Stock Investments – Investor Accounting and Reporting

Chapter 2: Stock Investments – Investor Accounting and Reporting

by Jeanne M. David, Ph.D., Univ. of Detroit Mercy

to accompany

Advanced Accounting ^{, 10 th 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 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

• 20% to 50% – presumes significant influence – equity method

• >50% – presumes control – consolidated financial

statements

Fair value (cost) method

Equity method Consolidated

financial

statements

2: Accounting Reflects Economics 2: Accounting Reflects Economics

Stock Investments – Investor Accounting and Reporting

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*

3a: Fair Value/Cost Method 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.

Investment in Sud 100,000

Cash 100,000

Cash 4,000

Dividend income 4,000

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.

3b: Equity Method 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.

Investment in Sud 100,000

Cash 100,000

Cash 4,000

Investment in Sud 4,000

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

4: Ability to Influence or Control 4: Ability to Influence or Control

Stock Investments – Investor Accounting and Reporting

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.

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.

5: Applying the Equity Method 5: Applying the Equity Method

Stock Investments – Investor Accounting and Reporting

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

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

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

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

Amortization and Investment Income

Cost/book value

differences: Initial

amount 1

^st

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.

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

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.

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

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

Investment in XYZ xxx

Retained earnings xxx

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

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

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

6: Impairment of Goodwill 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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