©cambridge business publishing, 2010 reporting business combinations 1 operations are accounted for...

©Cambridge Business Publishing, 2010©Cambridge Business Publishing, 2010

Reporting Business Combinations1

Operations are accounted for as separate entities throughout the year

Parent Subsidiary

Consolidated Entity

Acquirer Acquired company

Year-end Reporting Purposes

This chapter is limited to wholly-owned subsidiaries.


Purpose of Consolidated Financial Statements

To present results of operations and the financial position of a parent and all its subsidiaries as if the consolidated group were a single economic entity

Primarily for the benefit of owners and creditors of the parent

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Presumption Consolidated financial statements are more meaningful than separate statements when one entity in

the consolidated group directly or indirectly has a controlling financial interest in the other entity

Presumption Consolidated financial statements are more meaningful than separate statements when one entity in

the consolidated group directly or indirectly has a controlling financial interest in the other entity


Concept of Control

Requires ownership of a majority voting interest, by one entity, directly or indirectly, of more than 50 percent of the outstanding voting shares of another entity

SFAS 94 requirements Consolidate majority-owned entities Except when

Control is temporary, or Control is not present

Nonhomogeneity exception eliminated to avoid ‘off-balance-sheet financing’

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Financial Effects of Consolidation Manufacturing Company plans to buy the stock of Finance Corporation for $10 million cash. Balance sheets before Manufacturing Company acquires stock of Finance Corporation:

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Manufacturing Co. Finance Corp.

Total assets $220,000,000 $110,000,000

Total liabilities $115,000,000 $100,000,000Stockholders' equity 105,000,000 10,000,000Total liabilities and equity $220,000,000 $110,000,000

Entry to record statutory merger of Finance Corp. by Manufacturing Company:

Total assets 110,000,000 Total liabilities 100,000,000 Cash 10,000,000


Financial Effects of Equity Method

Suppose the equity method is used. Balance sheets before Manufacturing Company acquires stock of Finance Corporation:

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Manufacturing Co. Finance Corp.

Total assets $220,000,000 $110,000,000

Total liabilities $115,000,000 $100,000,000Stockholders' equity 105,000,000 10,000,000Total liabilities and equity $220,000,000 $110,000,000

Entry to record equity method acquisition of Finance Corporation:

Investment in Finance Corp. 10,000,000 Cash 10,000,000


Comparing Consolidation and Equity Method Leverage

As a Consolidated Entity

Total liabilities/ Total assets = 0.67

Total liabilities/ Total equity = 2.05

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Consolidated Balance Sheet of Manufacturing Company and Subsidiary

Total assets $320,000,000

Total liabilities $215,000,000Stockholders' equity 105,000,000Total liabilities and equity $320,000,000

Balance Sheet of Manufacturing Company using Equity Method

Other assets $210,000,000Investment in Finance Corp. 10,000,000Total assets $220,000,000

Total liabilities $115,000,000Stockholders' equity 105,000,000Total liabilities and equity $220,000,000

Using Equity Method Accounting

Total liabilities/ Total assets = 0.52

Total liabilities/ Total equity = 1.10


Control and Consolidation

Control exists for Investments in over 50% of the voting stock of

another company Consolidation required unless unusual

circumstances prevent control Consolidation is allowed if investment is less

than 50%

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Virtually all consolidated subsidiaries involving equity ownership have U.S.

parents with majority ownership.


Special Purpose Entities (SPEs)

Legal structures formed for specific business activities

Control may be obtained Without paying consideration, or With little or no equity investment

Frequently have no separate management or employees

Often obtain financing from debt Have small outside equity interest that

obtains a secure return with little or no risk

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Examples of SPEs9

Provide the opportunity to hide

debt and losses from investors

Provide the opportunity to hide

debt and losses from investors

ARB 51 and SFAS 94 do not apply.

ARB 51 and SFAS 94 do not apply.


Securitizations

Set up by a financial services company to buy loan or customer receivables from clients

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Allows clients to obtain immediate cash for

receivables

SPE issues debt securities backed by the receivables

SPE uses the money to buy

the receivables

SPE uses the collection proceeds to pay principal

and interest


Leasing

Created by a company to purchase long-term assets

Funding for purchases obtained through loans

SPE leases assets to the company SPE uses lease payments to pay interest

and principal on the debt

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Lease terms usually allow lessee to report the lease as an operating lease.


