Chapter 04

Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value

McGraw-Hill/Irwin Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objective 1

Understand and make equity-method journal entries related to the differential.

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Basic Concepts: Parent and Subsidiary

Parents books

Investment account initially contains the acquisition cost

FMV of net assets, Plus goodwill, or Minus bargain purchase price

Parent can use the cost or equity method

Balance sheet: Assets and Liabilities are recorded at BOOK values. Income statement: Expenses calculated based on BOOK values
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Subsidiarys books

Basic Concepts: Parent and Subsidiary

What happens when you consolidate the parents and subsidiarys books?

Remember:

The parents investment account is based on the actual acquisition price. The subs books contain only historical book values.

The parent needs to make adjustments for both

Balance Sheet, and Income Statement accounts. No goodwill No undervalued assets at the time of creation
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Why wasnt this a problem with created subs?

Basic Concepts: Income Statement Impacts Big Picture: Essentially, we switch the subs books
from BV to FMV in the consolidation process.

Income Statement effects

Asset Equipment Inventory Related Expense (as the asset expires) Depreciation Expense

Cost of Goods Sold Amortization Expense

Impairment Loss

Patent
Goodwill

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Basic Concepts: Income Statement Impacts Income Statement Effects

When Acquisition Price > Book Value Related Expense (as the asset expires) Depreciation Expense Income Statement Effect Too Low (understated)

Asset
Equipment Inventory Patent

Cost of Goods Sold Amortization Expense

Impairment Loss

If expenses are UNDERSTATED, then income is too high (OVERSTATED). Goodwill To fix the problem, Parent needs to INCREASE expenses.
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Example: Acquisition Price > Book Value

Pepper Inc., a calendar-year reporting company, acquired 100% of Salt Inc.s outstanding common stock at a cost of $442,500 on 12/31/X8. The analysis of the parents Investment account as of the acquisition date shows:

Book value element Common Stock Retained Earnings Under- or Over-valuation Inventory Land Equipment Covenant-not-to-compete Goodwill element Total Cost

Life remaining $130,000 117,000 (6,500) 39,000 85,000 52,000 26,000 $442,500 2 months Indefinite 10 years 4 years Indefinite
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Example: Acquisition Price > Book Value

Acquisition Price = BV GW 442,500 = 247,000 + + Identifiable Excess 169,500 +

+ 26,000

Results for 20X9 (based on Book Values):

Reported Income $78,000 Dividends Declared 45,500

What would the Subs income be based on Fair Values?

Lower COGS (because inventory is worth less) Extra depreciation on equipment Extra amortization of contract Total increase in expenses / decrease in income

$63,000 $ (6,500) 8,500 13,000 $ 15,000

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Consolidation: Equity Method The Parents initial investment in a sub is based on the FMV of the subs net assets (+/- GW).

Equity method entries:

Recording share of subs income Recording share of subs dividends

They should be based on the same FMV basis. Problem: Sub reports income based on BOOK VALUES

Solution: Parent has to record an adjustment to the

income and investment Equity Method accounts.

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Example: Equity Method

Results for 20X9 (based on Book Values):
Reported Income $78,000 Dividends Declared 45,500 Adjustment to Salts 20X9 income on Parents books: Lower COGS (because inventory is worth less) $ (6,500) Extra depreciation on equipment 8,500 Extra amortization of contract 13,000 Total increase in expenses / decrease in income $ 15,000 What entries would Pepper record in its general ledger related to Salts income and dividends for 20X9 under the equity method?
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Example: Equity Method Journal Entries

1. To record 100% share of Salts reported income:

Investment in Salt 78,000 Income from Salt

2.

78,000

To record 100% of Salts dividends declared: Dividend Receivable Investment in Salt 45,500 45,500

3.

To record additional expenses (based on FMV):

Income from Salt Investment in Salt 15,000 15,000

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Example: Equity Method Investment Adjustment

Calculate the correct ending balance in Peppers Investment in Salt account using the equity method: Called amortization of excess value Investment in Salt
Beginning Balance Net Income 442,500 78,000 Dividend Income Adjustment 45,500 15,000

Ending Balance

460,000

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Practice Quiz Question #1

A parent charges the amortization of its cost in excess of book value to: a. Goodwill expense. b. Excess cost expense. c. Excess cost & goodwill expense. d. Income from subsidiary. e. None of the above.

