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Slide 1-1
Chapter One
The Equity Method of ing for Investments McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-2
Reporting Investments in Corporate Equity Securities GAAP allows 3 approaches to reporting investments.
Note: These 3 approaches are not interchangeable. The characteristics of each investment will dictate the appropriate ing approach. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-3
Fair Value Method Details Details in in SFAS SFAS No. No. 115 115 Initial Initial Investment Investment is is recorded recorded at at cost. cost. Investments Investments in in equities equities of of other other companies companies are are classified classified as as either either Trading Trading Securities Securities or or Available-forAvailable-forSale Sale Securities Securities.. Income Income is is only only realized realized to to the the extent extent of of dividends dividends received. received.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-4
Equity Method Defined Defined by byAPB APB Opinion Opinion 18 18
and and SFAS SFAS No. No. 142. 142. Requires Requires that that the the investment investment is is sufficient sufficient to to insure insure significant significant influence. influence. Generally Generally used used when when ownership ownership is is between between 20% 20% & & 50%. 50%. Influence Influencecan can be be present presentwith with
much much smaller smaller ownership ownership percentages. percentages.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-5
Consolidation of Financial Statements Governed
by ARB No. 51, SFAS No. 141, and SFAS No. 142. Required when investor’s ownership exceeds 50% of investee. A single set of financial statements including the assets, liabilities, equities, revenues, and expenses for the parent company and all controlled subsidiary companies. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-6
Criteria for Determining Whether There is Influence Representation Representation on on the theinvestee’s investee’sBoard Board of of Directors Directors Participation Participationin in the theinvestee’s investee’spolicypolicymaking makingprocess process Material Materialintercompany intercompanytransactions. transactions. Interchange Interchange of of managerial managerialpersonnel. personnel. Technological Technologicaldependency. dependency. Extent Extent of ofownership ownership in in relationship relationshipto to other other ownership ownershippercentages. percentages.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-7
The Significance of the Size of the Investment Investor Ownership of Investee Shares Outstanding
{
Fair Value 0%
Equity Method 20%
Consolidated Financial Statements 50%
100%
In Insome somecases, cases,influence influenceor orcontrol controlmay may exist existwith withless lessthan than20% 20%ownership. ownership. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-8
The Significance of the Size of the Investment Investor Ownership of Investee Shares Outstanding
0%
Equity Method
{
Fair Value 20%
Consolidated Financial Statements 50%
100%
Significant Significantinfluence influenceis isgenerally generally assumed assumedwith with20% 20%to to50% 50% ownership. ownership. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-9
The Significance of the Size of the Investment Investor Ownership of Investee Shares Outstanding
0%
Equity Method 20%
Consolidated Financial Statements 50%
{
Fair Value
100%
Financial FinancialStatements Statementsof ofall allrelated related companies companiesmust mustbe beconsolidated. consolidated. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-10
Fair Value Method (Revisited) – using Available for Sale (AFS) securities
Purchase Dr Investment in AFS Cr Cash
XXXXX
Dividend Income Dr Cash Cr Dividend Income
XXXXX
XXXXX XXXXX
Change in Value of Security (Increase)1 Dr Market Value Adj. – AFS Cr Unrealised inc/dec in AFS2
XXXXX XXXXX
1 - The reverse is true for a decrease 2 – This appears in stock holders equity. If it were a “Held for Trading” security the gain would have appeared in the income statement as an “Unrealized loss on Trading Securities” McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-11
Equity Method Step 1: The investor records its investment in the investee at cost. Cost Cost can canbe bedefined defined by bycash cash paid paid or or Fair Fair Market Market Value Valueof ofStock Stockor or other other assets assetsgiven given up. up.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-12
Equity Method Step 2: The investor recognizes its proportionate share of the investee’s net income (or net loss) for the period.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-13
Equity Method Step 2: The investor recognizes its proportionate share of the investee’s net income (or net loss) for the period.
