1. Slide 5-1

2. Slide 5-2 Allocation and Depreciation of Differences Between Implied and Book Values Acquisition Advanced Accounting, Fourth Edition 55

3. Slide 5-3 1. 1.Calculate the difference between implied and book values and allocate to the subsidiary’s assets and liabilities. 2. 2.Describe FASB’s position on accounting for bargain acquisitions. 3. 3.Explain how goodwill is measured at the time of the acquisition. 4. 4.Describe how the allocation process differs if less than 100% of the subsidiary is acquired. 5. 5.Record the entries needed on the parent’s books to account for the investment under the three methods: the cost, the partial equity, and the complete equity methods. 6. 6.Prepare workpapers for the year of acquisition and the year(s) subsequent to the acquisition, assuming that the parent accounts for the investment using the cost, the partial equity, and the complete equity methods. 7. 7.Understand the allocation of the difference between implied and book values to long- term debt components. 8. 8.Explain how to allocate the difference between implied and book values when some assets have fair values below book values. 9. 9.Distinguish between recording the subsidiary depreciable assets at net versus gross fair values. 10. 10.Understand the concept of push down accounting. Learning Objectives

4. Slide 5-4 In the previous chapters, it was often assumed that any difference between IV and BV of equity of subsidiary was entirely attributable to the under or overvaluation of land, a nonamortizable assets on the books of the subsidiary. This chapter focus on a more complex and realistic allocation of the difference to various assets and liabilities in the consolidated balance sheet, and the depreciation or amortization of the difference in the consolidated financial statements.

5. Slide 5-5 The following two steps are taken in this case: Step 1: The difference between IV and BV is used first to adjust the individual assets and liabilities to their fair values on the date of acquisition. Step 2: After adjusting the assets and liabilities to fair values, any residual amount of the difference is treated like this:  Implied value > aggregate fair values = goodwill.  Implied value < aggregate fair values = bargain. Bargain is recognized as an ordinary gain. In the sense: - When we have a positive balance or a debit balance, we consider it as a goodwill. - When we have a negative balance or a credit balance, we consider it as bargain.

6. Slide 5-6 Bargain Rules under prior GAAP (before 2007 standard): 1.Acquired assets, except investments accounted for by the equity method, are recorded at fair market value. 2.Previously recorded goodwill on the books of seller is eliminated. 3.Long-lived assets (including in-process R&D and excluding long-term investments) are recorded at fair market value minus an adjustment for the bargain. 4.Extraordinary gain recorded if all long-lived assets are reduced to zero. LO 2 Current and proposed treatment of bargain acquisitions.

7. Slide 5-7 Bargain Rules: FASB Statement No. 141R, “Business Combinations,” [ASC 805-30-25-2], the negative (or credit) balance should be recognized as an ordinary gain in the year of acquisition. No assets should be recorded below their fair values. Allocation of Difference Between Implied and Book Values: Acquisition Date LO 2 Current and proposed treatment of bargain acquisitions.

8. Slide 5-8 In the event of a bargain acquisition (after carefully considering the fair valuation of all subsidiary assets and liabilities) the FASB requires the following accounting: a.an ordinary gain is reported in the financial statements of the consolidated entity. b.an ordinary loss is reported in the financial statements of the consolidated entity. c.negative goodwill is reported on the balance sheet. d.assets are written down to zero value, if needed. Review Question

9. Slide 5-9 E5-1: E5-1: On January 1, 2010, Pam Company purchased an 85% interest in Shaw Company for $540,000. On this date, Shaw Company had common stock of $400,000 and retained earnings of $140,000. An examination of Shaw Company’s assets and liabilities revealed that their book value was equal to their fair value except for marketable securities and equipment: Allocation of Difference Case 1: Implied Value “in Excess of” Fair Value

10. Slide 5-10 E5-1: E5-1: A. Prepare a Computation and Allocation Schedule for the difference between book value of equity acquired and the value implied by the purchase price. Allocation of Difference

11. Slide 5-11 E5-1 (variation): E5-1 (variation): Prepare the worksheet entries to eliminate the investment, recognize the noncontrolling interest, and to allocate the difference between implied and book. Allocation of Difference Common stock 400,000 Retained earnings140,000 Difference between Implied and Book 95,294 Investment in Shaw 540,000 Noncontrolling interest in Equity95,294 Marketable securities25,000 Equipment20,000 Goodwill 50,294 Difference between Implied and Book 95,294

