Prepared by: Jan Hájek Accounting 2 Lecture no 5

Basic assumption (not taken into account Deffered tax Exchange rate differeces Change in share volume Deconsolidation Etc.

The Objective Of Consolidation Parent Sub A Sub B Parent And Subs As If One Entity

International Convergence  IFRS No. 3 and IAS No. 27 Require 100 percent of the fair values of identifiable assets Require treating the non-controlling interest as part of shareholders’ equity Like entity approach except no 100 percent of goodwill Current proposals will record 100 percent of goodwill

User Needs  Creditors Consolidated Entity ≠ Legal Entity Creditors must look to single entity parent or subsidiary

User Needs  Taxation Authorities U.S. has consolidated tax return In Czech Republic – the single legal entities must file

User Needs  Non-Controlling Shareholders Must look to single entity statements to evaluate their investment  Majority Shareholders The major users of consolidated financial statements

Consolidation Policy

Terminology  The “correct” term is “Non-Controlling Interest” Control may not required holding a majority share of voting shares. Consolidation is still required  “Minority Interest” is still widely used In most cases, control requires a majority of the voting shares In these situations, Minority Interest is an appropriate description of the Non-Controlling Interest

Conceptual Alternatives In Consolidation Controlling Interest Non-Controlling Interest What Is The Nature Of This Interest?

Conceptual Alternatives In Consolidation  Proprietary Approach The Non-Controlling Interest is not part of the consolidated entity Like proportionate consolidation

Proprietary Approach Procedures  Assets: Only the parent’s share of fair values  Non-controlling interest In assets: None disclosed In income: None disclosed  Unrealized Profits: Eliminate parent’s share

Conceptual Alternatives In Consolidation  Parent Company Approach The Non-Controlling Interest is a debt-like interest in the consolidated entity Not used (IFRS, CAS)

Parent Company Approach Procedures  Assets: Includes subsidiary carrying values, plus the parent’s share of fair value changes  Non-controlling interest In assets: With the liabilities In income: Deducted in the determination of income (like interest)  Unrealized Profits: Eliminate parent’s share

Conceptual Alternatives In Consolidation  Entity Approach The Non-Controlling Interest is an equity interest in the consolidated entity The IFRS approach

Entity Approach Procedures  Assets: Includes 100 percent of subsidiary fair values  Non-controlling interest In assets: With shareholders’ equity In income: Shown as distribution of income (like preferred dividends)  Unrealized Profits: Eliminate 100 percent (upstream and downstream)

Conceptual Alternatives  Asset Value Example Parco owns 65 percent of the voting shares of Subco. Parco has Land with a carrying value of $1,000,000. Subco has Land with a carrying value of $500,000 and a fair value of $700,000.

Proprietary Approach Solution Parco ’ s Carrying Value $1,000, Percent Of Subco ’ s Fair Value [(65%)($700,000)] [(65%)($700,000)]455,000 Consolidated Land $1,455,000

Parent Company Approach Solution Parco ’ s Carrying Value $1,000,000 Subco ’ s Carrying Value 500, Percent Of Subco ’ s Fair Value Change [(65%)($700,000 - $500,000)] [(65%)($700,000 - $500,000)]130,000 Consolidated Land $1,630,000

Entity Approach Solution Parco ’ s Carrying Value $1,000, Percent Of Subco ’ s Fair Value 700,000 Consolidated Land $1,700,000

Evaluation  Proprietary Does not reflect the economic entity which is made up of 100 percent of both companies’ assets  Parent Company Non-controlling interest has none of the characteristics of debt  Entity Reflects properly the nature of the non- controlling interest Used in IFRSs (Current and Proposed)

Procedural Approaches  Consolidation to the Date of Acquisition  Consolidation in consequent years

Procedural Approaches  Every text has a different approach  Everyone who has ever taught the subject believes that they have a better way  Difficult to move between alternatives

Procedural Approaches  Work Sheets A mechanistic approach that is easy to use, provided a proper format is provided Provides no understanding of the underlying concepts

