Chapter 2: Consolidation of Financial Information

Question 1

What is a business combination?

Answer 1

A business combination is the process of forming a single economic entity by the uniting of two or more organizations under common ownership. The term also refers to the entity that results from this process.

Question 2

Describe the different types of legal arrangements that can take place to create a business combination.

Answer 2

(1) A statutory merger is created whenever two or more companies come together to form a business combination and only one remains in existence as an identifiable entity. This arrangement is often instituted by the acquisition of substantially all of an enterprise’s assets. (2) a statutory merger can also be produced by the acquisition of a company’s capital stock. This transaction is labeled a statutory merger if the acquired company transfers its assets and liabilities to the buyer and then legally dissolves as a corporation. (3) A statutory consolidation results when two or more companies transfer all of their assets or capital stock to a newly formed corporation. The original companies are being “consolidated” into the new entity. (4) A business combination is also formed whenever one company gains control over another through the acquisition of outstanding voting stock. Both companies retain their separate legal identities although the common ownership indicates that only a single economic entity exists

Question 3

What does the term consolidated financial statements mean?

Answer 3

Consolidated financial statements represent accounting information gathered from two or more separate companies. This data, although accumulated individually by the organizations, is brought together (or consolidated) to describe the single economic entity created by the business combination.

Question 4

Within the consolidation process, what is the purpose of a worksheet?

Answer 4

Companies that form a business combination will often retain their separate legal identities as well as their individual accounting systems. In such cases, internal financial data continues to be accumulated by each organization. Separate financial reports may be required for outside shareholders (a noncontrolling interest), the government, debt holders, etc. This information may also be utilized in corporate evaluations and other decision making. However, the business combination must periodically produce consolidated financial statements encompassing all of the companies within the single economic entity. A worksheet is used to organize and structure this process. The worksheet allows for a simulated consolidation to be carried out on a regular, periodic basis without affecting the financial records of the various component companies

Question 5

Jones Company obtains all of the common stock of Hudson, Inc., by issuing 50,000 shares of its own stock. Under these circumstances, why might the determination of a fair value for the consideration transferred be difficult?

Answer 5

Several situations can occur in which the fair value of the 50,000 shares being issued might be difficult to ascertain. These examples include:
• The shares may be newly issued (if Jones has just been created) so that no accurate value has yet been established;
• Jones may be a closely held corporation so that no fair value is available for its shares;
• The number of newly issued shares (especially if the amount is large in comparison to the quantity of previously outstanding shares) may cause the price of the stock to fluctuate widely so that no accurate fair value can be determined during a reasonable period of time;
• Jones’ stock may have historically experienced drastic swings in price. Thus, a quoted figure at any specific point in time may not be an adequate or representative value for long-term accounting purposes

Question 6

What is the accounting valuation basis for consolidating assets and liabilities in a business combination?

Answer 6

For combinations resulting in complete ownership, the acquisition method allocates the fair value of the consideration transferred to the separately recognized assets acquired and liabilities assumed based on their individual fair values

Question 7

How should a parent consolidate its subsidiary’s revenues and expenses?

Answer 7

The revenues and expenses (both current and past) of the parent are included within reported figures. However, the revenues and expenses of the subsidiary are only consolidated from the date of the acquisition forward. The operations of the subsidiary are only applicable to the business combination if earned subsequent to its creation

Question 8

Morgan Company acquires all of the outstanding shares of Jennings, Inc., for cash. Morgan transfers consideration more than the fair value of the company’s net assets. How should the payment in excess of fair value be accounted for in the consolidation process?

Answer 8

Morgan’s additional purchase price may be attributed to many factors: expected synergies between Morgan’s and Jennings’ assets, favorable earnings projections, competitive bidding to acquire Jennings, etc. In general however, under the acquisition method, any amount paid by the parent company in excess of the fair values of the subsidiary’s net assets is reported as goodwill.

Question 9

Catron Corporation is having liquidity problems, and as a result, it sells all of its outstanding stock to Lambert, Inc., for cash. Because of Catron’s problems, Lambert is able to acquire this stock at less than the fair value of the company’s net assets. How is this reduction in price accounted for within the consolidation process?

Answer 9

Under the acquisition method, in the vast majority of cases the assets acquired and liabilities assumed in a business combination are recorded at their fair values. If the fair value of the consideration transferred (including any contingent consideration) is less than the total net fair value assigned to the assets acquired and liabilities assumed, then an ordinary gain on bargain purchase is recognized for the difference.

Question 10

Sloane, Inc., issues 25,000 shares of its own common stock in exchange for all of the outstand- ing shares of Benjamin Company. Benjamin will remain a separately incorporated operation. How does Sloane record the issuance of these shares?

Answer 10

Shares issued are recorded at fair value as if the stock had been sold and the money obtained used to acquire the subsidiary. The Common Stock account is recorded at the par value of these shares with any excess amount attributed to additional paid-in capital.

Question 11

To obtain all of the stock of Molly, Inc., Harrison Corporation issued its own common stock. Harrison had to pay $98,000 to lawyers, accountants, and a stock brokerage firm in connection with services rendered during the creation of this business combination. In addition, Harrison paid $56,000 in costs associated with the stock issuance. How will these two costs be recorded?

Answer 11

Under the acquisition method, direct combination costs are not considered part of the fair value of the consideration transferred and thus are not included in the purchase price. These direct combination costs are allocated to expense in the period in which they occur. Stock issue costs are treated under the acquisition method in the same way as under the purchase method, i.e., as a reduction of APIC.

