consolidation of financial information

© The McGraw-Hill Companies, Inc., 2004

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Chapter Two

Consolidation Consolidation of Financial of Financial InformationInformation


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Why do Firms Combine?

Vertical integration. Cost savings. Quick access to new

markets. Economies of scale. More attractive

financing opportunities. Diversification of

business risk.

Vertical integration. Cost savings. Quick access to new

markets. Economies of scale. More attractive

financing opportunities. Diversification of

business risk.


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The Consolidation Process

Why Consolidated Statements? They are presumed to be more meaningful

that separate statements. They are considered necessary for a fair

presentation.

The consolidation of financial information into a single set of statements becomes necessary

whenever a single economic entity is created by the business combination of two or more

companies. - - ARB No. 51

The consolidation of financial information into a single set of statements becomes necessary

whenever a single economic entity is created by the business combination of two or more

companies. - - ARB No. 51


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Business Combinations

A business combination occurs when an enterprise

acquires net assets that constitute a business or equity interests of one or more other

enterprises and obtains control over that enterprise or enterprises. - - SFAS No. 141

A business combination occurs when an enterprise

acquires net assets that constitute a business or equity interests of one or more other

enterprises and obtains control over that enterprise or enterprises. - - SFAS No. 141


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Business CombinationsExh.2-2

ContinueContinue


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Business Combinations – Cont.Exh.2-2


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Parent Subsidiary

The Sub still prepares separate financial

statements

Consolidated financial statements

are prepared.

The parent does not prepare separate

financial statements

Consolidation of Financial Information


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GAAP Accounting Methods


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If the acquisition is made by issuing stock, the cost of the acquisition is

equal to the MARKET VALUE

of the stock issued.

If the acquisition is made by issuing stock, the cost of the acquisition is

equal to the MARKET VALUE

of the stock issued.

Purchase Method – SFAS 141

Used when when there is a change in ownership that results in control of one enterprise by another enterprise.

The appropriate valuation basis for any purchase transaction is “cost”.


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Purchase Method Situations

Dissolution of the acquired company:Cost = FMVCost > FMVCost < FMV

Separate incorporation is maintained.

Dissolution of the acquired company:Cost = FMVCost > FMVCost < FMV

Separate incorporation is maintained.


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Purchase Method - DissolutionCost = FMV

Ignore the Equity and Nominal accounts of the acquired company.

Determine FMV of the acquired company’s assets and liabilities.

Prepare a journal entry to recognize cost of the acquisition incorporate the FMV of acquired

company’s assets and liabilities into acquiring company’s books.


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Prepare the entry to record Large’s purchase.


On 1/1/04, Large acquired 100% of Tiny for $300,000 cash.


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Tiny’s fair market value was $300,000 which is equal to the price paid by Large. Record the

purchased assets at their market value.


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Purchase Method - DissolutionCost > FMV

At date of acquisition: Acquired company should

prepare a Balance Sheet as of the date of acquisition.

Acquired company’s income prior to acquisition is irrelevant to the acquiring company.

FMV of acquired company’s assets and liabilities is added to acquiring company’s books.

Difference between Cost and FMV is allocated to identifiable intangible assets and to goodwill.

Note: Goodwill should be viewed

as a residual amount

remaining after all other

identifiable and separable

intangible assets have been identified.

Note: Goodwill should be viewed

as a residual amount

remaining after all other

identifiable and separable

intangible assets have been identified.


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Small has no identifiable, separable intangible assets.


On 1/1/04, Huge acquires 100% of Small for $250,000 cash.


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Goodwill will be recorded as an intangible asset on Huge’s books, but will not be amortized.



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Prepare Large’s journal entry for this acquisition. Remember to record the

$33,000 of Goodwill.


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Purchase Method - DissolutionCost < FMV

When FMV exceeds cost, we have a Bargain Purchase.

Current assets and liabilities should be consolidated at their FMV.

Non-current assets should be recorded at a value between FMV and BV. i.e. each non-current asset’s

(including in-process R&D) FMV should be reduced by a proportionate share of the excess of FMV over cost.


