Chapter 25: Equity Investments Significant Influence, 20% to 50%

Accounting for Equity Securities with Significant Influence (Equity Method) When an investor holds 20% to 50% of a company’s voting stock, it is generally presumed they have significant influence over the investee. The equity method is used to account for these long-term investments, under which the investor adjusts the investment’s carrying amount to reflect their share of the investee's net income or losses and dividends. Steps and Journal Entries for Equity Method Investments Year 1 Transactions 1. Recording the Purchase of Stock (January 1): o Transaction: Garcia Company purchases 400 shares of Lopez Co. for $3,000, representing a 40% ownership stake, which implies significant influence. o Journal Entry:  Debit: Equity Method Investments—Lopez $3,000  Credit: Cash $3,000 2. Recording Dividends Received (August 1): o Transaction: Lopez declares and pays a cash dividend of $2 per share. Garcia receives $800 (400 shares × $2 per share). o Journal Entry:  Debit: Cash $800  Credit: Equity Method Investments—Lopez $800 o Explanation: Dividends received are recorded as a reduction in the investment account, reflecting a partial return of the investment rather than income. 3. Recording Share of Net Income (December 31): o Transaction: Lopez reports a net income of $2,500 for the year. Garcia’s share is $1,000 (40% × $2,500). o Journal Entry:  Debit: Equity Method Investments—Lopez $1,000  Credit: Earnings from Equity Method Investments $1,000 o Explanation: Garcia’s share of Lopez's net income is recorded as income and added to the investment’s carrying value. Year 2 Transactions 4. Recording Dividends Received (January 1): o Transaction: Lopez declares and pays a cash dividend of $2.25 per share. Garcia receives $900 (400 shares × $2.25). o Journal Entry:  Debit: Cash $900  Credit: Equity Method Investments—Lopez $900 5. Recording Share of Net Income (December 31): o o Transaction: Lopez reports a net income of $2,750 for the year. Garcia’s share is $1,100 (40% × $2,750). Journal Entry:  Debit: Equity Method Investments—Lopez $1,100  Credit: Earnings from Equity Method Investments $1,100 Year 3 Transaction 6. Recording the Sale of Shares (January 3): o Transaction: Garcia sells 100 shares of Lopez for $1,300 cash. To calculate the gain or loss, we need to determine the book value of the shares sold.  Book Value of Shares Sold: Total investment carrying amount before the sale (total of original cost, net income shares, and dividends) divided by the number of shares held, then multiplied by 100 shares sold.  If the book value per share sold is determined to be less than $1,300, the difference is a gain; otherwise, it’s a loss. o Journal Entry:  Debit: Cash $1,300  Debit or Credit: Equity Method Investments—Lopez (amount depends on the calculated book value of 100 shares sold)  Credit (if applicable): Gain on Sale of Investments (for any difference if cash received exceeds the book value) Summary of Financial Statement Reporting • • • Equity Method Investments Account: Carries the adjusted balance for the investment, incorporating initial cost, the investor’s share of net income, and dividends. Earnings from Equity Method Investments: Reported as income in the investor’s income statement. Gain or Loss on Sale of Investment: Calculated based on the difference between sale proceeds and the book value of the shares sold, reported on the income statement under "Other Revenues and Gains" or "Other Expenses and Losses." This process ensures that the investor's equity in the investee is accurately reflected according to their influence and participation in the investee's financial results.