- 1. Chapter Two Consolidation of Financial Information
McGraw-Hill/Irwin Copyright 2011 by The McGraw-Hill Companies, Inc.
All rights reserved.
2. Business Combinations
- Separate organizations may be tied together throughcommon
control
- The company which exerts control is known as the parent.
- The separate controlled companies are known as
subsidiaries.
- Financial statements which represent a parent and its
subsidiaries are known as consolidated financial statements
prepared as though the companies were aSINGLE ENTITY .
2- 3. Why do Organizations Combine?
- Quick access to new markets
- More attractive financing opportunities
- Diversification of business risk
2- 4. Scale of Recent Combinations 2- ACQUIRER TARGET COST (in $
billions) Pfizer Wyeth $67.3 InBev Anheuser-Busch 52.0 Bank of
America Merrill Lynch 29.1 Verizon Wireless Alltel 28.1 Mars Candy
Wm. Wrigley, Jr 23.2 Delta Airlines Northwest Airlines 3.4 5. The
Consolidation Process
- Why Consolidated Statements?
-
- They providemore meaningful informationthan separate
statements.
-
- Theymore fairly presentthe activities of the consolidated
companies.
There is a presumption that consolidated statements are more
meaningful.. and that they are usually necessary for a fair
presentation when one of the companies in the group has a
controlling financial interests.. - - FASB ASC (810-10-10-1) 2- 6.
Business Combinations Abusiness combinationrefers to a transaction
or other event in which an acquirer obtainscontrol over one or more
businesses.There arefive typesof combinations that are required to
prepare consolidated statements. 2- 7. Statutory Merger
(ThroughAsset Acquisition)
- Investoracquires assets(and often liabilities) of the
Investee
- Investeedissolvesand goes out of business
- Investees books arepermanently closedand the Investors books
areadjustedat the acquisition date for the newly acquired
accounts
- One entitysurvives and moves forward
2- 8. Statutory Merger (ThroughCapital Stock Acquisition)
- Investoracquiresallstock of the Investee, andthen transfers
assets and liabilities of the Investee to its own books.
- Investeedissolvesas a separate company but often remains as a
division of the Investor.
- One entitysurvives and moves forward
2- 9. Statutory Consolidation
- Anewly createdcompany receives all assets or stock of
theoriginal companies.
- Original companiesdissolve , but often remain as divisions of
the new company.
2- 10. Acquisition of Majority of Shares
- Investor acquires themajorityof voting stock of another
company, and is able tocontrol itsdecisions.
- Investor records theinvestmentin the stock of the
Investee.
- Investee remains in existence as a separate company, but as
asubsidiaryof the Investor, orparentcompany.
2- 11. Control Through Ownership ofVariable Interests
- Sponsoring Firm creates aSpecial Purpose Entity(SPE) intended
to engage in a specific activity
- Investor may bedifferent thanthe Sponsoring Firm
- SPE is aseparate legal entitywhose risks and rewards may flow
to Sponsoring Firm instead of to the equity investors.
- Control is established by
- agreement , not ownership.
2- 12. A Control Issue SPEs
- Special Purpose Entities (a popular type of variable interest
entity) were misused to hide debt and manipulate earnings.
- As a result, the FASB expanded the definition of control to
include these entities.
- The following indicate a controlling financial interest in a
variable interest entity:
-
- Ability to make decisions about the entitys activities
-
- Obligation to cover any expected losses of the entity
-
- The right to receive any expected residuals of the entity
2- 13. Consolidation of Financial Information 2- Parent
Subsidiary The Sub still prepares separate financial statements
Consolidated financial statements are prepared. The parent does not
prepare separate financial statements 14. What is to be
consolidated?
-
- All account balances areactuallyconsolidatedin the financial
recordsof the survivor.
- If separate incorporation maintained :
-
- Financial statement information is consolidated onwork
papersand not in the actual records
2- 15. When does consolidation occur?
-
- Permanentconsolidation occurs at the combination date.
- If separate incorporation maintained:
-
- Consolidation (on work papers,notin the actual records!!)
occurs regularly,whenever financial statements are prepared.
2- 16. How does consolidation affect the accounting records?
-
- Dissolved companys records areclosed out .
-
- Surviving companys accounts are adjusted toincludeall balances
of the dissolved company.
- If separate incorporation maintained:
-
- Each company continues to maintain itsown records .
2- 17. Reminder: GAAP Accounting Methods 2- 18. The Acquisition
Method EFFECTIVE IN 2009
- Used when there is a change in ownership, resulting incontrolof
one enterprise by another
- Requires accounting for the fair value of the acquired
businessas a wholeby recognizing and measuring:
-
- The fair value ofeach asset acquired andliability assumed
- Effectively converged withInternational Standards
2- 19. Acquisition Method (Continued)
- What must be determined atthe date of acquisition?
