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Chapter Two

Consolidation of
Financial
Information

Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Learning Objective 2-1

Discuss the motives for

business combinations.

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Reasons Firms Combine

 Vertical integration
 Cost savings
 Quick entry into new markets
 Economies of scale
 More attractive financing opportunities
 Diversification of business risk
 Business Expansion
 Increasingly competitive environment
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Recent Notable Business Combinations

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Learning Objective 2-2

Recognize when consolidation of

financial information into a single set
of statements is necessary.

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The Consolidation Process

“There is a presumption that consolidated statements

are more meaningful.. and that they are usually
necessary for a fair presentation when one of the
companies in the group… has a controlling financial
interest..” FASB ASC (810-10-10-1)

 Consolidated financial statements provide more meaningful

information than separate statements.
 Consolidated financial statements more fairly present the
activities of the consolidated companies.
 Yet, consolidated companies may retain their legal identities
as separate corporations.
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Learning Objective 2-3

Define the term business combination

and differentiate across various forms
of business combinations.

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Business Combinations

A business combination . . .
 refers to a transaction or other event in which an
acquirer obtains control over one or more businesses.
 is formed by a wide variety of transactions or events
with various formats.
 can differ widely in legal form.
 unites two or more enterprises into a single economic
entity that require consolidated financial statements.

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Business Combinations

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FASB Control Model

The FASB provides guidance and defines control when

accounting for business combinations with this control
model:
 The FASB ASC Glossary, in addition to majority share
ownership, further describes control as the direct or
indirect ability to determine the direction of management
and policies through ownership, contract, or otherwise.
 The FASB continues its effort to develop comprehensive
guidance for consolidation of all entities, including entities
controlled by voting interests.

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Consolidation of Financial Information

Parent’s Subsidiaries’
financial data financial data

brought together

To report the financial position, results of operations,

and cash flows for the combined entity.

Reciprocal accounts and intra-entity transactions

are adjusted or eliminated to. . .

Prepare a single set of consolidated financial statements.

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What is to be consolidated?

If dissolution occurs:
All appropriate account balances are
physically consolidated in the financial records
of the survivor.
If separate incorporation maintained: only the
Financial statement information (on work
papers, not the actual records) is consolidated.

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When does consolidation occur?

If dissolution occurs:
Permanent consolidation occurs at the
combination date.

If separate incorporation maintained:

the consolidation process is carried out at
regular intervals whenever financial statements
are to be prepared.

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How does consolidation affect the

accounting records?
If dissolution occurs:
Dissolved company’s records are closed out.
Surviving company’s accounts are adjusted to
include appropriate balances of the dissolved
company.
If separate incorporation is maintained:
Each company continues to retain its own records.
Worksheets facilitate the periodic consolidation
process without disturbing individual accounting
systems.

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Learning Objective 2-4

Describe the valuation principles of

the acquisition method.

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The Acquisition Method

The acquisition method embraces the fair value in

measuring the acquirer’s interest in the acquired
business.
Applying the acquisition method involves recognizing
and measuring:
 the consideration transferred for the acquired
business and any non-controlling interest.
 separately identified assets acquired and liabilities
assumed.
 goodwill, or a gain from a bargain purchase.
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LO 5
Fair Value

 Fair value is defined as the price that would be received to sell an

asset or paid to transfer a liability in an orderly transaction
between market participants at the measurement date.
 The Market Approach – The market approach estimates fair
values using other market transactions involving similar assets
or liabilities.
 The Income Approach – The income approach relies on
multiperiod estimates of future cash flows projected to be
generated by an asset.
 The Cost Approach – estimates fair values by reference to the
current cost of replacing an asset with another of comparable
economic utility.

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Acquisition Method

What if the consideration transferred does NOT

EQUAL the Fair Value of the Assets acquired?

