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

Question

AcadiFi · Accepted Answer

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**

```mermaid
flowchart TD
    A["Purchase Price: $420M"] --> B["Share of Book Equity: $315M (35% x $900M)"]
    A --> C["Excess Purchase Price: $105M"]
    C --> D["PP&E Fair Value Adj: $70M (35% x $200M)"]
    C --> E["Goodwill: $35M"]
    D --> F["Annual Amort: $7M/yr over 10 years"]
    F --> G["Reduces Equity Income Each Year"]
    E --> H["Not Amortized — Tested for Impairment"]
```

**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.

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

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