Question 12

LO1: Discuss the motives for business combinations.

Answer 12

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Question 13

LO2: Recognize when consolidation of financial information into a single set of statements is necessary.

Answer 13

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Question 14

LO3: Define the term business combination and differentiate across various forms of business combinations.

Answer 14

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Question 15

LO4: Describe the valuation principles of the acquisition method.

Answer 15

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Question 16

LO5: Determine the total fair value of the consideration transferred for an acquisition and allocate that fair value to specific subsidiary assets acquired (including goodwill) and liabilities assumed or to a gain on bargain purchase.

Answer 16

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Question 17

LO6: Prepare the journal entry to consolidate the accounts of a subsidiary if dissolution takes place

Answer 17

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Question 18

LO7: Prepare a worksheet to consolidate the accounts of two companies that form a business combination if dissolution does not take place.

Answer 18

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Question 19

LO8: Describe the two criteria for recognizing intangible assets apart from goodwill in a business combination

Answer 19

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Question 20

LO9: Appendix: Identify the general characteristics of the legacy purchase and pooling of interest methods of accounting for past business combinations. Understand the effects that persist today in financial statements from the use of these legacy methods.

Answer 20

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Question 21

What term is used to refer to a business combination in which only one of the original companies continues to exist?

Answer 21

The appropriate term is statutory merger.

Question 22

How are stock issuance costs accounted for in an acquisition business combination?

Answer 22

Stock issuance costs reduce the balance in the acquirer’s Additional Paid-In Capital in an acquisition business combination.

Question 23

What is the primary difference between recording an acquisition when the subsidiary is dissolved and when separate incorporation is maintained?

Answer 23

When the subsidiary is dissolved, the acquirer records in its books the fair value of individual assets and liabilities acquired as well as the resulting goodwill from the acquisition. However, when separate incorporation is maintained, the acquirer only records the total fair value of assets and liabilities acquired, as well as the resulting goodwill, in one account as an investment.

Question 24

How are direct combination costs accounted for in an acquisition transaction?

Answer 24

In an acquisition, direct combination costs are expensed in the period of the acquisition.

Question 25

Peterman Co. owns 55% of Samson Co. Under what circumstances would Peterman not be required to prepare consolidated financial statements?

Answer 25

Peterman would not be required to prepare consolidated financial statements if control of Samson is temporary or if, despite majority ownership, Peterman does not have control over Samson. A lack of control might exist if Samson is in a country that imposes restrictions on Peterman’s actions.

Question 26

How would you account for in-process research and development acquired in a business combination accounted for as an acquisition?

Answer 26

In-Process Research and Development is capitalized as an asset of the combination and reported as intangible assets with indefinite lives subject to impairment reviews.

Question 27

Elon Corp. obtained all of the common stock of Finley Co., paying slightly less than the fair value of Finley’s net assets acquired. How should the difference between the consideration transferred and the fair value of the net assets be treated if the transaction is accounted for as an acquisition?

Answer 27

The difference between the consideration transferred and the fair value of the net assets acquired is recognized as a gain on bargain purchase.

Question 28

For acquisition accounting, why are assets and liabilities of the subsidiary consolidated at fair value?

Answer 28

The acquisition transaction is assumed to occur through an orderly transaction between market participants at the measurement date of the acquisition. Thus identified assets and liabilities acquired have been assigned fair value for the transfer to the acquirer and this is a relevant and faithful representation for consolidation.

Question 29

Goodwill is often acquired as part of a business combination. Why, when separate incorporation is maintained, does Goodwill not appear on the Parent company’s trial balance as a separate account?

Answer 29

While the Goodwill does not appear on the Parent company’s books, it is implied as part of the account called Investment in Subsidiary. During the consolidation process, the Investment account is broken down into its component parts. Goodwill, along with other items such as subsidiary fair value adjustments, is then shown separately as part of the consolidated financial statement balances.

Question 30

How are direct combination costs, contingent consideration, and a bargain purchase reflected in recording an acquisition transaction?

Answer 30

The acquisition method embraces a fair value concept as measured by the fair value of consideration transferred. (1) Direct combination costs are expensed as incurred; (2) Contingent consideration obligations are recognized at their present value of the potential obligation as part of the acquisition consideration transferred; (3) When a bargain purchase occurs, the acquirer measures and recognizes the fair values of each of the assets acquired and liabilities assumed at the date of the combination, and as a result a gain on the bargain purchase is recognized at the acquisition date.

Question 31

How is contingent consideration accounted for in an acquisition business combination transaction?

Answer 31

The fair value approach of the acquisition method views contingent payments as part of the consideration transferred. Under this view, contingencies have a value to those who receive the consideration and represent measurable obligations of the acquirer. The amount of the contingent consideration is measured as the expected present value of a potential payment and increases the investment value recorded.

Question 32

How are bargain purchases accounted for in an acquisition business transaction?

Answer 32

A bargain purchase results when the collective fair values of the net identified assets acquired and liabilities assumed exceed the fair value of consideration transferred. The assets and liabilities acquired are recorded at their fair values and the bargain purchase is recorded as a Gain on Bargain Purchase

Question 33

Describe the accounting for direct costs, indirect costs, and issuance costs under the acquisition method of accounting for a business combination.

Answer 33

Direct and indirect combination costs are expensed and issuance costs reduce the otherwise fair value of the consideration issued under the acquisition method of accounting for business combinations.

Question 34

What is the difference in consolidated results between a business combination whereby the acquired company is dissolved, and a business combination whereby separate incorporation is maintained?

Answer 34

There is no difference in consolidated results.