© The McGraw-Hill Companies, Inc., 2001 Slide 2-1 McGraw-Hill/Irwin 2 C H A P T E R Consolidation of Financial Information Updated Sixth Edition

© The McGraw-Hill Companies, Inc., 2001 Slide 2-2 McGraw-Hill/Irwin Why do Firms Combine? Vertical integration. Cost savings. Quick access to new markets. Economies of scale. More attractive financing opportunities. Diversification of business risk. Vertical integration. Cost savings. Quick access to new markets. Economies of scale. More attractive financing opportunities. Diversification of business risk.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-3 McGraw-Hill/Irwin Business Combinations In a business combination, one company (parent) gains CONTROL over another company (called a “subsidiary” or “sub”). For reporting purposes, the combined companies are treated as if they were one. In a business combination, one company (parent) gains CONTROL over another company (called a “subsidiary” or “sub”). For reporting purposes, the combined companies are treated as if they were one.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-4 McGraw-Hill/Irwin There are 3 basic types of combinations. Statutory Merger Statutory Consolidation Acquisition of Majority Interest Business Combinations: Creating a Single Economic Entity

© The McGraw-Hill Companies, Inc., 2001 Slide 2-5 McGraw-Hill/Irwin Parent Subsidiary The Sub still prepares separate financial statements Consolidated financial statements are prepared. The parent does not prepare separate financial statements Consolidation of Financial Information

© The McGraw-Hill Companies, Inc., 2001 Slide 2-6 McGraw-Hill/Irwin GAAP Accounting Methods

© The McGraw-Hill Companies, Inc., 2001 Slide 2-7 McGraw-Hill/Irwin If the acquisition is made by issuing stock, the cost of the acquisition is equal to the MARKET VALUE of the stock issued. Purchase Method Used when one company “acquires” control of another company. Three basic criteria:  One company is clearly in the “acquiring” role.  A bargained exchange has taken place.  An historical cost figure can be determined.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-8 McGraw-Hill/Irwin Purchase Method Example Big wants control of Little. Big’s 2,000 stockholders hold a total of 2,500,000 shares of $10 par value Big stock. Little’s 1,000 stockholders hold a total of 600,000 shares of $5 par value Little stock. Little’s current market price is $30 per share.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-9 McGraw-Hill/Irwin Purchase Method Example Assume that Big purchases 100% of Little from Little’s stockholders for $18,000,000.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-10 McGraw-Hill/Irwin Purchase Method Example Assume that Big purchases 100% of Little from Little’s stockholders for $18,000,000.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-11 McGraw-Hill/Irwin Purchase Method Example Assume that Big purchases 100% of Little from Little’s stockholders for $18,000,000.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-12 McGraw-Hill/Irwin Purchase Method Example Assume that Big purchases 100% of Little from Little’s stockholders for $18,000,000.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-13 McGraw-Hill/Irwin Let’s look at some different situations where the Purchase Method would be used.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-14 McGraw-Hill/Irwin Purchase Method Situations Dissolution of the acquired company:  Cost = FMV  Cost > FMV  Cost < FMV Separate incorporation is maintained. Dissolution of the acquired company:  Cost = FMV  Cost > FMV  Cost < FMV Separate incorporation is maintained.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-15 McGraw-Hill/Irwin Purchase Method Cost = FMV, Dissolution Ignore the Equity and Nominal accounts of the acquired company. Determine FMV of the acquired company’s assets and liabilities. Prepare a journal entry to  recognize cost of the acquisition  incorporate the FMV of acquired company’s assets and liabilities into acquiring company’s books.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-16 McGraw-Hill/Irwin Prepare the entry to record Large’s purchase. Cost = FMV, Dissolution Example On 1/1/02, Large acquired 100% of Tiny for $300,000 cash.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-17 McGraw-Hill/Irwin Cost = FMV, Dissolution Example Tiny’s fair market value was $300,000 which is equal to the price paid by Large. Record the purchased assets at their market value.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-18 McGraw-Hill/Irwin Purchase Method Cost > FMV, Dissolution At date of acquisition:  Acquired company should prepare a B/S as of the date of acquisition.  Acquired company’s income prior to acquisition is irrelevant to the acquiring company. FMV of acquired company’s assets and liabilities is added to acquiring company’s books. Difference between Cost and FMV is allocated to goodwill and other intangibles. Note: Goodwill should be viewed as a residual amount remaining after all other identifiable and separable intangible assets have been identified.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-19 McGraw-Hill/Irwin Small has no identifiable, separable intangible assets. Cost > FMV, Dissolution Example On 1/1/02, Huge acquires 100% of Small for $250,000 cash.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-20 McGraw-Hill/Irwin Goodwill will be recorded as an intangible asset on Huge’s books, but will not be amortized. Cost > FMV, Dissolution Example

© The McGraw-Hill Companies, Inc., 2001 Slide 2-21 McGraw-Hill/Irwin Cost > FMV, Dissolution Example Large will record $33,000 of Goodwill and will record the other purchased assets at their FMV.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-22 McGraw-Hill/Irwin Purchase Method Cost < FMV, Dissolution FMV can occasionally exceed cost. Current assets and liabilities should be consolidated at their FMV. Long-term assets should be recorded at a value between FMV and BV.  each L-T asset’s FMV should be reduced by a proportionate share of the excess of FMV over cost.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-23 McGraw-Hill/Irwin Cost Substantially < FMV In the event that the difference is substantial enough to eliminate all the non-current asset balances of the acquired company The remainder is to be reported as an extraordinary gain (SFAS 141) In the event that the difference is substantial enough to eliminate all the non-current asset balances of the acquired company The remainder is to be reported as an extraordinary gain (SFAS 141)

© The McGraw-Hill Companies, Inc., 2001 Slide 2-24 McGraw-Hill/Irwin Let’s see what happens when the acquired company is not dissolved.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-25 McGraw-Hill/Irwin Purchase Method No Dissolution The acquired company continues as a separate entity.  The acquisition shows up on the Parent’s books in 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. The acquired company continues as a separate entity.  The acquisition shows up on the Parent’s books in 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.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-26 McGraw-Hill/Irwin Rules of Consolidation 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 FMV. Allocate any excess of cost over BV to identifiable, separable intangible assets or goodwill. Combine all account balances.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-27 McGraw-Hill/Irwin No Dissolution Example On 1/1/03, Huge acquires 100% of Small for $250,000 cash. Small holds a trademark that is valued at $25,000.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-28 McGraw-Hill/Irwin Ê Record the balances for each company in the worksheet.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-29 McGraw-Hill/Irwin ËRemove the investment account from the worksheet.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-30 McGraw-Hill/Irwin ÌRemove the subsidiary’s equity account balances. Let’s look at the computation of Goodwill next.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-31 McGraw-Hill/Irwin Goodwill Computation for Huge’s Acquisition of Small We use these numbers for steps #4 & #5.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-32 McGraw-Hill/Irwin ÍAdjust the subsidiary’s balances to FMV.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-33 McGraw-Hill/Irwin ÎRecord the trademark and the Goodwill.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-34 McGraw-Hill/Irwin ÏAdd the balances across the page.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-35 McGraw-Hill/Irwin Purchase Price Allocations - Additional Issues Consolidation Costs  Legal Fees, Direct Costs of Combination  Increase the Investment in Subsidiary account. Stock Issuance Costs  Broker Fees, Registration Fees, etc.  Decrease the Parent’s Paid- In Capital account. Consolidation Costs  Legal Fees, Direct Costs of Combination  Increase the Investment in Subsidiary account. Stock Issuance Costs  Broker Fees, Registration Fees, etc.  Decrease the Parent’s Paid- In Capital account.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-36 McGraw-Hill/Irwin Purchase Price Allocations - Additional Issues Intangibles  Often difficult to determine FMV  Better to assign an estimated value rather than include in Goodwill In-Process R&D  Should be expensed immediately upon acquisition. Intangibles  Often difficult to determine FMV  Better to assign an estimated value rather than include in Goodwill In-Process R&D  Should be expensed immediately upon acquisition.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-37 McGraw-Hill/Irwin SFAS 141 Business Combinations Intangible Asset Examples Customer Base Trademarked Brand Names Customer Routes Effective Advertising Programs Covenants Rights (broadcasting, development, use, etc.) Customer Base Trademarked Brand Names Customer Routes Effective Advertising Programs Covenants Rights (broadcasting, development, use, etc.) Databases Technological know- how Patents & Copyrights Strong labor relations Assembled, trained workforce Favorable government relations Databases Technological know- how Patents & Copyrights Strong labor relations Assembled, trained workforce Favorable government relations

© The McGraw-Hill Companies, Inc., 2001 Slide 2-38 McGraw-Hill/Irwin Let’s look at Pooling of Interests.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-39 McGraw-Hill/Irwin Pooling of Interests Historically, business combinations have been accounted for as “Purchases” or “Pooling of Interests.” In its SFAS 141, “Business Combinations”, the FASB states that all business combinations should be accounted for using the purchase method. Historically, business combinations have been accounted for as “Purchases” or “Pooling of Interests.” In its SFAS 141, “Business Combinations”, the FASB states that all business combinations should be accounted for using the purchase method.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-40 McGraw-Hill/Irwin Pooling of Interests The purchase method is not to be applied prospectively, leaving intact prior poolings of interests. Therefore, it is important to understand how to account for PAST poolings. The purchase method is not to be applied prospectively, leaving intact prior poolings of interests. Therefore, it is important to understand how to account for PAST poolings.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-41 McGraw-Hill/Irwin In a pooling, one company obtained essentially “all” of the other company’s stock. The transaction involvee the exchange of common stock. No exchange of cash was allowed. The ownership intersts of two, or more, companies were combined into one new company. No single company was dominant. Precise cost figures were difficult to obtain. To use pooling of interests, 12 strict criteria had to be met. Historical Review of Pooling of Interests

© The McGraw-Hill Companies, Inc., 2001 Slide 2-42 McGraw-Hill/Irwin Historical Review of Pooling of Interests The Book Values of the two combining companies were joined. No Goodwill was recorded. Revenues and expenses were combined retroactively for the two companies.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-43 McGraw-Hill/Irwin Historical Review of Pooling of Interests Both companies continued to exist. An Investment in Sub account was recorded on one company’s books (usually the larger). No Goodwill was recorded. Both companies were combined at BV. Both companies continued to exist. An Investment in Sub account was recorded on one company’s books (usually the larger). No Goodwill was recorded. Both companies were combined at BV.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-44 McGraw-Hill/Irwin Historical Review of Pooling of Interests Prior Period Adjustments were made to account for differences in the ways the two companies accounted for income. A journal entry was recorded to recognize the Investment in Subsidiary. The BV’s for both companies were entered on a consolidation worksheet. Prior Period Adjustments were made to account for differences in the ways the two companies accounted for income. A journal entry was recorded to recognize the Investment in Subsidiary. The BV’s for both companies were entered on a consolidation worksheet.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-45 McGraw-Hill/Irwin Continued Accounting for Pooling of Interests The Investment in Sub account must be eliminated.  Also eliminate the Sub’s Equity accounts to prevent double- counting.  They have already been included in the original Investment in Sub entry. Add together the BV’s of the remaining accounts.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-46 McGraw-Hill/Irwin On 12/31/99, EarthCo merged with Small, Inc. by giving 60,000 shares of $1 par value common stock (FMV = $30 per share) for substantially all of Small’s common shares. Using the information provided for EarthCo and Small, Inc., prepare the journal entry necessary to complete the combination, assuming Small was NOT dissolved. No Dissolution Example

© The McGraw-Hill Companies, Inc., 2001 Slide 2-47 McGraw-Hill/Irwin No Dissolution Example The Investment account for EarthCo should be equal to the BV of Small at the beginning of the period.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-48 McGraw-Hill/Irwin No Dissolution Example Prepare the entry to record the combination transaction.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-49 McGraw-Hill/Irwin No Dissolution Example Prepare the entry to record the combination transaction.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-50 McGraw-Hill/Irwin No Dissolution Example Prepare the entry to record the combination transaction.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-51 McGraw-Hill/Irwin No Dissolution Example Prepare the entry to record the combination transaction. Common Stock + Paid-In Capital in the entry should equal Common Stock + Paid-In Capital for Small. Since Small’s total was $80,000 ($70,000 + $10,000), and we have already entered $60,000 for the issued Common Stock of EarthCo, then we put $20,000 in Paid-In Capital here.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-52 McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2001 Slide 2-53 McGraw-Hill/Irwin Note the altered balances on EarthCo’s books.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-54 McGraw-Hill/Irwin Post the consolidating entry and add the balances.

© The McGraw-Hill Companies, Inc., 2001 Slide 2-55 McGraw-Hill/Irwin Unconsolidated Subsidiaries

© The McGraw-Hill Companies, Inc., 2001 Slide 2-56 McGraw-Hill/Irwin I can’t take much more of this! End of Chapter 2