Procedural Alternatives  Direct Calculations Of Required Balances The most efficient approach Requires complete understanding of concepts

Procedural Alternatives  Journal Entries into direct calculations Stresses an understanding of concepts Provides for movement towards direct calculations of required balances Is not dependent on the format of the problem Supported by a large quantity of problem material in this text

General Approach  Eliminate the investment account against the subsidiary Shareholders’ Equity at acquisition  Allocate the excess of the investment cost over the carrying values of the subsidiary assets to fair value changes and goodwill  Establish the Non-Controlling Interest At Acquisition

General Approach  Various adjustments and eliminations

General Approach  Allocate the subsidiary’s Retained Earnings since acquisition To Controlling Interest To Non-Controlling Interest

Investment Analysis Schedule Investment Cost $1,000,000 Subsidiary Shareholders ’ Equity ( 800,000) Differential (Excess Of Cost Over Book Value) $ 200,000 Fair Value Increase On Assets ( 20,000) Fair Value Decrease On Assets 30,000 Fair Value Increase On Liabilities 40,000 Fair Value Decrease On Liabilities ( 50,000) Goodwill$200,000 This type of analysis is required in almost every consolidation problem. The basic rules are as shown in this example. The numbers were created for this example.

Example – Consolidation At Acquisition Parco purchases 70 percent of the outstanding voting shares of Subco for cash of $735,000. Subco ’ s assets have a fair value of $1,400,000. ParcoSubco Assets$3,500,000$1,200,000 Liabilities$1,300,000 $ 500,000 Shareholders ’ Equity Common Stock Common Stock900,000200,000 Retained Earnings Retained Earnings1,300,000500,000 Total Equities $3,500,000$1,200,000

Example – Investment Analysis Schedule 70%100% Investment Cost $735,000$1,050,000 Book Value ( 490,000) ( 700,000) Differential$245,000 $ 350,000 Fair Value Increase On Assets ( 140,000) ( 200,000) Goodwill$105,000$150,000

Consolidated Balance Sheet Proprietary Approach Assets [$3,500,000 - $735,000 + (70%)($1,200,000 + $200,000)] (70%)($1,200,000 + $200,000)]$3,745,000 Goodwill105,000 Total Assets $3,850,000 Liabilities [$1,300,000 + (70%)($500,000)] $1,650,000 Shareholders ’ Equity Common Stock (Parco ’ s) Common Stock (Parco ’ s)900,000 Retained Earnings (Parco ’ s) Retained Earnings (Parco ’ s)1,300,000 Total Equities $3,850,000

Consolidated Balance Sheet Parent Company Approach Assets [$3,500,000 - $735,000 + (100%)($1,200,000) + (70%)($200,000)] + (100%)($1,200,000) + (70%)($200,000)]$4,105,000 Goodwill105,000 Total Assets $4,210,000 Liabilities Regular [$1,300,000 + (100%)($500,000)] Regular [$1,300,000 + (100%)($500,000)]$1,800,000 Non-Controlling Interest [(30%)($700,000)] Non-Controlling Interest [(30%)($700,000)]210,000 Total Liabilities $2,010,000 Shareholders ’ Equity Common Stock (Parco ’ s) Common Stock (Parco ’ s)900,000 Retained Earnings (Parco ’ s) Retained Earnings (Parco ’ s)1,300,000 Total Equities $4,210,000

Consolidated Balance Sheet Entity Approach Assets [$3,500,000 - $735,000 + (100%)($1,200,000 + $200,000)] (100%)($1,200,000 + $200,000)]$4,165,000 Goodwill150,000 Total Assets $4,315,000 Liabilities [$1,300,000 + (100%)($500,000)] $1,800,000 Shareholders ’ Equity Non-Controlling Interest [(30%)($1,050,000)] Non-Controlling Interest [(30%)($1,050,000)]315,000 Common Stock (Parco ’ s) Common Stock (Parco ’ s)900,000 Retained Earnings (Parco ’ s) Retained Earnings (Parco ’ s)1,300,000 Total Equities $4,315,000

