Lesson 3 The Equity Method of Accounting for Investments. Università degli Studi di Trieste D.E.A.M.S. Paolo Altin

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1 Lesson 3 The Equity Method of Accounting for Investments Università degli Studi di Trieste D.E.A.M.S. Paolo Altin 68

2 The Equity Method of Accounting for Investments In its annual report, The Coca-Cola Company describes its 32 percent investment in Coca-Cola FEMSA, a Mexican bottling company with operations throughout much of Latin America. The Coca-Cola Company uses the equity method to account for several of its bottling company investments including Coca-Cola FEMSA. The Coca-Cola Company states that its consolidated net income includes the Company s proportionate share of the net income or loss of these companies. The carrying values of our equity method investments are increased or decreased by our proportionate share of the net income or loss and other comprehensive income (loss) ( OCI ) of these companies. The carrying values of our equity method investments are also decreased by dividends we receive from the investees. 69

3 The Equity Method of Accounting for Investments Types of interest in other entities Subsidiary Interest Associate Interest Joint Arrangements Investment Interest Ownership 50% or more 20% - 49% Joint <20% Accounting Standards Accounting treatment IFRS 3 IAS 28 IFRS 11 IFRS 9 Control = consolidation Significant influence = Equity Method Joint Operation = it depends. Joint Ventures = Equity Method At fair value. 70

4 The Equity Method of Accounting for Investments International Standards recognize three ways to report investments in other companies: 1) Fair-Value Method 2) Consolidation 3) Equity Method The method selected depends upon the degree of influence the investor has over the investee. 71

5 The Equity Method of Accounting for Investments THE FAIR-VALUE METHOD Because of the limited level of ownership, the investor cannot expect to significantly affect the investee s operations or decision making. In fact, these shares are bought in anticipation of cash dividends or in appreciation of stock market values. Investments in equity securities are recorded at cost and subsequently adjusted to fair value (IFRS 9). 72

6 The Equity Method of Accounting for Investments THE FAIR-VALUE METHOD Investments classified as Trading Securities: Held for sale in the short term. Unrealized holding gains and losses are included in earnings (net income). Investments classified as Available-for-Sale Securities: Any Securities not classified as Trading. Unrealized holding gains and losses are reported in shareholders equity as other comprehensive income (i. e., not included in net income). Dividends received are recognized as income for both trading and available-for-sale securities. 73

7 The Equity Method of Accounting for Investments THE CONSOLIDATION OF FINANCIAL STATEMENTS Required when: Investor s ownership exceeds 50% of investee; Investor s ownership doesn t exceed 50% but we have control, according to IFRS 10 definition. One set of financial statements prepared to consolidate all accounts of the parent company and all of its controlled subsidiaries as a single entity. 74

8 The Equity Method of Accounting for Investments THE EQUITY METHOD Use when: Investor has the ability to exercise significant influence on the investee operations (whether influence is applied or not) Generally used when ownership is between 20% and 50%. Significant Influence might be present with much lower ownership percentages. 75

9 IAS 28 - Investments in Associates The International Accounting Standards Board (IASB), defines significant influence as the power to participate in the financial and operating policy decisions of the investee, but it is not control or joint control over those policies. If investor has 20% or more ownership, it is presumed to have significant influence, unless it is demonstrated not to be the case. If investor holds less than 20% ownership, it is presumed it does not have significant influence, unless influence can be clearly demonstrated

10 IAS 28 - Investments in Associates Under the equity method, the investment in an associate is initially recognized at cost and the carrying amount is increased or decreased to recognize the investor s share of the profit or loss of the investee after the date of acquisition. The investor s share of the profit or loss of the investee is recognized in the investor s profit or loss. Distributions received from an investee reduce the carrying amount of the investment

11 IAS 28 - Investments in Associates Significant influence is the power to participate in the financial and operating policy decisions of the investee. Significant influence is not control (which indicates a subsidiary) Significant influence is not joint control (which indicates an interest in a joint arrangement)

12 General Ownership Guidelines Investor Ownership of the Investee s Shares Outstanding Fair Value Equity Method Consolidated Financial Statements 0% 20% 50% 100% Usually lack of control or significant influence. Significant influence generally assumed (20% to 50% ownership). Financial statements of all related companies must be consolidated. 79 Hoyle, Schaefer, Doupnik

