 Hello and welcome to the session in which we will discuss the acquisition method. When we have a business combination or when we have consolidated financial statements, we use the acquisition method to buy the other company, the initial purchase. So it's very important that you understand how this process occurs, what are the journal entries for those financial statements or at least the initial journal entries. So you have to understand concepts or terms such as consideration transferred, separately identified assets, liabilities assumed, how to compute goodwill or again from the purchase. Now I'm going to go over this session using examples that explain the formula step by step. But don't go into the CPA exam and if you are finding difficulty with advanced accounting, this is your starting points. I'm going to start from zero today in this session. So whether you're an accounting student or a CPA candidate, I strongly suggest you take a look at my website farhatlectures.com. I don't replace your CPA review course. I'm a useful addition to that course. You keep your course. I can be a useful addition. I can help you understand the information differently. I can give you alternative explanation, alternative resources. By doing so, I can help you improve your score on the exam. Your risk is one month of subscription. Your potential gain is passing the exam. And if not for anything, take a look at my website to find out how well or not well your university doing on the CPA exam. I do have resources for other courses as well. If you haven't connected with me on LinkedIn, please do so. Take a look at my LinkedIn recommendation. Like this recording, share it with other connect with me on Instagram, Facebook, Twitter and Reddit. So when we buy a company, we're going to be using the acquisition method. So first think about it. What do you do when you buy something? Well, when you buy something, you have to find out how much you are paying given up. Well, that's consideration transferred. Now, when you pay for something, you usually pay for cash. Use cash. Companies, they might use cash. They might issue stocks. They might issue a bond to raise money. So there are more than one way to buy a company, but they're all called consideration transferred. First, you have to know how much did you pay for the acquired business? How much did you pay for that business and any non-controlling interest? Don't worry about the non-controlling interest for now. We'll discuss that later. But first, how much did you pay? Then what did you pay for? You have to identify the assets and any liabilities assumed, because when you buy a business, you are buying a bunch of assets, multiple assets. To keep it simple, let's assume you're buying a restaurant, a pizzeria. You're going to be buying the land. You're going to be buying the actual building. You might, you might, you'll be buying the equipment in the kitchen. You might be buying some supplies. You might be buying also tables and chairs. Now, any amount you paid above and beyond those identifiable asset, it's going to be called goodwill. Then if you pay less than the identifiable net assets, you have a gain. Don't worry. We're going to work an example, but simply put, we're going to work a comprehensive example for that matter. Simply put, you're going to pay an amount, let's assume you paid $10,000, $10,000 for something that's worth $2,000 for a business that's worth $2,000. How did I know the business worth $2,000? I bring everything to fair value. How did I come up with fair value? We'll discuss that later. Fair value is how much those assets are worth the day. Based on some criteria, we'll talk about that later. So let's assume it's worth eight rather than two. So if you pay 10 for something that's worth $8,000, what happened is you paid extra $2,000. Now, why did you pay the extra $2,000? Well, you have to allocate the difference. You have to allocate this difference to other assets, either tangible or intangible assets. And for the sake of simplicity here, we're going to assume there are no other assets that you can identify to allocate this $2,000 for. Because you paid 10, you identified all the assets, the chairs, the table, the building, the land, everything else. It's worth $8,000. You are left with $2,000. That extra $2,000, we're going to call it goodwill. It means you paid extra $2,000 for assets you really cannot identify. So why did you pay for that extra $2,000? Well, you could pay because of the location of the business. The location of the business is not on the balance sheet. You cannot identify this asset. Maybe the reputation of the business, maybe the chef that works there. Now, this is quite a cheap $10,000 pizzeria, but the point is you can add zeros as many as you want. Doesn't make a difference. But the point is goodwill is that excess amount you paid over the net book value, the net fair value of that business, net book value at fair value. And that's what goodwill is. Now, the best way to illustrate this is to work an example. Because if you work an example, you will see how this process works. Again, this