2-1

Baker / Lembke / King

Reporting
Intercorporate
Investments in
Common Stock
2
Electronic Presentation by
Douglas Cloud
Pepperdine University

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 2-2
Reporting Intercorporate Interest
• Some companies invest in other companies simply to earn a
favorable return by taking advantage of potentially
profitable situations.
• Reasons Companies Invest in Other Companies:
– Gain control over other companies
– Enter new market or product areas through companies established in those areas
– Ensure a supply of raw materials or other production inputs
– Ensure a customer for production output
– Gain economies associated with greater size
– Diversity
– Gain new technology
– Lessen competition
– Limit risk

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 2-3
Level of Common Stock Ownership

0% 20% 50% 100%

Influence not Significant Control

significant influence

Cost Equity Consolidation

Method Method

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 2-4
The Cost Method

Investor
Investor Company
Company purchases
purchases 2020 percent
percent ofof Investee
Investee
Company’s
Company’s common
common stock
stock for
for $100,000
$100,000 atat the
the beginning
beginning
of
of 20X1.
20X1. Influence
Influence isis determined
determined toto be
be not
not significant.
significant.

Investment in XYZ Company Stock 100,000

Cash 100,000
Record purchase of XYZ Company
stock.

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 2-5
The Cost Method

During
During the
the year,
year, XYZ
XYZ has
has net
net income
incomeof
of
$50,000
$50,000 and
and pays
pays dividends
dividends of
of $20,000.
$20,000.

Cash 4,000
Dividend Income 4,000
Record dividend income from XYZ
Company.
20% of $20,000

Note
Note that
that ABC
ABC records
records only
only its
its share
share of
of
the
the distributed
distributed earnings
earnings of
of XYZ.
XYZ.

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 2-6
Liquidating Dividends Illustrated
Amount of dividend distributed exceeding the
accumulated income
Investee Company

Year Net Income Dividends Cumulative

Undistributed Income
20X1 $ 100,000 $ 70,000 $30,000
20X2 $ 100,000 $120,000 $10,000
20X3 $ 100,000 $120,000 0
20X4 $ 100,000 $120,000 0
20X5 $ 100,000 $ 70,000 $30,000

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 2-7
Liquidating Dividends Illustrated

On
On January
January 2,
2, 20X1,
20X1, Investor
Investor Company
Company
purchases
purchases 10
10 percent
percent of
of Investee
Investee Company’s
Company’s
common
common stock.
stock. Investee
InvesteeCompany’s
Company’snet net income
income
isis $100,000
$100,000 and
and dividends
dividends paid
paid total
total $70,000.
$70,000.

Cash 7,000
Dividend Income 7,000
Record receipt of 20X1 dividend from
Investee Company.
10% of $70,000

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 2-8
Liquidating Dividends Illustrated

On
On January
January 2,
2, 20X2,
20X2, Investee
Investee Company’s
Company’s net net income
incomeisis
$100,000
$100,000 and
and dividends
dividends paid
paid total
total $120,000.
$120,000. Thus,
Thus,
Investee
Investee had
had cumulative
cumulative net
net income
income of of $200,000
$200,000 and
and
paid
paid cumulative
cumulative dividends
dividends of of $190,000.
$190,000.

Cash 12,000
Dividend Income 12,000
Record receipt of 20X1 dividend from
Investee Company.
10% of $120,000

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 2-9
Liquidating Dividends Illustrated

For
For 20X3,
20X3, Investee’s
Investee’s net
net income
income isis $100,000
$100,000 and
and
$120,000
$120,000 inin dividends
dividends are
are declared
declared and
and paid.
paid.
Cumulative
Cumulative net
net income
income isis now
now $300,000
$300,000 and
and
cumulative
cumulative dividends
dividends paid
paid total
total $310,000.
$310,000.

Cash 12,000
Investment in Investee Company Stock 1,000
Dividend Income 11,000
Record receipt of 20X3 dividend from
Investee Company.
10% of
($310,000
10% x $120,000
- $300,000)
($120,000 x 10%
- $10,000)

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 2-10
Equity Method
IsIsused
used for
forreporting
reportinginvestments,
investments,other
otherthan
than
temporary,
temporary,in incommon
commonstock...
stock...

 Corporate joint ventures.

 Companies in which the
investor’s voting stock interest
gives the investor the “ability to
exercise significant influence
over operating and financial
policies” of that company.

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 2-11
Equity Method

Significant
Significant Influence:
Influence: “An “An investment
investment
(direct
(direct or
or indirect)
indirect) of
of 20%
20% or or more
more of
of the
the
voting
voting stock
stock ofof an
an investee
investee should
should lead
lead to
to
the
the presumption
presumption that that in
in the
the absence
absence ofof
evidence
evidence to to the
the contrary
contrary an an investor
investor has
has the
the
ability
ability to
to exercise
exercise significant
significant influence
influence
over
over an
an investee.”
investee.”

McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
 2-12
APB 18--What is Significant Influence?

