Presentation on theme: "Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value Note: Students sometimes like to print slides as “handouts” with."— Presentation transcript:
1 Chapter 4Consolidation of Wholly Owned Subsidiaries Acquired at More than Book ValueNote: Students sometimes like to print slides as “handouts” with 1, 2, 3, 4, 6, or 9 slides per page for taking notes in class. It is sometimes best to print them using the “pure black and white” option on the color/gray scale dropdown menu to avoid dark boxes that are not conducive to note taking. Be aware that many instructors will only cover a sub-set of the slides available in this file. Also note that we have removed slides containing solutions to group or individual in-class exercises. You may want to print some slides (such as worksheets or slides with a large quantity of calculations) as a full page slide to facilitate working the exercise in class.
2 Learning Objective 1Understand and make equity-method journal entries related to the differential.
3 Basic Concepts: Parent and Subsidiary Parent’s booksInvestment account initially contains the acquisition costFMV of net assets,Plus goodwill, orMinus bargain purchase priceParent can use the cost or equity methodSubsidiary’s booksBalance sheet: Assets and Liabilities are recorded at BOOK values.Income statement: Expenses calculated based on BOOK values
4 Basic Concepts: Parent and Subsidiary What happens when you consolidate the parent’s and subsidiary’s books?Remember:The parent’s investment account is based on the actual acquisition price.The sub’s books contain only historical book values.The parent needs to make adjustments for bothBalance Sheet, andIncome Statement accounts.Why wasn’t this a problem with created subs?No goodwillNo undervalued assets at the time of creation
5 Basic Concepts: Income Statement Impacts Big Picture: Essentially, we switch the sub’s books from BV to FMV in the consolidation process.Income Statement effectsAssetRelated Expense(as the asset expires)EquipmentInventoryPatentGoodwill
6 Basic Concepts: Income Statement Impacts Income Statement EffectsWhen Acquisition Price > Book ValueAssetRelated Expense(as the asset expires)Income Statement EffectEquipmentInventoryPatentGoodwillIf expenses are _________________, then income is too high____________________.To fix the problem, Parent needs to _______________ expenses.
7 Example: Acquisition Price > Book Value Pepper Inc., a calendar-year reporting company, acquired 100% of Salt Inc.’s outstanding common stock at a cost of $442,500 on 12/31/X8. The analysis of the parent’s Investment account as of the acquisition date shows:Book value element Life remainingCommon Stock $130,000Retained Earnings 117,000Under- or Over-valuationInventory (6,500) 2 monthsLand 39,000 IndefiniteEquipment 85, yearsCovenant-not-to-compete 52,000 4 yearsGoodwill element ,000 IndefiniteTotal Cost $442,500
8 Example: Acquisition Price > Book Value Price = BV + Identifiable Excess + GWResults for 20X9 (based on Book Values):Reported IncomeDividends DeclaredWhat would the Sub’s income be based on Fair Values?Lower COGS (because inventory is worth less)Extra depreciation on equipmentExtra amortization of contractTotal increase in expenses / decrease in income
9 Consolidation: Equity Method The Parent’s initial investment in a sub is based on the FMV of the sub’s net assets (+/- GW).Equity method entries:Recording share of sub’s incomeRecording share of sub’s dividendsThey should be based on the same FMV basis.Problem: Sub reports income based on BOOK VALUESSolution: Parent has to record an adjustment to the income and investment “Equity Method” accounts.
10 Example: Equity Method Results for 20X9 (based on Book Values):Reported Income $78,000Dividends Declared 45,500Adjustment to Salt’s 20X9 income on Parent’s books:Lower COGS (because inventory is worth less) $ (6,500)Extra depreciation on equipment ,500Extra amortization of contract ,000Total increase in expenses / decrease in income $ 15,000What entries would Pepper record in its general ledger related to Salt’s income and dividends for 20X9 under the equity method?