- The Fair Value of assets and liabilities acquired, including
the value of purchasedIn-Process Research and Development(and
ignoring equity accounts)
- The value ofconsiderationtransferred
- The fair value of anycontingent considerationgiven, based on
risk and probability of payment
2- 20. Acquisition Method Fair Value
- Valuation of assets and liabilities is established using
- TheMarketApproach what is thevalue in similar exchanges?
- TheIncomeApproach what is the value of the discounted future
cash flows of the asset?
- TheCostApproach what wouldthe cost be to replace the assetor
liability with one of similarutility (wear and age)
2- 21. Acquisition Method - In-Process Research and Development
Costs
- Recognized and measured atfair valueon the acquisition
date
- Reported as anintangible assetwith an indefinite life
- Subject to periodic impairment reviews
2- 22. Acquisition Method (Continued)
- But what if theconsiderationtransferred doesNOT EQUALtheFair
Valueof the Assets acquired??
If the Consideration isLESSthan the Fair Value of the Assets
acquired, we got aBARGAIN !!And we will record aGAINon the
acquisition!! If the Consideration isMOREthan the Fair Value of the
Assets acquired, the difference is attributed toGOODWILL 2- 23.
Acquisition Method Example Purchase Price = Fair Value
- Lets look at an example where the Purchase Price = the Fair
Value of the Net Assets acquired.
Well use the financial information found in Exhibit 2.3 of the
text 2- 24. Acquisition Method ExamplePurchase Price = Fair Value
BigNetpays $2,550,000( $550,000cash and20,000unissued shares of its
$10 par value common stock that is currently selling for$100per
share) for all of Smallports assets and liabilities.Smallport
thendissolvesas a legal entity. As is typical, the $2,550,000 fair
value of the consideration transferred by BigNet represents the
fair value of the acquired Smallport business. 2- 25. Acquisition
Method - Example Purchase Price = Fair Value 2- BigNet Companys
Financial RecordsDecember 31 Current Assets . . . . . . . . . . . .
. . . . . . . . . . . 300,000 Computers and Equipment . . . . . . .
. . . . . .600,000 Capitalized Software . . . . . . . . . . . . . .
. . .1,200,000 Customer Contracts . . . . . . . . . . . . . . . . .
. . 700,000 Notes Payable . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . 250,000 Cash (paid by BigNet) . . . . . . .
. . . . . . . . . . . . . . . . . . .550,000 Common Stock (20,000
shares issued at $10 par value)200,000 Additional Paid-In Capital .
. . . . . . . . . . . . . . . . . . . . . 1,800,000 To record
acquisition of Smallport Company. Assets acquired and liabilities
assumed are recorded at fair value. 26. Acquisition Method Example
Purchase Price > Fair Value Use the same data as in the first
example, but increase the amount that BigNetincreasedthe amount
ofcashthey paid to$1,000,000 .Why would BigNet paymorethan the FV
ofSmallPorts Net Assets?? 2- 27. Acquisition Method Example
Purchase Price > Fair Value BigNet Companys Financial
RecordsDecember 31 Current Assets . . . . . . . . . . . . . . . . .
. . . . . . 300,000 Computers and Equipment . . . . . . . . . . . .
.600,000 Capitalized Software . . . . . . . . . . . . . . . .
.1,200,000 Customer Contracts . . . . . . . . . . . . . . . . . . .
700,000 Goodwill . . . . . . . . . . . . . . . . . . . . . . . . .
. . .450,000 Notes Payable . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . 250,000 Cash (paid by BigNet) . . . . . .
. . . . . . . . . . . . . . . . . . 1,000,000 Common Stock (20,000
shares issued at $10 par value)200,000 Additional Paid-In Capital .
. . . . . . . . . . . . . . . . . . . . . 1,800,000 To record
acquisition of Smallport Company. Assets acquired and liabilities
assumed are recorded at fair value. 2- 28. Acquisition Method
Example Purchase Price < Fair Value Lastly, lets use the same
data as in the first example, but this time, assume that BigNet
paysno cashconsideration, only the stock issuance is made.Why would
BigNet paylessthanthe FV of SmallPortsNet Assets?? 2- 29.
Acquisition Method Example Purchase Price < Fair Value BigNet
Companys Financial RecordsDecember 31 Current Assets . . . . . . .
. . . . . . . . . . . . . . . . 300,000 Computers and Equipment . .
. . . . . . . . . . .600,000 Capitalized Software . . . . . . . . .
. . . . . . . .1,200,000 Customer Contracts . . . . . . . . . . . .
. . . . . . . 700,000 Notes Payable . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . 250,000 Common Stock (20,000
shares issued at $10 par value)200,000 Additional Paid-In Capital .
