PROFESSOR: OK. And in this lesson, we're going to talk about accounting for investment in common stock, especially we're going to compare between the fair value method and equity method. And secondly, this is the first-- it's actually the first consolidation practice. And the first situation is that when a parent company acquires another company stock 100% at the book value without differential.

So let's first talk about accounting for investment common stock. So this is kind of review from-- of the intermediate accounting tool. So in the intermediate accounting, you probably learned about the accounting for stock investments. So based on-- depending on the share ownership, we have three different accounting.

The firstly, the fair value method, is usually when the-- when a parent company acquires less than 20% of another company acquired-- the acquiring stock. If that is the case, we usually consider that. There is no significant influence, which is a lacking influence on investing. If that is the case, we use the fair value method.

And for this part, for this variable method, the acquiring company-- acquiring or investing company and this record based on share-- based on the dividend declared from the investee. And also, investing company record the revenue or loss based on the change in fair value of the stock price.

A second method is the equity method. Usually, this is the case when investing company acquires an investee's company stock, at least 20%. OK, at least 20%. And we usually consider that the investing company can influence significantly on investee. And if that is the case, we invest in company record the profit when investing-- the investor record income based and the share of income should be recorded as the investing company's income.

And dividend declared by the investee is considered the return of capital. And this, actually, is not the income for the investing company, but instead, that is considered the reduction of investment. So basically, again, this is kind of review of there in intermediate accounting.

You've got to clearly know that the journal entry and also how to present in the financial statement for each method. For example, the fair value method, we record the fair value as a balance sheet amount. And also, what's the income statement effect, the share of dividend, and the fair value change.

Is the income for the fair method? In the case of equity method, the balance sheet is based on the adjust code based on-- and depending on the change based-- depending on the share of earnings and share of dividend. For the income statement effect from the equity method, that's the share of income from the investing.

So there is-- and also, especially when investing company acquires more than 50%, then we consider that investing company can control the investing. If there is a case, investing company or parent company is required to prepare for consolidated financial statement.

And there is an example of there-- of the comparing the equity method and the fair value method. So you can please take a time to review this journal entry. OK, so you got to know that clearly understand this journal entries for each method. And also, you got to know that what is the balance sheet amount and what's the income statement effect?

So, for example, the first case is that-- the example says that the company acquires 20% of another company stock. And the first case, a case one, is that does not gain a significant influence over the XYZ. If that is the case, because there is no-- the influence is not achieved. So if there is a case, the investing company needs to use the fair value method instead of equity method.

And the journal entry is-- the first journal entry related to the purchase journal entry. Second one, the share of dividend. So dividend declared by the investee, XYZ Company, is $20,000 and the ownership is 20%. So therefore, $4,000 of dividend income should be recorded by the investing company.

And also, at the end of the year, the stock price is-- of the investee is $98,000 and it has actually decreased from $100,000, which is a $2,000 decrease. That should be recorded as a unrealized loss, which is income statement effect. And also, that decrease in investment.

As a result, at the end of the year, XYZ, the parent company or investing company, needs to record an investment as $98,000 in the balance sheet. And income statement effect is that dividend income $4,000 minus unrealized loss $2,000. The net effect is positive $2,000.

In the second case, what if the parent company or investing company exercise an influence? If that is the case, we use the equity method. Based on equity method, the purchase journal entry the same, but notice that, in the case of equity method, investing company or parent company record income when investing record earnings.

So that's the 20% of the invested income, which is $60,000. That is a $12,000. Notice the journal entry, the debit investment in subsidiary credit income from subsidiary $12,000. So this income from subsidiary increased the investment and increase the income from subsidiary. So that's the equity entry.

And thirdly, for the dividend is considered the reduction of the investment and return of capital. So $20,000 of the dividend declared by the investee, the 20% is $4,000. That is the reduction of investment, not the investment-- dividend income. So notice that-- what's the credit count? The credit account is investment in XYZ for $4,000. So $4,000 of investment decreases.

As a consequence, what's the balance sheet effect? The balance sheet based on equity method, the parent company or investing company ABC should record $1 or a $108,000. $100,000 plus $12,000 minus $4,000, which is $108,000.

For the income statement, that's the-- what's the effect of income? So income should be recorded when XYZ report earnings. So that's $12,000. So that's the-- it's very important and this is a very important concept. And basically, for the consolidation, we special-- you got to pay special-- pay attention to the equity method entry. So now, let's take a look at another example of the-- this accounting first that investment.

