of gAdvanced gAccounting, g9/e
CHAPTER 1 g
g THE EQUITY METHOD OF ACCOUNTING FOR INVESTMENTS
g g g g g g
Chapter gOutline
I. Four gmethods gare gprincipally gused gto gaccount gfor gan ginvestment gin gequity gsecurities
galong gwith ga gfair gvalue goption.
A. Fair gvalue gmethod: gapplied gby gan ginvestor gwhen gonly ga gsmall gpercentage
gof ga gcompany’s gvoting gstock gis gheld.
1. The ginvestor grecognizes gincome gwhen gthe ginvestee gdeclares ga gdividend.
2. Portfolios gare greported gat gfair gvalue. gIf gfair gvalues gare gunavailable, ginvestment
gis greported gat gcost.
B. Cost gMethod: gapplied gto ginvestments gwithout ga greadily gdeterminable gfair gvalue.
gWhen gthe gfair gvalue gof gan ginvestment gin gequity gsecurities gis gnot greadily
gdeterminable, gand gthe ginvestment gprovides gneither gsignificant ginfluence gnor gcontrol,
gthe ginvestment gmay gbe gmeasured gat gcost. gThe ginvestment gremains gat gcost gunless
1. A gdemonstrable gimpairment goccurs gfor gthe ginvestment, gor
2. An gobservable gprice gchange goccurs gfor gidentical gor gsimilar ginvestments gof gthe
gsame gissuer.
The ginvestor gtypically grecognizes gits gshare gof ginvestee gdividends gdeclared gas
gdividend gincome.
C. Consolidation: gwhen gone gfirm gcontrols ganother g(e.g., gwhen ga gparent ghas ga
gmajority ginterest gin gthe gvoting gstock gof ga gsubsidiary gor gcontrol gthrough gvariable
ginterests, gtheir gfinancial gstatements gare gconsolidated gand greported gfor gthe
gcombined gentity.
D. Equity gmethod: gapplied gwhen gthe ginvestor ghas gthe gability gto gexercise
gsignificant ginfluence gover goperating gand gfinancial gpolicies gof gthe ginvestee.
1. Ability gto gsignificantly ginfluence ginvestee gis gindicated gby gseveral gfactors
gincluding grepresentation gon gthe gboard gof gdirectors, gparticipation gin gpolicy-
making, getc.
2. GAAP gguidelines gpresume gthe gequity gmethod gis gapplicable gif g20 gto g50 gpercent gof
gthe goutstanding gvoting gstock gof gthe ginvestee gis gheld gby gthe ginvestor.
Current gfinancial greporting gstandards gallow gfirms gto gelect gto guse gfair gvalue gfor gany gnew
ginvestment gin gequity gshares gincluding gthose gwhere gthe gequity gmethod gwould gotherwise
gapply. gHowever, gthe goption, gonce gtaken, gis girrevocable. gThe ginvestor grecognizes gboth
ginvestee gdividends gand gchanges gin gfair gvalue gover gtime gas gincome.
,of gAdvanced gAccounting, g9e
II. Accounting gfor gan ginvestment: gthe gequity gmethod
A. The ginvestor gadjusts gthe ginvestment gaccount gto greflect gall gchanges gin gthe gequity gof
gthe ginvestee gcompany.
B. The ginvestor gaccrues ginvestee gincome gwhen git gis greported gin gthe ginvestee’s
gfinancial gstatements.
C. Dividends gdeclared gby gthe ginvestee gcreate ga greduction gin gthe gcarrying gamount gof
gthe gInvestment gaccount. gThis gbook gassumes gall ginvestee gdividends gare gdeclared
gand gpaid gin gthe gsame greporting gperiod.
III. Special gaccounting gprocedures gused gin gthe gapplication gof gthe gequity gmethod
A. Reporting ga gchange gto gthe gequity gmethod gwhen gthe gability gto gsignificantly ginfluence
gan ginvestee gis gachieved gthrough ga gseries gof gacquisitions.
