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Chapter 4. Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value. Learning Objective 1. Understand and make equity-method journal entries related to the differential. Basic Concepts: Parent and Subsidiary. Parent’s books

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learning objective 1
Learning Objective 1

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

basic concepts parent and subsidiary
Basic Concepts: Parent and Subsidiary
  • Parent’s 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
  • Subsidiary’s books
    • Balance sheet: Assets and Liabilities are recorded at BOOK values.
    • Income statement: Expenses calculated based on BOOK values
basic concepts parent and subsidiary1
Basic Concepts: Parent and Subsidiary
  • What happens when you consolidate the parent’s and subsidiary’s books?
    • Remember:
      • The parent’s investment account is based on the actual acquisition price.
      • The sub’s books contain only historical book values.
  • The parent needs to make adjustments for both
    • Balance Sheet, and
    • Income Statement accounts.
  • Why wasn’t this a problem with created subs?
    • No goodwill
    • No undervalued assets at the time of creation
basic concepts income statement impacts1
Income Statement Effects

When Acquisition Price > Book Value

Basic Concepts: Income Statement Impacts

If expenses are _________________, then income is too high____________________.

To fix the problem, Parent needs to _______________ expenses.

example acquisition price book value
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 parent’s Investment account as of the acquisition date shows:

Book value elementLife remaining

Common Stock $130,000

Retained Earnings 117,000

Under- or Over-valuation

Inventory (6,500) 2 months

Land 39,000 Indefinite

Equipment 85,000 10 years

Covenant-not-to-compete 52,000 4 years

Goodwill element 26,000 Indefinite

Total Cost $442,500

example acquisition price book value1
Example: Acquisition Price > Book Value
  • Acquisition
    • Price = BV + Identifiable Excess + GW

Results for 20X9 (based on Book Values):

Reported Income

Dividends Declared

What would the Sub’s 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

consolidation equity method
Consolidation: Equity Method

The Parent’s initial investment in a sub is based on the FMV of the sub’s net assets (+/- GW).

  • Equity method entries:
    • Recording share of sub’s income
    • Recording share of sub’s 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.
example equity method
Example: Equity Method

Results for 20X9 (based on Book Values):

Reported Income $78,000

Dividends Declared 45,500

Adjustment to Salt’s 20X9 income on Parent’s 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 Salt’s income and dividends for 20X9 under the equity method?

example equity method journal entries
Example: Equity Method Journal Entries
  • To record 100% share of Salt’s reported income:

2. To record 100% of Salt’s dividends declared:

3. To record additional expenses (based on FMV):

example equity method investment adjustment
Example: Equity Method Investment Adjustment

Calculate the correct ending balance in Pepper’s Investment in Salt account using the equity method:

Investment in Salt

practice quiz question 1
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.

learning objective 2
Learning Objective 2

Understand and explain how consolidation procedures differ when there is a

differential.

simple example

$

P

Sub

Shareholders

Stock

S

Simple Example

Assume the BV of Sub’s 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 =

Excess value of identifiable assets =

Book value of

net assets =

understanding components of acquisition cost
Understanding Components of Acquisition Cost
  • Acquisition FMV of
    • Price = Assets + Goodwill
  • FMV of Extra
    • Assets = BV + Value
  • Acquisition Extra
    • Price = BV + Value + Goodwill

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

Why??

the consolidation process
The Consolidation Process
  • When a subsidiary is acquired (instead of created), the consolidation process is more complicated:
    • Must eliminate intercompany items (same)
    • Must update Sub’s assets and liabilities to FMV
    • Must recognize goodwill
summary of consolidation entries
Summary of Consolidation Entries
  • The basic elimination entry:
  • The excess value reclassification entry:

Common Stock (S) XX

Additional Paid-in Capital (S) XX

Retained Earnings, Beginning Balance (S) XX

Income from Sub XX

Investment in Sub BV

Dividends Declared XX

Asset 1 XX

Asset 2 XX

Goodwill XX

Investment in Sub Excess

summary of consolidation entries1
Summary of Consolidation Entries
  • The amortized excess value reclassification entry:
  • 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:

Cost of Sales XX

Other Expenses XX

Income from Sub XX

Accumulated Depreciation XX

Buildings and Equipment XX

practice quiz question 2
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.

learning objective 3
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.

group exercise 1 analyzing acquisition costs
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.

group exercise 1 solution
Group Exercise 1: Solution

How would this affect your worksheet elimination entries?

group exercise 1 solution acquisition costs
Group Exercise 1: Solution Acquisition Costs

What did we pay for?

Goodwill

Excess value of identifiable assets

1,600,000

Book value of

net assets of

the acquired

firm

Investment in Sub

group exercise 1 solution investment account
Group Exercise 1: Solution Investment Account

Investment in Sub

1,600,000

  • The basic elimination entry:
  • The excess value reclassification entry:

980,000

Common Stock 120,000

Additional Paid-in Capital 480,000

Retained Earnings 380,000

Investment in Sub 980,000

620,000

0

Inventory 50,000

Land 130,000

Buildings and Equipment 110,000

Patent 90,000

Long-term Debt 70,000

Goodwill (new) 340,000

Notes Receivable 60,000

Goodwill (old) 110,000

Investment in Sub 620,000

group exercise 1 solution worksheet entries
Group Exercise 1: Solution Worksheet Entries
  • The basic elimination entry:
  • The excess value reclassification entry:
  • The accumulated depreciation elimination entry:

Common Stock 120,000

Additional Paid-in Capital 480,000

Retained Earnings 380,000

Investment in Sub 980,000

Inventory 50,000

Land 130,000

Buildings and Equipment 110,000

Patent 90,000

Long-term Debt 70,000

Goodwill (new) 340,000

Notes Receivable 60,000

Goodwill (old) 110,000

Investment in Sub 620,000

Accumulated Depreciation 98,000

Building and Equipment 98,000

group exercise 1 solution depreciation entry
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

Accumulated Depreciation

708,000

98,000

group exercise 1 solution depreciation entry1
Group Exercise 1: Solution Depreciation Entry

3. The accumulated depreciation elimination entry:

Accumulated Depreciation 98,000

Building and Equipment 98,000

Buildings & Equipment

Accumulated Depreciation

708,000

98,000

98,000

98,000

610,000

0

Shows the Buildings and Equipment “as if” they have been recorded on the sub’s books as new assets at book value.

group exercise 1 solution reclass entry
Group Exercise 1: Solution Reclass Entry

3. The accumulated depreciation elimination entry:

Accumulated Depreciation 98,000

Building and Equipment 98,000

Buildings & Equipment

Accumulated Depreciation

708,000

98,000

98,000

98,000

BV

610,000

0

Excess Value Reclass

110,000

FMV

720,000

The excess value reclassification elimination entry

brings the Buildings and Equipment up to fair value.

group exercise 2 worksheet at acquisition
Group Exercise 2: Worksheet at Acquisition

Pepper acquired 100% of Salt’s outstanding stock for $442,500.

Required: Prepare the consolidation entries and worksheet.

group exercise 2 worksheet entries
Group Exercise 2: Worksheet Entries

Book Value Analysis:

Pepper’s Salt’s Equity Accounts, BV

Investment Common Retained

Account, BV Stock Earnings

Balances, 12/31/X8

Investment in Salt

EB 442,500

=

+

The Basic Elimination Entry:

Common Stock

Retained Earnings

Investment in Salt

Excess Value Analysis:

Pepper’s Salt’s 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

practice quiz question 3
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.

learning objective 4
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.

acquired at less than fair value of net assets
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.
basic concepts
Income Statement Effects

When Acquisition Price < BV

Basic Concepts

If expenses are ________________, then income is too low______________________.

