CHAPTER 6VARIABLE INTEREST ENTITIES, INTERCOMPANY DEBT

AND OTHER CONSOLIDATION ISSUES

Chapter Outline

I. Variable interest entities (VIEs)

A. VIEs typically take the form of a trust, partnership, joint venture, or corporation. In most cases a sponsoring firm creates these entities to engage in a limited and well-defined set of business activities. For example, a business may create a VIE to finance the acquisition of a large asset. The VIE purchases the asset using debt and equity financing, and then leases the asset back to the sponsoring firm. If their activities are strictly limited and the asset is pledged as collateral, VIEs are often viewed by lenders as less risky than their sponsoring firms. As a result, such arrangements can allow financing at lower interest rates than would otherwise be available to the sponsor.

B. Control of VIEs, by design, often does not rest with its equity holders. Instead, control is exercised through contractual arrangements with the sponsoring firm who becomes the "primary beneficiary" of the entity. These contracts can take the form of leases, participation rights, guarantees, or other residual interests. Through contracting, the primary beneficiary bears a majority of the risks and receives a majority of the rewards of the entity, often without owning any voting shares.

C. An entity whose control rests a primary beneficiary is referred to by FASB Interpretation 46R "Consolidation of Variable Interest Entities," (FIN 46R) as a variable interest entity. The following characteristics indicate a controlling financial interest in a variable interest entity.

1. The direct or indirect ability to make decisions about the entity's activities

2. The obligation to absorb the expected losses of the entity if they occur,

or

3. The right to receive the expected residual returns of the entity if they occur

The primary beneficiary bears the risks and receives the rewards of a variable interest entity and is considered to have a controlling financial interest.

D. FIN 46R reasons that if a "business enterprise has a controlling financial interest in a variable interest entity, assets, liabilities, and results of the activities of the variable interest entity should be included with those of the business enterprise." Therefore, primary beneficiaries must include their variable interest entities in their consolidated financial statements consistent with the provisions of SFAS 141R.

II. Intercompany debt transactions

A. No real consolidation problem is created when one member of a business combination loans money to another. The resulting receivable/payable accounts as well as the interest income expense balances are identical and can be directly offset in the consolidation process.

B. The acquisition of an affiliate's debt instrument from an outside party does require special handling so that consolidated financial statements can be produced.

1. Because the acquisition price will usually differ from the book value of the liability, a gain or loss has been created which is not recorded within the individual records of either company.

2. Because of the amortization of any associated discounts and/or premiums, the interest income being reported by the buyer will not correspond with the interest expense of the debtor.

C. In the year of acquisition, all intercompany accounts (the liability, the receivable, interest income, and interest expense) are eliminated within the consolidation process while the gain or loss (which produced all of the discrepancies because of the initial difference) is recognized.

1. Although several alternatives exist, this textbook assigns all income effects resulting from the retirement to the parent company, the party ultimately responsible for the decision to reacquire the debt.

2. Any noncontrolling interest is, therefore, not affected by the adjustments utilized to consolidate intercompany debt.

D. Even after the year of retirement, all intercompany accounts must be eliminated again in each subsequent consolidation; however, the beginning retained earnings of the parent company is adjusted rather than a gain or loss account.

1. The change in retained earnings is needed because a gain or loss was created in a prior year by the retirement of the debt, but only interest income and interest expense were recognized by the two parties.

2. The amount of the change made to retained earnings at any point in time is the original gain or loss adjusted for the subsequent amortization of discounts or premiums.

III. Subsidiary preferred stock

A. Subsidiary preferred shares not owned by the parent are a component of the noncontrolling interest.

B. In an acquisition, the fair value of any subsidiary preferred shares not acquired by the parent is added to any consideration transferred along with the fair value of the noncontrolling interest in common shares to compute the acquisition-date fair value of the subsidiary.

IV. Consolidated statement of cash flows

A. Statement is produced from consolidated balance sheet and income statement and not from the separate cash flow statements of the component companies.

B. Intercompany cash transfers are omitted from this statement because they do not occur with an outside, unrelated party.

C. The "Noncontrolling Interest's Share of the Subsidiary's Income'' is not included as a cash flow although any dividends paid to these outside owners is reported as a financing activity.

V. Consolidated earnings per shareA. This computation normally follows the pattern described in intermediate accounting textbooks.

For basic EPS, consolidated net income is divided by the weightedaverage number of parent shares outstanding. If convertibles (such as bonds or warrants) exist for the

parent shares, their weight must be included in computing diluted EPS but only if earnings per share is reduced.

1. The subsidiary's diluted earnings per share are computed first to arrive at (1) an earnings figure and (2) a shares figure.

2. The portion of the shares figure belonging to the parent is computed. That percentage of the subsidiary's diluted earnings is then added to the parent's income in order to complete the earnings per share computation.

VI. Subsidiary stock transactions

A. If the subsidiary issues new shares of stock or reacquires its own shares as treasury stock, a change is created in the book value underlying the parent's investment account. The increase or decrease should be reflected by the parent as an adjustment to this balance.

B. The book value of the subsidiary that corresponds to the parent's ownership is measured before and after the transaction with any alteration recorded directly to the investment account. The parent's additional paidin capital (or retained earnings) account is normally adjusted although the recognition of a gain or loss is an alternate accounting treatment.

C. Treasury stock acquired by the subsidiary may also necessitate a similar adjustment to the parent's investment account. In addition, any subsidiary treasury stock is eliminated within the consolidation process.

Learning Objectives

Having completed Chapter 6, students should have fulfilled each of the following learning objectives:

1. Describe a variable interest entity and primary beneficiary. Also should know when a variable interest entity is subject to consolidation.

2. Eliminate all intercompany debt accounts and recognize any associated gain or loss created whenever one company acquires an affiliate's debt instrument from an outside party.

3. Recognize that intercompany debt transactions require a constantly changing consolidation entry to be prepared for each subsequent period until the debt is formally retired.

4. Compute the appropriate amounts and make the worksheet entry needed in each subsequent consolidation when one company has purchased the debt of an affiliate directly from an outside parry.

5. Discuss the various theories as to the appropriate allocation of any income effect created by intercompany debt transactions and identify the assignment employed in this textbook (and the rationale for its use).

6. Understand that subsidiary preferred stocks not owned by the parent are initially valued in consolidated financial reports as noncontrolling interest at acquisition-date fair value.

7. Prepare a consolidated statement of cash flows.

8. Compute basic and diluted earnings per share for a business combination in which the subsidiary has dilutive convertible securities.

9. Identify subsidiary stock transactions that can impact the underlying book value figure recorded within the parent's Investment account.

10. Calculate the effect that a subsidiary stock transaction has on the parent's investment balance and make the required journal entry to record that impact.

Answer to Discussion Question

Who Lost the $300,000?

This case is designed to give life to a theoretical accounting issue discussed within the chapter: If a subsidiary's debt is retired, should the resulting gain or loss be assigned to the parent or to the subsidiary? The case attempts to illustrate that no clearcut solution to this question can be found. This lack of an absolute answer makes financial accounting both intriguing and frustrating. Interesting class discussion can be generated from this issue.

Students should note that the decision as to assignment only becomes necessary because of the presence of the noncontrolling interest. Regardless of the level of ownership all intercompany balances are simply eliminated on the worksheet with the gain or loss being recognized. Not until the time that the noncontrolling interest computations are made does the identity of the specific party become important.

All financial and operating decisions are assumed to be made in the best interest of the business entity as a whole. This debt would not have been retired unless corporate officials believed that Penston/Swansan would benefit from the decision. Thus, a strong argument can be made against any assignment to either separate party.

Students should be required to pick one method and justify its use. Discussion usually centers on the following issues:

Parent company officials made the actual choice that created the loss. Therefore, assigning the $300,000 to the subsidiary directs the impact of their reasoned decision to the wrong party. In effect, the subsidiary had nothing to do with this transaction (as indicated in the case) so that its financial records should not be affected by the $300,000 loss.

The debt was that of the subsidiary. Because the subsidiary's debt is being retired, all of the $300,000 should be attributed to that party. Financial records measure the results of transactions and the retirement simply culminates an earlier transaction made by the subsidiary. The parent is doing no more than acting as an agent for the subsidiary (as indicated in the case). If the subsidiary had acquired its own debt, for example, no question as to the assignment would have existed. Thus, changing that assignment simply because the parent was forced to be the acquirer is not justified.

Both parties were involved in the transaction so that some allocation of the loss is required. If, at the time of repurchase, a discount existed within the subsidiary's accounts, this figure would have been amortized to interest expense (if the debt had not been retired). Thus, the $300,000 loss was accepted now in place of the later amortization. This reasoning then assigns this portion of the loss to the subsidiary. Because the parent was forced to pay more than face value, that remaining portion is assigned to the buyer.

Answers to Questions

1. A variable interest entity (VIE) is a business structure that is designed to accomplish a specific purpose. A VIE can take the form of a trust, partnership, joint venture, or corporation although typically it has neither independent management nor

employees. The entity is frequently sponsored by another firm to achieve favorable financing rates.

2. Variable interests are contractual, ownership, or other pecuniary interests in an entity that change with changes in the entity's net asset value. Variable interests will absorb portions of a variable interest entity's expected losses if they occur or receive portions of the entity's expected residual returns if they occur. Variable interests typically are accompanied by contractual arrangements that provide decision making power to the owner of the variable interests. Examples of variable interests include debt guarantees, lease residual value guarantees, participation rights, and other financial interests.

3. The following characteristics are indicative of an enterprise qualifying as a primary beneficiary with a controlling financial interest in a VIE.

The direct or indirect ability to make decisions about the entity's activities

The obligation to absorb the expected losses of the entity if they occur, or

The right to receive the expected residual returns of the entity if they occur

4. Because the bonds were purchased from an outside party, the acquisition price is likely to differ from the book value of the debt as found on the subsidiary's records. This difference creates accounting problems in handling the intercompany transaction. From a consolidated perspective, the debt has been retired; a gain or loss should be reported with no further interest being recorded. In reality, each company will continue to maintain these bonds on their individual financial records. Also, because discounts and/or premiums are likely to be present, both of these account balances as well as the interest income/expense will change from period to period because of amortization. For reporting purposes, all individual accounts must be eliminated with the gain or loss being reported so that the events are shown from the vantage point of the consolidated entity.

5. If the bonds are acquired directly from the affiliate company, all reciprocal accounts will be equal in amount. The debt and the receivable will be in agreement so that no gain or loss is created. Interest income and interest expense should also reflect identical amounts. Therefore, the consolidation process for this type of intercompany debt requires no more than the offsetting of the various reciprocal balances.

6. The gain or loss to be reported is the difference between the price paid and the book value of the debt on the date of acquisition. For consolidation purposes, this gain or loss should be recognized immediately on the date of acquisition.

7. Because the bonds are still legally outstanding, they will continue to be found on both sets of financial records. Thus, each account (Bonds Payable, Investment in Bonds, Interest Expense, and Interest Income) must be eliminated within the consolidation process. Any gain or loss on the retirement as well as later effects on interest caused by amortization are also included to arrive at an adjustment to the beginning retained earnings of the parent company.