If the consideration is MORE than the

Fair Value of the Assets acquired, the
difference is attributed to GOODWILL

If the consideration is LESS than the

Fair Value of the Assets acquired, we
got a BARGAIN!! And we will record a
GAIN on the acquisition!!
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Learning Objective 2-5

Determine the total fair value of the

consideration transferred for an
acquisition and allocate that fair value to
specific subsidiary assets acquired
(including goodwill) and liabilities
assumed or to a gain on bargain purchase.

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Procedures for Consolidating

Financial Information

Legal and accounting distinctions divide business

combinations into separate categories. Various
procedures are utilized in this process according to
the following sequence:

1. Acquisition method when dissolution takes place.

2. Acquisition method when separate incorporation is

maintained.

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Acquisition Method Example

Purchase Price = Fair Value

Assume BigNet Company owns Internet communications

equipment and other business software applications. It
seeks to expand its operations and plans to acquire
Smallport on December 31. Smallport Company owns
similar assets.
Smallport’s net assets have a book value of $600,000 and a
fair value of $2,550,000. Fair values for assets and
liabilities are appraised; capital stock, retained earnings,
dividend, revenue, and expense accounts represent
historical measurements. The equity and income accounts
are not transferred in the combination.
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Acquisition Method Example

Purchase Price = Fair Value
Basic Consolidation Information

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Learning Objective 2-6

Prepare the journal entry to consolidate

the accounts of a subsidiary if dissolution
takes place.

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Consideration Transferred =
Net Identified Asset Fair Values

Dissolution of Subsidiary

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Consideration Transferred Exceeds

Net Identified Asset Fair Values
Dissolution of Subsidiary

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Consideration Transferred Is Less Than

Net Identified Asset Fair Values

Dissolution of Subsidiary

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Related Costs of Business Combinations

Acquisition Method - Accounting for Costs

Frequently Associated with Business Combinations

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Related Costs of Business Combinations

 Direct Costs of the acquisition (attorneys,

appraisers, accountants, investment bankers, etc.)
are NOT part of the fair value received, and are
immediately expensed.
 Indirect or Internal Costs of acquisition (secretarial
and management time) are period costs expensed as
incurred.
 Costs to register and issue securities related to the
acquisition reduce their fair value.
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Acquisition Method -
Subsidiary Is Not Dissolved

Separate Incorporation Maintained

Dissolution does not occur.
Consolidation process is similar to previous example.
Fair value is the basis for initial consolidation of
subsidiary’s net assets.
Subsidiary is a legally incorporated separate entity.
Each company maintains independent record-keeping
Consolidation of financial information is simulated.
Acquiring company does not physically record the
transaction.
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Learning Objective 2-7

Prepare a worksheet to consolidate the

accounts of two companies that form a
business combination if dissolution does
not take place.

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The Consolidation Worksheet

Consolidation worksheet entries (adjustments and eliminations)

are entered on the worksheet only.
Steps in the process:
1. Prior to constructing a worksheet, the parent prepares a
formal allocation of the acquisition date fair value similar to
the equity method procedures.
2. Financial information for Parent and Sub is recorded in the
first two columns of the worksheet (with Sub’s prior revenue
and expense already closed).

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The Consolidation Worksheet

continued. . .

3. Remove the Sub’s equity account balances.

4. Remove the Investment in Sub balance.
5. Allocate Sub’s Fair Values, including any excess of cost over
Book Value to identifiable assets or goodwill.
6. Combine all account balances and extend into the
Consolidated totals column.
7. Subtract consolidated expenses from revenues to arrive at net
income.

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Acquisition Method –
Consolidation Workpaper Example

Prior to constructing a worksheet, the parent prepares a

formal allocation of the acquisition date fair value similar to
the equity method procedures.

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Acquisition Method –
Consolidation Workpaper Example
The first two columns of the worksheet show the separate
companies’ acquisition-date book value financial figures.
BigNet’s accounts have been adjusted for the investment and
combination costs, and Smallport’s revenue, expense, and
dividend accounts have been closed to retained earnings.

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Acquisition Method – Consolidation

Workpaper Example continued . . .

