 Hello, and welcome to this session in which we would look about the equity method of accounting. This is going to be part one of two. And the reason is to cover the equity method in depth, I'm going to need to separate this recording into two components, part one and part two. The prior two methods, fair value and cost accounting, were covered in the prior session. Consolidation, it's going to be a lot of lectures that deals with consolidation. So remember this graph that I used earlier. If this is 100%, well, how do you report your investment? Depending on the degree of control. If you control up to 20% of the company, if you purchase up to 20%, you would use fair value or the cost method. Between 20 to 50, between 20 up to 50, this is where you would use the equity method. And we're going to explain this a little bit more. If you have 50% plus, if you have more than 50%, this is where you would have to use consolidation. So those are the guidelines. You're going to see, I'm going to explain later, that this is just a guideline. And we're going to go with this guideline as far as students are concerned in the real world. This is just a guideline. What does that mean? It means although you might have less than 20 or between 20 and 50 or less than 50, you would use different method. But this is what we do for us. Now, this topic is covered on the CPA exam, as well as advanced accounting. So whether you are an accounting student or a CPA candidate, I strongly suggest you take a look at my website, farhatlectures.com. I don't replace your CPA review course. What I can be a useful addition. I can be supplement. I can explain the material differently. I can offer you alternative explanation, alternative resources, alternative practice exercises to help you understand the material. By helping you understand the material better, you will do better on your review course and you will do better on your CPA exam. Look, your risk is one month of subscription. That's what you are risking. You try it. You find it helpful. You keep it. If not, you cancel. That's your risk. Your potential gain is passing the actual exam. Are you willing to take that risk? And I do have resources for other courses as well. If you haven't connected with me on LinkedIn, please do so. Take a look at my LinkedIn recommendation, connect with me on YouTube, subscribe, like my recording, connect with me on Instagram, Facebook, Twitter and Reddit. So we're going to talk about the equity method in depth, part one of one. And in the next session, we'll look at part two of two and I will tell you what I will be covering at the end of the session. So when we talked about the equity method, we said it's between 20 and 50%. If you own between 20 and 50%, the guideline says you should use the equity method and the reason behind it is this. If you own between 20 to 50% and this is quoted, you have the ability to exercise significant influence over the reporting and financial policies of the investing. So if you own between 20 and 60, 20 and 50%, you would have a saying in that company. Even though the investors hold 50% or less of the common stock. So that's the assumption. That's the basic idea is you have significant influence. Now, what determines significant influence? Yes, we said 20 to 50%, but that's not the only thing they look at. They would look at other indicators that determine whether you have the ability to exercise significant influence. So let's take a look at some of these conditions. Board of Directors is elected by the investor. So you have some people on the Board of Directors that you can elect. You can participate as an investor in strategic and policy making of the investing. You have a saying in what they are doing or what they plan to do. You have significant amount of transaction between the two companies, material transaction, management between the companies. Again, there's going to be like some program that they exchange managerial personnel. So you'll send your management to spend six months to learn about the company or they spend theirs. There's a technology interdependence or dependency. So your technology or your operation depend on their technology or their technology depend on your operation or both at the same time. So there's interdependence of technology. The proportional amount of investor share in relationship to other investments. So you do have a substantial share of your investment tied up to that particular company in relationship to other investments. So all these conditions are evaluated together. Yes, 20 to 50% is the guideline, but you have to look at other factors. This is just the guideline. What matters is, can you have significant influence that it can manifest itself through these through these conditions, through these conditions? Usually, electing the board of director, having some saying in that that's really a good indicator. Now, there are other issues that you need to be aware of when you are dealing with the 20 to 50%. For example, you could have 20 to 50%, but also you could have an agreement on the side. Although I own 20 to 50%, I don't have no saying with the company. Okay, so there will be an agreement between the investors that you surrender significant right as a shareholder. Although you own more than 20%, you own 30%. But tell them, look, although the agreement is you own 30%, but you have no saying. If there's the agreement, then you have no significant influence, although you have 30%. Again, what we have to look at is, is, do you have a saying in the company? Also, concentration of ownership operates the investee without regards of the views of the investors. Group of people, group of investors, control the company without regard to the other investors. So you also can ignore the 20 to 50%, although you own 30%, but you have no saying. Okay, also, the investor fails to be able to elect a board of directors. So if you fail to do so, somehow all the other investors gain up on you, you own 30%, but the other 70%, you know, you could not elect anyone. Guess what? You really have no significant