 Hello and welcome to this session in which we will discuss business combinations. Specifically, we're going to be starting with chapter one and within chapter one, I'm going to be focusing on investment and equity securities using the fair value method. So we're going to learn on how to account for investment using the fair value method. Now, bear in mind, this lecture is designed specifically for CPA candidate. In other words, if you are looking for more detailed information about this topic, if you feel this explanation was not deep enough for you, please use my advanced accounting course to learn more about this topic. But this session is based on my CPA exam notes that I provide on my website farhatlectures.com. So let's go ahead and get started. And how do you account for investment and equity securities? Where it all depends on the degree of percentage? What ownership do you own in this company? And your ability as an investor to control the other company? What does that mean? Well, you could own between 0 to 10 percent of the company. You could own 25 percent. You could own 40 percent of the other company. Well, depending on the percentage of ownership, you will determine how to account for this investment. Whenever an investor has between 0 and 20 percent, so if you own between 0 and 20 percent of the stock, of the common stock of the company, the interest does not have a significant influence. We assume here because you own between 0 to 20 percent. You don't have influence. You don't have enough voting power. You don't have enough stocks to have a saying in the company. Under those circumstances, you will be using the fair value method, which is the method I will be covering specifically in this session. Now, when your percentage is between 20 and 50 percent, now you own more than 20, but less than 50 percent. Now, the assumption is the investor will have the ability to influence the investor, the company that they invested in. Under those circumstances, we would use the equity method. And what is the equity method? We would learn about the equity method in the next session. Now, if you own more than 50 percent, 50 percent plus, you assume to have control. An investment of more than 50 percent in the investor's common stock create a parent subsidiary. The parent, let's assume the parent is the gap company and the subsidiary is Old Navy. Old Navy is the subsidiary. For example, gap stores, the gap, the company that sells clothing, they own more than 50 percent of the company called Old Navy. Well, guess what? Gap is the parent company. Old Navy is the subsidiary. And what they do under those circumstances, the two companies will be able to consolidate unless, unless Old Navy is going through a bankruptcy, then they cannot consolidate. Under normal circumstances, they would consolidate. Now, bear in mind, because this is CPA session, CPA review session. In addition, gap also they have guidelines if you have something called variable interest entity. Sometime if you have a variable interest entity in another company, you also have to consolidate with that other company. What is variable interest entity? There's a one whole session about variable interest entity. But the point I'm trying to make here is, yes, we look at your percentage to determine whether you have control or not. But there is another method. This is percentage means you're voting. The more stocks you have, the more voting power you have. Then we have a model called the VIE model. So under some circumstances, you might own 0% of some company and you still consolidate. You assume to have control over that company. How? We'll cover the VIE in a separate recording. But the point is bear in mind, you have a percentage level and also you have a VIE model. And this is a picture of the percentage model. Let's review 0 to 20%. You have no significant influence. We would use the fair value. And if we're using the fair value, we're going to see shortly that any changes in the fair value goes to net income. We'll work on that shortly. If you own more than 20 but less than 50, you assume to have a significant influence. And this is all a review. Under those circumstances where you'll use the equity method, don't worry about the equity method. We'll cover that next. If you own more than 20%, you assume to have control. You own more than 50%. Think about it. If you own more than 50%, you can vote yourself to be in control of the company. You have control under those circumstances. We consolidate and we're going to have to go over a few sessions over consolidation and we'll work on consolidation. So let's go ahead and dive into the notes. Now, what are equity securities? Well, equity securities includes various types of ownership shares such as common stock, preferred stock, the rights to acquire and dispose of those shares, such as options, calls, puts, warrant, all of those are equity securities. What is not equity securities? Redeemable preferred stock, convertible bonds, treasury stocks, those are not classified as equity securities because they don't provide you with any ownership interests. Now, bear in mind, when we talk about ownership interests, sorry, specifically, the equity securities we are referring to are common stock because common stock usually the only type of security that gives you voting power and the voting power is what gives you that influence or no influence. This is, it's an important point to, it's an