(Ch 1)

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` Chapter 1: The Equity Method of Accounting for Investments Table of Contents Topic 1: The Reporting of Investments in Corporate Equity Securities ........................................... 2 Topic 2: Application of the Equity Method .................................................................................... 5 Topic 3: Equity Method Accounting Procedures ............................................................................ 7 Topic 4: Equity Method – Additional Issues ..................................................................................... 12 Topic 5: Deferral of Intra-Entity Gross Profits in Inventory ........................................................... 14 Topic 6: Financial Reporting Effects and Equity Method Criticisms ............................................... 16 Topic 7: Fair-Value Reporting for Equity Method Investments ..................................................... 17

Topic 1: The Reporting of Investments in Corporate Equity Securities  Firms acquire many different types of assets to carry out their business. o Fixed asset : Dr. Equipment 100 Cr. Cash 100 o Inventory : Dr. Inventory 200 Cr. Cash 200 o Corporate equity security : Dr. Investment 300 Cr. Cash 300  While accounting for the acquisition of fixed assets or inventory is straightforward, accounting for “equity security” can be complex, which is the main topic of this chapter.  There are largely three different approaches to the ____________ financial reporting of investments in corporate equity securities: 1) ____________ , 2) ____________, and 3) _________________________ .  The investor’s ________________________ over the investee determines external reporting of investment. A. Fair-value Method  When investors have ________________________ over the investee’s operations & when FV is readily available (e.g., less than 20%)  The initial investment is recorded at cost  Adjusted to fair value in subsequent periods  Changes in FV  Recorded as gains/losses in the income statement  Dividends  Recorded as gains/losses in the income statement  An exception to the FV method - Cost Method ০ This method can replace the FV method when the FV of investment is not readily available. ০ It is different from the FV method in that c hanges in FV  usually not recorded. B. Equity Method (the focus of this chapter)  When investors have no control, but significant influence over the investee.  It is based on the accrual basis for recognizing the investor’s share of investee income (ASC 323). - Investee’s earnings  income - Investee’s dividends  a decrease in investment C. Consolidation of Financial Statements (Chapters 2 -5)  When investors _________________ as opposed to “influence”) over the investee’s operations (i.e., generally when they have more than 50% of voting stocks).  A single set of financial statements is required for external reporting purposes.  Internally investors still will use the FV method, Cost method, or Equity method throughout the year to keep track of their investment.  Consolidation of financial statements is required only for external reporting purposes. ACC 756 – Chapter 1 Page 2 of 21

Example (Exhibit 1.1) Big Company owns a 20% interest in Little Company purchased on 1/1/2017 for $210,000 when Little Company’s total market value was $1,050,000 (20% $1,050,000 = 210,000). Little Company reported a net income of $200,000 in 2017 and declared and paid cash dividends of $50,000. The market value of Little Company was $1,400,000. Provide journal entries to apply the 1) Fair- Value method, 2) Cost Method, and 3) Equity Method: On 1/1/2017 (The same J.E. for all three methods) A) Fair-Value Method To record a change in the fair value of Little Company ($1,400,000 – 1,050,000 × 20% =70,000).  The Investment in Little has the following balance at the end of 2017. Investment in Little B) Cost Method To record the collection of the cash dividend.  The Investment in Little has the following balance at the end of 2017. Investment in Little ACC 756 – Chapter 1 Page 3 of 21

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C) Equity- Method To accrue earnings of a 20 percent owned investee ($200,000 × 20%). To record a dividend declaration by Little Company ($50,000 × 20%). To record the collection of the cash dividend.  The Investment in Little has the following balance at the end of 2017. Investment in Little $ 240,000 Concept Quiz #1 1. A company acquires a rather large investment in another corporation. What criteria determine whether the investor should apply the equity method of accounting to this investment? 2. What accounting treatments are appropriate for investments in equity securities without readily determinable fair values? 3. When an investor uses the equity method to account for investments in common stock, the investor’s share of cash dividends from the investee should be recorded as a. A deduction from the investor’s share of the investee’s profits. b. Dividend income. c. A deduction from the stockholders’ equity account, Dividends to Stockholders. d. A deduction from the investment account. (AICPA adapted) ACC 756 – Chapter 1 Page 4 of 21

