Chapter 1: the Equity Method of Accounting for Investments

Chapter 1: The Equity Method of Accounting for Investments

I.Equity investments defined:

ownership of voting shares of other companies.

II.Financial statement reporting:

A.Income statement:

B.Statement of retained earnings:

C.Balance sheet:

III.Effects of influence on the financial reporting of investments:

A.Insignificant influence:

1.Equity investments are originally recorded

2.Equity investments are classified in two categories:

A.)Trading securities:

equity securities held for the purpose of selling them in the short term.

Balance sheet reporting is at fair value.

Income statement reporting includes dividends received and any unrealized holding gains and losses.

B.)Securities available-for-sale:

equity securities that are not classified as trading securities.

These securities may be sold in response to changing market conditions or anticipation of such changes.

Balance sheet reporting is at fair value.

Income statement reporting includes dividends received but does not include any unrealized holding gains and losses.

Unrealized holding gains and losses are reported in comprehensive income and included in stockholders' equity as accumulated other comprehensive income.

C.)Illustration of accounting for securities available-for-sale:

On February 1, 2006 the Lowell Corporation purchased 200 shares of Maine Corporation common stock at $15 per share and 500 shares of Vermont Corporation common stock at $20 per share. On February 1, 2006 there were 5,000,000 shares of Maine Corporation common stock outstanding and 2,000,000 shares of Vermont Corporation common stock outstanding. On July 10, 2006 Maine Corporation distributed a cash dividend of $.20 per share. On August 12, 2006 Vermont Corporation distributed a cash dividend of $.15 per share. On December 31, 2006 the Lowell Corporation still held all the shares it purchased in 2006. On December 31, 2006 the market price per share of Maine Corporation common stock was $17 and Vermont Corporation common stock was $23.

February 1, 2006: equity securities purchased

Equity Security / # of Shares / Cost per Share / Total Cost
Total Cost
Equity Security / # of Shares / Cost per Share / Total Cost
Maine Corp. / 200 / $15 / $3,000
Total Cost
Equity Security / # of Shares / Cost per Share / Total Cost
Maine Corp. / 200 / $15 / $3,000
Vermont Corp. / 500 / $20 / $10,000
Total Cost / $13,000

The Lowell Corporation would be affected by the purchase as follows.

Total
Resources / = / Sources of
Borrowed
Resources / + / Sources of
Owner
Invested
Resources / + / Sources of Management
Generated
Resources
Assets / = / Liabilities / + / Stockholders’ Equity
Total
Resources / = / Sources of
Borrowed
Resources / + / Sources of
Owner
Invested
Resources / + / Sources of Management
Generated
Resources
Assets / = / Liabilities / + / Stockholders’ Equity
+ $13,000
Investment in SAFS
- $13,000
Cash

The Lowell Corporation would record the purchase of equity securities through the following journal entry.

Posting
Date / Item / Ref. / Debits / Credits
Feb. 1
Investment in Maine and Vermont
Posting
Date / Item / Ref. / Debits / Credits
Feb. 1 / Investment in Securities Available-for-Sale / 13,000
Cash / 13,000
Investment in Maine and Vermont

July 10, 2006: Maine Corp. cash dividend received. 200 shares x $.20 per share = $40. The Lowell Corporation would be affected by the dividend as follows.

The Lowell Corporation would record the dividend through the following journal entry.

Posting
Date / Item / Ref. / Debits / Credits
July 10
Maine Corp. cash dividend
Posting
Date / Item / Ref. / Debits / Credits
July 10 / Cash / 40
Dividend Income / 40
Maine Corp. cash dividend

August 12, 2006: Vermont Corp. cash dividend received. 500 shares x $.15 per share = $75. The Lowell Corporation would be affected by the dividend as follows.

The Lowell Corporation would record the dividend through the following journal entry.

Posting
Date / Item / Ref. / Debits / Credits
Aug. 12
Vermont Corp. cash dividend
Posting
Date / Item / Ref. / Debits / Credits
Aug. 12 / Cash / 75
Dividend Income / 75
Vermont Corp. cash dividend

December 31, 2006: investment in equity securities adjusted to fair value.

