NON-PROFIT ACCOUNTING HW

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Chapter One

The Equity Method of Accounting for Investments

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Learning Objective 1-1

Describe in general the various methods of accounting for an investment in equity shares of another company.

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LO 1-1: Describe in general the various methods of accounting for an investment in equity shares of another company.

The Reporting of Investments in Corporate Equity Securities

GAAP recognizes four methods to report investments in other companies:

Fair-value method.

Cost method for equity securities without readily determinable fair values.

Consolidation of financial statements.

Equity method.

The method selected depends upon the degree of influence the investor (stockholder) has over the investee.

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Generally accepted accounting principles (GAAP) recognize four different approaches to the financial reporting of investments in corporate equity securities:

Fair-value method.

Cost method for equity securities without readily determinable fair values.

Consolidation of financial statements.

Equity method.

The financial statement reporting for a particular investment depends primarily on the degree of influence that the investor (stockholder) has over the investee, a factor most often indicated by the relative size of ownership. (The relative size of ownership is most often the key factor in assessing one company’s degree of influence over another. However, as discussed later in this chapter, other factors (e.g., contractual relationships between firms) can also provide influence or control over firms regardless of the percentage of shares owned). Because voting power typically accompanies ownership of equity shares, influence increases with the relative size of ownership. The resulting influence can be very little, a significant amount, or, in some cases, complete control.

Fair-Value Method

Use when:

Investor holds a small percentage of equity securities of investee.

Investor cannot significantly affect investee’s operations.

Investment is made in anticipation of dividends or market appreciation.

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In many instances, an investor possesses only a small percentage of an investee company’s outstanding stock, perhaps only a few shares. Because of the limited level of ownership, the investor cannot expect to significantly affect the investee’s operations or decision making. These shares are bought in anticipation of cash dividends or in appreciation of stock market values. Such investments are recorded at cost and periodically adjusted to fair value according to the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 321, “Investments—Equity Securities.”

Recording Fair-Value Method

Initial investments in equity securities when significant influence and control are not present are:

Recorded at cost.

Adjusted to fair value if fair value is determinable.

If fair value not determinable, remains at cost.

Changes in fair values are recognized as income.

Dividends declared on the securities are recognized as income.

As of December 15, 2017, available-for-sale category

with fair value changes recorded in other comprehensive income will no longer be available.

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These procedures are followed for equity security investments when neither significant influence nor control is present.

Initial investments in equity securities are recorded at cost and subsequently adjusted to fair value if fair value is readily determinable (typically by reference to market value); otherwise, the investment remains at cost.

Changes in the fair values of equity securities during a reporting period are recognized as income.

Dividends declared on the equity securities are recognized as income.

FASB Accounting Standards Update (ASU) No. 2016, Financial Instruments—Overall, requires equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income, unless fair values are not readily determinable. Thus, the previous available-for-sale category with fair value changes recorded in other comprehensive income will no longer be available. The ASU is effective for fiscal years beginning after December 15, 2017, with early adoption permitted.

Fair-Value Method and Impairment Assessment

GAAP allows for two fair value assessments that may affect cost method amounts reported on the financial statements:

Periodic assessment for impairment to determine if the fair value of the investment is less than its carrying amount.

Recognition of “observable price changes in orderly transactions for the identical or a similar investment of the same issuer” as unrealized holding gains (or losses).

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Investments in equity securities that employ the cost method often continue to be reported at their original cost over time. Income from cost method equity investments usually consists of the investor’s share of dividends declared by the investee. However, despite its emphasis on cost measurements, GAAP allows for two fair value assessments that may affect cost method amounts reported on the balance sheet and the income statement.

First, cost method equity investments periodically must be assessed for impairment to determine if the fair value of the investment is less than its carrying amount. The ASC allows a qualitative assessment to determine if impairment is likely. Because the fair value of a cost method equity investment is not readily available (by definition), if impairment is deemed likely, an entity must estimate a fair value for the investment to measure the amount (if any) of the impairment loss.

Second, ASC (321-10-35-2) allows for recognition of “observable price changes in orderly transactions for the identical or a similar investment of the same issuer.” Any unrealized holding gains (or losses) from these observable price changes are included in earnings with a corresponding adjustment to the investment account. So even if equity shares are only infrequently traded (and thus fair value is not readily determinable), such trades can provide a basis for financial statement recognition under the cost method for equity investments.

Consolidation of Financial Statements

Required when investor’s ownership exceeds 50 percent of an organization’s outstanding voting stock.

When a majority of voting stock is held, investor-investee relationship is so closely connected that the two corporations are viewed as a single entity.

One set of financial statements prepared to consolidate all accounts of the parent company and all of its controlled subsidiaries as a single entity.

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Many corporate investors acquire enough shares to gain actual control over an investee’s operation. In financial accounting, such control is often achieved when a stockholder accumulates more than 50 percent of an organization’s outstanding voting stock. At that point, rather than simply influencing the investee’s decisions, the investor clearly can direct the entire decision-making process.

Investor control over an investee presents a special accounting challenge. Normally, when a majority of voting stock is held, the investor-investee relationship is so closely connected that the two corporations are viewed as a single entity for reporting purposes. Hence, an entirely different set of accounting procedures is applicable. Control generally requires the consolidation of the accounting information produced by the individual companies. Thus, a single set of financial statements is created for external reporting purposes with all assets, liabilities, revenues, and expenses brought together.

