Equity Method net earnings: why are dividends not accounted for?

CFA Level II FRA
#1

This is question 14 of the afternoon session of the 2012 mock exam. Perhaps you have the exam so that I don’t have to post the entire question. The answer given is as follows:

Dagmar would be using the equity method to account for its investment in Elbe because of its classification as an associated company. Therefore, Dagmar will include its proportionate share of Elbe’s net earnings, less the amortization of the excess purchase price from the initial acquisition. Dagmar owns 30% (1.8 ÷ 6.0 million shares) of Elbe.

I have two questions:

  1. Everywhere I check the calculation for the earnings recognized in the equity method you take the portion of the earnings and subtract the portion of the dividends. Add this total to the acquirer’s income statement

  2. I have never seen the amortization of the excess purchase price being accounted for in the calculation.

All of the examples, except for this one, are pretty simple in my opinion. I’m affraid that I don’t see how the answer is the way that it is. What am I missing?

#2

I don’t think in the earnings you expense the dividends, The accounting would be an addition to cash and a subtraction to the investment on the balance sheet, not affecting the income statement.

As far as the amortization, that confused me too. I got this quesiton wrong, I don’t remember seeing that come up either in the EOC Q’s.

#3

For 1) You would still recognize the amount of dividends received as income on the Income Statement of the investor, right? You just increase the amount of the one line asset by Net Income - Dividends paid. If they paid out 100% of NI as a dividend then we would still have to recognize our share of that Cash received, but if they didn’t retain any earnings then we wouldn’t want to increase the value of the one line asset on the B/S because that increase is attributed to cash.

  1. I would assume that the investee’s depreciation expense is based on their book values, and not on the fair market values that you paid for, so you should be recognizing a higher depreciation expense than they would and thats why you would add it in. So you would add a depreciation expense in for premiums paid that were attributable to actual assets, but not for good will.

I didn’t look at the question and haven’t fully reviewed Investments in Associates, so I’m just thinking out loud here.

#4

Yea, I don’t remember anything about amortizing premium paid over book in the EOC Q’s, but I guess it makes sense.

I’m trying to save the 2012 Mock until about 2 weeks out. I don’t know if it makes sense, but its gonna be the best representation of the real exam so I wanted to save it until near the end.

#5

Schweser covered it in good detail and I have seen it in qbank questions. I found that if they say, the fixed assets are found to have a value of x greater than book and then tell you the number of years they depreciate assets that is a key to know that you need to depreciate and subtract from NI in equity method.

#6

Don’t think this is right. You don’t recognize dividends received as income in the equity method… You recognize your % ownership of NI as your revenue. If you recognized dividends it would be like double counting income received from the investee.

#7

Dividends are treated as a return of capital so they are deducted

#8

I think we’re on the same page, I just didn’t explain myself well. You recognize your % of NI no matter what they pay in dividends on the I/S.

I think the original poster was asking when you subtract dividends, and thats just to calculate how to increase the value of the asset on the B/S. So we recognize our % of NI on the I/S and then that gets broken down on the asset side of the B/S into what was received as a Cash Div and What increases the Book Value of the Equity Method Asset.

#9

in all the examples you’ve referred to, have you, seen any where there is excess purchase price involved for a 30% acquisition? Perhaps none.

@acq: $75 value investment acq for $100 => excess pp $25

so book $75 inestment inassoc $75; excess pp $25

income from assoc 1st yr = $30; re assess g/w let’s say it is $15 = <10> ==> net income = 20

ending b/s => $75 inv in assoc; excess pp $15 ; net income $20

This may be the first example of such. At least now, we know that we need to remove the excess amotization from income ……… thinking out loud here

#10

I think the difference lies in whether that $25 dollar premium is attributable to the diff between Book Value and Fair Value of assets. So any amount thats attributable to Fair Value over Book can be depreciated and all others are treated as Good Will and not depreciated.

So in your example if the book value is $75 and Fair value is $85 and it was purchased for 100 then we can depreciate $10 over the remaining useful lives of the assets and recognize 15 as good will that will be tested for impairment.

#11

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I think the difference lies in whether that $25 dollar premium is attributable to the diff between Book Value and Fair Value of assets. So any amount thats attributable to Fair Value over Book can be depreciated and all others are treated as Good Will and not depreciated.

So in your example if the book value is $75 and Fair value is $85 and it was purchased for 100 then we can depreciate $10 over the remaining useful lives of the assets and recognize 15 as good will that will be tested for impairment.

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This is exactly right… Just read it, FRA pg. 134, Sec 4.2, paragraph 2 gives the explanation.