Chapter 1

The Equity Method of Accounting for Investments

Investments in equity securities

• Fair Value - applies when investors hold only a small percentage of a company's voting stock
• Classified as available-for-sale and trading securities
• Income recognition generally occurs only when dividends are declared (note: unrealized holding gains and losses on trading securities are recognized in income)

• Consolidation - applies when an investor has control over an investee (see later chapters)
• Usually means the investor owns more than 50% of the investee
• Financial statements are consolidate and reported as one entity.
• The investor may use a variety of internal methods for accounting for its investment



• Equity method - applies when investor has the ability to exercise significant influence over operating and financial activities of the investee, particularly the ability to influence payment of dividends
• Significant influence - usually means that investor owns between 20 and 50% of the investee
• Significant influence - also indicated by representation on BOD, participation in policy-making, etc.

• Investment account is adjusted by investor to reflect all changes in the equity of the investee company
• Income is accrued by investor as soon as it is earned by the investee.
• Dividends declared by the investee reduce the carrying amount of the investment



• Controversy - recognition of income under the equity method when investor may never realize that income (i.e. investee will probably retain all or part of it)

Reporting a change in the equity method

• When the investor gains the ability to significantly influence through a series of acquisitions. Emphasis is on creating comparable financial statements.



• Initial purchase - accounted for using the fair value method until ability to significantly influence is attained.



• Retroactive adjustment - converts all previously reported figures to the equity method based on the percentage of shares owned in those periods.



• When the investor loses the ability to significantly influence the investee -

• Includes items that are reported separately by the investee - extraodinary items, prior period adjustments, etc.



• Should be presented separately by investor, if material to investor

• Operational losses reported by the investee create corresponding losses for the investor.
• The investment account can only be reduced to a zero (0) carrying amount.
• After that, investor discontinues using the equity method (i.e. don't report any further investee losses) until subsequent investee profits eliminate unrealized losses



• Permanent losses in value (impairment) should be recognized immediately by the investor.
• Apply SFAS 121 to determine if impaired
• Impairment losses cannot be recovered for assets held for use. (Can be recovered for assets held for sale)

• Apply equity method until the date of disposal to establish proper book value.



• Continue to apply the equity method if investor still has the ability to significantly influence the investee.

• Occurs when the investor pays more for investment in equity securities than the underlying book value of the assets and liabilities being purchase



• Allocation of excess of purchase price over book value
• Allocate to differences in fair value of identifiable investee accounts (such as inventory and equipment) first.
• Remainder represents goodwill



• Amounts allocated to depreciable assets require an additional entry to reduce the investment account accordingly. Note: the investor records the depreciation entry.



• Amounts allocated to goodwill have historically been amortized over periods less than or equal to 40 years. As of 2002, however, the useful life of goodwill is considered indefinite, and no goodwill amortization expense is allowed. Instead, goodwill is subjected to annual impairment reviews.

• Gains derived from intercompany transactions are not considered completely earned until the transferred goods are either consumed or resold to unrelated parties.



• Downstream sales of inventory
• Transfers from investors to investee
• Intercompany gain from the sale is initially deferred and recognized only upon eventual disposal by the investee
• Amount of gain 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
• Transfers from the investee to the investor
• Deferral of unrealized gains is identical for upstream and downstream transfers.