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Lesson

How Investors Account for Their Stock Investments

09:19 AM MT
09/06/2016

Introduction

Recording the Investment

Reporting the Investment

Fair-Value Method

Equity Method

Scenario 1: Purchase Price > Book Value (% Purchased)

Scenario 2: Purchase Price < Book Value (% Purchased)

Conclusion
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Introduction
This week, we focus on accounting for stock investments from the viewpoint of the
investor. As you learned in Intermediate Accounting, there are three methods of
accounting for an investment in the common stock of another company: the fair-value
method, consolidation of the financial statements, and the equity method.
Before we define these, let's decide when to use each method.

How Investors Account for Their Stock Investments

How Investors Account for Their Stock Investments

Recording the Investment

The level of influence also determines the appropriate reporting method for the
investment. As long as the investor holds a minority interest in the voting stock of an
investee, the investment will be reported only on the financial statements of the investor.
However, once the investor holds majority interest in the voting stock of the investee,
the financial statements of the investor and investee (parent and subsidiary) are
consolidated and reported as a combined entity, even though they remain separate
physical entities.

Reporting the Investment

The level of influence also determines the appropriate reporting method for the
investment. As long as the investor holds a minority interest in the voting stock of an
investee, the investment will be reported only on the financial statements of the investor.
However, once the investor holds majority interest in the voting stock of the investee,
the financial statements of the investor and investee (parent and subsidiary) are
consolidated and reported as a combined entity, even though they remain separate
physical entities.
Perhaps the easiest way to summarize these guidelines is through a diagram, so let's
take a look at one.
Click on image to enlarge

Now that we know when to apply the different methods in accounting for a stock
investment, let's make sure we know how to apply each method.
IFRS Update
Right now, IFRS presumes the same levels of investment or control reporting
required as in U.S. GAAP; that is to say, fair value up to 20% interest, equity reporting
from 2050%, and control/consolidation at 50% or more. There is, however, a provision

in IAS 28 that requires significant review of the investment control at less than 50%
interest. Should it be demonstrated that the investee has effective control at less than
50% interest, then consolidation may be required under IAS 28. The other major
difference in IFRS is that the disclosure requirements in investments are much more
substantial in IAS 28. This will be discussed at more length in Week 2.

Fair-Value Method
The fair-value method is the easiest method to apply. The investment is reported at
market value. If market value is unavailable, the investment is reported at cost. Income
is recognized when dividends are declared. Again, as you recall from Intermediate
Accounting, this is an available-for-sale investment initially recorded at cost and
subsequently adjusted to market value with the adjustment being recorded in the equity
section as other comprehensive income.
IFRS UPDATE
Here we have an interesting difference in IFRS 3 versus SFAS 141R.
International standards allow two methods of valuing a noncontrolling interest with a
transaction-by-transaction choice of method. Those choices are (1) fair value (as
mentioned above) and (2) proportionate interest in net assets, much like prior U.S.
GAAP accounting.
International Financial Reporting Standards (IFRS) Control Consolidation Rules:
IFRS, as outlined in International Accounting Standard (IAS) 27R, provides a controlbased reporting/consolidation requirement as opposed to the defined ownership basis
established in SFAS 141, 142, and ARB 51. This can be seen in situations in which a
parent may own less than one half of the voting rights, but obtains control for one of the
following reasons: (1) The parent has made agreements with other investors or voting
trusts; (2) the parent governs the financial and operating policies under an agreement;
(3) the parent has the power to appoint or remove a majority of the board of directors or
governing body; or (4) the parent can cast the majority of the votes of the board of
directors or governing body. The remaining alternative is the equity consolidation
method, omitting U.S. GAAP's fair value investment alternative.
In actuality, this situation may in fact be reversed, as in situations in which majority
ownership actually does not demonstrate or constitute control.

Lecture Topic
Type content here

Equity Method

The equity method of accounting isn't quite as simple as the fair-value method. The
journal entry at the time of purchase is the same entry that would be made under the
fair-value method.
DR

Investment in X Co.

$XXX

CR

Cash

$XXX

Think about the equity method like this: We are buying a percentage of ownership in
another company (via its stock). In other words, we become stockholders who own a
specific percentage of another company's equity. Think of this with respect to the
company in which we are investing.