To fix the problem, Parent needs to ____________________expenses.

practice quiz question 4
Practice Quiz Question #4

How do the elimination entries differ in a bargain purchase scenario from an 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.

learning objective 5
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.

group exercise 3
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 parent’s Investment account as of the acquisition date shows:

Book value elementLife remaining

Common Stock $130,000

Retained Earnings 117,000

Under- or Over-valuation

Inventory (6,500) 2 months

Land 39,000 Indefinite

Equipment 85,000 10 years

Covenant-not-to-compete 52,000 4 years

Goodwill element 26,000 Indefinite

Total Cost $442,500

group exercise 31
Group Exercise 3
  • Update the analyses of the Investment account through 12/31/X9.
  • Prepare all consolidation entries as of 12/31/X9.
  • 3. Prepare a consolidation worksheet at 12/31/X9. (The parent’s retained earnings as of 1/1/X9 were $455,000.
group exercise 3 worksheet entries
Group Exercise 3: Worksheet Entries

Book Value Calculations:

Pepper’s Salt’s Equity Accounts, BV

Investment Common Retained

Account, BV Stock Add PIC Earnings

Balances, 1/1/X9

Add: Net Income

Less Dividends

Balances, 12/31/X9

=

+

+

The Basic Elimination Entry:

Common Stock

Retained Earnings, 1/1/X9

Income from Salt

Dividends Declared

Investment in Salt

group exercise 3 worksheet entries1
Group Exercise 3: Worksheet Entries

Excess Value Calculations:

Pepper’s

Investment Salt’s Under- or (Over-) Valuation of Net Assets Element

Account Inventory Land Equipment Acc Dep Covenant Goodwill

Remaining Life Excess Cost 2 months Indefinite 10 years 4 years

Balances, 1/1/X9

Less: Amortization

Balances, 12/31/X9

=

The Excess Value Reclassification Entry:

The Amortized Excess Value

Reclassification Entry:

Land

Building & Equipment

Covenant N-T-C

Goodwill

Accumulated Depreciation

Investment in Salt

Depreciation Expense

S&A Expense

Cost of Sales

Income from Salt

The Accumulated Depreciation

Elimination Entry:

Accumulated Depreciation

Building & Equipment

group exercise 3 solution investment account
Group Exercise 3: SolutionInvestment Account

Beginning Balance:

Look back at the beginning and ending balances in the two charts you just prepared to find the numbers!

Goodwill =

26,000

Investment in Salt

BB 442,500

Identifiable Excess =

169,500

NI 78,000

45,500 Dividend

Book value =

247,000

15,000 Excess Amort.

EB 460,000

Ending Balance:

Goodwill =

26,000

Identifiable Excess =

154,500

Book value =

279,500

group exercise 3 worksheet entries2
Group Exercise 3: Worksheet Entries

Notice how the worksheet entries “eliminate” Pepper’s equity method accounts:

Investment in Salt

Income from Salt

BB 442,500

NI 78,000

78,000 NI

45,500 Dividend

15,000 Excess Amort. 15,000

EB 460,000

63,000 Adj. Balance

279,500 Basic 78,000

180,500 Excess Reclass

15,000 Excess Amort.

15,000

0

0

learning objective 6
Learning Objective 6

Understand and explain the elimination of basic intercompany transactions.

road map intercompany transactions
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)
arm s length transactions
Arm’s-Length Transactions

Q: What are “Arm’s-length” Transactions?

A: “Transactions that take place between completely independent parties.”

categories of transactions
Categories of Transactions
  • Arm’s 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-Arm’s Length Transactions
    • Usually referred to as “related party transactions.”
    • Includeall intercompany transactions.
types of related party transactions
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.
necessity of eliminating intercompany transactions
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.
intercompany transactions additional opportunities for fraud
Intercompany Transactions: Additional Opportunities for Fraud
  • Intercompany transactions sometimesoccur to
    • Conceal embezzlements.
    • Overstate reported profits.

