The Equity Method of Accounting for Investments

Topics: Generally Accepted Accounting Principles, Balance sheet, Book value Pages: 49 (11478 words) Published: May 31, 2011
Chapter 1
the equity method of accounting for investments

Chapter Outline

I. Three methods are principally used to account for an investment in equity securities. A. Fair-value method: applied by an investor when only a small percentage of a company’s voting stock is held. 1. Income is recognized when dividends are declared. 2. Portfolios are reported at market value. If market values are unavailable, investment is reported at cost.

B. 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 (FIN 46R), their financial statements are consolidated and reported for the combined entity.

C. Equity method: applied when the investor has the ability to exercise significant influence over operating and financial policies of the investee. 1. Ability to significantly influence investee is indicated by several factors including representation on the board of directors, participation in policy-making, etc. 2. According to a guideline established by the Accounting Principles Board, the equity method is presumed to be applicable if 20 to 50 percent of the outstanding voting stock of the investee is held by the investor. SFAS 159, The Fair Value Option for Financial Assets and Financial Liabilities (effective 2008) allows firms to elect to use fair value

II. Accounting for an investment: the equity method
A. The investment account is adjusted by the investor to reflect all changes in the equity of the investee company. B. Income is accrued by the investor as soon as it is earned by the investee. C. Dividends declared by the investee create a reduction in the carrying amount of the Investment account.

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. At the point in time that the equity method becomes applicable, a retroactive adjustment is made by the investor to convert all previously reported figures to the equity method based on percentage of shares owned in those periods. 3. This restatement establishes comparability between the financial statements of all years. B. Investee income from other than continuing operations 1. Income items such as extraordinary gains and losses and prior period adjustments that are reported separately by the investee should be shown in the same manner by the investor. 2. The materiality of this income element (as it affects the investor) continues to be a criterion for this separate disclosure. C. Investee losses

1. Losses reported by the investee create corresponding losses for the investor. 2. A permanent decline in the market value of an investee’s stock should also be recognized immediately by the investor. 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 equity method is consistently applied until the date of disposal to establish the 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 cost of investment over book value acquired
A.The price paid by an investor for equity securities can vary significantly from the underlying book value of the...
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