Chap003

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  • Chap003

    1. 1. Chapter Three Consolidations–Subsequent to the Date of Acquisition McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
    2. 2. Consolidation – The Effects of the Passage of Time <ul><li>So, what happens AFTER the date of acquisition? </li></ul><ul><li>As time passes, the investment account changes, and the consolidation process becomes more complex. </li></ul>3-
    3. 3. Consolidation – The Effects of the Passage of Time <ul><li>There are three methods the parent can use to account for its investment: </li></ul><ul><li>Equity Method </li></ul><ul><li>Initial Value Method </li></ul><ul><li>Partial Equity Method </li></ul>3-
    4. 4. Consolidation – The Effects of the Passage of Time For each subsidiary owned, there is an ASSET (the INVESTMENT account that represents the value of the investment), and an INCOME account that represents the earnings on the investment. Let’s briefly compare the three methods and how they affect these two accounts. 3-
    5. 5. Investment Accounting 3- Method Investment Account Income Account Equity Continually adjusted to reflect ownership of acquired company. Income accrued as earned; amortization and other adjustments are recognized. Initial Value Remains at Initially-Recorded cost Cash received is recorded as Dividend Income Partial Equity Adjusted only for accrued income and dividends received from acquired company. Income accrued as earned; no other adjustments recognized.
    6. 6. Investment Accounting 3- What is the advantage of each? Equity Method: The acquiring company totals give a true representation of consolidation figures. Initial Value (or “Cost”) Method: It is easy to apply and gives a good measurement of cash flows generated by the investment. Partial Equity Method: Usually gives balances approximating consolidation figures, but is easier to apply than equity method
    7. 7. Subsequent Consolidation - Equity Method <ul><li>FMV adjustments and other intangible assets, </li></ul><ul><li>The parent’s share of the sub’s income (loss), and </li></ul><ul><li>The receipt of dividends from the sub. </li></ul>During the year, the Parent will adjust its investment account for the Subsidiary under application of the equity method. The original investment, recorded at the date of acquisition, is adjusted for: 3-
    8. 8. Subsequent Consolidation - Equity Method Example Parrot Company obtains all of the outstanding common stock of Sun Company on January 1, 2010. Parrot acquires this stock for $800,000 in cash. Sun Company’s balances are shown below. 3- Book Values Fair Values 1/1/10 1/1/10 Difference Current assets . . . . . . . . . . . . . . . . . . .$ 320,000 $ 320,000 –0– Trademarks (indefinite life) . . . . . . . . . 200,000 220,000 20,000 Patented technology (10-year life) . . . . 320,000 450,000 130,000 Equipment (5-year life) . . . . . . . . . . . . .180,000 150,000 (30,000) Liabilities . . . . . . . . . . . . . . . . . . . . . . .(420,000) (420,000) –0– Net book value . . . . . . . . . . . . . . . . . .$ 600,000 $ 720,000 $120,000 Common stock—$40 par value . . . . .$(200,000) Additional paid-in capital . . . . . . . . . . . (20,000) Retained earnings, 1/1/10 . . . . . . . . . . (380,000)
    9. 9. Subsequent Consolidation - Equity Method Example 3- FV of consideration transferred by Parrot Company. . $ 800,000 Book Value of Sun Company . . . . . . . . . . . . . . . . . . . . .(600,000) Excess of fair value over book value . . . . . . . . . .200,000 Allocation to specific accounts based on fair values: Trademarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,000 Patented technology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130,000 Equipment (overvalued) . . . . . . . . . . . . . . . . . . . . . . . . . . (30,000) 120,000 Excess FV not specifically identified—goodwill. . . . . . . $ 80,000 PARROT COMPANY 100 Percent Acquisition of Sun Company Allocation of Acquisition-Date Subsidiary Fair Value January 1, 2010
    10. 10. Subsequent Consolidation - Equity Method Example Amortization computation: 3- Useful Annual Account Allocation Life Amortization Trademarks $ 20,000 Indefinite –0– Patented technology 130,000 10 years $13,000 Equipment (30,000) 5 years (6,000) Goodwill 80,000 Indefinite –0– $ 7,000 Amortization will be $7,000 annually for the first five years , until the equipment allocation is fully removed.
