2 - 1 ©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e,...

Stock Investments –Investor Accounting

Chapter 2

Learning Objective 1

Recognize investors’ varying

levels of influence or control

based on the level of

stock ownership.

Accounting for Stock Investment

GAAP for recording common stockacquisitions require that the investor

record the investment at its cost.

GAAP for recording common stockacquisitions require that the investor

record the investment at its cost.

Fair value/cost method Equity method

Concept Underlying Fair Value/Cost

and Equity Methods

Under the fair value/cost methodinvestments in common stock

are recorded at cost.

Under the fair value/cost methodinvestments in common stock

are recorded at cost.

Dividends from subsequent earningsare reported as dividend income.

Concept Underlying Fair Value/Cost

and Equity Methods

The equity method of accountingis essentially accrual accounting

for equity investments.

The equity method of accountingis essentially accrual accounting

for equity investments.

Investments are recorded at costand adjusted for earnings,

losses, and dividends.

Investments are recorded at costand adjusted for earnings,

losses, and dividends.

Anticipate how accounting adjusts

to reflect the economics underlying

varying levels of investor influence.

Economic Consequences of UsingFair Value/Cost and Equity

Methods

The different methods of accounting result indifferent investment amounts in the balance

sheet of the investor corporation and differentincome amounts in the income statement.

Methods

Investor can significantly influence orcontrol the operations of the investee.

Fair value/cost method is unacceptable.

Methods

The equity method is not a substitute forconsolidation, the income reported is

generally the same as the income reportedin consolidated financial statements.

Apply the fair value/cost and

equity methods of accounting

for stock investments.

Accounting Procedures Under theFair Value/Cost and Equity

Methods

July 1: Pilzner acquires 2,000 of the 10,000outstanding shares of Sud at $50 per share.

$50 per share equals the book valueand fair value of Sud’s net assets.

Sud net income for the year is $50,000.

Dividends of $20,000 are paid on November 1.

Fair Value/Cost Method

July 1Investment in Sud 100,000

Cash 100,000

November 1Cash 4,000

Dividend income 4,000

December 31 No entryNet marketable stock or market price = $50

Fair Value/Cost Method

Assume that Sud’s net income had been $30,000.

What is Pilzner’s share?

$30,000 × ½ × 20% = $3,000

December 31Dividend Income 1,000

Investment in Sud 1,000

Equity Method

July 1Investment in Sud 100,000

Cash 100,000

November 1Cash 4,000

Investment in Sud 4,000

Equity Method

December 31Investment in Sud 5,000

Income from Sud 5,000

$50,000 × ½ × 20% = $5,000

Identify factors beyond stock

ownership that affect an

investor’s ability to

exert influence or control.

Influence or Control

An investment of 20% or more of thevoting stock of an investee should

lead to a presumption that an investorhas the ability to exercise significant

influence over an investee.

The equity method should be followedby an investor whose investment invoting stock gives it the ability toexercise significant influence overoperating and financial policies on

an investee even though the investordoes not control the investee.

An investor may be able to exert significantinfluence over its investee with an

investment interest of less then 20%.

The equity method should not be applied ifthe investor’s ability to exert significantinfluence is temporary or if the investeesare foreign companies operating under

severe exchange restrictions or controls.

Apply the equity method to

purchase price allocations.

Equity Method:A One-Line Consolidation

Investment is reported in a singleamount on one line of the investor

company’s balance sheet

Investment income is reported ina single amount on one line of the

investor’s income statement.

Equity Investments at Acquisition

PJ, Inc., purchases 30% of SR outstandingvoting common stock on January 1

from existing stockholders.($2,000,000 cash plus 200,000 sharesof PJ $10 par common with a market

value of $15 per share)

Additional direct costs

SEC fees: $ 50,000Consulting and advisory fees: $100,000

How are these transactions recorded?

Investment in SR 5,000,000Common Stock, $10 par 2,000,000Additional Paid-in Capital 1,000,000Cash 2,000,000

To record acquisition of a 30% equity investmentin SR

Investment in SR 100,000Additional Paid-in Capital 50,000

Cash 150,000To record additional direct costs of purchasinga 30% equity interest in SR

Illustration of a PurchaseCombination

BookValue

AssetsCash $ 1,500 $ 1,500Net receivables 2,200 2,200Inventories 3,000 4,000Other current assets 3,300 3,100Equipment, net 5,000 8,000

Total assets $15,000 $18,800

FairValue

BookValue

LiabilitiesAccounts payable $ 1,000 $ 1,000Note payable 2,000 1,800

Common stock 10,000Retained earnings 2,000Total liabilities and stockholders’ equity $15,000

FairValue

$15,000 – 3,000 = $12,000 $12,000 × 30% = $3,600

Assignment of Excess CostOver Underlying Equity

BV$3,600

FMV$4,800

Cost$5,100

Investment in SR $5,100,000Book value of the interest acquired –3,600,000Excess cost over book value $1,500,000

Fair value – Book value × 30% = $1,200,000Amount assigned

Remainder assigned to goodwill $ 300,000

Inventories $ 300,000Other current assets (60,000)Equipment 900,000Note payable 60,000 Total $1,200,000

Accounting for Excess of Investment

Cost Over Book Value

What are PJ’s journal entries?

