Consolidation of Financial Information Chapter Two Consolidation of Financial Information McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Business Combinations 2-2 Separate organizations may be tied together through common control The company which exerts control is known as the “parent.” The separate controlled companies are known as “subsidiaries.” Financial statements which represent a parent and its subsidiaries are known as “consolidated” financial statements – prepared as though the companies were a SINGLE ENTITY.

Why do Organizations Combine? 2-3 Vertical integration Cost savings Quick access to new markets Economies of scale More attractive financing opportunities Diversification of business risk

Scale of Recent Combinations 2-4 ACQUIRER TARGET COST (in $ billions) Pfizer Wyeth $67.3 InBev Anheuser-Busch 52.0 Bank of America Merrill Lynch 29.1 Verizon Wireless Alltel 28.1 Mars Candy Wm. Wrigley, Jr 23.2 Delta Airlines Northwest Airlines 3.4

The Consolidation Process 2-5 “The consolidation of financial information into a single set of statements becomes necessary whenever a single economic entity is created by the business combination of two or more companies.” - - ARB No. 51 (August 1959) Why Consolidated Statements? They are presumed to be more meaningful than separate statements. They are considered necessary for fair presentation.

Business Combinations 2-6 SFAS 94 (October 1987) “Consolidated financial statements became common once it was recognized that boundaries between separate corporate entities must be ignored to report the business carried on by a group of affiliated corporations as the economic and financial whole that it actually is.”

Business Combinations 2-7 “A business combination occurs when an enterprise acquires net assets that constitute a business or equity interests of one or more other enterprises and obtains control over that enterprise or enterprises.” - - SFAS No. 141 2

Business Combinations 2-8 A business combination refers to a transaction or other event in which an acquirer obtains control over one or more businesses. There are five types of combinations that are required to prepare consolidated statements. 2

Business Combinations 2-9 Exh. 2-2 Continued 3

Business Combinations – Continued 2-10 Exh. 2-2 3

Consolidation of Financial Information 2-11 Subsidiary Parent The parent does not prepare separate financial statements Consolidated financial statements are prepared. The Sub still prepares separate financial statements 4

Reminder: GAAP Accounting Methods 2-12 5

A Control Issue – SPE’s 2-13 Special Purpose Entities (a popular type of “variable interest entity”) were misused to hide debt and manipulate earnings As a result, the FASB (in FIN 46R) expanded the definition of “control” beyond just the holding of a majority share position. The following indicate a controlling financial interest in a variable interest entity: Direct or indirect ability to make decisions about the entity’s activities Obligation to absorb any expected losses of the entity The right to receive any expected residuals of the entity

What is to be consolidated? 2-14 If dissolution occurs: All account balances are actually consolidated in the financial records of the survivor. If separate incorporation maintained: Financial statement information is consolidated on work papers and not in the actual records

When does consolidation occur? 2-15 If dissolution occurs: Permanent consolidation occurs at the combination date If separate incorporation maintained: Consolidation (on work papers, not in the actual records!!) occurs regularly, whenever financial statements are prepared

How does consolidation affect the accounting records? 2-16 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 maintained: Each company continues to maintain its own records

But if the Acquisition Method is new in 2009, 2-17 But if the Acquisition Method is new in 2009, what was the OLD method?? GAAP used to employ TWO other methods, which were “cost based” …

Legacy Methods – Purchase and Pooling of Interests Methods 2-18 Since the ACQUISITION METHOD is applied only to business combinations occurring in 2009 and after, the two prior methods are still in use. 2002 to 2008: PURCHASE METHOD Prior to 2002: PURCHASE METHOD or the POOLING OF INTERESTS METHOD 6

Purchase Method – Differences from the Acquisition Method 2-19 Valuation basis is “cost” The value of the consideration transferred, PLUS the direct costs of the acquisition, IGNORING any indirect costs of the acquisition, IGNORING any contingent payments. The total cost of the acquisition is allocated proportionately to the net assets based on their fair values, with any excess going to goodwill. 22

Purchase Method – SFAS 141 2-20 Employed when there is a change in ownership resulting in control of one enterprise by another. The appropriate valuation basis for any purchase transaction is “cost”. (Total value assigned to the net assets received equals the total cost of the acquisition.) When the acquisition is made by issuing stock, the cost of the acquisition equals the MARKET VALUE of the stock issued. 6

Accounting Challenge!!! 2-21 Allocation of “cost of acquisition” among the various assets and liabilities obtained. Allocation depends on the relation between total cost and “fair value” of the acquired firm’s assets and liabilities. FASB defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction of market participants at the measurement date.” (FASB, Statement of Financial Accounting Standards No. 157, Fair Value Measurements)

The Acquisition Method – EFFECTIVE IN 2009 2-22 Used when there is a change in ownership, resulting in control of one enterprise by another Requires accounting for the fair value of the acquired business as a whole by recognizing and measuring: Consideration transferred The fair value of each asset acquired and liability assumed Effectively converged with International Standards

The Acquisition Method 2-23 Proposed as a replacement for the Purchase Method Requires measurement of fair value of the acquired business as a whole Requires measurement and recognition of the fair values of the separately identified assets acquired and liabilities assumed

