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C. Investments Where Significant Influence Does Exist

C. Investments Where Significant Influence Does Exist

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Module 16: Investments



648





c. Another aspect of the equity method is the computation and accounting for the difference between the cost

of the investment and the book value of the acquired asset share at the investment date.







(1) The abundance of advanced accounting texts currently in print use an assortment of terms to describe

the characteristics of this concept. For purposes of uniformity, the following boldfaced terms shall be

used throughout this module.

Differential, which is the difference between the cost of the investment and the underlying book value

of the net assets of the investee. This difference can be either positive or negative, as follows:





Excess of Cost over Book Value, which is generally attributable to



•

Excess



of fair value over book value, when the fair values of the investee’s assets are greater than

their book values, and

•

Goodwill, when the investee has high earnings potential for which the investor has paid more than

the fair values of the other net assets





Excess of Book Value over Cost, which is generally attributable to







•Excess of book value over fair value, when the book values of the net assets of the investee are

greater than their fair values, and

•

Excess of fair value over cost, when the cost of the investment is less than even the fair values of the

investee’s net assets. Some authors term this “negative goodwill.”







If the differential is related to assets with finite useful lives, it will be amortized to the investment account.

Goodwill will not be amortized; it will be written down if the investment is determined to be impaired.



EXAMPLE



A Company purchased 20 shares of B Company’s 100 shares of common stock outstanding for $25,000.

The book value of B’s total net worth (i.e., stockholders’ equity) at the date of the investment was

$120,000. Any excess of cost over book value is due to equipment that has a ten-year remaining useful

life.

Investment cost

Book value of B Company

Percentage owned

Investor’s share

Excess of cost over book value (due to equipment)



$ 25,000

$120,000

20%

24,000

$1,000



Amortization over forty years

$1,000 ÷ 10 years = $100







d. Under the equity method, the Income from Investment account is a parallel income statement

account to the In­vestment in Stock balance sheet account. These two accounts should include all

the income recognition and amortization resulting from the investment.

NOTE: Under the equity method, dividends received from the investee are a reduction in the Investment

balance sheet account and are not part of the Income from Investment account.







e. Alternative levels of recording the results of intercompany transactions and amortization in both the invest­

ment and investment income accounts are used in accounting practice. The alternatives are presented below.



(1)

Cost adjusted for fair value method—No intercompany transactions or amortization are recognized in

ei­ther the investment account or investment income account under this method.

(2)

“Partial” equity—Includes recognition of percentage share of income or loss, dividends, and any

changes in the investment percentage. This method is often used for investments that will be consoli­

dated. Thus, amortization and other adjustments are made on the worksheets, not in the investment ac­

count.



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649



(3)

“Full” equity—In addition to the factors above, this level includes any necessary amortization or writeoff of the differential between the investment cost and book value of the investment. This level also rec­

ognizes the effects of any intercompany transactions (e.g., inventory, fixed assets, and bonds) between

the investor and investee corporations. All unconsolidated investments are reported in the financial

statements using the “full” equity method.



EXAMPLE

Assume the same facts for A Company and B Company as stated above. In addition, B Company earned $10,000 in­come for the

year and paid $6,000 in dividends. There were no intercompany transactions. If A Company does not have significant influence

over B Company, the investment would be accounted for by the cost adjusted for fair value method. If A Company can significantly influence B Company, the equity method is used to account for and report the investment. The appropriate entries are

Cost adjusted for fair value method

1. To record purchase of 20% interest

Investment in stock of B

25,000

Cash

25,000

2.To record percentage of share of investee’s reported

 income

No entry



3.To record percentage share of dividend received

  as distribution of income

Cash

1,200

Dividend income from investment

(20% × $6,000)

4.To record amortization of equipment in accordance

  with ASC Topic 323

No entry (no differential amortization under

  this method)



1,200



Equity method

Investment in stock of B

Cash



25,000

25,000



Investment in stock of B

Income from investment

(20% × $10,000)



2,000



Cash

Investment in stock of B



1,200



Income from investment

Investment in stock of B



100



2,000



1,200



100



The differences in the account balances under the equity method vs. the cost adjusted for fair value method reflect the different

income recognition processes and underlying asset valuation concepts of the two methods. The investment account balance

under the cost adjusted for fair value method remains at the investment cost of $25,000 (although sub­sequent changes in fair

value would require that the investment account be adjusted to fair value), while under the eq­uity method, the investment balance increases to $25,700. The $700 difference is the investor’s share of the increase in the investee’s undistributed earnings

less the investor’s amortization of the differential (excess of cost over the book value of the investment).

