An Introduction to Consolidated Financial Statements Chapter 3

An Introduction to Consolidated Financial Statements Chapter 3 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 -1

Learning Objective 1 Recognize the benefits and limitations of consolidated financial statements. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 -2

Business Combinations Consummated Through Stock Acquisitions Business combination One or more companies become subsidiaries of a common parent corporation. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 -3

The Reporting Entity Parent Financial Statements _____ _____ Subsidiary Financial Statements _____ _____ Consolidated Financial Statements _____ _____ © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 -4

The Reporting Entity A parent company may acquire a subsidiary in a very different industry from its own as a means of diversifying its overall business risk. There also legal reasons for maintaining separate identities. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 -5

The Parent-Subsidiary Relationship Parent Company Owns more than 50% of another company Affiliate © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 -6

The Parent-Subsidiary Relationship Parent Company 90% ownership Subsidiary A 80% ownership Subsidiary B © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 -7

Learning Objective 2 Understand the requirements for inclusion of a subsidiary in consolidated financial statements. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 -8

Consolidation Policy Consolidated financial statements provide information that is not included in the separate statements of the parent corporation. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 -9

Consolidation Policy A subsidiary can be excluded from consolidation in only two situations: 1 Control is likely to be temporary. 2 Control does not rest with the majority owner. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 10

Consolidation Policy Consolidation policy is usually presented under the following headings: Principles of consolidation Basis of consolidation © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 11

Parent and Subsidiary with Different Fiscal Periods Consolidated statements are prepared for and as of the end of the parent’s fiscal period. If the difference does not exceed three months… it is acceptable to use the subsidiary’s statements with disclosure. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 12

Learning Objective 3 Apply the consolidations concepts to parent company recording of the investment in a subsidiary company at the date of acquisition. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 13

Consolidated Balance Sheet at Date of Acquisition (100% at Book Value) Assets Current assets Cash Other current assets Total current assets Plant assets Less: Accum. depr. Total plant assets Investment in Skelly Total assets Penn Skelly $ 20, 000 45, 000 $ 65, 000 $ 75, 000 15, 000 $ 60, 000 40, 000 $165, 000 $10, 000 15, 000 $25, 000 $45, 000 $40, 000 0 $65, 000 Consolidated $ 30, 000 60, 000 $ 90, 000 $120, 000 $100, 000 0 $190, 000 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 14

Consolidated Balance Sheet at Date of Acquisition (100% at Book Value) Liabilities Penn Current liabilities Accounts payable $ 20, 000 Other current liabilities 25, 000 Total current liabilities $ 45, 000 Stockholders’ equity Capital stock $100, 000 Retained earnings 20, 000 Total stockholders’ equity$120, 000 Total liabilities and stockholders’ equity $165, 000 Skelly Consolidated $15, 000 10, 000 $25, 000 $ 35, 000 $ 70, 000 $30, 000 10, 000 $40, 000 $100, 000 20, 000 $120, 000 $65, 000 $190, 000 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 15

Learning Objective 4 Allocate the excess of the investment cost over the book value of the subsidiary at the date of acquisition. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 16

Parent Acquires 100% of Subsidiary with Goodwill Penn purchased all the stock of Skelly for $50, 000. Skelly stockholder’s equity is $40, 000. What is the consolidating (eliminating) entry? © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 17

Parent Acquires 100% of Subsidiary with Goodwill Capital Stock 30, 000 Retained Earnings 10, 000 Goodwill 10, 000 Investment in Skelly 50, 000 To eliminate reciprocal investment and equity accounts and to assign the excess of investment cost over book value acquired to goodwill © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 18

Learning Objective 5 Prepare a consolidated balance sheet at the date of acquisition, including preparation of eliminating entries. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 19

Consolidated Balance Sheet at Date of Acquisition (100% at Book Value) Assets Current assets Cash Other current assets Total current assets Plant assets Less: Accum. depr. Total plant assets Investment in Skelly Goodwill Total assets Penn $ 10, 000 45, 000 $ ……… $ 75, 000 15, 000 $ ……. . ---- Skelly Consolidated $10, 000 15, 000 $. . . . $45, 000 $. . $ ……. . $ ……… $. . . ---- ………. ----- © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 20

Consolidated Balance Sheet at Date of Acquisition (100% at Book Value) Liabilities Penn Current liabilities Accounts payable $ 20, 000 Other current liabilities 25, 000 Total current liabilities $ ……. Stockholders’ equity Capital stock $100, 000 Retained earnings 20, 000 Total stockholders’ equity$. . . Total liabilities and stockholders’ equity $. . . Skelly Consolidated $15, 000 10, 000 $. . $ ……. . ………. . $ ……. $30, 000 10, 000 $. . . ……. . $. . . . © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 21