Joint Ventures

Formed by two or more companies for specialized projects

Often requires large amounts of specialized skill and financing

Structure legally separates the projects’ risk from that of the sponsors Allows financing to be obtained at a lower

cost

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Consolidation at Date of Acquisition

When the companies remain as separate legal entities:

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Reports investment as one line on its balance sheet

Acquiring CompanyAcquiring Company

Makes no entry;Stock is owned by new shareholders

Acquired CompanyAcquired Company


Objectives of Consolidation

To report the affairs of a group of affiliated corporations as a single economic entity

Procedures designed to Remove the effects of reported transactions

and relationships between components of the reporting entity

Ensure that information reflects transactions with outside parties

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Consolidation Process

Assets and liabilities of the acquired company Revalued to fair value Combined with assets and liabilities of parent

Intercompany transactions and account balances are removed

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Process occurs each time financial statements are prepared

Process occurs each time financial statements are prepared


Consolidation Working Paper

Three elements Accounts of the parent company Accounts of the subsidiary company Eliminating entries to consolidate the accounts

Eliminate the investment account on the parent company’s books

Eliminate the stockholders’ equity accounts on the subsidiary’s books

Revalue subsidiary’s assets and liabilities from book value to fair value

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Consolidation ExampleAssume General Motors pays $35 million cash for all of the stock of Automagic Parts, Inc. on January 1, 2011. Balance sheets prior to acquisition are:

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General Motors Automagic Parts, Inc.Book Value

Dr(Cr)Book Value

Dr(Cr)Fair Value

Dr(Cr)Current assets $100,000,000 $ 2,000,000 $ 1,800,000Plant and equipment, net 400,000,000 50,000,000 80,000,000Patents and copyrights 10,000,000 1,000,000 3,200,000

Current liabilities (120,000,000) (10,000,000) (10,000,000)Long-term debt (300,000,000) (38,000,000) (40,000,000)Common stock, $1 par (10,000,000) (500,000) Additional paid-in capital (60,000,000) (2,000,000) Retained earnings (20,000,000) (2,500,000)

To record investment in the stock of Automagic Parts, Inc.:Investment in Automagic Parts 35,000,000 Cash 35,000,000


Consolidation Example continued

Calculate goodwill:

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Acquisition cost $35,000,000.Book value of Automagic (5,000,000)Cost in excess of Automagic's book value 30,000,000.Differences between fair value and book value : Current assets $ (200,000) Plant and equipment, net 30,000,000. Patents and copyrights 2,200,000. Long-term debt (2,000,000) (30,000,000)Goodwill $ 0.

Because the acquisition cost is equal to the fair value of the identifiable net assets, there is no goodwill.


Consolidation Example continued

(E) Eliminate the subsidiary’s acquisition date equity balances:

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Common stock, $1 par 500,000 Additional paid-in capital 2,000,000 Retained earnings 2,500,000 Investment in Automagic Parts 5,000,000

(R)Recognize acquisition date fair value revaluations: Plant and equipment, net 30,000,000 Patents and copyrights 2,200,000 Current assets 200,000 Long-term debt 2,000,000 Investment in Automagic Parts 30,000,000


Consolidation Working Paper for GM and Automagic

Accounts from Books EliminationsConsolidated

BalancesGM Automagic Dr Cr

Current assets $65,000,000 $2,000,000 $200,000 (R) $ 66,800,000 Plant and equipment, net 400,000,000 50,000,000 (R) $30,000,000 480,000,000 Patents and copyrights 10,000,000 1,000,000 (R) 2,200,000 13,200,000 Investment in Automagic 35,000,000 5,000,000 (E) 30,000,000 (R) Total assets $510,000,000 $53,000,000 $560,000,000 Current liabilities $120,000,000 $10,000,000 $130,000,000 Long-term debt 300,000,000 38,000,000 2,000,000 (R) 340,000,000 Common stock, $1 par 10,000,000 500,000 (E) 500,000 10,000,000 Additional paid-in capital 60,000,000 2,000,000 (E) 2,000,000 60,000,000 Retained earnings 20,000,000 2,500,000 (E) 2,500,000 20,000,000 Total liabilities and equity $510,000,000 $53,000,000 $37,200,000 $37,200,000 $560,000,000

