ISMChap003

CHAPTER 3CONSOLIDATIONS—SUBSEQUENT TOTHE DATE OF ACQUISITION I. Several factors serve to complicate the consolidation process when it occurs subsequentto the date of acquisition.In all combinations within its own internal records the acquiring company will utilize a specific method to account for the investment in the acquired company.1. Three alternatives are availablea. Initial value method (also known as the cost method)b. Equity methodc. Partial equity method2. Depending upon the method applied, the acquiring company will record earningsfrom its ownership of the acquired company. This total must be eliminated on theconsolidation worksheet and be replaced by the subsidiary’s r evenues andexpenses.3. Under each of these three methods, the balance in the Investment account willalso vary. It too must be removed in producing consolidated statements and bereplaced by the subsidiary’s assets and liabilities.II. For combinationssubsequent to the acquisition date, certain procedures are required. If the parent applies the equity method, the following process is appropriate.A. Assuming that the acquisition was made during the current fiscal period1. The parent adjusts its own In vestment account to reflect the subsidiary’s incomeand dividend declarations as well as any amortization expense relating to excessacquisition-date fair value over book value allocations and goodwill.2. Worksheet entries are then used to establish consolidated figures for reportingpurposes.a. Entry S offsets the subsidiary’s stockholders’ equity accounts against thebook value component of the Investment account (as of the acquisition date).b. Entry A recognizes the excess fair over book value allocations made tospecific subsidiary accounts and/or to goodwill.c. Entry I eliminates the investment income balance accrued by the parent.d. Entry D removes intra-entity dividend declarationse. Entry E recognizes the current excess amortization expenses on the excessfair over book value allocations.f. Entry P eliminates any intra-entity payable/receivable balances.B. Assuming that the acquisition was made during a previous fiscal period1. Most of the consolidation entries described above remain applicable regardlessof the time that has elapsed since the combination was formed.2. The amount of the subsidiary’s stockholders’ equity to be removed in Entry S willdiffer each period to reflect the balance as of the beginning of the current year3. The allocations established by entry A will also change in each subsequentconsolidation. Only the unamortized balances remaining as of the beginning ofthe current period are recognized in this entry.III. For a combination where the parent has applied an accounting method other than the equity method, the consolidation procedures described above must be modified.A. If the initial value method is applied by the parent company, the intra-entity dividendseliminated in Entry I will only consist of the dividends transferred from the subsidiary.No separate Entry D is needed.B. If the partial equity method is in use, the intra-entity income to be removed in Entry Iis the equity accrual only; no amortization expense is included. Intra-entity dividendsare eliminated through Entry D.C. In any time period after the year of acquisition.1. The initial value method recognizes neither income in excess of dividenddeclarations nor excess amortization expense. Thus, for all years prior to thecurrent period, both of these figures must be entered directly into theconsolidation. Entry*C is used for this purpose; it converts all prior amounts toequity method balances.2. The partial equity method does not recognize excess amortization expenses.Therefore, Entry*C converts the appropriate account balances to the equitymethod by recognizing the expense that relates to all of the past years.IV. Bargain purchasesA. As discussed in Chapter Two, bargain purchases occur when the parent companytransfers consideration less than net fair valuesof the subsidiary’s assets acquiredand liabilities assumed.B. The parent recognizes an excess of net asset fair value over the considerationtransferred as a ―gain on bargain purchas e.‖V. Goodwill ImpairmentA. When is goodwill impaired?1. Goodwill is considered impaired when the fair value of its related reporting unitfalls below its carrying value. Goodwill should not be amortized, but should betested for impairment at the reporting unit level (operating segment or loweridentifiable level).2. Goodwill should be tested for impairment at least annually.3. Interim impairment testing is necessary in the presence of negative indicatorssuch as an adverse change in the business climate or market, legal factors,regulatory action, an introduction of competition, or a loss of key personnel.B. How is goodwill tested for impairment?1. All acquired goodwill should be assigned to reporting units. It would not beunusual for the total amount of acquired goodwill to be divided among a numberof reporting units. Goodwill may be assigned to reporting units of the acquiringentity that are expected to benefit from the synergies of the combination eventhough other assets or liabilities of the acquired entity may not be assigned tothat reporting unit.2. Goodwill is tested for impairment through an optional assessment processfollowed by a two-step approach (if necessary).a. Entities are allowed the option of conducting a qualitative assessment ofgoodwill to assess whether the two-step testing procedure is required. Underthe qualitative assessment, management evaluates relevant events orcircumstances to determine whether it is more likely than not that the fairvalue of a reporting unit is less than its carrying amount. If