© The McGraw-Hill Companies, Inc., 2004 Slide 3-1 McGraw-Hill/Irwin Chapter Three Consolidations – Subsequent to the Date of Acquisition

© The McGraw-Hill Companies, Inc., 2004 Slide 3-2 McGraw-Hill/Irwin Consolidation - The Effects of the Passage of Time In Chapter 2, we looked at consolidation on the date of the combination was created. As time passes, the investment account changes, and the consolidation process becomes more complex. In Chapter 2, we looked at consolidation on the date of the combination was created. As time passes, the investment account changes, and the consolidation process becomes more complex.

© The McGraw-Hill Companies, Inc., 2004 Slide 3-3 McGraw-Hill/Irwin SFAS No Goodwill and Other Intangible Assets For fiscal periods beginning AFTER December 15, 2001, goodwill will no longer be amortized. The “nonamortization” rule will apply to both previously recognized and newly acquired goodwill. Any unamortized goodwill that arose from pre-SFAS 142 combinations will be henceforth carried on the books as a permanent asset.

© The McGraw-Hill Companies, Inc., 2004 Slide 3-4 McGraw-Hill/Irwin SFAS No Goodwill and Other Intangible Assets Generally, once goodwill has been recorded, the value will remain unchanged.

© The McGraw-Hill Companies, Inc., 2004 Slide 3-5 McGraw-Hill/Irwin Consolidation - The Effects of the Passage of Time The parent can account for its investment one of three ways: Equity Method Cost Method Partial Equity The parent can account for its investment one of three ways: Equity Method Cost Method Partial Equity Let’s compare the three methods briefly.

© The McGraw-Hill Companies, Inc., 2004 Slide 3-6 McGraw-Hill/Irwin Investment Accounting Exh. 3-1

© The McGraw-Hill Companies, Inc., 2004 Slide 3-7 McGraw-Hill/Irwin Before the consolidation balances can be determined, the Parent’s investment account must be adjusted to reflect the application of the equity method. Subsequent Consolidation - Equity Method  Record the Investment in Sub on the acquisition date.  Recognize the receipt of dividends from the sub.  Recognize a share of the sub’s income (loss).  FMV adjustments and other intangible assets.  Record the Investment in Sub on the acquisition date.  Recognize the receipt of dividends from the sub.  Recognize a share of the sub’s income (loss).  FMV adjustments and other intangible assets.

© The McGraw-Hill Companies, Inc., 2004 Slide 3-8 McGraw-Hill/Irwin On 1/1/05, Dad Co. purchases 100% of Kid, Inc. for $900,000 cash. Kid’s net assets on 1/1/05 was $600,000. Consolidation Example Equity Method

© The McGraw-Hill Companies, Inc., 2004 Slide 3-9 McGraw-Hill/Irwin Consolidation Example Equity Method Before preparing the Equity adjustments, determine the Goodwill and amortization expense.

© The McGraw-Hill Companies, Inc., 2004 Slide 3-10 McGraw-Hill/Irwin Assume that Current Assets have a remaining useful life of 1 year, and the buildings, has a remaining useful life of 10 years. Consolidation Example Equity Method Amortization computation:

© The McGraw-Hill Companies, Inc., 2004 Slide 3-11 McGraw-Hill/Irwin Amortization computation: Consolidation Example Equity Method

© The McGraw-Hill Companies, Inc., 2004 Slide 3-12 McGraw-Hill/Irwin First, prepare the entry to recognize Dad’s share of Kid’s net income. Dad owns 100% of Kid. Kid’s Net Income = $150,000 First, prepare the entry to recognize Dad’s share of Kid’s net income. Dad owns 100% of Kid. Kid’s Net Income = $150,000 Consolidation Example Equity Method

© The McGraw-Hill Companies, Inc., 2004 Slide 3-13 McGraw-Hill/Irwin Consolidation Example Equity Method

© The McGraw-Hill Companies, Inc., 2004 Slide 3-14 McGraw-Hill/Irwin Consolidation Example Equity Method Second, prepare the entry to recognize Dad’s share of Kid’s dividends. Dad owns 100% of Kid. Kid’s Net Income = $150,000 Second, prepare the entry to recognize Dad’s share of Kid’s dividends. Dad owns 100% of Kid. Kid’s Net Income = $150,000

© The McGraw-Hill Companies, Inc., 2004 Slide 3-15 McGraw-Hill/Irwin $400,000 dividends were paid by Kid to Dad during the year. Consolidation Example Equity Method

© The McGraw-Hill Companies, Inc., 2004 Slide 3-16 McGraw-Hill/Irwin Finally, record the amortization of the fair market value adjustments. Consolidation Example Equity Method

