Advanced Financial Accounting 7e (Baker Lembre King).Chap002

8/7/2019 Advanced Financial Accounting 7e (Baker Lembre King).Chap002

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cGraw-Hill/Irwin 2008 The McGraw-Hill Companies, Inc. All rights reserved

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Reporting Intercorporate Interests


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Reporting Intercorporate Interest

This chapter presents the accounting and

reporting procedures for investments incommon stock and for selected other typesof interests in other entities.


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Some companies invest in other companiessimply to earn a favorable return by taking

advantage of potentially profitable situations.

As indicated in the next slide, there are

various other reasons that companiesinvest in other companies.


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Reasons Companies Invest in OtherCompanies:

Gain control over other companies

Enter new market or product areasthrough companies established in those

areas Ensure a supply of raw materials or

other production inputs

[continued on next slide]


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Ensure a customer for production output

Gain economies associated with greatersize

Diversity

Gain new technology

Lessen competition

Limit risk


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Examples of intercorporate investments include:

IBMs acquisition of a sizable portion of

Intels stock to ensure a supply ofcomponents.

AT&Ts purchase of the stock of McCaw

Cellular Communications to gain afoothold in the cellular phone market.

Texacos acquisition of Getty Oils stockto acquire oil and gas reserves.


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Investments in Common Stock

The method used to account for investmentsin common stock depends on the level of

influence or control that the investor is able toexercise over the investee.


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The level of influence is the primary factordetermining whether the investor and

investee will present consolidated financialstatements or the investor will report theinvestment in common stock in its balance

sheet using either the cost method (adjustedto market value, if appropriate) or the equitymethod.


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Consolidation involves the combining for

financial reporting the individual assets,liabilities, revenues, and expenses of two ormore related companies as if they were part

of a single company.


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This process includes the elimination of all

intercompany ownership and activities (suchas intercompany sales and purchases, and

intercompany loans).


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Consolidation is normally appropriate where

one company, referred to as the parent,controls another company, referred to as thesubsidiary.

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An unconsolidated subsidiary should be

reported as an investment on the parentsbalance sheet. Unconsolidated subsidiariesare relatively rare.

The specific requirements for consolidationare discussed in Chapter 3.

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The equity method is used for externalreporting when the investor exercises

significant influence over the operating andfinancial policies of the investee andconsolidation is not appropriate.

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The equity method may not be used in place

of consolidation when consolidation isappropriate, and therefore its primary use isin reporting nonsubsidiary investments.

The equity method is used most often whenone company holds between 20 and 50percent of another companys common stock.

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The cost method is used for reportinginvestments in equity securities when both

consolidation and equity-method reportingare inappropriate underFASB 115.

If cost-method equity securities have readilydeterminable fair values, they must beadjusted to market value at year-end.

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Accounting During the Year

Versus Reporting at Year End

Under normal circumstances, companies

using the cost or equity method for financialreporting purposes at year end also use thatmethod for accounting for the investment on

their books during the year.

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Accounting During the Year

Versus Reporting at Year End

As discussed next, this is not the case with

respect to companies required to consolidatetheir investments in subsidiaries for financialreporting purposes.

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Accounting During the Year Versus

Reporting at Year End--Continued

When consolidated financial statements are

prepared for financial reporting purposes atyear end, the parent still must account forthe investment in the subsidiary during the

year (on its books)

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Accounting During the Year Versus

Reporting at Year End--Continued

Using the cost or equity method even though

the intercorporate investment and relatedincome must be eliminated in preparing theconsolidated statements at year end.

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Cost MethodInfluence Not Significant

(0 to 20 percent)

Intercorporate investments accounted for by

the cost method are carried by the investor athistorical cost.

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Cost MethodInfluence Not Significant(0 to 20 percent)

Income is recorded by the investor when

dividends are declared by the investee.

The cost method is used when the investorlacks the ability either to control or to exercise

significant influence over the investee.

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Cost Methodinfluence Not Significant

(0 to 20 percent)

At the time of purchase, the investor records

its investment in common stock at the totalcost incurred in making the purchase.

