© The McGraw-Hill Companies, Inc., 2004 Slide 1-1 McGraw-Hill/Irwin Chapter One The Equity Method of Accounting for Investments

© The McGraw-Hill Companies, Inc., 2004 Slide 1-2 McGraw-Hill/Irwin Reporting Investments in Corporate Equity Securities Note: These 3 approaches are not interchangeable. The characteristics of each investment will dictate the appropriate accounting approach. GAAP allows 3 approaches to reporting investments.

© The McGraw-Hill Companies, Inc., 2004 Slide 1-3 McGraw-Hill/Irwin Fair Value Method Details in SFAS No. 115 Initial Investment is recorded at cost. Initial Investment is recorded at cost. Investments in equities of other companies are classified as either Trading Securities or Available-for- Sale Securities. Investments in equities of other companies are classified as either Trading Securities or Available-for- Sale Securities. Income is only realized to the extent of dividends received. Income is only realized to the extent of dividends received. Details in SFAS No. 115 Initial Investment is recorded at cost. Initial Investment is recorded at cost. Investments in equities of other companies are classified as either Trading Securities or Available-for- Sale Securities. Investments in equities of other companies are classified as either Trading Securities or Available-for- Sale Securities. Income is only realized to the extent of dividends received. Income is only realized to the extent of dividends received.

© The McGraw-Hill Companies, Inc., 2004 Slide 1-4 McGraw-Hill/Irwin Consolidation of Financial Statements Governed by ARB No. 51, SFAS No. 141, and SFAS No 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.

© The McGraw-Hill Companies, Inc., 2004 Slide 1-5 McGraw-Hill/Irwin Equity Method Defined by APB Opinion 18 and SFAS No Requires that the investment is sufficient to insure significant influence. Generally used when ownership is between 20% & 50%.  Influence can be present with much smaller ownership percentages. Defined by APB Opinion 18 and SFAS No Requires that the investment is sufficient to insure significant influence. Generally used when ownership is between 20% & 50%.  Influence can be present with much smaller ownership percentages.

© The McGraw-Hill Companies, Inc., 2004 Slide 1-6 McGraw-Hill/Irwin Criteria for Determining Whether There is Influence Representation on the investee’s Board of Directors Participation in the investee’s policy- making process Material intercompany transactions. Interchange of managerial personnel. Technological dependency. Extent of ownership in relationship to other ownership percentages.

© The McGraw-Hill Companies, Inc., 2004 Slide 1-7 McGraw-Hill/Irwin { In some cases, influence or control may exist with less than 20% ownership. Investor Ownership of Investee Shares Outstanding 0%20%50%100% Fair Value Equity Method Consolidated Financial Statements The Significance of the Size of the Investment

© The McGraw-Hill Companies, Inc., 2004 Slide 1-8 McGraw-Hill/Irwin { Significant influence is generally assumed with 20% to 50% ownership. Investor Ownership of Investee Shares Outstanding The Significance of the Size of the Investment 0%20%50%100% Fair Value Equity Method Consolidated Financial Statements

© The McGraw-Hill Companies, Inc., 2004 Slide 1-9 McGraw-Hill/Irwin { Financial Statements of all related companies must be consolidated. Investor Ownership of Investee Shares Outstanding The Significance of the Size of the Investment 0%20%50%100% Fair Value Equity Method Consolidated Financial Statements

© The McGraw-Hill Companies, Inc., 2004 Slide 1-10 McGraw-Hill/Irwin Equity Method Step 1: The investor records its investment in the investee at cost. Cost can be defined by cash paid or Fair Market Value of Stock or other assets given up.

© The McGraw-Hill Companies, Inc., 2004 Slide 1-11 McGraw-Hill/Irwin Equity Method Step 2: The investor recognizes its proportionate share of the investee’s net income (or net loss) for the period.

© The McGraw-Hill Companies, Inc., 2004 Slide 1-12 McGraw-Hill/Irwin Equity Method Step 2: The investor recognizes its proportionate share of the investee’s net income (or net loss) for the period. This will appear as a separate line-item on the investor’s income statement.

© The McGraw-Hill Companies, Inc., 2004 Slide 1-13 McGraw-Hill/Irwin Equity Method Step 3: The investor reduces the investment account by the amount of dividends received from the investee.

© The McGraw-Hill Companies, Inc., 2004 Slide 1-14 McGraw-Hill/Irwin Let’s do an equity method example.

© The McGraw-Hill Companies, Inc., 2004 Slide 1-15 McGraw-Hill/Irwin 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.

© The McGraw-Hill Companies, Inc., 2004 Slide 1-16 McGraw-Hill/Irwin Equity Method Example – Step 2 On December 31, 2005, Small reports net income for the year of $300,000. Record Big’s journal entry.

© The McGraw-Hill Companies, Inc., 2004 Slide 1-17 McGraw-Hill/Irwin 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

© The McGraw-Hill Companies, Inc., 2004 Slide 1-18 McGraw-Hill/Irwin Equity Method Example – Step 3 On December 31, 2003, Big received a $25,000 dividend check from Small. Record Big’s journal entry. 25,000 60,00025,000

© The McGraw-Hill Companies, Inc., 2004 Slide 1-19 McGraw-Hill/Irwin Special Procedures for Special Situations Reporting a change to the equity method. Reporting investee income from sources other than continuing operations. Reporting investee losses. Reporting the sale of an equity investment.

