Chapter 5 Consolidation Subsequent To Acquisition No Intercompany

Conceptual Alternatives Income Statements (Ponto Owns 70 Percent of Sonto) Ponto Sales $500, 000 $200, 000 Cost Of Goods Sold $300, 000 $110, 000 80, 000 40, 000 Total Expenses $380, 000 $150, 000 Net Income $120, 000 $50, 000 Other Expenses © 2008 Clarence Byrd Inc. 2

Consolidated Income Statement Proprietary Solution Sales [$500, 000 + (70%)($200, 000)] $640, 000 Cost Of Goods Sold [$300, 000 + (70%)($110, 000)] $377, 000 Other Expenses [$80, 000 + (70%)($40, 000)] 108, 000 Total Expenses $485, 000 Net Income $155, 000 © 2008 Clarence Byrd Inc. 3

Consolidated Income Statement Parent Company Solution Sales ($500, 000 + $200, 000) $700, 000 Cost Of Goods Sold ($300, 000 + $110, 000) $410, 000 Other Expenses ($80, 000 + $40, 000) 120, 000 Total Expenses $530, 000 Combined Income $170, 000 Non-Controlling Interest [(30%)($50, 000)] Net Income © 2008 Clarence Byrd Inc. 15, 000 $155, 000 4

Consolidated Income Statement Entity Solution Sales ($500, 000 + $200, 000) $700, 000 Cost Of Goods Sold ($300, 000 + $110, 000) $410, 000 Other Expenses ($80, 000 + $40, 000) 120, 000 Total Expenses $530, 000 Net Income $170, 000 Non-Controlling Interest [(30%)($50, 000)] Increase In Retained Earnings © 2008 Clarence Byrd Inc. 15, 000 $155, 000 5

CICA Solution n Largely Parent Company • Extraordinary items disclosed on proprietary basis •

Classification of Problems n Open Trial Balance (Requires more than just a Balance Sheet)

Classification of Problems n Closed Trial Balance (Requires only a Balance Sheet) • Investment

Classification of Problems n n Focus on investment at cost Problems involving the equity

Step A Procedures n n Step A-1 Procedure Eliminate 100 percent of the Investment In Subsidiary account. Step A-2 Procedure Eliminate 100 percent of all the balances in the subsidiary’s common shareholders’ equity that are present on the acquisition date. Step A-3 Procedure Allocate any debit or credit Differential that is present at acquisition to the investor’s share of fair value changes on identifiable assets, fair value changes on identifiable liabilities, and positive or negative goodwill. Step A-4 Procedure Allocate to a Non-Controlling Interest account in the consolidated Balance Sheet, the non -controlling interest’s share of the book value of the total Shareholders’ Equity of the subsidiary at acquisition. © 2008 Clarence Byrd Inc. 10

Step A Procedures n n Complete coverage in Chapter 4 Will be repeated unchanged

Step B Procedures n Chapter 4 Coverage • Step B-1 Procedure Eliminate 100 percent of all intercompany assets and liabilities. n New In Chapter 5 • Realization of fair value changes • Goodwill impairment • Intercompany expenses and revenues • Intercompany dividends © 2008 Clarence Byrd Inc. 12

Step C n Distribution of subsidiary Retained Earnings since acquisition • Introduced in this

Step B(2) Realization of Fair Value Changes n Basic Concept • Acquisition amounts recorded in Step A • As assets are sold or used, the recorded fair value changes become realized • As the fair value changes become realized, the Step A amounts must be reduced, with the changes taken into income © 2008 Clarence Byrd Inc. 14

Step B(2) – Current Assets On January 1, 2008, Par acquires 100 percent of the voting shares of Sub has Inventories with a carrying value of $550, 000 and a fair value of $600, 000. During the year ending December 31, 2008, the Inventories are sold, with Sub recording a Cost Of Goods Sold of $550, 000. © 2008 Clarence Byrd Inc. 15

Step B(2) - Inventories n Required Adjustment 2008 Year Ending December 31, 2008 Cost Of Goods Sold Inventories n $50, 000 Increases Cost Of Goods Sold and reverses the Step A debit of $50, 000 © 2008 Clarence Byrd Inc. 16

