Refine your method to "Cost and Equity Methods"
Does it matter which method you use to account for investments? Yes! Learn the difference between using cost and equity methods and the factor that determines the proper method to use when taking the FAR section of the CPA Exam.
Roger Philipp, CPA presents:
REFINE YOUR METHOD TO “COST EQUITY METHODS”
Alright, the next area we’re going to talk about deals with cost equity…do I have good volume there, good volume? Yeah? Very nice. Alright, cost equity. So we’re talking about investments. We’re actually going to talk in two different sections, cost equity and the next section is called marketable securities. So, what I want to do is kind of walk you through the investments that we can make and it basically talks about how much stock do you own in the company. That would distinguish how we account for the investment. So, let’s come on over here, and we’re going to talk a little bit about some of the different methods. Basically, if I own 0 to 20%, that is called either the cost method or marketable securities. Now what this means is that I own 0 to 20% of the stock outstanding, so that is called the cost method. If I own 20 to 50%, that is called the equity method, and the equity method is also known as the one line consolidation. Now what it means is I’m going to be teaching you this thing called consolidations down the road, but basically it’s similar to consolidations but we consolidate in this one line item called investment. The next one is 50% plus, and that is called consolidations, and the implication here is that you have control. Remember? Back in the ’90s? Janet Jackson? Woo…control. Anyway, so that’s control. So, that is the implication, we have control of the entity. So, zero to 20 is cost, 20 to 50 is equity, 50 or more is consolidations. Now, as far as 0 to 20, 20 to 50, 0 to 20, 20 to 50 were called investor/investee. Fifty or more, they’re called, used to be called parent and subsidiary, then we changed it from one fad to 141R, we changed it to acquirer and aquiree. Acquirer, aquiree. So 0 to 20, 20 to 50, 50 or more. Zero to 20, 20 to 50, cost versus equity or marketable security, so in this first chapter, weíre talking about cost versus equity. The next chapter we’re going to talk about marketable securities, which means you own 0 to 20, but it has a market value, and in FAR 8, the very last section, we’re going to talk about consolidations. Why? Because in consolidations, basically, I own you, I control you, so we need to consolidate and put our numbers together. That means we have to reverse a lot of intercompany transactions. Well, I don’t want to show you how to reverse transactions I haven’t taught you yet. So, I’m going to teach you all the transactions, then at the end we’re going to reverse intercompany inventory, intercompany profit or loss, intercompany PP and E, intercompany gains, intercompany dividends, intercompany bonds and all that fun stuff. So, it’ll make more sense once I teach you bonds, how to reverse them. So, this is basically where we’re going. So, gain, 0 to 20 is cost or marketable security, 20 to 50 is equity. What is the difference between these two? Well, if you own 10% of Roger CPA Review, mmm hmm, am I a publicly traded company? Not yet. Therefore, cost. If you own a hundred shares of Microsoft, is it a publicly traded company? Yes. Does it have a fair market value? Yes. Then use marketable securities. So, what I want you to see is the distinction between which topic we’re going to be covering in which area and how the chapters compare. So, this chapter is cost versus equity. Zero to 20 is cost, 20 to 50 is equity, 50 or more is consolidations. What if you’re right at the cusp? 20? What if you’re right at the cusp? 50? Well, that’s what we’ll talk about in a minute as well. So let’s look in our notes and we’ll start to see the distinction. At the top of page one there, it says 0 to 20 is cost or marketable securities, cost or marketable securities. The implication is that no influence over the investee exist if the security isn’t marketable, use the cost. Twenty to 50, one line consolidation. The implication is that the investor has significant voting influence. Significant voting influence, which I’ll expand on, and then 50 or more, consolidations, which we’ll cover in FAR 8. Now, here’s what’s happening. The way that a company is organized, and we’ll talk about this in BEC and Auditing and a little bit in FAR as well. Here’s how a company’s organized. Here’s the group called the Board of Directors. They act as a board, they act as a group, and as far as the Board of Directors of the group, they are in charge of hiring the management, they’re in charge of declaring dividends, they’re in charge of buying back treasury stock, which is stock that is authorized, issued, but not outstanding. Now, the management runs the company for the stockholder. The stockholder gets to vote in the Board of Directors. So, I get to vote in the board, the board hires the management, the management runs the company for me, the shareholder. So, remember since day one I’ve been picking up and saying, “Whose statements are these?” And you all yell out, “Whose statements?” Craig? Management’s. Exactly. Management’s statements. So, management is responsible for these statements. So, management runs the company for me, I get to vote in the board, the board hires the management, the board declares the dividend. Let’s say for example I don’t like the management, so I go to the board meeting and I get to vote, I get to vote on the board. I say, “Hey board, I don’t like the president. Please get rid of them.” And the board says, “Well, I like the president because he’s my son-in-law.” So, I say, “Fine, I’m going to vote you out,” put a new board in who will then fire the president and hire a new one. So, the question is, how much influence do I have over them to them? If I own 0 to 20%, I have no influence over them, no influence over them. If I have 20 to 50, I have significant voting influence over them and them. If I own 50% or more, I control them. That’s why, what you’ll see as we go through the accounting, if I own 0 to 20%, I don’t have any control over them, so I don’t record a dividend until I get it. If I own 20 to 50% of them, that’s equity method, I have influence over them. That means when we make money, I know I’m going to get it in the form of a dividend eventually. Why? Because if they don’t declare a dividend, then what? If they don’t declare a dividend, then what does that say? That says that I’ll vote them out, put people in, I’ll eventually get the money. So that’s why with the equity method, I’m going to record they income as they earn it, not as I receive it. So, we’re going to have to look through that as we go through the different topics. Alright, you’ll see that. Now look at equity method. It says equity method ASC 323. The equity method is used when the investor has significant influence over the operating and financial policies of the investee. The method is more consistent with accrual accounting. Even if ownership of less than 20%, one must consider how much influence exists between the two. What are some of the factors? Some of the factors: significant intercompany transactions, officers of one company as officers of another, the investor is a major customer supplier. Circle the next bullet. The investor owns at least 20% of the voting common stock, but not if another person owns the majority. So, even if I own 30%, someone else owns 70, I would still do cost method. The investor has definite plans to acquire the additional stock. These are all implications, so this is again for a multiple choice question, you’re right at the cusp of 20, do you do cost or equity? It depends on the implication. Alright. Let’s jump ahead and let’s look at a problem here because what I’d like to do is kind of show you the journal entries that we’re going to go through. So look on about page four, and we’ll look at a problem together, and this is on? Very good. Testing. It says, “Example of both equity and cost. On 11-X1, we acquire 30% of a company for a thousand dollars. The fair value of the investee is 3000, and the book value is 2500.” What does that mean? Fair value means that’s how much the assets are worth today, book value means that’s how much they’re being carried in the books at. The difference is from property plant equipment with a fair value 500 higher than its book value. During the year, the investee reports income of 120 and pays dividends of 40. P P and E is being d-d-d-d-d-depreciated over 10 years and 10% of initial goodwill is impaired. There’s a lot of stuff in here I haven’t taught you yet. First of all, P P and E is Property Plant Equipment. We’re going to have to depreciate that. We’ve got goodwill has been impaired which means we’ve tested annually for impairment. If the value has dropped, then what do we do? We have to write it down. So, that’s basically what they’re telling us as we go through it. But again, what I want you to realize, it’s new in the course, right? We’re still in the first section. So, there’s stuff we haven’t covered yet. I want you to understand the concepts of the equity method, and then every week, every class, I’ll give you more, more and more information, and then all the sudden, boom, lights go on, you understand and become a CPA and find out what true happiness really means. Alright. So, what we need to do is go through the journal entries. Now we acquired 30% of the company for a thousand dollars, fair value’s 3000, book value is 2500. So, over here, I’m buying 30% of the company and paying a thousand dollars. Fair market value is 3000, book value is 2500. So, what I need to do, is I’m saying, and it’s called the one line consolidation because in all of these cases, here’s what I’m doing, let’s come back over to this board for a minute. In all of these cases, I’m debiting investment, crediting cash. So, on day one, I debit investment, credit cash. Here’s the deal, at the end of the year under cost, I still have an investment, under market I still have an investment, under equity, I still have an investment. Under consolidations I can’t have an investment myself because I control you. The whole process of consolidating is eliminating the investment. So, in all these cases I’m going to debit the investment, debit the investment at the beginning. At the end of the year, still have it, still have it. Consolidations, I get rid of it. I eliminate it. So, in this case I’m going to set up the investment. Then what I have to show you is what’s the difference between if it’s counted for this way, or this way, or this way. First we’re going to do this, equity method, which is the one line consolidation. It’s going to be comparable to this, but it’s data owning a hundred or 90 or 80. I only own 30% or 40%. Alright, so back over here. Nice and slow, we’ve got boom, boom, boom. So, here’s what I’ve got to keep track of…the difference between the purchase price, the fair market value of investees’ net assets and the book value of investees net assets. So, I’m going to keep track of what I paid, what it’s worth, what it’s in their books for. So, that’s what I paid, that’s the fair value of it and the book value. So in this particular case, I paid how much? A thousand dollars. So, I paid a thousand dollars. Now, what is this worth? It said over here the fair value is three million or 300,000 or 3000. I own 30% of that 3000, and that’s what? 900 bucks. So, really, I should have paid 900 dollars. They charged me a thousand. They charged me more. We’re going to call that goodwill. I bought 30%. What is their book value? Now, what is book value? The difference between these two means property plant equipment. They bought it and here’s how much it’s in their books for historical cost, but went up in value. That’s fair value. So it went up in value by what? 500 bucks and they said that was called PP and E which is property plant equipment. So, if I were to take 30% of my 2500, 30% of the book value is…what do we have…750? So that’s what I have to compare. I’ve got to compare these numbers to see what did I pay, what is it worth, what is it in their books for? So, here’s, I paid a thousand, it’s worth 900, and it’s in their books for 750. What does this represent? This represents 30% of what I paid, with what I paid, 30% of what they’re worth, 30% of the book value. Now, I have to keep track of these differences. The difference between what I paid what it’s worth is called goodwill. Now goodwill I’ll define next time in FAR 3. Actually, two times from now in FAR 3 in intangible assets. Goodwill is the unidentifiable asset that makes a business worth more than the sum of all its identifiable assets. In other words, you go to the store you go, ìMan, I’m thirsty. I need caffeine. I’m going to have a Mountain Dew. Mmm.î Now they have all these other sodas, but you like the Mountain Dew commercials, and so on and so forth. That’s called goodwill. So you go in…so if I were to buy Mountain Dew, the corporation’s assets are worth a billion dollars. That’s like their buildings, their sugar, the cans, their leases, their trade, but the difference is they’re going to charge me three billion. Why? Because that goodwill. Because people go, “I like Mountain Dew better than Sprite and everything else. I like the commercials.” So, that’s called goodwill. It’s the unidentifiable asset that makes a business worth more than the sum of all its identifiable assets, so we’ll define that in intangibles. What do we do every year? You test the value. If it’s been impaired, you write it down, you never recover it. So that’s called goodwill, in this case it’s a hundred bucks. Come on over this way a little bit. Thee we go. A hundred bucks. Now we got here 150. What is this 150? About 150 I’m going to call fair market value write-up. It’s more of a generic term, fair market value write-up, fair market value increment. Now on the exam this is usually one of three things. It’s either property plant equipment or land or inventory. Now, let’s see this 150 dollar difference. What do we do with that difference if, for example, it’s property plant equipment? What you do every year to PP and E? D-d-d-d-d-d-depreciate. Good. So if it’s 150 dollars, it’s going to live 10 years, we would depreciate it 15 bucks a year because I’ve got that 150 dollars, because 500 dollars 30% of that’s 150. That difference comes out every year. It’s going to be depreciated. That’s great. Now, what if instead the difference is land. Do we depreciate land? No, we assume land lives forever, unless you live in the hills of Malibu, right? Then the water comes and it washes away. But, land lives, so therefore you don’t depreciate it. We wouldn’t take anything out. Let’s see its inventory. What do you do to inventory? You eventually sell it. So, with inventory, inventory let’s see with inventory it could either be selling all of it, part of it, or none of it. So, what they’ll say with inventory is, if you sell all of it, you take out all 150, if you sell out half of it, you take out half, and if you sell none of it, take out none of it. So, these are all the different options of how we’re accounting for this difference. Again, this generic term fair market value write-up is either P P and E, land or inventory. If it’s property plant equipment, you d-d-d-d-depreciate. If it’s land, don’t take it out. If it’s inventory, you sell all, half or none. Now, that gives us a lot of information, but I’m trying to give you the overview. This is where we’re going. So, in the example, it said I paid a thousand dollars, it’s worth three thousand, the book value is 2500, so I paid a thousand, it’s worth 3000, 30% of that is that, and that is 30% of 2500 is 750. It’s said that all the assets were the same except for P P and E, which is depreciated over 10 years, and goodwill is impaired. You tested annually for impairment. Okay, so let’s do some journal entries. Here are the journal entries and let’s come over here. So I’m going to clean all this up take a mental picture of this. Ready? [click click, click click]. Very good. So, here’s the equity method. Alright. On the first day you buy your thousand dollars debit investment, a thousand dollars credit cash. Now, when I look at this investment, it’s really a breakdown of those three things. It’s really 750 book value, plus a hundred goodwill, plus 150 of the increase in P P and E, but it’s called the one line consolidation. Why? Because when I debit it, I don’t debit out the assets, I just debit what? Investment. But what does it really consist of? It consists of the investment, plus the goodwill, plus P P and E. Now, when I teach you consolidations, let’s say I were actually acquiring 100%, then I would actually set these accounts up as 750, 100 and 150. I’d actually set those up, So, if for example these work 100%, then I would account for them that way. Okay, so that’s that. Then, they earn income. I’m the investor, they’re the investee. So, the investee earns money. When they earn money, let’s think about it, if they’re worth more shouldn’t 30% be worth more? Mmm hmm. Therefore, I’m going to debit investment, and