FASB ASC Section 810-10-05, Variable Interest Entities

Includes entities controlled through special contractual arrangements (not through voting stock interests).

Intended to combat misuse of SPE’s (special purpose entities) to keep large amounts of assets and liabilities off the balance sheet known as “off-balance-sheet financing.”

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The FASB ASC Section 810-10-05 on variable interest entities expands the use of consolidated financial statements to include entities that are financially controlled through special contractual arrangements rather than through voting stock interests. Prior to the accounting requirements for variable interest entities, many firms (e.g., Enron) avoided consolidation of entities in which they owned little or no voting stock but otherwise were controlled through special contracts. These entities were frequently referred to as “special purpose entities (SPEs)” and provided vehicles for some firms to keep large amounts of assets and liabilities off their consolidated financial statements.

Equity Method

Use when:

Investor has the ability to exercise significant influence on investee operations (whether applied or not).

Ownership is between 20 percent and 50 percent.

Significant influence might be present with much lower ownership percentages.

Under the equity method, investor’s share of investee dividends declared are recorded as decreases in the investment account, not income.

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Another investment relationship is appropriately accounted for using the equity method. In many investments, although control is not achieved, the degree of ownership indicates the ability of the investor to exercise significant influence over the investee. Recall Coca-Cola’s 28 percent investment in Coca-Cola FEMSA’s voting stock. Through its ownership, Coca-Cola can undoubtedly influence Coca-Cola FEMSA’s decisions and operations.

To provide objective reporting for investments with significant influence, FASB ASC Topic 323, “Investments—Equity Method and Joint Ventures,” describes the use of the equity method. The equity method employs the accrual basis for recognizing the investor’s share of investee income. Accordingly, the investor recognizes income as it is earned by the investee. As noted in FASB ASC (para. 323-10-05-5), because of its significant influence over the investee, the investor has a degree of responsibility for the return on its investment and it is appropriate to include in the results of operations of the investor its share of earnings or losses of the investee.

Furthermore, under the equity method, the investor’s share of investee dividends declared are recorded as decreases in the investment account, not as income.

In today’s business world, many corporations hold significant ownership interests in other companies without having actual control. The Coca-Cola Company, for example, owns between 20 and 50 percent of several bottling companies, both domestic and international. Many other investments represent joint ventures in which two or more companies form a new enterprise to carry out a specified operating purpose. For example, Ford Motor Company and Sollers formed FordSollers, a passenger and commercial vehicle manufacturing, import, and distribution company in Russia. Each partner owns 50 percent of the joint venture. For each of these investments, the investors do not possess absolute control because they hold less than a majority of the voting stock. Thus, the preparation of consolidated financial statements is inappropriate. However, the large percentage of ownership indicates that each investor possesses some ability to affect the investee’s decision-making process.

Finally, as discussed at the end of this chapter, firms may elect a fair-value option in their financial reporting for certain financial assets and financial liabilities. Among the qualifying financial assets for fair-value reporting are significant influence investments otherwise accounted for by the equity method.

International Accounting Standard 28—Investments in Associates

The International Accounting Standards Board defines significant influence as the power to participate in the financial and operating policy decisions of the investee, but it is not control or joint control over those policies.

If investor has 20 percent or more ownership, it is presumed to have significant influence, unless it is demonstrated not to be the case.

If investor holds less than 20 percent ownership, it is presumed it does not have significant influence, unless influence can be clearly demonstrated.

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The International Accounting Standards Board (IASB), similar to the FASB, recognizes the need to take into account the significant influence that can occur when one firm holds a certain amount of voting shares of another. The IASB defines significant influence as the power to participate in the financial and operating policy decisions of the investee, but it is not control or joint control over those policies. The following describes the basics of the equity method in International Accounting Standard (IAS) 28:

If an investor holds, directly or indirectly (e.g., through subsidiaries), 20 percent or more of the voting power of the investee, it is presumed that the investor has significant influence, unless it can be clearly demonstrated that this is not the case. Conversely, if the investor holds, directly or indirectly (e.g., through subsidiaries), less than 20 percent of the voting power of the investee, it is presumed that the investor does not have significant influence, unless such influence can be clearly demonstrated. A substantial or majority ownership by another investor does not necessarily preclude an investor from having significant influence.

Under the equity method, the investment in an associate is initially recognized at cost and the carrying amount is increased or decreased to recognize the investor’s share of the profit or loss of the investee after the date of acquisition. The investor’s share of the profit or loss of the investee is recognized in the investor’s profit or loss. Distributions received from an investee reduce the carrying amount of the investment.

As seen from the above excerpt from IAS 28, the equity method concepts and applications described are virtually identical to those prescribed by the FASB ASC.

Learning Objective 1-2

Identify the sole criterion for applying the equity method of accounting and know the guidelines to assess whether the criterion is met.

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LO 1-2: Identify the sole criterion for applying the equity method of accounting and know the guidelines to assess whether the criterion is met.

Criteria for Utilizing the Equity Method

Significant Influence (FASB ASC Topic 323):

Representation on the investee’s board of directors.

Participation in the investee’s policy-making process.

Material intra-entity transactions.

Interchange of managerial personnel.

Technological dependency.

Other investee ownership percentages.