So this is another example. If you look at the information provided, so Small Company, S company, reported net income $40,000 and paid dividends at $15,000 during the year and company acquired 20% of S Company stock January 1st for $105,000. At the end of the year, December 31st, 20x7, M Company-- the fair value of the share-- fair value of the S company is $121,000. And M company, which is acquiring company reporting, operating income of $90,000.

So the first case, again, if M concludes the acquiring company is the M Company, Mock Corporation, is the-- is acquiring company or investing company-- so if M company can exercise their influence on S Company, if that's the case. So this is the keyword that, based on that, we can conclude that the M Company should use the-- apply the fair value method.

So again, what's the journal entry? So the firstly, the purchase. So investment in a debit, investment in subsidiary, credit cash, $105,000. And secondly, according to fair value method, the parent or acquiring

company record income based on the share of dividend declared by the subsidiary or a small company that's there.

So notice that the dividend declared by the Small Company was $15,000. But you got to be careful. These $15,000 is 100% dividend declared by the Small Company. Parent company, or acquiring company, should record income just share of this dividend, which is 20% of the $15,000. That is $3,000.

And what is the journal entry? And notice that, in this case, dividends actually is paid. So therefore, the debit account will be cash $3,000 and credit dividend income based on the fair value method.

And thirdly, another journal entry we got to do is that the fair value change. The fair value at the end of the year is turned out to be $121,000. And we got to compare this amount with the original cost, $105,000. The fair value has increased from $105,000 to $121,000. The increase is $16,000. That increase should be recorded as a gain, which is the income statement effect.

So what's the journal entry? Debit investment in S Company. So investment increased by $16,000. And unrealized gain on S Company is $16,000. So that's the journal entry for-- based on the fair value method. So additional question is that, what is the income reported by M Company? What is the income reported by the acquiring company?

Notice that the M Company, the parent company, has its own income, $90,000. And so this is the-- the income $90,000 is the acquiring company's own income. And we got at the income from a small company based on this entry. So income should be-- M Company's income will be eventually $90,000 is own income plus dividend income $3,000 and also unrealized gain, which is the $16,000. So that will be $109,000. That is the $109,000.

One other month should be reported as an investment in S Company in the balance sheet. So again, this is the fair value method. So that should be reported at the fair market price, which is $121,000.

So now, let's look at the equity methods. Again, the keyword here is exercise significant influence, so that is the indication that the company, M Company, should use the equity method for this investment.

So equity method-- according to the equity method, basically, the acquiring company, M Company, should report-- should record income when acquired company acquiring or invest in a small company report income-- by the share of income.

The income reported by the Small was the $40,000. So therefore, 20% of the $40,000. That's the $8,000. By that amount, the M Company should report income. So what's the journal entry? So we got increased investment in Small, which is $8,000, and credit income from Small, $8,000. That's the entry.

And dividend is considered the reduction of the investment. So dividend amount is, again, $15,000, 20% of the $15,000, that's $3,000. So again, because dividend is paid, debit account is cash $3,000. Notice that what's the credit account, that's the investment. That's the reduction of investment, not the dividend revenue. So $3,000.

So how much the income reported by the M Company based on this equity method? So again, we got to start with their-- the m company's own income, $90,000 plus an income from S Company based on share of income, which is $98,000. So that's the total income reported by M based on-- based on equity method. How much should be reported as an investment is Small in the balance sheet? So that is the-- that is basically-- that is called adjusted cost.

So what adjusted cost means then, we start from cost, but we adjust based on the share of income and share of dividend. So basically, we start from $105,000 and in share of income by the investee is the increased our investment. But share of dividend decreases our investment. So that's the $110,000. So that should be reported in the balance sheet.

And it's very-- and as you may-- as you probably learn from the intermediate accounting, it's-- I think it's very important for you to know that the-- how to show in the in the account, especially investment. According to the key account, that's the investment in subsidiary. So there's the starting from acquisition price And the share of income increase the investment. Investment decreases because of the share of subsidiary dividend.

So this is the thing that we talk about in this lesson. So if we plug in the number, so that's the actual price, $105,000. Share of income, which is 20% of $40,000, that's $8,000. Share of dividend, 20% of $15,000, that's $3000. As a reserve, the investment ending balance is then-- is $111,000.

In the later, we are going to see that the situation where there is another thing that affect the investment, that's the additional amortization. So there is a share of amortization expense. So this will be discussed later in the lesson four, especially when there is a differential. So we will discuss then this part in the chapter in the lesson four.