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Learning Objective 2

Understand and explain how consolidation procedures differ when there is a differential.

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Consolidation Concepts by Chapter

Wholly Owned Subsidiary Partially Owned Subsidiary

Investment = Book Value

Chapter 2

Chapter 3

No Differential

Investment > Book Value

Chapter 4
No NCI Shareholders

Chapter 5
NCI Shareholders

Differential

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Simple Example
Assume the BV of Subs net assets is $800 and that the FMV of the net assets is $1,000. Finally, assume that the acquisition price was $1,500. The acquisition price consists of three parts:

Goodwill = $500

Excess value of identifiable assets = $200 Book value of net assets = $800

Stock

Sub Shareholders

S
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Understanding Components of Acquisition Cost

Acquisition Price =

FMV of Assets

+ Goodwill = BV Extra Value +

FMV of Assets
Acquisition Price =

Extra Value

BV

+ Goodwill

Key: We need to keep track of each element of the purchase price separately! Why??

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The Consolidation Process When a subsidiary is acquired (instead of created), the consolidation process is more complicated:

Must eliminate intercompany items (same) Must update Subs assets and liabilities to FMV Must recognize goodwill

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Summary of Consolidation Entries

1. The basic elimination entry:
Common Stock (S) Additional Paid-in Capital (S) Retained Earnings, Beginning Balance (S) Income from Sub Investment in Sub Dividends Declared XX XX XX XX BV XX

1. The excess value reclassification entry:

Asset 1 Asset 2 Goodwill Investment in Sub XX XX XX Excess

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Summary of Consolidation Entries

1. The amortized excess value reclassification entry:
Cost of Sales Other Expenses Income from Sub XX XX

XX

This entry reclassifies the equity method amortization of cost in excess of book from Income from Sub to the appropriate expense accounts where the costs would have been had the sub used FMV instead of BV. 4. The accumulated depreciation elimination entry: Accumulated Depreciation Buildings and Equipment XX XX
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Practice Quiz Question #2

When P company pays more than the book value of net assets of the acquired company (S), how does the consolidation process differ?
a. P hires an outside accountant to do the work. b. P tracks the excess value and records it in the consolidation worksheet. c. S notifies P of the excess value. d. P and S ignore the excess amount paid.

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Learning Objective 3

Make calculations and prepare elimination entries for the consolidation of a wholly owned subsidiary when there is a complex positive differential at the acquisition date.

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Group Exercise 1: Analyzing Acquisition Costs

Prince Inc. acquired 100% of She-Ra Inc.s outstanding common stock for $1,600,000 cash. Divide the cost into its major elements and prepare the consolidation entries as of the acquisition date.
Cash Accounts Receivable Inventory Notes Receivable Land Buildings & Equipment Patent Goodwill Total Assets Payables & Accruals Long-term Debt Total Liabilities Common Stock Additional PIC Retained Earnings Total Equity Book Value Current Value Difference 60,000 60,000 160,000 160,000 300,000 350,000 50,000 100,000 40,000 (60,000) 500,000 630,000 130,000 610,000 720,000 110,000 50,000 140,000 90,000 110,000 (110,000) 1,890,000 2,100,000 160,000 750,000 910,000 120,000 480,000 380,000 980,000 160,000 680,000 840,000 70,000

Buildings and equipment net of $98,000 accumulated depreciation. Goodwill is from a prior acquisition.

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Group Exercise 1: Solution

Splitting of the Investment account: Total Cost Less: BV element (CS + Add PIC + RE) Total Excess Cost 1,600,000 (980,000) 620,000

Analysis of the Investment account -- excess cost elements: Under- or (over-) valuation of identifiable net assets Inventory 50,000 Notes Receivable (60,000) Land 130,000 Buildings & Equipment 110,000 Patent 90,000 Goodwill (110,000) Long-term Debt 70,000 280,000 Goodwill 340,000

How would this affect your worksheet elimination entries?

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Group Exercise 1: Solution Acquisition Costs

What did we pay for?

