ChapterOneTheEquityMethodofAccountingforInvestmentsMcGraw-Hill/IrwinCopyright?2013byTheMcGraw-HillCompanies,Inc.Allrightsreserved.AccountingforInvestmentsin

CorporateEquitySecuritiesGAAPrecognizes3waystoreportinvestmentsinothercompanies:

Fair-ValueMethodConsolidationEquityMethodThemethodselecteddependsuponthedegreeofinfluencetheinvestorhasovertheinvestee.1231-2FairValueMethodUsewhen:investorholdsasmallpercentage (usuallylessthan20%)ofequity securitiesofinvesteeInvestorcannotsignificantlyaffect investee’soperationsInvestmentismadeinanticipationofdividendsormarketappreciation.1-3FairValueMethod1-4InvestmentsclassifiedasTradingSecurities:Heldforsaleintheshortterm.Unrealizedholdinggainsandlossesareincludedinearnings(nete).InvestmentsclassifiedasAvailable-for-SaleSecurities:AnySecuritiesnotclassifiedasTrading.Unrealizedholdinggainsandlossesarereportedin shareholders’equityasothercomprehensive e(i.e.,notincludedinnete).Investmentsinequitysecuritiesarerecordedatcostandsubsequentlyadjustedtofairvalue.1-4Fair-ValueMethod–Applied

(FASBASCTopic320)Step1:Investorrecordsinvestmentintheinvesteeatcost. DebitCreditInvestmentinInvestee XXXXCash(orotherAssets/Stock) XXXXStep2:Investorrecognizesdividendeforcashdividendsreceivedfrominvestee. DebitCreditCash XXXXefromInvestment XXXX

1-51-5Fair-ValueMethod–Applied(continued…)Step3:Investoradjustsinvestmentaccounttofair- marketvalue(FMV)ifreadilydeterminableat reportingdateJournalentryifFMV>Cost: DebitCreditInvestment XXXXUnrealizedGainonInvestment** XXXX**IncludedinearningsontheestatementforTradingSecuritiesorinOtherComprehensiveeinShareholders’EquityforAvailable-for-SaleSecurities(excludedfromearnings)1-6Consolidationof

FinancialStatementsRequiredwhen:Investor’sownershipexceeds50%ofinvestee

exceptwhencontroldoesnotrestwiththemajorityinvestorOnesetoffinancialstatementspreparedtoconsolidateallaccountsoftheparentcompanyandallofitscontrolledsubsidiaries

ASASINGLEENTITY.1-71-7FASBASCsection810-10-05,VariableInterestEntities Includesentitiescontrolledthroughspecialcontractualarrangements(notthroughvotingstockinterests) IntendedtocombatmisuseofSPE’s(SpecialPurposeEntities)tokeeplargeamountsofassetsandliabilitiesoffthebalancesheetknownas“offbalancesheetfinancing”1-81-8Question1: GawCompanyowns15%ofthecommonstockofTraceCorporationandusedthefair-valuemethodtoaccountforthisinvestment.Tracereportedneteof$110,000for2011andpaiddividendsof$60,000onOctober1,2011.HowmucheshouldGawrecognizeonthisinvestmentin2011?A.$16,500B.$9,000C.$25,500D.$7,500E.$50,0001-91-9EquityMethodUsewhen:Investorhastheabilitytoexercisesignificantinfluenceontheinvesteeoperations(whetherinfluenceisappliedornot).Generallyusedwhenownershipisbetween20%and50%.SignificantInfluencemightbepresentwithmuchlowerownershippercentages.1-101-10InternationalStandard28InvestmentinAssociatesTheInternationalAccountingStandardsBoard(IASB),similartoFASB,defines“significantinfluence”asthepowertoparticipateinthefinancialandoperatingpolicydecisionsoftheinvestee,butitisnotcontrolorjointcontroloverthosepolicies.Ifinvestorhas20%ormoreownership,itispresumedtohavesignificantinfluence,unlessitisdemonstratednottobethecase.Ifinvestorholdslessthan20%ownership,itispresumeditdoesnothavesignificantinfluence,unlessinfluencecanbeclearlydemonstrated.

1-111-11WhatisSignificantInfluence?

