Chapter 3: Consolidations— Subsequent to the Date of Acquisition Flashcards
CCES Corporation acquires a controlling interest in Schmaling, Inc. CCES may utilize any one of three methods to internally account for this investment. Describe each of these methods, and indicate their advantages and disadvantages.
a. CCES Corp., for its own recordkeeping, may apply the equity method to the investment in Schmaling. Under this approach, the parent’s records parallel the activities of the subsidiary. The parent accrues income as it is earned by the subsidiary. Dividends paid by Schmaling reduce its book value; therefore, the CCES reduces the investment account. In addition, any excess amortization expense associated with the allocation of CCES’s purchase price is recognized through a periodic adjustment. By applying the equity method, both the parent’s income and investment balances accurately reflect consolidated totals. The equity method is especially helpful in monitoring the income of the business combination. This method can be, however, rather difficult to apply and a time consuming process.
b. The initial value method. The initial value method can also be utilized by CCES Corporation. Any dividends received are recognized as income but no other investment entries are made. Thus, the initial value method is easy to apply. However, the resulting account balances of the parent may not provide a reasonable representation of the totals that result from consolidating the two companies.
c. The partial equity method combines the advantages of the previous two techniques. Income is accrued as earned by the subsidiary as under the equity method. Similarly, dividends reduce the investment account. However, no other entries are recorded; more specifically, amortization is not recognized by the parent. The method is, therefore, easier to apply than the equity method but the subsidiary’s individual totals will still frequently approximate consolidated balances.
Maguire Company obtains 100 percent control over Williams Company. Several years after the takeover, consolidated financial statements are being produced. For each of the following accounts, briefly describe the values that should be included in consolidated totals.
a. Equipment.
b. Investment in Williams Company.
c. Dividends Paid.
d. Goodwill.
e. Revenues.
f. Expenses.
g. Common Stock.
h. Net Income.
a. The consolidated total for equipment is made up of the sum of Maguire’s book value, Williams’ book value, and any unamortized excess acquisition-date fair value over book value attributable to Williams’ equipment.
b. Although an Investment in Williams account is appropriately maintained by the parent, from a consolidation perspective the balance is intercompany in nature. Thus, the entire amount is eliminated in arriving at consolidated financial statements.
c. Only dividends paid to outside parties are included in consolidated statements. Because Maguire owns 100 percent of Williams, all of the subsidiary’s dividends are intercompany. Consequently, only the dividends paid by the parent company will be reported in the financial statements for this business combination.
d. Any acquisition-date goodwill must still be reported for consolidation purposes. Reductions to goodwill are made if goodwill is determined to be impaired.
e. Unless intercompany revenues have been recorded, consolidation is achieved in subsequent periods by adding the two book values together.
f. Consolidated expenses are determined by combining the parent’s and subsidiary amounts and then including any amortization expense associated with the purchase price. As will be discussed in detail in Chapter Five, intercompany expenses can also be present which require elimination in arriving at consolidated figures.
g. Only the parent’s common stock outstanding is included in consolidated totals.
h. The net income for a business combination is calculated as the difference between consolidated revenues and consolidated expenses.
When a parent company uses the equity method to account for an investment in a subsidiary, why do both the parent’s Net Income and Retained Earnings account balances agree with the consolidated totals?
Under the equity method, the parent accrues subsidiary earnings and amortization expense (associated with the acquisition price in a purchase) in the same manner as in the consolidation process. The equity method parallels consolidation. Thus, the parent’s net income and retained earnings each year will equal the consolidated totals.
When a parent company uses the equity method to account for investment in a subsidiary, the amortization expense entry recorded during the year is eliminated on a consolidation work- sheet as a component of Entry I. What is the necessity of removing this amortization?
In the consolidation process, excess amortizations must be recorded annually for any portion of the purchase price that is allocated to specific accounts (other than land or to goodwill). Although this expense can be simulated in total on the parent’s books by an equity method entry, the actual amortization of each allocated fair value adjustment is appropriate for consolidation. Hence, the effect of the parent’s equity method amortization entry is removed as part of Entry I so that the amortization of specific accounts (e.g., depreciation) can be recorded (in consolidation Entry E).
When a parent company applies the initial value method or the partial equity method to an investment, a worksheet adjustment must be made to the parent’s beginning Retained Earnings account (Entry *C) in every period after the year of acquisition. What is the necessity for this entry? Why is no similar entry found when the parent utilizes the equity method?