. . . . . . . . . . . . . . . . . . . . . 1,800,000 Gain on Bargain
Purchase . . . . . . . . . . . . . . . . . . . . . . 550,000 To
record acquisition of Smallport Company. Assets acquired and
liabilities assumed are recorded at fair value. 2- 30. Acquisition
Method Related Costs of Business Combinations
- Direct Costsof the acquisition (attorneys, appraisers,
accountants, investment bankers, etc.) areNOTpart of the fair value
received, and so areimmediately expensed
- Indirect orInternal Costsof acquisition (secretarial and
management time) areexpensed as incurred .
- Costs to register andissuesecuritiesrelated to
theacquisitionreducetheir fair value
2- 31. Acquisition Method No Dissolution
- If the acquired company doesnt dissolve, but continues as
aseparate entity :
- Separate recordsfor each company are still maintained.
-
- The acquired company isreportedon the Parents books (
Investment in Subsidiaryaccount).
- The adjusted balances for Parent andSubsidiary
areconsolidatedusing aworksheet only( noformaljournal
entries!)
2- 32. The Consolidation Worksheet 2-
- Parent prepares the allocation of the FV, including calculation
of gain or goodwill.
- The financial information for Parent and Sub are recorded in
the first two columns of the worksheet (with Subs prior revenue and
expense already closed).
- Remove theS ubs equity account balances.
- Remove the Investment inS ub balance.
- A llocate Subs Fair Values, including any excess of cost over
Book Value to identifiable assets or goodwill.
- Combine all account balances.
33. Acquisition Method Consolidation Workpaper Example 2- 34.
Purchase Price Allocations Additional Issues
- Intangiblesare assets that:
-
- Lack physical substance (excluding financial instruments)
-
- Arise from contractual or other legal rights
-
- Can be sold or otherwise separated from the acquired
enterprise
2- Note:If there was goodwill already recorded in the acquired
companys accounts, it is ignored in the allocation of the purchase
price. 35. Purchase Price Allocations -Additional Issues
- IPR&D that has reached technological feasibility, may be
capitalized as anintangible asset
-
- Determination of fair value is critical
- IPR&D is considered to have anindefinitelife, and is
reviewed forimpairment.
- Ongoing R&D isexpensedas incurred.
2- 36.
- But if theAcquisition Methodis new in 2009,
- GAAP used to employTWOother methods, which were cost based
2- 37. Legacy Methods Purchase and Pooling of Interests
Methods
- 2002 to 2008:PURCHASE METHOD
- Prior to 2002:PURCHASE METHOD
2- Since theACQUISITION METHODis applied only to business
combinations occurring in 2009 and after, the two prior methods are
still in use. 38. Purchase Method Differences from the Acquisition
Method
-
- The value of theconsiderationtransferred,
-
- PLUS thedirect costsof the acquisition,
-
- IGNORING anyindirect costsof the acquisition,
-
- IGNORING anycontingentpayments.
- The total cost of the acquisition isallocated proportionatelyto
the net assets based on their fair values,with anyexcessgoing
togoodwill .
2- 39. Purchase Method Purchase Price < Fair Value
- Then current assets and liabilities are recorded atfair value ,
and non-current assets arereduced proportionately , with the
followingexceptions :
-
- Financial assets other than equity method investments
-
- Assets to be disposed of by sale
-
- Prepaid assets related to pension or other post-retirement
benefit plans
2-
- BUT WHAT IF THE TOTALCOST ISLESS THANTHEFAIR VALUEOF THE NET
ASSETS ACQUIRED?
40. Purchase Method Purchase Price < Fair Value If difference
is substantial enough to eliminate all the non-current asset
balances of the acquired company . . . . . . The remainder is
reported as anextraordinary gain One other
significantdifferencefrom theAcquisition Method :In-Process R&D
isexpensedunder thePurchase Method , unless it has reached
technological feasibility. 2- 41.
- Prior to 2002, under certain criteria, combinations could be
accounted for as Pooling of Interests when one company purchased
all of another companys stock using its own stock as consideration
(no cash!)
- These Pooling combinations are leftintactgoing forward.
Pooling of Interests Historical Review 2- 42.
- The larger company records anInvestment in Subaccount.
- Consolidation is done on aworksheetonly, eliminating Investment
account and Subs equity accounts.
- The remainingBook Valuesof the combining companies are
simplyadded together .
- Revenues and expenses are combinedretrospectively , and
prospectively.
2- Pooling of Interests Historical Review 43. Summary
- Consolidation of financial information is required when one
organization gainscontrolof another.
- Ifdissolutionoccurs, the consolidation is recorded at the date
of acquisition and a single set of accounting records
continues.
- Ifseparate identities(and separate books) are maintained,
consolidation is done on a worksheet,notinvolving journal
entries.
- TheAcquisition Methodis currently GAAP, although the two prior
methods will continue in practice until those combinations are
dissolved.
2- 44. Possible Criticisms
- The Acquisition Method involves a departure from traditional
cost-based measurement.This violates theHistoric
CostPrinciple.
- The capitalization of IPR&D departs from the traditional
approach ofexpensingR&D as incurred.
2-