it is more likelythan not that the fair value of a reporting unit is less than its carrying amount,then the entity performs the two-step testing procedure. Otherwise, no furthertests are required.b. The first step simply compares the fair value amount of a reporting unit to itscarrying amount. If the fair value of the reporting unit exceeds its carryingamount, goodwill is not considered impaired and no further analysis isnecessary.c. The second step is a comparison of goodwill to its carrying amount. If theimplied value of a reporting unit’s goodwill is less than its carrying value,goodwill is considered impaired and a loss is recognized. The loss is equalto the amount by which goodwill exceeds its implied value.3. The implied value of goodwill should be calculated in the same manner thatgoodwill is calculated in a business combination. That is, an entity shouldallocate the fair value of the reporting unit to all of the assets and liabilities of thatunit (including any unrecognized intangible assets) as if the reporting unit hadbeen acquired in a business combination and the fair value of the reporting unitwas the value assigned at a subsidiary’s acquisition date. The excess―acquisition-date‖ fair value over the amounts assigned to assets and liabilities isthe implied value of goodwill. This allocation is performed only for purposes oftesting goodwill for impairment and does not require entities to record the ―step-up‖ in net assets or any unrecognized intangible as sets.C. How is the impairment recognized in financial statements?1. The aggregate amount of goodwill impairment losses should be presented asa separate line item in the operating section of the income statementunless a goodwill impairment loss is associated with a discontinued operation.2. A goodwill impairment loss associated with a discontinued operation shouldbe included (on a net-of-tax basis) within the results of discontinuedoperations.VI. Contingent considerationA. The fair value of any contingent consideration is included as part of the considerationtransferred.B. If the contingency results in a liability (typically a cash payment), changes in the fairvalue of the contingency are recognized in income as they occur.C. If the contingency calls for an additional equity issue at a later date, the acquisition-date fair value of the contingency is not adjusted over time. Any subsequent sharesissued as a consequence of the contingency are simply recorded at the originalacquisition-date fair value. This treatment is similar to other equity issues (e.g.,common stock, preferred stock, etc.) in the parent’s owners’ equity section.VII. Push-down accountingA. A subsidiary may record any acquisition-date fair value allocations directly onto itsown financial records rather than through the use of a worksheet. Subsequentamortization expense on these allocations could also be recorded by the subsidiary.B. Push-down accounting reports the assets and liabilities of the subsidiary at theamount the new owner paid. It also assists the new owner in evaluating theprofitability that the subsidiary is adding to the business combination.C. Push-down accounting can also make the consolidation process easier sinceallocations and amortization need not be included as worksheet entries.Answers to Discussion QuestionsHow Does a Company Really Decide which Investment Method to Apply?Students can come up with dozens of factors that Pilgrim should consider in choosing itsinternal method of accounting for its subsidiary, Crestwood Corporation. The following is only a partial list of possible points to consider.▪Use of the information. If Pilgrim does not monitor its subsidiary’s income levels closely, applying the equity method may be not be fruitful. A company must plan to use the data before the task of accumulation becomes worthwhile. For example, Crestwood may use the information for evaluating the performance of the subsidiary’s managers.▪Size of the subsidiary. If the subsidiary is large in comparison to Pilgrim, the effort required of the equity method may be important. Income levels would probably be significant.However, if the subsidiary is actually quite small in relation to the parent, the impact might not be material enough to warrant the extra effort.▪Size of dividend declarations. If Crestwood distributes most of its income as dividends, that figure will approximate equity income. Little additional information would be accrued by applying the equity method. In contrast, if dividends are small or not declared on a regular basis, a Dividend Income balance might vastly understate the profits to be recognized by the business combination.▪Amount of excess amortizations. If Pilgrim has paid a significant amount in excess of book value, its annual amortization charges are high, and use of the equity method might be preferred to show the amortization effect each reporting period. In this case, waiting until year end and recognizing all of the expense at one time through a worksheet entry might not be the best way to reflect the impact of the expense.▪Amount of intra-entity transactions. As with amortization, the volume of transfers can be an important element in deciding which accounting method to use. If few intra-entity sales are made, monitoring the subsidiary through the application of the equity method is less essential. Conversely, if the amount of these transactions IS significant, the added data can be helpful to company administrators evaluating operations.▪Sophistication of accounting systems. If Pilgrim and Crestwood both have advanced accounting systems, application of the equity method may be relatively easy. Unfortunately, if these systems are primitive, the cost and effort necessary to apply the equity method may outweigh any potential benefits.