Chapter Three Consolidations Subsequent to the Date of

Chapter Three Consolidations – Subsequent to the Date of Acquisition Copyright © 2015 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

Learning Objective 3 -1 Recognize the complexities in preparing consolidated financial reports that emerge from the passage of time. 3 -2

Consolidation – The Effects of the Passage of Time The passage of time creates complexities for internal record keeping and the balance of the investment account varies due to the accounting method used. A worksheet and consolidation entries are used to eliminate the investment account and record the subsidiary’s assets and liabilities to create a single set of financial statements for the combined business entity. 3 -3

Learning Objective 3 -2 Identify and describe the various methods available to a parent company in order to maintain its investment in subsidiary account in its internal records. 3 -4

Investment Accounting by Acquiring Company For each subsidiary owned, an asset, the investment account, and an income account are created to record the earnings on the investment. The acquiring company selects one of these three methods have emerged as the most prominent to account for its investment: Ø Equity Method Ø Initial Value Method Ø Partial Equity Method 3 -5

Investment Accounting by Acquiring Company What is the advantage of each? Equity Method: The acquiring company totals give a true representation of consolidation figures. Initial Value (or “Cost”) Method: It is easy to apply and gives a good measurement of cash flows generated by the investment. Partial Equity Method: Usually gives balances approximating consolidation figures, but is easier to apply than equity method 3 -6

Investment Accounting by Acquiring Company Comparison of internal reporting of investment methods. Method Investment Income Account Equity Continually adjusted to reflect ownership of acquired company. Income accrued as earned; amortization and other adjustments are recognized. Initial Value Remains at Initially. Recorded cost Dividends declared recorded as Dividend Income Partial Equity Adjusted only for accrued income and dividends declared by acquired company. Income accrued as earned; no other adjustments recognized. 3 -7

Learning Objective 3 -3 Prepare consolidated financial statements subsequent to acquisition when the parent has applied in its internal records: a. the equity method. b. the initial value method. c. the partial equity method. 3 -8

LO 3 -3 a Subsequent Consolidation – Equity Method During the year, the parent will adjust its investment account for the Subsidiary under application of the equity method. The original investment, recorded at the date of acquisition, is adjusted for: 1. FMV adjustments and other intangible assets, 2. The parent’s share of the sub’s income (loss), 3. The receipt of dividends from the sub. 3 -9

Subsequent Consolidation Equity Method Example Parrot Company obtains all of the outstanding common stock of Sun Company on January 1, 2014. Parrot acquires this stock for $800, 000 in cash. Sun Company’s balances are shown below. Book Values 1/1/14 Current assets. . . . $320, 000 Trademarks (indefinite life). . . . 200, 000 Patented technology (10 -year life). . . 320, 000 Equipment (5 -year life). . . 180, 000 Liabilities. . . (420, 000) Net book value. . . . $600, 000 Common stock—$40 par value. . $(200, 000) Additional paid-in capital. . (20, 000) Retained earnings, 1/1/14. . (380, 000) Fair Values 1/1/14 $ 320, 000 220, 000 450, 000 150, 000 (420, 000) $ 720, 000 Difference – 0– 20, 000 130, 000 (30, 000) – 0– $120, 000 3 -10

Subsequent Consolidation Equity Method Example PARROT COMPANY 100 Percent Acquisition of Sun Company Allocation of Acquisition-Date Subsidiary Fair Value January 1, 2014 FV of consideration transferred by Parrot Company. $ 800, 000 Net Book Value of Sun Company. . . . . (600, 000) Excess of fair value over book value. . 200, 000 Allocation to specific accounts based on fair values: Trademarks. . . . . $ 20, 000 Patented technology. . . . 130, 000 Equipment (overvalued). . . (30, 000) 120, 000 Excess FV not specifically identified—goodwill. . . $ 80, 000 3 -11

