Reporting Stock Investments of 20-50% of Equity
When the amount of stock purchased is between 20% and 50% of the common stock outstanding, the purchasing company's influence over the acquired company is often significant. The deciding factor, however, is significant influence or the ability for the investor to have a say in business decisions made by company owners. If other factors exist that reduce the influence, or if significant influence is gained at an ownership of less than 20%, the equity method may be appropriate. FASB interpretation 35 (FIN 35) underlines the circumstances where the investor is unable to exercise significant influence).
To account for this type of investment, the purchasing company uses the equity method. Under the equity method, the purchaser records its investment at the original cost. The balance of the investment increases by the pro-rata share of the investee's income and decreases by the pro-rata share of dividends declared by the subsidiary.
An example of how to apply the equity method to a stock investment -- assume ABC Corporation purchases 30% of XYZ Corporation (or 80,000 shares) and can exercise significant influence. The market price of the stock is USD 1. At the end of 201X, XYZ earns net income of 100,000 and declares a dividend of USD 1 per share. The following journal entries are made by ABC to record the investment in XYZ:
Journal entry for the stock investment purchase:
- DR - Investment in XYZ Corporation USD 80,000 (80,000 shares * USD 1 market price/share)
- CR - Cash USD 80,000
Journal entry to account for the pro-rata share of XYZ annual income:
- DR - Investment in XYZ Corporation USD 30,000 (100,000 net income * .30)
- CR - Equity in XYZ Corp. Income USD 30,000
Journal entry to account for the pro-rata share of XYZ dividends:
- DR - Dividends Receivable 80,000 (80,000 shares * USD 1 dividend per share)
- CR - Investment in XYZ Corporation 80,000
Goodwill and Equity Investments
At the time of purchase, goodwill can arise from the difference between the cost of the investment and the book value of the underlying assets. The component that can give rise to goodwill is: the difference between the fair market value of the underlying assets and their book value .
Goodwill
Goodwill is an accounting concept meaning the excess value of an asset acquired over its book value due to a company's competitive advantages.
Goodwill is no longer amortized under U.S. GAAP (FAS 142) of June 2001. Companies objected to the removal of the option to use pooling-of-interests, so amortization was removed by the Financial Accounting Standards Board as a concession. As of January 1, 2005, it is also forbidden under International Financial Reporting Standards. Goodwill can now only be impaired under these GAAP standards.
To test goodwill for impairment, companies are now required to determine the fair value of the reporting units, using the present value of future cash flow, and compare it to their carrying value (book value of assets plus goodwill minus liabilities). If the fair value is less than carrying value (impaired), the goodwill value needs to be reduced so that the fair value is equal to the carrying value. The impairment loss is reported as a separate line item on the income statement, and the new adjusted value of goodwill is reported in the balance sheet.