12. Slide 5-12 E5-1 (variation): E5-1 (variation): On January 1, 2010, Pam Company purchased an 85% interest in Shaw Company for $470,000. On this date, Shaw Company had common stock of $400,000 and retained earnings of $140,000. An examination of Shaw Company’s assets and liabilities revealed that their book value was equal to their fair value except for marketable securities and equipment: Allocation of Difference Case 2: Acquisition Cost “Less Than” Fair Value

13. Slide 5-13 Allocation of Difference E5-1 (variation): E5-1 (variation): Prepare a Computation and Allocation Schedule.

14. Slide 5-14 E5-1 (variation): E5-1 (variation): Prepare the worksheet entries. Allocation of Difference Common stock 400,000 Retained earnings140,000 Difference between Implied and Book 12,941 Investment in Shaw 470,000 Noncontrolling interest in Equity82,941 Marketable securities25,000 Equipment20,000 Gain on acquisition 27,250 Noncontrolling interest in equity 4,809 Difference between Implied and Book 12,941

15. Slide 5-15 When any portion of the difference between implied and book values is allocated to depreciable and amortizable assets, recorded income must be adjusted in determining consolidated net income in current and future periods. Adjustment is needed to reflect the difference between the amount of amortization and/or depreciation recorded by the subsidiary and the appropriate amount based on consolidated carrying values. Effect of Allocation and Depreciation of Differences on Consolidated Net Income: Year Subsequent To Acquisition

16. Slide 5-16 P5-4: P5-4: On January 1, 2010, Porter Company purchased an 80% interest in Salem Company for $850,000. At that time, Salem Company had capital stock of $550,000 and retained earnings of $80,000. Differences between the fair value and the book value of the identifiable assets of Salem Company were as follows: Consolidated Statements – Cost Method The book values of all other assets and liabilities of Salem Company were equal to their fair values on January 1, 2010. The equipment had a remaining life of five years. The inventory was sold in 2010. LO 4 Allocation of difference in a partially owned subsidiary. Year of Acquisition

17. Slide 5-17 P5-4: P5-4: Salem Company’s net income and dividends declared in 2010 and 2011 were as follows: 2010 Net Income of $100,000; Dividends Declared of $25,000; 2011 Net Income of $110,000; Dividends Declared of $35,000. Entries recorded on the books of Porter to reflect the acquisition of Salem and the receipt of dividends for 2010 are as follows: Consolidated Statements – Cost Method Investment in Salem850,000 Cash850,000 Cash20,000 Dividend income ($25,000 x 80%) 20,000 LO 4 Allocation of difference in a partially owned subsidiary. Year of Acquisition

18. Slide 5-18 P5-4: P5-4: A. Prepare a Computation and Allocation Schedule Consolidated Statements – Cost Method LO 4 Allocation of difference in a partially owned subsidiary. Year of Acquisition

19. Slide 5-19 P5-4: P5-4: B. 1. Prepare the worksheet entries for Dec. 31, 2010. Dividend income ($25,000 x 80%) 20,000 Dividends declared20,000 Beg. retained earnings - Salem 80,000 Common stock - Salem550,000 Difference between Cost and Book 432,500 LO 4 Allocation of difference in a partially owned subsidiary. Investment in Salem850,000 Consolidated Statements – Cost Method Noncontrolling interest in equity 212,500 Year of Acquisition

20. Slide 5-20 1-Cost of goods sold (beginning inventory) 40,000 Land65,000 LO 4 Allocation of difference in a partially owned subsidiary. Consolidated Statements – Cost Method Plant and equipment130,000 Goodwill197,500 Difference between cost and book432,500 2-Depreciation expense ($130,000/5) 26,000 Plant and equipment26,000 Year of Acquisition P5-4: P5-4: B. 1. Prepare the worksheet entries for Dec. 31, 2010. Note: if the inventory were still on hand on Dec.31,2010 the $40000 would be allocated to ending inventory in the balance sheet rather than COGS

21. Slide 5-21 Note: Entry no. 1 to Note: Entry no. 1 to Cost of Goods sold is appropriate only in the year of acquisition. In subsequent years, consolidated Cost of Goods Sold will have been reflected in 2011 consolidated net income and hence consolidated retained earnings at the end of 2011. Thus the adjustment ($40000 debit) in the future years will be to beginning retained earnings. (Parent company 80% and to NCI 20%).