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The rationale underlying the equity method is that an investor begins to gain the ability to influence the decision-making process of an investee as the level of ownership rises. According to FASB ASC Topic 323 on equity method investments, achieving this “ability to exercise significant influence over operating and financial policies of an investee even though the investor holds 50 percent or less of the common stock” is the sole criterion for requiring application of the equity method [FASB ASC (para. 323-10-15-3)].

FASB ASC Topic 323 provides guidance to the accountant by listing several conditions that indicate the presence of this degree of influence:

• Investor representation on the board of directors of the investee.

• Investor participation in the policy-making process of the investee.

• Material intra-entity transactions.

• Interchange of managerial personnel.

• Technological dependency.

• Extent of ownership by the investor in relation to the size and concentration of other ownership interests in the investee.

No single one of these guides should be used exclusively in assessing the applicability of the equity method. Instead, all are evaluated together to determine the presence or absence of the sole criterion: the ability to exercise significant influence over the investee.

Limitations of Equity Method Applicability

Regardless of investor’s degree of ownership, the equity method is not appropriate if investments demonstrate:

An agreement exists between investor and investee by which the investor surrenders significant rights as a shareholder.

A concentration of ownership operates the investee without regard for the views of the investor.

The investor attempts but fails to obtain representation on the investee’s board of directors.

If an entity can exercise control over investee, regardless of ownership level, consolidation is required.

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At first, the 20 to 50 percent rule may appear to be an arbitrarily chosen boundary range established merely to provide a consistent method of reporting for investments. However, the essential criterion is still the ability to significantly influence (but not control) the investee, rather than 20 to 50 percent ownership. If the absence of this ability is proven (or control exists), the equity method should not be applied regardless of the percentage of shares held. For example, the equity method is not appropriate for investments that demonstrate any of the following characteristics regardless of the investor’s degree of ownership:

An agreement exists between investor and investee by which the investor surrenders significant rights as a shareholder.

A concentration of ownership operates the investee without regard for the views of the investor.

The investor attempts but fails to obtain representation on the investee’s board of directors.

Alternatively, if an entity can exercise control over its investee, regardless of its ownership level, consolidation (rather than the equity method) is appropriate.

Extensions of Equity Method Applicability

For some investments that fall short of or exceed 20 to 50 percent ownership, the equity method is appropriately used for financial reporting.

Conditions can exist where the equity method is appropriate despite a majority ownership interest.

If the noncontrolling rights are so restrictive as to call into question whether control rests with the majority owner, the equity method is employed for financial reporting rather than consolidation.

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For some investments that either fall short of or exceed 20 to 50 percent ownership, the equity method is nonetheless appropriately used for financial reporting.

Conditions can also exist where the equity method is appropriate despite a majority ownership interest. In some instances, approval or veto rights granted to noncontrolling shareholders restrict the powers of the majority shareholder. Such rights may include approval over compensation, hiring, termination, and other critical operating and capital spending decisions of an entity. If the noncontrolling rights are so restrictive as to call into question whether control rests with the majority owner, the equity method is employed for financial reporting rather than consolidation.

Summary of Accounting Methods

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Accounting Methods Applicable in Various Stock Ownership Levels

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The table, page 7, indicates the method of accounting that is typically applicable to various stock investments.

Accounting for Increases in an Investment—The Equity Method

The investor increases the investment account as the investee earns and reports income. The investor uses the accrual method to record investment income—recognizing it in the same time period as the investee earns it.

Upward adjustments in the asset balance are recorded as soon as the investee makes a profit. The investor reduces the investment account if the investee reports a loss.

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After recording the cost of the acquisition, two equity method entries periodically record the investment’s impact:

The investor’s investment account increases as the investee recognizes and reports income. Also, the investor recognizes investment income using the accrual method—that is, in the same period as reported by the investee in its financial statements. Although the investor initially records the acquisition at cost, upward adjustments in the asset balance are recorded as soon as the investee makes a profit. The investor reduces the investment account if the investee reports a loss.

The investor decreases its investment account’s carrying value for its share of investee cash dividends. When the investee declares a cash dividend, its owners’ equity decreases.

The investor shall recognize its share of the earnings or losses of an investee in the periods for which they are reported by the investee in its financial statements.

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Accounting for Decreases in an Investment—The Equity Method

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The investor decreases its investment account for its share of investee cash dividends. When the investee declares a cash dividend, its owners’ equity decreases. The investor mirrors this change by recording a reduction in the carrying amount of the investment rather than recognizing the dividend as revenue. Because the investor recognizes income when the investee recognizes it, double counting would occur if the investor also recorded its share of subsequent investee dividends as revenue. Importantly, a cash dividend declaration is not an appropriate point for income recognition. As stated in FASB ASC (para. 323-10-35-4),

Under the equity method, an investor shall recognize its share of the earnings or losses of an investee in the periods for which they are reported by the investee in its financial statements rather than in the period in which an investee declares a dividend.

Because the investor can influence their timing, investee dividends cannot objectively measure income generated from the investment.

Equity Method Example

Big Company owns a 20 percent interest in Little Company purchased on January 1, 2017, for $200,000. Little reports net income of $250,000, $300,000, and $400,000, respectively, in the next three years while declaring dividends of $50,000, $100,000, and $200,000.

The fair values of Big’s investment in Little, as determined by market prices, were $245,000, $282,000, and $325,000 at the end of 2017, 2018, and 2019, respectively.

