Excess of Investment Cost Over Book Value Acquired
The most common problems in applying the equity method, it concerns investment costs that exceed the proportionate book value of the investee company. Unless the investor acquires its ownership at the time of the investee’s conception, paying an amount equal to book value is rare. A number of possible reasons exist for a difference between the book value of a company and the price of its stock. A company’s value at any time is based on a multitude of factors such as company profitability, the introduction of a new product, expected dividend payments, projected operating results, and general economic conditions.
Furthermore, stock prices are based, at least partially, on the perceived worth of a company’s net assets, amounts that often vary dramatically from underlying book values.
Asset and liability accounts shown on a balance sheet tend to measure historical costs rather than current value. In addition, these reported figures are affected by the specific accounting methods adopted by a company. Inventory costing methods such as LIFO and FIFO, for example, obviously lead to different book values as does each of the acceptable depreciation methods. If an investment is acquired at a price in excess of book value, logical reasons should explain the additional cost incurred by the investor. The source of the excess of cost over book value is important.
Income recognition requires matching the income generated from the investment with its cost. Excess costs allocated to fixed assets will likely be expensed over longer periods than costs allocated to inventory. In applying the equity method, the cause of such an excess payment can be divided into two general categories:
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•Specific investee assets and liabilities can have fair values that differ from their present book values. The excess payment can be identified directly with individual accounts such as inventory, equipment, franchise rights, and so on.
•The investor could be willing to pay an extra amount because future benefits are expected to accrue from the investment. Such benefits could be anticipated as the result of factors such as the estimated profitability of the investee or the relationship being established between the two companies. In this case, the additional payment is attributed to an intangible future value generally referred to as goodwill rather than to any specific investee asset or liability.
The preceding extra payments were made in connection with specific assets (equipment, patents, and goodwill).
Even though the actual dollar amounts are recorded within the investment account, a definite historical cost can be attributed to these assets. With a cost to the investor as well as a specified life, the payment relating to each asset (except land, goodwill, and other indefinite life intangibles) should be amortized over an appropriate time period.
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