8. The original gain is never recognized within the financial records of either company. Thus, within the consolidation process for the year of acquisition, the gain is directly recorded whereas (for each subsequent year) it is entered as an adjustment to beginning retained earnings. In addition, because the book value of the debt and the investment are not in agreement, the interest expense and interest income balances being recorded by the two

companies will differ each year because of the amortization process. This amortization effectively reduces the difference between the individual retained earnings balances and the total that is appropriate for the consolidated entity. Consequently, a smaller change is needed each period to arrive at the balance to be reported. For this reason, the annual adjustment to beginning retained earnings gradually decreases over the life of the bond.

9. No set rule exists for assigning the income effects that result from intercompany debt transactions although several different theories have been put forth over the years which include: (1) assignment of the entire amount to the debtor, (2) assignment of the entire amount to the buyer, and (3) allocation of the gain or loss between the two parties in some manner. This textbook attributes the entire income effect (the $45,000 gain in this case) to the parent company. Assignment to the parent is justified because that party is ultimately responsible for the decision being made to retire the debt. The answer to the discussion question included in this chapter analyzes this question in more detail.

10. Subsidiary outstanding preferred shares are part of the noncontrolling interest and are included in the consolidated financial statements at acquisition-date fair value and subsequently adjusted for their share of subsidiary income and dividends.

11. The consolidated statement of cash flows is developed from the information found in the consolidated balance sheet and income statement. Thus, the cash flows generated by operating, investing, and financing activities are identified only after the consolidation of these other statements.

12. The noncontrolling interest share of the subsidiary’s income is a component of consolidated net income. Consolidated net income then is adjusted for noncash and other items to arrive at consolidated cash flows from operations. Any dividends paid by the subsidiary to these outside owners are listed as a financing activity of the business combination because an actual cash outflow is created.

13. An alternative to the normal diluted earnings per share calculation is required whenever the subsidiary has dilutive convertible securities such as bonds or warrants. In this case, the potential impact of the conversion of subsidiary shares must be factored into the overall diluted earnings per share computation.

14. Basic Earnings per Share. The existence of subsidiary convertible securities does not affect consolidated basic EPS. Consolidated basic earnings per share is computed by dividing consolidated net income by the weighted average number of parent shares outstanding.

Diluted Earnings per Share. The subsidiary's diluted earnings per share is computed by including both convertible items. The portion of the parent's controlled shares to the total shares used in this calculation is then determined. Only this percentage (of the income figure used in the subsidiary's computation) is added to the parent's income in arriving at the diluted earnings per share for the business combination.

15. Several reasons could exist for a subsidiary to issue new shares of stock to outside parties. Clearly, additional financing is brought into the company by any such sale. Also, stock issuance may be used to entice new individuals to join the organization. Additional management personnel, as an example, might be attracted to the company in this manner. The company could also be forced to sell shares because of government regulation. Many countries require some degree of local ownership as a prerequisite for operating within that country.

16. Because the new stock was issued at a price above book value, the book value per share of Metcalf's stock has been increased. Consequently, the book value of Washburn's investment should be increased to reflect this change. To measure the effect, the underlying book value of Washburn's investment is calculated both before and after the new issuance. Because the increment is the result of a stock transaction, an increase is made to additional paidin capital although recording a gain or loss is currently allowed. Although the subsidiary's shares (both new and old) are eliminated in the consolidation process, the increase in the parent's APIC (or gain or loss) does carry into the consolidated figures. In addition, the percentage of the subsidiary attributed to the noncontrolling interest will have increased.

17. A stock dividend does not alter the book value of the subsidiary company and, thus, creates no effect on Washburn's investment account or on the consolidated figures. Hence, no entry is recorded at all by the parent company in connection with the subsidiary's stock dividend.

Answers to Problems

1. D

2. C

3. A

4. D

5. A

6. D Cash Flow from Operations:Net income................................................................... $45,000 Depreciation................................................................. 10,000 Trademark amortization.............................................. 15,000 Increase in accounts receivable................................ (17,000)Increase in inventory.................................................. (40,000)Increase in accounts payable.................................... 12,000 (20,000)Cash Flow from Operations....................................... $25,000

7. C Cash Flow from Financing Activities:Dividends to parent’s interest.................................... ($12,000)Dividends to noncontrolling interest (20% × $5,000) (1,000) Reduction in long-term notes payable...................... (25,000)Cash Flow from Financing Activities........................ ($38,000)

8. C

9. C

10.C Rodgers' Reported Balance....................................... $200,000

Ferdinal's reported balance ...................................... 80,000Eliminate interest expense—intercompany ............ 21,000Eliminate interest income—intercompany .............. (22,000)Recognize gain on retirement of debt ($212,000 – $199,000) 13,000

Consolidated net income ..................................... $292,000

11. B Eliminate interest expense—intercompany ............ $21,000Eliminate interest income—intercompany .............. (18,000)Recognize loss on retirement of debt ($206,000 – $189,000) (17,000)

Reduction in retained earnings, 1/1/10 ............... $(14,000)

12.B Ace reported income .................................................. $400,000Remove intercompany dividends (cost method)..... (7,000) $393,000Byrd reported income ................................................ 100,000Gain on extinguishment of debt ($48,300 – $46,600) 1,700Eliminate interest expense on "retired" debt

($48,300 x 10%) ..................................................... 4,830Eliminate interest income on "retired" debt

($46,600 x 12%) ..................................................... (5,592)Consolidated net income ................................ $493,938

13.D 30% of Byrd's reported income of $100,000; the intercompany debt transaction is attributed solely to the parent company.

14.A For 2010, the adjustment to beginning retained earnings should recognize the gain on the retirement of the debt, the elimination of the 2009 interest expense, and the elimination of the 2009 interest income.

Gain on Retirement of Bond

Original book value ............................................................... $10,600,0002006–2008 amortization ($600,000 ÷ 20 yrs. x 3 yrs.) ........ (90,000 )Book value, January 1, 2009 ................................................ $10,510,000Percentage of bonds retired ...................................... 40%Book value of retired bonds ................................................. $4,204,000Cash received ($4,000,000 x 96.6%) .................................... 3,864,000Gain on retirement of bonds ...................................... $340,000

Interest Expense on Intercompany Debt—2009Cash interest expense (9% x $4,000,000) ........................... $360,000Premium amortization ($30,000 per year total x 40%

retired portion of bonds) ................................................. (12,000)Interest expense on intercompany debt ............................. $348,000

Interest Income on Intercompany Debt—2009Cash interest income (9% x $4,000,000) ............................. $360,000Discount amortization ($136,000 ÷ 17 yrs.) ........................ 8,000

Interest income on intercompany debt ............................... $368,000

Adjustment to 1/1/10 Retained EarningsRecognition of 2009 gain on extinguishment of debt (above)..... $340,000Elimination of 2009 intercompany interest expense (above)....... 348,000Elimination of 2009 intercompany interest income (above)......... (368,000)

Increase in retained earnings, 1/1/10.........................$320,000

15.D Consideration transferred for preferred stock .............................. $424,000Consideration transferred for common stock .............................. 3,960,000Noncontrolling interest fair value for preferred ........................... 1,696,000Noncontrolling interest fair value for common ............................. 400,000Acquisition-date fair value .............................................................. 6,480,000Acquisition-date book value ........................................................... (6,000,000)Goodwill ............................................................................................ $480,000

16.C Consideration transferred for preferred stock .............................. $106,000

Consideration transferred for common stock .............................. 916,400Noncontrolling interest fair value for common ............................. 580,000Acquisition-date fair value .............................................................. $1,602,400Acquisition-date book value ........................................................... (1,500,000)Excess fair value............................................................................... $102,400

to building ....................................................................................... 50,000 to goodwill....................................................................................... $52,400

17.A Parent’s reported sales .............................................. $300,000Subsidiary's reported sales ...................................... 200,000Less: intercompany transfers ................................... (40,000)

Sales to outsiders ................................................. $460,000Eliminate increase in receivables (less cash collected) (30,000)

Cash generated by sales ...................................... $430,000

18.B Book value of subsidiary prior to issuing new shares(12,000 x $40) ......................................................... $480,000

Parent's ownership .................................................... 100%Book value acquired .................................................. $480,000

Book value of subsidiary after issuing new shares (abovevalue plus 3,000 shares at $50 each) .................. $630,000

Parent's ownership (12,000 ÷ 15,000 shares) .......... 80%Book value acquired .................................................. $504,000

Investment in Nestlum increases by $24,000 ($504,000 less $480,000)

19.A Because the parent acquired 80 percent of the new shares, its proportion of ownership has remained the same. Because the purchase price will necessarily equal 80 percent of the increase in the subsidiary's book value, no separate adjustment by the parent is required.

20.C Adjusted book value of subsidiary ($795,000 + $150,000) .......... $945,000Current parent ownership (32,000 shs. ÷ 50,000 shs.) ................. 64%

Book value acquired.................................................................... $604,800Book value acquired currently recorded in parent's invest-

ment account ($795,000 x 80%) ................................................. 636,000

Required adjustment—decrease ......................................... $(31,200)

21.D Adjusted book value of subsidiary ($795,000 – $192,000) ........... $603,000Current parent ownership (32,000 shs. ÷ 32,000 shs.) ................. 100%

Book value equivalency of parent's ownership ...................... $603,000Book value equivalency currently recorded in parent's invest-

ment account ($795,000 x 80%) ................................................. 636,000Required adjustment—decrease.......................................... $(33,000)

22. (10 minutes) (Qualification of Primary Beneficiary of a VIE)

Consolidation of a variable interest entity is required if a parent has a variable interest that will

Absorb a majority of the entity's expected losses if they occur

Receive a majority of the entity's expected residual returns if they occur

Because (1) HCO Media’s losses are limited by contract, and (2) Hillsborough has the right to receive the residual benefits of the sales generated on the HCO Media internet site above $500,000, Hillsborough should consolidate HCO Media.

23. (40 minutes) (VIE Qualifications for Consolidation)

a. The purpose of consolidated financial statements is to present the financial position and results of operations of a group of businesses as if they were a single entity. They are designed to provide information useful for making business and economic decisions—especially assessing amounts, timing, and uncertainty of prospective cash flows. Consolidated statements also provide more complete information about the resources, obligations, risks, and opportunities of an enterprise than separate statements.

b. According to FIN 46R, an entity qualifies as a VIE and is subject to consolidation if either of the following conditions exist.

The total equity at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties. In most cases, if equity at risk is less than 10% of total assets, the risk is deemed insufficient.

The equity investors in the VIE lack any one of the following three characteristics of a controlling financial interest.

1. The direct or indirect ability to make decisions about an entity's activities through voting rights or similar rights.

2. The obligation to absorb the expected losses of the entity if they occur (e.g., another firm may guarantee a return to the equity investors)

23. continued

3. The right to receive the expected residual returns of the entity (e.g., the investors' return may be capped by the entity's governing documents or other arrangements with variable interest holders).

