Chapter Two Consolidation of Financial Information McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Business Combinations  Most organizations, large and small, hold ownership in other companies.  FASB Accounting Standards Codification (ASC) Business Combinations (Topic 805) and Consolidation (Topic 810) provide guidance using the “acquisition method”.  The acquisition method embraces the fair value measurement for measuring and assessing business activity. 2-2

Business Combinations  Financial statements that represent a parent and its subsidiaries as a SINGLE ENTITY are known as “consolidated” financial statements.  Ownership can exist through a majority voting interest or with a lesser percentage of ownership through governance contracts, leases, or agreements with other stockholders. 2-3

Reasons Firms Combine  Vertical integration  Cost savings  Quick entry into new markets  Economies of scale  More attractive financing opportunities  Diversification of business risk  Business Expansion  Increasingly competitive environment LO 1 2-4

Recent Notable Business Combinations 2-5

The Consolidation Process  Consolidated financial statements provide more meaningful information than separate statements.  Consolidated financial statements more fairly present the activities of the consolidated companies.  Yet, consolidated companies may retain their legal identities as separate corporations. “There is a presumption that consolidated statements are more meaningful.. and that they are usually necessary for a fair presentation when one of the companies in the group… has a controlling financial interest..” FASB ASC ( ) LO 2 2-6

Business Combinations Business combinations...  can be achieved through transactions or events in which an acquirer obtains control over one or more businesses.  Create single economic entities.  Can be formed by a variety of events but can differ widely in legal form.  Require consolidated financial statements. LO 3 2-7

Business Combinations 2-8

FASB Control Model  The FASB provides guidance and defines control when accounting for business combinations with this control model:  “A reporting entity has the power to direct the activities of another entity when it has the current ability to direct the activities of the entity that significantly affect the entity's returns.”  The power criterion defines control both operationally through “majority voting shares” and conceptually through contractual rights. 2-9

Subsidiaries’ financial data Prepare a single set of consolidated financial statements. Parent’s financial data Consolidation of Financial Information 2-10 To report the financial position, results of operations, and cash flows for the combined entity. Reciprocal accounts and intra-entity transactions are adjusted or eliminated to... brought together 2-10

What is to be consolidated? If dissolution occurs: All account balances are actually consolidated in the financial records of the survivor. If separate incorporation maintained: Financial statement information (on work papers, not the actual records) is consolidated. 2-11

When does consolidation occur? If dissolution occurs: Permanent consolidation occurs at the combination date. If separate incorporation maintained: Consolidation occurs at regular intervals, whenever financial statements are prepared. 

How does consolidation affect the accounting records? If dissolution occurs: Dissolved company’s records are closed out. Surviving company’s accounts are adjusted to include all balances of the dissolved company. If separate incorporation is maintained: Each company continues to retain its own records.  worksheets facilitates the periodic consolidation process without disturbing individual accounting systems. 2-13

The Acquisition Method  Used to account for business combinations.  Requires recognizing and measuring at fair value:  Consideration transferred for the acquired business  Noncontrolling interest  Separately identified assets and liabilities  Goodwill or gain from a bargain purchase  Any contingent considerations. LO

Fair Value  Asset valuations established using…  The Market Approach – fair value can be estimated referencing similar market trades.  The Income Approach – fair value can be estimated using the discounted future cash flows of the asset.  The Cost Approach – estimates fair values by reference to the current cost of replacing an asset with another of comparable economic utility. LO

Acquisition Method What if the consideration transferred does NOT EQUAL the Fair Value of the Assets acquired? If the consideration is LESS than the Fair Value of the Assets acquired, we got a BARGAIN!! And we will record a GAIN on the acquisition!! If the consideration is MORE than the Fair Value of the Assets acquired, the difference is attributed to GOODWILL 2-16

Acquisition Method Example Purchase Price = Fair Value BigNet pays $2,550,000 ($550,000 cash and 20,000 unissued shares of its $10 par value common stock that is currently selling for $100 per share) for all of Smallport’s assets and liabilities. Smallport then dissolves as a legal entity. As is typical, the $2,550,000 fair value of the consideration transferred by BigNet represents the fair value of the acquired Smallport business. Dissolution of Subsidiary 2-17

Consideration Transferred = Net Identified Asset Fair Values BigNet Company’s Financial Records—December 31 Current Assets ,000 Computers and Equipment ,000 Capitalized Software ,200,000 Customer Contracts ,000 Notes Payable ,000 Cash (paid by BigNet) ,000 Common Stock (20,000 shares issued at $10 par value) 200,000 Additional Paid-In Capital ,800,000 To record acquisition of Smallport Company. Assets acquired and liabilities assumed are recorded at fair value. Dissolution of Subsidiary LO

Acquisition Method Example Purchase Price > Fair Value BigNet pays $3,000,000 ($1,000,000 cash and 20,000 unissued shares of its $10 par value common stock that is currently selling for $100 per share) for all of Smallport’s assets and liabilities. Smallport then dissolves as a legal entity. The $3,000,000 fair value of the consideration transferred by BigNet is greater than the fair value of the acquired Smallport business. Dissolution of Subsidiary 2-19

Acquisition Method Example Purchase Price > Fair Value BigNet Company’s Financial Records—December 31 Current Assets ,000 Computers and Equipment ,000 Capitalized Software ,200,000 Customer Contracts ,000 Goodwill ,000 Notes Payable ,000 Cash (paid by BigNet) ,000,000 Common Stock (20,000 shares at $10 par value) ,000 Additional Paid-In Capital ,800,000 To record acquisition of Smallport Company. Assets acquired and liabilities assumed are recorded at fair value. Dissolution of Subsidiary 2-20