The amount of the investment income to be recognized by the investor also depends upon the length of time during the

year the investment is owned.

For example, assume that A Company acquired the 20% interest on July 1, year 2, and B Company earned $10,000 of

income ratably over the period from January 1 to December 31, year 2. The entry to record A Company’s percentage share of

B Company’s income for the period of July 1 to December 31, year 2, would be

Cost adjusted for fair value method

No entry



Equity method

Investment in stock of B

Income from investment (20% × $10,000 × 6/12)



1,000

1,000



The receipt of the $1,200 dividends after the acquisition date would require additional analysis since the $1,200 divi­dend

received is greater than the investor’s share of the investee’s income ($1,000) since acquisition. The difference of $200 ($1,200

– $1,000) is a return of capital under the cost adjusted for fair value method, and is recorded as follows:

Cost adjusted for fair value method

Cash

1,200

Dividend income from investment

Investment in stock of B



1,000

200



Equity method

Cash

1,200

Investment in stock of B



1,200



The amortization of equipment will also be prorated to the time period the investment was held.



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650



Module 16: Investments



4.

Changes to or from the equity method—when an investor changes from the cost adjusted for fair value to

the equity method, the investment account must be adjusted retroactively and prior years’ income and retained

earnings must be retroactively restated.





a. A change to the equity method would be made if an investor made additional purchases of stock and, for the

first time, is able to exercise significant influence over the operating and financial decisions of the investee.







(1) Remember that ASC Topic 323 (APB 18) states that investments of 20% or more of the investee’s out­

standing stock carry the “presumption” that the investor has the ability to exercise significant influence.

Therefore, in most cases, when an investment of less than 20% increases to more than 20%, the investor

will retroactively change from the cost adjusted for fair value method to the equity method.







(a) The retroactive change to the equity method requires a prior period adjustment for the difference in

the investment account and retained earnings account between the amounts that were recognized in

prior periods under the cost adjusted for fair value method and the amounts that would have been

recognized if the equity method had been used.







1] In the full-year investment example on the previous page where A Company had a $25,000 bal­

ance in its Investment in B account under the cost adjusted for fair value method and $25,700

un­der the equity method, if A changed from the cost to the equity method because of its

increased influence over B, the change entry would be

Investment in B Company

Retained earnings

($700 = $2,000 – $1,200 – $100)























700



(b) In addition, any balance in the Unrealized holding gain or loss account must be reversed.

1] Assume that the fair value of the B Company stock had increased from $25,000 to $27,000 as of

the end of the year of acquisition. The investment account would have been debited for $2,000

and the Unrealized gain on MES account credited for $2,000 to bring the carrying value of the

stock up to its fair value. Upon retroactive change to the equity method, the following reversing

entry would be made:

Unrealized gain on MES

Investment in stock of B







700



2,000

2,000



(2) If the change is made at any time point other than the beginning of the fiscal period, the change entry

would also include an adjustment to the period’s Income from investment account to record the differ­

ence between the cost adjusted for fair value and equity methods handling of the investor’s share of the

investee’s income for the current period.

b. When an investor discontinues using the equity method because of an inability to influence the investee’s

finan­cial and operating policies, no retroactive restatement is allowed.

(1) An example of this would be a disposal of stock resulting in a decrease in the percentage of stock

owned from more than 20% to less than 20%.

(2) The earnings or losses that relate to the shares retained by the investor that were previously recognized

by the investor should remain as a part of the carrying amount.

(a) However, if dividends received by the investor in subsequent periods exceed the investor’s share of

the investee’s earnings for such periods, the excess should be accounted for as a return of capital

and recorded as a reduction in the investment carrying amount.

c. A T-account is used to exhibit the major changes in the Investment in stock account under the equity method.

Investment in Stock

Original cost of investment

Percentage share of investee’s income since acquisition

Amortization of excess of book value over cost

Increase above “significant influence” ownership—

  retroactive adjustment for change to equity



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Percentage share of investee’s losses since acquisition

Percentage share of dividends received

Amortization of excess of cost over book value

Disposal or sales of investment in stock



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651



d. In addition to the above, several adjustments may be added if the “full equity” method is used. This method

eliminates the effects of intercompany profits from transactions such as sales of inventory between the

inves­tor and investee corporations. This method is rarely required on the exam but candidates should briefly

re­view these additions in association with the discussion of the elimination entries required for consolidated

working papers presented later in Module 18.