An
Aninvestor
investorowning
owningless
lessthan
than20
20percent
percent
can
canstill
stillhave
havesignificant
significantinfluence.
influence. APB
APB
18
18stated
statedaanumber
numberof offactors
factorsthat
thatcould
could
indicate
indicatesuch
suchinfluence.
influence.

1. Representation on board of directors.

2. Participation in policy-making.
3. Material intercompany transactions.
4. Interchange of managerial personnel.
5. Technological dependency.
6. Size of investment in relation to
concentration of other shareholdings.

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 2-13
Equity Method--Recognition of Income

ABC
ABCCompany
Company acquires
acquires significant
significant influence
influence over
over XYZ
XYZ
Company
Company byby purchasing
purchasing 20 20 percent
percent of
of the
the common
common
stock
stock of
of XYZ
XYZ atat the
the beginning
beginning ofof the
the year.
year.

XYZ
XYZ reports
reports net
net income
income of
of $60,000.
$60,000.

Investment in XYZ Common Stock 12,000

Income from Investee 12,000
Record income from investment
in XYZ Co.
20% x $60,000
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 2-14
Equity Method--Recognition of Dividends

XYZ
XYZ declares
declares and
and pays
pays aa $20,000
$20,000 dividend.
dividend.

Cash 4,000
Investment in XYZ Company Stock 4,000
Record receipt of dividend from XYZ.

20% x $20,000

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 2-15
Equity Method--Carrying Amount

Investment in XYZ Common Stock

Original cost 100,000
Equity accrual Dividends
($60,000 x .20) 12,000 ($20,000 x .20) 4,000
Ending balance 108,000

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 2-16
Equity Method--Interim Acquisitions

ABC
ABCCompany
Company acquires
acquires 20
20 percent
percent of
of XYZ’s
XYZ’s
common
common stock
stock on
on October
October 11 for
for $109,000.
$109,000. XYZXYZ earns
earns
income
income of
of $60,000
$60,000 and
and pays
pays dividends
dividends ofof $20,000.
$20,000.

Investment in XYZ Common Stock

Original cost 109,000
Equity accrual Dividends
($60,000 x 1/4 x .20) 3,000 ($20,000 x .20) 4,000
Ending balance 108,000

McGraw-Hill/ Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
 2-17
Equity Method--Cost Exceeds Book Value

Ajax
Ajax Corporation
Corporation purchases
purchases 40 40 percent
percent of
of the
the common
common
stock
stock of
of Barclay
Barclay Company
Company on on January
January 1,
1, 20X1,
20X1,for
for
$200,000.
$200,000. Barclay
Barclay has
has net
net assets
assets with
with aa book
book value
value
of
of $400,000
$400,000 and
and aa fair
fair value
value ofof $465,000.
$465,000.

Cost of investment to Ajax $200,000

Book value of Ajax’s share of Barclay’s
net assets (.40 x $400,000) (160,000)
Differential $ 40,000

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 2-18
Equity Method--Cost Exceeds Book Value
Cost of Investment
$200,000 Excess of cost over
fair value of net
identifiable assets
$14,000
Fair value of net
identifiable assets
Total differential
(40% x $465,000)
$40,000
$186,000 Excess of fair value
over book value of
net identifiable
Book value of net assets
identifiable assets $26,000
(40% x $400,000)
$160,000
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 2-19
Equity Method--Cost Exceeds Book Value
Barclay
Barclay reports
reports net
net income
income of
of $80,000
$80,000 in
in 20X1.
20X1.
Investment in Barclay Stock 32,000
Income from Investee 32,000
Record equity-method income.

Barclay
Barclay declares
declares and
and pays
pays aa dividend
dividend of
of $20,000
$20,000 in
in 20X1.
20X1.

Cash 8,000
Investment in Barclay Stock 8,000
Record dividend from Barclay.

40% x $20,000
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 2-20
Equity Method--Cost Exceeds Book Value

The
The$40,000
$40,000excess
excesspaid
paidby
byAjax
Ajaxisisassigned
assignedto
toLand,
Land,$6,000,
$6,000,
Equipment,
Equipment,$20,000,
$20,000,and
andGoodwill,
Goodwill,$14,000.
$14,000. Equipment
Equipmentisis
depreciated
depreciatedfor
for55years,
years,but
butland
landand
andgoodwill
goodwillare
arenot.
not.

Equipment ($20,000 ÷ 5 years) $4,000

Income from Investee 4,000

Investment in Barclay Stock 4,000
Amortize differential.

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 2-21
Equity Method--Disposal of Assets
IfIfBarclay
Barclayhad
hadpurchased
purchasedthe
theland
landin
in20X0
20X0forfor$75,000
$75,000and
and
sells
sellsthe
theland
landin
in20X2
20X2for
for$125,000.
$125,000. Barclay
Barclayrecognizes
recognizesaagain
gain
on
onthe
thesale
saleof
of$50,000,
$50,000,and
andAjax’s
Ajax’sshare
shareisis$20,000
$20,000(40%).
(40%).