© The McGraw-Hill Companies, Inc., 2004 Slide 1-20 McGraw-Hill/Irwin ? Reporting a Change to the Equity Method. An investment that is too small to have significant influence is accounted for using the fair-value method. When ownership grows to the point where significant influence is established all accounts are restated so that the investor’s financial statements appear as if the equity method had been applied from the date of the first [original] acquisition. - - APB Opinion 18

© The McGraw-Hill Companies, Inc., 2004 Slide 1-21 McGraw-Hill/Irwin Restatement - Example Assume that Exxo Company acquires 5% of LipGloss Inc. on January 1, 2004 for $2,000,000. There is no significant influence. The investment is recorded at the time as an Available-for-Sale Investment. In 2004, LipGloss had net income of $300,000, and paid dividends of $140,000. Exxo would report the investment as indicated in the table below: Assume that Exxo Company acquires 5% of LipGloss Inc. on January 1, 2004 for $2,000,000. There is no significant influence. The investment is recorded at the time as an Available-for-Sale Investment. In 2004, LipGloss had net income of $300,000, and paid dividends of $140,000. Exxo would report the investment as indicated in the table below:

© The McGraw-Hill Companies, Inc., 2004 Slide 1-22 McGraw-Hill/Irwin Restatement - Example On January 1, 2005, Exxo buys an additional 15% interest in LipGloss, raising the total investment to 20%. The first thing that Exxo must do is restate the 12/31/04 numbers by applying the equity method to the 5% investment in LipGloss. We have to RESTATE the Investment account, put a balance in Equity in Investee Income, and eliminate the Dividend Revenue balance. On January 1, 2005, Exxo buys an additional 15% interest in LipGloss, raising the total investment to 20%. The first thing that Exxo must do is restate the 12/31/04 numbers by applying the equity method to the 5% investment in LipGloss. We have to RESTATE the Investment account, put a balance in Equity in Investee Income, and eliminate the Dividend Revenue balance.

© The McGraw-Hill Companies, Inc., 2004 Slide 1-23 McGraw-Hill/Irwin Restatement - Example An adjustment is recorded to the Investment account and to Retained Earnings (since Dividend Revenue has already been closed out).

© The McGraw-Hill Companies, Inc., 2004 Slide 1-24 McGraw-Hill/Irwin 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

© The McGraw-Hill Companies, Inc., 2004 Slide 1-25 McGraw-Hill/Irwin Reporting Investee Income from Other Sources Big owns 30% of Little. Little reports net income for 2005 of $120,000. Little’s Income includes operating income of $135,000 and an extraordinary loss of $15,000. Big’s equity method entry at year-end is: Big owns 30% of Little. Little reports net income for 2005 of $120,000. Little’s Income includes operating income of $135,000 and an extraordinary loss of $15,000. Big’s equity method entry at year-end is:

© The McGraw-Hill Companies, Inc., 2004 Slide 1-26 McGraw-Hill/Irwin Reporting Investee Losses Permanent Losses in Value A permanent decline in the investee’s market value is recorded as a reduction of the investment account. Permanent Losses in Value A permanent decline in the investee’s market value is recorded as a reduction of the investment account.

© The McGraw-Hill Companies, Inc., 2004 Slide 1-27 McGraw-Hill/Irwin Reporting Investee Losses Investment Reduced to Zero When the accumulated losses incurred by the investee and dividends paid by the investee reduce the investment account to zero, NO ADDITIONAL LOSSES are accrued. The balance remains at $0, until subsequent profits eliminate all UNRECORDED losses. Investment Reduced to Zero When the accumulated losses incurred by the investee and dividends paid by the investee reduce the investment account to zero, NO ADDITIONAL LOSSES are accrued. The balance remains at $0, until subsequent profits eliminate all UNRECORDED losses.

© The McGraw-Hill Companies, Inc., 2004 Slide 1-28 McGraw-Hill/Irwin Reporting the Sale of an Equity Investment If part of an investment is sold during the period...  The equity method continues to be applied up to the date of the transaction.  At the transaction date, a proportionate amount of the Investment account is removed.  If significant influence is lost, NO RETROACTIVE ADJUSTMENT is recorded.  The equity method continues to be applied up to the date of the transaction.  At the transaction date, a proportionate amount of the Investment account is removed.  If significant influence is lost, NO RETROACTIVE ADJUSTMENT is recorded.

© The McGraw-Hill Companies, Inc., 2004 Slide 1-29 McGraw-Hill/Irwin Reporting the Sale of an Equity Investment Alice Co. 30% (300,000 shares) of Sam, Inc.. The balance in Alice’s Investment account at March 31, 2005, is $268,000. If Alice Co. sells 10% of its shares (30,000 shares) on April 1, 200 for $100,000, what entry should Alice make on April 1, 2005? Alice Co. 30% (300,000 shares) of Sam, Inc.. The balance in Alice’s Investment account at March 31, 2005, is $268,000. If Alice Co. sells 10% of its shares (30,000 shares) on April 1, 200 for $100,000, what entry should Alice make on April 1, 2005? This brings the Investment account to a balance of $241,200 $268,000 ×.10% = $26,800

© The McGraw-Hill Companies, Inc., 2004 Slide 1-30 McGraw-Hill/Irwin Excess of Cost Over BV Acquired When Cost > BV acquired, the difference must be identified and accounted for.