11 Example: Equity Method Journal Entries To record 100% share of Salt’s reported income:2. To record 100% of Salt’s dividends declared:3. To record additional expenses (based on FMV):
12 Example: Equity Method Investment Adjustment Calculate the correct ending balance in Pepper’s Investment in Salt account using the equity method:Investment in Salt
13 Practice Quiz Question #1 A parent charges the amortization of its cost in excess of book value to:a. Goodwill expense.b. Excess cost expense.c. Excess cost & goodwill expense.d. Income from subsidiary.e. None of the above.
14 Learning Objective 2Understand and explain how consolidation procedures differ when there is adifferential.
15 Consolidation Concepts by Chapter Wholly Owned SubsidiaryPartially Owned SubsidiaryInvestment = Book ValueChapter 2Chapter 3No DifferentialInvestment > Book ValueChapter 4Chapter 5DifferentialNo NCI ShareholdersNCI Shareholders4-15
16 Excess value of identifiable assets = Simple ExampleAssume the BV of Sub’s net assets is $800 and that the FMV of the net assets is $1,000. Finally, assume that the acquisition price was $1,500. The acquisition price consists of three parts:Goodwill =PSStockSubShareholders$Excess value of identifiable assets =Book value ofnet assets =
17 Understanding Components of Acquisition Cost Acquisition FMV ofPrice = Assets + GoodwillFMV of ExtraAssets = BV + ValueAcquisition ExtraPrice = BV + Value + GoodwillKey: We need to keep track of each element of the purchase price separately!Why??
18 The Consolidation Process When a subsidiary is acquired (instead of created), the consolidation process is more complicated:Must eliminate intercompany items (same)Must update Sub’s assets and liabilities to FMVMust recognize goodwill
19 Summary of Consolidation Entries The basic elimination entry:The excess value reclassification entry:Common Stock (S) XXAdditional Paid-in Capital (S) XXRetained Earnings, Beginning Balance (S) XXIncome from Sub XXInvestment in Sub BVDividends Declared XXAsset 1 XXAsset 2 XXGoodwill XXInvestment in Sub Excess
20 Summary of Consolidation Entries The amortized excess value reclassification entry:This entry reclassifies the equity method amortization of cost in excess of book from Income from Sub to the appropriate expense accounts where the costs would have been had the sub used FMV instead of BV.4. The accumulated depreciation elimination entry:Cost of Sales XXOther Expenses XXIncome from Sub XXAccumulated Depreciation XXBuildings and Equipment XX
21 Practice Quiz Question #2 When P company pays more than the book value of net assets of the acquired company (S), how does the consolidation process differ?a. P hires an outside accountant to do the work.b. P tracks the excess value and records it in the consolidation worksheet.c. S notifies P of the excess value.d. P and S ignore the excess amount paid.
22 Learning Objective 3Make calculations and prepare elimination entries for the consolidation of awholly owned subsidiary when there is a complex positive differential at theacquisition date.
23 Group Exercise 1: Analyzing Acquisition Costs Prince Inc. acquired 100% of She-Ra Inc.’s outstanding common stock for $1,600,000 cash. Divide the cost into its major elements and prepare the consolidation entries as of the acquisition date.
24 Group Exercise 1: Solution How would this affect your worksheet elimination entries?
25 Group Exercise 1: Solution Acquisition Costs What did we pay for?Investment in Sub1,600,000GoodwillExcess value of identifiable assetsBook value ofnet assets ofthe acquiredfirm
26 Group Exercise 1: Solution Investment Account Investment in Sub1,600,000The basic elimination entry:The excess value reclassification entry:980,000Common Stock 120,000Additional Paid-in Capital 480,000Retained Earnings 380,000Investment in Sub 980,000620,000Inventory 50,000Land 130,000Buildings and Equipment 110,000Patent 90,000Long-term Debt 70,000Goodwill (new) 340,000Notes Receivable 60,000Goodwill (old) 110,000Investment in Sub 620,000
27 Group Exercise 1: Solution Worksheet Entries The basic elimination entry:The excess value reclassification entry:The accumulated depreciation elimination entry:Common Stock 120,000Additional Paid-in Capital 480,000Retained Earnings 380,000Investment in Sub 980,000Inventory 50,000Land 130,000Buildings and Equipment 110,000Patent 90,000Long-term Debt 70,000Goodwill (new) 340,000Notes Receivable 60,000Goodwill (old) 110,000Investment in Sub 620,000Accumulated Depreciation 98,000Building and Equipment 98,000
28 Group Exercise 1: Solution Depreciation Entry 3. The accumulated depreciation elimination entry: The book values at acquisition – remember the 610,000 was net of 98,000 in accumulated depreciation.Buildings & EquipmentAccumulated Depreciation708,00098,000
29 Group Exercise 1: Solution Depreciation Entry 3. The accumulated depreciation elimination entry:Accumulated Depreciation 98,000Building and Equipment 98,000Buildings & EquipmentAccumulated Depreciation708,00098,00098,00098,000610,000Shows the Buildings and Equipment “as if” they have been recorded on the sub’s books as new assets at book value.
