acquisition.
b)
Goodwill is not amortized but is subject to being written-off under the
impairment test.
(1) Highly subjective test.
(2) Permits “earnings management”.
(3) Difficult to audit.
6.
The equity method or consolidated statements?
a)
The method used will effect financial statements
(1) Under equity method the liabilities of the acquired company are not
included in the financial statements of the acquirer.
(2) Effects ratios, especially debt to equity.
(3) Equity method is considered by some to be a method of off-balancesheet financing.
b)
7.
Effect on financial statements may effect decision about what percentage
interest should be acquired.
Special purpose entites (SPEs).
a)
A separate entity created
(1) The SPE raises capital by issuing debt or equity to investors and
purchases property.
(2) Property is leased to the sponsor.
(3) Should the SPE be consolidated into the financial statements of the
sponsor?
(a) Not if sponsor doesn’t have control.
(b) Can be difficult to determine who actually contols the SPE.
b)
V.
Difficult and controversial area – Enron fraud utilized SPEs.
Consolidated financial statements. (Appendix 8A)
A.
If the investor controls the investee company (defined as the investor owning
greater than 50 percent of the investee's outstanding stock), then consolidated
financial statements are prepared.
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B.
1.
The purpose of consolidated financial statements is to report the combined
accounts of the investor and investee companies.
2.
Two types of investments.
a)
Business acquisitions—the investor and investee combine for accounting
purposes, but continue as separate legal entities.
b)
Business combinations or mergers—the investor and investee combine to
form one legal entity.
Business acquisitions and mergers are accounted for using the purchase method.
1.
With the purchase method, the parent is assumed to be purchasing the
subsidiary's assets and liabilities. The assets and liabilities should be valued
at their fair market values.
2.
Accounting for consolidations using the purchase method.
a)
Record the acquisition of the subsidiary at cost, which reflects the fair
market value of the subsidiary's net assets by debiting the investment in
subsidiary account.
b)
Eliminations and adjustments necessary to combine the balance sheets
of the parent and subsidiary.
(1) Eliminate the investment in subsidiary account.
(2) Record subsidiary's assets and liabilities at their fair market values.
(3) Record goodwill, if appropriate. Goodwill equals the excess paid
over the parent's share of the fair market value of the subsidiary's
net assets. Goodwill is no longer amortized.
(4) Record minority interest, if appropriate. Minority interest arises
when the parent purchases less than 100 percent of the
subsidiary's outstanding voting stock. Minority interest represents
the claims of the minority shareholders (i.e., shareholders other
than the parent) on the fair market value of the subsidiary's net
assets. Minority interest is calculated by multiplying the fair
market value of the subsidiary's net assets by the percentage of
outstanding voting stock owned by minority shareholders.
Minority interest is usually reported on the balance sheet between
long-term liabilities and shareholders' equity.
(5) Eliminate intercompany receivables and payables, if appropriate.
(6) Eliminate the investee's shareholders' equity.
c)
Eliminations and adjustments necessary to combine the income
statements of the parent and subsidiary.
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(1) The consolidated income statement should only reflect consolidated
income earned subsequent to the acquisition date.
(2) Intercompany revenues and expenses must be eliminated.
VI. International perspective.
VII. Review problems 1 and 2.
VIII. Ethics in the real world.
IX. Internet research exercise.
LECTURE TIPS
1.
Understanding the need for the very different methods used to account for equity securities
is aided by a general discussion of the nature of equity securities and the variety of reasons
for companies to invest in them. It is important for students to understand the economic
motivations and expectations behind each level of investment in order to understand the
rationale for the accounting method. Figure 8–8 from the text (which summarizes the
conditions under which the different methods are used) and end-of-chapter exercise 8–7
provide a vehicle to develop this understanding.
2.
Several end-of-chapter problems are particularly useful for demonstrating the different
accounting methods for equity securities, especially through comparison with other
methods. Problem 8–5 emphasizes trading versus available-for-sale classifications;
problem 8–8 compares the mark-to-market method with the equity method; and problem 8–
9 compares the equity method to consolidated financial statements.
ANSWERS TO IN-TEXT DISCUSSION QUESTIONS
334.
Short-term investments are listed in the current assets section of the balance sheet. To
be considered for such treatment, the investments must be both readily marketable and
management must intend to convert the investments into cash within the time period of
current assets (one year or the operating cycle, whichever is longer).
335.
Other long-term assets would be listed in the noncurrent section of Intel’s balance sheet.
To be treated as current assets, investments must be marketable; therefore,
nonmarketable securities must be shown in the noncurrent section.
335.
The accounting standard requires that management has the intention to convert the
investments to cash in order justify the current classification. PepsiCo may not have
violated the standard, even though one of the investments was not sold in the following
year, if management’s honest intention was, and remains, to sell the investment. The
difficulty is that such a determination is at best subjective, and managers have an
incentive to overstate current assets through such classifications.
337.
Dividend income of $.3 million means that Biomet received cash dividends of that
amount from investments in equity securities. Realized gains from short-term
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investments arose from the sale of investments at amounts $.8 million greater than the
cost of those securities.
339.
