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©Cambridge Business Publishing, 2010 Reporting Business Combinations 1 Operations are accounted for as separate entities throughout the year Parent Subsidiary.

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Presentation on theme: "©Cambridge Business Publishing, 2010 Reporting Business Combinations 1 Operations are accounted for as separate entities throughout the year Parent Subsidiary."— Presentation transcript:

1 ©Cambridge Business Publishing, 2010 Reporting Business Combinations 1 Operations are accounted for as separate entities throughout the year Parent Subsidiary Consolidated Entity Acquirer Acquired company Year-end Reporting Purposes This chapter is limited to wholly-owned subsidiaries.

2 ©Cambridge Business Publishing, 2010 Purpose of Consolidated Financial Statements  To present results of operations and the financial position of a parent and all its subsidiaries as if the consolidated group were a single economic entity  Primarily for the benefit of owners and creditors of the parent 2 Presumption Consolidated financial statements are more meaningful than separate statements when one entity in the consolidated group directly or indirectly has a controlling financial interest in the other entity

3 ©Cambridge Business Publishing, 2010 Concept of Control  Requires ownership of a majority voting interest, by one entity, directly or indirectly, of more than 50 percent of the outstanding voting shares of another entity  SFAS 94 requirements  Consolidate majority-owned entities  Except when  Control is temporary, or  Control is not present  Nonhomogeneity exception eliminated to avoid ‘off-balance-sheet financing’ 3

4 ©Cambridge Business Publishing, 2010 Financial Effects of Consolidation Manufacturing Company plans to buy the stock of Finance Corporation for $10 million cash. Balance sheets before Manufacturing Company acquires stock of Finance Corporation: 4 Manufacturing Co.Finance Corp. Total assets$220,000,000$110,000,000 Total liabilities$115,000,000$100,000,000 Stockholders' equity105,000,000 10,000,000 Total liabilities and equity$220,000,000$110,000,000 Entry to record statutory merger of Finance Corp. by Manufacturing Company: Total assets110,000,000 Total liabilities100,000,000 Cash10,000,000

5 ©Cambridge Business Publishing, 2010 Financial Effects of Equity Method Suppose the equity method is used. Balance sheets before Manufacturing Company acquires stock of Finance Corporation: 5 Manufacturing Co.Finance Corp. Total assets$220,000,000$110,000,000 Total liabilities$115,000,000$100,000,000 Stockholders' equity105,000,000 10,000,000 Total liabilities and equity$220,000,000$110,000,000 Entry to record equity method acquisition of Finance Corporation: Investment in Finance Corp.10,000,000 Cash10,000,000

6 ©Cambridge Business Publishing, 2010 Comparing Consolidation and Equity Method Leverage As a Consolidated Entity Total liabilities/ Total assets = 0.67 Total liabilities/ Total equity = 2.05 6 Consolidated Balance Sheet of Manufacturing Company and Subsidiary Total assets$320,000,000 Total liabilities$215,000,000 Stockholders' equity105,000,000 Total liabilities and equity$320,000,000 Balance Sheet of Manufacturing Company using Equity Method Other assets$210,000,000 Investment in Finance Corp. 10,000,000 Total assets$220,000,000 Total liabilities$115,000,000 Stockholders' equity 105,000,000 Total liabilities and equity$220,000,000 Using Equity Method Accounting Total liabilities/ Total assets = 0.52 Total liabilities/ Total equity = 1.10 Using Equity Method Accounting Total liabilities/ Total assets = 0.52 Total liabilities/ Total equity = 1.10

7 ©Cambridge Business Publishing, 2010 Control and Consolidation  Control exists for  Investments in over 50% of the voting stock of another company  Consolidation required unless unusual circumstances prevent control  Consolidation is allowed if investment is less than 50% 7 Virtually all consolidated subsidiaries involving equity ownership have U.S. parents with majority ownership.

8 ©Cambridge Business Publishing, 2010 Special Purpose Entities (SPEs)  Legal structures formed for specific business activities  Control may be obtained  Without paying consideration, or  With little or no equity investment  Frequently have no separate management or employees  Often obtain financing from debt  Have small outside equity interest that obtains a secure return with little or no risk 8

9 ©Cambridge Business Publishing, 2010 Examples of SPEs Securitizations Leasing Joint Ventures 9 Provide the opportunity to hide debt and losses from investors ARB 51 and SFAS 94 do not apply.