Investment in Sub
340,000 280,000 1,600,000

Goodwill

1,600,000

Excess value of identifiable assets

Book value of net assets of the acquired firm

980,000

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Group Exercise 1: Solution Investment Account

Investment in Sub

1,600,000
1. The basic elimination entry:
120,000 480,000 380,000 980,000 50,000 130,000 110,000 90,000 70,000 340,000 60,000 110,000 620,000
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Common Stock Additional Paid-in Capital Retained Earnings Investment in Sub

980,000 620,000

1.

The excess value reclassification entry:

Inventory Land Buildings and Equipment Patent Long-term Debt Goodwill (new) Notes Receivable Goodwill (old) Investment in Sub

Group Exercise 1: Solution Worksheet Entries

1. The basic elimination entry:
Common Stock Additional Paid-in Capital Retained Earnings Investment in Sub 120,000 480,000 380,000 980,000 50,000 130,000 110,000 90,000 70,000 340,000 60,000 110,000 620,000 98,000 98,000
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1.

The excess value reclassification entry:

Inventory Land Buildings and Equipment Patent Long-term Debt Goodwill (new) Notes Receivable Goodwill (old) Investment in Sub

1.

The accumulated depreciation elimination entry:

Accumulated Depreciation Building and Equipment

Group Exercise 1: Solution Depreciation Entry

3. The accumulated depreciation elimination entry: The book values at acquisition remember the 610,000 was net of 98,000 in accumulated depreciation.

Buildings & Equipment

708,000

Accumulated Depreciation
98,000

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Group Exercise 2: Worksheet at Acquisition

Pepper acquired 100% of Salts outstanding stock for $442,500. Required: Prepare the consolidation entries and worksheet.
Pepper, Inc. and Salt, Inc. Consolidated Worksheet as of December 31, 20X8 Elimination Entries Pepper Salt DR CR Balance Sheet Cash Accounts Receivable Inventory Investment in Sub: Book Value Excess Value Land Build & Equipment Acc Depreciation Covenant N-T-C Goodwill Total Assets Payables & Accruals Long-term Debt Common Stock Additional PIC Retained Earnings Total Liab. & Equity 38,500 97,500 136,500 247,000 195,500 130,000 325,000 (195,000) 26,000 91,000 104,000 Consolidated

Book Value Element: Common Stock Retained Earnings

130,000 117,000

91,000 265,200 (57,200)

Under-valuation Element: Inventory (6,500) Land 39,000 Equipment 85,000 Covenant N-T-C 52,000 Goodwill 26,000

975,000 104,000 26,000 390,000 455,000 975,000

520,000 78,000 195,000 130,000 117,000 520,000

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Group Exercise 2: Worksheet Entries

Book Value Analysis: Peppers Salts Equity Accounts, BV Investment Common Retained = Account, BV Stock Earnings Balances, 12/31/X8 The Basic Elimination Entry: Common Stock Retained Earnings Investment in Salt Excess Value Analysis: Peppers Salts Under- or (Over-) Valuation of Net Assets Element Investment Inventory Land Equipment Covenant Goodwill = Balances, 12/31/X8 The Excess Value Reclassification Entry: Land Building & Equipment Covenant N-T-C Goodwill Inventory Investment in Salt The Accumulated Depreciation Elimination Entry: Accumulated Depreciation Building & Equipment
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Investment in Salt
+ EB 442,500

Group Exercise 2: Worksheet at Year End

Pepper, Inc. and Salt, Inc. Consolidated Worksheet as of December 31, 20X8 Elimination Entries Pepper Salt DR CR Balance Sheet Cash 38,500 26,000 Accounts Receivable 97,500 91,000 Inventory 136,500 104,000 Investment in Sub: Book Value 247,000 Excess Value 195,500 Land 130,000 91,000 Build & Equipment 325,000 265,200 Acc Depreciation (195,000) (57,200) Covenant N-T-C Goodwill Total Assets 975,000 520,000 Payables & Accruals Long-term Debt Common Stock Additional PIC Retained Earnings Total Liab. & Equity 104,000 26,000 390,000 455,000 975,000 78,000 195,000 130,000 117,000 520,000 Consolidated

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Practice Quiz Question #3

An account of the acquired company that cannot be revalued to its current value under acquisition accounting is: a. Notes receivable. b. Bonds payable. c. Investment in marketable securities. d. Patents. e. None of the above.

