The first type of inter-corporate investments that we are going to analyze in this class is passive investments. We classify investments which give up to 20 percent ownership of a target firm as passive investments. Passive investments are made generally for trading reasons, such as price appreciation and dividends. We are going to use fair value option to account for these type of investments. What does fair value mean? Fair value simply refers to current market prices of investments. Fair value accounting involves three steps. One, investment is fair valued at each balance sheet date. Two, fair value changes are reported on the income statement. Three, if a target firm pays dividends to the acquiring firm, these dividends are recorded as dividend income on the income statement. An important note here is that, if the fair values cannot be determined reliably, for example, for private firms, we are going to use the cost methods. Under the cost method, the value of the investment never changes. The only thing that matters in the cost method is that, if a target firm pays dividends to the acquiring firm, these dividends are recorded as dividend income on the income statements. Let me give you an example here. Firm A, which is the acquiring firm, acquires 15 shares of Firm T, which is the target firm, from $10 per share on January 1st, 2022. Firm T has 100 shares issued and outstanding on January 1st, 2022. During the year ended December 31st, 2022, Firm T reports a net income of $300 and pays dividends of $200. Share price of Firm T on December 31st, 2022, is $14. Just to confirm, at the beginning of the year, share price was $10. It is $14 at the end of the year. Question number 1, provide the accounting entry on transaction worksheet on January 1st, 2022, associated with these investments. Basically, this question is asking the accounting entry to record investments. What do we know about this investment? Acquiring firm buys 15 shares from $10 each, meaning that acquiring firm spends $150 in total. In a transaction worksheet under assets, cash goes down by $150 and investment goes up by $150. The second question asks, the amount of investment on December 31st, 2022. First, we need to calculate the ownership percentage, just to choose the correct accounting methods. Firm T has 100 shares issued and outstanding in total. Therefore, 15 shares result in an ownership percentage of 15 percent. Since this is less than 20 percent, this is a passive type of investment. Therefore, we will use the fair value method. The amount of investment at the end of the year will be 15 shares times the share price at the end of the year, which is going to be $14 per share. Total investment at the end of the year 2022 is $210. The last question asks the accounting entries on a transaction worksheet on December 31st, 2022. In other words, this question asks the journey of this investment from $150 to $210. On the transaction worksheet, we start with the initial investment of $150 on January 1st, 2022. Next, the value of the investment goes up from $150 to $210, through a fair value adjustment of $60. In the second line, investment goes up by $60, and the $60 is also recorded on the income statement as a fair value gain. Is there anything else we need to record? Yes. We need to also record dividends. We know that in year 2022 Firm T pays total dividends of $200. Fifteen percent of $200 is paid to Firm A, so cash goes up by $30, and the same number is also recorded on the income statement as dividends income. At the end of the year, the net number on the income statement is reflected on retained earnings. On the income statement, we have two things so far, $60 from the fair value adjustment, and $30 from dividends income, resulting in $90 now reflected on retained earnings. Please also confirm that the ending amount of investment is $210 as we have calculated in the previous question.