is important. This is the basics. So you're starting here, you're advanced accounting. Although we're not going to be doing consolidation in this session, but this is the basis of it. So please pay attention to this example. And we're going to assume we're not going to dissolve. I'm sorry, we're going to assume we're going to be going to dissolve the other business. So the other business will be gone. So I'm going to go to the Excel sheet and work an example. This is the example that we're going to be working with now as a student, whether you are a CPA candidate or advanced accounting student, you have to be very comfortable with reading a balance sheet, how to read a balance sheet. Because if you don't know how to read a balance sheet, then you're going to find difficult to because look, there's a lot of numbers on the screen. How do I navigate through this? How do I make sense out of it? Well, what's going to happen is this, we have a buyer company. This is the buyer company. And we have a seller company. So the buyer company buying the seller company. And we have the buyer company book value. We have the seller company book value and we have the seller company fair value. So here's the book value of the buyer company. They have assets of 1.1 million, computer and equipment. They have no capitalized software. They have customer contract. They have notes payable. They're net asset. And what is net asset? Well, you need to understand this term. Net asset is the difference between your assets and your liabilities. So 2.6. It's the same thing. The net asset should be the same thing as your equity. Or net book value. Those are the same thing. Why? Because assets minus liabilities equal to equity. And let's see. The buyer company common stock is, they have a common stock par value of $10. This is a credit balance 1.6. Additional paid in capital $40,000. The parentheses are credit balances retained earnings as of the beginning of the year, $870,000. They declare dividend of $110,000. They have revenues of a million, which is a credit balance, expenses of $800,000. The owner's equity, as I told you, it should equal to the net asset, $2.6 million. And ending retained earnings is $960,000. Ending retained earnings is beginning retained earnings plus revenue minus expenses minus dividend. So this is what comes up with $960,000. This is the buyer company. I'm going over this just kind of, I want to make sure you are comfortable in reading the financial statements. Now these are the seller's book value. So we're buying this company and we're buying their assets, which they have current assets of $300,000 on the books. And that those current assets are also worth at fair value, $300,000. They have computer and equipment on the books. They're worth $400,000. But really in the real world, those are worth fair value, $600,000. So notice their computer and equipment are undervalued by $200,000. They have a capitalized software on the books worth $100,000. In the real world, that capitalized software is $1.2 million. It means somehow they either they wrote the software or they purchased it a long time ago and now it's worth more. Most likely they created the software themselves, but it doesn't really matter. So $1.2 million. A customer contract, they have no customer contract. They have, I'm sorry, I'm sorry. On the books, the customer contract is worth zero. They have really no customer contract on the books. But when we look at their customer contract, we think it's worth $700,000. The fair value of this customer contract is worth $700,000. And they also have a note spable of $800,000 on the books. For the fair value, it's worth $250,000. Why would you have a difference? It could be, it could have an adjustable rate, or it because interest rate did change relative to our note, but also liabilities could change in value. So when we compute the net book value at fair value, so this is how much this company is worth based on their fair value. So the net book value based on the book value is worth $600,000, but based on fair value, this company is worth $2,550,000. This is how much is this company worth. Now, when we pay, we would look at this number. We look at the net book value using the fair value figures because we're buying the company, we're buying their assets, we're going to value everything at fair value. Now, let's assume we have this deal. Let's assume we struck a deal with this company and we said we're going to pay them $550,000 in cash and we're going to issue 20,000 shares of our common stock, which has a, power value of $10 and the fair market value for our stock is $100. So let's see how much we paid. We paid cash $550,000 and $200,000, $20,000 common shares times $100. We paid an additional $2,000,000 in stocks. So we paid $2,550,000. This is how much consideration we're going to be given up for something that's worth $2,550,000. And guess what? It means we paid exactly the value of the company. We did not pay more. We did not pay less. Let's generalize the entry. So what did we do is we purchased their assets. So we're going to do, we're going to