Chapter One

The Equity Method of Accounting

for Investments

Fundamentals of
Advanced Accounting, 9e
Hoyle | Schaefer | Doupnik
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 Learning Objective 1-1

Describe motivations for a firm to gain

significant influence over another firm.

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 Why do firms buy common stock of
other firms?
 Temporary investment to earn a return on
idle cash
 Gain voting privileges to influence how a
firm operates

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 Learning Objective 1-2

Describe in general the various methods

of accounting for an investment in equity
shares of another company.

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 The Reporting of Investments in
Corporate Equity Securities
GAAP recognizes four methods to report
investments in other companies:
 Fair-value method.
 Cost method for equity securities without readily
determinable fair values.
 Consolidation of financial statements.
 Equity method.
The method selected depends upon the degree of
influence the investor (stockholder) has over the
investee.
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 Fair-Value Method

Use when:
 Investor holds a small percentage of
equity securities of investee.
 Investor cannot significantly affect
investee’s operations.
 Investment is made in anticipation of
dividends or market appreciation.

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 Recording Fair-Value Method
Initial investments in equity securities when significant
influence and control are not present are:
 Recorded at cost.
 Adjusted to fair value if fair value is determinable.
 If fair value is not determinable, remains at cost.
 Changes in fair values are recognized as income.
 Dividends declared on the securities are recognized as
income.

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 Cost Method (Investments in Equity Securities
without readily determinable fair values)

Investments in equity securities that employ the cost

method continue to be reported at original cost over time.
GAAP allows for two fair value assessments that may
affect cost method amounts reported on the financial
statements:
1. Periodic assessment for impairment to determine if
the fair value of the investment is less than its
carrying amount.
2. Recognition of “observable price changes in orderly
transactions for the identical or a similar investment
of the same issuer” as unrealized holding gains (or
losses).
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 Consolidation of
Financial Statements
 Required when investor’s ownership exceeds 50
percent of an organization’s outstanding voting
stock.
 When a majority of voting stock is held, the
investor-investee relationship is so closely
connected that the two corporations are viewed as
a single entity.
 One set of financial statements is prepared to
consolidate all accounts of the parent company
and all of its controlled subsidiaries as a single
entity.
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 FASB ASC Section 810-10-05, Variable
Interest Entities
 Includes entities controlled through special
contractual arrangements (not through voting
stock interests).
 Intended to combat misuse of SPEs (special
purpose entities) to keep large amounts of assets
and liabilities off the balance sheet, known as “off-
balance-sheet financing.”

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 Equity Method
Use when:
 Investor has the ability to exercise significant
influence on investee operations (whether applied or
not).
 Ownership is between 20 percent and 50 percent.
Significant influence might be present with much lower
ownership percentages.
Under the equity method, investor’s share of investee
dividends declared are recorded as decreases in the
investment account, not income.
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 Learning Objective 1-3

Identify the sole criterion for applying

the equity method of accounting and
know the guidelines to assess whether the
criterion is met.

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 Criteria for Utilizing
the Equity Method
Significant Influence (FASB ASC Topic 323):
 Representation on the investee’s board of directors.
 Participation in the investee’s policy-making process.
 Material intra-entity transactions.
 Interchange of managerial personnel.
 Technological dependency.
 Other investee ownership percentages.

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 Limitations of Equity Method
Applicability
Regardless of investor’s degree of ownership, the equity
method is not appropriate if investments demonstrate:
 An agreement exists between investor and investee by
which the investor surrenders significant rights as a
shareholder.
 A concentration of ownership operates the investee
without regard for the views of the investor.
 The investor attempts but fails to obtain
representation on the investee’s board of directors.
If an entity can exercise control over investee, regardless
of ownership level, consolidation is required.
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 Extensions of Equity Method
Applicability
 For some investments that fall short of or exceed
20 to 50 percent ownership, the equity method is
appropriately used for financial reporting.
 Conditions can exist where the equity method is
appropriate despite a majority ownership interest.
 For example, if the noncontrolling rights are so
restrictive as to call into question whether control rests
with the majority owner, the equity method is
employed for financial reporting rather than
consolidation.

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 Summary of Accounting Methods
Accounting Methods Applicable in Various Stock Ownership
Levels

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 Learning Objective 1-4

Describe the financial reporting for equity method

investments and prepare basic equity method journal
entries for an investor.

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 Accounting for Increases in an
Investment—The Equity Method
 The investor increases the investment account as
the investee earns and reports income. The
investor uses the accrual method to record
investment income—recognizing it in the same
time period as the investee earns it.
 The asset balance is increased as the investee
makes a profit. The investor reduces the
investment account if the investee reports a loss.