Consolidation is required if a parent has a variable interest that will

Absorb a majority of the entity's expected losses if they occur

Receive a majority of the entity's expected residual returns if they occur

Also, a direct or indirect ability to make decisions that significantly affect the results of the activities of a variable interest entity is a strong indication that an enterprise has one or both of the characteristics that would require consolidation of the variable interest entity.

c. Risks of the construction project that has TecPC has effectively shifted to the owners of the VIE

At the end of the 1st five-year lease term, if the parent opts to sell the facility, and the proceeds are insufficient to repay the VIE investors, TecPC may be required to pay up to 85% of the project's cost. Thus, a potential 15% risk.

During construction 11.1% of project cost potential termination loss.

Risks that remain with TecPC

Guarantees of return to VIE investors at market rate, if facility does not perform as expected TecPC is still obligated to pay market rates.

If lease is not renewed, TecPC must either purchase the facility or sell it on behalf of the VIE with a guarantee of Investors' (debt and equity) balances representing a risk of decline in market value of asset

Debt guarantees

d. TecPC possesses the following characteristics of a primary beneficiary Direct decision-making ability (end of five-year lease term)

Absorb a majority of the entity's expected losses if they occur (via debt guarantees and guaranteed lease payments and residual value)

Receive a majority of the entity's expected residual returns if they occur (via use of the facility and potential increase in its market value).

24. (10 minutes) (Consolidation of variable interest entity.)

a. Implied valuation and excess allocation for Softplus.Noncontrolling interest fair value $ 60,000Consideration transferred by Pantech 20,000

Total business fair value 80,000Fair value of VIE net assets 100,000Excess net asset value fair value $20,000

The $20,000 excess net asset fair value is recognized by PanTech as a bargain purchase. All SoftPlus’ assets and liabilities are recognized at their individual fair values.

Cash $20,000Marketing software 160,000Computer equipment 40,000Long-term debt (120,000)Noncontrolling interest (60,000)Pantech equity interest (20,000)Gain on bargain purchase (20,000)

-0-

b. Implied valuation and excess valuation for Softplus.Noncontrolling interest fair value 60,000Consideration transferred by Pantech 20,000

Total business fair value 80,000Fair value of VIE net identifiable assets 60,000Goodwill $20,000

When the business fair value of a VIE (that is a business) is greater than assessed asset values, all identifiable assets and liabilities are reported at fair values (unless a previously held interest) and the difference is treated as a goodwill.

Cash $20,000Marketing software 120,000Computer equipment 40,000Goodwill (excess business fair value) 20,000Long-term debt (120,000)Noncontrolling interest (60,000)Pantech equity interest (20,000)

-0-

25. (25 Minutes) (Consolidation entry for three consecutive years to report effects of intercompany bond acquisition. Straight-line method used.)

a. Book Value of Bonds Payable, January 1, 2009

Book value, January 1, 2007 ................................................... $1,050,000Amortization—2007–2008 ($5,000 per year

[$50,000 premium ÷ 10 years] for two years) ................... 10,000 Book value of bonds payable, January 1, 2009..................... $1,040,000Book value of 40% of bonds payable

(intercompany portion), January 1, 2009 ......................... $416,000

Gain on Retirement of Bonds, January 1, 2009Purchase price ($400,000 x 96%) ........................................... $384,000Book value of liability (computed above) .............................. 416,000Gain on retirement of bonds ................................................... $32,000

Book Value of Bonds Payable, December 31, 2009Book value, January 1, 2009 (computed above) ................... $1,040,000Amortization for 2009............................................................... 5,000 Book value of bonds payable, December 31, 2009............... $1,035,000Book value of 40% of bonds payable (intercompany portion),

December 31, 2009.............................................................. $414,000

Book Value of Investment, December 31, 2009Book value of investment, January 1, 2009 (purchase price) $384,000Amortization for 2009 ($16,000 discount ÷ 8yr. rem. life) . . 2,000Book value of investment, December 31, 2009 ..................... $386,000

Intercompany Interest Balances for 2009Interest expense:

Cash payment ($400,000 x 9%) ......................................... $36,000Amortization of premium for 2009 ($5,000 per year

multiplied by 40% intercompany portion) .................. 2,000Intercompany interest expense ........................................ $34,000

Interest income:Cash collection ($400,000 x 9%) ....................................... $36,000Amortization of discount for 2009 (above) ...................... 2,000Intercompany interest income .......................................... $38,000

CONSOLIDATION ENTRY B (2009)Bonds Payable ............................................................ 400,000Premium on Bonds Payable ...................................... 14,000Interest Income ........................................................... 38,000

Investment in Bonds .............................................. 386,000Interest Expense ..................................................... 34,000

Extraordinary Gain on Retirement of Bonds ....... 32,000(To eliminate accounts stemming from intercompany bonds [balances computed above] and to recognize gain on the retirement of this debt.)

25. (continued)

b. In 2010, because straightline amortization is used, the interest accounts remain unchanged at $38,000 and $34,000. However, the premium associated with the bond payable as well as the discount on the investment are affected by the $2,000 per year amortization. In addition, the gain now has to be included as a component of beginning retained earnings. Concurrently, the two interest balances recorded by the individual companies in 2009 are removed from retained earnings because they resulted after the intercompany retirement. Gain of $32,000 plus $34,000 expense removal less $38,000 income elimination gives $28,000 increase in retained earnings.

CONSOLIDATION ENTRY *B (2010)

Bonds Payable ..................................................... 400,000Premium on Bonds Payable ($2,000 amortization) 12,000Interest Income .................................................... 38,000

Investment in Bonds ($2,000 amortization) . . 388,000Interest Expense .............................................. 34,000Retained Earnings, 1/1/10 (Darges) ............... 28,000

(To remove intercompany bond accounts that remain on the individual records of both companies. Both debt and investment balances have been adjusted for 2009–10 amortization. Entry to retained earnings brings the totals reported by the individual companies [interest income and expense] to the balance of the original gain.)

c. As with part b, new premium and discount balances must be determined and then removed. The adjustment made to retained earnings takes into account that another year of interest expense ($34,000) and income ($38,000) have been closed into this equity account by the separate companies.

CONSOLIDATION ENTRY *B (2011)

Bonds Payable ...................................................... 400,000Premium on Bonds Payable ................................ 10,000Interest Income ..................................................... 38,000

Investment in Bonds ....................................... 390,000Interest Expense .............................................. 34,000Retained Earnings, 1/1/11 (Darges) ............... 24,000

(To remove intercompany bond accounts that remain on the individual records of both companies. Both debt and investment balances have

been adjusted for 2009– 2011 amortization. Entry to retained earnings brings the totals reported by the individual companies to the balance of the original gain.)

26. (12 Minutes) (Determine consolidated income statement accounts after acquisition of intercompany bonds.)

Interest Expense To Be Eliminated = $84,000 x 11% = $9,240

Interest Income To Be Eliminated = $108,000 x 8% = $8,640

Loss To Be Recognized = $108,000 – $84,000 = $24,000

CONSOLIDATED TOTALS

Revenues and Interest Income = $1,051,360 (add the two book values and eliminate interest income on intercompany bond)

Operating and Interest Expense = $751,760 (add the two book values and eliminate interest expense on intercompany bond)

Other Gains and Losses = $152,000 (add the two book values)

Loss on Retirement of Debt = $24,000 (computed above)

Net Income = $427,600 (consolidated revenues, interest income, and gains less consolidated operating and interest expense and losses)

27. (30 Minutes) (Consolidation entry for two years to report effects of intercompany bond acquisition. Effective rate method applied.)

a. Loss on Repurchase of BondCost of acquisition .......................................... $121,655Book value ($668,778 x 1/8) ............................ 83,597Loss on repurchase ........................................ $38,058

Interest Balances for 2009Interest income:

$121,655 x 6% ............................................. $7,299

Interest expense:$83,597 (book value [above]) x 10% ......... $8,360

Investment Balance, December 31, 2009Original cost, 1/1/09.......................................... $121,655Amortization of premium:

Cash interest ($100,000 x 8%) .................. $8,000Effective interest income (above) ............ 7,299 701

Investment, 12/31/09.............................. $120,954

27. (continued)Bonds Payable Balance, December 31, 2009

Book value, 1/1/09 (above) ............................. $83,597Amortization of discount:

Cash interest ($100,000 x 8%) .................. $8,000Effective interest expense (above) ........... 8,360 360

Bonds payable, 12/31/09....................... $83,957

Entry B—12/31/09Bonds Payable ................................................. 83,957Interest Income ................................................ 7,299Loss on Retirement of Debt ........................... 38,058

Investment in Bonds .................................. 120,954Interest Expense ........................................ 8,360

(To eliminate intercompany debt holdings and recognize loss on retirement.)

b. Interest Balances for 2010Interest income: $120,954 (investmentbalance for the year) x 6% ......................................... $7,257

Interest expense: $83,957 (liability balancefor the year) x 10% ..................................................... $8,396

Investment Balance, December 31, 2010Book value, January 1, 2010 (part a) ........................ $120,954Amortization of premium:

Cash interest ($100,000 x 8%) ............................. $8,000Effective interest income (above) ....................... 7,257 743

Investment balance, December 31, 2010....... $120,211

Bonds Payable Balance, December 31, 2010Book value, January 1, 2010 (part a) ........................ $83,957Amortization of discount:

Cash interest ($100,000 x 8%) ............................. $8,000Effective interest expense (above) ..................... 8,396 396

Bonds payable balance,December 31, 2010 .......................................... $84,353

Interest Balances for 2011Interest income: $120,211 (investment..................... $7,213

balance for the year [above]) x 6%

Interest expense: $84,353 (liability balancefor the year [above]) x 10% .................................. $8,435

27. (continued)

Investment Balance, December 31, 2011Book value, January 1, 2011 (above) ........................ $120,211Amortization of premium:

Cash interest ($100,000 x 8%) ............................. $8,000Effective interest income (above) ....................... 7,213 787

Investment balance, December 31, 2011........ $119,424

Bonds Payable Balance, December 31, 2011Book value, January 1, 2011 (above) ........................ $84,353Amortization of discount:

Cash interest ($100,000 x 8%) ............................. $8,000Effective interest expense (above) ..................... 8,435 435

Bonds payable balance,December 31, 2011 ..................................... $84,788

Adjustment Needed to Retained Earnings, January 1, 2011Loss on retirement of debt (part a) ........................... $38,058Balances currently in retained earnings:

Interest income: 2009 ($7,299)2010 (7,257) ($14,556)

Interest expense: 2009 $8,3602010 8,396 16,756 2,200

Reduction needed to beginning retainedearnings to arrive at consolidated total ........................... $35,858

Entry *B—12/31/11

Bonds Payable ............................................................ 84,788Interest Income ........................................................... 7,213Retained earnings, 1/1/11 (Parent) ............................ 35,858

Investment in Bonds ............................................. 119,424Interest Expense ................................................... 8,435

(To eliminate intercompany bond holdings and adjust beginning retained earnings balance of the parent to amount representing loss on retirement. Amounts computed above.)