This Thiswill willappear appear as asaa separate separate line-item line-itemon onthe theinvestor’s investor’s income incomestatement. statement. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-14
Equity Method Step 3: The investor reduces the investment by the amount of dividends received from the investee.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-15
Let’s do an equity method example.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-16
Equity Method Example – Step 1 On January 1, 2005, Big Corp. buys 20% of Small Inc. for $2,000,000 cash. Record Big’s journal entry.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-17
Equity Method Example – Step 2 On December 31, 2005, Small reports net income for the year of $300,000. Record Big’s journal entry.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-18
Equity Method Example – Step 2 Big owns 20% of Small and gets credit for 20% of Small’s income. 20% × $300,000 = $60,000
60,000 McGraw-Hill/Irwin
60,000
© The McGraw-Hill Companies, Inc.
Slide 1-19
Equity Method Example – Step 3 On December 31, 2003, Big received a $25,000 dividend check from Small. Record Big’s journal entry.
60,000 McGraw-Hill/Irwin
25,000
25,000
© The McGraw-Hill Companies, Inc.
Slide 1-20
Special Procedures for Special Situations Reporting Reporting aa change change to to the the equity equity method. method.
Reporting Reporting investee investee income income from from sources sources other other than than continuing continuing operations. operations. McGraw-Hill/Irwin
Reporting Reporting the the sale sale of of an an equity equity investment. investment.
Reporting Reporting investee investee losses. losses.
© The McGraw-Hill Companies, Inc.
Slide 1-21
Reporting a Change to the Equity Method.
An investment that is too small to have significant influence is ed for using the fair-value method. When ownership grows to the point where significant influence is established . . .
.. .. .. all all s s are arerestated restated so so that that the the investor’s investor’sfinancial financial statements statements appear appear as as ifif the the equity equity method method had had been been applied applied from from the thedate date of of the the first first [original] [original] acquisition. acquisition. -- --APB APB Opinion Opinion 18 18
?
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-22
Restatement - Example Assume Assumethat thatExxo ExxoCompany Companyacquires acquires5% 5%of of LipGloss LipGlossInc. Inc.on onJanuary January1, 1, 2004 2004for for$2,000,000. $2,000,000. There Thereis isno no significant significantinfluence. influence. The Theinvestment investment is is recorded recordedat at the thetime timeas asan anAvailable-for-Sale Available-for-Sale Investment. Investment. In In2004, 2004,LipGloss LipGlosshad had net net income incomeof of $300,000, $300,000,and and paid paiddividends dividendsof of $140,000. $140,000. Exxo Exxo would would report report the the investment investment as asindicated indicatedin inthe thetable tablebelow: below:
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-23
Fair Market Value entry The
entries for adjustment to FMV would also have been required. E.g. Assume that the FMV @ 31/12/2004 was $2,400,000. Then the following entry would have been made (as per SFAS115): Dr Market Value Adjustment - AFS 400,000 Cr Unrealized inc/dec in value of AFS 400,000
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-24
Restatement - Example On OnJanuary January1, 1,2005, 2005, Exxo Exxobuys buysan anadditional additional15% 15% interest interest in inLipGloss, LipGloss,raising raisingthe thetotal totalinvestment investment to to 20%. 20%. The Thefirst first thing thingthat thatExxo Exxo must must do do is isrestate restate the the 12/31/04 12/31/04numbers numbersby byapplying applying the theequity equitymethod methodto to the the5% 5%investment investment in in LipGloss. LipGloss. We Wehave haveto toRESTATE RESTATEthe theInvestment Investment , ,put putaa balance balancein inEquity Equityin inInvestee InvesteeIncome, Income,and andeliminate eliminate the theDividend DividendRevenue Revenue balance. balance.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-25
Restatement - Example An Anadjustment adjustmentis isrecorded recordedto tothe theInvestment Investment and andto to Retained Retained Earnings Earnings (since (sinceDividend Dividend Revenue Revenuehas has already alreadybeen been closed closed out). out).