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Big Company owns a 20 percent interest in Little Company purchased on January 1, 2017, for $200,000. Little then reports net income of $250,000, $300,000, and $400,000, respectively, in the next three years while declaring dividends of $50,000, $100,000, and $200,000. The fair values of Big’s investment in Little, as determined by market prices, were $245,000, $282,000, and $325,000 at the end of 2017, 2018, and 2019, respectively.

Fair-Value vs. Equity Method

*Equity in investee income is 20 percent of the current year income reported by Little Company.

†The carrying amount of an investment under the equity method is the original cost plus income recognized less dividends. For 2017, as an example, the $240,000 reported balance is the $200,000 cost plus $50,000 equity income less $10,000 in dividends.

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EXHIBIT 1.1 Comparison of Fair-Value Method (ASC 321) and Equity Method (ASC 323)

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Exhibit 1.1 compares the accounting for Big’s investment in Little across the two methods. The fair-value method carries the investment at its market values, presumed to be readily available in this example. Income is recognized both through changes in Little’s fair value and as Little declares dividends.

Equity in investee income is 20 percent of the current year income reported by Little Company. The carrying amount of an investment under the equity method is the original cost plus income recognized less dividends. For 2017, as an example, the $240,000 reported balance is the $200,000 cost plus $50,000 equity income less $10,000 in dividends.

Learning Objective 1-3

Prepare basic equity method journal entries for an investor and describe the financial reporting for equity method investments.

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LO 1-3: Prepare basic equity method journal entries for an investor and describe the financial reporting for equity method investments.

Equity Method Example—Journal Entries

Big Company records the following journal entries to

apply the equity method for its investment in Little Company for 2017:

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1st entry: Big accrues income based on the investee’s reported earnings.

2nd entry: Big records dividend declaration and reduction in Little’s net assets.

3rd entry: Big reports the collection of cash dividends.

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Little Company reported a net income of $250,000 during 2017 and declared and paid cash dividends of $50,000. These figures indicate that Little’s net assets have increased by $200,000 during the year. Therefore, in its financial records, Big Company records the following journal entries to apply the equity method.

In the first entry, Big accrues income based on the investee’s reported earnings. The second entry reflects the dividend declaration and the related reduction in Little’s net assets followed then by the cash collection. The $40,000 net increment recorded here in Big’s investment account ($50,000 – $10,000) represents 20 percent of the $200,000 increase in Little’s book value that occurred during the year.

Allocate the cost of an equity method investment and compute amortization expense to match revenues recognized from the investment to the excess of investor cost over investee book value.

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Learning Objective 1-4

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LO 1-4: Allocate the cost of an equity method investment and compute amortization expense to match revenues recognized from the investment to the excess of investor cost over investee book value.

Excess of Investment Cost over Book Value Acquired

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Differences may exist between a company’s book value and fair value because:

Fair value is based on multiple factors, including but not limited to profitability, new products, expected dividend payments, projected operating results, and general economic conditions.

Stock prices are based, partially, on the perceived worth of a company’s net assets, amounts that often vary from underlying book values.

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A number of possible reasons exist for a difference between the book value of a company and its fair value as reflected by the price of its stock. A company’s fair value at any time is based on a multitude of factors such as company profitability, the introduction of a new product, expected dividend payments, projected operating results, and general economic conditions. Furthermore, stock prices are based, at least partially, on the perceived worth of a company’s net assets, amounts that often vary dramatically from underlying book values.

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Excess of Investment Cost over Book Value Acquired (continued)

Asset and liability accounts on the balance sheet tend to measure historical costs rather than current value.

Reported figures are affected by the accounting methods selected and lead to different book values; for example:

Inventory costing methods (LIFO and FIFO).

Acceptable depreciation methods (straight-line, units of production).

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Many asset and liability accounts shown on a balance sheet tend to measure historical costs rather than current value. In addition, these reported figures are affected by the specific accounting methods adopted by a company. Inventory costing methods such as LIFO and FIFO, for example, obviously lead to different book values as does each of the acceptable depreciation methods.

Excess of Investment Cost over Book Value Acquired (concluded)

When purchase price exceeds book value of an investment acquired, the difference must be identified.

Assets may be undervalued on the investee’s books because:

The fair values (FV) of some assets and liabilities are different from their book values (BV).

The investor may be willing to pay extra because future benefits are expected to accrue from the investment.

Extra payment that cannot be attributed to a specific asset or liability is assigned to the intangible asset goodwill.

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When the purchase price exceeds the book value of an asset acquired, the difference must be identified. Assets may be undervalued on the investee’s books because:

The fair values (FV) of specific assets and liabilities are different from their book values (BV).

The investor may be willing to pay extra because future benefits are expected to accrue from the investment.

Extra payment that cannot be attributed to a specific asset or liability is assigned to the intangible asset called goodwill.

Excess of Investment Cost over Book Value Acquired Example

Grande Company is negotiating the acquisition of 30 percent of the outstanding shares of Chico Company. Chico’s balance sheet reports assets of $500,000 and liabilities of $300,000 for a net book value of $200,000.

Grande determines that Chico’s equipment is undervalued in the company’s financial records by $60,000. One of its patents is also undervalued, but only by $40,000.

Adding these valuation adjustments to Chico’s book value indicates that the company’s net assets are estimated to be valued at $300,000. Therefore, Grande offers $90,000 for a 30 percent share of the investee’s outstanding stock.

