Now, let's talk about a different type of accounting. When we buy a significant amount of a company, we're gonna use the equity method to account for this investment. Let's check it out. So when we have significant influence over a company, we're gonna, we're gonna have to use what gap requires the equity method. Okay, so let's talk about influence real quick. First, we're gonna have situations where we have no influence, and this is where we just buy a few shares of stock. Okay? So no influence is less Than 20% ownership. We have less than 20% ownership. We don't really have any sway in their decision making. Okay? And this is where we're gonna use the cost method to deal with these investments. So that's where we would label them as trading securities available for sale, held to maturity those type of investments that you have no influence over the company. So think about it. You own just a few shares in that situation, right? 20% of a company might sound pretty big, or maybe like 15%. Right? That still sounds pretty big. But we've kind of got this bright line where we say more than 20%. That's where we say we have significant influence. Okay, so we're gonna say between 20 and 50% ownership. So now you if you own 30% of the company, 40%, at these points, you're gonna use what's called the equity method and that's what we're going to focus on in this section. Okay. So we're focusing on these situations where you have significant influence, compare that to a controlling influence. So controlling influence is where you have more than 50%. So you have 51% right? More than 50%. 51%. 52% 100%. That's when you're gonna use consolidation, consolidation accounting. Okay, So let's think about this equity method. When you own 30 or 40% of the company. Remember when you have common stock, you're gonna be able to vote for who's on the board of the directors of the company. So, if you have enough shares of stock, you're gonna have some influence over who's gonna be on that board of directors. So you can You can vote for your pal to be on the board of directors and have some influence over what's going on there. When you have controlling interest, when you have 51% of the vote, well, you have the majority, right, you're gonna be able to say everyone who's on the board of directors, you're gonna have control over that. That's when you have a controlling interest. Okay? So here, we're in the situation where we have significant influence, were able to influence some of the decision making of the company. So, we're gonna use the equity method of accounting, we're no longer gonna do trading security held to maturity. We're gonna use a special, uh, form to, to account for this investment called equity method. So let's check out what the situations that happen in equity method, we're gonna have four common journal entries that we're gonna learn about. So when we do the equity method, we're gonna have the purchase of the investment just like we're used to, there's nothing crazy about the purchase. We're gonna purchase enough shares to have significant influence. So generally what they're going to show you is you buy a certain amount of shares and there's another amount of shares outstanding in the company and you're gonna have to deduce, hey, we bought a significant portion of this company based on the percentage of the total shares that you bought. Okay. So we'll see an example of that. But the purchase of the investment is very simple. You purchase it at cost right? You purchase it and you say whatever we paid for it, that is the journal entry we're gonna make, then we're gonna have the net income or the loss of the invest. E this is gonna be our investment income. Okay, we're gonna earn investment income based on the net income of the invest. E so this is where it gets different. The company that we bought, say we bought subsidiary company when we buy when we bought their stock, they're gonna earn net income. And since we own such a big portion of their company, we're gonna assume that from their net income. There's a portion of that, that's ours because we own so much of it, we own a percentage of that equal to our ownership percentage. So we're gonna earn investment income based on their net income. So that's a big difference there now dividends received, This is different as well when we receive dividends, in this case, it's going to lower our investment. Okay, So dividends that we receive lower the value of our investment. Okay, We'll see an example for that. And what we, what we have to make as a difference is that these dividends received are not investment income. Okay, So when we were dealing with trading securities available for sale securities, when we receive dividends, we said, hey, that's dividend revenue. Well, in this case, that's not, that's not how we deal with it. Okay, so that's a big difference here, is that the dividends received are not income and they are going to just be a reduction of our investment. So we'll see that as well. And then finally we sell the investment right? We sell the investment, we might have a gain or a loss when we sell the investment. Okay. And that's gonna be the difference between what's on our books and what we sell it for. Cool. So that's an overview of what we're going to learn now. Alright, so we're gonna go through each of these journal entries and see how the equity method flows were generally, once you get down with these four journal entries, you're gonna be pretty solid with the equity method. Okay, so we're just gonna purchase the investment, we're gonna earn investment income, we're going to receive dividends that reduce our investment, and then we're gonna sell the investment eventually. Cool. Alright, let's go ahead and start with those journal entries in the next video.

