 Hello and welcome to this session in which we would look at the equity section part 2 of 2 simply put in the prior session We looked we looked at the equity method part 1 of 2 So this is the second part of the equity method already covered the fair value the cost accounting the cost method in in previous session We're gonna cover consolidation in depth basically this topic talks about when do we use those? Accounting method to account for investments Remember depending on our degree of control. This is basically a review up to 20% If you control up to 20% of the company your two options are the fair value and the cost method if you control between 20 to 50 and remember we learn about that this rule is not really 100% applicable in the real world sometime you might control less than 20 you would use the equity method sometime more than 20 and not use The equity method in the real world, but as far as we're concerned between 20 to 50 This is what we use the equity method and if you control 50 Percent plus this is where we'll use consolidation and once again sometime you may not have to have 50 control plus to use Consolidation sometime you might have 50 control plus to you and you don't use the consolidation We talked about those different situation in the prior session those are the exceptions Those are where the case is not really clear. You have to actually look at the control This topic is extremely important whether you are an accounting students or a CPA candidate studying for the CPA exam So I strongly suggest you take a look at my website far hat lectures calm Most likely most likely you do have a CPA review course if you're studying for the CPA exam That's fine. I don't intend to replace your CPA review course My explanation is to be a useful addition to your CPA review course Help you understand the material that are provide you with alternative explanation and alternative resources Exercises through false multiple choice to help you understand your risk to try me is one month of subscription You try it. You like it. You keep it. You don't you cancel. You lost $30 your maximum gain is passing the exam Are you willing to take that risk? And if not for anything take a look at my website to find out how well or not while your university doing on the CPA exam I do have resources for other courses as well if you are an accounting student Also connect with me on LinkedIn if you haven't done so and take a look at my LinkedIn recommendation like this recording connect with me on Instagram Facebook Twitter and Reddit import to we're gonna be reporting change to the equity method Reporting investing income from sources other than continuing operation, which is part of it will be OCI reporting investing losses and Reporting sale of an equity investment. So what happened once we sell the equity investment starting with the reporting of change To the equity method. What happened? What are we talking about here? Well, you might start with less than 20 percent at first when you invest in a company Then you might add more and more to your investment to get to a point where you control where you own between 20 to 50 and remember once you own 20 to 50 that the the equity method will kicks in now You have to use the equity method because less than 20 We you have to use the fair value. So fast. It requires you that you do a prospective Treat this as a prospective approach Prospective means easy. You don't have to go back and change the prior year You have to take whatever you did up to this point and start using the new method Which will be the equity method going now from non equity to equity So this basically we're Requiring the cost of the new investment simply to be added to the current investment Gaining amounts when you purchase a new investment it gets added just like when you buy an investment It's recorded at cost for example, January 2020 alpha company exchange $84,000 cash for 10% ownership in Bailey. So we assume we have no significant influence We use the fair value and this is the data for Bailey company So this is January 1st. This is the fair value when we purchased it This is the book value and At the end of the year They the fair value was 890,000 therefore our investment is worth 89,000 how do I know this we own 10% we have to adjust it to fair value. So this is the investment January 1st, 2021, which is the following year. We purchased an additional 30,000 This is plus 30,000 not 30,000 additional 30% plus 30% Well, we had 10 plus 30 were up to 40 and we paid 267 let's take a look at the journal entry because now we have significant influence 40% should have give you significant influence now investment in Bailey 267 credit cash 267 this is to record the initial investment on January 1st, 2021 the carrying amount of the asset and the liability equal to the fair value except for an undervalued Which patent so we have an undervalued patent by 175,000 that has a 10-year life. What does that mean? It means the assets the fair value of the assets were the same as the book value Okay, the book is I'm sorry the same as the book value to 89,000 except for one Except for one asset, which was undervalued by 175,000. Okay What does that mean? Well when we started this come when we purchased this company when we started this purchase the snoop purchase the value of the company was 890,000 times 10% I told you the value was 89,000 now We are going to add 267,000 to this asset which will give us a total value book value of 356,000 Now the book value of the assets are 715,000 this is the book value and we own 40% 715 times 40% it's going to give us 286,000 well we have an access of 70,000 and what did we say this access? It's going to be Allocated to it's going to be allocated to the Patent and what's going to be it's going to be and it's