How do fair value adjustments to PP&E affect the equity method income reported by the investor?

Great question — this is one of the most commonly tested equity method mechanics on CFA Level II. Let me walk through it using Breston's investment in Navarro.

Step 1: Identify the Excess Purchase Price

Breston paid $420M for 35% of Navarro. Book equity is $900M, so Breston's proportionate share of book equity is:

35% x $900M = $315M

Excess purchase price = $420M - $315M = $105M

Step 2: Allocate the Excess to Identifiable Assets

The equipment is undervalued by $200M on Navarro's books. Breston's share of this undervaluation is:

35% x $200M = $70M

This $70M is allocated to PP&E. The remaining $105M - $70M = $35M goes to goodwill.

Step 3: Amortize the PP&E Adjustment

The $70M PP&E fair value adjustment must be depreciated over the equipment's 10-year remaining life:

Annual amortization = $70M / 10 = $7M per year

Step 4: Calculate Equity Method Income

If Navarro reports net income of $80M in year 1:

• Breston's share of net income: 35% x $80M = $28M
• Less: PP&E amortization adjustment = ($7M)
• Equity income recognized = $21M

Why does this happen? Navarro's own depreciation expense is based on the lower book value of its equipment. From Breston's perspective, the equipment is worth more and should generate higher depreciation. The amortization adjustment effectively corrects for this difference on Breston's books.

Key exam tip: Goodwill from an equity method investment is NOT amortized — it lives inside the investment account and is only tested for impairment. Only finite-lived asset adjustments (PP&E, patents, etc.) get amortized.

For more practice with equity method adjustments, check out our CFA Level II FRA question bank.