13 Special Procedures for Special Situations Special procedures are required in accounting for each of the following: 1) Reporting a change to the equity method. 2) Reporting investee income from sources other than continuing operations. 3) Reporting investee losses. 4) Reporting the sale of an equity investment. 80

14 Application of the Equity Method An understanding of the equity method is best gained by initially examining the treatment of two questions: What parameters identify the area of ownership for which the equity method is applicable? How should the investor report this investment and the income generated by it to reflect the relationship between the two companies? 81

15 Criteria for Utilizing the Equity Method The rationale underlying the equity method is that an investor begins to gain the ability to influence the decision-making process of an investee as the level of ownership rises. Clearly, a term such as the ability to exercise significant influence is nebulous and subject to a variety of judgements and interpretations in practice. At what point does the acquisition of one additional share of stock give an owner the ability to exercise significant influence? This decision becomes even more difficult in that only the ability to exercise significant influence need be present. There is no requirement that any actual influence must have ever been applied. 82

16 Criteria for Utilizing the Equity Method IFRS provides guidance to the accountant by listing several conditions that indicate the presence of this degree of influence: Investor representation on the board of directors; Investor participation in policy making, including decisions about dividends; Close relationship involving transactions between investor and investee (material intra-entity transactions); Interchange of managerial personnel; Provision of essential technical information. No single one of these guides should be used exclusively in assessing the applicability of the equity method. Instead, all are evaluated together to determine the presence or absence of the sole criterion: the ability to exercise significant influence over the investee. 83

17 Criteria for Utilizing the Equity Method If an investor holds between 20 and 50 percent of the voting stock of the investee, significant influence is normally assumed and the equity method is applied. However, the essential criterion is still the ability to significantly influence (but not control) the investee. If the ability is not proven, the equity method should not be applied regardless of the % of shares held. In the following examples, the equity method in not appropriate. An agreement exists between investor and investee by which the investor surrenders significant rights as a shareholder. A concentration of ownership operates the investee without regard for the views of the investor. The investor attempts but fails to obtain representation on the investee s board of directors. The investor is unable to exercise significant influence over the investee. 84

18 Applying the Equity Method In applying the equity method, the accounting objective is to report the investor s investment and investment income reflecting the close relationship between the companies. After recording the cost of acquisition, two equity method entries periodically record the investment s impact: 1) The investor s investment account increases as the investee earns and reports income. 2) The investor s investment account is decreases whenever a dividend is collected. 85

19 Applying the Equity Method 1) The investor s investment account increases as the investee earns and reports income. Also, the investor recognizes investment income using the accrual method that is, in the same time period as the investee earns it. If an investee reports income of $100,000, a 30 percent owner should immediately increase its own income by $30,000. This earnings accrual reflects the essence of the equity method by emphasizing the connection between the two companies; as the owners equity of the investee increases through the earnings process, the investment account also increases. 86

20 Applying the Equity Method Although the investor initially records the acquisition at cost, upward adjustments in the asset balance are recorded as soon as the investee makes a profit. A reduction is necessary if a loss is reported. 87

21 Applying the Equity Method 2. The investor s investment account is decreased whenever a dividend is collected. Because distribution of cash dividends reduces the carrying value of the investee company, the investor mirrors this change by recording the receipt as a decrease in the carrying value of the investment rather than as revenue. Once again, a parallel is established between the investment account and the underlying activities of the investee. The reduction in the investee s owners equity creates a decrease in the investment. Furthermore, because the investor immediately recognizes income when the investee earns it, double counting would occur if the investor also recorded subsequent dividend collections as revenue. 88

22 Applying the Equity Method Investee Event Income is earned. Loss is reported. Dividends are distributed. Investor Accounting Proportionate share of income is recognized. Proportionate share of loss reduces the investment account. Investor s share of investee dividends reduce the investment account. Application of the equity method causes the investment account on the investor s balance sheet to vary directly with changes in the investee s equity. 89

