Advanced Financial Reporting – Module 1

Contents
Advanced Financial Reporting – Module 1 ........................................................................... 1
Lesson 1.1 Overview of Accounting for Investment in Equity Securities- Part 1 ............. 1
Lesson 1.2 Control ........................................................................................................... 16
Lesson 1.3 Scope of ASC 805 – “Business Combinations” ............................................ 26
Lesson 1.4 Acquisition of a Group of Assets .................................................................. 31

Lesson 1.1 Overview of Accounting for Investment in Equity

Securities- Part 1

In Lesson 1, we will discuss the overview of accounting for investment in equity securities.
Companies often invest in equity securities of other companies, such as shares of common
stock. The accounting for investment in shares of common stock of another company is based
on the influence that the investor has over the investee.
Influence is generally determined based on the percentage of ownership held.

So if the ownership is more than 50 percentages, in this specific case, the presumed influence
is control, and the accounting method for initial recognition will be business combination,
Accounting Standards Codification 805. The subsequent accounting will be consolidation,
Accounting Standards Codification 810.
If the percentage of ownership is between 50 and 20 percentages, the presumed influence is
significant influence, but not control. The accounting method can be either, the equity
method of accounting; Accounting Standards Codification 323, or the fair value option;
Accounting Standards Codification 825.

But if the percentage of ownership is less than 20 percentages, in this specific case, the
investor has no influence or very little influence over the investee. Thus, the accounting
method must be fair value through net income; Accounting Standards Codification 321.
Under the equity method of accounting, the investor recognizes in its income statement its
share in the earnings or losses reported by the equity method investee. Investor shares in the
net income of the investee increases the equity income for the period. Thus, equity income is
credited and equity investment account is debited. Exactly the opposite
journal entry is recorded for the share in the net losses of the investee. In this case, equity
income is debited and the equity investment account is credited.

However, under the equity method of accounting, dividends received from equity method
investee decrease the carrying amount of equity method investment account. So the January
entry will be debit the cash received and credit the equity method investment account. Let's
see the following example.
On January 1, 2018, company A acquired for $80,000, 30,000 shares out of a total of 100,000
outstanding shares of common stock of company B. Company A did not elect the fair value
option for this specific investment.

In 2018, company B reported net income of $50,000, and at the end of the year Company B
declared and paid cash dividends of $20,000. So let's take a look at this example in detail.
First of all, we need to determine the accounting method for the investment in common stock
of company B. The accounting method is based on the influence that the investor has over the
investee, and influence is based on the percentage of ownership.

In our case, Company A holds 30,000 shares out of a total of 100,000 outstanding shares of
common stock of Company B. So 40,000 shares out a total of 100,000 outstanding shares
will give us 40 percentage of ownership. In case of 40 percentage of ownership, the presumed
influence is significant influence.
In case of significant influence, two accounting methods are available. Option number one is
the fair value option for the investment and common stock, and the second option is the
equity method of accounting. In our example, it was indicated that the fair value option was
not elected. So we must apply the equity method of accounting for the investment in common
stock of Company B. So the following January entry is recorded on January 1,2018,
the acquisition date. Company A paid $80,000 to acquire the shares of common stock of
Company B. So we will credit cash for $80,000 and equity method investment account is
debited for the same amount. Equity method investment. Also, $80,000. At the end of the
year, at December 31,2018, under the equity method of accounting, the investor must
recognize its share in the net income or losses reported by the investee. In 2018, Company B
recorded net income of $50,000. This was the net income of Company B in 2018. Company
A has 30 percentage ownership in Company B. So $15,000 is Company's A share in the net
income report of Company B. So we will credit equity income and we will debit equity
method investment account, $15,000.
Also at the end of the year, Company B declared and paid $20,000 of dividends. We know
that under the equity method of accounting, dividends received recognizes a decrease in
the investment account. So $20,000 of dividends were declared and paid by Company B.
Company A share of it 30 percentages. So it's $6,000. Since Company A receive this cash,
we will debit cash for $6,000 and we credit the equity method investment. Now, all the
activity under the equity method of accounting was recorded, and we can find the investment
account in the end of the year. So in 12/31/2018's balance sheet, the equity method
investment account is reported in following way. We initially recognize the investment of
$80,000 on
the acquisition date. Then we increase the investment account for the sharing the net income
reported by the equity method investee, and we decrease the investment account for the
dividends received from the investee. So the ending balance of the investment is $89,000. In
2018 income statement, equity income of $15,000 is reported. Equity income is $15,000.
Lesson 1.1 Overview of Accounting for Investment in Equity

Exactly as the investor recognizes each share, in the net income or losses reported by the
equity method investee. The investor must also recognize each share in the other
comprehensive income or losses reported by the investee. So the investor's share in other
comprehensive income amounts reported by the investee is recognized in its own other
comprehensive income, and as an increase or decrease in the investment account.

