 and welcome to the session. This is Professor Farhad in which we'd look at a CPA simulation. A CPA simulation is no more than a multiple choice presented in a different format. So do not be intimidated by a CPA simulation. For example, this question is about the fair value in the versus the equity method. It doesn't mean it's something different than a multiple choice because I can ask you about the fair value in the equity method in a multiple choice setting. All what the examiner does is they will take the information, break it into an exercise. Now this exercise, now how can you prepare for an exercise like this? Well, you use your CPA material, obviously whether you are taken back or Roger Gleim, you would use something similar to college exercises. So the simulation is basically an exercise that you see at the end of the chapter of your intermediate accounting, advanced accounting or governmental accounting. So this is what it is. So you have to be familiar with this information. Now how can I help you as Farhad lecturers? On my website you will find additional information for your CPA exam as well as your accounting courses for that matter to help you solve these questions. So I don't replace your backer, your Roger, your Wiley and your Gleim. You do need those courses, you may need additional explanation, the theory behind the material to help you understand the material because memorizing or only answering multiple choice will not help. So a strongly suggestive, you check out my website, at least check out how well is your university doing on your CPA exam. This will give you an idea about your performance. Please make sure to connect with me on LinkedIn and on YouTube. Let's go ahead and get started. So on this question you are being a series of transactions and they want you to account for them using the fair value option, the equity method, what's the effect on their income, what's effect on the balance sheet. So a lot of information, once again they could be a multiple choice, they could be a simulation. Let's work with them in a form of a simulation. So on January 4th we have Adam Bakery paid 340 million for 10 million shares of Maggie's common stock. So Adam bought Maggie, 30% of Maggie's investment represent 30% in the net asset and gave Adam, Maggie gave Adam the ability to exercise significant influence. This means if they want to use the equity method they have significant influence. Adam chooses the fair value method option for this investment. So notice Adam chooses the fair value option. That's important. Adam received dividend of $3 per share on December 15th toward the end of the year. Maggie reported net income of 230 million. The market value of Maggie's common stock on December 31st is $32 per share. On the purchase date the book value of Maggie's identifiable assets were 880 million and the fair value of Maggie's depreciable asset with an average remaining life of four years exceeded the book value by 120. Yes, usually the depreciable asset, the increase in value. Therefore we have a book value of 880 plus 120 an additional fair value. So the fair value of Maggie's company is 1 million. The remainder of the excess of the cost of the investment over the book value of the net asset purchase was a terrible to good will. We don't have to worry about this. So we're going to prepare the journal entries first using the fair value option show the effect on that income show the effect on the balance sheet. Then we're going to prepare the entries under the equity method. But again, once we're done with the equity method, we're going to go back and report everything at fair value. So I will show you both the equity and the fair value and what's the effect on that income? What's the effect on the balance sheet? Let's go ahead and get started. Starting with the first transaction when we purchased the company, January 4th. We're going to hear you're going to be using the fair value method. Here we're using the fair value. But Adam purchased the 10 million shares for 340 million. Simply put, you bought an asset buying a company. You are buying making an investment. That's simply an asset. So we debit an asset investment and equity securities 340 million credit cash 340 million. Simply put, you purchased an asset. So basically we're done with the first line. We purchased an asset. Done. The investment represents 30%. That's good information, but it's not really relevant for the fair value. That's done. Adam chooses the fair value. We already know this for this example. Adam received dividend of $3 per share on December 31st, on December 15, 2021. And Maggie's reported net income of 230 million. Now that's good. Maggie reported net income of 230 million. That's not really relevant for us nor it's not really relevant for us. Why not? Because since we are accounting for the investment at fair value, we don't care what they reported of net income. Therefore, we don't really do anything for net income. Now, we get paid $3 per share. Well, we have to account for