influence. So although you might own more than 20%, but you have no significant influence. Now, if you have control over the company, just like you could have an agreement where I give up my right, an agreement exists to surrender your right, you could also have an agreement where if you have less than 20%, or between 20 and 50%, but guess what? You control the company. So under these circumstances, control can be achieved through contractual arrangement called variable interests. So simply put, I don't have 50% plus, but guess what? I have an agreement that gives me the right to control this company. Guess what? Now, I'm no longer equity. It doesn't matter that 20 to 50. I control the company. If I control the company, then we move into the consolidation territory. It's no longer equity. Okay, for example, a company might create a separate legal entity in which it holds less than 50% of the voting interests, but control the whole entity through governance document or provisions or some sort of a contract. We agree that I make all the decision that specify decision-making power and the distribution of profit loss and losses. Well, you have here is variable interest entity or special purpose entity we'll talk about later on. So you don't own more than 50. You own less, you own between 20 and 50. It's not equity. Now you have control. Okay, sponsoring firm may require to include them in the consolidated financial statement, which is guess what? Consolidation, which is the fourth category. Okay, although you own less than 50%, those are special situation. Now, bear in mind, investors can always elect to choose something called the fair value option. What is the fair value option you own between 20 to 50? The guideline is this is equity. You would say, no, I'm not going to use the equity method. I'm going to use the fair value option. What is the fair value option? The fair value option means you would write up and down your investment based on the fair value of the company, not based on income and dividend, which we have to do in the equity method. So the fair value option is simply another option, like another option that you have. If you say, look, I'm going to elect the fair value, forget about consolidation, forget about equity, you are taking the fair value option. Also in some cases, guess what? The majority shareholder may not have control over the company because the minority shareholders restrict the power of the majority. How would they do so through agreements? Like what? They could restrict you in terms of compensating, hiring, termination and other critical and capital budgeting decision. Well, if they control you, if they can dictate, if the minority shareholders, they can dictate this, well, you might have the majority of the shares, but you don't control the company. An example is AT&T, when AT&T and Bell South owned Singular, AT&T owned 60%, Bell South 40, AT&T used the equity method because they really had no control over Singular, although they owned 60%, but the agreement between them and Bell South kind of restricted their ability to exercise that complete control, although it's more than 50. Now, the best way to do this is to look at actual numbers to see how accounting work, because we talked about the equity method and we said we have the fair value. We can value the investment at fair value. So you want to see the difference, but you really want to learn how the equity method works, because you should have learned about the fair value method in intermediate accounting. Let us assume Solar Company owns 20% interest in Mars company and they purchase it on January 1st for 210,000. Mars reported net income of 200,000, 300,000, 400,000 respectively, 21, 22, and 23. I'm sorry, 20, 21, and 22, while declaring dividend of 50,000, 100,000, and 200,000. So this is their income, net income, and this is their dividend amount. The fair value of Solar Company investment in Mars is 245 for 2021. At the end of the year, 282, 325, at the end of 2021, and 22. Now we're going to look to see how these numbers are reported if we use the equity method or if we use, if we elect to use the fair value method. Starting with year one, year one, 2020, we have net income of 200,000 and dividend of 50,000. So this is net income by Mars. The company that we purchased, they declared dividend of 50,000. Now, if we are accounting for this method, if we're accounting for this investment using the fair value method, we say we have dividend income, dividend income of 10,000. Why 10,000? Well, it's 50,000. They paid 50,000 and we own 20%, 50,000 times 10%. Accounting for Solar Company when influence is not significant, okay? Well, guess what? At the end of the year, the value of the company went from 200,000 to, from 200, I'm sorry, no. The value of the company went from 210 to 245. The value of the company changed by 35,000. This is if we are using which method? Fair value. So this is fair value and this is fair value. Now, accounting for Solar Company when the influence is not significant, so what's the carrying amount? How much do we report the investment at? We report the investment at the market price. This is also fair value. Now, let's assume now we have significant influence here if we use the equity method. If we use the equity method, what's going to happen? Accounting for Solar Company when influence is significant, guess what? When the company generated $50,000 of income, when they generated $50,000 of income, I'm sorry, not $50,000, we generated $200,000 of income. When they generated $200,000 of income, 40% of it is 20% of it is ours. Therefore, we're going to increase our investment, the investee income by 40,000. Now, how do we report the investment at the end of the year? Well, the investment at the end of the year, let me check something real quick, please. So we have, let's go back here, the net income was $200,000. Let me just do something real quick. I just want to double check the numbers. If it's for dealing with $200,000 times 0.2, that's $40,000. Yes. So from the income, we increase our investee income. The