Accounting for Investments and the Equity Method
CHAPTER 1: THE EQUITY METHOD OF ACCOUNTING FOR INVESTMENTS
I. Four Methods to Account for an Investment in Equity Securities
Four principal methods used to account for an investment in equity securities:
Fair Value Method
Used when the investor holds a small percentage of a company’s voting stock.
Recognizes income when the investee declares a dividend.
Portfolios are reported at fair value.
If fair values are unavailable, the investment is reported at cost.
Cost Method
Applied to investments without a readily determinable fair value.
Used when the investment does not provide significant influence or control.
The value remains at cost unless:
A demonstrable impairment occurs for the investment.
An observable price change occurs for identical or similar investments of the same issuer.
The investor recognizes dividends declared by the investee as dividend income.
Consolidation
Occurs when one firm controls another (e.g., a parent owning a majority interest in the voting stock of a subsidiary).
Financial statements are consolidated and reported for the combined entity.
Equity Method
Utilized when the investor can exercise significant influence over the operating and financial policies of the investee.
Ability to significantly influence is indicated by factors such as:
Representation on the board of directors.
Participation in policy-making.
GAAP guidelines state the equity method is applicable if the investor holds 20% to 50% of the outstanding voting stock of the investee.
Current financial reporting standards allow firms to elect to use fair value for any new investment in equity shares, including those where the equity method would typically apply. This choice is irrevocable.
The investor recognizes both investee dividends and changes in fair value as income.
II. Accounting for an Investment: The Equity Method
Adjustment of Investment Account
The investor adjusts the investment account to reflect all changes in the equity of the investee.
Accrual of Investee Income
The investor accrues investee income when it is reported in the investee’s financial statements.
Dividends Declared by the Investee
Dividends declared lead to a reduction in the carrying amount of the investment account.
Assumption: all investee dividends are declared and paid in the same reporting period.
III. Special Accounting Procedures in the Application of the Equity Method
Reporting a Change to the Equity Method
If the investor achieves the ability to significantly influence an investee through a series of acquisitions:
Initial purchases are accounted for using the fair value method (or at cost) until significant influence is attained.
Upon attaining significant influence, the investor applies the equity method prospectively.
The total fair value at the date significant influence is achieved is compared to the investee’s book value for future excess fair value amortizations.
Investee Income from Other than Continuing Operations
The investor recognizes its share of other comprehensive income (OCI) from the investee through the investment account and its own OCI.
Discontinued operations reported by the investee must be shown similarly by the investor.
Materiality is a criterion for separate disclosure of these income elements as they affect the investor.
Investee Losses
Losses reported by the investee correspond to losses for the investor.
A permanent decline in fair value of the investee’s stock is recognized immediately as an impairment loss by the investor.
Investee losses can reduce the investment account’s carrying value to zero, after which the equity method ceases to apply, and the fair value method is used.
Reporting the Sale of an Equity Investment
The investor applies the equity method until the disposal date to establish proper book value.
Post-sale, the equity method continues if enough shares remain to maintain significant influence over the investee. If that ability is lost, the fair value method is applied.
IV. Excess Investment Cost over Book Value Acquired
The price paid for equity securities often differs significantly from the investee’s book value due to the historical cost-based accounting model not tracking fair value changes.
Payments in excess of underlying book value may correspond to specific investee accounts, such as inventory or equipment.
An extra acquisition price may also reflect anticipated benefits from the investment, categorized as goodwill.
Goodwill is calculated as any excess payment not attributable to identifiable assets and liabilities of the investee.
Since goodwill is an indefinite-lived asset, it is not amortized.
V. Deferral of Intra-Entity Gross Profit in Inventory
The investor’s share of intra-entity profits in ending inventory is not recognized until the goods are consumed or resold to unrelated parties.
Downstream Sales of Inventory
“Downstream” refers to transfers made by the investor to the investee.
Intra-entity gross profits from these sales are deferred and recognized as income upon the inventory’s eventual disposal.
The deferral amount is calculated as the investor’s ownership percentage multiplied by the markup on remaining inventory at year-end.
Upstream Sales of Inventory
“Upstream” refers to transfers made by the investee to the investor.
The deferral process for intra-entity gross profits is the same for upstream and downstream transfers, although procedures differ within the consolidation process.