Step B(2) - Inventories n Required adjustment 2009 Year Ending December 31, 2009 Cost Of Goods Sold Inventories n $50, 000 This entry will be required in every subsequent year © 2008 Clarence Byrd Inc. 17

Step B(2) - Depreciable Assets On January 1, 2008, Par acquires 100 percent of the voting shares of Sub has a factory building with a carrying value of $810, 000 and a fair value of $900, 000. The building will be used for 3 years and retired on December 31, 2010 with no salvage value. It is subject to straight line amortization at the rate of $270, 000 per year. © 2008 Clarence Byrd Inc. 18

Step B(2) - Depreciable Assets n Required Adjustment 2008 Year Ending December 31, 2008 Amortization Expense ($90, 000 ÷ 3) Building (Net) n $30, 000 Increases Amortization Expense from $270, 000 ($810, 000 ÷ 3) to $300, 000 ($900, 000 ÷ 3). Reduces the Step A allocation from $90, 000 to $60, 000. © 2008 Clarence Byrd Inc. 19

Step B(2) - Depreciable Assets n Required adjustment 2009 Year Ending December 31, 2009 Retained Earnings (Opening) Amortization Expense Building (Net) n $30, 000 $60, 000 Reduces the opening Retained Earnings to reflect the 2008 amortization. Increases Amortization Expense from $270, 000 ($810, 000 ÷ 3) to $300, 000 ($900, 000 ÷ 3). Reduces the Step A allocation from $90, 000 to $30, 000. © 2008 Clarence Byrd Inc. 20

Step B(2) - Depreciable Assets n Required adjustment 2010 Year Ending December 31, 2010 Retained Earnings (Opening) Amortization Expense Building (Net) n $60, 000 30, 000 $90, 000 Reduces the opening Retained Earnings to reflect the 2008 and 2009 amortization. Increases Amortization Expense from $270, 000 ($810, 000 ÷ 3) to $300, 000 ($900, 000 ÷ 3). Reduces the Step A allocation from $90, 000 to Nil. © 2008 Clarence Byrd Inc. 21

Step B(2) Depreciable Assets n Required adjustment 2011 Year Ending December 31, 2011 Retained Earnings Building (Net) n $90, 000 This entry will be required in every subsequent year © 2008 Clarence Byrd Inc. 22

Step B(2) - Land On January 1, 2008, Par acquires 100 percent of the voting shares of Sub has Land with a carrying value of $450, 000 and a fair value of $600, 000. Sub sells this parcel of Land on December 31, 2011 for $700, 000. © 2008 Clarence Byrd Inc. 23

Step B(2) - Land As Land does not depreciate, no entry is required in

Step B(3) - Land n Sub’s entry when Land is sold Year Ending December

Step B(3) - Land n Required Consolidation Adjustment • Reduce gain to $100, 000 ($700, 000 - $600, 000) • Reverse the Step A allocation to Land Year Ending December 31, 2011 Gain On Sale Of Land © 2008 Clarence Byrd Inc. $150, 000 26

Step B(3) – Goodwill Impairment n n n Goodwill is no longer subject to amortization Must be tested annually for impairment If impaired: The Step A allocation must be adjusted and charged to income © 2008 Clarence Byrd Inc. 27

Step B(4) – Intercompany Expenses and Revenues n n Must be eliminated for purposes of consolidation Unless an unrealized profit is involved, the elimination does not change consolidated Net Income or the Non-Controlling Interest in income © 2008 Clarence Byrd Inc. 28

Step B(4) – Intercompany Expenses and Revenues n n During 2008, a subsidiary pays interest of $50, 000 to its parent Required adjustment: Year Ending December 31, 2008 Interest Revenue (Parent’s) Interest Expense (Subsidiary’s) © 2008 Clarence Byrd Inc. $50, 000 29

Step B(5) – Intercompany Dividends n Required Adjustments • Eliminate the Dividend Revenue recorded by the parent • Eliminate 100 percent of the Dividends Declared by the subsidiary n n Statement Of Retained Earnings contains parent company approach income (doesn’t include minority share) This means minority dividends cannot be shown in the Statement of Retained Earnings • Minority share of dividends debited to the Non-Controlling Interest in the Balance Sheet © 2008 Clarence Byrd Inc. 30

