Chapter 2: Stock Investments - Investor Accounting and Reporting

© Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc. publishing as Prentice Hall

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Chapter 2: Stock Investments – Investor Accounting and Reporting

by Jeanne M. David, Ph.D., Univ. of Detroit Mercy

to accompanyAdvanced Accounting, 10th editionby Floyd A. Beams, Robin P. Clement,

Joseph H. Anthony, and Suzanne Lowensohn


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Stock Investments: Objectives1. Recognize investors' varying levels of influence

or control, based on the level of stock ownership.2. Anticipate how accounting adjusts to reflect the

economics underlying varying levels of investor influence.

3. Apply the fair value/cost and equity methods of accounting for stock investments.

4. Identify factors beyond stock ownership that affect an investor's ability to exert influence or control.


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Objectives (continued)

5. Apply the equity method to purchase price allocations.

6. Learn how to test goodwill for impairment.


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1: Levels of Influence or Control1: Levels of Influence or ControlStock Investments – Investor Accounting and Reporting


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Levels of InfluencePercent Ownership of Voting Stock

>50%<20%

20-50%

• <20% – presumes lack of significant influence – fair value (cost) method• 20% to 50% – presumes significant influence – equity method• >50% – presumes control – consolidated financial statements

Fair value (cost)

method

Equity method

Consolidated financial

statements


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2: Accounting Reflects Economics2: Accounting Reflects EconomicsStock Investments – Investor Accounting and Reporting


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Accounting for the InvestmentDegree of influence

Investment's carrying value

Investment income

Lack of significant influence

Fair value (cost, if nonmarketable)

Dividends declared

Significant influence

Original cost adjusted to reflect periodic earnings and dividends, e.g., a proportionate share of investee's net assets

Proportionate share of investee's periodic earnings*

* If income were measured as dividends declared, by influencing or controlling dividend decisions, the investor could manipulate its own investment income.


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3a: Fair Value/Cost Method3a: Fair Value/Cost MethodStock Investments – Investor Accounting and Reporting


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Fair Value (Cost) MethodFASB Statement No. 115• At acquisition: Pilzner buys 2,000 shares of Sud

for $100,000.

• Pilzner receives $4,000 in dividends from Sud.

Investment in Sud 100,000 Cash 100,000

Cash 4,000 Dividend income 4,000


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Fair Value Method, at Year-end• Reduce dividend income recognized, if needed

• Adjust investment to fair valueAllowance to adjust available-for-sale securities to fair value

21,000

Other comprehensive income 21,000If fair value of increases to $120,000 and the Investment in Sud account balance is $99,000.

Dividend income 1,000 Investment in Sud 1,000

If Pilzner determines that cumulative dividends exceed its cumulative share of income by $1,000.


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3b: Equity Method3b: Equity MethodStock Investments – Investor Accounting and Reporting


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Equity MethodAPB Opinion No. 18• At acquisition: Pilzner buys 2,000 shares of Sud

for $100,000.

• Pilzner receives $4,000 in dividends from Sud.

Investment in Sud 100,000 Cash 100,000

Cash 4,000 Investment in Sud 4,000


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Equity Method, at Year-end• Pilzner determines that its share of Sud's income is

$5,000.

• The ending balance in the Investment in Sud is:

$100,000 cost - $4,000 dividends + $5,000 income = $101,000.

Cash 4,000 Investment in Sud 4,000


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4: Ability to Influence or Control4: Ability to Influence or ControlStock Investments – Investor Accounting and Reporting


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Significant Influence• 20% to 50% voting stock ownership is a

presumption of significant influence. Use the equity method.

• Don't use equity method if there is a lack of significant influence1. Opposition by investee,2. Surrender of significant shareholder rights,3. Concentration of majority ownership,4. Lack of information for equity method, and5. Failure to obtain board representation.


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Control• More than 50% voting stock ownership is

presumptive evidence of control. Prepare consolidated financial statements.

• Don't consolidate – if control is temporary or – if the parent lacks control

1. Legal reorganization or bankruptcy2. Severe foreign restrictions.


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5: Applying the Equity Method5: Applying the Equity MethodStock Investments – Investor Accounting and Reporting


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Acquisition Cost > FV net assetsFV net assets > BV net assetsPayne acquires 30% of Sloan for $5,000. Sloan's identifiable net

assets (assets less liabilities) are:Fair value: A – L = $18,800 - $2,800 = $16,000.Book value: A – L = E = $15,000 - $3,000 = $12,000

The $4,000 difference ($16,000 - $12,000) is due to:• $1,000 undervalued inventories sold this year,• $200 overvalued other current assets used this year,• $3,000 undervalued equipment with a life of 20 years, and• $200 overvalued notes payable due in 5 years.

$5,000 > 30%(16,000) > 30%(12,000)

$5,000 > $4,800 > $3,600


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Acquisition of Sloan StockAt acquisition, Payne pays $2,000 cash and issues common

stock with a fair value of $3,000 and par value of $2,000. Payne also pays $50 to register the securities and $100 in consulting fees.

