 in which you would look at CPA exam questions that deals with the equity method of investment. The equity method of investment is an important topic on the CPA exam so you cannot take the exam if you are not comfortable with this method. I'll tell you why not because when you take the exam and you have an issue, a weakness in the equity method or in the statement of cash flows or pension or deferred taxes or the conceptual framework or governmental accounting simply put with any topic. It's considered a major topic and practically their own major topic. You will not be able to pass the exam. I will tell you why. They might throw at you starting at the beginning of the exam an easy to medium question. Let's say easy question about the equity method and the AI CPA thinks that this question should be 80% of candidate get this question right. So it's considered easy 80 to 90%. If you get this question wrong it's gonna alert the software and in turn the AI CPA that you don't understand the equity method. Now they might give you a pass on this well maybe this individual misread the question did not under you know answered it quickly. Then they might give you another question about the equity method. If you get it wrong then now they are starting to believe that you don't understand the equity method. They'd give you a third question to confirm. You get it wrong. Then now you're heading toward a 75% less than 75% score which is a failing score. That's why for the CPA exam you have to be prepared. You have to understand all the topics and that's why when you fail you notice they gave you a disproportionate questions about the same topic. Repeatedly for example leases or the equity method and the reason is because they notice that weakness and they want to make sure they're failing you because of that weakness. Now how can I help you when it comes to that? Well my website farhatlectures.com whether you are an accounting student studying this topic or a CPA candidate especially if you're a CPA candidate I do provide detailed lessons about all various topics on the exam. No I don't replace your Wiley, your Glyne, your Roger and your Becker. I can be a useful addition you keep those courses I can be useful addition and by adding me I would say you can add 10 to 15 points to your score which will put you above 75%. My offer to you is this are you willing to invest $30 to try out my system I have it my system is subscription but you can cancel so your maximum loss is $30 your potential gain is passing the exam are you willing to take that chance just simply put throw away $30 to find out whether I can help you improve the score get over 75 and move on with your life or not you know it's something that you want to think about if I was in your shoes I will do that also if not for anything check out my website to find out how well or not well your university doing on the CPA exam I do have the score by section I do also have other accounting finance tax courses as well please check out my website if you haven't connected with me only then please do so and only then you can read detailed reviews from students that use my system also you can see this on my website and to see how well they how well they did on the exam by using my system please like this recording share it put it in playlist connect with me on Instagram as well as Facebook let's take a look at the first question on January 1st 2021 the company paid 1.1 million 870 thousand for 80 thousand shares of John vote in stock which represent 45% investment no allocation to Goodwill or other specific account was necessary significant influence over John was achieved by this acquisition John distributed dividend of $2 per share during 2021 and reported income of 720 well what was the balance in the investment account found in the financial record of these company as of December 31st 2021 so here basically what they're asking you is you have an investment account investment in equity and specifically investment in let's just call it investment in stocks not call it John this way you'll have an investment in stock well let's just that's fine put the word John so this is your account investment in stock you paid for this investments 1 million 870 thousand therefore when you paid for this investment you increase your investment account by that much it's a debit it's an asset now you purchased 45% well you're you don't control the company but 45% I would say you have some significant influence matter of fact they're telling you you achieve significant influence it means under those circumstances you have to use the equity method what does that mean if you have to use the equity method well it means you have to account for your investment based on the income in the dividend that the that the subsidiary is generating now to make I think I could have made this problem a little bit more confusing by give you the fair value of John stocks for example I'll tell you when you purchase it the stock was for $70 and now the stock is 75 to confuse you but if you're using the equity method fair value is not is not relevant so you do now your investment account will go up and down in proportion to your net income the net income of the investing and the dividend distributed by the investing let me explain first of all the John earned 720,000 what does that mean if they earn 720,000 you should increase your investment by 45% of that amount why 45% because you own on this company 45% therefore let's go ahead and find out how much 720,000 times 0.45 equal to that's equal 324,000 so what's gonna happen you're gonna increase your investment by 324,000 this is because of the net income so we accounted for the net income also the company paid $2 in dividend well they paid $2 in dividend you have 80,000 shares so you're received in cash $160,000 excellent you're gonna debit cash so for this entry you're gonna debit cash 160,000 what are you going to credit well what you're going to credit here is not dividend revenue you're going to credit the investment account you're gonna go you're gonna credit the investment account of John okay so since I gave you the entry for the dividend let me give you the entry for the for the 320,000 for the 324,000 you debit