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-26
Removal of Fair Market Value related s The
FMV related s would also have to be removed. i.e. : Dr Unrealized inc/dec in value of AFS 400,000 Cr Market Value Adjustment - AFS 400,000
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-27
Reporting Investee Income from Other Sources When
net income includes elements other than Operating Income, those elements should be separately reported on the investor’s income statement. Examples include: Extraordinary items Discontinued operations Prior period adjustments
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-28
Reporting Investee Income from Other Sources
Big Big owns owns 30% 30% of of Little. Little. Little Little reports reports net net income income for for 2005 2005 of of $120,000. $120,000. Little’s Little’s Income Income includes includes operating operating income income of of $135,000 $135,000 and and an an extraordinary extraordinary loss loss of of $15,000. $15,000. Big’s Big’s equity equity method method entry entry at at year-end year-end is: is:
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-29
Reporting Investee Losses Permanent Permanent Losses Losses in in Value Value A Apermanent permanent decline decline in in the the investee’s investee’s market market value value is is recorded recorded as as aa reduction reduction of of the the investment investment . .
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-30
Reporting Investee Losses Investment Investment Reduced Reduced to to Zero Zero When When the the accumulated accumulated losses losses incurred incurred by by the the investee investee and and dividends dividends paid paid by by the the investee investee reduce reduce the the investment investment to to zero, zero, NO NO ADDITIONAL ADDITIONAL LOSSES LOSSES are are accrued. accrued. The The balance balance remains remains at at $0, $0, until until subsequent subsequent profits profits eliminate eliminate all all UNRECORDED UNRECORDED losses. losses.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-31
Reporting the Sale of an Equity Investment If part of an investment is sold during the period . . . The Theequity equitymethod methodcontinues continues to tobe be
applied appliedup upto to the the date dateof of the the transaction. transaction. At At the thetransaction transaction date, date,aa proportionate proportionateamount amount of of the the Investment Investment is isremoved. removed. IfIf significant significantinfluence influenceis islost, lost, NO NO RETROACTIVE RETROACTIVEADJUSTMENT ADJUSTMENT is is recorded. recorded. (as (asis isthe the case casewhen when switching switchingfrom from FV FVto to Equity Equity method) method) McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-32
Reporting the Sale of an Equity Investment
Alice AliceCo. Co.30% 30%(300,000 (300,000shares) shares)of ofSam, Sam,Inc.. Inc.. The Thebalance balance in inAlice’s Alice’sInvestment Investment at atMarch March31, 31,2005, 2005,is is $268,000. $268,000. IfIfAlice AliceCo. Co.sells sells10% 10%of ofits itsshares shares(30,000 (30,000shares) shares)on on April April1, 1,2005 2005 for for$100,000, $100,000,what whatentry entryshould shouldAlice Alice make makeon onApril April1, 1,2005? 2005?
$268,000 × .10% = $26,800 This brings the Investment to a balance of $241,200 © The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
Slide 1-33
Excess of Cost Over BV Acquired When Cost > BV acquired, the difference must be identified and ed for.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-34
Excess of Cost Over BV Acquired The The amortization amortization of of the the difference difference associated associated with with the the undervalued undervalued assets assets is is recorded recorded as as aa reduction reduction of of both both the the Investment Investment and and the the Equity Equity in in Investee Investee Income Income . .
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-35
Excess of Cost Over BV Example On OnJanuary January1, 1,2005, 2005, Big BigCorp. Corp.
