 Hello, and welcome to the session in which you would look at investment in equity securities using the equity method. In the prior session, we looked at investment in equity securities using the fair value method. Please note that this lecture is designed for CPA candidate. If you would like to have more discussion and more in-depth discussion about the equity method, please go to Farhat Lectures to my advanced accounting course. But this one is designed for CPA exam candidate. So it's basically a review. The goal is to explain a little bit more than your typical CPA review course like Becker, Roger, Wiley, Gleam, but not as much as I would cover in my advanced accounting course. So a little bit more in-depth, but not as much as a typical course. So we're going to be going from page 9 basically to page 11. Hello, and welcome to this session in which we would look at investment in equity securities using the equity method. In the prior session, we looked at investment in equity securities using the fair value method. Please note that this lesson is designed specifically for CPA candidate. What does that mean? It means that this lecture is a quasi-review. It's a little bit more in-depth than your typical CPA review course like Becker, Roger, Wiley, Gleam, but it's a little bit less than when I cover this in my advanced accounting. So in this session, I would look at the equity method and basically I'm covering this session here, this section here. Again, would like... So when do we use the equity method? We use the equity method when we own between 20 to 50% of the company stocks. Well, what happened if we own below 20? Well, if we own below 20, we use the fair value method, fair value method, and this is what we covered in the prior session, fair value method. So this is done. Now we own between 20 to 50. The assumption is the investor has significant influence. It means you have enough power to vote the board of directors or vote yourself on the board. Therefore, you'd have to account for this investment using the equity method. This is what we're going to be doing today. So when the investor owns between 20 to 50, between 20 and 50% of the investor's voting stocks. And remember in the prior session, we said usually the voting stocks are common stock or even less sometime and have significant influence over the investee. The investment is accounted for using the equity method. Now in the real world, you could own less than 20% and have significant influence, but for the CPA exam and for accounting purposes, the cutoff is between 20 to 50%. When the investor, if you own between 20 to 50%, but you are not capable of exercising significant influence, in other words, you do own between 20 and 50%, but the subsidiary is in bankruptcy. Well, you cannot account for it using the equity method under those circumstances because you really have no saying when the subsidiary is in bankruptcy. Just be aware of this in case you saw multiple choice questions. You have no saying usually the court appoint a trustee. So that's why you have to be aware of this. So what do we need to be aware of from an accounting perspective? Well, we need to be aware of three things, mainly three things from the equity method. There are three main journal entries that we need to deal with. The first one is to record the initial investment cost. When we buy this investment, how do we record the investment? The second one is to record dividend received. Now we're going to be receiving dividend. How do we account for that dividend? And the third one is to report the investor shares and in the investee's earning. Well, when the company generate a profit or generate a loss, how do we account for the profit or the loss? Also, we have to account for access amortization. We'll talk about that later, but those are the three main journal entries. So starting with initial costs, that's the first thing. When you buy an investment, the first thing is you record the investment on the books. How do you do so? Well, the total value of the investment is equal to the fair value of the consideration paid plus any legal cost you might have incurred. So simply put, you will debit the investment for how much you paid for it, including legal cost and you credit cash if you paid cash, or you credit common stock and additional paid in capital if you issued stocks to buy this company. And don't worry, we'll work an example illustrating this point. What happened when the investee generate earnings? How do we account for the investee's earning? Simply put, the investee, the company that you purchased, 40-30% of it, now it's generating profit. Well, the investor would recognize it shares in the investee's earning. Simply put, we ignore the fair value fluctuation. So if we bought a company and their stock went up or their stock went down, if you're using the equity method, ignore the fair value fluctuation. If you're using the equity method, you would look at their earnings. You're kind of part of that company. You don't care about the fair value of it, the fair value of the stock, unless you are using the fair value option. If in the problem, they told you you are using the fair value, I'm going to put this in caps, option, then you will care about the fair value. But if you are not told you are using the fair value option, you would use the equity method. So simply put, if the investee, if the company that you invested in, the subsidiary generate income, well, you're going to increase your investment proportionally. So if they generated 100,000 of net income, if you own 20%, well, 20%, yes, that's going to give you significant influence. Then you increase your investment by 20,000, and you increase your investee's income, which is a income account, investee income, equity and earnings income account, you increase it by that much. We'll work an example. It's important to note that the earning to be used to compute the investor share and investee's earning are the investee's earning that are available to common shareholders. So what are the income that's available to common shareholders? Bear in mind if they have preferred dividend, you have to deduct the preferred dividend from their income, because the investor gets the income that belongs to the common shareholders. So if there's any dividend, you deduct the dividend to arrive to income available to shareholders. Just be aware of this small thing. So what