    11. 11. Subsequent Consolidation - Equity Method Example Parrot Company will record an entry at the date of acquisition, but what happens after that? Let’s assume Sun Company earns income of $100,000 in 2010 and pays a $40,0000 cash dividend on August 1, 2010. 3-
    12. 12. Subsequent Consolidation - Equity Method Example 3- 1/1/10 Investment in Sun Company . . . . . 800,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 800,000 To record the acquisition of Sun Company. 8/1/10 Cash . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 Investment in Sun Company. . . . . . . . . 40,000 To record receipt of cash dividend from subsidiary under the equity method. 12/31/10 Investment in Sun Company. . . . 100,000 Equity in Subsidiary Earnings . . . . . . 100,000 To accrue income earned by 100% owned subsidiary. 12/31/10 Equity in Subsidiary Earnings . . . . 7,000 Investment in Sun Company . . . . . . . . . 7,000 To recognize amortizations on allocations made in acquisition of subsidiary.
    13. 13. Subsequent Consolidation – Worksheet Entries 3- After the parent company’s books are updated under the equity method , how do we consolidate the two companies? We will prepare FIVE different entries for the consolidation workpaper !
    14. 14. Subsequent Consolidation - Worksheet Entries <ul><li>S) The Sub’s equity accounts are eliminated. </li></ul><ul><li>A) Other intangible assets are recorded and </li></ul><ul><li>the Sub’s assets are adjusted to FV . </li></ul><ul><li>I) The Equity in Sub Income account is </li></ul><ul><li>eliminated. </li></ul><ul><li>D) The Sub’s dividends are eliminated. </li></ul><ul><li>E) Amortization Expense is recorded for the </li></ul><ul><li>FMV adjustments and other intangible </li></ul><ul><li>assets that were recorded in consolidation. </li></ul>3-
    15. 15. Subsequent Consolidation – Equity Method – Example Entry S 3- Note: If this is the first year of the investment, and the investment was made at a time other than the beginning of the fiscal year, then pre-acquisition income of the sub must be accounted for in the retained earnings balance. Common Stock (Sun Company). . . . 200,000 APIC (Sun Company) . . . . . . . . . . . . 20,000 R/E, 1/1/10 (Sun Company) . . . . . . . 380,000 Investment in Sun Company . . . . . . . . . . 600,000
    16. 16. Subsequent Consolidation – Equity Method – Example Entry A 3- Trademarks . . . . . . . . . . . . . . .20,000 Patented technology . . . . . . .130,000 Goodwill . . . . . . . . . . . . . . . . .80,000 Equipment . . . . . . . . . . . . . . . . . . 30,000 Investment in Sun Company . . . 200,000 Note: In the first year , the FV adjustments for this entry are calculated in the allocation computation . In subsequent years , the FV adjustments must be reduced by any depreciation taken in prior consolidations.
    17. 17. Subsequent Consolidation – Equity Method–Example Entry I&D 3- Equity in Subsidiary Earnings . . .93,000 Investment in Sun Company. . . . . . . 93,000 Investment in Sun Company . . . . 40,000 Dividends Paid . . . . . . . . . . . . . . . . 40,000
    18. 18. Subsequent Consolidation – Equity Method – Example Entry E 3- <ul><ul><li>Remember: Never amortize land or goodwill! </li></ul></ul>Amortization Expense . . . . . . . . . 13,000 Equipment . . . . . . . . . . . . . . . . . . . 6,000 Patented Technology . . . . . . . . . . . . . . . . . . . 13,000 Depreciation Expense . . . . . . . . . . . . . . . . . . . 6,000
    19. 19. Applying the Initial Value Method If the Initial Value Method is used by the parent company to account for the investment, then the consolidation entries will change only slightly. Remember . . . The PARENT will record the sub’s activity differently under this method, so the Parent’s accounts will differ from the Equity Method . <ul><li>No adjustments are recorded in the Investment account for current year operations , dividends paid by the subsidiary, or amortization of purchase price allocations. </li></ul><ul><li>Dividends received from the subsidiary are recorded as Dividend Revenue . </li></ul>3-
