Chapter Two

Consolidation
of Financial
Information

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
2

Business Combinations

 Separate organizations tied together

through common control
 Financial statements which represent
more than one corporation are known
as “consolidated” financial
statements.
 The company which exerts control is
known as the “parent.”
 The separate controlled companies
whose information is consolidated are
known as “subsidiaries.”
3

Why do Firms Combine?

 Vertical
Vertical integration
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
businessriskrisk
4

Scale of Recent Combinations

ACQUIRER TARGET COST
(in billions of $)
AT&T BellSouth $67.0

J.P. Morgan Bank One 58.8

Chase
Sprint Nextel 35.2

Wachovia Bank Golden West 25.5

Financial
Walt Disney Pixar 7.4

Adidas Reebok 3.8

5

The Consolidation Process

“The
“Thepurpose
purposeof ofconsolidated
consolidatedfinancial
financialstatements
statementsisistotopresent,
present,
primarily
primarilyforforthe
thebenefit
benefitof
ofthe
theowners
ownersand andcreditors
creditorsof
ofthe
theparent,
parent,
the
theresults
resultsof
ofoperations
operationsandandthe
thefinancial
financialposition
positionof
ofaaparent
parent
company
companyand andallallits
itssubsidiaries
subsidiariesas
asififthe
theconsolidated
consolidatedgroup
groupwere
wereaa
single
singleeconomic
economicentity
entitywith
withone
oneor
ormore
morebranches
branchesorordivisions.”
divisions.”
----SFAS
SFAS160160(December
(December2007)2007)

Why Consolidated Statements?

 They are presumed to be more meaningful
than separate statements.
 They are considered necessary for fair
presentation.
6

Business Combinations

There is a presumption that consolidated financial

statements are more meaningful than separate financial
statements and that they are usually necessary for a fair
presentation when one of the entities in the consolidated
group directly or indirectly has a controlling financial
interest in the other entities (SFAS 160).

The usual condition for a controlling financial interest is

ownership of a majority voting interest, and, therefore,
as a general rule ownership by one entity, directly or
indirectly, of more than 50 per cent of the outstanding
voting shares of another entity is a condition pointing
toward consolidation (SFAS 160).
7 Exh.
2-2
Business Combinations

Continued
 Business Combinations –
8 Exh.
2-2

Continued
9
Consolidation of Financial
Information

Parent Subsidiary

The parent does not Consolidated The Sub still prepares

prepare separate financial statements separate financial
financial statements are prepared. statements
10

Reminder: GAAP Accounting Methods

11

A Control Issue – SPE’s

 Special Purpose Entities (a popular type of
“variable interest entity”) were misused to
hide debt and manipulate earnings
 As a result, the FASB (in FIN 46R) expanded
the definition of “control” beyond just the
holding of a majority share position.
 The following indicate a controlling financial
interest in a variable interest entity:
 Direct or indirect ability to make decisions about
the entity’s activities
 Obligation to absorb any expected losses of the
entity
 The right to receive any expected residuals of the
entity
12

What is to be consolidated?

 If dissolution occurs:
All account balances are actually
consolidated in the financial records of
the survivor.

 If separate incorporation maintained:

Financial statement
information is consolidated
on work papers and not in the
actual records
13

When does consolidation occur?

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

 If separate incorporation maintained:

Consolidation (on work papers, not in
the actual records!!) occurs regularly,
whenever financial statements are
prepared
 How does consolidation affect the
14

accounting records?
 If dissolution occurs:
Dissolved company’s records are
closed out.
Surviving company’s accounts are
adjusted to include all balances of the
dissolved company

 If separate incorporation maintained:

Each company continues to maintain
its own records
15
Acquisition Method – SFAS 141R (effective
for all combinations beginning in 2009)

 Employed when there is a change in

ownership resulting in control of one
enterprise by another.
 The valuation basis for most
acquisitions is the fair value of the
“consideration transferred” by the
acquirer at the date of acquisition.
 Consideration transferred includes
 Cash paid or fair value of stock issued
 Fair value of any contingent consideration
 Fair value of any other property transferred
16

Accounting Challenges!!!
 Allocation of “acquisition-date fair value” among the
various assets and liabilities obtained.

