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© 2003 McGraw-Hill Ryerson Limited

Chapter 5© 2003 McGraw-Hill Ryerson Limited

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Chapter 5

Consolidated Financial Statements Subsequent to Acquisition Date:

Equity Method

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Consolidation from the Equity Method• Outline

– Goodwill and other Intangibles– Goodwill impairment tests– Transitional Provisions– Consolidated income and retained earnings– Consolidation practices subsequent to acquisition– Examples– International View

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Goodwill and other Intangibles• As discussed in prior chapters, when an

intercorporate investment is made, the difference between the cost and underlying book value, the purchase discrepancy, must be allocated in order that the fair values at the date of the business combination are recognized in the accounts.

• In many cases, a significant proportion of the purchase price relates to intangible assets, including goodwill, acquired.

• This amount is recognized in the statements.

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Goodwill and other Intangibles• The cost of the purchase should be allocated

as follows: – all assets acquired and liabilities assumed in a

business combination, whether or not recognized in the financial statements of the acquired enterprise (except goodwill and future income taxes recognized by an acquired enterprise before its acquisition) should be assigned a portion of the total cost of the purchase based on their fair values at the date of acquisition; and

– the excess of the cost of the purchase over the net of the amounts assigned … should be recognized as an asset referred to as goodwill.

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Goodwill and other Intangibles• These Handbook provisions include two

important aspects of the process of accounting for business combinations:– There must be an examination of the assets

actually owned, including intangibles, with particular regard to the need for identification and valuation of unrecorded intangible assets

– The residual amount in a business combination is allocated to Goodwill, which represents the unallocated excess of the purchase price over the identifiable assets acquired

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Goodwill and other Intangibles• There has been significant debate on the

appropriate accounting treatment for intangible assets arising in business combinations, in part because of large variations internationally in the permissible treatment of these items

• The “playing field” was perceived to be uneven• In the interest of international harmonization,

and perhaps as a result of extensive “lobbying” by the business community, recent changes in the CICA Handbook attempt to resolve the debate and guide practice

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International View• There were simultaneous changes in the United

States and Mexico which have the same effect on accounting practices in those countries

• Concurrently, the pooling of interest approach (as discussed in Chapter 4) was abolished, and many changes were introduced to unify (if not standardize completely) accounting for intangible assets arising from business combinations in North America

• Beyond North America, there remains significant diversity in rules and practices

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Goodwill and other Intangibles• The implications of these rules are that much

effort must be devoted to the identification of the many potential assets which make up the value of a firm and the price paid – Prior rules allowed essentially all the residual

value, after tangible assets and high profile intangibles (such as patents) were assigned value, to be allocated to goodwill

– The new rules appear to require somewhat more care in the identification and assignment of values and provide extensive, detailed guidance in this area

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Goodwill and other Intangibles• Under the new Handbook provisions (s.1581.48),

an intangible asset should be recognized apart from goodwill when: – the asset results from contractual or other legal

rights (regardless of whether those rights are transferable or separable from the acquired enterprise or from other rights and obligations); or

– the asset is capable of being separated or divided from the acquired enterprise and sold, transferred, licensed, rented, or exchanged (regardless of whether there is an intent to do so).

– Otherwise it should be included in the amount recognized as goodwill.

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Goodwill and other Intangibles• When amounts assigned to intangible assets

are significant, required disclosure includes: – for intangible assets subject to amortization, the

total amount assigned and the amount assigned to each major intangible asset class;

– for intangible assets not subject to amortization, the total amount assigned and the amount assigned to each major intangible asset class; and

– for goodwill:• total goodwill and tax deductible amount; and• amount of goodwill by reportable segment.

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Goodwill and other Intangibles• Identifiable intangible assets are either

– Of limited life– Of indefinite (and perhaps infinite) life

• Assets with limited life should be amortized over the best estimate of the economic life, and are subject to a periodic review for impairment of value, under s. 3061, in the same manner as property, plant and equipment must be reviewed

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Goodwill and other Intangibles• Intangible assets not subject to amortization

should be tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired.

