Institut für Betriebswirtschaftslehre
Equity Investments -- Fair Value
Method and Equity Method
Prof. Hui Chen
Chapter 1 Advanced Financial Accounting, H. Chen 1
Intercorporate Equity Investments
Institut für Betriebswirtschaftslehre
Why do companies invest in other companies?
• To earn a high rate of return
• To secure certain operating or financing
arrangements with another company
How do companies account for their investments?
They do so based on
• the type of security (debt or equity) and
• their intent with respect to the investment
Intercorporate Equity Investments
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Percentage of Less than 20% Between 20% and More than 50%
Ownership 50%
Level of Influence Little or None Significant Control
influence
Valuation Method Fair Value Method Equity Method Consolidation
The method selected depends upon the degree of
influence the investor has over the investee.
Chapter 1 Advanced Financial Accounting, H. Chen 3
Intercorporate Equity Investments
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Chapter 1 Advanced Financial Accounting, H. Chen 4
Fair value method
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Use when:
• investor holds a small percentage (usually less than
20%) of equity securities of investee
• Investor cannot significantly affect investee’s
operations
• Investment is made in anticipation of dividends or
market appreciation.
• Investments are recorded at cost and subsequently
adjusted to fair value, if determinable, otherwise they
remain at cost.
Chapter 1 Advanced Financial Accounting, H. Chen 5
Equity Method
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Use when:
• Investor has the ability to exercise significant
influence on 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.
• Under the equity method, investor’s share of
investee dividends declared are recorded as
decreases in the investment account, not income.
Chapter 1 Advanced Financial Accounting, H. Chen 6
Consolidation of Financial Statements
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Use when:
• Investor’s ownership exceeds 50% of an organization’s
outstanding voting stock
• Control exists through legal or contractual arrangement,
even when the ownership is less than 50%.
• Special purpose entities must also be consolidated
(intended to combat misuse of SPEs to keep large
amounts of assets and liabilities off the balance sheet
known as “off balance sheet financing”)
• One set of financial statements prepared to consolidate
all accounts of the parent company and all of its
controlled subsidiaries as a single entity
Chapter 1 Advanced Financial Accounting, H. Chen 7
Fair value method
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Under IFRS, the presumption is that equity investments less
than 20% are held-for-trading.
• Investments valued at fair value.
• Record unrealized gains and losses in net income.
IFRS allows companies to classify some equity investments
less than 20% as non-trading.
• Investments valued at fair value.
• Record unrealized gains and losses in other comprehensive
income.
Chapter 1 Advanced Financial Accounting, H. Chen 8
Exercise – trading securities
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November 3, 2015, Republic Corp. purchased ordinary shares of
three companies, each investment representing less than a 20%
interest. These shares are held-for-trading.
Prepare journal entries for these investments.
Equity Investments 718,550
Cash 718,550
Chapter 1 Advanced Financial Accounting, H. Chen 9
Exercise – trading securities
Institut für Betriebswirtschaftslehre
On December 6, 2015, Republic receives a cash dividend of
€4,200 on its investment in the ordinary shares of Nestlé.
Prepare journal entry.
Cash 4,200
Dividend Revenue 4,200
Chapter 1 Advanced Financial Accounting, H. Chen 10
Exercise – trading securities
Institut für Betriebswirtschaftslehre
Prepare journal entries for the FV adjustment.
Unrealized Holding Gain or Loss—Income 35,550
Fair Value Adjustment 35,550
Chapter 1 Advanced Financial Accounting, H. Chen 11
Exercise – trading securities
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In addition, assume that on February 10, 2016, Republic purchased
€255,000 of Continental Trucking ordinary shares (20,000 shares
€12.75 per share), plus brokerage commissions of €1,850.
Republic’s equity investment portfolio as of December 31, 2016.
Chapter 1 Advanced Financial Accounting, H. Chen 12
Exercise – trading securities
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Prepare the journal entry for Republic.
Fair Value Adjustment 101,650
Unrealized Holding Gain or Loss—Income 101,650
Chapter 1 Advanced Financial Accounting, H. Chen 13
Exercise – non-trading securities
Institut für Betriebswirtschaftslehre
On December 10, 2015, Republic Corporation purchased 1,000
ordinary shares of Hawthorne Company for €20.75 per share
(total cost €20,750). The investment represents less than a 20
percent interest. Hawthorne is a distributor for Republic products
in certain locales, the laws of which require a minimum level of
share ownership of a company in that region. The investment in
Hawthorne meets this regulatory requirement. Republic
accounts for this investment at fair value.
Equity Investments 20,750
Cash 20,750
Chapter 1 Advanced Financial Accounting, H. Chen 14
Exercise – non-trading securities
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On December 27, 2015, Republic receives a cash dividend of
€450 on its investment in the ordinary shares of Hawthorne
Company. It records the cash dividend as follows.