acquired acquired 20% 20%of ofSmall Small Inc. Inc. for for $2,000,000 $2,000,000cash. cash. Assume Assumethat thatSmall’s Small’sassets assets had hadBV BVon on January January11of of $8,500,000. $8,500,000. Small Small owns ownsaa building building with with aaBV BVof of $500,000, $500,000, and andaaFMV FMVof of $700,000, $700,000, and and aa remaining remaininguseful useful life life of of 10 10 years. years. All All other other assets assets had had BV BV == FMV. FMV. Allocate Allocatethe thecost cost to to fair fairmarket market value valueadjustments adjustmentsand and Goodwill Goodwillacquired acquiredby byBig. Big. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-36
Excess of Cost Over BV Example
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-37
Excess of Cost Over BV Example
The The Building Building has has aa remaining remaininguseful usefullife life of of10 10years. years. Goodwill Goodwill is isnever neveramortized. amortized. Compute Computethe the amortization amortization expense expense for for Big Big at at12/31/05. 12/31/05.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-38
Amortization of Cost Over BV Example
Big’s Big’sequity equitymethod method entry entrywill will include includean an adjustment adjustment to tothe the investment investment of of$4,000. $4,000.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-39
Amortization of Cost Over BV Example
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-40
McGraw-Hill/Irwin
Let’s look at some intercompany transactions.
© The McGraw-Hill Companies, Inc.
Slide 1-41
Unrealized Gains in Inventory Sometimes d companies sell or buy inventory from each other.
INVESTOR INVESTOR Downstream Sale
INVESTEE INVESTEE McGraw-Hill/Irwin
INVESTOR INVESTOR Upstream Sale
INVESTEE INVESTEE
© The McGraw-Hill Companies, Inc.
Slide 1-42
Unrealized Gains in Inventory Let’s look at an Investor that has 200 units of inventory with a cost of $1,000.
INVESTOR INVESTOR
sells sells200 200units units of of inventory inventory with withaatotal total cost cost of of $1,000. $1,000.
McGraw-Hill/Irwin
Let us assume that the Investor sells the inventory to a 20% owned Investee for $1,250.
© The McGraw-Hill Companies, Inc.
Slide 1-43
Unrealized Gains in Inventory Let’s look at anofInvestor that has 200 Note that there is $250 intercompany profit. Note that there is $250 of intercompany profit. At At units of inventory UNREALIZED. with a cost of this thispoint pointitit is isconsidered considered UNREALIZED. $1,000.
INVESTOR INVESTOR
sells sells200 200units units of of inventory inventory with withaatotal total cost cost of of $1,000. $1,000.
20% ownership Intercompany Sale of 200 units
INVESTEE INVESTEE
buys buys200 200units units of ofinventory inventoryand and pays paysaa total totalof of $1,250. $1,250.
IfIf all all200 200units unitsare arenot not sold soldto toan anoutside outsideparty party during duringthe theperiod, period,we wewill will need need have haveunrealized, unrealized, intercompany intercompanyprofit profit that thatmust mustbe bedeferred. deferred. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-44
Unrealized Gains in Inventory 60 of the original 200 units (30%) are still “unsold” to a 3rd party. We must defer our share (20%) of the original $250 of intercompany profit that is unrealized (30%).
INVESTOR INVESTOR
sells sells200 200units units of of inventory inventory with withaatotal total cost cost of of $1,000. $1,000.
20% ownership Intercompany Sale of 200 units
Outside Party McGraw-Hill/Irwin
INVESTEE INVESTEE
buys buys200 200units units of ofinventory inventoryand and pays paysaa total totalof of $1,250. $1,250.
Investee sells only 140 units to a 3rd party
© The McGraw-Hill Companies, Inc.
Slide 1-45
Unrealized Gains in Inventory Compute
the deferral by multiplying:
The
required journal (for both upstream and downstream) is:
$250 × 30% × 20% = $15
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-46
Unrealized Gains in Inventory In Inthe theperiod periodfollowing followingthe theperiod periodof ofthe the
transfer, transfer,the theremaining remaininginventory inventoryis isoften often sold. sold. When Whenthat thathappens, happens,the theoriginal originalentry entryis is reversed reversed......
The reversal takes place in the period that the inventory is sold to an outside party. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-47
End of Chapter 1 And this is only the FIRST chapter?!
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Chapter One
The Equity Method of ing for Investments McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-2
Reporting Investments in Corporate Equity Securities GAAP allows 3 approaches to reporting investments.
