Chapter Two Consolidation of Financial Information Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Business Combinations Discuss the motives for business combinations. 2-2

Business Combinations  FASB Accounting Standards Codification (ASC) Business Combinations (Topic 805) and Consolidation (Topic 810) provide guidance using the “acquisition method”.  The acquisition method embraces the fair value measurement for measuring and assessing business activity. 2-3

Reasons Firms Combine  Vertical integration  Cost savings  Quick entry into new markets  Economies of scale  More attractive financing opportunities  Diversification of business risk  Business Expansion  Increasingly competitive environment 2-4

The Consolidation Process  Consolidated financial statements provide more meaningful information than separate statements.  Consolidated financial statements more fairly present the activities of the consolidated companies.  Yet, consolidated companies may retain their legal identities as separate corporations. “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 interest..” FASB ASC ( ) 2-5

Business Combinations Dissolution Vs. Separate Incorporation 2-6

Subsidiaries’ financial data (FMV) Prepare a single set of consolidated financial statements. Parent’s financial data (BV) Consolidation of Financial Information To report the financial position, results of operations, and cash flows for the combined entity. Reciprocal accounts and intra-entity transactions are adjusted or eliminated to... brought together 2-7

What is to be consolidated? dissolution If dissolution occurs: All appropriate account balances are physically consolidated in the financial records of the survivor Company. separate incorporation If separate incorporation is maintained: only the Financial statement information (on work papers, not on the books) is consolidated. 2-8

When does consolidation occur? dissolution If dissolution occurs: Permanent consolidation occurs at the combination date. separate incorporation If separate incorporation maintained: The consolidation process is carried out at regular intervals whenever financial statements are to be prepared. 2-9

How does consolidation affect the accounting records? dissolution If dissolution occurs: Dissolved company’s records are closed out. Surviving company’s accounts are adjusted to include appropriate balances of the dissolved company. separate incorporation If separate incorporation is maintained: Each company continues to retain its own records. Worksheets facilitate the periodic consolidation process without disturbing individual accounting systems. 2-10

The Acquisition Method The acquisition method embraces the fair value in measuring the acquirer’s interest in the acquired business. Applying the acquisition method involves recognizing and measuring:  the consideration transferred for the acquired business and any non-controlling interest.  separately identified assets acquired and liabilities assumed. or  goodwill, or a gain from a bargain purchase. 2-11

Procedures for Consolidating Financial Information Legal and accounting distinctions divide business combinations into separate categories. Various procedures are utilized in this process according to the following sequence: 1.Acquisition method when dissolution takes place. 2. Acquisition method when separate incorporation is maintained. 2-12

Acquisition Method Example Purchase Price = Fair Value Assume BigNet Company owns Internet communications equipment and other business software applications. It seeks to expand its operations and plans to acquire Smallport on December 31. Smallport’s net assets have a book value of $600,000 and a fair value of $2,550,000. Fair values for assets and liabilities are appraised; capital stock, retained earnings, dividend, revenue, and expense accounts represent historical measurements. The equity and income accounts are not transferred in the combination. 2-13

Acquisition Method Example Basic Consolidation Information 2-14

Consideration Transferred (2,550,000) = Net Identified Asset Fair Values Dissolution of Subsidiary 2-15

Consideration Transferred ($3,000,000) Exceeds Net Identified Asset Fair Values Dissolution of Subsidiary 2-16

Consideration Transferred ($2,000,000) Is Less Than Net Identified Asset Fair Values Dissolution of Subsidiary 2-17

Related Costs of Business Combinations Acquisition Method - Accounting for Costs Frequently Associated with Business Combinations 2-18

Related Costs of Business Combinations  Direct Costs of the acquisition (attorneys, appraisers, accountants, investment bankers, etc.) are NOT part of the fair value received, and are immediately expensed.  Indirect or Internal Costs of acquisition (secretarial and management time) are period costs expensed as incurred.  Costs to register and issue securities related to the acquisition reduce their fair value. 2-19

Acquisition Method - Subsidiary Is Not Dissolved Separate Incorporation Maintained  Dissolution does not occur.  Consolidation process is similar to previous example.  Fair value is the basis for initial consolidation of subsidiary’s net assets.  Subsidiary is a legally incorporated separate entity.  Each company maintains independent record-keeping  Consolidation of financial information is simulated.  Acquiring company does not physically record the transaction. 2-20

The Consolidation Worksheet Consolidation worksheet entries (adjustments and eliminations) are entered on the worksheet only. Steps in the process: 1.Prior to constructing a worksheet, the parent prepares a formal allocation of the acquisition date fair value similar to the equity method procedures. 2. Financial information for Parent and Sub is recorded in the first two columns of the worksheet (with Sub’s prior revenue and expense already closed). 2-21

The Consolidation Worksheet continued Remove the Sub’s equity account balances. 4.Remove the Investment in Sub balance. 5.Allocate Sub’s Fair Values, including any excess of cost over Book Value to identifiable assets or goodwill. 6.Combine all account balances and extend into the Consolidated totals column. 7.Subtract consolidated expenses from revenues to arrive at net income. 2-22

Acquisition Method – Consolidation Workpaper Example Now assume that the price paid is $2,620,000. Prior to constructing a worksheet, the parent prepares a formal allocation of the acquisition date fair value similar to the equity method procedures. 2-23

Acquisition Method – Consolidation Workpaper Example The first two columns of the worksheet show the separate companies’ acquisition-date book value financial figures. BigNet’s accounts have been adjusted for the investment and combination costs, and Smallport’s revenue, expense, and dividend accounts have been closed to retained earnings. 2-24

Acquisition Method – Consolidation Workpaper Example continued

Acquisition Method – Consolidation Workpaper Journal Entries 2-26

Acquisition Date Fair-Value Allocations – Additional Issues In determining whether to recognize an intangible asset in a business combination, two specific criteria are essential. 1. Does the intangible asset arise from contractual or other legal rights? 2. Is the intangible asset capable of being sold or otherwise separated from the acquired enterprise? 2-27

Acquisition Date Fair-Value Allocations – Additional Issues Intangibles are assets that:  Lack physical substance (excluding financial instruments)  Arise from contractual or other legal rights (most intangibles in business combinations meet the contractual-legal criterion).  Is capable of being sold or otherwise separated from the acquired enterprise Preexisting goodwill recorded in the acquired company’s accounts is ignored in the allocation of the purchase price. IPR&D that has reached technological feasibility is capitalized as an intangible asset at fair value with an indefinite life that is reviewed for impairment. Ongoing R&D is expensed as incurred. 2-28

Intangible Assets That Meet the Criteria for Recognition Separately from Goodwill 2-29

Legacy Methods Identify the general characteristics of the legacy purchase and pooling of interest methods of accounting for past business combinations. Understand the effects that persist today in financial statements from the use of these legacy methods. 2-30

Legacy Methods – Purchase and Pooling of Interests Methods  2002 to 2008: Purchase Method  Prior to 2002: Purchase Method Or The Pooling Of Interests Method Since the ACQUISITION METHOD is applied to business combinations occurring in 2009 and after, the two prior methods are still in use. 2-31