2 0 2 2

Accounting of Basic
Financial Assets

➢ Tin g Liu
➢ Be ij in g Te c h n o logy a n d
Bu s in e ss U n iv e r sity
• Ting Liu
• P h D. A c c o u n ti n g A s s o c i a te P r of e s s o r,
M a s te r A d v i s o r

• E xe c u t i ve D i r e cto r of I n t e r n a t i o n a l O f f i c e
• B u s i n e s s S c h o o l , B e i j i n g Te c h n o l o g y a n d
B u s i n e s s U n i v e r s i ty
• I n t e r n a t i o n a l H i g h - e n d A c c o u n ti n g Ta l e n ts
of t h e M i n i s tr y of F i n a n c e
• " Yo u n g Ta l e n t " of B e i j i n g U n i v er s i ti es
• C h i n e s e H i g h - e n d A c c o u n ti n g Ta l e n t
(academic)
• M e m b e r of Yo u t h C o m m i tte e ,
P h a r m a c e u ti c a l Po l i c y C o m m i t te e of C h i n a
H e a l th E c o n o m i c s A s s o c i a ti o n
• T h e e d i to r i a l b o a rd m e m b e r of J o u r n a l of
F i n a n c i a l M a n a g e m e n t Re s e a rch ( C h i n e s e )
• I n d e p e n d e n t d i r e c to r of l i s te d c o m p a n i e s
• E m a i l : l i u ti n g 321 52 35@h o tm a i l . c o m
• Te l : 1 3 8 1 0 172 462
Question

• If you are an investor, what will you do?

– A. Not invest in stock

– B. Invest in stock
Question

• How do you make a choice in so many kinds of

investment products?
– A. Redemption at any time
– B. 1~6 months
– C. Longer than 6 months
Question

• How to reflect these investments in your accounting

information system?
Investments (1 of 2)

Financial instruments:
Equity securities Debt securities

• Common stock • Bonds

• Preferred stock • Notes

• Purchased by individual investors, mutual funds, and

corporations
Investments (2 of 2)

• Objective:
– To earn a return from the dividends or interest the
securities pay or from increases in the market
prices of the securities (appreciation)
– To develop ongoing affiliations with the
companies whose securities are acquired
GAAP: Classifications of Debt Investments

Treatment of Unrealized Holding Investment Reported in the

Reporting Approach
Gains and Losses Balance Sheet at

Held-to-maturity (HTM): used for

debt that is planned to be held for its Not recognized Amortized Cost
entire life

Trading (TS): used for debt or equity Recognized in net income, and
that is held in an active trading therefore in retained earnings as part of Fair Value
account for immediate resale. shareholders' equity

Recognized in other comprehensive

Available-for-sale (AFS): used for
income, and therefore in accumulated
debt that does not qualify as held-to- Fair Value
other comprehensive income in
maturity or trading
shareholders' equity

Treatment of Unrealized Holding Gains and Losses → Key

difference among the reporting approaches is how we account for
unrealized holding gains and losses
GAAP: Reporting Categories for
Investments (1 of 2)
Characteristics of the Equity Investment Reporting Method Used by the Investor
Fair Value Through Net Income—similar to the
The Investor lacks significant Influence over
trading-securities approach used for debt; investment
the operating and financial policies of the
reported at fair value (with unrealized holding gains
investee (typically own less than 20% of voting
and losses included in net income), unless fair value
stock):
is not readily determinable*
The Investor has significant influence over the
Equity method—investment reported at cost
operating and financial policies of the investee
adjusted for investor’s share of subsequent earnings
(typically own between 20% and 50% of the
and dividends of the investee**
voting stock):
Consolidation–the financial statements of the
The investor controls the investee (typically
investor and investee are combined as if they are a
owns more than 50% of voting stock):
single company
GAAP: Financial Liability

• The following liabilities shall be measured at fair value and their

changes shall be counted as proceeds for subsequent measurement:
• ①Derivatives classified as liabilities.
• ②Financial liabilities in mixed financial instruments that are to be
divided into principal contracts and derivatives, and the subject
has irrevocably chosen to measure them at fair value.
• ③The guidelines in ASC480-10-35-3 do not cover financial
liabilities within ASC480.
Accounting for Debt Investments