Assets - liabilities = net assets

Assets - liabilities = stockholder's equity

Net assets = stockholder's equity

So if we are making a 40% investment in a company, we are actually buying 40% of the
value of a stockholder's equity. For our purposes, stockholder's equity will always be
only common stock, paid-in capital, and retained earnings. Start with the stockholder's
equity section of the company we are investing in and calculate the percentage being
purchased. That will equal our percentage of ownership in the net assets of the
company at book value and that may or may not be the cost of our investment.
We always need to compare the cost paid with the percentage of net assets purchased
at book value. If these amounts are different, then we need to account for this
difference. Any portion of the difference attributable to fair value of net assets needs to
be amortized. Any remaining difference that cannot be specifically identified as another
tangible or intangible asset is goodwill.
Going forward in applying the equity method subsequent to the acquisition, we do the
following.
Under the equity method, the investment account represents a specific percentage of
ownership in the stockholder's equity of the investee. The purpose of the equity method
is to continue to maintain our investment account to reflect that specific percentage of
ownership in the investee. Therefore, if the stockholder's equity section of the investee
changes, our investment account must also be adjusted to reflect that change. Now,
how will the stockholder's equity account of the investee change? It goes up for net
income and down for dividends. Therefore, we need to do the same to our investment
account, but only for the percentage of ownership that we own.
In addition, there are two other adjustments required to maintain the balance between
the investment account and our percentage of ownership in the stockholder's equity
section of the investee. One of these is the amortization of the difference in cost paid
and the percentage of net assets purchased at book value identified to specific net

assets. The other adjustment eliminates unrealized gain on an upstream intercompany

sale.
Amortization of the Difference Between Cost Paid and Percentage of Book Value
Purchased
The following are two scenariosone where the purchase price exceeds the book value
of the percentage purchased and one where the purchase price is less than the book
value of the percentage purchased.

Scenario 1
Start with the same steps above. We are always trying to explain the purchase price.
Calculate the percentage of the stockholder's equity account being purchased. That's
your starting point. Now determine the difference between fair value and book value and
multiply the result by the percentage being purchased. This is the identifiable difference
and the premium you are paying above book value. That premium (like a bond's
premium) needs to be amortized over the remaining life of the assets that created that
premium. If the assets are buildings or equipment, the amortization is over the
remaining life of the assets. If the asset is land, however, then that premium will never
be amortized; it will simply sit in the investment account until that land is sold, and then
we write off the premium. If the asset is inventory, we carry the premium until the
inventory is sold, and then we write it off.
Remember This
Here's a trick: If, on the CPA exam, they ask for the amount of goodwill when Company
A buys 40% of Company B, and they give you a balance sheet with a column for book
value and a column for fair value, just multiply the % times the total fair value of the
company. Compare that amount to the purchase price, and any difference is goodwill. It
is the amount we can't account for.
IFRS Update

There are a couple of interesting differences in IAS28 for the asset

accounting under the equity accounting method. The method generally
parallels that of U.S. GAAP, but extends the concept of fair value to
require the investee company to recognize (over the remaining life of the
major asset categories) any excess fair value over the purchase price as
income, on an annual basis. Further, it subjects any purchases where
there is goodwill (purchase price in excess of fair value), to annual
impairment tests by asset category. This is a substantial increase in the
amount of monitoring and reporting, not to mention a substantial
relationship with valuation associates.

Now, let's say that you

1.

calculate the percentage of ownership of the investee's stockholder's equity

account; and

2.

calculate the percentage of ownership of the difference between fair value and
book value and it still doesn't equal the purchase price.
When the difference between purchase price and the amounts you calculated cannot be
identified, the difference is goodwill. In other words, the plug is goodwill. As you are
probably aware, goodwill is no longer amortized but rather is subject to impairment
testing on at least an annual basis

Lecture Topic
T

Scenario 2: Purchase Price < Book Value (% Purchased)

In this scenario, we have a bargain purchase resulting in negative goodwill. Negative
goodwill needs to be prorated to the noncurrent assets by using the ratio (negative
goodwill/fair value of noncurrent assets only). Apply this ratio to the difference of fair
value and book value of each noncurrent asset. Basically, we are saying that we did not
pay fair value; rather, we received a discount, such as 10% off of each noncurrent
asset. If this allocation reduces noncurrent assets to zero, any remaining difference is
treated as an extraordinary gain.
Realize that all of this work is done on a worksheet schedule that never gets recorded.
We already have our journal entry at the time of purchase:

Dr.

Investment in X Co.

$XXX

Cr.

Cash

$XXX

Notice that the amount in this entry is the purchase price. We never record any
calculated goodwill or recognize any difference between fair value and book value.
These calculations are just a worksheet exercise used to explain the purchase price.
These differences between book value and fair value that can be identified (whether
positive or negative) must be amortized. It works like this: If you paid more than book
value, then the amortization will reduce the investment account balance.
Dr:

Equity in X Co. Income

$XXX

Cr:

Investment in X Co.

$XXX

You are writing down the premium you paid.

If you paid less than book value, you still have to amortize (this happens when an
asset's fair market value is less than the book value). The amortization has the effect of
increasing the investment account:
Dr:

Investment in X Co.

$XXX

Cr:

Equity in X Co. Income

$XXX

The Question
Smith Inc. has maintained an ownership interest in Watts Corporation for a number of
years. This investment has been accounted for by means of the equity method. What
transactions or events create changes in the investment in Watts Corporation account
being recorded by Smith?

