Slide

2-1

Chapter Two

Consolidation
of Financial
Information

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

Slide
2-2

Why do Firms Combine?

 Vertical
Verticalintegration.
integration.
 Cost
Costsavings.
savings.
 Quick
Quickaccess
accessto tonew
new
markets.
markets.
 Economies
Economiesof ofscale.
scale.
 More
Moreattractive
attractive
financing
financingopportunities.
opportunities.
 Diversification
Diversificationof of
business
businessrisk.
risk.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

Slide
2-3

The Consolidation Process

The
The consolidation
consolidation of of financial
financial information
information into
into aa
single
single set
set of
of statements
statements becomes
becomes necessary
necessary
whenever
whenever aa single
single economic
economic entity
entity isis created
created by
by
the
the business
business combination
combination of of two
two oror more
more
companies.
companies. -- -- ARB
ARB No. No. 51
51

Why Consolidated Statements?

 They are presumed to be more meaningful
that separate statements.
 They are considered necessary for a fair
presentation.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

Slide
2-4

Business Combinations

AA business
business combination
combination
occurs
occurs when
when an an enterprise
enterprise
acquires
acquires net
net assets
assets that
that
constitute
constitute aa business
business or or equity
equity
interests
interests of
of one
one oror more
more other
other
enterprises
enterprises andand obtains
obtains
control
control over
over that
that enterprise
enterprise or
or
enterprises.
enterprises. -- -- SFAS
SFAS No.No. 141
141

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

Slide Exh.
2-5 2-2
Business Combinations

Continue
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004
Slide Exh.
2-6 2-2
Business Combinations – Cont.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

 Consolidation of Financial
Slide
2-7

Information

Parent Subsidiary

The parent does not Consolidated The Sub still prepares

prepare separate financial statements separate financial
financial statements are prepared. statements
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004
Slide
2-8

GAAP Accounting Methods

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

Slide
2-9

Purchase Method – SFAS 141

 Used when when

there is a change in
ownership that IfIf the
theacquisition
acquisitionis is
results in control of made
madeby byissuing
issuing
one enterprise by stock,
stock, the
thecost
costofof
another enterprise. the
theacquisition
acquisitionis is
equal
equal to
to the
the
 The appropriate MARKET
MARKETVALUE VALUE
valuation basis for of
ofthe
the stock
stock
any purchase issued.
issued.
transaction is “cost”.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

Slide
2-10

Purchase Method Situations

 Dissolution
 Dissolution of
of the
the
acquired
acquired company:
company:
Cost
 Cost == FMV
FMV
Cost
 Cost >> FMV
FMV
Cost
 Cost << FMV
FMV
 Separate
 Separate
incorporation
incorporation is
is
maintained.
maintained.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

 Purchase Method - Dissolution
Slide
2-11

Cost = FMV
 Ignore the Equity and Nominal
accounts of the acquired
company.
 Determine FMV of the acquired
company’s assets and liabilities.
 Prepare a journal entry to
 recognize cost of the acquisition
 incorporate the FMV of acquired
company’s assets and liabilities
into acquiring company’s books.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

 Purchase Method - Dissolution
Slide
2-12

Cost = FMV
On 1/1/04, Large acquired 100% of Tiny
for $300,000 cash.

Prepare the entry to record Large’s

purchase.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004
 Purchase Method - Dissolution
Slide
2-13

Cost = FMV
Tiny’s fair market value was $300,000 which is
equal to the price paid by Large. Record the
purchased assets at their market value.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

 Purchase Method - Dissolution
Slide
2-14

Cost > FMV

 At date of acquisition:
 Acquired company should
prepare a Balance Sheet as of the Note:
Note:Goodwill
Goodwill
date of acquisition. should
shouldbe beviewed
viewed
 Acquired company’s income as
asaaresidual
residual
prior to acquisition is irrelevant amount
amount
to the acquiring company. remaining
remainingafter
after
 FMV of acquired company’s all
allother
other
assets and liabilities is added identifiable
identifiableand
and
to acquiring company’s books. separable
separable
intangible
intangibleassets
assets
 Difference between Cost and
have
havebeen
been
FMV is allocated to identifiable
identified.
identified.
intangible assets and to
goodwill.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

 Purchase Method - Dissolution
Slide
2-15

Cost > FMV

On 1/1/04, Huge acquires 100% of Small
for $250,000 cash.

