Advanced accounting 10th by a beams athony ch02

Apply the fair value/cost and equity methods of accounting for stock investments.. 3a: Fair Value/Cost MethodStock Investments – Investor Accounting and Reporting... Fair Value Method, a

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

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.

Objectives (continued)

5 Apply the equity method to purchase price allocations.

6 Learn how to test goodwill for impairment.

1: Levels of Influence or Control

Stock Investments – Investor Accounting and Reporting

Levels of Influence

• <20% – presumes lack of

significant influence – fair

value (cost) method

Equity method

Consolidated financial statements

2: Accounting Reflects Economics

Stock Investments – Investor Accounting and Reporting

Accounting for the Investment

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 *

3a: Fair Value/Cost Method

Stock Investments – Investor Accounting and Reporting

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.

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.

If Pilzner determines that cumulative dividends exceed its

cumulative share of income by $1,000.

3b: Equity Method

Stock Investments – Investor Accounting and Reporting

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.

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.

4: Ability to Influence or Control

Stock Investments – Investor Accounting and Reporting

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.

• 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.

5: Applying the Equity Method

Stock Investments – Investor Accounting and Reporting

Acquisition Cost > FV 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

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

Additional paid in capital 1,000 Additional paid in capital 50

Cost/Book Value Assignment

Less 30% book value = 30%(12,000) 3,600

Excess of cost over book value $1,400

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

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.

Amortization and Investment Income

Cost/book value

differences: amount Initial 1

st year amort excess at year-end Unamortized

Year-end Entry & Balance

Record the investment income

The ending balance in the investment account is:

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

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

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.

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

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

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

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

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

• 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

6: Impairment of Goodwill

Stock Investments – Investor Accounting and Reporting

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

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

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