advance accounting ch08

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Changes inChanges inOwnership InterestOwnership Interest

Advanced Accounting, Fifth Edition

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1. Identify the types of transactions that change the parent company’s ownership interest in a subsidiary.

2. Describe the process needed when the parent acquires subsidiary shares through multiple open market purchases.

3. Explain how the parent reports the difference between selling price and book value when shares are sold subsequent to acquisition.

4. Compute the controlling interest in income after the parent sells some shares of the subsidiary company.

5. Describe the effect on the eliminating process when the subsidiary issues new shares entirely to the parent, and the parent pays either more or less than the book value of the subsidiary shares.

6. Describe the impact on the parent’s investment account when the subsidiary issues new shares and either the new shares are purchased ratably by the parent and noncontrolling shareholders or entirely by the noncontrolling shareholders.

Learning ObjectivesLearning Objectives

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Changes in Ownership InterestChanges in Ownership Interest

LO 1 Changes in ownership and LO 1 Changes in ownership and differences between current and differences between current and proposed GAAP.proposed GAAP.

Parent company can increase its ownership interest in a subsidiary by either

1. buying additional subsidiary shares directly from third parties or

2. having a subsidiary purchase its (subsidiary’s) shares from third parties.

Parent company can decrease its ownership interest in a subsidiary by either

1. selling some subsidiary shares directly to third parties or 2. having a subsidiary sell additional shares (including

treasury shares) to third parties.

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Prior GAAP: Acquisitions of additional shares are handled in a step-by-step manner.

Sales of shares are handled the same as any sale of an asset.

The difference between the selling price and the basis of the shares sold is shown as a gain or loss in income.

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Current GAAP: Acquisitions that take place in stages or partial

sales:a. Measure and recognize acquiree’s identifiable assets

and liabilities at 100% of their fair values on date the acquirer obtains control, and

b. Recognize all acquiree’s goodwill (not just parent’s share), measured as difference between fair value of acquiree on acquisition date and fair value of identifiable net assets. (Continued

)

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Current GAAP: Acquisitions that take place in stages or partial

sales:c. Any previously held noncontrolling equity interests

should be remeasured to fair value, with resulting adjustment recognized in income.

d. After control is achieved, subsequent adjustments due to increased ownership are shown as Additional Contributed Capital, not as income.

e. If parent loses control, retained investment should be remeasured to fair value with adjustments recognized in net income.

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Parent Acquires Subsidiary Stock Parent Acquires Subsidiary Stock Through Several Open-Market PurchasesThrough Several Open-Market Purchases—Cost Method—Cost MethodCurrent GAAP FASB ASC paragraph 805-10-25-9:

Previously held noncontrolling equity interest should be remeasured to fair value when control is achieved, and the resulting adjustment should be recognized in net income. If a parent loses control but retains a noncontrolling interest, the portion retained should be remeasured to fair value on the date control is surrendered and the adjustment reflected in the income statement.

LO 2 Parent acquires subsidiary LO 2 Parent acquires subsidiary shares through multiple open market shares through multiple open market

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Several Open-Market Purchases—Cost Several Open-Market Purchases—Cost MethodMethodIllustration: S Company had 10,000 shares of $10 par value common stock outstanding during 2010–2013 and retained earnings as follows:

January 1, 2010 (1st stock purchase) $ 40,000January 1, 2012 (control achieved) 120,000January 1, 2013 185,000December 31, 2013 265,000

P Co. purchased S Co. common stock on the open market for cash:January 1, 2010 1,500 shares (15%) $ 24,000January 1, 2012 7,500 shares (75%) 187,500

Total 9,000 shares (90%) $211,500LO 2 Parent acquires subsidiary LO 2 Parent acquires subsidiary

shares through multiple open market shares through multiple open market

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Several Open-Market Purchases—Cost Several Open-Market Purchases—Cost MethodMethodThus on P’s books, the following entries are made:

Assumptions:1. Any difference between implied and book values of the purchases

relates solely to goodwill and is, therefore, not subject to amortization or depreciation but is reviewed periodically for impairment.