22. Slide 5-22 Investment in Salem60,000 Beg. Retained Earnings ‑ Porter Co. 60,000 احتساب مقدار الزيادة في الارباح المحتجزة من 1\1\2010 حتى 1\1\2011* Consolidated Statements – Cost Method Subsequent Year Salem 2010 income$100,000 Salem 2010 dividends declared- 25,000 Total75,000 Ownership percentage80% $ 60,000* To establish reciprocity/convert to equity as of 1/1/2011 P5-4: P5-4: C. 1. Prepare the worksheet entries for Dec. 31, 2011.

23. Slide 5-23 Dividend income ($35,000 x 80%) 28,000 Dividends declared28,000 Beg. retained earnings - Salem 1/1/2011* 155,000 Common stock - Salem550,000 Difference between Cost and Book 432,500 LO 4 Allocation of difference in a partially owned subsidiary. Investment (450.000+60.000)910,000 Consolidated Statements – Cost Method NCI (212,500+15,000)227,500 Subsequent Year *Beg. retained earnings = 80000+100000-75000=155.000

24. Slide 5-24 Noncontrolling interest (20% of previous year’s COGS) 8,000 Land 65,000 Consolidated Statements – Cost Method Plant and equipment 130,000 Goodwill 197,500 Difference between cost and book432,500 (To allocate the amount of difference between IV and BV at date of acquisition to specific assets and liabilities). 1/1 Retained Earnings (80% of previous year’s COGS) 32,000 Subsequent Year

25. Slide 5-25 Depreciation Expense (current year) ($130,000/5) 26,000 1/1 Retained Earnings (80% of previous year’s depreciation expense) 20,800 Noncontrolling interest (20% of previous year’s expense) 5,200 Plant and equipment (accumulated depreciation) 52,000 (To depreciate the amount of difference between the IV and BV allocated to equipment). Note: the adjustment in year 2 (and future years) is split between the CI and NCI in equity.

26. Slide 5-26 P5-4: P5-4: D. Prepare a consolidated financial statements workpaper for the year ended December 31, 2012. Although no goodwill impairment was reflected at the end of 2010 or 2011, the goodwill impairment test conducted at December 31, 2012 revealed implied goodwill from Salem to be only $150,000. The impairment has not been recorded in the books of the parent. (Hint: You can infer the method being used by the parent from the information in its trial balance.) Consolidated Statements – Cost Method Subsequent Year

27. Slide 5-27 Investment in Salem(150,000*80%)120,000 Beg. Retained Earnings ‑ Porter Co. 120,000 LO 4 Allocation of difference in a partially owned subsidiary. Consolidated Statements – Cost Method Subsequent Year Acquisition date retained earnings - Salem$ 80,000 Retained earnings 1/1/12 - Salem230,000 Increase150,000 Ownership percentage80% $ 120,000 To establish reciprocity/convert to equity as of 1/1/2012 P5-4: P5-4: D. Explanations of worksheet entries for Dec. 31, 2012.

28. Slide 5-28 Dividend income ($60,000 x 80%) 48,000 Dividends declared48,000 Beg. retained earnings 1-1-2012230,000 Common stock - Salem550,000 Difference between Cost and Book 432,500 LO 4 Allocation of difference in a partially owned subsidiary. Investment (850,000+120,000)970,000 Consolidated Statements – Cost Method NCI (212500+30,000)242,500 Subsequent Year P5-4 W P5-4 D. Worksheet entries for Dec. 31, 2012.

29. Slide 5-29 Noncontrolling interest 8,000 Land65,000 LO 4 Allocation of difference in a partially owned subsidiary. Consolidated Statements – Cost Method Plant and equipment130,000 Goodwill197,500 Difference between cost and book432,500 1/1 Retained Earnings – Porter 32,000 Subsequent Year P5-4 W P5-4 D. Worksheet entries for Dec. 31, 2012.

