1-1

Chapter One Learning Objective 1-1

Describe in general the various methods

of accounting for an investment in equity
The Equity shares of another company.
Method of
Accounting for
Investments

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The Reporting of Investments in

Fair-Value Method
Corporate Equity Securities
GAAP recognizes four methods to report Use when:
investments in other companies:
 Investor holds a small percentage of
 Fair-value method.
equity securities of investee.
 Cost method for equity securities without readily
determinable fair values.  Investor cannot significantly affect
 Consolidation of financial statements. investee’s operations.
 Equity method.  Investment is made in anticipation of
The method selected depends upon the degree of dividends or market appreciation.
influence the investor (stockholder) has over the
investee.
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 1-2

Fair-Value Method and

Recording Fair-Value Method
Impairment Assessment
Initial investments in equity securities when significant GAAP allows for two fair value assessments that may
influence and control are not present are: affect cost method amounts reported on the financial
 Recorded at cost. statements:
 Adjusted to fair value if fair value is determinable. 1. Periodic assessment for impairment to determine if
 If fair value not determinable, remains at cost.
the fair value of the investment is less than its
carrying amount.
 Changes in fair values are recognized as income.
2. Recognition of “observable price changes in orderly
 Dividends declared on the securities are recognized as
transactions for the identical or a similar investment
income.
of the same issuer” as unrealized holding gains (or
As of December 15, 2017, available-for-sale category losses).
with fair value changes recorded in other comprehensive
income will no longer be available.
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Consolidation of FASB ASC Section 810-10-05,

Financial Statements Variable Interest Entities
 Required when investor’s ownership exceeds 50  Includes entities controlled through special
percent of an organization’s outstanding voting contractual arrangements (not through voting
stock. stock interests).
 When a majority of voting stock is held, investor-  Intended to combat misuse of SPE’s (special
investee relationship is so closely connected that purpose entities) to keep large amounts of assets
the two corporations are viewed as a single entity. and liabilities off the balance sheet known as “off-
 One set of financial statements prepared to balance-sheet financing.”
consolidate all accounts of the parent company
and all of its controlled subsidiaries as a single
entity.

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 1-3

International Accounting Standard

Equity Method
28—Investments in Associates
Use when:  The International Accounting Standards Board defines
significant influence as the power to participate in the
 Investor has the ability to exercise significant
financial and operating policy decisions of the investee,
influence on investee operations (whether applied or
but it is not control or joint control over those policies.
not).
 If investor has 20 percent or more ownership, it is
 Ownership is between 20 percent and 50 percent. presumed to have significant influence, unless it is
Significant influence might be present with much lower demonstrated not to be the case.
ownership percentages.  If investor holds less than 20 percent ownership, it is
Under the equity method, investor’s share of investee presumed it does not have significant influence, unless
dividends declared are recorded as decreases in the influence can be clearly demonstrated.
investment account, not income.

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Criteria for Utilizing

Learning Objective 1-2
the Equity Method
Identify the sole criterion for applying Significant Influence (FASB ASC Topic 323):
the equity method of accounting and  Representation on the investee’s board of directors.
 Participation in the investee’s policy-making process.
know the guidelines to assess whether the
 Material intra-entity transactions.
criterion is met.
 Interchange of managerial personnel.
 Technological dependency.
 Other investee ownership percentages.

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 1-4

Limitations of Equity Method Extensions of Equity Method

Applicability Applicability
Regardless of investor’s degree of ownership, the equity  For some investments that fall short of or exceed
method is not appropriate if investments demonstrate: 20 to 50 percent ownership, the equity method is
 An agreement exists between investor and investee by appropriately used for financial reporting.
which the investor surrenders significant rights as a  Conditions can exist where the equity method is
shareholder. appropriate despite a majority ownership interest.
 A concentration of ownership operates the investee  If the noncontrolling rights are so restrictive as to
without regard for the views of the investor. call into question whether control rests with the
 The investor attempts but fails to obtain majority owner, the equity method is employed for
representation on the investee’s board of directors. financial reporting rather than consolidation.
If an entity can exercise control over investee, regardless
of ownership level, consolidation is required.
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Accounting for Increases in an

Summary of Accounting Methods
Investment—The Equity Method
Accounting Methods Applicable in Various Stock Ownership  The investor increases the investment account as
Levels 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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 1-5

Accounting for Decreases in an

Equity Method Example
Investment—The Equity Method
 The investor decreases its investment account’s Big Company owns a 20 percent interest in Little
carrying value for its share of investee cash Company purchased on January 1, 2017, for $200,000.
dividends. When the investee declares a cash Little reports net income of $250,000, $300,000, and
dividend, its owners’ equity decreases. $400,000, respectively, in the next three years while
declaring dividends of $50,000, $100,000, and $200,000.
 The investor shall recognize its share of the
earnings or losses of an investee in the periods for The fair values of Big’s investment in Little, as
which they are reported by the investee in its determined by market prices, were $245,000, $282,000,
and $325,000 at the end of 2017, 2018, and 2019,
financial statements.
respectively.

