1. Chapter 5 Electronic Presentations in Microsoft ® PowerPoint ® Prepared by James Myers, C.A. University of Toronto © 2008 McGraw-Hill Ryerson Limited

2. Chapter 5 © 2008 McGraw-Hill Ryerson Limited 2 Chapter 5 Consolidation Subsequent to Acquisition Date: Parent Uses Equity Method

3. Chapter 5 © 2008 McGraw-Hill Ryerson Limited 3 Learning Objectives –To explain the basic differences between the cost and equity methods of reporting investments –Describe the composition of and/or calculate consolidated net income –To explain how impairment tests are performed on long-lived assets, other intangibles, and goodwill –To calculate the amortization and/or impairment of purchase discrepancy on both an annual and cumulative basis –Explain how the matching principle is applied when amortizing or writing off the purchase discrepancy –Prepare journal entries under the equity method to report changes in the investment account during the year –Prepare consolidated financial statements in years subsequent to acquisition date when the parent has used the equity method to account for its investment.

4. Chapter 5 © 2008 McGraw-Hill Ryerson Limited 4 Method of Accounting for an Investment in a Subsidiary The investment account in the parent’s books may be maintained by the cost method, or the equity 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 since they both produce the same result. –The equity method provides more detailed information to management but the cost method is easier to apply.

5. Chapter 5 © 2008 McGraw-Hill Ryerson Limited 5 Method of Accounting for an Investment in a Subsidiary Handbook 3051.03 describes the cost method as: –A basis of accounting for long-term investment whereby the investment is initially recorded at cost; earnings from such investments are recognized only to the extent received or receivable –When the investment is in the form of shares, liquidating dividends received in excess of the investor’s pro rata share of post acquisition income are recorded as a reduction of the amount of the investment.

6. Chapter 5 © 2008 McGraw-Hill Ryerson Limited 6 Method of Accounting for an Investment in a Subsidiary The equity method is described as: –A basis of accounting for long-term investments whereby the investment is initially recorded at cost and the carrying value adjusted thereafter to include the investor’s pro-rata share of post acquisition retained earnings of the investee, computed by the consolidation method. The amount of the adjustment is included in the determination of net income by the investor and the investment account is also increased or decreased to reflect the investor’s share of capital transactions (including amounts recognized in other comprehensive income) and changes in accounting policies and corrections of errors relating to prior period financial statements applicable to post acquisition periods. Profit distributions received or receivable from an investee reduce the carrying amount of the investment.

7. Chapter 5 © 2008 McGraw-Hill Ryerson Limited 7 Accounting With the Equity Method Investment in Subsidiary Original Cost Income earned Dividends received P.D. Amortization Other adjustments* Balance *In later chapters

8. Chapter 5 © 2008 McGraw-Hill Ryerson Limited 8 Equity Method of Accounting Since the equity method includes the parent’s pro- rata share of the subsidiary’s post-acquisition retained earnings computed by the consolidation method, it produces the same net income and retained earnings on the parent’s separate entity financial statements as reported on the consolidated financial statements. The equity method is often referred to as a “one-line consolidation”, because it aggregates all consolidation adjustments in the parent’s investment revenue account, with offsetting entries to the parent’s investment in subsidiary account.

9. Chapter 5 © 2008 McGraw-Hill Ryerson Limited 9 Equity Method of Accounting When the investment account for the subsidiary is maintained under the equity method which reflects all consolidation adjustments, we know the following: –Parent’s net income equals consolidated net income –Parent’s retained earnings equals consolidated retained earnings

10. Chapter 5 © 2008 McGraw-Hill Ryerson Limited 10 Method of Accounting for an Investment in a Subsidiary When a company buys the shares of another company, the cost of these shares is recorded in an “investment account” in the parent’s general ledger. Parent and subsidiary remain separate legal entities each with their own accounting records and separate entity financial statements. Since the parent controls the subsidiary, consolidated financial statements are required in addition to the separate entity financial statements.

11. Chapter 5 © 2008 McGraw-Hill Ryerson Limited 11 Method of Accounting for an Investment in a Subsidiary This chapter is concerned with the process of consolidation when the investment account has been maintained using the equity method Problem material in the chapter illustrates this method.

12. Chapter 5 © 2008 McGraw-Hill Ryerson Limited 12 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 The amortization of the purchase discrepancy is reflected on the consolidated financial statements, not the subsidiary’s financial statements. The purchase discrepancy is amortized or written off on consolidation as if the parent had purchased the related net assets directly.

13. Chapter 5 © 2008 McGraw-Hill Ryerson Limited 13 Goodwill and other Intangibles On July 1, 2001, Section 1581, “Business Combinations,” and Section 3062, “Accounting for Goodwill and Other Intangible Assets,” were introduced in the Handbook In 2003 a related Section 3063, “Impairment of Long Lived Assets,” was also introduced These new sections provide more workable guidelines for the recognition and measurement of intangibles other than goodwill and, in addition, replace the annual amortization of goodwill with periodic reviews for impairment,

14. Chapter 5 © 2008 McGraw-Hill Ryerson Limited 14 Testing Long-Lived Assets for Impairment Intangible assets acquired in a business combination should be amortized over their useful lives unless their lives are indefinite. Intangible assets subject to amortization are subject to impairment testing under Handbook 3063. Impairment testing requires the estimation of future net cash flows associated with a long- lived asset or if not practical to associate with a single asset, with the smallest combination of such assets whose cash flows are independent of other groups of assets.