Note: These 3 approaches are not interchangeable. The characteristics of each investment will dictate the appropriate ing approach. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-3
Fair Value Method Details Details in in SFAS SFAS No. No. 115 115 Initial Initial Investment Investment is is recorded recorded at at cost. cost. Investments Investments in in equities equities of of other other companies companies are are classified classified as as either either Trading Trading Securities Securities or or Available-forAvailable-forSale Sale Securities Securities.. Income Income is is only only realized realized to to the the extent extent of of dividends dividends received. received.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-4
Equity Method Defined Defined by byAPB APB Opinion Opinion 18 18
and and SFAS SFAS No. No. 142. 142. Requires Requires that that the the investment investment is is sufficient sufficient to to insure insure significant significant influence. influence. Generally Generally used used when when ownership ownership is is between between 20% 20% & & 50%. 50%. Influence Influencecan can be be present presentwith with
much much smaller smaller ownership ownership percentages. percentages.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-5
Consolidation of Financial Statements Governed
by ARB No. 51, SFAS No. 141, and SFAS No. 142. Required when investor’s ownership exceeds 50% of investee. A single set of financial statements including the assets, liabilities, equities, revenues, and expenses for the parent company and all controlled subsidiary companies. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-6
Criteria for Determining Whether There is Influence Representation Representation on on the theinvestee’s investee’sBoard Board of of Directors Directors Participation Participationin in the theinvestee’s investee’spolicypolicymaking makingprocess process Material Materialintercompany intercompanytransactions. transactions. Interchange Interchange of of managerial managerialpersonnel. personnel. Technological Technologicaldependency. dependency. Extent Extent of ofownership ownership in in relationship relationshipto to other other ownership ownershippercentages. percentages.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-7
The Significance of the Size of the Investment Investor Ownership of Investee Shares Outstanding
{
Fair Value 0%
Equity Method 20%
Consolidated Financial Statements 50%
100%
In Insome somecases, cases,influence influenceor orcontrol controlmay may exist existwith withless lessthan than20% 20%ownership. ownership. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-8
The Significance of the Size of the Investment Investor Ownership of Investee Shares Outstanding
0%
Equity Method
{
Fair Value 20%
Consolidated Financial Statements 50%
100%
Significant Significantinfluence influenceis isgenerally generally assumed assumedwith with20% 20%to to50% 50% ownership. ownership. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-9
The Significance of the Size of the Investment Investor Ownership of Investee Shares Outstanding
0%
Equity Method 20%
Consolidated Financial Statements 50%
{
Fair Value
100%
Financial FinancialStatements Statementsof ofall allrelated related companies companiesmust mustbe beconsolidated. consolidated. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-10
Fair Value Method (Revisited) – using Available for Sale (AFS) securities
Purchase Dr Investment in AFS Cr Cash
XXXXX
Dividend Income Dr Cash Cr Dividend Income
XXXXX
XXXXX XXXXX
Change in Value of Security (Increase)1 Dr Market Value Adj. – AFS Cr Unrealised inc/dec in AFS2
XXXXX XXXXX
1 - The reverse is true for a decrease 2 – This appears in stock holders equity. If it were a “Held for Trading” security the gain would have appeared in the income statement as an “Unrealized loss on Trading Securities” McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-11
Equity Method Step 1: The investor records its investment in the investee at cost. Cost Cost can canbe bedefined defined by bycash cash paid paid or or Fair Fair Market Market Value Valueof ofStock Stockor or other other assets assetsgiven given up. up.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-12
Equity Method Step 2: The investor recognizes its proportionate share of the investee’s net income (or net loss) for the period.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-13
Equity Method Step 2: The investor recognizes its proportionate share of the investee’s net income (or net loss) for the period.
