Equity method of investment investment

dandman

I thought I got it, but the mock had to throw me a curve ball!
Cfa 2011 mock am #44

Why do they deduct the amortization from the equity ,method?
I got answer c but clearly, that's only half way there, you gotta take out other stuff too!
I thought it was original investment + proportional net income - proportional dividends

Any ideas?

MiniMe7

Your investment represents your proportionate control of the company.

Control = Equity
Equity = Asset - Liability, ie Net Assets

Although they don't have an explicit Equity line, you know Equity = Net Assets. So if your Investment (cash paid) > proportionate share of Equity, then you paid "too much" (based on historical cost).

Because historical cost is just that, this is the time you can measure the assets you purchased at Fair Value. Any excess price you paid will then be allocated to those assets whose Fair Value exceeded their Book Value. In this case, PP&E and Land both exceed their book value. Any remaining excess that can't be allocated goes to Goodwill.

Going forward, you can depreciate any of that excess allocated towards those assets. But REMEMBER, land can NEVER be depreciated! So even though Land and PP&E took some of that allocation, only the PP&E allocation can be depreciated.

Thus in the years following the transaction, both Investor & Investee will recognize a depreciation expense of that excess premium, by their respective ownership amount - this case being 32.5% for Suburban.

Another note, excess can also be allocated towards Inventory but it must then be expensed. To sum up, excess premium paid should be allocated to identifiable assets whose Fair value exceeds Book Value. The remaining excess goes to Goodwill.

PPE excess can be depreciated
Inventory excess must be expensed
Land excess cannot be depreciated.

genuinecfa

How do you know this stuff? I have either a) learned but forgot it entirely b) never seen it and I'm missing a book or two

ayodayo

Canadian Analyst,

The formula you have is correct for a company purchased at BV with no premium paid. mr. flinstones pointed out you have to account for that excess in purchase price and assign it to certain assets if possible. Once you've written up the assets to FV any remainder between the purchase price less the FV of net identifiable assets equals your goodwill. Because we're using the equity method there is no line item for GW on the BS.

Because some assets were marked up to FV when you invested into the company you now have to deduct your pro-rata share of excess depreciation from the income statement.



Edited 1 time(s). Last edit at Thursday, June 2, 2011 at 05:55PM by Chuckrox8.

tarunajwani

I'm totally unprepared so no worries. Rather than trying to memorize random rules, (if you have the time), try to understand the concepts more. Believe it or not, these accounting rules are somewhat intuitive - you just have to break it down the way I did above...



Edited 1 time(s). Last edit at Thursday, June 2, 2011 at 06:05PM by yabbadabbadoo.

Sportsman

Ok is an impairment equal to carrying value - fair value or is it book value - fair value?
They seem to be different sometimes and are equal sometimes, its getting confusing

kickthatcfa

Thanks, that does help I knew most of it so no worries, I'm not more confused. It's actually good to see it in perspective like that

5566

Under IFRS you can reverse losses on HTM and AFS debt securities. Never for equity under GAAP or IFRS.

bolligerallstar

^ Good catch, forgot about investment securities...