>> We're going to look at accounting
for investments for equity securities.
These are stocks, okay.
Notice when you're investing
in stock the percentage
of ownership in stock is very important.
We have three classifications.
If we own less than 20% of the
company stock, we're going to account
for the investment under the fair value method.
When we own between 20 and 50% of their stock,
we use something called the equity method
and when we own more than 50% of the
company's stock, we control the company.
We would consolidate, use
consolidation accounting.
We are not going to talk about
consolidation accounting in this video.
That's an entire class in advanced accounting,
okay, but we will look at the first two methods.
The good news here is unlike debt
securities we only have one classification
and that is what we call fair
value through net income,
which notice I put is the same conceptually as
trading securities for bonds, debt securities,
okay, but we call it fair
value through net income.
Think of it as trading securities.
Unrealized holding gains and losses are
recognized in net income for each period.
Okay. There used to be trading
and available-for-sale.
They decided to get rid of the
available-for-sale classification
and only use trading but they changed the
name to fair value through net income.
All right so we're going to look
at the following transactions
and the related journal entries.
When we invest, when we receive dividends, we're
going to do a fair value adjustment at the end
of each period and then when
we sell the investment
and these are relatively
straightforward journal entries.
On April 1 ABC invested $700,000 to
acquire 10,000 shares in XYZ Company.
This is less than 20% ownership,
okay, so we use the fair value method.
On September 1, ABC paid a
dividend of $4 per share.
We own 10,000 shares.
That'll be a $40,000 dividend.
So the journal entries on the day of investment
we debit the investment, we credit cash
and when we receive the dividend, we
debit cash and we credit dividend revenue.
Very straightforward.
On December 31 year end, the fair
value increased to $72 per share
and then 3 days later we sold the
investment for a total of $750,000.
So the investment was originally
recorded at $700,000.
At the end of the year it's now worth
$720,000, 10,000 times $72 per share, 720.
So notice we debit the fair
value adjustment account 20,000,
and we credit the unrealized holding
gain for net income for $20,000.
That's going to hit the income statement and
when you hit the income statement that means
that the unrealized holding is going to
get closed out, it's a closing entry,
but the fair value adjustment account will sit
on the balance sheet along with investments
and it shows that investments have increased
in value since we made the initial investment.
Okay, 3 days later we sell the
investment for $750,000, debit cash 750,
credit the investment account 700,000, credit
the fair value adjustment account 20,000
and we're going to recognize a $30,000
gain on sale in the following year.
So we made a total gain of 750 but 20,000 of
that gain was recognized in the previous period
on December 31 and then 30,000, the stock
went up sharply in a short amount of time,
we have a $30,000 gain in the new time period.
Those are the journal entries.
That's very straightforward
for fair value accounting.
Now when we own more than 20% but less than
50%, we don't have a controlling interest.
Let's take a look at this slide.
These are some things that are going
to arise related to the equity method
that we need to kind of recognize.
We have a long-term relationship
with this company.
We can influence management.
We have what's called significant
influence over management.
We probably have seats on
the Board of Directors, okay.
So when the investment does
well, our investment does well,
we do well, okay, and vice a versa okay.
When they have net income, then we're
going to increase our investment
by our percentage of ownership, okay.
If they lose money, we would
decrease our investment
by the same percentage of our ownership.
And when they pay a dividend, it's kind of
like conceptually when we pay a dividend.
Think back to when a company
pays a dividend, okay.
They're going to credit cash and they're going
to debit the dividend account
or retained earnings.
Remember dividends get closed
out to retained earnings.
So a debit to retained earnings
is a reduction, right.
Cash, which is an asset, goes down, retained
earnings, which is equity, goes down.
It's similar conceptually here.
We're going to receive cash, right,
that we get the dividend; however,
we're going to reduce the
value of our investment
because the company is giving out money.
It's shrinking, right, it's going down
in value by the amount of the dividend.
So we reduce our investment account when we
receive a dividend under the equity method.
Now let's take a look at what's going on here.
This is going to have some
ramifications in a little bit.
ABC Company purchase 30% of
XYZ Company for $750,000 cash.
We now own 30% of their stock.
Look at the balance sheet accounts
on the general ledger of XYZ.
That's the book value.
The building, okay, which has a 10-year
remaining life, no salvage value 500,000,
the land is 250, other net assets we'll
say 300,000, total net assets 1,000,050.
The fair value at the time we made the
investment you can see the building is a
million, the land is 500,000, other
net assets the same total fair value
of net assets was 1,800,000.
We paid, excuse me, the total fair value
of the company though is 2.5 million,
and when we acquired 30% of that,
our investment cost us $750,000.
Notice that the difference between the
fair value of net assets 1.8 million
and the total fair value the company of
2.5 million implies goodwill of $700,000.
So when we made the investment, it was based
on the fair value of the entire company 30%
of 2.5 million is how we came up with the
$750,000 price tag for our investment.
Okay, we're going to come
back to that in a little bit.
Okay, debit investment 750,000 credit cash.
There's the initial journal
entry for the investment.
XYZ had net income of 250,000
and they paid $100,000 dividend.
Thirty percent of that would be ours, right?
So we're going to increase our investment
by 30% of the 250 net income that's $75,000,
we debit the investment 75,000, and
we credit investment revenue $75,000.
Notice it's not cash.
We're recognizing our percentage of
the acquired stocks net income, okay,
by increasing our asset value of the investment
and recognizing revenue for
30% of their net income.
We also got a dividend of
$30,000, which is 30% of $100,000.
So we debit cash for the 30,000 we
received but notice we reduce the value
of our investment by $30,000, okay.
You almost have to think of it as
this is almost like our company.