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Eliminating entries appear in the Eliminations column

Elimination debits = Elimination credits

Exhibit 3.3


Consolidation with Goodwill and Previously Unreported Intangibles Example

IBM pays $25,000,000 in cash to acquire DataFile, Inc. on July 1, 2010. Fair values of DataFile's assets and liabilities are as follows:

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DataFile’s accounts: Fair ValueCurrent assets $2,000,000Plant and equipment 60,000,000 Patents and copyrights 5,000,000 Current liabilities 10,000,000 Long-term debt 40,000,000 Fair values of previously unreported intangible assets: Brand names $1,000,000 Favorable lease agreements 600,000 Assembled workforce 5,000,000 In-process contracts with potential customers 2,000,000 Contractual customer relationships 3,000,000

Exhibit 3.4


Consolidation with Goodwill and Previously Unreported Intangibles Example continued

IBM and DataFile, Inc.’s balance sheets immediately prior to acquisition on July 1, 2010:

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Exhibit 3.5IBM DataFileCurrent assets $ 40,000,000 $ 2,300,000Plant and equipment, net 150,000,000 50,000,000Patents and copyrights 3,000,000 1,000,000Total assets $193,000,000 $53,300,000 Current liabilities $ 15,000,000 $10,000,000Long-term debt 100,000,000 38,000,000Common stock, $0.50 par 2,000,000 500,000Additional paid-in capital 60,000,000 2,000,000Retained earnings 16,000,000 2,800,000Total liabilities and equity $193,000,000 $53,300,000



IBM’s entry to record the stock acquisition:

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Investment in DataFile 25,000,000 Cash 25,000,000

Calculate goodwill:Acquisition cost $25,000,000.Book value of DataFile (5,300,000)Cost in excess of DataFile's book value $19,700,000.Differences between fair value and book value:

Current assets $ (300,000) Plant and equipment, net 10,000,000. Patents and copyrights 4,000,000. Brand names 1,000,000. Favorable lease agreements 600,000. Contractual customer relationships 3,000,000. Long-term debt (2,000,000) 16,300,000.

Goodwill $ 3,400,000.



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(E) Eliminate DataFile’s equity balances: Common stock, $0.50 par 500,000 Additional paid-in capital 2,000,000 Retained earnings 2,800,000 Investment in DataFile 5,300,000

(R) Eliminate excess paid over book value and revalue DataFile’s assets and liabilities to fair value:

Plant and equipment, net 10,000,000 Patents and copyrights 4,000,000 Brand names 1,000,000 Favorable lease agreements 600,000 Contractual customer relationships 3,000,000 Goodwill 3,400,000 Current assets 300,000 Long-term debt 2,000,000 Investment in DataFile 19,700,000


Consolidation Working Paper 25

Consolidated balance sheet at date of acquisition

Accounts Taken from Books EliminationsConsolidated

BalancesIBM DataFile Dr Cr

Current assets $15,000,000 $2,300,000 $300,000 (R) $ 17,000,000 Plant and equipment, net 150,000,000 50,000,000 (R) $10,000,000 210,000,000 Patents and copyrights 3,000,000 1,000,000 (R) 4,000,000 8,000,000 Investment in DataFile 25,000,000 5,300,000 (E)

19,700,000 (R) Brand names (R) 1,000,000 1,000,000 Favorable lease agreements (R) 600,000 600,000 Contractual customer relationships (R) 3,000,000 3,000,000 Goodwill (R) 3,400,000 3,400,000 Total assets $193,000,000 $53,300,000 $243,000,000 Current liabilities $15,000,000 $10,000,000 $25,000,000 Long-term debt 100,000,000 38,000,000 2,000,000 (R) 140,000,000 Common stock, $0.50 par 2,000,000 500,000 (E) 500,000 2,000,000 Additional paid-in capital 60,000,000 2,000,000 (E) 2,000,000 60,000,000 Retained earnings 16,000,000 2,800,000 (E) 2,800,000 16,000,000 Total liabilities and equity $193,000,000 $53,300,000 $27,300,000 $27,300,000 $243,000,000

