BUSN 610 Advanced Accounting Assignment -
Question - Research and write a paper from a topic (advanced accounting).
Topic - Equity Method of Investing: Applicability, Issues and challenges
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In the modern business context many business forms around the world are investing in related businesses all over the world. Many cases involves in which companies are bought and acquired outright. In many other cases controlling stakes are bought. However in most of the cases a significant amount of ownership is purchased which does not amount to controlling interest in the target company. These investments made by big corporates often comes in the form of investing in equity stocks of the target company or in preferred stocks. Investments are also in some cases made in the form of a trust such investing in a hedge fund which has stakes in the company or in some kind of private equity funds etc.
Unless the investor company specifies these investments otherwise these types of significant investments are termed as equity investments and under which the investing company acquires a significant ownership in the investee not amounting to controlling stake. For the determination of the right accounting method to deal with such investments, the investing company and its management must know the legal for of the company in which investment has been made and the basis premise and the nature of these investments.
The current research assignment is aiming to deal with the emergence of the equity method which is developed for accounting for one company's investments in another and the circumstances under which the same can be employed and how the same is operable under different circumstances. Also the research would try to analyses issues that can arise in the process of implementation of the Equity Investment method.
Many corporate firms invest heavy in another corporation to gain control over the affairs of the firm and control is generally recognized when the investing company acquires and holds more than 50% of the voting stocks. When the investor company holds more than 50% of the voting stocks , in effect it has the power to direct the decision at the investee and hence exerts financial and other controls over the operations of the investee company. The legal control is more or less an universal practice US and EU and for example, PepsiCo has controlling stakes in more than few dozens of other companies which are known the subsidiaries.
However the investor control though investing in stocks often pose significant challenge of the investee company and both the companies can be viewed as one company for accounting reporting purpose. This necessitates an entirely different accounting perspectives.
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Equity method of Accounting for Consolidation
In some cases however the control is never achieved or not intended to be achieved by the investing company. However the investing company owns a large proportion of the stocks issued by the investing firm which is short of 50% shareholding but can give enough power to the investing company to significantly control the business operations of the investee firm. For example , a company which holds 35-40% of the investee company's stocks can easily influence many types of decisions made by the investee company and can appoint a large no of directors to the board of directors of the company. FASB ASC Topic 323 which is related to the Investments-Equity Method and Joint Ventures discusses the guidelines which must be used for accounting purpose and under the Equity method of consolidation the accrual method of accounting comes into play for recognizing the share of the investor company in the incomes generated by the Investee and as a result of which the investor company recognizes income in its financial statements. As prescribed under the FASB ASC (para. 323-10-05-5), because the investor company has invested significantly in the investee company it has the rights and responsibility to make sure the results of the company in which investments were made or stokcs were bought are included in the financial reports of the investor firm. This is imperative for making sure the firm generates enough return on investment in the given period of time (Hoyle, Schaefer, & Doupnik, 2016).
a) Equity method of accounting for consolidation calls for recording of the investments in the books of the investor firm at cost and it must be ensured that the same includes the costs of the transactions (Cottrell, 2012).
b) Further the investor company must proceed to identify the basic difference in the amount of investment made in the investee and the net assets of the investee on such reporting dates.
c) After the initial work of investment measurement under the equity method, the investing company would be required to make necessary adjustments to the same to further recognize the earnings gains and losses and changes in the capital invested.
d) It can be noted that if the investing company receives dividends form the investee the same would reduce the investments carrying value and if these is a basic difference at the date of acquisition then the investor company would be required to make impairments as required as and when the investee gains or losses.
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Criteria for Utilizing the Equity Method
FASB ASC Topic 323 which is related to the Investments-Equity Method and Joint Ventures discusses the guidelines which must be used for accounting purpose and the Equity method of consolidation must be used if the investor company's begins to have abilities to exert significant influence over the workings of the investee. Ability of influence means ability to influence the decisions making process and exert control over both operating and financial policies. ([FASB ASC (para. 323-10-15-3)].
However the ability to influence on the part of the investor company remains not fully discussed under the provisions of different standards being used. The same is subject to different interpretations and judgments being exercised by parties involved. It's difficult to say exactly at what point the party (investors) acquire the ability to exercise influence on the investee. However it must be noted that the standards don't require any actual influence to have been exerted and applied by the investor company to enable equity method.