Small has no identifiable, separable intangible

assets.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004
 Purchase Method - Dissolution
Slide
2-16

Cost > FMV

Goodwill will be recorded as an intangible asset

on Huge’s books, but will not be amortized.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004
 Purchase Method - Dissolution
Slide
2-17

Cost > FMV

Prepare Large’s journal entry for this
acquisition. Remember to record the
$33,000 of Goodwill.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

 Purchase Method - Dissolution
Slide
2-18

Cost < FMV

 When FMV exceeds cost, we
have a Bargain Purchase.
 Current assets and liabilities
should be consolidated at
their FMV.
 Non-current assets should
be recorded at a value
between FMV and BV.
 i.e. each non-current asset’s
(including in-process R&D)
FMV should be reduced by a
proportionate share of the
excess of FMV over cost.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004
 Purchase Method - Dissolution
Slide
2-19

Cost < FMV

In
In the
the event
event that
that the
the difference
difference is
is
substantial
substantial enough
enough to to eliminate
eliminate all
all
the
the non-current
non-current asset
asset balances
balances of
of
the
the acquired
acquired company
company .. .. ..

.. .. .. The
The remainder
remainder is
is to
to be
be
reported
reported as as an
an extraordinary
extraordinary gain
gain
(SFAS
(SFAS 141)
141)

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

Slide
2-20

Let’s see what happens

when the acquired company
is not dissolved.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

 Purchase Method
Slide
2-21

No Dissolution
 The
Theacquired
acquiredcompany
company
continues
continuesasasaaseparate
separate entity.
entity.
 The
 Theacquisition
acquisitionshows
showsup
upon
onthe
the
Parent’s
Parent’sbooks
booksininthe
theInvestment
Investment
in
inSubsidiary
Subsidiaryaccount.
account.
 Separate
Separaterecords
recordsforforeach
each
company
companyarearestill
stillmaintained.
maintained.
 The
Theadjusted
adjustedbalances
balancesfor
forthe
the
Parent
Parent and
andthe
theSubsidiary
Subsidiaryare
are
consolidated
consolidated using
usingaa
worksheet.
worksheet.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

Slide
2-22

Steps for Consolidation

1.
1. Record
Recordthe
thefinancial
financial information
informationfor
for
both
both Parent
Parentand
andSub
Subon
onthetheworksheet.
worksheet.
2.
2. Remove
Removethe
theInvestment
Investment in
in Sub
Sub balance.
balance.
3.
3. Remove
Remove the
the Sub’s
Sub’sequity
equityaccount
account
balances.
balances.
4.
4. Adjust
Adjustthe
theSub’s
Sub’snet
netassets
assetsto
toFMV.
FMV.
5.
5. Allocate
Allocateany
anyexcess
excessofof cost
cost over
overBV
BVto
to
identifiable,
identifiable,separable
separableintangible
intangibleassets
assets
or
orgoodwill.
goodwill.
6.
6. Combine
Combineall allaccount
accountbalances.
balances.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004
 No Dissolution
Slide
2-23

Example
On 1/1/05, Huge acquires 100% of Small
for $250,000 cash.

Small holds a trademark that is valued at

$25,000.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004
Slide
2-24

1.
1. Record
Recordthe the
balances
balancesfor for
each
eachcompany
company
in
in the
the
worksheet.
worksheet.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

Slide
2-25

2.
2. Remove
Removethe
the
investment
investment
account
accountfrom
from
the
theworksheet.
worksheet.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

Slide
2-26

3.
3. Remove
Remove the
the
subsidiary’s
subsidiary’s
equity
equityaccount
account
balances.
balances.