Acquisition Method Situations 2-24 Dissolution of the acquired company: Consideration = Net Fair Values of Assets and Liabilities Consideration > Net Fair Values of Assets and Liabilities Consideration < Net Fair Values of Assets and Liabilities Separate incorporation maintained. 17

Acquisition Method - Dissolution Consideration = Net Fair Values 2-25 Ignore the Equity and Nominal accounts of the acquired company. Determine fair value of the acquired company’s assets and liabilities. Prepare a journal entry to recognize the cost of acquisition incorporate the FV of the acquired company’s assets and liabilities into the acquiring company’s books. 18

Acquisition Method - Dissolution Consideration= Net Fair Values 2-26 BigNet agrees to pay $2,550,000 (cash of $550,000 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 itself 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. 19

Acquisition Method - Dissolution Consideration = Net Fair Values 2-27 20

Acquisition Method - Dissolution Consideration > Net Fair Values 2-28 FV of acquired company’s assets and liabilities is added to acquiring company’s books. Difference between the consideration and FV of acquired assets and liabilities is allocated to an unidentifiable asset known as goodwill. Note: Goodwill should be viewed as a residual amount remaining after all other identifiable and separable intangible assets have been recognized. 22

Acquisition Method - Dissolution Consideration > Net Fair Values 2-29 23

Acquisition Method - Dissolution Consideration < Net Fair Values 2-30 Bargain Purchase under acquisition method Fair value of consideration transferred $110,000 Fair value of net identifiable assets 120,000 Gain on bargain purchase $10,000 Journal entry on Allerton’s books: Current Assets 60,000 Building 50,000 Land 20,000 Trademark 30,000 Gain on bargain purchase 10,000 Liabilities 40,000 Cash 110,000 23

Let’s see what happens when the acquired company is not dissolved. 2-31 Let’s see what happens when the acquired company is not dissolved. 27

Acquisition Method - No Dissolution 2-32 The acquired company continues as a separate entity. Reported on Parent’s books as the Investment in Subsidiary account. Separate records for each company are still maintained. The adjusted balances for the Parent and the Subsidiary are consolidated using a worksheet (no formal journal entries!) 28

Steps for Consolidation 2-33 Record the financial information for both Parent and Sub on the worksheet. Remove the Investment in Sub balance. Remove the Sub’s equity account balances. Adjust the Sub’s net assets to FV. Allocate any excess of cost over BV to identifiable, separable intangible assets or goodwill. Combine all account balances. 6

No Dissolution Example On 1/1/08, Huge acquires 100% of Small for $250,000 cash. Small holds a trademark that is valued at $25,000. 30

Record the balances for each company in the worksheet. 31

Remove the investment account from the worksheet. 32

Remove the subsidiary’s equity account balances. Let’s look at the computation of Goodwill. 33

Goodwill Computation for Huge’s Acquisition of Small We use these numbers for steps #4 & #5. 24

Adjust the subsidiary’s balances to FMV. 34

Record the trademark and the Goodwill. 35

Add the balances across the page. 36

Business Combinations 2-42 Refer to exhibit 2.3 Bignet acquires Smallport for $2,600,000 and the fair value of the contingent performance liability is $20,000. Direct combination costs in the acquisition method are expensed and NOT included in the cost of acquisition. Therefore, total fair value of consideration transferred is $2,620,000.

2-43 31

No Dissolution Example 2-44 30

2-45 32

2-46 33

2-47 24

Acquisition Methods – Key Changes 2-48 Adopts a “business fair value” measurement approach as opposed to the traditional “cost-based” measure Direct combination costs will be expensed as incurred Contingent consideration obligations are recognized as part of the purchase price With bargain purchases, no assets will be recorded at less than fair value, which will produce recognized gains on purchase Allows for capitalization of Purchased In-Process Research and Development (IPR&D)

Capitalization of In-Process Research and Development Costs (IPR&D) 2-49 To be recognized and measured at fair value on the acquisition date Reported as intangible assets with indefinite lives Subject to periodic “impairment reviews”

Related Costs of Business Combinations (Acquisition Method) 2-50 Costs incurred for outside services (attorneys, appraisers, accountants, investment bankers, etc.) related to the combination are NOT considered part of the fair value received, and so are immediately expensed Internal costs of acquisition (secretarial and management time) are expensed as incurred. Costs to register and issue securities related to the acquisition reduce their fair value

Acquisition Method - Summary 2-51 Consideration transferred equals fair values of net assets acquired Assets acquired and liabilities assumed are recorded at their fair values Consideration transferred is greater than the fair values of net assets acquired Assets acquired and liabilities assumed are recorded at their fair values. Excess consideration recorded as goodwill Consideration transferred is less than the fair values of net assets acquired Assets acquired and liabilities assumed are recorded at their fair values. Excess of fair value over consideration is recorded as gain on bargain purchase

Summary 2-52 Consolidation of financial information is required when one organization gains control of another. If dissolution occurs, this consolidation is carried out at the date of acquisition and a single set of accounting records is maintained. If separate identities are maintained, consolidation is a periodic “worksheet” process not involving journal entries. Separate accounting records are maintained. The purchase method is currently GAAP, although the FASB has proposed changing to the Acquisition Method