Acquisition Method Example Purchase Price < Fair Value BigNet pays $2,000,000 by issuing 20,000 unissued shares of its $10 par value common stock that is currently selling for $100 per share for all of Smallport’s assets and liabilities. Smallport then dissolves as a legal entity. The $2,000,000 fair value of the consideration transferred by BigNet is less than the fair value of the acquired Smallport business. Dissolution of Subsidiary 2-21

Acquisition Method – Example Purchase Price < Fair Value BigNet Company’s Financial Records—December 31 Current Assets ,000 Computers and Equipment ,000 Capitalized Software ,200,000 Customer Contracts ,000 Notes Payable ,000 Common Stock (20,000 shares issued at $10 par value) 200,000 Additional Paid-In Capital ,800,000 Gain on Bargain Purchase ,000 To record acquisition of Smallport Company. Assets acquired and liabilities assumed are recorded at fair value. Dissolution of Subsidiary 2-22

Related Costs of Business Combinations  Direct Costs of the acquisition (attorneys, appraisers, accountants, investment bankers, etc.) are NOT part of the fair value received, and are immediately expensed.  Indirect or Internal Costs of acquisition (secretarial and management time) are period costs expensed as incurred.  Costs to register and issue securities related to the acquisition reduce their fair value. 2-23

Acquisition Method Separate Incorporation Maintained  Dissolution does not occur.  Consolidation process is similar to previous example.  Fair value is the basis for initial consolidation of subsidiary’s net assets.  Subsidiary is a legally incorporated separate entity.  Consolidation of financial information is simulated.  Acquiring company does not physically record the transaction. LO

The Consolidation Worksheet Consolidation worksheet entries (adjustments and eliminations) are entered on the worksheet only. Steps in the process: 1.Prior to constructing a worksheet, the parent prepares a formal allocation of the acquisition date fair value similar to the equity method procedures. 2. Financial information for Parent and Sub is recorded in the first two columns of the worksheet (with Sub’s prior revenue and expense already closed). LO

The Consolidation Worksheet continued Remove the Sub’s equity account balances. 4.Remove the Investment in Sub balance. 5.Allocate Sub’s Fair Values, including any excess of cost over Book Value to identifiable assets or goodwill. 6.Combine all account balances and extend into the Consolidated totals column. 7.Subtract consolidated expenses from revenues to arrive at net income. 2-26

Acquisition Method – Consolidation Workpaper Example 2-27

Acquisition Date Fair-Value Allocations – Additional Issues  Intangibles are assets that:  Lack physical substance (excluding financial instruments)  Arise from contractual or other legal rights  Can be sold or otherwise separated from the acquired enterprise  Preexisting goodwill recorded in the acquired company’s accounts is ignored in the allocation of the purchase price.  IPR&D that has reached technological feasibility is capitalized as an intangible asset at fair value with an indefinite life that is reviewed for impairment.  Ongoing R&D is expensed as incurred. LO

Convergence between U. S. and International Standards  IASB International Financial Reporting Standard 3 (IFRS 3) Revised and FASB ASC topics 805, Business Combinations, and 810, Consolidation, effectively converged accounting for business combinations.  In 2011, the IASB issued IFRS 10 Consolidated Financial Statements and IFRS 12 Disclosure of Interests in Other Entities - effective beginning in New definition of control focuses on the power to direct the activities of an entity, exposure to variable returns, and a linkage between power and returns. 2-29

Legacy Methods – Purchase and Pooling of Interests Methods  2002 to 2008: Purchase Method  Prior to 2002: Purchase Method Or The Pooling Of Interests Method Since the ACQUISITION METHOD is applied to business combinations occurring in 2009 and after, the two prior methods are still in use. LO

Purchase Method – Differences from the Acquisition Method  Valuation basis was “cost”  The value of the consideration transferred,  PLUS the direct costs of the acquisition,  IGNORE any indirect costs of the acquisition,  IGNORE any contingent payments.  The total cost of the acquisition was allocated proportionately to the net assets based on their fair values, with any excess going to goodwill. 2-31

Purchase Method – Purchase Price < Fair Value What if the total cost was less than the fair value? Under the purchase method, a bargain purchase occurred when the sum of the individual fair values of the acquired net assets exceeded the purchase cost. Current assets and liabilities were recorded at fair value, and some non-current assets were reduced proportionately. Long-term assets were reduced because their fair-value estimates were considered less reliable than current items and liabilities. 2-32

Purchase Method – Purchase Price < Fair Value If the difference in purchase price and fair value was substantial enough to eliminate all the non-current asset account balances of the acquired company, the remainder was reported as an extraordinary gain. In-Process R&D was expensed under the Purchase Method, unless it had reached technological feasibility. 2-33

Pooling of Interests Historical Review Prior to 2002, under certain criteria, combinations could be accounted for as “Pooling of Interests” when one company acquired all of another company’s stock – using its own stock as consideration (no cash!) These Pooling combinations are left intact going forward. 2-34

 Book values of the assets and liabilities of both companies became the book values reported by the combined entity.  The revenue and expense accounts were combined both before and after the combination.  Reported income was typically higher than under the purchase accounting method. Not only did firms retrospectively combine incomes, there was less depreciation and amortization expense. Pooling of Interests Historical Review 2-35

Summary Consolidation of financial information is required when one firm gains control of another. Current financial reporting standards require the acquisition method to be used in accounting for business combinations. Recognize Goodwill if the purchase price > fair value of net assets acquired; recognize a gain if purchase price < fair value of net assets. Particular attention should be paid to the recognition of intangible assets in business combinations. 2-36