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, but the equity method is no longer applied.  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, but the equity method is no longer applied. 1-1

Reporting the Sale of an Equity Investment Top Company owns 40 percent of the 100,000 outstanding shares of Bottom Company, an investment accounted for by the equity method. Although these 40,000 shares were acquired some years ago for $200,000, application of the equity method has increased the asset balance to $320,000 as of January 1, On July 1, 2008, Top elects to sell 10,000 of these shares (one-fourth of its investment) for $110,000 in cash, thereby reducing ownership in Bottom from 40 percent to 30 percent. Bottom Company reports income of $70,000 during the first six months of 2008 and distributes cash dividends of $30,

Excess of Cost Over BV Acquired When Cost > BV acquired, the difference must be identified and accounted for. 1-3

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. 1-4

Big Company is negotiating the acquisition of 30 percent of the outstanding shares of Little Company. Little’s balance sheet reports assets of $500,000 and liabilities of $300,000 for a net book value of $200,000. After investigation, Big determines that Little’s equipment (5 year remaining life) is undervalued in the company’s financial records by $60,000. One of its patents (10 year remaining life) is also undervalued, but only by $40,000. By adding these valuation adjustments to Little’s book value, Big arrives at an estimated $300,000 worth for the company’s net assets. Based on this computation, Big offers $90,000 for a 30 percent share of the investee’s outstanding stock. Big Company is negotiating the acquisition of 30 percent of the outstanding shares of Little Company. Little’s balance sheet reports assets of $500,000 and liabilities of $300,000 for a net book value of $200,000. After investigation, Big determines that Little’s equipment (5 year remaining life) is undervalued in the company’s financial records by $60,000. One of its patents (10 year remaining life) is also undervalued, but only by $40,000. By adding these valuation adjustments to Little’s book value, Big arrives at an estimated $300,000 worth for the company’s net assets. Based on this computation, Big offers $90,000 for a 30 percent share of the investee’s outstanding stock. Excess of Cost Over BV Example 1-5

Excess of Cost Over BV Example Book value of Little Company (assets minus liabilities [or stockholders’ equity]) $200,000 Undervaluation of equipment ,000 Undervaluation of patent ,000 Value of net assets $300,000 Portion being acquired % Acquisition price $ 90,

Amortization of Cost Over BV Example Payment by investor.... ……………..…… ,000 Percentage of book value acquired ($200,000 × 30%).. …………….…… ,000 Payment in excess of book value …………………..…30,000 Excess payment identified with specific assets: Equipment ($60,000 undervaluation × 30%). 18,000 Patent ($40,000 undervaluation × 30%) ,000 30,000 Excess payment not identified with specific assets—goodwill.. –0– Payment by investor.... ……………..…… ,000 Percentage of book value acquired ($200,000 × 30%).. …………….…… ,000 Payment in excess of book value …………………..…30,000 Excess payment identified with specific assets: Equipment ($60,000 undervaluation × 30%). 18,000 Patent ($40,000 undervaluation × 30%) ,000 30,000 Excess payment not identified with specific assets—goodwill.. –0– 1-7

Amortization of Cost Over BV 1-8

INVESTORINVESTOR INVESTEEINVESTEE INVESTORINVESTOR INVESTEEINVESTEE Downstream Sale Upstream Sale Unrealized Gains in Inventory Sometimes affiliated companies sell or buy inventory from each other. 1-9

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,

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 have unrealized, intercompany profit that must be deferred. 1-11

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%) remain “unsold” to an “outside” 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 1-12

Unrealized Gains in Inventory Compute the deferral by multiplying: The required journal entry is: $250 × 30% × 20% = $

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 during the period that the inventory is sold to an outside party. 1-14

Summary The equity method is applied to an investment whenever significant influence appears to exist. Significant influence is presumed whenever ownership is between 20 and 50% (however, each situation must be examined separately.) Investee income proportionately increases the investment, while dividends decrease it. The equity method is applied retroactively once significant influence is apparent. Excess payments of acquisition are assigned either to specific assets and liabilities or to goodwill. Assigned costs (other than to land or goodwill after 2001) are systematically amortized. This is applied until the date of disposal Intercompany markups on transferred assets are deferred until the items are consumed or sold to outside parties. 1-15

Possible Criticisms: Over-emphasis on possession of % voting stock in deciding on “significant influence” vs. “control” Possibility of “off-balance sheet financing” Potential manipulation of performance ratios WHAT DO YOU THINK????? 1-16