Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value

Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Chapter 4

Consolidation of Wholly Owned Subsidiaries Acquired at More than Book

Value

4-2

Learning Objective 4-1

Understand and make equity-method journal entries related to the

differential.

4-3

Basic Concepts: Parent and Subsidiary

Parent’s books Investment account initially contains the acquisition

cost FMV of net assets, Plus goodwill, or Minus bargain purchase price

Parent can use the cost or equity method

Subsidiary’s books Balance sheet: Assets and Liabilities are recorded at

BOOK values. Income statement: Expenses calculated based on

BOOK values

4-4

Basic Concepts: Parent and Subsidiary

What happens when you consolidate the parent’s and subsidiary’s books? Remember:

The parent’s investment account is based on the actual acquisition price.

The sub’s books contain only historical book values.

The parent needs to make adjustments for both Balance Sheet, and Income Statement accounts.

Why wasn’t this a problem with created subs? No goodwill No undervalued assets at the time of creation

4-5

Basic Concepts: Income Statement Impacts

Big Picture: Essentially, we switch the sub’s books from BV to FMV in the consolidation process.

Income Statement effects

AssetRelated Expense

(as the asset expires)

Equipment

Inventory

Patent

Goodwill

4-6

Basic Concepts: Income Statement Impacts

Income Statement Effects When Acquisition Price > Book Value


(as the asset expires)Income Statement

Effect

Equipment

Inventory

Patent

Goodwill

If expenses are _________________, then income is too high____________________.

To fix the problem, Parent needs to _______________ expenses.

4-7

Book value element Life remainingCommon Stock $130,000Retained Earnings 117,000

Under- or Over-valuation Inventory (6,500) 2 monthsLand 39,000 IndefiniteEquipment 85,000 10 yearsCovenant-not-to-compete 52,000 4 yearsGoodwill element 26,000 Indefinite

Total Cost $442,500

Example: Acquisition Price > Book Value

Pepper Inc., a calendar-year reporting company, acquired 100% of Salt Inc.’s outstanding common stock at a cost of $442,500 on 12/31/X8. The analysis of the parent’s Investment account as of the acquisition date shows:

4-8

Acquisition Price = BV + Identifiable Excess + GW

Results for 20X9 (based on Book Values):

Reported Income Dividends Declared

What would the Sub’s income be based on Fair Values?

Lower COGS (because inventory is worth less) Extra depreciation on equipment Extra amortization of contract Total increase in expenses / decrease in income

Example: Acquisition Price > Book Value

4-9

Consolidation: Equity Method

The Parent’s initial investment in a sub is based on the FMV of the sub’s net assets (+/- GW).

Equity method entries: Recording share of sub’s income

Recording share of sub’s dividends

They should be based on the same FMV basis. Problem: Sub reports income based on BOOK VALUES

Solution: Parent has to record an adjustment to the income and investment “Equity Method” accounts.

4-10

Results for 20X9 (based on Book Values):

Reported Income $78,000Dividends Declared 45,500

Adjustment to Salt’s 20X9 income on Parent’s books:

Lower COGS (because inventory is worth less) $ (6,500)Extra depreciation on equipment 8,500Extra amortization of contract 13,000Total increase in expenses / decrease in income $ 15,000

What entries would Pepper record in its general ledger related to Salt’s income and dividends for 20X9 under the equity method?

Example: Equity Method

4-11

Example: Equity Method Journal Entries

1. To record 100% share of Salt’s reported income:

2. To record 100% of Salt’s dividends declared:

3. To record additional expenses (based on FMV):

4-12

Example: Equity Method Investment Adjustment

Calculate the correct ending balance in Pepper’s Investment in Salt account using the equity method:

Investment in Salt

4-13

Practice Quiz Question #1

A parent charges the amortization of its cost in excess of book value to

a. Goodwill expense.b. Excess cost expense.c. Excess cost & goodwill expense.d. Income from subsidiary.e. None of the above.

4-14


Understand and explain how consolidation procedures

differ when there is adifferential.

