2. Chapter Three Consolidations - Subsequent to the Date of Acquisition McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

3. 3-2 Consolidation – The Effects of the Passage of Time The passage of time creates complexities for internal record keeping and the balance of the investment account varies due to the accounting method used. A worksheet and consolidation entries are used to eliminate the investment account and record the subsidiary’s assets and liabilities to create a single set of financial statements for the combined business entity. LO 1

4. 3-3 Investment Accounting by Acquiring Company The acquiring company selects one of these three methods to account for its investment: LO 2  Equity Method  Initial Value Method  Partial Equity Method For each subsidiary owned, there is an asset, the investment account, and an income account to record the earnings on the investment.

5. 3-4 Investment Accounting by Acquiring Company Comparison of internal reporting of investment methods. MethodInvestmentIncome Account EquityContinually adjusted to reflect ownership of acquired company. Income accrued as earned; amortization and other adjustments are recognized. Initial ValueRemains at Initially- Recorded cost Cash received is recorded as Dividend Income Partial EquityAdjusted only for accrued income and dividends received from acquired company. Income accrued as earned; no other adjustments recognized.

6. 3-5 Investment Accounting by Acquiring Company What is the advantage of each? Equity Method: The acquiring company totals give a true representation of consolidation figures. Initial Value (or “Cost”) Method: It is easy to apply and gives a good measurement of cash flows generated by the investment. Partial Equity Method: Usually gives balances approximating consolidation figures, but is easier to apply than equity method

7. 3-6 Investment Accounting by Acquiring Company  A parent’s choice of internal accounting method for subsidiary investments has no effect on the resulting consolidated financial statements.  The selection of a particular method does not affect the totals ultimately reported for the combined companies.  The internal accounting method used does require distinct procedures for consolidation of the financial information from the separate organizations. LO 3

8. 3-7 During the year, the parent will adjust its investment account for the Subsidiary under application of the equity method. The original investment, recorded at the date of acquisition, is adjusted for: Subsequent Consolidation – Equity Method 1.FMV adjustments and other intangible assets, 2.The parent’s share of the sub’s income (loss), 3.The receipt of dividends from the sub. LO 4a

9. Parrot Company obtains all of the outstanding common stock of Sun Company on January 1, 2012. Parrot acquires this stock for $800,000 in cash. Sun Company’s balances are shown below. Subsequent Consolidation - Equity Method Example Book Values Fair Values 1/1/12 1/1/12 Difference Current assets.................. $320,000 $ 320,000 –0– Trademarks (indefinite life)........ 200,000 220,000 20,000 Patented technology (10-year life)... 320,000 450,000 130,000 Equipment (5-year life)........... 180,000 150,000 (30,000) Liabilities.......................(420,000) (420,000) –0– Net book value.................. $600,000 $ 720,000 $120,000 Common stock—$40 par value....$(200,000) Additional paid-in capital.......... (20,000) Retained earnings, 1/1/12..........(380,000) 3-8

10. Subsequent Consolidation - Equity Method Example FV of consideration transferred by Parrot Company. $ 800,000 Net Book Value of Sun Company...................(600,000) Excess of fair value over book value.................200,000 Allocation to specific accounts based on fair values: Trademarks....................................$ 20,000 Patented technology............................. 130,000 Equipment (overvalued)......................... (30,000) 120,000 Excess FV not specifically identified—goodwill...... $ 80,000 PARROT COMPANY 100 Percent Acquisition of Sun Company Allocation of Acquisition-Date Subsidiary Fair Value January 1, 2012 3-9

11. Subsequent Consolidation - Equity Method Example Amortization computation: Useful Annual Account Allocation Life Amortization Trademarks $ 20,000 Indefinite –0– Patented technology 130,000 10 years $13,000 Equipment (30,000) 5 years (6,000) Goodwill 80,000 Indefinite – 0– $ 7,000 Amortization will be $7,000 annually for five years until the equipment fair value reduction is fully removed. 3-10

12. Subsequent Consolidation - Equity Method Example 1/1/12 Investment in Sun Company..... 800,000 Cash.......................... 800,000 To record the acquisition of Sun Company. 8/1/12 Cash......................... 40,000 Investment in Sun Company......... 40,000 To record receipt of cash dividend from subsidiary under the equity method. 12/31/12 Investment in Sun Company.... 100,000 Equity in Subsidiary Earnings...... 100,000 To accrue income earned by 100% owned subsidiary. 12/31/12 Equity in Subsidiary Earnings.... 7,000 Investment in Sun Company......... 7,000 To recognize amortizations on allocations made in acquisition of sub. Assume Sun Company earns income of $100,000 in 2012 and pays a $40,0000 cash dividend on August 1, 2012. 3-11

13. 3-12 Subsequent Consolidation - Worksheet Entries S) Eliminates the subsidiary’s Stockholders’ equity account beginning balances and the book value component within the parent’s investment account. A) Recognizes the unamortized Allocations as of the beginning of the current year associated with the adjustments to fair value. I) Eliminates the subsidiary Income accrued by the parent. D) Eliminates the subsidiary Dividends. E) Recognizes excess amortization Expenses for the current period on the allocations from the original adjustments to fair value. For the first year, the parent prepares five entries on the workpapers to consolidate the two companies.