income is $40,000. That's right. Accounting by Solar Company when the influence is significant, what's the carrying amount? The carrying amount is $240,000. Why $240,000? Well, this is what I have to explain this. We started with $210,000. Then the income was $40,000. Remember, we generated 20% of the income. Therefore, the investments is $250,000. Hold on a second. Why is it $240,000? If we're saying the income is $250,000, what did we do? Well, we also received dividend of $10,000. When you receive dividend under the equity method, you reduce your investment by the amount of the dividend you received. Well, let's see. Yes, your income is $40,000, but what they did is they gave you out of it $10,000. Then you have to reduce your investment by $10,000. Basically, when they distribute dividend, your investment account goes down by the amount of the dividend if you are using the equity method. Therefore, the book value of the equity is $240,000. I'm going to show you the value and the activity for the following year. Basically, you can look at them and hopefully you can follow. In case you're wondering, sometimes students, they find why is it $37,000? Why the value is $37,000? Well, you have to find the value between the prior year and this year. The value was $282,000 to $245,000. You should know this from intermediate accounting, but I'm not going to assume this. Minus $245,000, this is the $37,000. Obviously, you can do the $43,000 what's the change in fair value? The rest you should be able to figure out, I think. This is how you would account for it using the fair value versus the equity method. Now, let's take a look at the journal entry about the equity method. That's important. The journal entry for the equity method, for the $40,000, we increase the investment by $40,000 and we reduce, I'm sorry, we increase the investment and we increase the income. We debit investment, which is an asset, and we credit income, which is income or revenue account. The investment, remember, if we are looking at a T account, if we are looking at a T account for the investment, we started at $210,000. Now, we added $40,000 to the investment. Then the dividend was declared. We have dividend receivable because we expect to receive dividend and we reduce the investment. Remember, for the dividend, when we receive it, when we get the dividend from the company, it's from our own money. Basically, we are withdrawing our own money from the bank account. We earned $40,000, now we're taking it out, so it's going to reduce our investment. So, therefore, the investment is $240,000. Now, once they pay us the cash, we debit cash, credit dividend receivable. This is just basically when they pay the actual cash, but as soon as they declare the dividend, we reduce the investment. Now, the other thing we have to be aware of, there's an excess of investment cost over book value acquired. Most of the time, like 99.99% of the time, when you purchase a company, you're going to pay more than its book value. You rarely pay exactly the book value. Why? Because there are other factors that influence the price of the company because the book value is based on the book value, based on historical cost. So, paying for investments is not equal to the book value. That's rare. It's not equal to the book value. So, what happened is, what's the book value? Well, hopefully, you know what the book value is. It's the assets minus liabilities. That's the book value. And remember, the assets and the liabilities using the book value is different than their fair market value. There's going to be a difference between what you pay for and what the price of the market value is. Why? Many reasons, endless amount of reasons, unknown reasons, like unknown reasons, profitability of the company is profitable. Their assets are worth more. If they release a new product, their assets are worth more. If they expect it to pay dividend, discounted cash flow, it's more. If we have good projection, it's worth more. If we perceive worth of the company, not book value, how much the company is worth, if we perceive it, it's worth more, then it's worth more. So, assets and liabilities tend to be measured at historical cost rather than current value, which is the market value. Therefore, when we buy a company, it's always, it's not always usually, the fair market value is higher. Because we have inventory costing, we have LIFO versus FIFO. It's cost. The depreciation method that we use, it's going to be reducing the book value of the assets, of the long-term assets. Maybe the long-term assets are worth more, building equipment, so on and so forth. So, we have to allocate the cost of an equity method investment and compute amortization expense to match revenue recognized from the investment to the access of investor cost over investing book value. Well, that's a lot, but it's really not, it's not really that much. Simply put, when we pay extra money for the company, something over the book value, what we have to do, that extra will have to be allocated somewhere. There's a reason why we paid extra. We have to identify, why did we pay extra for that company? Why did we pay extra? Maybe because their inventory are under value, their inventory is at cost. But really, when we pay, when we buy a company, we pay market price. We don't pay historical price. Therefore, we paid more because they're inventory. Well, guess what? If that's the case, you're going to have to amortize this additional cost. Well, we paid more for the company because their building is worth more, their warehouses, their office building. Guess what? We paid more, we have to amortize. We have, in other words, because we paid more, we have access cost. That access cost, it's going to serve us for several years. Basically, we depreciate this, we depreciate this access cost. And we'll see this as an example. Now, if we cannot allocate this extra cost to any particular asset, then we assign this cost to Goodwill because we cannot identify any asset. The best way to illustrate what I just said is to actually work an example. So let's