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 Accounting for Decreases in an
Investment—The Equity Method
 The investor decreases its investment account’s
carrying value for its share of investee cash
dividends. When the investee declares a cash
dividend, its owners’ equity decreases.
 The investor shall recognize its share of the
earnings or losses of an investee in the periods for
which they are reported by the investee in its
financial statements.

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 Equity Method Example
Big Company owns a 20 percent interest in Little
Company purchased on January 1, 2023, for $210,000.
Little reports net income of $200,000, $300,000, and
$400,000, respectively, in the next three years while
declaring dividends of $50,000, $100,000, and $200,000.
The fair values of Big’s investment in Little, as
determined by market prices, were $245,000, $282,000,
and $325,000 at the end of 2023, 2024, and 2025,
respectively.

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 Fair-Value vs. Equity Method

*Equity in investee income is 20 percent of the current year income reported by

Little Company.
†The carrying amount of an investment under the equity method is the original
cost plus income recognized less dividends. For 2023, as an example, the
$240,000 reported balance is the $200,000 cost plus $50,000 equity income
less $10,000 in dividends.
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 Equity Method Example—Journal
Entries
Big Company records the following journal entries to
apply the equity method for its investment in Little Company for 2023:

1st entry: Big accrues income based on the investee’s reported earnings.
2nd entry: Big records dividend declaration and reduction in Little’s net
assets.
3rd entry: Big reports the collection of cash dividends.
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 Learning Objective 1-5

Allocate the cost of an equity method

investment and compute amortization
expense to match revenues recognized
from the investment to the excess of
investor cost over investee book value.

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 Excess of Investment Cost over Book
Value Acquired
Differences may exist between a company’s book
value and fair value because:
 Fair value is based on multiple factors, including
but not limited to profitability, new products,
expected dividend payments, projected operating
results, and general economic conditions.
 Stock prices are based, partially, on the perceived
worth of a company’s net assets, amounts that
often vary from underlying book values.

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 Excess of Investment Cost over Book
Value Acquired (continued)
 Asset and liability accounts on the balance sheet
tend to measure historical costs rather than
current value.
 Reported figures are affected by the accounting
methods selected and lead to different book
values; for example:
 Inventory costing methods (LIFO and FIFO).
 Acceptable depreciation methods (straight-line,
units of production).

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 Excess of Investment Cost over Book
Value Acquired (concluded)
 When purchase price exceeds book value of an investment
acquired, the difference must be identified.
 Assets may be undervalued on the investee’s books
because:
 The fair values (FV) of some assets and liabilities are
different from their book values (BV).
 The investor may be willing to pay extra because future
benefits are expected to accrue from the investment.
 Extra payment that cannot be attributed to a specific
asset or liability is assigned to the intangible asset
goodwill.

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 Excess of Investment Cost over Book
Value Acquired Example
Grande Company is negotiating the acquisition of 30 percent
of the outstanding shares of Chico Company. Chico’s balance
sheet reports assets of $500,000 and liabilities of $300,000 for a
net book value of $200,000.
Grande determines that Chico’s equipment is undervalued in
the company’s financial records by $60,000. One of its patents
is also undervalued, but only by $40,000.
Adding these valuation adjustments to Chico’s book value
indicates that the company’s net assets are estimated to be
valued at $300,000. Therefore, Grande offers $90,000 for a 30
percent share of the investee’s outstanding stock.

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 Excess of Investment Cost over Book
Value Acquired—Valuations
Grande’s purchase price is in excess of the proportionate share of Chico’s
book value, which can be attributed to two specific accounts: Equipment
and Patents.
No part of the extra payment is traceable to any other projected future
benefit. The cost of Grande’s investment is allocated as follows:

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 Excess of Investment Cost over Book
Value Acquired—Valuations (continued)
If the purchase price is raised to $125,000, then the purchase price is
allocated as follows:
The amount that can be attributed to two specific accounts: Equipment
and Patents is allocated.
Any extra payment is not traceable to any specific asset or liability is
assigned to the intangible asset goodwill.

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 The Amortization Process
Payment relating to each asset (except land, goodwill, and other
indefinite life intangibles) should be amortized over an
appropriate time period.

Goodwill associated with equity method investments and a business

combination, for the most part, is measured in the same manner. However,
because equity method goodwill is not separable from the related
investment, goodwill should not be separately tested for impairment. FASB
ASC (para. 350-20-35-59).

