Chapter Two CONSOLIDATION AT THE DATE OF ACQUISITION

Consolidated Financial Statements

Required since Accounting Research Bulletin (ARB) No. 51 (1959) Allowed exclusions for a variety of reasons Statement of Financial Accounting Standards No. 94, Consolidation of All Majority-Owned Subsidiaries eliminated the exclusions except: When control is temporary When control does not reside with the majority owner

Consolidated Financial Statements Weaknesses

Diverse businesses are more difficult to interpret Weak performers are more difficult to identify Consolidations make it difficult to compare entities to industry standards Financial ratios do not represent any particular part of the entity

Purchase Method
Investment account is recorded at the market value given Investment account represents ownership percentage of subsidiarys underlying assets and liabilities acquired

Consolidation Procedures Primary Objectives

To present on a combined basis The detailed asset, liability, and net worth position represented by the parent companys separate books, plus The individual values of the subsidiarys assets and liabilities acquired

Consolidation Issues
Acquisition Price (at book value or more than book value) Acquisition Timing (at beginning of year or during the year) Percent of subsidiary acquired (100% or less than 100%)

Worksheet Procedures
Worksheet eliminations are not posted Parent investment account and subsidiary equity accounts exactly offset when 100% of subsidiary stock is acquired, and Price paid equals subsidiarys book values

Investment Account and Subsidiary Equity Elimination

Investment account eliminated because
subsidiarys individual assets and liabilities are included instead parents net worth includes the investment in subsidiary value Consolidated statements are prepared for Parent Company stockholders

Subsidiary equity eliminated because

Acquisition Price Equals Book Value

Market value of subsidiary assets and liabilities equals book values Investment account balance exactly equals sum of Subsidiary equity accounts Subsidiary equity may include Preacquisition Earnings if acquisition is during year

Acquisition Price Equals Book Value

Consolidated revenues, expenses, assets, and liabilities are found by summing parent and subsidiary book value amounts

Acquisition Price Equals Book Value

Worksheet Elimination: Common Stock 1,000 Add Paid-in Cap 750 Retained Earnings 250 Invest in Sterling 2,000 Investment credit equals subsidiary equity accounts debited in acquisition at book value case

Acquisition Price Exceeds Book Value

Market value of subsidiarys assets and liabilities acquired become book value to consolidated entity
Purchase price for 100% Less: book value acquired Purchase Differential

Acquisition Price Exceeds Book Value

Purchase differential is first allocated to identifiable individual assets and liabilities having market greater than book value Any remaining purchase differential is either positive or negative goodwill

Reasons Negative Goodwill Exists

Something inherent that reduces overall company value such as rates of return below market expectations or pending litigation Estimation error on market value appraisals

Acquisition Price Exceeds Book Value (contd)

Example (Illustration 4) Purchase price - book value = purchase differential 2,400,000 - 2,000,000 = 400,000
Allocation: Inventory 130 (Illustration 3) P, P, and E 350 (000s omitted) Patents (200) Bonds Payable (105) Goodwill (400 175)

175 225

Acquisition Price Exceeds Book Value

Worksheet Elimination 4 (000s omitted) Common Stock 1,000 Add Paid-in Cap 750 2,000 BV Retained Earnings 250 Inventory 130 Prop, Plant, and Equip 350 MV>BV Goodwill 225 400 Patents 200 Discount on Bonds Pybl 105 Investment in Sterling 2,400

Acquisition at Beginning of Year

Worksheet includes only the balance sheet Only time when a worksheet elimination of Retained Earnings is made directly to the balance sheet account

Acquisition of Less Than 100%

For a business combination to exist, control of the subsidiary must be achieved Subsidiary stockholders not in control are called noncontrolling interest

Acquisition of Less Than 100%

Theories of consolidation Proportionate consolidation concept Parent company concept (current GAAP) Economic unit concept

