THE EQUITY METHOD OF ACCOUNTING FOR INVESTMENTS

CHAPTER 1

THE EQUITY METHOD OF ACCOUNTING FOR INVESTMENTS

Chapter Outline

• Three methods are principally used to account for an investment in equity securities along

with a fair value option.

A.Fair value method: applied by an investor when only a small percentage of a

company’s voting stock is held.

1.Income is recognized when the investee declares a dividend.

2.Portfolios are reported at fair value. If fair values are unavailable, investment is reported at cost.B.Consolidation: when one firm controls another (e.g., when a parent has a majority interest in the voting stock of a subsidiary or control through variable interests, their financial statements are consolidated and reported for the combined entity.C.Equity method: applied when the investor has the ability to exercise significant influence over operating and financial policies of the investee.

1.Ability to significantly influence investee is indicated by several factors including representation on the board of directors, participation in policy-making, etc.

2.GAAP guidelines presume the equity method is applicable if 20 to 50 percent of the outstanding voting stock of the investee is held by the investor.Current financial reporting standards allow firms to elect to use fair value for any new investment in equity shares including those where the equity method would otherwise apply. However, the option, once taken, is irrevocable. Investee dividends and changes in fair value over time are recognized as income.On February 14, 2013, the FASB issued a Proposed Accounting Standards Update (ASU) entitled, Recognition and Measurement of Financial Assets and Financial Liabilities. The proposed ASU would eliminate the fair-value option for investments that qualify for equity method treatment. Fair-value accounting, however, would be extended to “equity method” investments that meet the criteria for classification as held for sale.

II.Accounting for an investment: the equity method

A.The investment account is adjusted by the investor to reflect all changes in the equity of the investee company.B.Income is accrued by the investor as soon as it is earned by the investee.C.Dividends declared by the investee create a reduction in the carrying amount of the Investment account. The text assumes all investee dividends are declared and paid in the same reporting period.Advanced Accounting 12e Joe Hoyle Thomas SchaeferTimothy Doupnik (Solutions Manual All Chapters, 100% Original Verified, A+ Grade) 1-1 .

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Chapter 01 - The Equity Method of Accounting for Investments

III.Special accounting procedures used in the application of the equity method A.Reporting a change to the equity method when the ability to significantly influence an investee is achieved through a series of acquisitions.

1.Initial purchase(s) will be accounted for by means of the fair value method (or at cost) until the ability to significantly influence is attained.

2.At the point in time that the equity method becomes applicable, a retrospective adjustment is made by the investor to convert all previously reported figures to the equity method based on percentage of shares owned in those periods.

3.This restatement establishes financial statement comparability across years.B.Investee income from other than continuing operations 1.The investor recognizes its share of investee reported other comprehensive income (OCI) through the investment account and the investor’s own OCI.

2.Income items such as extraordinary gains and losses and discontinued operations that are reported separately by the investee should be shown in the same manner by the investor. The materiality of these other investee income elements (as it affects the investor) continues to be a criterion for separate disclosure.C.Investee losses 1.Losses reported by the investee create corresponding losses for the investor.

2.A permanent decline in the fair value of an investee’s stock should be recognized immediately by the investor as an impairment loss.

3.Investee losses can possibly reduce the carrying value of the investment account to a zero balance. At that point, the equity method ceases to be applicable and the fair-value method is subsequently used.D.Reporting the sale of an equity investment 1.The investor applies the equity method until the disposal date to establish a proper book value.

2.Following the sale, the equity method continues to be appropriate if enough shares are still held to maintain the investor’s ability to significantly influence the investee.If that ability has been lost, the fair-value method is subsequently used.IV.Excess investment cost over book value acquired A.The price an investor pays for equity securities often differs significantly from the investee’s underlying book value primarily because the historical cost based accounting model does not keep track of changes in a firm’s fair value.B.Payments made in excess of underlying book value can sometimes be identified with specific investee accounts such as inventory or equipment.C.An extra acquisition price can also be assigned to anticipated benefits that are expected to be derived from the investment. In accounting, these amounts are presumed to reflect an intangible asset referred to as goodwill. Goodwill is calculated as any excess payment that is not attributable to specific assets and liabilities of the investee. Because goodwill is an indefinite-lived asset, it is not amortized.