© The McGraw-Hill Companies, Inc., 2004 Slide 1-31 McGraw-Hill/Irwin Excess of Cost Over BV Acquired The amortization of the difference associated with the undervalued assets is recorded as a reduction of both the Investment account and the Equity in Investee Income account.

© The McGraw-Hill Companies, Inc., 2004 Slide 1-32 McGraw-Hill/Irwin On January 1, 2005, Big Corp. acquired 20% of Small Inc. for $2,000,000 cash. Assume that Small’s assets had BV on January 1 of $8,500,000. Small owns a building with a BV of $500,000, and a FMV of $700,000, and a remaining useful life of 10 years. All other assets had BV = FMV. Allocate the cost to fair market value adjustments and Goodwill acquired by Big. On January 1, 2005, Big Corp. acquired 20% of Small Inc. for $2,000,000 cash. Assume that Small’s assets had BV on January 1 of $8,500,000. Small owns a building with a BV of $500,000, and a FMV of $700,000, and a remaining useful life of 10 years. All other assets had BV = FMV. Allocate the cost to fair market value adjustments and Goodwill acquired by Big. Excess of Cost Over BV Example

© The McGraw-Hill Companies, Inc., 2004 Slide 1-33 McGraw-Hill/Irwin Excess of Cost Over BV Example

© The McGraw-Hill Companies, Inc., 2004 Slide 1-34 McGraw-Hill/Irwin Excess of Cost Over BV Example The Building has a remaining useful life of 10 years. Goodwill is never amortized. Compute the amortization expense for Big at 12/31/05.

© The McGraw-Hill Companies, Inc., 2004 Slide 1-35 McGraw-Hill/Irwin Amortization of Cost Over BV Example Big’s equity method entry will include an adjustment to the investment account of $4,000.

© The McGraw-Hill Companies, Inc., 2004 Slide 1-36 McGraw-Hill/Irwin Amortization of Cost Over BV Example

© The McGraw-Hill Companies, Inc., 2004 Slide 1-37 McGraw-Hill/Irwin Let’s look at some intercompany transactions.

© The McGraw-Hill Companies, Inc., 2004 Slide 1-38 McGraw-Hill/Irwin INVESTORINVESTOR INVESTEEINVESTEE INVESTORINVESTOR INVESTEEINVESTEE Downstream Sale Upstream Sale Unrealized Gains in Inventory Sometimes affiliated companies sell or buy inventory from each other.

© The McGraw-Hill Companies, Inc., 2004 Slide 1-39 McGraw-Hill/Irwin Unrealized Gains in Inventory Let’s look at an Investor that has 200 units of inventory with a cost of $1,000. INVESTOR sells 200 units of inventory with a total cost of $1,000. Let us assume that the Investor sells the inventory to a 20% owned Investee for $1,250.

© The McGraw-Hill Companies, Inc., 2004 Slide 1-40 McGraw-Hill/Irwin INVESTEE buys 200 units of inventory and pays a total of $1,250. Intercompany Sale of 200 units 20% ownership Unrealized Gains in Inventory INVESTOR sells 200 units of inventory with a total cost of $1,000. Let’s look at an Investor that has 200 units of inventory with a cost of $1,000. Note that there is $250 of intercompany profit. At this point it is considered UNREALIZED. If all 200 units are not sold to an outside party during the period, we will need have unrealized, intercompany profit that must be deferred.

© The McGraw-Hill Companies, Inc., 2004 Slide 1-41 McGraw-Hill/Irwin INVESTEE buys 200 units of inventory and pays a total of $1,250. Intercompany Sale of 200 units 20% ownership Unrealized Gains in Inventory INVESTOR sells 200 units of inventory with a total cost of $1, of the original 200 units (30%) are still “unsold” to a 3 rd party. We must defer our share (20%) of the original $250 of intercompany profit that is unrealized (30%). Investee sells only 140 units to a 3 rd party Outside Party

© The McGraw-Hill Companies, Inc., 2004 Slide 1-42 McGraw-Hill/Irwin Unrealized Gains in Inventory Compute the deferral by multiplying: The required journal is: $250 × 30% × 20% = $15

© The McGraw-Hill Companies, Inc., 2004 Slide 1-43 McGraw-Hill/Irwin Unrealized Gains in Inventory In the period following the period of the transfer, the remaining inventory is often sold. When that happens, the original entry is reversed... In the period following the period of the transfer, the remaining inventory is often sold. When that happens, the original entry is reversed... The reversal takes place in the period that the inventory is sold to an outside party.

© The McGraw-Hill Companies, Inc., 2004 Slide 1-44 McGraw-Hill/Irwin And this is only the FIRST chapter?! End of Chapter 1