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Notes Ch 1 - The Equity Method - ACCT 456 CHAPTER 1 NOTES...

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ACCT 456: C HAPTER 1 N OTES T HE E QUITY M ETHOD OF A CCOUNTING FOR I NVESTMENTS Companies purchase equity of other companies for a variety of reasons, including, but not limited to: A. Investing excess cash B. Access to geographic markets C. Access to inputs There are three different methods for accounting and reporting investments in the equity of other companies: 1. Fair Value Method 2. Equity 3. Consolidated Financial Statements T HE F AIR V ALUE M ETHOD (SFAS 115) Investments are recorded at historical cost They are adjusted to fair value , where fair value is readily available (such as for shares of publicly traded companies) If the shares are intended to be held for the short-term, they are classified as trading securities and any unrealized gains or losses are reported in the income statement . If the shares are not trading securities they are classified as available for sale and any unrealized gains or losses are reported as other comprehensive income in the equity section of the balance sheet. Any dividends received are reported as income C ONSOLIDATION OF F INANCIAL S TATEMENTS Whenever one company owns or controls over 50 % of the voting stock of another company, it is considered to have a controlling interest. In this situation, a single set of financial statements is prepared for the combined or consolidated entity. T HE E QUITY M ETHOD ~ 1 of 9 ~
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When a company’s investment in another company is between 20 and 50 % of the outstanding voting stock, then the investing company is considered to have significant influence on decisions and operations. As such, the equity method must be used. Under the equity method, the investor records income (and increases the basis of the investment) when income is earned by the investee. When dividends are received, the basis of the investment is decreased When should the equity method be used? Technical answer: when the investor has the ability to exercise significant influence. The General Test of Ownership (20% to 50% of outstanding voting shares) provides consistency in applying the Equity Method. But “significant influence” trumps the ownership test. Keep in mind that if the investor “controls” the investee, then the equity method is not used, but rather the financial statements will be consolidated.
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