Cash 450
Dividend Revenue 450
Chapter 1 Advanced Financial Accounting, H. Chen 15
Exercise – non-trading securities
Institut für Betriebswirtschaftslehre
At December 31, 2015, Republic’s investment in Hawthorne
has the carrying value and fair value shown.
Record this adjustment.
Fair Value Adjustment 3,250
Unrealized Holding Gain or Loss—Equity 3,250
Chapter 1 Advanced Financial Accounting, H. Chen 16
Exercise – non-trading securities
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Chapter 1 Advanced Financial Accounting, H. Chen 17
Exercise – non-trading securities
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On December 20, 2016, Republic sold all of its Hawthorne
Company ordinary shares receiving net proceeds of €22,500.
Prepare the journal entry to adjust the carrying value of the non-
trading investment.
Unrealized Holding Gain or Loss—Equity 1,500
Fair Value Adjustment 1,500
Chapter 1 Advanced Financial Accounting, H. Chen 18
Accounting for an Investment - Equity Method
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• The investor increases the investment account as
the investee earns and reports income. The investor
uses the accrual method to record investment
income —recognizing it in the same time period as
the investee earns it.
• The investor decreases its investment account’s
carrying value for its share of investee cash
dividends. When the investee declares a cash
dividend, its owners’ equity decreases.
Chapter 1 Advanced Financial Accounting, H. Chen 19
Fair Value vs. Equity Method
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Under fair value method:
• The cash dividends received from the investee is reported
as revenue (not the investee’s profit).
• The investor has no/little influence over the distribution of
the investee’s net income.
Under equity method:
• The investor reports as revenue its share of the investee’s
net income.
• With significant influence, the investor can ensure that the
investee will pay dividends, if desired.
• Dividend received from the investee reduces the carry
amount of Investment Account (“payment received” from
the investee).
Chapter 1 Advanced Financial Accounting, H. Chen 20
Sole Criterion for Utilizing the Equity Method
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Significant Influence
• Representation on the investee’s Board of Directors
• Participation in the investee’s policy-making process
• Material intra-entity transactions
• Interchange of managerial personnel
• Technological dependency
• Other investee ownership percentages
Chapter 1 Advanced Financial Accounting, H. Chen 21
When Equity Method is not Applicable
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The equity method is not appropriate for investments
that demonstrate any of the following characteristics
regardless of the investor’s degree of ownership:
• An agreement exists between investor and investee
by which the investor surrenders significant rights as
a shareholder.
• A concentration of ownership operates the investee
without regard for the views of the investor.
• The investor attempts but fails to obtain
representation on the investee’s board of directors.
What method should they use then?
Chapter 1 Advanced Financial Accounting, H. Chen 22
Exercise -- Equity Method
Institut für Betriebswirtschaftslehre
Assume that Big Company owns a 20% interest in
Little Company purchased on January 1, 2014, for
$200,000.
Little then reports net income of $200,000, $300,000,
and $400,000, respectively, in the next three years
while declaring dividends of $50,000, $100,000, and
$200,000.
Prepare journal entries related to the investment in
Little for Dec. 31, 2014.
Chapter 1 Advanced Financial Accounting, H. Chen 23
Exercise -- Equity Method
Institut für Betriebswirtschaftslehre
Big Company records the following journal entries to apply the
equity method for 2014:
Chapter 1 Advanced Financial Accounting, H. Chen 24
Exercise -- Equity Method
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Chapter 1 Advanced Financial Accounting, H. Chen 25
Exercise -- Equity Method vs. Fair Value
Holdings Between 20% and 50%
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Chapter 1 Advanced Financial Accounting, H. Chen 26
Excess of Investment Cost Over
Book Value Acquired
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• Fair values of specific investee assets and liabilities
can differ from their book values. Excess payment
can be identified directly with those accounts.
• If purchase price exceeds fair value, future benefits
are expected to accrue from the investment due to
estimated profitability of the investee or the
relationship established between the two
companies. The additional payment is attributed to
an intangible asset referred to as goodwill rather
than to any specific investee asset or liability.
Chapter 1 Advanced Financial Accounting, H. Chen 27
Excess of Cost Over Book Value
of Acquired Investment
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When Purchase Price > Book Value of an investment
acquired, the difference must be identified.
Assets may be undervalued on the investee’s books
because:
1. The fair values (FV) of some assets and liabilities are
different than their book values (BV).
2. The investor may be willing to pay extra because
future benefits are expected to accrue from the
investment.
Chapter 1 Advanced Financial Accounting, H. Chen 28
Exercise-- Excess of Investment Cost
Over Book Value Acquired
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Assume Grande Company is negotiating the acquisition of
30 percent of the outstanding shares of Chico Company.
Chico’s balance sheet reports assets of $500,000 and
liabilities of $300,000 for a net book value of $200,000.
After investigation, Grande determines that Chico’s
equipment is undervalued in the company’s financial
records by $60,000. One of its patents is also undervalued,
but only by $40,000.
