CHAPTER THREE

CONSOLIDATION OF FINANCIAL STATEMENTS

1
2
3
4
5

Expansion through corporate Takeovers

The consolidation process
Financial reporting for business combinations +
Procedure for consolidating financial information
Consolidations- subsequent to the date of acquisition
3.5.1 Goodwill and intangible assets investment accounting by the acquiring company
3.5.2 Investment recorded by the equity method
3.5.3 Investment recorded using cost or partial equity method
3.5.4 Intangible acquired in business combination and related amortizations
3.5.5 Purchase price- contingent consideration
3.5.6 Pooling interest
CONSOLIDATION OF FINANCIAL STATEMENTS

Consolidation of financial information is required for external reporting purposes

when one organization gains control of another, thus forming a single economic
entity. In many combinations, all but one of the companies is dissolved as a separate
legal corporation. Therefore, the consolidation process is carried out fully at the date
of acquisition to bring together all accounts into a single set of financial records. In
other combinations, the companies retain their identities as separate enterprises
and continue to maintain their own separate accounting systems. For these cases,
consolidation is a periodic process necessary whenever the parent produces external
financial statements. This periodic procedure is frequently accomplished through the
use of a worksheet and consolidation entries.
Under the acquisition method, the fair value of the consideration transferred provides
the starting point for valuing the acquired firm. The fair value of the consideration
transferred by the acquirer includes the fair value of any contingent consideration. The
acquired company assets and liabilities are consolidated at their individual
acquisition-date fair values. If the consideration transferred exceeds the total fair
value of the net assets, the residual amount is recognized in the consolidated financial
statements as goodwill, an intangible asset. Direct combination costs are expensed as
incurred because they are not part of the acquired business fair value.
When a bargain purchase occurs, individual assets and liabilities acquired continue to
be recorded at their fair values and a gain on bargain purchase is recognized. Also, in
contrast to past practice, the fair value of all acquired in-process research and
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development is recognized as an asset in business combinations subject to subsequent

impairment reviews.
Particular attention should be paid to the recognition of intangible assets in business
combinations. An intangible asset must be recognized in an acquiring firms financial
statement if the asset arises from a legal or contractual right (e.g., trademarks,
copyrights, artistic materials, royalty agreements). If the intangible asset does not
represent a legal or contractual right, the intangible will still be recognized if it is
capable of being separated from the firm (e.g., customer lists, non contractual
customer relationships, unpatented technology)
Past financial reporting standards required either the purchase method or the pooling
of interests method to account for business combinations. Because current GAAP
prohibits retrospective treatment, vestiges of the earlier acquisition methods will
remain in financial statements for many years to come.
The purchase method valued the acquired firm at cost including all direct
consolidation costs unless expended to issue stock. The acquired assets and liabilities
were consolidated at their fair values at the date of purchase. If the purchase cost
exceeded the fair value of the net acquired assets, the residual was recognized in the
consolidated financial statements as goodwill, an intangible asset. If the purchase
price was less than total fair value, certain consolidated assets were reported at less
than their individual fair values. Because of the bargain purchase, these noncurrent
assets were consolidated at amounts less than their fair values. The total reduction was
the difference between the acquisition cost and the net fair value of the subsidiarys
assets and liabilities. This figure is prorated based on the fair value of the various
noncurrent assets. An extraordinary gain was reported if the reduction exceeded the
total value of the applicable noncurrent assets.
The pooling of interests method was criticized often because it relied on book values
only and, therefore, ignored the exchange transaction that formed the economic entity.
Pooling ignored unrecorded intangible assets even though they were some of the main
value drivers among the target firms assets. Pooling were also questioned because of
the retroactive treatment of operating results. Consequently, companies were able to
increase reported earnings by pooling with another company rather than by improving
operating efficiency. Although firms needed to meet specific criteria to quality for
pooling of interests treatment, many large firms were able to employ this method.
After 2002, future use of the pooling method was prohibited.