 Allocation depends on the relation between the total

fair value of the acquired business and the collective
amount of the individual “fair values” of the acquired
firm’s assets and liabilities.

FASB defines fair value as “the price that would be

received to sell an asset or paid to transfer a liability
in an orderly transaction of market participants at the
measurement date.”
(FASB, “Statement of Financial Accounting Standards
No. 157,” Fair Value Measurements)
17

“Direct Costs” of Combination

 The fees to the following for advising

services in arranging and structuring
the combination:
 Investment bankers
 Accountants
 Attorneys

These amounts are considered expenses of

the period in which the combination takes
place. They are NOT consider an element
of the fair value received by the acquirer.
18

Acquisition Method Situations

 Dissolution
Dissolutionof
ofthe
theacquired
acquired
company:
company:
 Consideration transferred =
Consideration transferred =
Collective
Collectivefair
fairvalues
valuesof
ofthe
the
individual
individualasset
assetacquired
acquiredand
and
liabilities
liabilitiesassumed
assumed(FV)(FV)
 Consideration transferred = FV
Consideration transferred = FV
 Consideration transferred > FV
Consideration transferred > FV
 Consideration transferred < FV
Consideration transferred < FV

 Separate
Separateincorporation
incorporation
maintained.
maintained.
 Acquisition Method: Dissolution
19

Consideration transferred = Fair value

 Ignore the equity and nominal accounts
of the acquired company.
 Determine fair values of the acquired
company’s assets and liabilities.
 Prepare a journal entry to
 recognize the fair value of the
consideration transferred in the
acquisition
 incorporate the fair value of the
acquired company’s identifiable
assets and liabilities into the
acquiring company’s books.
 Acquisition Method: Dissolution
20

Consideration transferred = Fair value

BigNet agrees to pay $2,550,000 (cash of

$550,000 and 20,000 unissued shares of its
$10 par value common stock that is
currently selling for $100 per share) for all
of Smallport’s assets and liabilities.

Smallport then dissolves itself as a legal

entity. As is typical, the $2,550,000 fair
value of the consideration transferred by
BigNet represents the fair value of the
acquired Smallport business.
 Acquisition Method: Dissolution
21

Consideration transferred = Fair value

 Acquisition Method: Dissolution
22

Consideration transferred > Fair value

 FV of acquired company’s Note:

Note:Goodwill
Goodwill
assets and liabilities is added should
shouldbe beviewed
viewed
to acquiring company’s as
asaaresidual
residual
books. amount
amount
remaining
remainingafter after
all
allother
other
 Difference between identifiable
consideration transferred and identifiable
assets
assetsacquired
acquired
FV of identifiable assets and
andliabilities
liabilities
acquired and liabilities assumed
assumedare are
assumed is allocated to recognized.
recognized.
goodwill.
 Acquisition Method: Dissolution
23

Consideration transferred > Fair value

 Acquisition Method: Dissolution
24

Consideration transferred < Fair value

 In rare circumstances, the FV of the
identifiable assets acquired and
liabilities assumed may exceed the
consideration transferred.
 This excess FV is recognized as an
ordinary gain on a bargain
purchase.
 The FV of the of identifiable assets
acquired and liabilities assumed
then becomes the valuation basis
of the acquisition.
 Acquisition Method: Dissolution
25

Consideration transferred < Fair value

At
At acquisition
acquisition date,
date, each
each
subsidiary
subsidiary asset
asset andand liability
liability isis
reported
reported at
at its
its fair
fair value.
value. .. ..

.. .. .. The
The remainder
remainder is
is to
to be
be
reported
reported as as an
an ordinary
ordinary gain
gain on
on
bargain
bargain purchase
purchase (SFAS
(SFAS 141R)
141R)
26 Accounting for Additional Costs
Associated with Business
Combinations (SFAS 141R)
Direct combination costs Expense as incurred
(Accounting, legal,
investment banking and
appraisal fees, etc.)

