1. Chapter One The Equity Method of Accounting for Investments McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Accounting for Investments in Corporate Equity Securities GAAP recognizes 3 ways to report investments in other companies: Fair-Value Method Consolidation Equity Method The method selected depends upon the degree of influence the investor has over the investee. LO 1 1-2

3. Fair Value Method 1-3 Investments classified as Trading Securities:  Held for sale in the short term.  Unrealized holding gains and losses are included in earnings (net income). Investments classified as Available-for-Sale Securities:  Any Securities not classified as Trading.  Unrealized holding gains and losses are reported in shareholders’ equity as other comprehensive income (i. e., not included in net income). Investments in equity securities are recorded at cost and subsequently adjusted to fair value. 1-3

4. Consolidation of Financial Statements Required when: Investor’s ownership exceeds 50% of investee except when control does not rest with the majority investor One set of financial statements prepared to consolidate all accounts of the parent company and all of its controlled subsidiaries AS A SINGLE ENTITY. 1-4

5. Equity Method Use when: Investor has the ability to exercise significant influence on the investee operations (whether influence is applied or not) Generally used when ownership is between 20% and 50%. Significant Influence might be present with much lower ownership percentages. 1-5 LO 2 1-5

6. International Standard 28 Investment in Associates The International Accounting Standards Board (IASB), similar to FASB, defines “significant influence” as the power to participate in the financial and operating policy decisions of the investee, but it is not control or joint control over those policies. If investor has 20% or more ownership, it is presumed to have significant influence, unless it is demonstrated not to be the case. If investor holds less than 20% ownership, it is presumed it does not have significant influence, unless influence can be clearly demonstrated. 1-6

7. Investor Ownership of the Investee’s Shares Outstanding 0% 20% 50% 100% Fair Value Equity Method Consolidated Financial Statements General Ownership Guidelines Significant influence generally assumed (20% to 50% ownership). Usually lack of control or significant influence. Financial statements of all related companies must be consolidated. 1-7

8. Fair Value Equity Method Consolidated Financial Statements General Reporting Guidelines 1: Same as Fair Value 2: Investor recognizes its share (% of owner- ship) of investee’s net income (net loss) as an increase (decrease) in the investment account and dividends as a decrease. 1. Investor records investment at “cost”. 2. Investor recognizes cash dividends from investee as income. One set of financial statements are prepared to combine accounts of the investor and all of its investees AS A SINGLE ENTITY. LO 3 1-8

9. 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. 1-9

10. Excess of Cost Over Book Value of Acquired Investment When Cost > Book Value of an investment acquired, the difference must be identified. 1-10 LO 4 Assets may be undervalued because: 1.Fair values (FV) of some assets and liabilities on investee’s books are different than book values (BV). 2.Investor is willing to pay extra expecting future benefits to accrue from the investment. 3.Additional amount paid in excess of book value not allocated to undervalued assets is attributed to an intangible future value and recorded as Goodwill. 1-10

11. Reporting Sale of Equity Investment The equity method continues to be applied up to the date of the transaction. At the transaction date, the Investment account balance is reduced by the percentage of shares sold. If significant influence is lost, NO RETROACTIVE ADJUSTMENT is recorded, but the equity method is no longer applied. If part of an investment is sold during the period: LO 5 1-11

12. INVESTORINVESTOR INVESTEEINVESTEE INVESTORINVESTOR INVESTEEINVESTEE Downstream Sale Upstream Sale Unrealized Profits in Inventory Sometimes affiliated companies sell or buy inventory from each other in intra-entity transactions that necessitate special accounting procedures. 1-12 LO 6 1-12

13. Fair Value Reporting Option In 2007, FASB introduced a fair-value option An entity may irrevocably elect fair value as the initial and subsequent measurement for certain financial assets and financial liabilities including investments accounted for under the equity method. Under the fair-value option, changes in the fair value of the elected financial items are included in earnings. LO 7 1-13

14. Fair Value Option Investment that can otherwise be accounted for under the equity method Investment in non- marketable equity securities After 2007, under the Fair-value Option, changes in the fair value of these assets are reported in earnings. 1-14