1. Chapter Two Consolidation of Financial Information McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Business Combinations Separate organizations tied together through common control Financial statements which represent more than one corporation are known as “consolidated” financial statements. The company which exerts control is known as the “parent.” The separate controlled companies whose information is consolidated are known as “subsidiaries.” 2-2

3. Why do Firms Combine? Vertical integration Cost savings Quick access to new markets Economies of scale More attractive financing opportunities Diversification of business risk Vertical integration Cost savings Quick access to new markets Economies of scale More attractive financing opportunities Diversification of business risk 2-3

4. Scale of Recent Combinations ACQUIRER TARGET COST (in billions of $) AT&TBellSouth$67.0 J.P. Morgan Chase Bank One 58.8 SprintNextel 35.2 Wachovia BankGolden West Financial 25.5 Walt DisneyPixar 7.4 AdidasReebok 3.8 2-4

5. The Consolidation Process Why Consolidated Statements?  They are presumed to be more meaningful than separate statements.  They are considered necessary for fair presentation. “The purpose of consolidated financial statements is to present, primarily for the benefit of the owners and creditors of the parent, the results of operations and the financial position of a parent company and all its subsidiaries as if the consolidated group were a single economic entity with one or more branches or divisions.” - - SFAS 160 (December 2007) “The purpose of consolidated financial statements is to present, primarily for the benefit of the owners and creditors of the parent, the results of operations and the financial position of a parent company and all its subsidiaries as if the consolidated group were a single economic entity with one or more branches or divisions.” - - SFAS 160 (December 2007) 2-5

6. Business Combinations There is a presumption that consolidated financial statements are more meaningful than separate financial statements and that they are usually necessary for a fair presentation when one of the entities in the consolidated group directly or indirectly has a controlling financial interest in the other entities (SFAS 160). The usual condition for a controlling financial interest is ownership of a majority voting interest, and, therefore, as a general rule ownership by one entity, directly or indirectly, of more than 50 per cent of the outstanding voting shares of another entity is a condition pointing toward consolidation (SFAS 160). 2-6

7. Business Combinations Exh. 2-2Continued 2-7

8. Business Combinations – Continued Exh. 2-2 2-8

9. Parent Subsidiary The Sub still prepares separate financial statements Consolidated financial statements are prepared. The parent does not prepare separate financial statements Consolidation of Financial Information 2-9

10. Reminder: GAAP Accounting Methods 2-10

11. A Control Issue – SPE’s Special Purpose Entities (a popular type of “variable interest entity”) were misused to hide debt and manipulate earnings As a result, the FASB (in FIN 46R) expanded the definition of “control” beyond just the holding of a majority share position. The following indicate a controlling financial interest in a variable interest entity:  Direct or indirect ability to make decisions about the entity’s activities  Obligation to absorb any expected losses of the entity  The right to receive any expected residuals of the entity 2-11

12. What is to be consolidated? If dissolution occurs: All account balances are actually consolidated in the financial records of the survivor. If separate incorporation maintained: Financial statement information is consolidated on work papers and not in the actual records 2-12

13. When does consolidation occur? If dissolution occurs: Permanent consolidation occurs at the combination date If separate incorporation maintained: Consolidation (on work papers, not in the actual records!!) occurs regularly, whenever financial statements are prepared 2-13

14. How does consolidation affect the accounting records? If dissolution occurs: Dissolved company’s records are closed out. Surviving company’s accounts are adjusted to include all balances of the dissolved company If separate incorporation maintained: Each company continues to maintain its own records 2-14

15. Acquisition Method – SFAS 141R (effective for all combinations beginning in 2009) Employed when there is a change in ownership resulting in control of one enterprise by another. The valuation basis for most acquisitions is the fair value of the “consideration transferred” by the acquirer at the date of acquisition. Consideration transferred includes  Cash paid or fair value of stock issued  Fair value of any contingent consideration  Fair value of any other property transferred 2-15

16. Accounting Challenges!!! Allocation of “acquisition-date fair value” among the various assets and liabilities obtained. Allocation depends on the relation between the total fair value of the acquired business and the collective amount of the individual “fair values” of the acquired firm’s assets and liabilities. FASB defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction of market participants at the measurement date.” (FASB, “Statement of Financial Accounting Standards No. 157,” Fair Value Measurements) 2-16

