Ch. 1 Equity Method Inv. Flashcards
When using the equity method: company’s consolidated net income
Includes company’s proportionate share of net income/loss
From investee companies
Equity method is used for investments in companies if…
2) ownership interest in equity method
Company has the ability to exercise significant influence
Over operating and financial policies of investee
2) investor does not have control but owns 20-50% of company
So can exercise significant influence
3 different approaches for financial reporting of investments in equity securities under GAAP
1 fair value method
2 consolidation of financial statements
3 equity method
Influence increases with…
Relative size of ownership
When is fair value method for equity investments used?
When investor possess only small percentage of investee
Company’s outstanding stock
Investor can’t expect to significantly affect investee’s operations
Or decision making
How are initial investments in equity securities recorded on financial statements?
Recorded at cost and subsequently adjusted if FMV is readily
Determinable
Trading securities
Under fair value method, Equity securities held for sale in
short term
Reported at FMV, with unrealized gains and losses included in
Earnings
Available-for-sale securities
Under fair value method, are reported at fair value
Unrealized gains and losses are excluded from earnings and
Reported in separate component of shareholder’s equity as
Part of other comprehensive income
Fair Value method dividends
Dividends from investments are recognized as income for
Both trading and available for sale securities
Fair value method is used for equity investments when investor has…
Neither significant influence nor control
When does consolidation of financial statements occur for corporate investors?
When they have enough shares to gain actual control over
Investee’s operating
Accumulate over 50% of the shares outstanding of voting stock
Control generally requires what for accounting information?
Control generally requires consolidation of accounting information
Produced by individual companies
What does the equity method use to recognize income?
Uses accrual basis for recognizing investor’s share of investee
Income
Treatment of dividends under the equity method
Investor’s share of investee dividends declared are recorded
As decreases in investment account (not income)
Equity method is often used for what kind of business activity?
Joint ventures
Under the cost method, how is a declared dividend treated on the investor’s records?
Recorded as dividend income
IASB definition of significant influence
Power to participate in financial and operating policy decisions
Of investee,
but not have control/joint control over those policies
6 conditions that indicate presence of degree of influence for use of the equity method
1 investor representation on board of directors
2 investor participation in policy making process of investee
3 material intra-entity transactions
4 interchange of managerial personnel
5 technological dependency
6 extent of ownership by investor in relation to size and
concentration of other ownership interests in investee
Sole criterion for use of equity method
Ability to exercise influence over investee
3 situations where equity method isn’t appropriate for investments regardless of investor’s degree of ownership
1 agreement exists between investor and investee, where investor
Surrenders significant rights as a shareholder
2 concentration of ownership operates the investee without
Regard for views of investor
3 investor attempts, but fails to obtain representation on investee’s
Board of directors
If an entity can exercise control over its investee, regardless of ownership level…
Consolidation (rather than equity method) is appropriate
Variable interests
Control achieved through contractual and other arrangements
Financial control exists, absent of majority ownership interest
Extensions of equity method applicability
It’s possible to fall short or exceed 20-50% ownership and
Still use the equity method
Ex. Being a member of a business consortium that holds voting control of investee that you own less than 20% of, or own over 50% but have contract with another company that says you share control equally
Criterion and normal ownership level for fair value or cost method of accounting
Criterion: inability to significantly influence
Ownership: less than 20%
2 possible criterion for consolidated financial statements
1 control through voting interests
2 control through variable interests (governance documents,
Contracts)
2 possible normal ownership levels for consolidated financial statements
1 more than 50%
2 primary beneficiary status (no ownership required)
For users of investor’s financial statements, the equity method effects…
Both the timing or income recognition and carrying around of
Investment account
In applying the equity method, the accounting objective is to report…
The investor’s investment and investment income reflecting
Close relationship between the companies
After recording the cost of acquisition, what 2 equity method entries periodically record the investment’s impact?
1 investor’s investment account increases as investee earns and reports income
2 investor decreases its investment account for its share of
investee cash dividends
investor’s investment account increases as investee earns and reports income
Although investor initially records acquisition at cost, upward
Adjustments in asset balance are recorded as soon as investee
Makes profit
Reduction is necessary if loss is reported
Because investor can influence their timing, investee dividends…
Can’t objectively measure income generated from investment
One of the most common problems encountered in applying the equity method concerns…
Investment costs that exceed proportionate book value of
Investee company
A companies value at any time is based on a multitude of 5 common factors
1 company profitability 2 introduction of new project 3 expected dividend payments 4 projected operating results 5 general economic conditions
Stock prices are based (at least partially) on…
The perceived worth of a company’s net assets
These amounts often vary dramatically from the company’s
Underlying book value
Asset and liability accounts shown on the balance sheets tend to measure…
Historical cost rather than current value
What specific accounting methods adopted by companies lead to different book values?
