Chapter 3 An Introduction to Consolidated Financial Statements

Chapter 3: An Introduction to Consolidated Financial Statements by Jeanne M. David, Ph. D. , Univ. of Detroit Mercy to accompany Advanced Accounting, 10 th edition by Floyd A. Beams, Robin P. Clement, Joseph H. Anthony, and Suzanne Lowensohn © Pearson Education, Inc. publishing as Prentice Hall 3 -1

Intro to Consolidations: Objectives 1. Recognize the benefits and limitations of consolidated financial statements. 2. Understand the requirements for inclusion of a subsidiary in consolidated financial statements. 3. Apply the consolidation concepts to parent company recording of the investment in a subsidiary at the date of acquisition. 4. Allocate the excess of the fair value over the book value of the subsidiary at the date of acquisition. © Pearson Education, Inc. publishing as Prentice Hall 3 -2

Objectives (continued) 5. Learn the concept of noncontrolling interest when the parent company acquires less than 100% of the subsidiary's outstanding common stock. 6. Amortize the excess of the fair value over the book value in periods subsequent to the acquisition. 7. Prepare consolidated balance sheets subsequent to the date of acquisition, including preparation of elimination entries. 8. Apply the concepts underlying preparation of a consolidated income statement. © Pearson Education, Inc. publishing as Prentice Hall 3 -3

An Introduction to Consolidated Financial Statements 1: Benefits & Limitations © Pearson Education, Inc. publishing as Prentice Hall 3 -4

Business Acquisitions • FASB Statement 141 R • Business combinations occur – Acquire controlling interest in voting stock – More than 50% – May have control through indirect ownership • Consolidated financial statements – Primarily for owners & creditors of parent – Not for noncontrolling owners or subsidiary creditors © Pearson Education, Inc. publishing as Prentice Hall 3 -5

An Introduction to Consolidated Financial Statements 2: Subsidiaries © Pearson Education, Inc. publishing as Prentice Hall 3 -6

Who is a Subsidiary? • ARB No. 51 allowed broad discretion • FASB Statement No. 94 – Control based on share ownership • FASB Statement No. 160 – Financial control • Subsidiaries, or affiliates, continue as separate legal entities and reporting to their controlling and noncontrolling interests. © Pearson Education, Inc. publishing as Prentice Hall 3 -7

Consolidated Statements • Prepared by the parent company • Parent discloses – Consolidation policy, Reg. S-X – Exceptions to consolidation, temporary control and inability to obtain control • Fiscal year end – Use parent's FYE, but – May include subsidiary statements with FYE within 3 months of parent's FYE. • Disclose intervening material events © Pearson Education, Inc. publishing as Prentice Hall 3 -8

An Introduction to Consolidated Financial Statements 3: Parent Company Recording © Pearson Education, Inc. publishing as Prentice Hall 3 -9

Penn Example: Acquisition Cost = Fair Value = Book Value Skelly BV=FV Cash Other current assets Net plant assets Total Accounts payable Other liabilities Capital stock Retained earnings Total $10 15 40 $65 $15 10 30 10 $65 Penn acquires 100% of Skelly for $40, which equals the book value and fair values of the net assets acquired. Cost of acquisition $40 Less 100% book value 40 Excess of cost over book value $0 To consolidate, eliminate Penn's Investment account and Skelly's capital stock and retained earnings. © Pearson Education, Inc. publishing as Prentice Hall 3 -10

Balance sheets Cash Other curr. assets Separate Consolidated Penn Skelly Penn & Sub. $20 $10 $30 45 15 60 Net plant 60 Investment in Skelly 40 Total $165 Accounts payable $20 Other curr. liabilities 25 Capital stock 100 Retained earnings 20 Total $165 © Pearson Education, Inc. publishing as Prentice Hall 40 0 $65 $15 10 30 10 $65 100 0 $190 $35 35 100 20 $190 3 -11

An Introduction to Consolidated Financial Statements 4: Allocations at Acquisition Date © Pearson Education, Inc. publishing as Prentice Hall 3 -12

Cost, Fair Value and Book Value Acquisition cost, fair values of identifiable net assets and book values may differ. – Allocate excess or deficiency of cost over book value and determine goodwill, if any. – When BV = FV, excess is goodwill. Cost less BV = Excess to allocate – Allocate first to FV-BV differences – Remainder is goodwill (or bargain purchase) © Pearson Education, Inc. publishing as Prentice Hall 3 -13

