ADVANCE ACCOUNTING Ch03

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Consolidated Financial Consolidated Financial Statements—Date of AcquisitionStatements—Date of Acquisition

Advanced Accounting, Fifth Edition

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1. Understand the concept of control as used in reference to consolidations.2. Explain the role of a noncontrolling interest in business combinations.3. Describe the reasons why a company acquires a subsidiary rather than its

net assets.4. Describe the valuation and classification of accounts in consolidated

financial statements.5. List the requirements for inclusion of a subsidiary in consolidated financial

statements.6. Discuss the limitations of consolidated financial statements.7. Record the investment in the subsidiary on the parent’s books at the date

of acquisition.8. Prepare the consolidated workpapers and eliminating entries at the date of

acquisition.9. Compute and allocate the difference between implied value and book

value of the acquired firm’s equity.10. Discuss some of the similarities and differences between U.S. GAAP and

IFRS with respect to the preparation of consolidated financial statements at the date of acquisition.

Learning ObjectivesLearning Objectives

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Chapter Focus - Accounting for Stock AcquisitionsWhen one company controls another company through direct or indirect ownership of its voting stock.

Stock AcquisitionStock Acquisition

Acquiring company referred to as the parent.

Acquired company referred to as the subsidiary.Other shareholders considered noncontrolling interest.Parent records interest in subsidiary as an investment.If a subsidiary owns a controlling interest in one or more other companies, a chain of ownership is forged by which the parent company controls other companies.

LO 2 Noncontrolling interest (NCI).LO 2 Noncontrolling interest (NCI).

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The Securities and Exchange Commission defines a subsidiary as an affiliate controlled by another entity, directly or indirectly, through one or more intermediaries.

Control means the possession, direct or indirect, of the power to direct management and policies of another entity, whether through the ownership of voting shares, by contract, or otherwise.

Definitions of Subsidiary and ControlDefinitions of Subsidiary and Control

LO 1 Meaning of control.LO 1 Meaning of control.

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Control using U.S. GAAP:

the direct or indirect ability to determine the direction of management and policies

through ownership, contract, or otherwise

FASB ASC paragraph 810-10-15-8 states:

the usual condition for a controlling financial interest is ownership of a majority voting interest



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However, application of the majority voting interest requirement may not identify the party with a controlling financial interest because the controlling financial interest may be achieved through arrangements that do not involve voting interests.

The first step in determining whether the financial statements should be consolidated is to determine if the reporting entity has a variable interest in another entity, referred to as a potential variable interest entity (VIE).



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Definitions of ControlDefinitions of Control


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Requirements for the Inclusion of Requirements for the Inclusion of Subsidiaries in the Consolidated Subsidiaries in the Consolidated Financial StatementsFinancial Statements

LO 5 Requirements regarding consolidation of subsidiaries.LO 5 Requirements regarding consolidation of subsidiaries.

Purpose of consolidated statements - to present the operating results and the financial position of a parent and all its subsidiaries as if they are one economic entity.

Circumstances when majority-owned subsidiaries should be excluded from the consolidated statements:

1. Control does not rest with the majority owner.

2. Subsidiary operates under governmentally imposed uncertainty so severe as to raise significant doubt about the parent’s control.

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Advantages to acquiring a controlling interest in another company.

Reasons For Subsidiary CompaniesReasons For Subsidiary Companies

1. Stock acquisition is relatively simple.2. Control of subsidiary can be accomplished with a

smaller investment.3. Separate legal existence of affiliates provides an

element of protection of the parent’s assets.

LO 3 Acquiring assets or stock.LO 3 Acquiring assets or stock.

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Statements prepared for a parent company and its subsidiaries are called consolidated financial statements.

Consolidated Financial StatementsConsolidated Financial Statements

Ignore legal aspects of separate entities, focus on economic entity under “control” of management.Substance rather than form.Not substitute for statements prepared by separate subsidiaries, which may be used by:

Creditors Noncontrolling stockholders Regulatory agencies

LO 4 Valuation and classification of subsidiary assets and LO 4 Valuation and classification of subsidiary assets and liabilities.liabilities.

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Investments at the Date of AcquisitionInvestments at the Date of Acquisition

LO 7 Recording of investment at acquisition.LO 7 Recording of investment at acquisition.

Recording Investments at Cost (Parent’s Books)Stock investment is recorded at cost as measured by

fair value of the consideration given or consideration received, whichever is more clearly evident.