Consolidated Balance Sheet IFRS No. 3 and IAS No. 27 Assets [$3,500,000 - $735,000 + (100%)($1,200,000 + $200,000)] (100%)($1,200,000 + $200,000)]$4,165,000 Goodwill105,000 Total Assets $4,270,000 Liabilities [$1,300,000 + (100%)($500,000)] $1,800,000 Shareholders ’ Equity Non-Controlling Interest [(30%)($700,000 + $200,000)] Non-Controlling Interest [(30%)($700,000 + $200,000)]270,000 Common Stock (Parco ’ s) Common Stock (Parco ’ s)900,000 Retained Earnings (Parco ’ s) Retained Earnings (Parco ’ s)1,300,000 Total Equities $4,270,000

Consolidated Income statement Income Statements (Ponto Owns 70 Percent of Sonto) PontoSonto Sales$500,000$200,000 Cost Of Goods Sold $300,000$110,000 Other Expenses 80,00040,000 Total Expenses $380,000$150,000 Net Income $120,000$50,000

Consolidated Income Statement Proprietary Solution Sales [$500,000 + (70%)($200,000)] $640,000 Cost Of Goods Sold [$300,000 + (70%)($110,000)] $377,000 Other Expenses [$80,000 + (70%)($40,000)] 108,000 Total Expenses $485,000 Net Income $155,000

Consolidated Income Statement Parent Company Solution Sales ($500,000 + $200,000) $700,000 Cost Of Goods Sold ($300,000 + $110,000) $410,000 Other Expenses ($80,000 + $40,000) 120,000 Total Expenses $530,000 Combined Income $170,000 Non-Controlling Interest [(30%)($50,000)] 15,000 Net Income $155,000

Consolidated Income Statement Entity Solution Sales ($500,000 + $200,000) $700,000 Cost Of Goods Sold ($300,000 + $110,000) $410,000 Other Expenses ($80,000 + $40,000) 120,000 Total Expenses $530,000 Net Income $170,000 Non-Controlling Interest [(30%)($50,000)] 15,000 Increase In Retained Earnings $155,000

Consolidated Statement Of Cash Flows  In general, the procedures are the same for consolidated Cash Flow Statements as for single entity Cash Flow Statements  Preparation requires a consolidated Net Income figure

Consolidated Statement Of Cash Flows  Differences Non-Controlling Interest must be added back to get cash from operations The dividend figure in this statement (all dividends of parent and sub) will be different than the dividend figure in the Statement Of Retained Earnings (excludes dividends to non-controlling interest)

Consolidated Statement Of Cash Flows  Parent acquires additional subsidiary shares For cash from sub: an intercompany transaction that would be eliminated For cash from non-controlling shareholders: an outflow of consolidated cash  Similar analysis for sales of shares

Step B(2) Realization of Fair Value Changes  Basic Concept Acquisition amounts recorded in Step A As assets are sold or used, the recorded fair value changes become realized As the fair value changes become realized, the Step A amounts must be reduced, with the changes taken into income

Step B(2) – Current Assets On January 1, 2008, Par acquires 100 percent of the voting shares of Sub. Sub has Inventories with a carrying value of $550,000 and a fair value of $600,000. During the year ending December 31, 2008, the Inventories are sold, with Sub recording a Cost Of Goods Sold of $550,000.

Step B(2) - Inventories  Required Adjustment 2008  Increases Cost Of Goods Sold and reverses the Step A debit of $50,000 Year Ending December 31, 2008 Cost Of Goods Sold $50,000 Inventories$50,000

Step B(2) - Inventories  Required adjustment 2009  This entry will be required in every subsequent year Year Ending December 31, 2009 Cost Of Goods Sold $50,000 Inventories$50,000

Step B(2) - Depreciable Assets On January 1, 2008, Par acquires 100 percent of the voting shares of Sub. Sub has a factory building with a carrying value of $810,000 and a fair value of $900,000. The building will be used for 3 years and retired on December 31, 2010 with no salvage value. It is subject to straight line amortization at the rate of $270,000 per year.