30 Group Exercise 1: Solution Reclass Entry 3. The accumulated depreciation elimination entry:Accumulated Depreciation 98,000Building and Equipment 98,000Buildings & EquipmentAccumulated Depreciation708,00098,00098,00098,000BV610,000The excess value reclassification elimination entrybrings the Buildings and Equipment up to fair value.Excess Value ReclassFMV720,000110,000
31 Group Exercise 2: Worksheet at Acquisition Pepper acquired 100% of Salt’s outstanding stock for $442,500. Required: Prepare the consolidation entries and worksheet.
32 Group Exercise 2: Worksheet Entries Book Value Analysis:Pepper’s Salt’s Equity Accounts, BVInvestment Common RetainedAccount, BV Stock EarningsBalances, 12/31/X8Investment in SaltEB 442,500=+The Basic Elimination Entry:Common StockRetained EarningsInvestment in SaltExcess Value Analysis:Pepper’s Salt’s Under- or (Over-) Valuation of Net Assets ElementInvestment Inventory Land Equipment Covenant GoodwillBalances, 12/31/X8=The Excess Value Reclassification Entry:LandBuilding & EquipmentCovenant N-T-CGoodwillInventoryInvestment in SaltThe Accumulated DepreciationElimination Entry:Accumulated DepreciationBuilding & Equipment
34 Practice Quiz Question #3 An account of the acquired company that cannot be revalued to its current value under acquisition accounting is:a. Notes receivable.b. Bonds payable.c. Investment in marketable securities.d. Patents.e. None of the above.
35 of a wholly owned subsidiary when there is a complex bargain-purchase Learning Objective 4Make calculations and prepare elimination entries for the consolidationof a wholly owned subsidiary when there is a complex bargain-purchasedifferential.
36 Acquired at Less than Fair Value of Net Assets Bargain purchaseA business combination where the sum ofthe acquisition-date fair values of the consideration given,any equity interest already held by the acquirer, andany noncontrolling interestis less than the amounts at which the identifiable net assets must be valued at the acquisition date as specified by FASB 141R.The acquirer recognizes a gain for the difference.36
37 Income Statement Effect Basic ConceptsIncome Statement EffectsWhen Acquisition Price < BVAssetRelated Expense(as the asset expires)Income Statement EffectEquipmentInventoryPatentGoodwillIf expenses are ________________, then income is too low______________________.To fix the problem, Parent needs to ____________________expenses.
38 Practice Quiz Question #4 How do the elimination entries differ in a bargain purchase scenario from an acquisition at an amount greater than book value?a. The differential is ignored in a bargain purchase scenario.b. The parent company multiplies all numbers by −1.c. The elimination entry to reclassify expenses related to the differential increases reported expenses.d. The elimination entry to reclassify expenses related to the differential decreases reported expenses.
39 Learning Objective 5Prepare equity-method journal entries, elimination entries, and the consolidationworksheet for a wholly owned subsidiary when there is a complex positivedifferential.
