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CHAPTER 1
THE EQUITY METHOD OF ACCOUNTING FOR INVESTMENTS
Chapter Outline
I. Three methods are principally used to account for an investment in equity securities
along with a fair value option.
A. Fair value method: applied by an investor when only a small percentage of a
company’s voting stock is held.
1. Income is recognized when the investee declares a dividend.
2. Portfolios are reported at fair value. If fair values are unavailable, investment is
reported at cost.
B. Consolidation: when one firm controls another (e.g., when a parent has a majority
interest in the voting stock of a subsidiary or control through variable interests, their
financial statements are consolidated and reported for the combined entity.
C. Equity method: applied when the investor has the ability to exercise significant
influence over operating and financial policies of the investee.
1. Ability to significantly influence investee is indicated by several factors including
representation on the board of directors, participation in policy-making, etc.
2. GAAP guidelines presume the equity method is applicable if 20 to 50 percent of
the outstanding voting stock of the investee is held by the investor.
Current financial reporting standards allow firms to elect to use fair value for any new
investment in equity shares including those where the equity method would otherwise
apply. However, the option, once taken, is irrevocable. Investee dividends and changes
in fair value over time are recognized as income.
On February 14, 2013, the FASB issued a Proposed Accounting Standards Update
(ASU) entitled, Recognition and Measurement of Financial Assets and Financial
Liabilities. The proposed ASU would eliminate the fair-value option for investments that
qualify for equity method treatment. Fair-value accounting, however, would be extended
to “equity method” investments that meet the criteria for classification as held for sale.
II. Accounting for an investment: the equity method
A. The investment account is adjusted by the investor to reflect all changes in the equity
of the investee company.
B. Income is accrued by the investor as soon as it is earned by the investee.
C. Dividends declared by the investee create a reduction in the carrying amount of the
Investment account. The text assumes all investee dividends are declared and paid
in the same reporting period.
III. Special accounting procedures used in the application of the equity method
A. Reporting a change to the equity method when the ability to significantly influence an
investee is achieved through a series of acquisitions.
1. Initial purchase(s) will be accounted for by means of the fair value method (or at
cost) until the ability to significantly influence is attained.
2. At the point in time that the equity method becomes applicable, a retrospective
adjustment is made by the investor to convert all previously reported figures to
the equity method based on percentage of shares owned in those periods.
3. This restatement establishes financial statement comparability across years.
B. Investee income from other than continuing operations
1. The investor recognizes its share of investee reported other comprehensive
income (OCI) through the investment account and the investor’s own OCI.
2. Income items such as extraordinary gains and losses and discontinued
operations that are reported separately by the investee should be shown in the
same manner by the investor. The materiality of these other investee income
elements (as it affects the investor) continues to be a criterion for separate
disclosure.
C. Investee losses
1. Losses reported by the investee create corresponding losses for the investor.
2. A permanent decline in the fair value of an investee’s stock should be recognized
immediately by the investor as an impairment loss.
3. Investee losses can possibly reduce the carrying value of the investment account
to a zero balance. At that point, the equity method ceases to be applicable and
the fair-value method is subsequently used.
D. Reporting the sale of an equity investment
1. The investor applies the equity method until the disposal date to establish a
proper book value.
2. Following the sale, the equity method continues to be appropriate if enough
shares are still held to maintain the investor’s ability to significantly influence the
investee. If that ability has been lost, the fair-value method is subsequently used.
IV. Excess investment cost over book value acquired
A. The price an investor pays for equity securities often differs significantly from the
investee’s underlying book value primarily because the historical cost based
accounting model does not keep track of changes in a firm’s fair value.
B. Payments made in excess of underlying book value can sometimes be identified with
specific investee accounts such as inventory or equipment.
C. An extra acquisition price can also be assigned to anticipated benefits that are
expected to be derived from the investment. In accounting, these amounts are
presumed to reflect an intangible asset referred to as goodwill. Goodwill is
calculated as any excess payment that is not attributable to specific assets and
liabilities of the investee. Because goodwill is an indefinite-lived asset, it is not
amortized.
V. Deferral of unrealized gross profit in inventory
A. Profits derived from intra-entity transactions are not considered completely earned
until the transferred goods are either consumed or resold to unrelated parties.
B. Downstream sales of inventory
1. “Downstream” refers to transfers made by the investor to the investee.
2. Intra-entity gross profits from sales are initially deferred under the equity method
and then recognized as income at the time of the inventory’s eventual disposal.
3. The amount of gross profit to be deferred is the investor’s ownership percentage
multiplied by the markup on the merchandise remaining at the end of the year.
C. Upstream sales of inventory
1. “Upstream” refers to transfers made by the investee to the investor.
