Chapter One: The Equity Method of Accounting For Investments
Chapter One: The Equity Method of Accounting For Investments
Chapter One: The Equity Method of Accounting For Investments
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Fair-Value Method
Consolidation
Equity Method
The method is selected based upon the degree of influence the investor has over the investee.
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Available-for-Sale Securities
Any Securities not classified as Trading. Unrealized holding gains and losses are reported in shareholders equity as other comprehensive income (ie, not included in net income).
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Consolidation SPECIAL!!!!
FASB ASC Subsection 810-10-65, Variable Interest Entities, expands the use of consolidated financial statements: includes entities that are controlled through special contractual arrangements (rather than through voting stock interests). Intended to combat misuse of SPEs (Special Purpose Entities) by firms like Enron Part of the accounting defense against off balance sheet financing
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Equity Method
Used when the investor has the ability to exercise significant influence on the investee operations Generally used when ownership is between 20% and 50%. Significant Influence might be present with much lower ownership percentages. (The accountant must consider the particulars!!!)
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Investor Ownership of the Investees Shares Outstanding Fair Value Equity Method Consolidated Financial Statements
0%
20%
50%
100%
In some cases, influence or control may exist with less than 20% ownership.
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0%
20%
50%
100%
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0%
100%
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Remember:
The
ability to exert significant influence is the determining factor in applying the equity method
No
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Cost can be defined as cash paid or the Fair Market Value of other assets given up.
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Cost can be defined as cash paid or the Fair Market Value of other assets given up.
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Little Company reported net income of $200,000 during 2010 and paid cash dividends of $50,000. These figures indicate that Littles net assets have increased by $150,000 during the year. Big owns 20% of Little and records the following entries using the equity method. Investment in Little Company. . 40,000 Equity in Investee Income .. . . . . . . . . . 40,000 To accrue earnings of a 20 percent owned investee. Cash . . . . . . . . . . . . .. . . . . . 10,000 Investment in Little Company . .. . . . 10,000 To record receipt of cash dividend from investee.
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An investment that is too small to have significant influence is recorded using the fair-value method, but When ownership grows to the point where significant influence is established . . . . . . all accounts are restated so that the investors financial statements appear as if the equity method had been applied from the date of the first [original] acquisition. - - APB FASB ASC (para. 323-10-35-33)
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Retrospective Adjustment
$5,000 7,000 $12,000
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When net income includes elements other than Operating Income, these elements should be presented separately on the investors income statement. Examples include:
Discontinued operations Extraordinary items
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GENERAL JOURNAL
Date Date
Page
Debit Debit
Page
##
Credit Credit
##
31-Dec Investment in Tiny Company Extraordinary Loss of investee Equity in Investee's Income
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GENERAL JOURNAL
Date Description
Page
Debit
##
Credit
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Amortize the difference over the remaining useful life of the associated asset. For fiscal years beginning on or after Dec. 15, 2001, Goodwill will be carried forward without adjustment until the investment is sold or a permanent decline in value occurs.
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Page
Debit
##
Credit
$$$$ $$$$
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Big Company is negotiating the acquisition of 30% of the outstanding shares of Little Company. Littles balance sheet reports assets of $500,000 and liabilities of $300,000 for a net book value of $200,000. Upon review, Big determines that Littles equipment is undervalued in the financial records by $60,000, and of its patents is also undervalued, but only by $40,000.
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adding these valuation adjustments to Littles book value, Big arrives at an estimated $300,000 worth for the companys net assets. Based on this computation, Big should offer $90,000 for a 30% share of the investees outstanding stock.
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Excess payment identified with specific assets: Equipment (30% of $60,000 undervalued). . .$18,000 Patent (30% of $40,000 undervalued) . . . . . . . 12,000 30,000 Excess payment not identified with specific assetsgoodwill . . . . . . . . . . . . . . 0
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18,000 12,000
GENERAL JOURNAL
Date Description
Page
Debit
##
Credit
4,200 4,200
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INVESTOR
Downstream Sale
INVESTOR
Upstream Sale
INVESTEE
INVESTEE
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INVESTOR
sells 200 units of inventory with original cost of $1,000.
20% ownership
INVESTEE
buys inventory and pays a total of $1,250 to investor.
Outside Party
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Intercompany Profit
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Credit
Date
Description
Year End
15 15
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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
Page
Debit
##
Credit
Date
Description
Year End
15 15
The reversal takes place during the period that the inventory is sold to an outside party.
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Summary
There are three methods to account for an investment in another company, depending on the size of the investment and level of influence the investor is able to exercise over the investee. If the investor pays more than the Book Value of the investee, the excess payment is assigned to specific assets and liabilities, or to goodwill. Intercompany profits on transferred assets are deferred until the items are consumed or sold to outside parties.
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Possible Criticisms:
Over-emphasis on possession of 2050% voting stock in deciding on significant influence vs. control Possibility of off-balance sheet financing Potential manipulation of performance ratios