28. (35 Minutes) (Consolidation procedures and balances related to intercompany bonds. Both straightline and effective interest rate methods are used.)

a. Acquisition price of bonds ................................................................ $283,550Book value of bonds payable (see Schedule 1)

($443,497 x 50%) ............................................................................ (221,749)Loss on retirement .............................................................................. $61,801

SCHEDULE 1—Book Value of Bonds Payable

EffectiveBook Interest Cash YearEnd

Date Value (12% Rate) Interest Amortization Book Value2007 $435,763 $52,292 $50,000 $2,292 $438,0552008 $438,055 $52,567 $50,000 $2,567 $440,6222009 $440,622 $52,875 $50,000 $2,875 $443,497

b. Investment in Bloom BondsPurchase price—12/31/09........................................... $283,550Cash interest ($250,000 x 10%) ................................. $25,000Effective interest income ($283,550 x 8%) ............... 22,684

Amortization .......................................................... 2,316Investment in Bloom bonds, 12/31/10 ...................... $281,234

Bonds PayableBook value—12/31/09 (computed above) ................ $443,497Cash interest ($500,000 x 10%) ................................. $50,000Effective interest expense ($443,497 x 12%) ........... 53,220

Amortization .......................................................... 3,220Bonds payable, 12/31/10 ............................................ $446,717

Although not required, the consolidation entry as of 12/31/10 is as follows. The reduction in retained earnings represents the loss only; no intercompany interest was recognized in the previous year because the purchase was made on December 31.

Entry *B (2010)Bonds Payable ($446,717 x 50%) .............................. 223,359Interest Income ........................................................... 22,684Retained Earnings, 1/1/10 .......................................... 61,801

Interest Expense ($53,220 x 50%) ....................... 26,610Investment in Bloom Bonds ................................ 281,234

28. continued

c. Loss on Retirement of Bond

Because Bloom uses the straightline method of amortization, the loss on retirement must be computed again.

Original issue price—1/1/07 ......................................................... $435,763Discount amortization (2007–2009) ([$64,237 ÷ 11] x 3 years).. 17,519Book value 12/31/09 ...................................................................... $453,282

Intercompany portion of bonds payable (50%) .......................... $226,641Purchase price ............................................................................... 283,550Loss on retirement ........................................................................ $56,909

Investment in Bloom BondsPurchase price—12/31/09 ............................................................. $283,550Premium amortization (2010) ($33,550 ÷ 8) ................................. (4,194)

Book value 12/31/10 ................................................................. $279,356

Interest IncomeCash interest ($250,000 x 10%) .................................................... $25,000Premium amortization (above) ..................................................... (4,194)

Intercompany interest income—2010 .................................... $20,806

Bonds PayableOriginal issue price 1/1/07............................................................. $435,763Discount amortization (2007–2010) [($64,237 ÷ 11) x 4 years] .. 23,359

Book value 12/31/10 ................................................................. $459,122Opus ownership ....................................................................... 50%

Intercompany portion—12/31/10 ....................................... $229,561

Interest ExpenseCash interest ($250,000 x 10%) .................................................... $25,000Discount amortization ([$64,237 ÷ 11] x 1/2) ............................... 2,920

Intercompany interest expense—2010 .................................. $27,920

The reduction in retained earnings represents the loss only; no intercompany interest was recognized in the previous year because the purchase was made on December 31.

Entry *B (2010)Bonds Payable ............................................................ 229,561Interest Income ........................................................... 20,806Retained Earnings, 1/1/10 ......................................... 56,909

Interest Expense .................................................. 27,920Investment in Bloom Bonds ................................ 279,356

29.(8 Minutes) (Determine goodwill for a purchase in which subsidiary has both common stock and preferred stock)

Consideration transferred for common stock $1,600,000 Consideration transferred for preferred stock 630,000 Noncontrolling interest in common stock 400,000 Noncontrolling interest in preferred stock 270,000 Hepner’s acquisition-date fair value $2,900,000 Book value of Hepner 2,500,000 Goodwill $400,000

30. (30 Minutes) (Consolidation entries for a purchase where subsidiary has outstanding cumulative preferred stock.)

a. The preferred shares are entitled to the specified cumulative dividend. Thus, the noncontrolling interest's share of the subsidiary's income equals $160,000 or 8 percent of the preferred stock's par value.

b. Acquisition-Date Fair Value Allocation and AmortizationConsideration transferred ............................................................ $14,040,000Noncontrolling interest fair value (preferred shares)................. 2,000,000Acquisition-date fair value of Smith............................................. 16,040,000Book value ..................................................................................... (16,000,000)Franchises ...................................................................................... $40,000Period of amortization .................................................................. 40 yearsAnnual amortization ...................................................................... $1,000

Investment in Smith Account, December 31, 2009Consideration transferred, January 1, 2009 ............................... $14,040,000Equity accrual (income remaining for common stock

after preferred stock dividend) ............................................... 290,000Dividends collected ($360,000 total less $160,000

paid to preferred shareholders) ............................................. (200,000)Amortization for 2009 (above) .......................................................... (1,000 )Investment in Smith account, December 31, 2009...................... $14,129,000

c. Consolidation EntriesEntry S and A combined

Preferred Stock (Smith) ............................................. 2,000,000Common Stock (Smith) .............................................. 4,000,000Retained Earnings, 1/1/09 (Smith) ............................ 10,000,000Franchises ................................................................... 40,000

Investment in Smith......................................... 14,040,000Noncontrolling Interest in Smith, Inc............. 2,000,000

(To eliminate subsidiary stockholders’ equity, record excess fair values, and record outside ownership of subsidiary's preferred stock at fair value)

30. c. (continued)

Entry I Equity Income of Subsidiary ............................... 285,000Investment in Smith ........................................ 285,000

(To eliminate equity accrual made in connection with common stock [$290,000] along with excess amortization recorded by parent.)

Entry D Investment in Smith .............................................. 200,000Dividends Paid ................................................. 200,000

(To remove intercompany dividend payments made on common stock [see computation above].)

Entry E Amortization Expense .......................................... 1,000Franchises ........................................................ 1,000

(To recognize amortization of franchises for current year [see computation above].)

31. (30 Minutes) (Prepare consolidation entries for a purchase where subsidiary has outstanding preferred stock)

Consideration transferred for common stock $ 7,368,000 Consideration transferred for preferred stock 3,100,000 Noncontrolling interest in common stock 4,912,000 Acquisition-date fair value for Young $15,380,000 Young’s book value 15,000,000 Excess fair over book value 380,000 to building (5-year life) $200,000 to equipment (10-year life) (100,000 ) 100,000 to brand name (20-year life) $280,000

CONSOLIDATION ENTRIESEntries S and A combined

Preferred Stock (Young) ............................................ 1,000,000Common Stock (Young) ............................................. 4,000,000Retained Earnings (Young) ....................................... 10,000,000Brand name.................................................................. 280,000Building ...................................................................... 200,000

Equipment .............................................................. 100,000Investment in Young's Preferred Stock (100%) . 3,100,000Investment in Young's Common Stock (60%) .... 7,368,000Noncontrolling interest ........................................ 4,912,000

(To eliminate subsidiary stockholders’ equity, record excess acquisition-date fair values, and record outside ownership of subsidiary's preferred stock at acquisition-date fair value)

31. (continued)Entry I1

Dividend Income ......................................................... 80,000Dividends Paid ...................................................... 80,000

(To offset intercompany preferred stock dividend payments recognized as income by parent—$1,000,000 par value x 8% dividend rate.)

Entry I2Dividend Income ......................................................... 192,000

Dividends Paid ...................................................... 192,000(To eliminate intercompany dividend payments [60% of $320,000] on common stock. Because the $320,000 in dividends remaining after Entry I1 equals exactly 8 percent of the common stock par value, the participation factor does not affect the distribution.)

Entry EAmortization Expense ................................................ 44,000Equipment ................................................................... 10,000

Building .................................................................. 40,000Brand name ........................................................... 14,000

(To record 2009 amortization of specific accountsrecognized within acquisition price of preferred stock.)

32.(15 Minutes) (The effect that various events have on a consolidated statement of cash flows.)

Sale of building. The $44,000 in cash received from the sale is listed as a cash inflow within the company's investing activities. If the company is using the direct approach in presenting cash flows from operations, the $12,000 gain is merely omitted. However, if the indirect approach is in use, the gain (a positive) must be eliminated from net income by a subtraction.

Intercompany inventory transfers. Because these transactions do not occur with any parties outside of the business combination, they are not reflected in the consolidated statement of cash flows.

Dividend paid by the subsidiary. The $27,000 payment to the parent is eliminated in consolidated statements and is not a cash outflow from the consolidated entity. The remaining $3,000 payment to the noncontrolling interest is reported as a cash outflow from a financing activity.

Amortization of intangible asset. This $16,000 noncash expense appears in the consolidated income statement. If the combined companies are using the direct approach to present cash flows from operations, this expense is omitted. If the indirect approach is used, the expense must be removed from consolidated net income by an addition.

Decrease in accounts payable. Cash payments have been used to reduce this liability balance during the period. If the direct approach is used to present cash flows from operations, the change is added to cost of goods sold as one step in deriving the cash paid during the period for inventory (an outflow). If the indirect approach is applied, the decrease is subtracted from net income in arriving at the net cash generated from operations during the period.

33.(20 Minutes) (Determine cash flows from operations for a consolidated entity.)

NOTE–CORRECTION TO PROBLEM: The noncontrolling interest’s share of the subsidiary’s income is $9,800 (not $12,000 as listed on page 285 of text).

DIRECT APPROACHCash revenues (add book values, eliminate intercompany transfers,

and add decrease in accounts receivable) .................................... $648,000Cash inventory purchases (add book values, eliminate

intercompany transfers, eliminate unrealized gains, add increase in inventory, and add decrease in accounts payable)....................... (370,000)

Depreciation and amortization (omit as noncash expenses)............ -0-Other expenses (add book values) ...................................................... (40,000)Gain on sale of equipment (omit because this is an investing activity) -0-Equity in earnings of Wallace (not an operating cash flow) ............. -0-

Cash generated from operations .............................................. $238,000

INDIRECT APPROACHConsolidated net income (computed below) ...................................... $216,000

Adjustments:Depreciation and amortization .................................................. 61,000Gain on sale of equipment ......................................................... (30,000)Increase in inventory .................................................................. (11,000)Decrease in accounts receivable .............................................. 8,000Decrease in accounts payable .................................................. (6,000)

Cash generated from operations ......................................... $238,000

Consolidated Net Income = $206,200 + 9,800 = $216,000 or computation below:Revenues (add book values and subtract intercompany transfers) $640,000Cost of goods sold (add book values, less intercompany

transfers and beginning unrealized gain, plus endingunrealized gain) .......................................................................... (353,000)

Depreciation and amortization (add book values plusamortization from excess fair value allocations) .................... (61,000)

Other expenses (add book value) .................................................. (40,000)Gain on sale of equipment .............................................................. 30,000

Consolidated net income ........................................................... $216,000

34. (30 Minutes) (Compute basic and diluted earnings per share for a business combination.)

(Note: This question may require students to review earnings per share fundamentals analyzed in intermediate accounting.)

The following computations assume that Parent acquired its interest in Sub's bonds directly from Sub. Therefore, no gain or loss was created and interest income will exactly offset interest expense.

BASIC EARNINGS PER SHARE—BUSINESS COMBINATIONCONSOLIDATED NET INCOME Parent's reported income ......................................... $150,000 Sub's reported income ............................................. 130,000 Amortization expense ............................................... (10,000)

Consolidated net income ..................................... $270,000Parent shares outstanding .................................. 60,000

Basic earnings per share ($270,000 ÷ 60,000) ......... $4.50

DILUTED EARNINGS PER SHARE—SUBSIDIARYReported earnings after amortization............................. $120,000Shares outstanding ......................................................... 30,000Basic earnings per share (120,000 ÷ 30,000) ................ $4.00Sub's earnings assuming conversion of Sub's bonds

($120,000 plus $24,000 in interestsaved net of taxes) ..................................................... $144,000

Sub's shares assuming conversion of Sub's bonds(30,000 + 12,000) ......................................................... 42,000

Diluted earnings per share(144,000 ÷ 42,000) ....................................................... $3.43 (rounded)

Because diluted earnings per share is below basic earnings per share, the convertible bonds have a dilutive impact on the computation and should be included.

PARENT'S SHARE OF SUBSIDIARY'S DILUTED EARNINGSTotal shares used in computation above ...................... 42,000Parent's ownership (30,000 plus 20% of 12,000) .......... 32,400

Parent's portion of shares (32,400 ÷ 42,000) ........... 77% (rounded)Sub's earnings used in diluted computation

(above) ...................................................................... $144,000Parent's portion of shares .............................................. 77%

Earnings attributed to business combination ..............$110,88034. (continued)

DILUTED EARNINGS PER SHARE—BUSINESS COMBINATION Parent's separate income ............................................... $150,000Sub’s income applicable to computation

(see above) .................................................................. 110,880Interest saved (net of taxes) on assumed

conversion of parent's bonds ................................... 32,000Diluted earnings ............................................................... $292,880

Parent shares outstanding ............................................. 60,000Additional shares from assumed conversion

of parent's bonds ....................................................... 10,000Diluted shares .................................................................. 70,000Diluted earnings per share

($292,880 ÷ 70,000) ..................................................... $4.18 (rounded)

35. (10 Minutes) (Compute consolidated diluted earnings per share. Subsidiary has stock warrants outstanding.)

Figures For Sonston's Basic Earnings Per ShareNet Income ...................................................................... $200,000Shares outstanding ......................................................... 40,000Assumed Conversion of Stock Warrants ...................... 10,000Repurchase of Treasury Stock with Proceeds of StockWarrants (10,000 x $10 = $100,000 ÷ $20) ...................... (5,000) 5,000Shares for Basic Earnings Per Share Computation...... 45,000

Shares Controlled by Primus: 40,000 + (20% of 5,000) = 41,000Percentage of Total Held by Primus: 41,000 ÷ 45,000 = 91% (rounded)Income to be Included in Consolidated Diluted Earnings

Per Share – $200,000 x 91% = $182,000

Earnings Consolidated Diluted Earnings Per Share:Net Income – Primus ....................................................... $600,000Net Income included from Sonston ............................... 182,000

Earnings ...................................................................... $782,000Outstanding Shares of Primus ....................................... 100,000

CONSOLIDATED DILUTED EARNINGS PER SHARE = $782,000 ÷ 100,000 = $7.82

36. (15 Minutes) (Compute consolidated diluted earnings per share. Subsidiary has convertible bonds outstanding.)

Figures For Simon's Diluted Earnings Per ShareEarnings:Net Income ...................................................................... $290,000Interest Saved if Bonds Are Converted ......................... $80,000Tax on Saved Interest (30%) ........................................... (24,000) 56,000Earnings for Diluted Earnings Per Share ...................... $346,000

Shares:Outstanding ...................................................................... 80,000Assumed Conversion of Bonds ..................................... 30,000Shares For Diluted Earnings Per Share Computation. . 110,000

Shares Controlled by Garfun = 80,000 ÷ 110,000 = 73%(rounded)

Income to be Included in Consolidated Diluted EarningsPer Share = $346,000 x 73% = $252,580

Earnings for Consolidated Diluted Earnings Per Share:Net Income—Garfun ........................................................ $480,000Dividends to Garfun's Preferred Stock ......................... (15,000)Net Income included from Simon (above) .................... 252,580

Earnings ...................................................................... $717,580

Shares:Outstanding Shares of Garfun ....................................... 80,000

CONSOLIDATED DILUTED EARNINGS PER SHARE = $717,580 ÷ 80,000 = $8.97(rounded)

37. (35 Minutes) (Compute basic and diluted earnings per share for a business combination. Subsidiary has stock warrants and convertible bonds.)

(Note: This question may require students to review earnings per share fundamentals analyzed in intermediate accounting.)

The following computations assume that Mason acquired its interest in Dixon's bonds directly from Dixon. Thus, no gain or loss was created and interest income and interest expense will exactly offset.

37. (continued)BASIC EARNINGS PER SHARE—BUSINESS COMBINATION

Reported income (separate)—Mason ....................... $110,000Income of Dixon (80%) ............................................... 52,000Preferred stock dividends (5,000 x $4) .................... (20,000)

Earnings applicable to basic EPS ....................... $142,000Mason's outstanding shares ..................................... 50,000Basic earnings per share ($142,000 ÷ 50,000) ......... $2.84

DILUTED EARNINGS PER SHARE SUBSIDIARY (DIXON)Net income after amortization.................................... $65,000Interest (net of tax) saved assuming bond conversion 30,000

Income applicable to diluted EPS .................. $95,000

Shares outstanding .................................................... 30,000Assumed conversion of warrants ............................ 10,000Assumed acquisition of treasury stock with

proceeds of conversion [(10,000 x $20) ÷ $25] . . (8,000)Assumed conversion of bonds ................................. 20,000

Shares applicable to diluted EPS ........................ 52,000Diluted EPS—subsidiary ($95,000 ÷ 52,000) ............ $1.83 (rounded)

INCOME APPLICABLE TO PARENT—DILUTED EARNINGS PER SHAREShares used in diluted EPS computation ................ 52,000Shares controlled by Parent

(30,000 x 80% plus 15% x 20,000) ........................ 27,000Portion owned by Parent (27,000 ÷ 52,000) . . 52% (rounded)

Income used in diluted EPS computation ............... $95,000Income applicable to Parent—diluted EPS .............. $49,400

DILUTED EARNINGS PER SHARE—BUSINESS COMBINATIONReported income (separate)—Mason ....................... $110,000Income of Dixon (above) ............................................ $ 49,400Because of assumed conversion, preferred stock

dividends would not be paid ............................... -0-Earnings applicable to diluted EPS .......................... $159,400

Mason's outstanding shares ..................................... 50,000Assumed conversion of preferred stock

(5,000 x 4) ............................................................... 20,000Shares applicable to diluted EPS .................. 70,000

Diluted earnings per share($159,400 ÷ 70,000) ................................................ $2.27 (rounded)

38. (8 Minutes) (Effect of subsidiary stock issuance to public at a price above book value per share)

Book Value of Subsidiary Prior to Issuing New Shares(40,000 x $12) .............................................................. $480,000

Parent's Ownership ......................................................... 100%Book Value Equivalency of Ownership ......................... $480,000Book Value of Subsidiary After Issuing New Shares

(above value plus 10,000 shares at $15.75 each) . . . $637,500Parent's Ownership (40,000 ÷ 50,000 shares) ............... 80%Book Value Equivalency of Ownership ......................... $510,000

Investment in Rughty should be increased by $30,000 ($510,000 less $480,000)

39. (20 Minutes) (Effects of two different stock issuances by subsidiary.)

a. Prior to the issuance of the new shares, Davis owns an 80% interest in Maxwell (16,000 shares out of 20,000 shares). The underlying book value of this investment is $640,000 ($800,000 x 80%). Subsequent to the issuance, total book value of the subsidiary will have risen by $250,000 (the price of the stock) to $1,050,000. Davis' ownership, however, will only be 64% (16,000 ÷ 25,000). The book value underlying Davis' investment is now $672,000 (64% of $1,050,000) so that a $32,000 increase must be recorded by the parent.

Financial Records—Davis, IncorporatedInvestment in Maxwell ............................................... 32,000

Additional Paidin Capital ..................................... 32,000

b. The book value underlying Davis' investment is $640,000 (see above) prior to the issuance of the new shares. The 4,000 additional shares increase subsidiary's total book value by $100,000 (the price of the stock) to $900,000. Davis' ownership will have decreased to 2/3 (16,000 shares out of a total of 24,000) for a book value equivalency of just $600,000. Reducing the $640,000 (see a) to $600,000 requires a $40,000 decrease.

Financial Records—Davis, IncorporatedAdditional Paidin Capital ........................................... 40,000

Investment in Maxwell .......................................... 40,000

40.(55 Minutes) (Prepare consolidation entries following the subsidiary's issuance of shares to outside parties.)

Initially, Abraham owns 18,000 shares (or 90%) of Sparks' outstanding shares (the total number of shares can be determined by dividing the subsidiary's Common Stock account by the $10 par value attributed to each share). After the issuance of the additional 4,000 shares, an adjustment must be prepared by the parent company to reflect the change in the underlying book value of the subsidiary. Because that entry has not yet been recorded, it is included on the consolidation worksheet as Entry C1 (labeled in this manner because it is a correction). Next, because the controlling interest decreases to 75%, its share of the excess acquisition-date fair value also decreases for the same amount. This correction is seen below in Entry C2. The remainder of the consolidation procedures follow the normal pattern described in previous chapters.

Excess Acquisition-Date Fair Value Allocation and AmortizationFair value (consideration transferred plus NCI fair value) .......... $649,000Book value......................................................................................... (480,000)Payment in excess of book value ................................................... $169,000Allocated to land based on fair value............................................. 89,000Copyrights ........................................................................................ $80,000Life of Copyrights ............................................................................ 20 yearsAnnual amortization ......................................................................... $4,000

Adjustment for Stock TransactionAdjusted book value of subsidiary on date of transaction

($480,000 + $100,000 + $144,000) .............................................. $724,000Adjusted parent ownership (18,000 shares ÷ 24,000 shares) ...... 75%

Book value equivalency of parent ownership ......................... $543,000Book value equivalency of parent's investment

account before new issuance ($580,000 x 90%) ..................... 522,000Required increase (Entry C1) .......................................................... $21,000

Adjustment for Parent’s Decreased Share of Unamortized Excess Acquisition-Date Fair Value Excess acquisition-date fair value at 1/1/11

Land ............................................................................................ $89,000Copyrights ($80,000 less 2 years amortization)....................... 72,000Total 1/1/11 excess fair value over book value......................... 161,000Controlling interest new share................................................... 75%New controlling interest in excess fair value .......................... 120,750Controlling interest share based on original 90%................... 144,900

Reduction in Abraham’s share of excess fair value (Entry C2). . . $24,150

40. (continued)

CONSOLIDATION ENTRIESEntry C1

Investment in Sparks ................................................. 21,000Additional Paidin Capital (Abraham) .................. 21,000

(To record adjustment necessitated by subsidiarystock transaction, computation shown above.)

Entry C2Additional Paidin Capital (Abraham)......................... 24,150

Investment in Sparks............................................. 24,150(To record reduction in Abraham’s investment from transfer or acquisition-date excess fair value over book value to the noncontrolling interest share.)

Entry *CInvestment in Sparks ................................................. 82,800

Retained Earnings, 1/1/11 (Abraham) ................. 82,800(Because initial value method is applied, equity accrualfor 2009–2010 is needed [$100,000 less thetwo year’s amortization expense $4,000 x 2] x 90%)

Entry SCommon Stock (Sparks) ............................................ 240,000Additional Paidin Capital (Sparks) ........................... 104,000Retained Earnings, 1/1/11 (Sparks) .......................... 380,000

Investment in Sparks (75%) ................................. 543,000Noncontrolling Interest in Sparks, 1/1/11 (25%). 181,000

(To eliminate subsidiary stockholders' equity accountsagainst corresponding balance in Investment accountand to recognize noncontrolling interest. Stockholders’equity balances have been adjusted for increase in book value during 2009–2010 and the issuance by the subsidiary of 4,000 shares of stock on 1/1/11.)

Entry ALand ............................................................................ 89,000Copyrights ................................................................... 72,000

Investment in Sparks (75%).................................. 120,750Noncontrolling interest (25%) .............................. 40,250

(To recognize amounts within acquisition priceallocated to land and copyrights. Copyrights balancehas been reduced for 2009–2010 amortization to arriveat 1/1/11 balance. NCI now reflects its 25% share of theunamortized 1/1/11 balance.)

40. (continued)

Entry IDividend Income ......................................................... 15,000

Dividends Paid ...................................................... 15,000(To eliminate intercompany dividends recorded byparent as income [75% x $20,000].)

Entry EAmortization Expense ................................................ 4,000

Copyrights.............................................................. 4,000(To recognize current year amortization.)

41. (50 Minutes) (Prepare consolidation worksheet for business combination. Intercompany bond acquisition is made during the current year.)

Acquisition-date fair-value allocation and amortization:

Equipment $30,000 10year life $3,000 annual amortizationTrademarks $40,000 20year life $2,000 annual amortization

As indicated in the problem, the parent is applying the partial equity method. Hence an Entry *C must be recorded on the worksheet to convert the recorded figures (amortization is needed for the three years prior to 2012) to equity balances:

Amortization expense ($5,000 × 3 years) = .............. $15,000 (Entry *C)

Unrealized gain in ending inventory (downstream):Ending balance ........................................................... $10,000Markup ($20,000 ÷ $100,000) ..................................... 20%Unrealized gain to be eliminated .............................. $2,000 (Entry G)

Loss on extinguishment of bonds:Book value at date of repurchase .................................. $282,000Percentage repurchased ................................................. 50%Equivalent book value ..................................................... $141,000Amount paid ................................................................. 145,500Loss on extinguishment of bonds ................................. $4,500 (Entry B)

Amortization during 2012 changed the carrying value of the bond payable from $282,000 to $288,000 (found in the balance sheet) and the investment from $145,500 to $147,000. This amortization also affects interest income and expense accounts.

Entry A reflects remaining values after three years of amortizations.

41. continued Pavin and StablerConsolidation Worksheet

Year Ending December 31, 2012Consolidation Entries Consolidated

Accounts Pavin Stabler Debit Credit Totals Revenues............................................... $(740,000) $(505,000) (TI)100,000 $(1,145,000)Cost of goods sold............................... 455,000 240,000 (G) 2,000 (TI) 100,000 597,000Expenses............................................... 125,000 158,500 (E) 5,000 288,500Interest expense—bonds .................... 36,000 -0- (B) 18,000 18,000Interest income—bond investment..... -0- (16,500) (B) 16,500 -0-Loss on extinguishment of bonds....... -0- -0- (B) 4,500 4,500Equity in income of Stabler.................. (123,000) -0- (I) 123,000 -0-

Net income......................................... $(247,000) $(123,000) $(237,000)

Retained earnings, 1/1/12..................... $(345,000) (*C) 15,000 $(330,000)Retained earnings, 1/1/12..................... $(361,000) (S) 361,000 -0-Net income (above)............................... (247,000) (123,000) (237,000)Dividends paid...................................... 155,000 61,000 (D) 61,000 155,000Retained earnings, 12/31/12................. $(437,000) $(423,000) $(412,000)

Cash and receivables........................... $217,000 $35,000 (P) 33,000 $219,000Inventory................................................ 175,000 87,000 (G) 2,000 260,000Investment in Stabler............................ 613,000 -0- (D) 61,000 (*C) 15,000

(S) 481,000(A) 55,000 -0-(I) 123,000

Investment in Pavin bonds................... -0- 147,000 (B) 147,000 -0-Land, buildings, and equipment (net). 245,000 541,000 (A) 21,000 (E) 3,000 804,000Trademarks............................................ -0 - -0- (A) 34,000 (E) 2,000 32,000

Total assets........................................ $1,250,000 $810,000 $1,315,000

Accounts payable................................. $(225,000) $(167,000) (P) 33,000 $(359,000)Bonds payable...................................... (300,000) (100,000) (B) 150,000 (200,000)Discount on bonds............................... 12,000 -0- (B) 6,000 6,000Common stock...................................... (300,000) (120,000) (S) 120,000 (300,000)Retained earnings (above)................... (437,000) (423,000) (412,000)Total liabilities and stockholders’ equity $(1,250,000) $(810,000) 1,046,000 1,046,000 $(1,315,000)

42.(40 Minutes) (Prepare consolidation entries after intercompany bond acquisition.)

a. Allocation of Acquisition-date Excess Fair Value Consideration transferred ......................$312,000Noncontrolling interest fair value..............208,000Acquisition-date fair value.......................$520,000Book value acquired ..................................300,000Fair value in excess of book value .........$220,000 Annual Excess Excess allocated to patents based Life Amortizations on fair value............................................. 90,000 12 years $7,500Customer List...........................................$130,000 10 years 13,000

Total $20,500CONSOLIDATION ENTRIESEntry *TL

Investment in Herman ................................................ 7,000Land ...................................................................... 7,000

(To eliminate unrealized gain created by previous intercompany transfer. Investment is adjusted here because transfer was downstream and equity method has been applied by parent. Thus, retained earnings have already been corrected.)

Entry *GRetained Earnings 1/1/11 (Herman) .......................... 8,000

Cost of Goods Sold .............................................. 8,000(To remove unrealized inventory gain from prior year so that it can be properly realized in current year. Amount is computed as shown below.)

Intercompany profit—2010 ........................................ $25,000Transfer price—2010 .................................................. $125,000Markup ($25,000 ÷ $125,000) ..................................... 20%Unrealized gain in 1/1/11 inventory

($40,000 x 20%) ..................................................... $8,000

Entry SCommon Stock (Herman) .......................................... 100,000Retained Earnings, 1/1/11 (Herman)

(adjusted for Entry *G) .......................................... 292,000Investment in Herman (60%) .......................... 235,200Noncontrolling Interest in Herman (40%) ..... 156,800

(To eliminate Herman's stockholders' equity accounts and to record beginning of year balance for noncontrolling interest.)

42. a. (continued)

Entry APatents ...................................................................... 75,000Customer List.............................................................. 104,000

Investment in Herman .......................................... 107,400Noncontrolling interest ........................................ 71,600

(To recognize unamortized balances as of 1/1/11 of amounts allocated within original acquisition price. Allocations have been reduced by two years of amortizations.)

Entry IEquity Income of Herman........................................... 3,000

Investment in Herman...................................... 3,000(To eliminate intercompany equity income accrual)

Herman’s income.............................................................. $25,000Excess amortizations....................................................... (20,500)2010 intercompany inventory gross profit..................... 8,0002011 intercompany inventory gross profit..................... (7,500 ) Accrual-based income..................................................... $5,000Fred’s ownership percentage.......................................... 60 % Equity in earnings of Herman.......................................... $3,000

Entry DInvestment in Herman ................................................ 2,400

Dividends Paid ...................................................... 2,400(To eliminate intercompany dividend payments.)

Entry EAmortization Expense ................................................ 20,500

Patents.................................................................... 7,500Customer List......................................................... 13,000

(To recognize current year amortization expense.)

Entry PAccounts Payable ...................................................... 60,000

Accounts Receivable ............................................ 60,000(To remove intercompany debt created by inventory transfers.)

42.a. (continued)

Entry BBonds Payable ............................................................ 20,000Premium on Bonds Payable ...................................... 1,069Interest Income ........................................................... 1,873

Investment in Parent Bonds ................................ 19,005Interest Expense ................................................... 1,283Gain on Retirement of Bond................................. 2,654

(To eliminate effect created by bond acquisition and recognize the related retirement gain [$21,386 – $18,732]. Amounts are calculated below.)

Book Cash YearEndValue Effective Interest Excess Book

(given) Interest (8%) Amortizations ValueInvestment $18,732 $1,873 (10%) $1,600 $273 $19,005Liability 21,386 1,283 (6%) 1,600 317 21,069

Entry TlSales ............................................................................ 120,000

Cost of Goods Sold (or Purchases) .................... 120,000(To eliminate intercompany transfers made during current year.)

Entry GCost of Goods Sold .................................................... 7,500

Inventory................................................................. 7,500(To defer recognition of inventory transfer gains until subsequent year. Amount calculated as follows.)

Intercompany profit .............................................. $30,000Transfer price 2011 ............................................... $120,000Markup ($30,000 ÷ $120,000) ................................ 25%Unrealized gain in ending inventory ($30,000 x 25%) ................................................... $7,500

b. Herman's reported income for 2011 ......................................... $25,000Excess fair value amortization .................................................. (20,500)2010 unrealized gain recognized in 2011 (Entry *G) ............... 8,0002011 unrealized gain (Entry G) .................................................. (7,500)Herman's realized income for 2011............................................ $5,000Noncontrolling interest ownership ........................................... 40%Noncontrolling interest's share of the subsidiary's income... $2,000

Noncontrolling interest, 1/1/11 (Entries S and A) ................... $228,400 Noncontrolling interest's share of Herman's income (above) 2,000 Noncontrolling interest's share of Herman's dividends ($4,000 x 40%) ...................................................................... (1,600) Noncontrolling interest, 12/31/11................................................ $228,800

42. (continued)c. The balances in the individual records as of December 31, 2012 pertaining to

the Intercompany bonds are as follows:Beginning

Book Cash YearEndValue Effective Interest Excess Book

(see part a.) Interest (8%) Amortizations Value

Investment $19,005 $1,901 (10%) $1,600 $301 $19,306Liability 21,069 1,264 (6%) 1,600 336 20,733

The adjustment to recognize the original gain by the parent can be computed as follows:

Original gain on retirement (see part a) ........................ $2,654Interest income recorded on investment in 2011

(see part a) .................................................................. $1,873Interest expense recorded on liability in 2011

(see part a) ................................................................. 1,283 590Required increase as of January 1, 2012 ...................... $2,064

Entry *B (as of December 31, 2012)Bonds Payable............................................................. 20,000Premium on Bonds Payable ...................................... 733Interest Income ........................................................... 1,901

Investment in Herman .......................................... 2,064Investment in Parent Bonds ................................ 19,306Interest Expense ................................................... 1,264

(To remove accounts pertaining to intercompany bonds. "Investment in Herman" is adjusted here rather than retained earnings because equity method is being applied and gain is attributed to the parent.)

43. (50 Minutes) (Prepare consolidation entries for intercompany preferred stock and bonds. Determine specified account balances. Preferred stock is a debt instrument.)

a. Consideration transferred for common stock................... $552,800 Consideration transferred for preferred stock.................. 65,000 Noncontrolling interest in common stock......................... 138,200 Noncontrolling interest in preferred stock......................... 34,000 Lisa’s acquisition-date fair value........................................ $790,000 Book value of Lisa................................................................ 750,000 Excess assigned to franchises........................................... $40,000

CONSOLIDATION ENTRIES 1/1/09

Entry S and A combinedPreferred Stock (Lisa) ................................................ 100,000Common Stock (Lisa) ................................................ 200,000Retained Earnings, 1/1/09 (Lisa) ............................... 450,000Franchises ................................................................... 40,000

Investment in Lisa-common stock................. 552,800Investment in Lisa-preferred stock................ 65,000Noncontrolling Interest in Lisa, Inc................ 172,200

(To eliminate subsidiary stockholders’ equity, record excess acquisition-date fair values, and record outside ownership of subsidiary's preferred and common stock at acquisition-date fair values.)

b. Acquisition price of bonds, 1/2/09 ............................ $53,310Book value of bonds payable (½ acquired) ............. (44,175)

Loss on extinguishment of debt ......................... $9,135Interest income—Mona ($53,310 x 8%) .................... (rounded) $4,265Interest expense—Lisa ($44,175 x 14%) .................. (rounded) $6,185Investment in Lisa—bonds (book value)

Book value—date of acquisition, 1/2/09 ............. $53,310Cash interest ($50,000 x 10%) ............................. $5,000Effective interest (above) ..................................... 4,265 735

Investment in Lisa—bonds(book value as of 12/31/09) ............................. $52,575

43. b. (continued)Bonds payable (book value)

Book value—date of acquisition, 1/2/09 ............. $44,175Cash interest ($50,000 x 10%) ............................. $5,000Effective interest (above) ..................................... 6,185 1,185

Bonds payable (book value as of 12/31/09)... $45,360

CONSOLIDATION ENTRY B—December 31, 2009(all figures computed above)

Bonds Payable ............................................................ 50,000Interest Income (or Other Revenues) ....................... 4,265Extraordinary Loss on Retirement of Debt .............. 9,135

Discount on Bonds Payable ($50,000 – $45,360) 4,640Interest Expense.................................................... 6,185Investment in Lisa—Bonds .................................. 52,575

c. December 31, 2009 book values based on historical cost figures:Cost of fixed assets ................................................... $100,000Depreciation expense ($40,000 book value over

a 10year life) .......................................................... 4,000Accumulated depreciation (including current

expense) ................................................................. 64,000

December 31, 2009 book values based on transfer price:Cost of fixed assets ................................................... $120,000Depreciation expense (10year life) ........................... 12,000Accumulated depreciation ........................................ 12,000Gain on transfer of fixed assets

($120,000 – $40,000) book value .......................... 80,000

CONSOLIDATION ENTRY TA—December 31, 2009

Gain on Transfer of Fixed Assets (to remove) ........ 80,000Accumulated Depreciation ($64,000 – $12,000).. 52,000Depreciation Expense ($12,000 – $4,000) .......... 8,000Fixed Assets ($120,000 – $100,000) .................... 20,000

43. (continued)

d. Original allocation to franchises (given) ....................... $40,000Amortization at $1,000/year (2009–2010) ................. (2,000)Consolidated franchises—12/31/10 .......................... $38,000

Fixed assets (book values):Mona, Inc. .................................................................... $1,100,000Lisa Co. ...................................................................... 800,000Reduction necessitated by intercompany sale

($120,000 transfer price reduced to $100,000original cost) (see part c) ..................................... (20,000)

Consolidated fixed assets—12/31/10 ....................... $1,880,000

Accumulated depreciation (book values):Mona, Inc...................................................................... $300,000Lisa Co. ...................................................................... 200,000Increase needed to eliminate intercompanysale ($60,000 accumulated depreciation at timeof transfer less excess depreciation expense[$12,000 - $4,000] for 2009 and 2010) ....................... 44,000Consolidated Acc. Depr.—12/31/10.......................... $544,000

Expenses (book values):Mona, Inc................................................................. $220,000Lisa Co. .................................................................. 120,000

Recognition of amortization on Franchises ............ 1,000Elimination of interest expense on intercom-

pany debt ($45,360 [see part b] x 14%) (rounded) (6,350)Elimination of excess depreciation from

intercompany transfer of fixed assets($12,000– $4,000) ................................................... (8,000)

Consolidated expenses ........................................... $326,650

44.(35 Minutes) (Prepare statement of cash flows for a business combination.)

(Note: before working this problem, students may wish to review the statement of cash flows in an intermediate accounting textbook.)

Development of Cash Flow Balances

OPERATING ACTIVITIES—2009Revenues (the consolidated balance plus the decrease in

accounts receivable) ........................................................................ $890,000Cost of goods sold (cash purchases) (the consolidated

balance plus the increase in inventory plus thedecrease in accounts payable) ....................................................... 720,000

Depreciation and amortization (not cash expenses) ......................... -0-Gain on sale of building (sales price is shown below as

an investing activity) ........................................................................ -0-Interest expense (the consolidated balance) ..................................... 30,000Noncontrolling interest in subsidiary's income (does not

represent a cash flow although dividends paid to these outside owners is shown below as a financing activity) ............ -0-

INVESTING ACTIVITIES—2009Sale of building ($30,000 book value sold at a $20,000 gain)............ $50,000Purchase of equipment (Buildings and Equipment account

increased by $50,000. Building with a $30,000 book valuewas sold [a decrease]. Depreciation [without Databasesamortization] was $95,000 [a decrease]. Only a purchaseof $175,000 would turn these two decreases of $125,000 intoan increase of $50,000) .................................................................... 175,000

FINANCING ACTIVITIES—2009Dividends paid by parent (the consolidated balance) ....................... $100,000Dividends paid by subsidiary (amount paid to

noncontrolling interest—20%) ........................................................ 2,000Issuance of bonds ................................................................................. 100,000Issuance of common stock by the parent (increase in

common stock and additional paidin capital) ............................... 47,000

44. (continued)

ROGERS COMPANY AND CONSOLIDATED SUBSIDIARYStatement of Cash Flows

Year Ending December 31, 2009

CASH FROM OPERATIONSRevenues ..................................................................... $890,000Purchases ................................................................... (720,000)Expenses ..................................................................... (30,000)

Cash from operations ........................................... 140,000

CASH FLOWS—INVESTING ACTIVITIESSale of building ........................................................... $50,000Purchase of equipment .............................................. (175,000)

Cash from investing activities.............................. (125,000)

CASH FLOWS—FINANCING ACTIVITIESDividends paid ............................................................ $(102,000)Issuance of bonds ...................................................... 100,000Issuance of common stock ....................................... 47,000

Cash from financing activities ............................. 45,000Net increase in cash during 2009 ................................... 60,000Cash, January 1, 2009 ..................................................... 80,000Cash, December 31, 2009 ................................................ $140,000

The above statement uses the direct approach for computing cash flows from operations. If the indirect approach were to be used, the following computation would be appropriate.

CASH FROM OPERATIONSConsolidated net income................................................. $230,000Adjustment from accrual to cash:

Depreciation and amortization .................................. 100,000Gain on sale of building ............................................. (20,000)Decrease in accounts receivable .............................. 10,000Increase in inventory ................................................. (140,000)Decrease in accounts payable .................................. (40,000)

Cash from operations ........................................... $140,000

45.(40 Minutes) (Compute basic and diluted earnings per share. Subsidiary has stock warrants outstanding and convertible debt.)

(Text correction: Please note that the noncontrolling interest in Raleigh’s income listed in the text should read $21,000, not $26,000. The final net income line then becomes $(289,000) under the consolidated column.)

The subsidiary has two convertibles: warrants and bonds. Thus the subsidiary’s diluted earnings per share must be computed as a preliminary step to the calculations made for the business combination as a whole.

Based on the amount of the "Equity in earnings of Raleigh," and the use of the partial equity method, Alexander holds an 80 percent interest in Raleigh (or 24,000 shares).

BASIC EARNINGS PER SHARE—BUSINESS COMBINATIONAlexander’s separate income ......................................... $200,000Net effect of intercompany profit deferral and

recognition (COGS difference) ................................ 5,000Raleigh’s $130,000 separate income less $25,000

amortization (operating expense difference)........... 105,000Less: noncontrolling interest in consolidated income. (21,000)Consolidated net income to parent................................ $289,000Alexander’s preferred stock dividends ......................... (40,000)

Earnings applicable to basic EPS ............................ $249,000

Alexander's outstanding common shares .................... 50,000Basic earnings per share ($249,000 ÷ 50,000) .............. $4.98

DILUTED EARNINGS PER SHARE—SUBSIDIARY (RALEIGH)Net income after amortization......................................... $105,000Interest saved assuming conversion of bonds

(net of taxes) ............................................................... 22,000Income applicable to diluted EPS .................................. $127,000

Shares outstanding ......................................................... 30,000Assumed conversion of warrants .................................. 5,000Assumed acquisition of treasury stock with proceeds

of conversion ([5,000 x $10] ÷ $20) ........................... (2,500)Assumed conversion of bonds ...................................... 10,000

Shares applicable to diluted EPS ............................. 42,500Diluted earnings per share—subsidiary

($127,000 ÷ 42,500) ..................................................... $2.99 (rounded)

45. (continued)

INCOME APPLICABLE TO PARENT—DILUTED EARNINGS PER SHARE

Shares used in diluted EPS computation ..................... 42,500Shares controlled by parent (24,000 plus 50% of incre-

ment created by warrants [or 1,250]) ....................... 25,250

Portion owned by parent (25,250 ÷ 42,500) ................... 59.4% (rounded)Income applicable to parent—diluted EPS (59.4% of

$127,000) ..................................................................... $75,438

DILUTED EARNINGS PER SHARE—BUSINESS COMBINATIONAlexander’s separate income.......................................... $200,000Net effect of intercompany profit deferral and

recognition (COGS difference) ................................ 5,000Income of Raleigh to parent (computed above) ........... 75,438Because of assumed conversion, preferred stock divi-

dends would not be paid ........................................... -0-Earnings applicable to diluted EPS ............................... $280,438

Alexander's outstanding common shares .................... 50,000Assumed conversion of preferred stock

(10,000 x 2 shares) ..................................................... 20,000Shares applicable to diluted EPS ................................... 70,000Diluted earnings per share

($280,438 ÷ 70,000) ..................................................... $4.01 (rounded)

46.(50 Minutes) (Determine consolidated totals. Subsidiary has preferred shares outstanding that are equity instruments.)