30. Slide 5-30 LO 4 Allocation of difference in a partially owned subsidiary. Consolidated Statements – Cost Method Depreciation expense (current year)($130,000/5) 26,000 Plant and equipment78,000 Noncontrolling interest (previous 2 years) 10,400 1/1 Retained Earnings – Porter (previous 2 years) 41,600 Subsequent Year Impairment loss ($197,500 - $150,000) 47,500 Goodwill47,500 To record goodwill impairment P5-4 W P5-4 D. Worksheet entries for Dec. 31, 2012.

31. Slide 5-31 P5-4: D. 2012 Year Subsequent of Acquisition * Noncontrolling Interest in Income =.2  $170,000 – (.2 x $26,000) – (.2 x $47,500) = $19,300 Consolidated Statements – Cost Method

32. Slide 5-32 LO 4 Allocation of difference in a partially owned subsidiary. Subsequent Year P5-4: D. 2012 Year Subsequent of Acquisition Consolidated Statements – Cost Method

33. Slide 5-33 Consolidated Statements – Partial and Complete Equity Methods The equity methods (partial and complete) reflect the effects of certain transactions more fully than the cost method on the books of the parent. However consolidated totals are the same regardless of which method is used by the Parent company.

34. Slide 5-34 Notes payable, long-term debt, and other obligations of an acquired company should be valued for consolidation purposes at their fair values.  Quoted market prices are the best. If unavailable, then management’s best estimate based on  debt with similar characteristics or  valuation techniques such as present value. Additional Considerations Relating to Treatment of Difference Between Implied and Book Values Allocation of Difference between Implied and Book Values to Debt

35. Slide 5-35 On the date of acquisition, sometimes the  fair value of an asset is less than the amount recorded on the books of the subsidiary.  fair value of long-term debt may be greater rather than less than its recorded value on the books of the subsidiary. Allocating the Difference to Assets (Liabilities) with Fair Values Less (Greater) Than Book Values

36. Slide 5-36 E5-1 (Variation): E5-1 (Variation): On January 1, 2010, Pam Company purchased an 85% interest in Shaw Company for $540,000. On this date, Shaw Company had common stock of $400,000 and retained earnings of $140,000. An examination of Shaw Company’s assets and liabilities revealed that their book value was equal to their fair value except for marketable securities and equipment: Allocating the Difference to Assets (Liabilities) with Fair Values Less (Greater) Than Book Values

37. Slide 5-37 E5-1: E5-1: A. Prepare a Computation and Allocation Schedule for the difference between book value of equity acquired and the value implied by the purchase price. Allocation of Difference Cost Method

38. Slide 5-38 E5-1 (variation):first E5-1 (variation): At the end of the first year, the workpaper entries are: Allocation of Difference Marketable securities25,000 Equipment20,000 Goodwill 90,294 Difference between Implied and Book 95,294 Equipment,net 4,000 Depreciation expense ($20,000 / 5 years) 4,000 Note: the overvaluation of equipment will be amortized over the life of the asset as a reduction of depreciation expense. LO 8 Allocating when the fair value is below book value. Cost Method

39. Slide 5-39 E5-1 (variation):second E5-1 (variation): At the end of the second year, the workpaper entries are: Allocation of Difference Marketable securities25,000 Equipment20,000 Goodwill 90,294 Difference between Implied and Book 95,294 Equipment, net 8,000 Beg. retained earnings - Pam 3,400 LO 8 Allocating when the fair value is below book value. Noncontrolling interest in equity 600 Depreciation expense ($20,000 / 5 years) 4,000 Cost Method

40. Slide 5-40 E5-7: $400,000 $600,000. E5-7: On January 1, 2011, Packard Company purchased an 80% interest in Sage Company for $600,000. On this date Sage Company had common stock of $150,000 and retained earnings of $400,000. Sage Company’s equipment on the date of Packard Company’s purchase had a book value of $400,000 and a fair value of $600,000. All equipment had an estimated useful life of 10 years on January 2, 2006. Required: Prepare the December 31 consolidated financial statements workpaper entries for 2011 and 2012, recording accumulated depreciation as a separate balance. Reporting Accumulated Depreciation in Consolidated Financial Statements as a Separate Balance LO 9 Depreciable assets at net and gross values. Allocation of Difference

41. Slide 5-41 E5-7: E5-7: Prepare a Computation and Allocation Schedule. Allocation of Difference LO 9 Depreciable assets at net and gross values.