Now let discuss the differences between IFRS, International Financial Reporting Standards
and US GAAP in respect to significant influence. Under IFRS, the general rule is that
investment over which the investor has significant influence, investment in associates, must
be accounted for using the equity method.
Under IFRS, the fair value option may be applied only by specific types of entities, such as
mutual funds or venture capital organizations.

Under the fair value option, the investment is measured at its fair value on each balance sheet
date. Unrealized holding gains or losses on the changes in the fair value are recognized
directly in the income statement.
Dividends received from the investee are recognized as dividend income.

In case of little or no influence, the accounting method is fair value through net income. If the
fair value is readily determinable, the accounting is very similar to the accounting for fair
value option. It means, the investment again is measured at fair value on each balance sheet
date, unrealized gains or losses on the changes in the fair value are recognized directly in the
income statement and dividends received from the investee are recognized as dividend
income.
However, if the fair value of the investment is not readily determinable, and measurement
alternative may be elected by the investor. For example, the investee is a private company
and the stock listed market prices are not available.

Under the measurement alternative, the investment is measured at its historical cost, minus
any subsequent impairments plus or minus changing resulting from observable price changes
in orderly transactions for identical or similar investments of the same issuer.
So let us see the following example. On January 1 of 2018, Company A acquired 8,000
shares out of a total of 100,000 outstanding shares of common stock of company B. Company
B is a publicly traded company and its listed per share of stock prices on January 1,2018 and
at the end of 2018 were five dollar and eight dollar respectively.

In 2018, company B reported net income of $50,000, and at the end of the year, company B
declared and paid cash dividends of $20,000. So let's solve this problem with the document
we came up with.
As usual first of all, we need to determine the accounting method for the investment in
common stock of company B. So Company A acquired 8,000 shares out a total of 100,000
authentic shares of common stock of company B. So it will be eight percentage of ownership.
In the case of eight percentages, the presumed influence has either no influence or very little
influence. No influence or very little. So because the listed market prices of the shares are
available, they accounting method must be fair value through net income. Fair value through
net income is the accounting method.

The investment is always recorded at its initial cost, the amount company A paid to acquire
the shares of common stock of company B. So on January 1 of 2018, the investment account
is recorded at $40,000. We will debit investment $40,000, and we will credit cash $40,000.
At the end of the reporting period, at the end of the year, the investment must be reported at
its fair value. So the fair value of the investment at the end of the year, will be a dollar per
share. Company A holds 8,000 shares. The market price per share is eight dollar, so it's
$64,000. Then currently, the investment is reported at $40,000. Because initially the
investments was recognized at $40,000 on the acquisition date. So we have an increase in the
investment account of $24,000. Since we have an increase in the investment account, we will
debit the investment account, and again on the measurement, the investment to fair value
must be recognized. So we'll credit gain on the measurement to fair value.

Company B declared and paid $20,000 of dividends. Company A's share of it is eight
percentages. So it is $1,600 of cash was received by Company A. So we'll debit cash and
under the fair value net income method, dividends received are recognized as dividend
income. So dividend income is credited 1,600. So it marked them out the investment is
recorded in the end of the year. We know that in the end of the year their invested must be
reported its fair value. In at the end of the year balance sheet and 12/31/2018 balance sheet,
the investment is reported at its fair value of $64,000. In the income statement, in 2018
income statement, we recognize dividend income of $1.600, and also a gain on the
measurement of the investment to
fair value of $24,000, and gain on the measurement to fair value also of $24,000. So this was
a brief overview of accounting for investment in equity securities. In this course, we will
discuss the accounting for business combinations and situation in which the investor obtains
control more than 50 percentage of ownership over the investee.
Lesson 1.2 Control

In Lesson 2, we will discuss the meaning of control. So first of all, some basic terminology.
Business combination, is a transaction or other event in which an acquirer obtains control of
one or more businesses.

Control or controlling financial interests is the direct or indirect ability to determine the
direction of management and policies through ownership, contracts, or otherwise.
Parent company, is an entity that has a controlling financial interests in one or more
subsidiaries.

Subsidiary company, is an entity in which another entity known as its parent holds a
controlling
financial interests.
Consolidated financial statements, are the financial statements of a consolidated group of
entities that include a Parent and all of its subsidiaries presented as those of a single
economic entity.

