ADVANCED FINANCIAL ACCOUNTING

Video No.1
Exploring the nuances of the cost and equity methods of accounting for investments in other
companies. Here's a detailed summary:

Cost (or Fair Value) Method

 Applicability: This method is used when a company owns less than 20% of another company's stock.
 Features: Also known as the fair value or market value method, it allows for the recording of
investments as securities, emphasizing the ease of selling these securities in the open market.
 Accounting Entries:
 Dividends received from the investment are recognized as dividend revenue.
 Unrealized gains or losses (due to changes in the market value of the securities) are also
recognized.

Equity Method

 Applicability: Utilized when a company owns more than 20% but less than 50% of another company's
stock, indicating a significant influence over the investee.
 Features: Reflects the ability to influence the investee’s operating and financial policies.
 Accounting Entries:
 The investor recognizes their share of the investee's net income or loss, which reflects the
investor's participation in the investee's performance.

Examples and Accounting Entries

 Investment Acquisition:
 For a 15% ownership (cost method), securities are debited, and cash is credited for the
purchase.
 For a 25% ownership (equity method), the investment is recorded as "Investment in Shoeshine
Inc," reflecting potential participation in gains or losses.
 Price Fluctuations:
 If the stock's price decreases, the cost method records an unrealized loss. Conversely, if the
price increases, an unrealized gain is recorded.
 The equity method does not record journal entries for stock price fluctuations.
 Net Income from Investee:
 Under the equity method, an investor recognizes their share of the investee's net income or
loss. For instance, with a 25% stake and an investee net income of $550, the investor records
$137.5 as income from the investment.
 Dividends:
 Dividend payments received are recorded as dividend revenue in the cost method.
 Under the equity method, dividends might adjust the carrying amount of the investment but
are not directly recognized as income.

Key Takeaways
  The cost method focuses on the acquisition cost and market value changes of the investment, suitable
for minor stakes without significant influence.
 The equity method accounts for the investor's proportionate share of the investee's performance,
reflecting a strategic investment with significant influence.
 Accounting for dividends and price fluctuations varies significantly between the two methods, with
the equity method emphasizing the investor's share in the operational outcomes of the investee.

point out all the examples provided to illustrate the differences between the cost and equity
methods:

Examples Illustrating the Cost (or Fair Value) Method

1. Investment Acquisition Example:

 Scenario: A company purchases 250 shares of Shoeshine Inc. at $37 per share, totaling a 15%
ownership stake.
 Accounting Entry: The purchase is recorded by debiting securities and crediting cash, reflecting
the outflow of cash for the investment.
2. Price Decrease Example:
 Scenario: The share price of Shoeshine Inc. drops from $37 to $34, a decrease of $3 per share
for the 250 shares owned.
 Accounting Entry: An unrealized loss of $750 (250 shares * $3 decrease) is recorded, indicating
a decline in the investment's market value.
3. Price Increase Example:
 Scenario: The share price of Shoeshine Inc. increases from $37 to $39, an increase of $2 per
share for the 250 shares owned.
 Accounting Entry: An unrealized gain of $500 (250 shares * $2 increase) is recorded, reflecting
the increase in the investment's market value.

Examples Illustrating the Equity Method

1. Investment Acquisition Example (Continuation from Cost Method):

 Scenario: A company purchases another 250 shares of a company (presumably Shoeshine Inc.)
at $37 per share, totaling a 25% ownership stake.
 Accounting Entry: The purchase is recorded as an "Investment in Shoeshine Inc.," reflecting the
expectation of participating in its income or losses.
2. Net Income Sharing Example:
 Scenario: Shoeshine Inc. reports a net income of $550.
 Investor's Share: Owning 25% of Shoeshine Inc., the investing company records $137.5 (25% of
$550) as income from the investment.
3. Dividend Distribution Example:
 Scenario: Shoeshine Inc. issues a dividend of $400.
 Implication for Equity Method: The dividend might reduce the carrying amount of the
investment but is not recognized as income. The example doesn't explicitly state the accounting
entry for the equity method but emphasizes the impact of dividends on investors.

Video.2
This presentation delves into the intricacies of accounting for the acquisition of another company's stock, with
a spotlight on handling the surplus over book value. It particularly emphasizes the allocation of this excess
when employing the equity method in scenarios where the purchase price surpasses the book value of the
acquired investment's assets minus liabilities, or total equity, at the acquisition time.

