Investments THE EQUITY METHOD Investments in Equity Securities Equity securities are normally common stock, preferred stock or the rights to acquire such stock. If an investor company holds equity securities in an investee company the accounting for the investment is determined by the amount of influence or control attributed to the investor company. For all practical purposes the level of influence or control is determined by the percentage of ownership unless there are other factors that might override such consideration. Holdings of Less Than 20% If an investor company holds less than 20% of the stock of an investee company it is considered to be a passive investor. The investment is for the purpose of earning capital gains from appreciation on the stock and/or dividends if the stock pays dividends. Depending on management’s intent the stock will be accounted for as either a trading security or and available-for-sale security. Holdings Between 20% and 50% If an investor company owns 20% to 50% of the stock in an investee company there is a good change that it can exercise significant influence over the financial and operating policies of the investee company. Factors that indicate significant may include one or more of the following: (1) Representation on the board of directors (2) Participation in policy-making decisions (3) There are material intercompany transactions (4) There is an interchange of management personnel (5) There is technical dependency between the two entities (6) The extent of ownership in relation to other voting blocks of ownership Professional judgment is required to determine if an investor company exercises significant control. If it does the investor company must use the equity method in accounting for this investment. Equity Method There is a substantial economic relationship between the investor and the investee. Therefore, the investor will reflect its proportionate share of the economic transactions that take place in the investee corporation at the end of each accounting period. Example: Spencer Company purchased a 40% interest in Fido Chow on January 1, 2000 for $600,000. During the year Fido Chow had the following transactions. • Net income for year-ended December 31, 2000 was $250,000 • Dividends of $50,000 were declared and paid on November 1, 2000 Spencer Company will record the original investment at cost. As the investor, Spencer Company will record 40% of the net income at the end of the year as an increase in the investment account and 40% of the dividends as a decrease in the investment account. The following is a T-account of the investment in Fido Chow. F:\Teaching\3321\web\module3\c12\tnotes\c12b.doc 9:22:12 AM 1Investments Date Description Debit Credit1/1/00 Investment in Fido Chow 600,00011/1/00 Dividends received (40% * $50,000) 20,00012/31/00 Proportionate share of net income (40% * $250,000) 100,000Balance at 12/31/00 680,000T-Account: Investment in Fido Chow The three journal entries that Spencer Company would record would be as follows: DATE ACCOUNT DEBIT CREDIT1/1/00 Investment-Fido Chow 600,000 Cash 600,000To record investment in Fido Chow11/1/00 Cash 20,000 Investment-Fido Chow 20,000To record the receipt of dividends from investment in Fido Chow12/31/00 Investment-Fido Chow 100,000 Investment income-Fido Chow 100,000To record proportionate share of new income fro investment in Fido Chow In most situations the investor company will pay more for the stock than book value. The difference reflects the difference between market value and book value of the plant, property, and equipment, identifiable intangible assets, and goodwill. To the extent that some or all of the excess of the purchase price is allocated to depreciable assets an additional charge for depreciation needs to be made on the investor company’s books at the end of each accounting period. It is highly unlikely that an investment would be made at the beginning of the year. If the investment is made during the year the allocated share of net income and dividends and the additional depreciation must be prorated to reflect the number of months that the investor company held the investment during the current year. Exercise: On September 1, 2002, Spencer Company, a calendar year corporation, purchased for $300,000 a 25% interest in Alexander Company. This investment enables Spencer Company to exert significant influence over Alexander Company. The book value of Alexander Company at the date of the purchase was $600,000. It is estimated that 60% of the excess of market value over book value should be allocated to property, plant and equipment. The remaining service life of the property, plant, and equipment is 10 years. Spencer Company will allocate depreciation using the straight-line method. During the calendar year of 2002, Alexander Company earned net income of $180,000 and paid dividends of $60,000. The dividends were declared and paid at the end of each quarter. In the format provided, prepare the journal entry to record the purchase of this equity investment. F:\Teaching\3321\web\module3\c12\tnotes\c12b.doc 9:22:12 AM 2Investments Date Account Debit Credit9/1/02 Investment-Alexander Company CashTo record the purchase of the investment in Alexander Company Solution: Date Account Debit Credit9/1/02 Investment-Alexander Company 300,000 Cash 300,000To record the purchase of the investment in Alexander Company In the format provided, prepare the journal entry to record the receipt of the September 30, 2002 dividend. Date Account Debit Credit9/30/02 Cash Investment-Alexander CompanyTo record the receipt of the third quarter dividend from the investment in Alexander Company Solution: Date Account Debit Credit9/30/02 Cash 15,000 Investment-Alexander Company 15,000To record the receipt of the third quarter dividend from the investment in Alexander Company In the format provided, prepare the journal entry to record the receipt of the December 31, 2002 dividend. Date Account Debit Credit12/31/02 Cash Investment-Alexander CompanyTo record the receipt of the fourth quarter dividend from the investment in Alexander Company Solution: F:\Teaching\3321\web\module3\c12\tnotes\c12b.doc 9:22:12 AM 3Investments Date Account Debit Credit9/30/02 Cash 15,000 Investment-Alexander Company 15,000To record the receipt of the fourth quarter dividend from the investment in Alexander Company In the format provided,