1 Reporting Business Combinations Operations are accounted for as separate entities throughout the year Parent Subsidiary Acquirer Acquired company Year-end Reporting Purposes Consolidated Entity This chapter is limited to wholly-owned subsidiaries. ©Cambridge Business Publishing, 2010
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 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 ©Cambridge Business Publishing, 2010 2
3 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’ ©Cambridge Business Publishing, 2010
4 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: Manufacturing Co. Finance Corp. Total assets $220, 000 $110, 000 Total liabilities Stockholders' equity Total liabilities and equity $115, 000 $100, 000 105, 000 10, 000 $220, 000 $110, 000 Entry to record statutory merger of Finance Corp. by Manufacturing Company: Total assets Total liabilities Cash ©Cambridge Business Publishing, 2010 110, 000, 000 10, 000
5 Financial Effects of Equity Method Suppose the equity method is used. Balance sheets before Manufacturing Company acquires stock of Finance Corporation: Manufacturing Co. Finance Corp. Total assets $220, 000 $110, 000 Total liabilities Stockholders' equity Total liabilities and equity $115, 000 $100, 000 105, 000 10, 000 $220, 000 $110, 000 Entry to record equity method acquisition of Finance Corporation: Investment in Finance Corp. Cash ©Cambridge Business Publishing, 2010 10, 000, 000
Comparing Consolidation and Equity Method Leverage Consolidated Balance Sheet of Manufacturing Company and Subsidiary Total assets $320, 000 Total liabilities Stockholders' equity Total liabilities and equity $215, 000 105, 000 $320, 000 Balance Sheet of Manufacturing Company using Equity Method Other assets $210, 000 Investment in Finance Corp. 10, 000 Total assets $220, 000 Total liabilities Stockholders' equity Total liabilities and equity ©Cambridge Business Publishing, 2010 $115, 000 105, 000 $220, 000 As a Consolidated Entity Total liabilities/ Total assets = 0. 67 Total liabilities/ Total equity = 2. 05 Using Equity Method Accounting Total liabilities/ Total assets = 0. 52 Total liabilities/ Total equity = 1. 10 6
7 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% Virtually all consolidated subsidiaries involving equity ownership have U. S. parents with majority ownership. ©Cambridge Business Publishing, 2010
8 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 ©Cambridge Business Publishing, 2010
9 Examples of SPEs Securitizations Leasing Joint Ventures ©Cambridge Business Publishing, 2010 Provide the opportunity to hide debt and losses from investors Usually not consolidated ARB 51 and SFAS 94 do not apply.
10 Securitizations Set up by a financial services company to buy loan or customer receivables from clients SPE uses the money to buy the receivables Allows clients to obtain immediate cash for receivables ©Cambridge Business Publishing, 2010 SPE issues debt securities backed by the receivables SPE uses the collection proceeds to pay principal and interest
11 Leasing § Created by a company to purchase longterm 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 Lease terms usually allow lessee to report the lease as an operating lease. ©Cambridge Business Publishing, 2010
12 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 ©Cambridge Business Publishing, 2010
13 Consolidation at Date of Acquisition When the companies remain as separate legal entities: Acquiring Company Reports investment as one line on its balance sheet Acquired Company Makes no entry; Stock is owned by new shareholders ©Cambridge Business Publishing, 2010
14 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 Substance over form ©Cambridge Business Publishing, 2010
15 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 Process occurs each time financial statements are prepared ©Cambridge Business Publishing, 2010
16 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 ©Cambridge Business Publishing, 2010