It means, even though the Parent and the subsidies are separate legal entities. For financial
accounting purposes, they are considered to be a single economic entity, as if the subsidiary
is a division of the parent company and not a separate entity.
"The usual condition for controlling financial interests is ownership of a majority of voting
interests, and, therefore, as a general rule ownership by one reporting entity,

directly or indirectly of more than 50 percentages of the outstanding voting shares of another
entity is a condition pointing towards consolidation." Generally saying, holding of a majority
of voting interests more than 50 percentage of shares of common stock allows the election of
the majority of the boards of directors of the company, which allows to determine the
direction of management and policies of the company.
In some situations, devoting interested is not sufficient in determining which party as a
controlling financial interest in the company. In these specific cases, a variable interests
model should be applied to identify the primary beneficiary that must consolidate the target
company.

The primary beneficiary is the end of that must consolidate the target company. While the
target company is called the variable interest entity.
So let us see the following example. Company B was formed by issuing 100 shares of
common stock to company A for $1,000 only. But, to finance its operations, Company B took
a loan of five million dollar from company C. In this situation, we clearly can see that
Company C and Company A has more rights to the economic risks that are evolve of
Company B. Thus probably, Company C will be identified as a primary beneficiary, and
company C will need to consolidate Company B.

Direct ownership means that one entity directly holds the shares of common stock of another
entity.
So for example, Company A directly holds 80 percentages of the outstanding shares of
common stock of company B. In this situation, Company A, the Parent company has control
over Company B, the subsidiary, and Company A must report consolidated financial
statements in which it consolidates Company B.

The indirect ownership in another entity exists through the subsidiary of the company.
In this specific case, Company A indirectly through its subsidiary Company B holds the
majority of voting interest in Company C. Thus, in this case, Company A consolidates both
company B and company C.

Now let's see a little bit different structure. We have Company A that holds 40 percentage of
company B, and also 45 percentage of company C, and Company B hold 25 percentages of
company C.
So what do you think? Should Company A consolidate company B and Company C or not?

In this case, Company A has only direct ownership of 40 percentages in company B, and
direct ownership of 45 percentages in Company C. Thus company A will not consolidate
Company B and Company C. Company A has no direct ownership and Company C, since
company a does not control Company B.
However, if Company A was holding 60 percentage of company B, then it will consolidate
companies B and C. Now Company A controls Company B because it holds more than 50
percentage of ownership in company B, and also controls Company C. Company A has 70
percentage of voting interest in company C, 45 percentage is directly, and 25 percentages
indirectly through its subsidiary Company B.
Lesson 1.3 Scope of ASC 805 – “Business Combinations”

In less than 3, we will discuss the scope of accounting standard codification 805 business
combinations. Acquisition of a company, or a group of assets is accounted for in accordance
with accounting standard codification 805 business combinations guidance, only if the
company, or the group of assets acquired meets the definition of a business.
A business is an integrated set of activities and assets that is capable of being conducted and
managed for the purpose of providing a return in the form of dividends, lower costs, or any
other economic benefits directly to investor, or other owners, members, or participants. This
definition is definitely too general.

Let's discuss the elements of the business. A business consists of inputs and processes applied
to those inputs that have the ability to contribute to the creation of outputs. So we can see that
the three elements of a business as defined by FASB codification 805, our input process, and
output.
Businesses usually have outputs. However, outputs are not required for an integrated set to
qualify as a business. For example, a development stage entity can be a business although it
currently has no outputs at all.

Input is an economic resource that creates, or has the ability to contribute to the creation of
output when one or more processes are applied to it. For example, some tangible and
intangible assets acquired is an example of an input.
Process is a system, standard, protocol, convention, or rule that when applied to an input,
create or has the ability to contribute to the creation of outputs. For example, operational
processes and resource management processes.

Output is the results of inputs and processes that provide goods, or services to customers,
investment income such as dividends, or interest, or any other revenues.
When we acquire a company, or a group of assets, we need to determine whether this group
of assets constitutes a business or not. In order to do so, we will apply the business test.