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Fair-Value vs. Equity Method Learning Objective 1-3

EXHIBIT 1.1 Comparison of Fair-Value Method (ASC 321) and Equity Method (ASC 323)
Prepare basic equity method journal
entries for an investor and describe the
financial reporting for equity method
investments.

*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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 1-6

Equity Method Example—Journal Learning Objective 1-4

Entries
Big Company records the following journal entries to
apply the equity method for its investment in Little Company for 2017: 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.

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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Excess of Investment Cost over Book Excess of Investment Cost over Book
Value Acquired Value Acquired (continued)
Differences may exist between a company’s book  Asset and liability accounts on the balance sheet
value and fair value because: tend to measure historical costs rather than
 Fair value is based on multiple factors, including current value.
but not limited to profitability, new products,  Reported figures are affected by the accounting
expected dividend payments, projected operating methods selected and lead to different book
results, and general economic conditions. values; for example:
 Stock prices are based, partially, on the perceived  Inventory costing methods (LIFO and FIFO).
worth of a company’s net assets, amounts that  Acceptable depreciation methods (straight-line,
often vary from underlying book values. units of production).

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 1-7

Excess of Investment Cost over Book Excess of Investment Cost over Book
Value Acquired (concluded) Value Acquired Example
 When purchase price exceeds book value of an Grande Company is negotiating the acquisition of 30 percent
investment acquired, the difference must be identified. of the outstanding shares of Chico Company. Chico’s balance
 Assets may be undervalued on the investee’s books sheet reports assets of $500,000 and liabilities of $300,000 for a
because: net book value of $200,000.
 The fair values (FV) of some assets and liabilities are Grande determines that Chico’s equipment is undervalued in
different from their book values (BV). the company’s financial records by $60,000. One of its patents
 The investor may be willing to pay extra because is also undervalued, but only by $40,000.
future benefits are expected to accrue from the Adding these valuation adjustments to Chico’s book value
investment. indicates that the company’s net assets are estimated to be
 Extra payment that cannot be attributed to a specific valued at $300,000. Therefore, Grande offers $90,000 for a 30
asset or liability is assigned to the intangible asset percent share of the investee’s outstanding stock.
goodwill.
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Excess of Investment Cost over Book

The Amortization Process
Value Acquired—Valuations
Grande’s purchase price is in excess of the proportionate Payment relating to each asset (except land, goodwill, and other
share of Chico’s book value, which can be attributed to two indefinite life intangibles) should be amortized over an
specific accounts: Equipment and Patents. appropriate time period.
No part of the extra payment is traceable to any other
projected future benefit. The cost of Grande’s investment is
allocated as follows:

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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 1-8

The Amortization Process— Equity Method—Additional Issues

Journal Entries
To record the annual expense, Grande reduces the Special procedures are required in accounting for
investment balance in the same way it would amortize the each of the following:
cost of any other asset that had a limited life. At the end  Reporting a change to the equity method.
of the first year of holding the investment, the investor
records the following journal entry under the equity  Reporting investee income from sources other
method. than continuing operations.
 Reporting investee losses.
 Reporting the sale of an equity investment.

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Reporting a Change to the Equity

Learning Objective 1-5a
Method
Understand the financial reporting Report a change to the equity method if:
 An investment that was recorded using the cost or
consequences for a change to the equity fair-value method reaches the point where significant
method. 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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 1-9

Reporting a Change to the Reporting a Change to the Equity

Equity Method Example Method without Significant Influence
 Alpha Company acquires a 10 percent ownership  Alpha Company recognizes the increase in its 10
in Bailey Company on January 1, 2017, for percent ownership in Bailey Company at the end
$84,000. of 2017 and increases its investment account to
 Alpha company does not have the ability to exert $89,000.
significant influence over Bailey.  Because the fair-value method is used to account
 Alpha properly records the investment using the for the investment, Bailey’s $670,000 book value
fair-value method and recognizes in net income its balance at January 1, 2017, does not affect Alpha’s
10 percent ownership share of changes in Bailey’s accounting.
fair value.  On January 1, 2018, Alpha purchases an
additional 30 percent of Bailey’s outstanding
voting stock for $267,000.
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Reporting a Change to the Equity Recording a Change to the Equity

Method with Significant Influence Method
 On January 1, 2018, Alpha achieves the ability to Alpha prepares the following journal entry on January 1,
exercise significant influence over Bailey, and will 2018, to bring about prospective change to the equity method:
now apply the equity method to account for its
investment in Bailey.
 On January 1, 2018, Bailey’s carrying amounts for
Investment Allocation Schedule
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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 1-10

Recording a Change to the Equity Learning Objective 1-5b

Method (continued)
Bailey reports net income of $130,000 and declares and pays a Understand the financial reporting
$50,000 dividend at the end of 2018. Alpha records the
following journal entries: consequences for investee’s other
comprehensive income.

