(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

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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