Topic 2: Application of the Equity Method A. Criteria for Utilizing the Equity Method  Used when an investor obtains the ability to exercise significant influence .  Indicators of the presence of influence - Investor presentation on the board of directors of the investee - Investor participation in the policy-making process of the investee - Material intra-entity transactions - Interchange of managerial personnel - Technological dependency - The extent of ownership by the investor ( generally 20-50% )  Limitations of equity method applicability - If an investor’s ability to significantly influence the investee is not proven, the equity method cannot be applied even with 20-50% ownership.  Control over its investee through contractual arrangements is possible with less than 50% ownership (e.g., variable interest entities) - Consolidation of financial statements is required instead of the equity method.  Summary Criterion Normal Ownership Level Applicable Accounting Method Inability to significantly influence Less than 20% _____________________ Ability to significantly influence 20%–50% _____________________ Control through voting interests More than 50% _____________________ Control through variable interests Primary Beneficiary - no ownership required _____________________ B. Accounting for an investment - the Equity Method  The investment account on the investor’s balance sheet varies with changes in the investee’s equity Application of Equity Method Investee Event Investor Accounting Income is recognized. A proportionate share of income is recognized. Dividends are declared. The investor’s share of investee dividends reduces the investment account. ACC 756 – Chapter 1 Page 5 of 21

Concept Quiz #2 1. Which of the following cases indicates that the equity method of accounting is appropriate when the investor obtains 30% of the investee’s commons stocks? a. An agreement exists between the investor and investee according to which the investee surrenders significant rights as a shareholder. b. A concentration of ownership operates the investee without regard for the views of the investor c. The investor attempts but fails to obtain representation on the investee’s board of directors. d. Material intra-entity transactions. e. As the ownership is more than 20%, the investment automatically qualifies for the equity method. 2. When a majority ownership interest is present, consolidated financial statements are always required. True / False 3. On January 1, Puckett Company paid $1.6 million for 50,000 shares of Harrison’s voting common stock, which represents a 40 percent investment. No allocation to goodwill or other specific account was made. Significant influence over Harrison is achieved by this acquisition and so Puckett applies the equity method. Harrison declared a $2 per share dividend during the year and reported a net income of $560,000. What is the balance in the Investment in Harrison account found in Puckett’s financial records as of December 31? a. $1,724,000 b. $1,784,000 c. $1,844,000 d.$1,884,000 Solutions: ACC 756 – Chapter 1 Page 6 of 21

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Topic 3: Equity Method Accounting Procedures A. Equity Method – Anatomy : When investment cost = B.V of the investee  Company A (investor) acquires 100% of Company B (investee) by paying $300 cash and issuing $500 worth of its stock. B. Excess of Investment Cost over Book Value Acquired  The purchase price of a company’s stock (i.e., fair value) may be different from the book value of the company’s equity.  Book value represents mainly the historical cost of the company's assets and liabilities, while fair value reflects the current market value of those assets and liabilities.  The market price of a company's stock is often not related to the book value on its balance sheet, but rather reflects market expectations of the company's future profitability and growth potential.  For example: - Apple Inc’s book value of equity per share on 9/30/17 was $26.15, but Mkt Value/share was $151.82  Why Investment Cost (Purchase Price) > Book Value of Investee - Book values are often based on historical cost and do not reflect the current value of the assets and liabilities. - Net assets are valuable to investors based on their ability to generate future cash flows, and this can be much more valuable than their book values.  In such a case, the excess of the purchase price (or costs) over book value should be allocated as follows: ACC 756 – Chapter 1 Page 7 of 21

- First, the excess cost is allocated to the investee’s _____________________ . - Second, if the additional payment cannot be attributable to any assets or liabilities, then the investor recognizes an intangible asset: “ _____________________ ”. - Third, the excess cost will _____________________ future periods. ACC 756 – Chapter 1 Page 8 of 21

 Example- Grande Company acquires 30 percent of the outstanding shares of Chico Company for $125,000. Chico’s balance sheet reports assets of $500,000 and liabilities of $300,000 for a net book value of $200,000. After investigation, Grande determines that Chico’s equipment is undervalued in the company’s financial records by $60,000. One of its patents is also undervalued, but only by $40,000. Determine how the acquisition price is allocated.  Initial Recording: The entire cash payment is recorded as “Investment in Little Company” as follows: *Note that the excess amount is not allocated to its equipment, patents, or goodwill under the equity method, which is different from the consolidation case (Chapters 2 and 3) C. The Amortization Process  The excess payments to acquire definite-lived assets are subject to amortization over the useful life. - E.g., Land and goodwill are not subject to amortization  Goodwill implicit in equity method investment is not subject to annual impairment reviews. However, the asset impairments of equity investments are tested in their entirety.  Example: Account Cost Assigned Remaining Useful Life Annual Amortization Equipment $18,000 10 years Patent 12,000 5 years Goodwill 35,000 Indefinite 1 st -year Annual expense $4,200 Journal Entry: To record amortization of excess payment allocated to equipment and patent. (No expense account is established) ACC 756 – Chapter 1 Page 9 of 21

