FASB interpretation no. 35 has given the criteria to be applied in dealing with equity method of accounting for investment where an enterprise invest less than 50% of the voting stock in a company. Through the guideline given by APB opinion no. 18, equity method should be applied when an investor is able to exercise significant control over financial and operating policies. Though the ability to exercise control is based on percentage on ownership if there is evidence to the contrary then such presumption should not override the need for judgment. APB no.
18 was restricted to investment in voting common stock therefore the emerging issue task force(EITF issue no. 02-14) was set up to determine whether equity method of accounting could be applied to other investment vehicles other than common stock and how it will be applied to those investment(Williams & carcello, 2006). The consensus reached was that equity method of accounting should only be applied for an investment in common stock or when an investment is in-substance common stock. In-substance common stocks are those investments in an enterprise which has risk and reward similar to an entity’s common stock (Siegel, 2007).
The following characteristics should be considered by the board of director of painless. inc. in determining whether their investment in preferred stock is substantially similar to the entity’s common stock. Equity method and common stock 2 1. Subordination Where an investment in an enterprise has substantive liquidation preference over the entity common stock, then they cannot be regarded as in-substance common stock. However some liquidation preference which is not considered significant compared to purchase price of investment cannot be regarded as substantive. 2. Reward and risk
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The board needs to compare the risk and reward of that preferred stock to the enterprise common stock to determine if they are substantially similar. Where an investment does not participate in earning and neither appreciates nor depreciate similar to common stock then they cannot be considered as in-substance common stock. 3. Obligation to transfer value Where an investment holds redemption provision which are not available to common stock then such an investment is not substantially similar to common stock. Furthermore future fair value of both the investment and the common stock should be considered.
Where you expect to have a low correlation between the future fair value of preferred stock and common stock then such an investment is not in-substance common stock. In assessing the possibility of treating painless. inc investment in preferred stock as in-substance common stock then there is a need to check against the three characteristics. Such preferred stock hold a liquidation preference over common stock and in comparing the fair value at the time of investment of $15 million with the redemption amount of $15 million then such redemption is substantive and therefore
Equity method and common stock 3 cannot be considered as in-substance common stock. Furthermore since such preferred stock have cumulative divided it means that incase an entity experience loss in one year then the outstanding divided must be paid in the next financial year when profit are made therefore does not participate in risk and reward as common stock and hence cannot be regarded as in-substance common stock.
Finally the number of board members appointed by painless which is 3 compared to the total number of seven means that painless have no significance influence in financial and operation policies as board members are entrusted with the duty of drafting and implementing those policies therefore such an investment cannot be accounted for through the equity method (Morris, 2004).Equity method and common stock 4
Morris, J. E. (2004). Accounting for M&A, equity, and credit analysts. New York: McGraw-Hill. Siegel, J. G. (2007). Gaap handbook of policies and procedures. [Chicago, Ill. ]: CCH. Williams, J. R. , & Carcello, J. V. (2006). 2006 Miller GAAP guide level A: Restatement and analysis of current FASB standards. Chicago, IL: CCH. .
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