14. Subsequent Consolidation Equity Method Example Entry S Note: If this is the first year of the investment, and the investment was made at a time other than the beginning of the fiscal year, then pre-acquisition income of the sub must be accounted for in the retained earnings balance. Common Stock (Sun Company).... 200,000 APIC (Sun Company)............ 20,000 R/E, 1/1/1 (Sun Company)........ 380,000 Investment in Sun Company.......600,000 3-13

15. Subsequent Consolidation Equity Method Example Entry A Trademarks...............20,000 Patented technology....... 130,000 Goodwill..................80,000 Equipment................30,000 Investment in Sun Company 200,000 Note: In the first year, FV adjustments are calculated in the allocation computation. In subsequent years, FV adjustments must be reduced by any depreciation taken in prior consolidations. 3-14

16. Subsequent Consolidation Equity Method Example Entries I & D Equity in Subsidiary Earnings...93,000 Investment in Sun Company..... 93,000 Investment in Sun Company.... 40,000 Dividends Paid............... 40,000 Note: Entry I above removes Sun’s income recognized by Parrot during the year so Sun’s revenue and expense accounts (and current amortization expense) can be brought into the consolidated totals. Note: Entry D above removes the intra-entity transfer of cash for the dividends distributed to Parrot from Sun. 3-15

17. Subsequent Consolidation Equity Method Example Entry E Amortization Expense......... 13,000 Equipment....................6,000 Patented Technology...........13,000 Depreciation Expense...........6,000 Note that depreciation expense is reduced for the tangible asset equipment (fair value was less than book value). Patented Technology amortization expense was recognized for the year. 3-16

18. Applying the Initial Value Method If the Initial Value Method is used by the parent to account for the investment in the first year, the consolidation entries will change slightly. The parent will record the sub’s activity differently under this method, so the accounts will differ from the Equity Method. 1.No adjustments are recorded in the Investment account for current year income, dividends paid by the subsidiary, or amortization of purchase price allocations. 2.Dividends received from the subsidiary are recorded as Dividend Revenue. LO 4b 3-17

19. 3-18 Consolidation Entries - Initial Value Method Two entries for the initial value method are different than those for the equity method. Entry S is the same as the Equity Method. Entry A is the same as the Equity Method. Entry I is different using Initial Value Method: It eliminates the Parent’s Dividend Income account and the Sub’s Dividends Paid account. There is no Entry D. Entry E is the same as the Equity Method.

20. 3-19 Consolidation Entries – Partial Equity Method The same two entries differ for the Partial Equity Method. Entry S is the same as the Equity Method. Entry A is the same as the Equity Method. Entry I is different using Partial Equity Method: It eliminates the Parent’s equity in the sub’s income and reduces the investment account. Entry D eliminates the dividend income account. Entry E is the same as the Equity Method. LO 4c

21. 3-20 Consolidation Entries – Other than Equity Method  Entries S, A, and E are the same for all three methods.  The parent’s record-keeping is limited to two periodic journal entries:  annual accrual of subsidiary income and  receipt of dividends.  So, the Investment and Income account balances differ for the other methods, and so will the worksheet Entries I and D. Remember...

22. 3-21 Consolidation Entries – Subsequent Years  Neither the Initial Value or Partial Equity Method provides a full-accrual-based measure of the subsidiary activities on the parent’s income.  The initial value method uses the cash basis for income recognition.  The partial equity method only partially accrues subsidiary income.  A new worksheet adjustment is needed to convert the parent’s beginning of the year retained earnings balance to a full-accrual basis.

23. 3-22 Consolidation Entries – Subsequent Years  For consolidation purposes, the beginning retained earnings account must be increased (Initial Value Method) or decreased (Partial Equity Method) to create the same effect as the equity method.  Entry *C. The C refers to the Conversion being made to equity method (full accrual) totals. The asterisk indicates that this entry relates solely to transactions of prior periods.  Entry *C should be recorded before other worksheet entries to align the beginning balances for the year.

24. 3-23 Other Consolidation Entries In addition to the Entries S, A, I, D, E, and *C, intercompany debt (payables and/or receivables) must be eliminated in entry P. No matter which method the Parent chooses to record the Sub’s activity, the consolidated totals are always the same! This is because all the entries that were made during the year are eliminated regardless of the method used or the amount!

25. Goodwill and Other Intangible Assets (ASC Topic 350) FASB ASC Topic 350, “Intangibles-Goodwill and Other,” provides accounting standards for reporting income statement effects of either amortization or impairment of intangibles acquired in a business combination. In accounting for goodwill subsequent to the acquisition date, GAAP requires an impairment approach rather than amortization. LO 5 3-24

26. Goodwill and Other Intangible Assets (ASC Topic 350) Once goodwill has been recorded, the value will remain unchanged until: 1.All or part of the related subsidiary is sold, 2.There has been a permanent decline in value in which case we test for impairment and record an impairment loss if the item is impaired. LO 6 3-25

27. 3-26 Goodwill Impairment – Two-Step Test Step 1 Fair value (with allocated goodwill) is compared to the carrying value (including goodwill) of the consolidated entity’s reporting unit. Does fair value of the reporting unit exceed carrying value? Goodwill is NOT impaired. No further testing is required. A second step must be taken to test for impairment.

