 Hello and welcome to this session. This is Professor Farhad in which we would look at this CPA exam question that was sent to me by one of my subscribers. So if you are a member of Farhad Lectures.com and you do have questions about one of the questions that you have, you could always reach out to me. And if I feel that the question can benefit other people, I will do a YouTube and share it with everyone else. So let's go ahead and take a look at this question and see what we can do and what we can learn from this important question. Investor Inc bought 25% of the InvestiCorp outstanding stock on January 2nd year for 4.5 million. Simply put, we purchased 25% of another company we are using the equity method. First entry, we debit investment and equity 500,000, credit cash 500,000. The carrying amount of the investee's net asset at the purchase price total 1.5 million. Simply put, the book value of the investee was 1.5 million. Fair value and carrying value were the same for all items except a plant and inventory for which fair value exceed the carrying amount by 80,000 and 40,000. So we have a plant assets and we have inventory. And for those two assets, the plant assets exceeded the fair value by 80,000. And for inventory, we exceeded the fair value 40,000. The plant has a 10-year remaining use for life, no salvage value or inventory was sold during 2004. During 2004, Investee reported 200,000 of income paid $20,000 in cash. So simply put, we have a net income of 200,000 dividend of 20,000. Now on the exam day, you don't write all of this down. And on the exam day, what you do first is you come here and you would say, what am I looking for? Because I can ask you, you could be asked so many different questions about this data. The question is what amount should be reported on your income statement? So this is what you do on the exam day. This is not the exam day. This is an opportunity for you to learn. So I'm going through this step by step. There is no impairment of goodwill during year four. Assume that the investor uses the equity method to account for its investment. What amount should we report in the income statement? Okay, let's first take a look at the net income. The investing generated 200,000 of net income. Well, our share of net income is 25%. Well, it means our share is 25%. And 25% of $200,000 is 50,000. Here's what we do when we are using the equity method. If the investor reported net income, we increase our proportionate share of net income, which is 25%, which is equal to 50,000. Therefore, we debit investment 50,000. We credit revenue from equity investment or earnings from equity investment of 50,000. Excellent. Then the company reported $20,000 of cash dividend. Now, I should not do the cash dividend because it's not part of the question. But again, I'm here to kind of show you how this worked. When you have dividend in the equity and they paid you the cash, you'll take 20,000 multiplied by 25% your share of the cash. And that's going to give you $5,000. When you receive the dividend, the dividend would reduce your investment. Hold on a second. Are you saying I receive dividend? I reduce my investment. And the answer is yes. You would receive the cash of 5,000. You will reduce your investment by 5,000. And the reason is you already earned all the income from your investing. You already accounted for all the income. So all the income, remember, dividend comes out of revenue. So the $5,000 revenue that you received, right? It's already accounted as revenue. So you don't credit revenue again, okay? Or you don't credit dividend revenue. What you do is you reduce your investment because the investor's asset went down and your share is related to that. So this is pretty much so far so good. This is easy. This is basically so far. This is a simple equity method. Now what I'm doing here is I'm ignoring the additional information. Simply put, this is the answer. This is the entries that you make assuming we did not have this accept. Assuming we did not have this accept fair value adjustment, okay? That's the answer. That's the answer for any question they can ask you without this additional information. Obviously we cannot ignore this additional information. Now do we have to deal with it, okay? So if I have to answer the question right now, the revenue is 50,000. That's what goes on the income statement, but we're not done yet, okay? So they can ask me up to this point is what's my revenue assuming that's the only information I'm giving. They could ask me what is my balance and the equity? My balance and the equity is in my equity, investment and equity, I started with half a million, increased it by 50, reduced it by five. My balance is 545. I'm not being asked about this, but you know FYI. Now let's go back and deal what we have to deal with. Now when we purchase this investment, we're using the equity method. So what we did, part of this half a million, part of this half a million included the 80,000, part of it included the 80,000 of the extra, of the extra property, plant and equipment value, and 40,000 of the extra of the additional value and inventory. So when you paid, you paid for this extra, that's why you paid half a million, but you did not buy the whole company, you only purchased how much of those? 