15. Chapter 5 © 2008 McGraw-Hill Ryerson Limited 15 Testing Long-Lived Assets for Impairment The impairment test has two stages as follows: A test is performed to see whether the carrying amount of an asset (or asset group including associated liabilities) is recoverable based on the associated undiscounted cash flows exceeding the carrying amount The second stage requires comparing the carrying value of the asset (or group) with its fair market value, and if the fair value is the lower amount an impairment loss is recognized for the difference. Guidance is provided on determining fair value.

16. Chapter 5 © 2008 McGraw-Hill Ryerson Limited 16 Testing Long-Lived Assets for Impairment Fair value is defined as “the amount of consideration between knowledgeable, willing parties who are under no compulsion to act” [3063.03(b)] Fair value can be determined by using quoted market prices, if available, by making comparisons with the prices of other similar assets, or by valuation techniques such as discounted annual expected cash flows.

17. Chapter 5 © 2008 McGraw-Hill Ryerson Limited 17 Testing Goodwill for Impairment, Section 3062 Once recognized, goodwill is tested yearly for impairment, and if the fair value of the goodwill is less than its carrying amount, it is written down and a loss is reported in income. Goodwill impairment testing is conducted at the level of the reporting unit which is either an operating segment (Handbook Section 1701) or one level below (a “component” constituting a business for which separate financial information is available and reviewed regularly by management).

18. Chapter 5 © 2008 McGraw-Hill Ryerson Limited 18 Testing Goodwill for Impairment, Section 3062 Goodwill is allocated to reporting units as follows: –The total purchase price is allocated to each reporting unit –For each reporting unit, the allocated purchase price is compared with the parent’s share of the fair value of the unit’s net assets –The fair value of the subsidiary’s individual net assets is also allocated to each reporting unit This will become carrying value (amortized) when impairment tests are performed later –The difference is the goodwill of the reporting unit –The sum of each reporting unit’s goodwill equals the total acquisition goodwill

19. Chapter 5 © 2008 McGraw-Hill Ryerson Limited 19 Goodwill Impairment Tests The goodwill impairment test is complex and often requires significant professional judgment. The impairment test is a two stage process: –First, the fair value of a reporting unit should be compared with its carrying amount, including goodwill. If 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

20. Chapter 5 © 2008 McGraw-Hill Ryerson Limited 20 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. –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.

21. Chapter 5 © 2008 McGraw-Hill Ryerson Limited 21 Goodwill Impairment Tests –The goodwill impairment test is performed annually unless there are clear indications no impairment has occurred, such as: Very little change in the composition of assets and liabilities of the reporting unit since the most recent impairment test; and The most recent impairment test yielded a fair value that substantially exceed the carrying amount of the reporting unit; and There have been no adverse economic or other specific impairment events (e.g. loss of market share or product obsolescence) since the last impairment test.

22. Chapter 5 © 2008 McGraw-Hill Ryerson Limited 22 Consolidations: Equity Method For the Consolidated Income Statement: –The equity-accounted investment income balance is replaced by the individual 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

23. Chapter 5 © 2008 McGraw-Hill Ryerson Limited 23 Consolidations: Equity Method For the Consolidated Balance Sheet –The investment account is replaced by the individual assets and liabilities of the subsidiary in the consolidated balance sheet, adjusted by the unamortized purchase discrepancy (and eliminating intercompany balances, if any) –These adjustments are on working papers only, and are not posted to the general ledger of either parent or subsidiary. –Consolidated retained earnings does not have to be restated, as this amount equals the retained earnings of the parent (determined using the equity method)

24. Chapter 5 © 2008 McGraw-Hill Ryerson Limited 24 Consolidations: Equity Method 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 –Determination of any intercompany revenues and expenses, and receivables and payables (if applicable)

25. Chapter 5 © 2008 McGraw-Hill Ryerson Limited 25 Purchase discrepancy Assigned to Liabilities Interest rate changes result in differences between fair values and carrying values of liabilities assumed in a business combination. This difference is similar to a bond premium or discount that must be amortized over its remaining life. In 2006 with the introduction of Handbook 3855 the straight-line method of amortization is no longer permitted. The effective interest method of amortization is now required.

26. Chapter 5 © 2008 McGraw-Hill Ryerson Limited 26 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

27. Chapter 5 © 2008 McGraw-Hill Ryerson Limited 27 When control ceases When control ceases, the investment will no longer be consolidated as a subsidiary The former parent must determine how to account for the remaining investment, if any: –If significant influence exists, using the equity method –If available-for-sale with no ready market value, using the cost method –If available-for-sale with a ready market value, at fair value. –While operating a subsidiary to be disposed, according to the provisions of Handbook 3475 discontinued operations. As there is a change in circumstances, the new method does not lead to retroactive restatement