1. Ch. 3 Consolidated Financial Statements: Date of Acquisition
Learning objectives
Purpose of consolidated financial statements
Concept of control in equity investments
Concept of control in non-equity investments
Consolidated balance sheets
IFRS for consolidations

2. Reporting Business Combinations
Parent and Subsidiary account for their operations separately throughout the year
Remain as separate legal entities
Parent company uses the Equity method to record Investment in Subsidiary
For year-end reporting, Parent Company prepares Consolidated Financial Statements

3. 1. Purpose of Consolidated Financial Statements
Parent and subsidiaries as a single economic entity
Primarily for the benefit of owners and creditors of the parent
Consolidated financial statements are more meaningful than separate statements when one entity in the consolidated group directly or indirectly has a controlling financial interest in the other entity.

4. Motivations for Off-Balance Sheet Entities
Choice: Equity v. Consolidation method
( ) method omits assets and liabilities of the subsidiary from the parent’s balance sheet
( ) method reports higher assets and liabilities in the parent’s book
=> Leverage ratio?
Profitability?
Investors and banks view ( ) leverage as riskier.

5. Financial Effects of Equity Method
If parent uses the equity method: Balance sheets prior to the acquisition:
Parent
Subsidiary (BV &FV)
Total assets
$220
$110
Total liabilities
$115
$100
Stockholders' equity
105 10
Total liabilities and equity
Parent acquires 100% control of Subsidiary by paying $10
Parent’s Balance Sheet after the acquisition
Equity
method
Consolidation
Equity method
Assets
Liabilities
Stockholders Equity

6. 2. Control Through Equity Ownership
Usually control is obtained through ownership, directly or indirectly, of more than 50 percent of the outstanding voting shares of another entity
=>Voting Interest Model
Exceptions:
Control is temporary, or
Control is not present
Control may exist with less than majority ownership of outstanding voting shares
The key concept is control.

7. 3. Control Through Non-Equity Ownership
Special Purpose Entities (SPEs)
Legal structures formed for specific business activities
Control may be obtained with little or no equity investment
Frequently have no separate management or employees
Often obtain financing from debt
Often have a small outside equity interest that obtains a secure return with little or no risk

8. Often not consolidated
Examples of SPEs
Securitizations
Leasing
Joint ventures
Provide the opportunity to hide debt and losses from investors
Often not consolidated

9. Securitizations
Set up by a financial services company to buy loans or customer receivables from clients
SPE uses the money to buy the receivables
SPE issues debt securities backed by the receivables
Allows clients to obtain immediate cash for receivables
SPE uses the collection proceeds to pay principal and interest

10. Leasing SPE created to purchase long-term assets
Funding for purchases obtained through loans
SPE leases assets to the company
SPE uses lease payments to pay interest and principal on the debt
Lease terms usually allow lessee to report the lease as an operating lease.

11. Joint Ventures
Formed by two or more companies for specialized projects
Often requires specialized skill and significant debt financing
Structure legally separates the projects’ risk from that of the sponsors
Allows financing to be obtained at a lower cost

12. Enron and SPEs
Enron sponsored numerous legally but not financially separate ‘shadow entities’
Did not include SPEs in consolidation
Caused understating of debt and overstating of profitable nonmarket transactions with the SPEs
Collapse of Enron in 2001 highlighted the limitation of consolidation standards that focused on equity ownership

13. Variable Interest Model (ASC Topic 810)
Issued by FASB in 2003 to address the concept of control for off-balance-sheet entities
Provides guidance for
Identifying SPEs that meet the definition of variable interest entities (VIE)
Determining whether such entities must be consolidated
It must obtain guarantees from other parties to obtain debt financing
Equity holders do not have the usual rights and responsibilities of equity ownership
An entity is a VIE if

14. Consolidation Requirements under the Variable Interest Model
Under U.S. GAAP, a company must evaluate its relationships with SPEs to determine if consolidation is appropriate.
Two-step evaluation process:
1. Determine if entity’s equity investors lack the characteristics of a controlling interest.
These entities are variable interest entities (VIEs)
If entity is not a VIE, the voting interest model applies
2. If the entity is a VIE, determine if the company controls the VIE.
The controlling company is the VIE’s primary beneficiary
The primary beneficiary consolidates the VIE 15

15. Variable Interest Entity Characteristics
Insufficient equity to finance its activities without additional subordinated financial support
Equity investors lack the following controlling characteristics:
Ability to make decisions through voting or similar rights
Obligation to absorb expected entity losses
Right to receive the expected residual returns of the entity

16. Is an Entity a VIE?
Determining sufficiency of entity’s equity investment is challenging
Two qualitative ways to establish sufficiency
Provide evidence that entity can obtain financing on its own
Show that equity level is comparable with entities who can obtain financing without outside support
If qualitative analysis is not conclusive, a quantitative analysis may be used
Is the level of equity sufficient to absorb expected losses?

