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
along with a fair value option.
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 the investee declares a dividend.
2. Portfolios are reported at fair value. If fair 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, 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. GAAP guidelines presume the equity method is applicable if 20 to 50 percent of
the outstanding voting stock of the investee is held by the investor.
Current financial reporting standards allow firms to elect to use fair value for any new
investment in equity shares including those where the equity method would otherwise
apply. However, the option, once taken, is irrevocable. Investee dividends and changes
in fair value over time are recognized as income.
On February 14, 2013, the FASB issued a Proposed Accounting Standards Update
(ASU) entitled, Recognition and Measurement of Financial Assets and Financial
Liabilities. The proposed ASU would eliminate the fair-value option for investments that
qualify for equity method treatment. Fair-value accounting, however, would be extended
to “equity method” investments that meet the criteria for classification as held for sale.
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. The text assumes all investee dividends are declared and paid
in the same reporting period.
,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 retrospective
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 financial statement comparability across years.
B. Investee income from other than continuing operations
1. The investor recognizes its share of investee reported other comprehensive
income (OCI) through the investment account and the investor’s own OCI.
2. Income items such as extraordinary gains and losses and discontinued operations
that are reported separately by the investee should be shown in the same manner
by the investor. The materiality of these other investee income elements (as it
affects the investor) continues to be a criterion for separate disclosure.
C. Investee losses
1. Losses reported by the investee create corresponding losses for the investor.
2. A permanent decline in the fair value of an investee’s stock should be recognized
immediately by the investor as an impairment loss.
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.
A. Reporting the sale of an equity investment
1. The investor applies the equity method until the disposal date to establish a
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 investment cost over book value acquired
A. The price an investor pays for equity securities often differs significantly from the
investee’s underlying book value primarily because the historical cost based
accounting model does not keep track of changes in a firm’s fair value.
B. Payments made in excess of underlying book value can sometimes be identified with
specific investee accounts such as inventory or equipment.
C. An extra acquisition price can also be assigned to anticipated benefits that are
expected to be derived from the investment. In accounting, these amounts are
presumed to reflect an intangible asset referred to as goodwill. Goodwill is calculated
, as any excess payment that is not attributable to specific assets and liabilities of the
investee. Because goodwill is an indefinite-lived asset, it is not amortized.
V. Deferral of unrealized gross profit in inventory
A. Profits derived from intra-entity transactions are not considered completely earned
until the transferred goods are either consumed or resold to unrelated parties.
THE EQUITY METHOD OF ACCOUNTING FOR INVESTMENTS
Chapter Outline
I. Three methods are principally used to account for an investment in equity securities
along with a fair value option.
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 the investee declares a dividend.
2. Portfolios are reported at fair value. If fair 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, 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. GAAP guidelines presume the equity method is applicable if 20 to 50 percent of
the outstanding voting stock of the investee is held by the investor.
Current financial reporting standards allow firms to elect to use fair value for any new
investment in equity shares including those where the equity method would otherwise
apply. However, the option, once taken, is irrevocable. Investee dividends and changes
in fair value over time are recognized as income.
On February 14, 2013, the FASB issued a Proposed Accounting Standards Update
(ASU) entitled, Recognition and Measurement of Financial Assets and Financial
Liabilities. The proposed ASU would eliminate the fair-value option for investments that
qualify for equity method treatment. Fair-value accounting, however, would be extended
to “equity method” investments that meet the criteria for classification as held for sale.
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. The text assumes all investee dividends are declared and paid
in the same reporting period.
,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 retrospective
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 financial statement comparability across years.
B. Investee income from other than continuing operations
1. The investor recognizes its share of investee reported other comprehensive
income (OCI) through the investment account and the investor’s own OCI.
2. Income items such as extraordinary gains and losses and discontinued operations
that are reported separately by the investee should be shown in the same manner
by the investor. The materiality of these other investee income elements (as it
affects the investor) continues to be a criterion for separate disclosure.
C. Investee losses
1. Losses reported by the investee create corresponding losses for the investor.
2. A permanent decline in the fair value of an investee’s stock should be recognized
immediately by the investor as an impairment loss.
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.
A. Reporting the sale of an equity investment
1. The investor applies the equity method until the disposal date to establish a
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 investment cost over book value acquired
A. The price an investor pays for equity securities often differs significantly from the
investee’s underlying book value primarily because the historical cost based
accounting model does not keep track of changes in a firm’s fair value.
B. Payments made in excess of underlying book value can sometimes be identified with
specific investee accounts such as inventory or equipment.
C. An extra acquisition price can also be assigned to anticipated benefits that are
expected to be derived from the investment. In accounting, these amounts are
presumed to reflect an intangible asset referred to as goodwill. Goodwill is calculated
, as any excess payment that is not attributable to specific assets and liabilities of the
investee. Because goodwill is an indefinite-lived asset, it is not amortized.
V. Deferral of unrealized gross profit in inventory
A. Profits derived from intra-entity transactions are not considered completely earned
until the transferred goods are either consumed or resold to unrelated parties.