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 The Amortization Process—
Journal Entries
To record the annual expense, Grande reduces the
investment balance in the same way it would amortize the
cost of any other asset that had a limited life. At the end
of the first year of holding the investment, the investor
records the following journal entry under the equity
method.

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 International Accounting Standard
28—Investments in Associates
 The International Accounting Standards Board defines
significant influence as the power to participate in the
financial and operating policy decisions of the investee,
but it is not control or joint control over those policies.
 If investor has 20 percent or more ownership, it is
presumed to have significant influence, unless it is
demonstrated not to be the case.
 If investor holds less than 20 percent ownership, it is
presumed it does not have significant influence, unless
influence can be clearly demonstrated.

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 Learning Objective 1-6:
Equity Method—Additional Issues
Understand the financial reporting consequences for:
 A change to the equity method.
 Investee’s other comprehensive income.
 Investee losses.
 Sale of equity method investments.

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 Learning Objective 1-6a

Understand the financial reporting

consequences for a change to the equity
method.

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 Reporting a Change to the Equity
Method
Report a change to the equity method if:
 An investment that was recorded using the cost or
fair-value method reaches the point where significant
influence is established.
 When an investment qualifies for use of the equity
method, the investor adds the cost of acquiring
additional interest in the investee to the current basis
and adopts the equity method of accounting [(FASB
ASC (para. 323-10-35-33)].
 This prospective approach avoids the complexity of
restating prior period amounts.
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 Reporting a Change to the
Equity Method Example
 Alpha Company acquires a 10 percent ownership
in Bailey Company on January 1, 2023, for
$84,000.
 Alpha company does not have the ability to exert
significant influence over Bailey.
 Alpha properly records the investment using the
fair-value method and recognizes in net income its
10 percent ownership share of changes in Bailey’s
fair value.

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 Reporting a Change to the
Equity Method Example (continued)
 Fair values of Bailey’s common stock and book
value of company appear in the following table:

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 Reporting a Change to the Equity
Method without Significant Influence
 Alpha Company recognizes the increase in its 10
percent ownership in Bailey Company at the end
of 2023 and increases its investment account to
$89,000.
 Because the fair-value method is used to account
for the investment, Bailey’s $670,000 book value
balance at January 1, 2023 does not affect Alpha’s
accounting.
 On January 1, 2024, Alpha purchases an
additional 30 percent of Bailey’s outstanding
voting stock for $267,000.
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 Reporting a Change to the Equity
Method with Significant Influence
 On January 1, 2024, Alpha achieves the ability to
exercise significant influence over Bailey, and will
now apply the equity method to account for its
investment in Bailey.
 On January 1, 2024, Bailey’s carrying amounts for
its assets and liabilities equaled their fair values
except for a patent, which was undervalued by
$175,000 and had a 10-year remaining useful life.
 The fair value of Alpha’s total (40 percent)
investment serves as the valuation basis.

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 Recording a Change to the Equity
Method
Alpha prepares the following journal entry on January 1,
2024, to bring about prospective change to the equity method:

Investment Allocation Schedule

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 Recording a Change to the Equity
Method (continued)
Bailey reports net income of $130,000 and declares and pays a
$50,000 dividend at the end of 2024. Alpha records the
following journal entries:

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 Learning Objective 1-6b

Understand the financial reporting

consequences for investee’s other
comprehensive income.

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 Other Comprehensive Income (OCI)
 OCI is defined as revenues, expenses, gains, and losses that
under GAAP are included in comprehensive income but
excluded from net income.
 Items included in AOCI (Accumulated Other Comprehensive
Income) on the balance sheet are accumulated derivative net
gains and losses, foreign currency translation adjustments,
and certain pension adjustments.
 Equity method accounting requires that the investor record
its share of investee OCI and irregular items traditionally
found in net income.
 AOCI is reported in stockholders’ equity and represents a
source of change in investee company net assets that is
recognized under the equity method.
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 Learning Objective 1-6c

Understand the financial reporting

consequences for investee losses.

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 Reporting Investee Losses
 Declines in investment value can result due to a loss of
major customers, changes in economic conditions, loss of
a significant patent or other legal right, damage to the
company’s reputation, etc. A temporary drop in the fair
value of an investment is simply ignored.
 FASB ASC (para. 323-10-35-32) requires that a loss in
value of an investment which is other than a temporary
decline shall be recognized.
 A permanent decline in the investee’s fair market value
is recorded as an impairment loss and the investment
account is reduced to the fair value.