• The impairment test should consist of a comparison of the fair value of the intangible asset with its carrying amount. When the carrying amount of the intangible asset exceeds its fair value, an impairment loss should be recognized in an amount equal to the excess.

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Goodwill Impairment Tests• Goodwill is not to be amortized under the new

provisions, so is subject to special tests to determine if any impairment has occurred

• These impairment tests are carried out at the level of the “reporting unit”– The reporting unit is either a segment (s. 1701),

where the components have similar economic characteristics, or

– A segment component (a business for which discrete financial information is available and for which segment management may regularly review operating results)

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Goodwill Impairment Tests• A goodwill impairment loss should be

recognized when the carrying amount of the goodwill of a reporting unit exceeds the fair value of the goodwill.

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Goodwill Impairment Tests• A goodwill impairment loss should be

recognized when the carrying amount of the goodwill of a reporting unit exceeds the fair value of the goodwill.

• An impairment loss should not be reversed if the fair value subsequently increases.

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Goodwill Impairment Tests• A goodwill impairment loss should be

recognized when the carrying amount of the goodwill of a reporting unit exceeds the fair value of the goodwill.

• An impairment loss should not be reversed if the fair value subsequently increases.

• The fair value of goodwill can be measured only as a residual, not directly, in the same manner that it was initially computed at the time of the business combination which gave rise to recognition

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Goodwill Impairment Tests• The goodwill impairment test is a two stage

process:– First, the fair value of a reporting unit should be

compared with its carrying amount, including goodwill, in order to identify a potential impairment. When the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not to be impaired and the second step of the impairment test is unnecessary.

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Goodwill Impairment Tests– Second, when the carrying amount of a reporting

unit exceeds its fair value, the fair value of the reporting unit's goodwill should be compared with its carrying amount to measure the amount of the impairment loss, if any.

– The fair value of goodwill is determined in accordance with the guidance in paragraph 3062.32.

– When the carrying amount of reporting unit goodwill exceeds the fair value of the goodwill, an impairment loss should be recognized in an amount equal to the excess.

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Goodwill Impairment Tests• The fair value of goodwill is determined in the

same manner as the determination of the value of goodwill in a business combination.

• An enterprise allocates the fair value of a reporting unit to all of the assets and liabilities of the unit, whether or not recognized separately, as if the reporting unit had been acquired in a business combination and the fair value of the reporting unit was the price paid to acquire the reporting unit.

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Goodwill Impairment Tests• The excess of total fair value over assigned

amounts is the fair value of goodwill. • Although amounts are assigned to intangible

assets in this process, additional intangible assets are not recognized

• This allocation process is performed only for purposes of testing goodwill for impairment and does not cause an enterprise to write up or write down a recognized asset or liability or to recognize a previously unrecognized asset as a result of this allocation process.

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International View

There is significant variation internationally in the determination of the value of intangible assets and their treatment in the financial statements

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Transitional Provisions• Goodwill Impairment Test

– In accordance with the transitional provisions contained in Section 3062 of the CICA Handbook, an impairment loss recognized during the financial year in which the new recommendations are initially applied is recognized as the effect of a change in accounting policy and charged to opening retained earnings, without restatement of prior periods.

– This treatment is consistent with many other changes in accounting policy arising from changes in the provisions of the CICA Handbook

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Transitional Provisions

From the annual report, 2001

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Transitional Provisions

From the annual report, 2001

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Consolidated income and retained earnings• Consolidated income consists of:

– Net income of the parent from its own operations• Excludes dividends and other income from

subsidiary– Plus: Parent’s share of net income from subsidiary– Less: Amortization of the purchase discrepancy

• This approach can always be used to compute the value of consolidated net income, whether or not an income statement is to be prepared

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Consolidation from the Equity Method• At the date of acquisition, the financial

statements (especially the balance sheet) may be prepared as a “snapshot” at a point in time

• After acquisition, the consolidated financial statements must include the accounts of both the parent and the subsidiary, reported as one economic entity

