Stock Investments - Investor Accounting and Reporting

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Chapter 2

STOCK INVESTMENTS - INVESTOR ACCOUNTING AND REPORTING

Chapter Outline

Accounting for stock investments

AThe equity method is required for investments of 50% or less that give the investor an ability to exercise significant influence over the investee.

Illustration 2-1Accounting for Investments

% ownershipNormal Accounting Method

0 - 19Cost (adjusted to FMV as appropriate)

20 - 50 Equity

(presumed significant influence)

51 & upConsolidated Financial Statements

(assumed controlling interest)(FASB 94)

BIn the absence of evidence to the contrary, an investment of 20% or more is presumed to give the investor an ability to exercise significant influence. This is a rebuttable presumption.

1The equity method should not be used if the ability to exercise significant influence is temporary or if the investee is a foreign company operating under severe exchange restrictions or controls.

2FASB Interpretation No. 35 provides indicators of when the ability to exercise significant influence may be impaired:

aOpposition by the investee that challenges the investor’s influence

bSurrender of significant stockholder rights by agreement between investor and investee

cConcentration of majority ownership

dInadequate or untimely information to apply the equity method

eFailure to obtain representation on the investee’s board of directors

CThe fair value/cost method is used for common stock investments of less than 20% unless it can be demonstrated that the investor company has the ability to exercise significant influence over the investee company.

ACCOUNTING FOR NONCURRENT COMMON STOCK INVESTMENTS UNDER

THE FAIR VALUE/COST METHOD:

AIf the stock is marketable, the investment should be accounted for at fair value according to the provisions of FASB Statement No. 115, “Accounting for Certain Investments in Debt and Equity Securities.”

1Investment is initially recorded at cost

2The investment is adjusted to fair value at the end of the fiscal period

3Unrealized gains or losses are reported either in income or as an equity adjustment to the balance sheet, depending on the company’s intention for holding the stock

4Unrealized gains and losses associated with ‘trading’ securities are recorded as part of income

aTrading securities are very short term holdings, continued relationships are not expected.

5Unrealized gains and losses associated with ‘available for sale’ securities are considered “other comprehensive income” and are reported on the balance sheet as an equity adjustment.

aOnly dividend income and realized gains and losses impact income and EPS for available for sale securities

B If the stock is not marketable, the investment is accounted for using the cost method

1Investment is initially recorded at cost

2Dividends received are recorded as dividend income

aAn exception: Liquidating dividends are deducted from the investment account. Liquidating dividends are those dividends received in excess of the investor’s share of earnings after the stock is acquired and are considered a return of capital.

THE EQUITY METHOD AND FASB STATEMENT NO. 94 FOR ACCOUNTING FOR INVESTMENTS IN COMMON STOCK UNDER THE EQUITY METHOD

A FASB Statement No. 94

1Current GAAP requires consolidation of all majority-owned subsidiaries, except those for which control is temporary or does not rest with the parent company.

2An investment in an unconsolidated subsidiary is reported in the parent company’s financial statements using the cost or equity method, according to the parent’s ability to exercise significant influence (more coverage in chapter 3).

B Application of the equity method

1The investment is initially recorded at cost

2Subsequently, the investor records its share of the investee’s income as an increase to the investment account (losses will decrease the investment account)

3Dividends received from the investee are recorded as a decrease to the investment account

aThe investment account moves in the same direction as the investee’s net assets (for example, income increases assets for both)

4Additional adjustments are required

aIntercompany profits and losses are eliminated until realized.

bCost-book value differentials are accounted for as if the investee were a consolidated subsidiary

(1)The difference between the investment cost and the underlying equity is assigned to identifiable assets and liabilities based on their fair values with any remaining difference allocated to goodwill.

(2)The difference between investment cost and book value acquired will disappear over the remaining lives of identifiable assets and liabilities, except for amounts assigned to land, goodwill, and intangible assets having an indeterminate life, which are not amortized.