Example: BV ≠ FV but Cost = FV Piper acquires 100% of Sandy for $310. Sandy BV FV BV = 100 + 145 = $245 Cash $40 FV = 385 – 75 = $310 Receivables 30 30 Inventory 50 75 Plant, net 200 240 Total $320 $385 Liabilities $75 Capital stock 100 Retained earnings 145 Total Cost – FV = $0 goodwill $75 Cost 100% BV Excess of cost over BV $310 245 $65 $320 © Pearson Education, Inc. publishing as Prentice Hall 3 -14

Piper and Sandy (cont. ) Allocate to: Inventory 100%(+25) Plant 100%(+40) Total Amt Amort. 25 1 st yr 40 10 yrs $65 Piper's elimination worksheet entry: Capital stock 100 Retained earnings 145 Inventory 25 Plant 40 Investment in Sandy © Pearson Education, Inc. publishing as Prentice Hall 310 3 -15

Example: BV ≠ FV and Cost ≠ FV Panda acquires 100% of Salty for $530. BV = 250 + 190 = $440 Salty BV FV Cash $100 FV = 580 – 85 = $495 Receivables 40 40 Inventory 250 Plant, net 130 190 Total $520 $580 Liabilities $80 $85 Capital stock 250 Retained earnings 190 $520 Total Cost – FV = $35 goodwill © Pearson Education, Inc. publishing as Prentice Hall Cost 100% BV (250+190) Excess of cost over BV $530 440 $90 3 -16

Panda and Salty (cont. ) Allocate to: Plant Liabilities Goodwill Total Amt 60 -5 35 $90 Amort. 4 yrs 5 yrs - Panda's elimination worksheet entry: Capital stock Retained earnings Plant Goodwill Liabilities Investment in Salty © Pearson Education, Inc. publishing as Prentice Hall 250 190 60 35 5 530 3 -17

Example: BV ≠ FV and Cost ≠ FV Printemps acquires 100% of Summer for $185. BV = 75 + 105 = $180 Summer BV FV FV = 250 - 40 = $210 Cash $10 Receivables 30 30 Inventory 80 90 Plant, net 100 120 Total Liabilities Capital stock Retained earnings Total $220 $250 $40 75 105 $220 Cost 100% BV (75+105) Excess of cost over BV $40 $185 180 $5 © Pearson Education, Inc. publishing as Prentice Hall 3 -18

Printemps and Summer (cont. ) Allocate to: Inventory Plant, land Bargain purchase Total Amt 10 20 (25) $5 Amort. 1 st yr - Gain Printemps records the acquisition of Summer assuming a cash purchase as follows. Note that the investment account is recorded at its fair value and the bargain purchase is treated immediately as a gain. Investment in Summer Gain on Bargain purchase Cash © Pearson Education, Inc. publishing as Prentice Hall 210 25 185 3 -19

Worksheet Elimination Entry Unamortized excess equals $30 (gain is recognized) • $10 for undervalued inventory • $20 for undervalued land included in plant assets Printemps' elimination worksheet entry: Capital stock Retained earnings Unamortized excess Investment in Summer Inventory Plant Unamortized excess © Pearson Education, Inc. publishing as Prentice Hall 75 105 30 210 10 20 30 3 -20

Printemps Summer Adjustments Consol BV BV DR CR idated $30 $10 $40 50 30 80 10 190 450 100 20 570 Cash Receivables Inventory Plant, net Investment in Summer Unamortized excess Total Liabilities Capital stock Retained earnings Total 210 $840 $270 200 370 $840 © Pearson Education, Inc. publishing as Prentice Hall $220 $40 75 105 $220 210 30 0 75 105 240 $880 $310 200 370 $880 30 3 -21

An Introduction to Consolidated Financial Statements 5: Noncontrolling Interests © Pearson Education, Inc. publishing as Prentice Hall 3 -22

Noncontrolling Interest Parent owns less than 100% – Noncontrolling interest represents the minority shareholders – Part of stockholders' equity – Measured at fair value, based on parent's acquisition price • Parent pays $40, 000 for an 85% interest – Implied value of the full investee is 40, 000/85% = $47, 059. – Minority share = 15%(47, 059) = $7, 059. © Pearson Education, Inc. publishing as Prentice Hall 3 -23

