I am looking at Schweser Sample Exams, Exam 1, Afternoon, #74 Iberia (the parent) invests 40% of Midland. So we know we are using the equity method. Midland reports a loss of 5m and paid a dividend of 4m. Iberia (the parent) buys 1m shares common of Odessa. The transaction is “long term” so we know it’s Available for sale. Odessa reports net income 750m and paid a 3 euro per share dividend. What amount should Iberia recognize on its income statement as a result of its investment in Midland and Odessa? The answer is: 1m profit. Midland reports a 5m loss and Iberia owns 40% of Midland, using equity method, Iberia reports a 2m loss from Midland. ****** Question: WHAT ABOUT THE DIVIDENDS FROM MIDLAND??? ************ Iberia reports a 3m dividend income on its income statement from its investment in Odessa. What about those dividends from Midland under equity method?
Dividends from Sub are not included in the Income statement of Parent. They would only go to reduce the Investment account. Iberia: 2 Million Loss Odessa: 3 Million (3 Euro per share * 1 Million Shares) Odessa is an AFS investment - so no gains / losses on Income statement. So total gain: 1 Mill. (assuming both currencies are given in Euro).
thanks CPK, more to follow…
Hi,
Do you know why in that example, for Midland company, Cash doesn’t seem to increase as part of the Balance sheet when dividends are received? Only the investment is reduced but cash is not increased… Isn’t that weird??
In my mind the credit and debit transacitons in the Balance sheet for cash increased and investment reduced cancel each other but for some reason only the reduction in Investment seems to count.
In addition, the notes say that only when the market price decline is NOT temporary, the Carrying value for Available for Sale securities should be written down. However, the Balance Sheet amount for Odessa seems to ignore that and uses the fair value of 17 Euros per share rather than the purchase price (20 euros per share) even when the problem says that it’s a temporary decline in market price.
Please help!! 
Thanks!
From my opinion,It would be like this
Equity Method On parent B/S Asset Account : Investment in Company xxx : Record at Cost acquired and Value year to year change by NI-Dividend paid * %equity holding (like retain earning change) On parent I/S Account : Income from investment on Company xxx = %equity holding * NI any Dividend paid by company xxx are recogized in other account of I/S of parent According to the question , Company report NI = -5 , so income from investment in Company should be -2 Available for sale Record at fair value and any change in value will not be recogzied until it will be sold. So, income from this investment should come from solely on dividend = +3 please comment if i miss something
For the equity method investment, it would look like this:
Own 40% for equity method, so share of net income = .4 * 5 = (2mm)
Share of Dividends = .4 * 4 = 1.6mm
So, on BS -
Investment account using equity method = (2mm) - 1.6mm = Investment decreases by -3.6mm
Cash goes up by 1.6mm dividends
Net change in assets = (2mm)
Equity: Loss of 2mm - A = L + E Balances.
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AFS are marked to market because they are securities with unrealized G/L in OCI BUT dividends and interest are reported in Net Income. So they received 3mm in dividends
2mm loss + 3mm in Dividends = 1mm
Thanks for the answer!
Regarding the Value In Books of AFS, my understanding is that they are marked to market ONLY if the change is NOT temporary. However, the problem explicitely indicates that the decline from 20 to 17 Million Euros is just temporary. Hence No Unrealized G/L should have been registered in Equity account and its Fair Value registered in books should have been still 20 Million Euros.
I think this rule of temporary changes pertains only for IFRS but not sure…
I think you might be incorrect in that assumption (or at least in your logic), so be careful. There is a difference between an AFS security that has seen a G/L and an AFS sec that is impaired. For instance, if you buy a stock listed on the NYSE (very liquid), and the value declines from 20mm to 17mm over the course of the year, how would you know that the decline is other than temporary? I think the point of the question is that the unrealized loss of 3mm should go in equity. If they had said its going to be a permanent loss, than it would be impaired and you would recognize the loss in your income statement.
If it can be valued easily, meaning there is a quotable market price (as with any liquid security), you should always reflect the fair market value and any unrealized gains or losses with the unrealized g/l in Equity (ie if the FMV of the asset goes up, you reflect that in the asset account and unrealized G in equity).
If the security is impaired, meaning you finally realize you wont be able to get the value you’re carrying it at if you sold it, THEN the other than temporary effect comes in. Impaired securities are (usually) those that can’t be valued easily - for instance if you own a stake (less than 20% stock) that you paid 1mm for in small venture tech firm that is realizing that their technology won’t work. It’s stock, so there is no HTM option available.
Originally, your projections tell you that the firm is worth every penny for the stake, After time you realize the technology is a failure and you’ve wasted $1mm. Ie, there is no market/available price on it, but you realize its going to be a failure so you impair it and take a loss on IS.
Kwalew/CPK - Appreciate your above explanation, but I still fail to understand impact on I/S…please help.
I’m looking CFAI text example on page 178 -
A company investments 10% in B co. in Y1, loss of $3m in Y1 and then raises it to 50% in Y2. IFRS and HFT
Co B - Y1 NI 60, Div - 20 Loss of; Y2 - NI 68, Div - 22
Question #7 - For Y1 A’s EBT from contribution? Ans - Loss $3m + $2 m = $1m
Question # 9 - What is NI in Y2 for A? A has its own NI for Y2 = 75. So Ans = 75 + 0.5*68 = 109.
Now why are these 2 differently calculated when its same equity method, HFT? Why Y2 does not include Div share as in Y1 Simply not following…Can someone pls explain rational behind it?
Dont have the book in front of me, but you don’t care about company B’s income or loss when you hold a security as HFT (as in Year 1).
Only the market value of the investment should be represented (or, best representaion of the value of the investment if there’ no market price available). If you bought stock for 1mm, and the price of the stock rises, then you report that gain as income with a HFT security. Company B’s financial statements should have no representation on yours. Thus, for question 7, your interpretation seems incorret.
In year 2, when you up the stake ( and presumably have significant influence on the firm now), then you would use equity method, hold the investment on your BS at cost, and A’s income from B will be 50% ownership * B’s net income. A will report the cost of its investment in B on its BS, and will increase its investment by 50% of B’s net income.
* but in Y1 the dividends are included as income (in addition to changes in the FM value of the investment)
You are right. Now all makes sense :D!!
Thanks a lot!!
Yes, looking at your response to MissCleo, and seeing some examples it is making sense. Thank you.
Kwalew, nice expl.
can you also share your thoughts on how dividends need to be treated using equity method in case of a) parents BS b) parents IS
more specifically in Y2, net inc for B is 68mn and div = 22mn. Shouldn’t A record, 10% of B’s(NI - Div)? On A’s income statement?
As I think, dividends are not unrealized so must go thru income statement right? Even if you say they are in cash so cannot double count, then we say (NI - Div) % ?
so confusing… Need help
No - A will record just their share of the Net Income on their IS. Its all about the accounting treatment - Equity method assumes the parent can exert significant influence over the subsidiary (including their dividend policy), so basically the thought is that dividends should just be treated as a return of capital, not income. Therefore they don’t go through IS.
Company A reports their share of Company B’s net income in IS. (This amount flows to equity on the BS). With dividends, company A still ends up with the same amount of assets, just in a different form (cash vs investment in the asset).
Perfect, thanks