Business Combinations and Consolidated Financial Statements Flashcards
Consolidation: control over 50% ownership
under the voting interest model, consolidated financial statements are prepared when a parent-subsidiary relationship has been formed; an investor is considered to have parent status when control over an investee is established or more than 50% of the voting stock of the investee has been acquired
under U.S. GAAP, all majority-owned subsidiaries (domestic and foreign) must be consolidated except when significant doubt exists regarding the parent’s ability to control the subsidiary, such as when the subsidiary is in legal reorganization or bankruptcy and/or the subsidiary operates under sever foreign restrictions
Consolidation: controlling interest and noncontrolling interest (NCI)
business combinations that do not establish 100% ownership of a subsidiary by a parent company result in a portion of the subsidiary’s equity (net assets) being attributable to noncontrolling shareholders
an investor owning more than 50% of a subsidiary has a controlling interest in that subsidiary
noncontrolling interest is the portion of the equity (net assets) of a subsidiary that is not attributable to the parent; noncontrolling interest is reported at fair value in the equity section of the consolidated balance sheet, separately from the parent’s equity
What is a variable interest entity (VIE)?
it is a corporation, partnership, trust, LLC, or other legal structure used for business purposes that either does not have equity investors with voting rights or lacks the sufficient financial resources to support its activities
the primary beneficiary is the entity that is required to consolidate the VIE and it is the entity that has the power to direct the activities of a VIE that most significantly impact the entity’s economic performance and absorbs the expected VIE losses or receives the expected VIE residual returns
the primary beneficiary of a VIE must consolidate the VIE; under U.S. GAAP, all consolidate decisions are evaluated first under the VIE model; if consolidation is not required under the VIE model, then the investor (parent) company determines whether consolidation is necessary under the voting interest model (consolidate when ownership is more than 50% of the investee’s voting stock)
a variable interest exists when the company must absorb a portion of the business entity’s losses or receive a portion of the business entity’s expected residual returns
once a company has established that is has a variable interest in a business entity, the company must determine whether the business entity is a VIE; the business entity is a VIE if it has any of the following characteristics:
insufficient level of equity investment at risk
inability to make decisions or direct activities
no obligation to absorb entity’s expected losses
no right to received expected residual returns
disproportionately few voting rights
once a company has established that is has a variable interest in a business entity that is a VIE, the primary beneficiary must be determined; the primary beneficiary must consolidate the VIE
the company is the primary beneficiary if it has the power to direct the activities of a IE that most significantly impact the entity’s economic performance and the company absorbs the expected VIE losses or receives the expected VIE residual returns; if one party receives the expected residual returns and another party absorbs the expected losses, the party that absorbs the expected losses consolidates; it is possible for an entity to be a VIE, but have no primary beneficiary and, therefore, nobody consolidates
Acquisition method
in a business combination accounted for as an acquisition, the subsidiary may be acquired for cash, stock, debt securities, etc.
the investment is valued at the fair value of the consideration given or the fair value of the consideration received whichever is the more clearly evident; the accounting for an acquisition begins at the date of acquisition
the acquisition method has two distinct accounting characteristics: 100% of the net assets acquired (regardless of percentage acquired) are recorded at fair value with any unallocated balance remaining creating goodwill & when the companies are consolidated, the subsidiary’s entire equity (including its common stock, APIC, and retained earnings) is eliminated (not reported)
the parent’s basis is the acquisition price; the formula is:
fair value = acquisition price = investment in subsidiary
an acquiring corporation should adjust the following items during consolidation:
common stock, APIC, and retained earnings of subsidiary are eliminated
investment in subsidiary is eliminated
noncontrolling interest (NCI) is created
balance sheet of subsidiary is adjusted to fair value
identifiable intangible assets of the subsidiary are recorded at their fair value
goodwill (or gain) is required
the year-end consolidating JE known as the consolidating workpaper eliminating JE is:
DR common stock - subsidiary
DR APIC - subsidiary
DR retained earnings - subsidiary
CR investment in subsidiary
CR noncontrolling interest
DR balance sheet adjustments to FV
DR identifiable intangible assets to FV
DR goodwill
CAR: subsidiary equity acquired
the following formula is used to determine the book value of the assets acquired from the subsidiary:
assets - liabilities = equity
assets - liabilities = net book value
assets - liabilities = CAR (common stock - sub, APIC - sub, retained earnings - sub)
