Chapter 2

Reporting Intercorporate
Investments and
Consolidation of Wholly
Owned Subsidiaries with No
Differential

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objective 2-1

Understand and explain how

ownership and control can
influence the accounting
for investments in common
stock.

2-2
 Accounting for Investments in Common Stock

The method used to account for investments in

common stock depends on:
 the level of influence or control that the investor
is able to exercise over the investee.
 choices made by the investor because of options
available.

2-3
Financial Reporting Basis by Ownership Level
Default
assumption

2-4
 Investment vs. Ownership
 Consolidation eliminates the investment account and
replaces it with “the detail.”
Account for as
trading, AFS, or
Cost Investments
Usually equity method
and consolidation
Ownership Percentage (but cost method is
Equity method also okay here)
or Fair Value
Option
No
significant Control
Significant
influence
influence

0% 20% 50% 100%

2-5
 Investment vs. Ownership
 Consolidation eliminates the investment account and
replaces it with “the detail.”
Account for as
trading, AFS, or
Cost Investments
Usually equity method
and consolidation
Ownership Percentage (but cost method is
Equity method also okay here)
or Fair Value
Option
No
significant Control
Significant
influence
influence
Why is the cost
0% 20% 50% method okay? 100%

2-6
 Investment vs. Ownership
 Consolidation eliminates the investment account and
replaces it with “the detail.”
Account for as
trading, AFS, or
Cost Investments
Usually equity method
and consolidation
Ownership Percentage (but cost method is
Equity method also okay here)
or Fair Value The investment
account is eliminated
Option in the consolidated
No financial statements
significant Control
Significant
influence
influence
Why is the cost
0% 20% 50% method okay? 100%

2-7
 Accounting for Investments in Common Stock
 The Cost Method
 Used for reporting investments in equity securities
when both consolidation and equity-method reporting
are inappropriate
 The Equity Method
 Used when the investor exercises significant influence
over the operating and financial policies of the investee
and consolidation is not appropriate
 May not be used in place of consolidation if
consolidation is appropriate
 Its primary use is in reporting nonsubsidiary
investments
2-8
 Accounting for Investments in Common Stock

 Consolidation
 Involves combining for financial reporting the individual
assets, liabilities, revenues, and expenses of two or more
related companies as if they were part of a single company
 Normally is appropriate when one company, referred to as
the parent, controls another company, referred to as a
subsidiary
 A subsidiary that is not consolidated with the parent is
referred to as an unconsolidated subsidiary and is shown
as an investment on the parent’s balance sheet.

2-9
Practice Quiz Question #1

If Company A purchases 45% of the

outstanding common stock of Company B,
the investment in Company B should be
accounted for
a. as an available-for-sale investment.
b. as a consolidated subsidiary.
c. as a trading investment.
d. as an equity method investment.
e. none of the above.

2-10
Practice Quiz Question #1 Solution

If Company A purchases 45% of the

outstanding common stock of Company B,
the investment in Company B should be
accounted for
a. as an available-for-sale investment.
b. as a consolidated subsidiary.
c. as a trading investment.
d. as an equity method investment.
e. none of the above.

2-11
Learning Objective 2-2

Prepare journal entries

using the cost method for
accounting for investments

2-12
 The Cost Method: How It Works

 Record the investment at “cost.”

 General Rule:
 Leave it on the books at cost.

S
2-13
 The Cost Method: How It Works
 Review
 Assume P Corp creates a subsidiary, S Corp, and invests $100,000 cash
in exchange for all of the $1 par common stock (1,000 shares).
 What journal entries would P and S make at the time of the
investment?

P Corp:
P Investment in S Corp 100,000
Cash 100,000
S Corp:
S Cash 100,000
Common Stock 1,000
Additional PIC—CS 99,000

2-14
 The Cost Method: How It Works

 General Rule
 The investment remains on parent’s books at cost
 Record income at the parent level ONLY when

sub declares a dividend.

 Generally, the sub’s income does not affect
parent’s investment account balance.
 However, the parent cannot ignore the sub’s

losses.
 Parent writes-down investment ONLY IF value

has been impaired.

 Write-downs result in a NEW cost basis.