2. S Company distributes no dividends during the periods under consideration. Solution on

note pageLO 2 Parent acquires subsidiary LO 2 Parent acquires subsidiary

shares through multiple open market shares through multiple open market

January 1, 2010

January 1, 2012

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Several Open-Market Purchases—Cost Several Open-Market Purchases—Cost MethodMethodCalculation of IMPLIED Value of S Company:

Solution on note page

Payment by P Company for 75% interest 187,500$ Percent acquired 75%Implied value of S Company 250,000 Ownership interest 90%Implied value of 90% ownership interest 225,000$


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Several Open-Market Purchases—Cost Several Open-Market Purchases—Cost MethodMethodBecause P Company has owned a percentage of S Company (15%) since January 1, 2010, an entry is needed on P’s books to revalue the 1,500 shares purchased in 2010 to their fair value as of the date of control ( January 1, 2012).

Initial purchase price (1,500 shares at $16/share)

$24,000Change in retained earnings of S since acquisition 15%:

[.15 x ($120,000 - $40,000)]

12,000Carrying value (implied) of initial investment

$36,000

Thus the gain on revaluation of the initial shares is computed as:Implied value ($25/share 1,500)

$37,500Implied carrying value of initial shares

36,000Revaluation gain

$ 1,500


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The following entry is made on P company books.

Several Open-Market Purchases—Cost Several Open-Market Purchases—Cost MethodMethod

Investment in S Company 1,500Gain on revaluation

1,500A workpaper entry is needed on December 31, 2012, to convert to equity (establish reciprocity) from 2010 to the beginning of 2012.

Investment in S Company 12,0001/1 Retained Earnings—P Company

12,000[.15 x ($120,000 - $40,000) change in retained

earnings from 1/1/10 to 1/1/12]LO 2 Parent acquires subsidiary LO 2 Parent acquires subsidiary shares through multiple open market shares through multiple open market

purchasespurchases

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On the workpaper, the investment is eliminated by the following entry:


Common Stock—S Company 100,0001/1 Retained Earnings—S Company 120,000Difference between Implied and Book Value 30,000

Investment in S Company ($187,500 + $37,500) 225,000

Noncontrolling Interest in Equity 25,000LO 2 Parent acquires subsidiary LO 2 Parent acquires subsidiary

shares through multiple open market shares through multiple open market purchasespurchases

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Comparison to IFRS

IFRS 3, Business Combinations, provides the guidance for step acquisitions under international standards. Under IFRS 3, all previous ownership interests are adjusted to fair value, with any gain or loss recorded in earnings. This is similar to the rules issued by the FASB.



purchasespurchases

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Control Maintained

Sell Investment on Open-Market—Cost Sell Investment on Open-Market—Cost MethodMethod

Under FASB ASC paragraphs 810–10–45–22 and 24 the treatment of the sale of a portion of its investment by a parent company depends on whether or not the sale results in the loss of effective control of the subsidiary.

If control is maintained, no gain or loss is recognized in the income statement.

If control is lost, the entire interest is adjusted to fair value, and a gain or loss recorded in income on all shares owned prior to sale.

LO 3 Shares sold subsequent to LO 3 Shares sold subsequent to acquisition acquisition

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Illustration: P Company owns 9,000 shares of S Company that were revalued to $25 a share on the date of acquisition, or $225,000. Assume that P Company sold 1,800 shares of the 9,000 shares of S Company stock on July 1, 2013, for $84,600 ($47/share). The cost of the 1,800 shares sold equals $45,000 (or 20% of $225,000). After the sale, P Company retains control with a 72% ((9,000 x 80%)/10,000) interest. It should be noted that the 1,800 shares sold represent 18% of total S Company shares.


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Illustration: To record the sale of the shares, P Company makes the following entry in its books on July 1, 2013.Cash 84,600

Investment in S Company (20% x $225,000) 45,000

Additional Contributed Capital—P Company 39,600

After this entry, the balance in the investment in S Company account on P Company books will be $168,000 (or $24,000 $187,500 $1,500 $45,000).


