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Chapter 2
Reporting Intercorporate
Investments and Consolidation of
Wholly Owned Subsidiaries with No
Differential

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Accounting for Investments in Common
Stock
• Some companies invest in other companies simply to earn a favorable
return by taking advantage of the future earnings potential of their
investees
• Other reasons for acquiring interests in other entities include
• (1) gaining voting control,
• (2) entering new product markets by purchasing companies already
established in those areas,
• (3) ensuring a supply of raw materials or other production inputs,
• (4) ensuring a customer for production output,
• (5) gaining economies associated with greater size,
• (6) diversifying operations,
• (7) obtaining new technology,
• (8) lessening competition, and
• (9) limiting risk.
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Accounting for Investments in Common
Stock
• The method used to account for investments
in common stock depends:
– On the level of influence or control that the
investor is able to exercise over the investee
– On choices made by the investor because of
options available

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Financial Reporting Basis by Level of
Common Stock Ownership

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Accounting for Investments in Common
Stock
• Consolidation involves combining for financial
reporting the individual assets, liabilities,
revenues, and expenses of two or more related
companies as if they were part of a single
company
– Consolidation normally is appropriate when one
company, referred to as the parent, controls another
company, referred to as a subsidiary
– A subsidiary that is not consolidated with the parent is
referred to as an unconsolidated subsidiary and is
shown as an investment on the parent’s balance
sheet
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Accounting for Investments in Common
Stock
• The equity method is used when the investor
exercises significant influence over the operating
and financial policies of the investee and
consolidation is not appropriate
– May not be used in place of consolidation if
consolidation is appropriate
– Its primary use is in reporting nonsubsidiary
investments
• The cost method is used for reporting
investments in equity securities when both
consolidation and equity-method reporting are
inappropriate
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 The Cost Method

• Used when the investor lacks the ability

either to control or to exercise significant
influence over the investee
• Accounting Procedures
– The cost method is consistent with the
treatment normally accorded noncurrent assets

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 The Cost Method

– At the time of purchase, the investor records its

investment in common stock at the total cost
incurred in making the purchase
– The investment continues to be carried at its
original cost until the time of sale
– Income from the investment is recognized as
dividends are declared by the investee
– Recognition of investment income before a
dividend declaration is inappropriate

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 The Cost Method - Illustration

ABC Company acquires 20 percent of XYZ Company’s common stock for

$100,000 at the beginning of the year but does not gain significant influence
over XYZ. During the year, XYZ has net income of $60,000 and pays
dividends of $20,000. ABC Company records the following entries:

Investment in XYZ Company Stock 100,000

Cash 100,000
Record purchase of XYZ Company stock.

Cash 4,000
Dividend Income 4,000
Record dividend income from XYZ Company:
$20,000 x .20

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 The Cost Method

• Changes in the number of shares held

– Changes resulting from stock dividends, stock splits,
or reverse splits receive no formal recognition in the
accounts of the investor
• Purchases of additional shares
– Recorded at cost similar to initial purchase
– New percentage ownership is calculated to determine
whether switch to the equity method is required
• Sales of Shares
– Accounted for in the same manner as the sale of any
other noncurrent asset
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 The Equity Method

• The equity method is intended to reflect the

investor’s changing equity or interest in the
investee
• The investment is recorded at the initial
purchase price and adjusted each period for
the investor’s share of the investee’s profits
or losses and the dividends declared by the
investee

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 The Equity Method

• ASC 323-10-30 requires that the equity method

be used for:
1. Corporate joint ventures
2. Companies in which the investor’s voting stock
interest gives the investor the “ability to exercise
significant influence over operating and financial
policies” of that company
• “Significant influence” criterion - 20 percent rule
– In the absence of evidence to the contrary, an
investor holding 20 percent or more of an investee’s
voting stock is presumed to have the ability to
exercise significant influence over the investee
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 The Equity Method

• Investor’s equity in the investee

– The investor records its investment at the
original cost
– This amount is adjusted periodically:
Reported by Investee Effect on Investor’s Accounts
Net income Record income from investment
Increase investment account
Net loss Record loss from investment
Decrease investment account
Dividend declaration Record asset (cash or receivable)
Decrease investment account

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 The Equity Method - Illustration

ABC Company acquires significant influence over XYZ

Company by purchasing 20 percent of the common
stock of the XYZ Company for $100,000, XYZ earns
income of $60,000 and pays dividends of $20,000.
• Recognition of income
Investment in XYZ Company Stock 12,000
Income from Investee 12,000
Record income from investment in XYZ Company:
$60,000 x .20
– This entry (equity accrual) is normally is made as an
adjusting entry at the end of the period
– If the investee reports a loss, the investor recognizes its
share of the loss and reduces the carrying amount of the
investment by that amount
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 The Equity Method - Illustration