Step C – Concepts n n n Step A: Eliminate the noncontrolling share of Retained Earnings At Acquisition Step B: Make adjustments to the balance since acquisition Step C: Allocate the balance since acquisition to Non. Controlling Interest and consolidated Retained Earnings © 2008 Clarence Byrd Inc. 31

Step C Schedule Beginning Balance Of Retained Earnings Step A Elimination $1, 200, 000 ( Balance Since Acquisition Step B Adjustments (Fair Value Changes and Goodwill Impairment) $ 400, 000 ( Balance To Be Distributed To Non-Controlling Interest (20%) To Consolidated Retained Earnings 800, 000) $ ( 120, 000) 280, 000 56, 000) $ 224, 000 *Numbers created for this example © 2008 Clarence Byrd Inc. 32

Step C Schedule n This schedule will be modified in Chapter 6 to deal

Preparing The Statements n General Approach • Add parent and subsidiary figures • Add

Definitional Calculations n n Useful for checking figures arrived at through statements In problems

Consolidated Net Income – Definitional Calculation Parent Company Income Less: Intercompany Dividends $1, 000 ( $ Parent’s Equity In Subsidiary Net Income 60, 000) 940, 000 220, 000 $1, 160, 000 Fair Value And Goodwill Adjustments For Current Year Consolidated Net Income ( 105, 000) $1, 055, 000 *Numbers created for this example © 2008 Clarence Byrd Inc. 36

Consolidated Retained Earnings – Definitional Calculation Parent Company Closing Retained Earnings $3, 500, 000 Add: Parent’s Share Of Subsidiary Retained Earnings Since Acquisition 800, 000 $4, 300, 000 Fair Value And Goodwill Adjustments (Cumulative Amounts) Consolidated Retained Earnings ( 360, 000) $3, 940, 000 *Numbers created for this example © 2008 Clarence Byrd Inc. 37

Non-Controlling Interest Calculation - Balance Sheet n Using the procedures • • n Add: Step A Allocation Subtract: non-controlling dividends Add: Non-controlling interest in income Add: Step C allocation Direct Calculation Easier • Multiply the non-controlling interest percentage of ownership times the subsidiary’s common Shareholders’ Equity © 2008 Clarence Byrd Inc. 38

Subsidiary Preferred Shares n n If held intercompany: they will be eliminated If outstanding:

Application of the Equity Method n n Paragraph 3051. 08 Investment income as calculated by the equity method should be the amount necessary to increase or decrease the investor's income to that which would have been recognized if the results of the investee's operations had been consolidated with those of the investor. (August, 1978) “One Line Consolidation”: • All consolidation adjustments are treated as adjustments of investment income • No elimination of intercompany assets, liabilities, expenses, or revenues © 2008 Clarence Byrd Inc. 40

Investment Income Under The Equity Method Reported Investment Income (All Sources) Less: Intercompany Dividends $200, 000 ( 80, 000) $120, 000 Parent’s Equity In Subsidiary Net Income 150, 000 $270, 000 Fair Value And Goodwill Adjustments For Current Year Equity Method Investment Income ( 45, 000) $225, 000 *Numbers created for this example © 2008 Clarence Byrd Inc. 41

Investment Account Balance Under The Equity Method Investment Cost $1, 200, 000 Investor’s Equity In Investee Retained Earnings Since Acquisition 320, 000 $1, 520, 000 Fair Value And Goodwill Adjustments (Cumulative Since Acquisition) Equity Method Investment Account Balance ( 145, 000) $1, 375, 000 *Numbers created for this example © 2008 Clarence Byrd Inc. 42

Consolidated Statement Of Cash Flows n n In general, the procedures are the same for consolidated Cash Flow Statements as for single entity Cash Flow Statements Preparation requires a consolidated Net Income figure © 2008 Clarence Byrd Inc. 43

Consolidated Statement Of Cash Flows n Differences • Non-Controlling Interest must be added back to get cash from operations • The dividend figure in this statement (all dividends of parent and sub) will be different than the dividend figure in the Statement Of Retained Earnings (excludes dividends to non-controlling interest) © 2008 Clarence Byrd Inc. 44