Let’s
Let’slook
lookat
at
the
the
computation
computation
of
of Goodwill.
Goodwill.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

 Goodwill Computation for Huge’s
Slide
2-27

Acquisition of Small

Weuse
We usethese
thesenumbers
numbers
forsteps
for steps#4
#4&&#5.
#5.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

Slide
2-28

4.
4. Adjust
Adjust the
the
subsidiary’s
subsidiary’s
balances
balancestoto
FMV.
FMV.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

Slide
2-29

5.
5. Record
Recordthe
the
trademark
trademarkand
and
the
theGoodwill.
Goodwill.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

Slide
2-30
6.
6. Add
Addthe
thebalances
balances
across
acrossthe
thepage.
page.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

 Purchase Price Allocations -
Slide
2-31

Additional Issues
 Consolidation
ConsolidationCosts
Costs
 Legal
 LegalFees,
Fees,Direct
DirectCosts
Costs
of
ofCombination
Combination
 Increase
 Increasethe
theInvestment
Investmentin
in
Subsidiary
Subsidiaryaccount.
account.
 Stock
StockIssuance
IssuanceCosts
Costs
 Broker
 BrokerFees,
Fees,Registration
Registration
Fees,
Fees,etc.
etc.
 Decrease
 Decreasethe theParent’s
Parent’s
Paid-In
Paid-InCapital
Capitalaccount.
account.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

 Purchase Price Allocations -
Slide
2-32

Additional Issues, SFAS No. 141

 Intangibles
Intangibles
Current
 Current and
and noncurrent
noncurrent assets
assets
that
that lack
lackphysical
physical substance.
substance.
Do
 Donot
not include
includefinancial
financial
instruments.
instruments.
 When
When should
should an
an Intangible
Intangible
be
be recognized?
recognized?
Does
 Doesitit arise
arisefrom
fromcontractual
contractual
or
orother
otherlegal
legal rights?
rights?
Can
 Canititbe
besold
soldor orotherwise
otherwise
separated
separatedfrom
fromthetheacquired
acquired
enterprise?
enterprise?

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

 Purchase Price Allocations -
Slide Exh.
2-33 2-7

Additional Issues, SFAS No. 141

Intangible Asset Examples
 Customer
CustomerBase
Base  Databases
Databases
 Trademarked
TrademarkedBrand
Brand  Technological
Technologicalknow-
know-
Names
Names how
how
 Customer
CustomerRoutes
Routes  Patents
Patents&&Copyrights
Copyrights
 Effective
EffectiveAdvertising
Advertising  Strong
Stronglabor
laborrelations
relations
Programs Assembled,
Programs 
Assembled,trained
trained
 Covenants
Covenants workforce
workforce
 Rights
Rights(broadcasting,
(broadcasting,  Favorable
Favorablegovernment
government
development,
development,use,
use, relations
relations
etc.)
etc.)

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

 Purchase Price Allocations -
Slide
2-34

Additional Issues, SFAS No. 141

 In-Process
In-ProcessR&D
R&D
 Should
 Shouldbe
beexpensed
expensedimmediately
immediately
upon
uponacquisition,
acquisition,unless
unlessthere
there
are
arealternative
alternativefuture
futureuses.
uses.
•• Dr.
Dr.R&D
R&DExpense
Expense
•• Cr.
Cr.Investment
InvestmentininInvestee
Investee
 ItItcould
 couldalso
alsobe
bewritten-off
written-offvia
via
consolidation
consolidationentries
entries
 IPR&D
IPR&Dthat
thathas
hasreached
reached
technological
technologicalfeasibility,
feasibility,can
can
be
be “capitalized”.
“capitalized”.
 Determination
 Determinationof
offair
fairvalue
valueis
is
critical.
critical.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

Slide
2-35

Unconsolidated Subsidiaries

W h e n c a n a P a r e n t e x c lu d e a 5 0 %
o w n e d s u b s id ia r y fr o m c o n s o lid a tio n ?