2-15
 The Cost Method: Pros & Cons

 Pros
 Minimal G/L bookkeeping by parent
 Simple consolidation procedures
 Cons
 Overly conservative valuation
 Parent can manipulate its reported income.
 Why?
 Parent controls when sub pays dividends!
 PCO statements—if used internally or issued—
may be misleading.

2-16
 Example: The Cost Method
ABC Company acquires 20 percent of XYZ Company’s
common stock for $100,000 at the beginning of the year but
does not gain significant influence over XYZ. During the year,
XYZ has net income of $60,000 and pays dividends of
$20,000. ABC Company records the following entries:

Investment in XYZ Company Stock 100,000

Cash 100,000
Record purchase of XYZ Company stock.

Cash 4,000
Dividend Income 4,000
Record dividend income from XYZ Company stock: $20,000 x 0.20.

2-17
 The Cost Method

 Changes in the number of shares held

 Changes resulting from stock dividends, stock splits, or
reverse splits receive no formal recognition in the
accounts of the investor
 Purchases of additional shares
 Recorded at cost similar to initial purchase
 New percentage ownership is calculated to determine
whether switch to the equity method is required
 Sales of shares
 Accounted for in the same manner as the sale of any other
noncurrent asset

2-18
Practice Quiz Question #2

Under the cost method, a sub’s dividends

would:
a. NOT be eliminated in consolidation.
b. be the parent’s income from investment.
c. decrease the parent’s investment account.
d. increase the parent’s investment account.
e. none of the above.

2-19
Practice Quiz Question #2 Solution

Under the cost method, a sub’s dividends

would:
a. NOT be eliminated in consolidation.
b. be the parent’s income from investment.
c. decrease the parent’s investment account.
d. increase the parent’s investment account.
e. none of the above.

2-20
Learning Objective 2-3

Prepare journal entries

using the equity method
for accounting for
investments.

2-21
 The Equity Method: How It Works

 The equity method is accrual basis driven:

 Record income at the parent level based on sub’s earnings
and losses—a built in valuation technique.
 It isn’t the same as fair value accounting.
 Nevertheless, the investment generally goes up and down based
on the operations of the investee company.
 Sub’s dividends reduce the parent’s investment (the
parent has less invested).
Investment in Sub Income from Sub
Cost
Income Losses Losses Income
Dividends
Adj. Bal. 2-22
 The Equity Method: How It Works

The equity method is a two-way street!

The investment can be:
1. written up based on the sub’s income AND
2. written down based on sub losses and dividends

2-23
 The Equity Method: Pros and Cons

 Pros
 Based on economic activity—not the parent-
controlled dividend policy.
 Has two built-in checking figures:
 Consolidated NI = Parent’s NI
 Consolidated RE = Parent’s RE
 Cons
 Requires continual bookkeeping.
 Unnecessary work if PCO statements are not
used internally or issued to outsiders.

2-24
 The Equity Method

 The equity method is intended to reflect the

investor’s changing equity or interest in the
investee.
 The investment is recorded at the initial
purchase price and adjusted each period for
the investor’s share of the investee’s profits or
losses and the dividends declared by the
investee.

2-25
 The Equity Method

 the equity method is used for:

1. Companies in which the investor’s voting stock interest
gives the investor the “ability to exercise significant
influence over operating and financial policies” of that
company
 “Significant influence” criterion – 20 percent rule
 In the absence of evidence to the contrary, an investor
holding 20 percent or more of an investee’s voting stock
is presumed to have the ability to exercise significant
influence over the investee.

2-26
 The Equity Method

 Investor’s equity in the investee

 The investor records its investment at the
original cost
 This amount is adjusted periodically:

Reported by Investee Effect on Investor’s Accounts

Net income Record income from investment
Increase investment account
Net loss Record loss from investment
Decrease investment account
Dividend declaration Record asset (cash or receivable)
Decrease investment account

2-27
 Example: The Equity Method
ABC Company acquires significant influence over XYZ
Company by purchasing 20 percent of the common stock of
the XYZ Company for $100,000, XYZ earns income of $60,000
and pays dividends of $20,000.