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Cost Methodinfluence Not Significant

(0 to 20 percent)

After the time of purchase, the carrying

amount of the investment (i.e., the originalcost) remains unchanged under the costmethod until the time of sale (or unless there

is a liquidating dividendmore on this later).

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Once the investee declares a dividend, theinvestor has a legal claim against the

investee for a proportionate share of thedividend and realization of the income isconsidered certain enough to be recognized.

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Recognition of investment income before a

dividend declaration is consideredinappropriate because the investees incomeis not available to the owners until a dividend

is declareddividends do not accrue!!!

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Cost MethodExample

ABC Company purchases 20 percent of XYZCompanys common stock for $100,000 at the

beginning of the year but does not gainsignificant influence over XYZ.

Investment in XYZ

Company Stock $100,000

Cash $100,000

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Cost MethodExample

During the year, XYZ has net income of $50,000 andpays dividends of $20,000.

Cash ($20,000 X .20) $4,000

Dividend Income $4,000

NOTE: Liquidating dividends are discussed next.

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Cost MethodLiquidating Dividends

All dividends declared by the investee--in excessof its earnings since acquisition by the investor--are viewed by the investor as liquidatingdividends.

In the previous example, if XYZ had no earnings,

all dividends would have been viewed by ABCas liquidating dividends.

[Continued on next slide.]

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Cost MethodLiquidating Dividends

In turn, Investment in XYZ Company Stockwould be credited in lieu of Dividend Income.

Cash ($20,000 X .20) $4,000

Investment in XYZ

Common Stock $4,000

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The Equity MethodSignificant

Influence (20 to 50 percent)

APB 18 (as amended) provides theprofessional guidance regarding the equitymethod. The equity method of accounting forintercorporate investments in common stock

is intended to reflect the investors changingequity or interest in the investee.

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APB 18 establishes a 20 percent rulebecause assessing the degree of influencemay be difficult in some cases.

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Equity MethodSignificant Influence

Because of the ability to exercise significantinfluence over the policies of the investee,

realization of income from the investment isconsidered to be sufficiently assured towarrant recognition by the investor as theincome is earned by the investee.

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Equity MethodSignificant Influence

This differs from the case in which theinvestor does not have the ability to

significantly influence the investee and theinvestment must be reported using the costmethod; in that case, income form theinvestment is recognized only upondeclaration of a dividend by the investee.

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Unless proven otherwise, an investor holding20 percent or more of the voting stock ispresumed to have the ability to influence theinvestee.

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The equity method is a rather curious one in

that the balance in the investment accountgenerally does not reflect either cost ormarket value, nor does the balancenecessarily represent a pro rata share of the

investees book value.

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Influence (20 to 50 percent) Under the equity method, the investor

records its investment at the original cost.

This amount is adjusted periodically forchanges in the investees stockholders

equity occasioned by the investees profits (orlosses) and dividend declarations.

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Influence (20 to 50 percent) Reported by

Investee:

Net Income(Loss)

DividendDeclaration

Effect On Investor:

Record income (loss)

from investment andincrease (decrease)

investment account.

Record asset (cash orreceivable) and decrease

investment account.

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The Equity MethodEquity Accrual

Assume ABC Company acquires significantinfluence over XYZ Company by purchasing

20 percent of the common stock of the XYZCompany at the beginning of the year. XYZCompany reports income for the year of$60,000. ABC records its $12,000 share ofXYZs income with the following entry:

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The Equity MethodEquity Accrual

Investment in XYZ

Company Stock ($60,000 X .2) $12,000

Income from Investee $12,000

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Equity MethodRecognition of

Dividends Dividends from an investment are not

recognized as income under the equity

method because the investors share ofthe investees income is recognized as

it is earned by the investee.

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Dividends Instead, such dividends are viewed as

distributions of previously recognized

income that already has been capitalizedin the carrying amount of the investment.

