which of the following stock investments should be accounted for using the cost method? This is a topic that many people are looking for. star-trek-voyager.net is a channel providing useful information about learning, life, digital marketing and online courses …. it will help you have an overview and solid multi-faceted knowledge . Today, star-trek-voyager.net would like to introduce to you Equity Method of Accounting for Investments. Following along are instructions in the video below:
“This video. We re going to talk about how to use the equity method to to account for investments. So when you want between twenty and fifty percent of a stock you re deemed to have significant influence and so what significant influence means is that you could alter a firm s dividend policy right because you own so much let s say for example you own 40 of a company you could influence whether or not they issue a dividend in the given period. And the reason that this is important is because even though that firm you ve invested in might be incurring losses.
You could pressure them you could use this influence that you have to get them to issue a dividend and if we were accounting for things under the fair value method. When you own less than 20 of the firm shares. You would be recognizing income with that dividend. You would have dividend revenue.
So it would look like you are generating revenue from this investment. Even when the investment is losing money so to prevent firms from playing this game. That would basically develop the equity method in which what s going to happen. Here is you re going to recognize a proportionate share of net income or the net loss that the investi has so for example.
If you if you ve invested for you own 40 of that firms shares and then that firm has a loss you will have to book 40 of that loss or if they have net income you give 40 of that net income and you don t recognize any dividend revenue. You just recognize a proportionate share of their earnings or their losses. So let s walk through an example and make it a little easier to understand so let s say that we ve got tom s surf shop. You re interested in investing in them and they have 250 shares of stock outstanding so you decide you know what i think i really like this business.
I want to buy a hundred shares. I want to buy a hundred shares of tom surf shop. And if you do the math 100 divided by 250 that s going to be 04. So this is 40 100 shares is 40 of the company and so that cost you one hundred and seventy five thousand dollars.
So now we need to make a journal entry so what we re going to do is we re going to debit. The investment in tom surf shop just call it investment or whatever you like to call. It and we will debit that for a hundred and seventy five thousand dollars. Now we re just going to assume you pay cash.
So we re going to have a credit here for cash of one hundred and seventy five thousand dollars. And this is just to reflect the purchase of 40 of tom surf shop. Now we re going to have some action. Here.
So let s say that tom his surf shop. Reports net income of thirty two thousand dollars. So they made thirty two thousand dollars. And so now you re going to need to make a journal entry here so remember we re going to recognize the proportionate share of net income or in that loss.
We re going to recognize that so we see we ve got thirty two thousand dollars. But we re not going to recognize the whole thirty two thousand. We re going to recognize forty percent of that in thirty two thousand times. Forty percent is twelve thousand eight hundred so what we re going to do is we re going to recognize investment revenue.
We re going to have a credit here of twelve thousand eight hundred remember we don t recognize revenue or a law or excuse me revenue. If there s a dividend. We re only going to do it with a proportionate share of the net income. So we take our portion of this thirty two thousand and comes down to twelve thousand eight hundred of investment revenue or revenue from investment and tom surf shop.
However you want to put it and then the corresponding debit right we ve got we got a balance here we got to have a debit of twelve thousand eight hundred and what that debit is is it goes to investment in tom surf shop. It s actually going to increase the carrying value so if we were to look at this investment on the balance sheet right so we start out with one hundred and seventy five thousand well now we ve just debited it so now it would be one hundred seventy five thousand plus. Twelve thousand eight hundred that s what the carrying value of this investment would be on the balance sheet. Now let s say that there s a dividend issue by tom surf shop.
Now you might be thinking wait a minute. I thought you said that we don t recognize revenue from a dividend well. We don t under the equity method. We re not going to recognize revenue from this dividend.
However. We are going to have a journal entry because remember we re getting a portion of this dividend right we re getting forty percent. We own 40 of the company. We re going to get forty percent of this dividend.
So we have to do some kind of entry. We re just not going to recognize revenue from it so what we re going to do 40 percent of ten thousand is four thousand right so we re going to the cash is the easy part right we know that we received a. Dividend we received a cash dividend of 4000. Right that s just 40 percent of the total dividend that tom surf shop issued so we recognized that portion but now we re not going to credit dividend revenue.
So what we credit is actually investment in tom surf shop a dividend will actually reduce the carrying value of our investment on our balance sheet right so we see here s that we start 175000. And then we increase the carrying value when we had some revenue and then now we decrease it the carrying value with a dividend. But we don t recognize any income here right. It s different from the fair value method in that respect so if we were to think about our carrying value at this point our carrying value and then by carrying god i just mean if we were look at the balance sheet.
What is investment in term tom surf. Shop what is that show we have that 175000. That we originally paid plus. The twelve thousand five to twelve thousand eight hundred read that proportionate share of their net income and then minus the dividend of four thousand.
So it would be a hundred and eighty three thousand eight hundred dollars is the carrying value of the investment tom surf shop at the end of the period. Now know there s something really important here that you need to understand so unrealized. Gains or losses. Are not recognized under the equity method right because we re not doing the whole fair value thing.
Where we say oh we ve got an unrealized gain and and then so forth. We re not doing that however. However an investor right so like you for example you re investing in tom surf shop. You have the option to irrevocably elect to use the fair value method right and if you were to say you know what we re going to make an election to do the fair value method to to account for our investment in tom surf shop.
Then you would basically account for it exactly the same as if it were trading securities. When you own less than 20 percent. So remember we talked about in our video. When you say less than 20 percent.
We use that fair value method right where we do have the unreal eyes holding gains and losses. And so you just account for it with like trading securities. So any unrealized holding gains and losses would go to the ” ..
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