© The McGraw-Hill Companies, Inc., 2004 Slide 3-17 McGraw-Hill/Irwin The Amortization Expense from the earlier computation = $27,000 Consolidation Example Equity Method

© The McGraw-Hill Companies, Inc., 2004 Slide 3-18 McGraw-Hill/Irwin Subsequent Consolidation - Worksheet Entries 5 basic entries are posted to the worksheet.  The Sub’s equity accounts are eliminated.  The other intangible assets are recorded and the Sub’s assets are adjusted to FMV.  The Equity in Sub Income account is eliminated.  The Sub’s dividends are eliminated.  Amortization Expense is recorded for the FMV adjustments and other intangible assets associated with the consolidated entity. 5 basic entries are posted to the worksheet.  The Sub’s equity accounts are eliminated.  The other intangible assets are recorded and the Sub’s assets are adjusted to FMV.  The Equity in Sub Income account is eliminated.  The Sub’s dividends are eliminated.  Amortization Expense is recorded for the FMV adjustments and other intangible assets associated with the consolidated entity.

© The McGraw-Hill Companies, Inc., 2004 Slide 3-19 McGraw-Hill/Irwin Consolidation Entries Equity Method Entry S Eliminate the sub’s equity balances as of the beginning of the period. Plug the difference to Investment in Sub. Entry S Eliminate the sub’s equity balances as of the beginning of the period. Plug the difference to Investment in Sub. If (1) this is the first year of the investment, and (2) the investment was made at a time other than the beginning of the fiscal year, then Preacquisition Income must be accounted for (see Chapter 4).

© The McGraw-Hill Companies, Inc., 2004 Slide 3-20 McGraw-Hill/Irwin Consolidation Entries Equity Method Entry A Adjust sub’s assets and liabilities to FMV. Set up the Goodwill account and the other intangible assets. The difference is a reduction of the Investment in Subsidiary account. Entry A Adjust sub’s assets and liabilities to FMV. Set up the Goodwill account and the other intangible assets. The difference is a reduction of the Investment in Subsidiary account. In the first year of the investment, the FMV adjustments for this entry will be identified during the computation of Goodwill. In subsequent years, the FMV adjustments and the other intangible assets identified must be reduced by any depreciation taken in prior periods.

© The McGraw-Hill Companies, Inc., 2004 Slide 3-21 McGraw-Hill/Irwin Consolidation Entries Equity Method Entry I Eliminate the Equity in Sub Income account. Plug the difference to Investment in Sub. Entry I Eliminate the Equity in Sub Income account. Plug the difference to Investment in Sub.

© The McGraw-Hill Companies, Inc., 2004 Slide 3-22 McGraw-Hill/Irwin Consolidation Entries Equity Method Entry D Eliminate sub’s Dividends. Plug the difference to Investment in Sub. Entry D Eliminate sub’s Dividends. Plug the difference to Investment in Sub.

© The McGraw-Hill Companies, Inc., 2004 Slide 3-23 McGraw-Hill/Irwin Consolidation Entries Equity Method Entry E Record amortization expense for the period associated with the FMV adjustments and the other intangible assets identified during the combination. Remember to never amortize land or goodwill!

© The McGraw-Hill Companies, Inc., 2004 Slide 3-24 McGraw-Hill/Irwin Consolidation at 12/31/05 Equity Method Example Using the 12/31/05 adjusted balances, prepare the consolidation at 12/31/05.

© The McGraw-Hill Companies, Inc., 2004 Slide 3-25 McGraw-Hill/Irwin Note Dad’s updated numbers. Now, post the consolidation entries to the worksheet. Note Dad’s updated numbers. Now, post the consolidation entries to the worksheet.

© The McGraw-Hill Companies, Inc., 2004 Slide 3-26 McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2004 Slide 3-27 McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2004 Slide 3-28 McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2004 Slide 3-29 McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2004 Slide 3-30 McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2004 Slide 3-31 McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2004 Slide 3-32 McGraw-Hill/Irwin Applying the Cost Method If the COST METHOD is used by the parent company to account for the investment, then the consolidation entries will change only slightly. Remember... 1.No adjustments are recorded in the Investment account for current year operations, dividends paid by the subsidiary, or amortization of purchase price allocations. 2.Dividends received from the subsidiary are recorded as Dividend Revenue. 1.No adjustments are recorded in the Investment account for current year operations, dividends paid by the subsidiary, or amortization of purchase price allocations. 2.Dividends received from the subsidiary are recorded as Dividend Revenue.