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CONSOLIDATIONSSUBSEQUENT TO THE DATE OF ACQUISITION

The procedures used to consolidate financial information generated by the separate
companies in a business combination are affected by both the passage of time and the
method applied by the parent in accounting for the subsidiary. Thus, no single
consolidation process that is applicable to all business combinations can be described.
The parent might elect to utilize the equity method to account for a subsidiary. As
discussed in Chapter 1, the parent accrues income when earned by the subsidiary and
dividend receipts are recorded as reductions in the investment account. The effects of
excess fair-value amortizations or any intra-entity transactions also are reflected
within the parents financial records. The equity method provides the parent with
accurate information concerning the subsidiarys impact on consolidated totals;
however, it is usually somewhat complicated to apply.
The initial value method and the partial equity method are two alternatives to the
equity method. The initial value method recognizes only the subsidiarys dividends
as income while the asset balance remains at the acquisition-date fair value. This
approach is simple and provides a measure of cash flows between the two companies.
Under the partial equity method, the parent accrues the subsidiarys income as
earned but does not record adjustments that might be required by excess fair-value
amortizations or intra-entity transfers. The partial equity method is easier to apply
than the equity method, and, in many cases, the parents income is a reasonable
approximation of the consolidated total.
For a consolidation in any subsequent period, all reciprocal balances must be
eliminated. Thus, the subsidiarys equity accounts, the parents investment balance,
and intra-entity income, dividends, and liabilities are removed. In addition, the
remaining unamortized portions of the fair-value allocations are recognized along
with excess amortization expenses for the period. If the equity method has not been
applied, the parents beginning Retained Earnings account also must be adjusted for
any previous income or excess amortizations that have not yet been recorded.

For each subsidiary acquisition, the parent must assign the acquired assets and
liabilities (including goodwill) to individual reporting units of its combined
operations. The reporting units should be at the level of operating segment or lower
and must provide the basis for future assessments of fair value. Any value assigned to
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goodwill is not amortized but instead is tested annually for impairment. This test
consists of two steps. First, if the fair values of any of the consolidated entitys
reporting units fall below their carrying values, then the implied value of the
associated goodwill must be recomputed. Second, the recomputed implied value of
goodwill is compared to its carrying value. An impairment(damaged) loss must then
be recognized if the carrying value of goodwill exceeds its implied value.
The acquisition-date fair value assigned to a subsidiary can be based, at least in part,
on the fair value of any contingent consideration. For contingent obligations that meet
the definition of a liability, the obligation is adjusted for changes in fair value over
time with corresponding recognition of gains or losses from the revaluation. For
contingent obligations classified as equity, no re-measurement to fair value takes
place. In either case the initial value recognized in the combination does not change
regardless of whether the contingency is eventually paid or not.
Push-down accounting is the adjustment of the subsidiarys account balances to
recognize allocations and goodwill stemming from the parents acquisition.
Subsequent amortization of these figures also is recorded by the subsidiary as an
expense. At this time, push-down accounting is required by the SEC for the separate
statements of the subsidiary only when no substantial outside ownership exists.
The FASB is currently studying push-down accounting and may issue more specific
rules on its application. However, for internal reporting purposes, push-down
accounting is gaining popularity because it aids company officials in evaluating the
impact that the subsidiary has on the business combination.

Problems
1. Following are the account balances of Miller Company and Richmond Company as of
December 31. The fair values of Richmond Companys assets and liabilities are also
listed.
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Miller

Richmond

Richmond

Company

Company

Company

Book Values Book Values

Fair

12/31

12/31

12/31

$ 600,000

$ 200,000

$ 200,000

Values

Cash. . . . . . . . . . . . . . . . . . . . . . . .
Receivables. . . . . . . . . . . . . . . . . . .
Inventory . . . . . . . . . . . . . . . . . . . .

900,000

300,000

290,000

1,100,000

600,000

820,000

Buildings and equipment (net) . . . . 9,000,000

800,000

900,000

Unpatented technology . . . . . . . . .

500,000

100,000

In-process research
and development . . . . . . . . . . . .
Accounts payable . . . . . . . . . . . . . .

(400,000)

(200,000)

(200,000)

Notes payable. . . . . . . . . . . . . . . . .