25%. Now now what we have to do, we have to quote the appreciate because this is property, plant and equipment. This is plant asset. Property, plant and equipment are depreciated, but we don't depreciate them because we're not doing consolidation, but we have to account for this extra value that we purchased. What we do is, so let's assume we were doing, let's assume we actually bought the property, plant and equipment. Therefore what we do is we debit depreciation expense, it's 80,000 divided by 10, $8,000 a year, credit accumulated depreciation, $8,000 a year. That's assuming we purchased the property, plant and equipment, okay? But again, we did not purchase the property, plant and equipment, we purchased enough shares to have equity, equity share in the company, 25%. So what we need to do now, we need to account for that in quote depreciation expense without recording the depreciation expense. How do we do so? Well, if we purchased the 25% of the company, so we're going to take 80,000 times 0.25, so basically our share of this extra property, plant and equipment, let's see what our share is. So if we take 80,000 times 0.25, that's equal to 20,000, and this 20,000 is depreciated over 10 years, therefore we have to reduce our income by an additional $2,000. Now how do we reduce our income? Well, we can debit an expense, but we cannot debit an expense. What we do is, is we reduce our revenue from investee. You remember this account revenue from investee or we can call it earning from investee or earning from the equity investment, it doesn't matter, we're going to debit. And when we debit, it's like, when we debit a revenue or earning, it's like recording an expense. And what we do is we reduce our investment in the equity. So what we did now, we accounted for this $2,000 of in quote depreciation expense without recording the actual depreciation expense. Now if this was a consolidation, we would have to record actual depreciation expense. Remember, this is the equity method. So we're done with property, plant and equipment. What's left? What's left is the inventory of 40,000. Same exact concept. If we purchased 25% of the company, we purchased 25% of this, 25% of this is 10,000. Now what we need to do, we need to amortize or spread the expense, spread the expense, spread the expense. How do we spread the expense for this? Well, let's think about it. It's, this is the 25%. So we purchased 25%. It's all sold. How do we spread the expense? Well, same concept. We don't debit cost of goods sold. What we do is we reduce inventory by the same amount. I'm sorry, not inventory. We reduce revenue by the same amount. Therefore, we debit revenue for $10,000 and reduce our investment in equity by $10,000. So this is what we do. So those are the journal entries. That's excellent. That's good. And basically what we're doing is basically we accounted for the inventory for this extra 10,000. Now for this, for the remainder for the property, plant and equipment, we're going to have to do this over several years until we get root of the whole 20,000. Now, okay, all said and done, let's try to answer the question now. We can now remove this calculator. How much is reported on the income statement? Well, we have to know what accounts are on the income statement. Simply put, we started with $50,000 reduced by two, reduced it by 10. So $50,000 minus in total $12,000 will give us $38,000. And this is the answer for this question. This is the answer because the question is how much we would report on the income statement. The question could have also asked how much we would report on the balance sheet as far as investment and equity. Well, we started our investment with half a million. We got net income of $50,000. Then we received dividend of $5,000. We accounted for depreciation of $2,000. We accounted for the inventory of $10,000. Then we have to net this out. So they could ask you, what is the number on the income statement? What is the number on the balance sheet? I'll have to net it. $550 minus $15 is $535 minus $2 is $533. If my math is right, my investment is $533. Now also, they could tell you at the end of the year, we sold this investment for $535. If that's the case, then we have a gain of $2,000. If we sold it for $530,000, then we have a loss of $3,000. Or they may tell you, we sold half of this investment for some X amount. Well, you take this $533, break it in half, or we sold 40%. Take 40% of the cost and compare the cost to what you sold it for. You might have a gain or a loss. So again, many questions could be asked here. Now, if you ask me, I highly doubt it. I mean, you could. I'm not highly doubt it. It doesn't mean it's not possible that you would receive, that you would see this type of questions on the exam, on the multiple choice. You could. I'm not saying you could not. You could. But I think this will be maybe presented to you in a form of a, of assimilation. This could be presented in a form of assimilation, basically giving you this information and asking you for the entries. And that's why I input the answers as entries rather than multiple choice. I could have also gave you A, B, C, D. And I would give you something like, I don't know, what was the answer? The answer was $38,000. I'll give you $35,000. I'll give you $36,700. I could give you $38,000 and I could give you $50,000. And I would say select the right answer. The right answer is $38,000. So the point is, this could be assimilation. This could be a multiple choice. It doesn't matter. As long as you understand the concept of the equity investment, this, it doesn't matter. Just bring it on. It doesn't matter. So so what I'm going to ask you is, I'm going to invite you to check out my website, farhatlectures.com. This is what I teach. I teach the equity method in my intermediate accounting courses. I also teach it obviously the same one. It will be listed under your CPA exam far, whatever course you are using, whether you are using Becker, Sargent, Roger, Wiley. I have supplemental course for practically, for practically your major CPA courses. Check out my resources. My fee is nominal, practically nominal. You're studying for your CPA exam. You are making a lifetime investment, an investment that's going to pay you dividend for years. Don't shortchange yourself. I can add, if you are serious, I can add 10 to 15 points to your CPA exam. 10 to 15 points. Study hard, good luck, and stay safe.