• Recognition of dividends
Cash 4000
Investment in XYZ Company Stock 4000
Record receipt of dividend from XYZ: $20,000 x .20

• Carrying amount of the investment

Investment in XYZ Common Stock

Original cost 100,000
Equity accrual Dividends
($60,000 x .20) 12,000 ($20,000 x .20) 4,000
Ending balance 108,000
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 The Equity Method

• Purchases of additional shares

– If the equity method was being used to account
for shares already held, the acquisition involves
adding the cost of the new shares to the
investment account and applying the equity
method from the date of acquisition forward
– New and old investments in the same stock are
combined for financial reporting purposes

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 The Equity Method

• Sale of shares
– Treated the same as the sale of any noncurrent asset
– First, the investment account is adjusted to the date
of sale for the investor’s share of the investee’s
current earnings
– Then, a gain or loss is recognized for the difference
between the proceeds received and the carrying
amount of the shares sold
– If only part of the investment is sold, the investor must
decide whether to continue using the equity method
or to change to the cost method

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The Cost and Equity Methods
Compared

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 The Fair Value Option
• ASC 825-10-45 permits but does not require
companies to make fair value measurements
– Option available only for investments that are not
required to be consolidated
– Rather than using the cost or equity method to report
nonsubsidiary investments in common stock,
investors may report those investments at fair value
– The investor remeasures the investment to its fair
value at the end of each period
– The change in value is then recognized in income for
the period
– Normally the investor recognizes dividend income in
the same manner as under the cost method
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 The Fair Value Option - Illustrated
Ajax Corporation purchases 40 percent of Barclay Company’s common stock
on January 1, 20X1, for $200,000. Barclay has net assets on that date with a
book value of $400,000 and fair value of $465,000. On March 1, 20X1, Ajax
receives a cash dividend of $1,500 from Barclay. On March 31, 20X1, Ajax
determines the fair value of its investment in Barclay to be $207,000. During
the first quarter of 20X1, Ajax records the following entries:

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Ex 2-4

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Ex 2-4

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Ex 2-9

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Ex 2-9

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 Consolidation Procedures

• The starting point for preparing consolidated

financial statements is the books of the
separate consolidating companies
– The consolidated entity has no books
– Amounts in the consolidated financial
statements originate on the books of the parent
or a subsidiary or in the consolidation
workpaper

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 Consolidation Workpapers
• The consolidation workpaper is a mechanism for:
– Combining the accounts of the separate companies
involved in the consolidation
– Adjusting the combined balances to the amounts that
would be reported if all consolidating companies were
actually a single company
• When consolidated statements are prepared, the
account balances are taken from the separate
books of the parent and each subsidiary and placed
in the consolidation workpaper
• The consolidated statements are prepared, after
adjustments and eliminations, from the amounts in
the workpaper
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 Consolidation Workpapers

• Eliminating entries
– Used to adjust the totals of the individual account
balances of the separate consolidating companies to
reflect the amounts that would appear if all the legally
separate companies were actually a single company
– Appear only in the consolidating workpapers and do not
affect the books of the separate companies
– Used to increase or decrease the combined totals for
individual accounts so that only transactions with
external parties are reflected in the consolidated
amounts
– They do not carry over from period to period

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 Consolidated Balance Sheet with
Wholly Owned Subsidiary - Illustration
Balance Sheets of Peerless Products and Special Foods,
January 1, 20X1, Immediately before Combination
Peerless Special
Products Foods
Assets
Cash $350,000 $50,000
Accounts Receivable 75,000 50,000
Inventory 100,000 60,000
Land 175,000 40,000
Buildings and Equipment 800,000 600,000
Accumulated Depreciation (400,000) (300,000)
Total Assets $1,100,000 $500,000
Liabilities and Stockholders’ Equity
Accounts Payable $100,000 $100,000
Bonds Payable 200,000 100,000
Common Stock 500,000 200,000
Retained Earnings 300,000 100,000
Back
Total Liabilities and Equity $1,100,000 $500,000
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 100 percent ownership acquired at
book value
• Peerless acquires all of Special Foods’ common
stock for $300,000, an amount equal to the fair
value of Special Foods as a whole
– On the date of combination, the fair values of Special
Foods’ individual assets and liabilities are equal to
their book values
– Peerless records the stock acquisition on its books:

January 1, 20X1
Investment in Special Foods Stock 300,000
Cash 300,000
Record purchase of Special Foods stock.