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Learning Objective 4

Make calculations and prepare elimination entries for the consolidation of a wholly owned subsidiary when there is a complex bargain-purchase differential.

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Acquired at Less than Fair Value of Net Assets

Bargain purchase

A business combination where the sum of

the acquisition-date fair values of the consideration given, any equity interest already held by the acquirer, and any noncontrolling interest

is less than the amounts at which the identifiable net assets must be valued at the acquisition date as specified by FASB 141R. The acquirer recognizes a gain for the difference.
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Basic Concepts
Income Statement Effects

When Acquisition Price < BV Related Expense (as the asset expires) Depreciation Expense Income Statement Effect Too High (overstated)

Asset
Equipment Inventory Patent

Cost of Goods Sold Amortization Expense

Impairment Loss

If expenses are OVERSTATED, then income is too low (UNDERSTATED). Goodwill To fix the problem, Parent needs to DECREASE expenses.
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Practice Quiz Question #4

How do the elimination entries differ in a bargain purchase scenario from a acquisition at an amount greater than book value?
a. The differential is ignored in a bargain purchase scenario. b. The parent company multiplies all numbers by 1. c. The elimination entry to reclassify expenses related to the differential increases reported expenses. d. The elimination entry to reclassify expenses related to the differential decreases reported expenses.

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Learning Objective 5

Prepare equity-method journal entries, elimination entries, and the consolidation worksheet for a wholly owned subsidiary when there is a complex positive differential.

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Group Exercise 3
Pepper Inc., a calendar-year reporting company, acquired 100% of Salt Inc.s outstanding common stock at a cost of $442,500 on 12/31/X8. The analysis of the parents Investment account as of the acquisition date shows:

Book value element Common Stock Retained Earnings Under- or Over-valuation Inventory Land Equipment Covenant-not-to-compete Goodwill element Total Cost

Life remaining $130,000 117,000 (6,500) 39,000 85,000 52,000 26,000 $442,500 2 months Indefinite 10 years 4 years Indefinite
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Group Exercise 3
1. Update the analyses of the Investment account through 12/31/X9. 1. Prepare all consolidation entries as of 12/31/X9.
3. Prepare a consolidation worksheet at 12/31/X9. (The parents retained earnings as of 1/1/X9 were $455,000.
Pepper, Inc. and Salt, Inc. Consolidated Worksheet as of December 31, 20X9 Elimination Entries Pepper Salt DR DR Income Statement Sales 1,235,000 780,000 Cost of Sales (598,000) (370,500) Depreciation Expense (78,000) (19,500) S&A Expense (481,000) (312,000) Income from Salt 63,000 Net Income 141,000 78,000 Statement of Retained Earnings Balance, 1/1/X9 455,000 117,000 Add: Net Income 141,000 78,000 Less: Dividends (104,000) (45,500) Balance, 12/31/X9 492,000 149,500 Balance Sheet Cash 77,500 32,500 Accounts Receivable 123,500 78,000 Inventory 149,500 156,000 Investment in Salt: Book Value 279,500 Excess Cost 180,500 Land 130,000 91,000 Build & Equip 325,000 291,200 Acc Depreciation (273,000) (76,700) Covenant N-T-C Goodwill Total Assets 992,500 572,000 Payables & Accruals 84,500 97,500 Long-term Debt 26,000 195,000 Common Stock 390,000 130,000 Retained Earnings 492,000 149,500 Total Liab & Equity 992,500 572,000 Consolidated

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Group Exercise 3: Worksheet Entries

Book Value Calculations: Peppers Salts Equity Accounts, BV Investment Common Account, BV Stock Add PIC Balances, 1/1/X9 Add: Net Income Less Dividends Balances, 12/31/X9 The Basic Elimination Entry:

Retained = Earnings

Common Stock Retained Earnings, 1/1/X9 Income from Salt Dividends Declared Investment in Salt
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Group Exercise 3: Worksheet Entries

Excess Value Calculations: Peppers Investment Salts Under- or (Over-) Valuation of Net Assets Element Account Inventory Land Equipment Acc Dep Covenant = Remaining Life Excess Cost 2 months Indefinite 10 years Balances, 1/1/X9 Less: Amortization Balances, 12/31/X9

