1. Electronic Presentations in Microsoft ® PowerPoint ® Prepared by Peter Secord Saint Mary’s University © 2003 McGraw-Hill Ryerson Limited

2. Chapter 6 © 2003 McGraw-Hill Ryerson Limited 2 Chapter 6 Consolidated Financial Statements Subsequent to Acquisition Date: Cost Method

3. Chapter 6 © 2003 McGraw-Hill Ryerson Limited 3 Consolidation from the Cost Method Outline –Consolidation from the cost method –Subsidiary acquired during the year –Subsidiary with discontinued operations –Subsidiary with extraordinary items –Exceptions from consolidation (Handbook section 1300)

4. Chapter 6 © 2003 McGraw-Hill Ryerson Limited 4 Consolidation from the Cost Method When a company buys the shares of another company, the cost of these shares is recorded in an “investment account” When the intercorporate investment is a subsidiary, the external financial reporting will nearly always be through the presentation of consolidated financial statements However, the parent company must continue to maintain the investment account for the subsidiary, as the actual companies generally remain as separate legal entities

5. Chapter 6 © 2003 McGraw-Hill Ryerson Limited 5 Consolidation from the Cost Method The investment account may be maintained by the cost method, or the equity method (or by any other systematic method!) Choice of method to employ is at the discretion of the company involved, as this is a matter of internal accounting policy, not covered by the Handbook provisions for external reporting Annual reports and virtually all other external reporting will include consolidated financial statements, so we are concerned with the process of consolidation - preparation of these statements

6. Chapter 6 © 2003 McGraw-Hill Ryerson Limited 6 Consolidation from the Cost Method This chapter is concerned with the background for the process of consolidation when the “investment account” has been maintained using the cost method Use of the cost method by the parent generally means that the original cost of the investment is maintained in the investment account, and that no periodic updates have been made This is contrasted with the investment account maintained under the equity method

7. Chapter 6 © 2003 McGraw-Hill Ryerson Limited 7 Investment Account: Equity Method Investment in Subsidiary Original Cost Income earned Dividends received P.D. Amortization Other adjustments Balance Change in RE

8. Chapter 6 © 2003 McGraw-Hill Ryerson Limited 8 Investment Account: Cost Method Investment in Subsidiary Original Cost Balance (Occasionally, Liquidating Dividends)

9. Chapter 6 © 2003 McGraw-Hill Ryerson Limited 9 Consolidation from the Cost Method Use of the cost method by the parent generally means that the investment revenue recognized from the investment consists only of dividends received (and will often be labelled dividend revenue) This is contrasted with the investment revenue recognized under the equity method, which potentially consists of several components for each subsidiary company

10. Chapter 6 © 2003 McGraw-Hill Ryerson Limited 10 Investment Revenue: Equity Method Investment Revenue Share of Sub Net Income Total Amortization of purchase discrepancy Other adjustments

11. Chapter 6 © 2003 McGraw-Hill Ryerson Limited 11 Investment Revenue: Cost Method Investment Revenue Dividends received Total

12. Chapter 6 © 2003 McGraw-Hill Ryerson Limited 12 What are the differences? The differences in both income and the investment account, and retained earnings have essentially only two components –The undistributed income of the subsidiary –The amortization of the purchase discrepancy Later, we will see that these are also the only differences in retained earnings under the two methods

13. Chapter 6 © 2003 McGraw-Hill Ryerson Limited 13 Consolidation from the Cost Method One approach to consolidation from the cost method is simply to update the investment account and to compute income as if the equity method had been used, instead of the cost method As equity method income is exactly equal to consolidated income, this approach is certainly valid, and provides useful check digits for preparation of consolidated statements This approach involves filling in the gaps in the investment account for the subsidiary