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Assume that Grande Company is negotiating the acquisition of 30 percent of the outstanding shares of Chico Company. Chico’s balance sheet reports assets of $500,000 and liabilities of $300,000 for a net book value of $200,000. After investigation, Grande determines that Chico’s equipment is undervalued in the company’s financial records by $60,000. One of its patents is also undervalued, but only by $40,000. By adding these valuation adjustments to Chico’s book value, Grande arrives at an estimated $300,000 worth for the company’s net assets. Based on this computation, Grande offers $90,000 for a 30 percent share of the investee’s outstanding stock.

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Grande’s purchase price is in excess of the proportionate share of Chico’s book value, which can be attributed to two specific accounts: Equipment and Patents.

No part of the extra payment is traceable to any other projected future benefit. The cost of Grande’s investment is allocated as follows:

Excess of Investment Cost over Book Value Acquired—Valuations

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Although Grande’s purchase price is in excess of the proportionate share of Chico’s book value, this additional amount can be attributed to two specific accounts: Equipment and Patents. No part of the extra payment is traceable to any other projected future benefit. Thus, the cost of Grande’s investment is allocated as shown.

The Amortization Process

Payment relating to each asset (except land, goodwill, and other indefinite life intangibles) should be amortized over an appropriate time period.

Goodwill associated with equity method investments, for the most part, is measured in the same manner as goodwill arising from a business combination, tested for declines in value and impairment. Equity method investments are tested in their entirety for permanent declines in value.

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The payment relating to each asset (except land, goodwill, and other indefinite life intangibles) should be amortized over an appropriate time period.

Goodwill associated with equity method investments, for the most part, is measured in the same manner as goodwill arising from a business combination. One difference is that goodwill arising from a business combination is subject to annual impairment reviews, whereas goodwill implicit in equity investments is not. Equity method investments are tested in their entirety for permanent declines in value.

The Amortization Process— Journal Entries

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To record the annual expense, Grande reduces the investment balance in the same way it would amortize the cost of any other asset that had a limited life. At the end of the first year of holding the investment, the investor records the following journal entry under the equity method.

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Grande reduces the investment balance in the same way it would amortize the cost of any other asset that had a limited life. Therefore, at the end of the first year of holding the investment, the investor records a journal entry under the equity method.

Equity Method—Additional Issues

Special procedures are required in accounting for each of the following:

Reporting a change to the equity method.

Reporting investee income from sources other than continuing operations.

Reporting investee losses.

Reporting the sale of an equity investment.

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The previous sections on equity income accruals and excess cost amortizations provide the basics for applying the equity method. However, special procedures are required in accounting for each of the following:

Reporting a change to the equity method.

Reporting investee income from sources other than continuing operations.

Reporting investee losses.

Reporting the sale of an equity investment.

Learning Objective 1-5a

Understand the financial reporting consequences for a change to the equity method.

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LO 1-5a: Understand the financial reporting consequences for a change to the equity method.

Reporting a Change to the Equity Method

Report a change to the equity method if:

An investment that was recorded using the cost or fair-value method reaches the point where significant influence is established.

When an investment qualifies for use of the equity method, the investor adds the cost of acquiring additional interest in the investee to the current basis and adopts the equity method of accounting [(FASB ASC (para. 323-10-35-33)].

This prospective approach avoids the complexity of restating prior period amounts.

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The investor could possess only a minor ownership for some years before purchasing enough additional shares to require conversion to the equity method. Before the investor achieves significant influence, any investment should be reported by either the fair-value method, or if the investment fair value is not readily determinable, the cost method. After the investment reaches the point at which the equity method becomes applicable, a technical question arises about the appropriate means of changing from one method to the other.

FASB ASC (para. 323-10-35-33) addresses the issue of how to account for an investment in the common stock of an investee that, through additional stock acquisition or other means (e.g., increased degree of influence, reduction of investee’s outstanding stock, etc.) becomes qualified for use of the equity method.

If an investment qualifies for use of the equity method . . . , the investor shall add the cost of acquiring the additional interest in the investee (if any) to the current basis of the investor’s previously held interest and adopt the equity method of accounting as of the date the investment becomes qualified for equity method accounting.

The FASB requires a prospective approach by requiring that the cost of any new share acquired simply be added to the current investment carrying amount. By mandating prospective treatment, the FASB avoids the complexity of restating prior period amounts.

Reporting a Change to the Equity Method Example

Alpha Company acquires a 10 percent ownership in Bailey Company on January 1, 2017, for $84,000.

Alpha company does not have the ability to exert significant influence over Bailey.

Alpha properly records the investment using the fair-value method and recognizes in net income its 10 percent ownership share of changes in Bailey’s fair value.

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Assume that on January 1, 2017, Alpha Company exchanges $84,000 for a 10 percent ownership in Bailey Company. At the time of the transaction, officials of Alpha do not believe that their company gained the ability to exert significant influence over Bailey. Alpha properly accounts for the investment using the fair-value method and recognizes in net income its 10 percent ownership share of changes in Bailey’s fair value.

Reporting a Change to the Equity Method without Significant Influence

Alpha Company recognizes the increase in its 10 percent ownership in Bailey Company at the end of 2017 and increases its investment account to $89,000.

Because the fair-value method is used to account for the investment, Bailey’s $670,000 book value balance at January 1, 2017, does not affect Alpha’s accounting.

On January 1, 2018, Alpha purchases an additional 30 percent of Bailey’s outstanding voting stock for $267,000.