• Debt Security
– Specified date when it matures
– Face amount paid to investors on maturity
– In the meantime, interest paid to investors
Debt Investment: Bonds Purchased at a
Discount (1 of 2)
On July 1, 2018, Masterwear Industries issued $700,000
of 12% bonds, dated July 1. Interest of $42,000 is payable
semiannually on June 30 and December 31. The bonds
mature in three years, on June 30, 2021. The market
interest rate for bonds of similar risk and maturity is 14%.
The entire bond issue was purchased by United
Intergroup, Inc.
Debt Investment: Bonds Purchased at a
Discount (2 of 2)
Calculation of the Price of the Bonds

Interest $ 42,000 × 4.76654 = $200,195

Principal (face amount) $700,000 × 0.66634 = 466,438

Present value (price) of the bonds $666,633

• Present value of $1 table: n = 6, i = 7% → 0.66634

• Present value of an ordinary annuity of $1 table: n = 6,
i = 7% → 4.76654
Bond Investments: Premiums and Discounts

• Fair value of a bond changes when market interest

rates change
• Market value of a fixed-rate investment moves in the
opposite direction of market rates of interest

Interest rate sold

 Market rate ⎯⎯ ⎯ ⎯at⎯
⎯→ Premium
(stated rate)
Interest rate sold
 Market rate ⎯⎯ ⎯ ⎯at⎯
⎯→ Discount
(stated rate)
Recording the Purchase of a Debt
Investment
Journal Entry – July 1, 2018 Debit Credit
Investment in bonds 700,000
Discount on bond investment 33,367
Cash 666,633
Amortization Schedule—Discount
Cash Increase in Outstanding
Date Effective Interest
Interest Balance Balance

7/1/2018 $666,633

12/31/2018 $ 42,000 .07 (666,633) = $ 46,664 $ 4,664 671,297

6/30/2019 42,000 .07 (671,297) = 46,991 4,991 676,288

12/31/2019 42,000 .07 (676,288) = 47,340 5,340 681,628

6/30/2020 42,000 .07 (681,628) = 47,714 5,714 687,342

12/31/2020 42,000 .07 (687,342) = 48,114 6,114 693,456

6/30/2021 42,000 .07 (693,456) = 48,544 6,544 700,000

$252,000 $285,367 $33,367

• $700,000 × 6% → $ 42,000
• $46,664 − $42,000 → $ 4,664
• $666,633 + $4,664 → 671,297
• $666,633 → .07 (666,633) = $ 46,664
Recording Interest Revenue

Face amount ($700,000) × Stated rate [12% ÷ 2] =

Interest received ($42,000)
Outstanding balance ($666,633) × Market rate [14% ÷ 2]
= Interest revenue ($46,664)
Three Classifications of Debt
Investments
Treatment of Unrealized Holding Investment Reported in the
Reporting Approach
Gains and Losses Balance Sheet at

Held-to-maturity (HTM): used for

debt that is planned to be held for its Not recognized Amortized Cost
entire life

Trading (TS): used for debt or equity Recognized in net income, and
that is held in an active trading therefore in retained earnings as part of Fair Value
account for immediate resale. shareholders' equity

Recognized in other comprehensive

Available-for-sale (AFS): used for
income, and therefore in accumulated
debt that does not qualify as held-to- Fair Value
other comprehensive income in
maturity or trading
shareholders' equity

Treatment of Unrealized Holding Gains and Losses →

Key difference among the reporting approaches is how we
account for unrealized holding gains and losses
Disclosure about Investments
—Bank of America
Note 1 (in part): Securities
Debt securities which management has the intent and
ability to hold to maturity are classified as held-to-
maturity (HTM) and reported at amortized cost. Debt
securities that are bought and held principally for the
purpose of resale in the near term are classified as trading
and are carried at fair value with unrealized gains and
losses included in trading account profits (losses). Other
debt securities are classified as AFS and carried at fair
value with net unrealized gains and losses Included in
accumulated OCI on an after-tax basis.
For HTM Investments, Do Not Recognize
Unrealized Holding Gains and Losses (1 of 2)
Example:
The Wall Street Journal indicates that the fair value of the
Masterwear bonds on 12/31/2018 is $714,943. How will
United account for this increase in fair value?
For HTM Investments, Do Not Recognize
Unrealized Holding Gains and Losses (2 of 2)
• If viewed as an HTM investment:
– The change in fair value will be ignored so long as
it is viewed as temporary
– The investment simply will be recorded at
amortized cost
– United will disclose the fair value of its HTM
investments in a note to the financial statements
– It will not recognize any fair value changes in the
income statement or balance sheet
Sale of HTM Investments (1 of 2)