17. “Direct Costs” of Combination The fees to the following for advising services in arranging and structuring the combination:  Investment bankers  Accountants  Attorneys These amounts are considered expenses of the period in which the combination takes place. They are NOT consider an element of the fair value received by the acquirer. 2-17

18. Acquisition Method Situations Dissolution of the acquired company:  Consideration transferred = Collective fair values of the individual asset acquired and liabilities assumed (FV)  Consideration transferred = FV  Consideration transferred > FV  Consideration transferred < FV Separate incorporation maintained. Dissolution of the acquired company:  Consideration transferred = Collective fair values of the individual asset acquired and liabilities assumed (FV)  Consideration transferred = FV  Consideration transferred > FV  Consideration transferred < FV Separate incorporation maintained. 2-18

19. Acquisition Method: Dissolution Consideration transferred = Fair value Ignore the equity and nominal accounts of the acquired company. Determine fair values of the acquired company’s assets and liabilities. Prepare a journal entry to  recognize the fair value of the consideration transferred in the acquisition  incorporate the fair value of the acquired company’s identifiable assets and liabilities into the acquiring company’s books. 2-19

20. Acquisition Method: Dissolution Consideration transferred = Fair value BigNet agrees to pay $2,550,000 (cash of $550,000 and 20,000 unissued shares of its $10 par value common stock that is currently selling for $100 per share) for all of Smallport’s assets and liabilities. Smallport then dissolves itself as 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. 2-20

21. Acquisition Method: Dissolution Consideration transferred = Fair value 2-21

22. Acquisition Method: Dissolution Consideration transferred > Fair value FV of acquired company’s assets and liabilities is added to acquiring company’s books. Difference between consideration transferred and FV of identifiable assets acquired and liabilities assumed is allocated to goodwill. Note: Goodwill should be viewed as a residual amount remaining after all other identifiable assets acquired and liabilities assumed are recognized. 2-22

23. Acquisition Method: Dissolution Consideration transferred > Fair value 2-23

24. Acquisition Method: Dissolution Consideration transferred < Fair value In rare circumstances, the FV of the identifiable assets acquired and liabilities assumed may exceed the consideration transferred. This excess FV is recognized as an ordinary gain on a bargain purchase. The FV of the of identifiable assets acquired and liabilities assumed then becomes the valuation basis of the acquisition. 2-24

25. Acquisition Method: Dissolution Consideration transferred < Fair value At acquisition date, each subsidiary asset and liability is reported at its fair value...... The remainder is to be reported as an ordinary gain on bargain purchase (SFAS 141R) At acquisition date, each subsidiary asset and liability is reported at its fair value...... The remainder is to be reported as an ordinary gain on bargain purchase (SFAS 141R) 2-25

26. Accounting for Additional Costs Associated with Business Combinations (SFAS 141R) Direct combination costs (Accounting, legal, investment banking and appraisal fees, etc.) Expense as incurred Indirect combination costs (additional internal costs such as secretarial or managerial time) Expense as incurred Costs to register and issue securities Reduce the value assigned to the fair value of the securities issued (typically as a debit to APIC) 2-26

27. Let’s see what happens when the acquired company is not dissolved. 2-27

28. Acquisition Method - No Dissolution The acquired company continues as a separate entity.  Reported on Parent’s books as the Investment in Subsidiary account. Separate records for each company are still maintained. The adjusted balances for the Parent and the Subsidiary are consolidated using a worksheet (no formal journal entries!) The acquired company continues as a separate entity.  Reported on Parent’s books as the Investment in Subsidiary account. Separate records for each company are still maintained. The adjusted balances for the Parent and the Subsidiary are consolidated using a worksheet (no formal journal entries!) 2-28

29. Steps for Consolidation 1.Record the financial information for both Parent and Sub on the worksheet. 2.Remove the Investment in Sub balance. 3.Remove the Sub’s equity account balances. 4.Adjust the identifiable assets acquired and liabilities assumed to FV. 5.Allocate any remaining excess of consideration transferred over BV to goodwill. 6. Combine all account balances. 2-29