 Recognition of income
 This entry (equity accrual) is normally made as an adjusting
entry at the end of the period
 If the investee reports a loss, the investor recognizes its share
of the loss and reduces the carrying amount of the
investment by that amount

Investment in XYZ Company Stock 12,000

Income from XYZ Company 12,000
Record income from investment in XYZ Company ($60,000 x 0.20).

2-28
 Example: The Equity Method

 Recognition of dividends
Cash 4,000
Investment in XYZ Company Stock 4,000
Record receipt of dividend from XYZ Company ($20,000 x 0.20).

 Carrying amount of the investment

Investment in XYZ Common Stock

Original Cost 100,000
Equity Accrual Dividends
(60,000 x 0.20) 12,000 ($20,000 x 0.20) 4,000

Ending Balance 108,000

2-29
 The Equity Method

 Acquisition at Interim Date

 No income earned by the investee before the
date of acquisition may be accrued by the
investor
 Acquisition between balance sheet dates
 The amount of income earned by the investee from
the date of acquisition to the end of the fiscal period
may need to be estimated by the investor in
recording the equity accrual

2-30
 The Equity Method

 Purchases of additional shares

 If the equity method was being used to account
for shares already held, the acquisition involves
adding the cost of the new shares to the
investment account and applying the equity
method from the date of acquisition forward.
 New and old investments in the same stock are
combined for financial reporting purposes.

2-31
 The Equity Method

 Sale of shares
 Treated the same as the sale of any noncurrent asset
 First, the investment account is adjusted to the date
of sale for the investor’s share of the investee’s
current earnings
 Then, a gain or loss is recognized for the difference
between the proceeds received and the carrying
amount of the shares sold
 If only part of the investment is sold, the investor
must decide whether to continue using the equity
method or to change to the cost method

2-32
Practice Quiz Question #3

Under the equity method, a sub’s

dividends would:
a. NOT be eliminated in consolidation.
b. be the parent’s income from investment.
c. decrease the parent’s investment account.
d. increase the parent’s investment account.
e. none of the above.

2-33
Practice Quiz Question #3 Solution

Under the equity method, a sub’s

dividends would:
a. NOT be eliminated in consolidation.
b. be the parent’s income from investment.
c. decrease the parent’s investment account.
d. increase the parent’s investment account.
e. none of the above.

2-34
Practice Quiz Question #4

Under the equity method, a sub’s losses

would:
a. never reduce the parent’s income.
b. normally reduce the parent’s income.
c. always reduce the parent’s income.
d. always be eliminated in consolidation.
e. none of the above.

2-35
Practice Quiz Question #4 Solution

Under the equity method, a sub’s losses

would:
a. never reduce the parent’s income.
b. normally reduce the parent’s income.
c. always reduce the parent’s income.
d. always be eliminated in consolidation.
e. none of the above.

2-36
Learning Objective 2-4

Understand and explain

differences between the
cost and equity methods.

2-37
 The Cost and Equity Methods Compared
Item Cost Method Equity Method
Recorded amount of Original cost Original Cost
investment at date of
acquisition
Usual carrying amount of Original cost Original cost increased
investment subsequent to (decreased) by investor’s share
acquisition of investee’s income (loss) and
decreased by investor’s share of
investee’s dividends
Income recognition by Investor’s share of Investor’s share of investee’s
investor investee’s dividends earnings since acquisition,
declared from earnings whether distributed or not
since acquisition
Investee dividends from Income Reduction of investment
earnings since acquisition by
investor
Investee dividends in excess Reduction of investment Reduction of investment
of earnings since acquisition
by investor

2-38
 Example: Equity Method versus Cost Method
Pea Corporation created Soup Corporation with a transfer of $500 cash.
During Soup Corp.’s first year of operations, it generated a net loss of $100
and paid no dividends. During Soup Corp.’s second year of operations, it
generated net income of $200 and paid dividends of $50. What is the
balance in the Investment in Sub account on Parent’s books at the end of
year 2 using the equity method?

Investment in Sub
Beginning balance
Net Loss
500
100
Ending balance
Dividends
400
¨ What ifNet
Parent uses the cost method?
income 50 $500 COST!!!
¨ What journal entries would Parent make under each method?
200 2-39
 Summary of Year 1 Equity Method Entries

Investment in Soup Corp. 500

Cash 500
Record the initial investment in Soup Corp.

