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