Before I begin with my topic of the day, I wanted to share an interesting article on Investing in Gold. With sudden rise in price of Gold, it seems, everyone's getting more passionate about buying yellow metal. Then I landed on this article in Money magazine " Coming down with Gold fever" and I had to ask myself...Is it another bull run? The truth is Gold prices may rise further but this is not the right time to invest in it. The article stated that it is a myth to consider precious metal offering better protection than stock or bonds against inflation. So, what is an investor's best bet? Invest prudently at different points in time for better returns as timing to buy can never be perfect and definitely investing in Gold is a good way to diversify one's portfolio.
Now coming back to today’s subject for dialogue “Accounting for Investments-Equity Method” laid out in Codification Topic 323 (APB Opinion No 18). This method is applicable if an investment enables the investor/parent to influence the operating or financial decisions of the investee/subsidiary. In other words, the parent company exercises significant influence over the subsidiary and holds 20% or more of the voting stock in it. Furthermore, the equity method of accounting meets the objectives of accrual accounting than does the cost method. The cost method is generally followed for investments in noncontrolled corporations and unconsolidated subsidiaries.
It is important to understand the meaning of "significant influence". It is indicated by many factors, some of them being:-
- Level of Parent Co's representation in the Board of Directors;
- Parent's ability to make policy decisions for the subsidiary; or
- Parent being the single largest shareholder of the subsidiary.
Upon acquisition, the initial investment is recorded at cost and subsequent to acquisition, the Investment and Investment Income account are adjusted periodically by recognizing the share of investee's earnings. I have explained this in more detail by charting a T account of "Investment Account". Refer to the link below to view the file.
Accounting for Investments - Cost Method ( Codification 325 formerly referred as APB 18) - This method is applicable when the investor is not able to exercise significant influence over the investee and generally is evidenced by lack of ability to take policy decisions, temporary investment, holds non-voting preferred stock or ownership in voting stock is less than 20%.
Upon acquisition, the investment is recorded at Cost. Unlike Equity Method, the investment account under this method is not adjusted for investor's share of investee's income. Dividend is recorded as income and an adjustment is made for liquidating dividends (i.e dividends distributed by the investee exceed the investor's share of earnings since acquisition are treated as return of capital and recorded as reduction of the investment account).
Example: P Co acquired 20% stock of S Co on Jan 1, Year 1 and S Co's net income for year 1 was $10,000. During the year P Co received dividend of $2,300.
Liquidating dividends = $2,300 - (20% of 10,000) = $300
Journal entry: Dr Cash $2,300
Cr Dividend Income $2,000
Cr Investment in S Co $300
Now, keeping the facts of the case same, try out the entries under the equity method and compare the end result. You will notice that under both the methods Investment in S Co is reduced by the amount of liquidating dividend.
To summarize Investments are accounted for by one of three methods — the cost method (Codification Topic 325/APB 18), the fair value method (Codification Topic 320/FAS 115) of which I talked in my last blog post , and the equity method (addressed in Topic 323/APB 18).
Focus on how investment account and investment income account get affected by various transactions under Equity method. Remember, investment and investment Income accounts are always reciprocal to each other except for when the dividend is received by the Investor.
With this, I wind up the topic related to Investments. I have tried to wrap the significant areas related thereto and and earnestly wish that you find it useful.