Ch2

Stock investment-investor Accounting and reporting

This chapter focuses on equity investments in which the
investor maintains the investment account on a continuous
basis. It includes accounting for investments under the fair
value/cost (fair value for marketable securities and cost for
nonmarketable securities) method, in which the investor
does not have the ability to influence the activities of the
investee, as well as the equity method of accounting, in which
an investor can exercise significant influence over the
investee’s operations. Generally accepted accounting
principles (GAAP) generally prescribe equity method
accounting for investments that represent a 20 percent
ownership through a 50 percent ownership in the investee.
Investors also use the equity method for parent-company
accounting for investments in subsidiaries. This situation
arises when the investor controls the operating, investing, and
financing decisions of the investee through ownership of
more than 50 percent of the voting stock of the investee as the
result of a combination in which one or more companies
became subsidiaries. For financial-reporting purposes,
business combinations require preparation of consolidated
financial statements.
ACCOUNTING FOR STOCK INVESTMENTS

Generally accepted accounting principles (GAAP) for

recording common stock acquisitions requires that the
investor record the investment at cost (which is equal to fair
value at acquisition). The basic guidelines measure
investment costs by including cash disbursed; the fair value
of other assets given or securities issued; and additional direct
costs of obtaining the investment, other than the costs of
registering and issuing equity securities, which GAAP
charges to additional paid-in capital. One of the two basic
methods of accounting for common stock investments
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generally applies— the fair value (cost) method or the
equity method.

• <20% – presumes lack of significant influence – fair value (cost)

method
• 20% to 50% – presumes significant influence – equity method
• >50% – presumes control – consolidated financial statements

Entries
Items In fair value (cost) method In equity method
Investment Investment Investment in (A)
Cash Cash
Dividend Cash Cash
Dividend revenue Investment
Earning No entries Investment
Income

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 4,00
0
Dividend income 4,000

Equity Method:
At acquisition: Pilzner buys 2,000 shares of Sud for $100,000.

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 Investment in Sud 100,000

Cash 100,000

Pilzner receives $4,000 in dividends from Sud.

Cash 4,000

Investment in Sud 4,000

Example (1): Assume that AAA Corporation acquires 2,000 of the 10,000
outstanding shares of BBB Corporation at $25 per share on July 1. Assume the
book value and fair value of BBB’s assets and liabilities are equal. Further, the
cash paid equals 20 percent of the fair value of BBB’s net assets. BBB’s net
income for the fiscal year ending December 31 is $25,000 and dividends of
$10,000 are paid on November 1.
If there is evidence of an inability to exercise significant influence, AAA should
apply the fair value/cost method, revaluing the investment account to fair
market value at the end of the accounting period. Otherwise, the equity method
is required. Accounting by AAA under the two methods is as follows:

% OF Acquisition AAA in BBB = 2000 acquires / 10,000 outstanding = 20%

Record entry:
Items Equity method Fair value cost method
Investment Investment in BBB (+A) 50000 Investment in BBB(+A) 50000
Cash (-A) 50000 Cash(-A) 50000
25*2000=50000 25*2000=50000
Dividend Cash (+A) 2000 Cash(+A) 2000
Investment in BBB (-A) 2000 Dividend rev (R, +SE) 2000
10000*20%= 2000 10000*20%= 2000
Earning Investment in BBB (+A) 2500
Income from BBB(R, +SE) NO entry
2500 25000*20%*6\12= 2500
 Investment on Equity method = 50000 + 2500- 2000 = 50500
 Investment on fair value/Cost method = 50000

Here is a summary of Pop’s equity method investment account

activity:
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 July 1 Initial cost $50,000
November 1 Dividends received (2,000)
December 31 Recognize 20% of Son’s
net income for 1/2 year 2,500
December 31 Ending balance $50,500

Example (2): Assume that AAA Corporation acquires 2,000 of the 10,000
outstanding shares of BBB Corporation at $25 per share on July 1. Assume the
book value and fair value of BBB’s assets and liabilities are equal. Further, the
cash paid equals 20 percent of the fair value of BBB’s net assets. BBB’s net
income for the fiscal year ending December 31 is $15,000 and dividends of
$10,000 are paid on November 1.