report everything. So notice first, let me show you their assets. We're going to buy their assets. We're going to transfer their assets to our books at fair value. So notice what's going to happen. I'm going to go ahead and transfer all the assets at fair value. So notice those numbers are all coming from the fair value column. So notice they're all coming from the fair value column. Let me, fair value column, let me put them in a different color. Okay. And the reason I want to show it to you in a different color, because when you bring something on the books, you bring it at fair value. We're going to have bring their assets, their computer at fair value, their capitalized asset at fair value, and their customer contract at fair value. Now we also, when we bought them, we also, we are responsible for their notes payable now, because when you buy, when you buy a company, you buy their assets, also you buy their liabilities. Therefore, we have to bring the liabilities on the books for $250,000. This is the liability. Also, again, you bring it at fair value. You paid cash, $550,000. That's the, that's the credit. And you issued stocks. You issued stocks, $20,000 shares times $10, which is the common stock and anything that's left, which is additional paid in capital. Because remember, you issued the stocks, the $20,000 shares times $100. So the stocks are worth $2,000,000. $200,000 went to the common stock and $1.8 went to additional paid in capital. Anything remaining goes to additional paid in capital. So this is what you did. You purchased the company and you paid exactly how much it's worth, $2.5 million. Now you bought the company, that's another deal, and you paid actually $1,000,000 in cash. Now here's what happened. You paid $1,000,000 in cash plus you issued the stocks of $2,000,000. Now you paid for the company $3,000,000. You paid for the company $3,000,000. What does that mean? It means you paid extra. We identified all the assets that we can identify. So what happened is it's $3,000,000. The company is worth $2,550,000. That's all how much is the company is worth. It means there's a good will of $450,000 under this scenario. So under this scenario, we're going to first put the assets on the books, the assets that we are familiar with. You just saw earlier, current assets, computer equipment, capitalized software. Then we're going to add a new asset to the table, a new asset to our list of assets, and that's good will. Good will is the new asset. This is a new asset, new asset on the books. Then we're going to do the same thing. We're going to put the liabilities on the books. We're going to pay the cash of a million, issue the common stock, and the paid in capital. So notice here, we paid a million versus, let me make the screen so you can see it side by side. We paid a million versus $550,000. So this additional money that we paid brought us a new asset called good will. Remember good will is not amortized. Good will is subject to impairment. Now let's assume we purchased this company, and the deal was we pay no cash, and we're going to issue 20,000 shares of stocks. So we're going to be only using stocks. So if we're only using stocks, those stocks, those 20,000 shares are worth $2 million, and we bought the company that's worth $2,550,000. So we have a negative $550,000. So we paid less for this company. So this is the company's on sale. This is a good catch. Now what do we call this extra $550,000 that we purchased? We called it a gain. It used to be called negative good will. There's no negative good will. We got a good deal. We have a gain. Well, we do the same thing. We're going to bring the assets and the liabilities on the books just at fair value. But what's going to happen too? Now we are going to have a gain. So notice we bring the liabilities. Now we have gain on bargain purchase, gain on bargain purchase of $550,000. It's basically a gain. It's an income account. It goes on the income statement, and we're done. Common stock, paid in capital, we issue the stocks. So notice the difference. So the three scenarios is we paid exactly what the company is worth. We paid a little bit more. And the only thing that we can think of is good will. We could not find any additional assets to identify endless. And what I mean by this, let's assume the company has a patent that was not on their books, just like this customer contract. It was not on the book. We put it on the books. If they had a patent, we have to put it on the books, but they don't have anything. They don't have a patent. They had customer contract. We put it on the books, and we end up with good will. And in the third example, we assume that we had a good deal. If we had a good deal, if we paid less than the fair value, net net book value, we have a gain on bargain purchase. Now let's go back to the PowerPoint slides and look up at few discuss few more issues that we need to be familiar with. One of the issues is how to determine the fair value, that column where we put everything at fair value. There are many, many methods that will identify three methods. One is the fair value