 Hello, and welcome to this session in which we would look at the equity method. When do we use the equity method? Well, one thing we have to know, we have to be investing in equity, not in debt. So in the prior session, we looked at various investments in debt, we looked at various investment in equity. Well, when do we use the equity method? We use the equity method when we own stocks in another company and debt ownership amounts to between 20 to 50%. So the big picture is this. Investment in stocks and equity, obviously it's called the equity method. This should be easy to remember and you own more than 20, but less than 50%. What happened if you own more than 50% if you own more than 50%, you'll have control. Then you have a relationship between a parent and a subsidiary and investor and an investor. We don't cover 50% plus investment in intermediate accounting. This topic, if you want to look at consolidation, when we consolidate more than 50%, go to Farhat Lectures and this is what we do, is cover consolidation in depth. In this session, I would look at the basic introduction of the equity method. But it's very important that you understand the big picture. It's going to be simple illustration, but simple, powerful illustration. I will work examples in other sessions, but this is going to be a very simple illustration. If you're looking for more, go to my website and look at more additional lectures from advanced accounting about the equity method. So, again, we have to own between 20% to 50%. What would that give us if we own between 20% to 50%? The assumption here is this. You have enough votes because you own 20% to 50% of the company to have what's called significant influence. What is significant influence? It means you can vote one of the board of directors. I see they're all males in this picture. This is just random, but that's fine. It means you have influence to vote one of these individuals. If you can do so, then you have some influence over the company. Unless evidence to the contrary exists, what does that mean? That means you might own 30%, but another person owns 70%. Well, if that's the case, you really have no significant influence because the 70% can control everything. But in the absence of this, we have to assume you have a significant influence. Now, from an accounting perspective, from an educational perspective, from the CPA exam perspective, that we don't have to worry about this. More than 20 up to 50, you have significant influence. Under those circumstances, we will use the equity method. Now, the best way to illustrate the equity method is to take a look at a simple example. Before we look at the simple example, I would like to remind you whether you are a student or a CPA candidate. To take a look at my website, farhatlectures.com. I don't replace your CPA review course nor your accounting courses. My motto is saving accounting students and CPA candidate one at a time by providing you resources, lectures, multiple choice, through false. That's going to help you understand the material better. This is a list, what a partial list of all the accounting courses that I cover. My CPA resources are aligned with your Becker, Wiley, Roger, and Gleam. So it's very easy to go back and forth between my material and your CPA review course on my website. In addition to thousands of multiple choice questions, I give you access to 1,500 previously released AI CPA actual exam questions with detailed solution. So if you're a CPA candidate, you want to take a look at those before you sit for the exam. Also, if you have not connected with me on LinkedIn, please do so. And take a look at my LinkedIn recommendation, like this recording. It helps me a lot. Connect with me on Instagram. I'm trying to grow my Instagram followers, Facebook, Twitter, and Reddit. So let's start by looking at a simple example. First, we record the investment at cost. So when we purchase an investment, we record it at cost. Let's assume we purchased 30% of Adam Company common stock by paying $100,000. Now on the exam day, on the CPA exam, they don't tell you, pay attention. It's 30%. They don't tell you, pay attention. It's the equity method. They will tell you 30%. Something they don't even give you the percentage. They will tell you we purchased 10,000 shares of the company that has 30,000 shares outstanding. Well, you have to understand that 10 divided by 30, 1 third or 33%, that's equity method. So you have to be very careful if you are dealing with investments. Because once you go above 20%, then you're going to be accounting for the investment using the equity method. So be aware of this. Now, we debit investment in equity securities, 100,000. We assume we paid cash. We credit cash 100,000. Nothing to it. We just purchase an investment in securities, debit and asset, credit cash. Very simple. Subsequently, what do we have to do? After we make this investment. Since we have significant influence, we have to adjust our investment account. So simply put, we're going to have to keep track of this investment account. Investment in securities of 100,000. And please listen to me carefully. Here's what's going to happen. Every time Adam Company report net income, our investment will increase by the proportionate share of net income. What does that mean? It means we own 30%. If they report a million dollar, we qualify for 300,000. This is what I mean by this. Every time the company pays dividend, every time Adam Company pays dividend, it's going to reduce our investment. Huh? Why would that be? Well, I'll explain shortly, but this is how we do it. Net income will increase our investment. Dividend would reduce our investment. Just like net income increase our investment, net loss will do the same thing. If the company generated net loss, net loss would reduce our investment. So let's take a look and see what