14. Chapter 6 © 2003 McGraw-Hill Ryerson Limited 14 Restatement to the equity method When parent income has been presented under the cost method, and restatement to the equity method is required: –Begin with parent net income as reported –Deduct dividends from subsidiary –Balance is parent income from own operations –Add Parent’s share of subsidiary net income –Deduct: amortization of purchase discrepancy Result is parent net income, equity method This equals consolidated net income

15. Chapter 6 © 2003 McGraw-Hill Ryerson Limited 15 Restatement to the equity method Consolidation may be carried out using “spread sheet” working papers or by the direct approach –The direct approach also requires supporting calculations –Key among these is the computation of consolidated retained earnings Consolidated retained earnings includes the accumulated net income less dividends of the parent and the parent’s share of net income of the subsidiary earned since acquisition

16. Chapter 6 © 2003 McGraw-Hill Ryerson Limited 16 Consolidated Retained Earnings Parent retained earnings Parent’s share, change in Sub RE since acquisition P.D. Amortization Other adjustments Balance

17. Chapter 6 © 2003 McGraw-Hill Ryerson Limited 17 Consolidated Retained Earnings Note that Consolidated Retained Earnings displays precisely the same adjustments as the investment account –the “other half” of the same entries is shown These consolidation adjustments keep the financial statements in balance Independent calculations of the two related amounts provide a useful “proof” of the consolidated accounts

18. Chapter 6 © 2003 McGraw-Hill Ryerson Limited 18 Subsidiary acquired during year Earnings and amortization are recorded only for the period since the date of acquisition This will generally require very specific calculations as to when income accrued and a clear split between pre- and post- acquisition earnings for statement preparation

19. Chapter 6 © 2003 McGraw-Hill Ryerson Limited 19 Subsidiary acquired during year For the users of the financial statements: –Since results of operations are reflected only from the date of acquisition, it is desirable to provide supplemental information, on a proforma basis showing the results of operations as though the companies had combined at the beginning of the fiscal period, in order to assist users of financial statements in their assessment of the potential effect of the acquisition on earnings. –It may also be desirable to provide, in the year immediately following the year of acquisition, supplemental information in order to provide a full year's comparative figures for the combination.

20. Chapter 6 © 2003 McGraw-Hill Ryerson Limited 20 Subsidiary with discontinued operations Discontinued operations are the operations of a business segment that has been sold, abandoned, shut down or otherwise disposed of, or that is the subject of a formal plan of disposal. –A business segment is a component of an entity, the activities of which represent a line of business significant to the entity as a whole.

21. Chapter 6 © 2003 McGraw-Hill Ryerson Limited 21 Subsidiary with discontinued operations When a subsidiary is to be disposed of, and is significant, it should be accounted for as a discontinued operation When a subsidiary to the reporting entity has a significant discontinued operation, separate disclosure is also necessary This is based on the requirement that non- controlling interest is based on earnings before such items, and that these items are material on the basis of their nature, not their amount

22. Chapter 6 © 2003 McGraw-Hill Ryerson Limited 22 Subsidiary with discontinued operations The results of discontinued operations should be included in net income and reported separately for the current and prior periods The results of discontinued operations should include and separately disclose the following, net of applicable income taxes: –the results of the operations prior to the measurement date; and –the net gain or loss from discontinued operations other than any extraordinary gain or loss

23. Chapter 6 © 2003 McGraw-Hill Ryerson Limited 23 Subsidiary with discontinued operations The net gain or loss from discontinued operations should include both the actual or estimated gain or loss on disposal, and the actual or estimated results of operations, if any, between the measurement date and the disposal date. A net loss from discontinued operations should be provided for at the measurement date whereas a net gain should be recognized only when realized.

24. Chapter 6 © 2003 McGraw-Hill Ryerson Limited 24 Subsidiary with extraordinary items Extraordinary items are items which result from transactions or events that have all of the following characteristics: –they are not expected to occur frequently over several years; –they do not typify the normal business activities of the entity; and –they do not depend primarily on decisions or determinations by management or owners.