I’m in a credit this account called equity in earnings. Now this equity in earnings goes to the income statement. So, what’s happening? Remember, I have significant voting influence which means I own 30% of you. When you made money, I know I’m going to get in it the form of a dividend because if you guys don’t declare a dividend I’m going to vote you out and put someone else in there. So, therefore, when you earn it, I record it, even though I haven’t touched the money. Now let’s look back at the question it said they had earnings of 120. So, if they have earnings of 120, that means 30% of 120…120 times 30% is 36 and 36. Now, they’re going to pay me a dividend. Now when they pay a dividend, what’s happening? Now I’m going to get cash, but do I record it as income? No, I’ve already recorded it as income because I recorded it as income when they earned it, not when I received it. So, therefore, I’m going to credit investment. Why? Because here’s the concept: When they earn money, they’re worth more, my investment goes up. When they pay money, it comes out of retained earnings, their equity is less, my investment is less. So, you can think of it this way, my investment follows their equity balance. I feel like I’m in Hawaii, do a little hula dance. So, that’s what’s happening is they go up, my investment goes up, as they go down, = my investment goes down. Now, this is something I’m going to plant your head now, will mean something to, like, 3% of you, but once I teach you consolidations I’m going to teach you non-controlling interest, used to be called minority interest. It’s the same thing. Non-controlling interest is they only own a few percentages. As they go up, non-controlling interest goes up. As they pay dividends non-con…so I’m going to show you that down the road. Those are for people that have already studied for the exam, people that understand that a little bit. There’s a comparison there, but don’t worry about it until FAR 8. So, we have our cash we have an investment. How much was their dividend? It was 40 bucks. 40 bucks at 30% is 12. So, debit cash 12, credit investment 12. So, if I were to look at an investment t account, it would look as follows: I bought the investment, debit investment a thousand. They made money, investment goes up. They pay dividends, investment goes down. So, you can see how the investment goes up and down and up and down up and down. That’s what’s happening. That’s how the investment is changing. This last entry is going to be the confusing one. This I’m going to call amortization depreciation or impairment, and this is for that excess between what I paid and the book value. So, here’s what we need to do. Let’s walk down here slowly, come on down, here we go. So, here’s what’s going on. Here’s what I paid, here’s what it’s worth, here’s what it’s in their books for. Now, with goodwill as I’ll teach you down the road, we have to test goodwill every year for impairment. In this case, they said goodwill was impaired so let’s say goodwill is a hundred bucks, and lets say goodwill is supposed to last…what did we say? Ten, oh no, it was impaired by ten dollars, so it should be 90. We need to take out 10, and it said P P and E is being depreciated over 10 years. We need to take out 15. That gives me 25 dollars in total. So, of this thousand dollars, I need to back out 10 because goodwill went down, I need a backup 15 because property plant equipment was depreciated. Now remember, I never debited goodwill. If you would have debited the account called goodwill, then you would take it out of goodwill, but I never debited goodwill. What did I do? I debited the investment. Now watch this. Here’s kind of what I’m showing you. If, let’s say, for example, what do we do? Let’s say for example…my brain went blank. Who are you? Where am I? Why are you looking at me? No. Oh, so let’s say I would have debited an asset which I get. I get an investment for a thousand which was what? 750 book value, plus 150 P P and E, plus a hundred goodwill. So, I debit investment, credited cash. Now, if I wanted to take some out, if this were goodwill, if I would have debited goodwill, then when the value goes down, I would credit goodwill, the asset, and I would also debit some kind of expense or loss. So I would call it impairment loss or depreciation expense or something like that. Well, so notice that I would take it out of the asset. Well, I never really set up goodwill. Instead, where is it? Instead, it’s in the investment. That’s why when I take it out, I credit the investment. And the debit’s going to be to expense or loss. But what’s an expense or loss? How about a reduction in income? How might a reduction of that equity in earnings account? And that equity in earnings…so if you come back over here, what I’m basically saying is that the equity in earnings account is going to be adjusted. So, that says that…do you see this journal entry? It’s basically the opposite. And here’s what I’m doing. Instead of debit investment and credit income, I’m going to reduce income by debiting equity in earnings and crediting investment. And I’m going to do that for how much? I’m going to do that for the 10 and the 5. So, let’s come down here. A little faster. There you go. Alright. So we’re going to do that for what? The 10 and there’s 15. So, what we’re doing is, goodwill was impaired by 10, take out 10, that means the asset comes down by 10, P P and E gets depreciated for 10 years, which is 15 bucks a year, the total is 10 and 15, or 25. So, 25 has to come out of this investment. So, what we’re going to do is take it out by debiting equity in earnings 25 credit investment 25. What does that represent? The 10 for goodwill, and the 15 for amortization of depreciation expense. Because normally you would debit depreciation expense and credit accumulated depreciation. What does that do? It reduces income, reduces an asset. Well, instead we never debited assets, so we’re going to reduce equity in earnings, which is this, reducing income, and reducing the asset because that’s where the asset is, taking it out. So, if I put that on my little t account, 20 plus 36 minus 12 minus 25, that means I have 37, 36, 999 is the ending investment. The two questions they like to ask is either: How much is your investment? 