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D. Illustration (page 13) – Equity Method with Amortization Expense Tall Company purchases 20 percent of Short Company for $200,000. Tall can exercise significant influence over the investee on January 1, 2017, when Short holds net assets with a book value of $700,000. Tall believes that the investee’s building (10-year remaining life) is undervalued within the financial records by $80,000 and equipment with a 5-year remaining life is undervalued by $120,000. Any goodwill established by this purchase is considered to have an indefinite life. During 2017, Short reports a net income of $150,000 and at year-end declares a cash dividend of $60,000. 1. Record the purchase of Short Company on Jan 1, 2017. 2. Record income recognition and dividend receipt on Dec 31, 2017. 3. Record Annual Amortization on Dec 31, 2017. The consideration transferred (i.e., purchase price) Percentage of 1/1/17 book value ($700,000 × 20%) Payment in excess of book value Excess payment identified with specific assets: Building ($80,000 × 20%) Equipment ($120,000 × 20%) Excess payment not identified with specific assets—goodwill Asset Attributed Cost Remaining Useful Life Annual Amortization Building Equipment Goodwill Total for 2017 ACC 756 – Chapter 1 Page 10 of 21

E. Conceptual Summary - Why do we need to amortize the excess cost?  A simple illustration - All depreciable assets are subject to depreciation (or amortization). - Suppose an investor acquires 100% of ABC Company, which has only one type of asset (Equipment with a useful life of 10 years) and no liabilities. The company has a book value of $1,000 for the equipment, but the fair value is $3,000. The investor pays $3,000 to acquire ABC Company. - What should be the total depreciation expense/year to the investor? - Ans: Since the investor’s total cost was $3,000, the depreciation base and the annual depreciation should be $300 ($3,000 / 10 years). - It is important to note that the total depreciation is not just $100 as the investor’s total cost was $3,000 in acquiring the asset. - ABC Company continues to operate under its own name after the acquisition and will continue to depreciate the asset for $100 per year ($1,000 / 10 years). - Therefore, the investor only needs to depreciate an additional $200. We call this additional $200 “amortization expense”. This way, the investor’s total depreciation will be $300 ($100 by ABC Company and $200 by the investor). Concept Quiz #3 1. In a stock acquisition accounted for by the equity method, a portion of the purchase price often is attributed to goodwill or to specific assets or liabilities. How are these amounts determined at acquisition? How are these amounts accounted for in subsequent periods? 2. Franklin purchases 40 percent of Johnson Company on January 1 for $500,000. Although Franklin did not use it, this acquisition gave Franklin the ability to apply significant influence on Johnson’s operating and financing policies. Johnson reports assets on that date of $1,400,000 with liabilities of $500,000. One building with a seven-year remaining life is undervalued on Johnson’s books by $140,000. Also, Johnson’s book value for its trademark (10-year remaining life) is undervalued by $210,000. During the year, Johnson reports net income of $90,000 while declaring dividends of $30,000. What is the Investment in Johnson Company balance (equity method) in Franklin’s financial records as of December 31? ACC 756 – Chapter 1 Page 11 of 21

Concept Quiz #3 - Solutions ACC 756 – Chapter 1 Page 12 of 21

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Topic 4: Equity Method – Additional Issues A. Reporting a Change to the Equity Method  When a firm needs to change the accounting method from fair-value (or cost) to equity method because of changes in an investor’s ability to influence an investee.  Starting 2017, the FASB requires a prospective approach - The cost of a new share acquired is added to the current investment carrying amount. - No retrospective adjustment is required anymore.  Illustration - Interested readers may want to follow Alpha Company’s accounting for the additional acquisition of Bailey’s share on page 15 (FYI only). - Please note that changes in investment in Bailey are as follows: Investment in Bailey Jan 1, 2017 $ 84,000 <-- Initial investment for 10% interest $ 5,000 <-- An increase in fair value Dec 31, 2017 $ 267,000 <-- Additional acquisition for 30% interest Jan 1, 2018 $ 356,000 <-- 40% ownership - To account for the investment in Bailey Company, Alpha Company will use the Fair Value Method in 2017 , but the Equity Method starting in 2018 . B. Reporting Investee’s Other Comprehensive Income and Irregular Items  Under the equity method, the investor records its share of the investee OCI, and it will be included in accumulated other comprehensive income (AOCI).  Example: When the Norris Company reports a $500,000 net income and $80,000 in OCI, prepare a journal entry for the investor who owns a 30% interest in Norris Company. ($500,000 x 30% = 150,000 & $80,000 x 30% = 24,000) C. Reporting Investee Losses under the Equity Method  Accounting for net losses (as opposed to net income) is handled in the same manner as net income cases.  When there is a permanent decline in equity investment (i.e., an asset impairment occurs), the loss is recognized, and the investment value is reduced to fair value. (intermediate accounting topic)  Once the Investment is reduced to zero - The investor should stop using the equity method, i.e., the investor will not have a negative balance. - The investment retains a zero balance until subsequent investee profits offset all unrecognized losses. ACC 756 – Chapter 1 Page 13 of 21