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At the end of 2017, Alpha recognizes the increase in its 10 percent share of Bailey’s fair value and increases its investment account to $89,000. Because the fair-value method is used to account for the investment, Bailey’s $670,000 book value balance at January 1, 2017, does not affect Alpha’s accounting

Then on January 1, 2018, Alpha purchases an additional 30 percent of Bailey’s outstanding voting stock for $267,000 and achieves the ability to significantly influence the investee’s decision making. Alpha will now apply the equity method to account for its investment in Bailey.

Reporting a Change to the Equity Method with Significant Influence

On January 1, 2018, Alpha achieves the ability to exercise significant influence over Bailey, and will now apply the equity method to account for its investment in Bailey.

On January 1, 2018, Bailey’s carrying amounts for its assets and liabilities equaled their fair values except for a patent, which was undervalued by $175,000 and had a 10-year remaining useful life.

The fair value of Alpha’s total (40 percent) investment serves as the valuation basis.

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With the purchase on January 1, 2018, Alpha achieves the ability to significantly influence the investee’s decision making. Alpha will now apply the equity method to account for its investment in Bailey.

To determine the proper amount of excess fair value amortization required in applying the equity method, Alpha prepares an investment allocation schedule. The fair value of Alpha’s total (40 percent) investment serves as the valuation basis for the allocation schedule.

Recording a Change to the Equity Method

Investment Allocation Schedule

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Alpha prepares the following journal entry on January 1, 2018, to bring about prospective change to the equity method:

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On January 1, 2018, Alpha achieves the ability to exercise significant influence over Bailey. To bring about the prospective change to the equity method, Alpha prepares the journal entry as shown on January 1, 2018.

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Bailey reports net income of $130,000 and declares and pays a $50,000 dividend at the end of 2018. Alpha records the following journal entries:

Recording a Change to the Equity Method (continued)

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We next assume that Bailey reports net income of $130,000 and declares and pays a $50,000 dividend at the end of 2018. Accordingly, Alpha applies the equity method and records the three journal entries as shown at the end of 2018.

Understand the financial reporting consequences for investee’s other comprehensive income.

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Learning Objective 1-5b

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LO 1-5b: Understand the financial reporting consequences for investee’s other comprehensive income.

Other Comprehensive Income (OCI)

OCI is defined as revenues, expenses, gains, and losses that under GAAP are included in comprehensive income but excluded from net income.

Items included in AOCI (Accumulated Other Comprehensive Income) on the balance sheet are accumulated derivative net gains and losses, foreign currency translation adjustments, and certain pension adjustments.

Equity method accounting requires that the investor record its share of investee OCI and irregular items traditionally found in net income.

AOCI is reported in stockholders’ equity and represents a source of change in investee company net assets that is recognized under the equity method.

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In many cases, reported net income and dividends sufficiently capture changes in an investee’s owners’ equity. When an investee company’s activities require recognition of other comprehensive income (OCI), its owners’ equity (and net assets) will reflect changes not captured in its reported net income.

OCI is defined as revenues, expenses, gains, and losses that under generally accepted accounting principles are included in comprehensive income but excluded from net income. OCI is accumulated and reported in stockholders’ equity.

Equity method accounting requires that the investor record its share of investee OCI, which then is included in its balance sheet as Accumulated Other Comprehensive Income (AOCI).

Included in AOCI are items such as accumulated derivative net gains and losses, foreign currency translation adjustments, and certain pension adjustments.

OCI thus represents a source of change in investee company net assets that is recognized under the equity method.

Other equity method recognition issues arise for irregular items traditionally included within net income. For example, an investee may report income (loss) from discontinued operations as components of its current net income. In such cases, the equity method requires the investor to record and report its share of these items in recognizing equity earnings of the investee.

Understand the financial reporting consequences for investee losses.

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Learning Objective 1-5c

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LO 1-5c: Understand the financial reporting consequences for investee losses.

Reporting Investee Losses

Declines in investment value can result due to a loss of major customers, changes in economic conditions, loss of a significant patent or other legal right, damage to the company’s reputation, etc. A temporary drop in the fair value of an investment is simply ignored.

FASB ASC (para. 323-10-35-32) requires that a loss in value of an investment which is other than a temporary decline shall be recognized.

A permanent decline in the investee’s fair market value is recorded as an impairment loss and the investment account is reduced to the fair value.

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Investments can suffer permanent losses in fair value that are not evident through equity method accounting. Such declines can be caused by the loss of major customers, changes in economic conditions, loss of a significant patent or other legal right, damage to the company’s reputation, and the like. The FASB ASC (para. 323-10-35-32) provides the following guidance:

A loss in value of an investment which is other than a temporary decline shall be recognized. Evidence of a loss in value might include, but would not necessarily be limited to, absence of an ability to recover the carrying amount of the investment or inability of the investee to sustain an earnings capacity that would justify the carrying amount of the investment.

Thus, when a permanent decline in an equity method investment’s value occurs, the investor must recognize an impairment loss and reduce the asset to fair value.

However, this loss must be permanent before such recognition becomes necessary. Under the equity method, a temporary drop in the fair value of an investment is simply ignored.

When accumulated losses incurred and dividends paid by the investee reduce the investment account to $-0-, no further loss can be accrued. A temporary decline is ignored!

Once the original cost of the investment has been eliminated, no additional losses can accrue to the investor.