In step number 1 of the business test, we need to ask the following question. Is substantially
all of the fair value of the gross assets acquired concentrated in a single identifiable assets, or
group of similar identifiable assets? If the answer to this question is yes, this is not the
business, this is a regular acquisition of group of assets. But if the answer to this question is
No, we need to ask the second question. Were the input and substantive process that
significantly contribute to the ability to create output acquired? Again, if the answer to this
question is No, it's not a business, it's irregular acquisition group of assets. But if the answer
to this question is yes, the group of assets constitute a business and we are seeing the scope of
accounting standard codification 805. So basically, this was the test to determine whether a
group of assets acquired constitute the business. In the I engagement part of the course, we
will discuss the business test more in depths.
Lesson 1.4 Acquisition of a Group of Assets

In Lesson 4, we will discuss the accounting for assets acquisition. Why was it so important to
determine whether the group of assets acquired constitutes a business or not? It was so
important because it will affect the accounting for this acquisition. If it was a business, we
will apply the accounting standards codification 805 guidance, the business combinations.
We will discuss in depth in this course, the accounting for business combination. But if the
group of assets acquired does not constitute a business, you'll account for this transaction as a
regular asset acquisition.
In a regular asset acquisition, the cost of the group of assets acquired must be allocated to the
individual assets acquired and liabilities assumed based on their relative fair values, and it
must not give rise to goodwill.

Direct acquisition costs, in case of assets acquisition, are included in the total cost of the
group of assets acquired. Thus, direct acquisition costs are capitalized to the cost of assets
acquired based on their relative fair values.
Now, let's see an example of an accounting for asset acquisition. On January 1 of 2019,
company A purchased a component of company B for $75,000. The component includes the
following assets: equipment, building, and patent with fair values of $50,000, $30,000, and
$20,000 respectively.

Transaction cost of $5,000 were incurred by a company A. Now, assume that this component,
this group of assets, is not a business, as was defined in the accounting standards codification
805.
The purchase price of $75,000 and the transaction costs of $5,000 are allocated to the
individual assets acquired based on their relative fair values. So at what amounts the asserts
acquires are recognized on the acquisition date?

As we said, the cost of the assets acquired and the transaction costs are allocated to the assets
acquired based on their relative fair values. So the fair value of the equipment was $50,000,
the fair value of the building was $30,000, and the fair value of the patent was $20,000. The
total fair value of all the assets was $100,000. The fair value of the equipment of $50,000 out
of
a total of $100,000, the total fair value of all the asset will be 50 percentages. The same idea
for the building, 30,000 fair value of the building out of a total of fair value of $100,000
will be 30 percentages. The same idea for the patents. The direct acquisition costs and the
cost of the group of assets acquired together will be $80,000. So equipment is recognized at
$40,000, building is recognized at $24,000, and the patent is recognized at $16,000. All in all,
the entire group of assets acquired and the transaction cost will be $80,000.

So verge on entry should be recorded on the acquisition date. First of all, we paid $80,000 to
acquire the group of assets and the direct acquisition cost. So we're going to credit cash
$80,000, and then we will debit all the assets acquired. The equipment is debited for $40,000,
the building is debited for $24,000, and the patents will be debited at $16,000.

The accounting for assets acquisition and business combination is absolutely different. So the
following are the major differences between business combinations and asset acquisition:
direct acquisition cost in a business combination will be expensed as incurred. In an asset
acquisition, direct acquisition costs are capitalized to assets' cost based on the relative fair
values.
Goodwill, goodwill and intangible assets can be recognized only in the business combination.
Goodwill is never recognized in an asset acquisition.

Initial recognition of assets and liabilities: in a business combination, identifiable assets

acquired and liabilities assumed are recognized as the acquisition date fair values. In an asset
acquisition, allocation of cost based on relative fair values. In addition, some intangible assets
can be recognized only in the business combination, but not in a regular asset acquisition. For
example, in process research and development asset, it can be recognized only in the business
combination, and not in asset acquisition.
Using the data from the previous example, let's assume that company A paid $115,000 for the
component acquired from company B, and

let's assume the component acquired also includes the trained employees that perform all the
necessary strategic and management processes that create output. So now, in this specific
case, the group of assets acquired is a business. So we're visiting the scope of accounting
standards codification 805, so we must apply the business combinations guidance.
First of all, if it's a business combination, direct acquisition related cost of $5,000 must be
expensed as incurred. So we're going to credit cash. We paid cash of $5,000, and we're going
to debit an expense, acquisition related cost, which is an expense for $5,000.

Also, in a business combination, all the identifiable assets acquired are recognized at their
acquisition date fair values.
So verge of entry will be recorded in case of business combination. We paid cash of
$115,000, so cash is credited. Then the assets acquired are recognized based on the
acquisition date fair values. The fair value of the equipment was $50,000, the fair value of the
building was $30,000, and the fair value of the patents was $20,000. But so far, the journal
entry is not balanced. In a business combination, the excess of the fair value of consideration
transfer, the cash of $115,000, or the fair value of identifiable net assets acquired of $100,000
is recognized as goodwill. Thus, goodwill is debited for $15,000. Goodwill is an intangible
asset that is recognized only in the business combination. In Module 2, we will discuss way
more in depth how to calculate goodwill using the goodwill equation.