999. How much is the income statement effect? Investment balance sheet, cash balance sheet, investment balance sheet, equity earnings income statement. Cash balance sheet, investment balance sheet, equity earnings, income statement and investment balance sheet. So, the net effect here is credit 36, debit 25, 11 dollars. That’s the income statement effect. So, those are the journal entries you’ll see there in the notes for the equity method. All right, now let’s turn back to page 1 and some points of interest. Bottom of page 1, it says, the investment is originally recorded at cost, which we did, we debited investment. Very good. It says that as the investee earns money, this is recorded as in increase in the investor’s books based on the percentage they own. I own 30%. This is considered equity in earnings and is shown in the income statement. Dividends received are considered a reduction of the investment account and do not show up on the income statement because, remember, the dividends are a reduction in the investment because we already included it in the income statement. Any difference between what you paid and the book value must be accounted for. The differences are either P P and E, which is depreciated, inventory, which is written off when sold, or land and goodwill. Those are the differences that we’re looking at. So, again, you can kind of see how all of these items are kind of put together, how all of these items are accounted for. Alright. That is called the equity method. Let’s do the same question again under the cost method. Look at page 4. It says cost method. When no significant influence exists, we then must determine if the investment has a readily determinable market value. If the market value exists, use marketable securities. If the market value does not exist, use the cost method. So, again, marketable securities method that I’m going to teach you in the next chapter. Today just the cost in equity. Alrighty. Now, let’s look at the example on page 5 because we’re going to look at the same example we just did, but it says let’s look at the same example for the cost method if you own between…owns 30%. Now remember, I said if you want 30% normally equity unless you have less shares than someone else, then they are going to do equity and you’re going to cost. So, let’s just assume we’re doing 30%, same numbers, but we’re doing the cost method. It says here, first journal entry, record a cost, then record percentage, dividends and then depreciation and so on. Well, the cost method is really nice. Why? Because, remember, the cost method, I own zero to 20%. If I own zero to 20%, how much influence do I have over the company? None. Therefore, I don’t record money until I touch it. So, let’s do the cost method right here. Under the cost method, when you buy the investment, what do you do? Debit investment for a thousand, credit cash for a thousand. The second thing, when they earn money, now here’s the nice thing, when they are on money, I may never get that money. Therefore, when they earn money, you know what I’m going to do? Nothing because I may not get it. Now when they pay a dividend, I’m going to debit cash, and the dividend was 12 bucks, now I credit dividend income. And where does dividend income go? It goes to my income statement, income statement. So that’s called dividend income, goes to my income statement. Alright. And then finally, amortization, depreciation, impairment. Guess what? No entry. So what’s kind of nice here is under the cost method, here’s what it looks like. Here’s my investment. I buy it for 1000. They make money, no change. They pay dividends. No change. Amortization. No change. At the end of the year, what is it? Cost. It’s the same cost because whatever it cost me, that’s what I’m recording it for. So notice that, again, what’s nice about this, is under the cost method, it’s pretty straightforward. The only exception is, and again you’ll see the journal entries in your notes, if you look back on about page 4, it has some points of interest on the cost method. The original investment is recorded a cost, which we did right here…cost. Then it says when the investee earns money, no journal entry. And then, when the dividend is received, give it an income and amortization depreciation you don’t have worry about. However, the one thing we do have to be concerned with is, if the value is…let’s say they give you a dividend, but they tell you it’s not coming out earnings. That’s called a liquidating dividend. Now watch this. You see this journal entry cash dividend income? That’s assuming it’s coming out a earnings. If instead they call it a liquidating dividend, also called a return of capital, what that means is that they are giving you money but it is not coming out of earnings, it’s coming out of your investment. So, in that case, when you get that, if it’s a liquidating dividend, it would be coming out of investment, you credit investment. So, instead of crediting income, take it out of investment. You shouldn’t be taxed on it? Why not? It’s return…I bought it for a thousand and made no money and they gave me 20 bucks. I guess that 20 bucks didn’t come out of earnings. That came out of my