1. Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 4 Consolidation of Wholly-Owned Subsidiaries Acquired at More than Book Value

2. 4-2 Learning Objective 1 Understand and make equity-method journal entries related to the differential.

3. 4-3 Basic Concepts: Parent and Subsidiary  Parent’s books Investment account initially contains the acquisition cost FMV of net assets, Plus goodwill, or Minus bargain purchase price Parent can use the cost or equity method  Subsidiary’s books Balance sheet: Assets and Liabilities are recorded at BOOK values. Income statement: Expenses calculated based on BOOK values

4. 4-4 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 both Balance Sheet, and Income Statement accounts.  Why wasn’t this a problem with created subs? No goodwill No undervalued assets at the time of creation

5. 4-5 Basic Concepts: Income Statement Impacts  Big Picture: Essentially, we switch the sub’s books from BV to FMV in the consolidation process.  Income Statement effects Asset Related Expense (as the asset expires) Equipment Inventory Patent Goodwill Depreciation Expense Cost of Goods Sold Amortization Expense Impairment Loss

6. 4-6 Basic Concepts: Income Statement Impacts  Income Statement Effects When Acquisition Price > Book Value Asset Related Expense (as the asset expires) Income Statement Effect Equipment Inventory Patent Goodwill Depreciation Expense Cost of Goods Sold Amortization Expense Impairment Loss Too Low (understated) If expenses are UNDERSTATED, then income is too high (OVERSTATED). To fix the problem, Parent needs to INCREASE expenses.

7. 4-7 Book value elementLife remaining Common Stock$130,000 Retained Earnings117,000 Under- or Over-valuation Inventory(6,500)2 months Land39,000Indefinite Equipment85,00010 years Covenant-not-to-compete52,0004 years Goodwill element 26,000Indefinite Total Cost$442,500 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:

8. 4-8 Acquisition Price=BV+Identifiable Excess+ GW Results for 20X9 (based on Book Values): Reported Income$78,000 Dividends Declared 45,500 What would the Sub’s income be based on Fair Values? Lower COGS (because inventory is worth less)$ (6,500) Extra depreciation on equipment 8,500 Extra amortization of contract 13,000 Total increase in expenses / decrease in income$ 15,000 $63,000 Example: Acquisition Price > Book Value 442,500=247,000+169,500+26,000

9. 4-9 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 income Recording share of sub’s dividends They should be based on the same FMV basis. Problem: Sub reports income based on BOOK VALUES Solution: Parent has to record an adjustment to the income and investment “Equity Method” accounts.

10. 4-10 Results for 20X9 (based on Book Values): Reported Income$78,000 Dividends Declared 45,500 Adjustment to Salt’s 20X9 income on Parent’s books: Lower COGS (because inventory is worth less) $ (6,500) Extra depreciation on equipment 8,500 Extra amortization of contract 13,000 Total increase in expenses / decrease in income$ 15,000 What entries would Pepper record in its general ledger related to Salt’s income and dividends for 20X9 under the equity method? Example: Equity Method

11. 4-11 Example: Equity Method Journal Entries 1.To record 100% share of Salt’s reported income: Investment in Salt78,000 Income from Salt78,000 2.To record 100% of Salt’s dividends declared: Dividend Receivable45,500 Investment in Salt45,500 3.To record additional expenses (based on FMV): Income from Salt15,000 Investment in Salt15,000

12. 4-12 Called “amortization of excess value” Example: Equity Method Investment Adjustment Calculate the correct ending balance in Pepper’s Investment in Salt account using the equity method: Investment in Salt Beginning Balance442,500 Net Income78,000 Ending Balance460,000 Dividend45,500 Income Adjustment15,000

13. 4-13 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. 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. 4-14 Practice Quiz Question #1 Solution 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. 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.

15. 4-15 Learning Objective 2 Understand and explain how consolidation procedures differ when there is a differential. Understand and explain how consolidation procedures differ when there is a differential.