Subsequent Consolidation Equity Method Example Amortization computation: Account Allocation Trademarks $ 20, 000 Patented technology 130, 000 Equipment (30, 000) Goodwill 80, 000 Useful Life Indefinite 10 years 5 years Indefinite Annual Amortization – 0– $13, 000 (6, 000) – 0– $ 7, 000 Amortization will be $7, 000 annually for five years until the equipment fair value reduction is fully removed. 3 -12

Subsequent Consolidation Equity Method Example Assume Sun Company earns income of $100, 000 in 2014 and pays a $40, 000 cash dividend on August 1, 2014. 3 -13

Subsequent Consolidation Worksheet Entries For the first year, the parent prepares five entries on the workpapers to consolidate the two companies. S) Eliminates the subsidiary’s Stockholders’ equity account beginning balances and the book value component within the parent’s investment account. A) Recognizes the unamortized Allocations as of the beginning of the current year associated with the adjustments to fair value. I) Eliminates the subsidiary Income accrued by the parent. D) Eliminates the subsidiary Dividends. E) Recognizes excess amortization Expenses for the current period on the allocations from the original adjustments to fair value. 3 -14

Subsequent Consolidation Equity Method Example Entry S Note: If this is the first year of the investment, and the investment was made at a time other than the beginning of the fiscal year, then pre-acquisition income of the sub must be accounted for in the retained earnings balance. 3 -15

Subsequent Consolidation Equity Method Example Entry A Note: In the first year, FV adjustments are calculated in the allocation computation. In subsequent years, FV adjustments must be reduced by any depreciation taken in prior consolidations. 3 -16

Subsequent Consolidation Equity Method Example Entries I & D Note: Entry I removes Sun’s income recognized by Parrot during the year so Sun’s revenue and expense accounts (and current amortization expense) can be brought into the consolidated totals. Note: Entry D removes the intra-entity transfer of cash for the dividends distributed to Parrot from Sun. 3 -17

Subsequent Consolidation Equity Method Example Entry E Note that depreciation expense is reduced for the tangible asset equipment (fair value was less than book value). Patented Technology amortization expense was recognized for the year. 3 -18

LO 3 -3 b Applying the Initial Value Method The parent company can use the initial value method or the partial equity method for internal record-keeping. Application of either alternative changes the balances recorded by the parent over time and the consolidation process, but neither of these approaches affect any of the final consolidated balances reported. Just three parent’s accounts vary because of the method applied: • Investment account. • Income recognized from the subsidiary. • Parent’s retained earnings (periods after year of combination). 3 -19

Applying the Initial Value Method If the Initial Value Method is used by the parent to account for the investment in the first year, the consolidation entries will change slightly. The parent will record the sub’s activity differently under this method, so the accounts will differ from the Equity Method. 1. No adjustments are recorded in the Investment account for current year income, dividends paid by the subsidiary, or amortization of purchase price allocations. 2. Dividends received from the subsidiary are recorded as Dividend Revenue. 3 -20

Consolidation Entries Initial Value Method Two entries for the initial value method are different than those for the equity method. Entry S is the same as the Equity Method. Entry A is the same as the Equity Method. Entry I is different using Initial Value Method: It eliminates the Parent’s Dividend Income account and the Sub’s Dividends Paid account. There is no Entry D. Entry E is the same as the Equity Method. 3 -21

LO 3 -3 c Consolidation Entries – Partial Equity Method The same two entries differ for the Partial Equity Method. Entry S is the same as the Equity Method. Entry A is the same as the Equity Method. Entry I is different using Partial Equity Method: eliminates the Parent’s equity in the sub’s income and reduces the investment account. It Entry D eliminates the dividend income account. Entry E is the same as the Equity Method. 3 -22

Consolidation Entries – Other than Equity Method Remember. . . Ø Entries S, A, and E are the same for all three methods. Ø The parent’s record-keeping is limited to two periodic journal entries: Ø annual accrual of subsidiary income and Ø receipt of dividends. Ø So, the Investment and Income account balances differ for the other methods, and so will the worksheet Entries I and D. 3 -23