(FASBASCTopic323)Representationontheinvestee’sBoardofDirectorsParticipationintheinvestee’spolicy-making processMaterialpanytransactionsInterchangeofmanagerialpersonnelTechnologicaldependencyOtherinvestorownershippercentages1-121-12InvestorOwnershipoftheInvestee’sSharesOutstanding0%20%50%100%FairValueEquityMethodConsolidatedFinancialStatementsGeneralOwnershipGuidelinesSignificantinfluencegenerallyassumed(20%to50%ownership).Usuallylackofcontrolorsignificantinfluence.Financialstatementsofallrelatedcompaniesmustbeconsolidated.1-13Question2:Acompanyshouldalwaysusetheequitymethodtoaccountforaninvestmentif:A.ithastheabilitytoexercisesignificantinfluenceovertheoperatingpoliciesoftheinvestee.B.itowns30%ofanothercompany’sstock.C.ithasacontrollinginterest(morethan50%)ofanothercompany’sstock.D.theinvestmentwasmadeprimarilytoearnareturnonexcesscash.E.itdoesnothavetheabilitytoexercisesignificantinfluenceovertheoperatingpoliciesoftheinvestee.1-141-14FairValueEquityMethodConsolidatedFinancialStatementsGeneralReportingGuidelines1:SameasFair Value2:Investorrecognizes itsshare(%of ownership) ofinvestee’snet e(netloss) asanincrease (decrease)inthe investment accountand3. Recordsdividends asadecrease.1.Investorrecordsinvestmentat“cost”.2.Investorrecognizescashdividendsfrominvesteease.OnesetoffinancialstatementsarepreparedtocombineaccountsoftheinvestorandallofitsinvesteesASASINGLEENTITY.1-15EquityMethod–AppliedStep1DebitCreditInvestmentinInvesteeXXXXCash(orotherAssets/Stock) XXXXStep2DebitCreditInvestmentinInvestee XXXXEquityinInvesteee XXXXIfnetloss:DebitCreditEquityinInvesteee XXXXInvestmentinInvestee XXXX1-161-16EquityMethod–Applied

(Continued…)Step3:Investorreducestheinvestmentaccountbytheamountofcashdividendsreceivedfromtheinvestee. DebitCreditCash XXXXInvestmentinInvestee XXXX1-171-17EquityMethodExampleLittleCompanyreportedneteof$200,000during2012andpaidcashdividendsof$50,000.ThesefiguresindicatethatLittle’snetassetshaveincreasedby$150,000duringtheyear.Bigowns20%ofLittleandrecordsthefollowingentries. Debit Credit InvestmentinLittleCompany..40,000 EquityinInvesteee.....………40,000 Toaccrueearningsofa20percentownedinvestee.1-18Cash........................10,000InvestmentinLittleCompany........10,000Torecordreceiptofcashdividendfrominvestee.1-18SpecialProceduresforSpecialSituationsReportingachangetotheequitymethod.Reportinginvesteeefromsourcesotherthancontinuingoperations.Reportinginvesteelosses.Reportingthesaleofanequityinvestment.1-191-19ReportingaChangetotheEquityMethodReportachangetotheequitymethodif:Aninvestmentthatwasrecordedusingthefair-valuemethodreachesthepointwheresignificantinfluenceisestablished.Allaccountsarerestatedretroactivelysotheinvestor’sfinancialstatementsappearasiftheequitymethodhadbeenappliedfromthedateofthefirstacquisition.(FASBASCpara.323-10-35-33)1-201-20ReportingaChangetotheEquityMethod(RetroactiveAdjustment)GiantCompanyacquiresa10%ownershipinSmallCompanyonJanuary1,2012.GiantcompanydoesnothavetheabilitytoexertsignificantinfluenceoverSmall.Giantproperlyrecordstheinvestmentusingthefair-valuemethodasanavailable-for-salesecurity.OnJanuary1,2014,Giantpurchasesanother30%ofSmall’soutstandingstock,therebyachievingtheabilitytosignificantlyinfluenceSmall’sdecisions.1-211-21ReportingaChangetotheEquityMethod(RetroactiveAdjustment)1-22YearEquityinInvesteee(10%)eReportedfromDividendsRetrospectiveAdjustment2012$7,000$2,000$5,000201311,0004,0007,000TotalAdjustmenttoRetainedEarnings:$12,000Theerestatementfortheseearlieryearscanbecomputedasfollows:WouldhavereportedundertheequitymethodDidreportunderthefair-marketvaluemethod1-22JournalEntriestoReportChangetoEquityMethod DebitCreditInvestmentinSmallCompany.................12,000RetainedEarnings-PriorPeriodAdjustment-EquityinInvesteee.........................12,000 Toadjust2012and2013recordssothatinvestmentisaccountedforusingtheequitymethodinaconsistentmanner.UnrealizedHoldingGain-Shareholders’Equity.....13,000FairValueAdjustment(Available-for-Sale)...........13,000Toremovetheinvestor’spercentageoftheincreaseinfairvalue(10%*$130,000)fromstockholders’equityandtheavailable-for-saleportfoliovaluationaccount.1-23ReportingInvesteeefromSourcesotherthanOperationsWhenneteincludeselementsotherthanOperatinge,theseelementsshouldbepresentedseparatelyontheinvestor’sestatement.Examplesinclude:DiscontinuedoperationsExtraordinaryitemsOthercomprehensivee1-241-24ReportingInvesteeefromOtherSourcesLargeCompanyowns40%ofthevotingstockofTinyCompanyandaccountsforthisinvestmentusingtheequitymethod.In2012,Tinyreportsneteof$200,000,resultingfrom$250,000inefromcontinuingoperationsanda$50,000extraordinaryloss.LargeCompanyincreasesthevalueofitsinvestmentby$80,000,basedon40%ofthe$200,000netfigure.Large’sEquityMethodentryatyear-endis:1-25 DebitCreditInvestmentinTinyCompany...........80,000ExtraordinaryLossofInvestee...........20,000EquityinInvesteee.......................100,000Toaccrueoperatingeandextraordinarylossfromequityinvestment.1-25ReportingInvesteeLossesApermanent