Consideration given may include cash, other assets, debt securities, stock of the acquiring company.

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E3-2: On January 1, 2011, Polo Company purchased 100% of the common stock of Save Company by issuing 40,000 shares of its (Polo’s) $10 par value common stock with a market price of $17.50 per share. Polo incurred cash expenses of $20,000 for registering and issuing the common stock. The stockholders’ equity section of the two company’s balance sheets on December 31, 2010, were:

Common stock, $10 par value $350,000 $320,000Other contributed capital 590,000 175,000Retained earnings 380,000 205,000

Polo Save



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E3-2: Prepare the journal entry on the books of Polo Company to record the purchase of the common stock of Save Company and related expenses.

Investment in Save (40,000 x $17.50) 700,000Common Stock

400,000 Other Contributed Capital 300,000

Other Contributed Capital 20,000Cash

20,000



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Assets and liabilities are summed, regardless of whether the parent owns 100% or a smaller controlling interest.

Consolidated Balance Sheets: Use of Consolidated Balance Sheets: Use of WorkpapersWorkpapers

Noncontrolling interests (NCI) are reflected as a component of owners’ equity.Eliminations must be made to cancel the effects of transactions among the parent and its subsidiaries.A workpaper is frequently used to summarize the effects of various additions and eliminations.

LO 8 Preparing consolidated statements using a workpaper.LO 8 Preparing consolidated statements using a workpaper.

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LO 8 Preparing consolidated statements using a workpaper.LO 8 Preparing consolidated statements using a workpaper.

Intercompany receivable (payable) Intercompany payable (receivable)AgainstAdvances to subsidiary (from subsidiary) Advances from parent (to parent)Against

Interest revenue (interest expense) Interest expense (interest revenue)AgainstDividend revenue (dividends declared)

Dividends declared (dividend revenue)Against

Management fee received from subsidiary Management fee paid to parentAgainst

Sales to subsidiary (purchases of inventory from subsidiary)

Purchases of inventory from parent (sales to parent)Against

Parent’s Accounts Subsidiary’s Accounts

Investment in subsidiary Equity accountsAgainst

Intercompany Accounts to Be Eliminated

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Investment EliminationIt is necessary to eliminate the investment account of the parent company against the related stockholders’ equity of the subsidiary to avoid double counting of these net assets.

When parent’s share of subsidiary’s equity is eliminated against the investment account, subsidiary’s net assets are substituted for the investment account in the consolidated balance sheet.


LO 8 Investment is eliminated for consolidated statements.LO 8 Investment is eliminated for consolidated statements.

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Investment Elimination


LO 9 Computing and allocating the LO 9 Computing and allocating the difference between implied and difference between implied and book value (CAD).book value (CAD).

“Computation and Allocation of Difference between Implied Value and Book Value”

Step 1: Determine percentage of stock acquired.Step 2: Divide purchase price by the percentage

acquired to calculate the implied value of the subsidiary.

Step 3: Difference between step 2 and book value of subsidiary’s equity must be allocated to adjust the underlying assets and liabilities of the acquired company.

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The prior steps lead to the following possible cases:Case 1. The implied value (IV) of the subsidiary is equal to the book

value of the subsidiary’s equity (IV = BV), anda. The parent company acquires 100% of the subsidiary’s stock; orb. The parent company acquires less than 100% of the subsidiary’s stock.

Case 2. The implied value of the subsidiary exceeds the book value of the subsidiary’s equity (IV > BV), anda. The parent company acquires 100% of the subsidiary’s stock; orb. The parent company acquires less than 100% of the subsidiary’s stock.

Case 3. The implied value of the subsidiary is less than the book value of the subsidiary’s equity (IV < BV), anda. The parent company acquires 100% of the subsidiary’s stock; orb. The parent company acquires less than 100% of the subsidiary’s stock.

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Case 1(a): Implied Value of Subsidiary Is Equal to Book Value of Subsidiary Company’s Equity (IV BV)—100% of Stock Acquired.



Illustration: Assume that on January 1, 2013, P Company acquired all the outstanding stock (10,000 shares) of S Company for cash of $160,000. What journal entry would P Company make to record the shares of S Company acquired?