▪The timeliness and accuracy of income figures generated by Crestwood. If the subsidiary reports operating results on a regular basis (such as weekly or monthly) and these figures prove to be reliable, equity totals recorded by Pilgrim may serve as valuable information to the parent. However, if Crestwood's reports are slow and often require later adjustment, Pilgrim's use of the equity method will provide only questionable results.Answers to Questions1. a. CCES Corp., for its own recordkeeping, may apply the equity method toitsInvestment in Schmaling. Under this approach, the parent's records parallel theactivities of the subsidiary. The parent accrues income as it is earned by thesubsidiary. Dividends declared by Schmaling reduce its book value; therefore,CCESreduces the investment account. In addition, any excess amortization expenseassociated with CCES's acquisition-date fair value allocations is recognized througha periodic adjustment. By applying the equity method, both the parent’s income andinvestment balances accurately reflect consolidated totals. The equity method isespecially helpful in monitoring the income of the business combination. This methodcan be, however, rather difficult to apply and a time consuming process.b. The initial value method. The initial value methodcan also be utilized by CCESCorporation. Any dividends declaredare recognized as income but no otherinvestment entries are made. Thus, the initial value method is easy to apply.However, the resulting account balances of the parent may not provide a reasonablerepresentation of the totals that result from consolidating the two companies.c. The partial equity method combines the advantages of the previous two techniques.Income is accrued as earned by the subsidiary as under the equity method. Similarly,dividends reduce the investment account. However, no other entries are recorded;more specifically, amortization is not recognized by the parent. The method is,therefore, easier to apply than the equity method but the subsidiary's individual totalswill still frequently approximate consolidated balances.2. a. The consolidated total for equipment is made up of the sum of Maguire’s book value,Williams’ book value, and any unamortized excess acquisition-date fair value overbook value attributable to Williams’ equipment.b. Although an Investment in Williams account is appropriately maintained by theparent, from a consolidation perspective the balance is intra-entity in nature. Thus,the entire amount is eliminated in arriving at consolidated financial statements.c. Only dividends declared to outside parties are included in consolidated statements.Because Maguire owns 100 percent of Williams, all of the subsidiary's dividends areintra-entity. Consequently, only the dividends declared by the parent company will bereported in the financial statements for this business combination.d. Any acquisition-date goodwill must still be reported for consolidation purposes.Reductions to goodwill are made if goodwill is determined to be impaired.e. Unless intra-entity revenues have been recorded, consolidation is achieved insubsequent periods by adding the two book values together.f. Consolidated expenses are determined by combining the parent's and subsidiaryamounts including any amortization expense associated with the acquisition-date fairvalue allocations. As discussed in Chapter Five, intra-entity expenses can alsorequire elimination in arriving at consolidated figures.g. Only the parent’s common stock outstanding is included in consolidated totals.h. The net income for a business combination is calculated as the difference betweenconsolidated revenues and consolidated expenses.3. Under the equity method, the parent accrues subsidiary earnings and amortizationexpense (associated with acquisition-date fair value allocations) in the same manner as in the consolidation process. The equity method parallels consolidation. Thus, the parent’s net income and retained earnings each year will equal the consolidated totals. 4. In the consolidation process, excess amortizations must be recognized annually for anyportion of the acquisition-date fair value allocations to specific assets or liabilities (other than indefinite-lived assets). Although this expense can be simulated in total on the parent's books by an equity method entry, the actual amortization of each allocated fair value adjustment is appropriate for consolidation. Hence, the effect of the parent's equity method amortization entry is removed as part of Entry I so that the amortization of specific accounts (e.g., depreciation) can be recognized (in consolidation Entry E).5. When a parent applies theinitial value method, no accrual is recorded to reflect thesubsidiary's change in book value subsequent to acquisition. Recognition of excess amortizations relating to the acquisition is also omitted by the parent. The partial equity method, in contrast, records the subsidiary’s book value increases and decreases but not amortizations. Consequently, for both of these methods, a technique must be employed in the consolidation process to recognize the omitted figures. Entry *C simply brings the parent's figures (more specifically, the beginning retained earnings balance and the investment account) up-to-date as of the first day of the current year. If the acquirer applies the initial value method, changes in the subsidiary's book value in previous years are recognized on the worksheet along with the appropriate amount of amortization expense. For the partial equity method, only the amortization relating to these prior years needs