Income from Soup Corp. 100

Investment in Soup. Corp. 100
Record Pea Corp.’s 100% share of Soup Corp.’s Year 1 net loss.

Investment in Soup Corp. Income from Soup Corp.

Acquisition Price 500 Net Loss Net Loss 100

100
Ending Balance 400 Dividends Ending Balance 100

2-40
 Summary of Year 2 Equity Method Entries

Investment in Soup Corp. 200

Income from Soup Corp. 200
Record Pea Corp.’s 100% share of Soup Corp.’s Year 2 income.

Cash 50
Investment in Soup. Corp. 50
Record Pea Corp.’s 100% share of Soup Corp.’s Year 2 dividends

Investment in Soup Corp. Income from Soup Corp.

Beginning Balance 400
Net Income 200 Net Income 200
Dividends

Ending Balance 550 50 Ending Balance 200

2-41
 Example: Equity versus Cost Method

Equity Method Cost Method

Investment in Soup Corp. 500 Investment in Soup Corp. 500

Cash 500 Cash 500

Income from Soup Corp. 100 No Entry

Investment in Soup Corp. 100

Investment in Soup Corp. 200 No Entry

Income from Soup Corp. 200

Cash 50 Cash 50
Investment in Soup Corp. 50 Dividend Income 50

2-42
 Practice Quiz Question #5

On 1/1/X4, Phillip invested $650,000 in Sleeper (100%

owned). For 20X4, Sleeper:
(1) earned $90,000,
(2) declared dividends of $60,000, and
(3) paid dividends of $40,000.
What amounts does Phillip report?
Cost Equity
Investment income for 20X4
Investment in Sleeper at year-end
Retained earnings increase

2-43
 Practice Quiz Question #5 Solution

On 1/1/X4, Phillip invested $650,000 in Sleeper (100%

owned). For 20X4, Sleeper:
(1) earned $90,000,
(2) declared dividends of $60,000, and
(3) paid dividends of $40,000.
What amounts does Phillip report?
Cost Equity
Investment income for 20X4 $60,000 $90,000
Investment in Sleeper at year-end $650,000 $680,000
Retained earnings increase $60,000 $90,000

2-44
Learning Objective 2-5

Prepare journal entries

using the fair value
option.

2-45
 The Fair Value Option
 The accounting standards permit but does not
require companies to make fair value measurements
 Option available only for investments that are not
required to be consolidated
 Rather than using the cost or equity method to report
nonsubsidiary investments in common stock, investors
may report those investments at fair value
 The investor remeasures the investment to its fair value at
the end of each period
 The change in value is then recognized in income for the
period
 Normally the investor recognizes dividend income in the
same manner as under the cost method

2-46
 Example: The Fair Value Option
Ajax Corporation purchases 40 percent of Barclay Company’s common stock on
January 1, 20X1, for $200,000. Barclay has net assets on that date with a book
value of $400,000 and fair value of $465,000. On March 1, 20X1, Ajax receives a
cash dividend of $1,500 from Barclay. On March 31, 20X1, Ajax determines the fair
value of its investment in Barclay to be $207,000. During the first quarter of 20X1,
Ajax records the following entries:

January 1, 20X1
Investment in Barclay Stock 200,000
Cash 200,000
Record purchase of Barclay Company stock.

March1, 20X1
Cash 1,500
Dividend Income 1,500
Record dividend income from Barclay Company.

March 31, 20X1

Investment in Barclay Stock 7,000
Unrealized Gain on Increase in Value of Barclay Stock 7,000
Record increase in value of Barclay stock. 2-47
Learning Objective 2-6

Make calculations and

prepare basic elimination
entries for a simple
consolidation.

2-48
 Overview of the Consolidation Process

 Chapter 2 introduces the most simple setting for a

consolidation.
 The subsidiary is wholly owned.
 It is either a created subsidiary or we assume it is
purchased for an amount equal to the book value of net
assets.