42. Slide 5-42 Assume that P company acquires a 90% interest in S company on January 1, 2011 and that the difference (IV &BV) in the amount of $200,000 is entirely attributable to equipment with an original life of nine years and a remaining life on January 1, 2011, of five years. Pertinent information regarding the equipment is presented as follows: Fair ValueBook Value Diff. Equipment (gross)$1200,000900,000300,000X - Accumulated Dep.400,000300,000100,0001/3 X Equipment (net)800,000600,000200,0002/3X X – 1/3X = 2/3 X X – 1/3X = (200,000) X = 300,000 ،1/3 X = 100,000

43. Slide 5-43 When accumulated depreciation is reported as a separate balance in the consolidated financial statements, the workpaper entry to allocate and depreciate the difference between IV and BV must be slightly modified. When accumulated depreciation is reported as a separate balance in the consolidated financial statements, the workpaper entry to allocate and depreciate the difference between IV and BV must be slightly modified. Let; Let; Amount of difference allocated to Equipment (gross) = X Amount of the difference allocated to Accumulated depreciation = 5/10 X The total difference allocated to Equipment (net) = 5/10 X X – 5/10X = 5/10X 0.5X = 200,000 X = 400,000 Allocated to Equipment = 400,000 Allocated to Accumulated Depreciation = 400000 * 5/10= 200,000

44. Slide 5-44 E5-7: E5-7: Prepare the December 31 consolidated financial statements workpaper entries for 2011 and 2012. Allocation of Difference Equipment400,000 Accumulated depreciation 200,000 Difference between Implied and Book 200,000 Depreciation Expense ($400,000/10) 40,000 Accumulated Depreciation 40,000 Cost & Partial Equity Method LO 9 Depreciable assets at net and gross values.

45. Slide 5-45 E5-7: E5-7: Prepare the December 31 consolidated financial statements workpaper entries for 2011 and 2012. Allocation of Difference Equipment400,000 Accumulated depreciation 200,000 Difference between Implied and Book 200,000 1/1 Retained Earnings -Packard Co. 32,000 1/1 Noncontrolling interest 8,000 Depreciation Expense ($400,000/10) 40,000 Accumulated Depreciation 80,000 LO 9 Depreciable assets at net and gross values. * Complete equity method: debit to 1/1 Retained Earnings – Packard Co. would be replaced with a debit to Investment in Sage Company Cost & Partial Equity Method

46. Slide 5-46 Disposal of Depreciable Assets by Subsidiary LO 9 Depreciable assets at net and gross values. Allocation of Difference In the year of sale, any gain or loss recognized by the subsidiary on the disposal of an asset to which any of the difference between implied and book value has been allocated must be adjusted in the consolidated statements workpaper. Depreciable Assets Used in Manufacturing When the difference between implied and book values is allocated to depreciable assets used in manufacturing, workpaper entries may be more complex because the current and previous years additional depreciation may need to be allocated among work in process, finished goods, and cost of goods sold.

47. Slide 5-47 Push Down Accounting Push down accounting is the establishment of a new accounting and reporting basis for a subsidiary company. The valuation implied by the price of the stock to the parent company is “pushed down” to the subsidiary and used to restate its assets (including goodwill) and liabilities in its separate financial statements.

48. Slide 5-48 LO 10 Push down of accounting to the subsidiary’s books. Push Down Accounting Arguments for and against Push Down Accounting Three important factors that should be considered in determining the appropriateness of push down accounting are: 1.Whether the subsidiary has outstanding debt held by the public. 2.Whether the subsidiary has outstanding a senior class of capital stock not acquired by the parent company. 3.The level at which a major change in ownership of an entity should be deemed to have occurred, for example, 100%, 90%, 51%.

49. Slide 5-49 LO 10 Push down of accounting to the subsidiary’s books. Push Down Accounting Status of Push Down Accounting As a general rule, the SEC requires push down accounting when the ownership change is greater than 95% and objects to push down accounting when the ownership change is less than 80%. In addition, the SEC staff in SAB No. 54 expresses the view that the existence of outstanding public debt, preferred stock, or a significant noncontrolling interest in a subsidiary might impact the parent company’s ability to control the form of ownership. In these circumstances, push down accounting, though not required, is an acceptable accounting method.

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