10 ©Cambridge Business Publishing, 2010 Securitizations Set up by a financial services company to buy loan or customer receivables from clients 10 Allows clients to obtain immediate cash for receivables SPE issues debt securities backed by the receivables SPE uses the money to buy the receivables SPE uses the collection proceeds to pay principal and interest

11 ©Cambridge Business Publishing, 2010 Leasing  Created by a company to purchase long- term assets  Funding for purchases obtained through loans  SPE leases assets to the company  SPE uses lease payments to pay interest and principal on the debt 11 Lease terms usually allow lessee to report the lease as an operating lease.

12 ©Cambridge Business Publishing, 2010 Joint Ventures  Formed by two or more companies for specialized projects  Often requires large amounts of specialized skill and financing  Structure legally separates the projects’ risk from that of the sponsors  Allows financing to be obtained at a lower cost 12

13 ©Cambridge Business Publishing, 2010 Consolidation at Date of Acquisition When the companies remain as separate legal entities: 13 Reports investment as one line on its balance sheet Acquiring Company Makes no entry; Stock is owned by new shareholders Acquired Company

14 ©Cambridge Business Publishing, 2010 Objectives of Consolidation  To report the affairs of a group of affiliated corporations as a single economic entity  Procedures designed to  Remove the effects of reported transactions and relationships between components of the reporting entity  Ensure that information reflects transactions with outside parties 14

15 ©Cambridge Business Publishing, 2010 Consolidation Process  Assets and liabilities of the acquired company  Revalued to fair value  Combined with assets and liabilities of parent  Intercompany transactions and account balances are removed 15 Process occurs each time financial statements are prepared

16 ©Cambridge Business Publishing, 2010 Consolidation Working Paper  Three elements  Accounts of the parent company  Accounts of the subsidiary company  Eliminating entries to consolidate the accounts  Eliminate the investment account on the parent company’s books  Eliminate the stockholders’ equity accounts on the subsidiary’s books  Revalue subsidiary’s assets and liabilities from book value to fair value 16

17 ©Cambridge Business Publishing, 2010 Consolidation Example Assume General Motors pays $35 million cash for all of the stock of Automagic Parts, Inc. on January 1, 2011. Balance sheets prior to acquisition are: 17 General MotorsAutomagic Parts, Inc. Book Value Dr(Cr) Fair Value Dr(Cr) Current assets $100,000,000 $ 2,000,000 $ 1,800,000 Plant and equipment, net 400,000,000 50,000,000 80,000,000 Patents and copyrights 10,000,000 1,000,000 3,200,000 Current liabilities(120,000,000)(10,000,000) Long-term debt (300,000,000) (38,000,000) (40,000,000) Common stock, $1 par (10,000,000) (500,000) Additional paid-in capital (60,000,000) (2,000,000) Retained earnings (20,000,000) (2,500,000) To record investment in the stock of Automagic Parts, Inc.: Investment in Automagic Parts35,000,000 Cash 35,000,000

18 ©Cambridge Business Publishing, 2010 Consolidation Example continued Calculate goodwill: 18 Acquisition cost $35,000,000. Book value of Automagic (5,000,000) Cost in excess of Automagic's book value 30,000,000. Differences between fair value and book value: Current assets$ (200,000) Plant and equipment, net30,000,000. Patents and copyrights2,200,000. Long-term debt(2,000,000)(30,000,000) Goodwill $ 0. Because the acquisition cost is equal to the fair value of the identifiable net assets, there is no goodwill.

19 ©Cambridge Business Publishing, 2010 Consolidation Example continued (E) Eliminate the subsidiary’s acquisition date equity balances: 19 Common stock, $1 par 500,000 Additional paid-in capital 2,000,000 Retained earnings 2,500,000 Investment in Automagic Parts 5,000,000 (R)Recognize acquisition date fair value revaluations: Plant and equipment, net 30,000,000 Patents and copyrights 2,200,000 Current assets200,000 Long-term debt 2,000,000 Investment in Automagic Parts 30,000,000