On July 1, 2018, Masterwear Industries issued $700,000

of 12% bonds, dated July 1. Interest of $42,000 is payable
semiannually on June 30 and December 31. The bonds
mature in three years, on June 30, 2021. The market
interest rate for bonds of similar risk and maturity is 14%.
The entire bond issue was purchased by United
Intergroup, Inc.
Due to unforeseen circumstances the company decided to
sell its debt investment for $725,000 on January 5, 2019.
Sale of HTM Investments (2 of 2)

Journal Entry – Jan 5, 2019 Debit Credit

Cash 725,000
Discount on bond investment 28,703
Investment in Masterwear bonds 700,000
Gain on sale of investments
53,703

($33,367 − $4,664) → 28,703

Financial Statement Presentation
—HTM (1 of 2)
• Income Statement and Statement of Comprehensive
Income:
– Realized gains and losses are shown in net income
in the period in which securities are sold
– Unrealized holding gains and losses are disclosed
in notes to financial statements
– Do not affect other comprehensive income (OCI)
Financial Statement Presentation
—HTM (2 of 2)
• Balance Sheet:
– Investments in HTM securities are reported at
amortized cost
– Fair values of those investments are disclosed in
the notes to financial statements
• Cash Flow Statement:
– Cash flows from buying and selling trading
securities are classified as investing activities
Reporting Held-to-Maturity Investments
Fair value 公允价值

• The price that would be received to sell an asset or paid

to transfer a liability in an orderly transaction between
market participants at the measurement date.（ASC
820）
Three Levels of Fair Value Measurement

• Level 1- quoted prices in active markets for identical assets or

liabilities.

• Level 2- market observable. The first involves less-active markets

for identical assets and liabilities; this category is ranked lower
because the market consensus about value may not be strong. The
second arises when the owned assets and owed liabilities are
similar to, but not the same as, those traded in a market.
• Level 3- market unobservable. Fair value is also estimated using
a valuation technique.
ENRON
Fair Value and Enron Scandal(2001)

• “Market to Market”: Enron counted projected earnings from long-

term energy contracts as current income. This was money that
might not be collected for many years.
– The 2nd quarterly report of 2001, the unrealized gains were $7
400 million while the EBITDA was $6 090 million.
• Robert Hermann, the Enron’s general tax counsel at the time, was
told by Skilling that their accounting method allowed Enron to
make money and grow without bringing in a lot of taxable cash.
For Reference

• Enron: The Smartest Guys in the Room

• Film
• http://www.tudou.com/programs/view/_Ry-mUHYPcs/
• Book (English Edition)
• https://www.amazon.cn/图书
/dp/1591846609/ref=sr_1_1?s=books&ie=UTF8&qid=148760373
1&sr=1-1&keywords=the+smartest+guys+in+the+room
Trading Securities (TS) (1 of 2)

• Investments in debt or equity securities acquired

principally for the purpose of selling them in the near
term
– Active buying and selling of securities
– Holding period generally is measured in hours and
days rather than months or years
– Typically reported among the investor’s current
assets
Trading Securities (TS) (2 of 2)

• Fair value information is more relevant, so

– Carried at fair value on the balance sheet, and
– Unrealized holding gains and losses are included
in net income in the period in which fair value
changes
Adjust Trading Security Investments to Fair
Value (2018) (1 of 2)
Assuming the Masterwear bonds have a fair value of
$714,943 as of December 31, 2018, the table shows the
calculation of the balance in the fair value adjustment
account that is required on that date.
December 31,2018

Security Amortized Cost Fair Value FV Adj Bal

Masterwear $671,297 $714,943 $43,646
Adjust Trading Security Investments to Fair
Value (2018) (2 of 2)
Fair Value Changes in Period of Sale

From ASC 320-10-40-1:

With respect to trading securities, because all changes in a

trading security’s fair value are reported in earnings as
they occur, the sale of a trading security does not
necessarily give rise to a gain or loss. Generally, a debit to
cash (or trade date receivable) is recorded for the sales
proceeds, and a credit is recorded to remove the security
at its fair value (or sales price). … Some adjustment to
this procedure will be necessary for entities that have not
yet recorded the security’s change in fair value up to the
point of sale (perhaps because fair value changes are
recorded at the end of each day).
Sale of Trading Security Investments (1 of 3)

Assuming that United sells the bond for $725,000 on

January 5, 2019.
1. Adjust trading securities to fair value (2019)
January 5, 2019

