The information presented below is based on Roger CPA Review: Financial Accounting and Reporting (2016).
INVESTMENTS IN THE STOCK OF OTHER ENTITIES
An investor may acquire equity securities (common or preferred stock), debt securities(bonds) and derivatives (stock rights) in other companies. When a company acquires common stock, we need to determine the appropriate method of accounting for the investment, and this will depend primarily upon the amount of stock that is owned by the investor.
- 0-20% Cost method or marketable securities
- The implication is that no influence over the investee company exists.
- If the security isn’t marketable, use the cost method
- 20-50% Equity method. (one-line consolidation)
- The implication is that the investor has significant voting influence over the investee.
- 50% + Consolidation (Section 31)
- The implication is that the investor has control over the investee.
- Members of the investor company constitute a majority of the board of director of the board of directors of the investee.
Equity Method (ASC323)
The equity method is used when the investor has significant influence over the operating and financial policies of the investee. This method is more consistent with accrual accounting. Even if ownership is less than 20%, one must consider how much influence exists between the two entities. Some factors to consider:
- Significant intercompany transactions, or technological dependency.
- Officers of the investor serving as officers or board members of the investee.
- The investor is a major customer or supplier of the investee
- The investor owns at least 20% of the voting stock of the investee(but not if another shareholder or small voting block owns a majority and exercises total control)
- The investor has definite plans to acquire additional stock in the future to bring their interest up to at least 20%
Some points of interest (equity method)
- The investment is originally recorded at Cost
- As the investee earns money, this is recorded as an increase on the invetor’s books based on the % the investor owns. This is considered “equity in earnings” and is shown on the income statement as a component of continuing operations
- Dividends received are considered a reduction of the investment account and do NOT show up on the income statement.
- Any difference paid between the purchase price paid for the investee and the book value of the investee’s net assets much be accounted for.
- Those differences are considered:
- FMV write up of assets (FMV increment)
- PP&E – depreciated
- Inventory – written off when sold
- Land – not depreciated but written off when sold
- Goodwill – not amortized but impairment losses recognized
Ownership of preferred stock cannot, by itself, give an investor significant influence, but the investor may have such influence due to other causes, and use the equity method of accounting for the preferred stock investment. Preferred stock income under the equity method is equal to the dividends allocated to it. For non-cumulative preferred stock, this will equal declared dividends only.
The equity method of accounting, used when the investor has significant influence, is more consistent with accrual accounting. The investment is still recorded initially at purchase price, but subsequent income changes the account balance on a continuous basis. The investor reports its share of the investee’s income as an increase in tis investment account, with offsetting recognition of equity in earning of investee on the income statement. Dividends reduce the investment carrying value and are not reported in come in the investor’s income statement.
For example, let’s assume the investor paid $300 on 1/1/x1 to acquire 30% of the stock of the investee, at a time when the investee’s net assets(equity) equaled $1,000, so that the original investment equaled the investor’s 30% share of equity. In 20×1, the investee reported net income of $400 and paid dividends totaling $100 to stockholders of record on 12/31/x1 with a payment date of 1/7/x2. The investment entry is:
1/1/x1 Investment (Long-Term Asset) 300
Cash 300
The entry to report the investor’s share of income is:
12/31/x1 Investment 120
Equity in Investee Income(I/S Acct) 120
The entry to record the dividend?
12/31/x1 Dividends receivable 30
Investment 30
Of course, there is also an entry on 1/7/x2 for the collection of the receivable. Notice that the investor’s investment account changes as the equity of the investee changes ( this is one reason it is known as the equity method):
| Investee | Investor | |||
| S/E of Investee | Investment (30%) | |||
| Purchase Data, 1/1/x1 | $ 1,000 | $ 300 | ||
| Net Income | 400 | 120 | ||
| Dividends | -100 | -30 | ||
| Balance | 1300 | 390 |
In the example above, the $300 purchase price equaled 30% of the equity of the investee,. When the purchase price exceeds the investor’s share of equity, the excess needs to be identified, and accounted for in an appropriate manner. First, any assets with fair values differing from carrying values are identified, and the investor determines their percentage share of that excess (or deficiency). Any remaining excess is assumed to represent goodwill on the purchase.
The excess of the cost of the investment over book value is not reported separate on the financial statement; it is include in the investment. Nevertheless, it will have an impact on the subsequent reporting of income by the investor that depends on the nature of the asses causing the difference:
- Depreciable and amortizable assets – differences will be amortized against the reported equity in investee income based on the appropriate life of the asset.
- Goodwill – amount initially recorded will later reduce reported income in periods that impairment losses are recognized.
- All assets – outstanding differences will be written off against reported income at the time the asset is sold.
Assume the investor’s 30% investment in the previous example cost $380 instead of $300, that $10 of the excess was attributable to inventory, which was sold during 20×1, $30 was attributable to land, which was still owned by the investee at the end of 20×1, and the remaining $40 represented a building, with an estimated useful life of 40 years. The inventory excess should be written off in 20×1, the land excess should remain, and building depreciation of $40/40=$1 should be recorded in 20×1. As a result, the equity in investee income reported by the investor is $109, computed as follows:
| Net income of investee | 400 | |
| Percentage | 30% | |
| Investor share | 120 | |
| Inventory | -10 | |
| Land | 0 | |
| Building | -1 | |
| Equity in investee income | 109 |
Examine the changes in the investment account in 20×1, in comparison to the changes in the investor’s share of the investee’s equity:
| S/E of Investee | Investment (30%) | Equity(30%) | Excess | ||
| Purchase Data, 1/1/x1 | $ 1,000 | $ 300 | $ 300 | $ 80 | |
| Net Income | 400 | 109 | 120 | -11 | |
| Dividends | -100 | -30 | -30 | — | |
| Balance | 1300 | 459 | 390 | 69 |
By including the adjustments for the sale of inventory and depreciation on the building in income, the excess of cost over book value in the initial investment is gradually being written off. After the land is sold by the investee and building is completely depreciated, the investment will equal equity, and further reported income will be at straight percentages.
— Linden Lake
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