Wholly Owned Partially Owned

Subsidiary Subsidiary

Investment = Book Value Chapter 2 Chapter 3

Investment > Book Value Chapter 4 Chapter 5

2-49
 Overview of the Consolidation Process

 The objective is to combine the financial statements

of two or more entities as if they are a single
corporation.
 The consolidation worksheet facilitates the
combining of the two companies.
 Certain accounts need to be eliminated in the
consolidation process to avoid “double counting.”
 Replaces “one-line” consolidation with the “detail.”

2-50
 The Consolidation Worksheet (Fig. 2-3, p. 61)
Elimination Entries  
Parent Subsidiary DR CR Consolidated
Income Statement      
Revenues      
Expense
Expense
Net Income      
     
Statement of Retained Earnings      
Retained Earnings (1/1)      
Add: Net Income
Less: Dividends
Retained Earnings (12/31)      
Balance Sheet      
Assets      

Total Assets
Liabilities

Equity
Common Stock
Retained Earnings
Total Liabilities and Equity
2-51
 Overview of the Consolidation Process

 In the consolidation worksheet, the three

financial statements need to articulate.
 Net income from the income statement carries down to
the statement of retained earnings.
 The ending balance in retained earnings carries down to
the balance sheet.
 Elimination entries are entered into the
“Elimination Entries” column (debit or credit)
to eliminate any amounts that would result in
“double counting.”

2-52
 The Basic Elimination Entry: The Equity Method

 What needs to be eliminated?

 The parent’s investment account
 It represents the initial investment adjusted
for the parent’s cumulative share of the
subsidiary’s income and dividends.
 The parent’s income from sub account
 The subsidiary’s equity accounts

2-53
 Example: Equity Method
Pea Corporation created Soup Corporation with a transfer of $500 cash.
During Soup Corp.’s first year of operations, it generated a net loss of $100
and paid no dividends. During Soup Corp.’s second year of operations, it
generated net income of $200 and paid dividends of $50. What is the
balance in the Investment in Sub account on Parent’s books at the end of
year 2 using the equity method?

Investment in Sub
Beginning balance
Net Loss
500
100
Ending balance
Dividends
400
¨ What accounts
Net incomeneed to be eliminated?
50
¨ How are they eliminated?
200 2-54
 The Basic Elimination Entry: Equity Method
 The investment account represents the initial investment
adjusted for the parents cumulative share of the subsidiary’s
income and dividends.
 Therefore, the elimination entry eliminates:
 The subsidiary’s paid-in capital accounts (original investment)
 Beginning retained earnings (past earnings / dividends)
 The subsidiary’s current year earnings and dividends
 Generically, it looks like this:

Common Stock XXX

Additional Paid-in Capital XXX
Retained Earnings (Beginning Balance) XXX
Income from Sub XXX
Dividends Declared
XXX
Investment in Sub
XXX 2-55
 The Basic Elimination Entry: Equity Method
Additional
Total Common =
Paid-In Retained + +

Book Value Stock Capital Earnings

Original Book Value 400) 50 450 (100)
+ Net Income 200 200)
- Dividends (50)
(50)
Ending Book Value 550 50 45050)
Note that the “blue” numbers appear Note that this is a
in the basic elimination entry. deficit balance!
Basic Elimination Entry
Common Stock ¬ Original amount invested (100%)
Additional Paid-in Capital ¬ Original amount invested (100%)
Income from Soup Corp. ¬ Soup Corp.’s reported income
Retained Earnings (BB) ¬ Beginning balance in retained earnings
Dividends Declared ¬ 100% of Soup Corp.’s dividends
Investment in Soup Corp. ¬ Net book value in investment account
2-56
 The Basic Elimination Entry: Equity Method
Additional
Total Common =
Paid-In Retained + +

