Conceptually, in business combinations, acquiror buys target firm's assets and liabilities from their fair values. Due to conservatism principle in accounting, balance sheet values of especially the assets are understated. Payments to target shareholders over the net fair value of assets is considered as goodwill. Net fair value of assets means the difference between total fair value of assets and total fair value of liabilities. In other words, under equity method of accounting, investment has three components. One, book value of net assets. Book value means balance sheet value of net assets. Net assets means the difference between total assets and total liabilities. The second component of investment is fair value adjustment. It is the difference between book value of net assets and fair value of net assets. The third component is goodwill. It is the payment by the acquiring firms, over and above the total net fair value of assets. Fair value adjustment plus goodwill is called as acquisition accounting premium in some textbooks. Let's go through another example here. Following is the balance sheet and fair value data of Firm T on January 1st, 2022. Record the accounting entry on this day, if Firm A Purchases 30 percent of Firm T's common shares for $1,250. Here is the Firm T's balance sheet on January 1st, 2022. In the second column we see the book value numbers. These are the numbers on the balance sheets of Firm T. In the third column, we're also given the fair value of assets and liabilities. For example, the book value of machinery is $1,300, but the fair value is $2,300. Similarly, book value of liabilities is $500 but the fair value of liabilities is $900. How do we record this investment? We know the total size of the investment is $1,250. Therefore, cash account decreases by 1,250 and investment account increases by 1,250. What are the components of this investment? Investment has three components. Book value of assets, fair value adjustment, and goodwill. Book value of net assets is the difference between total assets of $2,000 minus total liabilities of $500. Since the acquiring firm owns 30 percent of the target firm, the book value of assets component of the investment is $450. The second component of investment is fair value adjustment. Fair value adjustment for machinery is $1,000. Fair value adjustment for liabilities is $400, resulting in net fair value adjustment of $600. Since the acquiring firm owns 30 percent of the target firm, the fair value adjustment component of the investment is $180. The third component of the investment is goodwill. Goodwill is calculated as total investment $1,250 minus book value of assets of $450 minus fair value adjustment of $180. This gives us a goodwill amount of $620. This slide makes the point that through its investment, acquiring firm is entitled to 30 percent of each asset and liability of Firm T. This ownership includes both book values and fair values of the assets and liabilities. For example, acquiring firm owns 30 percent of book value of cash of Firm T. The total book value of cash is $700, resulting in $210 allocation to acquiring firm. We can do similar calculations for book values of other assets and liabilities, as well as for the fair value adjustments. Finally, the amount of goodwill is $620. Some students ask me from time to time, why one firm invest in another firm by buying its shares rather than directly buying target firm's assets and liabilities. Assets acquisitions are not very common in practice. This is because, first, it is generally very costly to transfer the titles of assets and liabilities. Second, assets acquisitions can increase legal liability. When an acquiring firm buys shares of a target firm, both of these firms are still separate legal entities. If, for example, there is something wrong with the target firm, target firm will have the legal liability not the acquiring firm. If the acquiring firm buys the assets and liabilities of the target firm, possible legal troubles of the target firm are transferred to the acquiring firm. Due to these two reasons, firms prefer investing in another firm by buying shares rather than directly purchasing assets and liabilities. In the previous example, we have seen that there was a fair value adjustment created, so what do we do with fair value adjustment? Since an acquiror purchases a target firm from fair values, acquiror needs to amortize fair value adjustment in the future periods. What does this mean? Let me please give you an example and show you what's going on. Firm A purchases 40 percent of common stock of Firm T for $2,000 on January 1st, 2022. Firm T reports net assets equal to $3,000 on January 1st, 2022. Firm T's net assets values approximate their fair values except a building. Building fair value exceeds its book value by $500 and building has five years of remaining life. Firm T reports a net income of $200 and pays dividends of $100 during 2022 and 2023. Question number 1 asks to determine the total amount and components of investment account on January 1st, 2022. The amount of investment is $2,000. What are the components of this investment? First, 40 percent of book value of net assets, which is according to the question, $3,000. Second, 40 percent of the fair value adjustment of $500. The third component is goodwill, which is calculated as $2,000 minus $1,200 minus $200. Therefore, the goodwill amount is $600. The second question asks to record activity associated with investment in Firm T in fiscal years 2022 and 2023. On January 1st, 2022, there will be an initial investment recorded. Cash goes down by $2,000 and investment is created as $2,000. Second, the target firm makes net income of $200, this increases the investment of the acquiring firm by 40 percent times $200, which is equal to $80. The other side of this transaction is, $80 of equity income on the income statement