17 Consolidation Example Assume 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: Current assets Plant and equipment, net Patents and copyrights General Motors Automagic Parts, Inc. Book Value Fair Value Dr(Cr) $100, 000 $ 2, 000 $ 1, 800, 000 400, 000 50, 000 80, 000 10, 000 1, 000 3, 200, 000 Current liabilities Long-term debt Common stock, $1 par Additional paid-in capital Retained earnings (120, 000) (300, 000) (10, 000) (60, 000) (20, 000) (10, 000) (38, 000) (500, 000) (2, 500, 000) (10, 000) (40, 000) To record investment in the stock of Automagic Parts, Inc. : Investment in Automagic Parts Cash ©Cambridge Business Publishing, 2010 35, 000, 000
18 Consolidation Example continued Calculate goodwill: Acquisition cost $35, 000. Book value of Automagic (5, 000) Cost in excess of Automagic's book value 30, 000. Differences between fair value and book value : Current assets $ (200, 000) Plant and equipment, net 30, 000. Patents and copyrights 2, 200, 000. Long-term debt (2, 000) (30, 000) Goodwill $ 0. Because the acquisition cost is equal to the fair value of the identifiable net assets, there is no goodwill. ©Cambridge Business Publishing, 2010
19 Consolidation Example continued (E) Eliminate the subsidiary’s acquisition date equity balances: Common stock, $1 par Additional paid-in capital Retained earnings Investment in Automagic Parts 500, 000 2, 500, 000 5, 000 (R)Recognize acquisition date fair value revaluations: Plant and equipment, net Patents and copyrights Current assets Long-term debt Investment in Automagic Parts ©Cambridge Business Publishing, 2010 30, 000 2, 200, 000 2, 000 30, 000
20 Consolidation Working Paper for GM and Automagic Eliminating entries appear in the Eliminations column Current assets Plant and equipment, net Patents and copyrights Investment in Automagic Total assets Current liabilities Long-term debt Common stock, $1 par Additional paid-in capital Retained earnings Total liabilities and equity Exhibit 3. 3 Accounts from Books Eliminations GM Automagic Dr Cr $65, 000, 000 $200, 000 (R) 400, 000 50, 000 (R) $30, 000, 000 1, 000 (R) 2, 200, 000 35, 000, 000 (E) 30, 000 (R) $510, 000 $53, 000 $120, 000 $10, 000 300, 000 38, 000 2, 000 (R) 10, 000 500, 000 (E) 500, 000 60, 000 2, 000 (E) 2, 000 20, 000 2, 500, 000 (E) 2, 500, 000 $510, 000 $53, 000 $37, 200, 000 Elimination debits = Elimination credits ©Cambridge Business Publishing, 2010 Consolidated Balances $ 66, 800, 000 480, 000 13, 200, 000 $560, 000 $130, 000 340, 000 10, 000 60, 000 20, 000 $560, 000
Consolidation with Goodwill and Previously Unreported Intangibles Example IBM pays $25, 000 in cash to acquire Data. File, Inc. on July 1, 2010. Fair values of Data. File's assets and liabilities are as follows: Exhibit 3. 4 Data. File’s accounts: Current assets Plant and equipment Patents and copyrights Current liabilities Long-term debt Fair values of previously unreported intangible assets: Brand names Favorable lease agreements Assembled workforce In-process contracts with potential customers Contractual customer relationships ©Cambridge Business Publishing, 2010 Fair Value $2, 000 60, 000 5, 000 10, 000 40, 000 $1, 000 600, 000 5, 000 2, 000 3, 000 21
Consolidation with Goodwill and Previously Unreported Intangibles Example continued IBM and Data. File, Inc. ’s balance sheets immediately prior to acquisition on July 1, 2010: Current assets Plant and equipment, net Patents and copyrights Total assets Current liabilities Long-term debt Common stock, $0. 50 par Additional paid-in capital Retained earnings Total liabilities and equity ©Cambridge Business Publishing, 2010 IBM $ 40, 000 150, 000 3, 000 $193, 000 Data. File $ 2, 300, 000 50, 000 1, 000 $53, 300, 000 $ 15, 000 100, 000 2, 000 60, 000 16, 000 $193, 000 $10, 000 38, 000 500, 000 2, 800, 000 $53, 300, 000 Exhibit 3. 5 22
Consolidation with Goodwill and Previously Unreported Intangibles Example continued IBM’s entry to record the stock acquisition: Investment in Data. File Cash 25, 000, 000 Calculate goodwill: Acquisition cost $25, 000. Book value of Data. File (5, 300, 000) Cost in excess of Data. File's book value $19, 700, 000. Differences between fair value and book value: Current assets $ (300, 000) Plant and equipment, net 10, 000. Patents and copyrights 4, 000. Brand names 1, 000. Favorable lease agreements 600, 000. Contractual customer relationships 3, 000. Long-term debt (2, 000) 16, 300, 000. Goodwill $ 3, 400, 000. ©Cambridge Business Publishing, 2010 23