Exhibit 3.6


Consolidation with Bargain Purchase

Occurs when the fair values of the identifiable net assets of the acquired company total more than the acquisition price

Parent company reports the difference as a gain on acquisition

No goodwill reported in consolidation

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Consolidation with Bargain Purchase Example

Assume that IBM pays only $20 million in cash for all the stock of DataFile.

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IBM’s entry to record the stock acquisition:Investment in DataFile 21,600,000 Gain on acquisition 1,600,000 Cash 20,000,000

Calculate gain:Acquisition cost $20,000,000.Book value of DataFile (5,300,000)Cost in excess of DataFile's book value 14,700,000.Differences between fair value and book value 16,300,000. Gain on acquisition $1,600,000.


Consolidation with Bargain Purchase Example continued

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Exhibit 3.7

Gain becomes part of parent’s retained earnings

Accounts from Books EliminationsConsolidated

BalancesIBM DataFile Dr Cr

Current assets $20,000,000 $2,300,000 $ 300,000 (R) $ 22,000,000Plant and equipment, net 150,000,000 50,000,000 (R) $10,000,000 210,000,000 Patents and copyrights 3,000,000 1,000,000 (R) 4,000,000 8,000,000 Investment in DataFile 21,600,000 5,300,000 (E) 16,300,000 (R) Brand names (R) 1,000,000 1,000,000 Favorable lease agreements (R) 600,000 600,000 Contractual customer relationships (R) 3,000,000 3,000,000 Total assets $194,600,000 $53,300,000 $244,600,000 Current liabilities $ 15,000,000 $10,000,000 $25,000,000 Long-term debt 100,000,000 38,000,000 2,000,000 (R) 140,000,000 Common stock, $0.50 par 2,000,000 500,000 (E) 500,000 2,000,000 Additional paid-in capital 60,000,000 2,000,000 (E) 2,000,000 60,000,000 Retained earnings 17,600,000 2,800,000 (E) 2,800,000 17,600,000 Total liabilities and equity $194,600,000 $53,300,000 $23,900,000 $23,900,000 $244,600,000


Special Issue: Depreciable Assets Acquiring company reports acquired assets

at fair value Fair value at date of acquisition = original

cost to acquiring company for consolidation purposes

Original cost and related accumulated depreciation on books of subsidiary are not relevant to acquiring company

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Special Issue: Previously Reported Goodwill

May exist on subsidiary’s books if another company had previously been acquired by the subsidiary

Acquiring company assigns a zero value to goodwill acquired Not an identifiable asset

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Consolidating a Subsidiary Reporting Goodwill

Assume General Motors acquires Powerdown, Inc. for $40 million. Powerdown’s balance sheet:

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Book Value Fair ValueVarious identifiable assets $50,000,000 $80,000,000Goodwill 10,000,000 9,000,000Total assets $60,000,000

Liabilities $55,000,000 $55,000,000Stockholders' equity 5,000,000 Total liabilities and equity $60,000,000

Acquisition cost $40,000,000.Book value of Powerdown (5,000,000)Cost in excess of Powerdown's book value $35,000,000.Differences between fair value and book value: Various identifiable assets $30,000,000. Previously recorded goodwill (10,000,000) 20,000,000.Goodwill $15,000,000.

Calculation of goodwill:


IFRS for Consolidations Principles-based application of control

concept Conditions leading to consolidation

Control over more than half the voting rights Power to control major decisions due to statute

or agreement Power to appoint or remove the majority of

board members Power to cast the majority of votes at board

meetings Requires consideration of potential voting

rights

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©cambridge business publishing, 2010 reporting business combinations 1 operations are accounted for...

Documents

total liabilities total

total liabilities100

total assets110

subsidiary total assets

equity method leverage

cambridge business publishing

stock of finance corporation

consolidated group