declineintheinvestee’sfairmarketvalueisrecordedasanimpairmentlossandtheinvestmentaccountisreducedtothefairvalue.Atemporarydeclineisignored!!!1-26ReportingInvesteeLosses

(Continued…)InvestmentReducedtoZeroWhenaccumulatedlossesincurredanddividendspaidbytheinvesteereducetheinvestmentaccountto$-0-,NOADDITIONALLOSSESareaccrued(unlessafurthercommitmenthasbeenmade).Balanceremainsat$-0-,untilsubsequentprofitseliminateallUNREALIZEDlosses.Investordiscontinuesusingtheequitymethodratherthanrecordanegativebalance.1-271-27ExcessofCostOverBookValueofAcquiredInvestmentWhenCost>BookValueofaninvestmentacquired,thedifferencemustbeidentified.1-28Assetsmaybeundervaluedontheinvestee’sbooksbecause:Thefairvalues(FV)ofsomeassetsandliabilities aredifferentthantheirbookvalues(BV).Theinvestormaybewillingtopayextrabecause futurebenefitsareexpectedtoaccruefromthe investment.1-28WhenCost>BVofassetacquired,thedifferencemustbeidentifiedandaccountedforcorrectlyintheaccountingrecords.1-29Sourceofdifference:Assetsundervaluedontheinvestee’sbookGoodwillAccountingmethod:Amortizethedifference(FV–BV)overtheremainingusefullifeoftheassociatedasset.Goodwilliscarriedforwardwithoutadjustmentuntiltheinvestmentissoldorapermanentdeclineinvalueoftheinvestmentoccurs.ExcessofCostOverBookValue(Continued…)1-29ExcessofCostOverBookValue(Continued…)1-30ADDITIONALamountpaidinexcessofbookvaluenotallocatedtoundervaluedassetsisattributedtoanintangiblefuturevalueandrecordedasGOODWILLEquitymethodgoodwillaccountsarenotseparablefromtheinvestment,andarenotseparatelytestedforimpairment.1-30ExcessofCostOverBookValue(Continued…)1-31TallCompanypurchased20percentofShortCompanyonJanuary1,2013for$200,000,andtheequitymethodisapplied.Shortnetassetshaveabookvalueof$700,000.Abuilding(10-yearlife)isundervaluedby$80,000andequipment(5-yearlife)isundervaluedby$120,000.Goodwill,ifany,isconsideredtohaveanindefinitelife.During2013,Shortreportsaneteof$150,000andpaysacashdividendatyear’sendof$60,000.Allocationandamortizationofcostsarepresentedbelow:1-31ExcessofCostOverBookValue(Continued…)AmortizationofthedifferenceassociatedwiththeundervaluedassetsreducesboththeInvestmentaccountandtheEquityinInvesteeeaccount.1-32Theinvestoramortizesthecostoftheassetsovertheirremainingusefullives.Attheendoftheyear,theinvestorinShortCompanywillrecordthefollowingjournalentry:1-32ReportingSaleofEquityInvestmentTheequitymethodcontinuestobeapplieduptothedateofthetransaction.Atthetransactiondate,theInvestmentaccountbalanceisreducedbythepercentageofsharessold.Ifsignificantinfluenceislost,NORETROACTIVEADJUSTMENTisrecorded,buttheequitymethodisnolongerapplied.Ifpartofaninvestmentissoldduringtheperiod:1-33ReportingtheSaleofanEquityInvestment(Continued…)TopCompanyowns40%ofthe100,000outstandingsharesofBottomCo.,andaccountsforitusingtheequitymethod.The40,000shareswereacquiredfor$200,000,andundertheequitymethod,theassetbalanceincreasedto$320,000asofJanuary1,2012.BottomCompanyreportedeof$70,000duringthefirstsixmonthsof2012anddistributedcashdividendsof$30,000.1-341-34ReportingtheSaleofanEquityInvestment(Continued…)OnJuly1,2012,Topsells10,000oftheshares(1/4ofitsinvestment)for$110,000incash,reducingownershipinBottomfrom40%to30%.1-35

DebitCreditCash..........................110,000InvestmentinBottomCompany.........84,000GainonSaleofInvestment..............26,000Torecordthesaleof?oftheinvestment.