Step B(2) - Depreciable Assets  Required Adjustment 2008  Increases Amortization Expense from $270,000 ($810,000 ÷ 3) to $300,000 ($900,000 ÷ 3). Reduces the Step A allocation from $90,000 to $60,000. Year Ending December 31, 2008 Amortization Expense ($90,000 ÷ 3) $30,000 Building (Net) $30,000

Step B(2) - Depreciable Assets  Required adjustment 2009  Reduces the opening Retained Earnings to reflect the 2008 amortization. Increases Amortization Expense from $270,000 ($810,000 ÷ 3) to $300,000 ($900,000 ÷ 3). Reduces the Step A allocation from $90,000 to $30,000. Year Ending December 31, 2009 Retained Earnings (Opening) $30,000 Amortization Expense 30,000 Building (Net) $60,000

Step B(2) - Depreciable Assets  Required adjustment 2010  Reduces the opening Retained Earnings to reflect the 2008 and 2009 amortization. Increases Amortization Expense from $270,000 ($810,000 ÷ 3) to $300,000 ($900,000 ÷ 3). Reduces the Step A allocation from $90,000 to Nil. Year Ending December 31, 2010 Retained Earnings (Opening) $60,000 Amortization Expense 30,000 Building (Net) $90,000

Step B(2) Depreciable Assets  Required adjustment 2011  This entry will be required in every subsequent year Year Ending December 31, 2011 Retained Earnings $90,000 Building (Net) $90,000

Step B(2) - Land On January 1, 2008, Par acquires 100 percent of the voting shares of Sub. Sub has Land with a carrying value of $450,000 and a fair value of $600,000. Sub sells this parcel of Land on December 31, 2011 for $700,000.

Step B(2) - Land As Land does not depreciate, no entry is required in 2008, 2009, or 2010.

Step B(3) - Land  Sub’s entry when Land is sold Year Ending December 31, 2011 Cash$700,000 Gain On Sale Of Land $250,000 Land450,000

Step B(3) - Land  Required Consolidation Adjustment Reduce gain to $100,000 ($700,000 - $600,000) Reverse the Step A allocation to Land Year Ending December 31, 2011 Gain On Sale Of Land $150,000 Land$150,000

Step B(3) – Goodwill Impairment  Goodwill is no longer subject to amortization  Must be tested annually for impairment  If impaired: The Step A allocation must be adjusted and charged to income

Step B(4) – Intercompany Expenses and Revenues  Must be eliminated for purposes of consolidation  Unless an unrealized profit is involved, the elimination does not change consolidated Net Income or the Non- Controlling Interest in income

Step B(4) – Intercompany Expenses and Revenues  During 2008, a subsidiary pays interest of $50,000 to its parent  Required adjustment: Year Ending December 31, 2008 Interest Revenue (Parent ’ s) $50,000 Interest Expense (Subsidiary ’ s) $50,000

Step B(5) – Intercompany Dividends  Required Adjustments Eliminate the Dividend Revenue recorded by the parent Eliminate 100 percent of the Dividends Declared by the subsidiary ○ Statement Of Retained Earnings contains parent company approach income (doesn’t include minority share) ○ This means minority dividends cannot be shown in the Statement of Retained Earnings Minority share of dividends debited to the Non-Controlling Interest in the Balance Sheet

Step B(6) - Unrealized Profits  Examples to be used Intercompany land sales Intercompany inventory sales Intercompany sale of depreciable asset

Unrealized Profits – Sale of Land Example Patco owns 70 percent of the voting shares of Satco. On January 1, 2008, Satco sells Land with a cost of $200,000 to Patco for $250,000. On January 1, 2010, Patco sells the Land to an outside party for $325,000. In 2008, Patco records the Land at $250,000 and Satco records a Gain On Sale Of Land of $50,000. In 2010, Patco records a Gain of $75,000.