(3)If the book value acquired is greater than the investment cost, the difference should be allocated against non-current assets other than marketable securities with any remaining amount treated as an extraordinary gain (negative goodwill).

cThe investment is reported on one line of the investor’s balance sheet and income on one line of the investor’s income statement, a one-line consolidation

(1) Except extraordinary and other below-the-line items

CAccounting for an interim investment

1Absent evidence to the contrary, income of the investee is assumed to be earned proportionately throughout the year

2The investee’s book value at an interim date is determined by adding income earned from the last statement date to beginning stockholders’ equity and deducting dividends declared to the date of purchase

DInvestments acquired step-by-step

1An investor may acquire significant influence through a series of purchases

2Prior to obtaining significant influence, the fair value/cost method is used. When an investment qualifies for the equity method, the investment account is adjusted to the equity method and the investor’s retained earnings are adjusted retroactively.

aThis is a change in reporting entity and is requires retroactive restatement if material

ESale of an equity interest

1When an investor reduces its equity interest in an investee to below 20%, the retained investment is accounted for under the fair value/cost method

aGain or loss from the equity interest sold is the difference between the selling price and the book value of the equity interest immediately before the sale

bImmediately after the sale, the balance of the investment account becomes the new cost basis

FInvestees with preferred stock

1Special adjustments are necessary when investees have both common and preferred stock outstanding

2Investee’s stockholders’ equity must be allocated into its common and preferred stock components

3Investee’s net income must also be allocated into common and preferred stock components

4Call or liquidating premiums and dividends in arrears must also be considered

5Further coverage in Chapter 10

Disclosures for equity investments

AMaterialinvestments accounted for by the equity method require disclosure of

1Summarized information about the investee’s assets, liabilities, and results of operations in financial statement notes

2The investee’s name and percent of ownership in common stock, the investor’s accounting policies with respect to investments in common stock, the cost/book value differentials and accounting treatment

3The aggregate value of each identified investment for which quoted market prices are available

BRelated party transactions

1Related party transactions arise when one of the transacting parties has the ability to significantly influence the operations of the other

2There is no presumption of arms-length bargaining between the related parties

3Required disclosures include the nature of the relationship, a description of the transaction, the dollar amount of the transaction (and any change in the method used to establish the terms of the transaction), and amounts due to or due from related parties at the balance sheet date for each balance sheet presented.

TESTING GOODWILL FOR IMPAIRMENT

AFASB Statement No. 142 eliminates former requirements to amortize goodwill, rather, goodwill must be periodically tested for impairment

1Firms may find this valuable for two reasons

aFirms may recognize significant impairment losses on initial adoption which are treated as a “cumulative effect of an accounting change” (appears after “income from operations”)

bFirms will no longer report annual goodwill expense charges

BRecognizing and measuring impairment losses is a two-step process

1First, carrying value is compared to fair value at the business reporting unit level

aIf fair value is greater than carrying value, goodwill is deemed unimpaired and no further action is necessary

bIf carrying value is greater than fair value, the firm proceeds to step 2

2Step 2, when necessary, requires a comparison of the carrying value of goodwill with its implied fair value

3The implied fair value of goodwillis determined in the same manner used to originally record the goodwill at the business combination date

aAllocate the fair value of the reporting unit to all identifiable assets and liabilities as if they had made the purchase on the measurement date, and any excess is the implied fair value of goodwill

4The fair value of the reporting unit is the amount for which it could be purchased or sold in a current, arm’s-length transaction

aCurrent market prices (in an active market) are considered the most reliable indicator of fair value

CGoodwill impairment testing must be done at least annually

1More frequent testing may be required if certain events occur such as adverse changes in the legal or business climate, new and unanticipated competition, loss of key personnel, and other similar events

DReporting and disclosure

1Material aggregate amounts of goodwill must be reported as a separate line item on the balance sheet

2Goodwill impairment losses are shown separately in the income statement

EEquity method investments

1Many of the rules regarding goodwill in purchase method business combinations (parent acquiring a controlling interest in a sub) also apply to goodwill arising from use of the equity method

2One notable exception is the rule regarding goodwill impairments

a Impairment tests for equity investments continue to follow guidance from APB Opinion No. 18 which require impairment tests be performed based on fair value versus book value of the investment taken as a whole

NEW STANDARD – FAS Statement 159 – The Fair Value Option for Financial Assets and Financial Liabilities – Including an amendment of FASB Statement No. 115

1)Firms have option to record equity method investments at fair value. The option may be elected on an investment by investment basis.