23 Applying the Equity Method The investor BIG acquires a 20% interest in another company, LITTLE for $ 200,000. If the investor has the ability to significantly influence the investee, the equity method may be utilized. 2012: LITTLE reports net income of $ 200,000 and pays dividends for $ 50,000. Year Income of LITTLE Dividends paid by LITTLE Equity in Investee Income Carrying Value of Investment ,000 50,000 40, ,000 Equity in investee income is 20% of the current year income reported by LITTLE. It is the original cost plus income recognized less dividends received. (200+0,2*200-0,2*50) 90

24 Applying the Equity Method Year Income of LITTLE Dividends paid by LITTLE Equity in Investee Income Carrying Value of Investment ,000 50,000 40, , , , , ,000 Total 91

25 Applying the Equity Method Year Income of LITTLE Dividends paid by LITTLE Equity in Investee Income Carrying Value of Investment ,000 50,000 40, , , ,000 60, , , ,000 80, ,000 Total 180,000 ( ,2*300-0,2*100) The tables shows that the carrying value of the investment fluctuates each year under the equity method. 92

26 Accounting Procedures The investor accrues its percentage of the earnings reported by the investee each period. Dividend declarations reduce the investment balance to reflect the decrease in the investee s book value. LITTLE reported a net income of $200,000 during 2012 and paid cash dividends of $50,000. These figures indicate that Little s net assets have increased by $150,000 during the year. Therefore, in its financial records, BIG records the following journal entries to apply the equity method: 93

27 Accounting Procedures In the first entry, BIG accrues income based on the investee s reported earnings even though this amount greatly exceeds the cash dividend. The second entry reflects the actual receipt of the dividend and the related reduction in Little s net assets. 94

28 Excess of Investment Cost Over Book Value Acquired When Cost > Book Value of an investment acquired, the difference must be identified. One of the most common problems in applying the equity method. For which reasons cost and book value may differ? 95

29 Excess of Investment Cost Over Book Value Acquired For which reasons cost and book value may differ? Company s value based on many factors: profitability, introduction of new product, expected dividend payments, projected operating results, general economic conditions, etc. Stock prices are based, at least partially, on the perceived worth of a company s net assets (that often vary a lot from underlying book values). Asset and liability accounts shown on a balance sheet tend to measure historical costs rather than current value. These figures are in addition affected by the specific accounting methods adopted (e.g. LIFO and FIFO lead to different book values). 96

30 Excess of Investment Cost Over Book Value Acquired When Cost > Book Value of an investment acquired, the difference must be identified. The source of the excess of cost over book value is important. Two categories: 1. Fair values (FV) of some assets and liabilities on investee s books are different than book values (BV). 2. Investor is willing to pay extra expecting future benefits to accrue from the investment. Additional amount paid in excess of book value not allocated to undervalued assets is attributed to an intangible future value and recorded as Goodwill. 97

31 Excess of Investment Cost Over Book Value Acquired BIG is negotiating the acquisition of 30% of the outstanding shares of LITTLE. BIG s balance sheet reports assets of $500,000 and liabilities of $300,000 for a net book value of $200,000. After investigation, BIG determines that LITTLE s equipment is undervalued in the company s financial records by $60,000. One of its patents is also undervalued, but only by $40,000. By adding these valuation adjustments to LITTLE s book value, BIG arrives at an estimated $300,000 worth for the company s net assets. Based on this computation, BIG offers $90,000 for a 30 percent share of the investee s outstanding stock. 98

32 Excess of Investment Cost Over Book Value Acquired Book value of LITTLE (assets minus liabilities or stockholders equity 200,000 Undervaluation of equipment 60,000 Undervaluation of patent 40,000 Value of net assets 300,000 Portion being acquired 30% Purchase price 90,000 99

33 Excess of Investment Cost Over Book Value Acquired The purchase price is in excess of the proportionate share of LITTLE s book value. This additional amount can be attributed to two specific accounts: Equipment and Patents. No part of the extra payment is traceable to any other projected future benefit. 100

34 Excess of Investment Cost Over Book Value Acquired The cost of BIG s investment is allocated as follows: Payment by investor 90,000 % of book value acquired (30%) 60,000 Payment in excess of book value 30,000 Excess payment identified with specific assets: Equipment (60,000*30%) 18,000 Patent (40,000*30%) 12,000 Excess payment not identified with specific assets goodwill 30,

