 Hello and welcome to the session. This is Professor Farhad in which we would look at the equity method. This topic is covered in financial accounting, intermediate accounting and much, much more in depth in a course called advanced accounting. I do have intermediate and advanced accounting on my YouTube channel. This topic is also covered heavily on the CPA exam. As always, I would like to remind you to connect with me on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have 1,700 plus accounting, auditing, tax and finance lectures. This is a list of all the courses that I covered, including many CPA questions. Connect with me on Instagram. Like my lectures, share them. If they benefit you, it means they might benefit other people. Also on my website, farhadlectures.com, you will have additional resources to supplement your accounting education or study for the CPA exam. A lot of multiple choice through faults, exercises, notes, PowerPoint slides to supplement your education. The prerequisite for this recording, because this is about investments, you can check for the prerequisite in the description. So let's talk about equity investments. So when we invest in equity, when we buy stocks, how do we account for those investments? So when company A buys stocks in company B, whether it all depends on your ownership level, do you own less than 20%? If you own less than 20%, we will use either the cost or the market value method, because here we are assuming you have insignificant or you lack significant influence. Simply put, you have no saying in the company. If you own less than 20% of a particular company, you have no saying in that company. Therefore, it's you lack significant influence and this is the method that we looked at in the prior session. You could look at the description. If you own between 20 to 50%, you would use something called the equity method. Now this is what we're gonna be looking at today, the equity method. Here you assume to have significant influence. Here you have significant influence. What does that mean? It means you can vote the board of directors, you can vote yourself to be one, you can maybe get a position in management, so you have some influence, therefore you would use the equity method. If you own more than 50%, well here once you own 50% plus, you become the majority shareholder. Now you have to consolidate the financial statements and this is what you would learn in my advanced accounting course where you would learn about consolidation and we don't cover this in financial accounting, this is an introductory course. So how do we account for investments and equity securities with significant influence? Well, in this course, it's pretty simple, but it's very important that you learn the simple, learn the basics, because once you learn the basics and intermediate, we don't add that much to this topic, but believe me in advanced accounting, we're going to add a lot about this equity method. So the first thing is when you buy the investment, just like every other investments, every other assets, it's initially recorded at cost, then the investment, that investment is increased, it's gonna increase by the proportionate share of the investee's earning, huh? What does that mean? It means you're gonna wait until your investee, the company that you invested in, report their earning. And if you own 30% of the company, you're gonna increase your investment by 30% of the earning that they reported. Guess what? If they report losses, you're gonna reduce your investments by 30% of their losses, then you are going to decrease your investment account by dividend received. So let me show you that the account will explain this later, little bit more in details. So this is what we have. We have an account called investment in equity. So you have some sort of an equity investments, and here's what's gonna happen. Every time you have net income, it's gonna increase your investments. Every time you have a net loss, it's gonna reduce your investment. And every time you have dividend, it's gonna reduce your investment. Don't worry, we'll explain why dividend reduce your investment shortly when we work with numbers. It's easier to see it with numbers. So let's take a look at an example to see how this all fits. First, you're gonna buy an investment. January 1st, micron record a purchase of 3000 shares, representing 30% of star common stock at a total of 70,650. Now here's what I want you to kind of look for the first. Notice they told you you purchased 30%. It means you're gonna be using the equity method. On the CPA exam or in the homework, they may not tell you explicitly you're gonna be using the equity method. They assume since it's 30%, you're gonna be using the equity method. So let's take a look at the journal entries. First one we purchased. Simply put, we debit the investment, long star investment, long-term investment star and credit cash, basically recorded at cost. Now what we do, we wait until star reports their earning and star reported $20,000 in net income and they paid out half of them in cash dividend, which is 10,000. So remember, when they report net income, we qualify for 30% of that. Basically it's our net income. And what's gonna happen with that 20,000 times 30%, that's 6,000. We are going to increase our investment by 6,000. So we're gonna increase this investment by 6,000. And then on the second slide, we're gonna see all the T-account entries. And we're gonna credit basically an earnings account, earnings from long-term investments, $7,000. That's done. Now, they also paid us $10,000 in cash dividend. How much are we going to get? We're gonna get 30% of that, which is $3,000. Excellent, we're gonna debit cash $3,000. What are we going to credit? Well, the key here is to remember we're using the equity method. What does that mean? Remember what we said, when you receive dividend, it's gonna reduce your investment. And the answer is why? Well, here's why. Here's what they did. Remember, dividend, this cash, this $3,000 cash is coming from your earnings. It's coming from net income. All what they did is they're giving you $3,000 in cash, which means they are, okay, it's coming from your revenue or it's coming from your asset. It's coming from assets and revenue that you generated in your investing. Now, all what they're doing is they're giving you the cash. So what they did, they took the investment that you have in their company and turned part of it into cash. So of the $6,000 that you had in your investment, they paid it out in cash. Well, you did receive the cash, that's excellent. But you cannot consider this revenue again. You cannot say, I'm gonna credit dividend revenue because if you say I'm gonna credit dividend revenue, then your revenue equal to 9,000. Why 9,000? Well, you recorded 6,000 initially, then you're gonna record another 3,000. Therefore, it's not dividend revenue. All what they're