Investment in Sloan 5,000 Cash 2,000Common stock, at par 2,000Additional paid in capital 1,000

Additional paid in capital 50Investment expense 100

Cash 150


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Cost/Book Value AssignmentCost of acquisition $5,000Less 30% book value = 30%(12,000) 3,600Excess of cost over book value $1,400

Assigned to: Amount AmortizationInventories 30%(+1,000) $300 1st yearOther curr. assets 30%(-200) (60) 1st yearEquipment 30%(+3,000) 900 20 yearsNote payable 30%(+200) 60 5 yearsGoodwill (to balance) 200 NoneTotal $1,400


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Dividends and IncomePayne receives $300 dividends from Sloan.

Sloan reports net income of $900. Payne will recognize its share (30%) of Sloan's

income, but will adjust it for amortization of the differences between book and fair values.

Cash 300 Investment in Sloan 300


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Amortization and Investment IncomeCost/book value differences:

Initial amount

1st year amort.

Unamortized excess at year-end

Inventories $300 ($300) $0Other curr. Assets (60) 60 0Equipment 900 (45) 855Note payable 60 (12) 48Goodwill 200 0 200Total $1,400 ($297) $1,103

Investment income is 30% of Sloan's net income – amortization30%($3,000) – $297 = $603.


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Year-end Entry & BalanceRecord the investment income

The ending balance in the investment account is:

5,000 – 300 + 603= 5,303.

Cost – dividends + investment income

Investment in Sloan 603 Income from Sloan 603


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More on Cost/Book Value Assignment• On acquisition date, compare:

– Cost of acquisition,– Book value of net assets, and– Fair value of identifiable net assets

• Cost of the investment includes cash paid, fair value of securities issued, and debt assumed.

• The book value of the investee's net assets = assets – liabilities, or = stockholders' equity


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Fair Values Used in Assignment• Identifiable net assets include all the investee's

assets and liabilities, whether recorded or not– Fair value of research in progress– Fair value of contingent liabilities– Fair value of unrecorded patents

• Exception: use book value for pensions and deferred taxes.

• If cost > fair value, goodwill exists.• If cost < fair value, a bargain purchase exists.


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Bargain PurchaseWhen the acquisition cost is less than the fair

value of the identifiable net assets, a gain is recognized on the acquisition.

The investment is recorded at the fair value of the identifiable net assets

Investment in ABC xxx Cash, CS, APIC xxxGain on bargain purchase xxx


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Interim AcquisitionsBook value of net assets = BV equity.If equity is given as beginning of year, add current

earnings and deduct dividends to date.Amortization for first, partial, year:

– Take full amortization for inventory and other current assets disposed of by year-end.

– Take partial year's amortization for equipment, buildings, and debt to be written off over multiple years.

Record dividends if after the acquisition date.


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Acquisition in Stages• Also called a step-by-step acquisition.• Fair value (cost) method equity method

– Retroactive adjustment• Investee's growth in retained earnings is

– Excess of income over dividends declared• Investment account desired balance using equity

method = original cost + share of growth in retained earnings – amortization, if any

Investment in XYZ xxx Retained earnings xxx


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Sale of Equity Investment• Sale of investment that results in a lack of

significant influence over the investee• Equity method fair value (cost) method

– Prospective treatment• For the sale

– Reduce the investment account for a proportionate share of the stock sold

– Record a gain or loss on the sale• Apply the fair value (cost) method to remaining

investment


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Stock Purchased from InvesteeIf stock is purchased from old shareholders, the

percentage ownership is based on the shares outstanding and the investee's equity is not changed.

• If acquired directly from the investee:• Percentage acquired = shares acquired / (shares

acquired + previously outstanding shares)• Investee's new stockholders' equity = Previous

equity + value received for new shares


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Investee with Preferred Stock• Compare cost of acquisition to the book value of the

common stock. = Total equity – book value of preferred stock** BV of PS = call value + dividends in arrears

• Dividends received will be a portion of the dividends to common shareholders= total dividends – current PS dividends

• Investment income is based on income available to common shareholders= investee net income – PS dividends**** Pref. Div. = current dividend if cumulative, or

dividends declared if noncumulative.


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Special Reporting Issues• If material, the investor continues separate

reporting of extraordinary items and/or discontinued operations of the investee– Income from Investee is based on income

before discontinued operations or extraordinary items

• Optionally, the investor may report its equity investments at fair market value, FASB Statement Nos. 159 and 157


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Disclosures• For significant equity investees

– Name, percent ownership– Accounting policy– Difference between investment carrying

value and underlying equity in net assets– Aggregate market value– Summarized asset, liability, operations

• Related party disclosures FASB Statement No. 57


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6: Impairment of Goodwill6: Impairment of GoodwillStock Investments – Investor Accounting and Reporting


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Impairment of Goodwill• Test annually, and if significant events occur (e.g.,

adverse legal factors or loss of key personnel)• FASB Statement No. 142: Two step process1. If the fair value of the whole reporting unit < the carrying

value of the reporting unit including its goodwill, there might be impairment.– If no implied impairment, step 2 is not needed.– Use quoted market prices of reporting unit, or

valuation techniques applied to similar groups of assets and liabilities.

2. If the implied fair value of the goodwill < the carrying value of the goodwill, record an impairment loss for the difference.


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Impairment of Equity Investments• Goodwill implied in equity investments is not

tested for impairment.• The investment itself is tested for impairment.• APB Opinion No. 18


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Chapter 2: Stock Investments - Investor Accounting and Reporting

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