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Other Comprehensive Income (OCI) Learning Objective 1-5c

 OCI is defined as revenues, expenses, gains, and losses that
under GAAP are included in comprehensive income but
Understand the financial reporting
excluded from net income. consequences for investee losses.
 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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 1-11

Reporting Investee Losses Investment Reduced to Zero

 Declines in investment value can result due to a loss of  When accumulated losses incurred and dividends
major customers, changes in economic conditions, loss paid by the investee reduce the investment
of a significant patent or other legal right, damage to the account to $-0-, no further loss can be accrued. A
company’s reputation, etc. A temporary drop in the fair
temporary decline is ignored!
value of an investment is simply ignored.
 FASB ASC (para. 323-10-35-32) requires that a loss in
 Once the original cost of the investment has been
value of an investment which is other than a temporary eliminated, no additional losses can accrue to the
decline shall be recognized. investor.
 A permanent decline in the investee’s fair market value  Future equity income will be offset by these losses
is recorded as an impairment loss and the investment prior to recording equity income in our results.
account is reduced to the fair value.

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Reporting the Sale of an Equity

Learning Objective 1-5d
Investment
Understand the financial reporting If part of an investment is sold during the period:
 The equity method is applied up to the transaction date.
consequences for sales of equity method
 At the transaction date, the Investment account balance
investments. 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 mandates a
restatement of prior periods, unlike when the investor’s
change is to the fair-value method.

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 1-12

Learning Objective 1-6 Deferral of Intra-Entity Gross Profits

in Inventory
Describe the rationale and computations Many equity acquisitions establish ties between companies
to facilitate the direct purchase and sale of inventory items.
to defer gross profits on intra-entity Such intra-entity transactions can occur either on a regular
inventory sales until the goods are either basis or sporadically.
consumed or sold to outside parties. EXHIBIT 1.2 Downstream and Upstream Sales

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Downstream Sales of Inventory— Downstream Sales of Inventory—Investor

Investor Sales to Investee Sales to Investee Journal Entries
 Profit recognition is delayed until buyer disposes of the If gross profit on an original intra-entity sale is 30 percent of $10,000 in
goods. 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.
 Investor decreases current equity income to reflect the
Current equity income decreases by $1,200 to defer the intra-entity profit
deferred portion of the intra-entity profit.
and temporarily remove 30 percent of the profit from the investor’s books
 When this inventory is eventually consumed or sold to in 2018 until the investee disposes of the inventory in 2019.
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. Reverse the preceding deferral entry to move the profit into the year of
 An alternative treatment would be the direct reduction of the sale to outside customers.
investor’s inventory balance as a means of accounting for this
deferred amount.

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 1-13

Upstream Sales of Inventory— Upstream Sales of Inventory—Investee

Investee Sales to Investor Sales to Investor Journal Entries
 Upstream sales of inventory are reported in the same 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.
manner as downstream sales.
The investee reports net income of $120,000 for the year. The investor
 Profit recognition is delayed until buyer disposes of the records a journal entry to reflect the basic accrual of the investee’s
goods. earnings.

 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 A second entry is required of the investor at year-end. Income accrual is
by decreasing the investment account rather than the reduced, and the investor defers its portion of the intra-entity gross profit.
inventory balance.
 When this inventory is eventually consumed or sold to
unrelated parties, the deferral is reversed.
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Financial Reporting Effects Criticisms of the Equity Method

Measurements of financial performance often affect  Emphasizing the 20–50 percent of voting
the following: stock in determining significant influence
 The firm’s ability to raise capital. versus control.
 Managerial compensation.  Allowing off-balance-sheet financing.
 The ability to meet debt covenants and future
 Potentially biasing performance ratios.
interest rates.
 Managers’ reputations.

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 1-14

Learning Objective 1-7 Fair-Value Reporting Option

Explain the rationale and reporting  An entity may irrevocably elect fair value as the
initial and subsequent measurement for certain
implications of fair-value accounting for financial assets and financial liabilities, including
investments otherwise accounted for by investments accounted for under the equity
the equity method. method.
 Under the fair-value option, changes in the fair
value of the elected financial items are included in
earnings.

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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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