Indirect combination costs Expense as incurred

(additional internal costs
such as secretarial or
managerial time)

Costs to register and issue Reduce the value assigned

securities to the fair value of the
securities issued (typically
as a debit to APIC)
27

Let’s see what happens

when the acquired company
is not dissolved.
28
Acquisition Method - No
Dissolution
 The
Theacquired
acquiredcompany
company
continues
continuesasasaaseparate
separateentity.
entity.
 Reported
 Reportedon
onParent’s
Parent’sbooks
booksas
as
the
theInvestment
Investmentin
inSubsidiary
Subsidiary
account.
account.
 Separate
Separaterecords
recordsfor foreach
each
company
companyarearestill
still maintained.
maintained.
 The
Theadjusted
adjustedbalances
balancesfor forthe
the
Parent
Parentand
andthe
theSubsidiary
Subsidiaryare are
consolidated
consolidated using
usingaa
worksheet
worksheet(no(noformal
formal journal
journal
entries!)
entries!)
29

Steps for Consolidation

1.
1. Record
Recordthe
thefinancial
financial information
informationfor
for
both
bothParent
Parentand
andSub
Subon onthe
theworksheet.
worksheet.
2.
2. Remove
Removethe
theInvestment
Investmentin
inSub
Subbalance.
balance.
3.
3. Remove
Removethe theSub’s
Sub’sequity
equityaccount
account
balances.
balances.
4.
4. Adjust
Adjustthe
theidentifiable
identifiableassets
assetsacquired
acquired
and
andliabilities
liabilitiesassumed
assumedto toFV.
FV.
5.
5. Allocate
Allocateany
anyremaining
remainingexcess
excessofof
consideration
considerationtransferred
transferredover
overBVBVto
to
goodwill.
goodwill.
6.
6. Combine
Combineall all account
accountbalances.
balances.
30

No Dissolution Example
31
32
33
34
35
Acquisition Fair Value Allocations:
Additional Issues, SFAS No. 141R
 Intangibles
Intangibles
Current
 Currentand
andnoncurrent
noncurrentassets
assets
that
thatlack
lackphysical
physical substance.
substance.
Do
 Donot
notinclude
includefinancial
financial
instruments.
instruments.
 When
When should
should an
an Intangible
Intangible
be
be recognized?
recognized?
Does
 Doesititarise
arisefrom
fromcontractual
contractual
or
orother
otherlegal
legal rights?
rights?
Can
 Canititbe
besold
soldor orotherwise
otherwise
separated
separatedfrom
fromthetheacquired
acquired
enterprise?
enterprise?
 Exh.
Acquisition Fair Value Allocations:
36
2-7

Additional Issues, SFAS No. 141R

Intangible Asset Examples

 Customer
CustomerBase
Base  Databases
Databases
 Brand
BrandNames
Names  Technological
Technologicalknow-
know-
 Trademarks how
how
Trademarks
Customer  Patents
Patents&&Copyrights

CustomerRoutes
Routes Copyrights
Royalty  Franchise
Franchiseagreements

Royaltyagreements
agreements agreements
Internet  Noncompetition

Internetdomain
domainnames
names Noncompetition
Rights agreements
agreements

Rights(broadcasting,
(broadcasting,
development,  Many,
Many,many,
many,more
development,use,
use, more
etc.)
etc.)
 Acquisition Fair Value Allocations:
37

Additional Issues, SFAS No. 141R

 In-Process
In-Process R&D
R&D
Should
 Shouldbe
berecognized
recognizedat
at
acquisition
acquisitiondatedateas
asanan
ASSET.
ASSET.
Determination
 Determinationof offair
fairvalue
value
is
iscritical.
critical.
Subsequent
 Subsequentto toacquisition,
acquisition,
the
theIPR&D
IPR&Dassets
assetsare
are
tested
testedfor
forimpairment
impairmentat at
least
leastannually.
annually.
38

Unconsolidated Subsidiaries

W hen can a P arent exclude a 50%

ow ned subsidiary from consolidation?