column. Third, the target firm pays total dividends of $100, out of which 40 percent is paid to the acquiring firm. Therefore, cash increases by $40 and investment decreases by $40. Just to remind you, dividends reduce investment in equity method of accounting. What do we do about fair value adjustment? Please recall that, the share of fair value adjustment of the acquiring firm is $200. Fair value adjustment is like the appreciation of the net assets during the acquisition process. Therefore, just like most assets, fair value adjustments are depreciated or amortized. This depreciation and amortization is recorded by the acquiror because in the books of the target firm, the value of the net assets do not change. We know that, fair value adjustment is due to a building which has five years of remaining life. Therefore, we depreciate fair value adjustment of $200 equally over the next five years. The first year of fair value adjustment depreciation will be $40. At the end of the year, the net number on the income statement will be reflected on retained earnings. The net number on the income statement is $80 minus $40, which is going to be net $40. We will then close all accounts. This process is repeated in year 2023. Investment increases due to net income reported by the target firm, it decreases due to dividend payments by the target firm, investment also decreases due to depreciation or amortization of fair value adjustment. Let's please take a moment to revisit the investment equation. We discussed that investment has three components. Book value of assets, fair value adjustment, and goodwill. We have just seen in the previous example, that fair value adjustment is subject to periodic depreciation or amortization. Therefore, we can adjust the investment equation and replace fair value adjustment with unamortized, which is remaining portion of fair value adjustments. Let's apply this new framework in an example. Firm A purchases 20 percent of common stock of Firm T for $1,500 on January 1st, 2021. Firm T reports net assets equal to $5,000 on January 1st, 2021. Firm T's net assets' values approximate their fair values except the machine. Machine fair value exceeds its book value by $800 and machine has 10 years of remaining life. Firm T reports a net income of $300 and pays dividends of $150 during 2021. Here we are given Firm T balance sheet at the end of year 2021. Question 1 asks the amount of equity investment on December 31, 2021. We need to start answering this question by first recording the initial investment on January 1, 2021. Initial investment is $1,500. On the transaction worksheet, cash goes down by $1,500 and the same number is recorded as an increase in investment. Can we analyze the components of this investment? Yes. Investment has three components. Book will have assets, fair value adjustment and goodwill. What is the book value of net assets? Book value of net assets is given in the question and it is $5,000 on January 1, 2021. We multiply book value of assets with ownership percentage of 20 percent. The second component of investment is fair value adjustment. According to question, a machine has a total fair value adjustment of $800. We multiply $800 with the ownership percentage of 20 percent and we will find $160. Finally, the rest of the investment is goodwill, which is calculated as 1,500 minus 1,000, minus 160, resulting in a goodwill balance of $340. Can we now examine the journey of this investment in year 2021? Beginning amount of investment is $1500. Under equity methods, investment increases when the target firm reports a profit. What is the size of target firm net income in year 2021? It is $300. When we multiply the target firm's profit with ownership percentage of 20 percent, we find that investment increases by $60. The other side of this transaction is equity income of $60 on the income statement. Dividends reduce investments. Total dividend payments by the target firm in year 2021 is $150. Therefore, acquiring firm's investment decrease by $150 times 20 percent, which is going to be $30. The other side of this transaction is cash increase of $30. We next record fair value adjustment amortization. Fair value adjustment allocated to the acquiror firm due to a machine with 10 years of remaining life was $160. Therefore, annual fair value adjustment, depreciation, and amortization is $16. Investment decreases by $16 and the other side of this transaction is a $16 loss created on income statement. Finally, the net number on the income statement, which is 44, would reflect our retained earnings and we close all accounts. Please note that the closing balance of investment is $1,514. Is there any other way to calculate the investment at the end of year 2021? We can use the framework that we have just discussed in this lesson. We know that investment has three components: book value of assets, unamortized portion of fair value adjustment, and goodwill. What is the net book value of assets at the end of the year? If we go back to the balance sheet given in the question, total assets is $6,000, total liabilities is $850, resulting in net book value of assets of $5,150. We then multiply this amount with ownership percentage of 20 percent. The second component of investment is unamortized portion of fair value adjustments. Fair value adjustment of the machine at the beginning of the year 2021 is $800 and the machine has 10 years of remaining life. Therefore, fair value adjustment will amortize or depreciate $80 per year, resulting in $720 unamortized portion of fair value adjustment on December 31, 2021. We also multiply this amount with ownership percentage of 20 percent. Goodwill is not periodically amortized and doesn't change over time. Therefore, goodwill amount is still $340. If we sum all these three components of investment, we find $1,514, which confirms our calculations in the previous slide.