The ability to influence on the part of the investor company can be gauged from the followings which has bene listed by the FASB ASC topic 323:
a) Investor company has been represented in the investee company's board of directors.
b) Investor company has been represented in the decision making process of the investee company
c) There has been evidence of many intercompany transactions after the stockholding acquisition ahs taken place.
d) Both the investor company and the investee company has interchanged the managerial personnel.
e) One of the companies have become dependent upon the other in technical matters.
f) Extent of ownership is gauged form the size and nature of the investee company's business and the presence of other big investors in shareholding of the investee company.
However it shall be remembered that one of these conditions must not be sued exclusively for finding and assessing if the investor company has control over the investee. All of the conditions must not be used in isolation and must be used together to know if the ability to influence exists. This is why FASB specifically provides for automatic assumption of the ability to influence if the investor owns more than 20% of the stocks and less than 50% of the stocks in the investee firm and thus equity method of consolidation and reporting be applied automatically (Hoyle, Schaefer, & Doupnik, 2016).
This means if the investor has ownership of stocks amounting to 20% or more either directly or indirectly in the investee firm, the same amounts to voluntary assumption of control or ability to control and influence and hence equity method be applicable if there is nothing to suggest existence of something contrary.
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Extensions of Equity Method Applicability
In some cases however, it has been demonstrated in the past that investor forms have gone on to disclose the ability to influence on their even when they don't possess 1/5th stockholding and it was fund that their stockholding is as low as 10% -13%. This means companies when they feel that they have significant ability to influence the decision making proves can proceed to adopt the equity method voluntary. For example, in the recent past International paper company adopted the equity method on its own (voluntarily) even if the company held only 13% stocks in Scitex corporation.
However, the company in its financial statements disclosed that it is able to exert influence over the investee ( Scitex corporation) as the international paper company was in a shareowners agreement with 2 other companies as a result of which they own a consolidated 39% in the investee company.
There can also be different conditions under which the equity method becomes appropriate for disclosure in the financial statements despite majority ownership interest. For example under certain category of conditions, the minority shareholders might be given a veto power which restricts the decision making ability of the majority shareholders. For example, the minority shareholders might have control over adoption of a compensation package to the directors and CEO etc. Also the veto power given to the minority can also respect the long term investing powers of the board of directors. Thus if the rights enjoyed by the minority is pretty restrictive the same can be construed as ability to influence and hence must be recognized as Equity investments. This has been demonstrated in the case of AT&T disclosing in its financial reports prior to its undertaking the acquisition of Bellsouth that it hold or accounts for approx. 60% of the shares issued by Cingular corporation including the share held by the Bellsouth. However despite having the majority in Cingular, AT&T accounted for its investment under Equity method as the minority rights were pretty rigid and restrictive (BAKER & CORTRELL, 2011).
Equity method of accounting for consolidation calls for recording of the investments in the books of the investor firm at cost and it must be ensured that the same includes the costs of the transactions. Further the investor company must proceed to identify the basic difference in the amount of investment made in the investee and the net assets of the investee on such reporting dates.
After the initial work of investment measurement under the equity method, the investing company would be required to make necessary adjustments to the same to further recognize the earnings gains and losses and changes in the capital invested. It can be noted that if the investing company receives dividends form the investee the same would reduce the investments carrying value and if these is a basic difference at the date of acquisition then the investor company would be required to make impairments as required as and when the investee gains or loses (Cottrell, 2012).
The investing company's total amount reported in the investment amount would increase if the investing company receives a dividend from the investee. The income can also be reported under accrual system as well. Thus if the income is earned but not received form the investee the same can be reported in the financial statements. Similarly a deduction would be recorded if the investee reports a loss in the relevant accounting period.
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The net effects of the earning process are as follows:
If income is earned by the investee company
The estimated share of the income investee would be added back to the balance in the investment a/c using the accrual method.
If loss is reported by the investee company
The estimated share of the loss by investee would be reduced from the balance in the investment a/c using the accrual method.
If the investee company declares divined
The same would be shown in the books of the investor company as a deduction form the investment account.
The investor's investment account is would be expected to be reduced by the amount of dividend collected by the investor company as the cash dividends paid by the investee would reduce the book value of the investee company and thus the investor company would be required to show this as a reduction in the carrying amount of the investment value and not to be shown as revenue. Further it shall also be noted that receiving dividends are not seen as an objective measure of generation of income and hence deducted (Chang, 2013).