investment 324 and you credit revenue from investment 324 so this is the for the net income so why do we reduce the investment by the dividend we reduce the investment because this is the same amount so simply put you already accounted for all the revenue 324,000 is all the revenue that you generated from your investment all what's happening now when they gave you the 160 they turn the revenue into cash that's all what they did they turn some of the investment they cashed out actually yes they cashed out 160,000 now we can find out what is your balance in this account simply put we're gonna take 1,870,000 increase it by 324,000 reduce it by 160,000 and that's going to give you a balance of 2,034,000 now you want to make sure you understand how the equity this is a basic real basic question about the equity method I consider basic but if you understand the basic that's all what you need to build on your knowledge but if you don't understand the basics then you will find difficult time answering question let's take a look at this easy straightforward question a necessary condition to use the equity method what's a necessary condition for reporting an equity investment which is what we worked earlier is that investor company must have what to use the equity method okay have the ability to exercise significant influence over the operating and financial policies of the investing I would say that looks like a good answer let's look at the other answers only at least 30% now let me tell you this let's look at answer A and answer B when you study for the CPA exam they'll tell you anything above 20 to 25 you would use the you would use the you would use the equity method so anything above 20 to 25 up to 50 obviously because above 50 you have control you would use the equity method okay let me just show you this graph real quick not graph just some some numbers so here's what happens 0 to 20% you would use the the cost or the fair value to be more specific let's use fair value you would use the fair value method for your investment between 20 again 20 to 25 to 50 percent up to 50 percent so let's make it 20 to 50 but sometimes they say 20 to 25 but they don't give you anything between 20 to 25 20 to 50 you would have to use the equity method and anything 50 plus you would have to consolidate you'd have to you have control and you have to consolidate now here you would say 30% is equity method but if you have to choose between A and B you would choose A because what matters what matters is do you have significant influence can you exercise significant influence and this is what determine whether you would use the equity method or not the reason is this because in the real world you could have only 15% okay you could only have 15% and if you exercise significant influence because because all the other investors they own one to half a percent then you have significant influence so the key to the equity method is the word significant influence so B if we don't if we did not have a as an answer B will be a good choice but between A and B you will choose A because what matter is the word significant influence over the operating and financial policies of the investee so that's why bay is B is not wrong but a is a better answer C possess control over the interest in the investee's voting stock here you would use consolidation control you would need 50% plus for financial accounting purposes do not have the ability to exercise significant influence absolutely that's the exact opposite to use the equity method you have to have significant influence and what does significant influence means it means you have enough shares of stocks where you can maybe vote yourself on the board of directors or vote someone that you trust and by doing so you can assign management so you do have some influence over the company under those circumstances you would use the equity method let's take a look at this question in 2020 sub reported net income of 650 for 2021 sub reported net income of 800,000 dividend of 250 were paid in each of the two years was the reported balance of the parent investment in sub so we have a sub and a parent and it seems without even reading the question we're looking at the sub investment we invested in a sub during 2020 the parent acquired 30% outstanding stock of a sub for 1.6 million but is there asking me for the investment balance I'm gonna start right here 1.6 million debit investment credit cash if I paid cash I could paid also stocks the investment gave the parent company the ability to exercise significant influence that's it that's all what I have to know to know I have to account for this investment using the equity method sub's asset on that date were 7.2 million with liabilities of 3.4 million any access of the cost over book value was attributed attributed to unrecorded patent have a remaining useful life of 10 years so whatever as whatever extra extra money we paid for this investment the reason we paid for it because the subsidiary did have a patent but that patent was not recorded on their books because maybe they created the patent themselves but now since we purchased the company we have the right to record that pattern that gives us the right to record the patent okay so now they're asking us what should be the balance basically simply put they're asking us about the balance in the sub okay so what do we have to do first we have to find out well we have net income we have dividend over the years but also we have another asset to worry about it's the patent let's start let's see the assets has were recorded a 7.2 million liabilities were 3.4 million let's start with that so let's see what was the book value 3.8 million we purchased 30% of this 30% of this and that's gonna give us 1,140,000 hold on a second we paid 1.6 million so we paid 1.6 million so we paid 1.6 million for this investment it's right here we paid 1.6 million for something that's worth 1,140,000 in other words we paid access 460,000 now we are told we are told the reason we paid this much the reason we paid this much is because you know any access is attributed attributed to this patent well simply put we have a new asset called a patent so we're gonna record this new asset on our books 