happened. Adam Company reported net income of 20,000 for the year. Well, that's good. If they reported 20,000, 20,000 times 30%, that's going to give us $6,000. We're going to increase our investment by $6,000. And we are going to credit some sort of a revenue or earning from equity investment. So this is an asset and this is basically a revenue account. And our investment now is 106. That's great. Our investment went up and we generated revenue. Adam Company paid $6,000 in dividend. So they paid $6,000 in dividend. Of that amount, we're going to be receiving 30%. Well, 30% of 6,000 is 1,800. And as a result, I'm going to debit cash 1,800. Now, we have to be careful here where I just told you. I told you that when you receive dividend, when you receive dividend, you're going to have to reduce your investment. So they send you the cash. That's easy. They send you a check. They wire the money. It doesn't matter. I debit cash. What is the credit for? Under the equity method, the credit is for the investment. It means we are going to be reducing the investment by 1,800. Now, first, I'm going to tell you, just make sure you know the rules. Then I'm going to explain to you why we do so. Now, we have to understand, and hopefully we know this, that dividend comes out of earnings. So when the company generate net income, net profits, or the company generate revenues minus expenses, then they get to net income. Now, we know this company's net income was how much? 20,000. So this was 20,000. Then what the company did, and of this amount, 6,000 is ours. 6,000 was already recorded as revenue. Now, the company, they took the 6,000, and they distribute 6,000 of it. OK? This was not intended. But yeah, we increase our investment by 6,000 by the amount of the revenue. This is the revenue. Now, what they did is they distributed 6,000 in cash for dividend. We received of the 6,000, 1,800. Now, why do we reduce our investment if that's the case? Shouldn't it be dividend revenue? It will be dividend revenue if we don't have equity, if we're not using the equity method. The reason is this. The 1,800 that they distribute in cash, this is part of the 6,000 that we already recorded as revenue. So simply put, we earned $6,000 from this company, from our investment in Adam. Now, what they did is, and we recorded that 6,000 fully. Now, of that 6,000, they translate. They send us a check for that amount, 1,800. Well, if they send us a check, well, that's fine. Our cash will go up. But since they took it out of our earning from the company, our investment in that company goes down. So notice what happened. Asset goes up, asset goes down. So it's the same for us. Simply put, our investment, they basically cash out. They gave us some of our investment back. Because we recorded the whole 6,000 as part of the investment. Now, I'm going to give you another analogy. Maybe it will help you. Let's assume for one particular year, you had a CD, a certificate of deposit in the bank, $100,000. Now, you earned 6%, yeah, right. But let's assume that's the case. So you earned $6,000. So at December 31st, they send you a statement said you earned $6,000 in interest revenue. You'll be happy. Great, I earned $6,000. Now, January 2nd, two days later, you went to the bank and you took out 2,000. You went to the ATM machine. So they would allow you to take out 2,000 and you took out 2,000. Well, can you say, well, I earned 6,000. Now, I have 8,000. Now, my total interest is, they credit my account 2,000. I took out 2. Now, my total interest revenue is 8. Absolutely not. What you did is you took the 2,000 out of the 6. What does that mean? It means reduce your interest revenue. Now, basically, you cashed it out. And this is basically how it works when it comes to, when it comes to dividend for the equity investment. Now, the investment account cannot fall below zero. So simply put, if I ask you, what is the balance here, you would just say, OK, 100,000 plus 6,000 minus 1,800. Now, why is that important? Why do you have to keep track of this? Because on the CPA exam or in your accounting class, they might ask you to do what? They might ask you to assume we're going to be selling the investment. So your balance now is 104,200. And they may say something like this. You sold 50% of this investment, 50% of this. Well, 50% of this, and they'll give you a price, for example, 80,000. You sold 50% of your Adam Company stocks. Let's not make it 50%. Yeah, it doesn't matter. Let's make it 50%, because it's going to fall below 20. But that's not the discussion here. So let's assume you sold it for 80,000. What do you have to do? You have to know what's your basis. So if you're selling it for 80,000, this is the cash you are receiving. What are you comparing the cash to? Well, that's why you have to keep track of your investment. So 104,200. And you multiply it by 50%, multiplied by 0.5. So your basis are 52,100. Now you would compare, I sold my investment for 80,000 with the basis of 52,100. And you'll figure out your gain. If the company kept on incurring losses, again, the account could go down to zero, cannot go further than zero for the investment account. Obviously, what you want to do is you want to go to my website, farhatlectures.com, look at more exercises, multiple choice questions, resources that deal with this topic. Once again, this topic is also covered in advanced accounting. So this is basic. This is like really, really basic equity method. But this is what you need for this course. Farhatlectures.com is where you would need to get more if you want to go into advanced topic about the equity method in my advanced accounting course. Invest in yourself. Don't shortchange yourself. The CPA exam is worth it. Your accounting courses are worth it. You're investing in yourself. That's not an expense. Good luck, study hard, and of course, stay safe.