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Consolidation from the Equity Method• When a company buys the shares of another

company, the cost of these shares is recorded in an “investment account”

• When the intercorporate investment is a subsidiary, the external financial reporting will nearly always be through the presentation of consolidated financial statements

• However, the parent company must continue to maintain the investment account for the subsidiary, as the actual companies generally remain as separate legal entities

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Consolidation from the Equity Method• The investment account may be maintained by

the cost method, or the equity method (or by any other systematic method)– The choice of method to employ is entirely at the

discretion of the company involved, as this is a matter of internal accounting policy, not external reporting - there are no strong conceptual arguments in favour of either approach

• Virtually all external reporting will include consolidated financial statements, so we are concerned with background for consolidation - preparation of these statements

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Consolidation from the Equity Method• This chapter is concerned with the process of

consolidation when the “investment account” has been maintained using the equity method

• Problem material illustrates this approach• Use of the equity method by the parent generally

means that the original cost of the investment has been periodically updated for– Earnings and dividend distributions of the subsidiary– Amortization of the purchase price discrepancy, as

applicable– Other consolidation adjustments (such as unrealized

profits), as covered in later chapters

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Consolidation from the Equity MethodInvestment in Subsidiary

Original Cost

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Consolidation from the Equity MethodInvestment in Subsidiary

Original Cost Income earned

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Consolidation from the Equity MethodInvestment in Subsidiary

Original Cost Income earned

Dividends received

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Consolidation from the Equity MethodInvestment in Subsidiary

Original Cost Income earned

Dividends received

P.D. Amortization

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Consolidation from the Equity MethodInvestment in Subsidiary

Original Cost Income earned

Dividends received

P.D. Amortization

Other adjustments*

Balance

*In later chapters

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Consolidations: Direct Approach• Although working papers are preferred by

some, a direct approach to the preparation of consolidated financial statements can be significantly more efficient

• When the investment account for the subsidiary is maintained under the equity method:– Parent’s net income equals consolidated net

income– Parent’s retained earnings equals consolidated

retained earnings

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Consolidations: Direct Approach• These true relationships assist greatly in the

preparation of consolidated financial statements

• For the Consolidated Income Statement:– The account investment income (under the equity

method) is replaced by the reported revenues and expenses of the subsidiary, adjusted for the amortization of the purchase discrepancy (and intercompany transactions, if any)

– These adjustments are on working papers only• For Consolidated Retained Earnings

– No adjustments are necessary

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Consolidations: Direct Approach• For the Consolidated Balance Sheet

– The investment account is replaced by the individual assets and liabilities of the subsidiary in the consolidated balance sheet, restated by the unamortized purchase discrepancy (and intercompany balances, if any)

– These adjustments are on working papers only, and are not posted to the general ledger

– Consolidated retained earnings does not have to be restated, as this amount equals the retained earnings of the parent company (determined using the equity method)

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Consolidations: Direct Approach• The direct approach to the preparation of

statements relies on supporting calculations:– The calculation and allocation of the purchase

discrepancy– An amortization schedule for the purchase

discrepancy• Annual amortization amounts for the income

statement• Unamortized amounts for the balance sheet

– Careful determination of any intercompany revenues and expenses, and receivables and payables (if applicable)

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When control ceases? • When control ceases, the investment will no

longer be consolidated as a subsidiary• The “parent” must determine how to account

for the remaining investment, if any:– If a portfolio investment, using the cost method– If significant influence exist, using the equity

method– Discontinued operations, under Handbook s. 3475

• As there is a change in circumstances, the new method does not lead to retroactive restatement

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Intercompany receivables and payables• Related companies often have extensive

transactions within the group– Some companies have the vast majority of their

purchases or sales (or both) to a related company– Vertical integration is one of the principal reasons

intercorporate investments are made• All intercompany sales must be eliminated in

consolidation, against the related purchase• All intercompany balances (including

receivables and payables) are eliminated– This is discussed in the next several chapters