1. Initial gpurchase(s) gwill gbe gaccounted gfor gby gmeans gof gthe gfair gvalue gmethod g(or
gat gcost) guntil gthe gability gto gsignificantly ginfluence gis gattained.
2. When gthe gability gto gexercise gsignificant ginfluence goccurs gfollowing ga gseries gof
gstock gpurchases, gthe ginvestor gapplies gthe gequity gmethod gprospectively. gThe
gtotal gfair gvalue gat gthe gdate gsignificant ginfluence gis gattained gis gcompared gto gthe
ginvestee’s gbook gvalue gto gdetermine gfuture gexcess gfair gvalue gamortizations.
B. Investee gincome gfrom gother gthan gcontinuing goperations
1. The ginvestor grecognizes gits gshare gof ginvestee greported gother
gcomprehensive gincome g(OCI) gthrough gthe ginvestment gaccount gand gthe
ginvestor’s gown gOCI.
2. Income gitems gsuch gas gdiscontinued goperations gthat gare greported gseparately gby
gthe ginvestee gshould gbe gshown gin gthe gsame gmanner gby gthe ginvestor. gThe
gmateriality gof gthese gother ginvestee gincome gelements g(as git gaffects gthe ginvestor)
gcontinues gto gbe ga gcriterion gfor gseparate gdisclosure.
C. Investee glosses
1. Losses greported gby gthe ginvestee gcreate gcorresponding glosses gfor gthe ginvestor.
2. A gpermanent gdecline gin gthe gfair gvalue gof gan ginvestee’s gstock gshould gbe
grecognized gimmediately gby gthe ginvestor gas gan gimpairment gloss.
3. Investee glosses gcan gpossibly greduce gthe gcarrying gvalue gof gthe ginvestment
gaccount gto ga gzero gbalance. gAt gthat gpoint, gthe gequity gmethod gceases gto gbe
gapplicable gand gthe gfair-value gmethod gis gsubsequently gused.
D. Reporting gthe gsale gof gan gequity ginvestment
1. The ginvestor gapplies gthe gequity gmethod guntil gthe gdisposal gdate gto gestablish ga
gproper gbook gvalue.
2. Following gthe gsale, gthe gequity gmethod gcontinues gto gbe gappropriate gif genough
gshares gare gstill gheld gto gmaintain gthe ginvestor’s gability gto gsignificantly ginfluence
gthe ginvestee. gIf gthat gability ghas gbeen glost, gthe gfair-value gmethod gis gsubsequently
gused.
IV. Excess ginvestment gcost gover gbook gvalue gacquired
A. The gprice gan ginvestor gpays gfor gequity gsecurities goften gdiffers gsignificantly gfrom
gthe ginvestee’s gunderlying gbook gvalue gprimarily gbecause gthe ghistorical gcost
gbased gaccounting gmodel gdoes gnot gkeep gtrack gof gchanges gin ga gfirm’s gfair
gvalue.
B. Payments gmade gin gexcess gof gunderlying gbook gvalue gcan gsometimes gbe gidentified
gwith gspecific ginvestee gaccounts gsuch gas ginventory gor gequipment.
C. An gextra gacquisition gprice gcan galso gbe gassigned gto ganticipated gbenefits gthat gare
,gexpected gto gbe gderived gfrom gthe ginvestment. gIn gaccounting, gthese gamounts gare
gpresumed gto greflect gan gintangible gasset greferred gto gas ggoodwill. gGoodwill gis
gcalculated
, of gAdvanced gAccounting, g9/e
as gany gexcess gpayment gthat gis gnot gattributable gto gspecific gidentifiable gassets gand
gliabilities gof gthe ginvestee. gBecause ggoodwill gis gan gindefinite-lived gasset, git gis gnot
gamortized.
V. Deferral gof gintra-entity ggross gprofit gin ginventory
A. The ginvestor’s gshare gof gintra-entity gprofits gin gending ginventory gare gnot grecognized
guntil gthe gtransferred ggoods gare geither gconsumed gor guntil gthey gare gresold gto gunrelated
gparties.