Your Answer
Compare Answers

Scenario 2
Wowthat's a lot of information to deal with concerning the equity method. To make
sure you absorbed it all, try the following exercise.
Interactive Excel Exercise

See if this helps: Equity method. If the Show Answer button in this Excel
exercise is not working, do the following.
1.
Go to the Developer tab (if you don't see the Developer tab, click
the
button and select Excel Options on the bottom right-hand side

next to Exit Excel).

2.

After clicking on the Developer tab, click on Macro Security>Macro

Settings.
Select "Disable all macros with notification."
Now click on the Macro button. Look for the security warning on the top
left side.

Scenario 1: Purchase Price > Book Value (% Purchased)

Start with the same steps above. We are always trying to explain the purchase price.
Calculate the percentage of the stockholder's equity account being purchased. That's
your starting point. Now determine the difference between fair value and book value and
multiply the result by the percentage being purchased. This is the identifiable difference
and the premium you are paying above book value. That premium (like a bond's
premium) needs to be amortized over the remaining life of the assets that created that
premium. If the assets are buildings or equipment, the amortization is over the
remaining life of the assets. If the asset is land, however, then that premium will never
be amortized; it will simply sit in the investment account until that land is sold, and then
we write off the premium. If the asset is inventory, we carry the premium until the
inventory is sold, and then we write it off.

Remember This
Here's a trick: If, on the CPA exam, they ask for the amount of goodwill when Company
A buys 40% of Company B, and they give you a balance sheet with a column for book
value and a column for fair value, just multiply the % by the total fair value of the
company. Compare that amount to the purchase price, and any difference is goodwill. It
is the amount we can't account for.

IFRS Update
There are a couple of interesting differences in IAS 28 for asset accounting
under the equity accounting method. The method generally parallels that of U.S. GAAP,
but extends the concept of fair value to require the investee company to recognize (over
the remaining life of the major asset categories) any excess fair value over the purchase
price as income, on an annual basis. Further, it subjects any purchases where there is
goodwill (purchase price in excess of fair value), to annual impairment tests by asset
category. This is a substantial increase in the amount of monitoring and reporting, not to
mention a substantial relationship with valuation associates.

Scenario 2: Purchase Price < Book Value (% Purchased)

In this scenario, we have a bargain purchase resulting in negative goodwill. Negative
goodwill needs to be prorated to the noncurrent assets by using the ratio (negative
goodwill/fair value of noncurrent assets only). Apply this ratio to the difference of fair
value and book value of each noncurrent asset. Basically, we are saying that we did not
pay fair value; rather, we received a discount, such as 10% off of each noncurrent
asset. If this allocation reduces noncurrent assets to zero, any remaining difference is
treated as an extraordinary gain.
Realize that all of this work is done on a worksheet schedule that never gets recorded.
We already have our journal entry at the time of purchase.
Dr.

Investment in X Co.

$XXX

Cr.

Cash

$XXX

Notice that the amount in this entry is the purchase price. We never record any
calculated goodwill or recognize any difference between fair value and book value.
These calculations are just a worksheet exercise used to explain the purchase price.
These differences between book value and fair value that can be identified (whether
positive or negative) must be amortized. It works like this: If you paid more than book
value, then the amortization will reduce the investment account balance.
Dr:

Equity in X Co. Income

$XXX

Cr:

Investment in X Co.

$XXX

You are writing down the premium you paid.

If you paid less than book value, you still have to amortize (this happens when an
asset's fair market value is less than the book value). The amortization has the effect of
increasing the investment account.
Dr:

Investment in X Co.

$XXX

Cr:

Equity in X Co. Income

$XXX

You are writing down the discount you received.

Finally, the last adjustment required to maintain the balance between the investment
account and our percentage of ownership in the investee's stockholder's equity is the
deferral of unrealized gain on any upstream intercompany sale.
Dr:

Equity in X Co. Income

$XXX

Cr:

Investment in X Co.

$XXX

The Question
Smith Inc. has maintained an ownership interest in Watts Corporation for a number of
years. This investment has been accounted for by means of the equity method. What
transactions or events create changes in the investment in Watts Corporation account
being recorded by Smith?

Your Answer
Compare Answers

Conclusion
Wowthat's a lot of information to deal with concerning the equity method. To make
sure you absorbed it all, try the following exercise.
Interactive Excel Exercise
See if this helps: Equity method. If the Show Answer button in this Excel exercise is
not working, do the following.

1.

Go to the Developer tab (if you don't see the Developer tab, click the
button and select Excel Options on the bottom right-hand side next to Exit
Excel).

1.

After clicking on the Developer tab, click on Macro Security -> Macro Settings.
Select "Disable all macros with notification."
Now click on the Macro button. Look for the security warning on the top left side.

Click Options and select "Enable content."

Go to Tools -> Macro -> Security and change your security setting to low.
The correct solution is also available in Doc Sharing.