Investments between 20 percent and 50 percent give the acquiring firm significant influence over the target firm but not control. So what does significant influence mean? If there is significant influence, the acquiring firm can affect but not dictate the operational and financial policies of the target firm. We can use two accounting methods if an acquiring firm has significant influence on a target firm. Fair value accounting, just like the accounting for passive investments or equity methods. In practice, most acquiring firms with significant influence use equity method of accounting. Under equity method of accounting, investment increases or decreases and income from equity investment or the loss from the equity investment is created according to the target firm's net income. In other words, if the target firm reports an income, the acquiring firm will also report equity income. If the target firm reports a loss, the acquiring firm will also report an equity loss. I know this sounds complicated. I will show an example soon. Finally, if the target firm pays dividends to the acquiring firm, these dividends reduce investment and increase the cash account. Please note that under equity method of accounting, dividends do not increase the acquiring firm's income on income statements. To summarize, under equity method of accounting, investment account mirrors changes in the shareholder's equity of the target firm. If the target firm makes income, this will increase both shareholders equity of the target firm and the investment account recorded by the acquiring firm. On the other hand, if the target firm pays dividends, this reduces both shareholders equity of the target firm and the investment account recorded by the accounting firm. This sounds quite complicated. Why do we use equity method of accounting? We are using equity method of accounting to prevent acquiring firms, to exploit the target firms. What can happen is that acquiring firm can significantly affect, for example, dividend policy of the target firm and can ask the target firm to pay high dividends to show as dividend income. However, this is a behavior that we want to discourage. Therefore, in equity method of accounting, dividend payments from the target firm do not affect the acquiring firm's net income. Instead, acquiring firm can show net income from its investment only if the target firm shows net income. This gives incentive to the acquiring firms to help the operations of the target firms to make them profitable. Let's solve another example. Firm A acquires 25 shares of Firm T from $10 per share on January 1, 2022. Firm T has 100 shares issued and outstanding on January 1, 2022. Assume that fair value of Firm T is equal to its book value. During the year end at December 31, 2022, Firm T reports a net income of $300 and pays dividends of $200. Share price of firm T on December 31, 2022 is $14 per share. Question 1 asks to provide the accounting entry on transaction worksheet on January 1, 2022. What is the amount of investment here? Acquiring firm acquires 25 shares. Each of these shares has a value of $10. Therefore, the initial amount of investment in this question is $250. In the transaction worksheet, cash goes down by $250 and investment goes up by $250. Question number 2 asks the amount of investment on December 31, 2022. First, we need to calculate the ownership percentage to identify the accounting method that we will use. Twenty five shares give the acquiring firm 25 percent ownership, resulting in significant influence. We can use either fair value accounting or the equity method of accounting. I will choose equity method of accounting. How does investment account change in 2022 under equity method? There is an initial investment of $250. This is the amount of investment on January 1, 2022. Investment goes up when the target firm shows a profit. We know that the target firm profit in year 2022 is $300. Firm A owns 25 percent of the target firm. Therefore, investment goes up by 25 percent of $300. We also know that if the target firm pays dividends, this reduces investment. The investment decreases by 25 percent of $200, which is the total dividend payment by the target firm in year 2022. If we sum all these, we will find that the amount of investment at the end of year 2022 is $275. Question 3 asks to provide the accounting entry on transaction worksheet on December 31, 2022. At the beginning of the year 2022, the acquiring firm makes an initial investment of $250. Cash account goes down by $250 and investment account goes up by $250. During the year 2022, target firm makes a net income of $300, and therefore, the acquiring firm investment increases by 25 percent of $300, which is $75. We also create an equity income of $75 under income statement column. Next, in year 2022, the target firm pays $200 of dividends in total, out of which 25 percent is paid to the Firm A. Therefore, cash goes up by $50 and investment decreases by $50. Finally, the net balance on the income statement column is reflected on retained earnings. The only thing that we have on the income statement is $75 of equity income. We will then close the accounts. Please note that the amount of investment at the end of year 2022 is confirmed as $275.