Unrealized Profits – Sale of Land Required Adjustment Gain On Sale Of Land $50,000 Land Land$50,000 This adjustment will reduce the Non-Controlling Interest in income by $15,000 [(30%)($50,000)] and consolidated Net Income by $35,000 [(70%)($50,000)]. If the transaction had been a downstream sale, the journal entry would be the same. However, consolidated Net Income would be reduced by the full $50,000, with no effect on the Non-Controlling Interest.

Unrealized Profits – Sale of Land Required Adjustment Satco’s Opening Retained Earnings $50,000 Land Land$50,000 This adjustment will reduce the Non-Controlling Interest in the Balance Sheet by $15,000 [(30%)($50,000)] and consolidated Retained Earnings by $35,000 [(70%)($50,000)].

Unrealized Profits – Sale of Land Required Adjustments Satco’s Opening Retained Earnings $50,000 Land Land$50,000 Land$50,000 Gain On Sale Of Land Gain On Sale Of Land$50,000 The first entry removes the gain from Satco’s opening Retained Earnings. The second adds it to 2010 income, with 30 percent going to the Non-Controlling Interest and 70 percent going to consolidated Net Income. Patco’s entry to record its $75,000 gain is not affected.

Unrealized Inventory Profits  Communicating the amount Amount is stated Gross profit as a percent of sales price Gross margin as a percent of cost Calculate from income statement data (rare)

Closing Inventory Profits Example Patco owns 70 percent of the voting shares of Satco. During 2008, Satco sells merchandise to Patco for $500,000. The merchandise is priced to provide Satco with a Gross Margin of 40 percent. On December 31, 2008, one-half of this merchandise is still in the Inventories of Patco.

Closing Inventory Profits Required Eliminations Sales$500,000 Cost Of Goods Sold Cost Of Goods Sold$500,000 Cost Of Goods Sold [(40%)(1/2)($500,000)] [(40%)(1/2)($500,000)]$100,000 Inventories Inventories$100,000 As this was an upstream transaction, the second entry will reduce the Non-Controlling Interest by $30,000 [(30%)($100,000)] and consolidated Net Income by $70,000 [(70%)($100,000)].

Opening Inventory Profits  2008 profits will still be unrealized at beginning of 2009  As they are current assets, the profits will normally be realized during 2009  Remove from opening Retained Earnings and add to 2009 income

Opening Inventory Profits Required Elimination Satco’s Opening Retained Earnings $100,000 Cost Of Goods Sold Cost Of Goods Sold$100,000 This entry will reduce Satco’s opening Retained Earnings by $100,000. This reduction will be split pro rata between the Non-Controlling Interest and consolidated Retained Earnings. It will increase the Non- Controlling Interest in income by $30,000 [(30%)($100,000)] and consolidated Net Income by $70,000 [(70%)($100,000)].

Unrealized Profits on Sales of Depreciable Assets Example Patco owns 70 percent of the voting shares of Satco. On January 1, 2008, Satco sells equipment to Patco for $225,000. The equipment, which has a remaining useful life of 3 years, has a carrying value of $150,000 on the books of Satco. Both companies using straight line amortization, with Patco charging $75,000 to expense in each of the years 2008 through The asset is retired on December 31, 2010.

Unrealized Profits on Sales of Depreciable Assets Realization Concepts With land and inventories, realization of intercompany profits occurs when the assets are sold. With depreciable assets, realization of intercompany profits occurs as the assets are used. Think of use as a sort of “ piecemeal ” sale of the depreciable asset.

Unrealized Profits on Sales of Depreciable Assets Required Eliminations Gain On Sale $75,000 Depreciable Asset (Net) Depreciable Asset (Net)$50,000 Amortization Expense Amortization Expense25,000 This entry eliminates the gain, reduces the net value of the asset by $50,000 ($75,000 - $25,000), and reduces Amortization Expense from $75,000 to $50,000. As this was an upstream transaction, the entry will reduce the Non-Controlling Interest by $15,000 [(30%)($50,000)] and consolidated Net Income by $35,000 [(70%)($50,000)].

Unrealized Profits on Sales of Depreciable Assets Required Eliminations Satco’s Opening Retained Earnings $50,000 Depreciable Asset (Net) Depreciable Asset (Net)$25,000 Amortization Expense Amortization Expense25,000 At this point, the unrealized gain is $50,000, an amount that must be removed from Satco’s opening Retained Earnings.