• Deferral of unrealized gross profit in inventory

A.Profits derived from intra-entity transactions are not considered completely earned until the transferred goods are either consumed or resold to unrelated parties.1-2 .

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Chapter 01 - The Equity Method of Accounting for Investments

• Downstream sales of inventory
• “Downstream” refers to transfers made by the investor to the investee.
• Intra-entity gross profits from sales are initially deferred under the equity method

and then recognized as income at the time of the inventory’s eventual disposal.

• The amount of gross profit to be deferred is the investor’s ownership percentage

multiplied by the markup on the merchandise remaining at the end of the year.

• Upstream sales of inventory
• “Upstream” refers to transfers made by the investee to the investor.
• Under the equity method, the deferral process for unrealized profits is identical for

upstream and downstream transfers. The procedures are separately identified in Chapter One because the handling does vary within the consolidation process.

Answers to Discussion Questions

The textbook includes discussion questions to stimulate student thought and discussion. These questions are also designed to allow students to consider relevant issues that might otherwise be overlooked. Some of these questions may be addressed by the instructor in class to motivate student discussion. Students should be encouraged to begin by defining the issue(s) in each case. Next, authoritative accounting literature (FASB ASC) or other relevant literature can be consulted as a preliminary step in arriving at logical actions. Frequently, the FASB Accounting Standards Codification will provide the necessary support.

Unfortunately, in accounting, definitive resolutions to financial reporting questions are not always available. Students often seem to believe that all accounting issues have been resolved in the past so that accounting education is only a matter of learning to apply historically prescribed procedures. However, in actual practice, the only real answer is often the one that provides the fairest representation of the a firm’s transactions. If an authoritative solution is not available, students should be directed to list all of the issues involved and the consequences of possible alternative actions. The various factors presented can be weighed to produce a viable solution.

The discussion questions are designed to help students develop research and critical thinking skills in addressing issues that go beyond the purely mechanical elements of accounting.

Did the Cost Method Invite Manipulation?The cost method of accounting for investments often caused a lack of objectivity in reported income figures. With a large block of the investee’s voting shares, an investor could influence the amount and timing of the investee’s dividend declarations. Thus, when enjoying a good earnings year, an investor might influence the investee to withhold declaring a dividend until needed in a subsequent year. Alternatively, if the investor judged that its current year earnings “needed a boost,” it might influence the investee to declare a current year dividend. The equity method effectively removes managers’ ability to increase current income (or defer income to future periods) through their influence over the timing and amounts of investee dividend declarations.At first glance it may seem that the fair value method allows managers to manipulate income because investee dividends are recorded as income by the investor. However, dividends paid typically are accompanied by a decrease in fair value (also recognized in income), thus leaving reported net income unaffected..

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Chapter 01 - The Equity Method of Accounting for Investments

Does the Equity Method Really Apply Here?The discussion in the case between the two accountants is limited to the reason for the investment acquisition and the current percentage of ownership. Instead, they should be examining the actual interaction that currently exists between the two companies. Although the ability to exercise significant influence over operating and financial policies appears to be a rather vague criterion, ASC 323 "Investments—Equity Method and Joint Ventures," clearly specifies

actual events that indicate this level of authority (paragraph 323-10-15-6):

Ability to exercise that influence may be indicated in several ways, such as representation on the board of directors, participation in policy-making processes, material intra-entity transactions, interchange of managerial personnel, or technological dependency. Another important consideration is the extent of ownership by an investor in relation to the concentration of other shareholdings, but substantial or majority ownership of the voting stock of an investee company by another investor does not necessarily preclude the ability to exercise significant influence by the investor.

In this case, the accountants would be wise to determine whether Dennis Bostitch or any other member of the Highland Laboratories administration is participating in the management of Abraham, Inc. If any individual from Highland's organization is on Abraham’s board of directors or is participating in management decisions, the equity method would seem to be appropriate.Likewise, if significant transactions have occurred between the companies (such as loans by Highland to Abraham), the ability to apply significant influence becomes much more evident.

However, if James Abraham continues to operate Abraham, Inc., with little or no regard for Highland, the equity method should not be applied. This possibility seems especially likely in this case since one stockholder, James Abraham, continues to hold a majority (2/3) of the voting stock. Thus, evidence of the ability to apply significant influence must be present before the equity method is viewed as applicable. The mere holding of 1/3 of the stock is not conclusive.

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