Security Amortized Cost Fair Value FV Adj Bal

Masterwear $671,297 $725,000 $53,703
Sale of Trading Security Investments (2 of 3)
Sale of Trading Security Investments (3 of 3)

2. Record the sale transaction

What If the Company Doesn’t Update FV
Adjustment as of 1/5/19? (1 of 2)
As noted in FASB ASC 320-10-40, for expediency
companies may not update the fair value adjustment to the
fair value as of the date of sale before recording the sale.
In our example, the fair value adjustment balance was
$43,646 on December 31, 2018, and United would record
the following sale entry on January 5, 2019:
What If the Company Doesn’t Update FV
Adjustment as of 1/5/19? (2 of 2)
Financial Statement Presentation: Trading
Securities (1 of 2)
• Income statement and statement of comprehensive
income:
– Gains and losses are included in the income
statement in the periods in which fair value changes,
regardless of whether they are realized or
unrealized
– Do not affect other comprehensive income (OCI)
Financial Statement Presentation: Trading
Securities (2 of 2)
• Balance sheet:
– Investments in trading securities are reported at fair
value, typically as current assets
• Cash flow statement:
– Cash flows from buying and selling trading
securities are classified as operating activities
Reporting Trading Securities
(Ignoring income taxes)
Statement of Comprehensive
Income 2018 2019
Revenues $ $
Expenses
Other income (expense):
Interest revenue 45,664 0
Gain and losses on trading securities 43,646 10,057
Net income 90,310 10,057
Other comprehensive income (OCI) 0 0
Comprehensive income (Net income + OCI) $90,310 $10,057
Balance Sheet
Assets:
Trading securities 714,943 0
Shareholders’ equity:
Retained earnings 90,310 100,367
Statement of Cash Flows (direct method)
Operating activities:
Cash from interest received 42,000 0
Purchase of trading securities (666,633) 0
Sale of trading securities 0 725,000
Debt Investments Classified as Available-for-
Sale Securities
• Available-for-sale (AFS) securities aren’t held for trading
or designated as held to maturity

– The investment is available for sale

– Reported in balance sheet at fair value

– Unrealized gains and losses are not included in net

income but reported in statement of comprehensive
income as other comprehensive income (OCI)
Adjust AFS Investments to Fair Value (1 of 2)

Let’s assume the Masterwear bond investment is

classified as AFS. As of December 31, 2018,
Masterwear has recorded the purchase of the bonds
on July 1, 2018, as well as receipt of the first
semiannual interest payment, so the bonds have an
amortized cost of $671,297. The fair value of the
bonds on December 31, 2018, is $714,943.
Adjust AFS Investments to Fair Value (2 of 2)

December 31, 2018

Security Amortized Cost Fair Value FV Adj Bal

Masterwear $671,297 $714,943 $43,646

Sale of AFS Investments (1 of 4)

Assuming that United sells the Masterwear bond for

$725,000 on January 5, 2019.
January 5, 2019

Security Amortized Cost Fair Value FV Adj Bal

Masterwear $671,297 $725,000 $53,703

Sale of AFS Investments (2 of 4)
Sale of AFS Investments (3 of 4)

Assuming that United sells the bond for $725,000 on January

5, 2019.
2. Reverse previous fair value adjustments
Sale of AFS Investments (4 of 4)

Assuming that Masterwear sells the bond for $725,000 on

January 5, 2019.
3. Record the sale transaction
Journal Entry – Jan 5, 2019 Debit Credit
Cash 725,000
Discount on bond investment 28,703

Investment in Masterwear bonds 700,000

Gain on AFS investment—NI 53,703
Financial Statement Presentation:
AFS (1 of 2)
• Income statement and statement of
comprehensive income:

– Gains and losses are shown in OCI in the

periods in which changes in fair value occur

– Those amounts are reclassified out of OCI and

recognized in net income in the periods in
which securities are sold
Financial Statement Presentation:
AFS (2 of 2)
• Balance sheet:

– Investments in AFS securities are reported at fair value

– Unrealized holding gains and losses become part of

AOCI in shareholders’ equity, and are reclassified out
of AOCI in the periods in which securities are sold

• Cash flow statement:

– Cash flows from buying and selling AFS securities are

classified as investing activities
Reporting Available-for-Sale Securities
Investments in Securities Available-for-
Sale—Cisco Systems (1 of 2)
• Item 1A: Risk Factors (in part)
– We maintain an investment portfolio of various holdings, types,
and maturities. These securities are Generally classified as
available-for-sale and, consequently, are recorded on our
Consolidated Balance Sheets at fair value with unrealized gains
or losses reported as a component of accumulated other
comprehensive income.
Investments in Securities Available-for-
Sale—Cisco Systems (2 of 2)
• Note 8: Investments (in part)
– The following tables summarize the company’s available-for-sale
investments ($ in millions):

Gross
Amortized Gross Unrealized
July 25, 2015 Unrealized Fair value
Cost losses
Gains
Fixed income securities:
U.S. Government $ 29,904 $ 41 $ (6) $29,939
U.S. Government agency 3,662 2 (1) 3,663
Non-U.S. Gov’t agency 1,128 1 (1) 1,128
Corporate debt securities 15,802 34 (53) 15,783
U.S agency mortgage-backed 1,456 8 (3) 1,461
Total fixed income securities 51,952 86 (64) 51,974
Comparison of HTM, TS, and AFS
Approaches
Transfers between Reporting Categories

Transfer from: To: Unrealized Gain or Loss from Transfer at Fair Value

Either HTM or Include in current net income the total unrealized gain or loss, as
Trading
AFS if it all occurred in the current period.

Include in current net income any unrealized gain or loss that

Either HTM or occurred in the current period prior to the transfer. (Unrealized
Trading
AFS gains and losses that occurred in prior periods already were
included in net income in those periods.)

No current income effect. Report total unrealized gain or loss as a

Held-to-maturity Available-for-sale
separate component of shareholders’ equity (in AOCI).

No current income effect. Don’t write off any existing unrealized

Available-for- holding gain or loss in AOCI, but amortize it to net income over
Held-to-maturity
sale the remaining life of the security (fair value amount becomes the
security’s amortized cost basis).
Transfers between Investment Categories
(IFRS)
IFRS U.S. GAAP
Transfer Between Investment Categories

• Allows transfers of debt investments out of

the FVTPL category into FVTOCI or HTM • Allows transfers out of the
in “rare circumstances” trading security category, but
• Transfers of debt investments between the reclassifications under this
amortized cost, FVTOCI, and FVTPL continue to be rarer events
categories occurs only if the company than that occurred under
changes its business model with respect to IFRS with this change
the debt investment
Fair Value Option (FVO—HTM & AFS)

The election is optional but irrevocable on the date

of investment purchase. Under FVO:

HTM and AFS investments are shown in the balance

sheets at fair value

Unrealized gains and losses are recognized in net

income in the period in which they occur

Purchases and sales of investments are likely to be

classified as investing activities
Fair Value Option—IFRS vs. GAAP

IFRS0 U.S. GAAP

Fair Value Option

More restrictive than U.S. standards for

Less restrictive than IFRS. It indicates
determining when firms are allowed to
that the intent of the fair value option is
elect the fair value option. Under both
to address specific circumstances, but
IAS No. 39 and IFRS No. 9, companies
it does not require that those
can elect the fair value option only in
circumstances exist.
specific circumstances.
Impairment of Debt Investments
(1 of 3)
• If fair value of an HTM or AFS investment declines below
the amortized cost of the investment and is deemed to be
other-than-temporary (OTT), a company recognizes an
OTT impairment loss in earnings
Impairment of Debt Investments
(2 of 3)
• Beginning in 2020 companies will be required to use the
Current Expected Credit Loss model (CECL) to account
for impairments of HTM and AFS investments

‒ CECL model uses the allowance method

‒ Requires recognizing impairments of HTM and AFS

investments regardless if deemed OTT

‒ Impairment of debt investments likely to be recognized

sooner than under current approach
Impairment of Debt Investments
(3 of 3)

IFRS U.S. GAAP

Impairments
Impairment of debt investments is calculated using the Impairment of debt investments is calculated using
expected credit loss (“ECL”) model. the CECL model.
IFRS ECL model calculates the expected credit losses
U.S. CECL model calculates the expected credit
over the remaining life of the investment
losses over the remaining life of the investment,
if there has been a significant increase in credit risk. If
regardless of whether there has been a significant
the credit risk of a debt investment has not increased,
increase in credit risk. Because of this, it tends to
the estimate of credit losses only considers credit
recognize impairment losses earlier, and in higher
losses that result from default events that are possible
amounts, than are recognized under IFRS.
within the next 12 months. This approach tends to
accrue relatively little credit loss.
Accounting for Equity Investments