So let's start with the purchase journal entry on january 1st year one big old company purchased 50,000 shares of small boy companies, 125,000 outstanding shares of common stock at a market price of $25 per share. So notice they told us the amount of shares we bought and the amount outstanding. So if we bought 50,000 shares out of 100 and 25,000 shares outstanding, That means we bought 40% of the company, right? 50,000 divided by 125, that's .4, which is 40% of the company. Okay? So since we bought 40%, that's between the 20 and 50% threshold, we have to use the equity method right? We're gonna use the equity method. Okay? So the next thing we need to know is, how many shares did we buy? We bought 50,000 shares at a price of $25. So how much did we spend? Remember that's what's important for our journal entry is the total amount 50,000 times 25. So what does that come out to? 50,000 times $25? Well that means we spent $1,250,000 on the investment. Right? So buy all the shares, we spend $1,250,000. So that's the amount of our asset. So what we're gonna do is we're gonna have an asset for the investment and we're gonna call it like equity method investment or something like that. I don't feel like writing out equity method every time. So I'm gonna say E. M. Investment. Okay And this is the debit because we're creating an asset for this investment of one million, 250,000. So the E. M. investment, let me write that a little closer. That's our debit. And how did how did we buy this? We bought it with cash. Right, so we're going to credit cash for one million, 250,000. Okay, so this journal entry is pretty similar to things we're used to nothing too crazy here. We're purchasing something what we have to create the asset and get rid of the cash. So we're gonna have our investments increase by one million, 250,000. And our cash is going to decrease by the same amount. So our net asset are our net our total assets stay the same amount here. Right? We we didn't have any increase in the total asset amount. We just bought some investment with some cash. Alright, this journal entry is pretty easy. Let's go ahead And move on to the next journal entries. But I want you to remember this is always important. You always want to calculate the percentage of your ownership because you're gonna be using that percentage throughout all the journal entries. Okay, so we own 40% of the company. Let's check out how that affects our journal entries

So our next journal entry is for our investment income. The company that we bought shares of is going to be earning net income or it could have a net loss possibly. Right? But let's focus on the net income first when it has net income, well, a percentage of that net income is ours and that's based on our percent ownership. Right? So we saw in this case that we had 40% of the company was owned, so 40% of their net income is ours. So let's go ahead and see how this journal entry is made On december 31st year one small boy company reported net income of 560,000. So this is the company that we bought, right? We bought small boy company 40% of their company and they had net income of 560,000. So 40% of that net income is ours. So let's see how much that comes out to 560,000 times 40% 0.4. Let's find out what that number is. It comes out to 224,000. Okay, so 224,000 is our investment income. But notice what we do in this situation whenever we get investment income, we're gonna increase our investment account by that amount. So what we're gonna do is we're going to debit the equity method investment account which remember this is an asset. So we're increasing the value of the asset by 224,000. We didn't receive cash or anything. Right? This is net income of that company. So we're increasing the value of our asset. This is almost like we're increasing the retained earnings of our asset here. If you think of it as like this subsection of your balance sheet with its own retained earnings, there was this earnings that it had and it's gonna increase the value of this asset. Cool. So the equity method investment is 224,000. And we're going to credit investment income. Okay, this investment income right here, this is going to the income statement. The income statement is gonna show that we earned 224,000 And it's gonna show this as as an income to our company in our non operating section. Right? It'll show this income. Cool. So we saw that our investment increases by 224,000, which is the the amount of the net income attributable to us and let me get out of the way the investment income goes to our income statement and it increases our net income. So it's going to increase our equity by 224,000. Cool. Alright. So notice this is very different than what we were doing when we had our cost method investments in trading securities and available for sale securities and things like that. We never did anything like this. So this is very different. I want you guys to be familiar with this, it's not too difficult. You just have to be uh familiar with these different rules. Okay, so this is what happens with investment income. Let's try investment loss.