Consolidated Statement Of Cash Flows n Parent acquires additional subsidiary shares • For cash from sub: an intercompany transaction that would be eliminated • For cash from non-controlling shareholders: an outflow of consolidated cash n Similar analysis for sales of shares © 2008 Clarence Byrd Inc. 45

Section 1540 on Business Combinations n Paragraph 1540. 42 The aggregate cash flows arising from each of business combinations accounted for using the purchase method and disposals of business units should be presented separately and classified as cash flows from investing activities. (August, 1998) © 2008 Clarence Byrd Inc. 46

Section 1540 on Business Combinations n Paragraph 1540. 43 An enterprise should disclose, in aggregate, in respect of both business combinations accounted for using the purchase method and disposals of business units during the period each of the following: n (a) the total purchase or disposal consideration; n (b) the portion of the purchase or disposal consideration composed of cash and cash equivalents; n (c) the amount of cash and cash equivalents acquired or disposed of; and n (d) the total assets, other than cash or cash equivalents, and total liabilities acquired or disposed of. (August, 1998) © 2008 Clarence Byrd Inc. 47

Step-By-Step Acquisitions n Paragraph 1600. 13 Where an investment in a subsidiary is acquired through two or more purchases, the parent company's interest in the subsidiary's identifiable assets and liabilities should be determined as follows: • (a) the assignable costs of the subsidiary's identifiable assets and liabilities should be determined as at each date on which an investment was required; • (b) the parent company's interest in the subsidiary's identifiable assets and liabilities acquired at each step in the purchase should be based on the assignable costs of all such assets and liabilities at that date. (April, 1975) © 2008 Clarence Byrd Inc. 48

Step-By-Step Acquisitions n Implementation Issues • 1 st purchases without significant influence No need to acquire fair value data n Use fair values at the time of the first application of the equity method n • Numerous small purchases can be accounted for as one step © 2008 Clarence Byrd Inc. 49

Step-By-Step Acquisitions n Procedures • Nothing really new – multiple applications of the same procedures • Journal entries do not work for this type of problem • Rely on direct definitional calculations © 2008 Clarence Byrd Inc. 50

Step-By-Step Retained Earnings Example On January 1, 2008, Part acquires 20 percent of the shares of Smart. At that time Smart has Retained Earnings of $2, 000. On January 1, 2009, Part acquires an additional 40 percent of Smart. At that time Smart has Retained Earnings of $2, 400, 000. On December 31, 2009, Part has Retained Earnings of $4, 000 and Smart has Retained Earnings of $2, 600, 000. © 2008 Clarence Byrd Inc. 51

Step-By-Step Retained Earnings Consolidated Retained Earnings – December 31, 2009 Part’s Balance $4, 000 Equity Pickups 1 st Purchase [(20%)($2, 600, 000 – $2, 000)] $120, 000 2 nd Purchase [(40%)($2, 600, 000 – $2, 400, 000)] 80, 000 Consolidated Retained Earnings 200, 000 $4, 200, 000 *This solution ignores possible Step B Adjustments © 2008 Clarence Byrd Inc. 52

Step-By-Step Retained Earnings Alternative Calculation Consolidated Retained Earnings – December 31, 2009 Part’s Balance $4, 000 Equity Pickups 1 st Purchase [(20%)($2, 400, 000 – $2, 000)] $ 80, 000 2 nd Purchase [(60%)($2, 600, 000 – $2, 400, 000)] 120, 000 Consolidated Retained Earnings 200, 000 $4, 200, 000 *This solution ignores possible Step B Adjustments © 2008 Clarence Byrd Inc. 53

Summary Of Consolidation Procedures n n Step A-1 Procedure Eliminate 100 percent of the Investment In Subsidiary account. Step A-2 Procedure Eliminate 100 percent of all the acquisition date balances in the subsidiary’s shareholders’ equity (includes both contributed capital and retained earnings). Step A-3 Procedure Allocate any debit or credit Differential that is present at acquisition to the investor’s share of fair value changes on identifiable assets, fair value changes on identifiable liabilities, and positive or negative goodwill. Step A-4 Procedure Allocate to a Non-Controlling Interest account in the consolidated Balance Sheet, the non-controlling interest’s share of the at acquisition book value of the common shareholders’ equity of the subsidiary (includes both contributed capital and retained earnings). © 2008 Clarence Byrd Inc. 54