• Critical events that an investor experiences in the life of

an investment

‒Purchasing the investment

‒Recognizing investment revenue

• For debt: Interest

• For equity: Dividends

‒Holding the investment during periods in which the

investment’s fair value changes

• Unrealized holding gains and losses

‒Selling the investment

Reporting Categories for Investments (1 of 2)

Characteristics of the Equity Investment Reporting Method Used by the Investor

Fair Value Through Net Income—similar to the
The Investor lacks significant Influence over
trading-securities approach used for debt; investment
the operating and financial policies of the
reported at fair value (with unrealized holding gains
investee (typically own less than 20% of voting
and losses included in net income), unless fair value
stock):
is not readily determinable*
The Investor has significant influence over the
Equity method—investment reported at cost
operating and financial policies of the investee
adjusted for investor’s share of subsequent earnings
(typically own between 20% and 50% of the
and dividends of the investee**
voting stock):
Consolidation–the financial statements of the
The investor controls the investee (typically
investor and investee are combined as if they are a
owns more than 50% of voting stock):
single company
Reporting Categories for Investments (2 of 2)

*Later in this chapter we discuss in an Additional

Consideration box the alternative approach that is
used if fair value is not readily determinable.

**If the investor elects the fair value option, this

type of investment also can be accounted for using
the fair-value-through-net-income approach.
 What Is Significant Influence?
If an investor owns 20% of the voting stock of an investee, it is presumed that
the investor has significant influence over the financial and operating policies
of the investee. The presumption can be overcome if :
1. the investee challenges the investor’s ability to exercise significant
influence through litigation or other methods.

2. the investor surrenders significant shareholder rights in a signed agreement.

3. the investor is unable to acquire sufficient information about the investee to

apply the equity method.

4. the investor tries and fails to obtain representation on the board of directors
of the investee.
What Is Control?

Control is the power to govern the financial and operating policies of an enterprise so as to obtain benefits f
rom its operating activities. Where an investing enterprise is able to exercise control over the
investee, the investee is a subsidiary of the investing enterprise and shall be included in
the consolidated financial statements of the investing enterprise.

An investing enterprise shall account for a long-term equity investment in a subsidiary using the
cost method as prescribed in this Standard, and then make appropriate adjustments using the equity method
when preparing the consolidated financial statements.

• Usually > 50% equity ownership

• Although =< 50% equity ownership, control >50% voting rights through agreements with other
shareholders.
• Although =< 50% equity ownership,
a. The ownership of an investor is far larger compared with others.
b. Investor hold potential voting rights though holding transferrable bonds or exercisable warrants.
c. Other rights. Such as assign over 50% members of board of director, and has right to decide investee’s
operation.
When the Investor Lacks Significant
Influence (1 of 2)
Less than 20% of voting shares
• Lacks significant influence over the investee
• The following events during 2018 and 2019 pertain to
United Intergroup’s investment in the common stock of
Arjent, Inc.:
July 1, 2018 Purchase Arjent, Inc., common stock for $1,500,000

Recognize investment revenue for a $75,000 cash

December 31, 2018
dividend received from Arjent

Record a fair value adjustment to recognize a decline in

December 31, 2018
the value of the Arjent stock investment to $1,450,000

January 5, 2019 Sell the Arjent stock for $1,446,000

When the Investor Lacks Significant
Influence (2 of 2)
Purchase Investments
Journal Entry – July 1, 2018 Debit Credit
Investment in Arjent stock 1,500,000
Cash 1,500,000

Recognize Investment Revenue

Journal Entry – Dec 31, 2018 Debit Credit
Cash 75,000
Dividend revenue 75,000
Adjust Equity Investments to Fair Value
(2018) (1 of 2)
Adjust investments to fair value
• Valued the Arjent stock at $1,450,000

December 31, 2018

Security Cost Fair Value FV Adj Bal

Arjent $1,500,000 $1,450,000 $(50,000)

Adjust Equity Investments to Fair Value
(2018) (2 of 2)
Sell the Equity Investment
(1 of 3)
Step 1. Adjust securities to fair value (2019)

Security Cost Fair Value FV Adj Bal

Arjent $1,500,000 $1,446,000 $(54,000)