to be recognized.No similar entry to *C is needed whenthe parent applies the equity method. The parent will record changes in the subsidiary's book value as well as excess amortization each year. Thus, under the equity method, the parent's investment and beginning retained earnings balances are both correctly established and need no further adjustment.6. Lambert's loan payable and the receivable held by Jenkins are intra-entity accounts. Theconsolidation process offsets these reciprocal balances. The $100,000 is neither a debt to nor a receivable from an unrelated (or outside) party and is, therefore, not reported in consolidated financial statements. Any interest income/expense recognized on this loan is also intra-entity in nature and must likewise be eliminated.7. Because Benns applies the equity method, the $920,000 is composed of four balances:a. The original consideration transferred by the parent;b. Benns’ annual accruals to recognize subsidiary net income as it is earnedc. The reductions that are created by the subsidiary's declaration of dividendsd. The periodic amortization recognized by Benns in connection with the allocationsidentified with its acquisition-date fair value allocations.8. The $100,000 attributed to goodwill is reported at its original amount unless a portion ofgoodwill is impaired or a unit of the business where goodwill resides is sold.9. A parent should consider recognizing an impairment loss for goodwill associated withanacquired subsidiary when, at the reporting unit level, the fair value is less than its carrying amount. Goodwill is reduced when its carrying value is less than its fair value.To compute fair value for goodwill, its implied value is calculated by subtracting the fair values of the reporting unit’s identifiable net assets from its total fair value. The impairment is recognized as a loss from continuing operations.10. The acquisition-date fair value of the contingent payment is part of the considerationtransferred by Reimers to acquireRollins and thus is part of the overall fair value assigned to the acquisition. If the contingency is a liability (to be settled in cash or other assets) then the liability is adjusted to fair value through time. If the contingency is a component of equity (e.g., to be settled by the parent issuing equity shares), then the equity instrument is not adjusted to fair value over time.11. At present, the Securities and Exchange Commission requires the use of push-downaccounting for the separate financial statements of a subsidiary where no substantial outside ownership exists. Thus, if Company A owns all of Company B, the push-down method of accounting is appropriate for the separately issued statements of Company B.The SEC normally requires push-down accounting where 95 percent of a subsidiary is acquired and the company has no outstanding public debt or preferred stock.Push-down accounting may be required if 80-95 percent of the outstanding voting stock is acquired. Push-down accounting uses the consideration transferred as the valuation basis for the subsidiary in consolidated reports. For example, if a piece of land costs Company B $10,000 but Company A allocatesa $13,000 fair value to the land in acquiring Company B, the land has a basis to the current owners of B of $13,000. If B's financial records had been united with A at the time of the acquisition, the land would have been reported at $13,000. Thus, keeping the $10,000 figure simply because separate incorporation is maintained is viewed, by proponents of push-down accounting, as unjustified.12. When push-down accounting is applied, the subsidiary adjusts the book value of itsassets and liabilities based on the acquisition-date fair value allocations. The subsidiary then recognizes periodic amortization expense on those allocations with definite lives.Therefore, the subsidiary’s recorded income equals its impact on consolidated earnings.The parent uses no special procedures when push-down accounting is being applied.However, if the equity method is in use, amortization need not be recognized by the parent since that expense is included in the figure reported by the subsidiary.Answers to Problems1. A2. B3. A4. A Paar’s equipment book value—12/31/14 ............................ $294,000Kimmel’s equipment book value—12/31/14 ....................... 190,400 Original acquisition-date allocation to Kimmel's equipment($400,000 – $272,000) ........................................................... 128,000 Amortization of allocation($128,000 ÷ 10 years for 3 years) ................................... (38,400) Consolidated equipment ...................................................... $574,0005. A6. B7. D8. B9. B Phoenix revenues $498,000Phoenix expenses 350,000Net income before Sedona effect 148,000Equity income from Sedona 55,000Consolidated net income $203,000-or-Consolidated revenues $783,000Consolidated expenses (includes $35K amortization) 580,000Consolidated net income $203,00010. A (same as Phoenix because of equity method use).11. C Consideration transferred at fair value $600,000Book value acquired 420,000Excess fair over book value 180,000to equipment 80,000to customer list (4-year remaining life) $100,000Three years since acquisition, ¼ of acquisition-date value remains.12. B13. C14. D The $105,000 excess acquisition-date fair value allocation to equipment is"pushed-down" to the subsidiary and increases its balance to $441,500.The consolidated balance is $871,500($430,000 book value for Crawfordplus fair value for Nashville $441,500).15. (35 Minutes) (Determine consolidated retained earnings when parent usesvarious accounting methods. Determine Entry *C for each of these methods)a. CONSOLIDATED RETAINED EARNINGS--EQUITY METHODHerbert (parent) balance—1/1/14 ................................... $400,000Herbert income—2014 .................................................... 