go ahead and work a comprehensive example. We have a company that purchased, I'm going to call a toll company, purchased 20% of short company for $200,000. So that's how much they pay. And we are told they can exercise significant influence. Let's purchase the company. Debit investment and short company credit cash. So this is easy. It's cost we purchased the company. The acquisition is made on January 1st when short company net book value equal to $700,000. So the net book value equal to $700,000. Their assets minus their liabilities. Tolled company believes the investee's building is undervalued. It's a 10-year building. And by $80,000 in the equipment, they have a five-year value undervalued by $120,000. So what they're saying is it means we paid more because they are undervalued. Good. In any Goodwill, if there's any Goodwill established, it's considered to have an indefinite life. Now, how do we determine whether we paid more or less for this company? Let's start to see how much did we pay. We paid $200,000 and we purchased 20%. 20% of what? 20% of $700,000. What is 20% of $700,000 is $140,000. Hold on a second. So I paid $200,000 for something that's worth on the book, $40,000. What does that mean? It means I have access, $140,000. I paid $60,000 in access. This is the access of the cost of the book value of the company. Well, the Tolled believe that the investee's building is undervalued within the financial record by $80,000. Well, if they are undervalued by $80,000, and we bought 80% of this, it means if we take $80,000 times 20%, that's equal to $16,000, and the equipment are also undervalued, $120,000, and they are undervalued by 20%. We bought that extra, that's $24,000. So guess what? Now what we're going to do is this. We're going to go ahead, let me see if I can change colors here. Of that $60,000, we said $16,000 is explained by the value of the building. This is the building, the $80,000, and $24,000 of that $60,000 is explained by the value of the asset. Now, even though we allocated, of the $60,000, we allocated $16,000 to the building, $21,000, $24,000, I'm sorry, $16,000 to the building, and $24,000 to the equipment, we still have access of $20,000. Now, why did we pay this $20,000? Since we can't find anything, we're going to call this goodwill. Therefore, the computation would look something like this. This is how much we paid. The book value is $140,000, we paid $60,000 extra. We're going to allocate, we paid 20% more for the building, for the building and access, 20% more for the equipment, that's $40,000, and the remaining is $20,000 that goes into goodwill. Now, we're going to see the journal entry in a moment. Now, the company that we purchased had income of $150,000 and dividend of $60,000. They made the profit of $160,000, dividend of $50,000. What's going to happen using the equity method? We're going to increase our investment by $30,000, why $30,000? $150,000, it's the profit that they made, times 20%. Then they paid dividend of $60,000, $60,000 times 20% gives us $12,000, debit dividend receivable, or you could debit cash and credit investment. So notice net income bring the investment up, dividend bring the investment down. So if I ask you what is the value of this asset, of this investment started at $200,000 plus $30,000 minus $12,000. So this is the answer for the value of the investment. Now, let's take a look at what we're going to do with this extra assets. Remember, we said the building has a life of 10 years and the equipment has a life of five. What's going to happen? We're going to prepare a schedule and we're going to take $16,000, that's the extra divided by 10 years and we're going to amortize $1,600 per year. The equipment, $24,000, they have a life of five years. We're going to amortize $4,800. So every year we're going to amortize $6,400, not every year until we first five years and this should be gone and what's left will be the remaining, which is the building. So this is the entry that we have to do. We reduce income and we reduce the asset because that's extra expenses for us as investors. We paid extra for those assets, those extra expenses, though those extra assets, just like any other assets will have to be expensed. But since we paid them, we didn't pay them separately, we paid for the whole company. So simply put, we are going to amortize those excess assets through amortization expense, we reduce our income, we reduce our investment. So simply put, the investment, if we go back here, if we go back, I think I deleted this, did I? No, I did not. So basically what I have to do here, again, subtract from here negative, how much was it? $6,400, $6,400, reduce my investment by $6,400 to find out what's my investment account. Now, this is, as I said, I'm going to break this into two parts. In part two, I would look at the changes and when we change the method, the equity method, when we go from non-equity to equity or from equity to consolidation, we're going to look at reporting investee's income from sources other than continuing operation. When the investee, when our investments, the business that we invested in has income other than continuing operation, reporting investee losses, basically the opposite, we reduce our investment and reporting the sale of an equity investment. Sometime we could sell the whole thing and bring it down to zero. This will be in part two. Again, I want to break this into two parts. It's much easier to manage, but this is everything you need to know about the equity method. At the end of this recording, I'm going to remind you that I can help you pass the CPA exam. This is what I do. I help you pass the exam. How so? I explain the material differently, differently than your Wiley, Gleam, Roger, Becker or any other course you have. I give you alternative explanation. If you like the way I do it, look, give me a shot, subscribe for a month. I have helped hundreds, I'm sorry, thousands of students pass the exam. I can help you. Take a look at my LinkedIn account. Your risk is one month. Good luck, study hard and of course, stay safe.