As there are constant changes made to the Investment made , the application of the method of equity investment would most likely to cause the balances in the investment to vary as per the investors equity. If investee equity is expected to rise then the balance in the investment account is likely to rise.
Reporting a Change to the Equity Method
It might be quite timely to say that in many cases the investor firm might not have gained the ability to influence in the first lace and gradually the ability to influence comes from the subsequent acquisition of the stocks in the investee. Thus it might be quite likely that the investor might have waited for many years before getting the ability to influence. However it is more likely that if the ability to influence is not there it is highly likely that the investor used the fair value method of reporting the investment. However, as soon as the level of investment reach the significant influence level the investor is most likely to choose the equity method and switch away form the fair value method.
As per the provisions set aside by the FASB ASC (para. 323-10-35-33), this issue is addressed and the provisions clearly mandates that if the investor reaches a level where there is significant influence, then the investor company would have to apply the equity method and apply the same with retrospective effect. This clearly suggests that FASB is in the favor of retrospective adjustments to ensure that comparability factor is ensured in reporting in the books of the investor company.
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Permanent Losses in Value
Sometimes the investment might lose the value on a permanent basis and if the same happens then the same might not be evident in the Equity method. Such loss of value in the permanent basis, then the same needs to be accounted for. Such permanent losses can come in the form of loss of customer base, reputational damage as a result of product mishandling, and might also be a result of loss of value as a result of losing patents. However even if value is lost permanently , the same might not be reported immediately in the investment account under the equity method. To deal with this the provisions of the FASB ASC (para. 323-10-35-32) has made certain arrangement like discussed below:
a) A loss of value on a permanent basis rather than a temporary basis must be recognized. Generally, the permanent loss of value in the invested amount can be recognized if the investor lose the ability to recover the carrying value of the investments.
b) A loss of value on a permanent basis might be a situation under which the investee loses the ability to earn profits on a consistent basis and efforts made might not be enough to gain sustainable earning capacity.
Also under the equity method the loss of temporary basis is just have to be ignored. However the amount of permanent impairment by the investor company must be undertaken on the basis of some valuation methods being used like using the market prices being quoted or other methods of similar nature (Beams, 2012).
Critical Review and Thinking
For the application of the equity method of investment in other companies the 20-50% limit set is beginning to feel like an arbitrary limit imposed. On the other hand the criteria shall be the evidence of the ability to influence and not the % limit. Thus to, me if there is not ability to influence then the equity method of investing reporting shall not be used at all as it does not prove anything except just providing an uniform platform for reporting. So if a firm cant influence the business of the investee it really hardly matters to the investors at large if the investor company has 40% of the ownership of the stocks or even 50%.
Also it appears that in the following cases the equity method of accounting for investments might not be appropriate even if the investor company has 50% ownership of the investee stocks:
a) If there is an agreement between the investor company and the firm in which investment has been made under which the significant rights are surrendered by the investor company.
b) The present ownership of the investee company operates the business operations disregarding the opinions and feelers of the investor company as it has majority shareholding.
c) If the investing company has made attempts but failed to secure place in the board of directors and hence not bene able to exert influence over the investee.
In each of these situations described above as the investor company is not being able to exert significant influence the critical feeling is that equity method is not equitable and justified and must not be applied.
Equity method is quite universal in use and widely accepted because of regulatory guidelines. The method is quite different form the consolidation method under which the investor company has bene able to exercise full control over the investee. And the rules requires the investor firm to undertake timely adjustments to the investment account in the form of incomes generated by the investee or even when the investee pays dividend. Its natural that incomes generated by the investee would increase the value of the investment and losses would reduce the balance in the investment account . Also it can be remembered that a permanent loss of value is required to be deducted in the investment account as well. Whats interesting is that if the losses are gradual and profits are not generated then investment account balance can be reduced to zero. This is possible if the investee incurs huge losses on a continuous basis. The account would ne maintained but it can't be reversed until the investee generates the income which is sufficient enough to reverse all the cumulative losses. It can be concluded by saying that the equity method is one of the fairest methods for investment accounting despite a few limitations it has (BAKER & CORTRELL, 2011).
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