CHAPTER 5

ANSWERS TO QUESTIONS

1. a. The ―difference between implied and book value‖ is the total difference between the value of
the subsidiary in total, as implied by the acquisition cost of an investment in that subsidiary, and
the book value of the subsidiary’s equity on the date of the acquisition (note that equity is the
same as net assets).

b. The excess of implied value over fair value, or ―Goodwill,‖ is the excess of the value of the
subsidiary, as implied by the amount paid by the parent, over the fair value of the identifiable net
assets of that subsidiary on the date of acquisition.

c. The ―excess of fair value over implied value‖ is the excess of the fair value of the identifiable
net assets of a subsidiary (all assets other than goodwill minus liabilities) on the acquisition date over
the value of the subsidiary as implied by the amount paid by the parent. This may be referred to as a
bargain acquisition.

d. An excess of book value over fair value describes a situation where some (or all) of the
subsidiary’s assets need to be written down rather than up (or liabilities need to be increased, or both).
It does not, however, tell us whether the acquisition results in the recording of goodwill or an ordinary
gain (in a bargain acquisition). That determination depends on the comparison of fair value of
identifiable net assets and the implied value (purchase price divided by percentage acquired), referred
to in parts (b) and (c) above.

2. The ―difference between implied and book value‖ and the ―Goodwill‖ are a part of the cost of an
investment and are included in the amount recorded in the investment account. Although not recorded
separately in the records of the parent company, these amounts must be known in order to prepare
the consolidated financial statements.

3. In allocating the difference between implied and book value to specific assets of a less than wholly
owned subsidiary, the difference between the fair value and book value of each asset on the date of
acquisition is reflected by adjusting each asset upward or downward to fair value (marked to market)
in its entirety, regardless of the percentage acquired by the parent company.

4. If the parent’s share of the fair value exceeds the cost, then the entire fair value similarly exceeds the
implied value of the subsidiary. This constitutes a bargain acquisition, and under proposed GAAP
(ED No. 1204-001), the excess is recorded as an ordinary gain in the period of the acquisition. Past
GAAP (APB Opinion No. 16) differed in that it provided that the excess of fair value over cost should
be allocated to reduce proportionally the values assigned to noncurrent assets with certain exceptions.
If such noncurrent assets were reduced to zero (or to the noncontrolling percentage, if there was one)
by this allocation, any remaining excess was recorded as an extraordinary gain.

5. The recording of an ordinary (or extraordinary gain) on an acquisition flies in the face of the rules of
revenue recognition because no earnings process has been completed. On the other hand, a decision
to record certain assets below their fair values is arbitrary, and also rather confusing (how far should
they be reduced?) The reason that bargain acquisitions are unlikely to occur very often is because
they suggest that the usual assumptions of an arm’s length transaction have been

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violated. In most accounting scenarios, we assume that both parties are negotiating for a reasonable
exchange price and that price, once established, represents fair value both for the item given up and
the item received. In the case of a business combination, there is not a single item being exchanged
but rather a number of assets and liabilities. Nonetheless, the assumption is still that both parties are
negotiating for a fair valuation. If one party is able to obtain a bargain, it most likely indicates that
the other party was being influenced by non-quantitative considerations, such as a wish to retire
quickly, health concerns, etc.

6. If P Company acquires a 100 percent interest in S Company the land will be included in the
consolidated financial statements at its fair value on the date of acquisition of $1,500,000. If P
Company acquires an 80 percent interest in S Company, the land will still be included in the
consolidated financial statements at $1,500,000, and the noncontrolling interest would be charged
with its share of the fair value adjustment.

7. (d). Once the determination is made that none of the assets are over-valued (and none of the liabilities
under-valued), the bargain is reflected as an ordinary gain of $10,000 in the year of acquisition.

8. (b). The ―excess of fair value over implied value‖ is reported as an ordinary gain under the FASB
exposure draft on business combinations (ED 1204-001).

