Finance

1. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-1
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

2. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-2
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.

3. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-3
Objectives (continued)
5. Apply the equity method to purchase price
allocations.
6. Learn how to test goodwill for impairment.

4. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-4
1: Levels of Influence or Control
Stock Investments – Investor Accounting and Reporting

5. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-5
Levels of Influence
Percent Ownership of Voting Stock
>50%
<20%
20-50%
• <20% – presumes lack of
significant influence – fair
value (cost) method
• 20% to 50% – presumes
significant influence – equity
method
• >50% – presumes control –
consolidated financial
statements
Fair value
(cost)
method
Equity
method
Consolidated
financial
statements

6. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-6
2: Accounting Reflects Economics
Stock Investments – Investor Accounting and Reporting

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

8. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-8
3a: Fair Value/Cost Method
Stock Investments – Investor Accounting and Reporting

9. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-9
Fair Value (Cost) Method
FASB Statement No. 115
• At acquisition: Pilzner buys 2,000 shares of Sud
for $100,000.
• Pilzner receives $4,000 in dividends from Sud.
Investment in Sud 100,000
Cash 100,000
Cash 4,000
Dividend income 4,000

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

11. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-11
3b: Equity Method
Stock Investments – Investor Accounting and Reporting

12. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-12
Equity Method
APB Opinion No. 18
• At acquisition: Pilzner buys 2,000 shares of Sud
for $100,000.
• Pilzner receives $4,000 in dividends from Sud.
Investment in Sud 100,000
Cash 100,000
Cash 4,000
Investment in Sud 4,000

13. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-13
Equity Method, at Year-end
• Pilzner determines that its share of Sud's income is
$5,000.
• The ending balance in the Investment in Sud is:
$100,000 cost - $4,000 dividends + $5,000 income
= $101,000.
Cash 4,000
Investment in Sud 4,000

14. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-14
4: Ability to Influence or Control
Stock Investments – Investor Accounting and Reporting

15. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-15
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.

16. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-16
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.

17. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-17
5: Applying the Equity Method
Stock Investments – Investor Accounting and Reporting

18. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-18
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

19. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-19
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

20. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-20
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

21. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-21
Dividends and Income
Payne receives $300 dividends from Sloan.
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.
Cash 300
Investment in Sloan 300

22. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-22
Amortization and Investment Income
Cost/book value
differences:
Initial
amount
1st year
amort.
Unamortized
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.

23. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-23
Year-end Entry & Balance
Record the investment income
The ending balance in the investment account is:
5,000 – 300 + 603
= 5,303.
Cost – dividends + investment income
Investment in Sloan 603
Income from Sloan 603

24. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-24
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

25. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-25
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.

26. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-26
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

27. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-27
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.

28. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-28
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

29. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-29
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

30. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-30
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

31. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-31
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.

32. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-32
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

33. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-33
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

34. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-34
6: Impairment of Goodwill
Stock Investments – Investor Accounting and Reporting

35. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-35
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.

36. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-36
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

37. © Pearson Education, Inc. publishing as Prentice Hall© Pearson Education, Inc.
publishing as Prentice Hall
2-37
Copyright © 2009 Pearson Education, Inc.
Publishing as Prentice Hall
All rights reserved. No part of this publication may be reproduced,
stored in a retrieval system, or transmitted, in any form or by any
means, electronic, mechanical, photocopying, recording, or
otherwise, without the prior written permission of the publisher.
Printed in the United States of America.