This Thiswill willappear appear as asaa separate separate line-item line-itemon onthe theinvestor’s investor’s income incomestatement. statement. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-14
Equity Method Step 3: The investor reduces the investment by the amount of dividends received from the investee.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-15
Let’s do an equity method example.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-16
Equity Method Example – Step 1 On January 1, 2005, Big Corp. buys 20% of Small Inc. for $2,000,000 cash. Record Big’s journal entry.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-17
Equity Method Example – Step 2 On December 31, 2005, Small reports net income for the year of $300,000. Record Big’s journal entry.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-18
Equity Method Example – Step 2 Big owns 20% of Small and gets credit for 20% of Small’s income. 20% × $300,000 = $60,000
60,000 McGraw-Hill/Irwin
60,000
© The McGraw-Hill Companies, Inc.
Slide 1-19
Equity Method Example – Step 3 On December 31, 2003, Big received a $25,000 dividend check from Small. Record Big’s journal entry.
60,000 McGraw-Hill/Irwin
25,000
25,000
© The McGraw-Hill Companies, Inc.
Slide 1-20
Special Procedures for Special Situations Reporting Reporting aa change change to to the the equity equity method. method.
Reporting Reporting investee investee income income from from sources sources other other than than continuing continuing operations. operations. McGraw-Hill/Irwin
Reporting Reporting the the sale sale of of an an equity equity investment. investment.
Reporting Reporting investee investee losses. losses.
© The McGraw-Hill Companies, Inc.
Slide 1-21
Reporting a Change to the Equity Method.
An investment that is too small to have significant influence is ed for using the fair-value method. When ownership grows to the point where significant influence is established . . .
.. .. .. all all s s are arerestated restated so so that that the the investor’s investor’sfinancial financial statements statements appear appear as as ifif the the equity equity method method had had been been applied applied from from the thedate date of of the the first first [original] [original] acquisition. acquisition. -- --APB APB Opinion Opinion 18 18
?
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-22
Restatement - Example Assume Assumethat thatExxo ExxoCompany Companyacquires acquires5% 5%of of LipGloss LipGlossInc. Inc.on onJanuary January1, 1, 2004 2004for for$2,000,000. $2,000,000. There Thereis isno no significant significantinfluence. influence. The Theinvestment investment is is recorded recordedat at the thetime timeas asan anAvailable-for-Sale Available-for-Sale Investment. Investment. In In2004, 2004,LipGloss LipGlosshad had net net income incomeof of $300,000, $300,000,and and paid paiddividends dividendsof of $140,000. $140,000. Exxo Exxo would would report report the the investment investment as asindicated indicatedin inthe thetable tablebelow: below:
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-23
Fair Market Value entry The
entries for adjustment to FMV would also have been required. E.g. Assume that the FMV @ 31/12/2004 was $2,400,000. Then the following entry would have been made (as per SFAS115): Dr Market Value Adjustment - AFS 400,000 Cr Unrealized inc/dec in value of AFS 400,000
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-24
Restatement - Example On OnJanuary January1, 1,2005, 2005, Exxo Exxobuys buysan anadditional additional15% 15% interest interest in inLipGloss, LipGloss,raising raisingthe thetotal totalinvestment investment to to 20%. 20%. The Thefirst first thing thingthat thatExxo Exxo must must do do is isrestate restate the the 12/31/04 12/31/04numbers numbersby byapplying applying the theequity equitymethod methodto to the the5% 5%investment investment in in LipGloss. LipGloss. We Wehave haveto toRESTATE RESTATEthe theInvestment Investment , ,put putaa balance balancein inEquity Equityin inInvestee InvesteeIncome, Income,and andeliminate eliminate the theDividend DividendRevenue Revenue balance. balance.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-25
Restatement - Example An Anadjustment adjustmentis isrecorded recordedto tothe theInvestment Investment and andto to Retained Retained Earnings Earnings (since (sinceDividend Dividend Revenue Revenuehas has already alreadybeen been closed closed out). out).
