I would like to record about the key points of the US CPA exam content.
<Create and note the points based on mainly Becker’s workbook>
Equity method rule
- Although the general quantitative threshold for applying the equity method is between 20 percent and 50 percent ownership of the subsidiary by the parent company, the most important factor is the extent to which the parent has significant influence.
- While 20 percent to 50 percent voting common stock ownership typically indicates the need for the equity method, the key is whether significant influence exists. Even when an investor owns less than 20 percent, if they exercise significant influence, they will use the equity method.
- At the point at which the investor’s carrying amount of the investment is reduced to zero due to investee losses, the application of the equity method is suspended. The investor can resume applying the equity method once the investee has returned to profitability and any net losses allocated to the investor during the suspension period are covered by the investor’s share of the investee’s net income.
- The investment accounts balance will be increased by the equity in earnings and decrease by dividend received.
- Under the equity method, the incorporation of earnings and losses means capturing the investor’s share of the investee’s profits and losses in the investor’s P&L from the time of the initial investment onward.
- The cash dividends earned by the company are treated as a return of capital, not investment income. They should not be subtracted from investment income.
- When significant influence is acquired, the equity method is adopted from that date and going forward. Retroactive adjustments are not required.
- Under the equity method of accounting, the investment increases when the investee company generates net income and decreases when the investee company generates a net loss. The investment will also decrease when the investee declares dividends.
Initial recognition of the investment
- Accounting Treatment of Inventory : When the fair value of inventory exceeds its carrying amount, this excess is recorded at the initial recognition of the investment under the equity method as part of the revaluation of the acquired company’s net assets. Under the equity method, the investor’s share of the investee’s net income is reflected in the investor’s income statement based on their percentage ownership. When inventory is sold, the cost of goods sold (COGS) includes the excess fair value, which means that the initially recorded excess is realized as COGS, thereby reducing the investee’s current period profits.
- Accounting Treatment of Land : When the fair value of land exceeds its carrying value, the gain is typically not recognized in the accounts until it is realized (when the land is sold). Since land is a non-depreciable asset, its revaluation gains are not recorded as part of the annual earnings under the equity method. The gain from land valuation is only realized and reflected in the investor’s earnings when the land is eventually sold. This is because the gain on land is due to market value fluctuations rather than operational activities.
- Summary : The main difference in the accounting treatment of inventory and land lies in the fact that the excess fair value of inventory impacts COGS as soon as it is sold, whereas the gain on land is not realized until the land is sold. This distinction arises because inventory is a consumable asset used within the normal business cycle, whereas land is a non-consumable asset whose value fluctuates based on market conditions. When applying the equity method, it is crucial to understand how the valuation of these assets affects the financial statements of the investee company.
Liquidating dividend, Capital Reduction
- Capital reduction with a refund: Cash 100 / Equity Method Investments 100
- Capital reduction without a refund: Equity Method Loss 100 / Equity Method Investments 100.
Goodwill calculation
<Scope of Application>
- Actual Investment amount (30%): 200,000 – Net book value amount (500,000 X 30%) 150,000 = Total excess amount: 50,000
- Allocated to identifiable net assets: FV 600,000 – 500,000 = 100,000 X 30% = 30,000
- Excess to goodwill = 50,000 – 30,000 = 20,000
- If the above 30,000 is undervalued equipment and the useful life is 5 years, the excess fair value amortization is 30,000 / 5 years = 6000, which affect the Equity method investment income.
- Any goodwill created in an investment accounted for under the equity method. It is neither amortized nor tested for impairment. The entire investment using the equity method is subject to the impairment test.
Cash Dividend
- Cash dividends are treated as a return of capital rather than investment income.
- (DR) Dividend Receivable XX (CR) Investment in Securities XX
Stock Dividend
- A stock dividend is a dividend paid in the form of additional shares rather than cash. This method allows a company to distribute additional shares to its existing shareholders instead of cash.
- Memorandum Entry When a stock dividend is received, the number of shares increases, but the ownership percentage in the net assets remains the same. Therefore, instead of making a formal journal entry, a memorandum entry is used.
- Reduction of Unit Cost of Investment With the addition of new shares, the total number of the shares owned increases. However, the total investment remains unchanged. Therefore, the total investment cost is spread over a larger number of shares, reducing the unit cost of each Guard share.
Preferred stock
- The Preferred stock will be accounted for the fair value method because the investment in the preferred stock does not allow the shareholder to exercise significant influence.