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From a consolidated standpoint, the cost of the shares sold ($45,000) needs to be adjusted for 18% of the undistributed earnings since the date of acquisition.


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The correct consolidated amount of additional contributed capital on is:

An adjustment is needed on the workpapers to reduce additional contributed capital:


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Equity Method—Purchase and Sale of Equity Method—Purchase and Sale of StockStock

When more than one purchase is made before control is obtained, the acquisition date is defined as the date at which control is achieved.

To illustrate the procedures followed for open-market purchases and sales of subsidiary stock under the equity method, the previous cost method example will be used.


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Illustration: S Company had 10,000 shares of $10 par value common stock outstanding during 2010–2013 and retained earnings as follows:

January 1, 2010 (1st stock purchase) $ 40,000January 1, 2012 (control achieved) 120,000January 1, 2013 185,000December 31, 2013 265,000

P Co. purchased S Co. common stock on the open market for cash:January 1, 2010 1,500 shares (15%) $ 24,000January 1, 2012 7,500 shares (75%) 187,500

Total 9,000 shares (90%) $211,500



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Assumptions:1. Any difference between implied and book value of net assets

acquired relates to goodwill.

2. S Company distributed no dividends during the periods under consideration. Since no dividends were declared, the change in retained earnings represents the net income for that year.

3. P Company sold 1,800 shares of S Company stock on July 1, 2013, for $84,600.



P Company’s Books:1/1/10 1/1/12

Investment in S 24,000 Investment in S 187,500 Cash 24,000 Cash 187,500

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Since P Company now has a 90% interest in S Company and intends to apply the equity method, the investment account must be restated to recognize P Company’s share (15%) of the increase in S Company’s retained earnings from January 1, 2010, to January 1, 2012.


Investment in S Company 12,0001/1 Retained Earnings—P Company 12,000

[.15 x ($120,000 x $40,000) or the change in retained earnings from 1/1/10 to 1/1/12].


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To adjust the investment to fair value as of the date of acquisition, the gain on revaluation of the initial shares is computed as:


P Company’s BooksInvestment in S Company 1,500

Gain on revaluation 1,500


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P Company will recognize its share of S Company income for 2012 as follows:


Investment in S Company 58,500Equity in Subsidiary Income 58,500

[90% x ($185,000 - $120,000)]


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Assuming P Company received a six month interim income statement from S Company reporting $40,000 of net income, the following entry will be made by P Company on June 30, 2013.



(90% x $40,000)

1/1/10 Purchase (15%) $ 24,0001/1/12 Adjustment of 15% to fair value 1,5001/1/12 Purchase (75%) 187,5001/1/12 Adjustment 12,00012/31/12 Subsidiary Income 58,5006/30/13 Subsidiary Income 36,000Balance $319,500

Investment in S

Company

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To record the sale of the S Company shares on July 1, 2013, P Company will make the following entry (recall that P Company is selling 20% of its shares):


Cash 84,600Investment in S Company* 63,900Additional contributed capital 20,700

* $63,900 = 20% of $319,500, the carrying value of the investment.


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After the sale of the 1,800 shares, P Company holds a 72% interest in S Company. For the second six months of 2013 (and for subsequent periods), P Company will recognize 72% of the reported income and dividends received from S Company. The December 31, 2013, book entry by P Company is:



($40,000 X 72%)


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Loss of Control


Under FASB ASC paragraphs 810–10–45–22 and 24 the treatment of the sale of a portion of its investment by a parent company depends on whether or not the sale results in the loss of effective control of the subsidiary.

If control is maintained, no gain or loss is recognized in the income statement.

If control is lost, the entire interest is adjusted to fair value, and a gain or loss recorded in income on all shares owned prior to sale.