thousand. So, it’s a return of capital liquidating dividend. Now notice back over here under the equity method, pretty much every dividend is treated as kind of a liquidating dividend because you recorded income when they earned it, liquidating dividend in a sense. So, that’s called a liquidating dividend which you will see under the cost method. Alright, so you’ll see those journal entries in the notes as far as how they are all compared. Alright, let’s turn about two pages up to about page seven or so where it says the purchase of life insurance, life insurance. Now life insurance, that is something that has a cash surrender value, and a cash surrender value means that if you turn this life insurance in, they will give you some money. So, let’s call the cash surrender, in a sense it’s a form of an investment, that’s why it’s covered here in the investment section. All you need to know is, if you’re paying, let’s say you’re paying 25 dollars cash and let’s say they told you that your cash surrender value went up by 10 bucks, they’re going to say, “How much is your insurance expense?” The difference, which is 15. What is cash surrender value? It is an asset, generally a non-current asset, shows up in your financial statements. The next section says changes in ownership. What if you change your ownership percentage? In other words, what if I used to own 40%, now I go down to 10, or I used to own 10%, now I go to 40? The question is, how do you account for those differences? Hmm. That’s interesting. So, let’s see how to account for those differences. So, what we’re really looking at here is I owned 20, I now in 40, or vice versa. Alrighty. So, let’s say I go from equity to cost. That means I used to own 40%, now I own 10%, for example. What it means is, I used to do the equity method…this way a little bit. Thank you. The equity method. What is the equity? The equity method says when you make money, it goes up, you pay dividends, it goes down. You have an amortization it goes down. You make money, it goes up. You pay dividends, it goes down and so on, and so it goes up and down. That’s equity. Now I sold off. I own 40, I sold off 30, now I own 10%. What does that mean? Now I’m going to use the cost method. Don’t go back! I used 40, 40 now just do 10 forward, so we’re going to call that prospective. What is prospective mean? Today and tomorrow. Versus cost to equity. I used to own 10, now I own 40. Now when I own 10 under the cost method, I bought it. They made money, no change. They paid dividends, no change. They made money, no change. They paid it, now I own whoop, 40. What do I do? From here, they make money, goes up, they pay dividends, it goes down, like that, but what I need to do is, I need to retroactively go back to when I first bought the investment, and I’m going to only own 10%, but I’m going to act as if it was the equity method but for 10%. So, in this case, I’m in a retroactive adjustment. So what do I do? So I own 10%, 10%, now 40. So, I go back to last year, pick up 10% of their income down as is 10% of their dividends. Year before, 10% of the income, 10% of the dividends. So, if you look in your notes, you’ll see here, equity to cost, example 40 to 10, use cost method going forward, called prospective, today and tomorrow. Equity method or cost to equity, retrospectively apply the equity method but only for the percentage you previously owned. So, what do we do? Prior period adjustment, which I’ll teach you down the road, and go back and pick it up but again only for that percentage owned. It says fair value accounting fasb 159. Basically what it says is you have the option of accounting for everything at fair value. Drop down, third bullet down, it says for the equity method, the securities were revalued to fair value and any gain or loss is recorded in earnings for the period. So, if we did the equity method, it makes it a lot easier. Why? You buy the investment, the value goes up. Whoop. Debit investment, credit income. It goes down. Whoop. Take it out of income. So what you would do is just the fair value option, and the fair value option is, once its picked, you can’t change it and then you would just account for your investment under fair value, which makes it a lot easier. But, what do they like to test you? They like to test on the ugly difficult stuff, which is the stuff that I just taught you. It says that the company does that, the company purchases additional shares of stock, thus qualifying for the equity method. If the fair value option is elected the investment would be carried at fair value and any new realized gain/loss is recognized in earnings. Once the fair value option is elected, it is irrevocable. What does irrevocable mean? You can’t go back, you can’t change it. Alright. Let’s do a couple of changes…couple of changes…let’s do a couple of questions. Starting out with question numero uno, question number one. Now, I’m going to teach you a very, very important trick, and I want you to remember this for the rest of your studying FAR and for the rest your life. What is it? When you get a problem, look at the choices. A, B, C, D are all number choices. Whenever you get a question like that, they always tend to give you information that you don’t really need. So, what I want you to do is read the last sentence first, see what it is they’re asking for, then go to the background. So, the last sentence first says, “What amount should Sage report its income statement from the investment in Adams for the year ended December 31st, X3.” So, they want know what amount should Sage report in its income statement for earning. So, we’re looking at the income statement, income statement. So, think about over here, these journal entries. With the income