40 Group Exercise 3Pepper Inc., a calendar-year reporting company, acquired 100% of Salt Inc.’s outstanding common stock at a cost of $442,500 on 12/31/X8. The analysis of the parent’s Investment account as of the acquisition date shows:Book value element Life remainingCommon Stock $130,000Retained Earnings 117,000Under- or Over-valuationInventory (6,500) 2 monthsLand 39,000 IndefiniteEquipment 85, yearsCovenant-not-to-compete 52,000 4 yearsGoodwill element ,000 IndefiniteTotal Cost $442,500
41 Group Exercise 3Update the analyses of the Investment account through 12/31/X9.Prepare all consolidation entries as of 12/31/X9.3. Prepare a consolidation worksheet at 12/31/X9. (The parent’s retained earnings as of 1/1/X9 were $455,000.
42 Group Exercise 3: Worksheet Entries Book Value Calculations:Pepper’s Salt’s Equity Accounts, BVInvestment Common RetainedAccount, BV Stock Add PIC EarningsBalances, 1/1/X9Add: Net IncomeLess DividendsBalances, 12/31/X9=++The Basic Elimination Entry:Common StockRetained Earnings, 1/1/X9Income from SaltDividends DeclaredInvestment in Salt
43 Group Exercise 3: Worksheet Entries Excess Value Calculations:Pepper’sInvestment Salt’s Under- or (Over-) Valuation of Net Assets ElementAccount Inventory Land Equipment Acc Dep Covenant GoodwillRemaining Life Excess Cost 2 months Indefinite 10 years 4 yearsBalances, 1/1/X9Less: AmortizationBalances, 12/31/X9=The Excess Value Reclassification Entry:The Amortized Excess ValueReclassification Entry:LandBuilding & EquipmentCovenant N-T-CGoodwillAccumulated DepreciationInvestment in SaltDepreciation ExpenseS&A ExpenseCost of SalesIncome from SaltThe Accumulated DepreciationElimination Entry:Accumulated DepreciationBuilding & Equipment
44 Group Exercise 3: Solution Investment Account Beginning Balance:Goodwill =26,000Investment in SaltBB 442,500Identifiable Excess =169,500NI ,00045,500 DividendBook value =247,00015,000 Excess Amort.EB 460,000Ending Balance:Goodwill =26,000Look back at the beginning and ending balances in the two charts you just prepared to find the numbers!Identifiable Excess =154,500Book value =279,500
45 Group Exercise 3: Worksheet Entries Notice how the worksheet entries “eliminate” Pepper’s equity method accounts:Investment in SaltIncome from SaltBB 442,500NI ,00078,000 NI45,500 Dividend15,000 Excess Amort. 15,000EB 460,00063,000 Adj. Balance279,500 Basic ,000180,500 Excess Reclass15,00015,000 Excess Amort.
49 Arm’s-Length Transactions Q: What are “Arm’s-length” Transactions? A: “Transactions that take place between completely independent parties.”
50 Categories of Transactions Arm’s Length TransactionsThe only transactions that can be reported in the consolidated statements.We want to report the results of our interactions with outside parties!Non-Arm’s Length TransactionsUsually referred to as “related party transactions.”Include all intercompany transactions.
51 Types of “Related Party” Transactions Involving only IndividualsTransactions among family members.Involving CorporationsWith management and other employees.With directors and stockholders.With affiliates (controlled entities).Probably constitutes at least 99% of all corporate related-party transactions.
52 Necessity of Eliminating Intercompany Transactions Eliminate all intercompany transactions in consolidation:Because they are internal transactions from a consolidated perspective.Not because they are related-party transactions.Only transactions with outside unrelated parties can be reported in the consolidated statements.
53 Intercompany Transactions: Additional Opportunities for Fraud Intercompany transactions sometimes occur toConceal embezzlements.Overstate reported profits.= 5
54 Group Exercise 4: Intercompany Loan & Interest Princess Inc. owns 100% of Solo Inc.’s common stock. On 11/1/X8, Princess lent $150,000 to Solo. The loan is to be repaid on 1/30/X9 along with $6,000 of interest. All aspects of the intercompany transaction were properly recorded by each company in its separate books.Required:What amounts should be reported in each company’s separate 20X8 income statement and 12/31/X8 balance sheet (asset and liability sections only)?Prepare and post to your format the consolidation entries as of 12/31/X8, relating only to these accounts.