16. 4-16 Consolidation Concepts by Chapter Wholly Owned Subsidiary Partially Owned Subsidiary Investment = Book Value Chapter 2Chapter 3 No Differential Investment > Book Value Chapter 4Chapter 5 Differential No NCI Shareholders NCI Shareholders

17. 4-17 Simple Example P S Stock Sub Shareholders $ Book value of net assets = $800 Excess value of identifiable assets = $200 Goodwill = $500 Assume 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:

18. 4-18 Understanding Components of Acquisition Cost AcquisitionFMV of Price=Assets+Goodwill Key:We need to keep track of each element of the purchase price separately! Why?? FMV ofExtra Assets=BV +Value AcquisitionExtra Price=BV+Value+Goodwill

19. 4-19 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 FMV Must recognize goodwill

20. 4-20 Summary of Consolidation Entries 1.The basic elimination entry: 2.The excess value reclassification entry: Asset 1XX Asset 2XX GoodwillXX Investment in SubExcess Common Stock (S)XX Additional Paid-in Capital (S)XX Retained Earnings, Beginning Balance (S)XX Income from SubXX Investment in SubBV Dividends DeclaredXX

21. 4-21 Summary of Consolidation Entries 3.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 SalesXX Other ExpensesXX Income from SubXX Accumulated DepreciationXX Buildings and EquipmentXX

22. 4-22 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. 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.

23. 4-23 Practice Quiz Question #2 Solution 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. 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.

24. 4-24 Learning Objective 3 Make calculations and prepare elimination entries for the consolidation of a wholly owned subsidiary when there is a complex positive differential at the acquisition date. Make calculations and prepare elimination entries for the consolidation of a wholly owned subsidiary when there is a complex positive differential at the acquisition date.

25. 4-25 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.

26. 4-26 Group Exercise 1: Solution How would this affect your worksheet elimination entries?

27. 4-27 1,600,000 Book value of net assets of the acquired firm 980,000 Excess value of identifiable assets 280,000 340,000 Group Exercise 1: Solution Acquisition Costs What did we pay for? 1,600,000 Investment in Sub Goodwill

28. 4-28 1,600,000 980,000 620,000 0 Group Exercise 1: Solution Investment Account 1.The basic elimination entry: 2.The excess value reclassification entry: Inventory50,000 Land130,000 Buildings and Equipment110,000 Patent90,000 Long-term Debt70,000 Goodwill (new)340,000 Notes Receivable60,000 Goodwill (old)110,000 Investment in Sub620,000 Common Stock120,000 Additional Paid-in Capital480,000 Retained Earnings380,000 Investment in Sub980,000 Investment in Sub

29. 4-29 Group Exercise 1: Solution Worksheet Entries 1.The basic elimination entry: 2.The excess value reclassification entry: 3.The accumulated depreciation elimination entry: Inventory50,000 Land130,000 Buildings and Equipment110,000 Patent90,000 Long-term Debt70,000 Goodwill (new)340,000 Notes Receivable60,000 Goodwill (old)110,000 Investment in Sub620,000 Common Stock120,000 Additional Paid-in Capital480,000 Retained Earnings380,000 Investment in Sub980,000 Accumulated Depreciation98,000 Building and Equipment98,000

30. 4-30 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. 708,000 Buildings & Equipment 98,000 Accumulated Depreciation

31. 4-31 Group Exercise 1: Solution Depreciation Entry 3.The accumulated depreciation elimination entry: Accumulated Depreciation98,000 Building and Equipment98,000 708,000 Buildings & Equipment 98,000 Accumulated Depreciation 98,000 610,000 0 Shows the Buildings and Equipment “as if” they have been recorded on the sub’s books as new assets at book value.

32. 4-32 Group Exercise 1: Solution Reclass Entry 3.The accumulated depreciation elimination entry: Accumulated Depreciation98,000 Building and Equipment98,000 708,000 Buildings & Equipment 98,000 Accumulated Depreciation 98,000 610,000 0 BV 110,000 The excess value reclassification elimination entry brings the Buildings and Equipment up to fair value. Excess Value Reclass FMV720,000

33. 4-33 Group Exercise 2: Worksheet at Acquisition Pepper acquired 100% of Salt’s outstanding stock for $442,500. Required: Prepare the consolidation entries and worksheet.

34. 4-34 Group Exercise 2: Worksheet Entries Book Value Analysis: Pepper’sSalt’s Equity Accounts, BV InvestmentCommonRetained Account, BVStockEarnings Balances, 12/31/X8 += The Basic Elimination Entry: Common Stock Retained Earnings Investment in Salt EB 442,500 Investment in Salt Cons. Excess Value Analysis: Pepper’sSalt’s Under- or (Over-) Valuation of Net Assets Element InvestmentInventoryLandEquipmentCovenantGoodwill Balances, 12/31/X8 = The Excess Value Reclassification Entry: Land Building & Equipment Covenant N-T-C Goodwill Inventory Investment in Salt Accumulated Depreciation Building & Equipment The Accumulated Depreciation Elimination Entry:

35. 4-35 Group Exercise 2: Worksheet Entries Book Value Analysis: Pepper’sSalt’s Equity Accounts, BV InvestmentCommonRetained Account, BVStockEarnings Balances, 12/31/X8247,000130,000117,000 += The Basic Elimination Entry: Common Stock Retained Earnings Investment in Salt EB 442,500 Investment in Salt Cons. Excess Value Analysis: Pepper’sSalt’s Under- or (Over-) Valuation of Net Assets Element InvestmentInventoryLandEquipmentCovenantGoodwill Balances, 12/31/X8 = The Excess Value Reclassification Entry: Land Building & Equipment Covenant N-T-C Goodwill Inventory Investment in Salt Accumulated Depreciation Building & Equipment The Accumulated Depreciation Elimination Entry:

36. 4-36 Group Exercise 2: Worksheet Entries Book Value Analysis: Pepper’sSalt’s Equity Accounts, BV InvestmentCommonRetained Account, BVStockEarnings Balances, 12/31/X8247,000130,000117,000 += The Basic Elimination Entry: Common Stock130,000 Retained Earnings117,000 Investment in Salt247,000 EB 442,500 Investment in Salt Cons. Excess Value Analysis: Pepper’sSalt’s Under- or (Over-) Valuation of Net Assets Element InvestmentInventoryLandEquipmentCovenantGoodwill Balances, 12/31/X8 = The Excess Value Reclassification Entry: Land Building & Equipment Covenant N-T-C Goodwill Inventory Investment in Salt Accumulated Depreciation Building & Equipment The Accumulated Depreciation Elimination Entry:

37. 4-37 Group Exercise 2: Worksheet Entries Book Value Analysis: Pepper’sSalt’s Equity Accounts, BV InvestmentCommonRetained Account, BVStockEarnings Balances, 12/31/X8247,000130,000117,000 += The Basic Elimination Entry: Common Stock130,000 Retained Earnings117,000 Investment in Salt247,000 EB 442,500 Investment in Salt Cons. Excess Value Analysis: Pepper’sSalt’s Under- or (Over-) Valuation of Net Assets Element InvestmentInventoryLandEquipmentCovenantGoodwill Balances, 12/31/X8195,500(6,500)39,00085,00052,00026,000 = The Excess Value Reclassification Entry: Land Building & Equipment Covenant N-T-C Goodwill Inventory Investment in Salt Accumulated Depreciation Building & Equipment The Accumulated Depreciation Elimination Entry:

38. 4-38 Group Exercise 2: Worksheet Entries Book Value Analysis: Pepper’sSalt’s Equity Accounts, BV InvestmentCommonRetained Account, BVStockEarnings Balances, 12/31/X8247,000130,000117,000 += The Basic Elimination Entry: Common Stock130,000 Retained Earnings117,000 Investment in Salt247,000 EB 442,500 Investment in Salt Cons. Excess Value Analysis: Pepper’sSalt’s Under- or (Over-) Valuation of Net Assets Element InvestmentInventoryLandEquipmentCovenantGoodwill Balances, 12/31/X8195,500(6,500)39,00085,00052,00026,000 = The Excess Value Reclassification Entry: Land39,000 Building & Equipment85,000 Covenant N-T-C52,000 Goodwill26,000 Inventory6,500 Investment in Salt195,500 Accumulated Depreciation Building & Equipment The Accumulated Depreciation Elimination Entry:

39. 4-39 Group Exercise 2: Worksheet Entries Book Value Analysis: Pepper’sSalt’s Equity Accounts, BV InvestmentCommonRetained Account, BVStockEarnings Balances, 12/31/X8247,000130,000117,000 += The Basic Elimination Entry: Common Stock130,000 Retained Earnings117,000 Investment in Salt247,000 EB 442,500 Investment in Salt 247,000 Basic Cons. 0 195,500 Excess Value Reclass Excess Value Analysis: Pepper’sSalt’s Under- or (Over-) Valuation of Net Assets Element InvestmentInventoryLandEquipmentCovenantGoodwill Balances, 12/31/X8195,500(6,500)39,00085,00052,00026,000 = The Excess Value Reclassification Entry: Land39,000 Building & Equipment85,000 Covenant N-T-C52,000 Goodwill26,000 Inventory6,500 Investment in Salt195,500 Accumulated Depreciation Building & Equipment The Accumulated Depreciation Elimination Entry:

40. 4-40 Group Exercise 2: Worksheet Entries Book Value Analysis: Pepper’sSalt’s Equity Accounts, BV InvestmentCommonRetained Account, BVStockEarnings Balances, 12/31/X8247,000130,000117,000 += The Basic Elimination Entry: Common Stock130,000 Retained Earnings117,000 Investment in Salt247,000 EB 442,500 Investment in Salt 247,000 Basic Cons. 0 195,500 Excess Value Reclass Excess Value Analysis: Pepper’sSalt’s Under- or (Over-) Valuation of Net Assets Element InvestmentInventoryLandEquipmentCovenantGoodwill Balances, 12/31/X8195,500(6,500)39,00085,00052,00026,000 = The Excess Value Reclassification Entry: Land39,000 Building & Equipment85,000 Covenant N-T-C52,000 Goodwill26,000 Inventory6,500 Investment in Salt195,500 Accumulated Depreciation57,200 Building & Equipment57,200 The Accumulated Depreciation Elimination Entry:

41. 4-41 Group Exercise 2: Worksheet at Year End

42. 4-42 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. 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.

43. 4-43 Practice Quiz Question #3 Solution 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. 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.

44. 4-44 Learning Objective 4 Make calculations and prepare elimination entries for the consolidation of a wholly owned subsidiary when there is a complex bargain-purchase differential. Make calculations and prepare elimination entries for the consolidation of a wholly owned subsidiary when there is a complex bargain-purchase differential.

45. 4-45 Acquired at Less than Fair Value of Net Assets  Bargain purchase A business combination where the sum of the acquisition-date fair values of the consideration given, any equity interest already held by the acquirer, and any noncontrolling interest is 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.

46. 4-46 Basic Concepts  Income Statement Effects When Acquisition Price < BV Asset Related Expense (as the asset expires) Income Statement Effect Equipment Inventory Patent Goodwill Depreciation Expense Cost of Goods Sold Amortization Expense Impairment Loss Too High (overstated) If expenses are OVERSTATED, then income is too low (UNDERSTATED). To fix the problem, Parent needs to DECREASE expenses.

47. 4-47 Practice Quiz Question #4 How do the elimination entries differ in a bargain purchase scenario from a 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. e.The elimination entry to reclassify expenses related to the differential decreases reported expenses. How do the elimination entries differ in a bargain purchase scenario from a 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. e.The elimination entry to reclassify expenses related to the differential decreases reported expenses.

48. 4-48 Practice Quiz Question #4 Solution How do the elimination entries differ in a bargain purchase scenario from a 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. e.The elimination entry to reclassify expenses related to the differential decreases reported expenses. How do the elimination entries differ in a bargain purchase scenario from a 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. e.The elimination entry to reclassify expenses related to the differential decreases reported expenses.

49. 4-49 Learning Objective 5 Prepare equity-method journal entries, elimination entries, and the consolidation worksheet for a wholly owned subsidiary when there is a complex positive differential. Prepare equity-method journal entries, elimination entries, and the consolidation worksheet for a wholly owned subsidiary when there is a complex positive differential.

50. 4-50 Book value elementLife remaining Common Stock$130,000 Retained Earnings117,000 Under- or Over-valuation Inventory(6,500)2 months Land39,000Indefinite Equipment85,00010 years Covenant-not-to-compete52,0004 years Goodwill element 26,000Indefinite Total Cost$442,500 Group Exercise 3 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:

51. 4-51 1.Update the analyses of the Investment account through 12/31/X9. 2.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. Group Exercise 3

52. 4-52 Group Exercise 3: Worksheet Entries Book Value Calculations: Pepper’sSalt’s Equity Accounts, BV InvestmentCommonRetained Account, BVStockAdd PICEarnings Balances, 1/1/X9 Add: Net Income Less Dividends Balances, 12/31/X9 += The Basic Elimination Entry: Common Stock Retained Earnings, 1/1/X9 Income from Salt Dividends Declared Investment in Salt +

53. 4-53 Group Exercise 3: Worksheet Entries Book Value Calculations: Pepper’sSalt’s Equity Accounts, BV InvestmentCommonRetained Account, BVStockAdd PICEarnings Balances, 1/1/X9247,000130,0000117,000 Add: Net Income 78,00078,000 Less Dividends(45,500)(45,500) Balances, 12/31/X9279,500130,0000149,500 += The Basic Elimination Entry: Common Stock Retained Earnings, 1/1/X9 Income from Salt Dividends Declared Investment in Salt +

54. 4-54 Group Exercise 3: Worksheet Entries Book Value Calculations: Pepper’sSalt’s Equity Accounts, BV InvestmentCommonRetained Account, BVStockAdd PICEarnings Balances, 1/1/X9247,000130,0000117,000 Add: Net Income78,00078,000 Less Dividends(45,500)(45,500) Balances, 12/31/X9279,500130,0000149,500 += The Basic Elimination Entry: Common Stock130,000 Retained Earnings, 1/1/X9117,000 Income from Salt78,000 Dividends Declared45,500 Investment in Salt279,500 +

55. 4-55 Group Exercise 3: Worksheet Entries Excess Value Calculations: Pepper’s Investment Salt’s Under- or (Over-) Valuation of Net Assets Element Account InventoryLandEquipmentAcc DepCovenantGoodwill Remaining Life Excess Cost 2 monthsIndefinite10 years4 years Balances, 1/1/X9 Less: Amortization Balances, 12/31/X9 = The Excess Value Reclassification Entry: Land Building & Equipment Covenant N-T-C Goodwill Accumulated Depreciation Investment in Salt Accumulated Depreciation Building & Equipment The Accumulated Depreciation Elimination Entry: The Amortized Excess Value Reclassification Entry: Depreciation Expense S&A Expense Cost of Sales Income from Salt

56. 4-56 Group Exercise 3: Worksheet Entries Land Building & Equipment Covenant N-T-C Goodwill Accumulated Depreciation Investment in Salt Accumulated Depreciation Building & Equipment The Accumulated Depreciation Elimination Entry: The Amortized Excess Value Reclassification Entry: Depreciation Expense S&A Expense Cost of Sales Income from Salt Excess Value Calculations: Pepper’s Investment Salt’s Under- or (Over-) Valuation of Net Assets Element Account InventoryLandEquipmentAcc DepCovenantGoodwill Remaining Life Excess Cost 2 monthsIndefinite10 years4 years Balances, 1/1/X9195,500(6,500)39,00085,00052,00026,000 Less: Amortization(15,000)6,5000(8,500)(13,000) Balances, 12/31/X9180,500039,00085,000(8,500)39,00026,000 = The Excess Value Reclassification Entry:

57. 4-57 Group Exercise 3: Worksheet Entries Excess Value Calculations: Pepper’s Investment Salt’s Under- or (Over-) Valuation of Net Assets Element Account InventoryLandEquipmentAcc DepCovenantGoodwill Remaining Life Excess Cost 2 monthsIndefinite10 years4 years Balances, 1/1/X9195,500(6,500)39,00085,00052,00026,000 Less: Amortization(15,000)6,5000(8,500)(13,000) Balances, 12/31/X9180,500039,00085,000(8,500)39,00026,000 = The Excess Value Reclassification Entry: Land39,000 Building & Equipment85,000 Covenant N-T-C39,000 Goodwill26,000 Accumulated Depreciation8,500 Investment in Salt180,500 Accumulated Depreciation Building & Equipment The Accumulated Depreciation Elimination Entry: The Amortized Excess Value Reclassification Entry: Depreciation Expense S&A Expense Cost of Sales Income from Salt

58. 4-58 Group Exercise 3: Worksheet Entries Excess Value Calculations: Pepper’s Investment Salt’s Under- or (Over-) Valuation of Net Assets Element Account InventoryLandEquipmentAcc DepCovenantGoodwill Remaining Life Excess Cost 2 monthsIndefinite10 years4 years Balances, 1/1/X9195,500(6,500)39,00085,00052,00026,000 Less: Amortization(15,000)6,5000(8,500)(13,000) Balances, 12/31/X9180,500039,00085,000(8,500)39,00026,000 = The Excess Value Reclassification Entry: Land39,000 Building & Equipment85,000 Covenant N-T-C39,000 Goodwill26,000 Accumulated Depreciation8,500 Investment in Salt180,500 Accumulated Depreciation Building & Equipment The Accumulated Depreciation Elimination Entry: The Amortized Excess Value Reclassification Entry: Depreciation Expense8,500 S&A Expense13,000 Cost of Sales6,500 Income from Salt15,000

59. 4-59 Group Exercise 3: Worksheet Entries Excess Value Calculations: Pepper’s Investment Salt’s Under- or (Over-) Valuation of Net Assets Element Account InventoryLandEquipmentAcc DepCovenantGoodwill Remaining Life Excess Cost 2 monthsIndefinite10 years4 years Balances, 1/1/X9195,500(6,500)39,00085,00052,00026,000 Less: Amortization(15,000)6,5000(8,500)(13,000) Balances, 12/31/X9180,500039,00085,000(8,500)39,00026,000 = The Excess Value Reclassification Entry: Land39,000 Building & Equipment85,000 Covenant N-T-C39,000 Goodwill26,000 Accumulated Depreciation8,500 Investment in Salt180,500 Accumulated Depreciation57,200 Building & Equipment57,200 The Accumulated Depreciation Elimination Entry: The Amortized Excess Value Reclassification Entry: Depreciation Expense8,500 S&A Expense13,000 Cost of Sales6,500 Income from Salt15,000

60. 4-60 Book value = 247,000 Identifiable Excess = 169,500 Group Exercise 3: Solution Investment Account BB 442,500 Investment in Salt Goodwill = 26,000 Look back at the beginning and ending balances in the two charts you just prepared to find the numbers! Book value = 279,500 Identifiable Excess = 154,500 Goodwill = 26,000 NI 78,000 45,500 Dividend 15,000 Excess Amort. EB 460,000 Beginning Balance: Ending Balance:

61. 4-61 Group Exercise 3: Worksheet Entries Investment in SaltIncome from Salt Notice how the worksheet entries “eliminate” Pepper’s equity method accounts: BB 442,500 NI 78,000 45,500Dividend 15,000Excess Amort. 15,000 EB 460,000 78,000 NI 279,500Basic 78,000 180,500Excess Reclass 00 63,000 Adj. Balance 15,000 Excess Amort. 15,000

62. 4-62 Group Exercise 3: Completed Worksheet

63. 4-63 Learning Objective 6 Understand and explain the elimination of basic intercompany transactions.

64. 4-64 Road Map: Intercompany Transactions  Typical intercompany transactions Intercompany reciprocal accounts (Chapter 4) Inventory transfers (Chapter 6) Fixed asset transfers (Chapter 7) Intercompany Indebtedness (Chapter 8)

65. 4-65 Arm’s-Length Transactions Q:What are “Arm’s-length” Transactions? A:“Transactions that take place between completely independent parties.”

66. 4-66 Categories of Transactions  Arm’s Length Transactions The 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 Transactions Usually referred to as “related party transactions.” Include all intercompany transactions.

67. 4-67 Types of “Related Party” Transactions  Involving only Individuals Transactions among family members.  Involving Corporations With management and other employees. With directors and stockholders. With affiliates (controlled entities). Probably constitutes at least 99% of all corporate related-party transactions.

68. 4-68 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.

69. 4-69 Intercompany Transactions: Additional Opportunities for Fraud  Intercompany transactions sometimes occur to Conceal embezzlements. Overstate reported profits. 2 + 2 = 5

70. 4-70 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. Group Exercise 4: Intercompany Loan & Interest Required: 1.What amounts should be reported in each company’s separate 20X8 income statement and 12/31/X8 balance sheet (asset and liability sections only)? 2.Prepare and post to your format the consolidation entries as of 12/31/X8, relating only to these accounts.

71. 4-71 How would you eliminate each item? Group Exercise 4: Solution Three things to think about: 1. Note receivable / payable 2. Interest revenue / expense 3. Interest receivable / payable 1.Note Payable (sub)XXX Note Receivable (parent)XXX 2.Interest Revenue (parent)XXX Interest Expense (sub)XXX 3.Interest Payable (sub)XXX Interest Receivable (parent)XXX

72. 4-72 Practice Quiz Question #5 Intercompany income statement accounts are eliminated in consolidation because they are deemed to be: a.Artificial transactions. b.Potentially manipulative transactions. c.Internal transactions. d.At amounts that are not determined on arms-length basis. e.none of the above. Intercompany income statement accounts are eliminated in consolidation because they are deemed to be: a.Artificial transactions. b.Potentially manipulative transactions. c.Internal transactions. d.At amounts that are not determined on arms-length basis. e.none of the above.

73. 4-73 Practice Quiz Question #5 Solution Intercompany income statement accounts are eliminated in consolidation because they are deemed to be: a.Artificial transactions. b.Potentially manipulative transactions. c.Internal transactions. d.At amounts that are not determined on arms-length basis. e.none of the above. Intercompany income statement accounts are eliminated in consolidation because they are deemed to be: a.Artificial transactions. b.Potentially manipulative transactions. c.Internal transactions. d.At amounts that are not determined on arms-length basis. e.none of the above.

74. 4-74 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: a.$0 b.$10,000 c.$20,000 d.$30,000 e.$40,000 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: a.$0 b.$10,000 c.$20,000 d.$30,000 e.$40,000

75. 4-75 Practice Quiz Question #6 Solution 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: a.$0 b.$10,000 c.$20,000 d.$30,000 e.$40,000 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: a.$0 b.$10,000 c.$20,000 d.$30,000 e.$40,000

76. 4-76 Learning Objective 7 Understand and explain the basics of push-down accounting.

77. 4-77 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 Accounting Force Sub to revalue to FMV Non-Push-Down Accounting Account for the “extra” value separately. Parent Sub

78. 4-78 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 difference A = L + E X Revaluation Capital

79. 4-79 Nonpush-Down Accounting: The HARDER Way  Non-Push-Down Accounting: 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).

80. 4-80 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 differ Who does the work– parent or sub?

81. 4-81 Push-Down vs. Non-Push-Down Accounting: The Bottom Line  The consolidated financial statement amounts are the SAME whether the parent selects: Push-down accounting or Non-push-down accounting. ONLY the accounting procedures differ.

82. 4-82 Parent’s Amortization of Cost in Excess of Book Value: How Handled?  Non-push-down accounting Equity Method Recorded in parent’s general ledger Maintains built-in checking features Cost Method Recorded on consolidation worksheets  Push-down accounting Parent has no amortization – sub records the amortization

83. 4-83 Consolidated Financial Statements Sub’s Income Statement (Based on Book Values) Sub’s Balance Sheet (Based on Book Values) Sub’s Income Statement (Based on Fair Values) Sub’s Balance Sheet (Based on Fair Values) Parent’s Adjustments For Excess Value (Consolidation Process) + + = = Push-down AccountingNon-push-down Accounting Actually, these numbers are only part of the consolidated financial statements.

84. 4-84 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.

85. 4-85 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. 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.

86. 4-86 Practice Quiz Question #7 Solution 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. 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.

87. 4-87 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. 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.

88. 4-88 Practice Quiz Question #8 Solution 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. 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.

89. 4-89 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. 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.

90. 4-90 Practice Quiz Question #9 Solution 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. 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.

91. Conclusion The End 4-91