statement, what they’re saying basically is that balance sheet, balance sheet, balance sheet, income statement, balance sheet, balance sheet, income statement…they’re looking for this number. That’s what they’re looking for in this journal entry. Okay? So, that’s what we have to look for. Alright. It says Sage, Inc. bought 40% of Adams Court outstanding common stock for 40,000…400,000. The carrying amount of their net assets at the purchase date totaled 900. The fair value and carrying amount were the same for all items except for plant and inventory, for which their fair values exceeded their carrying amounts by 90 and 10, respectively. Now let me mention that word respectively because some of you are not familiar with it. Respectively means the first word goes with the first number, second word goes with the second number. Respectively. So it says here plant and inventory, so plant, P P and E 90, inventory 10. The plan has an eighteen-year life, eighteen years, and the inventory was sold during the year, so all the inventory was sold. Remember I said you can sell half or none. Here they sold it all. During X3, Adams had income a 120 and paid dividends of twenty. What amount should Sage, Inc. report on its income statement for the year ended December 31st, X3. Alright. So we bought 40% of the company on January 2nd, X3. Alright, so we need to go through and figure out some amounts. So let’s start up here. And we’ve got purchase price. I paid how much? Was it 400,000 dollars. Now if you look back over here, they’re telling us that we have 40% of the company, we paid 400,000, fair market value was…the carrying amount, the carrying amount and was 900. So, carrying value was 900. It said carrying value and fair value with the same except for plant and inventory, for which this is 90 and 10. That means fair value must be a million bucks. So I had to kind of work my way backwards to get the million. So, carrying value was 900. I get 40%. Nine times 4 is 360. They got fair value as a million. I get 40%, which is 400, which is what I paid, which means there’s no goodwill. So, if we’re to set this up, purchase price 400, fair value is 400, the book value is 360. So notice here there’s no goodwill, here there’s 40 dollars of fair value write-up. They told me what’s the fair value write-up. They said the fair value write-up of P P and E was, oh here it is, 90 and 10. Now if I own 40% of that, ten at 40% is 4, 90 at 40%, that is 36, there’s your 40. So, 4 goes to inventory, 36 goes to P P and E. So back over here, the 44, which is 10% of the amount, goes to inventory and 36 goes to P P and E. They said all the inventory was sold, so I’m going to take all four out, and P P and E is depreciated over 18 years, which is 2 bucks a year, so I’m going to take 6 dollars out o my investment. Let me do that again because I know it gets confusing. What they’re saying is, I paid 400 for something worth 400, but it’s in your book for 360, which means that if I want to write your investment up to, you know what it cost me, 400, that means that 40 dollars of it represents the increase in value of the assets. That means that if I pick up your property plant equipment, I’m going to have to depreciate the excess 90% of that 0f 36. I’m going to have to depreciate the other inventory part, 4 dollars. That’s going to get sold. So, of this 40 dollars, I’m going to take out 6 this year. The next year I’m going to take out to 2 2 2 2 2 2 for 18 years. So that’s what I’m depreciating. So that’s how it looks as far as the numbers. So now let’s do the journal entries, and we’re doing the equity method…that’s way over here. Okay. So, I buy the investment, debit investment 400, credit cash 400. Then, they earn money. In the problem it said they earned 120 of income and 20 of dividends. So, they earned 120 at 40%, which is 48, 48 and they paid dividends of 20 at 40%, which is 8. So debit cash for 8, credit investment for 8. And amortization appreciation was the 2 of inventory and the 4 of 2 of P P and E, 4 of inventory sold, 6 and 6. So if I put this in a t account, I buy it for 400, then I’d invest the income of 48 is my share, they paid dividends of 8 and amortization appreciation is 6, gives me 448 minus 8 is 440, 434. So my ending investment is 434 if they ask me. Let’s say I sold off half of it? What would I do? Get a cash credit investment, half of this, difference gain or loss. The other thing is, and of course if I sold off half my 40% I have 20%, let’s say they said use cost method, I would do equity to cost prospective, cost to equity retrospective, retroactive, same thing. Alright. Let’s see here and they’re asking for income. Balance sheet, balance sheet, balance sheet, income. Balance sheet, balance sheet, income 48 minus 6 is 42. So what is the income statement of fact? Answer B is 42, so again I know that was kind of a long way to get there but that’s 42. Look at question number two. Theoretical question. Now theoretical questions are tricky because a lot of times people, you really have to think hard, because you’re like, “Wow. I thought I understood it, but now the theory is throwing me off.” Let’s see what it says. Par Co. uses the equity method to account for its January 1st purchase of Tune, Inc.’s common stock. On January 1st, the fair value of Tune’s FIFO inventory and land exceeded their carrying amount. How do these excesses of fair value over carrying amounts affect the reported equity in Tune’s earnings? So, what they’re saying is…hmmm…I use the equity method, and how does inventory land? Alright. So, let’s see. Now, it’s kind of a tricky question, but let’s look over here and see what they’re getting at. What they’re really saying is, if I buy this difference, here, this difference, fair value write-up…what could it be? It could be P P and E, land or inventory. How does this affect your income? Well, it affects income by being depreciated or amortized or sold, so if you sell inventory what does it do? Decrease income because it’s like debit expense credit debit costs it gets sold credit inventory. Here? No effect because land doesn’t get depreciated. Here, you depreciate P P and E, it comes down. So, what’s the answer? P P and E decrease, land, no effect, inventory, decrease. Let’s look back at my journal entries again, too, because, look up here. How much was my income? 