Future equity income will be offset by these losses prior to recording equity income in our results.

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Investment Reduced to Zero

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Through the recognition of reported losses as well as any permanent drops in fair value, the investment account can eventually be reduced to a zero balance. This condition is most likely to occur if the investee has suffered extreme losses or if the original purchase was made at a low, bargain price. Regardless of the reason, the carrying amount of the investment account is sometimes eliminated in total.

Once the original cost of the investment has been eliminated, no additional losses can accrue to the investor (since the entire cost has been written off). Future equity income will be offset by these losses prior to recording equity income in our results.

Learning Objective 1-5d

Understand the financial reporting consequences for sales of equity method investments.

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LO 1-5d: Understand the financial reporting consequences for sales of equity method investments.

Reporting the Sale of an Equity Investment

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If part of an investment is sold during the period:

The equity method is applied up to the transaction date.

At the transaction date, the Investment account balance is reduced by the percentage of shares sold.

If significant influence is lost, NO RETROACTIVE ADJUSTMENT is recorded if the investor is required to change FROM the equity method to the fair-value method.

Note: A change TO the equity method is also treated prospectively.

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At any time, the investor can choose to sell part or all of its holdings in the investee company. If a sale occurs, the equity method continues to be applied until the transaction date, thus establishing an appropriate carrying amount for the investment. The investor then reduces this balance by the percentage of shares sold.

If an investor is required to change from the equity method to the fair-value method, no retrospective adjustment is made. As previously demonstrated, a change to the equity method is also treated prospectively.

Learning Objective 1-6

Describe the rationale and computations to defer gross profits on intra-entity inventory sales until the goods are either consumed or sold to outside parties.

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LO 1-6: Describe the rationale and computations to defer gross profits on intra-entity inventory sales until the goods are either consumed by the owner or sold to outside parties.

Deferral of Intra-Entity Gross Profits in Inventory

Many equity acquisitions establish ties between companies to facilitate the direct purchase and sale of inventory items. Such intra-entity transactions can occur either on a regular basis or sporadically.

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EXHIBIT 1.2 Downstream and Upstream Sales

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Many equity acquisitions establish ties between companies to facilitate the direct purchase and sale of inventory items. The significant influence relationship between an investor and investee in many ways creates its own entity that works to achieve business objectives. Thus, we use the term intra-entity to describe sales between an investor and its equity method investee.

Intra-entity sales require special accounting to ensure proper timing for profit recognition.

Transactions between related companies are identified as either downstream or upstream. Downstream sales refer to the investor’s sale of an item to the investee. Conversely, an upstream sale describes one that the investee makes to the investor.

Downstream Sales of Inventory— Investor Sales to Investee

Profit recognition is delayed until buyer disposes of the goods.

Investor decreases current equity income to reflect the deferred portion of the intra-entity profit.

When this inventory is eventually consumed or sold to unrelated parties, the deferral is no longer needed.

The investor should recognize the deferred intra-entity gross profit. Recognition shifts from the year of inventory transfer to the year in which the sale to unrelated customers occurred.

An alternative treatment would be the direct reduction of the investor’s inventory balance as a means of accounting for this deferred amount.

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The investor has made downstream sales to the investee. In applying the equity method, recognition of the related profit must be delayed until the buyer disposes of these goods.

After calculating the appropriate deferral, the investor decreases current equity income to reflect the deferred portion of the intra-entity profit. In the subsequent year, when this inventory is eventually consumed by the investee or sold to unrelated parties, the deferral is no longer needed. Because a sale to an outside party has now occurred, the investor should recognize the deferred intra-entity gross profit. Recognition shifts from the year of inventory transfer to the year in which the sale to customers outside of the affiliated entity takes place.

An alternative treatment would be the direct reduction of the investor’s inventory balance as a means of accounting for this deferred amount. Although this alternative is acceptable, decreasing the investment account remains the traditional approach for deferring gross profits, even for upstream sales.

Downstream Sales of Inventory—Investor Sales to Investee Journal Entries

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If gross profit on an original intra-entity sale is 30 percent of $10,000 in sales, investor profit associated with the sale is $3,000. If 40 percent of investee’s stock is held, just $1,200 of the profit is deferred.

Current equity income decreases by $1,200 to defer the intra-entity profit and temporarily remove 30 percent of the profit from the investor’s books in 2018 until the investee disposes of the inventory in 2019.

Reverse the preceding deferral entry to move the profit into the year of sale to outside customers.

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For example, if the gross profit on an original intra-entity sale was 30 percent of a $10,000 sale, investor profit associated with the remaining items is $3,000 ($10,000 × 30%). However, 40 percent of the investee’s stock is held. Therefore, just $1,200 ($3,000 × 40%) of this profit is deferred. Investor’s ownership percentage reflects the intra-entity portion of the profit. The total $3,000 gross profit within the ending inventory balance is not the amount deferred. Rather, 40 percent of that gross profit is viewed as the currently deferred figure.

After calculating the appropriate deferral, the investor decreases current equity income by $1,200 to reflect the deferred portion of the intra-entity profit. This procedure temporarily removes this portion of the profit from the investor’s books in 2018 until the investee disposes of the inventory in 2019.

By merely reversing the preceding deferral entry, the accountant succeeds in moving the investor’s profit into the appropriate time period. Recognition shifts from the year of inventory transfer to the year in which the sale to customers outside of the affiliated entity takes place.