35 Excess of Investment Cost Over Book Value Acquired Assume that LITTLE s owners reject BIG s proposed $90,000 price. They believe that the value of the company as a going concern is higher than the fair value of its net assets. Because the management of BIG believes that valuable synergies will be created through this purchase, the bid price is raised to $125,000 and accepted. How will the price of acquisition be allocated? 102

36 Excess of Investment Cost Over Book Value Acquired The cost of BIG s investment is allocated as follows: Payment by investor % of book value acquired (30%) Payment in excess of book value Excess payment identified with specific assets: Equipment (60,000*30%) Patent (40,000*30%) Excess payment not identified with specific assets goodwill 103

37 Excess of Investment Cost Over Book Value Acquired The cost of BIG s investment is allocated as follows: Payment by investor 125,000 % of book value acquired (30%) 60,000 Payment in excess of book value 65,000 Excess payment identified with specific assets: Equipment (60,000*30%) 18,000 Patent (40,000*30%) 12,000 Excess payment not identified with specific assets goodwill 30,000 35,

38 Excess of Investment Cost Over Book Value Acquired Any extra payment that cannot be attributed to a specific asset or liability is assigned to the intangible asset goodwill. Under the equity method, the investor enters total cost in a single investment account regardless of the allocation of any excess purchase price. If all parties accept BIG s bid of $125,000, the acquisition is initially recorded at that amount despite the internal assignments made to equipment, patents, and goodwill. The entire $125,000 was paid to acquire this investment, and it is recorded as such. 105

39 Excess of Investment Cost Over Book Value Acquired In this case, goodwill is presumed to have an indefinite life. Goodwill associated with equity method investments, for the most part, is accounted for in the same manner as goodwill arising from a business combination. One difference is that goodwill arising from a business combination is subject to annual impairment reviews, whereas goodwill implicit in equity investments is not. Equity method investments are tested in their entirety for permanent declines in value. Because equity method goodwill is not separable from the related investment, goodwill should not be separately tested for impairment. 106

40 Excess of Investment Cost Over Book Value Acquired Tall Company purchases 20 % of Short Company for $200,000. Tall can exercise significant influence over the investee. The acquisition is made on January 1, 2013, when Short holds net assets with a book value of $700,000. Tall believes that the investee s building (10-year life) is undervalued within the financial records by $80,000 and equipment with a 5-year life is undervalued by $120,000. Any goodwill established by this purchase is considered to have an indefinite life. During 2013, Short reports a net income of $150,000 and pays a cash dividend at year s end of $60,

41 Excess of Investment Cost Over Book Value Acquired To record acquisition of 20% of outstanding shares of Short Company. To accrue 20% of the 2013 reported earnings of investee (150,000 * 20%) To record receipt of 2013 cash dividend (60,000*20%) 108

42 Excess of Investment Cost Over Book Value Acquired An allocation of Tall s $200,000 purchase price must be made to determine whether an additional adjusting entry is necessary to recognize annual amortization associated with the extra payment: Payment by investor % of book value acquired (...%) Payment in excess of book value Excess payment identified with specific assets: Building Equipment Excess payment not identified with specific assets goodwill 109

43 Excess of Investment Cost Over Book Value Acquired An allocation of Tall s $200,000 purchase price must be made to determine whether an additional adjusting entry is necessary to recognize annual amortization associated with the extra payment: Payment by investor 200,000 % of book value acquired (700,000 x 20%) 140,000 Payment in excess of book value 60,000 Excess payment identified with specific assets: Building (80,000*20%) 16,000 Equipment (120,000*20%) 24,000 Excess payment not identified with specific assets goodwill 40,000 20,

44 Excess of Investment Cost Over Book Value Acquired As can be seen, $16,000 of the purchase price is assigned to a building, $24,000 to equipment, with the remaining $20,000 attributed to goodwill. For each asset with a definite useful life, periodic amortization is required. Asset Attributed Cost Useful Life Annual Amortization Building 16, years 1,6000 Equipment 24,000 5 years 4,8000 Goodwill 20,000 Indefinite -0- Total for ,

45 Excess of Investment Cost Over Book Value Acquired At the end of 2013, Tall must also record the following adjustment in connection with these cost allocations: Although these entries are shown separately here for better explanation, Tall would probably net the income accrual for the year ($30,000) and the amortization ($6,400) to create a single entry increasing the investment and recognizing equity income of $23,600. Thus, the first-year return on Tall Company s beginning investment balance (defined as equity earnings/beginning investment balance) is equal to 11.80% ($23,600/$200,000). 112

46 Reporting Sale of Equity Investment If part of an investment is sold during the period: The equity method continues to be applied up to the date of the transaction. At the transaction date, the Investment account balance is reduced by the percentage of shares sold. If significant influence is lost, NO RETROACTIVE ADJUSTMENT is recorded, but the equity method is no longer applied. 113

47 Reporting Sale of Equity Investment Top Company owns 40% of the 100,000 outstanding shares of Bottom Company, an investment accounted for by the equity method. Although these 40,000 shares were acquired some years ago for $200,000, application of the equity method has increased the asset balance to $320,000 as of January 1, On July 1, 2013, Top elects to sell 10,000 of these shares (onefourth of its investment) for $110,000 in cash, thereby reducing ownership in Bottom from 40 percent to 30 percent. Bottom Company reports income of $70,000 during the first six months of 2013 and distributes cash dividends of $30,

48 Reporting Sale of Equity Investment Top, as the investor, initially makes the following journal entries on July 1, 2013, to accrue the proper income and establish the correct investment balance: These two entries increase the carrying value of Top s investment by $16,000, creating a balance of $336,000 as of July 1,

49 Reporting Sale of Equity Investment The sale of one-fourth of these shares can then be recorded as follows: After the sale is completed, Top continues to apply the equity method to this investment based on 30 % ownership rather than 40 percent. However, if the sale had been of sufficient magnitude to cause Top to lose its ability to exercise significant influence over Bottom, the equity method ceases to be applicable. 116

50 Reporting Investee Losses Same treatment of profits. The investor recognizes the appropriate percentage of each loss and reduces the carrying value of the investment account. Special situations: Permanent loss in value Investment reduced to zero 117

51 Reporting Investee Losses Permanent loss in value Can be caused by: loss of major customers, changes in economic conditions, loss of a significant patent or other legal right damage to the company s reputation others. When a permanent decline in an equity method investment s value occurs, the investor must recognize an impairment loss and reduce the asset to fair value. The loss must be permanent. 118

52 Reporting Investee Losses The Corporation reviews equity method investments for impairment whenever events or changes in circumstances indicate that an other than temporary decline in value has occurred. The amount of the impairment is based on quoted market prices, where available, or other valuation techniques. 119

53 Reporting Investee Losses Investment reduced to zero This condition is most likely to occur if the investee has suffered extreme losses or if the original purchase was made at a low bargain price. The carrying value of the investment account could conceivably be eliminated in total. When an investment account is reduced to zero, the investor should discontinue using the equity method rather than establish a negative balance. The investment retains a zero balance until subsequent investee profits eliminate all unrealized losses. No additional losses can accrue to the investor. 120

54 Reporting Investee Losses This Company explains the discontinued use of the equity method when the investment account has been reduced to zero: When the Company s share of cumulative losses equals its investment and the Company has no obligation or intention to fund such additional losses, the Company suspends applying the equity method.... The Company will not be able to record any equity in income with respect to an entity until its share of future profits is sufficient to recover any cumulative losses that have not previously been recorded. 121

55 Equity Method Reporting Effects Business decisions (including equity investments) involve the assessment of a wide range of consequences. Managers are very interested in how financial statements report the effects of their decisions. This attention to financial reporting effects arises because measurements of financial performance often affect the following: The firm s ability to raise capital. Managerial compensation. The ability to meet debt covenants and future interest rates. Managers reputations. Consequently, prior to making investment decisions, firms will study and assess the prospective effects of applying the equity method on the income reported in financial statements. 122

56 Criticisms of the Equity Method Emphasizing the percent of voting stock in determining significant influence versus control. Allowing off-balance sheet financing. Potentially biasing performance ratios. Even today, if Coca-Cola consolidates its equity method investments in which it owns more than 40 percent of the outstanding voting stock, Coke s total liabilities increase by almost 300 percent, substantially raising its debt-to-equity ratio from 1.24 to Media reports indicate that the debtrating agencies actually calculate Coke s ratios on a pro forma basis assuming consolidation. Accounting Horizons,