Investment in subsidiary: original carrying amount
the original carrying amount of the investment in subsidiary account on the parent’s books is:
original cost - measured by the fair value (on the date the acquisition is completed) of the consideration given (debit: investment in sub)
business combination costs/expenses in an acquisition are treated as follows:
direct out-of-pocket costs and indirect costs are expensed (debit: expense)
stock registration and issuance costs such as SEC filing fees are a direct reduction of the value of the stock issued (debit: APIC)
Investment in subsidiary: contingent consideration
contingent consideration is an obligation of the parent company to transfer additional assets or equity interests to the former shareholders of the subsidiary if specified conditions are met
contingent consideration is recorded by the parent on the acquisition date by adding an estimate of the probable settlement cost to the investment in subsidiary and crediting the liability expected value of contingent consideration
Investment in subsidiary: parent company accounting for the investment in the subsidiary
after the acquisition date, the parent uses either the cost method or the equity method to account for the investment in subsidiary in its accounting records; the equity method and cost method are used by the parent company for internal accounting purposes only; when the consolidated financial statements are prepared, the investment in subsidiary’s account is eliminated
cost method - the investment in subsidiary account does not change after the acquisition date; no adjustments are made to account for the parent’s share of subsidiary income; dividends received from the subsidiary are recorded by the parent as dividend income
equity method - the equity method that is used by the parent company to account for the investment in subsidiary is the same method used by an investor that exercises significant influence over an investee; under the equity method, the investment in subsidiary increases by the parent company’s share of the subsidiary’s net income with a corresponding credit to the income statement account, equity in subsidiary/subsidiary income; dividends received from the subsidiary decrease the investment in subsidiary
the advantage of the equity method is that changes in the subsidiary’s equity are reflected in the parent’s investment in subsidiary account, which simplifies the elimination of the investment in subsidiary when the consolidated financial statements are prepared
Noncontrolling interest (NCI)
business combinations that do not establish 100% ownership of a subsidiary by a parent will result in a portion of the subsidiary’s equity (net assets) being attributed to noncontrolling shareholders; noncontrolling interest must be reported at fair value in the equity section of the consolidated balance sheet, separately from the parent’s equity; this includes the noncontrolling interest’s share of any goodwill
acquisition date computation:
fair value of subsidiary * noncontrolling interest percentage = noncontrolling interest
noncontrolling interest after the acquisition date computation:
beginning noncontrolling interest + NCI share of subsidiary net income - NCI share of subsidiary dividends = ending noncontrolling interest
net income attributable to the noncontrolling interest computation:
subsidiary’s income - subsidiary’s expenses = subsidiary’s net income
subsidiary’s net income * noncontrolling interest percentage = net income attributable to the noncontrolling interest
Balance sheet adjustment to fair value, identifiable intangible asset adjustment to fair value, and goodwill (gain)
under the acquisition method, the fair value of the subsidiary is equal to the acquisition cost plus any noncontrolling interest at fair value
FV subsidiary = acquisition cost + NCI at FV
on the acquisition date, the fair value of the subsidiary must be compared with the respective assets and liabilities of the subsidiary; any difference between the fair value of the subsidiary and the book value acquired will require an adjustment to the following 3 areas: balance sheet, identifiable intangible assets, and goodwill
when acquiring a subsidiary with a fair value (acquisition price + fair value of NCI) that is grater than the fair value of 100% of the underlying assets acquired, the following steps are required:
step 1 - balance sheet adjusted to fair value
step 2 - identifiable intangible assets to fair value
these identifiable intangible assets are separated into 2 categories:
finite life - amortize over the remaining life; subject to the two-step impairment test
infinite life - do not amortize; subject to the one-step impairment test
in-process R&D should be recognized as an intangible asset separately from goodwill at the acquisition date (need valuation); do not immediately write-off
step 3 - goodwill
allocate any remaining acquisition cost to goodwill
goodwill = FV subsidiary - FV subsidiary net assets
this goodwill is generally not amortized; acquisition goodwill is subject to impairment testing; in the period it is determined to be impaired, it is written down and charged as an expense against income on the income statement
when acquiring a corporation/subsidiary with a fair value that is less than the fair value of 100% of the underlying assets required, the following steps are required:
step 1 - balance sheet adjusted to fair value
step 2 - identifiable intangible assets to fair value
step 3 - gain