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 Investment Reduced to Zero
 When accumulated losses incurred and dividends
paid by the investee reduce the investment
account to $-0-, no further loss can be accrued.
 Once the original cost of the investment has been
eliminated, no additional losses can accrue to the
investor.
 Future equity income will be offset by these losses
prior to recording equity income in our results.

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 Learning Objective 1-6d

Understand the financial reporting

consequences for sales of equity method
investments.

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 Reporting the Sale of an Equity
Investment
If part of an investment is sold during the period:
 The equity method is applied up to the transaction date.
 At the transaction date, the Investment account balance
is reduced by the percentage of shares sold.
 If significant influence is lost, NO RETROACTIVE
ADJUSTMENT is recorded if the investor is required to
change FROM the equity method to the fair-value
method.
 Note: A change TO the equity method is also treated
prospectively.

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 Learning Objective 1-7

Describe the rationale and computations

to defer the investor’s share of gross
profits on intra-entity inventory sales
until the goods are either consumed by
the owner or sold to outside parties.

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 Deferral of Intra-Entity Gross Profits
in Inventory
Many equity acquisitions establish ties between companies
to facilitate the direct purchase and sale of inventory items.
Intra-entity sales require special accounting to ensure
proper timing for profit recognition.
EXHIBIT 1.2 Downstream and Upstream Sales

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 Downstream Sales of Inventory—
Investor Sales to Investee
 Profit recognition is delayed until buyer disposes of the
goods.
 Investor decreases current equity income to reflect the
deferred portion of the intra-entity profit.
 When this inventory is eventually consumed or sold to
unrelated parties, the deferral is no longer needed.
 The investor should recognize the deferred intra-entity gross
profit. Recognition shifts from the year of inventory transfer
to the year in which the sale to unrelated customers occurred.
 An alternative treatment would be the direct reduction of the
investor’s inventory balance as a means of accounting for this
deferred amount.

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 Downstream Sales of Inventory—Investor
Sales to Investee Journal Entries
If gross profit on an original intra-entity sale is 30 percent of $10,000 in
sales, investor profit associated with the sale is $3,000. If 40 percent of
investee’s stock is held, just $1,200 of the profit is deferred.
Current equity income decreases by $1,200 to defer the intra-entity profit
and temporarily remove 30 percent of the profit from the investor’s books
in 2024 until the investee disposes of the inventory in 2025.

Reverse the preceding deferral entry to move the profit into the year of
sale to outside customers.

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 Upstream Sales of Inventory—Investee
Sales to Investor
 Upstream sales of inventory are reported in the same
manner as downstream sales.
 Profit recognition is delayed until buyer disposes of the
goods.
 Investor decreases current equity income to reflect the
deferred portion of the intra-entity profit.
 The investor’s own inventory account contains the
deferred gross profit. Recognition of profit is deferred
by decreasing the investment account rather than the
inventory balance.
 When this inventory is eventually consumed or sold to
unrelated parties, the deferral is reversed.
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 Upstream Sales of Inventory—Investee
Sales to Investor Journal Entries
Suppose the investee sells merchandise costing $40,000 to the investor for
$60,000, and at year’s end, the investor still retains $15,000 of the goods.
The investee reports net income of $120,000 for the year. The investor
records a journal entry to reflect the basic accrual of the investee’s
earnings.

A second entry is required of the investor at year-end. Income accrual is

reduced, and the investor defers its portion of the intra-entity gross profit.

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 Financial Reporting Effects

Measurements of financial performance often affect

the following:
 The firm’s ability to raise capital.
 Managerial compensation.
 The ability to meet debt covenants and future
interest rates.
 Managers’ reputations.

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 Criticisms of the Equity Method

 Emphasizing the 20–50 percent of voting

stock in determining significant influence
versus control.
 Allowing off-balance-sheet financing.
 Potentially biasing performance ratios.

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 Learning Objective 1-8

Explain the rationale and reporting

implications of fair-value accounting for
investments otherwise accounted for by
the equity method.

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 Fair-Value Reporting Option
 An entity may irrevocably elect fair value as the
initial and subsequent measurement for certain
financial assets and financial liabilities, including
investments accounted for under the equity
method.
 Under the fair-value option, changes in the fair
value of the elected financial items are included in
earnings.

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 Fair-Value Reporting Option
(continued)
 The fair-value option improves financial
reporting. It provides entities with the opportunity
to mitigate volatility in reported earnings caused
by measuring related assets and liabilities
differently without having to apply complex hedge
accounting provisions.
 The fair-value option matches asset valuation with
fair-value reporting requirements for many
liabilities.

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