2)Option must continue as long as investment is owned.

3)Fair Value is recalculated annually. Changes are included in investor’s net income with the offsetting cumulative amount recorded in a valuation allowance.

4)Separate disclosure is required.

Description of assignment materialMinutes

Questions (14)

Exercises (16)

E2-15 MC general10

E2-2AICPA 8 MC general and problem-type 35

E2-3[Trevor/Bowman] Calculate percentage ownership and goodwill from12

investment acquired directly from investee

E2-4[Carson/Medley] Calculate income for 30% midyear investment15

E2-5[Dokey/Oakey] Calculate income and investment balance for 40% full15

year investment with allocation of excess to undervalued assets

E2-6[Martin/Neighbors] Journal entry to record income from 40% investee with 10

loss from discontinued operations

E2-74 MC problem-type20

E2-8[Raython/Treaton] Calculate investment balance 4 years after acquisition15

E2-9[Nickie/Runner] Calculate income from investee and the investment20

balance when the investee’s capital structure includes preferred stock

E2-10[Arbor/Tree] Calculate income and investment balance for 25% midyear15

investment

E2-11[Ratterman/Twizzle] Adjust investment account and determine investment25

income when an additional investment qualifies investee for the equity

method of accounting

E2-12[River/Tall] Journal entries (investment in previously unissued stock)15

E2-13[BIP/Crown] Prepare journal entries and an income statement, and20

determine the investment account balance (investee with extraordinary

loss)

E2-14 [Valley/Water] Calculate income and investment account balance20

(investee has preferred stock)

E2-15[Park/Steele] Calculate implied fair value of goodwill10

E2-16[Flash/Alpha/Beta] Calculating and reporting impairment losses

in the income statement10

Problems (16)

P2-1 [Ritter/Telly] Computations for a midyear purchase (investee has 25

an extraordinary gain)

P2-2 [Putter/Siegal] Journal entries for midyear investment (cost and 20

equity methods)

P2-3 [Vatter/Zelda] Computations for 30% investee (excess allocated20

to inventories, building, and goodwill)

P2-4 [Diller/Dormer] Journal entries for midyear 40% investment (excess 20

allocated to land, equipment, and goodwill)

P2-5 [Earth-Q/Tremor] Prepare an allocation schedule, compute income15

and the investment balance

P2-6 [Pauly/Stapleton] Computations (midyear acquisition) 20

P2-7 [Dill/Larkspur] Partial income statement (investee with extraordinary item)10

P2-8 [Hazel/Brady] Step-by-step acquisition of equity interest over several 25

years and purchase of stock from investee

P2-9 [Provo/Sigma] Computations and journal entries (excess book value over 20

cost)

P2-10 [Creape/Tantani] Prepare allocation schedules under two different stock 20

market price assumptions (negative goodwill)

P2-11 [Prudy/Spandix] Computations (piecemeal acquisition of investment) 25

P2-12 [Pilot/Sassy] Computations and a correcting entry (errors) 25

P2-13 [Publican/Samaritan] Allocation schedule and computations (excess cost 25

over fair value)

P2-14 [Publican/Samaritan] Allocation schedule and computations (excess fair 30

value over cost)

P2-15[Cooper] Calculating and reporting impairment losses10

P2-16[Cardinal] Calculating and reporting impairment losses and recoveries 10

Internet assignment

Ford’s 2006 annual report is used to study Ford’s intercompany investments.

Case Study

Coca Cola’s 2006 annual report is used to understand the equity method.