2. Under the equity method, the deferral process for unrealized profits is identical
for upstream and downstream transfers. The procedures are separately
identified in Chapter One because the handling does vary within the
consolidation process.
Answers to Discussion Questions
The textbook includes discussion questions to stimulate student thought and discussion. These
questions are also designed to allow students to consider relevant issues that might otherwise
be overlooked. Some of these questions may be addressed by the instructor in class to motivate
Unfortunately, in accounting, definitive resolutions to financial reporting questions are not always
available. Students often seem to believe that all accounting issues have been resolved in the
past so that accounting education is only a matter of learning to apply historically prescribed
The discussion questions are designed to help students develop research and critical thinking
skills in addressing issues that go beyond the purely mechanical elements of accounting.
Did the Cost Method Invite Manipulation?
The cost method of accounting for investments often caused a lack of objectivity in reported
income figures. With a large block of the investee’s voting shares, an investor could influence
the amount and timing of the investee’s dividend declarations. Thus, when enjoying a good
earnings year, an investor might influence the investee to withhold declaring a dividend until
needed in a subsequent year. Alternatively, if the investor judged that its current year earnings
Does the Equity Method Really Apply Here?
The discussion in the case between the two accountants is limited to the reason for the
investment acquisition and the current percentage of ownership. Instead, they should be
examining the actual interaction that currently exists between the two companies. Although the
Ability to exercise that influence may be indicated in several ways, such as representation on
the board of directors, participation in policy-making processes, material intra-entity
transactions, interchange of managerial personnel, or technological dependency. Another
In this case, the accountants would be wise to determine whether Dennis Bostitch or any other
member of the Highland Laboratories administration is participating in the management of
However, if James Abraham continues to operate Abraham, Inc., with little or no regard for
Highland, the equity method should not be applied. This possibility seems especially likely in
Answers to Questions
1. The equity method should be applied if the ability to exercise significant influence over the
operating and financial policies of the investee has been achieved by the investor. However,
2. According to FASB ASC paragraph 323-10-15-6 "Ability to exercise that influence may be
indicated in several ways, such as representation on the board of directors, participation in
policy-making processes, material intra-entity transactions, interchange of managerial
3. The dividends are reported as a deduction from the investment account, not revenue, to
avoid reporting the income from the investee twice. The equity method is appropriate when
an investor has the ability to exercise significant influence over the operating and financing
decisions of an investee. Because dividends represent financing decisions, the investor may
have the ability to influence dividend timing. If dividends were recorded as income,
4. If Jones cannot significantly influence the operating and financial policies of Sandridge, the
equity method should not be applied regardless of the ownership level. However, an owner
Examples of indications that an investor may be unable to exercise significant influence over
the operating and financial policies of an investee include (ASC 323-10-15-10):
a. Opposition by the investee, such as litigation or complaints to governmental regulatory
authorities, challenges the investor's ability to exercise significant influence.
b. The investor and investee sign an agreement under which the investor surrenders
significant rights as a shareholder.
5. The following events necessitate changes in this investment account.
a. Net income earned by Watts would be reflected by an increase in the investment
balance whereas a reported loss is shown as a reduction to that same account.
b. Dividends declared by the investee decrease its book value, thus requiring a
corresponding reduction to be recorded in the investment balance.
6. The equity method has been criticized because it allows the investor to recognize income
that may not be received in any usable form during the foreseeable future. Income is being
Many companies have contractual provisions (e.g., debt covenants, managerial
compensation contracts) based on ratios in the main body of the financial statements.
Relative to consolidation, a firm employing the equity method will report smaller values for
7. FASB ASC Topic 323 requires that a change to the equity method be reflected by a
retrospective adjustment. Although a different method may have been appropriate for the
8. In reporting equity earnings for the current year, Riggins must separate its accrual into two
9. Under the equity method, losses are recognized by an investor at the time that they are
reported by the investee. However, because of the conservatism inherent in accounting, any
10. Following the guidelines established by the ASC, Wilson would recognize an equity loss of
$120,000 (40 percent) stemming from Andrews' reported loss. However, since the book
11. In accounting, goodwill is derived as a residual figure. It is the investor's cost in excess of its
share of the fair value of the investee assets and liabilities. Although a portion of the
acquisition price may represent either goodwill or valuation adjustments to specific investee
assets and liabilities, the investor records the entire cost in a single investment account. No
12. On June 19, Princeton removes the portion of this investment account that has been sold
and recognizes the resulting gross profit or loss. For proper valuation purposes, the equity
method is applied (based on the 40 percent ownership) from the beginning of Princeton's
13. Downstream sales are made by the investor to the investee while upstream sales are from
the investee to the investor. These titles have been derived from the traditional positions
14. The unrealized portion of an intra-entity gross profit is computed based on the markup on
any transferred inventory retained by the buyer at year's end. The markup percentage
15. Intra-entity transfers do not affect the financial reporting of the investee except that the
related party transactions must be appropriately disclosed and labeled.