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Purchase Method - DissolutionCost < FMV

In the event that the difference is substantial enough to eliminate all the non-current asset balances of

the acquired company . . .

. . . The remainder is to be reported as an extraordinary gain

(SFAS 141)

In the event that the difference is substantial enough to eliminate all the non-current asset balances of

the acquired company . . .

. . . The remainder is to be reported as an extraordinary gain

(SFAS 141)


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Let’s see what happens Let’s see what happens when the acquired company when the acquired company

is not dissolved.is not dissolved.


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Purchase MethodNo Dissolution

The acquired company continues as a separate entity. The acquisition shows up on the

Parent’s books in the Investment in Subsidiary account.

Separate records for each company are still maintained.

The adjusted balances for the Parent and the Subsidiary are consolidated using a worksheet.

The acquired company continues as a separate entity. The acquisition shows up on the

Parent’s books in the Investment in Subsidiary account.

Separate records for each company are still maintained.

The adjusted balances for the Parent and the Subsidiary are consolidated using a worksheet.


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Steps for Consolidation

1. Record the financial information for both Parent and Sub on the worksheet.

1. Record the financial information for both Parent and Sub on the worksheet.

2. Remove the Investment in Sub balance.2. Remove the Investment in Sub balance.

3. Remove the Sub’s equity account balances.

3. Remove the Sub’s equity account balances.

4. Adjust the Sub’s net assets to FMV.4. Adjust the Sub’s net assets to FMV.

5. Allocate any excess of cost over BV to identifiable, separable intangible assets

or goodwill.

5. Allocate any excess of cost over BV to identifiable, separable intangible assets

or goodwill.

6. Combine all account balances.6. Combine all account balances.


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No DissolutionExample

On 1/1/05, Huge acquires 100% of Small for $250,000 cash.

Small holds a trademark that is valued at $25,000.


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1. Record the balances for

each company in the

worksheet.

1. Record the balances for

each company in the

worksheet.


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2. Remove the investment

account from the worksheet.

2. Remove the investment

account from the worksheet.


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3. Remove the subsidiary’s

equity account balances.

3. Remove the subsidiary’s

equity account balances.

Let’s look at the

computation of Goodwill.

Let’s look at the

computation of Goodwill.


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Goodwill Computation for Huge’s Acquisition of Small

We use these numbers for steps #4 & #5.

We use these numbers for steps #4 & #5.


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4. Adjust the subsidiary’s balances to

FMV.

4. Adjust the subsidiary’s balances to

FMV.


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5. Record the trademark and the Goodwill.

5. Record the trademark and the Goodwill.


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6. Add the balances across the page.

6. Add the balances across the page.


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Purchase Price Allocations - Additional Issues

Consolidation Costs Legal Fees, Direct Costs

of Combination Increase the Investment in

Subsidiary account.

Stock Issuance Costs Broker Fees, Registration

Fees, etc. Decrease the Parent’s

Paid-In Capital account.

Consolidation Costs Legal Fees, Direct Costs

of Combination Increase the Investment in

Subsidiary account.

Stock Issuance Costs Broker Fees, Registration

Fees, etc. Decrease the Parent’s

Paid-In Capital account.


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Purchase Price Allocations - Additional Issues, SFAS No. 141

Intangibles Current and noncurrent assets

that lack physical substance. Do not include financial

instruments. When should an Intangible

be recognized? Does it arise from contractual

or other legal rights? Can it be sold or otherwise

separated from the acquired enterprise?

Intangibles Current and noncurrent assets

that lack physical substance. Do not include financial

instruments. When should an Intangible

be recognized? Does it arise from contractual

or other legal rights? Can it be sold or otherwise

separated from the acquired enterprise?


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Intangible Asset Examples

Customer Base Trademarked Brand

Names Customer Routes Effective Advertising

Programs Covenants Rights (broadcasting,

development, use, etc.)

Customer Base Trademarked Brand

Names Customer Routes Effective Advertising

Programs Covenants Rights (broadcasting,

development, use, etc.)