Example: Noncontrolling Interests Popo acquires 80% of Sine for $400 when Sine had capital stock of $200 and retained earnings of $175. Sine's assets and liabilities equaled their fair values except for buildings which are undervalued by $50. Buildings have a 10 -year remaining life. Cost of 80% of Sine Implied value of Sine (400/80%) Book value (200+175) Excess over book value © Pearson Education, Inc. publishing as Prentice Hall $400 $500 375 $125 Allocate to: Building $50 Goodwill 75 Total $125 3 -24

Elimination Entry Popo's elimination worksheet entry: Capital stock Retained earnings Building Goodwill Investment in Sine Noncontrolling interest 200 175 50 75 400 100 An unamortized excess account could have been used for the excess assigned to the building and goodwill. © Pearson Education, Inc. publishing as Prentice Hall 3 -25

Cash Receivables Inventory Building, net Investment in Sine Goodwill Total Liabilities Capital stock Retained earnings Noncontrolling interest Total Popo BV $50 130 80 300 400 $960 $150 250 560 $960 © Pearson Education, Inc. publishing as Prentice Hall Sine BV $10 50 100 240 $400 $25 200 175 $400 Adjustments Consol. DR CR idated $60 180 50 590 400 0 75 $1, 085 $175 200 250 175 560 100 $1, 085 500 3 -26

An Introduction to Consolidated Financial Statements 6: Amortizations After Acquisition © Pearson Education, Inc. publishing as Prentice Hall 3 -27

Unamortized Excess assigned to assets and liabilities are amortized according to the account Balance sheet Amortization account period Inventories and Generally, 1 st year other current assets Buildings, Remaining life at equipment, patents, business combination Land, copyrights Not amortized Long term debt Time to maturity © Pearson Education, Inc. publishing as Prentice Hall Income statement account Cost of sales and other expense Depreciation and amortization expense Interest expense 3 -28

Piper and Sandy (cont. ) Cost 100% BV Excess Inventory Plant Total $310 245 $65 Allocate to: Inventory Plant Total Amt Amort. 25 1 st yr 40 10 yrs $65 Beginning Current Ending unamortized year's unamortized excess amortization excess 25 (25) 0 40 (4) 36 65 (29) 36 © Pearson Education, Inc. publishing as Prentice Hall 3 -29

Panda and Salty (cont. ) Cost 100% BV Excess Plant Liabilities Goodwill Total $530 440 $90 Allocate to: Plant Liabilities Goodwill Total Amt 60 -5 35 $90 Amort. 4 yrs 5 yrs - Beginning Current Ending unamortized year's unamortized excess amortization excess 60 (15) 45 (5) 1 (4) 35 0 35 90 14 76 © Pearson Education, Inc. publishing as Prentice Hall 3 -30

Printemps and Summer (cont. ) Cost 100% BV Excess Inventory Land Total $185 180 $5 Allocate to: Inventory Plant, land Bargain purchase Total Amt 10 20 (25) $5 Amort. 1 st yr - Gain Beginning Current Ending unamortized year's unamortized excess amortization excess 10 (10) 0 20 30 (10) 20 © Pearson Education, Inc. publishing as Prentice Hall 3 -31

An Introduction to Consolidated Financial Statements 7: Subsequent Balance Sheets © Pearson Education, Inc. publishing as Prentice Hall 3 -32

Balance Sheets After Acquisition In preparing a consolidated balance sheet – Eliminate the parent's Investment in Subsidiary – Eliminate the subsidiary's equity accounts (common stock, retained earnings, etc. ) – Adjust asset and liability accounts for any unamortized excess balance – Record goodwill, if any – Record Noncontrolling Interest, if any © Pearson Education, Inc. publishing as Prentice Hall 3 -33

Popo and Sine (cont. ) Cost of 80% of Sine Implied value of Sine Book value Excess Building Goodwill Total $400 $500 375 $125 Allocate to: Building $50 10 yrs Goodwill 75 - Total $125 Beginning Current Ending unamortized year's unamortized excess amortization excess 50 (5) 45 75 0 75 125 (5) 120 © Pearson Education, Inc. publishing as Prentice Hall 3 -34

