Equity Method Accounting: Advanced Topics [CFA Level 2 Notes #30]

Excess of Purchase Price Over Book Value Acquired

OK so the case we just saw assumed Book Value = Fair Value for Company B. But come on — in real life, when Company A buys into Company B, the basis isn’t BV. It’s the FV at the moment of acquisition!!!

And here’s the thing: when you’re not just nibbling on a small stake but actually swallowing a big chunk of the company, the seller is going to want more on top of FV. The vibe of the conversation: “Ohhh my~ the fact that you’re buying that much means you’re planning to step into management here too, riiight? Sounds like you’ll need to pay a little extra for that management-participation slice.. we good?”

The notes call that extra payment a control premium. Here, though, the 30% stake gives A significant influence, not control; think of it as the negotiated premium above A’s share of the identifiable net assets’ FV.

So let’s look at this kind of case (and obviously — this is the only kind of case that’s ever going to show up on the exam).

Two steps are getting smushed together here:

➀ From here on, BV≠FV is fair game, and the basis has to be FV.
➁ Whatever they ask for on top of that FV is, in character, Goodwill!!

A pays 360 for 30% of B: B’s assets restated at fair value come to 1,500 and its liabilities to 500, so net assets are 1,000 at FV; B’s owners ask 1,200 with the premium, so 60 of the 360 is goodwill

B’s own income statement on book values: sales 600, cost of goods sold 300, depreciation 80, net income 220, which must not flow straight into A’s investment income

And let’s say B’s performance comes in like this — all inventory sold, cash revenue 600, no other expenses except depreciation — so Net Income works out to 220. But you cannot use that 220 to compute equity-method income!!! Because A isn’t looking at B on a BV basis. A is looking on an FV basis. So you’ve gotta reconstruct the I/S from that FV lens.

B’s income statement rebuilt at fair value: sales 600, cost of goods sold 400, depreciation 160 (800 over 5 years), net income 40; 30% of it gives A investment income of 12

Year-end: A’s investment is 360 + 12 = 372, which is 30% of 1,240, B’s year-end net assets of 720 plus the PPE step-up of 320 still left and the 200 premium; the goodwill stays inside the investment instead of getting its own account

I really didn’t want to get into this section, but now that I’m down in the consolidation chapter.. I had to scroll all the way back up here to write it (sobbing) (real talk: this grey text is something I came back up here to write while I was in the middle of the consolidation part lol).

Originally, when you study equity-method accounting, there are 3 things to keep in your head total. If I sort which parts of those 3 actually matter for CFA studying, it shakes out like this..

➀ BV≠FV: the part that gets distorted because of over/understatement of net assets ← Heavily tested in the CFA curriculum
➁ The part paid on top of FV: Goodwill ← Heavily tested in the CFA curriculum
➂ Intercompany transactions with associates (up-stream & down-stream) ← Not a big focus of CFA questions

Curriculum example: Red buys 30% of Blue for 80,000 dollars when Blue’s book value is 200,000 dollars and its equipment is worth 50,000 dollars more than book, so the 20,000 dollar excess is 15,000 for the equipment and 5,000 of goodwill

Part A: goodwill from the purchase; Part B: Red’s income from Blue for the year; Part C: Red’s year-end investment in Blue

Part A? Meh — Goodwill is $5,000, easy enough.

Part B is where it actually gets real, but before we dive in for real, keep this stuck in your head.

(Time for Gungseo, the dead-serious font lol. the old editor doesn’t have Gungseo;;)

The equity method, at the end of the day, is just 2 things: ➀ whatever profit the associate posted — my share of it is mine! ➁ When a dividend gets paid, it offsets!!

That’s it. The whole thing. Two bullets.

BUT — when you recognize income → it has to be income from my perspective, i.e. through the FV-at-acquisition lens!!!

That’s the whole game.

OK first, let me work out the income from what I (Red) actually see. Blue’s out here saying its Net Income is $100,000, but yeah.. that’s what you think.

From where I’m standing, P.P.E. is marked up by $50,000, so the extra depreciation on that markup — $50,000 over 10 years straight-line, a.k.a. $5,000 — should’ve been expensed on top.

So I’m knocking another $5,000 off the Net Income you’re quoting me!!! Which means Blue’s N/I as I see it is $95,000, and 30% of that — $28,500 — is mine!!!!

Red’s year-end investment two ways: 80,000 + 28,500 - 18,000 = 90,500 dollars, or 30% of (266,667 + 95,000 - 60,000) = 90,500 dollars

Since the CFA exam usually asks about the following year, this approach will carry you through exam day. If this were a CPA problem, they usually push it to the year after next — like x3, x4 — and if you don’t have the right-hand side absolutely cold, there is no way you’re solving it in time..

For us though, the exam usually stops right about here!! The stuff past this point is what crawls out when they really crank the difficulty knob up..?

Well, just how hard can it possibly be..??? Yeahhh yeah yeah, very hard lol.

Heads-up. The figures here are the original notes, slips and all. A few things to watch for:

In the Red and Blue example, the book value of 200,000 dollars is that of Blue’s identifiable net assets (assets minus liabilities), not of its assets; the solution and the notes use it that way, so the numbers are unaffected.

Excess of Purchase Price Over Book Value Acquired

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