 Hello, and welcome to this session. This is Professor Farhad. In this session, we would look at change in reporting entity. This topic is part of accounting changes, which we were discussing, such as change in accounting principle, which we handled retrospectively, change in accounting estimate, which we handled prospectively. So basically, I want to make sure at this point, you know what retrospectively is prospectively. If not, please view the prior recording. Now, what do we mean by change in reporting entity? Well, we have to go back and review few terms to be familiar with this concept. Remember, if one company owns stocks ownership in another company, if they own between zero to 20% of the stock of the other company, we consider this ownership as passive. You have no saying in the company. Therefore, you would handle the investment using what's called the fair value. Sometimes they call it cost, cost or fair value means the same thing. It means you would adjust your stocks, you adjust your vested interests, your equity interests, up and down as the stock price of that subsidiary goes up and down. Now, if you own more than 20, but less than 50, here you have what's called significant influence. If you have significant influence, because you own a substantial number of shares, you would have to use the equity method. Under the equity method, you will adjust your investment in proportion to the earnings from the subsidiary. So if the subsidiary is reported net income of a million, you own 30%, you would increase your investment by 30%. And if they pay dividend, the dividend reduce your investment using the equity method. Now, I'm assuming the fair value and the equity method, if not go to the investment section of my lessons and view those, but I'm assuming you know those if you are looking at change in reporting entity. Once you own more than 50% of a particular company, now you control this company. Control means you have to consolidate with your parent company. It means this company, the subsidiary is part of your parent company. So it has to be combined with your financial statement. So when that happened, so what does that mean? At some point you might own between 20 to 50% of a particular company, let's assume 40%. Then you purchase an additional 20 and that additional 20, now you own that company. If you own that company, it's going to change your consolidated financial statement. That new company, that new company at 60%, that's a new company, it has to be added to your company's financial statement rather than reporting income and dividend as part of your investment. And that's a substantial change. When that happened, when you consolidate, once you have a new company that's being consolidated and you are presenting competitive financial statements, let's assume we're in year X5. And X5, you have control of a company for the first time. If you are showing X5 and year X4, guess what? You have to show, you have to go back and show year X4 as if you own the company in year X4. Why? Because when you report the company in X5, you have control, you're going to show a lot of revenue and a lot of expenses that are not comparable to X4, but because in X4 you did not consolidate. So if you're showing X5 and X4, obviously you have to show as if it was consolidated, then the two companies, the two, the two years, not the two companies, the two years are comparable to each other. So simply put, if you have, if you consolidate, if this is a new consolidation and you're showing competitive financial statement, you have to treat this retrospectively. If you are showing prior financial statements, you have to change them. So this way they are competitive. And the same concept, if you go from consolidation to no consolidation, you removed some of those subsidiaries. And sometimes one subsidiary, if you remove it, it could be a substantial portion of your companies, of the parent company. Therefore, if you remove it and you're showing competitive financial statement, you remove it in X5 and you're showing X4, if you remove it from X5 and keeping it in X4, the numbers will be so weird because this might show a lot of revenues and suddenly your revenue went down. Why? Well, your revenue did not really go down, you no longer consolidating that company. So that's why you have to show competitively, you have to restate. So once you show it competitively, you have to show them both the same way as if the consolidation took place, or if the consolidation was removed. So make sure you know this. Now what happens now, if we go from the zero to 20 to 20 to 50, so basically going from the cost method, changing from cost to equity, or going from, for example, you own between 20 and 50 and you sold the shares and you went from equity to cost. So remember, when you go into consolidation, you have to go back and retrospectively change, especially if you are not especially, if you are showing competitive financial statement. Now we need to discuss what happened when you go from equity to cost or cost to equity. Now before we discuss this, most likely you are either an accounting student or a CPA candidate. Welcome. The reason you are watching this because you need help and I'm glad you are here. Go step further, go to farhatlectures.com where I have additional resources, lectures, multiple choice through false exercises. That's going to help you do better in your accounting courses, as well as your CPA exam preparation. I'm a useful addition. I don't replace, I'm a useful addition to your CPA review course. Don't hesitate, invest in yourself. If you have not connected with me on LinkedIn, please do so. Take a look at my LinkedIn recommendation. Like this recording. If you are watching, it's benefiting you. Like it. Share it with others. Connect with me on Instagram, Facebook, Twitter, and Reddit. So let's take a look first at change from the equity. It means going from equity to cost. Well, the first thing, easy, no retrospective. We don't have to go back. Simply put, we go change from equity and we're going back to here. So for example, we used to own 40% and we sold, you know, 25% interest. Now we are into the 0 to 20% interest going from equity to fair