Investment in S Company $160,000Cash

$160,000

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Balance Sheet P Company S CompanyCash 40,000$ 40,000$ Other current assets 280,000 100,000 Plant and equipment 240,000 80,000 Land 80,000 40,000 Investment in Sill 160,000

Total assets 800,000$ 260,000$

Liabilities 120,000$ 100,000$ Common stock 400,000 100,000 Other Contributed capital 80,000 20,000 Retained earnings 200,000 40,000

Total Liab. and Equity 800,000$ 260,000$

Case 1(a): The balance sheets of both companies immediately after the acquisition of shares is as follows:



Price paid $160,000% acquired 100%Implied value 160,000Book value 160,000Difference $0

Implied value = Book value

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Case 1(a): The workpaper to consolidate the balance sheets for P and S on Jan. 1, 2013, date of acquisition, is presented below:



ConsolidatedBalance Sheet P Company S Company Debit Credit BalancesCash 40,000$ 40,000$ 80,000$ Other current assets 280,000 100,000 380,000 Plant and equipment 240,000 80,000 320,000 Land 80,000 40,000 120,000 Investment in Sill 160,000 160,000

Total assets 800,000$ 260,000$ 1,060,000$

Liabilities 120,000$ 100,000$ 220,000$ Common stock 400,000 100,000 500,000 Other Contributed capital 80,000 20,000 100,000 Retained earnings 200,000 40,000 240,000

Total Liab. and Equity 800,000$ 260,000$ 1,060,000$

Eliminations

Adjusting and eliminating entries are made on the workpaper for the preparation of consolidated statements.

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ConsolidatedBalance Sheet P Company S Company Debit Credit BalancesCash 40,000$ 40,000$ 80,000$ Other current assets 280,000 100,000 380,000 Plant and equipment 240,000 80,000 320,000 Land 80,000 40,000 120,000 Investment in Sill 160,000 160,000 -

Total assets 800,000$ 260,000$ 900,000$

Liabilities 120,000$ 100,000$ 220,000$ Common stock 400,000 100,000 100,000 400,000 Other Contributed capital 80,000 20,000 20,000 80,000 Retained earnings 200,000 40,000 40,000 200,000

Total Liab. and Equity 800,000$ 260,000$ 160,000$ 160,000$ 900,000$

Eliminations

Case 1(a): The workpaper to consolidate the balance sheets for P and S on Jan. 1, 2013, date of acquisition, is presented below:

Solution on notes page

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Case 1(a): The workpaper entry to eliminate S Company’s stockholders’ equity against the investment account is:



Common stock (S) 100,000Other contributed capital (S) 20,000Retained earnings (S) 40,000

Investment in S Company 160,000

This is a workpaper-only entry.

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Case 1(a): Note the following on the workpaper.



1. The investment account and related subsidiary’s stockholders’ equity have been eliminated and the subsidiary’s net assets substituted for the investment account.

2. Consolidated assets and liabilities consist of the sum of the parent and subsidiary assets and liabilities in each classification.

3. Consolidated stockholders’ equity is the same as the parent company’s stockholders’ equity.

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Case 1(b): Parent’s Cost of Investment Is Equal to Book Value of Subsidiary’s Stock Acquired (IV=BV) - Partial Ownership.



Illustration: Assume that on January 1, 2013, P Company acquired 90% (9,000 shares) of the stock of S Company for $144,000. What journal entry would P Company make to record the shares of S Company acquired?


$144,000

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Balance Sheet P Company S CompanyCash 56,000$ 40,000$ Other current assets 280,000 100,000 Plant and equipment 240,000 80,000 Land 80,000 40,000 Investment in Sill 144,000

Total assets 800,000$ 260,000$

Liabilities 120,000$ 100,000$ Common stock 400,000 100,000 Other Contributed capital 80,000 20,000 Retained earnings 200,000 40,000 Noncontrolling interest


Case 1(b): The balance sheets of both companies immediately after the acquisition of shares is as follows:

Price paid $144,000% acquired 90%Implied value 160,000Book value 160,000Difference $0


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90% 10%Parent Noncontrolling TotalShare Share Value

Purchase price and implied value 144,000$ 16,000$ 160,000$ Less: Book value of equity acquired:

Common stock 90,000 10,000 100,000 Other contributed capital 18,000 2,000 20,000 Retained earnings 36,000 4,000 40,000 Total book value 144,000$ 16,000$ 160,000$

Difference between implied and book value -$ -$ -$

Case 1(b): Computation and Allocation of Difference between Implied and Book Values:

