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Chapter 2: Stock Investments

Investor Accounting and Reporting


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

to accompany
Advanced Accounting, 10th edition
by Floyd A. Beams, Robin P. Clement,
Joseph H. Anthony, and Suzanne Lowensohn

Pearson Education, Inc. publishing as Prentice Hal 2-1


Stock Investments: Objectives
1. 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.
Pearson Education, Inc. publishing as Prentice Hal 2-2
Objectives (continued)
5. Apply the equity method to purchase price
allocations.
6. Learn how to test goodwill for impairment.

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Stock Investments Investor Accounting and Reporting
1: Levels of Influence or Control

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Levels of Influence

<20% presumes lack of


significant influence fair
Fair value
value (cost) method (cost)
20% to 50% presumes Consolidated
method
significant influence equity financial
method statements Equity
method
>50% presumes control
consolidated financial
statements

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Stock Investments Investor Accounting and Reporting
2: Accounting Reflects Economics

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Accounting for the Investment
Degree of Investment's carrying Investment
influence value income
Lack of Fair value (cost, if Dividends declared
significant nonmarketable)
influence
Significant Original cost adjusted to Proportionate share
influence reflect periodic earnings of investee's
and dividends, e.g., a periodic earnings*
proportionate share of
investee's net assets
* If income were measured as dividends declared, by influencing or controlling
dividend decisions, the investor could manipulate its own investment income.
Pearson Education, Inc. publishing as Prentice Hal 2-7
Stock Investments Investor Accounting and Reporting
3a: Fair Value/Cost Method

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Fair Value (Cost) Method
FASB Statement No. 115
At acquisition: Pilzner buys 2,000 shares of Sud
for $100,000.
Investment in Sud 100,000
Cash 100,000
Pilzner receives $4,000 in dividends from Sud.
Cash 4,000
Dividend income 4,000

Pearson Education, Inc. publishing as Prentice Hal 2-9


Fair Value Method, at Year-end
Reduce dividend income recognized, if needed
Dividend income 1,000
Investment in Sud 1,000
If Pilzner determines that cumulative dividends exceed its
cumulative share of income by $1,000.
Adjust investment to fair value
Allowance to adjust available-for- 21,000
sale securities to fair value
Other comprehensive income 21,000
If fair value of increases to $120,000 and the Investment in
Sud account balance is $99,000.
Pearson Education, Inc. publishing as Prentice Hal 2-10
Stock Investments Investor Accounting and Reporting
3b: Equity Method

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Equity Method
APB Opinion No. 18
At acquisition: Pilzner buys 2,000 shares of Sud
for $100,000.
Investment in Sud 100,000
Cash 100,000
Pilzner receives $4,000 in dividends from Sud.
Cash 4,000
Investment in Sud 4,000

Pearson Education, Inc. publishing as Prentice Hal 2-12


Equity Method, at Year-end
Pilzner determines that its share of Sud's income is
$5,000.
Cash 4,000
Investment in Sud 4,000
The ending balance in the Investment in Sud is:

$100,000 cost - $4,000 dividends + $5,000 income


= $101,000.

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Stock Investments Investor Accounting and Reporting
4: Ability to Influence or Control

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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 influence
1. Opposition by investee,
2. Surrender of significant shareholder rights,
3. Concentration of majority ownership,
4. Lack of information for equity method, and
5. Failure to obtain board representation.

Pearson Education, Inc. publishing as Prentice Hal 2-15


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 bankruptcy
2. Severe foreign restrictions.

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Stock Investments Investor Accounting and Reporting
5: Applying the Equity Method

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Acquisition Cost > FV net assets
FV net assets > BV net assets
Payne 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
Pearson Education, Inc. publishing as Prentice Hal 2-18
Acquisition of Sloan Stock
At 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 2,000
Common stock, at par 2,000
Additional paid in capital 1,000
Additional paid in capital 50
Investment expense 100
Cash 150
Pearson Education, Inc. publishing as Prentice Hal 2-19
Cost/Book Value Assignment
Cost of acquisition $5,000
Less 30% book value = 30%(12,000) 3,600
Excess of cost over book value $1,400
Assigned to: Amount Amortization
Inventories 30%(+1,000) $300 1st year
Other curr. assets 30%(-200) (60) 1st year
Equipment 30%(+3,000) 900 20 years
Note payable 30%(+200) 60 5 years
Goodwill (to balance) 200 None
Total $1,400
Pearson Education, Inc. publishing as Prentice Hal 2-20
Dividends and Income
Payne receives $300 dividends from Sloan.
Cash 300
Investment in Sloan 300
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.

Pearson Education, Inc. publishing as Prentice Hal 2-21


Amortization and Investment Income
Cost/book value Initial 1st year Unamortized
differences: amount amort. excess at year-end
Inventories $300 ($300) $0
Other curr. Assets (60) 60 0
Equipment 900 (45) 855
Note payable 60 (12) 48
Goodwill 200 0 200
Total $1,400 ($297) $1,103
Investment income is 30% of Sloan's net income amortization
30%($3,000) $297 = $603.
Pearson Education, Inc. publishing as Prentice Hal 2-22
Year-end Entry & Balance
Record the investment income
Investment in Sloan 603
Income from Sloan 603
The ending balance in the investment account is:

Cost dividends + investment income


5,000 300 + 603
= 5,303.

Pearson Education, Inc. publishing as Prentice Hal 2-23


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.

Pearson Education, Inc. publishing as Prentice Hal 2-25


Bargain Purchase
When 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 xxx
Gain on bargain purchase xxx

Pearson Education, Inc. publishing as Prentice Hal 2-26


Interim Acquisitions
Book 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.

Pearson Education, Inc. publishing as Prentice Hal 2-27


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
Pearson Education, Inc. publishing as Prentice Hal 2-28
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
Pearson Education, Inc. publishing as Prentice Hal 2-29
Stock Purchased from Investee
If 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

Pearson Education, Inc. publishing as Prentice Hal 2-30


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.
Pearson Education, Inc. publishing as Prentice Hal 2-31
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

Pearson Education, Inc. publishing as Prentice Hal 2-32


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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Stock Investments Investor Accounting and Reporting
6: Impairment of Goodwill

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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 process
1. 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.
Pearson Education, Inc. publishing as Prentice Hal 2-35
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

Pearson Education, Inc. publishing as Prentice Hal 2-36


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Publishing as Prentice Hall

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