Allocating Excess Over Book Value

 Initial Steps: The difference between the purchase price and the book value must first be allocated to
assets and liabilities that are under or overvalued. This is essential because the fair value of some
assets and liabilities may diverge from their book values.
 Rationale: Investors might be willing to pay a premium over book value in anticipation of deriving
future benefits from the investment.
 Assignment to Specific Assets and Liabilities: The excess amount is first assigned to specific assets or
liabilities that are undervalued or overvalued. The unallocated remainder of this excess is then
designated as goodwill, an intangible asset that is subject to impairment testing, rather than
amortization.

Accounting for Goodwill and Asset Valuation

 Treatment of Goodwill: Goodwill arises when the purchase price exceeds the fair value of the net
identifiable assets and is carried at cost less any accumulated impairment losses. It does not undergo
amortization but is tested annually for impairment.
 Depreciation and Amortization: Tangible assets (PPE) are depreciated, while intangible assets are
amortized over their useful lives, except when an asset's life is deemed indefinite, in which case it is
not amortized.

Example Scenario

 Acquisition Details: Big Company intends to acquire a 30% stake in Little Company. Little's balance
sheet shows assets of $500,000 and liabilities of $300,000. Further analysis reveals undervalued
equipment and patents by $60,000 and $40,000, respectively.
 Investment Consideration: Big offers $120,000 for the stake, leading to the allocation of excess
purchase price to the undervalued assets and subsequently calculating goodwill.

Equity Method vs. Fair Value Option

 Equity Method Application: Involves recognizing income proportional to the investee's net income,
adjusted for depreciation or amortization of the excess allocated to specific assets, and then adjusting
the investment account accordingly.
 Fair Value Option: Instead of the equity method, electing the fair value option involves adjusting the
investment to its fair market value at each reporting date, independent of underlying asset
amortization or depreciation.

Financial Implications

 Equity Income Reporting: Under the equity method, Big Company reports its share of Little's net
income, adjusted for its share of amortization or depreciation, as investment income.
 Investment Account Adjustments: The investment account is adjusted for recorded equity income and
dividends received, reflecting the investment's carrying amount at the end of each year.
  Fair Value Adjustments: If the fair value option is elected, the investment account is adjusted to reflect
fair market value changes, with dividends received not affecting the investment's carrying amount.

Conclusion

This presentation outlines the procedures and considerations for accounting for investments in another
company's stock, highlighting the allocation of purchase price excess and the selection between the equity
method and the fair value option for investment accounting.

Example: Acquisition of Little Company by Big Company

 Background Information:
 Entities Involved: Big Company is negotiating to acquire a stake in Little Company.
 Financials of Little Company: Little Company's balance sheet shows assets valued at $500,000
and liabilities amounting to $300,000.
 Valuation Adjustments:
 Equipment Valuation: After an investigation, Big Company determines that Little Company's
equipment, with a remaining life of 5 years, is undervalued by $60,000.
 Patent Valuation: Additionally, one of Little Company's patents, with a ten-year remaining life,
is found to be undervalued by $40,000.
 Acquisition Offer:
 On January 1st, 2017, Big Company offers $120,000 for a 30% share of Little Company's
outstanding stock.
 Financial Performance of Little Company:
 For the Year 2017: Little Company reports a net income of $100,000 and pays dividends of
$12,000.
 For the Year 2018: Little Company reports a net income of $120,000 and pays dividends of
$15,000.
 Accounting Methods and Calculations:
 Equity Method Initial Calculations:
 Determination of net book value based on Little Company's assets and liabilities.
 Calculation of goodwill and the assignment of excess purchase price to undervalued
assets (equipment and patents).
 Equity Income Reporting and Investment Account Adjustments:
 Calculation of equity income Big Company would report for 2017 and 2018, taking into
account its share of Little's net income adjusted for amortization/depreciation of the
revalued assets.
 Adjustment of Big Company's investment account based on the equity income reported
and dividends received.
 Fair Value Option:
 Financial Impact:
 Consideration of the fair value option where Big Company elects to adjust the
investment to its fair market value at the end of 2017 and 2018.
 Calculation of investment income and the new balance in the investment account under
the fair value option.