30. No Dissolution Example 2-30

31. 2-31

32. 2-32

33. 2-33

34. 2-34

35. Acquisition Fair Value Allocations: Additional Issues, SFAS No. 141R Intangibles  Current and noncurrent assets that lack physical substance.  Do not include financial instruments. When should an Intangible be recognized?  Does it arise from contractual or other legal rights?  Can it be sold or otherwise separated from the acquired enterprise? Intangibles  Current and noncurrent assets that lack physical substance.  Do not include financial instruments. When should an Intangible be recognized?  Does it arise from contractual or other legal rights?  Can it be sold or otherwise separated from the acquired enterprise? 2-35

36. Acquisition Fair Value Allocations: Additional Issues, SFAS No. 141R Intangible Asset Examples Customer Base Brand Names Trademarks Customer Routes Royalty agreements Internet domain names Rights (broadcasting, development, use, etc.) Customer Base Brand Names Trademarks Customer Routes Royalty agreements Internet domain names Rights (broadcasting, development, use, etc.) Databases Technological know- how Patents & Copyrights Franchise agreements Noncompetition agreements Many, many, more Databases Technological know- how Patents & Copyrights Franchise agreements Noncompetition agreements Many, many, more Exh. 2-7 2-36

37. Acquisition Fair Value Allocations: Additional Issues, SFAS No. 141R In-Process R&D  Should be recognized at acquisition date as an ASSET.  Determination of fair value is critical.  Subsequent to acquisition, the IPR&D assets are tested for impairment at least annually. In-Process R&D  Should be recognized at acquisition date as an ASSET.  Determination of fair value is critical.  Subsequent to acquisition, the IPR&D assets are tested for impairment at least annually. 2-37

38. Unconsolidated Subsidiaries 2-38

39. LEGACY ACCOUNTING METHODS FOR BUSINESS COMBINATIONS Prior to the SFAS 141R acquisition method (effective 2009), the FASB required either the  Purchase method (GAAP through 2008, SFAS 141)  Pooling of interests method (GAAP through 6/30/02, APB 16)

40. Purchase Method Situations: GAAP for new combinations through 2008 Dissolution of the acquired company: Purchase Price = Fair Value Purchase Price > FV Purchase Price < FV Separate incorporation maintained. Dissolution of the acquired company: Purchase Price = Fair Value Purchase Price > FV Purchase Price < FV Separate incorporation maintained. 2-40

41. Purchase Method: Dissolution Purchase Price > or = Fair Value Ignore the equity and nominal accounts of the acquired company. Determine fair value of the acquired company’s assets and liabilities. Prepare a journal entry to  recognize the cost of acquisition  incorporate the FV of the acquired company’s assets and liabilities into the acquiring company’s books.  Recognize goodwill as the excess of cost over FV of the net assets acquired.  Record any acquired in-process research and development as an expense 2-41

42. Purchase Method: Dissolution Purchase Price > Fair Value Archer agrees to pay $1,200,000 (10,000 unissued shares of its $1 par value common stock that is currently selling for $120 per share) for all of Baker’s assets and liabilities. Archer also paid $25,000 cash for legal and accounting fees directly related to the acquisition. Baker then dissolves itself as a legal entity. Under the purchase method both the fair value of the stock issued and the direct acquisition costs are included in the cost-based valuation of the combination. 2-42

43. Purchase Method: Dissolution Purchase Price > Fair Value 2-43 Acquisition-date information for Baker Co.

44. Purchase Method: Dissolution Purchase Price < Fair Value When fair value exceeds cost, full allocation of fair value is not possible. Current assets and liabilities should be consolidated at their fair value. Non-current assets should be proportionately reduced in value (with some exceptions) 2-44

45. Purchase Method - Dissolution Purchase Price < Fair Value According to SFAS 141, the following non- current assets are exceptions to the proportionate reduction, and should be recorded at assessed fair values:  Financial assets other than equity method investments  Assets to be disposed of by sale  Deferred tax assets  Prepaid assets related to pension or other post- retirement benefit plans 2-45