LO 4 Controlling interest in incomeLO 4 Controlling interest in income

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The parent accounts for the deconsolidation by recognizing a gain or loss in net income attributable to the parent, measured as the difference between:

1. The carrying value of S Company2. The sum of the following:

a. The fair value of the consideration receivedb. The fair value of the retained noncontrolling

interest (at the date of deconsolidation)c. The carrying value of the former noncontrolling

interest (at the date of deconsolidation). This amount also includes any accumulated other comprehensive income attributable to the noncontrolling interest.


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Illustration: Suppose P Company owns 9,000 shares of S Company (90% of S Company) that were acquired at $25 a share (or $225,000) on January 1, 2012. During 2012, S Company reported $60,000 of income and did not pay any dividends.

Investment (9,000 x $25) 225,000Cash 225,000



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On January 1, 2013, P Company sold two-thirds of its investment (6,000 shares) of S Company stock, for $180,000 ($30/share). After the sale, P Company has lost control and now only maintains a 30% ((9,000 - 6,000)/10,000) interest. The carrying value of S company, on January 1, 2013, is computed as follows:


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The gain or loss in net income attributable to P Company is computed as follows:



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To record the sale of the shares, P Company makes the following entry in its books on January 1, 2013.



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Because P Company now holds a 30% (not controlling) interest in S Company, the investment must be carried on the books using the equity method.

Thus the investment account must be adjusted for previous earnings of S Company (i.e., the reciprocity entry usually made on the consolidated workpaper).


Investment in S Company (60,000 x .90) 54,0001/1 Retained Earnings-P Company

54,000


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The newly issued shares may be purchased 1. entirely by the parent company,

2. partly by the parent company and partly by the noncontrolling stockholders, or

3. entirely by the noncontrolling stockholders.

Subsidiary Issues StockSubsidiary Issues Stock

LO 5 Subsidiary issues new shares LO 5 Subsidiary issues new shares entirely to parententirely to parent

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New Shares Issued above Existing Carrying Value per Share


Illustration: P Company purchased 14,000 shares (70%) of S Company’s $10 par value common stock on January 1, 2006, for $210,000, which included a $20,000 excess of implied over book value; the excess cost was assigned to land. S Company’s retained earnings on January 1, 2006, were $50,000.


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On January 1, 2014, P Company purchased 4,000 additional shares of S Company stock directly from S Company at its current market price of $22 per share ($88,000). This price is greater than the existing book value per share of S Company. Noncontrolling stockholders elected not to participate in the new issue. S Company’s stockholders equity on January 1, 2014, was:

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If a workpaper were prepared immediately after the purchase of the new shares, the workpaper entries to establish reciprocity (convert to equity) and eliminate the investment account would be:

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New Shares Issued at or below the Existing Carrying Value per Share


Illustration: The shares are issued at their book value of $17.50 per share (or $70,000), the computation is as follows:


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Although the noncontrolling stockholders’ percentage of ownership decreases from 30% to 25%, their share of the net assets of S Company decreased only by the land value transferred, as shown here:


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Assume the new shares were issued at $14 per share (or $56,000). The excess of book value over cost is computed as follows:

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Journal entry by P Company to record the purchase of the new shares is:


P Company’s BooksInvestment in S company 56,000 Cash 56,000

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Workpaper entries:


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New Shares Purchased Ratably by Parent and Noncontrolling Stockholders

If the noncontrolling stockholders had elected to exercise their rights, the percentage of stock owned by the parent and noncontrolling stockholders after the new issue would be the same as their respective interests prior to the new issue.

LO 6 Noncontrolling shareholders LO 6 Noncontrolling shareholders acquire new shares issued by acquire new shares issued by

subsidiarysubsidiary

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New Shares Purchased Entirely by Noncontrolling Stockholders

As long as the number of new shares issued is not so large that it reduces the parent’s percentage of ownership below that needed for control, new financing can be made available and control retained.

Issuance of new shares to noncontrolling stockholders reduces the parent’s percentage of ownership.

Economic substance of the transaction is a sale of interest by P Company.

LO 6 Noncontrolling shareholders LO 6 Noncontrolling shareholders acquire new shares issued by acquire new shares issued by

subsidiarysubsidiary

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advance accounting ch08

Economy & Finance