55 Group Exercise 4: Solution Three things to think about:Note receivable / payableInterest revenue / expenseInterest receivable / payableHow would youeliminate each item?1. Note Payable (sub) XXXNote Receivable (parent) XXX2. Interest Revenue (parent) XXXInterest Expense (sub) XXX3. Interest Payable (sub) XXXInterest Receivable (parent) XXX
56 Practice Quiz Question #5 Intercompany income statement accounts are eliminated in consolidation because they are deemed to be:Artificial transactions.Potentially manipulative transactions.Internal transactions.At amounts that are not determined on arms-length basis.none of the above.
57 Practice Quiz Question #6 In 20X8, Scott incurred $90,000 of inter-company interest charges. Of this amount, Scott paid $70,000 cash to its parent and capitalized $40,000 to a discrete construction project. The unrealized intercompany profit at 12/31/X8 is:$0$10,000$20,000$30,000$40,000
58 Understand and explain the basics of push-down accounting. Learning Objective 7Understand and explain the basics of push-down accounting.
59 Purchase Price > Book Value What happens if you pay more than the book value of the subsidiary’s assets?This is the case MOST of the time!Parent has two options:Push-Down AccountingForce Sub to revalue to FMVNon-Push-Down AccountingAccount for the “extra” value separately.ParentSub
60 Push-Down Accounting: The EASIER Way Push-Down Accounting (an absolute gem)In the subsidiary’s general ledger:Adjust assets and liabilities to FV based on the parent’s acquisition price.This establishes a new basis of accounting.Record goodwill.Record “Revaluation Capital” for the differenceA = L ERevaluation CapitalX
61 Nonpush-Down Accounting: The HARDER Way Don’t touch the subsidiary’s general ledger (treat like a “sacred cow”).Make fair value adjustments and record goodwill in consolidation (on the worksheets).
62 Consolidation Consequences: Push-Down vs. Non-Push-Down Push-down accounting:Consolidation effort is minimal (has received the “Better Book-keeping” stamp of approval).Non-push-down accounting:Consolidation effort is cumbersome (often a headache).The consolidated financial statement amounts are the SAME either way!ONLY the accounting procedures differWho does the work– parent or sub?
63 Parent’s Amortization of Cost in Excess of Book Value: How Handled? Non-push-down accountingEquity MethodRecorded in parent’s general ledgerMaintains built-in checking featuresCost MethodRecorded on consolidation worksheetsPush-down accountingParent has no amortization – sub records the amortization
64 Consolidated Financial Statements Actually, these numbers are only part of the consolidated financial statements.Non-push-down AccountingPush-down AccountingSub’sIncome Statement(Based onBook Values)Balance SheetParent’sAdjustmentsForExcessValue(ConsolidationProcess)Sub’sIncome Statement(Based onFair Values)Balance Sheet+=
65 Postacquisition Subsidiary Earnings: Reportable Earnings Under Acquisition Method ONLY the subsidiary’s postacquisition earnings are reported in the consolidated financial statements.For a mid-year acquisition, only consolidate earnings after the acquisition date.The same is true for dividends declared.The subsidiary’s preacquisition earnings (included in its retained earnings account) are always eliminated against the parent’s Investment account in consolidation.
66 Practice Quiz Question #7 A parent records amortization of excess value under which method?a. Push-down basis of accounting.b. Non-push down basis of accounting.c. Both A and B.d. None of the above.
67 Practice Quiz Question #8 Push-down-accounting can be used:a. Only in a goodwill situation.b. Only in a bargain purchase situation.c. In either a goodwill situation or a bargain purchase situation.d. Only in a cost = book value situation.e. None of the above.
68 Practice Quiz Question #9 The consolidated financial statements are identical regardless of whether the parent:a. Uses push-down or non-push-down accounting.b. Acquires 100% of the common stock or 100% of the assets.c. Both A and B.d. Neither A or B.