Describe the accounting for minority, active investments

MINORITY, ACTIVE INVESTMENTS

When an investor owns less than a majority of the voting stock of another corporation, the accountant must judge when the investor can exert significant influence. For the sake of uniformity, U.S. GAAP and IFRS presume that significant influence exists at 20% ownership (that is, when the investor owns 20% or more of the voting stock of the investee). Significant influence can exist at lower ownership levels, provided management has a contractual or other basis to demonstrate that influence.

U.S. GAAP and IFRS require firms to account for minority, active investments, generally those where the investor owns between 20% and 50%, using the equity method. Under the equity method, the investor recognizes as revenue (expense) each period its share of the net income (loss) of the investee. The investor recognizes dividends received from the investee as a return (reduction) of investment, not as income.

EQUITY METHOD: RATIONALE

In order to describe and illustrate the accounting for minority, active investments in common shares and majority, active investments in common shares, we designate the acquiring corporation (the investor) as P, for purchaser or for parent, depending on the context, and the acquired corporation (the investee) as S, for seller or for subsidiary.

P measures its investments in available-for-sale marketable securities at fair value on the balance sheet and recognizes income only when it receives a dividend (revenue) or sells some of the securities at a gain or loss. (P recognizes unrealized changes in the fair value of available-for-sale securities in other comprehensive income, not in earnings.) Suppose, as often happens, that S follows a policy of financing its own operations using assets generated through the retention of earnings, consistently declaring dividends less than its net income or no dividends at all. The fair value of S's shares will probably increase to reflect this retention of assets, but P reports income only from the dividends it receives—the increase in the fair value of S's common stock will not appear in earnings until P realizes the fair value increase. Because P, by assumption, exerts significant influence over S, it can affect S's dividend policy, which in turn affects P's net income. For example, if P would like to increase its income for a particular period, it can pressure S to raise S's dividend for the period or pay a special dividend. When P can so easily manage its own net income (via influencing the dividend policy of S), measuring its investment in S at fair value and reporting unrealized gains and losses in other comprehensive income will not reasonably reflect P's net income from investing in S. The rationale for the equity method is that it better measures an investor's income from investing activities when, because of its ownership interest, it can exert significant influence over the operations and dividend policy of the investee.

EQUITY METHOD: PROCEDURES

The equity method records the initial purchase of an investment at acquisition cost, just as for minority, passive investments. Each period, P treats as revenue its share of the periodic earnings, not the dividends, of S. P treats dividends declared by S as a reduction of P's Investment in Stock of S account. If the earnings of the investee include profit or loss from transactions between the investor and investee, the investor eliminates these amounts from earnings before accruing its share of the investee's earnings.

The Equity in Earnings of Affiliate account is a revenue account. Firms that apply IFRS more commonly use an alternative title, Equity in Earnings of Associate (or Associated Companies).

P records income earned by S as an increase in investment, while the dividend returns part
of the investment and decreases the Investment in Stock of S account.

Excess Purchase Price on Acquisition of Equity Method Investment

P's investment in S represents a proportionate share of the shareholders' equity of S. P may pay more than the carrying value for this investment. That is, P's payment for S may exceed its proportionate interest in the balance sheet carrying value of the net assets (assets minus liabilities), or shareholders' equity, of S at the date of acquisition.

P may pay a premium because the fair values of S's net assets differ from their carrying values, or because of unrecorded assets (for example, trade secrets). The investor's accounting for the excess purchase price embedded in the Investment in Stock of S account is similar to the treatment of an excess purchase price in a business combination. The investor identifies any recorded assets and liabilities with fair values that differ from their carrying values, as well as any unrecorded assets and liabilities. The investor attributes the excess purchase price to these assets and liabilities, based on the investor's proportionate ownership interest, and any remaining excess purchase price to goodwill.

P does not reclassify this excess out of its Investment in Stock of S account to Buildings and Equipment and to Goodwill. However, P must amortize (or depreciate) any amount attributed to assets with limited lives. Thus, P must depreciate the premium attributed to buildings and equipment over their remaining useful lives. U.S. GAAP and IFRS do not permit the investor to amortize the excess purchase price attributed to goodwill and other assets with indefinite lives. Instead, the investor must test the investment account annually for possible impairment. Impairment occurs when the balance sheet carrying value exceeds the fair value of the investment. The investor applies the impairment test to its investment in the investee, not to the investee's individual assets and liabilities.

Recognizing the Investor's Share of the Investee's Other Comprehensive Income

In addition to recognizing the investor's share of the investee's net income, the investor also recognizes its share of the investee's other comprehensive income. The investor can combine its share of the elements of other comprehensive income of the investee with similar items arising from its own operations.

Fair Value Option for Equity Method Investments

Firms can elect to report certain qualifying financial assets and financial liabilities at fair value each period and recognize unrealized holding gains and losses in net income. Firms may apply the fair value option to certain equity method investments.

Summary of Accounting for Investments Under the Equity Method

On the balance sheet, an investment accounted for with the equity method appears among noncurrent assets. The amount shown generally equals the acquisition cost of the shares, plus P's share of S's undistributed earnings (or losses) since the date P acquired the shares, plus or minus amortization of any excess cost at the date of acquisition attributable to assets with limited lives. On the income statement, P reports each period its share of S's income (or loss) as revenue (or expense), as well as any amortization of excess cost. P also recognizes its share of the investee's other comprehensive income. The accounting method that the investor, P, uses does not affect the separate financial statements of the investee.