D. Reporting the Sale of an Equity Investment  When an investor is required to change from the equity method to the fair-value method, no retrospective adjustment is made. (i.e., prospective approach).  The remaining book value of the investment becomes the new cost for the fair-value method. Concept Quiz #4 1. Wilson Company acquired 40 percent of Andrews Company at a bargain price because of losses expected to result from Andrews’s failure in marketing several new products. Wilson paid only $100,000, although Andrews’s corresponding book value was much higher. In the first year after acquisition, Andrews lost $300,000. In applying the equity method, how should Wilson account for this loss? 2. Hawkins Company has owned 10 percent of Larker, Inc. for the past several years. This ownership did not allow Hawkins to have significant influence over Larker. Recently, Hawkins acquired an additional 30 percent of Larker and now will use the equity method. How will the investor report change? a. A cumulative effect of an accounting change is shown in the current income statement. b. A retrospective adjustment is made to restate all prior years presented using the equity method. c. No change is recorded; the equity method is used from the date of the new acquisition. d. Hawkins will report the change as a component of accumulated other comprehensive income. 3. When an equity method investment account is reduced to a zero balance a. The investor should establish a negative investment account balance for any future losses reported by the investee. b. The investor should discontinue using the equity method until the investee begins paying dividends. c. Future losses are reported as unusual items in the investor’s income statement. d. The investment retains a zero balance until subsequent investee profits eliminate all unrecognized losses. Solutions: ACC 756 – Chapter 1 Page 14 of 21

Topic 5: Deferral of Intra-Entity Gross Profits in Inventory A. Intra-Entity Sales  It is a sale between an investor and its investee.  Special accounting treatment - The investor needs to defer its share of the profit from intra-equity sales until the buyers’ ultimate disposition of the goods (i.e., either through internal consumption or sales to an unrelated party).  Downstream sale vs. Upstream sale - Accounting treatments for downstream and upstream sales are the same for the equity method (Ch 1) - Accounting treatments are different for consolidation cases (Ch 5) B. Downstream Sales of Inventory  Illustration - Major Company owns a 40 percent share of Minor Company (i.e., equity method). In 2018, Major sells inventory to Minor for $50,000. This figure includes a gross profit of 30 percent, or $15,000. By the end of 2018, Minor has sold $40,000 of these goods to outside parties while retaining $10,000 in inventory for sale during the subsequent year. - Determine how much of Major’s gross profit of $15,000 in 2018 should be deferred & make a proper journal entry. - In 2019, the remaining inventory ($10,000) is consumed by Minor Company. Make a proper journal entry Solution : Deferred Gross Profit - Note that the $50,000 sales price becomes the cost to the buyer (Minor), which includes $15,000 gross profit (or 30% of the sales price). Whenever you see the unsold inventory by the buyer (Minor), you need to defer the gross profit included in the ending inventory recognized by the seller (Major). If nothing was sold to the 3 rd party, then the entire profit (30% of EI (50,000)) should be deferred. If everything was sold, nothing will be deferred. However, in this case, out of $50,000, $40,000 is sold, and $10,000 is unsold (ending inventory). Therefore, the gross profit included in $10,000 will be deferred. The calculation is as follows: Remaining Ending Inventory Gross Profit Percentage Gross Profit in Ending Inventory Investor Ownership Percentage Deferred Intra-Entity Gross Profit Journal Entries 2018 Intra-Entity Gross Profit Deferral 2019 Subsequent Recognition of Intra-Entity Gross Profit ACC 756 – Chapter 1 Page 15 of 21