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Acquisition Method – Consolidation

Workpaper Journal Entries

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Learning Objective 2-8

Describe the two criteria for recognizing

intangible assets apart from goodwill in a
business combination.

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Acquisition Date Fair-Value Allocations –

Additional Issues

In determining whether to recognize an intangible

asset in a business combination, two specific criteria
are essential.

1. Does the intangible asset arise from contractual or

other legal rights?

2. Is the intangible asset capable of being sold or

otherwise separated from the acquired enterprise?

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Acquisition Date Fair-Value Allocations –

Additional Issues
Intangibles are assets that:
 Lack physical substance (excluding financial instruments)
 Arise from contractual or other legal rights (most intangibles
in business combinations meet the contractual-legal criterion).
 Is capable of being sold or otherwise separated from the
acquired enterprise
Preexisting goodwill recorded in the acquired company’s accounts
is ignored in the allocation of the purchase price.
IPR&D that has reached technological feasibility is capitalized as
an intangible asset at fair value with an indefinite life that is
reviewed for impairment.
Ongoing R&D is expensed as incurred.

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Intangible Assets That Meet the Criteria for

Recognition Separately from Goodwill

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Convergence between U. S. and

International Standards

IASB International Financial Reporting Standard 3 (IFRS 3)

Revised and FASB ASC topics 805, Business Combinations, and
810, Consolidation, effectively converged accounting for
business combinations.
In 2011, the IASB issued IFRS 10 Consolidated Financial
Statements and IFRS 12 Disclosure of Interests in Other Entities -
effective beginning in 2013.
New definition of control focuses on the power to direct the
activities of an entity, exposure to variable returns, and a
linkage between power and returns.

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Learning Objective 2-9

Identify the general characteristics of the

legacy purchase and pooling of interest
methods of accounting for past business
combinations.
Understand the effects that persist today
in financial statements from the use of
these legacy methods.

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Legacy Methods – Purchase and Pooling

of Interests Methods

Since the ACQUISITION METHOD is applied to

business combinations occurring in 2009 and after,
the two prior methods are still in use.

 2002 to 2008: Purchase Method

 Prior to 2002: Purchase Method

Or The Pooling Of Interests Method

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Purchase Method – An Application

of the Cost Method

How the cost-based purchase method differs from the

fair value-based acquisition method.
 Acquisition date allocations (including bargain
purchases)
 Direct combination costs
 Contingent consideration
 In-Process R&D expensed under the Purchase
Method, unless it had reached technological feasibility

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Purchase Method – An Application

of the Cost Method

 Valuation basis was “cost”

 The value of the consideration transferred,
 PLUS the direct costs of the acquisition,
 IGNORE any indirect costs of the acquisition,
 IGNORE any contingent payments.

 The total cost of the acquisition was allocated

proportionately to the net assets based on their fair
values, with any excess going to goodwill.

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Purchase Method –
Purchase Price < Fair Value

Under the purchase method, a bargain purchase occurred when

the sum of the individual fair values of the acquired net assets
exceeded the purchase cost.
Current assets and liabilities were recorded at fair value, and
some non-current assets were reduced proportionately. Long-term
assets were reduced because their fair-value estimates were
considered less reliable than current items and liabilities.

If the difference in purchase price and fair value was substantial

enough to eliminate all the non-current asset account balances of
the acquired company, the remainder was reported as an
extraordinary gain.
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Pooling of Interests
Historical Review

Prior to 2002, under certain criteria, combinations

could be accounted for as “Pooling of Interests” when
one company acquired all of another company’s stock
– using its own stock as consideration (no cash!)

These Pooling combinations are left intact going

forward.

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Pooling of Interests
Historical Review

 Book values of the assets and liabilities of both

companies became the book values reported by the
combined entity.
 The revenue and expense accounts were
combined both before and after the combination.
 Reported income was typically higher than under the
purchase accounting method. Not only did firms
retrospectively combine incomes, there was less
depreciation and amortization expense.

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