Databases Technological know-

how Patents & Copyrights Strong labor relations Assembled, trained

workforce Favorable government

relations

Databases Technological know-

how Patents & Copyrights Strong labor relations Assembled, trained

workforce Favorable government

relations

Exh.2-7


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In-Process R&D Should be expensed immediately

upon acquisition, unless there are alternative future uses.• Dr. R&D Expense

• Cr. Investment in Investee It could also be written-off via

consolidation entries

IPR&D that has reached technological feasibility, can be “capitalized”. Determination of fair value is

critical.

In-Process R&D Should be expensed immediately

upon acquisition, unless there are alternative future uses.• Dr. R&D Expense

• Cr. Investment in Investee It could also be written-off via

consolidation entries

IPR&D that has reached technological feasibility, can be “capitalized”. Determination of fair value is

critical.


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Unconsolidated Subsidiaries

S F A S N o . 9 4

W h e n c o n t r o l d o e s n o ta c t u a l l y r e s t w i t h t h e 5 0 %

o w n e r s .

W h e n c a n a P a r e n t e x c l u d e a 5 0 %o w n e d s u b s i d i a r y f r o m c o n s o l i d a t i o n ?


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Pooling of Interests

Historically, many business combinations have been

accounted for as “Pooling of Interests.”

In its SFAS 141, “Business Combinations”, the FASB

states that all business combinations should be accounted for using the

“Purchase MethodPurchase Method”.

Historically, many business combinations have been

accounted for as “Pooling of Interests.”

In its SFAS 141, “Business Combinations”, the FASB

states that all business combinations should be accounted for using the

“Purchase MethodPurchase Method”.


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Pooling of Interests

According to SFAS No. 141, the purchase method is to be applied prospectively.

Past poolings of interests are left intact by SFAS No. 141.

Therefore, it is important to understand how to account

for PAST poolings.

According to SFAS No. 141, the purchase method is to be applied prospectively.

Past poolings of interests are left intact by SFAS No. 141.

Therefore, it is important to understand how to account

for PAST poolings.


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In a pooling, one company obtained

essentially “all” of the other company’s

stock.

In a pooling, one company obtained

essentially “all” of the other company’s

stock.

The transaction involved the

exchange of common stock. No exchange of cash was allowed.

The transaction involved the

exchange of common stock. No exchange of cash was allowed.

The ownership interests of two, or more, companies were combined into one new company.

No single company was dominant.

Precise cost figures were difficult to obtain.

To use pooling of interests, 12 strict criteria had to be met.

Historical Review of Pooling of Interests. Read the book for details!


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Historical Review of Pooling of Interests

The Book Values of the two combining companies were

joined. No Goodwill was recorded.

The Book Values of the two combining companies were

joined. No Goodwill was recorded.

Revenues and expenses were combined retroactively for the

two companies. This created superior earnings, hence its

preference.

Revenues and expenses were combined retroactively for the

two companies. This created superior earnings, hence its

preference.


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If both companies continued to exist, an Investment in Sub account was recorded on one company’s books (usually the larger).

No Goodwill was recorded.

Both companies were combined at BV.

If both companies continued to exist, an Investment in Sub account was recorded on one company’s books (usually the larger).

No Goodwill was recorded.

Both companies were combined at BV.


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Prior Period Adjustments were made to account for differences in the ways the two companies accounted for income.

A journal entry was recorded to recognize the Investment in Subsidiary.

The BV’s for both companies were entered on a consolidation worksheet.

Prior Period Adjustments were made to account for differences in the ways the two companies accounted for income.

A journal entry was recorded to recognize the Investment in Subsidiary.

The BV’s for both companies were entered on a consolidation worksheet.


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Continued Accounting for Pooling of Interests

The Investment in Sub account must be eliminated. Also eliminate the Sub’s

Equity accounts to prevent double-counting.

They have already been included in the original Investment in Sub entry.

Add together the BV’s of the remaining accounts.

THE END OF CHAPTER 2

Education

consolidation of financial information