28. 3-27 Determination of Implied Fair Value of Goodwill 1.Allocate the fair value of the reporting unit to all its identifiable assets and liabilities. 2.Subtract the fair value of the net assets from the fair value of the reporting unit. The excess is “implied goodwill”. 3.Compare the resulting “implied goodwill” to the “recorded goodwill” on the books. The implied value of goodwill is calculated similar to the initial determination of goodwill in a business combination.

29. 3-28 Goodwill Impairment – Two-Step Test Implied value of the related goodwill can be determined using quoted market prices, similar businesses, or present value of future cash flows. Step 2 Is “implied goodwill” less than “recorded goodwill”? An impairment loss is recorded for the excess carrying value over implied fair value. Goodwill is NOT impaired. No further testing is required.

30. Goodwill Impairment Test Example  On January 1, 2013, Newcall Corporation was formed to consolidate operations of three companies in a deal valued at $2.9 billion.  Each of the three former firms is considered an operating segment and will be maintained as a subsidiary of Newcall.  One firm comprises two divisions, and the other two firms are treated as independent reporting units.  Newcall recognized $221 million as goodwill at the merger date and allocated this entire/amount to its reporting units. 3-29

31. Goodwill Impairment Test Example Newcall’s Acquisition Fair Value Reporting Units Goodwill January 1, 2013 DSM Wired $ 22,000,000 $950,000,000 DSM Wireless 155,000,000 748,000,000 Rocketel 38,000,000 492,000,000 Visiontalk 6,000,000 710,000,000 Newcall tests for goodwill impairment of DSM Wireless. The implied fair value of goodwill is compared to its carrying value using the following allocation of the fair value of DSM Wireless at year end… 3-30

32. Goodwill Impairment Test Example DSM Wireless Dec. 31, 2013, fair value $600,000,000 Fair values of DSM Wireless net assets at Dec. 31, 2013: Current asset $ 50,000,000 Property 125,000,000 Equipment 265,000,000 Subscriber list 140,000,000 Patented technology 185,000,000 Current liabilities (44,000,000) Long-term debt (125,000,000) Value assigned to identifiable net assets 596,000,000 Value assigned to goodwill 4,000,000 Carrying value before impairment 155,000,000 Impairment loss $151,000,000 3-31

33. 3-32 Goodwill Impairment Test Example  Goodwill is now valued at $4,000,000.  Newcall reports a $151,000,000 a separate line item goodwill impairment loss in the operating section of its consolidated income statement.  Additional disclosures required: (1) the facts and circumstances leading to the impairment (2) the method used to determine fair value of the associated reporting unit.  The reported values for all of DSM Wireless’ remaining assets and liabilities do not change.

34. 3-33 Comparison of U.S. GAAP and International Accounting Standards Under US GAAP: Goodwill is allocated to reporting units, usually operating segments, expected to benefit from it. A two-step process is used to test for impairment. If the carrying amount of goodwill is more than its implied value, an impairment loss is recognized. IFRS Under IAS 36: Goodwill is allocated to cash-generating units – at a level much lower than an operating segment. A one-step process is used to test for impairment. Goodwill is reduced for any excess carrying value, down to zero, and then other assets are reduced pro-rata.

35. 3-34 Other Intangibles All identified intangible assets should be amortized over their economic useful life unless such life is considered indefinite - that extends beyond the foreseeable future. Intangible assets with indefinite lives are not amortized. They are tested for impairment on an annual basis. The asset’s carrying value is compared to its fair value. If fair value is less than carrying value, the intangible asset is considered impaired and an impairment loss is recognized. The asset’s carrying value is reduced accordingly.

36. 3-35 Contingent Consideration in Business Combinations If part of the consideration to be transferred in an acquisition is contingent on a future event:  The acquiring firm estimates the fair value of a cash contingency and records a liability equal to the present value of the future payment.  The liability will continue to be measured at fair value with adjustments recognized in income.  Contingent stock payments are reported as a component of stockholders’ equity, and are not remeasured at fair value. LO 7

37. 3-36 Push Down Accounting Push-down accounting permits an acquired subsidiary to record fair value allocations and subsequent amortization in its accounting records. SEC requires push-down accounting for separate subsidiary statements when no substantial outside ownership exists. Generally limited for external reporting, but increasingly popular internally. Simplifies the consolidation process. Provides better information for internal evaluation. LO 8

38. 3-37 Summary Procedures used to consolidate financial information for a business combination are affected by the passage of time and the method applied by the parent in accounting for the subsidiary. Three methods are used to account for a subsidiary: Initial Value, Partial Equity, and Equity methods. Fair value is assigned to net assets of the acquired company and any excess purchase price is assigned to goodwill. Goodwill must be periodically tested for impairment.