20 ©Cambridge Business Publishing, 2010 Consolidation Working Paper for GM and Automagic Accounts from BooksEliminations Consolidated Balances GMAutomagicDrCr Current assets$65,000,000$2,000,000 $200,000 (R) $ 66,800,000 Plant and equipment, net400,000,00050,000,000 (R) $30,000,000 480,000,000 Patents and copyrights10,000,0001,000,000 (R) 2,200,000 13,200,000 Investment in Automagic35,000,000 5,000,000 (E) 30,000,000 (R) Total assets$510,000,000$53,000,000 $560,000,000 Current liabilities$120,000,000$10,000,000 $130,000,000 Long-term debt300,000,00038,000,000 2,000,000 (R) 340,000,000 Common stock, $1 par10,000,000500,000 (E) 500,000 10,000,000 Additional paid-in capital60,000,0002,000,000 (E) 2,000,000 60,000,000 Retained earnings20,000,0002,500,000 (E) 2,500,000 20,000,000 Total liabilities and equity$510,000,000$53,000,000 $37,200,000 $560,000,000 20 Eliminating entries appear in the Eliminations column Elimination debits = Elimination credits Exhibit 3.3

21 ©Cambridge Business Publishing, 2010 Consolidation with Goodwill and Previously Unreported Intangibles Example IBM pays $25,000,000 in cash to acquire DataFile, Inc. on July 1, 2010. Fair values of DataFile's assets and liabilities are as follows: 21 DataFile’s accounts:Fair Value Current assets$2,000,000 Plant and equipment60,000,000 Patents and copyrights5,000,000 Current liabilities10,000,000 Long-term debt40,000,000 Fair values of previously unreported intangible assets: Brand names$1,000,000 Favorable lease agreements600,000 Assembled workforce5,000,000 In-process contracts with potential customers2,000,000 Contractual customer relationships3,000,000 Exhibit 3.4

22 ©Cambridge Business Publishing, 2010 Consolidation with Goodwill and Previously Unreported Intangibles Example continued IBM and DataFile, Inc.’s balance sheets immediately prior to acquisition on July 1, 2010: 22 Exhibit 3.5 IBMDataFile Current assets$ 40,000,000$ 2,300,000 Plant and equipment, net150,000,00050,000,000 Patents and copyrights 3,000,000 1,000,000 Total assets$193,000,000$53,300,000 Current liabilities$ 15,000,000$10,000,000 Long-term debt100,000,00038,000,000 Common stock, $0.50 par2,000,000500,000 Additional paid-in capital60,000,0002,000,000 Retained earnings 16,000,0002,800,000 Total liabilities and equity$193,000,000$53,300,000

23 ©Cambridge Business Publishing, 2010 Consolidation with Goodwill and Previously Unreported Intangibles Example continued IBM’s entry to record the stock acquisition: 23 Investment in DataFile25,000,000 Cash 25,000,000 Calculate goodwill: Acquisition cost $25,000,000. Book value of DataFile (5,300,000) Cost in excess of DataFile's book value $19,700,000. Differences between fair value and book value: Current assets$ (300,000) Plant and equipment, net10,000,000. Patents and copyrights4,000,000. Brand names1,000,000. Favorable lease agreements600,000. Contractual customer relationships3,000,000. Long-term debt(2,000,000)16,300,000. Goodwill $ 3,400,000.

24 ©Cambridge Business Publishing, 2010 Consolidation with Goodwill and Previously Unreported Intangibles Example continued 24 (E) Eliminate DataFile’s equity balances: Common stock, $0.50 par 500,000 Additional paid-in capital 2,000,000 Retained earnings 2,800,000 Investment in DataFile 5,300,000 (R) Eliminate excess paid over book value and revalue DataFile’s assets and liabilities to fair value: Plant and equipment, net10,000,000 Patents and copyrights4,000,000 Brand names1,000,000 Favorable lease agreements600,000 Contractual customer relationships3,000,000 Goodwill3,400,000 Current assets 300,000 Long-term debt 2,000,000 Investment in DataFile 19,700,000

25 ©Cambridge Business Publishing, 2010 Consolidation Working Paper 25 Consolidated balance sheet at date of acquisition Accounts Taken from BooksEliminations Consolidated Balances IBMDataFileDrCr Current assets$15,000,000$2,300,000 $300,000 (R) $ 17,000,000 Plant and equipment, net150,000,00050,000,000 (R) $10,000,000 210,000,000 Patents and copyrights3,000,0001,000,000 (R) 4,000,000 8,000,000 Investment in DataFile25,000,000 5,300,000 (E) 19,700,000 (R) Brand names (R) 1,000,000 Favorable lease agreements (R) 600,000 Contractual customer relationships (R) 3,000,000 Goodwill (R) 3,400,000 Total assets $193,000,000$53,300,000 $243,000,000 Current liabilities$15,000,000$10,000,000 $25,000,000 Long-term debt100,000,00038,000,000 2,000,000 (R) 140,000,000 Common stock, $0.50 par2,000,000500,000 (E) 500,000 2,000,000 Additional paid-in capital60,000,0002,000,000 (E) 2,000,000 60,000,000 Retained earnings16,000,0002,800,000 (E) 2,800,000 16,000,000 Total liabilities and equity$193,000,000$53,300,000$27,300,000 $243,000,000 Exhibit 3.6