So now we'll have a situation where the the company that we bought their stock has a loss instead of having net income during the year, that company can have a loss. So let's see what happens in that situation on december 31st year two. So the next year small boy company reported a net loss of 100,000. So we own 40% of the company, so we own 40% of their net loss 100,000 times 0.4 is equal to 40,000 loss. Right? So we had an investment lost this period. So if you think about it, it's like the retained earnings of our company has decreased because we've lost some money out of this investment. Okay, so this 40,000 loss, we're gonna do exactly the opposite that we did before. So we need to lower the value of the investment. So our equity method investment Is being decreased in this case because we had this loss of 40,000 and we have to take an investment loss just like we had an investment income in the previous one. Well this investment loss is decreasing our net income on our books, right? So when we show our income statement as a big old company, big old company will show this this investment loss on its income statement of 40,000. cool. So this is very similar to when we had the net income in the previous example. Well, this is like having negative net income. Right? So we have to flip the journal entry and reduce our investment and take the investment loss. So we're gonna see that the equity method investment decreased by 40,000 and we had this investment loss that goes to our income statement and it reduces our equity by reducing our net income. So there we go. Nothing too crazy there. Let's move on to the next journal entry where we're gonna receive dividends. Cool. Let's

So remember we talked about four journal entries, we're going to see an equity method, we see the purchase, we're gonna see the net income of the invest e then the dividends received, that we're gonna deal with now and finally the sale of the asset. So let's deal with the dividends received here. So when we receive dividends, this is almost like a reduction of our retained earnings in our investment. Okay, So we're gonna have this investment account and we're receiving part of that investment back there saying, hey, here's some of the money that you have from your investment from the earnings that we've made. So remember we've been putting that net income from the investment, we've been putting it into the investment account. Now we're receiving some of that money from the investing. So we're going to reduce that investment account. So this is very different than from the cost method where we did trading securities and available for sale securities, right? We we were taking dividend revenue, never do that with the equity method. That's gonna be totally wrong. We don't have dividend revenue with the equity method, we just reduced the investment. So it says January Year three small boy company declared and paid dividends of 420,000. So guess how much dividends we're gonna receive, we're gonna receive 40% of that, right? We receive 40% of the total dividends they pay. So if we do 4,420,000 times 400.4, it comes out to 100 and 68,000. Okay, so notice how often we're using that 40% ownership. It comes up in all our journal entries after our cost, right? We're using it to to value the net income that we receive and the dividends is going to be at that 40%. Cool. So you you're gonna be you really have to figure out that percentage and keep track of it. So we're gonna receive 100 and 68,000 in dividends. So we're gonna receive cash, right, This is going to be cash that we received of 100 and 68,000. But what's gonna be the credit? Remember we reduced the investment, We don't take dividend revenue, we reduce the investment by the cash we receive 168,000. This is almost like a payout of our investment that we've put in. Okay, so 100 68,000 is going to be the reduction of the investment. We have cash received of 100 and 68,000 and the investment is decreasing by 100 and 68,000. So our assets stay the same there because we're decreasing the investment by the amount. Alright, so as you see these journal entries, as you do more and more examples of equity method, you're gonna see that it's always the same. You just got to keep track of your percentage and these journal entries always look the same. Cool, let's go ahead and move on to the next journalist

alright when it comes time to sell our equity method investment, it's important to know what the final value is in the investment account because we have to calculate our gain or or loss based on the difference between the selling price and the book value. So it's always helpful to use a T. Account. So when we think about our equity method investments, we're gonna have a T. Account that's gonna have our beginning balance which is usually what we purchased it for. Right, we purchase it for some amount and then we increase it whenever there's net income, right? Whenever we have net income of the investor, we're gonna have our I'll say percentage net income of the invest E. That's gonna increase our investment. Just like we saw in our examples and what's gonna decrease our investment? Well that's if we have I'll put it right here next to this 1% net loss of the investing that will decrease our investment account, our asset. And what else decreases it? Our percentage of the dividends, right? When we receive dividends from the investor, Well that's going to decrease our investment and it'll leave us with our ending balance in the account. Right? So notice doesn't this look very similar to another account we've dealt with when we deal with T. Accounts And the based formula, there's an account that we have a beginning balance. It increases by net income, it decreases by dividends and then it ends up with an ending balance, it looks like retained earnings, doesn't it? Except this is our investment in another company. So you can almost think of this as almost our retained earnings in this other company. Okay, So it's like our equity in this other company and that's why it's called the equity method. We're keeping track of the equity that we have of their earnings and of their dividends paid, reducing our equity in them, right? So it looks very similar as far as the T. Account goes. Um so notice we purchased the investment, we increase it by the net income or decrease it by the net loss and then we decrease it by the dividends to get to our ending balance. So in our example, if we plug in the numbers that we've had in our journal entries, well our purchase price was 1,250,000. Right? And that's what we saw in the first entry. We debited the asset, the equity method investment, we debited it for the million 250. Then we had the net income during year one, right? The year one. So this was the purchase, Let me do it in a different color. So this was the purchase right here. Then we have the year one income. And in year one they earned uh our percentage was 224,000 of their net income. Right are 40% of their total net income came to 224,000. And that increased our value there. And in year two there was a loss Which decreased our investment by 40,000. And then in years. Uh and then in year three, they paid some dividends right? We had the dividends that also decreased our investment by 100 and 68,000. Right? A 168,000 was the decrease. And that gets us to the ending balance in our investment. So what's gonna be the ending balance after all of these transactions? Let's go ahead and calculate it. We're gonna start with the one million, 250,000. We're gonna add 224,000. Subtract 40,000 and subtract 168,000. And that gets us to our final balance of one million, 266,000. So after all of these years of income and payment of dividends and the loss right. Our ending balance in the account is one million, 266,000. So what what you really want to be familiar with is those four entries that we dealt, with right the purchase of the investment. the percentage of the net income or the loss, and then the percentage of the dividends finally gets us to our ending balance that we're going to compare to our selling price. Okay, So now let's go ahead and let's look at the selling price of this investment. Actually, let's take a pause here with the now that we've figured out the book value, let's take a pause and we'll do the gain and the sale gain on the sale and the loss on the sale in the next video.