Consolidation Entries – Subsequent Years Ø Neither the Initial Value or Partial Equity Method provides a full-accrual-based measure of the subsidiary activities on the parent’s income. Ø The initial value method uses the cash basis for income recognition. The partial equity method only partially accrues subsidiary income. Ø A new worksheet adjustment is needed to convert the parent’s beginning of the year retained earnings balance to a full-accrual basis. Ø 3 -24

Consolidation Entries – Subsequent Years Ø For consolidation purposes, the beginning retained earnings account must be increased (Initial Value Method) or decreased (Partial Equity Method) to create the same effect as the equity method. Ø Entry *C. The C refers to the Conversion being made to equity method (full accrual) totals. The asterisk indicates that this entry relates solely to transactions of prior periods. Ø Entry *C should be recorded before other worksheet entries to align the beginning balances for the year. 3 -25

Other Consolidation Entries In addition to the Entries S, A, I, D, E, and *C, intercompany debt (payables and/or receivables) must be eliminated in entry P. No matter which method the Parent chooses to record the Sub’s activity, the consolidated totals are always the same! This is because all the entries that were made during the year are eliminated regardless of the method used or the amount! 3 -26

Consolidated Totals Subsequent to Acquisition 3 -27

Learning Objective 3 -4 Understand that a parent’s internal accounting method for its subsidiary investments has no effect on the resulting consolidated financial statements. 3 -28

Investment Accounting by Acquiring Company A parent’s choice of internal accounting method for subsidiary investments has no effect on the resulting consolidated financial statements. Ø The selection of a particular method does not affect the totals ultimately reported for the combined companies. Ø ØThe internal accounting method used does require distinct procedures for consolidation of the financial information from the separate organizations. 3 -29

Learning Objective 3 -5 Discuss the rationale for the goodwill impairment testing approach. 3 -30

Goodwill and Other Intangible Assets (ASC Topic 350) FASB ASC Topic 350, “Intangibles-Goodwill and Other, ” provides accounting standards for reporting income statement effects of impairment of intangibles acquired in a business combination. In accounting for goodwill subsequent to the acquisition date, GAAP requires an impairment approach rather than amortization. 3 -31

Learning Objective 3 -6 Describe the procedures for conducting a goodwill impairment test. 3 -32

Goodwill and Other Intangible Assets (ASC Topic 350) Once goodwill has been recorded, the value will remain unchanged until: 1. All or part of the related subsidiary is sold, 2. There has been a permanent decline in value in which case we test for impairment and record an impairment loss if the item is impaired. 3 -33

Goodwill Impairment – Two-Step Test Step 1 Fair value (with allocated goodwill) is compared to the carrying value (including goodwill) of the consolidated entity’s reporting unit. Does fair value of the reporting unit exceed carrying value? Goodwill is NOT impaired. No further testing is required. A second step must be taken to test for impairment. 3 -34

Determination of Implied Fair Value of Goodwill The implied value of goodwill is calculated similar to the initial determination of goodwill in a business combination. 1. Allocate the fair value of the reporting unit to all its identifiable assets and liabilities. 2. Subtract the fair value of the net assets from the fair value of the reporting unit. The excess is “implied goodwill”. 3. Compare the resulting “implied goodwill” to the “recorded goodwill” on the books. 3 -35

Goodwill Impairment—Qualitative Assessment: Goodwill Impairment Test - Step One Stop 3 -36

Goodwill Impairment – Two-Step Test Implied value of the related goodwill can be determined using quoted market prices, similar businesses, or present value of future cash flows. Step 2 Is “implied goodwill” less than “recorded goodwill”? Goodwill is NOT impaired. No further testing is required. An impairment loss is recorded for the excess carrying value over implied fair value. 3 -37

Goodwill Impairment—Qualitative Assessment: Goodwill Impairment Test -Step Two Stop 3 -38