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C. Upstream Sales of Inventory  For the equity method, the accounting treatment of upstream sales is the same as that of downstream sales. (i.e., identical deferred gross profit or journal entries)  However, instead of using the “Investment” account, an “Inventory” account can be used. Concept Quiz #5 1. How is the investor’s share of gross profit on intra-entity sales calculated? Under the equity method, how does the deferral of gross profit affect the recognition of equity income? 2. How are intra-entity transfers reported in an investee’s separate financial statements if the investor is using the equity method? 3. Panner, Inc. owns 30 percent of Watkins and applies the equity method. During the current year, Panner buys inventory costing $54,000 and then sells it to Watkins for $90,000. At the end of the year, Watkins still holds only $20,000 of merchandise. What amount of gross profit must Panner defer in reporting this investment using the equity method? a.$2,400 b.$4,800 c.$8,000 d.$10,800 Solutions ACC 756 – Chapter 1 Page 16 of 21

Topic 6: Financial Reporting Effects and Equity Method Criticisms A. Criticism of the equity method  Do managers have any incentives to report their investment using the equity method rather than through consolidation? - YES!  The 20-50 % voting stock does not automatically mean “significant influence”, rather it can mean “control”.  Then consolidation may be more appropriate. - Through contractual agreement ০ Debt arrangements, ০ Long-term sale and purchase agreements, or ০ Board membership agreements - With less than 50% of ownership, the investing company can avoid consolidation requirements  So that the reporting company can avoid reporting “assets” and liabilities of the investee (i.e., to keep it “off-balance sheet”).  Which will lead to higher ROA or lower debt-to-equity ratio. ACC 756 – Chapter 1 Page 17 of 21

Topic 7: Fair-Value Reporting for Equity Method Investments  US GAAP allows a fair-value option for the investments otherwise accounted for under the equity method.  Click here for more readings on FV accounting.  Once an entity elects the fair value accounting options (as discussed earlier on page 2), the decision is irrevocable.  Once the fair value option is adopted, firms will report investments’ fair value as an asset and changes in fair value as earnings, as discussed earlier on page 2 (fair-value method). - No amortization of the cost - No intra-entity profit adjustment  FASB ASC (para. 825-10-10-1) “ to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions.” - the fair-value option is designed to match asset valuation with fair-value reporting requirements for many liabilities. Concept Quiz #7 1. Under fair-value accounting for an equity investment, which of the following affects the income the investor recognizes from its ownership of the investee? a. The investee’s reported income adjusted for excess cost over book value amortizations. b. Changes in the fair value of the investor’s ownership shares of the investee. c. Intra-entity profits from upstream sales. d. Other comprehensive income reported by the investee. 2. On January 1, 2017, Alison, Inc. paid $60,000 for a 40 percent interest in Hollister Corporation’s common stock. This investee had assets with a book value of $200,000 and liabilities of $75,000. A patent held by Hollister having a $5,000 book value was actually worth $20,000. This patent had a six-year remaining life. Any further excess cost associated with this acquisition was attributed to goodwill. During 2017, Hollister earned income of $30,000 and declared and paid dividends of $10,000. In 2018, it had income of $50,000 and dividends of $15,000. During 2018, the fair value of Allison’s investment in Hollister had risen from $68,000 to $75,000. a. Assuming Alison uses the equity method, what balance should appear in the Investment in Hollister account as of December 31, 2018? b. Assuming Alison uses fair-value accounting, what income from the investment in Hollister should be reported for 2018? ACC 756 – Chapter 1 Page 18 of 21

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ACC 756 – Chapter 1 Page 19 of 21

ACC 756 – Chapter 1 Page 20 of 21

Learning Objectives - After studying this chapter, you should be able to: LO1-1 Describe in general the various methods of accounting for an investment in equity shares of another company. LO1-2 Identify the sole criterion for applying the equity method of accounting and know the guidelines to assess whether the criterion is met. LO1-3 Describe the financial reporting for equity method investments and prepare basic equity method journal entries for an investor. LO1-4 Allocate the cost of an equity method investment and compute amortization expense to match revenues recognized from the investment to the excess of investor cost over investee book value. LO1-5 Understand the financial reporting consequences for: a. A change to the equity method. b. Investee’s other comprehensive income. c. Investee losses. d. Sales of equity method investments. LO1-6 Describe the rationale and computations to defer the investor’s share of gross profits on intra-entity inventory sales until the goods are either consumed by the owner or sold to outside parties. LO1-7 Explain the rationale and reporting implications of fair-value accounting for investments otherwise accounted for by the equity method. (FYI only) ------------------------------------------------ The End of Chapter 1 Notes ------------------------------------------------------ ACC 756 – Chapter 1 Page 21 of 21

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(Ch 1)

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