Equity Security / Cost / Fair Value
Maine Corp.: 200 shares / $3,000
Vermont Corp.: 500 shares / $10,000
Totals / $13,000
Equity Security / Cost / Fair Value
Maine Corp.: 200 shares / $3,000 / $3,400
Vermont Corp.: 500 shares / $10,000 / $11,500
Totals / $13,000 / $14,900

The Lowell Corporation would be affected by the fair value adjustment as follows.

The Lowell Corporation would record the fair value adjustment through the following journal entry.

Posting
Date / Item / Ref. / Debits / Credits
Dec. 31
Fair value adjustment of SAFS
Posting
Date / Item / Ref. / Debits / Credits
Dec. 31 / Fair Value Adjustment, SAFS / 1,900
Unrealized Inc./Dec. in Value of SAFS / 1,900
Fair value adjustment of SAFS

Note: The Unrealized holding gains and losses are reported in comprehensive income (not on the income statement) and included in stockholders' equity as accumulated other comprehensive income.

B.Significant influence: 20% to 50% owned.

1.Equity investments are originally recorded

2.The investment account increases

3.The investment account decreases by

4.Illustration of the equity method of accounting for investments in equity securities:

On January 2, 2006 the Lowell Corporation purchased 40,000 shares of New Hampshire Corporation common stock at $10 per share. On January 2, 2006 there were 100,000 shares of New Hampshire Corporation common stock outstanding. On September 30, 2006 the New Hampshire Corporation paid cash dividends of $.25 per share. For the year ended December 31, 2006 the New Hampshire Corporation reported net income of $80,000.

January 2, 2006: equity security purchased. 40,000 shares x $10 per share = $400,000. The Lowell Corporation would be affected by the purchase as follows.

The Lowell Corporation would record the purchase of equity securities through the following journal entry.

Posting
Date / Item / Ref. / Debits / Credits
Jan. 2
Investment in New Hampshire Corp.
Posting
Date / Item / Ref. / Debits / Credits
Jan. 2 / Investment in New Hampshire Corp. / 400,000
Cash / 400,000
Investment in New Hampshire Corp.

September 30, 2006: New Hampshire Corp. cash dividend received. 40,000 shares x $.25 per share = $10,000. The Lowell Corporation would be affected by the dividend as follows.

The Lowell Corporation would record the dividend through the following journal entry.

Posting
Date / Item / Ref. / Debits / Credits
Sept. 30
New Hampshire Corp. cash dividend
Posting
Date / Item / Ref. / Debits / Credits
Sept. 30 / Cash / 10,000
Investment in New Hampshire Corp. / 10,000
New Hampshire Corp. cash dividend

December 31, 2006: New Hampshire Corp. income recognized. The Lowell Corporation's ownership percentage in the New Hampshire Corporation is 40% (40,000 shares owned by Lowell Corporation / 100,000 total shares of New Hampshire Corporation common stock = .40). $80,000 New Hampshire Corporation 2006 income x .40 = $32,000, which is the Lowell Corporation's share of the New Hampshire Corporation's income. The Lowell Corporation would be affected by its share of the New Hampshire Corporation income as follows.

The Lowell Corporation would record its share of the New Hampshire Corporation income through the following journal entry.

Posting
Date / Item / Ref. / Debits / Credits
Dec. 31
New Hampshire Corp. income
Posting
Date / Item / Ref. / Debits / Credits
Dec. 31 / Investment in New Hampshire Corp. / 32,000
Equity in New Hampshire Corp. Income / 32,000
New Hampshire Corp. income

The net effect on the Lowell Corporation by the above transactions is

Cash / Investment in
New Hampshire Corp. / Retained Earnings
Cash / Investment in
New Hampshire Corp. / Retained Earnings
$400,000 / $400,000
$10,000 / $10,000
$32,000 / $32,000
$390,000 / $422,000 / $32,000

C.Reporting a change from the fair value method to the equity method.

1.a change in the Investment asset account equal to the change in the Retained Earnings account. This records the investor's ownership interest in the investee's prior income less dividends.