Consolidation Concepts by Chapter

Wholly Owned Subsidiary

Partially Owned Subsidiary

Investment = Book Value Chapter 2 Chapter 3 No

Differential

Investment > Book Value Chapter 4 Chapter 5 Differential

No NCI Shareholders

NCI Shareholders

4-15

4-16

Simple Example

P

S

Stock

SubShareholders

$

Book value of net assets =

Excess value of identifiable

assets =

Goodwill =

Assume the BV of Sub’s net assets is $800 and that the FMV of the net assets is $1,000. Finally, assume that the acquisition price was $1,500. The acquisition price consists of three parts:

4-17

Understanding Components of Acquisition Cost

Acquisition FMV of Price = Assets + Goodwill

Key: We need to keep track of each element of the purchase price separately! Why??

FMV of Extra Assets = BV + Value

Acquisition Extra Price = BV + Value + Goodwill

4-18

The Consolidation Process

When a subsidiary is acquired (instead of created), the consolidation process is more complicated: Must eliminate intercompany items (same). Must update Sub’s assets and liabilities to FMV. Must recognize goodwill.

4-19

Summary of Consolidation Entries

1. The basic elimination entry:

2. The excess value reclassification entry:

Asset 1 XXAsset 2 XXGoodwill XX

Investment in Sub Excess

Common Stock (S) XXAdditional Paid-in Capital (S) XXRetained Earnings, Beginning Balance (S) XXIncome from Sub XX

Investment in Sub BVDividends Declared XX

4-20

Summary of Consolidation Entries

3. The amortized excess value reclassification entry:

This entry reclassifies the equity method amortization of cost in excess of book from Income from Sub to the appropriate expense accounts where the costs would have been had the sub used FMV instead of BV.

4. The accumulated depreciation elimination entry:

Cost of Sales XXOther Expenses XX

Income from Sub XX

Accumulated Depreciation XXBuildings and Equipment XX

4-21


When P company pays more than the book value of net assets of the acquired company (S), how does the consolidation process differ?

a. P hires an outside accountant to do the work.

b. P tracks the excess value and records it in the consolidation worksheet.

c. S notifies P of the excess value.d. P and S ignore the excess amount paid.

4-22


Make calculations and prepare elimination entries for the

consolidation of awholly owned subsidiary when

there is a complex positive differential at theacquisition date.

4-23

Group Exercise 1: Analyzing Acquisition Costs Prince Inc. acquired 100% of She-Ra Inc.’s outstanding common stock for $1,600,000 cash. Divide the cost into its major elements and prepare the consolidation entries as of the acquisition date.

Book Value Current Value DifferenceCash 60,000 60,000 - Accounts Receivable 160,000 160,000 - Inventory 300,000 350,000 50,000 Notes Receivable 100,000 40,000 (60,000) Land 500,000 630,000 130,000 Buildings & Equipment 610,000 720,000 110,000 Patent 50,000 140,000 90,000 Goodwill 110,000 - (110,000) Total Assets 1,890,000 2,100,000

Payables & Accruals 160,000 160,000 - Long-term Debt 750,000 680,000 70,000 Total Liabilities 910,000 840,000

Common Stock 120,000 Additional PIC 480,000 Retained Earnings 380,000 Total Equity 980,000

Buildings and equipment net of $98,000 accumulated depreciation. Goodwill is from a prior acquisition.

4-24

Group Exercise 1: Solution

How would this affect your worksheet elimination entries?

Splitting of the Investment account:Total CostLess: BV element (CS + Add PIC + RE)Total Excess Cost

Analysis of the Investment account -- excess cost elements:Under- or (over-) valuation of identifiable net assets Inventory Notes Receivable Land Buildings & Equipment Patent Goodwill Long-term Debt

4-25

1,600,000

Book value of net assets of the acquired

firm

Excess value of identifiable

assets

Group Exercise 1: Solution Acquisition Costs

What did we pay for? Investment in Sub

Goodwill

4-26

1,600,000980,000

620,000

0

Group Exercise 1: Solution Investment Account

1. The basic elimination entry:


Inventory 50,000Land 130,000Buildings and Equipment 110,000Patent 90,000Long-term Debt 70,000Goodwill (new) 340,000

