Equity Method

Question 1

When should you use the equity method?

Answer 1

it is used to account for investments if significant influence can be exercised by the investor over the investee; consolidated statements should be presented when ownership is greater than 50% and there is control over the investee

Question 2

What is significant influence?

Answer 2

it is when a company owns 20-50% of voting stock of another “investee” company and is presumed to be able to exercise significant influence over the operating and financial policies of that investee and, therefore, must use the equity method when presenting the investment in that investee in consolidated financial statements that include other consolidated entities, but not that investee or unconsolidated parent company financial statements

the CPA exam frequently presents questions in which the ownership percentage is below 20%, but the “ability to exercise significant influence” exists; the equity method is the correct method of accounting for these investments

Question 3

How to record the equity method

Answer 3

under the equity method, the investment is originally recorded at the price paid to acquire the investment; the investment account is subsequently adjusted as the net assets of the investee change through the earning of income and payment of dividends; the investment account increases by the investors share of the investee’s net income with a corresponding credit to the investor’s income statement account (equity in subsidiary/investee income); the distribution of dividends by the investee reduces the investment balance; continuing losses by an investee may result in a decrease of the investment account to a zero balance

3 main journal entries are used to account for an equity method investment:

journal entry to record investment at cost (FV of consideration plus legal fees)

journal entry to record increase in the investment by the investor’s share of the earnings of the investee

journal entry to record decrease in the investment by the investor’s share of the cash dividends from the investee

an easy way to remember the GAAP accounting rules for the equity method is to think of it as a bank account and use your base analysis

beginning balance
add: investor’s share of investee’s earnings (like bank interest; income when earned)
substract: investor’s share of investee’s dividends (like bank withdrawals)
ending balance

Question 4

How to treat investments in investee common and preferred stock

Answer 4

if an investor company owns both common and preferred stock of an investee company, the “significant influence” test is generally met by the amount of common stock owned (which is usually the only voting stock); the calculation of the income from subsidiary (or investee) to be reported on the income statement includes: preferred stock dividends and share of earnings available to common shareholders (net income reduced by preferred dividends)

Question 5

How to account for asset fair value differences and goodwill

Answer 5

the excess of an asset’s fair value over its book value is amortized over the life of the asset (excess caused by land is not amortized); this additional amortization causes the investor’s share of the investee’s net income to decrease

to better under this journal entry and its impact, think of the amortization of excess purchase price (premium) as a bank service charge; the equity method, which we treat like a bank account, will have the account balance (balance sheet asset) reduced by this bank service charge and also will have the net earnings form the account reduced by this service charge

the fair value excess attributable to goodwill is not amortized and is not subject to a separate impairment test; however, the total equity method investment (including goodwill) must be analyzed at least annually for impairment

Question 6

Equity method impairment

Answer 6

an impairment loss on an equity method investment is recognized when the following two conditions occur:
the fair value of the investment falls below the carrying value of the investment & the entity believes the decline in value is other than temporary
if both conditions are met, the entity reports the impairment loss on the income statement and the carrying value of the investment is reduced to the lower fair value on the balance sheet; under U.S. GAAP, the impairment loss is not permitted to be reversed if the fair value of the investment increases in subsequent periods

Question 7

Transition to the equity method

Answer 7

when significant influence is acquired, it is necessary to record a change from the fair value method to the equity method by doing the following on the date the investment qualifies for the equity method:

add the cost of acquiring the additional interest in the investee to the carrying value of the previously held investment & adopt the equity method as of that date and going forward; retroactive adjustments are not required

for equity securities without readily determinable fair values, if transitioning to the equity method due to an observable transaction, the investment must be remeasured immediately before the transition; if transitioning from the equity method, the investment must be remeasured immediately after the transition