this. We have to account for this. Why? Because we actually receive dividend. Well, if we receive dividend, we're going to have to debit cash because dividend is in cash. We're going to debit cash 26 million. And we are going to credit, we are going to credit dividend revenue 26 million. So simply put, I'm sorry, receive dividend rather than $3, $2.60. I apologize. So receive dividend of $2.60. Therefore, debit cash 26 credit dividend revenue 26. Now, at the end of the year, so basically we're done with the dividend. So I just made an error. It was $2.60. For this example, at the end of the year, the fair market value of the stock is $32. Now what happened is this, if you purchased a few purchase 10 million shares for $340 million, it means the cost per share, the cost is $34. What happened at the end of the year? The cost went down to $32. So therefore, you have a loss of $2. What does that mean? It means you have to record a loss, a fair value adjustment, a fair value adjustment. It's a loss. So when you have a fair value adjustment, what you do is you should have a credit and fair value adjustment. So I'm going to show you how to use the fair value adjustment, but this session is not about this account. If you want to learn about fair value adjustment, please go to my website. So here what we're doing is we are adjusting the portfolio or the investment to market. So simply put, the fair value adjustment is zero because this is the first year we purchase this investment. Therefore, the fair value because we have a loss, we should have a balance. We should have a balance because we have a loss. We should have a balance of 20. Well, guess what? If the balance should be 20 because our losses are 20 because $2 times 10 million equal to 20 million. Therefore, we have to credit fair value adjustment. Well, when we credit fair value adjustments, what do we debit? We debit a loss. We debit a loss of 20 million. Therefore, we debit a loss on investment and that loss goes into net income and we credit fair value adjustment of 20 million. Now, if you don't know how to adjust your portfolio to market or your security to market, please go to my website. I do extensive explanation and extensive review of this topic. Okay. Now, going through all these transactions using the fair value method, the question is, what's the effect on income? Simply put, how much goes on the income statement? Well, the dividend revenue goes on the income statement, 26 million right here, then minus the loss. So we have a plus 6 million on income. What is the value of your investment? Well, the value of my investment, I purchased it at 340. Then I am going to have a fair value adjustment credit of 20, which is a contra asset, my fair value adjustment equal to 320. And this is the fair value, pretty straight forward concept accounting for these transactions. So basically what we did is we purchased the stock, no entry when they reported net income, recorded the revenue, the cash dividend revenue, and we adjusted the investment at the end of the year. We're going to do the same thing, but now we're going to be using the equity method that after we use the equity method, we go back and we adjust everything to market. Let's start with the equity method. We purchased 310 million worth of 340 million debit, investment and equity affiliate, which is an asset credit cash. So rather than call it just investment and equity securities, we call it an equity affiliate, but it's the same concept. It doesn't really matter, they're both assets, you made an investment. Now, so we're done with this, purchase the investment, we're done with this. Now, this is important. We have significant influence. So the company received, not company, our investee, which is Maggie's, reported 230 million. That's good. Now, if Maggie reported 230 million, we are going to get 30% of that. We're going to get 30% of that. Therefore, what we do is we'll take 230 million, 230 million and multiply it by 30%. And that is our share of income. So 230 times 0.3, we're going to record 69 as an increase in the investment. So this is important. So I'm going to have this investment account here, investment and equity affiliate. It's this account here, investment and equity affiliate. I started with 340. Now, how do you do investment under the equity method? Under the equity method, you will increase your investment by the proportionate income that the investor report, the investor report, the 230, you qualify. 69 million is kind of yours from the income. It belongs to you. Therefore, you increase your investment and you credit a revenue account, investment revenue of 69 million. So we're done with the income. Now, also, they, again, not two, it's 260, they paid you 10 million times $2.60. You're going to debit cash 26 million. Now, under the equity method, what do you credit when you receive dividend? Now, think about it. Where is dividend coming from? Where dividend is coming from income? Dividend is coming from income. So you remember this income here, the 230 million? 