Chapter One

The Equity Method of

Accounting for Investment
 Cont’d
• At present, generally accepted accounting principles
(GAAP) recognize three different approaches to the
financial reporting of investments in corporate equity
securities:
The fair-value method.
The consolidation of financial statements.
The 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
typically indicated by the relative size of ownership.
 Fair-Value Method
• 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 320, Investments
—Debt and Equity Securities.
Cont’d
• Dividends received are recognized as income
• Investments in equities of other companies are
classified either as Trading or Available-for-
Sale Securities
• Trading securities are held for the purpose of re-
sale in the short term. Unrealized holding gains
and losses are included in reported earnings.
• Available-for-sale securities are those not
classified as trading. Unrealized holding gains
and losses are reported in shareholders’equity as
other comprehensive income. (They are not
included in earnings.)
 Fair-Value Method-Applied
(FASB ASC Topic 320)
Step 1.Investor records investment in the investee
at cost.
Investment In Investee……xxxx
Cash(other Asset/ Stock)……….xxxx
Step 2. Investor recognize dividend income for
cash dividends received from investee.
Cash ……………..xxxx
Income from Investment…….xxxx
Cont’d
Step 3: Investor adjust Investment account to fair
market value(FMV) if readily determinable at
reporting date.
Journal entry if FMV >Cost:
Investment…………………………..xxxx
Unrealized Gain on Investment **…..xxxx
** Included in earnings on the income statement for
Trading Securities or in other Comprehensive
Income in Shareholders’ Equity for available for
sale (excluded from earnings)
 Consolidation of Financial
Statements
• Required when investor’s ownership exceeds
50% of investee
• In financial accounting, such control is recognized
whenever 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.
• 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
• Included entities controlled through special
contractual arrangement(not through voting
stock interest)
• Intended to combat misuse of SPE’S to keep
large amount of asset and liabilities off the
balance sheet known as “off balance sheet
financing”
• This is done by the company to:
Transfer risk
Transfer debt
 Equity Method
• Required when an investor has the ability to
“significantly influence "the investee.
• Generally used when ownership is between 20% to
50%. ™

• For example Recall Coca- Cola’s 32 percent investment in

Coca-Cola FEMSA’s voting stock. Through its ownership,
Coca-Cola can undoubtedly influence Coca-Cola FEMSA’s
decisions and operations.
• 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
inter- national.
Cont’d
• 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. IAS
• If an investor holds, directly or indirectly (e.g., through
subsidiaries), 20 per cent 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 per cent 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.
Cont’d
• 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
sig- nificant influence over the investee, the
investor
• Under the equity method, dividends received
from an investee are recorded as decreases
in the investment account, not as income.
Cont’d
• 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.
Cont’d
APPLICATION OF THE EQUITY METHOD

Criteria for Utilizing the Equity Method

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 policymaking 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
Cont’d
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.

In each of these situations, because the investor is unable to

exercise significant influence over its investee, the equity
method is not applied.
 Cont’d
• The following table indicates the method of
accounting that is typically applicable to
various stock investments:
Criterion Normal Ownership Applicable
level Accounting Method
Inability to significantly Less than 20% Fair value
influence
Ability to significantly 20%–50% Equity method
influence
Control through voting More than 50% Consolidated financial
interests statements
Control through variable Primary beneficiary Consolidated financial
interests (governance status (no ownership statements
documents, status (no required)
ownership statements
Accounting for an Investment—The
Equity Method
• After recording the cost of the acquisition, two equity
method entries periodically record the investment’s
impact:
1. The investor’s investment account increases as the
investee earns and reports income
 the investor recognizes investment income using the
accrual method
 If an investee reports income of $100,000, a 30 percent
owner should immediately increase its own income by
$30,000.
2.The investor’s investment account is decreased
whenever a dividend is collected.
 The reduction in the investee’s owners’ equity creates a
decrease in the investment.
Cont’d
Step 1: The investor records its investment in
the investee at cost.
Journal entry:
Debit –Investment in Investee
Credit –Cash (or other assets/stock)

Cost can be defined by cash paid or the fair value of stock or other assets
given up.
Cont’d
• Step 2: The investor recognizes its
proportionate (pro rata) share of the investee’s
net income (or net loss) for the period.
• Journal entry at end of period:
Debit –Investment in Investee
Credit –Equity in Investee Income

This will appear as a separate line-item on the investor’s

income statement.
Cont’d
• If net loss:
Equity in Investee Income……xxx
Investment in Investee…………….xxx
• Step 3: The investor reduces the investment
account by the amount of cash dividends
received from the investee.
• Journal entry when cash dividends received:
Debit –Cash
Credit –Investment in Investee
Cont’d
• Comparison of Fair-Value Method (ASC 32
0) and Equity Method (ASC 323)
Special Procedures for Special
Situations

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
 Reporting a Change to the equity
Method.
• Report a Change to the equity Method if:
An investment that was recorded using the fair value
method reaches the point where significant
influence is established.
All accounts are restated retroactively so the
investor’s financial statement appear as if the
equity method had been applied from the date of
first acquisition.(FASB ASC para.323 )
Reporting Investee income from sources other than
continuing operations
 When net income included elements other than
operating income, these elements should be
presented separately on the investor’s income
statement.
Example
• Extraordinary items
• Other comprehensive income
Credited not by Equity in investee income rather
equity interest in extraordinary gain/ loss.
 Reporting Investee Losses
• A permanent decline in the investee’s fair
market value is recorded as an impairment loss
and the investment account is reduced to fair
value.
• A temporary decline is ignored.
• Investment reduce zero
• When accumulative losses incurred and
dividends paid by the investee reduce the
investment account to 0, no additional loss are
accrued(unless a further commitment has
been made).
Cont’d
• Balance remain at 0 until subsequent profits
eliminate all Unrealized losses.
• Investor discontinues using the equity method
rather than record a negative balance.
Excess of Cost Over Book Value of Acquired
Investment
• When cost > Book Value of an investment
acquired, the difference must be identified.
• Asset may be undervalued on the investee’s book
because:
1.The fair values(FV) of some asset and liabilities
are different than their book values(BV).
2.The investor may be willing to pay extra because
future benefit are expected to accrue from the
investment.
• When Cost >BV of asset acquired, the difference must be identified
and accounted for correctly in the account record.

Source of difference : Accounting Method:

Amortize the difference
Assets undervalued
(FV- BV) over the remaining
on the investee’s useful life of the associated
book asset.

Accounting method
Source of Goodwill is carried forward
difference : without adjustment until the
Good will investment is sold or
permanent decline in value of
the investment occurs.
 Reporting sale of equity investment
• If part of an investment is sold during the
period:
The equity method continues to applied up
to the date of the transaction.
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, but the equity
method is no longer applied.
 Criticism of the Equity Method
1. Over emphasis on possession of 20-50%
voting stock on deciding significant influence
vs. control.
2. Allowing off-balance sheet financing
3. Potential manipulation performance ratio
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