Ajax’s share of Barclay's reported gain $20,000

Portion of Ajax’s differential related to land (6,000)
Gain to be recognized by Ajax $14,000

Income from Investee 6,000

Investment in Barclay Stock 6,000
Remove differential related to Barclay’s
land sold.

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 2-22
Equity Method--Purchase Additional Shares

ABC
ABC Company
Company purchases
purchases 20 20 percent
percent of
of XYZ’s
XYZ’s common
common
stock
stock on
on January
January 2,
2, 20X1,
20X1, and
and another
another 10
10 percent
percent on
on
July
July 1,
1, 20X1,
20X1, and
and the
the stock
stock purchases
purchases are
are at
at book
book value.
value.

Income, January 2 to June 30: $20,000 x .20 $ 4,000

Income, July 1 to December 31: $30,000 x .30 9,000
Income from Investment, 20X1 $13,000

Investment in XYZ Stock 13,000

Income from Investee 13,000

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 2-23
Equity Method--Purchase Additional Shares
XYZ
XYZ declares
declares and
and pays
pays aa $10,000
$10,000 dividend
dividend on
on
January
January 15
15 and
and again
again onon July
July 15.
15.

January 15 dividend: $10,000 x .20 $2,000

July 15 dividend: $10,000 x .30 3,000
Reduction in Investment, 20X1 $5,000
January 15, 20X1
Cash 2,000
Investment in XYZ Stock 2,000
July 15, 20X1
Cash 3,000
Investment in XYZ Stock 3,000

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 2-24
Equity Method--Change to Equity Method
Aron
Aron Corporation
Corporation purchases
purchases 1515 percent
percent of
of Zenon
Zenon
Company’s
Company’s common
common stock
stockon
on January
January 2,
2, 20X1
20X1 and
and
another
another 10
10 percent
percent on
on January
January 2,
2, 20X4.
20X4. Aron
Aron switches
switches
to
to the
the equity
equity method
method on
on January
January 2,
2,20X4.
20X4.
Zenon Investment Income Reported by
Aron Originally under Restated under
Year Net Income Dividends Cost Equity

20X1 $15,000 $10,000 $1,500 $2,250

20X2 18,000 10,000 1,500 2,700
20X3 22,000 10,000 1,500 3,300
$55,000 $30,000 $4,500 $8,250

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 2-25
Equity Method--Change to Equity Method

The
The investment
investment account
account and and retained
retained earnings
earnings of
of Aaron
Aaron
are
are restated
restated as
as ifif the
the equity
equity method
method had
had been
been applied
applied
from
fromthe
the date
date ofof the
the original
original acquisition.
acquisition.
Investment in Zenon Common Stock 3,750
Retained Earnings 3,750
Restate investment account from cost to
equity method.
$8,250 - $4,500

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 2-26
FASB Interpretation No. 35
Evidence that an investor is unable to exercise significant
influence over an investee:
1. Opposition by the investee.
2. The investor and investee sign an agreement in which the
investor surrenders significant rights as a shareholder.
3. Majority ownership of the investee is concentrated among
a small group of shareholders who operate the investee
without regard to the views of the investor.
4. The investor, desiring more information than is available
to the investee’s other shareholders, tries to obtain that
information, and fails.
5. The investor tries and fails to obtain representation on the
investee’s board of directors.
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 2-27
Chapter Three to Chapter Ten
• Three different approaches are followed by
companies (in practice) in accounting for their
consolidated subsidiary during the year:
– The fully adjusted equity method
(a.k.a., the equity method that was
discussed in this chapter)
– The basic equity method.
– The cost method.

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 2-28
Chapter Three to Chapter Ten
• In essence, the basic equity method is a modified
version of the equity method discussed in this
chapter.
• Specifically, the basic equity method avoids
“unrealized profit transactions” that will be
eliminated during the consolidation process.
• While the basic equity method is “Not GAAP,”
use of the basic equity method may help provide
some “clerical savings” for the parent company—
as well as students and teachers.
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 2-29
Unrealized Intercompany Profits
• Unrealized intercompany profits overstate earnings.
Thus the equity method entry to remove the
unrealized profit will be the opposite of the
“equity accrual” entry, that is, with respect to
the accounts debited or credited.
• The company sold inventory to investee for
$10,000. The original cost is $8,000.
To record equity method income of $9,000 (assumed).
Investment in Investee Company $9,000
Income from Investee Company $9,000

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 2-30
Unrealized Intercompany Profits
To remove unrealized intercompany profit of
$2,000 (e.g. inventory sold is still retained by
Investee)
Income from Investee Company $2,000
Investment in Investee Company $2,000
Suppose next year all the inventory is sold, then
the entry to realize the previously unrealized
intercompany profit of $2,000
Investment in Investee Company $2,000
Income from Investee Company $2,000

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 2-31
Chapter Two
Chapter Two

The
End
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