value. Well, now we have to use the fair value method because we're no longer qualified under the equity. We no longer own between 20 to 50%. And all previously gains and losses recognized under the equity method are part of the carrying value. Now real quick, I'm just going to do a quick review here. You have your investment account under the equity method under the equity method. Every time the subsidiary earns profit, you increase your investment. Every time the subsidiaries incur a loss, you reduce your investment. All those changes increases and decreases from gains and losses, they stay, they become part of the carrying value. So you don't change the number. Your cost basis is the carrying amount of the investment at the date of the change. So whatever that investment account is, it becomes your cost basis for the fair value you're starting from there. You don't have to go back and retrospectively do anything. No retrospective application, which is easy. You don't have to go back and change any figures. No change of prior period or periods. It's done. It's easy. And you would, what you would do is you will apply the new method when the equity method no longer applicable. So let's assume sometime March 3rd, you went from the equity because you sold your interest to the fair value. You will stop there and you will start using the fair value method. And at the end of the reporting period, you would record any unrealized gain or loss gains or losses, basically as the difference between the carrying amount that you started with and the fair value of that investment and life is good. Life is easy. We should all know how to deal with the unrealized holding gain or loss. If not, go to my investment chapter. The assumption here, this is basically advanced topic. So you know how to deal with recording unrealized holding gain or losses. Now we're going to go to equity. We're going to go to equity. Simply put, let's assume we have 15% and we really like the company. We're going to add another 15 and go to 30%. Now we went into the equity territory. What do we have to do? Again, no retrospective going from cost to equity, no prior adjustment is needed. Instead what we're going to do account for the effect of the change in the period of the change and in future period. Obviously it's going to affect future period as long as we have this significant influence. So the investor company add the cost of acquiring the additional stocks in the investee's company to the cost basis of the previously held interest. So simply put, whatever you paid here, you add to them, whatever you paid to get to the 30%. You add the cost. Now the best way to illustrate this is to actually look at an example. Let's assume on January 1st, Adam company purchases 10% stock interest in Avis company for 900,000. Well, 10% means you have no significant influence. Obviously you have no control. We debit equity investment 900,000, credit cash 900,000. By the end of the year, the fair value of Avis investment was 1,025,000. Well, fair value went up. We're using the fair value method. We have to write up our, not write it up, adjust our investment. We're going to debit fair value for 125,000 and we're going to credit unrealized holding gain or loss, which is a gain now and it's going to go to income for 125,000. And this is basically an example of the fair value method, adjusting your investment to fair value. Now on December 31st, 20x1, let's assume January 1st, x2, just kind of, you know, January 1st, x2. So January 1st, x2, Adam company purchases an additional 20%. Now we started with 10 plus 20. Now we're up to 30%. What does that mean? It means now we have to account for the investment going forward using the equity method. And we paid half a million. We debit the equity investment that we're going to call it Avis. It's a separate equity investment because now this 900,000 was part of our investment. So we have a new equity investment and we paid half a million. We credit cash half a million. Now what do we have to do? We have to reclassify the equity investment of this 900,000. So this 900,000, remember, it has to be added to this half a million. So what do we do? We debit the equity investment of Avis 900,000. We credit the equity investment, this one. So we remove this one and we transfer it into this one. Okay, the equity investment. Also we no longer need this fair value account. This 125,000 is no longer needed because we no longer using the fair value. So what do we have to do? If we have a credit, if we have a debit to fair value, we have to credit fair value. And what do we have to do? Well, since we recorded the income, we also have to take out the income. But guess what? This is a new year. We can't go back and take out the income. What do we do? We reduce retained earnings. What we're going to do, we're going to reduce retained earning to eliminate this income of 125,000. And we're going to credit the fair value adjustment to remove this 125,000. And simply put, going forward, we have an investment at equity started with half a million, sorry, started with actually 900,000 technically, then we added half a million to it. We have an investment, an equity investment of 5.9 million. Starting next year, we're going to look at Avis net income. And if Avis earn net income, we're going to increase our, you know, let's assume Avis earned a million dollar of net income times 30%. It means we'll increase our investment by 300,000. And when Avis pays dividend, it's going to reduce our investment in the, our investment in Avis account. And if we, if Avis incur losses, our equity investment will absorb the proportion of share, which is 30% of the losses in our investment. So this is what you have to do. What should you do now? Go to farhatlectures.com and work MCQs, true, false, look at additional exercises that's going to help you solidify this topic. Don't take chances when you're studying for your CPA exam, studying for your accounting courses, invest in your career. Once you are done with this, once you earn your degree, once you get your certification, you can focus on other things in life. Don't shortchange yourself. Good luck. Study hard. And of course, stay safe.