Chapter 7

Consolidated Financial
Statements:
Subsequent to Date of
Business Combination

McGrawHill/Irwin

TheMcGrawHillCompanies,Inc.2006

Scope of Chapter
Accounting

for operating results of both wholly

owned and partially owned subsidiaries is
described and illustrated.
Accounting for inter-company transactions not
involving a profit (gain) or a loss, as well as
those involving a profit or a loss, are dealt with.

Accounting For Operating Results

Of Wholly Owned Subsidiaries
Accounting

for operating results of

consolidated subsidiaries, a parent
company may choose either of the two
methods:
Equity Method of Accounting
Cost Method of Accounting

Equity Method
Parent company recognizes its share of the
subsidiarys net income or net loss
Adjusted for depreciation and amortization of
differences between current fair values and
carrying amounts of a subsidiarys identifiable net
assets on the date of business combination
Share of dividends declared by the subsidiary.

Equity Method
Equity

method of accounting is quite similar

to home office accounting for a branchs
operations.
Proponents claim that equity method
stresses the economic substance of the
parent-subsidiary relationship.
Dividends declared by a subsidiary do not
constitute revenue to the parent company.
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Equity Method
Proponents

of the method maintain that the

method is consistent with the accrual basis of
accounting
It recognizes increases or decreases in the
carrying amount of the parent companys
investment in the subsidiary
When they are realized by the subsidiary as net
income or net loss, not when they are paid by
the subsidiary as dividends.
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Cost Method
Parent

company accounts for the operations of

a subsidiary only to the extent that dividends
are declared by the subsidiary.
Net income or net loss of the subsidiary is not
recognized by the parent company.
Supporters of the method contend that the
method appropriately recognizes the legal form
of parent subsidiary relationship.
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Cost Method
Dividends

declared by subsidiary are

recognized as revenue by the parent
company.
Dividends declared by subsidiary in excess
of post-combination net income constitute a
reduction of the carrying amount of the
parent companys investment in the
subsidiary.
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Cost Method
According

to the proponents of the cost

method, a parent company realizes revenue
from an investment in a subsidiary when the
subsidiary declares dividend
Not when the subsidiary reports net income.

Choosing Between Equity Method

And Cost Method
Consolidated

financial statement amounts are

the same, regardless of which method is used
to account for subsidiarys operations.
Working paper eliminations used in the two
methods are different.

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Working Paper Eliminations for

Equity Method
Three

components of the subsidiarys stock

holders equity are reciprocal to the parent
companys Investment Ledger Account.
Subsidiarys beginning-of-year retained
earnings amount is eliminated.
Subsidiarys dividends are an offset to the
subsidiarys retained earnings.
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Working Paper Eliminations for

Equity Method
Balance

of the parent companys

Investment Ledger Account is net of the
dividends received from the subsidiary.
Elimination of the subsidiarys beginning-ofyear retained earnings makes beginning-ofyear consolidated retained earnings
identical to the end-of-previous-year
consolidated retained earnings.
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Working Paper Eliminations for

Equity Method
Debits

to the subsidiarys plant assets,

patent, and goodwill bring into the
consolidated balance sheet the unamortized differences between current
fair values and carrying amounts of the
subsidiarys assets on the date of the
business combination.

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Working Paper Eliminations for

Equity Method
Amount

of the parent companys intercompany investment income is an

element of the balance of the parents
Investment Ledger Account.

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Working Paper Eliminations for

Equity Method
In

effect, the elimination of the intercompany investment income comprises

a reclassification of the inter-company
investment income to the adjusted
components of the subsidiarys net
income in the consolidated income
statement.

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Working Paper Eliminations for

Equity Method
Increases

in the subsidiarys cost of

goods sold and operating expenses, in
effect, reclassify the comparable
decrease in the parent companys
Investment ledger account under the
equity method of accounting.

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Emphasized Aspects of
Working Paper
Inter-company

receivable and payable,

placed in adjacent columns on the same
line, are offset without a formal elimination.
Elimination cancels all inter-company
transactions and balances not dealt with by
the offset described above.

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Emphasized Aspects of
Working Paper
Elimination

cancels the subsidiarys retained

earnings balance at the beginning-of-year
FIFO is used by subsidiary to account for
inventories;
Difference

attributable to subsidiarys beginning inventories

is allocated to cost of goods sold for the year ended

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Emphasized Aspects of
Working Paper
Income

tax effects of the eliminations

increase in subsidiarys expenses are not
included in the elimination.
One of the effects of the elimination is to
reduce the differences between the current
fair values and the carrying amounts of the
subsidiarys net assets
excepting

land and goodwill, on the business

combination date.

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Emphasized Aspects of
Working Paper

Parent companys use of the equity method of

accounting results in the equalities described
below:

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Parent Company Net Income = Consolidated Net Income.

Parent Company Retained Earnings = Consolidated Retained Earnings.

Despite the equalities, consolidated financial

statements are superior to parent company
financial statements for the presentation of
financial position and operating results of parent
and subsidiary companies.

Closing Entries

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After consolidated financial statements have been

completed, both the parent and its subsidiary
companies prepare and post closing entries, to
complete the accounting cycle for the year.
Subsidiarys closing entries are prepared in the usual
fashion.
Parent companys use of equity method of accounting
necessitates specialized closing entries.

Closing Entries
Equity

method of accounting disregards legal

form in favor of economic substance
State corporation laws generally require
separate accounting for retained earnings
available for dividends to stockholders.

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Accounting for Operating Results

of Partially Owned Subsidiaries
Accounting

for the operating results of a

partially owned subsidiary requires the
computation of the minority interest in net
income or net losses of the subsidiary.

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Accounting for Operating Results

of Partially Owned Subsidiaries
Under

the economic unit concept, the

consolidated income statement of a
parent company and its partially owned
subsidiaries includes an allocation of
total consolidated income to the parent
company and the minority interest.

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Concluding Comments
In

todays financial accounting

environment, the equity method of
accounting for a subsidiarys operations is
preferable to the cost method for the
following reasons:
The

equity method is consistent with the accrual basis of

accounting
Emphasizes economic substance of the parent company
subsidiary relationship, while the cost method
emphasizes legal form.

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Concluding Comments

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Equity method permits the use of parent company

journal entries to reflect many items that must be
included in working paper eliminations in the cost method
Formal journal entries in the accounting records provide
a better record than do working paper eliminations.
Equity method facilitates issuance of separate financial
statements, if required by SEC regulations or other
considerations.
Equity method provides a useful self checking technique.