©The McGraw-Hill Companies, Inc. 2006McGraw-Hill/Irwin Chapter 7 Consolidated Financial Statements: Subsequent to Date of Business Combination

2 Scope of Chapter Accounting for operating results of both wholly owned and partially owned subsidiaries is described and illustrated. Accounting for inter-company transactions not involving a profit (gain) or a loss, as well as those involving a profit or a loss, are dealt with.

3 Accounting For Operating Results Of Wholly Owned Subsidiaries Accounting for operating results of consolidated subsidiaries, a parent company may choose either of the two methods: – Equity Method of Accounting – Cost Method of Accounting

4 Equity Method Parent company recognizes its share of the subsidiary’s net income or net loss Adjusted for depreciation and amortization of differences between current fair values and carrying amounts of a subsidiary’s identifiable net assets on the date of business combination Share of dividends declared by the subsidiary.

5 Equity Method Equity method of accounting is quite similar to home office accounting for a branch’s operations. Proponents claim that equity method stresses the economic substance of the parent-subsidiary relationship. Dividends declared by a subsidiary do not constitute revenue to the parent company.

6 Equity Method Proponents of the method maintain that the method is consistent with the accrual basis of accounting It recognizes increases or decreases in the carrying amount of the parent company’s investment in the subsidiary When they are realized by the subsidiary as net income or net loss, not when they are paid by the subsidiary as dividends.

7 Cost Method Parent company accounts for the operations of a subsidiary only to the extent that dividends are declared by the subsidiary. Net income or net loss of the subsidiary is not recognized by the parent company. Supporters of the method contend that the method appropriately recognizes the legal form of parent – subsidiary relationship.

8 Cost Method Dividends declared by subsidiary are recognized as revenue by the parent company. Dividends declared by subsidiary in excess of post-combination net income constitute a reduction of the carrying amount of the parent company’s investment in the subsidiary.

9 Cost Method According to the proponents of the cost method, a parent company realizes revenue from an investment in a subsidiary when the subsidiary declares dividend Not when the subsidiary reports net income.

10 Choosing Between Equity Method And Cost Method Consolidated financial statement amounts are the same, regardless of which method is used to account for subsidiary’s operations. Working paper eliminations used in the two methods are different.

11 Working Paper Eliminations for Equity Method Three components of the subsidiary’s stock holders’ equity are reciprocal to the parent company’s Investment Ledger Account. Subsidiary’s beginning-of-year retained earnings amount is eliminated. Subsidiary’s dividends are an offset to the subsidiary’s retained earnings.

12 Working Paper Eliminations for Equity Method Balance of the parent company’s Investment Ledger Account is net of the dividends received from the subsidiary. Elimination of the subsidiary’s beginning-of- year retained earnings makes beginning-of- year consolidated retained earnings identical to the end-of-previous-year consolidated retained earnings.

13 Working Paper Eliminations for Equity Method Debits to the subsidiary’s plant assets, patent, and goodwill bring into the consolidated balance sheet the un- amortized differences between current fair values and carrying amounts of the subsidiary’s assets on the date of the business combination.

14 Working Paper Eliminations for Equity Method Amount of the parent company’s inter- company investment income is an element of the balance of the parent’s Investment Ledger Account.

15 Working Paper Eliminations for Equity Method In effect, the elimination of the inter- company investment income comprises a reclassification of the inter-company investment income to the adjusted components of the subsidiary’s net income in the consolidated income statement.

16 Working Paper Eliminations for Equity Method Increases in the subsidiary’s cost of goods sold and operating expenses, in effect, reclassify the comparable decrease in the parent company’s Investment ledger account under the equity method of accounting.

17 Emphasized Aspects of Working Paper Inter-company receivable and payable, placed in adjacent columns on the same line, are offset without a formal elimination. Elimination cancels all inter-company transactions and balances not dealt with by the offset described above.

18 Emphasized Aspects of Working Paper Elimination cancels the subsidiary’s retained earnings balance at the beginning-of-year FIFO is used by subsidiary to account for inventories; Difference attributable to subsidiary’s beginning inventories is allocated to cost of goods sold for the year ended

19 Emphasized Aspects of Working Paper Income tax effects of the elimination’s increase in subsidiary’s expenses are not included in the elimination. One of the effects of the elimination is to reduce the differences between the current fair values and the carrying amounts of the subsidiary’s net assets excepting land and goodwill, on the business combination date.

20 Emphasized Aspects of Working Paper Parent company’s use of the equity method of accounting results in the equalities described below: – Parent Company Net Income = Consolidated Net Income. – Parent Company Retained Earnings = Consolidated Retained Earnings. Despite the equalities, consolidated financial statements are superior to parent company financial statements for the presentation of financial position and operating results of parent and subsidiary companies.

21 Closing Entries After consolidated financial statements have been completed, both the parent and its subsidiary companies prepare and post closing entries, to complete the accounting cycle for the year. Subsidiary’s closing entries are prepared in the usual fashion. Parent company’s use of equity method of accounting necessitates specialized closing entries.

22 Closing Entries Equity method of accounting disregards legal form in favor of economic substance State corporation laws generally require separate accounting for retained earnings available for dividends to stockholders.

23 Accounting for Operating Results of Partially Owned Subsidiaries Accounting for the operating results of a partially owned subsidiary requires the computation of the minority interest in net income or net losses of the subsidiary.

24 Accounting for Operating Results of Partially Owned Subsidiaries Under the economic unit concept, the consolidated income statement of a parent company and its partially owned subsidiaries includes an allocation of total consolidated income to the parent company and the minority interest.

25 Concluding Comments In today’s financial accounting environment, the equity method of accounting for a subsidiary’s operations is preferable to the cost method for the following reasons: The equity method is consistent with the accrual basis of accounting Emphasizes economic substance of the parent company – subsidiary relationship, while the cost method emphasizes legal form.

26 Concluding Comments -Equity method permits the use of parent company journal entries to reflect many items that must be included in working paper eliminations in the cost method – Formal journal entries in the accounting records provide a better record than do working paper eliminations. – Equity method facilitates issuance of separate financial statements, if required by SEC regulations or other considerations. – Equity method provides a useful self checking technique.