Sell the Equity Investment
(2 of 3)
Sell the Equity Investment
(3 of 3)
Step 2. Record the sale
Adjust Equity Investments to Fair Value
(2019)
Security Cost Fair Value FV Adj Bal
Arjent $1,500,000 $1,300,000 $(200,000)
Financial Statement Presentation—Equity
Securities
• Balance sheet:

‒Short term: Current assets

‒Long term: Noncurrent assets

• Cash flow statement:

‒Short term: Operating activities

‒Long term: Investing activities

• Notes to financial statement:

‒Disclose the portion of unrealized gains and losses for the period

‒How carrying value was calculated when fair value is not readily
determinable
When the Investor Has Significant
Influence—The Equity Method
•Significant influence usually is assumed to exist if
the investor owns between 20% and 50% of the
investee’s voting shares
‒ If more than 50%, the investor has control
•What does significant influence mean?
‒ Decisions can be swayed in the direction the
investor desires
•Investment is accounted for by the equity method
How the Equity Method Relates to
Consolidated Financial Statements (1 of 2)
•Consolidate if the investor has a controlling
interest:

– Company owns more than 50% of the voting

stock of another company

– The investor is referred to as the parent and

the investee is termed the subsidiary

– The parent and subsidiary are considered to be

a single reporting entity
How the Equity Method Relates to
Consolidated Financial Statements (2 of 2)
• Consolidated financial statements:

– Combine the individual elements of the parent

and subsidiary statements into a single financial
statement

• Goodwill:
‒ Difference on the date of acquisition between the
acquisition price and the sum of the fair values
of the acquired net assets
‒ Recognized as an asset
Equity Method—Purchase of Investment
(1 of 2)
United Intergroup purchased 30% of Arjent, Inc.’s,
common stock for $1,500,000 cash.
Book Value on Arjent’s Fair Value at Time of
Account
Financial Statement United’s Investment

Buildings (10-year remaining useful $1,000,000 $2,000,000

life, no salvage value)
Land 500,000 1,000,000
Other net assets 600,000 600,000
Net assets 2,100,000 3,600,000
Goodwill 1,400,000 (to balance)
Total fair value of Arjent = $5,000,000
Equity Method—Purchase of Investment
(2 of 2)
Total fair value of Arjent = $5,000,000

× 30% purchased
$1,500,000 Purchase price

Other information:
Arjent’s 2018 net income: $500,000

Arjent’s 2018 dividends: $250,000

Equity Method—Recognizing Investment
Income (1 of 2)
United Intergroup purchased 30% of Arjent, Inc.’s,
common stock for $1,500,000 cash.
Book Value on Arjent’s Fair Value at Time of
Account
Financial Statement United’s Investment

Buildings (10-year remaining useful $1,000,000 $2,000,000

life, no salvage value)
Land 500,000 1,000,000
Other net assets 600,000 600,000
Net assets 2,100,000 3,600,000
Goodwill 1,400,000 (to balance)
Total fair value of Arjent = $5,000,000
Equity Method—Recognizing Investment
Income (2 of 2)
Total fair value of Arjent = $5,000,000
× 30% purchased
$1,500,000 Purchase price

Other information:
Arjent’s 2018 net income: $500,000

Arjent’s 2018 dividends: $250,000

30% × 500,000 → 150,000

Equity Method—Receiving Dividends (1 of 2)

United Intergroup purchased 30% of Arjent, Inc.’s,

common stock for $1,500,000 cash.
Book Value on Arjent’s Fair Value at Time of
Account
Financial Statement United’s Investment

Buildings (10-year remaining useful $1,000,000 $2,000,000

life, no salvage value)
Land 500,000 1,000,000
Other net assets 600,000 600,000
Net assets 2,100,000 3,600,000
Goodwill 1,400,000 (to balance)
Total fair value of Arjent = $5,000,000
Equity Method—Receiving Dividends (2 of 2)

Total fair value of Arjent = $5,000,000

× 30% purchased
$1,500,000 Purchase price

Other information:
Arjent’s 2018 net income: $500,000

Arjent’s 2018 dividends: $250,000

30% × 250,000 → 75,000

Further Adjustments under the Equity
Method (1 of 2)
•Occur when investor ’s expenditure to acquire an
investment exceeds the book value of the underlying
net assets acquired
•Purpose:
‒To approximate the effects of consolidation,
without actually consolidating financial statements
Further Adjustments under the Equity
Method (2 of 2)
•Amortizing the differential between purchase price
and book value:
‒ Adjust investment account and investment
revenue to act as if consolidation procedures had
been followed
▪ If assets would have been written up to fair
value, act as if that happened
▪ Impute higher expenses in subsequent periods
when those assets are expensed, such that
▪ Earnings are lower by the investor’s share in
that additional expense
 Learning Objective 12 -7