By adding these valuation adjustments to Chico’s book
value, Grande arrives at an estimated $300,000 worth for
the company’s net assets. Based on this computation,
Grande pays $125,000 for a 30 percent share of the
investee’s outstanding stock.
Chapter 1 Advanced Financial Accounting, H. Chen 29
Exercise-- Excess of Investment Cost
Over Book Value Acquired
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1. What is the amount of goodwill associated with the
investment?
2. Assume the acquisition was successfully completed on
Jan. 1, 2015. What is the total amount of excess
amortization for Grande’s 30% investment in Chico for
the year 2015? What about for the year 2020?
Chapter 1 Advanced Financial Accounting, H. Chen 30
Exercise-- Excess of Investment Cost
Over Book Value Acquired
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Any extra payment that cannot be attributed to a specific asset or
liability is assigned to the intangible asset goodwill. The actual
purchase price can be computed by different techniques or simply
as a result from negotiations.
Chapter 1 Advanced Financial Accounting, H. Chen 31
Exercise-- Excess of Investment Cost
Over Book Value Acquired
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Payment relating to each asset (except land, goodwill, and other indefinite
life intangibles) should be amortized over an appropriate time period.
Goodwill associated with equity method investments, for the most part, is
measured in the same manner as goodwill arising from a business
combination, tested for declines in value and impairment. Goodwill,
implicit in equity investments, is not.
Chapter 1 Advanced Financial Accounting, H. Chen 32
Reporting a Change to the Equity Method
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Report a change to the equity method if:
• An investment that was recorded using the fair-
value method reaches the point where significant
influence is established.
• All accounts are restated retroactively so the
investor’s financial statements appear as if the
equity method had been applied from the date of
the first acquisition.
Chapter 1 Advanced Financial Accounting, H. Chen 33
Reporting Sale of Equity Investment
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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, 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.
Chapter 1 Advanced Financial Accounting, H. Chen 34
Investee Other Comprehensive Income
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• OCI is defined as revenues, expenses, gains, and
losses that are included in comprehensive income but
excluded from net income.
• Accumulated Other Comprehensive Income (AOCI)
includes unrealized holding gains and losses on
available-for-sale securities, foreign currency
translation adjustments, and certain pension
adjustments.
• OCI is accumulated and reported in stockholders’
equity and represents a source of change in investee
company net assets that is recognized under the
equity method.
Chapter 1 Advanced Financial Accounting, H. Chen 35
Reporting Investee Losses
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• A permanent decline in the investee’s fair market
value is recorded as an impairment loss and the
investment account is reduced to the fair value.
• When accumulated losses incurred and dividends
paid by the investee reduce the investment account to
$-0-, no further loss can be accrued.
• Investor discontinues using the equity method rather
than record a negative balance. Balance remains at $-
0-, until subsequent profits eliminate all unrecognized
losses. A temporary decline is ignored!
Chapter 1 Advanced Financial Accounting, H. Chen 36
Deferral of Unrealized Profits in Inventory
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Many equity acquisitions establish ties between
companies to facilitate the direct purchase and sale of
inventory items. Such intra-entity transactions can occur
either on a regular basis or only sporadically.
INVESTOR INVESTOR
Downstream Upstream
Sale Sale
INVESTEE INVESTEE
Chapter 1 Advanced Financial Accounting, H. Chen 37
Deferral of Unrealized Profits in Inventory
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• The seller of the goods retains a partial stake in the
inventory for as long as the buyer holds it.
• The earning process is not considered complete at the
time of the original sale.
• Reporting the profit is delayed until the inventory is
consumed within operations or resold to an unrelated
party.
• At the disposition of the inventory, the original sale is
culminated and gross profit is recognized.
Chapter 1 Advanced Financial Accounting, H. Chen 38
Deferral of Unrealized Profits in Inventory
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Clancy Incorporated, sold $210,000 of its inventory to
Reid Company during 2013 for $350,000. Reid sold
$224,000 of this merchandise in 2013 with the remainder
to be disposed of during 2014. Assume Clancy owns
30% of Reid and applies the equity method.
1. What journal entry will be recorded at the end of 2013
to defer the unrealized intra-entity profits?
2. What journal entry will be recorded in 2014 to realize
the intra-entity profit that was deferred in 2013?
Chapter 1 Advanced Financial Accounting, H. Chen 39
Criticisms of the Equity Method
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• Over-emphasis on possession of 20-50% voting stock
in deciding on significant influence vs. control
• Allowing off-balance sheet financing
• Potential manipulation of performance ratios
Chapter 1 Advanced Financial Accounting, H. Chen 40
Financial Reporting Effects of Different
Institut Types of Accounting for Investment
für Betriebswirtschaftslehre
The choice of accounting method for investment matters!
Measurements of financial performance often affect the
following:
• The firm’s ability to raise capital.
• Managerial compensation.
• The ability to meet debt covenants and future interest
rates.
• Managers’ reputations.
Chapter 1 Advanced Financial Accounting, H. Chen 41
