Sunday, August 7, 2022

Equity Method vs Fair Value Method | Investments

How a company accounts for an investment will differ significantly based on whether the company uses the fair value method or the equity method to account for that investment now the fair value method is generally used when the company owns less than 20 percent of the company in which it's invested if the company owns twenty to fifty percent of.

The company in which it's invested it's generally presumed to have significant influence over the investee okay so then in that case you would use the equity method now the accounting matters because under the fair value method okay if you own less than twenty percent of the company you're invested in then the investors income is going to be affected.

By any unrealized gains or losses the stock and the investees so if the stock price of the company they're invested in goes up and they haven't sold the stock they're going to have an unrealized gain if the stock were to go down they'd have an unrealized loss also if the investor receives dividends from the investee then they're going to recognize dividend.

Revenue so unrealized gains and losses and dividends received will affect the investor's net income now with the equity method neither of those two things matter okay unrealized gains are not going to affect the investor's income under the equity method and dividends received are not going to be income under the equity method so then.

What would affect the investor's income the investor will take a proportionate share of the investee's net income or net loss and they will recognize so let's say that the investee had a hundred thousand dollars in net income and they owned 30 percent okay they would take 30 of that 100 000 of net income and they would recognize that as.

Investment revenue okay so they'll basically recognize either investment revenue or a loss on the investment based on their proportionate share of ownership in the investee now under either of these methods equity method or fair value method if the company actually sells the investment and has a realized gain or loss that would affect.

The the income of the investor and also in either of these cases an asset could be impaired you'd have an asset impairment and that would affect that would decrease the the profit of the investor i'm just focusing on the differences here okay and i'm going to show you some examples of how the equity method and fair value method would.

Result in different outcomes for the investor uh in terms of their effect on their p l so let's say berkshire hathaway owns five percent of a company called chocolate ham okay berkshire acquired the stock on january 1st 2020 for four hundred thousand dollars okay and then they received a dividend of ten thousand.

Dollars uh on june 30th of 2020. okay so they made the investment uh six months later they got a dividend and then they report that company in which they had invested okay the investee chocolate ham they report net income of a hundred thousand dollars uh for the year ended december 31st 2020 and then the fair value of berkshire's investment in.

Chocolate ham on december 31st 2020 is 600 000 so i'm going to show you how to break all this apart and to figure out how is berkshire hathaway's uh profit going to be affected by all these things going on with chocolate ham so let's take a look so in terms of so first of all we have to say okay which method are we gonna apply the fair value method or.

Are we gonna use the equity method well in this case it says they own five percent of the company so we're going to use the fair value method so that means that unrealized gains are losses and also dividends are going to affect berkshire's profit okay so their pre-tax income for berkshire hathaway is going to increase by 210 000.

Now that's the ten thousand dollars of dividend revenue which we said there's ten thousand dollar dividend they receive right there so that's revenue to berkshire hathaway okay and then there's a two hundred thousand dollar unrealized gain what is that well they bought the stock for four hundred 000 and at the end of the year you see now the stock is.

Worth 600 000. so the difference between 600 000 and 400 000 is 200 000 so it's an unrealized gain because it went up in value so basically 200 plus 10 000 there's 210 000 increase in pre-tax income for berkshire hathaway now if you want to see the journal entries here's what would be they'll be the journal entries for for berkshire hathaway so.

When they uh purchase uh the stock in chocolate ham you debit the investment account credit cash when they get the dividends they gotta debit the cash count as their cash dividends and then credit dividend revenue and then they have to mark the investment to market and december 31st uh when the investment has increased in value okay.

So it's increase oop i got a little mistake so there so that's actually 200 000 that is increased in value all right let me mark that out 200 000 because it went from 400 000 to 600 000. so we have a two hundred thousand dollar increase in the investment and then we credit unrealized gain for two hundred.

Thousand dollars okay so that's the effect if we're using the fair value method but let's say that we're not using the fair value method let's say that berkshire owned 25 of chocolate ham and is therefore presumed to have significant influence over chocolate ham now we're gonna have the same facts as above but now the.

Accounting is gonna be different okay here's here's basically what's gonna happen in terms of berkshire's profit the unrealized gain okay the fact that the fair value went up to 600 000 we're going to disregard that okay that under the equity method an unrealized game that does not affect berkshire's uh profit okay we're not going to record.

Any journal entry for that now when berkshire receives the dividend we're going to have to make a journal entry because berkshire is going to get 10 000 cash but we're not going to record dividend revenue actually we're going to decrease the investment account so basically the dividend is not going to be revenue we're not going to have an.

Unrealized gain how is berkshire's profit going to be effective when they own 25 percent instead of five percent and they use the equity method they're going to take 25 of chocolate ham's net income so in this case that'd be uh 25 of 100 000 is 25 000. berkshire is going to recognize 25 000 of investment revenue okay so berkshire's pre-tax.

Income will go up by 25 000. see it's very different the fair value method we had 210 000 effect on berkshire's pre-tax income and here it's just 25 000. okay now if you want to see the journal entries here uh so here let's scroll down we'll see the journal entries right now when you acquire the investment that's the.

Same whether it's fair value or equity method in each case you're debiting the investment account crediting cash but when you receive the dividend on june 30th okay we're debiting cash like we did before but you're not crediting dividend revenue instead you're just crediting the investment account so you're actually reducing the the asset.

The investment on the on the balance sheet okay now december 31st you're not going to record you're not going to mark the asset to fair value and have the unrealized gain however that proportionate share of the investee's net income which was uh 25 percent of a hundred thousand 25 000 you're gonna record that you're gonna credit.

Investment revenue okay then you're gonna debit the investment account so if you wanted to know what amount this investment would be on berkshire hathaway's balance sheet as of december 31st under the equity method it would be 400 000 minus 10 000 plus uh 25 000. okay so that we call.

That the carrying value of the investment the amount of appear on the balance sheet and uh that would be 415 000 under the equity method uh that this asset would be on the balance sheet for berkshire hathaway

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