Next, we will solve an exercise about consolidation after the initial investments. Firm A and Firm T balance sheets on January 1st, 2022, are presented in the next slide. Firm A acquires all shares of Firm T from $15 per share on January 1st, 2022. Firm T has 100 shares issued and outstanding on January 1st, 2022. Firm T's net assets' values approximate their fair values except plant, property, and equipment. Plant, property, and equipment fair value exceeds its book value by $300 and plant, property, and equipment has five years of remaining life. Suppose that the only transactions that happened in year 2022 are that Firm T reports a net income of $300, all cash, and pays dividends of $200. We are given Firm A and Firm T balance sheets before investment is recorded. Question number 1 asks to provide the accounting entry on (a) transaction worksheet on January 1st, 2022. We will start with calculating total amount of investments. We know that (the) acquiring firm purchases 100 shares of the target firm from $15 each, meaning that the initial amount of investment is $1,500. In the transaction worksheet, cash goes down by $1,500 and investment is created as $1,500. If you look at the updated balance sheet of the acquiring firm, cash decreases from $2,500 to $1,000 and we create an investment account of $1,500. The second question asks to provide the consolidated balance sheet on December 31st, 2022. We answer this question by recording the journey of this investment in year 2022. There is an initial investment of $1,500. Cash goes down by $1,500 and the investment is created as $1,500 in the first line of the transaction worksheet. Please note that Firm A still uses (the) equity method to account for its investments in its separate financial statements. Under (the) equity method of accounting, investment increases when the target firm records a net income. In this example, target firm's net income is $300. Therefore, in the second line, investment increased by $300 and we create an equity income on the income statement as $300. Under (the) equity method of accounting, investment decreases when the target firm pays dividends. In this example, (the) target firm pays dividends of $200. Therefore, investment decreases by $200 and cash increases by $200. Under (the) equity method of accounting, fair value adjustment is subject to periodic amortization or depreciation. Total fair value adjustment is $300 due to a building which has five years of remaining life. Therefore, annual fair value adjustment amortization is $60. Fair value adjustment amortization reduces investment and creates a loss on the income statements. Finally, the net amount on income statement column is reflected on the retained earnings. Net balance on income statement column is $240, which is going to be reflected on retained earnings. We can then close all accounts. Please note that the ending balance of investment is $1,540. We can calculate the ending amount of investment by following the investment equation as well. Investment has three components: book value of assets, fair value adjustment, and goodwill. On January 1st, 2022, book value of assets is $1,000. Fair value adjustment is $300 due to a building which has five years of remaining life. Therefore, goodwill is $200. On December 31st, 2022, we can follow the investment framework again to calculate year end investment. Book value of assets at the end of the year 2022 is $1,100. This can be calculated as beginning book value of assets of $1,000 plus cash net income of $300, minus cash dividend payments of $200. Fair value adjustment at the end of the year 2022 is 240. This is calculated as original fair value adjustment of $300 minus first year's fair value adjustment amortization of $60. Finally, goodwill doesn't change over time and it is still $200. If we sum all three components of the investment, we find that investment on December 31st, 2022 is $1,540. In summary, we can calculate investment either by starting with the initial investment and recording equity method of accounting entries, or using the investment framework where investment has three components: book value of assets, fair value adjustment, and goodwill. We can now prepare (the) consolidated balance sheet on December 31st, 2022. Please note that five accounts of Firm A and Firm T have changed between the beginning and the end of year 2022. First, cash balance of Firm A increased by $200 due to dividend payment from Firm T. Second, equity investment account of Firm A has increased by $40 as we have seen in the previous slide due to accounting for equity investments. Three, shareholders equity of Firm A increases by $240 due to equity income of $300 and loss from fair value adjustment amortization of $60. Four, cash balance of Firm T has increased by $100, which is the difference between cash net income of $300 and cash dividend payments of $200. Finally, shareholder's equity of Firm T increased by $100, which is the difference between net income of $300 and dividend payments of $200. We can then start the consolidation process. Consolidated cash is $2,000, which is simply a summation of cash balance of Firm A and Firm T. Consolidated plant, property, and equipment includes plant, property, and equipment balances of Firm A and Firm T, as well as the unamortized portion of fair value adjustment of 240. We remove equity investment and create goodwill of $200. Consolidated liabilities is $2,500, which is simply a summation of liabilities balances of Firm A and Firm T. Consolidated shareholders equity is 4,740, which is the same as shareholders equity of Firm A. What did we learn in this example? We learned that consolidation is an ongoing process. (The) acquiror accounts for its control type of investment in a target firm using the equity method, but whenever (the) acquiror needs to report its financial statements externally, it has to consolidate. Please note that despite consolidation, acquiror and target firms are still separate legal entities. They have separate financial statements. We just combine them whenever they need to be reported externally.