Notes Receivable 60,000Goodwill (old) 110,000Investment in Sub 620,000

Common Stock 120,000Additional Paid-in Capital 480,000Retained Earnings 380,000

Investment in Sub 980,000

Investment in Sub

4-27

Group Exercise 1: Solution Worksheet Entries 1. The basic elimination entry:


3. The accumulated depreciation elimination entry:

Inventory 50,000Land 130,000Buildings and Equipment 110,000Patent 90,000Long-term Debt 70,000Goodwill (new) 340,000

Notes Receivable 60,000Goodwill (old) 110,000Investment in Sub 620,000

Common Stock 120,000Additional Paid-in Capital 480,000Retained Earnings 380,000

Investment in Sub 980,000

Accumulated Depreciation 98,000Building and Equipment 98,000

4-28

Group Exercise 1: Solution Depreciation Entry 3. The accumulated depreciation elimination entry: The book

values at acquisition – remember the 610,000 was net of 98,000 in accumulated depreciation.

708,000

Buildings & Equipment

98,000

Accumulated Depreciation

4-29

Group Exercise 1: Solution Depreciation Entry 3. The accumulated depreciation elimination entry:


708,000


98,000


98,000 98,000

610,000 0

Shows the Buildings and Equipment “as if” they have been recorded on the sub’s books as new assets at book value.

4-30

Group Exercise 1: Solution Reclass Entry 3. The accumulated depreciation elimination entry:


708,000


98,000


98,000 98,000

610,000 0BV110,000

The excess value reclassification elimination entrybrings the Buildings and Equipment up to fair value.

Excess Value ReclassFMV 720,000

4-31

Elimination Entries Consoli-Pepper Salt DR CR dated

Balance SheetCash 38,500 26,000 Accounts Receivable 97,500 91,000 Inventory 136,500 104,000 Investment in Sub: Book Value 247,000 Excess Value 195,500 Land 130,000 91,000 Build & Equipment 325,000 265,200 Acc Depreciation (195,000) (57,200) Covenant N-T-CGoodwill Total Assets 975,000 520,000 Payables & Accruals 104,000 78,000 Long-term Debt 26,000 195,000

Common Stock 390,000 130,000 Additional PICRetained Earnings 455,000 117,000 Total Liab. & Equity 975,000 520,000

Pepper, Inc. and Salt, Inc.Consolidated Worksheet as of December 31, 20X8

Group Exercise 2: Worksheet at Acquisition Pepper acquired 100% of Salt’s outstanding stock for $442,500.Required: Prepare the consolidation entries and worksheet.

Book Value Element:Common Stock 130,000 Retained Earnings 117,000

Under-valuation Element:Inventory (6,500) Land 39,000 Equipment 85,000 Covenant N-T-C 52,000 Goodwill 26,000

4-32

Group Exercise 2: Worksheet EntriesBook Value Analysis:

Pepper’s Salt’s Equity Accounts, BVInvestment Common RetainedAccount, BV Stock Earnings

Balances, 12/31/X8

+=

The Basic Elimination Entry:

Common StockRetained Earnings

Investment in Salt

EB 442,500

Investment in Salt

Excess Value Analysis:Pepper’s Salt’s Under- or (Over-) Valuation of Net Assets Element

Investment Inventory Land Equipment Covenant Goodwill

Balances, 12/31/X8=

The Excess Value Reclassification Entry:

LandBuilding & EquipmentCovenant N-T-CGoodwill

InventoryInvestment in Salt

Accumulated DepreciationBuilding & Equipment

The Accumulated Depreciation Elimination Entry:

4-33

Group Exercise 2: Worksheet at Year End

Consoli-Pepper Salt DR CR dated

Balance SheetCash 38,500 26,000 Accounts Receivable 97,500 91,000 Inventory 136,500 104,000 Investment in Sub: Book Value 247,000 Excess Value 195,500 Land 130,000 91,000 Build & Equipment 325,000 265,200 Acc Depreciation (195,000) (57,200) Covenant N-T-CGoodwill Total Assets 975,000 520,000

Payables & Accruals 104,000 78,000 Long-term Debt 26,000 195,000 Common Stock 390,000 130,000 Additional PICRetained Earnings 455,000 117,000 Total Liab. & Equity 975,000 520,000

Pepper, Inc. and Salt, Inc.Consolidated Worksheet as of December 31, 20X8

Elimination Entries

4-34


An account of the acquired company that cannot be revalued to its current value under acquisition accounting is

a. Notes receivable.b. Bonds payable.c. Investment in marketable securities.d. Patents.e. None of the above.