9. Under the entity theory, the noncontrolling interest shares in the adjustment of consolidated net assets
for the difference between implied and book value. The noncontrolling interest is also affected by
the amortization or depreciation in the consolidated workpapers of the difference between implied
and book value. Assuming that implied value exceeds book value, the effect will generally be to
lower the noncontrolling interest in reported earnings because of its (the noncontrolling interest’s)
share of the excess depreciation and amortization charges, additional cost of goods sold, impairment
of goodwill, etc.

ANSWERS TO BUSINESS ETHICS CASE

This case brings an interesting question to the table for discussion. As the article by Mano points
out, each individual must decide for himself or herself how to respond to the gray issues that are
bound to arise in life. Ultimately life is more about being at peace with ourselves and leaving a
legacy of a life well-lived and values taught through our example to the generations that we leave
behind us than it is about accumulating wealth (that we cannot take to the grave). The individual,
had he acted on the advice, may have been guilty of insider trading as the information available
to him was, apparently, not available publicly. Although there is no clear-cut definition of what
constitutes insider trading, the gray area implies uncertainty; and this uncertainty can in many
cases result in decisions that have severe implications both professionally and personally.

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ANSWERS TO EXERCISES

Exercise 5-1

Part A

Computation and Allocation of Difference Schedule

Parent Non- Entire
Share Controlling Value
Share
Purchase price and implied value $540,000 95,294 635,294 *
Less: Book value of equity acquired:
Common stock 340,000 60,000 400,000
Retained earnings 119,000 21,000 140,000
Total book value 459,000 81,000 540,000
Difference between implied and book value 81,000 14,294 95,294
Marketable Securities ($45,000 – $20,000) (21,250) (3,750) (25,000)
Equipment ($140,000 – $120,000) (17,000) (3,000) (20,000)
Balance 42,750 7,544 50,294
Goodwill (42,750) (7,544) (50,294)
Balance -0- -0- -0-

*$540,000/.85

Part B
Marketable securities $ 45,000
Equipment (net) 140,000
Goodwill 50,294

Exercise 5-2

Computation and Allocation of Difference Schedule

Parent Non- Entire
Share Controlling Value
Share
Purchase price and implied value $585,000 195,000 780,000 *
Less: Book value of equity acquired 450,000 150,000 600,000
Difference between implied and book value 135,000 45,000 180,000
Equipment ($705,000 – $525,000) (135,000) (45,000) (180,000)
Balance -0- -0- -0-

*$585,000/.75

Part A Equipment 180,000

Difference between Implied and Book Value 180,000

Depreciation Expense ($180,000/10) 18,000

Accumulated Depreciation 18,000

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Exercise 5-2 (continued)

Part B
The asset has a value of $180,000 with 10 years of a 15 year life (i.e. 2/3). Therefore, the implied gross
value of the asset is $270,000 (or $180,000 2/3).

Equipment ($180,000 2/3) 270,000

Accumulated Depreciation (1/3 $270,000) 90,000
Difference between Implied and Book Value 180,000

Depreciation Expense ($180,000/10) 18,000

Accumulated Depreciation 18,000

Exercise 5-3

Part A Investment in Saddler Corporation 525,000

Cash 525,000

Part B Computation and Allocation of Difference Schedule

Parent Non- Entire
Share Controlling Value
Share
Purchase price and implied value $525,000 131,250 656,250 *
Less: Book value of equity acquired 480,000 120,000 600,000
Difference between implied and book value 45,000 11,250 56,250
Inventory (16,000) (4,000) (20,000)
Marketable Securities (20,000) (5,000) (25,000)
Plant and Equipment (24,000) (6,000) (30,000)
Balance (excess of FV over implied value) (15,000) (3,750) (18,750)
Gain 15,000
Increase Noncontrolling interest to fair value of assets 3,750
Total allocated bargain 18,750
Balance -0- -0- -0-

*$525,000/.80