These lectures cover the difference between the cost method and equity method when preparing consolidated balance sheet and consolidated income statement.
The equity method is used to account for investments.
Investments in Stocks
Consolidated Financial Statements--Cost Method (Pt 1)
Consolidated Financial Statements--Cost Method (Pt 2)
Consolidated Financial Statements in Subsequent Year
Consolidated Financial Statements--Equity Method (Pt 1)
Consolidated Financial Statements--Equity Method (Pt 2)
Consolidation Equity Method--Full Year Alternative Method
With few exceptions, all subsidiaries (investments in which the investor has a controlling interest), as well as other entities controlled by the investor, either directly or indirectly, must be consolidated and may not be reported as separate investments in the consolidated financial statements. The equity method is used to account for investments in investees in which the investor has significant influence but not control (usually more than 20%) unless the fair value option is chosen at acquisition. For investments in investees where the investor does not have significant influence (normally less than 20%), the investment should be reported at its fair value.
The most important difference between the cost and equity methods pertains to the period in which the parent recognizes subsidiary income on its books. If the cost method is in use, the parent recognizes its share of subsidiary income only when dividends are declared by the subsidiary. Under the partial equity method, the investor will recognize its share of the subsidiary’s income when re- ported by the subsidiary, regardless of whether dividends have been distributed. A debit to cash and a credit to the investment account record the receipt of dividends under the partial equity method. The complete equity method differs from the partial equity method in that the share of subsidiary income is often adjusted from the amount reported by the subsidiary (e.g., for depreciation on the excess of market over book values).
Accounting workpapers are helpful in accumulating, classifying, and arranging data for the prepa- ration of consolidated financial statements. The three-section 6 workpaper format used in this text includes a separate section for each of three basic financial statements—income state- ment, retained earnings statement, and balance sheet. In some cases the input to the workpaper comes from the individual financial statements of the affiliates to be consolidated, in which case the three-section workpaper is particularly appropriate. At other times, however, input may be from affiliate trial balances, and the data must be arranged in financial statement form before the workpaper can be completed.
The schedule begins with the cost (or purchase price) and divides this amount by the percentage acquired to compute the implied value of the subsidiary. Next, the book value of the subsidiary’s equity at the date of acquisition is subtracted from the implied value. This difference is then allocated to adjust the assets and/or liabilities of the subsidiary for differences between their book values and fair values. Any remaining excess is labeled as 8 goodwill. Special rules apply for bargain purchases.
Under the cost method, dividends declared by the subsidiary are eliminated against dividend income recorded by the parent. The investment account is eliminated against the equity accounts of the subsidiary, and an account is created for the noncontrolling interest in equity. The difference between implied and book values is recorded in a separate account by that name. The difference is then allocated to adjust underlying assets and/or liabilities, and to record goodwill in some cases. Under the equity method, the dividends declared by the subsidiary are eliminated against the investment account, as is the equity in subsidiary income. In subsequent years, the cost method requires an initial entry to establish reciprocity or con- vert to equity. This entry debits the investment account and credits retained earnings of the parent (for the change in retained earnings of the subsidiary from the date of acquisition to the beginning of the current year multiplied by the parent’s ownership percentage).
If an investment in the common stock of a subsidiary is made during the year rather than on the first day, only the subsidiary revenues, expenses, gains, and losses for the period after acquisition are included in the consolidated income statement.
In the preparation of a consolidated statement of cash flows, the starting point un- der the indirect approach should be consolidated net income (including the noncontrolling interest). Subsidiary dividend payments to noncontrolling shareholders represent a Financing outflow of cash. Subsidiary dividend payments to the parent company represent an intercompany transfer and thus are not reflected on the consolidated statement of cash flows. The cost of acquiring additional subsidiary shares of common stock is an Investing outflow of cash if the purchase is made from outsiders, but not if made directly from the subsidiary.
Any cash spent or received in the acquisition itself should be reflected in the Investing activities section of the consolidated statement of cash flows. The issuance of stock or debt would appear in the Notes to the Financial Statements as a significant noncash investing and financing activity.
In the United States, the investments are referred to as “equity investments”; under international standards, the investments are referred to as “investments in associates.” Potential voting rights are considered under international standards in determining significant influence, while potential voting rights are not explicitly considered under U.S. GAAP.