48. What happened to income? It went from 48 down to 42. Why? It went down because of equity in our because of this amortization depreciation. What was in here? Cost of what sold for inventory. What was in here? Amortization of goodwill. What was in here? Depreciation. What’s not in there? Land because you don’t depreciate land. So you can see they’re just saying what would make this go down? Those items. So that’s…let’s look at the question. Inventory excess? Yes, because when you sell it goes down. Land? No. If they ask you about P P and E? Yes. Alright, so again I want you to start to understand those concepts. Alright, in a minute let me talk about how it has affected by IFRS. Okay under IFRS, look in your notes, it says the last page in the chapter investments in financial instruments under of other entities under IFRS. Now it says the term investments refers to investments that are held as HFT, which is held for trading, available for sale, held to maturity and equity method. What did we talk about this chapter? Just the equity method. Now a financial instrument is classified as either fair value through profit or loss or the equity method. The equity method is what I just showed you, so the equity method is, if you look over here, you’ll see the equity method is all these journal entries I just showed you that would be the same. So that the equity method. However, this other thing fair value through profit and loss, this seems kind of new. I don’t remember talking about that. It says an asset is classified as fair value through profit or loss. It is re-measured to fair value at the end of each accounting period and any proper losses recorded in where? In income. So you buy the investment, it goes up, basically you debit the investment, credit some income, it goes down, credit investment debit some kind of loss. Profit or loss is recorded. In order to be classified as fair value through profit or loss, the equity must have an active market in which to determine the fair value. You can’t just objectively go, “I think it’s this.” You have to have an active market, and that active market is used to determine what the fair value really is. So that’s what IFRS is saying is we’re looking for this active market. It says investments in associates may be accounted for using either the equity method or the fair value through profit or loss. To qualify for the equity method you must not significant influence which is the same thing we already learned under gap, so that’s the same 20 to 50%, you have some kind a significant influence. As with gap, the equity method requires investment to be recorded at cost. Investors’ share of profit or loss is recognized, investors’ share of dividend is recognized; however, if the cost is greater than their share of their fair value, it is not recorded as goodwill. Instead, it says it’s if the cost of the investment is greater than the share, it is not recorded as goodwill, the portion of the cost of the investment over the carrying amount is amortized as the assets are realized. If the cost is less than the fair value, then what we used to call negative goodwill, this difference is recognized as income. So, instead of recording goodwill, you’re either going to have this excess and the amortize it in, or you’re going to have less, which is like negative goodwill. And then what do you do there? Then you’re going to record that on the income statement. It says here an impairment of an investment is recognized if the carrying value is greater than the recovered amount. So basically if you have an impairment loss, which we could always have, then you would write it down. I’ll talk more about impairment losses in the next section for marketable securities, but basically, just like everything else, if you have any kind of impairment loss, that is where the carrying value is greater than the recoverable amount, then you could write that off as well. So again, the big difference though here is that the difference between what you paid and what it’s worth is going to be amortized. Debit expense, credit investment. If instead you paid less, then it would be recorded as income on the income statement. So if you look over here, what they’re saying is this part is the same, this part instead is not going to be recorded as goodwill, you’re going to put it in the asset account and then you’re going to debit expense and credit and amortize it out. If this amount is less, then you’re going to record that as a gain, as income. So again, that’s one of the big differences as well. Let’s try a question. How about question number 5? And then we’ll get a break. It says, “Under IFRS, an equity investment may be accounted for using the equity method if the investor has significant influence over the investee. Significant influence is indicated by what?” Well, even if you don’t understand IFRS, same rules: 20 to 50%. That is generally the thing. 20 to 50%. That would be your 20 to 50 percent, that would be the amount that you can see.
Sign Up to Learn More!
Join our mailing list today to get notified of new discount offers, course updates, Roger CPA Review news, and more!