26 ©Cambridge Business Publishing, 2010 Consolidation with Bargain Purchase  Occurs when the fair values of the identifiable net assets of the acquired company total more than the acquisition price  Parent company reports the difference as a gain on acquisition  No goodwill reported in consolidation 26

27 ©Cambridge Business Publishing, 2010 Consolidation with Bargain Purchase Example Assume that IBM pays only $20 million in cash for all the stock of DataFile. 27 IBM’s entry to record the stock acquisition: Investment in DataFile21,600,000 Gain on acquisition1,600,000 Cash 20,000,000 Calculate gain: Acquisition cost$20,000,000. Book value of DataFile (5,300,000) Cost in excess of DataFile's book value14,700,000. Differences between fair value and book value 16,300,000. Gain on acquisition$1,600,000.

28 ©Cambridge Business Publishing, 2010 Consolidation with Bargain Purchase Example continued 28 Exhibit 3.7 Gain becomes part of parent’s retained earnings Accounts from BooksEliminations Consolidated Balances IBMDataFileDrCr Current assets$20,000,000$2,300,000 $ 300,000 (R) $ 22,000,000 Plant and equipment, net150,000,00050,000,000 (R) $10,000,000 210,000,000 Patents and copyrights3,000,0001,000,000 (R) 4,000,000 8,000,000 Investment in DataFile21,600,000 5,300,000 (E) 16,300,000 (R) Brand names (R) 1,000,000 Favorable lease agreements (R) 600,000 Contractual customer relationships (R) 3,000,000 Total assets$194,600,000$53,300,000 $244,600,000 Current liabilities$ 15,000,000$10,000,000 $25,000,000 Long-term debt100,000,00038,000,000 2,000,000 (R) 140,000,000 Common stock, $0.50 par2,000,000500,000 (E) 500,000 2,000,000 Additional paid-in capital60,000,0002,000,000 (E) 2,000,000 60,000,000 Retained earnings17,600,0002,800,000 (E) 2,800,000 17,600,000 Total liabilities and equity$194,600,000$53,300,000$23,900,000 $244,600,000

29 ©Cambridge Business Publishing, 2010 Special Issue: Depreciable Assets  Acquiring company reports acquired assets at fair value  Fair value at date of acquisition = original cost to acquiring company for consolidation purposes  Original cost and related accumulated depreciation on books of subsidiary are not relevant to acquiring company 29

30 ©Cambridge Business Publishing, 2010 Special Issue: Previously Reported Goodwill  May exist on subsidiary’s books if another company had previously been acquired by the subsidiary  Acquiring company assigns a zero value to goodwill acquired  Not an identifiable asset 30

31 ©Cambridge Business Publishing, 2010 Consolidating a Subsidiary Reporting Goodwill Assume General Motors acquires Powerdown, Inc. for $40 million. Powerdown’s balance sheet: 31 Book ValueFair Value Various identifiable assets$50,000,000$80,000,000 Goodwill 10,000,0009,000,000 Total assets$60,000,000 Liabilities$55,000,000 Stockholders' equity 5,000,000 Total liabilities and equity$60,000,000 Acquisition cost $40,000,000. Book value of Powerdown (5,000,000) Cost in excess of Powerdown's book value $35,000,000. Differences between fair value and book value: Various identifiable assets$30,000,000. Previously recorded goodwill (10,000,000)20,000,000. Goodwill $15,000,000. Calculation of goodwill:

32 ©Cambridge Business Publishing, 2010 IFRS for Consolidations  Principles-based application of control concept  Conditions leading to consolidation  Control over more than half the voting rights  Power to control major decisions due to statute or agreement  Power to appoint or remove the majority of board members  Power to cast the majority of votes at board meetings  Requires consideration of potential voting rights 32

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