Hi,
Page 80 of Schwser says that when an investee is profitable, and its dividend payout is less than 100%, the equity method usually results in higher earnings as compared to the accounting methods used for minority passive investments.
How is this possible?
Under equity method, you also account for fair value allocation of the purcahse price to the inestee’s fixed assets as additional depreciation.
So shouldn’t the earnings be lower under equity method.
Please help!
Under the equity method the parent includes its proportional share of the subsidiary’s income on its (the parent’s) income statement, whereas under investment in securities, the parent includes its proportional share of the subsidiary’s dividends on its (the parent’s) income statement. If the dividend payout is less than 100% of the subsidiary’s net income, the equity method will show higher earnings.
If, under the equity method, the parent has excess depreciation, then the extra earnings will be less than the proportional share of the subsidiary’s earnings. However, unless the excess depreciation is quite high compared to the subsidiary’s earnings, or the subsidiary’s dividend payout ratio is quite high, it’s still likely that the earnings net of excess depreciation will exceed the dividends; once again, it’s likely that the equity method will show higher earnings.
Wow. Thanks for the magic magician!
Indeed confusing but very helpful explaination!
My pleasure.
omg give this guy a hacksaw.