W hen control does not

actually rest w ith the 50% ow ners,
e.g., bankruptcy, substantive m inority rights, etc.

S F A S N o . 94
LEGACY ACCOUNTING METHODS FOR
BUSINESS COMBINATIONS
Prior to the SFAS 141R acquisition
method (effective 2009), the FASB
required either the
 Purchase method (GAAP
through 2008, SFAS 141)
 Pooling of interests method
(GAAP through 6/30/02, APB
16)
40
Purchase Method Situations:
GAAP for new combinations through 2008

 Dissolution
 Dissolution of
of the
the
acquired
acquired company:
company:
Purchase
Purchase Price
Price == Fair
Fair
Value
Value
Purchase
Purchase Price
Price >> FV
FV
Purchase
Purchase Price
Price << FV
FV
 Separate
 Separate
incorporation
incorporation
maintained.
maintained.
 Purchase Method: Dissolution
41

Purchase Price > or = Fair Value

 Ignore the equity and nominal accounts
of the acquired company.
 Determine fair value of the acquired
company’s assets and liabilities.
 Prepare a journal entry to
 recognize the cost of acquisition
 incorporate the FV of the acquired
company’s assets and liabilities into the
acquiring company’s books.
 Recognize goodwill as the excess of cost
over FV of the net assets acquired.
 Record any acquired in-process research
and development as an expense
42
Purchase Method: Dissolution
Purchase Price > Fair Value
Archer agrees to pay $1,200,000 (10,000
unissued shares of its $1 par value common stock
that is currently selling for $120 per share) for all
of Baker’s assets and liabilities. Archer also paid
$25,000 cash for legal and accounting fees
directly related to the acquisition.

Baker then dissolves itself as a legal entity. Under

the purchase method both the fair value of the
stock issued and the direct acquisition costs are
included in the cost-based valuation of the
combination.
43
Purchase Method: Dissolution
Purchase Price > Fair Value
Acquisition-date information for Baker Co.
44
Purchase Method: Dissolution
Purchase Price < Fair Value
 When fair value exceeds
cost, full allocation of fair
value is not possible.
 Current assets and liabilities
should be consolidated at
their fair value.
 Non-current assets should
be proportionately reduced
in value (with some
exceptions)
45
Purchase Method - Dissolution
Purchase Price < Fair Value
 According to SFAS 141, the following non-
current assets are exceptions to the
proportionate reduction, and should be
recorded at assessed fair values:

 Financial assets other than equity method

investments
 Assets to be disposed of by sale
 Deferred tax assets
 Prepaid assets related to pension or other post-
retirement benefit plans
46
Purchase Method - Dissolution
Purchase Price < Fair Value

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)
47 Accounting for Additional Costs
Associated with Business
Combinations (SFAS 141)
Direct combination costs Include in the purchase
(Accounting, legal, price of the acquired firm
investment banking and
appraisal fees, etc.)

Indirect combination costs Expense as incurred

(additional internal costs
such as secretarial or
managerial time)

Costs to register and issue Reduce the value assigned

securities to the fair value of the
securities issued (typically
as a debit to APIC)
48

Pooling of Interests

Historically,
Historically, many
many business
business
combinations
combinations werewere
accounted
accounted forfor as
as “Pooling
“Pooling
of
of Interests.”
Interests.”
In
In SFAS
SFAS 141R,
141R, “Business
“Business
Combinations”,
Combinations”, the the FASB
FASB
stated
stated that
that all
all business
business
combinations
combinations shouldshould be
be
accounted
accounted forfor using
using the
the
““Acquisition
Acquisition Method”.
Method
Method”.
Method
49