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Dividends

In effect, all dividends from the investee are

treated as liquidating dividends under theequity method. Thus, if ABC Company owns20 percent of XYZs common stock and XYZ

declares and pays a $20,000 dividend, thefollowing entry is recorded on the books ofABC to record its share of the dividend:

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Dividends

Cash ($20,000 X .20) $4,000Investment in XYZ

Company Stock $4,000

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Equity MethodAcquisition at Interim Date

When an investment is purchased, theinvestor begins accruing income from the

investee under the equity method at the dateof acquisition.

No income earned by the investee before thedate of acquisition of the investment may beaccrued by the investor.

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Equity MethodAcquisition at InterimDate (Continued)

When the purchase occurs between balance

sheet dates, the amount of income earned bythe investee from the date of the acquisitionto the end of the fiscal period may need to be

estimated by the investor in recording theequity accrual.

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For example, if the acquisition (20 percent

interest) was transacted on October 1 andthe investee earned $60,000 for the entireyear, the investor would have an equity

accrual of $3,000 (i.e., $60,000 X .20 X 3/12= $3,000).

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WARNING: Watch out for liquidating

dividends when acquisitions

are transacted at interim dates.

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Investment Cost VersusUnderlying Book Value

When one corporation buys the commonstock of another, the purchase price normally

is based on the market price of the sharesacquired rather than the book values of theinvestees assets and liabilities.

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As a result, there often is a differencebetween the cost of the investment to the

investor and the book value of the investorsproportionate share of the underlying netassets of the investee.

This difference is referred to as a differential.

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The differential represents the amount paid

by the investor in excess of the book value ofthe investment and is included in theinvestment amount.

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Hence, the amortization or reduction of thedifferential involves the reduction of the

investment account. At the same time, the investors net income

must be reduced by an equal amount to

recognize that a portion of the amount paidfor the investment has expired.

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There are several reasons the cost of aninvestment might exceed the book valueof the underlying net assets and give riseto a positive differential.

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One reason is that the investees assets

may be worth more than their book value. Another reason could be the existence of

unrecorded goodwill associated with theexcess earning power of the investee.

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Purchase differentials related to a limited life

asset (e.g., equipment) should be amortizedover the life of the related asset.

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If the purchase differential has a debit

balance, the equity method entry to amortizethe purchase differential will be the oppositeof the equity accrual entry, that is, withrespect to the accounts debited or credited.

Examples are provided on next slide.

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To record equity method income of $9,000(assumed).

Investment in Investee Company $9,000Income from Investee Company $9,000

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To amortize debit purchase differential of$4,000 (assumed).

Income from Investee Company $4,000Investment in Investee Company $4,000

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Any portion of the differential that is related toland is not amortized since land has an

unlimited life. Any portion of the differential that represents

goodwill (referred to as equity method

goodwill) is neither amortized nor writtendown for impairment.

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However, an impairment loss on theinvestment itself should be recognized if it

suffers a decline in the value that is otherthan temporary.

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Disposal of Differential-RelatedAssets

If the investee disposes of any asset to which

the differential relates, that portion of thedifferential must be removed from theinvestment account on the investors books.

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Disposal of Differential-RelatedAssets

When this is done, the investors share of the

investees gain or loss on disposal of theasset must be adjusted to reflect the fact thatthe investor paid more for its proportionateshare of that asset than did the investee.

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Impairment of Investment Value

As with many assets, accounting standardsrequire that equity-method investments bewritten down if their value is impaired.

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Impairment of Investment Value

If the market value of the investment declines

materially below its equity-method carryingamount, and the decline in value isconsidered other than temporary, the carryingamount of the investment should be writtendown to the market value and a lossrecognized.

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Impairment of Investment Value-cont

The new lower value serves as a startingpoint for continued application of the equity

method.

Subsequent recoveries in the value of the

investment may not be recognized.

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Changes in Number of Shares Held

A change in the number of common shares

held by an investor resulting from a stockdividend, split, or reverse split is treated inthe same way as under the cost method.

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Changes in Number of Shares Held

No formal accounting recognition is required

on the books of the investor. On the other hand, purchases and sales of

shares do require formal recognition.

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Purchases of Additional Shares

A purchase of additional shares of commonstock already held by an investor andaccounted for using the equity method simplyinvolves adding the cost of the new shares tothe investment account and applying theequity method in the normal manner from the

date of acquisition forward.

