Question

explain the cost/fair value, equity and consolidation methods of accounting?

Answer 1

What is Fair Value?

Ans: Fair value refers to the actual value of an asset – a product, stock, or security – that is agreed upon by both the seller and the buyer. Fair value is applicable to a product that is sold or traded in the market where it belongs or under normal conditions – and not to one that is being liquidated. It is determined in order to come up with an amount or value that is fair to the buyer without putting the seller on the losing end.

For example, Company A sells its stocks to company B at $30 per share. Company B’s owner thinks he could sell the stock at $50 per share once he acquires it and so decides to buy a million shares at the original price. Despite the large profit potential for Company B, the sale is considered fair value because the price was agreed by both sides and they both benefit from the sale.

Fair Value vs. Market Value

• Market value fluctuates more than fair value.
• It may be based on the most recent pricing or quotation of an asset. For example, if during the last three months, the value of a share in Company A was $30 and during the most recent evaluation, it went down to $20, then its market value is $20.
• Market value is dependent on supply and demand in the market where the asset is bought and sold. For example, a house that is to be sold will see its price determined by existing market conditions in the local area.

If the owner tries to sell a property for $200,000 during a low time in the real estate market, then it might not get sold because the demand is low. But if it is offered for $500,000 during a high time, it may get sold at that price.

Advantages of Fair Value Accounting

Fair value accounting measures the actual or estimated value of an asset. It is one of the most commonly used financial accounting methods because of its advantages, which include:

1. Accuracy of valuation

2. True measure of income

3. Adaptable to different types of assets

4. Helps businesses survive

Equity Method of Accounting:

What is the Equity Method?

Ans: The equity method is a type of accounting used for intercorporate investments. This method is used when the investor holds significant influence over the investee but does not exercise full control over it, as in the relationship between a parent company and its subsidiary. In this case, the terminology of “parent” and “subsidiary” are not used, unlike in the consolidation method where the investor exerts full control over its investee. Instead, in instances where it’s appropriate to use the equity method of accounting, the investee is often referred to as an “associate” or “affiliate”.

Although the following is only a general guideline, an investor is deemed to have significant influence over an investee if it owns between 20% to 50% of the investee’s shares or voting rights. If, however, the investor has less than 20% of the investee’s shares but still has a significant influence in its operations, then the investor must still use the equity method and not the cost method.

How does the equity method work?

Ans: Unlike with the consolidation method, in using the equity method there is no consolidation and elimination process. Instead, the investor will report its proportionate share of the investee’s equity as an investment (at cost). Profit and loss from the investee increase the investment account by an amount proportionate to the investor’s shares in the investee. This is known as the “equity pick-up.” Dividends paid out by the investee are deducted from this account.

Example:

Intex Inc. purchases 30% of Zombie Corp for $500,000. At the end of the year, Zombie Corp reports a net income of $100,000 and a dividend of $50,000 to its shareholders.

When Intex makes the purchase, it records its investment under “Investments in Associates/Affiliates”, a long-term asset account. The transaction is recorded at cost.

Dr.	Investments in Associates	500,000
	Cr.	Cash	500,000

Intex receives dividends of $15,000, which is 30% of $50,000, and records a reduction in their investment account. The reason for this is that they have received money from their investee. In other words, there is an outflow of cash from the investee, as reflected in the reduced investment account.

Dr.	Cash	15,000
	Cr.	Investments in Associates	15,000

Finally, Intex records the net income from Zombie as an increase to its Investment account.

Dr.	Investments in Associates	30,000
	Cr.	Investment Revenue	30,000

The ending balance in their “Investments in Associates” account at year-end is $515,000. This represents a $15,000 increase from their investment cost.

This reconciles with their portion of Zombie’s retained earnings. Zombie has Net Income of $100,000, which is reduced by the $50,000 dividend. Thus, Zombie’s retained earnings for the year are $50,000. Lion’s portion of this $50,000 is $15,000.

What is the consolidation method in Accounting?

Ans:

The consolidation method is a type of investment accounting used for consolidating the financial statements of majority ownership investments. This method can only be used when the investor possesses effective control of the investee or subsidiary, which often, but not always, assumes the investor owns at least 50.1% of the subsidiary shares or voting rights.The consolidation method works by reporting the subsidiary’s balances in a combined statement along with the parent company’s balances, hence “consolidated”. Under the consolidation method, a parent company combines its own revenue with 100% of the revenue of the subsidiary.

How does the consolidation method work?

Ans:

The parent company will report the “investment in subsidiary” as an asset, with the subsidiary reporting the equivalent equity owned by the parent as equity on its own accounts. At the consolidated level, an elimination adjustment must be added so that the consolidated statement is not overstated by the amount of equity held by the parent. The elimination adjustment is made with the intent of offsetting the intercompany transaction, such that the values are not double-counted at the consolidated level.

Example

Parent Company has recently just begun operation and, thus, has a simple financial structure. Mr. Parent, the sole owner of Parent Company, injects $20M cash into his business. This appears as the following journal entry.

Dr.	Cash	20,000,000
	Cr.	Shareholder’s Equity	20,000,000

As such, Parent Company’s balances are now 20M in assets and 20M in equity.

The next month, Parent Company sets up Child Inc, a new subsidiary. Parent Company invests $10M in the company for 100% of its equity. On Parent’s books, this shows up as the following.

Dr.	Investments in Subsidiary	10,000,000
	Cr.	Cash	10,000,000

Parent Company now has $10M less cash, but still has a total of $20M in assets.

On Child’s books, the same transaction would show up as follows.

Dr.	Cash	10,000,000
	Cr.	Shareholder’s Equity	10,000,000

At the end of the year, Parent Company must create a consolidated statement for itself and Child Inc. Assuming no other transactions occur in the year, the consolidated statement would look like the following:

	Parent Company	Child Inc.	Elimination Adjustment	Consolidated
Assets
Cash	10,000,000	10,000,000		20,000,000
Investment in Subsidiary	10,000,000		-10,000,000	0
Equity
Shareholder's Equity	20,000,000	10,000,000	-10,000,000	20,000,000