FINANCIAL ACCOUNTING WEEK 7 INVESTMENTS IN EQUITY SECURITIES

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1 FINANCIAL ACCOUNTING WEEK 7 INVESTMENTS IN EQUITY SECURITIES I. Learning Objectives A. Understand the criteria that must be met before a security can be listed in the current assets section of the balance sheet. B. Understand how to account for trading and availablefor-sale securities. C. Understand the effect upon the financial statements from the cost method and the equity method. Understand the conditions under which each method is used. D. Understand consolidated financial statements and be able to explain when they are prepared. Explain how they are different from financial statements prepared using the equity method. E. Understand how goodwill is created. II. Criteria to classify Equity Securities as current A. The securities must be readily marketable. This criterion implies that the security can be sold and converted into cash at will. B. Management intends to convert the investment to cash within the time period of current assets. 1. Management's incentives to "window dress" current assets through the classification of equity securities. 2. Auditors can examine the company's past practices and the nature and size of the investment to determine management's intentions. C. If either criterion is not met, the investment must be included in the long-term investment section. 1

2 III. Marketable A. Definition - The security can be sold and converted into cash on demand. B. If marketable, need to ask the two other questions to determine accounting treatment. (Note p. 333) C. If not marketable, security is probably held for longterm. Accounting treatment depends upon percentage owned. 0-20% Cost 20-50% Equity 50% + Consolidated IV. Intent to Liquidate A. If no intent, then account for securities as long-term investments. (Later) B. If intent exists, then include as current assets as: 1. Trading, or 2. Available for Sale. C. Trading 1. Definition - Securities bought and sold for the purpose of generating profits from short-term price changes. 2. These are accounted for using mark-to-market accounting. (See chart on website, Supplemental Materials, week 7.) a. Securities are carried on the balance sheet at current market values. b. Method is criticized because of the distinction between trading and available for sale securities and that management has some control over net income. 3. Mark-to-market accounting - Trading a. At purchase, recorded at cost. b. Dividend income recognized when dividends are 2

3 declared. c. End of period - (1) Unrealized holding gains/losses reflected on the Income Statement. (2) Current FMV of securities reflected on the Balance Sheet. d. Gain/Loss on Sale is computed based upon the current value on the balance sheet. D. Available for Sale 1. Definition - Securities which are not trading and not held to maturity. 2. These are accounted for using mark-to-market accounting. Securities are carried on the balance sheet at current market values. 3. Mark-to-market accounting - Available for Sale E. Homework a. At purchase, recorded at cost. b. Dividend income recognized when dividends are declared. c. End of period - (1) Current FMV of securities reflected on the Balance Sheet. (2) Unrealized holding gains/losses reflected in the Equity section of the Balance Sheet. d. Gain/Loss on Sale is computed based upon original cost. e. Also, see Medtronic, website, Supplemental Materials, week E E8-4. F. Reclassification 1. Trading to available-for-sale - recognize unrealized holding gains and losses since the end the most recently prepared Balance Sheet. 3

4 2. Available-for-sale to trading - recognize unrealized holding gains and losses that have occurred since the end of the preceding period and those that are shown in the stockholders' equity section of the most recently prepared Balance Sheet. V. Long-term equity investments A. The accounting treatment used for long-term investments depends upon the investor's potential to influence the investee company, in other words, the percentage owned. 1. If the investor has little potential to influence the investee company, which is defined as owning less than 20% of the investee's outstanding stock, then the marketability of the investee's stock determines the appropriate accounting treatment. a. If the investee's stock is marketable, then the mark-to market method is used. b. If the investee's stock is not marketable, then the cost method is used. 2. Cost method a. The investment is initially recorded at cost, which includes any incidental costs like brokerage fees. No revaluation occurs. b. Dividends declared by the investee are recognized as revenue when they are declared. c. The investment is carried on the books at cost until it is sold or until a permanent impairment in value. B. If the investor can exert significant influence over the investee company, which is defined as owning between 20% and 50% of the investee's outstanding stock, then the investment, regardless of whether the investee's stock is marketable or not, should be accounted for using the equity method. 1. At purchase, the investment is initially recorded at cost, which includes any incidental costs like brokerage fees. 2. When dividends are declared, this is considered a return OF investment. Effect is: + Cash - Long-Term Investment 4

5 3. At the end of the period a. Net Income of the investee increases the Long-Term Investment, and the investor's share of the investee's net income flows to the investor's Income Statement. b. Net Loss of the investee decreases the Long- Term Investment, and the investor's share of the investee's net loss flows to the investor's Income Statement. c. SuperValu, see website, Supplemental Materials, week 7. d. Ecolab, see website, Supplemental Materials, week Gain/Loss from Disposition 5. E C. If the investor controls the investee company, (defined as the investor owning greater than 50% of the investee's outstanding stock) then consolidated statements are prepared. 1. The purpose of consolidated financial statements is to report the combined accounts of the investor and investee companies. This should provide a better picture of the overall structure and performance of the combined entity. 2. Types a. Business acquisitions - the investor and investee combine for accounting purposes, but continue as separate legal entities. b. Business combinations or mergers - the investor and investee combine to form one legal entity. D. As of July 1, 2001, all business combinations should be accounted for using the purchase method. With the purchase method, the parent is assumed to be purchasing the subsidiary's assets and liabilities. 1. The assets and liabilities should be valued and recorded at their fair market values. 2. The difference between the purchase price and the net FMV of the subsidiary's assets and liabilities is recorded as goodwill. 5

6 3. As of July 1, 2001, goodwill should not be amortized. Goodwill should be reviewed for impairment when an event or series of events occur indicating that goodwill of a reporting unit might be impaired. 4. On the consolidated Balance Sheet, intercompany receivables and payables are eliminated. 5. On the consolidated Income Statement, intercompany revenues and expenses are eliminated. E. Homework a. E8-7 b. BE8-5. VI. Key Questions A. Is it marketable? B. What is its intended holding period? C. How much of the equity (%) do you own? D. Based upon the answers to these questions, different accounting treatment occurs. VII. Review Learning Objectives 6