Unrealized Profits on Sales of Depreciable Assets Required Eliminations – 2010 Satco’s Opening Retained Earnings $25,000 Depreciable Asset (Net) Depreciable Asset (Net)Nil Amortization Expense Amortization Expense$25,000 At the end of 2010, the intercompany gain has been fully realized and no further entries will be required in 2011 and subsequent years.

Step C Schedule (With Unrealized Profits) Beginning Balance Of Retained Earnings $1,200,000 Step A Elimination ( 800,000) Balance Since Acquisition $ 400,000 Adjustments For Upstream Profits ( 110,000) Adjusted Balance Since Acquisition $ 290,000 Non-Controlling Share (20%) ( 58,000) Available To Controlling Interest $ 232,000 Adjustments For Fair Value Changes and Goodwill Impairment and Goodwill Impairment ( 120,000) To Consolidated Retained Earnings $ 112,000 *Numbers created for this example

Consolidated Net Income – Definitional Calculation Parent Company Income $1,000,000 Less: Intercompany Dividends ( 60,000) $ 940,000 Parent’s Equity In Subsidiary Net Income After Adjustments For Unrealized Upstream Profits Adjustments For Unrealized Upstream Profits220,000 $1,160,000 Fair Value And Goodwill Adjustments For Current Year For Current Year ( 105,000) Adjustments For Downstream Profits ( 45,000) Consolidated Net Income $1,055,000 *Numbers created for this example

Consolidated Retained Earnings – Definitional Calculation Parent Company Closing Retained Earnings $3,500,000 Add: Parent’s Share Of Subsidiary Retained Earnings Since Acquisition Retained Earnings Since Acquisition Adjusted For Upstream Profits Adjusted For Upstream Profits800,000 $4,300,000 Fair Value And Goodwill Adjustments (Cumulative Amounts) (Cumulative Amounts) ( 360,000) Adjustments For Downstream Profits ( 120,000) Consolidated Retained Earnings $3,820,000 *Numbers created for this example

Application of the Equity Method  “One Line Consolidation”: All consolidation adjustments are treated as adjustments of investment income No elimination of intercompany assets, liabilities, expenses, or revenues

Investment Income Under The Equity Method (With Unrealized Profits) Reported Investment Income (All Sources) $200,000 Less: Intercompany Dividends ( 80,000) $120,000 Parent’s Equity In Investee’s Net Income Adjusted For Upstream Profits Adjusted For Upstream Profits150,000 $270,000 Fair Value And Goodwill Adjustments For Current Year For Current Year ( 45,000) Adjustments For Downstream Profits ( 75,000) Equity Method Investment Income $150,000 *Numbers created for this example

Investment Account Balance Under The Equity Method (With Unrealized Profits) Investment Cost $1,200,000 Investor’s Equity In Investee’s Retained Earnings Since Acquisition Adjusted For Upstream Profits Since Acquisition Adjusted For Upstream Profits320,000 $1,520,000 Fair Value And Goodwill Adjustments (Cumulative Since Acquisition) (Cumulative Since Acquisition) ( 145,000) Adjustments For Downstream Profits ( 75,000) Equity Method Investment Account Balance $1,300,000 *Numbers created for this example

The amount charged when one division sells goods or services to another division. Battery DivisionAuto Division Batteries Transfer Prices

A higher transfer price for batteries means greater profits for the Battery Division. Auto DivisionBattery Division Transfer Prices The transfer price affects the profit measure for both buying and selling divisions.

... lower profits for the Auto Division. Auto DivisionBattery Division A higher transfer price for batteries means... Transfer Prices The transfer price affects the profit measure for both buying and selling divisions.

Many companies use the external market value of goods transferred as the transfer price. Transfer Prices Transfer prices have no direct effect upon the company’s overall net income.

When the external market value of goods transferred is unavailable... Transfer Prices Negotiated transfer price Cost-plus transfer price