© The McGraw-Hill Companies, Inc., 2004 Slide 3-33 McGraw-Hill/Irwin Consolidation Entries Cost Method Entry S Eliminate the sub’s equity balances as of the beginning of the period. Plug the difference to Investment in Sub. This entry is the same under both the Equity Method and the Cost Method. Entry S Eliminate the sub’s equity balances as of the beginning of the period. Plug the difference to Investment in Sub. This entry is the same under both the Equity Method and the Cost Method.

© The McGraw-Hill Companies, Inc., 2004 Slide 3-34 McGraw-Hill/Irwin Consolidation Entries Cost Method Entry A Adjust sub’s assets and liabilities to FMV. Set up the Goodwill account and the other intangible assets. The difference is a reduction of the Investment in Subsidiary account. This entry is the same under both the Equity Method and the Cost Method. Entry A Adjust sub’s assets and liabilities to FMV. Set up the Goodwill account and the other intangible assets. The difference is a reduction of the Investment in Subsidiary account. This entry is the same under both the Equity Method and the Cost Method.

© The McGraw-Hill Companies, Inc., 2004 Slide 3-35 McGraw-Hill/Irwin Consolidation Entries Cost Method Entry I This entry is different under the Cost Method. Eliminate the Parent’s Dividend Income account. Also, eliminate the Sub’s Dividends Paid account. Entry I This entry is different under the Cost Method. Eliminate the Parent’s Dividend Income account. Also, eliminate the Sub’s Dividends Paid account.

© The McGraw-Hill Companies, Inc., 2004 Slide 3-36 McGraw-Hill/Irwin Consolidation Entries Cost Method Entry D Under the Cost Method we DO NOT make an Entry D. Entry D Under the Cost Method we DO NOT make an Entry D.

© The McGraw-Hill Companies, Inc., 2004 Slide 3-37 McGraw-Hill/Irwin Consolidation Entries Cost Method Entry E Regardless of the method used, we must record the amortization of the purchase price allocations. This entry is the same as the Equity Method. Entry E Regardless of the method used, we must record the amortization of the purchase price allocations. This entry is the same as the Equity Method.

© The McGraw-Hill Companies, Inc., 2004 Slide 3-38 McGraw-Hill/Irwin Other Consolidation Entries In addition to the Entries S, A, I, D, & E, you must also eliminate intercompany payables or receivables. So far, we have assumed that the parent acquired 100% of the subsidiary in the combination. If control acquired is < than 100%, an additional adjustment must be made (see Chapter 4). In addition to the Entries S, A, I, D, & E, you must also eliminate intercompany payables or receivables. So far, we have assumed that the parent acquired 100% of the subsidiary in the combination. If control acquired is < than 100%, an additional adjustment must be made (see Chapter 4).

© The McGraw-Hill Companies, Inc., 2004 Slide 3-39 McGraw-Hill/Irwin Goodwill Impairment Goodwill is not amortized.  It is assigned an “indefinite” useful life. Generally, goodwill will be carried at it’s acquisition cost. At some future point in time, the goodwill may become permanently impaired. Goodwill is not amortized.  It is assigned an “indefinite” useful life. Generally, goodwill will be carried at it’s acquisition cost. At some future point in time, the goodwill may become permanently impaired. SFAS No. 142 calls for an annual test of impairment for Goodwill.

© The McGraw-Hill Companies, Inc., 2004 Slide 3-40 McGraw-Hill/Irwin Goodwill Impairment Examples Exh. 3-15

© The McGraw-Hill Companies, Inc., 2004 Slide 3-41 McGraw-Hill/Irwin Goodwill Impairment Test Step 1  Compare fair value of REPORTING UNIT to carrying value of the REPORTING UNIT Step 2  Compare fair value of GOODWILL to carrying value of GOODWILL Step 1  Compare fair value of REPORTING UNIT to carrying value of the REPORTING UNIT Step 2  Compare fair value of GOODWILL to carrying value of GOODWILL

© The McGraw-Hill Companies, Inc., 2004 Slide 3-42 McGraw-Hill/Irwin Goodwill Impairment Test - Step 1 Is the Fair Value of a Reporting Unit Less Than Carrying Value? Compare the Reporting Unit’s Fair Value to its Carrying Value. If Fair Value of the Reporting Unit is < Carrying Value, GO TO STEP 2. Recompute Fair Value if the previous Fair Value can not be used? Compare the Reporting Unit’s Fair Value to its Carrying Value. If Fair Value of the Reporting Unit is < Carrying Value, GO TO STEP 2. Recompute Fair Value if the previous Fair Value can not be used?