B. Downstream gsales gof ginventory
1. “Downstream” grefers gto gtransfers gmade gby gthe ginvestor gto gthe ginvestee.
2. Intra-entity ggross gprofits gfrom gsales gare ginitially gdeferred gunder gthe gequity
gmethod gand gthen grecognized gas gincome gat gthe gtime gof gthe ginventory’s
geventual gdisposal.
3. The gamount gof ggross gprofit gto gbe gdeferred gis gthe ginvestor’s gownership
gpercentage gmultiplied gby gthe gmarkup gon gthe gmerchandise gremaining gat gthe
gend gof gthe gyear.
C. Upstream gsales gof ginventory
1. “Upstream” grefers gto gtransfers gmade gby gthe ginvestee gto gthe ginvestor.
2. Under gthe gequity gmethod, gthe gdeferral gprocess gfor gintra-entity ggross gprofits gis
gidentical gfor gupstream gand gdownstream gtransfers. gThe gprocedures gare
gseparately gidentified gin gChapter gOne gbecause gthe ghandling gdoes gvary gwithin gthe
gconsolidation gprocess.
Answers gto gDiscussion gQuestions
The gtextbook gincludes gdiscussion gquestions gto gstimulate gstudent gthought gand gdiscussion.
gThese gquestions gare galso gdesigned gto gallow gstudents gto gconsider grelevant gissues gthat gmight
gotherwise gbe goverlooked. gSome gof gthese gquestions gmay gbe gaddressed gby gthe ginstructor gin
gclass gto gmotivate gstudent gdiscussion. gStudents gshould gbe gencouraged gto gbegin gby gdefining gthe
gissue(s) gin geach gcase. gNext, gauthoritative gaccounting gliterature g(FASB gASC) gor gother grelevant
gliterature gcan gbe gconsulted gas ga gpreliminary gstep gin garriving gat glogical gactions. gFrequently, gthe
gFASB gAccounting gStandards gCodification gwill gprovide gthe gnecessary gsupport.
Unfortunately, gin gaccounting, gdefinitive gresolutions gto gfinancial greporting gquestions gare gnot
galways gavailable. gStudents goften gseem gto gbelieve gthat gall gaccounting gissues ghave gbeen
gresolved gin gthe gpast gso gthat gaccounting geducation gis gonly ga gmatter gof glearning gto gapply
ghistorically gprescribed gprocedures. gHowever, gin gactual gpractice, gthe gonly greal ganswer gis goften
gthe gone gthat gprovides gthe gfairest grepresentation gof gthe gfirm’s gtransactions. gIf gan gauthoritative
gsolution gis gnot gavailable, gstudents gshould gbe gdirected gto glist gall gof gthe gissues ginvolved gand gthe
gconsequences gof gpossible galternative gactions. gThe gvarious gfactors gpresented gcan gbe gweighed
gto gproduce ga gviable gsolution.
The gdiscussion gquestions gare gdesigned gto ghelp gstudents gdevelop gresearch gand gcritical gthinking
gskills gin gaddressing gissues gthat ggo gbeyond gthe gpurely gmechanical gelements gof gaccounting.
Did gthe gCost gMethod gInvite gManipulation?
The gcost gmethod gof gaccounting gfor ginvestments goften gcaused ga glack gof gobjectivity gin greported
gincome gfigures. gWith ga glarge gblock gof gthe ginvestee’s gvoting gshares, gan ginvestor gcould ginfluence
gthe gamount gand gtiming gof gthe ginvestee’s gdividend gdeclarations. gThus, gwhen genjoying ga ggood
gearnings gyear, gan ginvestor gmight ginfluence gthe ginvestee gto gwithhold gdeclaring ga gdividend guntil
gneeded gin ga gsubsequent gyear. gAlternatively, gif gthe ginvestor gjudged gthat gits gcurrent gyear
gearnings g“needed ga gboost,” git gmight ginfluence gthe ginvestee gto gdeclare ga gcurrent gyear gdividend.
