1. Electronic Presentations in Microsoft ® PowerPoint ® Prepared by Peter Secord Saint Mary’s University © 2003 McGraw-Hill Ryerson Limited

2. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 2 Chapter 5 Consolidated Financial Statements Subsequent to Acquisition Date: Equity Method

3. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 3 Consolidation from the Equity Method Outline –Goodwill and other Intangibles –Goodwill impairment tests –Transitional Provisions –Consolidated income and retained earnings –Consolidation practices subsequent to acquisition –Examples –International View

4. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 4 Goodwill and other Intangibles As discussed in prior chapters, when an intercorporate investment is made, the difference between the cost and underlying book value, the purchase discrepancy, must be allocated in order that the fair values at the date of the business combination are recognized in the accounts. In many cases, a significant proportion of the purchase price relates to intangible assets, including goodwill, acquired. This amount is recognized in the statements.

5. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 5 Goodwill and other Intangibles The cost of the purchase should be allocated as follows: –all assets acquired and liabilities assumed in a business combination, whether or not recognized in the financial statements of the acquired enterprise (except goodwill and future income taxes recognized by an acquired enterprise before its acquisition) should be assigned a portion of the total cost of the purchase based on their fair values at the date of acquisition; and –the excess of the cost of the purchase over the net of the amounts assigned … should be recognized as an asset referred to as goodwill.

6. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 6 Goodwill and other Intangibles These Handbook provisions include two important aspects of the process of accounting for business combinations: –There must be an examination of the assets actually owned, including intangibles, with particular regard to the need for identification and valuation of unrecorded intangible assets –The residual amount in a business combination is allocated to Goodwill, which represents the unallocated excess of the purchase price over the identifiable assets acquired

7. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 7 Goodwill and other Intangibles There has been significant debate on the appropriate accounting treatment for intangible assets arising in business combinations, in part because of large variations internationally in the permissible treatment of these items The “playing field” was perceived to be uneven In the interest of international harmonization, and perhaps as a result of extensive “lobbying” by the business community, recent changes in the CICA Handbook attempt to resolve the debate and guide practice

8. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 8 International View There were simultaneous changes in the United States and Mexico which have the same effect on accounting practices in those countries Concurrently, the pooling of interest approach (as discussed in Chapter 4) was abolished, and many changes were introduced to unify (if not standardize completely) accounting for intangible assets arising from business combinations in North America Beyond North America, there remains significant diversity in rules and practices

9. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 9 Goodwill and other Intangibles The implications of these rules are that much effort must be devoted to the identification of the many potential assets which make up the value of a firm and the price paid –Prior rules allowed essentially all the residual value, after tangible assets and high profile intangibles (such as patents) were assigned value, to be allocated to goodwill –The new rules appear to require somewhat more care in the identification and assignment of values and provide extensive, detailed guidance in this area

10. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 10 Goodwill and other Intangibles Under the new Handbook provisions (s.1581.48), an intangible asset should be recognized apart from goodwill when: –the asset results from contractual or other legal rights (regardless of whether those rights are transferable or separable from the acquired enterprise or from other rights and obligations); or –the asset is capable of being separated or divided from the acquired enterprise and sold, transferred, licensed, rented, or exchanged (regardless of whether there is an intent to do so). –Otherwise it should be included in the amount recognized as goodwill.

11. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 11 Goodwill and other Intangibles When amounts assigned to intangible assets are significant, required disclosure includes: –for intangible assets subject to amortization, the total amount assigned and the amount assigned to each major intangible asset class; –for intangible assets not subject to amortization, the total amount assigned and the amount assigned to each major intangible asset class; and –for goodwill: total goodwill and tax deductible amount; and amount of goodwill by reportable segment.

12. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 12 Goodwill and other Intangibles Identifiable intangible assets are either –Of limited life –Of indefinite (and perhaps infinite) life Assets with limited life should be amortized over the best estimate of the economic life, and are subject to a periodic review for impairment of value, under s. 3061, in the same manner as property, plant and equipment must be reviewed

13. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 13 Goodwill and other Intangibles Intangible assets not subject to amortization should be tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. The impairment test should consist of a comparison of the fair value of the intangible asset with its carrying amount. When the carrying amount of the intangible asset exceeds its fair value, an impairment loss should be recognized in an amount equal to the excess.

14. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 14 Goodwill Impairment Tests Goodwill is not to be amortized under the new provisions, so is subject to special tests to determine if any impairment has occurred These impairment tests are carried out at the level of the “reporting unit” –The reporting unit is either a segment (s. 1701), where the components have similar economic characteristics, or –A segment component (a business for which discrete financial information is available and for which segment management may regularly review operating results)

15. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 15 Goodwill Impairment Tests A goodwill impairment loss should be recognized when the carrying amount of the goodwill of a reporting unit exceeds the fair value of the goodwill.

16. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 16 Goodwill Impairment Tests A goodwill impairment loss should be recognized when the carrying amount of the goodwill of a reporting unit exceeds the fair value of the goodwill. An impairment loss should not be reversed if the fair value subsequently increases.

17. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 17 Goodwill Impairment Tests A goodwill impairment loss should be recognized when the carrying amount of the goodwill of a reporting unit exceeds the fair value of the goodwill. An impairment loss should not be reversed if the fair value subsequently increases. The fair value of goodwill can be measured only as a residual, not directly, in the same manner that it was initially computed at the time of the business combination which gave rise to recognition

18. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 18 Goodwill Impairment Tests The goodwill impairment test is a two stage process: –First, the fair value of a reporting unit should be compared with its carrying amount, including goodwill, in order to identify a potential impairment. When the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not to be impaired and the second step of the impairment test is unnecessary.

19. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 19 Goodwill Impairment Tests –Second, when the carrying amount of a reporting unit exceeds its fair value, the fair value of the reporting unit's goodwill should be compared with its carrying amount to measure the amount of the impairment loss, if any. –The fair value of goodwill is determined in accordance with the guidance in paragraph 3062.32. –When the carrying amount of reporting unit goodwill exceeds the fair value of the goodwill, an impairment loss should be recognized in an amount equal to the excess.

20. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 20 Goodwill Impairment Tests The fair value of goodwill is determined in the same manner as the determination of the value of goodwill in a business combination. An enterprise allocates the fair value of a reporting unit to all of the assets and liabilities of the unit, whether or not recognized separately, as if the reporting unit had been acquired in a business combination and the fair value of the reporting unit was the price paid to acquire the reporting unit.

21. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 21 Goodwill Impairment Tests The excess of total fair value over assigned amounts is the fair value of goodwill. Although amounts are assigned to intangible assets in this process, additional intangible assets are not recognized This allocation process is performed only for purposes of testing goodwill for impairment and does not cause an enterprise to write up or write down a recognized asset or liability or to recognize a previously unrecognized asset as a result of this allocation process.

22. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 22 International View There is significant variation internationally in the determination of the value of intangible assets and their treatment in the financial statements

23. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 23 Transitional Provisions Goodwill Impairment Test –In accordance with the transitional provisions contained in Section 3062 of the CICA Handbook, an impairment loss recognized during the financial year in which the new recommendations are initially applied is recognized as the effect of a change in accounting policy and charged to opening retained earnings, without restatement of prior periods. –This treatment is consistent with many other changes in accounting policy arising from changes in the provisions of the CICA Handbook

24. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 24 Transitional Provisions From the annual report, 2001

25. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 25 Transitional Provisions From the annual report, 2001

26. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 26 Consolidated income and retained earnings Consolidated income consists of: –Net income of the parent from its own operations Excludes dividends and other income from subsidiary –Plus: Parent’s share of net income from subsidiary –Less: Amortization of the purchase discrepancy This approach can always be used to compute the value of consolidated net income, whether or not an income statement is to be prepared

27. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 27 Consolidation from the Equity Method At the date of acquisition, the financial statements (especially the balance sheet) may be prepared as a “snapshot” at a point in time After acquisition, the consolidated financial statements must include the accounts of both the parent and the subsidiary, reported as one economic entity

28. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 28 Consolidation from the Equity Method When a company buys the shares of another company, the cost of these shares is recorded in an “investment account” When the intercorporate investment is a subsidiary, the external financial reporting will nearly always be through the presentation of consolidated financial statements However, the parent company must continue to maintain the investment account for the subsidiary, as the actual companies generally remain as separate legal entities

29. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 29 Consolidation from the Equity Method The investment account may be maintained by the cost method, or the equity method (or by any other systematic method) –The choice of method to employ is entirely at the discretion of the company involved, as this is a matter of internal accounting policy, not external reporting - there are no strong conceptual arguments in favour of either approach Virtually all external reporting will include consolidated financial statements, so we are concerned with background for consolidation - preparation of these statements

30. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 30 Consolidation from the Equity Method This chapter is concerned with the process of consolidation when the “investment account” has been maintained using the equity method Problem material illustrates this approach Use of the equity method by the parent generally means that the original cost of the investment has been periodically updated for –Earnings and dividend distributions of the subsidiary –Amortization of the purchase price discrepancy, as applicable –Other consolidation adjustments (such as unrealized profits), as covered in later chapters

31. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 31 Consolidation from the Equity Method Investment in Subsidiary Original Cost

32. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 32 Consolidation from the Equity Method Investment in Subsidiary Original Cost Income earned

33. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 33 Consolidation from the Equity Method Investment in Subsidiary Original Cost Income earned Dividends received

34. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 34 Consolidation from the Equity Method Investment in Subsidiary Original Cost Income earned Dividends received P.D. Amortization

35. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 35 Consolidation from the Equity Method Investment in Subsidiary Original Cost Income earned Dividends received P.D. Amortization Other adjustments* Balance *In later chapters

36. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 36 Consolidations: Direct Approach Although working papers are preferred by some, a direct approach to the preparation of consolidated financial statements can be significantly more efficient When the investment account for the subsidiary is maintained under the equity method: –Parent’s net income equals consolidated net income –Parent’s retained earnings equals consolidated retained earnings

37. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 37 Consolidations: Direct Approach These true relationships assist greatly in the preparation of consolidated financial statements For the Consolidated Income Statement: –The account investment income (under the equity method) is replaced by the reported revenues and expenses of the subsidiary, adjusted for the amortization of the purchase discrepancy (and intercompany transactions, if any) –These adjustments are on working papers only For Consolidated Retained Earnings –No adjustments are necessary

38. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 38 Consolidations: Direct Approach For the Consolidated Balance Sheet –The investment account is replaced by the individual assets and liabilities of the subsidiary in the consolidated balance sheet, restated by the unamortized purchase discrepancy (and intercompany balances, if any) –These adjustments are on working papers only, and are not posted to the general ledger –Consolidated retained earnings does not have to be restated, as this amount equals the retained earnings of the parent company (determined using the equity method)

39. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 39 Consolidations: Direct Approach The direct approach to the preparation of statements relies on supporting calculations: –The calculation and allocation of the purchase discrepancy –An amortization schedule for the purchase discrepancy Annual amortization amounts for the income statement Unamortized amounts for the balance sheet –Careful determination of any intercompany revenues and expenses, and receivables and payables (if applicable)

40. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 40 When control ceases? When control ceases, the investment will no longer be consolidated as a subsidiary The “parent” must determine how to account for the remaining investment, if any: –If a portfolio investment, using the cost method –If significant influence exist, using the equity method –Discontinued operations, under Handbook s. 3475 As there is a change in circumstances, the new method does not lead to retroactive restatement

41. Chapter 5 © 2003 McGraw-Hill Ryerson Limited 41 Intercompany receivables and payables Related companies often have extensive transactions within the group –Some companies have the vast majority of their purchases or sales (or both) to a related company –Vertical integration is one of the principal reasons intercorporate investments are made All intercompany sales must be eliminated in consolidation, against the related purchase All intercompany balances (including receivables and payables) are eliminated –This is discussed in the next several chapters