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-26
Removal of Fair Market Value related s The
FMV related s would also have to be removed. i.e. : Dr Unrealized inc/dec in value of AFS 400,000 Cr Market Value Adjustment - AFS 400,000
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-27
Reporting Investee Income from Other Sources When
net income includes elements other than Operating Income, those elements should be separately reported on the investor’s income statement. Examples include: Extraordinary items Discontinued operations Prior period adjustments
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-28
Reporting Investee Income from Other Sources
Big Big owns owns 30% 30% of of Little. Little. Little Little reports reports net net income income for for 2005 2005 of of $120,000. $120,000. Little’s Little’s Income Income includes includes operating operating income income of of $135,000 $135,000 and and an an extraordinary extraordinary loss loss of of $15,000. $15,000. Big’s Big’s equity equity method method entry entry at at year-end year-end is: is:
McGraw-Hill/Irwin
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Slide 1-29
Reporting Investee Losses Permanent Permanent Losses Losses in in Value Value A Apermanent permanent decline decline in in the the investee’s investee’s market market value value is is recorded recorded as as aa reduction reduction of of the the investment investment . .
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-30
Reporting Investee Losses Investment Investment Reduced Reduced to to Zero Zero When When the the accumulated accumulated losses losses incurred incurred by by the the investee investee and and dividends dividends paid paid by by the the investee investee reduce reduce the the investment investment to to zero, zero, NO NO ADDITIONAL ADDITIONAL LOSSES LOSSES are are accrued. accrued. The The balance balance remains remains at at $0, $0, until until subsequent subsequent profits profits eliminate eliminate all all UNRECORDED UNRECORDED losses. losses.
McGraw-Hill/Irwin
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Slide 1-31
Reporting the Sale of an Equity Investment If part of an investment is sold during the period . . . The Theequity equitymethod methodcontinues continues to tobe be
applied appliedup upto to the the date dateof of the the transaction. transaction. At At the thetransaction transaction date, date,aa proportionate proportionateamount amount of of the the Investment Investment is isremoved. removed. IfIf significant significantinfluence influenceis islost, lost, NO NO RETROACTIVE RETROACTIVEADJUSTMENT ADJUSTMENT is is recorded. recorded. (as (asis isthe the case casewhen when switching switchingfrom from FV FVto to Equity Equity method) method) McGraw-Hill/Irwin
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Slide 1-32
Reporting the Sale of an Equity Investment
Alice AliceCo. Co.30% 30%(300,000 (300,000shares) shares)of ofSam, Sam,Inc.. Inc.. The Thebalance balance in inAlice’s Alice’sInvestment Investment at atMarch March31, 31,2005, 2005,is is $268,000. $268,000. IfIfAlice AliceCo. Co.sells sells10% 10%of ofits itsshares shares(30,000 (30,000shares) shares)on on April April1, 1,2005 2005 for for$100,000, $100,000,what whatentry entryshould shouldAlice Alice make makeon onApril April1, 1,2005? 2005?
$268,000 × .10% = $26,800 This brings the Investment to a balance of $241,200 © The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin
Slide 1-33
Excess of Cost Over BV Acquired When Cost > BV acquired, the difference must be identified and ed for.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-34
Excess of Cost Over BV Acquired The The amortization amortization of of the the difference difference associated associated with with the the undervalued undervalued assets assets is is recorded recorded as as aa reduction reduction of of both both the the Investment Investment and and the the Equity Equity in in Investee Investee Income Income . .
McGraw-Hill/Irwin
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Slide 1-35
Excess of Cost Over BV Example On OnJanuary January1, 1,2005, 2005, Big BigCorp. Corp.
