2. Chapter Three Consolidations – Subsequent to the Date of Acquisition McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

3. Consolidation - The Effects of the Passage of Time In Chapter 2, we looked at consolidation on the date 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 the combination was created. As time passes, the investment account changes, and the consolidation process becomes more complex. 3-2

4. SFAS No. 142 - Goodwill and Other Intangible Assets For fiscal periods beginning AFTER December 15, 2001, goodwill is no longer amortized. The “nonamortization” rule is applied to both previously recognized and newly acquired goodwill. Any unamortized goodwill arising from pre-SFAS 142 combinations is carried on the books as a permanent asset (subject to impairment). 3-3

5. SFAS No. 142 - Goodwill and Other Intangible Assets Generally, once goodwill is recognized, its value remains unchanged. Generally, once goodwill is recognized, its value remains unchanged. 3-4

6. Consolidation - The Effects of the Passage of Time The parent can account for its investment in one of three ways: Equity Method Initial Value Method Partial Equity Method The parent can account for its investment in one of three ways: Equity Method Initial Value Method Partial Equity Method Let’s briefly compare the three methods 3-5

7. Investment Accounting Exh. 3-1 3-6

8. Before the consolidation balances can be determined, the Parent’s investment account must be adjusted to reflect application of the equity method. Subsequent Consolidation - Equity Method Equity method review:  Record the Investment in Sub on the acquisition date at fair value.  Recognize receipt of dividends from the sub.  Recognize a share of the sub’s income (loss).  Excess fair over book value amortizations adjust the income recognized in 3. Equity method review:  Record the Investment in Sub on the acquisition date at fair value.  Recognize receipt of dividends from the sub.  Recognize a share of the sub’s income (loss).  Excess fair over book value amortizations adjust the income recognized in 3. 3-7

9. Parrot Company obtains all of the outstanding common stock of Sun Company on January 1, 2009. Parrot acquires this stock for $800,000 in cash. Consolidation Example Equity Method 3-8

10. Consolidation Example Equity Method 3-9

11. Consolidation Example Equity Method Amortization computation: 3-10

12. Consolidation Example Equity Method 3-11

13. Consolidation Example Equity Method- Consolidation Entry S 3-12

14. Consolidation Example Equity Method 3-13

15. Consolidation Example Equity Method 3-14

16. Consolidation Example Equity Method 3-15

17. Consolidation Example Equity Method 3-16

18. Subsequent Consolidation - Worksheet Entries 5 basic entries are posted to the worksheet.  The Sub’s equity accounts are eliminated (S)  Other intangible assets are recognized and the Sub’s assets are adjusted to fair value (A)  The Equity in Sub Income account is eliminated (I)  The Sub’s dividends are eliminated (D)  Amortization expense is recognized for the FV adjustments and other intangible assets associated with the consolidated entity (E) 5 basic entries are posted to the worksheet.  The Sub’s equity accounts are eliminated (S)  Other intangible assets are recognized and the Sub’s assets are adjusted to fair value (A)  The Equity in Sub Income account is eliminated (I)  The Sub’s dividends are eliminated (D)  Amortization expense is recognized for the FV adjustments and other intangible assets associated with the consolidated entity (E) 3-17

19. Consolidation Entries Equity Method Entry S Eliminate the sub’s equity balances as of the beginning of the period. Assign the difference to “Investment in Sub.” Entry S Eliminate the sub’s equity balances as of the beginning of the period. Assign the difference to “Investment in Sub.” 3-18

20. Consolidation Entries Equity Method Entry A Adjust sub’s assets and liabilities to FV. Set up the Goodwill account and the other intangible assets. The net amount of these adjustments reduces the Investment in Subsidiary account. Entry A Adjust sub’s assets and liabilities to FV. Set up the Goodwill account and the other intangible assets. The net amount of these adjustments reduces the Investment in Subsidiary account. In the first year of the investment, the FV adjustments for this entry will be identified during the computation of Goodwill. In subsequent years, the FV adjustments and the other intangible assets identified must be reduced by any amortization taken in prior periods. 3-19

21. Consolidation Entries Equity Method Entry I Eliminate the Equity in Sub Income account. Assign the difference to Investment in Sub. Entry I Eliminate the Equity in Sub Income account. Assign the difference to Investment in Sub. 3-20

22. Consolidation Entries Equity Method Entry D Eliminate sub’s Dividends. Assign the difference to Investment in Sub. Entry D Eliminate sub’s Dividends. Assign the difference to Investment in Sub. 3-21

23. Consolidation Entries Equity Method Entry E Record amortization expense for the period associated with the FV adjustments and the other intangible assets identified during the combination. Remember: Never amortize land, indefinite- lived assets, or goodwill! 3-22

24. Applying the Initial Value Method If the parent uses the Initial Value Method to account for the investment, then the consolidation entries will change only slightly. Remember, under the initial value method... 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 Income. 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 Income. 3-23