4-35


Make calculations and prepare elimination entries for the

consolidationof a wholly owned subsidiary

when there is a complex bargain-purchase

differential.

4-36

Acquired at Less than Fair Value of Net Assets

Bargain purchase A business combination where the sum of

the acquisition-date fair values of the consideration given,

any equity interest already held by the acquirer, and

any noncontrolling interest

is less than the amounts at which the identifiable net assets must be valued at the acquisition date as specified by ASC 805-10-20.

The acquirer recognizes a gain for the difference.

4-37

Basic Concepts

Income Statement Effects When Acquisition Price < BV


(as the asset expires)Income Statement

Effect

Equipment

Inventory

Patent

Goodwill

If expenses are ________________, then income is too low______________________.

To fix the problem, Parent needs to ____________________expenses.

4-38


How do the elimination entries differ in a bargain purchase scenario from an acquisition at an amount greater than book value?

a. The differential is ignored in a bargain purchase scenario.

b. The parent company multiplies all numbers by −1.c. The elimination entry to reclassify expenses related

to the differential increases reported expenses.d. The elimination entry to reclassify expenses related

to the differential decreases reported expenses.

4-39


Prepare equity-method journal entries, elimination entries, and

the consolidationworksheet for a wholly owned

subsidiary when there is a complex positive

differential.

4-40

Book value element Life remainingCommon Stock $130,000Retained Earnings 117,000

Under- or Over-valuation Inventory (6,500) 2 monthsLand 39,000 IndefiniteEquipment 85,000 10 yearsCovenant-not-to-compete 52,000 4 yearsGoodwill element 26,000 Indefinite

Total Cost $442,500

Group Exercise 3

Pepper Inc., a calendar-year reporting company, acquired 100% of Salt Inc.’s outstanding common stock at a cost of $442,500 on 12/31/X8. The analysis of the parent’s Investment account as of the acquisition date shows:

4-41

1. Update the analyses of the Investment account through 12/31/X9.

2. Prepare all consolidation entries as of 12/31/X9.

3. Prepare a consolidation worksheet at 12/31/X9. (The parent’s retained earnings as of 1/1/X9 were $455,000.

Group Exercise 3

Consoli-Pepper Salt DR DR dated

Income StatementSales 1,235,000 780,000Cost of Sales (598,000) (370,500)Depreciation Expense (78,000) (19,500)S&A Expense (481,000) (312,000)Income from Salt 63,000 Net Income 141,000 78,000Statement of Retained EarningsBalance, 1/1/X9 455,000 117,000Add: Net Income 141,000 78,000Less: Dividends (104,000) (45,500)Balance, 12/31/X9 492,000 149,500Balance SheetCash 77,500 32,500Accounts Receivable 123,500 78,000Inventory 149,500 156,000Investment in Salt: Book Value 279,500 Excess Cost 180,500Land 130,000 91,000Build & Equip 325,000 291,200Acc Depreciation (273,000) (76,700)Covenant N-T-CGoodwill Total Assets 992,500 572,000Payables & Accruals 84,500 97,500Long-term Debt 26,000 195,000Common Stock 390,000 130,000Retained Earnings 492,000 149,500 Total Liab & Equity 992,500 572,000

Consolidated Worksheet as of December 31, 20X9Pepper, Inc. and Salt, Inc.