happened when they paid dividend? Under the equity method, dividend received by the investor do not hit the income statement. Why? Because simply put, you're already accounted for that dividend. How? Because the dividend comes out of net income. So your subsidiary generate revenues minus expenses and will give you net income. Now the net income percentage is already accounted for. Why? Because you took net income, you multiply it by a percentage and you increase your investment by that percentage. Now when the company pays dividend, guess what? They paid the dividend out of net income. Well, you already accounted for all of net income as income. So you cannot count the income twice. Therefore, what happened when they pay dividend? You're basically, you are cashing out your earnings. Simply put, you are withdrawing the earnings. Therefore, when they pay dividend under the equity method, you are going to increase your cash. Obviously, you received your cash and you are going to reduce. You're going to credit your investment because now you are cashing it out. They're giving you back, they're cashing out the earnings from your investment. Now, let's take a look at one more thing we need to be aware of, access of assets, fair value over net book value. The difference between the assets, net book value and the fair value should be amortized over the remaining useful life of the asset. So sometime what happened, you pay for certain assets more than their book value. For example, you bought a piece of equipment. Well, you paid more for the company and part of it is because of that piece of equipment. Well, because you paid extra, that piece of equipment will need to be amortized. Don't worry, we'll work an example. I always say this. The amortization decreased the investment and investing account and is recorded as follow. We're going to debit earnings. So we're going to reduce our income and credit the investment, the investment in investing. We're going to debit earnings. Basically, debit earnings means what? We're going to debit, debit basically amortization expense, reducing income and reducing our investment. Please note, only the appreciable asset are subject to this amortization. And always remember to amortize the difference between the fair value and the book value of the asset acquired. So the asset acquired could be a piece of equipment, a building, a machinery. Remember, it has to be subject to depreciation, not the difference between the fair value, total fair value of the company and the total asset and their book value because that's that's called something else. Okay, that's you're not dealing with goodwill here. You're dealing with one particular asset. Okay, so if there's any access of the purchase price over the asset fair value that represent goodwill. Now note, goodwill is not accounted for under the equity method. Goodwill created is an investment account for using the equity method is neither amortized nor tested for impairment. It's just ignored. It's just ignored. However, the entire investment is tested for impairment and any permanent decline is recognized in income, recognized as losses in income. And don't worry, again, we're going to start to work an example. Simply put, there's no goodwill. You don't create a goodwill. What you do every year, you look at your investment value and you'll test it for impairment. Now the best way to illustrate all these concepts is to actually work an example. But let's talk about one more thing is impairment. As previously mentioned, when using the equity method, the entire investment is tested for impairment. An impairment loss should be recognized in the income statement when the carrying value of the investment when the book value of the investment is greater than the fair value provided it's probable that the decline is permanent. Also know for us gap, the reversal of any previously impaired loss is prohibited. Simply an easy multiple choice question. Let's start with a simple exercise to illustrate the equity concept. On January 1st, company A paid 400,000 to buy 20,000 shares of 50,000 shares of company B. At that date, the net book value of being that asset was equal to its fair value. So book value equal to fair value, keeping it as an easy example. During year one, company B earned 370, which is the subsidiary and declared dividend of 320. Determine the percentage of ownership and determine how to account for this investment. Well, the first thing we need to know, how are we going to account for this investment? We purchased 20 out of 50,000 shares. We own 40% of this company. Well, if we own between 20 to 40%, the absence of any other additional information, we would use the equity method. We assume to have significant influence and we're going to be using the equity method. That's the first thing. Two, let's prepare the journal entry to account for the investment at acquisition. That's the first thing you have to do, how to account for this investment. Well, company A paid $400,000 for the ownership of 40%. In giving that the net book value of the company A equal to 1 million, therefore there is no difference between the amount paid and the value of the investment, because we paid exactly the book value of the company and the fair value equal to each other. Therefore, we debit investment and investing $400,000, credit cash $400,000 since we paid cash. We'll work an example where we issued stocks for this. Determine the value of investment A at year end and prepare the journal entries when the investing generate income and pay dividend. Let's take a look at this. When using the equity method, the value of the investment increases by the investor share of the investor's income. That's how it increases and it decreases by the amount of dividend. Well, given that company B earned $370,000 in year one and paid $320,000 of cash dividend, now we can compute the ending balance of the investment. Well, we started the investment with $400,000. Then the earnings is $370,000. We're going to take $370,000 multiplied by 0.4. This is our share of earning that's going to increase our investment by $148,000. Then we are going to deduct the dividend amount which is $320,000 and we are going to receive 40% minus $128,000. That's going to give us a value of the investment, book value of $420,000. How do we journalize the entries? Well, for the income we're going to debit the investment, we're going