Consideration transferred for common and preferred stock$560,000 Skyler’s book value 450,000 Excess fair value assigned to intangible asset (10-year life)$110,000

Annual amortization $11,000

Ending Unrealized GainEnding inventory (at transfer price) ............................... $18,000

Markup ($30,000 ÷ $90,000) ....................................... 33 ⅓ % Ending unrealized gain (increase made to cost

of goods sold to defer gain) ................................ $6,000

46. (continued)Paisley, Inc. and Skyler Corp.

Consolidation WorksheetYear Ending December 31, 2009

Consolidation EntriesConsolidated Accounts Paisley, Inc. Skyler Corp. Debit Credit Totals Sales................................................ $(800,000) $(400,000) (TI) 90,000 $(1,110,000)Cost of goods sold......................... 528,000 260,000 (G) 6,000 (TI) 90,000 704,000Expenses......................................... 180,000 130,000 (E) 11,000 (ED) 2,000 319,000Gain on sale of equipment............. (8,000) -0- (TA) 8,000 -0-

Net income.................................... $(100,000) $(10,000) $(87,000)

Retained earnings, 1/1/09............... $(400,000) $(150,000) (S) 150,000 $(400,000)Net income...................................... (100,000) (10,000) (87,000)Dividends paid................................ 60,000 -0- 60,000

Retained earnings, 12/31/09........ $(440,000) $(160,000) $(427,000)

Cash................................................. $30,000 $40,000 $70,000Accounts receivable....................... 300,000 100,000 (P) 28,000 372,000Inventory.......................................... 260,000 180,000 (G) 6,000 434,000Investment in Skyler Corp. ............. 560,000 -0- (S) 450,000 -0-

(A) 110,000Land, buildings, and equipment.... 680,000 500,000 (TA) 10,000 1,190,000Accumulated depreciation............. (180,000) (90,000) (ED) 2,000 (TA) 18,000 (286,000)Intangible Asset.............................. -0- -0- (A) 110,000 (E) 11,000 99,000

Total assets.................................. $1,650,000 $730,000 $1,879,000

Accounts payable........................... $(140,000) $(90,000) (P) 28,000 $(202,000)Long-term liabilities........................ (240,000) (180,000) (420,000)Preferred stock................................ -0- (100,000) (S) 100,000 -0-Common stock................................ (620,000) (200,000) (S) 200,000 (620,000)Additional paid-in capital............... (210,000) -0- (210,000)Retained earnings, 12/31/09........... (440,000) (160,000) (427,000)

Total liabilities and stockholders’ equity $(1,650,000) $(730,000) $(1,879,000)46. (continued)

Effect of Intercompany Equipment Transfer

Transfer price

Recorded value.................................................................................. $20,000Depreciation expense ($20,000 ÷ 4)................................................ 5,000Accumulated depreciation............................................................... 5,000Gain on sale ($20,000 – $12,000)..................................................... 8,000

Historical cost Recorded value.................................................................................. $30,000Depreciation expense ($12,000 ÷ 4)................................................ 3,000Accumulated depreciation ($18,000 + $3,000)............................... 21,000

CONSOLIDATED TOTALS

Sales = $1,110,000 (add book values and eliminate intercompany transfers) Cost of Goods Sold = $704,000 (add book values, eliminate intercompany transfers, and eliminate ending unrealized gain [computed above])

Expenses = $319,000 (add book values and include amortization of intangibles and eliminate $2,000 excess equipment depreciation) Gain on Sale of Equipment = $0 (intercompany balance is eliminated) Net Income = $87,000 (consolidated revenues less consolidated expenses) Retained Earnings, 1/1/09 = $400,000 (parent company figure only because subsidiary was not acquired until current year) Dividends Paid = $60,000 (parent balance only) Retained Earnings, 12/31/09 = $427,000 (consolidated beginning retained earnings plus net income less dividends paid) Cash = $70,000 (add book values) Accounts Receivable = $372,000 (add book values after eliminating inter-company balance) Inventory = $434,000 (add book values after eliminating unrealized gain) Investment in Skyler Corporation = $0 (intercompany account is eliminated so that individual asset and liability accounts of subsidiary can be included)

Land, Buildings, and Equipment = $1,190,000 (add book values and increase transferred asset from transfer price to historical cost [see above]) Accumulated Depreciation = $286,000 (add book values and adjust balance for transferred asset from transfer price figure to historical cost (see above]) Intangible Asset = $99,000 (original allocations less one year amortization) Total Assets = $1,879,000 (summation of consolidated accounts) Accounts Payable = $202,000 (add book values and remove intercompany balance) Long-Term Liabilities = $420,000 (add book values) Preferred Stock = $0 (subsidiary outstanding shares are eliminated)

46. (continued)

Common Stock = $620,000 (parent balance only)Additional Paid-in Capital = $210,000 (parent balance only)Retained Earnings, 12/31/09 = $427,000 (computed above)Total Liabilities and Equities = $1,879,000 (summation of consolidated accounts)

Many students may choose to prepare a worksheet for this problem. Thus, the following is an explanation of that approach.

CONSOLIDATED ENTRIES

Entry SPreferred Stock (Skyler)............................................. 100,000Common Stock (Skyler).............................................. 200,000Retained Earnings, 1/1/09........................................... 150,000

Investment in Skyler Corp.................................... 450,000(To eliminate stockholder’s equity of subsidiary allocable to common and preferred stockholdings.)

Entry AIntangible Asset .......................................................... 110,000

Investment in Skyler Corp.................................... 110,000(To recognize amounts paid within acquisition prices that are attributed to Intangible Asset.)

Entry E

Amortization Expense................................................. 11,000Intangible Asset..................................................... 11,000

(To record current year’s amortization of intangible asset.)

Entry P

Accounts Payable....................................................... 28,000Accounts Receivable............................................. 28,000

(To eliminate intercompany debt.)

Entry TAEquipment.................................................................... 10,000Gain on Sale of Equipment......................................... 8,000

Accumulated Depreciation................................... 18,000(To eliminate financial effects as of 1/1/09 created by intercompany transfer of equipment.)

Entry TI

Sales ............................................................................ 90,000Cost of Goods Sold............................................... 90,000

(To eliminate intercompany inventory transfers for the current year.)46. (continued)

Entry GCost of Goods Sold..................................................... 6,000

Inventory................................................................. 6,000(To defer unrealized intercompany gain remaining at the end of the current year. Markup is 33⅓% [$30,000 gross profit ÷ $90,000 transfer price] indicating that the ending inventory of $18,000 contains an unrealized profit of $6,000 [$18,000 x 33⅓%].)

Entry EDAccumulated Depreciation......................................... 2,000

Depreciation Expense........................................... 2,000(To eliminate excess depreciation resulting from intercompany gain of $8,000 on transfer of equipment [see Entry TA]. Equipment is being depreciated over a remaining life of four years.)

47. (30 minutes) (Consolidated Cash Flow Statement with current year business combination)

Plaster Inc. and Subsidiary Stucco CompanyConsolidated Statement of Cash Flows

For the year ended 12/31/09

Consolidated net income $274,000Depreciation expense $187,500Amortization expense 8,750Decrease in accounts receivable (net of acquisition) 3,600Increase in inventory (net of acquisition) (102,000)Decrease in accounts payable (net of acquisition) (8,000 ) 89,850Net cash provided by operations $363,850

Purchase of Stucco Company assets (net of cash acquired)Net cash used in investing activities (856,000)

Issue long-term debt $800,000Dividends (108,000)Net cash provided by financing activities 692,000

Increase in cash 1/1/09 to 12/31/09 199,850

Beginning Cash, 1/1/09 43,000Ending cash, 12/31/09 $242,850

Excel Case–Intercompany Bonds

Bonds with a stated rate of 11% sold to yield 12%

Eff. Yield12% 1,000,000.00 0.32197 321,973.24

110,000.00 5.65022 621,524.53943,497.77 56,502.23

2008 943,497.77 113,219.73 110,000.00 3,219.732009 946,717.50 113,606.10 110,000.00 3,606.102010 950,323.60 114,038.83 110,000.00 4,038.832011 954,362.43 114,523.49 110,000.00 4,523.492012 958,885.93 115,066.31 110,000.00 5,066.312013 963,952.24 115,674.27 110,000.00 5,674.272014 969,626.51 116,355.18 110,000.00 6,355.182015 975,981.69 117,117.80 110,000.00 7,117.802016 983,099.49 117,971.94 110,000.00 7,971.942017 991,071.43 118,928.57 110,000.00 8,928.57

1,000,000.00 56,502.23

Consolidated Worksheet Entry 12 /31/10 Bonds Payable 954,362.43Interest Revenue 117,523.20Loss on retirement 0.00

Gain on retirement 46,299.01Investment in Bonds 911,547.79Interest Expense 114,038.83

Bonds retired by affiliate on 1/1/10 at 904,024.59Eff. Yield

13% 1,000,000.00 0.37616 376,159.86110,000.00 4.79877 527,864.73

904,024.59 95,975.41

2010 904,024.59 117,523.20 110,000.00 7,523.202011 911,547.79 118,501.21 110,000.00 8,501.212012 920,049.00 119,606.37 110,000.00 9,606.372013 929,655.37 120,855.20 110,000.00 10,855.202014 940,510.57 122,266.37 110,000.00 12,266.372015 952,776.95 123,861.00 110,000.00 13,861.002016 966,637.95 125,662.93 110,000.00 15,662.932017 982,300.88 127,699.12 110,000.00 17,699.12

1,000,000.00 95,975.41

Financial Reporting Research and Analysis Case

The number of potential solutions is large. Searches in Lexis-Nexis, Edgar, etc. will produce numerous examples of consolidations of VIEs. For example, Walt Disney Company prepares a before and after disclosure of its newly consolidated VIEs Euro Disney and Hong Kong Disneyland as follows (12-31-04):

Before Euro Disney and Hong Euro Disney, Hong Kong Disneyland Kong Disneyland Consolidation and Adjustments TotalCash and cash equivalents $1,730 $312 $2,042Other current assets 7,103 224 7,327 Total current assets 8,833 536 9,369

Investments 1,991 (699) 1,292Fixed assets 12,529 3,953 16,482Intangible assets 2,815 -- 2,815Goodwill 16,966 -- 16,966Other assets 6,843 135 6,978Total assets $49,977 $3,925 $53,902 Current portion of borrowings $1,872 $2,221 $4,093Other current liabilities 6,349 617 6,966Total current liabilities 8,221 2,838 11,059

Borrowings 8,850 545 9,395Deferred income taxes 2,950 -- 2,950Other long term liabilities 3,394 225 3,619Minority interests 487 311 798Shareholders' equity 26,075 6 26,081Total liabilities and shareholders' equity $49,977 $3,925 $53,902