Learning Objective 6 Learn the concept of minority interest when the parent company acquires less than 100% of the subsidiary’s outstanding common stock. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 22

Consolidated Balance Sheet at Date of Acquisition (100% at Book Value) Assets Current assets Cash Other current assets Total current assets Plant assets Less: Accum. depr. Total plant assets Investment in Skelly Goodwill Total assets Penn Skelly $ 10, 000 45, 000 $ 55, 000 $ 75, 000 15, 000 $ 60, 000 50, 000 $10, 000 15, 000 $25, 000 $45, 000 $40, 000 $ 20, 000 60, 000 $ 80, 000 $120, 000 $100, 000 $65, 000 14, 000 $194, 000 $165, 000 Consolidated © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 23

Consolidated Balance Sheet at Date of Acquisition (100% at Book Value) Liabilities Penn Current liabilities Accounts payable $ 20, 000 Other current liabilities 25, 000 Total current liabilities $ 45, 000 Minority interest Stockholders’ equity Capital stock $100, 000 Retained earnings 20, 000 Total stockholders’ equity$120, 000 Total liabilities and stockholders’ equity $165, 000 Skelly Consolidated $15, 000 10, 000 $25, 000 $ 35, 000 $ 70, 000 $ 4, 000 $30, 000 10, 000 $40, 000 $100, 000 20, 000 $120, 000 $65, 000 $194, 000 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 24

Minority Interest Minority interest in subsidiaries is generally shown in a single amount in the liability section of the consolidated balance sheet. The alternatives are to include the minority interest in consolidated stockholders’ equity or to place it in a separate minority interest section. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 25

Minority Interest The interest of minority stockholders represents equity investments in the consolidated net assets by stockholders of the company affiliated with the parent. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 26

Learning Objective 7 Prepare consolidated balance sheets subsequent to the date of acquisition, including preparation of eliminating entries. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 27

Consolidated Balance Sheet After Acquisition 1. Penn acquired a 90% interest in Skelly on January 1 for $50, 000 when Skelly’s stockholders’ equity was $40, 000. 2. The accounts payable of Skelly includes $5, 000 owed to Penn. 3. During the year, Skelly had income of $20, 000 and declared $10, 000 dividends. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 28

Consolidated Balance Sheet After Acquisition What is the balance in the investment in Skelly’s account at December 31? Original investment January 1 + 90% of Skelly’s net income – 90% of Skelly’s dividends Investment account balance $50, 000 18, 000 – 9, 000 $59, 000 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 29

Consolidated Balance Sheet After Acquisition Capital Stock 30, 000 Retained Earnings 20, 000 Goodwill 14, 000 Investment in Skelly 59, 000 Minority Interest 5, 000 To eliminate reciprocal investment and equity balances, record goodwill, and enter the minority interest © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 30

Consolidated Balance Sheet After Acquisition Dividends Payable 9, 000 Dividends Receivable 9, 000 To eliminate reciprocal dividends receivable and payable Accounts Payable 5, 000 Accounts Receivable 5, 000 To eliminate intercompany receivable and accounts payable © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 31

Effect of Allocation on Consolidated Balance Sheet at Acquisition The separate books of the affiliated companies do not record cost/book value differentials in acquisitions that create parent-subsidiary relationships. Working paper procedures are used to adjust subsidiary book values to reflect the cost/book differentials. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 32

Effect of Allocation on Consolidated Balance Sheet at Acquisition The adjusted amounts appear in the consolidated balance sheet. The amount of the adjustment to individual assets and liabilities is determined using an investment cost-allocation schedule. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 33

Effect of Allocation on Consolidated Balance Sheet at Acquisition On Dec. 3, 2003, Pilot purchases 90% of Sand Corporation’s outstanding common stock for $5, 000 cash plus 100, 000 shares of $10 stock with a market value of $5, 000. Additional costs are $300, 000. $200, 000 is recorded as cost of the investment. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 34

Effect of Allocation on Consolidated Balance Sheet at Acquisition Sand Corporation (000) Assets Cash Net receivables Inventories Other current assets Land Building, net Equipment, net Total assets Book Value Fair Value $ 200 300 500 400 600 4, 000 2, 000 $8, 000 $ 200 300 600 400 800 5, 000 1, 700 $9, 000 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 35

Effect of Allocation on Consolidated Balance Sheet at Acquisition Sand Corporation (000) Liabilities Accounts payable Notes payable Common stock Paid-in capital Retained earnings Total liabilities and stockholders’ equity Book Value Fair Value $ 700 1, 400 4, 000 1, 000 900 $ 700 1, 300 $8, 000 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 36

