Learn about Investment in Securities with Significant Influence

A long-term investment classified as equity securities with significant influence Long-term investment when the investor is able to exert significant influence over the investee; investors owning 20 percent or more (but less than 50 percent) of voting stock are presumed to exert significant influence. implies that the investor can exert significant influence over the investee. An investor that owns 20% or more (but not more than 50%) of a company’s voting stock is usually presumed to have a significant influence over the investee. In some cases, however, the 20% test of significant influence is overruled by other, more persuasive, evidence. This evidence can either lower the 20% requirement or increase it.

The equity method Accounting method used for long-term investments when the investor has “significant influence” over the investee. of accounting and reporting is used for long-term investments in equity securities with significant influence, which is explained in this section.

Long-term investments in equity securities with significant influence are recorded at cost when acquired. To illustrate, Micron Co. records the purchase of 3,000 shares (30%) of Star Co. common stock at a total cost of $70,650 on January 1, 2010, as follows.

 



The investee’s (Star) earnings increase both its net assets and the claim of the investor (Micron) on the investee’s net assets. Thus, when the investee reports its earnings, the investor records its share of those earnings in its investment account. To illustrate, assume that Star reports net income of $20,000 for 2010. Micron then records its 30% share of those earnings as follows.

 



The debit reflects the increase in Micron’s equity in Star. The credit reflects 30% of Star’s net income. Earnings from Long-Term Investment is a temporary account (closed to Income Summary at each period-end) and is reported on the investor’s (Micron’s) income statement. If the investee incurs a net loss instead of a net income, the investor records its share of the loss and reduces (credits) its investment account. The investor closes this earnings or loss account to Income Summary.
The receipt of cash dividends is not revenue under the equity method because the investor has already recorded its share of the investee’s earnings. Instead, cash dividends received by an investor from an investee are viewed as a conversion of one asset to another; that is, dividends reduce the balance of the investment account. To illustrate, Star declares and pays $10,000 in cash dividends on its common stock. Micron records its 30% share of these dividends received on January 9, 2011, as:

 



The book value of an investment under the equity method equals the cost of the investment plus (minus) the investor’s equity in the undistributed (distributed) earnings of the investee. Once Micron records these transactions, its Long-Term Investments account appears as in Exhibit 15.6.

EXHIBIT 15.6 Investment in Star Common Stock (Ledger Account)

Point: Security prices are sometimes listed in fractions. For example, a debt security with a price of 22¼ is the same as $22.25.

Micron’s account balance on January 9, 2011, for its investment in Star is $73,650. This is the investment’s cost plus Micron’s equity in Star’s earnings since its purchase less Micron’s equity in Star’s cash dividends since its purchase. When an investment in equity securities is sold, the gain or loss is computed by comparing proceeds from the sale with the book value of the investment on the date of sale. If Micron sells its Star stock for $80,000 on January 10, 2011, it records the sale as: