1. © The McGraw-Hill Companies, Inc., 2004 Slide 2-1 McGraw-Hill/Irwin Chapter Two Consolidation of Financial Information

2. © The McGraw-Hill Companies, Inc., 2004 Slide 2-2 McGraw-Hill/Irwin 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.

3. © The McGraw-Hill Companies, Inc., 2004 Slide 2-3 McGraw-Hill/Irwin The Consolidation Process Why Consolidated Statements?  They are presumed to be more meaningful that separate statements.  They are considered necessary for a fair presentation. The consolidation of financial information into a single set of statements becomes necessary whenever a single economic entity is created by the business combination of two or more companies. - - ARB No. 51

4. © The McGraw-Hill Companies, Inc., 2004 Slide 2-4 McGraw-Hill/Irwin Business Combinations A business combination occurs when an enterprise acquires net assets that constitute a business or equity interests of one or more other enterprises and obtains control over that enterprise or enterprises. - - SFAS No. 141

5. © The McGraw-Hill Companies, Inc., 2004 Slide 2-5 McGraw-Hill/Irwin Business Combinations Exh. 2-2Continue

6. © The McGraw-Hill Companies, Inc., 2004 Slide 2-6 McGraw-Hill/Irwin Business Combinations – Cont. Exh. 2-2

7. © The McGraw-Hill Companies, Inc., 2004 Slide 2-7 McGraw-Hill/Irwin 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

8. © The McGraw-Hill Companies, Inc., 2004 Slide 2-8 McGraw-Hill/Irwin GAAP Accounting Methods

9. © The McGraw-Hill Companies, Inc., 2004 Slide 2-9 McGraw-Hill/Irwin If the acquisition is made by issuing stock, the cost of the acquisition is equal to the MARKET VALUE of the stock issued. Purchase Method – SFAS 141 Used when when there is a change in ownership that results in control of one enterprise by another enterprise. The appropriate valuation basis for any purchase transaction is “cost”.

10. © The McGraw-Hill Companies, Inc., 2004 Slide 2-10 McGraw-Hill/Irwin Let’s look at some different situations where the Purchase Method would be used.

11. © The McGraw-Hill Companies, Inc., 2004 Slide 2-11 McGraw-Hill/Irwin Purchase Method Situations Dissolution of the acquired company:  Cost = FMV  Cost > FMV  Cost < FMV Separate incorporation is maintained. Dissolution of the acquired company:  Cost = FMV  Cost > FMV  Cost < FMV Separate incorporation is maintained.

12. © The McGraw-Hill Companies, Inc., 2004 Slide 2-12 McGraw-Hill/Irwin Purchase Method - Dissolution Cost = FMV Ignore the Equity and Nominal accounts of the acquired company. Determine FMV of the acquired company’s assets and liabilities. Prepare a journal entry to  recognize cost of the acquisition  incorporate the FMV of acquired company’s assets and liabilities into acquiring company’s books.

13. © The McGraw-Hill Companies, Inc., 2004 Slide 2-13 McGraw-Hill/Irwin Prepare the entry to record Large’s purchase. Purchase Method - Dissolution Cost = FMV On 1/1/04, Large acquired 100% of Tiny for $300,000 cash.

14. © The McGraw-Hill Companies, Inc., 2004 Slide 2-14 McGraw-Hill/Irwin Purchase Method - Dissolution Cost = FMV Tiny’s fair market value was $300,000 which is equal to the price paid by Large. Record the purchased assets at their market value.

15. © The McGraw-Hill Companies, Inc., 2004 Slide 2-15 McGraw-Hill/Irwin Purchase Method - Dissolution Cost > FMV At date of acquisition:  Acquired company should prepare a Balance Sheet as of the date of acquisition.  Acquired company’s income prior to acquisition is irrelevant to the acquiring company. FMV of acquired company’s assets and liabilities is added to acquiring company’s books. Difference between Cost and FMV is allocated to identifiable intangible assets and to goodwill. Note: Goodwill should be viewed as a residual amount remaining after all other identifiable and separable intangible assets have been identified.

16. © The McGraw-Hill Companies, Inc., 2004 Slide 2-16 McGraw-Hill/Irwin Small has no identifiable, separable intangible assets. Purchase Method - Dissolution Cost > FMV On 1/1/04, Huge acquires 100% of Small for $250,000 cash.

17. © The McGraw-Hill Companies, Inc., 2004 Slide 2-17 McGraw-Hill/Irwin Goodwill will be recorded as an intangible asset on Huge’s books, but will not be amortized. Purchase Method - Dissolution Cost > FMV

18. © The McGraw-Hill Companies, Inc., 2004 Slide 2-18 McGraw-Hill/Irwin Purchase Method - Dissolution Cost > FMV Prepare Large’s journal entry for this acquisition. Remember to record the $33,000 of Goodwill.

19. © The McGraw-Hill Companies, Inc., 2004 Slide 2-19 McGraw-Hill/Irwin Purchase Method - Dissolution Cost < FMV When FMV exceeds cost, we have a Bargain Purchase. Current assets and liabilities should be consolidated at their FMV. Long-term assets should be recorded at a value between FMV and BV.  each L-T asset’s FMV should be reduced by a proportionate share of the excess of FMV over cost.

20. © The McGraw-Hill Companies, Inc., 2004 Slide 2-20 McGraw-Hill/Irwin Purchase Method - Dissolution Cost < FMV 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)

21. © The McGraw-Hill Companies, Inc., 2004 Slide 2-21 McGraw-Hill/Irwin Let’s see what happens when the acquired company is not dissolved.

22. © The McGraw-Hill Companies, Inc., 2004 Slide 2-22 McGraw-Hill/Irwin Purchase Method No Dissolution The acquired company continues as a separate entity.  The acquisition shows up on the Parent’s books in 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. The acquired company continues as a separate entity.  The acquisition shows up on the Parent’s books in 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.

23. © The McGraw-Hill Companies, Inc., 2004 Slide 2-23 McGraw-Hill/Irwin 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 Sub’s net assets to FMV. 5.Allocate any excess of cost over BV to identifiable, separable intangible assets or goodwill. 6. Combine all account balances.

24. © The McGraw-Hill Companies, Inc., 2004 Slide 2-24 McGraw-Hill/Irwin No Dissolution Example On 1/1/05, Huge acquires 100% of Small for $250,000 cash. Small holds a trademark that is valued at $25,000.

25. © The McGraw-Hill Companies, Inc., 2004 Slide 2-25 McGraw-Hill/Irwin 1. Record the balances for each company in the worksheet.

26. © The McGraw-Hill Companies, Inc., 2004 Slide 2-26 McGraw-Hill/Irwin 2.Remove the investment account from the worksheet.

27. © The McGraw-Hill Companies, Inc., 2004 Slide 2-27 McGraw-Hill/Irwin 3.Remove the subsidiary’s equity account balances. Let’s look at the computation of Goodwill.

28. © The McGraw-Hill Companies, Inc., 2004 Slide 2-28 McGraw-Hill/Irwin Goodwill Computation for Huge’s Acquisition of Small We use these numbers for steps #4 & #5.

29. © The McGraw-Hill Companies, Inc., 2004 Slide 2-29 McGraw-Hill/Irwin 4.Adjust the subsidiary’s balances to FMV.

30. © The McGraw-Hill Companies, Inc., 2004 Slide 2-30 McGraw-Hill/Irwin 5.Record the trademark and the Goodwill.

31. © The McGraw-Hill Companies, Inc., 2004 Slide 2-31 McGraw-Hill/Irwin 6.Add the balances across the page.

32. © The McGraw-Hill Companies, Inc., 2004 Slide 2-32 McGraw-Hill/Irwin Purchase Price Allocations - Additional Issues Consolidation Costs  Legal Fees, Direct Costs of Combination  Increase the Investment in Subsidiary account. Stock Issuance Costs  Broker Fees, Registration Fees, etc.  Decrease the Parent’s Paid-In Capital account. Consolidation Costs  Legal Fees, Direct Costs of Combination  Increase the Investment in Subsidiary account. Stock Issuance Costs  Broker Fees, Registration Fees, etc.  Decrease the Parent’s Paid-In Capital account.

33. © The McGraw-Hill Companies, Inc., 2004 Slide 2-33 McGraw-Hill/Irwin Purchase Price Allocations - Additional Issues, SFAS No. 141 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?

34. © The McGraw-Hill Companies, Inc., 2004 Slide 2-34 McGraw-Hill/Irwin Purchase Price Allocations - Additional Issues, SFAS No. 141 Intangible Asset Examples Customer Base Trademarked Brand Names Customer Routes Effective Advertising Programs Covenants Rights (broadcasting, development, use, etc.) Customer Base Trademarked Brand Names Customer Routes Effective Advertising Programs Covenants Rights (broadcasting, development, use, etc.) Databases Technological know- how Patents & Copyrights Strong labor relations Assembled, trained workforce Favorable government relations Databases Technological know- how Patents & Copyrights Strong labor relations Assembled, trained workforce Favorable government relations Exh. 2-7

35. © The McGraw-Hill Companies, Inc., 2004 Slide 2-35 McGraw-Hill/Irwin Purchase Price Allocations - Additional Issues, SFAS No. 141 In-Process R&D  Should be expensed immediately upon acquisition, unless there are alternative future uses. IPR&D that has reached technological feasibility, can be “capitalized”.  Determination of fair value is critical. In-Process R&D  Should be expensed immediately upon acquisition, unless there are alternative future uses. IPR&D that has reached technological feasibility, can be “capitalized”.  Determination of fair value is critical.

36. © The McGraw-Hill Companies, Inc., 2004 Slide 2-36 McGraw-Hill/Irwin Unconsolidated Subsidiaries

37. © The McGraw-Hill Companies, Inc., 2004 Slide 2-37 McGraw-Hill/Irwin Let’s look at Pooling of Interests.

38. © The McGraw-Hill Companies, Inc., 2004 Slide 2-38 McGraw-Hill/Irwin Pooling of Interests Historically, many business combinations have been accounted for as “Pooling of Interests.” Purchase Method In its SFAS 141, “Business Combinations”, the FASB states that all business combinations should be accounted for using the “Purchase Method”. Historically, many business combinations have been accounted for as “Pooling of Interests.” Purchase Method In its SFAS 141, “Business Combinations”, the FASB states that all business combinations should be accounted for using the “Purchase Method”.

39. © The McGraw-Hill Companies, Inc., 2004 Slide 2-39 McGraw-Hill/Irwin Pooling of Interests According to SFAS No. 141, the purchase method is not to be applied prospectively to past Poolings of Interest. Past poolings of interests are left intact by SFAS No. 141. Therefore, it is important to understand how to account for PAST poolings. According to SFAS No. 141, the purchase method is not to be applied prospectively to past Poolings of Interest. Past poolings of interests are left intact by SFAS No. 141. Therefore, it is important to understand how to account for PAST poolings.

40. © The McGraw-Hill Companies, Inc., 2004 Slide 2-40 McGraw-Hill/Irwin 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. Precise cost figures were difficult to obtain. To use pooling of interests, 12 strict criteria had to be met. Historical Review of Pooling of Interests

41. © The McGraw-Hill Companies, Inc., 2004 Slide 2-41 McGraw-Hill/Irwin Historical Review of Pooling of Interests The Book Values of the two combining companies were joined. No Goodwill was recorded. Revenues and expenses were combined retroactively for the two companies.

42. © The McGraw-Hill Companies, Inc., 2004 Slide 2-42 McGraw-Hill/Irwin Historical Review of Pooling of Interests Both companies continued to exist. An Investment in Sub account was recorded on one company’s books (usually the larger). No Goodwill was recorded. Both companies were combined at BV. Both companies continued to exist. An Investment in Sub account was recorded on one company’s books (usually the larger). No Goodwill was recorded. Both companies were combined at BV.

43. © The McGraw-Hill Companies, Inc., 2004 Slide 2-43 McGraw-Hill/Irwin 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 the Investment in Subsidiary. The BV’s for both companies were entered on a consolidation worksheet. 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 the Investment in Subsidiary. The BV’s for both companies were entered on a consolidation worksheet.

44. © The McGraw-Hill Companies, Inc., 2004 Slide 2-44 McGraw-Hill/Irwin Continued Accounting for Pooling of Interests The Investment in Sub account must be eliminated.  Also eliminate the Sub’s Equity accounts to prevent double-counting.  They have already been included in the original Investment in Sub entry. Add together the BV’s of the remaining accounts.

45. © The McGraw-Hill Companies, Inc., 2004 Slide 2-45 McGraw-Hill/Irwin I can’t take much more of this! End of Chapter 2