25. Converting from the initial value method to the equity method When the parent employs the initial value method, the parent’s books (and pre-consolidation statements) reflect the cash basis of income recognition for its equity in subsidiary earnings since acquisition date. The consolidated statements, however, must reflect the accrual basis. So, worksheet adjustments convert the investment and retained earnings accounts of the parent from: Cash Basis toAccrual Basis (Initial Value Method)(Equity Method) When the parent employs the initial value method, the parent’s books (and pre-consolidation statements) reflect the cash basis of income recognition for its equity in subsidiary earnings since acquisition date. The consolidated statements, however, must reflect the accrual basis. So, worksheet adjustments convert the investment and retained earnings accounts of the parent from: Cash Basis toAccrual Basis (Initial Value Method)(Equity Method)

26. Converting from the initial value method to the equity method (Adj. *C) The Conversion Adjustment: Investment in Sxx Retained earnings-P (January 1) xx where xx = P’s %  (change in subsidiary RE from acquisition date to the beginning of the current year less accumulated excess amortizations for the same time period) *C enters all post-acquisition changes in subsidiary RE into the parent’s RE. Note: This adjustment is not needed in the first year subsequent to acquisition.

27. Consolidation Entries Initial Value Method Entry S Eliminate the sub’s equity balances as of the beginning of the period. Assign the difference to Investment in Sub. This entry is the same under both the Equity Method and the Initial Value Method. Entry S Eliminate the sub’s equity balances as of the beginning of the period. Assign the difference to Investment in Sub. This entry is the same under both the Equity Method and the Initial Value Method. 3-26

28. Consolidation Entries Initial Value Method Entry A Adjust sub’s assets and liabilities to FV. 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 Initial Value Method. Entry A Adjust sub’s assets and liabilities to FV. 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 Initial Value Method. 3-27

29. Consolidation Entries: Initial Value Method Entry I This entry is different under the Initial Value Method. Eliminate the Parent’s Dividend Income account. Also, eliminate the Sub’s Dividends Paid account. Entry I This entry is different under the Initial Value Method. Eliminate the Parent’s Dividend Income account. Also, eliminate the Sub’s Dividends Paid account. 3-28

30. Consolidation Entries Initial Value Method Entry D Under the Initial Value Method we DO NOT make an Entry D. Entry D Under the Initial Value Method we DO NOT make an Entry D. 3-29

31. Consolidation Entries Initial Value 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. 3-30

32. Other Consolidation Entries In addition to the Entries *C, 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 less than 100%, an additional adjustment must be made (see Chapter 4). In addition to the Entries *C, 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 less than 100%, an additional adjustment must be made (see Chapter 4). 3-31

33. Goodwill Impairment Goodwill is not amortized. Generally, goodwill will be carried at its acquisition-date assigned value. At some future point in time, goodwill may become either partially or completely impaired. Goodwill is not amortized. Generally, goodwill will be carried at its acquisition-date assigned value. At some future point in time, goodwill may become either partially or completely impaired. SFAS 142 calls for an annual test of possible Goodwill impairment. 3-32

34. Goodwill Impairment Examples Exh. 3-15 3-33

35. 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 3-34

36. 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 cannot 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 cannot be used 3-35

37. 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. 3-36

38. 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 impairment loss (ordinary income) 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 impairment loss (ordinary income) 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 ? 3-37

39. 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. 3-38

40. 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 3-39

41. 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. 3-40

42. 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. 3-41

43. Goodwill Impairment Test Example 3-42

44. Goodwill Impairment Test Example 3-43

45. Goodwill Impairment Test Example 3-44

46. Acquisition Method – Accounting for Contingent Consideration Under SFAS 141R, the acquiring firm must estimate the fair value of any contingent performance obligation. How? Any or all of the following:  An estimate of the future cash flow(s)  Expectations about possible variations in the amount or timing of future cash flows  The time value of money, represented by the risk-free rate of interest  The price for bearing the uncertainty inherent in the asset or liability  Other factors, including illiquidity and market imperfections (These are described in FASB Concepts Statement No. 7) 3-45

47. Push Down Accounting Direct recording of acquisition-date fair value allocations and subsequent amortizations by a subsidiary Currently, there is little official guidance (Focus is on parent’s records and required consolidation procedures) Generally limited for external reporting, but increasingly popular internally 3-46

48. Summary The passage of time and the method applied by the parent in accounting for the subsidiary affect the consolidation procedures Alternative methods include initial value, partial equity and equity methods. Key worksheet entries include income recognition, allocation of values, amortization and elimination of reciprocal balances. Changes may occur in the accounting for contingent consideration involved in business combinations 3-47

49. Possible Criticisms Some critics contend that the purchase of an entity effectively creates a new entity and, therefore, valuation changes should be “pushed down” to the subsidiary’s records Goodwill impairment is controversial as some argue that it is difficult to objectively measure and can lead to financial statement manipulation WHAT DO YOU THINK ????? 3-48