The Equity Method

Indications of Significant Influence

Journal Entries

• Investor representation on the investee's board of directors.
• Investor participates in the decision-making process of the investee.
• Material intra-entity transactions.
• Interchange of managerial personnel.
• Technological dependency.
• Extent of ownership by the investor in relation to the size and concentration of other ownership interests in the investee.

All of these guidelines are evaluated together to determine if the investor has the ability to exercise significantly influence over the investee.

Investment in Johnson Company 36,000

Equity in Investee Income 36,000

To accrue earnings of a 40 percent owned investee (90,000 x 40%).

Dividend Receivable 12,000

Investment in Johnson Company 12,000

To record a dividend declaration by Johnson Company (30,000 x 40%).

Cash 12,000

Dividend Receivable 12,000

To record collection of the cash dividend.

Annual Amortization

Journal Entry

Equity in Investee Income 16,400

Investment in Johnson 16,400

To record annual amortization of excess payment allocated to building ($8,000) and trademark ($8,400).

Criticisms of the Equity Method

• Emphasizing the 20-50 percent of voting stock in determining significant influence.

• Allowing off-balance sheet financing.

• Potentially biasing performance ratios.

Equity Method

The Equity Method

Lexis Hanssen, Julia Miller, Frank Schuster

• Used when an investor has the ability to significantly influence an investee.

• If an investor holds between 20 and 50 percent of the voting stock of an investee, significant influence is assumed and the equity method is applied.

Example

Franklin purchases 40% of Johnson Company on January 1 for $500,000. Although Franklin did not use it, this acquisition gave Franklin the ability to apply significant influence to Johnson’s operating and financing policies. Johnson reports assets on that date of $1,400,000 with liabilities of $500,000. One building with a seven year life is undervalued on Johnson’s books by $140,000. Also, Johnson’s book value for its trademark (10 year life) is undervalued by $210,000. During the year, Johnson reports net income of $90,000 while declaring dividends of $30,000. What is the Investment in Johnson Company balance in Franklin’s financial records as of December 31?

Application of the Equity Method

Purchase price of investment $ 500,000

Basic income accrual ($90,000 × 40%) 36,000

Dividends declared ($30,000 × 40%) (12,000)

Amortization (16,400)

Investment in Johnson Company $ 507,600

Purchase price of Johnson stock $ 500,000

Book value of Johnson ($900,000 × 40%) (360,000)

Cost in excess of book value $ 140,000

Payment identified with undervalued assets:

Building ($140,000 × 40%) 56,000 / 7 yrs. $ 8,000

Trademark ($210,000 × 40%) 84,000 / 10 yrs. 8,400

Total Annual Amortization $ 16,400

• The investor's investment account increases as the investee earns and reports income.

• The investor decreases its investment account for its share of investee cash dividends.