0:01 in this video we're going to talk about
0:03 how to use the equity method to account
0:05 for investments so when you want between
0:07 twenty and fifty percent of a company
0:10 stock you're deemed to have significant
0:12 influence and so what significant
0:14 influence means is that you could alter
0:16 a firm's dividend policy right because
0:18 you own so much let's say for example
0:21 you own 40% of a company you could
0:22 influence whether or not they issue a
0:24 dividend in the given period and the
0:26 reason that this is important is because
0:29 even though that firm you've invested in
0:31 might be incurring losses you could
0:33 pressure them you could use this
0:35 influence that you have to get them to
0:37 issue a dividend and if we were
0:38 accounting for things under the fair
0:41 value method when you own less than 20%
0:43 of the firm shares you would be
0:45 recognizing income with that dividend
0:47 you would have dividend revenue so it
0:49 would look like you are generating
0:51 revenue from this investment even when
0:53 the investment is losing money so to
0:55 prevent firms from playing this game
0:57 that would basically develop the equity
0:59 method in which what's going to happen
1:00 here is you're going to recognize a
1:03 proportionate share of net income or the
1:07 net loss that the investi has so for
1:09 example if you if you've invested for
1:11 you own 40% of that firms shares and
1:14 then that firm has a loss you will have
1:17 to book 40% of that loss or if they have
1:19 net income you give 40% of that net
1:22 income and you don't recognize any
1:24 dividend revenue you just recognize a
1:26 proportionate share of their earnings or
1:28 their losses so let's walk through an
1:29 example and make it a little easier to
1:31 understand so let's say that we've got
1:34 Tom's surf shop you're interested in
1:36 investing in them and they have 250
1:39 shares of stock outstanding so you
1:40 decide you know what I think I really
1:42 like this business I want to buy a
1:44 hundred shares I want to buy a hundred
1:46 shares of Tom surf shop and if you do
1:49 the math 100 divided by 250 that's going
1:53 to be 0.4 so this is 40% 100 shares is
1:56 40% of the company and so that cost you
1:58 one hundred and seventy five thousand
1:59 dollars so now we need to make a journal
2:02 entry so what we're going to do is we're
2:04 going to debit the investment in Tom
2:07 surf shop just call it investment or
2:09 whatever you like to call it and we will
2:10 debit that for a hundred and seventy
2:13 five thousand dollars
2:14 now we're just going to assume you pay
2:16 cash so we're going to have a credit
2:18 here for cash of one hundred and seventy
2:20 five thousand dollars and this is just
2:24 to reflect the purchase of 40% of Tom
2:26 surf shop now we're going to have some
2:29 action here so let's say that Tom his
2:32 surf shop reports net income of thirty
2:34 two thousand dollars
2:35 so they made thirty two thousand dollars
2:37 and so now you're going to need to make
2:40 a journal entry here so remember we're
2:42 going to recognize the proportionate
2:44 share of net income or in that loss
2:47 we're going to recognize that so we see
2:48 we've got thirty two thousand dollars
2:50 but we're not going to recognize the
2:51 whole thirty two thousand we're going to
2:53 recognize forty percent of that in
2:55 thirty two thousand times forty percent
2:58 is twelve thousand eight hundred so what
2:59 we're going to do is we're going to
3:00 recognize investment revenue we're going
3:02 to have a credit here of twelve thousand
3:04 eight hundred remember we don't
3:07 recognize revenue or a law or excuse me
3:09 revenue if there's a dividend we're only
3:10 going to do it with a proportionate
3:12 share of the net income so we take our
3:14 portion of this thirty two thousand and
3:16 comes down to twelve thousand eight
3:18 hundred of investment revenue or revenue
3:20 from investment and Tom surf shop
3:22 however you want to put it and then the
3:24 corresponding debit right we've got we
3:25 got a balance here we got to have a
3:27 debit of twelve thousand eight hundred
3:30 and what that debit is is it goes to
3:32 investment in Tom surf shop it's
3:35 actually going to increase the carrying
3:37 value so if we were to look at this
3:39 investment on the balance sheet right so
3:41 we start out with one hundred and
3:42 seventy five thousand well now we've
3:45 just debited it so now it would be one
3:46 hundred seventy-five thousand plus
3:48 twelve thousand eight hundred that's
3:50 what the carrying value of this
3:51 investment would be on the balance sheet
3:54 now let's say that there's a dividend
3:56 issue by Tom surf shop now you might be
3:58 thinking wait a minute I thought you
4:01 said that we don't recognize revenue
4:03 from a dividend well we don't under the
4:04 equity method we're not going to
4:06 recognize revenue from this dividend
4:08 however we are going to have a journal
4:10 entry because remember we're getting a
4:12 portion of this dividend right we're
4:15 getting forty percent we own 40% of the
4:16 company we're going to get forty percent
4:19 of this dividend so we have to do some
4:20 kind of entry we're just not going to
4:23 recognize revenue from it so what we're
4:25 going to do 40 percent of ten thousand
4:27 is four thousand right so
4:29 we're going to the cash is the easy part
4:30 right we know that we received a
4:33 dividend we received a cash dividend of
4:35 $4,000 right that's just 40 percent of
4:38 the total dividend that Tom surf shop
4:41 issued so we recognized that portion but
4:43 now we're not going to credit dividend
4:46 revenue so what we credit is actually
4:49 investment in Tom surf shop a dividend
4:51 will actually reduce the carrying value
4:55 of our investment on our balance sheet
4:57 right so we see here's that we start
5:00 175,000 and then we increase the
5:02 carrying value when we had some revenue
5:05 and then now we decrease it the carrying
5:07 value with a dividend but we don't
5:09 recognize any income here right it's
5:11 different from the fair value method in
5:12 that respect so if we were to think
5:14 about our carrying value at this point
5:16 our carrying value and then by carrying
5:17 God I just mean if we were look at the
5:20 balance sheet what is investment in term
5:22 Tom surf shop what is that show we have
5:24 that 175,000 that we originally paid
5:27 plus the twelve thousand five to twelve
5:28 thousand eight hundred read that
5:30 proportionate share of their net income
5:32 and then minus the dividend of four
5:34 thousand so it would be a hundred and
5:35 eighty three thousand eight hundred
5:37 dollars is the carrying value of the
5:39 investment Tom surf shop at the end of
5:42 the period now know there's something
5:43 really important here that you need to understand
5:44 understand
5:48 so unrealized gains or losses are not
5:50 recognized under the equity method right
5:52 because we're not doing the whole fair
5:54 value thing where we say oh we've got an
5:56 unrealized gain and and then so forth
6:00 we're not doing that however however an
6:02 investor right so like you for example
6:04 you're investing in Tom surf shop you
6:08 have the option to irrevocably elect to
6:11 use the fair value method right and if
6:13 you were to say you know what we're
6:15 going to make an election to do the fair
6:17 value method to to account for our
6:19 investment in Tom surf shop then you
6:21 would basically account for it exactly
6:24 the same as if it were trading
6:26 securities when you own less than 20
6:28 percent so remember we talked about in
6:30 our video when you say less than 20
6:33 percent we use that fair value method
6:35 right where we do have the unreal eyes
6:38 holding gains and losses and so you just
6:39 account for it with like trading
6:41 securities so any unrealized
6:43 holding gains and losses would go to the
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