Goodwill 4 years

The Excess Value Reclassification Entry: Land Building & Equipment Covenant N-T-C Goodwill Accumulated Depreciation Investment in Salt

The Amortized Excess Value Reclassification Entry: Depreciation Expense S&A Expense Cost of Sales Income from Salt The Accumulated Depreciation Elimination Entry: Accumulated Depreciation Building & Equipment
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Group Exercise 3: Solution Investment Account

Beginning Balance:

Goodwill = 26,000 Identifiable Excess = 169,500 Book value = 247,000

Ending Balance:

Investment in Salt
BB 442,500 NI 78,000 45,500 Dividend 15,000 Excess Amort. EB 460,000

Goodwill = 26,000
Identifiable Excess = 154,500

Book value = 279,500

Look back at the beginning and ending balances in the two charts you just prepared to find the numbers!
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Group Exercise 3: Worksheet Entries

Notice how the worksheet entries eliminate Peppers equity method accounts:

Investment in Salt
BB 442,500 NI 78,000

Income from Salt

78,000 NI

45,500 Dividend 15,000 Excess Amort. 15,000 EB 460,000 63,000 Adj. Balance

279,500 Basic
0

78,000
15,000 Excess Amort. 0

180,500 Excess Reclass

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Group Exercise 3: Completed Worksheet

Pepper, Inc. and Salt, Inc. Consolidated Worksheet as of December 31, 20X9 Elimination Entries Pepper Salt DR DR Income Statement Sales 1,235,000 780,000 Cost of Sales (598,000) (370,500) Depreciation Expense (78,000) (19,500) S&A Expense (481,000) (312,000) Income from Salt 63,000 Net Income 141,000 78,000 Statement of Retained Earnings Balance, 1/1/X9 455,000 117,000 Add: Net Income 141,000 78,000 Less: Dividends (104,000) (45,500) Balance, 12/31/X9 492,000 149,500 Balance Sheet Cash 77,500 32,500 Accounts Receivable 123,500 78,000 Inventory 149,500 156,000 Investment in Salt: Book Value 279,500 Excess Cost 180,500 Land 130,000 91,000 Build & Equip 325,000 291,200 Acc Depreciation (273,000) (76,700) Covenant N-T-C Goodwill Total Assets 992,500 572,000 Payables & Accruals 84,500 97,500 Long-term Debt 26,000 195,000 Common Stock 390,000 130,000 Retained Earnings 492,000 149,500 Total Liab & Equity 992,500 572,000 Consolidated

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Learning Objective 6

Understand and explain the elimination of basic intercompany transactions.

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Road Map: Intercompany Transactions Typical intercompany transactions

Intercompany reciprocal accounts (Chapter 4) Inventory transfers (Chapter 6) Fixed asset transfers (Chapter 7)

Intercompany Indebtedness (Chapter 8)

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Arms-Length Transactions Q: What are Arms-length Transactions?

A:

Transactions that take place between completely independent parties.

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Categories of Transactions Arms Length Transactions

The only transactions that can be reported in the

consolidated statements.
We want to report the results of our interactions

with outside parties!

Non-Arms Length Transactions

Usually referred to as related party transactions. Include all intercompany transactions.

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Types of Related Party Transactions Involving only Individuals

Transactions among family members.

Involving Corporations
With management and other employees. With directors and stockholders. With affiliates (controlled entities).

Probably constitutes at least 99% of all corporate related-party transactions.

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Necessity of Eliminating Intercompany Transactions

Eliminate all intercompany transactions in consolidation:

Because they are internal transactions from a

consolidated perspective.
Not because they are related-party transactions.
Only transactions with outside unrelated parties

can be reported in the consolidated statements.

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Intercompany Transactions: Additional Opportunities for Fraud

Intercompany transactions sometimes occur to

Conceal embezzlements. Overstate reported profits.