Source of Differences between the

Investment and the Book Value of Net Assets
Acquired

Difference
Investee Net Net Assets Attributed to:
Assets Purchased

Cost $5,000,000 × 30% = $1,500,000

Goodwill: $420,000
Fair value $3,600,000 × $1,080,000
30% = Undervaluation of:
Buildings $300,000
Land $150,000
Book value $2,100,000 × $630,000
30% =
 Learning Objective 12 -7

Equity Method—Adjustments for Additional

Depreciation (1 of 2)
Fair Value at
Book Value on Arjent’s
Account Time of United’s
Financial Statement
Investment

Buildings (10-year remaining useful life, $1,000,000 $2,000,000

no salvage value)
Land 500,000 1,000,000
Other net assets 600,000 600,000
Net assets 2,100,000 3,600,000
Goodwill 1,400,000 (to balance)
Total fair value of Arjent = $5,000,000
 Learning Objective 12 -7

Equity Method—Adjustments for Additional

Depreciation (2 of 2)
Total fair value of Arjent = $5,000,000
× 30% purchased
$1,500,000 Purchase price

Arjent’s 2018 net income: $500,000

Arjent’s 2018 dividends: $250,000

30% × [$2,000,000 − 1,000,000] ÷ 10 yrs. → 30,000

 Learning Objective 12 -7

No Adjustments for Land or Goodwill

• Land:

‒Land is not depreciated

‒Difference between the fair value and book value of the

land would not cause higher expenses

• Goodwill:

‒ Unlike most of the other intangible assets, goodwill is

not amortized

‒ Acquiring goodwill will not cause higher expenses

 Learning Objective 12 -7

Adjustments for Other Assets and Liabilities

•If the fair value of purchased inventory exceeds its

book value, the period in which that inventory is
sold should be identified
‒Inventory is usually sold in the next year
•Investment revenue and its investment in the stock
is reduced in the next year by the amount of the
differential attributable to inventory
Reporting the Investment

The fair value of the investment shares at the end of the

reporting period is not reported when using the equity method.
Instead, the investment account is reported at:

Original cost + Investor ’s share of the investee’s net income −

The portion of the earnings received as dividends

The balance of United’s 30% investment in Arjent at

December 31, 2018, is calculated as:
Reporting the Investment: Losses & Mid-
Year (1 of 2)
•When the investee reports a net loss:
‒The investment account would be decreased by
the investor ’s share of the investee’s net loss
•When the investment is acquired in mid-year:
‒Only recognize the investor’s share of the year ’s
activity
‒Example: If United purchased 30% of Arjent on
October 1:
Reporting the Investment: Losses & Mid-
Year (2 of 2)
Investment in Arjent Stock
Cost 1,500,000
Share of income
(3/12 × $150,000) 37,500 Depreciation adjustment
7,500 (3/12 × $30,000)
Dividends
18,750 (3/12 × $75,000)
1,511,250
Equity Method Investments on the Balance
Sheet—AT&T
Dec 31, 2015 Dec 31, 2014
Total current assets $ 35,992 $ 33,606
Property, plant, and equipment—Net 124,450 112,898
Goodwill 104,568 69,692
Licenses 93,093 60,824
Customer lists and relationships—Net 18,208 812
Other intangible assets—net 9,409 5,327
Investments in equity affiliates 1,606 250
Other assets 15,346 13,425
Total assets $402,672 $296,834
What If Conditions Change?

•A change to or from the equity method to another

method
‒No adjustment is made to the remaining carrying
amount of the investment (except to account for any
purchase or sale of shares)
‒Previous method is discontinued and the new
method applied from then on
‒The balance in the investment account serves as the
starting point for the new method
If an Equity Method Investment is Sold
(1 of 2)
• When an investment reported by the equity method is
sold:
Selling price > Book (carrying) value → Gain is
recognized
Selling price < Book (carrying) value → Loss is
recognized
Example:
The balance of United’s 30% investment in Arjent at
December 31, 2019, is $1,545,000. United sells its
investment in Arjent on January 1, 2019, for $1,446,000.
If an Equity Method Investment is Sold
(2 of 2)
Comparison of Fair Value and the Equity
Methods
Thank Yo u !