Let's please remember, the accounting for intercompany investment depends on the amount of investment. If a company purchases up to 20% of another firm, we classify these investments as passive investments. For passive investments, we are going to use fair value accounting. When a firm buys between 20 and 50% of another firm, we are going to classify these investments as significant influence type of investments. For these investments, we can either use fair value accounting, just like the passive type of investments, or equity method of accounting. If a firm buys more than 50% of the target firm, we will classify these investments as control type of investments. The accounting method for control type of investments is consolidation. Firms may obtain significant influence or control in stages. For example, an acquirer may first make a passive investment and then obtain significant influence by purchasing additional shares. This is called step acquisition or business combination achieved in stages. In a business combination achieved in stages, the acquirer shall remeasure its previously held equity interest in the acquiree at its acquisition date fair value and recognize the resulting gain or loss, if any, in earnings. Let me please give you an example here. Firm A acquires 15 shares of Firm T from $10 per share on January 1st, 2022. Firm T has 100 shares issued and outstanding on January 1, 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 dollars per share. Firm A acquires (the) remaining 85 shares of Firm T for $1,300 on January 1st, 2023. Assume that Firm T's net assets' values approximate their fair values. Question number one asks to provide the accounting entry on (a) transaction worksheet on January 1st, 2022, associated with this investment. Basically, this question is asking the accounting entry to acquire the investment. So what do we know about the investment? (The) acquiring firm buys 15 shares from $10 each, meaning that (the) acquiring firm spends $150 in total. In a transaction worksheet, under assets, cash goes down by $150 and investment goes up by one $150. The second question asks the amount of investment on December 31st, 2022. First, we need to calculate the ownership percentage to choose the correct accounting method. Firm T has 100 shares issued and outstanding in total. Therefore, 15 shares result in an ownership percentage of 15%. Since this is less than 20%, this is a passive type of investment. Therefore, we will use the fair value methods. 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 third 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 column as 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. 15% 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 income statement, we have two things so far, $60 from the fair value adjustment and $30 from the dividends income, resulting in $90 now reflected on retained earnings. Please also confirme that the ending amount of investment is $210 as we have calculated in the previous question. The last question asks to provide (the) accounting entry on (a) transaction worksheet on January 1st, 2023. Let's please remember that, in step acquisitions, the acquirer fair values (the) previous investment before the additional investment is made. However, in this particular question, we don't need to fair value (the) previous investment because the previous investment, which is worth now $210, is already fair valued. Therefore, we record directly the new investment on January 1st, 2023. Cash decreases by $1300 and investment increases by $1300. Let's solve another example. Firm A acquires 25 shares of Firm T from $10 per share on January 1st, 2022. Firm T has 100 shares issued and outstanding on January 1, 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 per share. Firm A acquires (the) remaining 75 shares of Firm T for $1200 on January 1st, 2023. Assume that Firm T's net asset's values approximate their fair values. Question 1 asks to provide the accounting entry on (a) transaction worksheet on January 1st, 2022. What is the amount of investment here? (The) acquiring firm acquires 25 shares. Each of these shares has a value of $10. Therefore, the initial amount of investment is $250. In the transaction worksheet, cash goes down by $250 and investment goes up by $250. Question number two asks the amount of investment on December 31st, 2022. First, we need to calculate the ownership percentage to identify the accounting method that we will use. 25 shares give the acquiring firm 25% ownership, resulting in significant influence. We can use either fair value accounting or the equity method of accounting. I will choose (the) equity method of accounting here. How does investment change, in year 2022, under (the) equity method? There is an initial investment of $250. This is the amount of investment on January 1st, 2022. Investment goes up when target firm shows a profit. We know that target firm profit in year 2022 is $300. Firm A owns 25% of the target firm. Therefore, investment goes up by 25% of $300. We also know that if the target firm pays dividends, this reduces investment. The investment decreases by 25% of $200, which is the total dividend payment by the target firm in 2022. If we sum all these, we find that the amount of investment, at the end of the year 2022, is $275. Question 3 asks to provide the accounting entry on (a) transaction worksheet on December 31st, 2022. At the beginning of the year 2022, the acquiring firm makes an initial investment of $250. Cash account goes down by 250 and the investment account goes up by $250. During the year ended 2022, the target firm makes a net income of $300 and therefore, the acquirer firm investment increases by 25% of $300, which is $75. We also create an equity income of $75 under income statement. Next, in year 2022, the target firm pays $200 dividends in total, out of which 25% is paid to the Firm A. Therefore, cash goes up by $50 and investment decreases by $50. Finally, the net balance on income statement is reflected on retained earnings. The only thing that we have on the income statement is $75 of equity income. We will then close the accounts. Please note that the amount of investment at the end of the year 2022 is confirmed as $275. The last question asks to provide the accounting entry on (a) transaction worksheet on January 1st, 2023. Let's please remember that, in step acquisitions, the acquirer fair values (the) previous investment before the additional investment is made. In this question, previous investment is fair valued on January 1st, 2023. The amount of fair value adjustment is 25 shares times $14 —this is how much investment should be—minus $275, the value of the investment under (the) equity method. And if we do the algebra, we will find that fair value adjustment is $75. In the transaction worksheet, investment increases by $75 and the same number is also recorded under income statement as fair valuation gain. We then record the new investment on January 1st, 2023. Cash decreases by $1200 and investment increases by $1200.