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Purchases of Additional Shares-Cont

The new and old investments in the same

stock are combined for financial reportingpurposes.

Income accruing to the new shares can berecognized by the investor only from the date

of acquisition forward.

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Determination of Significant Influence

The general rule established in APB 18 isthat the equity method is appropriate where

the investor, by virtue of its common stockinterest in an investee, is able to exercisesignificant influence over the operating andfinancial policies of the investee.

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Determination of Significant Influence

In the absence of other evidence, commonstock ownership of 20 percent or more is

viewed as indicating that the investor is ableto exercise significant influence over theinvestee.

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Investments in Partnerships

Pronouncements of the FASB generally

relate to corporations rather thanpartnerships. Thus, companies holding equityinvestments in partnerships generally havemore flexibility but less guidance in reportingtheir investments.

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Investments in Partnerships

Companies with ownership interests in

partnerships typically choose one of thefollowing methods for reporting investments:cost method, equity method, consolidation, orpro-rata consolidation.

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Unrealized Intercompany Profits

UnderAPB 18, intercompany sales do not

result in the realization of income until theintercompany profit is confirmed in someway, usually through a transaction with anunrelated party.

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Thus, unrealized intercompany profits must

be eliminated from both consolidatedfinancial statement amounts as well as equitymethod amounts.

The term for the application of the equity

method that includes the adjustment forunrealized intercompany profits is fullyadjusted equity method.

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Unrealized intercompany profits overstateearnings. Thus the equity method entry to

remove the unrealized profit will be theopposite of the equity accrual entry, thatis, with respect to the accounts debited or

credited.

Examples are provided on the next slide.

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To record equity method income of $9,000

(assumed).Investment in Investee Company $9,000

Income from Investee Company

$9,000

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To remove unrealized intercompany profit of$2,000 (assumed).

Income from Investee Company $2,000

Investment in Investee Company $2,000

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Tax Allocation Procedures

Intercompany income accruals and dividend

transfers must be considered in computingincome tax expense for the period.

If separate tax returns are filed, the invester

is taxed on the dividends received rather thanthe tax reported.

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Tax Allocation Procedures

Deferred tax accruals are not needed even

though temporary differences occur betweenthe recognition of investment income by theinvestor and realization through dividendtransfers from the investee whenconsolidated tax returns are filed.

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Chapter Three to Chapter Ten

Three different approaches are followed bycompanies (in practice) in accounting for their

consolidated subsidiary during the year:

The fully adjusted equity method(a.k.a., the equity method).

The basic equity method.

The cost method.

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The cost method and the fully adjusted

equity method (a.k.a., the equity method)were previously discussed in this chapter.

The basic equity method is used in Chapters3 to 10 and is discussed in the next slide.

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In essence, the basic equity method is a

modified version of the equity methoddiscussed in this chapter.

Specifically, the basic equity method avoids

unrealized profit transactions that will beeliminated during the consolidation process.

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While the basic equity method is Not GAAP,

use of the basic equity method may helpprovide some clerical savings for the parentcompanyas well as students and teachers.

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You Will Survive Chapter 2 !!!

There are two sets of accounting

records (i.e., books) to analyze.

You should always ask yourself

does the information relate to theinvestor or the investee or both ?

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If consolidation is required, the investor may bereferred to as the parent company and the

investee may be referred to as the subsidiarycompany.

The cost method and the equity method are bothaccounting methods and reporting methods, that is,

they are used during the year as well as at year-end, respectively.

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Unless consolidation is required, the investor

would usually use the same method foraccounting and reporting purposes.

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If consolidation is required, all balancesrelated to either the cost method or the equity

method are eliminated when preparing theconsolidated financial statementsthuseither method may be used during the year.

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There is only one trick to the cost method

liquidating dividends. Rememberdividends do not accrue.

Rememberonly use post-acquisition earnings.

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Think of the equity method in terms of threelevels (and start with the bottom

level):

Top level--Unrealized profits

Middle levelDifferential Base or bottom level--Book value

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