W h e n c o n tro l d o e s n o t
a c t u a ll y r e s t w i t h th e 5 0 %
o w n e rs.

SFAS N o. 94

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

Slide
2-36

Pooling of Interests

Historically,
Historically, many
many business
business
combinations
combinations have have been
been
accounted
accounted for for as
as “Pooling
“Pooling
of
of Interests.”
Interests.”
In
In its
its SFAS
SFAS 141,
141, “Business
“Business
Combinations”,
Combinations”, the the FASB
FASB
states
states that
that all
all business
business
combinations
combinations shouldshould bebe
accounted
accounted for for using
using the
the
““Purchase
Purchase Method”.
Method
Method”.
Method

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

Slide
2-37

Pooling of Interests

According
AccordingtotoSFAS
SFASNo.
No.141,
141,the
the
purchase
purchasemethod
methodis
isto
tobe
be
applied
appliedprospectively.
prospectively.
Past
Past poolings
poolingsof ofinterests
interestsare
are
left
left intact
intact by
bySFAS
SFASNo.No.141.
141.
Therefore,
Therefore, ititis
isimportant
important to
to
understand
understandhow howto
to account
account
for
forPAST
PASTpoolings.
poolings.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

 Historical Review of Pooling of
Slide
2-38

Interests. Read the book for details!

In
Inaapooling,
pooling,one
one
 The ownership interests of
company
companyobtained
obtained two, or more, companies
essentially
essentially “all”
“all”of
ofthe
the were combined into one
other
othercompany’s
company’s new company.
stock.
stock.  No single company was
dominant.
 Precise cost figures were
The
Thetransaction
transaction difficult to obtain.
involved
involved the
the
exchange  To use pooling of
exchangeof ofcommon
common
stock. interests, 12 strict criteria
stock. NoNoexchange
exchange
of had to be met.
ofcash
cashwas
wasallowed.
allowed.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

 Historical Review of Pooling of
Slide
2-39

Interests

The
TheBook
BookValues
Valuesof
ofthe
thetwo
two
combining
combining companies
companies were
were
joined.
joined. No
NoGoodwill
Goodwillwas
was
recorded.
recorded.

Revenues
Revenuesand
andexpenses
expenses were
were
combined
combinedretroactively
retroactively for
for the
the
two
twocompanies.
companies. This
Thiscreated
created
superior
superiorearnings,
earnings,hence
henceits
its
preference.
preference.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004
 Historical Review of Pooling of
Slide
2-40

Interests
 IfIf both
both companies
companies
continued
continued toto exist,
exist, an
an
Investment
Investment inin Sub
Sub
account
account was
was recorded
recorded on
on
one
one company’s
company’s booksbooks
(usually
(usually the
the larger).
larger).
 No
No Goodwill
Goodwill was was
recorded.
recorded.
 Both
Both companies
companies were were
combined
combined at at BV.
BV.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

 Historical Review of Pooling of
Slide
2-41

Interests
 Prior
PriorPeriod
PeriodAdjustments
Adjustments werewere
made
madeto to account
account for
for
differences
differencesinin the
theways
ways the
thetwo
two
companies
companiesaccounted
accountedfor for
income.
income.
 AAjournal
journal entry
entrywas
wasrecorded
recorded
to
torecognize
recognizethe
the Investment
Investmentin in
Subsidiary.
Subsidiary.
 The
TheBV’s
BV’sfor
forboth
bothcompanies
companies
were
wereentered
enteredononaa
consolidation
consolidationworksheet.
worksheet.

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004

 Continued Accounting for Pooling
Slide
2-42

of Interests
 The Investment in Sub
account must be
eliminated.
 Also eliminate the Sub’s
Equity accounts to
prevent double-counting.
 They have already been
included in the original
Investment in Sub entry.
 Add together the BV’s of
the remaining accounts.

THE END OF CHAPTER 2

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2004