40,000Herbert dividends—2014 (subsidiary dividends areintra-entity and, thus, eliminated) ............................ (10,000) Rambis income—2014 (not included in parent's income) 20,000Amortization—2014 ......................................................... (12,000)Herbert income—2015 .................................................... 50,000Herbert dividends—2015 ................................................ (10,000)Rambis income—2015 .................................................... 30,000Amortization—2015 ......................................................... (12,000)Consolidated retained earnings, 12/31/15 ..................... $496,000 PARTIAL EQUITY METHOD AND INITIAL VALUE METHODConsolidated RE are the same regardless of the method in use: thebeginning balance plus the income less the dividends of the parent plusthe income of the subsidiary less amortization expense. Thus,December 31, 2015consolidated RE are $496,000 as computed above.b. Investment in Rambis—equity methodRambis fair value 1/1/14............................................................. $574,000Rambis income 2014 .................................................................. 20,000Rambis dividends 2014.............................................................. (5,000)Herbert’s 2014 excess fair over book value amortization ...... (12,000)$577,000Investment in Rambis—partial equity methodRambis fair value 1/1/14............................................................. $574,000Rambis income 2014 .................................................................. 20,000Rambis dividends 2014.............................................................. (5,000)$589,000Investment in Rambis—Initial value methodRambis fair value 1/1/14............................................................. $574,000$574,00015. (continued)c. ENTRY *C▪EQUITY METHODNo entry is needed to convert the past figures to the equity methodsince that method has already been applied.▪PARTIAL EQUITY METHODAmortization for the prior years (only 2014 in this case) has not beenrecorded and must be brought into the consolidation through worksheetentry *C:ENTRY *CRetained earnings, 1/1/15 (Parent) ..................... 12,000Investment in Rambis .................................... 12,000 (To recognize2014 amortization in consolidated figures. Expense wasomitted because of application of partial equity method.) ▪INITIAL VALUE METHODAmortization for the prior years (only 2014 in this case) has not beenrecorded and must be brought into the consolidation through worksheetentry *C. In addition, only dividend income has been recorded by theparent ($5,000 in 2014). In this prior year, Rambis reported net income of$20,000. Thus, the parent has not recorded the $15,000 income inexcess of dividends. That amount must also be included in theconsolidation through entry *C:ENTRY *CInvestment in Rambis ......................................... 3,000Retained earnings, 1/1/15(Parent) ................ 3,000 (To recognize2014unrecognized subsidiary earnings as part of theparent’s retained earnings. $15,000 net income of subsidiary was notrecorded by parent (income in excess of dividends). Amortizationexpense of $12,000 was not recorded under theinitial value method.Note that *C adjustments bring the parent’s January 1, 2015 RetainedEarnings balance equal to that of the equity method.16. (30 Minutes) (A variety of questions on equity method, initial value method,and partial equity method.)a. An allocation of the acquisition price (based on the fair value of theshares issued) must be made first.Acquisition fair value (consideration paid by Haynes) $135,000Book value equivalency ................................................. (100,000)Excess of Turner fair value over book value ............... $35,000Excess fair value assigned to specific Remaining Annual excessaccounts based on fair value life amortizations Equipment ........................... $5,000 5 yrs. $1,000Customer List ...................... 30,000 10 yrs. 3,000$4,000 Acquisition-date fair value ............................................. $135,0002014 Income accrual ...................................................... 110,0002014 Dividends declared by Turner .............................. (50,000)2014 Amortizations (above) ........................................... (4,000)2015 Income accrual ...................................................... 130,0002015 Dividends declared by Turner .............................. (40,000)2015 Amortizations ........................................................ (4,000)Investment in Turner account balance ......................... $277,000b. Net income of Haynes .................................................... $240,000Net Income of Turner ..................................................... 130,000Depreciation expense ..................................................... (1,000)Amortization expense ..................................................... (3,000) Consolidated net income 2015 ................................. $366,000c. Equipment balance Haynes ........................................... $500,000Equipment balance Turner ............................................ 300,000Allocation based on fair value (above) ......................... 5,000Depreciation for 2014-2015 ............................................. (2,000)Consolidated equipment—December 31, 2015 ............. $803,000Parent's choice of an investment method has no impact on consolidatedtotals.。