230 million. When the investor, when Maggie pays the dividend, it's going to come out of this income. You already accounted for all this income. That's yours. So simply put, your net income is here. Now, the dividend comes out of this income. So when they pay you this income, when they pay you cash, your investment account goes down by 26 million. Therefore, you debit cash 26 million. You credit investment by 20, 26 million, 26 million. And this is for the dividend. This is for net income. So net income increase your investment, dividend reduce your investment. Now, what else are we told in this problem since we're using the equity method? We are told when we purchase this company, the book value were 880 million. There was an additional fair value to the depreciable asset. In total, we had, the company was worth a million. What happened is this. So you did buy, in a sense, you did buy those 100, that extra fair value. Now, what happened is this, you cannot count this extra fair value because kind of, you over, not you overpaid, you paid for the fair value. But you have to make an adjustment. So simply put, of this 120 million, you got 40% of it. I'm sorry, 30%. So you got 40 million of this. You got 40 million of the 120 million. Simply put, you paid, you did not buy the whole company. You bought only 40%, which is 30%, 30%, not 40, which is 40 million. Now, what's going to happen is this, that 40 million that you have, you're going to have to reduce your income by because it's going to, it's basically, in a sense, it's an increase in depreciation. You're going to take this 100, the 40 million and divide it by four, 120 million times, let's do it again, 100 and pull the calculator here. This way we don't make any mathematical mistake. We have 120 times 0.3, which should be, oh, should be, sorry, should be, that's why that's the math, 36 divided by four, nine. Therefore, it's 36. That's what I thought. This is 36 million. So you purchased this 36 million. 36 million will have divided by four equal to nine. So what happened is this, you're going to have to reduce your income by nine, nine million because this is extra depreciation. Therefore, you debit investment revenue, credit investment and affiliates. What you do is you reduce your investment account by an additional nine million and this is for the depreciation adjustment. Again, if you have any questions about how we did this, this is a whole topic by itself. This is a whole topic by itself. Go to fourhatlectures.com, but this is what we do since there was extra fair value that we purchased, we reduce revenue by that extra fair value of depreciation. Now, at the end of the year, we are told the stock price. Now, let's first find the investment account. Well, if we take, let's do it on a calculator, this way we don't make any math errors. So we take 314 million, we started with plus 69 in revenue minus 26 in dividend minus nine as depreciation adjustment. So right now the balance is 374. Well, is this the true balance in investment? No, they tell us at the end of the day, we chose to use the fair value. Although we account for it using the equity method at the end of the year, we adjust. Well, how much do we have to adjust the investment to? We have to adjust the investment to fair value. What is the fair value adjustment? 320 million, which is 10 million shares times 32. What does that mean? It means I have to reduce my investment by an additional 54 million. So I have to make an adjustment, reduce my investment by 54 million. Therefore, I debit a loss 54 million. I'm reducing my investment and it goes into net income because I choose to report this investment at fair value and I credit my fair value, which is right here at 54 million. Now my balance is correct 320 million. So let's look at the effect of net income overall for this method. We're starting with investment revenue of 69, investment revenue of nine. So what else? So we have investment revenue. This goes on net income. This is no net income. We have no debit, sorry, credit revenue, which is 69 minus 9 equal to 60 minus 54, which is a loss. It goes on the income statement. So the net effect is 6 million. That's net in effect. And what's the investment balance? The investment balance is 320 million. And hopefully you knew they should be the same as the prior method because in the prior method, in the prior method, we use the fair value method, 6 million and 320 million. So they both they should equal to each other because after we after we accounted for it during the year using the equity method at the end of the year, we adjusted to fair value and we are allowed to do so. Once again, I'm going to invite you to check out my website forhatlectures.com. Here's my proposal to you. You might be studying for the CPA exam. My subscription per month is $29. You can cancel. So all your risks $29, $29.99 to be more specific to maybe have a chance of increasing your score by 10 to 15 points. 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