Goodwill Impairment Test Example Newcall’s Reporting Units DSM Wired DSM Wireless Vision Talk Goodwill $ 22, 000 155, 000 38, 000 Acquisition Fair Value January 1, 2015 $950, 000 748, 000 502, 000 Newcall tests for goodwill impairment of DSM Wireless. The implied fair value of goodwill is compared to its carrying value using the following allocation of the fair value of DSM Wireless at year end… 3 -39

Goodwill Impairment Test Example DSM Wireless Dec. 31, 2015, fair value $600, 000 Fair values of DSM Wireless net assets at Dec. 31, 2015: Current asset $ 50, 000 Property 125, 000 Equipment 265, 000 Subscriber list 140, 000 Patented technology 185, 000 Current liabilities (44, 000) Long-term debt (125, 000) Value assigned to identifiable net assets 596, 000 Value assigned to goodwill 4, 000 Carrying value before impairment 155, 000 Impairment loss $151, 000 3 -40

Goodwill Impairment Test Example ØGoodwill is now valued at $4, 000. ØNewcall reports a $151, 000 separate line item goodwill impairment loss in the operating section of its consolidated income statement. ØAdditional disclosures required: (1) the facts and circumstances leading to the impairment (2) the method used to determine fair value of the associated reporting unit. ØThe reported values for all of DSM Wireless’ remaining assets and liabilities do not change. 3 -41

Zero or Negative Carrying Amounts The ASC requires special application of testing procedures if a reporting unit has a zero or negative carrying amount. In that case, the ASC permits an entity to forego step 2 of impairment test unless it is more likely than not that goodwill is impaired. The entity must consider the same factors as in the qualitative assessment for individual reporting units. 3 -42

Comparison of U. S. GAAP and International Accounting Standards Under US GAAP: Goodwill is allocated to reporting units, usually operating segments, expected to benefit from it. A two-step process is used to test for impairment. If the carrying amount of goodwill is more than its implied value, an impairment loss is recognized. IFRS Under IAS 36: Goodwill is allocated to cashgenerating units – at a level much lower than an operating segment. A one-step process is used to test for impairment. Goodwill is reduced for any excess carrying value, down to zero, and then other assets are reduced pro-rata. 3 -43

Other Intangibles All identified intangible assets with finite lives should be amortized over their economic useful life that reflects the pattern of decline in the economic usefulness of the asset. Factors that should be considered in determining the useful life of an intangible asset include • Legal, regulatory, or contractual provisions. • The effects of obsolescence, demand, competition, industry stability, rate of technological change, and expected changes in distribution channels. 3 -44

Other Intangibles Intangible assets with indefinite lives (extends beyond the foreseeable future) are tested for impairment on an annual basis. An entity has the option to first perform qualitative assessments to determine whether “it is more likely than not” the asset is impaired. If so, a quantitative test must be performed. The asset’s carrying value is compared to its fair value. If fair value is less than carrying value, the intangible asset is considered impaired an impairment loss is recognized. The asset’s carrying value is reduced accordingly. 3 -45

Learning Objective 3 -7 Understand the accounting and reporting for contingent consideration subsequent to a business acquisition. 3 -46

Contingent Consideration in Business Combinations If part of the consideration to be transferred in an acquisition is contingent on a future event: Ø The acquiring firm estimates the fair value of a cash contingency and records a liability equal to the present value of the future payment. Ø The liability will continue to be measured at fair value with adjustments recognized in income. Ø Contingent stock payments are reported as a component of stockholders’ equity, and are not remeasured at fair value. 3 -47

Learning Objective 3 -8 Understand in general the requirements of push-down accounting and when its use is appropriate. 3 -48

Push Down Accounting Push-down accounting permits acquired subsidiary to record fair value allocations and subsequent amortization in its accounting records. SEC requires push-down accounting for separate subsidiary statements if no substantial outside ownership exists. Generally limited for external reporting, also used internally. Method simplifies the consolidation process and provides better information for internal evaluation. 3 -49