    20. 20. Consolidation Entries - Initial Value Method <ul><li>Entry S </li></ul><ul><li>Eliminate the sub’s equity balances as of the beginning of the period. </li></ul><ul><li>This entry is the same under the Equity Method and the Initial Value Method. </li></ul>3-
    21. 21. Consolidation Entries – Initial Value Method <ul><li>Entry A </li></ul><ul><ul><li>Adjust sub’s assets and liabilities to FV , and set up the intangible asset accounts. </li></ul></ul><ul><ul><li>This entry is the same under the Equity Method and the Initial Value Method. </li></ul></ul>3-
    22. 22. Consolidation Entries – Initial Value Method <ul><li>Entry I </li></ul><ul><li>This entry is different under the Initial Value Method. </li></ul><ul><li>Eliminate the Parent’s Dividend Income account and the Sub’s Dividends Paid account. </li></ul>3-
    23. 23. Consolidation Entries – Initial Value Method <ul><li>Entry D </li></ul><ul><li>Under the Initial Value Method we DO NOT make an Entry D. </li></ul>3-
    24. 24. Consolidation Entries - Initial Value Method <ul><li>Entry E </li></ul><ul><li>Record the amortization of the purchase price allocations . </li></ul><ul><ul><li>This entry is the same under the Equity Method and the Initial Value Method. </li></ul></ul>3-
    25. 25. Consolidation Entries – Partial Equity Method <ul><li>If the Parent uses the Partial Equity Method, what will change from the previous two methods? </li></ul>So, the Investment and Income account balances will differ from the other methods, and so will worksheet Entries I and D . <ul><li>Remember, the Parent’s record-keeping is limited to two periodic journal entries: </li></ul><ul><li>the annual accrual of subsidiary income and </li></ul><ul><li>the receipt of dividends. </li></ul>3-
    26. 26. Other Consolidation Entries <ul><li>In addition to the Entries S, A, I, D, & E, we will also eliminate intercompany payables or receivables . </li></ul>3- AND, if control acquired is less than 100% , an additional adjustment must be made (see Chapter 4).
    27. 27. Consolidation Entries – ALL METHODS <ul><li>Now, check out the consolidated results! </li></ul><ul><li>No matter which method the Parent chooses to record the Sub’s activity, the consolidated totals end up the SAME ! </li></ul><ul><li>This is because we are eliminating all the entries that we made during the year, regardless of the method used, and regardless of the amount ! </li></ul>3-
    28. 28. Goodwill and Other Intangible Assets (ASC Topic 350) AFTER December 15, 2001, goodwill is no longer amortized. This applies to both previously recognized and newly acquired goodwill. Unamortized goodwill left from prior combinations is carried on the books as a permanent asset (subject to impairment review). 3-
    29. 29. Goodwill and Other Intangible Assets (ASC Topic 350) Generally, once goodwill has been recorded, the value will remain unchanged . 3- <ul><li>We will adjust goodwill on the consolidated balance sheet if : </li></ul><ul><li>We sell all or part of the related subsidiary, or </li></ul><ul><li>We determine that there has been a permanent decline in value (in which case we record the impairment as an extraordinary item). </li></ul>
    30. 30. Goodwill Impairment – Two-Step Test <ul><li>Step 1 </li></ul><ul><li>Is the fair value of the Reporting Unit less than its carrying value? </li></ul><ul><li>If NO , then Goodwill is NOT impaired, and there is no further testing required. </li></ul><ul><li>If YES , go to Step 2… </li></ul>3-
    31. 31. Goodwill Impairment – Two-Step Test 3- Step 2 Is the fair value of Goodwill less than its carrying value? If NO , then Goodwill is NOT impaired, and there is no further testing required. If YES , then an extraordinary impairment loss is recorded.