We own a significant portion of it and so
when our company pays a dividend cash
goes down, the investment goes down, okay.
So we're saying, okay, we received
the cash, but our investment,
the company is now a little bit smaller because
they paid out this dividend and so we're going
to reduce our investment in XYZ by
the amount of the dividend, okay.
So you may like I said hit pause, review
it, think about it before going on,
but under the equity method when you have
significant influence over management,
you own between 20 and 50%, their net
income will increase our investment
and when they pay a dividend
it decreases our investment.
Let's take a look at these next two slides.
They're very wordy so we're going to
kind of read through them together.
I want you to think about them.
Hit pause any time you need to
because this is complicated stuff.
If ABC Company acquired more than 50% of XYZ
stock, ABC, which would be the parent company,
would have a controlling interest in XYZ.
XYZ is now called the subsidiary.
ABC would use consolidation accounting,
okay, which is a whole different area
which we're not going to talk about, okay.
And when they prepare financial
statements, they combine
or consolidate the two companies
financial statements into one set
of consolidated financial statements.
Before this is done when the acquisition
of more than 50% of the stock took place,
ABC recognizes the fair value of all
of XYZ's assets and liabilities, okay.
Remember assets minus liabilities
we call net assets, okay,
so we acquired more than 50% in this example.
So we have to update all those accounts from
the old book value to the current market value.
This change will produce changes in
other numbers such as depreciation
and amortization expense, cost
of goods sold and other accounts.
Think depreciation for a moment.
If the company had an old book
value that was say $50,000
and now because of the acquisition
the fair value is now $80,000,
when we depreciate the asset using
the new fair value that's going
to create higher depreciation, right,
than if you calculate depreciation based
on the book value of 50,000, okay.
Now this relates to what we do with
the equity method of accounting.
So we had to talk about this.
When we invest in XYZ using the equity method,
we only record the investment
of XYZ in our records.
We debit the investment account.
We do not record accounts receivable,
inventory, land, buildings, et cetera,
we don't record any liabilities
for that matter, okay.
This investment is recorded in our records
at the amount we paid, which
was the fair value, okay.
That's an amount higher than the book value
of the net assets, which is consistent
with consolidation accounting
and it's supposed to be.
XYZ continues to run their business
and their general ledger maintains all
of those asset liabilities at their book value.
So they record depreciation and
amortization expense and cost
of goods sold based on their book values.
These expenses that they're recording are
lower than what we would record had we had
to record depreciation and amortization
based on the fair value that we paid.
So they're using book value to calculate
depreciation and their net income was based
on their book value and the
related depreciation.
Those numbers, those expenses are lower
than what we record considering our
investment is at fair value, okay.
We're going to go back in a moment to
look at that earlier slide to just kind
of highlight the differences
in the values, okay.
We're going to look at the difference
being the book value and fair value, okay,
and a couple of things to point out.
To keep things simple we only made a couple of
differences between book value and fair value.
First, the building has a book value
on XYZ's financial statement,
financial records of 500,000.
The fair value at the time we
invested in them was $1 million.
Very normal for real estate in
particular to increase in value.
Land had a book value of 250, had a fair value
of 500,000 at the time we made the investment
and everything else we kept the same, okay.
So those numbers should look
familiar because that's just the same
as the previous slide minus a few things.
Now land does not get depreciated.
So the fact that there's a
difference between book value
and fair value doesn't have
any impact on how we account
for this investment because
there's no depreciation.
The building, however, is a different story.
Notice the building has a 10-year
remaining life, no salvage value
and we'll assume straight-line
depreciation to keep life simple.
XYZ would have recorded depreciation
of 500,000 divided by 10 years
so that's $50,000 of depreciation for the year.
Had they used $1 million that would have
resulted in $100,000 of depreciation.
Note the difference between
book value and fair value.
When they calculated net income, they used
50,000 depreciation expense and, of course,
our portion of that would have been the 30%.
So the net income they reported was 250,000.
We got 30% of that we increased
our investment by $75,000.
Given that we're carrying this investment
at fair value we need to make an adjustment
to those accounts that are being carried at
fair value, but the income that we recorded
from XYZ was calculated based
on their book value, okay.
So the difference between the
depreciation they recorded
and what the depreciation would have
been using fair value is $50,000.
Our percentage of that would
have been 30%, which is 15,000,
and so the depreciation expense affecting us
in our records would have been $15,000
higher had fair value been used.
If the depreciation expense is $15,000 higher,
then our portion of the net income
would have been $15,000 lower, okay.
Again had fair value been used depreciation
expense would have been $50,000 higher.
Our 30% of that is 15,000.
The higher the depreciation
expense the lower the net income.
So our net income, which we used to increase
our investment, should be less by $15,000.
So, notice what we do, where in a credit the
investment account by 15,000 and we're going
to debit the investment revenue by 15,000 and
that's going to take into account the difference
between fair value and book value
when calculating depreciation.
This is probably the trickiest part of the
entire equity method is making these types
of adjustments, okay, because we
recorded the investment at fair value.
XYZ is determining net income based on their
book value; two different numbers, okay.
So take a good look at that.
Here's what our account looks
like when all is said and done.
There is the original investment debit 750,
the 75,000 was our 30% of their net income.
Remember their net income was
250,000, 250 times 30% is 75.
They paid a $100,000 dividend.
We debited cash, we credited the investment
account to reduce the investment by 30,000
and then the last entry is that
depreciation adjustment of $15,000,
which reduces our investment as well.
Our year-end balance in the
investment account is $780,000.
Now I'll just mention briefly that we would
ignore fair value at year-end unless we chose
to adopt the fair value option, which
is available in a variety of scenarios,
okay, but we'll leave it at that.
So that's investments in equity securities.