going to be Expensed amortized over 10 years so 70 divided by 10 is 7,000 and this is the computation This is the computation. Okay. Now. What's going to happen is this? Let's assume Bailey reports their income of 130,000 and declare the dividend of 50,000 What do we have to do? Well, we're going to have to increase our investment by the income. Well, how do we do so? Well? We debit investment in Bailey and let's take a look at this if we take if we take 130,000 times 0.4 which is our ownership. It's going to give us 52,000 52,000 so why did we record 45,000? Well, we record 45,000 because we also have a patent Remember at an access cost of 70,000 divided by 10 we have to amortize 10,000 so when we amortize 10,000 52 minus 7 it's going to give us 45 so simply put we combine the two entries Otherwise, we had to debit equity and invest the income 7,000 credit and investment in Bailey So we have to do really is to do this as if we're going to break it down into two. This will be 52,000 Then we have to debit equity Investee income 7,000 credit Investment in Bailey 7,000 and those two together will give us the entry that we have of of A 45,000 but all we did is we combined them also for the dividend we debit dividend receivable 20,000 credit investment in Bailey 20,000 when we receive the cash we debit cash Credit dividend receivable. So this is how we account for this. So how do we report investees? other comprehensive income and irregular items those items they bypass the income statement OCI is Bypass the income statement and irregular items could be discontinued operations. How do we report for this? Okay, OCI you need to know what this is other comprehensive income It's earning that bypass net income earning or losses for that matter Accumulated derivatives net gains or losses you need to be familiar with those from intermediate accounting foreign currency translation adjustment search Certain pension adjustments. So what we do we either have a loss or a gain But we don't report on the income statement We report in the equity section of the balance sheet also we could have again as I said as a regular items We could have this continued operation So the equity method require us that the investor record its share of investees OCI Which is included in the balance sheet as? Accumulated other comprehensive income a OCI. So if they have OCI we have to absorb part of that OCI Okay, for example, big company purchase 30% of the voting stock of small company We have significant influence no access amortization resulted from this investments That's fine in 2020 they reported income of half a million excellent. We debit investment 150 credit equity investing in income 150. This is for the 30% I'm sorry for the 30% of half a million now small company also reported notice 80,000 in OCI from pension and other adjustments gain. So they have a gain of 80,000 well, what does that mean? Well, if I've small company reported this OCI our share of that OCI is 24,000 we debit investment in small company. We credit OCI other comprehensive income of investee We have to absorb 30% of that simply put now if we had a discontinued operation Let's assume small company discontinued one of their operation and they either have a gain or a loss That gain or a loss will be reported as a regular income. It's not reported separately Although it's reported separately on the income statement, but what we do is it will be part of the regular income Impairment and equity investment is something else that we have to deal with as part of our equity investment Okay, what is impairment impairment is when the company suffer a permanent loss in the value of the investment So you purchase an investment, but it's a permanent loss permanent loss It's gonna go down and there's no chance it's gonna go up now Why would that happen reason for impairment? We have made a lot of reasons for impairment many many reasons But could be you lost a major customer and that's your major customer and as a result You know the investment and this company because would they rely on this customer? It's gonna go down permanently. They cannot recover changes in economic conditions Could COVID could be one of them loss of significant patent or other legal rights So you used to rely on a patent or some legal right and you lost those Damage to the company's reputation and many others. Okay, what do you have to do a loss in value? Which is other than temporary other than temporary means permanent because if it's temporary You don't do anything if it's temper if it's permanent it shall be recognized You just have to book the loss. Okay, evidence of the loss might include But would not be necessary limited to the absence of the ability to recover the carrying amount of the investment Or the inability of the investor to sustain earning capacity that would justify carrying the amount of the investment So simply put there's a test for impairment And if that test is if you pass the test of impairment, you have to absorb the losses You have to absorb Impairment losses. You have to record them once, you know that they are Permanent not temporary because sometimes also because because of gov. Maybe your investment will go down But it's only temporary but because if it's COVID and it's permanent then you have to write it down you have to write down your investment take a loss and Sometime you could have you have to reduce your investment to zero now Why would the investment would be reduced to zero? Well, you have to understand how the equity investment work And the equity investment when you purchase the investment you record it at cost then in subsequent years you might have Net income and when you have net income, it's gonna increase the investment Well, if you suffer, let's assume you suffer a loss. Well, when you suffer