CHAPTER 1 g
g THE EQUITY METHOD OF ACCOUNTING FOR INVESTMENTS
g g g g g g
Chapter gOutline
I. Four gmethods gare gprincipally gused gto gaccount gfor gan ginvestment gin gequity gsecurities
galong gwith ga gfair gvalue goption.
A. Fair gvalue gmethod: gapplied gby gan ginvestor gwhen gonly ga gsmall gpercentage
gof ga gcompany’s gvoting gstock gis gheld.
1. The ginvestor grecognizes gincome gwhen gthe ginvestee gdeclares ga gdividend.
2. Portfolios gare greported gat gfair gvalue. gIf gfair gvalues gare gunavailable, ginvestment
gis greported gat gcost.
B. Cost gMethod: gapplied gto ginvestments gwithout ga greadily gdeterminable gfair gvalue.
gWhen gthe gfair gvalue gof gan ginvestment gin gequity gsecurities gis gnot greadily
gdeterminable, gand gthe ginvestment gprovides gneither gsignificant ginfluence gnor gcontrol,
gthe ginvestment gmay gbe gmeasured gat gcost. gThe ginvestment gremains gat gcost gunless
1. A gdemonstrable gimpairment goccurs gfor gthe ginvestment, gor
2. An gobservable gprice gchange goccurs gfor gidentical gor gsimilar ginvestments gof gthe
gsame gissuer.
The ginvestor gtypically grecognizes gits gshare gof ginvestee gdividends gdeclared gas
gdividend gincome.
C. Consolidation: gwhen gone gfirm gcontrols ganother g(e.g., gwhen ga gparent ghas ga
gmajority ginterest gin gthe gvoting gstock gof ga gsubsidiary gor gcontrol gthrough gvariable
ginterests, gtheir gfinancial gstatements gare gconsolidated gand greported gfor gthe
gcombined gentity.
D. Equity gmethod: gapplied gwhen gthe ginvestor ghas gthe gability gto gexercise
gsignificant ginfluence gover goperating gand gfinancial gpolicies gof gthe ginvestee.
1. Ability gto gsignificantly ginfluence ginvestee gis gindicated gby gseveral gfactors
gincluding grepresentation gon gthe gboard gof gdirectors, gparticipation gin gpolicy-
making, getc.
2. GAAP gguidelines gpresume gthe gequity gmethod gis gapplicable gif g20 gto g50 gpercent gof
gthe goutstanding gvoting gstock gof gthe ginvestee gis gheld gby gthe ginvestor.
Current gfinancial greporting gstandards gallow gfirms gto gelect gto guse gfair gvalue gfor gany gnew
ginvestment gin gequity gshares gincluding gthose gwhere gthe gequity gmethod gwould gotherwise
gapply. gHowever, gthe goption, gonce gtaken, gis girrevocable. gThe ginvestor grecognizes gboth
ginvestee gdividends gand gchanges gin gfair gvalue gover gtime gas gincome.
,of gAdvanced gAccounting, g9e
II. Accounting gfor gan ginvestment: gthe gequity gmethod
A. The ginvestor gadjusts gthe ginvestment gaccount gto greflect gall gchanges gin gthe gequity gof
gthe ginvestee gcompany.
B. The ginvestor gaccrues ginvestee gincome gwhen git gis greported gin gthe ginvestee’s
gfinancial gstatements.
C. Dividends gdeclared gby gthe ginvestee gcreate ga greduction gin gthe gcarrying gamount gof
gthe gInvestment gaccount. gThis gbook gassumes gall ginvestee gdividends gare gdeclared
gand gpaid gin gthe gsame greporting gperiod.
III. Special gaccounting gprocedures gused gin gthe gapplication gof gthe gequity gmethod
A. Reporting ga gchange gto gthe gequity gmethod gwhen gthe gability gto gsignificantly ginfluence
gan ginvestee gis gachieved gthrough ga gseries gof gacquisitions.