doing is they're giving you the earnings that you already earned and recorded as revenue. So it's the credit is long-term investments. Therefore, they're reducing your investments. Well, that's the bad news. The asset going down. Well, the good news is they gave you cash. The asset goes up. So it's that $6,000 that you have. Simply put, you have money in the bank. You have $10,000 in the bank. You went to the ATM machine and you would drew $500. Now you have $500 in your pocket. It's the same thing. You still have 10,000. The bank account is 9,500. Now the bank has, you have in your account 9,500, but in your pocket you have 500, so you still have 10,000. Same concept. You already recorded that earnings. All what they're doing now is giving you the earnings in cash. So remember that. That's why you will credit long-term investments. So you reduce your long-term investments. Now let's take a look at the T account what we did in this whole thing. This is the investment account. This is the beginning. You, when you purchased it at cost, you add the net earnings and the balance became 76,750. Then you're reduced it by 3,000 by the amount of dividend. The ending balance is 73,650. Now sometime on the exam or on the homework, we're gonna tell you, you sold this investment for 80,000. If you sold this investment for 80,000, your proceeds are for 80,000. Then you have a gain for the difference. So remember the difference now, the balance is 73,650. So be careful about this. Let's take a look at another example to kind of consolidate what we just learned. Prepare the, prepare entries to record the following transaction of Garcia company. Okay, the Garcia company, they purchased 400 shares of Lopez. So Garcia company, we call Garcia company is the parent company. We share Lopez as the subsidiary. Or Garcia is also called the investor. And Lopez is the investee. Okay, so they purchased 400 shares of the common stock for 3,000. Lopez has 1,000 shares of common stock outstanding and its policies will be slightly influenced by Garcia. Here they gave you a hint that you're gonna have significant influence. And think about it, if you bought 400 out of 1,000, you own 40% now of Lopez, which is, you have to use the equity method. Lopez declared dividend at $2 per share. They announced their income of 2,500. And this is in year one. In year two, they declared and paid dividend. And they declared their income. Then Garcia sold 100 shares for 1300. So we're gonna have to journalize these entries. Basically that's what we are being asked to do. Now keep in mind, here's what we have. We have the long-term investments. So under, this is what Garcia. Garcia will have a long-term investments in Lopez. And Lopez, the investee will report the earnings. So here's what's gonna happen. Lopez will earn that income. That's fine. Then they will generate net loss and retained earning. Then they will pay dividend and retained earnings. So this is what the investee does. So when they have income, retained earning goes up. When they have a net loss, retained earning goes down. When they have dividend retained earnings goes down. Now what's gonna happen to Lopez, what's gonna happen is the net income, the net income that Lopez, which is 40% of this net income increases Lopez investments. You know, in our situation, 40% of net income. The net loss reduces Lopez investment by that percentage, 40% and dividend reduces Lopez investments. So let's take a look at the transactions and see how they all fit together, just kind of journalize them. First, we purchased 400 shares for 3000. We debit long-term investments in Lopez 3000 and we credit cash 3000. Now the second thing is they pay dividend. Well, this is the entry. Let's look at the entry for each one. So the retained earnings is whatever the retained earnings is. Now Lopez, the first thing is, let's look at the T-account. The T-account for Lopez is established long-term investments for 3000, okay? Now, Lopez declared and pay cash dividend of $2.00. When they pay cash dividend, their retained earnings goes down. Debit and we receive 40% of that. We received 40% of that. We is Lopez. So we're gonna debit cash 400 shares times $2.00, $800. And we're gonna reduce Lopez investments. Remember, every time the investee pays dividend, it's a reduction in our investment because our investee is reducing their value. Basically, we reduce our value proportionally. Then they have a net income of 2500. Remember that income, it's gonna increase Lopez's retained earnings and that's gonna increase our investment by 40% of 2500, which is $1,000. Debit our investments, credit the earnings. So this is basically, we purchased it, we received dividend, we recorded the net income. So basically here, we increase our investment. Now this is the balance. Now we can compute this. How much is the balance? It's 4,000 minus 800. The balance is 3,200. Now, remember that for year two, we declared and paid dividend of 225, a total of 2250. Once again, we're gonna receive 40% of that, which is 400 shares times 225. In cash, we reduce the investment by 900. We reduce the investment by 900. Then the company generated 2,750 of earnings. Lopez retained earnings goes up. Our investment goes up by 40%, which is 2750. I'm sorry, of 2750, which is 1,100. So this is for year two. Notice we now we could compute the new balance for the investment. So we add 3,000 plus 1,000 plus 1,100, which is 5,000, 5,100 minus 1,700. And this will be the balance. Now we sold, Garcia sold 100 shares. Now actually I'm gonna have to do this computation because we have to kind of know what we're doing here. So let me do the computation. Then, and you're gonna see why I did this is because I wanna show you when we sold 100 shares, we sold 1 fourth or 25% of it. So we have 5,100 minus 1,700. The balance is 3,400. Now what we did is we sold of the balance is 3,400. We sold 0.25, 1 fourth of that. So we multiply this by 0.25. We sold 850 of our investments for 1,300. Therefore we have a gain. So we're gonna debit cash 1,300 for the cash. Credit, low pass, long-term investments. Again, 25%, 1 fourth of 3,400, 850. Then the difference is a gain. So notice we did not sell the whole investment. We sold, we did not sell the whole investments. We sold 1 fourth of it. 1 fourth of it, we got more than the cost of it. Therefore we have a gain, excellent. And this is an actual gain that goes on the income statement. If you like this recording, please like it, share it, put it in playlist as always. I would like to invite you to visit my website for additional resources, especially if you're studying for your CPA exam. I can get you those seven to 15 extra points that you're looking for to pass the exam, put it behind you. Study hard for your accounting courses. Accounting is worth it, good luck. And in the next recording, we would look at accounting for international operation. Good luck and stay safe.