Elimination Entries

4-42

Group Exercise 3: Worksheet Entries

Book Value Calculations:Pepper’s Salt’s Equity Accounts, BV

Investment Common RetainedAccount, BV Stock Add PIC Earnings

Balances, 1/1/X9

Add: Net Income Less Dividends

Balances, 12/31/X9

+=

The Basic Elimination Entry:

Common StockRetained Earnings, 1/1/X9Income from Salt

Dividends DeclaredInvestment in Salt

+

4-43


Excess Value Calculations:Pepper’s

Investment Salt’s Under- or (Over-) Valuation of Net Assets ElementAccount Inventory Land Equipment Acc Dep Covenant

Goodwill Remaining Life Excess Cost 2 months Indefinite 10 years 4 years

Balances, 1/1/X9

Less: Amortization

Balances, 12/31/X9

=

The Excess Value Reclassification Entry:

LandBuilding & EquipmentCovenant N-T-CGoodwill

Accumulated DepreciationInvestment in Salt

Accumulated DepreciationBuilding & Equipment

The Accumulated Depreciation Elimination Entry:

The Amortized Excess Value Reclassification Entry:

Depreciation ExpenseS&A Expense

Cost of SalesIncome from Salt

4-44

Book value = 247,000

Identifiable Excess =169,500

Group Exercise 3: Solution Investment Account

BB 442,500

Investment in SaltGoodwill =

26,000

Look back at the beginning and ending balances in the two charts you just prepared to

find the numbers!Book value = 279,500

Identifiable Excess =154,500

Goodwill =26,000

NI 78,00045,500 Dividend15,000 Excess Amort.

EB 460,000

Beginning Balance:

Ending Balance:

4-45

15,000 Excess Amort.15,000


Investment in Salt Income from Salt

Notice how the worksheet entries “eliminate” Pepper’s equity method accounts:

BB 442,500NI 78,000

45,500 Dividend 15,000 Excess Amort. 15,000

EB 460,000

78,000 NI

279,500 Basic 78,000

180,500 Excess Reclass

0 0

63,000 Adj. Balance

4-46

Group Exercise 3: Completed Worksheet

Consoli-Pepper Salt DR DR dated

Income StatementSales 1,235,000 780,000Cost of Sales (598,000) (370,500)Depreciation Expense (78,000) (19,500)S&A Expense (481,000) (312,000)Income from Salt 63,000 Net Income 141,000 78,000Statement of Retained EarningsBalance, 1/1/X9 455,000 117,000Add: Net Income 141,000 78,000Less: Dividends (104,000) (45,500)Balance, 12/31/X9 492,000 149,500Balance SheetCash 77,500 32,500Accounts Receivable 123,500 78,000Inventory 149,500 156,000Investment in Salt: Book Value 279,500 Excess Cost 180,500Land 130,000 91,000Build & Equip 325,000 291,200Acc Depreciation (273,000) (76,700)Covenant N-T-CGoodwill Total Assets 992,500 572,000Payables & Accruals 84,500 97,500Long-term Debt 26,000 195,000Common Stock 390,000 130,000Retained Earnings 492,000 149,500 Total Liab & Equity 992,500 572,000

Consolidated Worksheet as of December 31, 20X9Pepper, Inc. and Salt, Inc.

Elimination Entries

4-47


Understand and explain the elimination of basic

intercompany transactions.

4-48

Road Map: Intercompany Transactions

Typical intercompany transactions Intercompany reciprocal accounts (Chapter 4) Inventory transfers (Chapter 6) Fixed asset transfers (Chapter 7) Intercompany Indebtedness (Chapter 8)

4-49

Intercompany Transactions

Questions

Answers

4-50

How would you eliminate each item?

Group Exercise 4: Solution

Three things to think about:1. Note receivable / payable2. Interest revenue / expense3. Interest receivable / payable

1. Note Payable (sub) XXXNote Receivable (parent) XXX

2. Interest Revenue (parent) XXXInterest Expense (sub) XXX

3. Interest Payable (sub) XXXInterest Receivable (parent) XXX

4-51

Princess Inc. owns 100% of Solo Inc.’s common stock. On 11/1/X8, Princess lent $150,000 to Solo. The loan is to be repaid on 1/30/X9 along with $6,000 of interest. All aspects of the intercompany transaction were properly recorded by each company in its separate books.