important point to point out. So preferred stock, even if you own older preferred stock, you have no control because you don't vote. If you don't vote, you have no saying in the company. So when, when a company owns between zero to 20 and another company, I know I'm repeating myself, this is a review, they don't have a significant influence. It accounts for the investment using the fair value with gain and losses reported immediately in the income statement, which we'll see that now under some circumstances, let's assume the fair value of the equity securities. Let's assume you own common stock in a particular company, but that company is private. What does that mean? It means we don't know the fair value of the stock. If it's a public company, it's easy. Under those circumstances, GAAP will allow you to use the cost method, but you have to test the investment for impairment. This is if you cannot find, practically find the fair value of the investment. Okay. Again, it's important to note that when assessing whether the company has significant influence, the amount of common stock, not preferred stock is what we look at because common stock gives you voting power. So if you own stocks in PepsiCo and Walmart and Coca Cola and Apple computers and Amazon, each stock will give you one share. One stock gives you one vote. So you have to have the voting power. So let's take a look at how to account. Now let's dive into the accounting part of an investment at fair value. Okay. In the investor's book, the main journal entry associated with investments accounted for using the fair value consists of the initial investment and recording subsequent dividend and obviously if you sold the investment. So when we are using the fair value, first we have to determine what is our cost, the initial investment and what happens subsequently after we record the investment, what happened. And this is what we need to work on. When the fair value method is used, the total value of the investment and the investor represent the total investment cost and is equal to the fair value of the consideration paid. So how do you record the initial investment? How much did you pay for it? Plus any legal cost. So if you paid any legal cost, you add that to your investment. So the journal entry would look something like this. You debit the investment and investee. You'll have an investment, which is an asset and you will credit. If you paid for it, you will credit cash or if you paid stocks, if you issued stocks to the other party, you will credit common stock and additional paid in capital. So notice you could either pay cash, common stock, or basically a combination. You can pay some in cash, some in common stock. Now bear in mind, once again, you record the investment based on the consideration paid plus any legal cost. How to account for dividend received? What happened if they pay the dividend? When the investee pays dividend, when the investee distributes dividend, the investor recognizes the dividend as dividend revenue. Now bear in mind, this is where we're using the fair value method because if we're using something other than the fair value, like the equity method or consolidation, we have to learn how to deal with this. As long as the dividend is paid out of cumulative earnings, in other words, it's coming out of net income. Any excess dividend, so if they pay you dividend and excess of their earnings, it's going to be considered the return of capital and it's going to reduce our investment, which we will see an example how to do so. So to record the entry for dividend received, we'll debit cash and credit dividend revenue, assuming this is a non-liquidating dividend. Non-liquidating dividend means they are paying us the dividend from their earnings. So they made a profit and the assumption is the dividend is coming out of earnings. Now if dividend is coming, if the payment is coming not from earning, the company is not making a profit and they pay us dividend, we debit cash and we reduce our investments, it's considered return of capital. So highlights, fair value method dividend received are recognized as dividend revenue, again to the extent of the cumulative earnings. Liquidating dividend are deducted from the investment account, which we'll see an example shortly. Okay, sale of the investment. The investment is reported on the balance sheet at fair value and we keep that fair value up to date. When sold, the investment should be written off, we'll write it off, and the difference between the selling price and the amount reported at fair value is considered gain or loss, actual gain or loss on the income statement, which we'll see an example and it's time to look at an example. On January 1, company A paid 75,000 to purchase 4,000 shares of the 50,000 shares of company B, so A is buying B. In addition, A incurred and paid 7,600 in legal cost, a little bit of expensive, but that's fine, it's for the sake of the illustration. At the end of year one, company B has a retained earning of 178,000 and paid cash dividend of 300,000. Notice, I'm giving you an example where the dividend paid is an access of retained earnings, that means we're going to have a liquidating dividend. First, determine the percentage of ownership of company A and company B, and why do we need to know this? To determine how to account for this investment. Well, let's think about it. We own 4,000 out of 50,000 shares, we own 8% of company B. Well, if we own 8% of company B, which method are we going to be using? Fair value method. Now that's easy. Now we need to use the fair value method. Prepare the journal entry to account for the investment at acquisition. Well, at acquisition, we paid 75,000 plus 7,600. Well, under those circumstances, we paid 82,600, which is again the cost plus 75,000 plus 7,600. 