Chapter 8: Investment in Equity Securities

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Chapter 8Investment in Equity Securities

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Investment in Marketable Equity Securities -
Overview

• Equity investments represent ownership of another
  companys outstanding common stock.
• Marketable equity investments are actively traded
  on a public stock exchange.
• By owning shares of common stock, the investor
  owns a part of the company, represented by the
  percentage ownership.
• There are different accounting rules for
• (1) less than 20 percent ownership.
• (2) between 20 and 50 percent ownership.
• (3) greater than 50 percent ownership.

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(1) Less than 20 ownership.

• If marketable securities, use the mark-to market
  method.
• Carries securities on balance sheet at market
  value.
• Revaluation at the end of each period based on
  new market price
• Unrealized gains (or losses) are recognized as
  the investment is valued up (or down).
• Treatment of the Unrealized G/L depends on
  classification of security
• (a) Trading securities.
• (b) Available-for-sale securities.

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(a) Trading Securities

• Trading securities held for the short term, with
  purpose of selling securities for profit.
• At purchase - record at cost to acquire.
• Activity during the year - record declaration of
  cash dividends, and recognize Dividend Income
  on the Income Statement
• Dividends Receivable xx
• Dividend Income xx

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(a) Trading Securities

• For securities on hand at the end of the
  accounting period - revalue to market value and
  record Unrealized Gain/Loss on Income
  Statement.
• When sold - recognize Gain/Loss on Sale on
  Income Statement for any balance since the last
  revaluation.

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(b) Available-for-sale Securities

• Available-for-sale (AFS) securities may be held
  for the short term or for long term, depending on
  managements intentions.
• At purchase - record at cost to acquire.
• Activity during the year - record declaration of
  cash dividends, and recognize Dividend Income
  on the Income Statement
• Dividends Receivable xx
• Dividend Income xx

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(b) Available-for-sale Securities

• For securities on hand at the end of the
  accounting period - revalue to market value and
  record Unrealized Gain/Loss on Balance Sheet
  (as part of Other Comprehensive Income in
  Stockholders Equity).
• When sold - recognize Gain/Loss on Sale on
  Income Statement for total difference between
  original cost and selling price.

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(2) From 20 to 50 Investment

• Because investment represents significant
  influence of investor, we cannot account for
  investments the same way as Trading or AFS.
• Specifically, we cannot recognize Dividend
  Income as dividends are declared, because the
  investor could dictate income to be recognized
  from the investee (investor could have investee
  declare a dividend to investor).

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(2) From 20 to 50 Investment

• The equity method increases the investment
  account and recognizes investors portion of
  income as investee earns it (reports income to
  investor).
• The equity method decreases the investment
  account as investee declares dividends to the
  investor.
• The equity method reflects the investors portion
  of goodwill purchased.

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Equity Method Journal Entries

• On investors books
• 1. When investment purchased
• L.T. Investment xx
• Cash, etc. xx
• 2. When dividends declared to investor
• Dividends Receivable xx
• L.T. Investment xx
• 3. When income reported by investee to investor
  (from investees I/S)
• L.T. Investment xx
• Income from Investment xx

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Equity Method and Goodwill

• Note the Investment account contains any
  implied goodwill in the purchase. Goodwill is
  not explicitly reported until the ownership is
  sufficient to consolidate the investment (more
  discussion in the appendix).

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Illustration - Equity Method

• Company P purchases 30 of the outstanding common
  stock of Company S on January 2, 2005 for
  400,000 cash. At the time of acquisition,
  Company S had total net assets of 1,000,000 fair
  value (and book value). Note that net assets
  assets - liabilities equity.
• During 2005, Company S reported net income of
  300,000 to its shareholders, and declared
  100,000 dividends to its shareholders.

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Illustration - Equity Method

• Required
• 1. Prepare all journal entries necessary (on
  Company Ps books) to record this investment
  using the equity method of accounting.
• 2. Calculate (a) the value that would be reported
  in Company Ps 12/31/05 balance sheet for its
  L.T. Investment in Company S, and (b) the Income
  from Company S reported on Ps income statement
  for 2005.

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Requirement 1.Journal Entries on Ps Books

• 1. Acquisition
• Note the 400,000 investment includes 100,000
  goodwill, calculated as
• Cash paid 400,000
• - Fair market value acquired
• 1,000,000 x 30 -300,000
• Difference goodwill 100,000

L.T. Investment 400,000 Cash 400,000
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Requirement 1.Journal Entries on Ps Books

• 2. Dividends declared (100,000 x 30)
• 3. Income reported (300,000 x 30)

Div. Receivable 30,000 L.T. Investment
30,000
L. T. Investment 90,000 Income from S
90,000
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Requirement 2 - Calculate balances

• The L.T. Investment account
• 400,000 (DR) Invest.
• - 30,000 (CR) Dividends from S
• 90,000 (DR) Income from S
• 460,000 (DR) balance at 12/31/05
• The Income from S account
• 90,000 (CR) Income from S for 2005

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Cautions Regarding Equity Method

• This method will give rise to a difference
  between reported net income (loss) and cash flow
  from operations.
• It ignores market price.
• 20-50 percent is not always a valid indication of
  significant influence.
• It generates off-balance sheet financing - one
  line on the balance sheet may actually represent
  a percentage ownership in a number of assets and
  liabilities (more in appendix).
• Issues are more complex than illustrated in this
  chapter.

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(3)Greater than 50 Investment

• If an investor has majority control, the
  investment is recorded using the equity method,
  and a parent/subsidiary relationship is
  established.
• At the end of the period, the financials of the
  parent and subsidiary must be combined, or
  consolidated, for external financial reporting.
• Goodwill is recognized as a separate asset in the
  consolidation.

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Accounting for Equity Securities
Marketable?
Yes
Intend to liquidate within time period of current
assets?
Proportion of voting shares
Accounting Treatment
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Accounting for Equity Securities
Marketable?
No
Intend to liquidate within time period of current
assets?
Proportion of voting shares
Accounting Treatment