(1?4X$336,000=$84,000).1-35INVESTORINVESTEEINVESTORINVESTEEDownstreamSaleUpstreamSaleUnrealizedProfitsinInventorySometimesaffiliatedcompaniessellorbuyinventoryfromeachotherinintra-entitytransactionsthatnecessitatespecialaccountingprocedures.1-361-36UnrealizedProfitsinInventoryThesellerofthegoodsretainsapartialstakeintheinventoryforaslongasthebuyerholdsit.Theearningprocessisnotconsideredcompleteatthetimeoftheoriginalsale.Reportingtheprofitisdelayeduntiltheinventoryisconsumedwithinoperationsorresoldtoanunrelatedparty.Atthedispositionoftheinventory,theoriginalsaleisculminatedandgrossprofitisrecognized.1-371-37UnrealizedProfitsinInventory

ExampleAninvestorowns40%interestinaninvesteetowhichitsellsinventoryatacostof$50,000(adownstreamsale).Thepriceincludesagrossprofit(GP)of30%or$15,000.Investeesells$40,000oftheinventorytooutsideparties,butretains$10,000attheendoftheyear.Grossprofitonthe$10,000ofremaininginventorywillbeDEFERREDinthefinancialreportsuntilthegoodsaresoldtoanOUTSIDEPARTY.1-381-38UnrealizedProfitsinInventory

ExampleThepanyprofitof$1,200[(30%GPX$10,000inventory)]X40%ownership]isunearnedandrecordedasUNREALIZEDintra-entitygrossprofitfortheaccountingperiod.Thedeferraldecreasestheinvestor’scurrentequityeandtheinvestmentaccountby$1,200toreflecttheunearnedportionoftheintra-entityprofit.Whentheinventoryiseventuallysoldtounrelatedparties,theearningsprocessiscomplete.Theinvestorwillrecognizethe$1,200byreversingthedeferralentryandrecognizetheprofitintheappropriatetimeperiod.1-391-39Question3Whichstatementistrueconcerningunrealizedprofitsinintra-entityinventorytransferswhenaninvestorusestheequitymethod?A.Theinvestorandinvesteemakereciprocalentriestodeferandrealizeinventoryprofits.B.Thesameadjustmentsaremadeforupstreamanddownstreamtransfers.C.Differentadjustmentsaremadeforupstreamanddownstreamtransfers.D.Noadjustmentsarenecessary.E.Adjustmentswillbemadeonlywhenprofitsareknownuponsaletooutsiders.1-401-40CriticismsoftheEquityMethodOver-emphasisonpossessionof20-50%votingstockindecidingonsignificantinfluencevs.controlAllowingoff-balancesheetfinancingPotentialmanipulationofperformanceratios1-411-41FairValueReportingOptionIn2007,FASBintroducedafair-valueoptionAnentitymayirrevocablyelectfairvalueastheinitialandsubsequentmeasurementforcertainfinancialassetsandfinancialliabilitiesincludinginvestmentsaccountedforundertheequitymethod.Underthefair-valueoption,changesinthefairvalueoftheelectedfinancialitemsareincludedinearnings.1-42FairValueOptionInvestmentthatcanotherwisebeaccountedforundertheequitymethodInvestmentinnon-marketableequitysecuritiesAndAfter2007,undertheFair-valueOption,changesinthefairvalueoftheseassetsarereportedinearnings.1-43Question4OnJanuary4,2010,Trycker,Inc.acquired40%oftheoutstandingcommonstockofInkblotCo.for$2,400,000.ThisinvestmentgaveTryckertheabilitytoexercisesignificantinfluenceoverInkblot.Inkblot’sassetsonthatdatewererecordedat$8,000,000withliabilitiesof$2,000,000.Therewerenootherdifferencesbetweenbookandfairvalues.During2010,Inkblotreportedneteof$500,000andpaiddividendsof$300,000.ThefairvalueofInkblotatDecember31,2010is$7,000,000.TryckerelectsthefairvalueoptionforitsinvestmentinInkblot.1-44Question4(continued)HowaredividendsreceivedfromInkblotreflectedinTrycker’saccountingrecordsfor2010?A.ReduceInvestmentinInkblotby$280,000.B.IncreaseInvestmentinInkblotby$280,000.C.ReduceInvestmentinInkblotby$120,000.D.IncreaseInvestmentinInkblotby$120,000.E.IncreaseDividendeby$120,000.1-45SummaryAccountingmethodsusedforinvestmentsinothercompaniesdependonpercentageofownershipandlevelofinfluenceinvestorscanexerciseoverinvestees.Ifaninvestorpaysmorethanbookvalueoftheinvestee,theexcesspaymentisas