Pooling of Interests

According
AccordingtotoSFAS
SFASNo.
No. 141R,
141R, the
the
acquisition
acquisitionmethod
methodisisnot
notto
to
be
beretrospectively
retrospectivelyapplied
applied to
to
past
past“Poolings
“Poolingsof
ofInterest.”
Interest.”
Past
Pastpoolings
poolingsofofinterests
interestsare
are
left
leftintact
intactby
bySFAS
SFASNo.No. 141R.
141R.
Therefore,
Therefore, ititis
isimportant
importantto
to
understand
understandhow how to
toaccount
account
for
forPAST
PASTpoolings.
poolings.
50
Historical Review of Pooling of
Interests

In
 The ownership interests of two,
Inaapooling,
pooling, one
one or more, companies were
company
companyobtained
obtained combined into one new
essentially
essentially“all”
“all”of
ofthe
the company.
other
othercompany’s
company’s  No single company was
stock.
stock. dominant.
 There was a continuity of
previous ownership interests,
The
Thetransaction
transaction not a purchase/sale.
involved
involvedthe
the  To use pooling of interests, 12
exchange
exchangeof ofcommon
common strict criteria had to be met.
stock.
stock. NoNoexchange
exchange
of
ofcash
cashwas
wasallowed.
allowed.
51
Historical Review of Pooling of
Interests

The
TheBook
BookValues
Valuesof
ofthe
thetwo
two
combining
combiningcompanies
companieswere
were
joined.
joined. No
NoGoodwill
Goodwill was
was
recorded.
recorded. Internally
Internallydeveloped
developed
intangibles
intangiblesdeveloped
developedbybythe
the
sub
subwere
weretypically
typicallynot
not
recognized.
recognized.
Revenues
Revenuesand andexpenses
expenseswere
were
combined
combinedretroactively
retroactivelyfor
forthe
the
two
twocompanies.
companies.
52
Historical Review of Pooling of
Interests
 Because
Becausepoolings
poolingsinvolved
involved
exchanges
exchangesof ofvoting
votingstock,
stock,aa
continuity
continuityofofownership
ownershipwas wasdeemed
deemed
to
toexist.
exist.
 Neither
NeitherGoodwill
Goodwillnor norany
anyunrecorded
unrecorded
intangibles
intangibleswere
wererecorded.
recorded.
 Both
Bothcompanies
companieswerewerecombined
combinedat at
BV.
BV.
 The
Thepooling
poolingmethod
methodwas wasoften
often
criticized
criticizedfor
forit’s
it’slack
lackofof
completeness,
completeness,comparability
comparabilityto toother
other
methods,
methods,andandrelevance
relevanceforfordecision
decision
makers.
makers.
53
Historical Review of Pooling of
Interests
 Prior
PriorPeriod
PeriodAdjustments
Adjustmentswere were
made
madeto toaccount
accountfor for
differences
differencesin inthe
theways
waysthe
thetwo
two
companies
companiesaccounted
accountedfor for
income.
income.
 AAjournal
journal entry
entrywaswasrecorded
recorded
to
torecognize
recognizeeither
eitheranan
Investment
Investmentin inSubsidiary
Subsidiary (sub(sub
not
notdissolved)
dissolved)or orthe
the
individually
individuallyacquired
acquiredassets
assets
and
andliabilities
liabilities(if
(ifthe
thesub
subwas
was
dissolved).
dissolved).
 Accounting for Pooling of Interests in
54

Subsequent Periods: Dissolution

 The Investment in Sub
account must be
eliminated against the
Sub’s Equity accounts
 Add together the BV’s of
the remaining accounts.
 No excess amortization is
applicable, because no
acquisition-date write-ups
occurred.
55

Summary
 Consolidation of financial information is required
when one organization gains control of another.
 If dissolution occurs, this consolidation is carried out
at the date of acquisition and a single set of
accounting records is maintained.
 If separate identities are maintained, consolidation is
a periodic “worksheet” process not involving journal
entries. Separate accounting records are maintained.
 The acquisition method is GAAP beginning in 2009.
 Legacy effects for the purchase method (for
combinations occurring through 2008) and the
pooling method (through 6/30/2002) remain in
subsequent year’s financial reports.