acquired acquired 20% 20%of ofSmall Small Inc. Inc. for for $2,000,000 $2,000,000cash. cash. Assume Assumethat thatSmall’s Small’sassets assets had hadBV BVon on January January11of of $8,500,000. $8,500,000. Small Small owns ownsaa building building with with aaBV BVof of $500,000, $500,000, and andaaFMV FMVof of $700,000, $700,000, and and aa remaining remaininguseful useful life life of of 10 10 years. years. All All other other assets assets had had BV BV == FMV. FMV. Allocate Allocatethe thecost cost to to fair fairmarket market value valueadjustments adjustmentsand and Goodwill Goodwillacquired acquiredby byBig. Big. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-36
Excess of Cost Over BV Example
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-37
Excess of Cost Over BV Example
The The Building Building has has aa remaining remaininguseful usefullife life of of10 10years. years. Goodwill Goodwill is isnever neveramortized. amortized. Compute Computethe the amortization amortization expense expense for for Big Big at at12/31/05. 12/31/05.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-38
Amortization of Cost Over BV Example
Big’s Big’sequity equitymethod method entry entrywill will include includean an adjustment adjustment to tothe the investment investment of of$4,000. $4,000.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-39
Amortization of Cost Over BV Example
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-40
McGraw-Hill/Irwin
Let’s look at some intercompany transactions.
© The McGraw-Hill Companies, Inc.
Slide 1-41
Unrealized Gains in Inventory Sometimes d companies sell or buy inventory from each other.
INVESTOR INVESTOR Downstream Sale
INVESTEE INVESTEE McGraw-Hill/Irwin
INVESTOR INVESTOR Upstream Sale
INVESTEE INVESTEE
© The McGraw-Hill Companies, Inc.
Slide 1-42
Unrealized Gains in Inventory Let’s look at an Investor that has 200 units of inventory with a cost of $1,000.
INVESTOR INVESTOR
sells sells200 200units units of of inventory inventory with withaatotal total cost cost of of $1,000. $1,000.
McGraw-Hill/Irwin
Let us assume that the Investor sells the inventory to a 20% owned Investee for $1,250.
© The McGraw-Hill Companies, Inc.
Slide 1-43
Unrealized Gains in Inventory Let’s look at anofInvestor that has 200 Note that there is $250 intercompany profit. Note that there is $250 of intercompany profit. At At units of inventory UNREALIZED. with a cost of this thispoint pointitit is isconsidered considered UNREALIZED. $1,000.
INVESTOR INVESTOR
sells sells200 200units units of of inventory inventory with withaatotal total cost cost of of $1,000. $1,000.
20% ownership Intercompany Sale of 200 units
INVESTEE INVESTEE
buys buys200 200units units of ofinventory inventoryand and pays paysaa total totalof of $1,250. $1,250.
IfIf all all200 200units unitsare arenot not sold soldto toan anoutside outsideparty party during duringthe theperiod, period,we wewill will need need have haveunrealized, unrealized, intercompany intercompanyprofit profit that thatmust mustbe bedeferred. deferred. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-44
Unrealized Gains in Inventory 60 of the original 200 units (30%) are still “unsold” to a 3rd party. We must defer our share (20%) of the original $250 of intercompany profit that is unrealized (30%).
INVESTOR INVESTOR
sells sells200 200units units of of inventory inventory with withaatotal total cost cost of of $1,000. $1,000.
20% ownership Intercompany Sale of 200 units
Outside Party McGraw-Hill/Irwin
INVESTEE INVESTEE
buys buys200 200units units of ofinventory inventoryand and pays paysaa total totalof of $1,250. $1,250.
Investee sells only 140 units to a 3rd party
© The McGraw-Hill Companies, Inc.
Slide 1-45
Unrealized Gains in Inventory Compute
the deferral by multiplying:
The
required journal (for both upstream and downstream) is:
$250 × 30% × 20% = $15
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-46
Unrealized Gains in Inventory In Inthe theperiod periodfollowing followingthe theperiod periodof ofthe the
transfer, transfer,the theremaining remaininginventory inventoryis isoften often sold. sold. When Whenthat thathappens, happens,the theoriginal originalentry entryis is reversed reversed......
The reversal takes place in the period that the inventory is sold to an outside party. McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
Slide 1-47
End of Chapter 1 And this is only the FIRST chapter?!
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc.
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