2 + 2 = 5

group exercise 4 intercompany loan interest
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:
  • What amounts should be reported in each company’s separate 20X8 income statement and 12/31/X8 balance sheet (asset and liability sections only)?
  • Prepare and post to your format the consolidation entries as of 12/31/X8, relating only to these accounts.
group exercise 4 solution

How would you

eliminate each item?

Group Exercise 4: Solution

Three things to think about:

  • Note receivable / payable
  • Interest revenue / expense
  • Interest receivable / payable
  • 1. Note Payable (sub) XXX
      • Note Receivable (parent) XXX
  • 2. Interest Revenue (parent) XXX
      • Interest Expense (sub) XXX
  • 3. Interest Payable (sub) XXX
      • Interest Receivable (parent) XXX
practice quiz question 5
Practice Quiz Question #5

Intercompany income statement accounts are eliminated in consolidation because they are deemed to be:

Artificial transactions.

Potentially manipulative transactions.

Internal transactions.

At amounts that are not determined on arms-length basis.

none of the above.

practice quiz question 6
Practice Quiz Question #6

In 20X8, Scott incurred $90,000 of inter-company 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:

  • $0
  • $10,000
  • $20,000
  • $30,000
  • $40,000
learning objective 7
Learning Objective 7

Understand and explain the basics of push-down accounting.

purchase price book value
Purchase Price > Book Value
  • What happens if you pay more than the book value of the subsidiary’s assets?
    • This is the case MOST of the time!
  • Parent has two options:
    • Push-Down Accounting
      • Force Sub to revalue to FMV
    • Non-Push-Down Accounting
      • Account for the “extra” value separately.

Parent

Sub

push down accounting the easier way
Push-Down Accounting: The EASIER Way
  • Push-Down Accounting(an absolute gem)
    • In the subsidiary’s general ledger:
      • Adjust assets and liabilities to FVbased on the parent’s acquisition price.
        • This establishes a new basis of accounting.
      • Record goodwill.
      • Record “Revaluation Capital” for the difference

A = L + E

Revaluation Capital

X

nonpush down accounting the harder way
Nonpush-Down Accounting: The HARDER Way
  • Non-Push-Down Accounting:
    • Don’t touch the subsidiary’s general ledger (treat like a “sacred cow”).
    • Make fair value adjustments and record goodwill in consolidation (on the worksheets).
consolidation consequences push down vs non push down
Consolidation Consequences: Push-Down vs. Non-Push-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?
parent s amortization of cost in excess of book value how handled
Parent’s Amortization of Cost in Excess of Book Value: How Handled?
  • Non-push-down accounting
    • Equity Method
      • Recorded in parent’s general ledger
      • Maintains built-in checking features
    • Cost Method
      • Recorded on consolidation worksheets
  • Push-down accounting
    • Parent has no amortization – sub records the amortization
consolidated financial statements

Sub’s

Income Statement

(Based on

Book Values)

Sub’s

Income Statement

(Based on

Fair Values)

+

=

Sub’s

Balance Sheet

(Based on

Book Values)

Sub’s

Balance Sheet

(Based on

Fair Values)

+

=

Consolidated Financial Statements

Actually, these numbers are only part of the consolidated financial statements.

Non-push-down Accounting

Push-down Accounting

Parent’s

Adjustments

For

Excess

Value

(Consolidation

Process)

postacquisition subsidiary earnings reportable earnings under acquisition method
Postacquisition Subsidiary Earnings: Reportable Earnings Under Acquisition Method
  • ONLY the subsidiary’s 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 subsidiary’s preacquisition earnings (included in its retained earnings account) are always eliminated against the parent’s Investment account in consolidation.
practice quiz question 7
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.

practice quiz question 8
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.

practice quiz question 9
Practice Quiz Question #9

The consolidated financial statements are identical regardless of whether the parent:

a. Uses push-down or non-push-downaccounting.

b. Acquires 100% of the common stock or 100% of the assets.

c. Both A and B.

d. Neither A or B.

conclusion
Conclusion

The End

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