In this video, we walk through 5 FAR practice questions teaching about calculating the carrying amount of equity method investments. These questions are from FAR content area 2 on the AICPA CPA exam blueprints: Select Balance Sheet Accounts.
The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.
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How to Calculate the Carrying Amount of Equity Method Investments (Excluding Impairment)
When using the equity method to account for investments in another company, understanding how to calculate the carrying amount is essential for CPA exam candidates. This guide will walk you through the key concepts, including significant influence, the treatment of dividends, net income, and the necessary calculations. We’ll also provide examples to solidify your understanding.
Understanding Significant Influence and the Equity Method
The equity method is applied when an investor has significant influence over the investee’s financial and operating decisions. This influence is typically assumed when the investor owns 20% to 50% of the voting shares of the investee. However, significant influence can exist even with less than 20% ownership if the investor has other means of impacting decisions, such as representation on the board of directors or being a key advisor.
Example:
- If Company A owns 30% of Company B’s voting shares, it is presumed to have significant influence, making the equity method appropriate.
- Alternatively, if Company C owns only 15% of Company D’s voting shares but holds two seats on Company D’s eight-member board, Company C may still use the equity method due to its ability to influence decisions.
Calculating the Carrying Amount of an Equity Method Investment
The carrying amount of an equity method investment is adjusted each year based on the investor’s share of the investee’s net income or loss and dividends received. The initial investment amount is adjusted for these factors, and it can also involve prorating net income if the investment was acquired partway through a year.
Step-by-Step Process:
- Initial Investment: The calculation starts with the amount paid for the initial stake in the investee.
- Example: On January 1, Company A purchases a 30% stake in Company B for $600,000. The initial carrying amount is $600,000.
- Adjusting for Net Income: The investor’s share of the investee’s net income increases the carrying amount.
- If the investee reports $200,000 in net income for the year, Company A’s share is 30% × $200,000 = $60,000.
- The adjusted investment balance is $600,000 + $60,000 = $660,000.
- Adjusting for Dividends: Dividends paid by the investee to the investor are considered a return of investment and reduce the carrying amount.
- If Company B pays $0.50 per share in dividends and Company A holds 20,000 shares, the total dividends received are 20,000 × $0.50 = $10,000.
- The new carrying amount is $660,000 – $10,000 = $650,000.
- Partial-Year Adjustments: If the investment is acquired partway through the year, the share of net income must be prorated based on the months held.
- Example: On April 1, Company A acquires a 30% stake in Company B, and Company B earns $400,000 evenly throughout the year.
- Since Company A only held the investment for 9 months (April to December), prorate the net income:
Net income for 9 months = $400,000 × (9/12) = $300,000. - Company A’s share of this net income is 30% × $300,000 = $90,000.
- If dividends of $0.30 per share were paid on December 31, and Company A holds 20,000 shares, then the total dividends are 20,000 × $0.30 = $6,000.
- The carrying amount would adjust as follows:
Initial investment = $600,000
Adjusted for net income = $600,000 + $90,000 = $690,000
Adjusted for dividends = $690,000 – $6,000 = $684,000.
Impact of Preferred Shares on Calculations
When the investor holds a different ownership percentage in preferred shares than in common shares, these shares are treated separately. The investor’s share of net income is based on the common shares, while preferred dividends are allocated based on the preferred share ownership.
Example:
- Company A owns 15% of the common shares and 35% of the preferred shares of Company B.
- Company B reports $500,000 in net income and pays $93,500 in preferred dividends.
- Calculate Company A’s share of income:
- Net income available to common shareholders = $500,000 – $93,500 = $406,500.
- Company A’s share of common net income = 15% × $406,500 = $60,975.
- Company A’s share of preferred dividends = 35% × $93,500 = $32,725.
- Total income recognized by Company A = $60,975 + $32,725 = $93,700.
Key Takeaways
- Significant influence is the critical determinant for using the equity method, and it can be present even with less than 20% ownership if the investor has a substantial role in decision-making.
- Adjustments to the carrying amount include the investor’s share of net income or loss and subtracting dividends received, which are treated as a return of investment.
- Timing matters: If an investment is acquired partway through the year, prorate the net income or loss to reflect the period of ownership.
- Different ownership stakes in common and preferred shares require separate calculations for net income and dividend shares.