Summary Of Consolidation Procedures n n n Step B-1 Procedure Eliminate 100 percent of all intercompany assets and liabilities. Step B-2 Procedure Give recognition to the post-acquisition realization of acquisition date fair value changes on assets and liabilities that have been used up or sold during the post-acquisition period. To the extent that this realization occurred in prior periods, recognition will require an adjustment of the opening retained earnings of the subsidiary. Alternatively, if the realization occurred in the current period, the adjustment will be to the subsidiary’s current period expenses, revenues, gains, or losses. Step B-3 Procedure Recognize current and cumulative goodwill impairment losses that have been measured since the acquisition of the subsidiary and the initial recognition of the goodwill balance. To the extent that the impairment took place during the current period, the measured amount will be charged to Goodwill Impairment Loss. To the extent that it occurred in prior periods, it will be charged to retained earnings. © 2008 Clarence Byrd Inc. 55

Summary Of Consolidation Procedures n n Step B-4 Procedure Eliminate 100 percent of all intercompany expenses and revenues. Step B-5 Procedure Eliminate 100 percent of subsidiary dividends declared. The parent’s share of this amount will be deducted from the revenues of the parent company and the non-controlling interest’s share of this amount will be deducted from the Non-Controlling Interest in the Balance Sheet. © 2008 Clarence Byrd Inc. 56

Summary Of Consolidation Procedures n n Step C-1 Procedure Determine the appropriate allocation of the subsidiary’s adjusted retained earnings since acquisition. The Non-Controlling Interest’s share will be based on book value. After the Non-Controlling Interest’s share is subtracted, the resulting balance will be adjusted for the fair value write-offs called for in Step B(2), as well as any goodwill impairment as described in Step B(3). The balance remaining after these adjustments will be allocated to consolidated Retained Earnings. Step C-2 Procedure Eliminate the subsidiary’s adjusted Retained Earnings since acquisition. This amount will be allocated to the Non-Controlling Interest in the consolidated Balance Sheet and to consolidated Retained Earnings as determined in Step C-1. © 2008 Clarence Byrd Inc. 57

Summary Of Definitional Calculations n Identifiable Assets And Liabilities The amount to be included in the consolidated Balance Sheet for any identifiable asset or liability is calculated as follows: • 100 percent of the carrying value of the identifiable asset (liability) on the books of the parent company at the Balance Sheet date; plus • 100 percent of the carrying value of the identifiable asset (liability) on the books of the subsidiary company at the Balance Sheet date; plus (minus) • the parent company’s share of the fair value increase (decrease) on the asset (liability) (i. e. , the parent company’s share of the difference between the fair value of the subsidiary’s asset or liability at time of acquisition and the carrying value of that asset or liability at the time of acquisition); minus (plus) • amortization of the parent company’s share of the fair value increase (decrease) on the asset (liability) for the period since acquisition to the current Balance Sheet date. © 2008 Clarence Byrd Inc. 58

Summary Of Definitional Calculations n Goodwill The Goodwill to be recorded in the consolidated Balance Sheet is equal to: • the excess of the cost of the investment over the parent company’s share of the fair values of the subsidiary’s net assets at the time of acquisition; minus • the amount of any goodwill impairment that has been recognized in the period since the acquisition to the current Balance Sheet date. © 2008 Clarence Byrd Inc. 59

Summary Of Definitional Calculations n Non-Controlling Interest - Balance Sheet The Non. Controlling Interest to be recorded in the consolidated Balance Sheet is an amount equal to the non-controlling interest’s ownership percentage of the book value of the subsidiary’s common stock equity at the Balance Sheet date. © 2008 Clarence Byrd Inc. 60

Summary Of Definitional Calculations n Contributed Capital The Contributed Capital to be recorded in the consolidated Balance Sheet is equal to the contributed capital from the single entity Balance Sheet of the parent company. © 2008 Clarence Byrd Inc. 61

