[Anonymous]

Hello everyone,

I’m studying for FAR with Becker. I encountered a simulation question using the equity method for investment accounting.

It follows the basics.

Investment value =’s Cost + % earnings – % dividends

But then there is a bizzare adjustment at the end I’ve not seen.

It says in the question all assets equal carrying value except one – an equipment undervalued by $100k with a 5 year life.

The investment value is lowered by the % of additional depreciation that year.

Am I missing something?

[sancasuki]

Are you trying to figure out goodwill for a recently bought company? We need to see the question.

[hasy]

I can only think that has to be due to consolidation.

Character cannot be developed in ease and quiet. Only through experience of trial and suffering can the soul be strengthened, ambition inspired, and success achieved - Helen Keller

-

BEC 80 (10/23/15)
FAR 72 (4/2/15); 83 (7/11/16)
REG 52 (4/28/15)
AUD (9/9/16)

Roger + NINJA MCQ + WTB

[Bnots]

I believe that is the correct application of the equity method.

Consider, Company A invests in Company B.

Company B's balance sheet shows:

Assets 100
Liabilities 90
SE 10

Company A pays 6 to acquire 40% of Company B, which based on Company B's books is worth (100-90) * 40% = 4.

In other words, Company A's investment implies that Company B's net assets have a fair value greater than what is currently recorded on Company B's books. For example, instead of being worth 100, total assets might be worth 105 [(105-90) * 40% = 6].

If Company A had acquired enough of Company B to consolidate, Company B's net assets at the time of acquisition would be revalued at fair value and any remaining difference would be accounted for as Goodwill.

In the case where Company A has not acquired enough of Company B to consolidate, there is no explicit revaluation of Company B's assets to fair value. However, we don't want to just ignore the difference, so we kinda sorta pretend like a consolidation has taken place. Some or even all (common for textbook problems) of that difference can be attributed to Company B's depreciable assets having fair values higher than their carrying values on Company B's books.

Now, if those depreciable assets had been recorded on Company B's books at their higher fair value, depreciation recognized by Company B over the same useful life would be higher, and this would result in a greater depreciation expense and lower net income, and therefore lower investment income recognized by Company A and a smaller debit to Company A's investment in Company B. So Company A accounts for this additional depreciation itself (note that in this particular context it is also sometimes called amortization). The implication being that at the end of the assets' useful lives, their fair value and their carrying value on Company B's books is now the same.

Given the above, the adjusting entry looks like you might expect it would, reversing some of the income previously recognized:

Dr. Income from investment in Company B XXXX
Cr. Investment in Company B XXXX

In the case of your sim, the implied fair value of the equipment is $100,000 higher than the book value. The investor depreciates its share of that difference over the 5-year remaining useful life.

That's always been my understanding of it anyway. Somebody feel free to correct me if I'm wrong.

ASC 323-10-35 is where it's addressed in the codification.

[Author]

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