25. Chapter 6 © 2003 McGraw-Hill Ryerson Limited 25 Subsidiary with extraordinary items An item which is considered extraordinary at the level of the subsidiary company will generally be extraordinary at the level of the parent as well, although this may not necessarily appear to be the case –The event might not be material relative to the larger scale of the parent company However, section 1600-67 requires: Where there are discontinued operations or extraordinary items, the parent company's portion of such items should be disclosed.

26. Chapter 6 © 2003 McGraw-Hill Ryerson Limited 26 Exceptions from Consolidation Many arguments have been presented to create exceptions to consolidation requirements. –Many of these were widely acknowledged as valid reasons not to consolidate. Over the years, essentially all of these exceptions (different industries, incompatible accounting policies, foreign location, etc.) have been nullified in favour of the comprehensive consolidation requirements based essentially on the criterion of control. All subsidiaries must be consolidated!

27. Chapter 6 © 2003 McGraw-Hill Ryerson Limited 27 Exceptions from Consolidation Handbook Section 1300, effective for fiscal years beginning on or after January 1, 2002, introduces a strictly limited exception to the requirement to present consolidated financial statements for certain qualifying enterprises

28. Chapter 6 © 2003 McGraw-Hill Ryerson Limited 28 Exceptions from Consolidation An enterprise is a qualifying enterprise for purposes of the differential reporting options when and only when: –it is a non-publicly accountable enterprise; and –its owners unanimously consent to the application of differential reporting options in accordance with paragraph 1300.13 Non-publicly accountable enterprises are enterprises other than public enterprises, co-operatives, regulated financial institutions, rate-regulated enterprises, government business enterprises and government business-type organizations as defined in the CICA Public Sector Accounting Handbook.

29. Chapter 6 © 2003 McGraw-Hill Ryerson Limited 29 Exceptions from Consolidation Qualifying enterprises will include most private corporations, partnerships, and proprietorships - each of which can have subsidiary companies The selection of the differential reporting options establishes the basis for preparing a qualifying enterprise's financial statements within generally accepted accounting principles and should be consented to in writing by all of the owners prior to the date of completion of the financial statements

30. Chapter 6 © 2003 McGraw-Hill Ryerson Limited 30 Exceptions from Consolidation An enterprise should select only one set of accounting policies, including differential reporting options, in any particular year for purposes of reporting to the owners. When an enterprise prepares an additional set of financial statements using different accounting policies for tax or other purposes, those financial statements should include a reference to the owners' financial statements.

31. Chapter 6 © 2003 McGraw-Hill Ryerson Limited 31 Exceptions from Consolidation An enterprise that qualifies under Section 1300 may elect to use either the equity method or the cost method to account for subsidiaries that would otherwise be consolidated in accordance with paragraph 1590.16. All subsidiaries should be accounted for using the same method. A loss in value of an investment in a non- consolidated subsidiary that is other than a temporary decline should be written down to recognize the loss.

32. Chapter 6 © 2003 McGraw-Hill Ryerson Limited 32 Exceptions from Consolidation When an enterprise applies one of the alternative methods (cost or equity) permitted by paragraph 1590.26, the financial statements should be described as being prepared on a non-consolidated basis and each statement should be labelled accordingly. Investments in non-consolidated subsidiaries should be presented separately in the balance sheet. Income or loss from those investments should be presented separately in the income statement.

33. Chapter 6 © 2003 McGraw-Hill Ryerson Limited 33 Exceptions from Consolidation An enterprise that has applied one of the alternative methods permitted by paragraph 1590.26 should disclose: –the basis used to account for subsidiaries; and –the particulars of any shares or other securities issued by the enterprise that are owned by non- consolidated subsidiaries. –When an enterprise applies one of the alternative methods permitted by paragraph 1590.26, the requirements of Section 3840 (Related Party Transactions), apply to intercompany transactions that would otherwise have been eliminated on consolidation.