Consolidation with Goodwill and Previously Unreported Intangibles Example continued (E) Eliminate Data. File’s equity balances: Common stock, $0. 50 par Additional paid-in capital Retained earnings Investment in Data. File 500, 000 2, 800, 000 5, 300, 000 (R) Eliminate excess paid over book value and revalue Data. File’s assets and liabilities to fair value: Plant and equipment, net 10, 000 Patents and copyrights 4, 000 Brand names 1, 000 Favorable lease agreements 600, 000 Contractual customer relationships 3, 000 Goodwill 3, 400, 000 Current assets 300, 000 Long-term debt , 000 2 Investment in Data. File 19, 700, 000 ©Cambridge Business Publishing, 2010 24
25 Consolidation Working Paper Accounts Taken from Books IBM Data. File Exhibit 3. 6 Eliminations Dr Consolidated Balances Cr Current assets $15, 000 $2, 300, 000 $300, 000 (R) Plant and equipment, net 150, 000, 000 (R) $10, 000 Patents and copyrights 3, 000 1, 000 (R) 4, 000 Investment in Data. File 25, 000 5, 300, 000 (E) 19, 700, 000 (R) Brand names (R) 1, 000 Favorable lease agreements 600, 000 (R) Contractual customer relationships (R) 3, 000 Goodwill (R) 3, 400, 000 $193, 000 $53, 300, 000 Total assets Current liabilities $15, 000 $10, 000 Long-term debt 100, 000 38, 000 2, 000 (R) Common stock, $0. 50 par 2, 000 500, 000 (E) 500, 000 Additional paid-in capital 60, 000 2, 000 (E) 2, 000 Retained earnings 16, 000 2, 800, 000 (E) 2, 800, 000 Total liabilities and equity $193, 000 $53, 300, 000 $27, 300, 000 Consolidated balance sheet at date of acquisition ©Cambridge Business Publishing, 2010 $ 17, 000 210, 000 8, 000 1, 000 600, 000 3, 400, 000 $243, 000 $25, 000 140, 000 2, 000 60, 000 16, 000 $243, 000
26 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 ©Cambridge Business Publishing, 2010
Consolidation with Bargain Purchase Example Assume that IBM pays only $20 million in cash for all the stock of Data. File. Calculate gain: Acquisition cost Book value of Data. File Cost in excess of Data. File's book value Differences between fair value and book value Gain on acquisition $20, 000. (5, 300, 000) 14, 700, 000. 16, 300, 000. $1, 600, 000. IBM’s entry to record the stock acquisition: Investment in Data. File Gain on acquisition Cash ©Cambridge Business Publishing, 2010 21, 600, 000 20, 000 27
Consolidation with Bargain Purchase Example 28 continued Exhibit 3. 7 Accounts from Books Eliminations IBM Data. File Dr Cr Current assets $20, 000 $2, 300, 000 $ 300, 000 (R) Plant and equipment, net 150, 000, 000 (R) $10, 000 Patents and copyrights 3, 000 1, 000 (R) 4, 000 Investment in Data. File 21, 600, 000 5, 300, 000 (E) 16, 300, 000 (R) Brand names 1, 000 (R) Favorable lease agreements 600, 000 (R) Contractual customer relationships 3, 000 (R) Total assets $194, 600, 000 $53, 300, 000 Current liabilities $ 15, 000 $10, 000 Long-term debt 100, 000 38, 000 2, 000 (R) Common stock, $0. 50 par 2, 000 500, 000 (E) 500, 000 Additional paid-in capital 60, 000 2, 000 (E) 2, 000 Retained earnings 17, 600, 000 2, 800, 000 (E) 2, 800, 000 Total liabilities and equity $194, 600, 000 $53, 300, 000 $23, 900, 000 Gain becomes part of parent’s retained earnings ©Cambridge Business Publishing, 2010 Consolidated Balances $ 22, 000 210, 000 8, 000 1, 000 600, 000 3, 000 $244, 600, 000 $25, 000 140, 000 2, 000 60, 000 17, 600, 000 $244, 600, 000
29 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 ©Cambridge Business Publishing, 2010
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 ©Cambridge Business Publishing, 2010 30
Consolidating a Subsidiary Reporting Goodwill Assume General Motors acquires Powerdown, Inc. for $40 million. Powerdown’s balance sheet: Book Value Fair Value $50, 000 $80, 000 10, 000 9, 000 $60, 000 Various identifiable assets Goodwill Total assets Liabilities Stockholders' equity Total liabilities and equity $55, 000, 000 5, 000 $60, 000 Calculation of goodwill: Acquisition cost Book value of Powerdown Cost in excess of Powerdown's book value Differences between fair value and book value: Various identifiable assets Previously recorded goodwill Goodwill ©Cambridge Business Publishing, 2010 $40, 000. (5, 000) $35, 000. $30, 000. (10, 000) 20, 000. $15, 000. 31
32 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 ©Cambridge Business Publishing, 2010
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