approach. What's the fair value approach? Well, what's the ongoing price for similar assets in similar industry, okay, in similar industry, not similar assets in similar industry? What are the prices of those assets in similar industries in similar areas, or the value of liabilities, or the value of liabilities? So that's the fair value approach. Looking at similar to what you have. If you have a building, what's that building? What's that next? The building next to you is worth. Assuming it's in the same area, the square footage is a comparative, so on and so forth. If you have a warehouse, if you have inventory, so find the fair value. This is basically similar to real estate approach. Like if you own a home, you would receive, you know, from real estate agency, this is how much is your home is worth. They would say this is the fair value of your home. How did they come up with the fair value of your home? They look at other homes sold in your area similar to yours, and that will be the fair value because there's no active market for homes, but something similar to you is an active market. Another approach to value a company to find the fair value is to find the income approach. And here what you do is we use the discounted future cash flow, giving a certain market or discount rate depending on the industry. This is another way to find fair value, the discounted future cash flow approach. Why? Because we cannot find something similar to our assets. So what we do is we say, okay, how much these assets are going to generate in cash, discount that cash to the present using a market rate, and this is how much the company is worth. The third method is the cost approach, or basically replacement cost. How much will cost us to replace those assets? And this will be the, how do we determine the fair value? Now, this is more challenging if the assets that we have are unique to our business. So if we have specialized equipment, well, if we have to find the cost, we have to talk to a manufacturing company, they have to give us an estimate because there's no similar asset to us. It's so unique to our business. But those are three methods that we can use to determine fair value. Okay, we don't really, we don't have to worry about this as accounting students, basically in the real world, you know, it's either, if it's a publicly traded company, it's easy. If it's not, usually it's the income approach, which is the discounted cash flow is used or a combination. It doesn't have to be the income approach, but that's, and whatever approach you use, by the way, it will be disclosed to the, obviously, disclosed to the person that's buying because they want to know how the appraiser came up with that, with that number. You might incur additional costs when buying another company. Those costs will be considered either direct or indirect, like accounting, legal, investment banking, appraisal fee. So you need those additional costs to buy the other company. What do you have to do with these costs? Guess what? Expense them. Simply put, they are expensed. You might also incur indirect combination costs, such as internal costs, such as allocating the managerial costs, secretarial costs that was incurred in this process to buy the company. Also, those costs are expensed. Hold on. Is everything expensed? Not really. Cost incurred to register and issue stocks. And usually that question comes up on the CPA exam. So just be aware. Cost incurred to register or issue the stocks is a reduction in the additional paid in capital. Simply put, not expense. So this cost is not expense. Now, the best way to illustrate those is just to go through an example. Let's assume the buyer pays an additional 100,000 in accounting and attorney fees related to that business combination. We're going to debit professional service expenses, which is expense and credit cash. I mean, this is credit to cash. We might incur internal secretarial and administrative costs of 75,000 that are directly related to this business combination. Again, it is an expense, salaries and administrative expense, credit, either cash or accounts payable. Now we also incurred cost to register and issue the buyer securities to register and issue buyer securities issued in the business combination. We paid 20,000. So notice what's going to happen now. We're going to debit additional paid in capital, not expense. This additional 20,000 additional paid in capital and we're going to credit. If we paid cash, we credit cash. So notice here when we register and issue the stocks, the securities, we don't debit an expense. This is not an expense. We debit additional paid in capital. Just make sure you're aware of these rules, especially for the CPA exam. At the end of this recording, I'm going to remind you whether you are a CPA candidate or an accounting students, I strongly suggest you take a look at my website, farhatlectures.com. I don't replace your CPA review course. I will be a useful addition to your CPA review course. Your risk is one month of subscription. Your potential gain is passing the exam. Good luck, study hard, and stay safe.