1 LIFO
2 FIFO
3 different depreciation methods
Income recognition for investments
Requires matching income generated from investment with its
Cost
Excess costs allocated to fixed assets will likely be expensed over longer periods than…
Costs allocated to inventory
In applying the equity method, the cause of excess payment can be divided into 2 general categories
1 specific assets and liabilities differ have FMVs that differ from
Their present book values
2 investor may pay extra amount because it expects future benefits
To accrue from investment
Goodwill
Any extra payment that can’t be attributed to a specific asset
Or liability is assigned to goodwill
Which payments should not be amortized because there is no useful life? 3
1 land
2 goodwill
3 indefinite life intangibles
Goodwill associated with equity method investments vs. Goodwill associated with business combinations
Goodwill associated with a business combination is subject to
Annual impairment reviews
Whereas goodwill implicit in equity investment combinations
Is not
Equity method investments are tested in their entirety for…
Permanent declines in value
Special procedures involved in equity method accounting in the 4 following areas
1 reporting a change to the equity method
2 reporting investee income from sources other than continuing
Operations
3 reporting investee losses
4 reporting sale of an equity investment
Reporting a change to the equity method (from the fair value method)
Financial statements adjusted retroactively
All accounts are restated so investor’s financial statements
Appear as if equity method has been applied from date of 1st
Acquisition
Under the Equity method: when an investee company’s activities require recognition of other comprehensive income (OCI)…
Its owner’s equity (and net assets) will reflect changes not
captured in its reported net income
Other Comprehensive Income (OCI), 2 things
Revenues, expenses, gains and losses under GAAP are included
In comprehensive income but excluded for net income
OCI is accumulated and reported in stock holders equity
AOCI
Accumulated Other Comprehensive Income
3 items included in Accumulated Other Comprehensive Income (AOCI)
1 unrealized holding gains and losses
2 foreign currency translation adjustments
3 certain pension adjustments
OCI represents a source of change in the investee company…
Net assets that is recognized under the equity method
Equity method: reporting investee losses
Investor recognizes appropriate percentage of each loss
And reduces carrying amount of investment account
Loss in value of an investment which is other than temporary
Shall be recognized
Evidence of loss of value on investment account 2
1 absence of ability to recover carrying amount of investment
2 inability of investee to sustain earnings capacity to justify
Carrying amount
What can lead to permanent losses in fair value? 4 things
1 loss of major customers
2 changes in economic conditions
3 loss of significant patent or legal right
4 damage to company’s reputation
When a permanent decline in an equity method investment’s value occurs, the investor must…
Recognize an impairment loss and reduce asset to fair value
Under the equity method, a temporary drop in FMV is…
Simply ignored
When an investment account is reduced to zero
Investor should discontinue using equity method rather than
establish negative balance
The investment retains a zero balance until subsequent investee
Profits eliminate all unrecognized losses
Investment reduced to zero: once the original cost of investment has been eliminated…
No additional losses can accrue to investor (since entire cost has
been written off)
Reporting sale of equity method investment
1 continue to use equity method as long as still own over 20%
2 if sold significant amount to own under 20%, use fair value
Method
Switch from equity method to fair value method
Remaining book value becomes new cost figure for investment
No retrospective adjustment is made to financial statements
Because of the relationship between investor and investee, the seller of the goods is said to retain partial stake in the inventory for…
As long as buyer holds it
The earning process is not considered complete at time of…
Original sale
Income recognition must be deferred until…
Substantial accomplishment is proven
Equity method: reporting related profit on intra entity transfers
Delayed until buyer’s ultimate disposition of goods
When inventory is eventually consumed within operations or
Resold to an unrelated party, original sale is culminated and
Gross profit is fully recognized
Downstream transfers
Investor’s sale of an item to the investee
Upstream sale
Sale that investee makes to investor
2 types of intra entity sales
1 downstream transfers
2 upstream sales
Direction of intra-entity sales does not affect…
Reported equity method balances for investments when significant
Influence exists
Direction of intra entity sales has definite consequences when…
Financial control requires consolidation of financial statements
Unlike consolidated financial statements, the equity method reports upstream sales of inventory…
In the same manner as downstream sales
Under the equity method for investments with significant influence, the direction of the sale between investor and investee (upstream or downstream) has…
No effect on final amounts reported in financial statements
The investor’s own inventory account contains unrealized profit in…
An upstream sale
In upstream sales, what is the traditional approach for deferring unrealized gross profits?
Decreasing the investment
Deferred unrealized gross profit is adjusted solely through which account?
Adjusted solely Through the equity income account
4 disclosures of related party transactions
1 nature of relationship
2 description of transactions
3 dollar amounts of transactions
4 amounts due to or from any related parties at year end
Attention to financial reporting effects of business decisions arises because measurements of financial performance affect the following 4 items
1 firm’s ability to raise capital
2 managerial compensation
3 ability to meet debt covenants and future interest rates
4 manager’s reputations
3 main reasons equity method is criticized
1 emphasizing 20-50 percent of voting stock in determining
Significant influence vs. Control
2 allowing off-balance sheet financing
3 potentially bias ing performance ratios
Equity method: off balance sheet financing 3 things
1 By keeping ownership below 50%, company can keep assets
And liabilities off balance sheet
2 Leads to higher rates of return for assets and sales and lower
Debt to equity ratios reported in consolidated statements
3 must be disclosed in supplementary info in financial statements
Fair value option
In 2007, FASB introduced a fair-value option
where entity may Irrevocably elect fair value as initial and subsequent measurement attribute for certain financial assets and liabilities
Fair value option is designed to limit…
Volatility in earnings that occurs when some financial items are
Measured using cost based attributes and others using fair value
Under the 2013 FASB proposal, firms would only be able to use fair value accounting for equity method investments…
Held for sale