Acquisition of Less Than 100%

Proponents of all three consolidation concepts agree that the parents ownership share of the following should be included in the consolidated financial statements: Revenues and Expenses Assets and Liabilities, including goodwill paid to acquire the subsidiary

Proportionate Consolidation Concept

Ownership is essential to recognition in the consolidated financial statements Consolidated statements prepared only for parent company stockholders Noncontrolling interest is not disclosed Eliminate noncontrolling interest share of subsidiary accounts in consolidation worksheet

Parent Company Concept

Ownership and control are essential to recognition in consolidated financial statements Subsidiary assets and liabilities recognized as a hybrid of Market values for the percentage acquired by the parent company book values for the percentage not acquired

Parent Company Concept

Asset and liability market value recognition based on verifiable transaction for the part acquired Noncontrolling interest should be disclosed in a separate category between liabilities and owners equity

Parent Company Concept

Consolidated income statement should include all revenues and expenses Subtract income to noncontrolling interest to determine consolidated net income

Economic Unit Concept

Control is essential to recognition in the consolidated financial statements Full market value of subsidiary assets and liabilities included on consolidated balance sheet All of subsidiarys revenues and expenses are included on the consolidated income statement

Economic Unit Concept

Consolidated net income is calculated and then divided between parent company and noncontrolling interest Noncontrolling interest is disclosed in the equity section of the consolidated balance sheet Two approaches to recognizing goodwill: full goodwill and purchased goodwill

Economic Unit Concept Full Goodwill

Total goodwill is imputed and recorded Example: parent identifies goodwill of $60,000 in a 75% acquisition. Total goodwill is imputed: .75(total goodwill) = 60,000 total goodwill = 60,000/.75 total goodwill = $80,000

Economic Unit Concept Purchased Goodwill

Only parents goodwill is recognized on the consolidated balance sheet Argues that estimation of noncontrolling interest portion of goodwill is too unreliable FASB proposal chooses full goodwill approach

Acquisition of Less Than 100%

Purchase differential recognized on the consolidated balance sheet is full imputed market value of subsidiary net assets including goodwill

Acquisition of Less Than 100%

Noncontrolling Interest is created in equity section of consolidated balance sheet
Noncontrolling interest ALWAYS equals subsidiary imputed market value X noncontrolling interest percentage

Acquisition of Less Than 100% During the Year

Both subsidiary preacquisition earnings, and current year dividends prior to acquisition are eliminated because they reduce subsidiary equity and have not been closed to Retained Earnings This procedure is same for 100% and less than 100% ownership

Noncontrolling Interest Recognition (000s omitted)

(From Illustration 12)
Common Stock 1,000 Add Paid-in Cap 750 Retained Earnings 160 Preacquisition Earnings 90 Purchase Differentials 400 2,400 MV Investment in Sterling
Noncontrolling Interest Dividends (if any) 2,000 BV

2,160 240 XX

Consolidated Financial Statements - Strength

Includes detailed reporting of significant revenue and expenses, assets and liabilities, cash receipts and payments

Purchase and Pooling of Interests

Fundamental difference: assumption regarding ownership Purchase method Assumes there is a change in ownership Arms length transaction for market value Change in ownership may result in asset and liability revaluation

Purchase and Pooling of Interests

Pooling of interests method:
Uniting of ownership interests No acquisition for market value assumed Assets and liabilities accounted for at book value

Purchase and Pooling of Interests

Pooling of interests method:
Pooling of interests method was discontinued in 2001 Existing combinations that used pooling were grandfathered

Using a Separate Accumulated Depreciation Account

Special procedures are necessary to consolidate when depreciable fixed assets are not reported net of accumulated depreciation View asset as if newly purchased at market value

Using a Separate Accumulated Depreciation Account

In worksheet elimination:

Eliminate existing balance in Accumulated Depreciation Adjust historical cost to market

Push-Down Accounting
Securities and Exchange Commission requirement for some subsidiaries when Subsidiary issues separate statements Large percentage owned by parent
Subsidiarys net assets must be reported based on market values estimated as a result of the acquisition