Assignment of Excess Cost over Underlying Equity Investment in Sand 10, 000 Common Stock 1, 000 Additional Paid-in Capital 4, 000 Cash 5, 000 To record 90% acquisition of Sand Corporation © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 37

Assignment of Excess Cost over Underlying Equity Investment in Sand 200 Additional Paid-in Capital 100 Cash 300 To record additional costs of combining with Sand © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 38

Allocation of Excess Cost over Underlying Equity Investment in Sand Book value of interest acquired $5, 900, 000 × 90% = Excess of cost over BV $10, 200, 000 (5, 310, 000) $ 4, 890, 000 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 39

Allocation of Excess Cost over Underlying Equity Fair Book Excess × 90% = – Value Allocated Inventories 600 Land 800 Building net 5, 000 Equipment, net 1, 700 Notes payable 1, 300 Total allocated Remainder to goodwill Total 500 600 4, 000 2, 000 1, 400 90 180 900 (270) 90 990 3, 900 4, 890 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 40

Consolidated Working Papers December 31, 2003 Adjustments and Eliminations Dr. Cr. Account Title Cash Receivables, net Inventories Other current assets Land Building, net Equipment, net Investment in Sand Goodwill Unamortized excess Pilot 1, 300 700 900 600 1, 200 8, 000 7, 000 10, 200 Sand 200 300 500 b 400 600 b 4, 000 b 2, 000 Total assets 29, 900 8, 000 90 180 900 b 3, 900 a 4, 890 Consolidated Balance Sheet 1, 500 1, 000 1, 490 1, 000 1, 980 12, 900 b 270 8, 730 a 10, 200 3, 900 b 4, 890 32, 500 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 41

Consolidated Working Papers December 31, 2003 Account Title Pilot Accounts payable 2, 000 Notes payable 3, 700 Common stock 11, 000 Other paid-in capital 8, 900 Retained earnings 4, 300 Sand 700 1, 400 4, 000 1, 000 900 Minority interest Total liabilities and stockholders’ equity Adjustments and Eliminations Dr. Cr. b 90 a 4, 000 a 1, 000 a 900 a 29, 900 8, 000 590 Consolidated Balance Sheet 2, 700 5, 010 11, 000 8, 900 4, 300 590 32, 500 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 42

Learning Objective 8 Apply the concepts underlying preparation of a consolidated income statement. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 43

Consolidated Income Statement The difference between a consolidated an unconsolidated income statement of the parent company lies in the detail presented rather than the net income amount. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 44

Learning Objective 9 Amortize the excess of the investment cost over the book value in periods subsequent to the acquisition. © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 45

Effect of Amortization on Consolidated Balance Sheet after Acquisition Income for 2004: Sand’s net income Pilot’s income (excluding income from Sand) $ 800, 000 $2, 523, 500 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 46

Effect of Amortization on Consolidated Balance Sheet after Acquisition Dividends Paid: Sand Pilot $ 300, 000 $1, 500, 000 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 47

Effect of Amortization on Consolidated Balance Sheet after Acquisition Amortization of excess: Undervalued inventories sold in 2004 Undervalued land still held Undervalued building (45 years useful life) Overvalued equipment (5 years useful life) Overvalued notes payable retired in 2004 Goodwill (no amortization) © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 48

Consolidated Working Papers December 31, 2004 Adjustments and Eliminations Dr. Cr. Account Title Cash Receivables, net Inventories Other current assets Land Building, net Equipment, net Investment in Sand Goodwill Unamortized excess Pilot Sand 253. 5 100 540 200 1, 300 600 800 500 1, 200 600 b 180 9, 500 3, 800 b 880 8, 000 1, 800 10, 504 b 3, 900 a 4, 744 Total assets 32, 097. 5 7, 600 Consolidated Balance Sheet 353. 5 740 1, 900 1, 300 1, 980 12, 900 b 216 8, 730 a 10, 504 3, 900 b 4, 744 33, 937. 5 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 49

Consolidated Working Papers December 31, 2004 Adjustments and Eliminations Dr. Cr. Account Title Pilot Sand Accounts payable 2, 300 1, 200 Notes payable 4, 000 Common stock 11, 000 4, 000 a 4, 000 Other paid-in capital 8, 900 1, 000 a 1, 000 Retained earnings 5, 897. 5 1, 400 a 1, 400 Minority interest Total liabilities and stockholders’ equity a 32, 097. 5 7, 600 640 Consolidated Balance Sheet 3, 500 4, 000 11, 000 8, 900 5, 897. 5 640 33, 937. 5 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 50

End of Chapter 3 © 2003 Prentice Hall Business Publishing, Advanced Accounting 8/e, Beams/Anthony/Clement/Lowensohn 3 - 51