,Chapter 01 - The Equity Method of Accounting for Investments – Hoyle, Schaefer, Doupnik, Advanced Accounting,
15e
CHAPTER 1
THE EQUITY METHOD OF ACCOUNTING FOR INVESTMENTS
Chapter Outline
I. Four methods are principally used to account for an investment in equity securities along
with a fair value option.
A. Fair value method: applied by an investor when only a small percentage of a company’s
voting stock is held.
1. The investor recognizes income when the investee declares a dividend.
2. Portfolios are reported at fair value. If fair values are unavailable, investment is
reported at cost.
B. Cost Method: applied to investments without a readily determinable fair value. When the
fair value of an investment in equity securities is not readily determinable, and the
investment provides neither significant influence nor control, the investment may be
measured at cost. The investment remains at cost unless
1. A demonstrable impairment occurs for the investment, or
2. An observable price change occurs for identical or similar investments of the same
issuer.
The investor typically recognizes its share of investee dividends declared as dividend
income.
C. Consolidation: when one firm controls another (e.g., when a parent has a majority
interest in the voting stock of a subsidiary or control through variable interests, their
financial statements are consolidated and reported for the combined entity.
D. Equity method: applied when the investor has the ability to exercise significant influence
over operating and financial policies of the investee.
3. Ability to significantly influence investee is indicated by several factors including
representation on the board of directors, participation in policy-making, etc.
4. GAAP guidelines presume the equity method is applicable if 20 to 50 percent of the
outstanding voting stock of the investee is held by the investor.
Current financial reporting standards allow firms to elect to use fair value for any new
investment in equity shares including those where the equity method would otherwise apply.
However, the option, once taken, is irrevocable. The investor recognizes both investee
dividends and changes in fair value over time as income.
II. Accounting for an investment: the equity method
A. The investor adjusts the investment account to reflect all changes in the equity of the
investee company.
B. The investor accrues investee income when it is reported in the investee’s financial
statements.
C. Dividends declared by the investee create a reduction in the carrying amount of the
Investment account. This book assumes all investee dividends are declared and paid
in the same reporting period.
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,Chapter 01 - The Equity Method of Accounting for Investments – Hoyle, Schaefer, Doupnik, Advanced Accounting,
15e
III. Special accounting procedures used in the application of the equity method
A. Reporting a change to the equity method when the ability to significantly influence an
investee is achieved through a series of acquisitions.
1. Initial purchase(s) will be accounted for by means of the fair value method (or at
cost) until the ability to significantly influence is attained.
2. When the ability to exercise significant influence occurs following a series of stock
purchases, the investor applies the equity method prospectively. The total fair value
at the date significant influence is attained is compared to the investee’s book value
to determine future excess fair value amortizations.
B. Investee income from other than continuing operations
1. The investor recognizes its share of investee reported other comprehensive income
(OCI) through the investment account and the investor’s own OCI.
2. Income items such as discontinued operations that are reported separately by the
investee should be shown in the same manner by the investor. The materiality of
these other investee income elements (as it affects the investor) continues to be a
criterion for separate disclosure.
C. Investee losses
1. Losses reported by the investee create corresponding losses for the investor.
2. A permanent decline in the fair value of an investee’s stock should be recognized
immediately by the investor as an impairment loss.
3. Investee losses can possibly reduce the carrying value of the investment account to
a zero balance. At that point, the equity method ceases to be applicable and the
fair-value method is subsequently used.
D. Reporting the sale of an equity investment
1. The investor applies the equity method until the disposal date to establish a proper
book value.
2. Following the sale, the equity method continues to be appropriate if enough shares
are still held to maintain the investor’s ability to significantly influence the investee.
If that ability has been lost, the fair-value method is subsequently used.
IV. Excess investment cost over book value acquired
A. The price an investor pays for equity securities often differs significantly from the
investee’s underlying book value primarily because the historical cost based
accounting model does not keep track of changes in a firm’s fair value.
B. Payments made in excess of underlying book value can sometimes be identified with
specific investee accounts such as inventory or equipment.
C. An extra acquisition price can also be assigned to anticipated benefits that are
expected to be derived from the investment. In accounting, these amounts are
presumed to reflect an intangible asset referred to as goodwill. Goodwill is calculated
as any excess payment that is not attributable to specific identifiable assets and
liabilities of the investee. Because goodwill is an indefinite-lived asset, it is not
amortized.
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, Chapter 01 - The Equity Method of Accounting for Investments – Hoyle, Schaefer, Doupnik, Advanced Accounting,
15e
V. Deferral of intra-entity gross profit in inventory
A. The investor’s share of intra-entity profits in ending inventory are not recognized until
the transferred goods are either consumed or until they are resold to unrelated parties.
B. Downstream sales of inventory
1. “Downstream” refers to transfers made by the investor to the investee.
2. Intra-entity gross profits from sales are initially deferred under the equity method and
then recognized as income at the time of the inventory’s eventual disposal.
3. The amount of gross profit to be deferred is the investor’s ownership percentage
multiplied by the markup on the merchandise remaining at the end of the year.
C. Upstream sales of inventory
1. “Upstream” refers to transfers made by the investee to the investor.
2. Under the equity method, the deferral process for intra-entity gross profits is identical
for upstream and downstream transfers. The procedures are separately identified
in Chapter One because the handling does vary within the consolidation process.
Answers to Discussion Questions
The textbook includes discussion questions to stimulate student thought and discussion. These
questions are also designed to allow students to consider relevant issues that might otherwise be
overlooked. Some of these questions may be addressed by the instructor in class to motivate
student discussion. Students should be encouraged to begin by defining the issue(s) in each case.
Next, authoritative accounting literature (FASB ASC) or other relevant literature can be consulted
as a preliminary step in arriving at logical actions. Frequently, the FASB Accounting Standards
Codification will provide the necessary support.
Unfortunately, in accounting, definitive resolutions to financial reporting questions are not always
available. Students often seem to believe that all accounting issues have been resolved in the past
so that accounting education is only a matter of learning to apply historically prescribed procedures.
However, in actual practice, the only real answer is often the one that provides the fairest
representation of the firm’s transactions. If an authoritative solution is not available, students should
be directed to list all of the issues involved and the consequences of possible alternative actions.
The various factors presented can be weighed to produce a viable solution.
The discussion questions are designed to help students develop research and critical thinking skills
in addressing issues that go beyond the purely mechanical elements of accounting.
Did the Cost Method Invite Manipulation?
The cost method of accounting for investments often caused a lack of objectivity in reported income
figures. With a large block of the investee’s voting shares, an investor could influence the amount
and timing of the investee’s dividend declarations. Thus, when enjoying a good earnings year, an
investor might influence the investee to withhold declaring a dividend until needed in a subsequent
year. Alternatively, if the investor judged that its current year earnings “needed a boost,” it might
influence the investee to declare a current year dividend. The equity method effectively removes
managers’ ability to increase current income (or defer income to future periods) through their
influence over the timing and amounts of investee dividend declarations.
At first glance it may seem that the fair value method allows managers to manipulate income
because investee dividends are recorded as income by the investor. However, dividends paid
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