Can someone please help with a clear difference on these two?
Under which ones do you record dividends?
Under which ones do you record proportionate share of investees net income?
If you classify an equity investment as an investment in securities – trading securities, available-for-sale securities, designated-at-fair-value securities – then dividends you receive are income shown on the income statement.
If you record an equity investment as an investment in an affiliate – and you use the equity method – then the income shown on the income statement is your proportional share of the affiliate’s net income (which also increases the “investment in affiliate” account on the balance sheet), and dividends are treated as a return of capital; dividends reduce the “investment in affiliate” account on the balance sheet.
I’m pretty comfortable with this concept but one thing always bugged me - why don’t the dividends flow through P&L? They just go directly to reducing the balance sheet account. Do they impact CFI?
Because on P&L you’re showing your proportional share of the affiliate’s net income, of which the dividends are (presumably) only a fraction.
Recall from Level I that dividends received (under US GAAP) are classified as CFO, and I’ve seen no mention of any different treatment when using the equity method. I doubt that it would ever show up on a Level II exam, but if it did, I’d classify those dividends as CFO.
Thanks, S2000.
My pleasure.
Thanks for this.
Just while we are on the subject, could you kindly help with my confusion on the below?
You invested £300,000 in Jango. debt securities (with a 6% stated rate on par value, payable each 31 December). The par value of the securities was £275,000. On 31 December 2008, the fair value of your investment in Jango is £350,000. Assume that the market interest rate in effect when the bonds were purchased was 4.5%
Scenerio 1: D esignate it as held to maturity:
— Coupon recieved net the amount of amortization is recorded as an investment income on the income statement {16,500 - 3000 = 13,500}
— Cash is increased by the amount of dividends recieved. {16,500}
— Carrying amount is decreased by the amount of amortization. {300,000 - 3000 = 297,000)
Balance sheet remains balanced:— Total assets increased by 13,500, Total Equity increased by 13,500
Question: In the CFAI text, it states that Shareholders Equity is not affected, surely that must be wrong then? Since Investement Income will increase the amount of net income?
Scenerio 2 : Designate as Held for trading
— Coupon recieved net the amount of amortization is recorded as an investment income on the income statement {16,500 - 3000 = 13,500}
— Unrealized gain is reported {53,000}
— Cash is increased by amount of coupon recieved : {16500}
— Carrying amount is reported at fair value {350,000}
Balanced Equation; Total assets increased by 66,500, Total Equity increased by 66,500
Question: — How is the unrealized gain calculated to be 53,000? This is the amount stated in the CFAI text and it makes sense because it is the amount that allows for a balanced equation, but i can’t for some reason figure out why 53,000 and not 50,000.
— Why does the Investment income refelect the amount of amortization since this debt security is being held at fair value for trading?
Bloodline,
Regarding Q1, I think this is unfortunate wording. Of course anything that passes through income impacts equity, so what they probably had in mind was no effect on equity aside from from what was reported in income.
Regarding Q2: the unrealised fair value gain, which in the case of held for trading securities goes to the income statement, is the difference between the security’s value under the amortised cost approach and its actual market value:
Amortised cost (as computed under the ‘held to maturity’ assumption) = 300,000 + 13,500 (accrual of interest income at 4.5% x 300,000) - 16,500 (coupon receipt) = 297,000.
The carrying value must however equal 350,000 (as the secuirty is recorded a fair value), so you need to adjust the amortised cost upward by 53,000.
The effect is such, that the income statement receives two entries: +13,500 (4.5% of 300,0000), which represents the accrual of interest income, and +53,000, which is the fair value gain. Many institutions will report these in different I/S lines.
At the same time, the balance sheet value of the security increases by 50,000 = +13,500 (interest accrual via I/S) - 16,500 (coupon receipt reflected in cash) + 53,000 (fair value gain via I/S).
Also note that if this security had been available for sale, its carrying amount would change by the same amount and due to the same three factors as above. However, the 53,000 fair value gain would go to Equity (via O.C.I. rather than to income).
Makes perfect sense. I get it now, thank you so very much.
Brilliant! you are welcome.