(3,400,000)

(1,100,000)

(1,100,000)

____________________________________
Totals . . . . . . . . . . . . . . . . . . . . .

$ 7,800,000

$ 600,000

1,510,000

====================================
Common stock$20 par value . . . $ (2,000,000)
Common stock$5 par value . . . .

$ (220,000)

Additional paid-in capital . . . . . . . . (900,000)

(100,000)

Retained earnings, 1/1 . . . . . . . . . . (2,300,000)

(130,000)

Revenues . . . . . . . . . . . . . . . . . . . .

(6,000,000)

Expenses . . . . . . . . . . . . . . . . . . . .

3,400,000

(900,000)
750,000

Note: Parentheses indicate a credit balance.

Additional Information (not reflected in the preceding figures)

On December 31, Miller issues 50,000 shares of its $20 par value common stock for
all of the outstanding shares of Richmond Company.

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 As part of the acquisition agreement, Miller agrees to pay the former owners of
Richmond $250,000 if certain profit projections are realized over the next three years.
Miller calculates the acquisition date fair value of this contingency at $100,000.
In creating this combination, Miller pays $10,000 in stock issue costs and $20,000 in
accounting and legal fees.
Required
A. Millers stock has a fair value of $32.00 per share. Using the acquisition method:
1. Prepare the necessary journal entries if Miller dissolves Richmond so it is no longer
a separate legal entity.
2. Assume instead that Richmond will retain separate legal incorporation and maintain
its own accounting systems. Prepare a worksheet to consolidate the accounts of the
two companies.
B. If Millers stock has a fair value of $26.00 per share, describe how the consolidated
balances would differ from the results in requirement (a).
2. On January 1, 2011, Top Company acquired all of Bottom Companys outstanding
common stock for $842,000 in cash. As of that date, one of Bottoms buildings with a
12-year remaining life was undervalued on its financial records by $72,000.
Equipment with a 10-year life was undervalued, but only by $10,000. The book
values of all of Bottoms other assets and liabilities were equal to their fair values at
that time except for an unrecorded licensing agreement with an assessed value of
$40,000 and a 20-year remaining useful life. Bottoms book value at the acquisition
date was $720,000.
During 2011, Bottom reported net income of $100,000 and paid $30,000 in dividends.
Earnings were $120,000 in 2012 with $20,000 in dividends distributed by the
subsidiary. As of December 31, 2013, the companies reported the following selected
balances, which include all revenues and expenses for the year:

Top Company

Bottom Company

December 31, 2013

Debit
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Credit

December 31, 2013

Debit

Credit
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_______________________________________________
Buildings . . . . . . . . . . . . . . . . $1,540,000
Cash and receivables . . . . . . .

$460,000

50,000

Common stock . . . . . . . . . . .

90,000
$ 900,000

$400,000

Dividends paid . . . . . . . . . . .

70,000

10,000

Equipment . . . . . . . . . . . . . .

280,000

200,000

Cost of goods sold . . . . . . . .

500,000

120,000

Depreciation expense . . . . . .

100,000

60,000

Inventory . . . . . . . . . . . . . . . .

280,000

260,000

Land . . . . . . . . . . . . . . . . . . .

330,000

250,000

Liabilities . . . . . . . . . . . . . . . .

480,000

260,000

Retained earnings, 1/1/13 . . .

1,360,000

490,000

Revenues . . . . . . . . . . . . . . .

900,000

300,000

__________________________________________________________________________
Required
A. If Top applies the equity method, what is its investment account balance as of
December 31, 2013?
B. If Top applies the initial value method, what is its investment account balance as of
December 31, 2013?
C. Regardless of the accounting method in use by Top, what are the consolidated
totals as of December 31, 2013, for each of the following accounts?
Buildings

Revenues

Equipment

Net Income

Land

Investment in Bottom

Depreciation

Expense Dividends Paid

Amortization

Expense Cost of Goods Sold

D. Prepare the worksheet entries required on December 31, 2013, to consolidate the
financial records of these two companies. Assume that Top applied the equity method
to its investment account.
E. How would the worksheet entries in requirement (d) be altered if Top has used the
initial value method?

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