Book Value Stock Capital Earnings

Original Book Value 400) 50 450 (100)
+ Net Income 200 200)
- Dividends (50)
(50)
Ending Book Value 550 50 45050)
Note that the “blue” numbers appear Note that this is a
in the basic elimination entry. deficit balance!
Basic Elimination Entry
Common Stock 50 ¬ Original amount invested (100%)
Additional Paid-in Capital 450 ¬ Original amount invested (100%)
Income from Soup Corp. 200 ¬ Soup Corp.’s reported income
Retained Earnings (BB) ¬ Beginning balance in retained earnings
100 ¬ 100% of Soup Corp.’s dividends
Dividends Declared ¬ Net book value in investment account
2-57
 Basic Elimination Entry: The Equity Method
Basic Elimination Entry
Common Stock 50
Additional Paid-in Capital 450
Income from Soup Corp. 200
Retained Earnings (BB)
100
Dividends Declared
50
Investment in Soup Corp.
550
Investment in Soup Corp. Income from Soup Corp.
Beginning Balance 400
Net Income 200 Net Income 200
Dividends

Ending Balance 550 50 Ending Balance 200

Basic

0 200 0
550 2-58
Learning Objective 2-7

Prepare a
consolidation
worksheet.

2-59
Worksheet: Pre-Consolidation Balances

2-60
Worksheet: Draw lines

2-61
Worksheet: Eliminations, Sub-totals, Carry down

2-62
Worksheet: Eliminations, Sub-totals, Carry down

2-63
Worksheet: Add across

2-64
Worksheet: Add across

2-65
Worksheet: Add across

2-66
Worksheet: Add across

2-67
Worksheet: Completed

2-68
 The Equity Method: Things to Remember in
Consolidation
 Consolidated net income EQUALS the
parent’s net income.
Parent Consolidated
$350 = $350

 Consolidated retained earnings EQUALS

the parent’s retained earnings.
Parent Consolidated
$400 = $400

2-69
Group Exercise 1

REQUIRED
• Assume Pinkett
acquired Smith on
1/1/11
• Prepare all
elimination
entries as of
12/31/11.
• Prepare a
consolidation
worksheet at
12/31/11.
• Assume Smith’s
accumulated
depreciation on
1/1/11 was
$20,000.

2-70
 Group Exercise 1
Objective:
 Eliminate equity accounts of Sub
 Eliminate equity method accounts of Parent.
Book Value Calculations
Total Common Retained
= +
Book Value Stock Earnings
Original Book Value
+ Net Income
- Dividends
Ending Book Value

Basic Elimination Entry

Common Stock
Retained Earnings (BB)
Income from Smith, Inc.
Dividends Declared
Investment in Smith, Inc.
2-71
 Group Exercise 1: Solution
Objective:
 Eliminate equity accounts of Sub Note that the “blue”
 Eliminate equity method accounts of Parent. numbers appear in the
basic elimination entry.
Book Value Calculations
Total Common Retained
= +
Book Value Stock Earnings
Original Book Value 132,000) 60,000 72,000
+ Net Income 36,000 36,000)
- Dividends (12,000)
(12,000)
Ending Book Value 156,000 60,000 96,000)
Basic Elimination Entry
Common Stock
Retained Earnings (BB)
Income from Smith, Inc.
Dividends Declared
Investment in Smith, Inc.
2-72
 Group Exercise 1: Solution
Objective:
 Eliminate equity accounts of Sub
 Eliminate equity method accounts of Parent.
Book Value Calculations
Total Common Retained
= +
Book Value Stock Earnings
Original Book Value 132,000) 60,000 72,000
+ Net Income 36,000 36,000)
- Dividends (12,000)
(12,000)
Ending Book Value 156,000 60,000 96,000)
Basic Elimination Entry
Common Stock 60,000
Retained Earnings (BB) 72,000
Income from Smith, Inc. 36,000
Dividends Declared 12,000
Investment in Smith, Inc. 156,000
2-73
 Group Exercise 1: Solution
The optional accumulated depreciation elimination entry:

Accumulated Depreciation 20,000

Buildings and Equipment 20,000

Property, Plant & Equipment Accumulated Depreciation

20,000
210,000

2-74
 Group Exercise 1: Solution
The optional accumulated depreciation elimination entry:

Accumulated Depreciation 20,000

Buildings and Equipment 20,000

Property, Plant & Equipment Accumulated Depreciation

20,000
210,000

20,000 20,000
0

190,000

Shows the Buildings and Equipment “as if” they have been
recorded on the Sub’s books as new assets at book value.

2-75
Group Exercise 1: Solution

2-76
Group Exercise 1: Solution

2-77