Investment in Stock (continued)

Realized portion of intercompany profit from

  last period confirmed this period



Elimination of unrealized portion of intercompany

  profit transactions from current period



NOW REVIEW MULTIPLE-CHOICE QUESTIONS 32 THROUGH 48









D. Equity Method and Deferred Income Taxes

1. Recognition of deferred taxes may be required when the equity method is used.

a. The difference between the income recognized using the equity method and the dividends received from the

in­vestee represents a temporary difference for which interperiod allocation is necessary.

NOTE: Companies are allowed to exclude 80% of the dividend income from domestic investees. If an in­vestor

owns 80% or more of the investee’s stock, the dividend exclusion is increased to 100% (i.e., no taxes are due on

investee dividend distributions). The dividend exclusion (dividends received deduction) is a permanent difference.



















E. The Fair Value Option

1. An entity may elect to value its securities at fair value.

a. A firm can elect the fair value option on an instrument-by-instrument basis.

b. If the firm elects the fair value option for reporting available-for-sale or held-to-maturity securities, the secu­

rity is revalued to fair value and any gain or loss is recorded in earnings for the period.

c. Likewise, if the fair value option is elected for instruments that would otherwise be reported using the equity

method, the securities are revalued to fair value. Any gain or loss is recorded in earnings for the period.

d. If the fair value option is elected for instruments that would normally use the equity method, it must be ap­

plied to all interests in that entity (i.e., both debt and equity instruments would be valued at fair value).







2. The fair value option can be elected on the date an investment is first recognized, or when the investment no

longer qualifies for fair value treatment.







a. For example, if Company A has a trading security in Company B stock and acquires more than 20% of

Com­pany B, the rules of the equity method of reporting would normally be applied. However, if the fair

value op­tion is elected, Company A is no longer required to use the equity method, but instead values the

security at year-end at fair value. Any unrealized gain or loss is recognized in earnings for the period.







3. The rules for the statement of cash flows continue to apply for determining the classification of a purchase or

sale of security on the statement of cash flows. Additional disclosures in the notes to the financial statements

are re­quired if the fair value option is elected. Refer to the outline of SFAS 159 (ASC Topic 825) for these

disclosures.







F. Stock Dividends and Splits

Stock dividends and stock splits are not recorded as income. The recipient continues to own the same propor­tion

of the investee as before the stock split or stock dividend. The investor should make a memo entry to record the

receipt of the additional shares and recompute the per share cost of the stock.







G. Stock Rights







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2. A discussion of deferred income taxes arising from equity method investments and several examples are pro­

vided in Module 14, Deferred Taxes.



1. Investors in common stock occasionally receive stock rights to purchase additional common stock below

the exist­ing market price. The investee company has probably issued the stock rights to satisfy the investor’s



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652



preemptive right to maintain an existing level of ownership of the investee. It is possible to waive these preemp­

tive rights in some jurisdictions.





2. Rights are issued below the existing market price to encourage the exercise of the rights (i.e., the investor’s use

thereof resulting in acquisitions of additional shares of stock).







a. The rights are separable, having their own markets, and should be accounted for separately from the invest­

ment in common stock.

b. The rights represent a possible dilution of investor ownership and should be recorded by allocating the cost

of the stock between the market value of the rights and the market value of the stock.









(1) This is accomplished by multiplying the following ratio by the cost basis of the stock:

Market value of right

Market value of right + Market value of stock







3. The following entry is made to record the receipt of the rights:

Investment in stock rights

Investment in common stock







xx



4. The rights can be sold or exercised. The entry for exercise is

Investment in common stock

Investment in stock rights

Cash







xx



xx

xx

xx



5. If the stock rights lapse

Loss on expiration of stock rights

Investment in stock rights



xx

xx



EXAMPLE

A Company acquired 1,000 shares of common stock in B Company for $12,000. A Company subsequently received two stock

rights for every share owned in B Company. Four rights and $12 are required to purchase one new share of common stock. At

the date of issuance the market value of the stock rights and the common stock is $5 and $20, re­spectively. The entry to record

the receipt of the rights is as follows:

Investment in stock rights

Investment in common stock



4,000

4,000



The $4,000 above was computed as follows:

Total market value of rights

Total market value of shares

Combined market value

Cost allocated to stock rights

Cost allocated to common stock



2,000 rights × $5 = $10,000

1,000 shares × $20 = $20,000

$30,000

$10,000 × $12,000 = $4,000

$30,000

$20,000 × $12,000 = $8,000

$30,000



If A uses 800 rights to purchase 200 additional shares of stock, the following entry would be made to record the trans­action.

NOTE: $2 ($4,000 ÷ 2,000 rights) of cost is assigned to each stock right and $8 ($8,000 ÷ 1,000 shares) of cost

to each share of stock.



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