Chapter 2 Reporting lntercorporcie lnt'estntents and Consoliclution oJ'Wholll Owtrcd Subsirlutnes vrillt No DiJJerential

or to exercise significant influence over the investee. The inability of an investor to

exercise either control or significant influence over an investee may result from the size
of the investment, usually at common stock ownership levels of less than 20 percent. In
some situations, other f'actors, sllch as the existence of a majority shareholder, prevent
the investor from exercising significant influence regardless of the size of the investment.
(See Appendix 24 for a discussion of additional factors that may influence the use of the
cost or equity methods.)

Accounting Procedures under the Cost Method

The cost method is consistent with the treatment normally accorded noncurrent assets. At
the time of purchase, the investor records its investrnent in common stock at the total cost
incurred in making the purchase. Subsequently, the carrying amount of the investment
remains unchanged under the cost method; the investment continues to be carried at its
original cost until it is sold. Income from the investment is recognized by the investor as
dividends are declared by the investee. Once the investee declares a dividend, the inves-
tor has a legal claim against the investee for a proportion.rte share of the dividend, and
realization of the income is considered certain enough to be recognized. Recognition of
investment income before a dividend declaration is considered inappropriate because the
investee's income is not available to the owners until a dividend is declared.
To illustrate the cost method, assume that ABC Company purchases 20 percent of
XYZ Company's common stock for $100,000 at the beginning of the year but does not
gain significant influence over XYZ. During the year, XYZ has net income of $60,000
and declares dividends of $20,000. Assuming the dividend is paid later, ABC Company
records the following entries relating to its investment in XYZ:

(1) lnvestment in XYZ Company Stock 100,000

Cash 100,000
Record purchase of XYZ Company stock

(2) Dividends Receivable 4,000

Dividend lncome 4.000
Record dividend declared by XYZ Company ($20,000 x 0.20)

Note that ABC records only its share of XYZ's distributed earnings and makes no
entry for the undistributed portion. The carrying amount of the investment is still the
original cost of $100,000.

Declaration of Dividends in Excess of Earnings since Acquisition

A special treatment is required under the cost method in situations in which an inves-
tor holds common stock in a company that declares dividends in excess of the cumula-
tive income it has earned since the investor acquired its stock. The dividends received
are viewed first as representing earnings of the investee from the purchase date of the
investment to the dividend declaration date. All dividends declared by the investee in
excess of its earnings since acquisition by the investor are viewed by the investor as
liquidating dividends. The investor's share of these liquidating dividends is treated as a
return of capital, and the investment account balance is reduced by that amount. Blocks
of an investee's stock acquired at different times should be treated separately for purposes
of computing liquidating dividends.

Liquidating Dividends Example

To illustrate the computation of liquidating dividends received by the investor, assume
that Investor Company purchases 10 percent of the common stock of Investee Com-
pany on January 2,20X1. The annual income and dividends of Investee, the amount
52 Chapter 2 Reporting Intercorporote Investmetfi\ antl Consolidution of Whollt ov,ned Subsicliaries
with No Dffirertial

of dividend income recognized by Investor each year under the cost method. and the
reduction of the carrying amount of Investor's investment in Investee when appropriate
are as follows:

lnvestee Company lnvestor Company

Cumulative Reduction
Net Undistributed Cash Dividend of
Year lncome Dividends lncome Received lncome lnvestment
20xi $100,000 $ 70,000 $30,000 $ 7,000 $ 7,000
20x2 100,000 120,000 10,000 12,000 12,000
20x3 100,000 .:: , ! 20,.000 :', j ,,' 0 12,000 1 1,000 $'t ,000
20x^ 100,000 120,000 0 12,000 10,000 2,000
20x5 100,000 70.000 30,000 7,000 7,000

Investor Company records its l0 percent share of Investee's dividend as income in

20X1 because the income of Investee exceeds its dividend. In 2)X2,Investee,s dividend
exceeds earnings for the year, but the cumulative dividends declared since January
2,
20X1, the date Investor acquired Investee's stock, do not exceed Investee's eamings since
that date. Hence, Investor again records its 10 percent share of the dividend as inco"me.
By
the end of 20X3, dividends declared by Investee since January 2,2OXl, total
$310,00b
while Investee's income since that date totals only $300,000. Thus, from Investor,s point
of view, $10,000 of the 20X3 dividend represents a retum of capital while the remaining
$ 1 10,000 represents a distribution of earnings. Investor's share of each amount is
l0 perl
cent. The entry to record the 20X3 dividend on Investor's books is:

(3) Cash
lnvestment in Investee i,000
Dividend Income 'l 1,000
Record receipt of 20X3 dividend from Investee.
$12,000: $120,000 x 0.10
-
$1,000 = ($310,000 $3oO,O0o) + 0 10
$1 1,000 = ($120,000 -
gjo,0O0) + o.1O

Once the investor has recorded a liquidating dividend, the comparison in future periods
between cumulative eamings and dividends of the investee stroutA be based on the date
of the last liquidating dividend rather than the date the investor acquired the investee's
stock. In this example, Investor Company records liquidating clividends in 20X3 and
20X4' In years after 20X4, Investor compares earning.s and dividends of Investee from
the dalte of the most recent liquidating cliviclend in 20X4 rather than comparing from
January 2,20X1. Inve stor considers the entire dividend paid in 20X5 to be a distribution
of earnings.

Acquisition at lnterim Date

The acquisition of an investment at a date other than the beginning or end of a fiscal
period generally does not create any major problems when the cost method is used to
account fbr the investment. The only potential difficulty involves determining whether
some part of the payment received by the investor is a liquidating dividencl when the
investee declares a dividend soon afier the investor purchases stock in the investee. In this
situation. the investor must estimate the amount of the investee's earnings fbr the portion
of the period during which the investor held rhe investee's stock and may record cliviOend
income only on that portion. " : .)^,
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