For the past 5 years, Herbert has maintained an investment (properly accounted f
ID: 2452672 • Letter: F
Question
For the past 5 years, Herbert has maintained an investment (properly accounted for and reported upon) in Broome amounting to a 10% interest in the voting common stock of Broome. The purchase price was $700,000 and the underlying net equity in Broome at the date of purchase was $620,000. On January 2 of the current year, Herbert purchased an additional 15% of the voting common stock of Broome for $1,200,000; the underlying net equity of additional investment at January 2 was $1,000,000. Broome has been profitable and has paid dividends annually since Herbert's initial acquisition.
Discuss how this increase in ownership affects the accounting for and reporting upon the investment in Broome. Include in your discussion adjustments, if any, to the amount shown prior to the increase in investment to bring the amount into conformity with GAAP. Also include how the company would report in current and subsequent periods.
Explanation / Answer
As per Generally Accepted Accounting Principles, there are three approaches to recognizing investments in equity securities. They are the fair-value method, equity method and consolidation method.
The Financial Accounting Standards Board has provided a general ownership test in order to improve the consistency in applying the ownership criteria and appropriate accounting method. Under that if company A has less than 20% share in a company B it is generally presumed that company A does not exercise significant influence and fair-value method is applied. On the other hand, if company A owns between 20-50% in company B it is presumed that company A has significant influence over company B and equity method is applied.
In the above caselet, as Herbert’s ownership in Broome has increased from 10% to 25%, Herbert will account for its investment in Broome under the Equity method as compared to Fair-Value method earlier. Under the equity method, the investment in Broome will be recorded at cost rather than fair value under the fair value method. Due to change in the accounting method for investments to equity method from fair-value method earlier, a prior period adjustment needs to be recognised in the current year to reflect applicability of equity method from the date of initial investment.
In the balance sheet, as the underlying value (fair value) of equity was lower than the purchase price Herbert would have recognised USD 80,000 as a negative fair value adjustment to stockholders equity. This needs to be reversed under the equity method as investments are recorded at cost. Thus, we will debit investment account by USD 80,000 and credit unrealized loss on Broome for USD 80,000.
The income statement prior period adjustment will be calculated as follows. All the dividend income received over the last five years will be reduced from cash. Under the equity method, Herbert will increase the carrying value of his investment by 25% share of net profit of Broome and deduct 25% share of dividend from the carrying value of the investment for the respective years.
These adjustments would allow Herbert to arrive at the adjusted carrying value of the investment as of January 2 five years later. Alternatively, Herbert may also make a single adjustment to the carrying value by adding 25% share of net income of Broome and deducting 25% share of dividend income for the five years. The journal entry would be debit Investments and credit Retained Earnings in books of Herbert.
On January 2, Herbert will add USD 1,200,000 as cost of the investment. In the subsequent periods as well, the company will add 25% of the share of net income of Broome to carrying value of investment and deduct 25% of share of dividend from carrying value of investment.