a loss, it's the opposite So this is how you would treat a loss. A loss would reduce your investment. So when you have a loss, you're gonna debit loss from Investee and you're gonna credit the investment. This is what we're talking about here You debit the loss and you credit the investment. So you have a loss, but the investment will go down now also What could happen remember when we receive dividend dividend also? Reduces the investment Also, what we learned if you have an impairment just basically treated the same thing loss from impairment debit investee Investment gets a credit also. It's gonna go down. So what happened if over the over the years you would drew money You incurred NL net loss and you incur impairment Whatever you have if you incur if you have more More credits than debits. Well, you could have a negative balance. You cannot have a negative balance You could reduce it down to zero and they cannot have a negative balance and keep track of that account separately Until you recover you bring it back to zero then you bring it back to the box So it could be reduced down to zero due to losses dividend payout and payment losses and also what happens sometime is you can sell your equity investments So the investor can choose to sell all of it or part of it. It doesn't really matter if a sale occur You know the equity continue to be applied until the transaction date up to that date That's establishing the appropriate carrying amount of the investment Assuming that the after the sale you still have significant influence You just keep on going if this if you stop to have significant influence after the sale then from the sale date You have to treat it as a fair value. Let's assume and you go down to fair value Okay, the investor reduces the balance by the percentage of the shares sold assuming you're selling part of it The best way to illustrate this is to work an example Assume top company owns 40% of the outstanding shares of bottom company, which is an equity investment Any access cost over top shares bottom is considered goodwill. So we have goodwill We don't have to worry about reducing the access the asset balance is 320,000 is of January 1st 2021 bottom report net income of 70,000 during the first six months of 2021 and the clear cash dividend of 30,000 Excellent. What do we have to do now? We have to debit investment in bottom increase for that six-month net income of 28,000 which is 70,000 times 40% and Increase our equity income by 28,000 don't have to do the same thing with the dividend debit a dividend receivable Debate a credit investment and income then when we receive the cash debit cash credit receivable Remember again, we can remove the receivable debit cash credit investment. Okay now bear in mind the balance was 320,000 at the beginning of the year add the 28 for the income subtract 12 from the From the dividend you end up with 336,000 as of the date of the sale So this is important because we have to determine what happened after this balance after the date Okay, so they're telling you the income is 70,000 and 30,000 if they don't tell you the income for the for the first six Month is that much they give you the yearly income then you have to prorate per year Which is you allocate half to the first six months and the other half assuming you're using the equity method for the following six Month if you lose the equity method now use goodwill because you sold so many Then you basically ignored net income for subsequent period because now you're using the fair value method Assuming July 1st, which when the balance was 336,000 you sold 10,000 of the 40,000 shares Which is one fourth and you received 110,000 and you reduced your ownership from 40 to 30 because you had 40 So you still using the equity method. Let's take a look at the journal entry. Well, you received cash 110 One fourth if we take 336 divided by 4 One fourth is 84,000 so you sold something that's worth 84,000 for 110 you have a gain of 26 now if you sold it for less than 84. Let's assume you sold it for 80,000 Let's assume you sold it for 80,000 Then you would have a let better than again, you'll have a loss of 4,000 you have you would have a loss of 4,000 Okay, but you did not you sold it at a game. Therefore, you have a gain After the seal is complete we were gonna keep using the equity method because we're still above 30% If the sale let's assume you sold rather than 10 you sold all the way up 225 and you reduce your ownership to 15 now you'd have to use the fair value How would the fair value be used simply put you're gonna take the remaining whatever the the 15% the 15% of the 336 336 times 15% this will be your balance as of July 1st Which is 15% of the company you still have 15,000 shares at the end of the year You would look at the fair value of those 15,000 shares and you adjust them you ignore net income You ignore dividend because you will start to use the fair value method Okay, so the remaining book value becomes the new cost and you just keep going No Retrospective adjustment it's all prospective so you don't have to worry about going back and changing the prior years and The end we looked at the beginning of the session if we change from the equity method change to the equity method If we went from fair value to equity Also, it's considered Prospectively, which is easy. You don't have to back. You don't have to go back and change any prior years Again at the end of this recording I would like to remind you that if you are a CPA candidate check out my website for hat lectures calm I can be useful addition to your CPA review course. I can explain the material Differently your risk is one month. Don't shortchange yourself. You invest in your career once in your lifetime Pass the CPA once good luck study hard and of course stay safe