to increase the investment $148,000 and we are going to increase income by $148,000. For the dividend amount which is $128,000, we're going to receive the cash. That's great. We receive the cash, $128,000. However, we reduce the investment by $128,000. So from a T-account perspective, investment in B would look something like this. We started with $400,000. Then we increased it by $148,000. Then we reduced it by $128,000 for the dividend received. And as a result, the investment will have an ending balance, if my math is right, a $420,000. Let's take a look at a little bit more involved example where we have excess amortization as well. On January 1st, Company A issued 10,000 shares. Now, they issued 10,000 shares of its $20 par value stock at 50. So they sold them at 50. So 10,000 times 50 is what they're paying to acquire 40% interest in Company B. Here I'm telling you, it's 40%. You know in the absence of any other information, we're using the equity method. In addition, Company A incurred 7,600 in legal cost and they paid this in cash, incurred and paid. At that date, the net book value of B's net asset was equal to a million, that's the book value of the net asset, and the fair value is 1.2. So there's a difference. Well, we are told the only difference between the book value and the fair value related to property being depreciated over its remaining useful life of five years. So notice here, we have an extra thing to work with and that's that piece of property that's going to be depreciated over five years. During year one, Company B earned 370,000, declared dividend of 320. Basically, simply put the same numbers except a different scenario. Determine the method that A would use. Obviously, we're going to use the equity method and let's prepare the entry for the acquisition. So we're going to be using the equity method, that's easy. So how do we account for the initial cost? Well, we paid, we issued 1,000 shares times $50 per share, that's equal to half a million. So we paid half a million for the company, plus we paid 7,600 in legal cost. So the total cost 507,600. We debit investment 507,600. The 7,600 is paid in cash. We credit the cash. Then we credit common stock. Remember, how much do we credit common stock? The number of shares, 1,000 shares times the par value of 20. Remember, common stock is always credited, the number of shares times the par value. This is important. We'll give us a credit of 200,000 and simply put additional paid in capital is a plug of 300,000. So this is the initial cost. Now, compute the difference between the acquired asset book value and fair value and determine the implied goodwill value. Well, let's see. The total net book value of company B net asset at the time of the acquisition is a million. That's the book value. The share of company A in book value equal to 400,000. That's the book value. 40% of the book value is 400,000. The fair value of company B net asset is 1.2 million. We are giving this. Therefore, the shares of company A in the fair value of company B net asset equal to 480,000 because 1.2 million times 40%. Simply put, we have an access of 80,000. And we are told this 80,000 belongs to a piece of property. So the difference is 80,000. This difference should be depreciated over the remaining useful life of the property, which we already determined. It's five years. On the other hand, goodwill is computed as the difference between the value of the consideration paid to acquire the 40% and ownership in company B. Therefore, it's equal to we paid half a million. We paid $20,000 more. This is the implied goodwill. What do we do with this implied goodwill? Nada. We don't do anything with it. Simply put, goodwill is ignored. But what happened on a regular basis, we're going to test the investment for impairment. So we ignored the goodwill. This is the implied goodwill, but we don't record it. Record the journal entry to depreciate the difference in fair value. Now, remember we have that extra 80,000. Well, that extra 80,000 will be depreciated over the remaining five years. So every year, at the end of the year, we are going to debit equity, debit equity and invest the income. The reason I say equity because we are going to debit really amortization expense and amortization expense will reduce your equity, amortization expense, 16,000 and reduce the investment by 16,000. So debit equity and invest the income, basically reducing income, which is debiting an expense. But it's very important to say that you are reducing your equity and reducing your investment and this happens over five, five periods, five years. Let's go ahead and book the journal entries, which we already know how to book the journal entries for income. The income is 148. We did it in the prior example and the dividend is 128. Now, we have to keep in mind what is the value of the investment. So let's do the T account again, investment and B investment and B company. We started with 507,600. That's what we started with. Then we are going to reduce the investment by 16,000 for the amount of amortization. Then we are going to increase the investment by the amount of income, 128. Then we are going to reduce the investment by the amount of dividend, I'm sorry, income is 148, 148, which is 40% of the earning reduced by the amount of dividend, 40% of the dividend is 128. All in all, now we have an investment that's worth 511,600. 511,600. Now let's go through one more step. Assume that the fair value of the investment at the end of year one is 475 and the company believe this decline in value result from a permanent shutdown of the production of one of its main product. Now we have an impairment loss to compute. Remember, now the value is 475, the fair value. However, we have it on the books of 511,600. So 511,600 minus 475 that we're testing for impairment. This is going to give us an impairment loss. The difference is 36,600. We'll simply put, we're going to debit a loss, which is part of life, part of the income statement, income from operation, 36,600 and reduce our investment by 36,600. So this is the impairment. This is what we need to do. So basically this is the equity method in a nutshell. What should you do? Go to farhatlectures.com, work, MCQs. I also have true and false to help you understand this topic. Study for your exam. The CPA exam is worth it. Don't shortchange yourself. Good luck, study hard and of course stay safe.