Alright. So now that we found the ending balance in our investment which was right here, right? We found our ending balance to be one million, 266,000. We can compare that to our selling price to see if we had a gain or a sales gain or a loss on the sale. So the company is gonna report a gain on the sale if the selling price is greater than the book price right? Greater than the book value of the investment. So if the selling price is greater than the book value, well, we have a gain right, it was on our books for a certain amount and we sold it for more than that amount. So let's look at this on january 2nd year three big old company sold its investment in small boy company for 1,400,000. So there we go, 1,400,000 is the selling price. So how much cash are we gonna receive? 1,400,000. So we're gonna debit cash for 1,400,000. And now we have to get the investment off of our books, it had a debit balance as we see from the t account of 1,266,000. Well, we're gonna use a credit to get rid of it. Right? So we're going to credit our our investment asset equity method investment 4 1,266,000. And guess what the difference is the difference is the gain on the sale, right? This gain on the sale is going to our income statement gain on sale of investment Is gonna be on our income statement. And what amount is that gonna be? It's just the difference between these two numbers, right? 1,400,000 -1266000. We had a $134,000 gain on the sale of this investment. Right? So nothing too crazy. This is very similar to when we sell any sort of asset, we need to get the asset off of our books, we're gonna receive some cash and then we have to plug in the gain or the loss depending on the difference between the numbers. Okay, So if we look on our On our balance sheet, how is this gonna affect assets, liabilities and equity? Well, cash is going to increase by 1,400,000. Our investment is now gone. The equity method investment Is going to decrease by 1,266,000. So there was a net increase in our assets there by the same amount of the gain. The game is 100 and 34,000. So our equity increased and our assets increased by that amount. Cool, alright, let's pause and we'll do the loss on the investment

So let's imagine instead of selling it out again, we had sold it at a loss. So we'll still have that same book value that we had up above the book value that we saw in our t account of 1,266,000. Well let's compare that here in this example. So we're gonna report a loss in if the selling price is below the book value, right? The selling price is below the book value while we sold it at a loss. So on january 2nd year three big old company sold its investment in small boy company for 1,100,000. So again, how much cash did we receive? Well, we received one million. 100,000 for this sale. So that's gonna be our debit and we need to get the investment off of our books, right? So we need a credit to the investment equity method investment and that's going to be for the book value of one million, 266,000. Just like we saw in our T. Account 1,266,000. So how do we make this balance? What we need the loss right? We have a loss because we had it on our books for 1 to 66, but we sold it for less than that. So we're gonna need another debit of 100 and 66,000 to make this balance out. And that's gonna be the loss on the sale of investment. And that will go to our income statement, right? So we saw that we got cash Of 1.1 million. That was an increase to our assets. But we had to decrease our assets by the amount of the investment, which is one million to 66,000. So we had a net decrease there in our assets, And then the net decrease in the assets is matched by this loss on our income statement of 166,000 and everything stays balanced there. Okay. So very similar to the game. Except we sold it at a lower price than our book value. Cool. Alright, let's try some practice problems related to the equity method.