Upstream Sales of Inventory—Investee Sales to Investor

Upstream sales of inventory are reported in the same manner as downstream sales.

Profit recognition is delayed until buyer disposes of the goods.

Investor decreases current equity income to reflect the deferred portion of the intra-entity profit.

The investor’s own inventory account contains the deferred gross profit. Recognition of profit is deferred by decreasing the investment account rather than the inventory balance.

When this inventory is eventually consumed or sold to unrelated parties, the deferral is reversed.

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Unlike consolidated financial statements, the equity method reports upstream sales of inventory in the same manner as downstream sales. The investor’s share of gross profits remaining in ending inventory are deferred until the items are used or sold to unrelated parties.

Again, a deferral of the gross profit created by the intra-entity sale is necessary for proper timing of income recognition. Under the equity method for investments with significant influence, the direction of the sale between the investor and investee (upstream or downstream) has no effect on the final amounts reported in the financial statements.

The income accrual is reduced because the investor defers its portion of the intra-entity gross profit. When the investor eventually consumes or sells the merchandise, the deferral is reversed. The effects of the inventory transfer are reported in the proper accounting period when sales to an outside party allow the recognition of the previously deferred intra-entity gross profit.

In an upstream sale, the investor’s own inventory account contains the deferred gross profit. The previous entry, though, defers recognition of this profit by decreasing the investor’s investment account rather than the inventory balance. An alternative treatment would be the direct reduction of the investor’s inventory balance as a means of accounting for the deferred amount. Although this alternative is acceptable, decreasing the investment account remains the traditional approach for deferring gross profits, even for upstream sales.

Upstream Sales of Inventory—Investee Sales to Investor Journal Entries

Suppose the investee sells merchandise costing $40,000 to the investor for $60,000, and at year’s end, the investor still retains $15,000 of the goods. The investee reports net income of $120,000 for the year. The investor records a journal entry to reflect the basic accrual of the investee’s earnings.

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A second entry is required of the investor at year-end. Income accrual is reduced, and the investor defers its portion of the intra-entity gross profit.

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During the current year, the investee sells merchandise costing $40,000 to the investor for $60,000. At the end of the fiscal period, the investor still retains $15,000 of the goods. The investee reports net income of $120,000 for the year. The investor records a journal entry to reflect the basic accrual of the investee’s earnings.

Based on this calculation, a second entry is required of the investor at year-end. After the adjustment, the investor reports earnings from this equity investment of $46,000 ($48,000 − $2,000). The income accrual is reduced because the investor defers its portion of the intra-entity gross profit. When the investor eventually consumes or sells the $15,000 in merchandise, the preceding journal entry is reversed. In this way, the effects of the inventory transfer are reported in the proper accounting period when sales to an outside party allow the recognition of the previously deferred intra-entity gross profit. The previous entry defers recognition of profit by decreasing the investor’s investment account rather than the inventory balance.

Financial Reporting Effects

Measurements of financial performance often affect the following:

The firm’s ability to raise capital.

Managerial compensation.

The ability to meet debt covenants and future interest rates.

Managers’ reputations.

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It is important to realize that business decisions, including equity investments, typically involve the assessment of a wide range of consequences. For example, managers frequently are very interested in how financial statements report the effects of their decisions. This attention to financial reporting effects of business decisions arises because measurements of financial performance often affect the following:

The firm’s ability to raise capital.

Managerial compensation.

The ability to meet debt covenants and future interest rates.

Managers’ reputations.

Criticisms of the Equity Method

Emphasizing the 20–50 percent of voting stock in determining significant influence versus control.

Allowing off-balance-sheet financing.

Potentially biasing performance ratios.

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Over the past several decades, thousands of business firms have accounted for their investments using the equity method. Recently, however, the equity method has come under criticism for the following:

Emphasizing the 20–50 percent of voting stock in determining significant influence versus control.

Allowing off-balance-sheet financing.

Potentially biasing performance ratios.

The guidelines for the equity method suggest that a 20–50 percent ownership of voting shares indicates significant influence that falls short of control. But can one firm exert “control” over another firm absent an interest of more than 50 percent? Clearly, if one firm controls another, consolidation is the appropriate financial reporting technique. However, over the years, firms have learned ways to control other firms despite owning less than 50 percent of voting shares.

Learning Objective 1-7

Explain the rationale and reporting implications of fair-value accounting for investments otherwise accounted for by the equity method.

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LO 1-7: Explain the rationale and reporting implications of fair-value accounting for investments otherwise accounted for by the equity method.

Fair-Value Reporting Option

An entity may irrevocably elect fair value as the initial and subsequent measurement for certain financial assets and financial liabilities, including investments accounted for under the equity method.

Under the fair-value option, changes in the fair value of the elected financial items are included in earnings.

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Financial reporting standards allow a fair-value option under which an entity may irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and financial liabilities. Under the fair-value option, changes in the fair value of the elected financial items are included in earnings. Among the many financial assets available for the fair-value option were investments otherwise accounted for under the equity method.

Fair-Value Reporting Option (continued)

The fair-value option improves financial reporting. It provides entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions.

The fair-value option matches asset valuation with fair-value reporting requirements for many liabilities.

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As FASB ASC (para. 825-10-10-1) observes, the objective of the fair-value option is

to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions.

Thus, the fair-value option is designed to match asset valuation with fair-value reporting requirements for many liabilities.