Items Equity method Fair value cost method

Investment Investment in BBB(+A) 50000 Investment in BBB(+A) 50000
Cash(-A) 50000 Cash(-A) 50000
25*2000=50000 25*2000=50000
Dividend Cash (+A) 2000 Cash (+A) 2000
Investment in BBB(-A) 2000 Dividend Income(R, +SE) 2000
10000*20%= 2000 10000*20%= 2000
Earning Investment in BBB(+A) 1500 Dividend Income(-R, - SE) 500
Income from BBB(R, +SE) Investment in BBB(-A) 500
1500 15000*20%*6\12= 1500 2000-1500=500

Example (3): Assume that Pam Company purchases 30 percent of Sun

Company’s outstanding voting common stock on January 1 from existing
stockholders for $2,000,000 cash plus 200,000 shares of Pam Company $10 par
common stock with a market value of $15 per share. Additional cash costs of the
equity interest consist of $50,000 for registration of the shares and $100,000 for
consulting and advisory fees. Assume that the following book value and fair
value information for Sun Company at January 1 is available:
Item BV SUN FV SUN
Cash 1,500,000 1,500,000
Receivables—net 2,200,000 2,200,000
Inventories 3,000,000 4,000,000
Other current assets 3,300,000 3,100,000
Equipment—net 5,000,000 8,000,000
Total assets 15,000,000 18,800,000
Accounts payable 1,000,000 1,000,000
Note payable, due in five years 2,000,000 1,800,000
Common stock 10,000,000
Retained earnings 2,000,000
Total liabilities and stockholders’ equity 15,000,000

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 Assume that Sun pays dividends of $1,000,000 on July 1 and reports net income
of $3,000,000 for the year. The excess cost over book value is amortized as
follows:
Amortization Rates
Excess allocated to:
Inventories—sold in the current year 100%
Other current assets—disposed of in the current year 100%
Equipment—depreciated over 20 years 5%
Note payable—due in 5 years 20%

Entries:

Investment Jan 1
Investment in sun 5,000,000
Cash 2,000,000
Common stock 2,000.000
Additional paid in capital 1,000,000

Expenses Jan 1
Investment expense 100,000
Additional paid-in capital 50,000
cash 150,000

Dividend July 1
*
Cash 300,000
Investment in sun 300,000
*
1,000,000*30% = 300,000
Earning 31/12
Total excess of cost over book value acquired
Item FV BV % investment excess Income
Net Income% =3000000*30% =900,000 900,000
Inventory 4,000,000 3,000,000 30% 300,000 (300,000)
Other current asset 3,100,000 3,300,000 30% (60,000) 60,000
Equipment 8,000,000 5,000,000 30% 900,000 (45,000)
Note payable 1,800,000 2,000,000 30% 60,000 (12,000)
Total Excess 1,200,000 (297,000)
Income from sun 603,000

Entries:
Investment 603,000
Income from sun 603,000
The ending balance in the investment account is: 5,000 – 300 + 603 = 5,303

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Example (4): Assume that Pop also acquires a 25 percent interest in ABC
Corporation for $110,000 on January 1, at which time ABC’s net assets consist
of the following:
Item BV FV
Inventories 240,000 260,000
Other current asset 100,000 100,000
Equipment-net 50,000 50,000
Building 140,000 200,000
Total asset 530,000 610,00
Less: liabilities 130,000 130,00
Net assets 400,000 480,000
ABC’s net income and dividends for the year are $60,000 and $40,000,
respectively. The undervalued inventory items were sold during the year, and
the undervalued buildings had a four-year remaining useful life when Pop
acquired its 25 percent interest.
Entries:
Investment Jan 1

Investment in ABC 110,000

Cash 110,000

To record dividends received.

*
Cash 10,000
Investment in ABC 10,000
*
40,000*25%=10,000

Total excess 31/12

Item FV BV % investment excess Income

Net Income% =60000*25% =15,000 15,000
Inventory 260,000 240,000 25% 5,000 (5,000)
Building 200,000 140,000 25% 15,000 (3,750)
Total Excess 20000 (8,750)
Income from ABC 6,250

Earning 31/12
Investment in ABC 6,250
Income from ABC 6,250

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