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100 percent ownership acquired at
book value
Balance Sheets of Peerless Products and Special Foods,
January 1, 20X1, Immediately after Combination
Peerless Special
Products Foods
Assets
Cash $50,000 $50,000
Accounts Receivable 75,000 50,000
Inventory 100,000 60,000
Land 175,000 40,000
Buildings and Equipment 800,000 600,000
Accumulated Depreciation (400,000) (300,000)
Investment in Special Foods Stock 300,000
Total Assets $1,100,000 $500,000
Liabilities and Stockholders’ Equity
Accounts Payable $100,000 $100,000
Bonds Payable 200,000 100,000
Common Stock 500,000 200,000
Retained Earnings 300,000 100,000
Total Liabilities and Equity $1,100,000 $500,000
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 Workpaper for Consolidated Balance Sheet,
January 1, 20X1, Date of Combination;
100 Percent Acquisition at Book Value

Investment elimination entry

E(2) Common Stock—Special Foods 200,000
Retained Earnings 100,000
Investment in Special Foods Stock 300,000
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 100 percent ownership acquired at
book value
• The consolidated balance sheet is prepared directly
from the last column of the consolidation workpaper

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 Consolidation Subsequent to
Acquisition
• The approach followed to prepare a complete set of
consolidated financial statements subsequent to a
business combination is quite similar to that used to
prepare a consolidated balance sheet as of the date
of combination
– However, in addition to the assets and liabilities, the
revenues and expenses of the consolidating companies
must be combined
– Eliminations must be made in the consolidation
workpaper so that the consolidated statements appear
as if they are the financial statements of a single
company
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 Consolidation Subsequent to
Acquisition
• Consolidated Net Income
– In the absence of transactions among the
consolidating companies, consolidated net
income is equal to the parent’s income from its
own operations, excluding any investment
income from consolidated subsidiaries, plus the
net income from each of the consolidated
subsidiaries, adjusted for any differential write-
off
– Includes 100 percent of the revenues and
expenses regardless of the parent’s percentage
ownership
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 Consolidation Subsequent to
Acquisition
• Consolidated retained earnings
– That portion of the consolidated enterprise’s
undistributed earnings accruing to the parent
company shareholders
– Consolidated retained earnings at the end of
the period is equal to the beginning
consolidated retained earnings balance plus
consolidated net income attributable to the
controlling interest, less dividends declared by
the parent company

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Format for Comprehensive Three-Part Consolidation Workpaper

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 Consolidated Financial Statements—100
Percent Ownership Acquired at Book Value

Assume that on January 1, 20X1, Peerless Products Corporation acquires

all of the common stock of Special Foods Inc. for $300,000, an amount
equal to the book value of Special Foods on that date. At that time, Special
Foods has $200,000 of common stock outstanding and retained earnings of
$100,000. Following information is available:

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Consolidated Financial Statements—100 Percent
Ownership Acquired at Book Value

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December 31, 20X1, Equity-Method Workpaper for
Consolidated Financial Statements, Initial Year
of Ownership; 100 Percent Acquisition at Book Value

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Consolidated Financial Statements—100 Percent
Ownership Acquired at Book Value

Second and subsequent years of ownership Peerless’s separate

income from its own operations for 20X2 is $160,000, and its dividends
total $60,000. Special Foods reports net income of $75,000 in 20X2 and
pays dividends of $40,000. Entries:
Cash 40,000
Investment in Special Foods Stock 40,000
Record dividends from Special Foods: $40,000 x 1.00
Investment in Special Foods Stock 75,000
Income from Subsidiary 75,000
Record equity-method income: $75,000 x 1.00
Eliminating Entries
E(22) Income from Subsidiary 75,000
Dividends Declared 40,000
Investment in Special Foods Stock 35,000
Eliminate income from subsidiary.

E(23) Common Stock—Special Foods 200,000

Retained Earnings, January 1 120,000
Investment in Special Foods Stock 320,000
Eliminate beginning investment balance.
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Consolidated Financial Statements—100 Percent
Ownership Acquired at Book Value

• Consolidated net income and retained

earnings

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 Intercompany Receivables and
Payables
• All forms of intercompany receivables and
payables need to be eliminated when
consolidated financial statements are
prepared
• If no eliminating entry is made, both the
consolidated assets and liabilities are
overstated by an equal amount

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