75,000 plus 7,600. We debit the investment and we credit cash since we paid cash. Now let's assume that company A, instead of purchasing the investment using cash, issued 5,000 shares of its $10 par value common stock at $15. So the stock is selling at $15. That's the stock. So if we take, let's just make sure we all have the numbers down. So 5,000 shares times $15 is 75,000. So we paid for the company 75,000 by issuing shares. Well, first let's issue the shares. We credit common stock, 5,000 shares at $10, which will give us common stock of 50,000. We're going to credit cash because we have to pay for the legal fees separately. That's the assumption here. We paid for the legal fees separately in cash, 7,600 credit cash. The investment, we're going to debit the investment 75,000 plus 7,600. That's the investment. And the remainder is a plug, which is additional paid in capital. Always keep additional paid in capital as the last journal entry. This is assuming we issued stocks to buy company B. Now, determine the value of the investment at year end and prepare the journal entries related to the dividend received and the revenue earned by company B as of year one. Well, let's see. When the fair value method is used, the value of the investment is affected by the changes in the fair value of the investment and is reduced by the amount of liquidating dividend. So if we receive any liquidating dividend, we reduce the investment by that. Noting that liquidating dividend are those dividend paid in excess of retained earnings, which I already told you in this example, I gave you a payment of dividend and access. So let's see. Company B had retained earnings of 178. They paid $300,000 in dividend. Well, therefore, out of the 300,000, 122 is what? 122 is liquidating dividend because out of the 300,000, we could all only assume 178 is dividend and remainder is liquidating dividend. Now, company A owns 8% of company B. Well, if it owns 8%, we're going to be receiving 8% of what they paid. 8% of 300,000 is 24,000. Now, we're going to take this 24,000. The amount segregated between non-liquidating dividend, which is 178 times 8% in liquidating dividend because the amount also we own 8%, we're also receiving some liquidating and some non-liquidating dividend. So 178 times 8% will give us 14,424. Therefore, if we have 24,000, we're going to be receiving 24,000 in total. We're going to be splitting it between 14,240 as non-liquidating and the remainder 9,760 as liquidating dividend, which is the difference between 24,000 and 14,224. Let's take a look at the journal entry. We debit cash, 24,000, our non-liquidating dividend, which is dividend income or dividend revenue, 14,240, and we credit the investment of 9,760. Now, bear in mind what you need to see is this. If this is your investment in B, in company B, in company B, you started the investment. Remember, you started the investment at 86. Let's see how much did we start with the investment for? 8,2600. You started the investment at 8,2600. Now you're going to reduce the investment by 9,760. Now you have a new value for the investment. Now, given that the investment is accounted for using the fair value, company A would not record any journal entries recorded to income earned by company B. So you ignore the income earned by company B because you're using the fair value method. Now, assume that the securities were sold on January 3rd, year 2, for 82,750. So now we sold those stocks for 82,750. What happened? Well, again, let's go back and look at our investment. Again, we are keeping track of our investment in B company. We started at 82,600. Then we reduced our investment by 9,760. Let's see what was our investment. By the time we made the sale, 82,600 minus 9,760, our investment is worth 72,840. Now we sold the investment. Well, if we sold the investment, we have to remove it. We have to credit the investment 72,840. And this is the credit. And we sold it for 82,750. Well, the difference between 82,750 and 72,840 is a gain of 9,910. Now, bear in mind, on the CPA exam, they may tell you you sold only 50% or 40%. So what you do is, if you sold only 50% of this, you will take 72,840 times 50% that will be your cost. And you will compare that to how much you sold it for to determine whether you have a gain or a loss or you multiply it by 40%. If you sold 40% or 30% or whatever that percentage is, in this example, I assumed I told you you sold everything. Therefore, the investment in B is gone. Now, again, at the end of this recording, this is for CPA candidate. If you want more details, go to farhatlectures.com where I have an advanced accounting and you should have, if you have subscription to my CPA resources, you have subscription to the other one, you'll have access to it. In the next session, we would look at investment in equity securities using the equity method. Once again, if you're not a subscriber, think about subscribing now. Go to farhatlectures.com and work additional multiple choice questions to consolidate this knowledge. Good luck. Study hard. I'm always here to support you and good luck.