1. Initial gpurchase(s) gwill gbe gaccounted gfor gby gmeans gof gthe gfair gvalue gmethod g(or
gat gcost) guntil gthe gability gto gsignificantly ginfluence gis gattained.
2. When gthe gability gto gexercise gsignificant ginfluence goccurs gfollowing ga gseries gof
gstock gpurchases, gthe ginvestor gapplies gthe gequity gmethod gprospectively. gThe
gtotal gfair gvalue gat gthe gdate gsignificant ginfluence gis gattained gis gcompared gto gthe
ginvestee’s gbook gvalue gto gdetermine gfuture gexcess gfair gvalue gamortizations.
B. Investee gincome gfrom gother gthan gcontinuing goperations
1. The ginvestor grecognizes gits gshare gof ginvestee greported gother
gcomprehensive gincome g(OCI) gthrough gthe ginvestment gaccount gand gthe
ginvestor’s gown gOCI.
2. Income gitems gsuch gas gdiscontinued goperations gthat gare greported gseparately gby
gthe ginvestee gshould gbe gshown gin gthe gsame gmanner gby gthe ginvestor. gThe
gmateriality gof gthese gother ginvestee gincome gelements g(as git gaffects gthe ginvestor)
gcontinues gto gbe ga gcriterion gfor gseparate gdisclosure.
C. Investee glosses
1. Losses greported gby gthe ginvestee gcreate gcorresponding glosses gfor gthe ginvestor.
2. A gpermanent gdecline gin gthe gfair gvalue gof gan ginvestee’s gstock gshould gbe
grecognized gimmediately gby gthe ginvestor gas gan gimpairment gloss.
3. Investee glosses gcan gpossibly greduce gthe gcarrying gvalue gof gthe ginvestment
gaccount gto ga gzero gbalance. gAt gthat gpoint, gthe gequity gmethod gceases gto gbe
gapplicable gand gthe gfair-value gmethod gis gsubsequently gused.
D. Reporting gthe gsale gof gan gequity ginvestment
1. The ginvestor gapplies gthe gequity gmethod guntil gthe gdisposal gdate gto gestablish ga
gproper gbook gvalue.
2. Following gthe gsale, gthe gequity gmethod gcontinues gto gbe gappropriate gif genough
gshares gare gstill gheld gto gmaintain gthe ginvestor’s gability gto gsignificantly ginfluence
gthe ginvestee. gIf gthat gability ghas gbeen glost, gthe gfair-value gmethod gis gsubsequently
gused.
IV. Excess ginvestment gcost gover gbook gvalue gacquired
A. The gprice gan ginvestor gpays gfor gequity gsecurities goften gdiffers gsignificantly gfrom
gthe ginvestee’s gunderlying gbook gvalue gprimarily gbecause gthe ghistorical gcost
gbased gaccounting gmodel gdoes gnot gkeep gtrack gof gchanges gin ga gfirm’s gfair
gvalue.
B. Payments gmade gin gexcess gof gunderlying gbook gvalue gcan gsometimes gbe gidentified
gwith gspecific ginvestee gaccounts gsuch gas ginventory gor gequipment.
C. An gextra gacquisition gprice gcan galso gbe gassigned gto ganticipated gbenefits gthat gare
,gexpected gto gbe gderived gfrom gthe ginvestment. gIn gaccounting, gthese gamounts gare
gpresumed gto greflect gan gintangible gasset greferred gto gas ggoodwill. gGoodwill gis
gcalculated
, of gAdvanced gAccounting, g9/e
as gany gexcess gpayment gthat gis gnot gattributable gto gspecific gidentifiable gassets gand
gliabilities gof gthe ginvestee. gBecause ggoodwill gis gan gindefinite-lived gasset, git gis gnot
gamortized.
V. Deferral gof gintra-entity ggross gprofit gin ginventory
A. The ginvestor’s gshare gof gintra-entity gprofits gin gending ginventory gare gnot grecognized
guntil gthe gtransferred ggoods gare geither gconsumed gor guntil gthey gare gresold gto gunrelated
gparties.
