11/25/2017 Business Basics: Investment in Equity Securities - Reynolds Center

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by Steven Orpurt / August 15, 2016

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T
his is one of a series of articles, Covering Financials,focused on nancial accounting disclosures and how
you as a journalist can interpret and report on them. The rst four articles (see related links) introduce the
nancial accounting concepts utilized in this and future articles. If you have a topic you are interested in, post
your request in the comments or email me atsteven.orpurt@asu.edu.

Investment Accounting
Last week we explored the accounting for debt securities. Like investment in debt, many entities invest
substantial sums of wealth into equity securities. Lets explore the accounting for equity investments, including
issues capital market participants encounter interpreting the accounting. There are similarities with the
accounting for debt and you might also be interested in last weeks article entitled Investment in Debt
Securities. (The accounting for equity investments is complicated, so well defer discussing consolidation
accounting until next week.)

Accounting for Equity Securities

When managers purchase equity securities they record them as an asset at the price paid. They then classify
the equity securities into one of four categories as shown in the table. These four categories are important
because the accounting di ers among them.

Like debt, the di erent categories and accounting exist because the FASB acknowledges that entities purchase
equity for di erent reasons. The key perspective the FASB has taken when an entity purchases equity is to
categorize equities (and account for them) based on percentage of ownership signaling level of in uence over
the investee (the entity whose stock was purchased).

In a diagram:

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11/25/2017 Business Basics: Investment in Equity Securities - Reynolds Center

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Lets discuss each category and at the same time the notion of percent of ownership and level of in uence to
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help us better understand the accounting.

Trading Category Happy Thanksgiving!

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Suppose an entity purchases a few shares of stock in another company. The ownership percentage is small, ideas for your local
Thanksgiving
less than 20 percent of the investee entitys outstanding shares, thus the purchasing entity is assumed to have
little or no in uence over the investee. The FASB then reasoned that fair value is an appropriate method for November 24, 2017
measuring the value of the investment because the purchasing entity has no in uence over share price. As
well discuss, when the purchasing entity has in uence, fair value isnt utilized. Fair value means that the value
shown on the balance sheet is the market price of the equity shares at the date of the balance sheet. Contrast Happy Thanksgiving!
fair value with, say, property owned by the entity, which is shown on the balance sheet at historical cost. While Share this!
most assets are not recorded at fair value, many capital market participants agree that fair values are sensible
November 24, 2017
for trading securities. Since the purchasing entity intends to earn short term trading gains they record any
short-term share price gains or losses as part of net income.

Very few entities hold trading securities. As mentioned in the Investment in Bonds article last week,
managers like to have control over net income. They want control because they often earn bonuses based on
earnings and are expected to attain certain levels of earnings by security analysts, banks, creditors, customers
and equity investors. The problem with trading securities is that any market price change is re ected in net
income. If market-wide bad news occurs during the last week of the year, then the entity would record the
decrease in fair value of trading securities as a loss included in net income. Most managers consider such an
event outside their control, so they want to avoid this scenario. They have done so by engaging in minimal or
no trading activities. You will nd only a few examples of non- nancial entities with material trading securities
listed as assets.

AFS Classi cation

Many entities purchase equity shares that they dont intend to trade for short term gains. If they purchase a
small percent of the investees outstanding shares, less than 20 percent, then the purchasing entity is assumed
to have little or no in uence over the investee. Like trading securities, the FASB reasoned that fair value is an
appropriate method for measuring the asset value. But since management isnt actively trading the equity
shares, market price changes are recorded only in other comprehensive income, not net income. If the shares
are eventually sold, then gains and losses recorded in other comprehensive income are reclassi ed to net
income.

As discussed in the Investment in Bonds article last week, this accounting gives managers a slush fund to
increase net income at short notice. All they have to do is sell AFS equity (or bond) securities that have gone up
in value and the price gains are reclassi ed from other comprehensive income to net income. Likewise, if an
entitys earnings from non-investment sources are above expectation, managers might decide to sell AFS
securities with losses. It often takes a close reading of an entitys footnotes to determine whether they have
sold AFS securities with gains, and then whether managers did so to reach a net income goal or not. Academic
surveys of managers indicate that they do engage in this sort of behavior, although it may not be material to
the nancial statements except in a few cases.

Equity Method
When an entity purchases a signi cant percentage of the shares of another entity, they will have in uence
over that entity. Accounting principles assume that ownership of shares between 20 and 50 percent implies
in uence over the investee. In uence means that the purchasing entity can in uence operational decisions.
Examples include in uencing whether to expand capacity, raise or lower products prices, outsource
operations, engage in research, issue shares or debt, etc. Given in uence over operational decisions, the FASB
reasoned that also means in uence over net income and share price of the investee. Therefore, fair value is an
inappropriate accounting approach to record equity method investments in investee equity (because the

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purchaser in uences fair value thus it is no longer fair). The equity method, then, ignores fair value and
instead records the investment at initial cost plus the purchasing entitys share of the investees net income (or
minus a net loss). For example, if entity A purchases 30 percent of the shares of investee B, then entity A
records the cost of its investment as an asset. Then, as time passes, it increases its asset value by 30 percent of
investee Bs net income. It also shows its 30 percent share of the investees net income on its own income
statement. If investee B declares dividends, a further adjustment is made. Equity method accounting is utterly
di erent from fair value accounting, motivated by in uence over the investee.

When interpreting equity method investments, the primary roadblock that investors encounter addressesa
basic question: How to interpret the meaning of the original cost of an investment plus or minus a percentage
share of an investees net income or net loss? Many investors will look to footnotes or other information to
ascertain a fair value estimate for the equity method investment. Investors should perhapscreate their own
fair value estimate.

Equity method disclosures are informative, however. If an investee generates high net income, it may signal
future good fortune for the purchasing entity. The reason is that many equity method investments are in
suppliers, distributors and other entities with similar or related business activities.

Lets take a quick look at an equity method illustration.

As you can see, Equity Method Investments, at $12,318 million ($12.318 billion), are one of the largest assets
for Coca-Cola. The income statement (not shown) records Equity Income of $489 million for 2015. Studying the
nancial statements, we can learn that the equity investments are in Coca-Colas bottlers. The footnotes
contain abbreviated nancial statements for the bottlers. Here are those nancials:

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Note that the Net income attributable to common shareowners of $2,234 million in 2015 and the total equity
of $27,735 represent values for the bottlers. Coca-Cola owns a percentage of these bottlers, ranging from 17
to 29 percent. For instance, the $489 million of Equity Income recorded by Coca-Cola is 22 percent of bottlers
income of $2,234, and in-line with Coca-Colas ownership percentages.

Next week: Consolidation accounting.

Related Posts
Investment in Debt Securities
Business Basics: Intangible Asset Accounting
Property, Plant and Equipment (PPE): Covering Financials

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