After 1 year: Cash Receivables Inventory Building, net Investment in Sine Total Popo $40 110 90 280 404 $924 Sine $15 85 100 235 $435 Liabilities Capital stock Retained earnings Popo $100 250 574 Sine $50 200 185 Total $924 $435 Popo's elimination worksheet entry: Capital stock Retained earnings Unamortized excess Investment in Sine (80%) Noncontrolling interest (20%) Building Goodwill Unamortized excess © Pearson Education, Inc. publishing as Prentice Hall 200 185 120 404 101 45 75 120 3 -35

After 1 year: Popo BV $40 110 90 280 404 Cash Receivables Inventory Building, net Investment in Sine Goodwill Sine BV $15 85 100 235 Unamortized excess 120 Total $924 Liabilities $100 Capital stock 250 Retained earnings 574 Noncontrolling interest Total $924 Adjustments DR CR 45 404 75 © Pearson Education, Inc. publishing as Prentice Hall $435 $50 200 185 $435 120 200 185 101 505 Consolidated $55 190 560 0 75 $1, 075 $150 250 574 101 $1, 075 505 3 -36

Key Balance Sheet Items • Investment in Subsidiary does not exist on the consolidated balance sheet • Equity on the consolidated balance sheet consists of the parent's equity plus the noncontrolling interest. • Noncontrolling interest is proportional to the Investment in Subsidiary account when the equity method is used. $101 = $404 x. 20/. 80 © Pearson Education, Inc. publishing as Prentice Hall 3 -37

An Introduction to Consolidated Financial Statements 8: Consolidated Income Statements © Pearson Education, Inc. publishing as Prentice Hall 3 -38

Comprehensive Example, Data Pilot acquires 90% of Sand on 12/31/2009 for $4, 333 when Sand's equity consists of $4, 000 common stock, $1, 000 other paid in capital, and $900 retained earnings. On that date Sand's inventories, land buildings are understated by $100, $200, and $1, 000, respectively and its equipment and notes payable are overstated by $300 and $100. © Pearson Education, Inc. publishing as Prentice Hall 3 -39

Assignment and Amortization Cost of 90% of Sand $10, 200 Implied value of Sand 10, 200/. 90 $11, 333 Book value (4000+1000+900) Excess over book value Inventory Land Building Equipment Note payable Goodwill Total 5, 900 $5, 433 Unamortized excess 1/1/10 100 200 1, 000 (300) 100 4, 333 5, 433 © Pearson Education, Inc. publishing as Prentice Hall Allocate to: Inventory Land Building Equipment Note payable Goodwill Total Current amortization (100) 0 (25) 60 (100) 0 (165) $100 200 1, 000 (300) 100 4, 333 $5, 433 1 st yr - 40 yrs 5 yrs 1 st yr - Unamortized excess 12/31/10 0 200 975 (240) 0 4, 333 5, 268 3 -40

Pilot Sand Consol. * $9, 523. 50 $2, 200. 00 $11, 723. 50 571. 50 $0. 00 (4, 000. 00) (700. 00) (4, 800. 00) (200. 00) (80. 00) (305. 00) (700. 00) (360. 00) (1, 000. 00) (1, 800. 00) (120. 00) (1, 920. 00) (300. 00) (140. 00) (540. 00) $3, 095. 00 $800. 00 $3, 158. 50 Sales Income from Sand Cost of sales Depreciation exp - bldg Depreciation exp - equip Other expense Interest expense Net income Total consolidated income Noncontrolling interest share 63. 50 Controlling interest share $3, 095. 00 * Cost of sales, building depreciation and interest expense are increased by $100, $25, and $100, and equipment depreciation is $60 lower than the sum of Pilot and Sand. © Pearson Education, Inc. publishing as Prentice Hall 3 -41

Key Income Statement Items • The Income from Subsidiary account is eliminated. • Current period amortizations are included in the appropriate expense accounts. • Noncontrolling interest share of net income is proportional to the Income from Subsidiary under the equity method. $571. 50 x. 10/. 90 = $63. 50 © Pearson Education, Inc. publishing as Prentice Hall 3 -42

Push-Down Accounting • SEC requirement – Subsidiary is substantially wholly-owned (approx. 90%) – No publicly held debt or preferred stock • Books of the subsidiary are adjusted – Assets, including goodwill, and liabilities revalued based on acquisition price – Retained earnings is replaced by Push-Down Capital which includes retained earnings and the valuation adjustments © Pearson Education, Inc. publishing as Prentice Hall 3 -43

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