460,000 that's why now what are we gonna do with the patent what do we do with the patent we gonna we're gonna amortize it and they're telling us it's over a useful life of 10 years so this is gonna become relevant for us when we do the investment account simply put we're gonna take this 460,000 dollar patent divided by 10 equal to 46,000 dollar per year now I doubt that they will give you a question this would require this much computation on the exam day but this is this is not my purpose my purpose is to teach you the equity method that's why those questions are a little bit long is because I want you to learn the concept now now let's go ahead and start to update the investment account the first year we had an end income of 650 well what do we do with the 650 we're gonna take this we have an income of 650 what do we do with the 650,000 we're gonna multiply it by 30% and as a result it's gonna increase our equity account by let me let me pull the calculator because there's a lot of calculation in this problem it's gonna increase our investment account starting with okay so 650,000 times 0.3 and that's gonna increase our let me use a different color increase our okay increase our investment by 195,000 again for the following year we had an income of 800,000 800,000 we're gonna multiply it by 0.3 and that's gonna give us an additional increase in the investment account of 240,000 now they paid dividend of 250 for two years so that made it easy for us so we're gonna take 500,000 multiplied by 0.3 which is 150,000 and what does that mean it means we reduce our investment by 150,000 so it's so far so good so this is net income for year one net income for year two which increase our investment and this is dividend are we done yet no we are not done yet why not because we're gonna have an additional reduction in the investment account as a result of this amortization so this amortization because it's gonna it's basically amortization expense it's simply put it's gonna reduce our investment for two consecutive years of 46,000 so simply put I'm gonna put this in a different color this additional cost okay 46,000 this is for the amortization year one 46,000 for the amortization year two this is for the patent amortizing the patent that we created on the books that we created on the books because we purchased this company therefore after all we after all said and done now we can compute our balance which is 1.6 million the starting investment balance 1.6 million plus 195,000 plus 195,000 plus 240,000 for year two income minus 150 for the dividend for two years dividend that's what this was for two years minus 46,000 minus ups I put minus 460,000 minus 46 minus 46 and this should give us if my math is right because I you know I did let me put plus 460 to take it out and do the computation again minus 46,000 minus 46,000 and that's gonna give us 1,793,000 and the answer is a okay so this is the answer for the investment account let's take a look at this question maybe we need the calculator let's keep the calculator out here on January 4th 2021 parent company purchased 40,000 shares or 40% of the common stock paying 900,000 there was no goodwill or any other cost allocation associated with the investment so notice the equity method involved a lot of stuff but here we're trying to keep things simple parent has a significant influence over the sub I'm gonna be using the equity method during 2021 the sub reported income of 240 paid dividend of 75 on January 2nd the parent company sold 5,000 shares for 125 so here's what they're saying is you made an investment then you sold part of that investment they want us to compute you know the investment balance simply put the investment balance let's start with the let's start with the investment so we have an investment we purchased it for 900,000 debit investment credit cash 900,000 parent we have significant influence they report the 240,000 of income that's fine of that we're gonna get we have 40% of that and that's 96,000 we're gonna increase our investment by 96,000 they reported dividend of 75,000 again our share of that is 40% and as a result we're gonna get 30,000 so we're gonna reduce our investment by 30,000 now the the account balance now you have to understand that we have to first compute the account balance 966 and this 966 represent 40,000 shares remember we purchased 40,000 shares of stocks 40,000 shares of those 40,000 shares we sold 5,000 shares well we can say well if I sold 4,000 I'm sorry 5,000 then I have to find out what is 5,000 what is 5,000 divided by 40,000 simply put what proportion of my investment I sold so I sold 5,000 divided by 5,000 simply put 5 divided by 40 let me just clear this 5 divided by 40 I sold 12.5% of my investment this is how much I sold of my investment what is 12.5 we're gonna take 12.5 multiplied by 966,000 so I sold I sold if I multiply this by 966,000 I sold 120,750 of my investment and I sold it for 125,000 okay so simply put okay they're asking us they're not asking us about the gain if they're asking us about the gain on the sale the gain would have been minus 125,000 the gain on the sale would have been 4,250 they're not they're not asking us about the gain they're asking us what should be the balance well what should be the balances we need to reduce now our we need to reduce our investment reduce because we sold 120,750 12.5 so we're gonna take 966,000 and we're gonna reduce it by 120,750 and that's gonna give us 845 to 50 845 to 50 the balance is 845 to 50 and this is the answer again I could have asked you what's the gain what is the gain the gain would have been 4,000 we calculated 4,250 so this is basically a series of questions about the equity method once again at the end of this recording I'm gonna invite you to check out my website farhatlactures.com especially if you're studying for your CPA exam I can help you understand the material better then the CPA review course simultaneously not then simultaneously the CPA review course will help you prepare for the exam hand-in-hand between farhat lectures and any of these courses will help you succeed substantially on the exam don't shortchange yourself the CPA exam is a lifetime investment good luck study hard and stay safe