1. ACC 424 Financial Reporting II Lecture 5 Introduction to consolidations

2. 2 Agenda Nature of consolidated financial statements Why consolidate? Who has to consolidate? Consolidation at acquisition Consolidation after acquisition

3. 3 Nature of consolidation Consolidated financial statements report the financial affairs of affiliated corporations as though they are a single firm –A parent corporation & its subsidiaries are often referred to as affiliated corporations No separate books for the consolidated entity. Each affiliated corporation has its own set of books & financial statements –The statements are prepared using working papers (spreadsheets) Intercompany transactions are eliminated: – e.g., revenues are the revenues from sales of the group to outside customers Intercompany receivables & payables are also eliminated

4. 4 Nature of consolidation Consolidation’s effect on financial statements can be significant Prior to FAS 94 (1987) corporations did not have to consolidate financial subsidiaries. If the big 3 US automakers had consolidated their financial subsidiaries in 1986, the effects would have been substantial: Return on Assets Debt/Equity Unconsolidated Consolidated Unconsolidated Consolidated Ford 9%4% 1.6 5.4 GM 4%2% 1.4 3.9 Chrysler10%5% 1.7 5.2 Average Impact -52%+207% Source: Seidler (1987)

5. 5 Why consolidate? Rationale for required consolidation –Information motivation Consolidations required to avoid “fooling” investors & creditors (e.g., financial subsidiaries used to keep debt off balance sheets) Current concern that joint ventures and other devices used for the same purpose Among informed users (banks & securities firms) who lobbied on FAS 94 there was little support for the standard (Mian & Smith, 1990) Evidence from voluntary consolidations –Australia in 1930s & 1950s (Whittred) –Of financial, insurance & real estate subsidiaries in the US prior to FAS 94 (Mian & Smith) Evidence from insurance company debt contracts –Contracts undo the equity method of accounting for unconsolidated subsidiaries

6. 6 Who has to consolidate? Current standards A parent owning >50% of the voting stock (legal control) except: i) if control is temporary; or ii) control does not rest with the majority owner (legal reorganization, bankruptcy, severe foreign exchange restrictions, controls or government imposed uncertainties)

7. 7 Who has to consolidate? Exposure Draft, February, 1999 as modified to 12/31/99 A parent must consolidate each subsidiary that it controls. Once a subsidiary is consolidated must be consolidated until parent ceases to control it Control involves 2 essential characteristics –A parent’s non-shared decision-making ability –A parent’s ability to use that power to increase to increase the benefits it derives & limit the losses it suffers from the subsidiary’s activities

8. 8 Who has to consolidate? Exposure Draft, February, 1999 as modified to 12/31/99 Control is presumed if an entity (including its subsidiaries): –Has majority voting interest in the election of a corporation’s governing body or a right to appoint a majority of the members of that body –Has a large minority voting interest in the election of the governing body and no other party or organized group of parties has a significant voting interest –Has a unilateral ability to Obtain a majority voting interest in the election of the governing body or Obtain a right to appoint a majority of the governing body via currently exercisable rights and expected benefits of exercising rights exceeds expected cost –Is the only general partner in a limited partnership A minority interest is large if it exceeds 50% of votes typically cast in a corporation’s election of directors For example, if only 60% of eligible votes are typically cast, 35% would be deemed large

9. 9 Consolidation at acquisition E3.4 1. Give the journal entry to record the business combination as a purchase & elimination entries necessary to prepare a consolidated balance sheet at the business combination date assuming the purchase method is used. 2. Give the journal entry to record the business combination as a pooling of interests & elimination entries necessary to prepare a consolidated balance sheet at the business combination date assuming the pooling of interests method is used.

10. 10 Consolidation at acquisition E3.4 - Purchase First determine the differential between price & book value (premium or discount) Market value of shares issued$2,000,000 Accountants’ & attorneys’ fees 100,000 Total acquisition cost$2,100,000 Net book value acquired.9  $2,000,000$1,800,000 Differential (premium)$ 300,000 Allocation to fair market values of assets & liabilities and goodwill Increase in the value of inventory.9  $100,000 $ 90,000 Increase in net plant assets.9  $200,000 180,000 Increase in LT marketable securities.9  $20,000 18,000 $288,000 Less Increase in LT debt.9  $100,000 90,000 Share of value increase of identifiable net assets $198,000 Goodwill 102,000 Differential (premium) $300,000

11. 11 Consolidation at acquisition E3.4 - Purchase Journal entry in Giant’s books to record combination Investment in Small $2,100,000 Common stock & Additional PIC $2,000,000 Cash 100,000 Elimination entries in consolidated statement working papers (1) Purchase premium$ 300,000 Investment in Small $ 300,000 To reclassify the purchase premium (2) Inventories$ 90,000 Plant assets (net) 180,000 Long-term marketable securities 18,000 Goodwill 102,000 Long-term Debt$ 90,000 Purchase premium 300,000 To allocate purchase premium (3)Capital stock - Small$ 400,000 Retained earnings - Small 1,600,000 Investment in Small$1,800,000 Minority interest in Small 200,000 To eliminate the Investment in Small & establish Minority Interest

12. 12 Consolidation at acquisition E3.4 - purchase

13. 13 Consolidation at acquisition E3.4 - points on purchase –The individual assets & liabilities of Small replace the Giant’s Investment in Small in the consolidated financial statements –To that end Investment in Small is eliminated against Small’s stockholders’ equity and the purchase premium leaving minority interest –Small’s individual assets & liabilities are increased by 90% of valuation difference and goodwill is included at 90% of its value –The exposure draft would increase individual assets & liabilities by 100% of the valuation difference by increasing minority interest for its share of the write-up –As of January, 1997, the board has also decided to increase goodwill to 100% of its value by including the minority share –Note minority interest in subsidiary would be called noncontrolling interest in subsidiary under the exposure draft

14. 14 Consolidation at acquisition E3.4 - pooling Journal entry in Giant’s books to record combination Investment in Small$1,800,000 Expenses of business combination 100,000 Stockholders’ equity $1,800,000 Cash 100,000 Elimination in consolidated statement working papers Capital stock - Small$ 400,000 Retained earnings - Small 1,600,000 Investment in Small$1,800,000 Minority interest in Small 200,000

15. 15 Consolidation at acquisition E3.4 - pooling