Summary Of Definitional Calculations n Retained Earnings The Retained Earnings amount to be included in the consolidated Balance Sheet is calculated as follows: • 100 percent of the Retained Earnings of the parent company; plus (minus) • the parent company’s share of the subsidiary’s Retained Earnings (Deficit) since acquisition; plus (minus) • 100 percent of the adjustments to consolidated expenses, revenues, gains, and losses for realized fair value changes during the period since acquisition to the current Balance Sheet date; minus • 100 percent of any goodwill impairment that has been recognized since the acquisition to the current Balance Sheet date. © 2008 Clarence Byrd Inc. 62

Summary Of Definitional Calculations n Revenue The amount of any revenue to be included in the consolidated Income Statement is calculated as follows: • 100 percent of the amount reported in the parent company’s financial statements; plus • 100 percent of the amount reported in the subsidiary’s financial statements; minus • 100 percent of any intercompany amounts included in the parent or subsidiary figures; plus (minus) • the parent’s share of any fair value changes realized during the period through usage or sale of subsidiary assets (fair value amortization and amounts realized through the sale of subsidiary assets prior to the end of their economic life). It would be unusual for fair value realizations to be related to revenues. However, it could happen. For example, amortization of a fair value change on a long-term receivable would be treated as an adjustment of interest revenue. © 2008 Clarence Byrd Inc. 63

Summary Of Definitional Calculations n Expense The amount of any expense to be included in the consolidated Income Statement is calculated as follows: • 100 percent of the amount reported in the parent company’s financial statements; plus • 100 percent of the amount reported in the subsidiary’s financial statements; minus • 100 percent of any intercompany amounts included in the parent or subsidiary figures; plus (minus) • the parent’s share of any fair value changes realized during the period through usage or sale of subsidiary assets (fair value amortization and amounts realized through the sale of subsidiary assets prior to the end of their economic life). © 2008 Clarence Byrd Inc. 64

Summary Of Definitional Calculations n Goodwill Impairment Loss If the required annual test of goodwill for impairment determines that any impairment has occurred during the current period, this amount will be recorded as a Goodwill Impairment Loss. © 2008 Clarence Byrd Inc. 65

Summary Of Definitional Calculations n n n Non-Controlling Interest - Income Statement The non-controlling interest in the consolidated Income Statement is an amount equal to the non-controlling interest’s ownership percentage of the reported Net Income. Note that, if the subsidiary has extraordinary items or results from discontinued operations, this Non-Controlling Interest will be based on the subsidiary’s Income Before Extraordinary Items And Discontinued Operations. Also note that, in situations where there are preferred shares with a prior claim on the income of the subsidiary, the Non-Controlling Interest to be disclosed in the consolidated Income Statement will include such claims. © 2008 Clarence Byrd Inc. 66

Summary Of Definitional Calculations n Consolidated Net Income can be calculated as follows: • 100 percent of the parent company’s Net Income, excluding dividends received from the subsidiary; plus (minus) • the parent’s share of the subsidiary’s reported Net Income (Net Loss); plus (minus) • the parent’s share of any fair value changes realized during the period through usage or sale of subsidiary assets (fair value amortization and amounts realized through the sale of subsidiary assets prior to the end of their economic life); minus • any Goodwill Impairment Loss that is recognized during the period. © 2008 Clarence Byrd Inc. 67

International Convergence n Standards • IFRS No. 3, Business Combinations • IAS No. 27,

International Convergence n Differences (Current Standards) • Asset Valuation IFRS No. 3 requires that 100 percent of fair value changes on identifiable assets be recognized at the time of acquisition. Section 1581 only allows the acquirer’s share to be recognized. Note, however, IFRS No. 3 does not allow the recognition of 100 percent of goodwill. Only the acquirer’s share of this asset can be recognized. • Non-Controlling Interest Consistent with the entity approach, IAS No. 27 requires the non-controlling interest to be presented as a component of consolidated Shareholders’ Equity. The value to be recognized will include the non-controlling interest’s share of fair value changes on identifiable assets. • Terminology IAS No. 27 continues to use the term Minority Interest, rather than the more accurate Non-Controlling Interest. However, this is certain to be changed by the amendments resulting from the FASB/IASB project. Given this, we will ignore this difference in presenting examples based on current IFRSs. © 2008 Clarence Byrd Inc. 69

International Convergence n Proposals • At this time (December, 2007), it appears that the IASB will require the recognition of 100 percent of goodwill • There may also be a different approach to its measurement © 2008 Clarence Byrd Inc. 70