2.a change in the Fair Value Adjustment asset account equal to the change in the Unrealized Increase/Decrease in Value of SAFS stockholders' equity account. This eliminates the change in fair value of the investee's stock recognized since the date it was acquired.

D.Reporting investee income on classified income statements. Investee income should be reported in different classifications, such as operating income, discontinued operations, and extraordinary items.

E.Accounting for the excess of investment cost over the book value of assets acquired.

It is very rare that the market value of a company's common stock equals the stock's book value. As a result, when an investor purchases the stock of a company (investee), the investor usually pays more than the stock's book value. In general, investors are willing to pay more than book value for stock for two reasons:

(1)

(2)

1.Calculating excess payment:

Value of purchased company (investee) implied by purchase price

- Book value of purchased company (investee)

= Excess payment

On January 2, 2006 the Lowell Corporation purchased 40% of the common stock of the Massachusetts Corporation for $600,000. On January 2, 2006, the Massachusetts Corporation reported assets of $2,000,000 and liabilities of $800,000. Based on its analysis, the Lowell Corporation estimates that the Massachusetts Corporation's land is undervalued by $20,000 and its building is undervalued by $180,000.

Market value
Book value
Excess payment
Undervalued land
Undervalued building
Goodwill
Excess payment
Market value / $1,500,000
Book value / $1,200,000
Excess payment / $300,000
Undervalued land / $20,000
Undervalued building / $180,000 / $200,000
Goodwill / $100,000
Excess payment / $300,000

Since the Lowell Corporation acquired "only" 40% of the Massachusetts Corporation for $600,000, it would view its share of the Massachusetts Corporation as follows.

Total / 40%
Market value / $1,500,000
Book value / $1,200,000
Excess payment / $300,000
Undervalued land / $20,000
Undervalued building / $180,000
Goodwill / $100,000
Excess payment / $300,000
Total / 40%
Market value / $1,500,000 / $600,000
Book value / $1,200,000 / $480,000
Excess payment / $300,000 / $120,000
Undervalued land / $20,000 / $8,000
Undervalued building / $180,000 / $72,000
Goodwill / $100,000 / $40,000
Excess payment / $300,000 / $120,000

In terms of its $600,000 investment in the Massachusetts Corporation, the Lowell Corporation views it as follows:

Assets - liabilities ($1,200,000 x .40)
"Additional" land ($20,000 x .40)
"Additional" building ($180,000 x .40)
Goodwill ($100,000 x .40)
Total investment
Assets - liabilities ($1,200,000 x .40) / $480,000
"Additional" land ($20,000 x .40) / $8,000
"Additional" building ($180,000 x .40) / $72,000
Goodwill ($100,000 x .40) / $40,000
Total investment / $600,000

2.Amortizing excess payment:

Illustration of excess payment amortization:

Continuing the Lowell Corporation's purchase of the Massachusetts Corporation, assume that the Lowell Corporation estimates that the Massachusetts Corporation building has a remaining estimated useful life of 10 years and that goodwill has an indefinite life.

Based on its estimates, the Lowell Corporation would amortize its excess payments for the Massachusetts Corporation as follows.

Asset / Dollar
Amount / Useful Life / Amortization
Per year
Land / $8,000
Building / $72,000
Goodwill / $40,000
Totals / $120,000
Asset / Dollar
Amount / Useful Life / Amortization
Per year
Land / $8,000 / Unlimited / $0
Building / $72,000 / 10 years / $7,200
Goodwill / $40,000 / Indefinite / $0
Totals / $120,000 / $7,200

The Lowell Corporation would be affected by the amortization of the excess payment as follows.

The Lowell Corporation would record the amortization of the excess payment through the following journal entry.

Posting
Date / Item / Ref. / Debits / Credits
Dec. 31
Massachusetts Corp. amortization
Posting
Date / Item / Ref. / Debits / Credits
Dec. 31 / Equity in Massachusetts Corp. Income / 7,200
Investment in Massachusetts Corp. / 7,200
Massachusetts Corp. amortization

IV.Accounting for related party transactions:

any investee/investor profits included in ending inventories should be eliminated.