46. Purchase Method - Dissolution Purchase Price < Fair Value In the event that the difference is substantial enough to eliminate all the non-current asset balances of the acquired company...... The remainder is to be reported as an extraordinary gain (SFAS 141) In the event that the difference is substantial enough to eliminate all the non-current asset balances of the acquired company...... The remainder is to be reported as an extraordinary gain (SFAS 141) 2-46

47. Accounting for Additional Costs Associated with Business Combinations (SFAS 141) Direct combination costs (Accounting, legal, investment banking and appraisal fees, etc.) Include in the purchase price of the acquired firm Indirect combination costs (additional internal costs such as secretarial or managerial time) Expense as incurred Costs to register and issue securities Reduce the value assigned to the fair value of the securities issued (typically as a debit to APIC) 2-47

48. Pooling of Interests Historically, many business combinations were accounted for as “Pooling of Interests.” Acquisition Method In SFAS 141R, “Business Combinations”, the FASB stated that all business combinations should be accounted for using the “Acquisition Method”. Historically, many business combinations were accounted for as “Pooling of Interests.” Acquisition Method In SFAS 141R, “Business Combinations”, the FASB stated that all business combinations should be accounted for using the “Acquisition Method”. 2-48

49. Pooling of Interests According to SFAS No. 141R, the acquisition method is not to be retrospectively applied to past “Poolings of Interest.” Past poolings of interests are left intact by SFAS No. 141R. Therefore, it is important to understand how to account for PAST poolings. According to SFAS No. 141R, the acquisition method is not to be retrospectively applied to past “Poolings of Interest.” Past poolings of interests are left intact by SFAS No. 141R. Therefore, it is important to understand how to account for PAST poolings. 2-49

50. In a pooling, one company obtained essentially “all” of the other company’s stock. The transaction involved the exchange of common stock. No exchange of cash was allowed. The ownership interests of two, or more, companies were combined into one new company. No single company was dominant. There was a continuity of previous ownership interests, not a purchase/sale. To use pooling of interests, 12 strict criteria had to be met. Historical Review of Pooling of Interests 2-50

51. Historical Review of Pooling of Interests The Book Values of the two combining companies were joined. No Goodwill was recorded. Internally developed intangibles developed by the sub were typically not recognized. Revenues and expenses were combined retroactively for the two companies. 2-51

52. Historical Review of Pooling of Interests Because poolings involved exchanges of voting stock, a continuity of ownership was deemed to exist. Neither Goodwill nor any unrecorded intangibles were recorded. Both companies were combined at BV. The pooling method was often criticized for it’s lack of completeness, comparability to other methods, and relevance for decision makers. Because poolings involved exchanges of voting stock, a continuity of ownership was deemed to exist. Neither Goodwill nor any unrecorded intangibles were recorded. Both companies were combined at BV. The pooling method was often criticized for it’s lack of completeness, comparability to other methods, and relevance for decision makers. 2-52

53. Historical Review of Pooling of Interests Prior Period Adjustments were made to account for differences in the ways the two companies accounted for income. A journal entry was recorded to recognize either an Investment in Subsidiary (sub not dissolved) or the individually acquired assets and liabilities (if the sub was dissolved). Prior Period Adjustments were made to account for differences in the ways the two companies accounted for income. A journal entry was recorded to recognize either an Investment in Subsidiary (sub not dissolved) or the individually acquired assets and liabilities (if the sub was dissolved). 2-53

54. Accounting for Pooling of Interests in Subsequent Periods: Dissolution The Investment in Sub account must be eliminated against the Sub’s Equity accounts Add together the BV’s of the remaining accounts. No excess amortization is applicable, because no acquisition-date write-ups occurred. 2-54

55. Summary Consolidation of financial information is required when one organization gains control of another. If dissolution occurs, this consolidation is carried out at the date of acquisition and a single set of accounting records is maintained. If separate identities are maintained, consolidation is a periodic “worksheet” process not involving journal entries. Separate accounting records are maintained. The acquisition method is GAAP beginning in 2009. Legacy effects for the purchase method (for combinations occurring through 2008) and the pooling method (through 6/30/2002) remain in subsequent year’s financial reports. 2-55