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

2. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 2 Chapter 4 Consolidated Statements on Date of Acquisition

3. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 3 Consolidated Statements at Acquisition Outline –Consolidation at acquisition –Consolidation theories Proprietary Entity Parent company –Examples –International view

4. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 4 Consolidated Statements at Acquisition At the time an intercorporate investment is made, there is generally a difference between the cost of the investment and the underlying book value (shareholders equity) of the company acquired This difference, the purchase discrepancy, must be allocated to the various assets and liabilities of the acquired company, with any residual allocated to goodwill arising on acquisition

5. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 5 Consolidated Statements at Acquisition Whether the acquirer has purchased 100% of the company or not, the process of allocation of the purchase discrepancy must be addressed We often require a complex series of appraisals and allocations, in order for both balance sheet and income statement amounts to be presented fairly after the acquisition is consummated

6. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 6 Consolidated Statements at Acquisition We must initially compute the aggregate value of the consideration paid (Handbook s. 1581.22) : –The cost of the purchase to the acquirer should be determined by the fair value of the consideration given or the acquirer's share of the fair value of the net assets or equity interests acquired, whichever is more reliably measurable, except when the transaction does not represent the culmination of the earnings process. –The cost includes the direct costs of the business combination. Costs of registering and issuing shares issued should be treated as a capital transaction. Indirect expenses are expensed when incurred.

7. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 7 Consolidated Statements at Acquisition In accounting for a business combination effected by issuing shares, the quoted market price of the shares issued generally is used to estimate the fair value of the acquired enterprise after recognizing possible effects of price fluctuations, quantities traded, issue costs, and similar items. The value of the shares is based on their market price over a reasonable period before and after the date the terms of the business combination are agreed to and announced. –When the quoted market price of shares issued to effect a business combination is not representative of their fair value, the net assets received, including goodwill, and the extent of the adjustment of the quoted market price of the shares issued, are assessed to determine the amount to be recorded.

8. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 8 Consolidated Statements at Acquisition We then compare the consideration given up to the (acquirers percent of the) underlying book value of the company acquired. The difference between the cost and underlying book value, the purchase discrepancy, must be allocated in order that the fair values at the date of the business combination are recognized in the accounts. Fair values are recognized at that time, as a new basis of accountability is established by the terms of the purchase and the business combination.

9. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 9 Consolidated Statements at Acquisition

10. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 10 Consolidated Statements at Acquisition

11. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 11 Consolidated Statements at Acquisition

12. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 12 Allocation of the Purchase Price Example:On December 31, 2001, the balance sheets of the Power Company and the Pro Company are as follows: Power ProPro (FV) Cash$ 500$ 800 Accounts Receivable 1,500 1,700 Inventories 2,000 1,500 Plant & Equipment (net) 2,500 4,000 $4,300 Total Assets$6,500$8,000 Current liabilities$ 700$ 400 Long term liabilities 800 500 $ 400 Common shares 3,300 2,500 Retained earnings 1,700 4,600 Total Equities$6,500$8,000

13. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 13 Allocation of the Purchase Price Power Company has 100,000 shares of common stock outstanding; Pro Company has 45,000 shares. On January 1, 2002 Power issued an additional 90,000 shares of common stock in exchange for all the outstanding shares of Pro. All assets and liabilities have book values equal to fair values, except as noted. Market value of the new shares issued was $90 per share.

14. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 14 Allocation of the Purchase Price To prepare consolidated financial statements, we first calculate and allocate the purchase price discrepancy: Purchase Price (90,000 shares @ $90) $8,100 Dr Less: Book value acquired: Common shares 2,500 Retained earnings 4,600 7,100 x 100% 7,100 Cr Purchase price discrepancy:$1,000 Dr Allocated to (amounts in thousands): Item(Fair Value - Book Value) (x %) Plant & Equipment (4,300 - 4,000) x 100%$ 300 Dr Long term liabilities (400 - 500) x 100% 100 Dr Total allocated to Identifiable Net Assets$ 400 Dr Remainder: Allocated to Goodwill 600 Dr Total Allocated $1,000 Dr

15. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 15 Allocation of the Purchase Price The basic process of consolidation of financial statements involves adding together the amounts recorded on the books of the parent and subsidiary, with certain adjustments and eliminations This allocation of the purchase price discrepancy may easily be stated as a journal entry, which serves to eliminate the investment account of the parent against the shareholders equity of the subsidiary, as well as recording the allocation of the purchase discrepancy Further, all significant intercompany balances, transactions and profits are eliminated in consolidation.

16. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 16 Allocation of the Purchase Price This entry would have been made by Power to record the investment: Investment in Pro8,100 Common Shares8,100 The working paper entry required to perform the allocation and elimination is: Common Shares - Pro2,500 Retained earnings - Pro4,600 Plant & Equipment 300 Long Term Liabilities - Discount 100 Goodwill 600 Investment in Pro8,100

17. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 17 Acquisitions: International View In Canada and the United States, Goodwill arising in a business combination is recognized as an asset in the consolidated financial statements, and is subject to periodic review of the recorded value There are many other possible treatments of the amount we refer to as Goodwill. These include asset with amortization, debit to reserve (equity) accounts, and immediate write off to expense in the period of acquisition.

18. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 18 Acquisitions: International View The financial statements of Bayer AG, a German company which reports under International Accounting Standards, included the following note Intangible assets –Goodwill,including that resulting from capital consolidation, is capitalized in accordance with IAS 22 and amortized on a straight-line basis over a maximum estimated useful life of 20 years.The value of goodwill is reassessed regularly and written down if necessary.

19. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 19 Acquisitions: International View Heineken of the Netherlands included this note on newly acquired companies; accounting policies employed are very different from those used in Canada

20. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 20 Push Down Accounting The practice of push down accounting may be used in Canada, if the parent company owns 90% or more of the subsidiary The amounts to be presented on the consolidated financial statements are unlikely to be different when push down accounting is used, as the use of push down accounting does not change the fair values to be presented in the financial statements - it causes them to be recorded in the books of account, not just on the working papers.

21. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 21 Conceptual Alternatives The acquisition of less than 100% of the shares of a subsidiary company introduces the possibility of a variety of conceptual approaches to consolidation which do not arise with a 100% acquisition The most important of these approaches are –The Parent Company approach –The Entity approach –The Proprietary Approach Parent Company approach is GAAP in Canada

22. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 22 The Parent Company Approach Under the Parent Company approach, the fair values of the assets acquired and liabilities assumed in the consolidation are adopted for the consolidated statements, but only to the extent of the proportionate interest acquired Accordingly, the value of assets acquired and liabilities assumed is a hybid: book value on the subsidiarys books plus the parents share of the fair value increment

23. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 23 The Parent Company Approach The generally accepted "parent company" approach requires that fair values be recognized only to the extent of the proportion confirmed by the purchase. That is, with a 90% purchase of a subsidiary, full book value is recorded for each asset, plus a fair value increment based on 90% of the difference between fair and book values. Consolidated amounts are the sum of the: Book value of Parent Company's Net Assets Book value of Subsidiary Company Net Assets, and Excess of fair value over book value of Sub assets, for the percentage acquired only.

24. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 24 The Parent Company Approach The Noncontrolling (Minority) interest is valued on the basis of the book value reported by the subsidiary company The shares owned by the minority were not a part of the business combination transaction, and accordingly have not been revalued as a part of the business combination process

25. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 25 The Entity Approach Although the Parent Company approach is GAAP in Canada, the Entity approach is an important conceptual alternative The key distinctions have to do with how the purchase discrepancy is computed and allocated, and how minority interest is valued Under the entity approach, the cost paid by the parent in the acquisition is assumed to be representative of the fair value of the entire company

26. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 26 The Entity Approach Accordingly, the price per share paid by the parent is effectively extrapolated to the shares not acquired, to establish a fair value for the entire company. As a result: –Assets acquired and liabilities assumed are valued at their total fair value at the date of acquisition –Non-controlling interest is valued on the basis of the market value of the company acquired, not the underlying book value

27. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 27 The Proprietary Approach Although the parent company approach is GAAP for virtually all consolidations in Canada, the proprietary appoach might be said to have a niche market in Canada The proprietary appoach, also known as proportionate consolidation, is the manner in which joint ventures are consolidated with the accounts of the parent company, the venturer In the broader framework of consolidations, this approach is not GAAP, yet is a valid approach with sound underlying reasoning

28. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 28 The Proprietary Approach The proprietary approach incorporates the amounts recorded by the subsidiary into the consolidated financial statements at fair value at the date of acquisition, but only to the extent of the proportion acquired The basis of the inclusion in this manner is that the investor shares in the risks and rewards of ownership in direct proportion to the shareholding percentage With a joint venture, joint control of the venture makes this treatment appropriate

29. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 29 The Proprietary Approach This approach is not generally accepted in Canada for subsidiaries, as consolidation practices are based on the concept of control –if the parent controls the subsidiary company, then all the assets and related liabilities are included in the consolidated statements (and the contribution of non-controlling interests is acknowledged) –With the characteristic formal agreement of a joint venture, the extent of participation only is consolidated, as this portrays the real economic value of the relationship –A joint venture is distinct from a parent - subsidiary relationship, both conceptually and managerially

30. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 30 Contingent Consideration Generally, the values established in a business combination are established on a once and for ever basis However, what happens when a portion of the total cost of the acquisition is variable, so the eventual total cost is not known with certainty at the date of acquisition of the subsidiary?

31. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 31 Contingent Consideration When the amount of any contingent consideration can be reasonably estimated at the date of acquisition and the outcome of the contingency can be determined beyond reasonable doubt, the contingent consideration should be recognized at that date as part of the cost of the purchase. When the amount of contingent consideration cannot be reasonably estimated or the outcome of the contingency cannot be determined without reasonable doubt, details of the contingency should be disclosed. Neither a liability nor outstanding equity instruments are recognized until the contingency is resolved and consideration is issued or becomes issuable.

32. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 32 Contingent Consideration Contingent consideration arises in a variety of circumstances, and leads to adjustments to the purchase price and its allocation, and ultimately the value of goodwill to be recognized.

33. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 33 Reverse Takeovers A reverse takeover arises when one company issues so many shares in a business combination that the control of the group passes to the company (or new shareholders) which have received the newly issued shares –Although this may be generally infrequent in practice, it is a common way for companies to obtain a listing on a stock exchange or to take advantage of existing brand names held by a smaller company - it rarely happens by accident!! –The accounting treatment must reflect the economic substance of the business combination transaction

34. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 34 Reverse Takeovers This reverse takeover is the subject of case 4-5

35. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 35 International View What conceptual approaches to preparation of consolidated financial statements are seen in Canada? The Handbook is clear that the parent company approach is to be used: –The non-controlling interest in the subsidiary's assets and liabilities should be reflected in terms of carrying values recorded in the accounting records of the subsidiary company (s. 1600.15). There is rarely, if ever, disclosure of this aspect of consolidation, as there is no accounting policy choice permitted.

36. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 36 International View What conceptual approaches to preparation of consolidated financial statements are used in other countries? –Rules and practices vary widely. –The permitted approaches differ somewhat in the manner that they are described in the notes to the financial statements. Although proportionate consolidation (proprietary theory) is often noted, it is rare for a company to state unequivocally that the entity approach has been used, rather that the parent company approach. The notes to the statements must be studied!!

37. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 37 International View In consolidated statements in Canada, the minority (non- controlling) interest consists of all outside equity interest in consolidated subsidiaries. These interests would include both common and preferred shares. Disclosure of aggregate non-controlling interest is required, as is the allocation of subsidiary income, but without details. Notes to the financial statements may include further details, but additional disclosure requirements are not specified in the Handbook.

38. Chapter 4 © 2003 McGraw-Hill Ryerson Limited 38 International View In Britain, it is common to present capital and reserves (shareholders equity), then minority interest, distinguishing between common (equity) and preferred (non-equity) shares (further detail in notes)