    32. 32. Goodwill Impairment Test <ul><li>How is the acquisition value assigned to the Reporting Unit? </li></ul><ul><li>How is the fair value of the Reporting Unit determined? </li></ul><ul><li>How is the implied fair value of goodwill determined? </li></ul>Is it that easy?? No. There are three complexities . 3-
    33. 33. <ul><li>A Reporting Unit can be: </li></ul><ul><li>A component of an operating segment </li></ul><ul><li>A segment of an enterprise </li></ul><ul><li>The entire enterprise </li></ul>Assignment of Acquisition Value to the Reporting Unit Goodwill must be assigned to a related REPORTING UNIT. 3-
    34. 34. <ul><li>Fair Value can be based on </li></ul><ul><li>Market price , if the reporting unit is publicly traded, or </li></ul><ul><li>Market price of comparable businesses , or </li></ul><ul><li>Business valuation techniques using PV. </li></ul>Periodic Determination of the Fair Value of a Reporting Unit 3-
    35. 35. <ul><li>Allocate the purchase price to all identifiable assets and liabilities of the reporting unit. </li></ul><ul><li>Compare the resulting “implied goodwill” to the goodwill on the books. </li></ul><ul><li>If “implied goodwill” is less than recorded goodwill, impairment has occurred. </li></ul>Determination of the Implied Fair Value of Goodwill The implied fair value of Goodwill is calculated in a similar manner as the determination of goodwill in a business combination. 3-
    36. 36. Goodwill Impairment Test - Example 3- <ul><li>On January 1, 2011, Newcall Corporation was formed to consolidate operations of three communications companies in a deal valued at $2.9 billion. </li></ul><ul><li>Each of the three former firms is considered an operating segment and will be maintained as a subsidiary of Newcall. </li></ul><ul><li>Additionally, one firm comprises two divisions, that along with the other two firms are treated as independent reporting units. </li></ul><ul><li>Newcall recognized $221 million as goodwill at the merger date and allocated this entire/amount to its reporting units. </li></ul><ul><li>That information and each unit’s acquisition fair value follow. </li></ul>
    37. 37. Goodwill Impairment Test Example 3- Newcall’s Acquisition Fair Value Reporting Units Goodwill January 1, 2011 DSM Wired $ 22,000,000 $950,000,000 DSM Wireless 155,000,000 748,000,000 Rocketel 38,000,000 492,000,000 Visiontalk 6,000,000 710,000,000 Newcall then compares the implied fair value of the DSM Wireless goodwill to its carrying value using the following allocation of the fair value of DSM Wireless at year end …
    38. 38. Goodwill Impairment Test Example 3- DSM Wireless Dec. 31, 2011, fair value $600,000,000 Fair values of DSM Wireless net assets at Dec. 31, 2011: Current assets $ 50,000,000 Property 125,000,000 Equipment 265,000,000 Subscriber list 140,000,000 Patented technology 185,000,000 Current liabilities (44,000,000) Long-term debt (125,000,000) Value assigned to identifiable net assets 596,000,000 Value assigned to goodwill 4,000,000 Carrying value before impairment 155,000,000 Impairment loss $151,000,000
    39. 39. International Accounting Standards <ul><li>Under US GAAP: </li></ul><ul><li>Goodwill is allocated to Reporting Units, usually operating segments. </li></ul><ul><li>A two-step process is used to test for impairment. </li></ul><ul><li>If the carrying amount of goodwill is more than its implied value, an extraordinary loss is recognized. </li></ul>3- <ul><li>Under IAS: </li></ul><ul><li>Goodwill is allocated to cash-generating units – at a level much lower than an operating segment. </li></ul><ul><li>A one-step process is used to test for impairment. </li></ul><ul><li>Goodwill is reduced for any excess carrying value, down to zero, and then other assets are reduced pro-rata. </li></ul>How does goodwill treatment compare to International Accounting Standards ?
    40. 40. Acquisition Method – Accounting for Contingent Consideration What if part of the consideration to be transferred is contingent on a future event ? Then the acquiring firm must estimate the fair value of the contingent portion and record a liability in consolidation. 3- <ul><li>The amount of the payment, times </li></ul><ul><li>The likelihood it will be paid, times, </li></ul><ul><li>A factor for the time value of money (represented as [1 / (1+%)] </li></ul>
    41. 41. Push Down Accounting <ul><li>The acquisition-date fair value is recorded directly in the books of the Subsidiary. </li></ul><ul><li>SEC encourages Push Down Accounting for separate Subsidiary statements when the Parent owns substantially all of the Subsidiary. </li></ul><ul><li>Generally limited for external reporting, but increasingly popular internally . </li></ul>3-
    42. 42. Summary <ul><li>The Parent’s method of accounting for the investment in the subsidiary affect the consolidation procedures . </li></ul><ul><li>Methods include: </li></ul><ul><ul><li>Initial Value </li></ul></ul><ul><ul><li>Partial Equity </li></ul></ul><ul><ul><li>Equity. </li></ul></ul><ul><li>Key worksheet entries include: </li></ul><ul><ul><li>Income Recognition </li></ul></ul><ul><ul><li>Allocation of Values </li></ul></ul><ul><ul><li>Amortization </li></ul></ul><ul><ul><li>Elimination of reciprocal balances </li></ul></ul>3-
    43. 43. Possible Criticisms <ul><li>Some critics contend that the purchase of an entity effectively creates a new entity and, therefore, valuation changes should be “ pushed down ” to the subsidiary’s records. </li></ul><ul><li>Goodwill impairment is controversial as some argue that it is difficult to objectively measure and can lead to financial statement manipulation . </li></ul><ul><li>WHAT DO YOU THINK ??? </li></ul>3-

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