Group Exercise 4: Intercompany Loan & Interest

Required:

1. What amounts should be reported in each company’s separate 20X8 income statement and 12/31/X8 balance sheet (asset and liability sections only)?

2. Prepare and post to your format the consolidation entries as of 12/31/X8, relating only to these accounts.

4-52


Intercompany income statement accounts are eliminated in consolidation because they are deemed to be:

a. artificial transactions. b. potentially manipulative transactions.c. internal transactions. d. at amounts that are not determined

on arms-length basis. e. None of the above.

4-53


In 20X8, Scott incurred $90,000 of inter-company interest charges. Of this amount, Scott paid $70,000 cash to its parent and capitalized $40,000 to a discrete construction project. The unrealized intercompany profit at 12/31/X8 is

a. $0.b. $10,000.c. $20,000.d. $30,000.e. $40,000.

4-54


Understand and explain the basics of push-down

accounting.

4-55

Purchase Price > Book Value

What happens if you pay more than the book value of the subsidiary’s assets? This is the case MOST of the time!

Parent has two options: Push-Down Accounting

Force Sub to revalue to FMV

Non-Push-Down Accounting Account for the “extra” value separately.

Parent

Sub

4-56

Push-Down Accounting: The EASIER Way

Push-Down Accounting (an absolute gem) In the subsidiary’s general ledger:

Adjust assets and liabilities to FVbased on the parent’s acquisition price. This establishes a new basis of accounting.

Record goodwill. Record “Revaluation Capital” for the difference

A = L + EX

Revaluation Capital

4-57

Nonpush-Down Accounting: The HARDER Way

Non-Push-Down Accounting: Don’t touch the subsidiary’s general ledger

(treat like a “sacred cow”). Make fair value adjustments and record

goodwill in consolidation (on the worksheets).

4-58

Consolidation Consequences: Push-Down vs. Non-Push-Down

Push-down accounting: Consolidation effort is minimal (has received the

“Better Bookkeeping” stamp of approval).

Non-push-down accounting: Consolidation effort is cumbersome (often a

headache).

The consolidated financial statement amounts are the SAME either way! ONLY the accounting procedures differ Who does the work– parent or sub?

4-59

Parent’s Amortization of Cost in Excess of Book Value: How Handled?

Non-push-down accountingEquity Method

Recorded in parent’s general ledger Maintains built-in checking features

Cost Method Recorded on consolidation worksheets

Push-down accountingParent has no amortization – sub records

the amortization

4-60

Consolidated Financial Statements

Sub’s Income Statement

(Based on Book Values)

Sub’s Balance Sheet

(Based on Book Values)

Sub’s Income Statement

(Based on Fair Values)

Sub’s Balance Sheet

(Based on Fair Values)

Parent’s Adjustments

ForExcess Value

(ConsolidationProcess)

+

+

=

=

Push-down AccountingNon-push-down Accounting

Actually, these numbers are only part of the consolidated financial statements.

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Postacquisition Subsidiary Earnings: Reportable Earnings Under Acquisition Method

ONLY the subsidiary’s postacquisition earnings are reported in the consolidated financial statements. For a mid-year acquisition, only consolidate earnings

after the acquisition date. The same is true for dividends declared.

The subsidiary’s preacquisition earnings (included in its retained earnings account) are always eliminated against the parent’s Investment account in consolidation.

4-62


A parent records amortization of excess value under which method?

a. Push-down basis of accounting.b. Non-push down basis of accounting.c. Both A and B.d. None of the above.

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Push-down-accounting can be used a. only in a goodwill situation. b. only in a bargain purchase situation. c. in either a goodwill situation or a

bargain purchase situation. d. only in a cost = book value situation. e. None of the above.

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The consolidated financial statements are identical regardless of whether the parent

a. uses push-down or non-push-downaccounting.

b. acquires 100% of the common stock or 100% of the assets.

c. Both A and B.d. Neither A or B.

Conclusion

The End

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Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value

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