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ConsolidatedBalance Sheet P Company S Company Debit Credit BalancesCash 56,000$ 40,000$ 96,000$ Other current assets 280,000 100,000 380,000 Plant and equipment 240,000 80,000 320,000 Land 80,000 40,000 120,000 Investment in Sill 144,000 144,000

Total assets 800,000$ 260,000$ 1,060,000$

Liabilities 120,000$ 100,000$ 220,000$ Common stock 400,000 100,000 500,000 Other Contributed capital 80,000 20,000 100,000 Retained earnings 200,000 40,000 240,000 Noncontrolling interest -

Total Liab. and Equity 800,000$ 260,000$ 1,060,000$

Eliminations

Case 1(b): The workpaper to consolidate the balance sheets for P and S on Jan. 1, 2013, date of acquisition, is presented below:

Solution on notes page

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ConsolidatedBalance Sheet P Company S Company Debit Credit BalancesCash 56,000$ 40,000$ 96,000$ Other current assets 280,000 100,000 380,000 Plant and equipment 240,000 80,000 320,000 Land 80,000 40,000 120,000 Investment in Sill 144,000 144,000 -

Total assets 800,000$ 260,000$ 916,000$

Liabilities 120,000$ 100,000$ 220,000$ Common stock 400,000 100,000 100,000 400,000 Other Contributed capital 80,000 20,000 20,000 80,000 Retained earnings 200,000 40,000 40,000 200,000 Noncontrolling interest 16,000 16,000


Eliminations


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Case 1(b): The workpaper entry to eliminate S Company’s stockholders’ equity against the investment account is:




Investment in S Company 144,000Noncontrolling interest in equity 16,000

(establish the NCI)

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Case 2(b): Implied Value Exceeds Book Value of Subsidiary Company’s Equity (IV>BV)—Partial Ownership.





$148,000

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Balance Sheet P Company S CompanyCash 52,000$ 40,000$ Other current assets 280,000 100,000 Plant and equipment 240,000 80,000 Land 80,000 40,000 Investment in Sill 148,000 Difference (IV>BV)

Total assets 800,000$ 260,000$




Price paid $148,000% acquired 80%Implied value 185,000Book value 160,000Difference $25,000


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Difference between implied and book value 20,000$ 5,000$ 25,000$ Land revaluation (mark to market) (20,000) (5,000) (25,000) Balance -$ -$ -$


We assume the entire difference is attributable to land with a current value higher than historical

cost.

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ConsolidatedBalance Sheet P Company S Company Debit Credit BalancesCash 52,000$ 40,000$ 92,000$ Other current assets 280,000 100,000 380,000 Plant and equipment 240,000 80,000 320,000 Land 80,000 40,000 25,000 145,000 Investment in Sill 148,000 148,000 - Difference (IV>BV) 25,000 25,000 -

Total assets 800,000$ 260,000$ 937,000$



Eliminations


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Case 2(b): The workpaper (elimination) entries are as follows:



Common stock (S) 100,000Other contributed capital (S) 20,000Retained earnings (S) 40,000Difference between IV and BV 25,000

Investment in S Company 148,000Noncontrolling interest in equity 37,000

#1

Land 25,000 Difference between IV and BV

25,000

#2

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Case 2(b): Reasons an Acquiring Company May Pay More Than Book Value.



1. Fair value of specific tangible or intangible assets of the subsidiary may exceed its recorded value because of appreciation.

2. Excess payment may indicate existence of goodwill.

3. Liabilities, generally long-term, may be overvalued.

4. A variety of market factors may affect the price paid.

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Case 3(b): Implied Value of Subsidiary is Less Than Book Value (IV<BV)—Partial Ownership.





$120,000

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Balance Sheet P Company S CompanyCash 80,000$ 40,000$ Other current assets 280,000 100,000 Plant and equipment 240,000 80,000 Land 80,000 40,000 Investment in Sill 120,000 Difference (IV<BV)

Total assets 800,000$ 260,000$




Price paid $120,000% acquired 80%Implied value 150,000Book value 160,000Difference $10,000


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Difference between implied and book value (8,000)$ (2,000)$ (10,000)$ Plant & equipment (mark to market) 8,000 2,000 10,000 Balance -$ -$ -$


Assume the difference is attributable to plant and equipment, in this case an overvaluation of

$10,000.