17. Expected Present Value
Quantitative Analysis of VIE Status Is equity investment sufficient enough to absorb expected losses?
SPE is formed with $15,000 in equity and $133,000 in debt. All cash flows are expected to occur at end of year 1.
Expected Cash Flows
Present Value at 5%
Probability
Expected Present Value
Investment Fair Value
Residual Returns
Expected Gains
Expected Losses
$189,000
$180,000
0.75
$135,000
$148,000
$32,000.
$24,000
63,000
60,000
0.15
9,000
148,000
(88,000)
($13,200)
42,000
40,000
0.10
4,000
(108,000)
(10,800)
($24,000)
Equity interest of $15,000 is less than $24,000 expected losses
Entity is a VIE
MC 3

18. Who Must Consolidate a VIE?
Primary beneficiary consolidates
Attributes of primary beneficiary
Power to direct VIE’s significant activities
Obligation to absorb significant losses/right to receive significant benefits of VIE

19. Summary of Consolidation Rules19

20. 4. Consolidation at Date of Acquisition
When the companies remain as separate legal entities:
Acquiring Company
Reports investment as one line on its balance sheet
Makes no entry;
Stock is now owned by parent
Acquired Company

21. Preliminary Issues Different currencies
Must first convert financial records of the subsidiary into U.S. dollars before consolidation (Ch. 7)
Different accounting principles
Convert non-U.S. GAAP subsidiary’s records to U.S. GAAP
Different accounting years
Subsidiary usually adjusts its year-end to conform with that of the parent
Year-ends may differ up to 3 months

22. Consolidation Process at Date of Acquisition
Assets and liabilities of the acquiree are revalued to fair value and combined with assets and liabilities of parent
Intercompany transactions and account balances are removed to ensure that information reflects transactions with outside parties
Process occurs each time financial statements are prepared

23. Consolidation Working Paper
Three elements
Parent (P) company’s balance sheet
Subsidiary (Sub) company’s balance sheet
Eliminating entries to consolidate the accounts
Eliminate Sub’s Equity and P’s Investment asset
Revalue Sub’s assets and liabilities to fair value
P3.2

24. Consolidation With Bargain Purchase
Occurs when the fair values of the identifiable net assets of the acquired company are greater than the acquisition price
Parent company reports the difference as a gain on acquisition
No goodwill reported in consolidation
P3.4

25. Special Issues 1. In consolidation working paper, use net PPE
2. Reported goodwill by acquiree
May exist on subsidiary’s books if the subsidiary had previously acquired another company
Acquiring company assigns a zero fair value to previously acquired goodwill
Not an identifiable asset

26. Consolidating a Subsidiary Reporting Goodwill
Assume Quality Motors acquires Renco, Inc. for $120 million. Renco’s balance sheet:
Book Value
Fair Value
Identifiable assets
$70,000,000
$90,000,000
Goodwill
5,000,000
Total assets
$75,000,000
Liabilities
$65,000,000
 $65,000,000
Stockholders' equity
10,000,000
Total liabilities and equity
Calculation of goodwill:
Acquisition cost
$ 120,000,000
Book value of Renco
(10,000,000)
Cost in excess of Renco's book value
$110,000,000.
Differences between fair value and book value:
Identifiable assets
$20,000,000.
Previously recorded goodwill
(5,000,000)
15,000,000.
Goodwill
$ 95,000,000.

27. 6. IFRS for When to Consolidate
IFRS 10 effective in 2013
Only basis for consolidation for all entities is control
Control is achieved by all three of these elements:
Power over the investee
Exposure or rights to the investee’s variable returns
Ability to use power over the investee to influence the amount of returns to the investor
Examples of how control is achieved
Equity voting rights
Rights to appoint or remove key personnel
Power to appoint or remove the majority of board members
Power to cast the majority of votes at board meetings