© The McGraw-Hill Companies, Inc., 2004 Slide 3-43 McGraw-Hill/Irwin Goodwill Impairment Test - Step 1 Is the Fair Value of a Reporting Unit Less Than Carrying Value? Use the most recent Fair Value if: The net assets of the reporting unit have not changed significantly since the most recent fair value determination. AND The most recent fair value determination > the carrying amount of the reporting unit by a substantial margin. AND It is remote that computing a new fair value would result in an amount < the current carrying amount of the reporting unit.

© The McGraw-Hill Companies, Inc., 2004 Slide 3-44 McGraw-Hill/Irwin Goodwill Impairment Test - Step 2 If the fair value of a reporting unit < its carrying value, then Step 2 is performed. If goodwill’s fair value falls below its carrying value, then impairment has occurred, and an extraordinary impairment loss is recorded. If the fair value of a reporting unit < its carrying value, then Step 2 is performed. If goodwill’s fair value falls below its carrying value, then impairment has occurred, and an extraordinary impairment loss is recorded. Three Complexities Arise  The assignment of acquisition value to reporting units  The periodic determination of the fair values of reporting units  The determination of the implied fair value of goodwill ?

© The McGraw-Hill Companies, Inc., 2004 Slide 3-45 McGraw-Hill/Irwin A Reporting Unit can be: A component of an operating segment. A segment of an enterprise. The entire enterprise. A Reporting Unit can be: A component of an operating segment. A segment of an enterprise. The entire enterprise. Assignment of Acquisition Value to Reporting Units To better assess potential declines in value for goodwill, the goodwill must be assigned to its related REPORTING UNIT.

© The McGraw-Hill Companies, Inc., 2004 Slide 3-46 McGraw-Hill/Irwin Basis for determining fair value: Market price, if the reporting unit is publicly traded. Market price of comparable businesses. Business valuation techniques using PV. Basis for determining fair value: Market price, if the reporting unit is publicly traded. Market price of comparable businesses. Business valuation techniques using PV. Periodic Determination of the Fair Value of a Reporting Unit

© The McGraw-Hill Companies, Inc., 2004 Slide 3-47 McGraw-Hill/Irwin Use the fair value of the reporting unit as the “purchase price”. Allocate the “purchase price” to all identifiable assets and liabilities of the reporting unit. Compare the resulting “implied goodwill” to the goodwill on the books. If “implied goodwill” < recorded goodwill, impairment has occurred. Use the fair value of the reporting unit as the “purchase price”. Allocate the “purchase price” to all identifiable assets and liabilities of the reporting unit. Compare the resulting “implied goodwill” to the goodwill on the books. If “implied goodwill” < recorded goodwill, impairment has occurred. Determination of the Implied Fair Value of Goodwill implied The “implied” fair value of Goodwill is calculated in a similar manner as the determination of goodwill in a business combination.

© The McGraw-Hill Companies, Inc., 2004 Slide 3-48 McGraw-Hill/Irwin Closing Observations Related to the Testing of Goodwill for Impairment Determining the “fair value” of the reporting segment adds a new, potentially costly periodic task of consolidated financial reporting. The fair values of the assets and liabilities of the reporting unit used in the test for impairment do not impact the amounts reported on the consolidated financial statements. A decline in the value of the reporting unit does NOT necessarily signal an impairment of goodwill under SFAS No. 142.

© The McGraw-Hill Companies, Inc., 2004 Slide 3-49 McGraw-Hill/Irwin Goodwill Impairment Test Example Assume the fair value of Dad Co.’s investment in Kid, Inc. at 12/31/06 has fallen to $450,000. Is Goodwill Impaired?

© The McGraw-Hill Companies, Inc., 2004 Slide 3-50 McGraw-Hill/Irwin Goodwill Impairment Test Example STEP 1 Fair value of the investment < the carrying amount of the investment, so go to Step 2.

© The McGraw-Hill Companies, Inc., 2004 Slide 3-51 McGraw-Hill/Irwin Goodwill Impairment Test Example STEP 2 The implied Goodwill < the carrying amount of the Goodwill, so an impairment write- down is necessary.

© The McGraw-Hill Companies, Inc., 2004 Slide 3-52 McGraw-Hill/Irwin Goodwill Impairment Test Example Goodwill Impairment Entry The Goodwill needs to be written down by $50,000. The entry should be recorded as an extraordinary item on the consolidated financial statements, if it is material. Goodwill Impairment Entry The Goodwill needs to be written down by $50,000. The entry should be recorded as an extraordinary item on the consolidated financial statements, if it is material.

© The McGraw-Hill Companies, Inc., 2004 Slide 3-53 McGraw-Hill/Irwin This stuff is a breeze, ain’t it? End of Chapter 3