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ConsolidatedBalance Sheet P Company S Company Debit Credit BalancesCash 80,000$ 40,000$ 120,000$ Other current assets 280,000 100,000 380,000 Plant and equipment 240,000 80,000 320,000 Land 80,000 40,000 10,000 110,000 Investment in Sill 120,000 120,000 - Difference (IV>BV) 10,000 10,000 -

Total assets 800,000$ 260,000$ 930,000$



Eliminations


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Case 3(b): The workpaper (elimination) entries are as follows:




Difference between IV and BV 10,000Investment in S Company

120,000Noncontrolling interest in equity 30,000

#1

Difference between IV and BV 10,000 Plant and equipment

10,000

#2

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The noncontrolling interest in the subsidiary is reported as:

a. Assetb. Liabilityc. Equityd. Expense

Review QuestionReview Question



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Subsidiary Treasury Stock Holdings



A subsidiary may hold some of its own shares as treasury stock at the time the parent company acquires its interest.

Because the treasury stock account represents a contra stockholders’ equity account, it must be eliminated by a credit when the investment account and subsidiary company’s equity accounts are eliminated on the workpaper.

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Other Intercompany Balance Sheet Eliminations



Intercompany accounts receivable, notes receivable, and interest receivable, for example, must be eliminated against the reciprocal accounts payable, notes payable, and interest payable.

The full amount of all intercompany receivables and payables is eliminated without regard to the percentage of control held by the parent company.

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Adjusting Entries Prior to Eliminating Entries



At times, workpaper adjustments to accounting data may be needed before appropriate eliminating entries can be accomplished.

Make on workpaper in eliminations columns or

Adjust the subsidiary’s statements prior to their entry on the workpaper.

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Which of the following adjustments do notnot occur in the consolidating process?

a. Elimination of parent’s retained earningsb. Elimination of intra-company balancesc. Allocations of difference between implied and

book valuesd. Elimination of the investment account

Review QuestionReview Question



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For Example:Little information of value in consolidated statements because they contain insufficient detail about the individual subsidiaries.

Highly diversified companies operating across several industries, often the result of mergers and acquisitions, are difficult to analyze or compare.

LO 6 Limitations of consolidated statements.LO 6 Limitations of consolidated statements.

Limitations of Consolidated Limitations of Consolidated StatementsStatements

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IFRS Versus U.S. GAAPIFRS Versus U.S. GAAP

LO 10 Similarities and differences between U.S. GAAP and IFRS. LO 10 Similarities and differences between U.S. GAAP and IFRS.

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Deferred Taxes on the Date of Deferred Taxes on the Date of AcquisitionAcquisition

APPENDIX AIf a purchase acquisition is tax-free to the seller

Tax bases of the acquired assets and liabilities are carried forward at historical book values.

Assets and liabilities of the acquired company are recorded on the consolidated books at adjusted fair value.

Under current guidelines, the tax effects of the difference between consolidated book values and the tax bases must be recorded as deferred tax liabilities or assets.

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Illustration: Suppose that Purchasing Company acquires90% of Selling Company by issuing stock valued at $800,000. The only difference between book value and fair value relates to depreciable plant and equipment. Plant and equipment has a market value of $400,000 and a book value of $250,000. All other book values approximate market values. Assume that the combination qualifies as a nontaxable exchange. On the date of acquisition, Selling Company’s book value of equity is $600,000, which includes $150,000 of common stock and $450,000 of retained earnings. Assume a 30% tax rate. Consider the following Computation and Allocation Schedule with and without considering deferred taxes.

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The workpaper entry to eliminate the investment account is as follows:


Entries for allocation with and without deferred taxes.

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FASB has issued guidance for the consolidation of special-purpose entities (SPEs) through Interpretation No. 46(R) “Consolidation of Variable Interest Entities” and SFAS No. 167, “Amendments to FASB Interpretation No. 46(R)[ASC 810–10–30].” An enterprise shall consolidate a variable interest entity (VIE) when that enterprise has a variable interest (or combination of variable interests) that provides the enterprise with a controlling financial interest on the basis of the certain provisions (listed below).FASB Statement No. 167 requires ongoing reassessments of whether an enterprise is the primary beneficiary of a variable interest entity.

Consolidation of Variable Interest Consolidation of Variable Interest EntitiesEntities APPENDIX B

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Economy & Finance

ADVANCE ACCOUNTING Ch03