16. Under fair value accounting, firms report the investment’s fair value as an asset and
changes in fair value as earnings. Dividends from an investee are included in earnings
Answers to Problems
1. D
6. A Acquisition price............................................................................... $1,600,000
7. A Acquisition price............................................................................... $700,000
Income accruals: 2014—$170,000 × 20%........................................ 34,000
2015—$210,000 × 20%....................................... 42,000
Amortization (see below): 2014....................................................... (10,000)
2015—$70,000 × 20%..................................................... (14 ,000)
Investment in Martes, December 31, 2015...................................... $728 ,000
Excess cost over book value to patent.......................................... $100 ,000
Annual amortization (10 year remaining life) ................................ $10 ,000
8. B Purchase price of Johnson stock................... $500,000
Cost in excess of book value.................... $140,000
Remaining Annual
Payment identified with undervalued............. life amortization
Building ($140,000 × 40%).......................... 56,000 7 yrs. $8,000
Investment purchase price.............................................. $500,000
Basic income accrual ($90,000 × 40%)...................... 36,000
Investment in Johnson..................................................... $507 ,600
9. D The 2014 purchase is reported using the equity method.
Purchase price of Evan stock.......................................................... $600,000
Book value of Evan stock ($1,200,000 × 40%)............................... (480 ,000)
Cost on January 1, 2014................................................................... $600,000
2014 Income accrued ($140,000 x 40%).......................................... 56,000
2014 Dividend ($50,000 × 40%)........................................................ (20,000)
10. D
11. A Gross profit rate (GPR): $36,000 ÷ $90,000 = 40%
Inventory remaining at year-end..................................................... $20,000
GPR..................................................................................................... × 40%
12.B Purchase price of Steinbart shares................................................. $530,000
Book value of Steinbart shares ($1,200,000 × 40%)...................... (480 ,000)
2014 Gross profit rate = $30,000 ÷ $100,000 = 30%
2015 Gross profit rate = $54,000 ÷ $150,000 = 36%
2015—Equity income in Steinbart:
Amortization (above)........................................................................ (2,500)
Recognition of 2014 unrealized gross profit
($25,000 × 30% GPR × 40% ownership)..................................... 3,000
Deferral of 2015 unrealized gross profit
13. (6 minutes) (Investment account after one year)
Purchase price....................................................................................... $1,160,000
Basic 2015 equity accrual ($260,000 × 40%)...................................... 104,000
Amortization of copyright:
Excess payment ($1,160,000 – $820,000 = $340,000)
14. (7 minutes)
a. Purchase price................................................................................... $ 2,290,000
Equity income accrual ($720,000 × 35%)........................................ 252,000
Investment in Steel at December 31, 2015..................................... $2 ,500,000
b. Equity income of Steel = $252,000 (does not include OCI share which is
reported separately).
15. (15 minutes) (Investment account after 2 years)
a. Acquisition price................................................................................... $2,700,000
Book value acquired ($5,175,000 × 20%)............................................ 1 ,035,000
Excess payment.................................................................................... $1,665,000
Amortization:
Computing equipment ($140,000 ÷ 7)........................................ $ 20,000
Patented technology ($780,000 ÷ 3)........................................... 260,000
b. Basic equity accrual 2014 ($1,800,000 × 20%)................................... $360,000
Basic equity accrual 2015 ($1,985,000 × 20%)................................... $397,000
c. Acquisition price................................................................................... $2,700,000
Equity in 2014 earnings of Sauk Trail (above)................................... 80,000
Investment in Sauk Trail, 12/31/14....................................................... $2,750,000
Equity in 2015 earnings of Sauk Trail (above)................................... $117,000
16.(10 minutes) (Investment account after 2 years with fair value accounting
included)
a. Acquisition price................................................................................... $60,000
Book value—assets minus liabilities ($125,000 × 40%)................ 50 ,000
Amortization:
Patent ($6,000 ÷ 6)....................................................................... $1,000
Goodwill........................................................................................ -0-
Annual amortization............................................................... $1 ,000
Acquisition price............................................................................... $60,000
Basic equity accrual 2014 ($30,000 × 40%).................................... 12,000
Dividends—2015............................................................................... (6,000)
Amortization—2015 (above)............................................................. (1 ,000)
Investment in Holister, 12/31/15....................................................... $80 ,000
b. Dividend income ($15,000 × 40%)................................................... $6,000