B. Downstream gsales gof ginventory
1. “Downstream” grefers gto gtransfers gmade gby gthe ginvestor gto gthe ginvestee.
2. Intra-entity ggross gprofits gfrom gsales gare ginitially gdeferred gunder gthe gequity
gmethod gand gthen grecognized gas gincome gat gthe gtime gof gthe ginventory’s
geventual gdisposal.
3. The gamount gof ggross gprofit gto gbe gdeferred gis gthe ginvestor’s gownership
gpercentage gmultiplied gby gthe gmarkup gon gthe gmerchandise gremaining gat gthe
gend gof gthe gyear.
C. Upstream gsales gof ginventory
1. “Upstream” grefers gto gtransfers gmade gby gthe ginvestee gto gthe ginvestor.
2. Under gthe gequity gmethod, gthe gdeferral gprocess gfor gintra-entity ggross gprofits gis
gidentical gfor gupstream gand gdownstream gtransfers. gThe gprocedures gare
gseparately gidentified gin gChapter gOne gbecause gthe ghandling gdoes gvary gwithin gthe
gconsolidation gprocess.
Answers gto gDiscussion gQuestions
The gtextbook gincludes gdiscussion gquestions gto gstimulate gstudent gthought gand gdiscussion.
gThese gquestions gare galso gdesigned gto gallow gstudents gto gconsider grelevant gissues gthat gmight
gotherwise gbe goverlooked. gSome gof gthese gquestions gmay gbe gaddressed gby gthe ginstructor gin
gclass gto gmotivate gstudent gdiscussion. gStudents gshould gbe gencouraged gto gbegin gby gdefining gthe
gissue(s) gin geach gcase. gNext, gauthoritative gaccounting gliterature g(FASB gASC) gor gother grelevant
gliterature gcan gbe gconsulted gas ga gpreliminary gstep gin garriving gat glogical gactions. gFrequently, gthe
gFASB gAccounting gStandards gCodification gwill gprovide gthe gnecessary gsupport.
Unfortunately, gin gaccounting, gdefinitive gresolutions gto gfinancial greporting gquestions gare gnot
galways gavailable. gStudents goften gseem gto gbelieve gthat gall gaccounting gissues ghave gbeen
gresolved gin gthe gpast gso gthat gaccounting geducation gis gonly ga gmatter gof glearning gto gapply
ghistorically gprescribed gprocedures. gHowever, gin gactual gpractice, gthe gonly greal ganswer gis goften
gthe gone gthat gprovides gthe gfairest grepresentation gof gthe gfirm’s gtransactions. gIf gan gauthoritative
gsolution gis gnot gavailable, gstudents gshould gbe gdirected gto glist gall gof gthe gissues ginvolved gand gthe
gconsequences gof gpossible galternative gactions. gThe gvarious gfactors gpresented gcan gbe gweighed
gto gproduce ga gviable gsolution.
The gdiscussion gquestions gare gdesigned gto ghelp gstudents gdevelop gresearch gand gcritical gthinking
gskills gin gaddressing gissues gthat ggo gbeyond gthe gpurely gmechanical gelements gof gaccounting.
Did gthe gCost gMethod gInvite gManipulation?
The gcost gmethod gof gaccounting gfor ginvestments goften gcaused ga glack gof gobjectivity gin greported
gincome gfigures. gWith ga glarge gblock gof gthe ginvestee’s gvoting gshares, gan ginvestor gcould ginfluence
gthe gamount gand gtiming gof gthe ginvestee’s gdividend gdeclarations. gThus, gwhen genjoying ga ggood
gearnings gyear, gan ginvestor gmight ginfluence gthe ginvestee gto gwithhold gdeclaring ga gdividend guntil
gneeded gin ga gsubsequent gyear. gAlternatively, gif gthe ginvestor gjudged gthat gits gcurrent gyear
gearnings g“needed ga gboost,” git gmight ginfluence gthe ginvestee gto gdeclare ga gcurrent gyear gdividend.