2 + 2 = 5
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Group Exercise 4: Intercompany Loan & Interest

Princess Inc. owns 100% of Solo Inc.s common stock. On 11/1/X8, Princess lent $150,000 to Solo. The loan is to be repaid on 1/30/X9 along with $6,000 of interest. All aspects of the intercompany transaction were properly recorded by each company in its separate books.
Required: 1. What amounts should be reported in each companys separate 20X8 income statement and 12/31/X8 balance sheet (asset and liability sections only)? 2. Prepare and post to your format the consolidation entries as of 12/31/X8, relating only to these accounts.
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Group Exercise 4: Solution

Three things to think about: 1. Note receivable / payable 2. Interest revenue / expense 3. Interest receivable / payable
1. 2. 3. Note Payable (sub) Note Receivable (parent) Interest Revenue (parent) Interest Expense (sub) Interest Payable (sub) Interest Receivable (parent)

How would you eliminate each item?

XXX XXX XXX XXX XXX

XXX

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Practice Quiz Question #5

Intercompany income statement accounts are eliminated in consolidation because they are deemed to be: a.Artificial transactions. b.Potentially manipulative transactions. c.Internal transactions. d.At amounts that are not determined on arms-length basis. e.none of the above.

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Practice Quiz Question #6

In 20X8, Scott incurred $90,000 of intercompany interest charges. Of this amount, Scott paid $70,000 cash to its parent and capitalized $40,000 to a discrete construction project. The unrealized intercompany profit at 12/31/X8 is: a.$0 b.$10,000 c.$20,000 d.$30,000 e.$40,000
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Learning Objective 7

Understand and explain the basics of push-down accounting.

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Purchase Price > Book Value What happens if you pay more than the book value of the subsidiarys assets?

This is the case MOST of the time! Push-Down Accounting

Parent

Parent has two options:

Force Sub to revalue to FMV Account for the extra value separately.

Sub

Non-Push-Down Accounting

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Push-Down Accounting: The EASIER Way

Push-Down Accounting (an absolute gem)

In the subsidiarys general ledger:

Adjust assets and liabilities to FV based on the parents acquisition price.

This establishes a new basis of accounting.

Record goodwill. Record Revaluation Capital for the difference

Revaluation Capital X

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Nonpush-Down Accounting: The HARDER Way

Non-Push-Down Accounting:

Dont touch the subsidiarys general ledger (treat like a sacred cow).
Make fair value adjustments and record goodwill in consolidation (on the worksheets).

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Consolidation Consequences: Push-Down vs. NonPush-Down

Push-down accounting:

Consolidation effort is minimal (has received the Better Book-keeping stamp of approval).

Non-push-down accounting:

Consolidation effort is cumbersome (often a headache).

The consolidated financial statement amounts are the SAME either way!

ONLY the accounting procedures differ Who does the work parent or sub?
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Parents Amortization of Cost in Excess of Book Value: How Handled?

Non-push-down accounting
Equity Method

Recorded in parents general ledger Maintains built-in checking features Recorded on consolidation worksheets

Cost Method

Push-down accounting
Parent

has no amortization sub records the amortization

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Consolidated Financial Statements

Actually, these numbers are only part of the consolidated financial statements. Non-push-down Accounting Push-down Accounting

Subs Income Statement (Based on Book Values)

+ +

Subs Balance Sheet (Based on Book Values)

Parents Adjustments For Excess Value (Consolidation Process)

= =

Subs Income Statement (Based on Fair Values)

Subs Balance Sheet (Based on Fair Values)

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Postacquisition Subsidiary Earnings: Reportable Earnings Under Acquisition Method

ONLY the subsidiarys postacquisition earnings are reported in the consolidated financial statements.

For a mid-year acquisition, only consolidate earnings after the acquisition date. The same is true for dividends declared.

The subsidiarys preacquisition earnings (included in its retained earnings account) are always eliminated against the parents Investment account in consolidation.

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Practice Quiz Question #7

A parent records amortization of excess value under which method? a. Push-down basis of accounting. b. Non-push down basis of accounting. c. Both A and B. d. None of the above.

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Practice Quiz Question #8

Push-down-accounting can be used: a. Only in a goodwill situation. b. Only in a bargain purchase situation. c. In either a goodwill situation or a bargain purchase situation. d. Only in a cost = book value situation. e. None of the above.

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Practice Quiz Question #9

The consolidated financial statements are identical regardless of whether the parent: a. Uses push-down or non-push-down accounting. b. Acquires 100% of the common stock or 100% of the assets. c. Both A and B. d. Neither A or B.

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