Assume SR pays dividends of $1,000,000on July 1, and reports net income of

$3,000,000 for the year.

July 1Cash 300,000

Investment in SR 300,000To record additional dividends receivedfrom SR at 30% equity interest in SR

December 31Investment in SR 900,000

Income from SR 900,000To record equity in income of SR

December 31Income from SR 300,000

Investment in SR 300,000To write off excess allocated to inventory

December 31Investment in SR 60,000

Income from SR 60,000To record income credit for overvaluedother current assets disposed of

Investment in SR 45,000To record depreciation on excess allocatedto undervalued equipment with a 20-yearremaining useful life ($900,000 ÷ 20)

Investment in SR 12,000To amortize the excess allocated to theovervalued note payable over the remaininglife of the note ($60,000 ÷ 5)

Investment5,100,000 300,000 900,000 300,000 60,000 45,000

12,000

Income from SR 300,000 900,000 45,000 60,000 12,000

Excess of Book Value AcquiredOver Investment Cost

Post Corporation purchases 50% of the outstanding voting common stock of

Taylor on January 1 for $40,000.

Taylor’s stockholders’ equity Jan 1: $100,000Add: Income 20,000

Deduct: Dividends paid 7/1 – 5,000Stockholders’ equity 12/31 $115,000

Assignment of Excess Costover Underlying Equity

BV$50,000

Cost$40,000

Excess of Book Value AcquiredOver Investment Cost

$100,000 × 50% – $40,000 = $10,000

This is the excess book value over cost.

The excess is assigned to:Inventories $(1,000)Equipment $(9,000)

Negative Goodwill

Post acquires a 25% interest inSaxon for $110,000

Saxon net income and dividends forthe year are $60,000 and $40,000

BookValue

AssetsInventories $240,000 $260,000Other current assets 100,000 100,000Equipment, net 50,000 50,000Building, net 140,000 200,000

Total assets $530,000 $610,000Liabilities 130,000 130,000Net assets $400,000 $480,000

FairValueSaxon’s net assets

Assignment of Excess Costover Underlying Equity

BV$100,000

FMV$120,000

Cost$110,000

Negative Goodwill

$110,000 – $120,000 = – $10,000

This is the excess of FMV over cost.

Interim Acquisitions of anInvestment Interest

Accounting for equity investmentsbecomes more specific when thefirm makes acquisitions within

an accounting period.

Investment in a Step-by-StepAcquisition

An investor may acquire the ability to exercisesignificant influence over the operating and

financial policies of an investee in a series ofstock acquisitions, rather than in a single purchase.

Sale of an Equity Interest

When an investor sells a portion of an equityinvestment that reduces its interest at 20%or less than the level necessary to exercise

significant influence the equity methodis no longer appropriate.

Stock Purchases Directlyfrom the Investee

Karl Corporation purchases 20,000 of previouslyunissued common stock from Master Co. for

$450,000 on January 1, 2004.

Shares outstanding after new shares are issued:December 31, 2003 20,000Issued to Karl 20,000Total 40,000

Stock Purchases Directlyfrom the Investee

Master’s stockholders’ equity before issuance($200,000 capital stock+ $150,000 retained earnings) $350,000Sale to Karl 450,000Master’s stockholder after issuance $800,000Book value acquired by Karl $400,000

Investee Corporation withPreferred Stock

Some adjustments are necessary whenan investee has preferred as well as

common stock outstanding.

Extraordinary Items, Cumulative-Effect-Type, and Other

Considerations

Ordinary

Extraordinary

Cumulative-effect

Disclosures for Equity Investees

Name of each investee and percentage of ownership.

Accounting policies of the investor with respectto investments in common stock.

Difference between the carried amount of investment and the amount of underlying equity in net assets.

Related Party Transactions

These transactions arise when one of the transacting parties has the ability to influence

significantly the operations of the other.

End of Chapter 2

2 - 1 ©2003 Prentice Hall Business Publishing, Advanced Accounting 8/e,...

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