With $18.2 billion invested in marketable securities, Apple’s balance sheet could suffer
from declines in the market. If most of the securities were treated as available for sale, a
decline in the market value of the securities would not affect the income statement or the
statement of cash flows. Conversely, improvements in the market could cause an
increase in market values and an improvement in the balance sheet (but not the income
statement or the statement of cash flows). If the securities were classified as trading by
Apple’s management, the market value fluctuations in the portfolio of securities would
affect the income statement.
339.
Unrealized gains (or losses) on available-for-sale securities are considered permanent
accounts and are carried in the shareholders’ equity section of the balance sheet. If the
investments were considered trading securities, these gains or losses would be
considered temporary accounts, would appear on the income statement, and would be
reflected in retained earnings.
340.
The net unrealized losses on available-for-sale securities would be reflected in the
statement of shareholders’ equity. If the equity investments were considered trading
rather than available-for-sale, the losses would be reflected in the income statement.
341.
An analyst would be interested in the amount of comprehensive income because it
provides an estimate of the overall change in a company’s wealth during a period from
other than investments by owners or distributions to them. The wide variety of options for
disclosure of comprehensive income would not be of great concern, because the
standard for determination of the amount of comprehensive income is the same for all
companies, and the statement of comprehensive income must be prominently displayed.
342.
The acquisitions of Kinko’s and Mail Boxes, Etc, by FedEx and UPS were strategic in
nature and were not motivated by a desire to generate income from dividends or to
benefit from stock appreciation. These acquisitions were made to take advantage of
perceived synergies between the investor corporations and the acquired corporations
and perceived competitive advantages that would flow from these synergies.
344.
Intel’s equity investment constituting only 8% of the affiliate company’s outstanding
common shares would be accounted for under the equity method if Intel had the ability
to significantly influence the operating decisions and management policies of the
affiliate. Such influence might be indicated by representation on the board of directors,
interchange of management personnel, the frequency and nature of transactions
between companies or other factors.
345.
The investments by Boeing and Lockhead Martin Corp in United Launch Alliance were
accounted for using the equity method. Each of these companies reported their
investment as an asset, investments, in the case of Boeing and “other assets” in the
case of Lockhead Martin.
345.
The increase in the investment account could have been caused by 1) new investments
in equity securities, by 2) Lilly’s pro-rata share of earnings reported by the corporations
Lilly had invested in, or by 3) cash dividends received by Lilly from its equity method
affiliates. The investment in equity securities account is adjusted when new securities
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are acquired, when old securities are sold (or written-off), when dividends are received
from equity method affiliates, and (annually) for the pro-rata share of income (or loss) of
equity method affiliates
346.
The $874 million net loss from equity method investments would have included CocaCola’s 35% share of the $4.4 billion loss reported by Coca-Cola Enterprises, or $1.54
billion. Because Coca Cola’s share of the loss in Coca-Cola Enterprises exceeded their
loss from all their equity method investments combined, we can infer that the other
equity method investments of performed better and generated income for Coca Cola of
$666 million.
349.
Target Corporation’s financial statements are referred to as consolidated because they
are the combined (consolidated) financial statements of Target Corporation and Target’s
controlled subsidiaries.
351.
The quote from the footnotes in General Electric’s recent financial statement means that
net income was reduced by a write-off of goodwill in the amount of $1.2 billion. The
write-off was taken because the goodwill that had been recorded in connection with the
acquisitions of GECS IT Solutions and GECS U.S. Auto and Home was discovered to
have little or no value. Consequently, under the impairment test, it was necessary to
write the goodwill associated with these two acquisitions down to its actual (negligible)
value.
353.
Coca-Cola’s 30% interest in the bottling companies is currently carried using the equity
method. If Coca-Cola increased its ownership interest beyond 50%, the assets and
liabilities of the bottling affiliates would be incorporated into the consolidated financial
statements and Coca-Cola’s ratio of liabilities to total assets would go up. The bottling
companies have a liabilities to total assets ratio of .705 ($35.3 billion ÷ $50.1 billion),
compared to Coca-Cola’s liabilities to total assets ratio of .496 ($20.1 billion ÷ $40.5
billion).
353. Enron used the SPEs to hide liabilities. Because the SPEs were not consolidated into
Enron’s financial statements, the liabilities and the losses of the SPEs were not disclosed.
Non-disclosure of this information misled investors.
333. Before the financial statements of foreign subsidiaries can be consolidated into the
financial statements of the consolidated group, they need to be translated from the local
currency into US dollars. Because of fluctuations in exchange rates between the foreign
currency and the US dollar, the translation process usually reveals gains or losses due to
these currency fluctuations. These gains and losses are known as foreign currency
translation adjustments. Depending on the type of subsidiary, the foreign currency
translation adjustments are reported in either the consolidated income statement (for Type
I subsidiaries) or in the statement of comprehensive income (for Type II subsidiaries). The
-$299 million currency adjustment cumulative balance reported on the balance sheet
reflects the sum of all the currency translation adjustments for Type II foreign subsidiaries
over the life of the consolidated entity. The -$11.0 billion currency translation adjustment
reported on the 2008 statement of comprehensive income reflects the adjustment for the
year 2008. The balance of the currency translation adjustment on the 2007 balance sheet
would have been $10.7 billion.