When the initial value method is applied by the parent company, no accrual is recorded to reflect the subsidiary’s change in book value during the years following acquisition. Furthermore, recognition of excess amortizations relating to the acquisition price is also omitted by the parent. The partial equity method, in contrast, records the subsidiary’s book value increases and decreases but not amortizations. Consequently, for both of these methods, a technique must be established within the consolidation process to record the omitted figures. Entry *C simply brings the parent’s records (more specifically, the beginning retained earnings balance and the investment account) up to date as of the first day of the current year. If the initial value method has been applied by the acquiring company, any changes in the subsidiary’s book value in previous years must be recognized on the worksheet along with the appropriate amount of amortization expense. For the partial equity method, only the amortization relating to these prior years needs to be recognized.
No similar entry is needed if the equity method has been applied; changes in the subsidiary’s book value as well as excess amortization expense will be recorded each year by the parent. Thus, under the equity method, the parent’s investment and beginning retained earnings balances are both correctly established without further adjustment.
Several years ago, Jenkins Company acquired a controlling interest in Lambert Company. Lambert recently borrowed $100,000 from Jenkins. In consolidating the financial records of these two companies, how will this debt be handled?
Lambert’s loan payable and the receivable held by Jenkins are intercompany accounts. As such, the reciprocal balances should be offset in the consolidation process. The $100,000 is not a debt to or a receivable from an unrelated (or outside) party and should, therefore, not be reported in consolidated financial statements. Additionally any interest income/expense recognized on this loan is also intercompany in nature and must likewise be eliminated.
Benns adopts the equity method for its 100 percent investment in Waters. At the end of six years, Benns reports an investment in Waters of $920,000. What figures constitute this balance?
Because Benns applies the equity method, the $920,000 is composed of four balances:
a. The original consideration transferred by the parent;
b. The annual accruals made by Benns to recognize income as it is earned by the subsidiary;
c. The reductions that are created by the subsidiary’s payment of dividends;
d. The periodic amortization recognized by Benns in connection with the allocations identified with its purchase price.
One company acquired another in a transaction in which $100,000 of the acquisition price is assigned to goodwill. Several years later, a worksheet is being produced to consolidate these two companies. How is the reported value of the goodwill determined at this date?
The $100,000 attributed to goodwill is reported at its original amount unless a portion of goodwill is impaired or a unit of the business where goodwill resides is sold.
When should a parent consider recognizing an impairment loss for goodwill associated with a subsidiary? How should the loss be reported in the financial statements?
A parent should consider recognizing an impairment loss for goodwill associated with a purchased subsidiary when, at the reporting unit level, the fair value is less than its carrying amount. Goodwill is reduced when its carrying value is less than its fair value. To compute fair value for goodwill, its implied value is calculated by subtracting the fair values of the reporting unit’s identifiable net assets from its total fair value. The impairment is recognized as a loss from continuing operations.
Reimers Company acquires Rollins Corporation on January 1, 2012. As part of the agreement, the parent states that an additional $100,000 payment to the former owners of Rollins will be made in 2014, if Rollins achieves certain income thresholds during the first two years following the acquisition. How should Reimers account for this contingency in its 2012 consolidated financial statements?
The acquisition-date fair value of the contingent payment is part of the consideration transferred by Reimers to acquire Rollins and thus is part of the overall fair value assigned to the acquisition. If the contingency is a liability (to be settled in cash or other assets) then the liability is adjusted to fair value through time. If the contingency is a component of equity (e.g., to be settled by the parent issuing equity shares), then the equity instrument is not adjusted to fair value over time.
When is the use of push-down accounting required, and what is the rationale for its application?
At present, the Securities and Exchange Commission requires the use of push down accounting for the separate financial statements of a subsidiary where no substantial outside ownership exists. Thus, if Company A owns all of Company B, the push down method of accounting is appropriate for the separately issued statements of Company B. The SEC normally requires push down accounting where 95 percent of a subsidiary is acquired and the company has no outstanding public debt or preferred stock.
Push down accounting may be required if 80 95 percent of the outstanding voting stock is purchased. Push down accounting is justified in that the consideration transferred by provides the valuation basis for the subsidiary in consolidated reports. For example, if a piece of land costs Company B $10,000 but Company A pays $13,000 for the land when acquiring Company B, the land has a basis to the current owners of B of $13,000. If B’s financial records had been united with A at the time of the acquisition, the land would have been reported at $13,000. Thus, leaving the $10,000 figure simply because separate incorporation is maintained is viewed, by proponents of push down accounting, as unjustified.
How are the individual financial records of both the parent and the subsidiary affected when push-down accounting is being applied?
When push down accounting is applied, the subsidiary adjusts the book value of its assets and liabilities based on the acquisition-date fair value allocations. The subsidiary then recognizes eriodic amortization expense on those allocations with definite lives. Therefore, the income recorded by the subsidiary represents its impact on consolidated earnings.
The parent uses no special procedures when push down accounting is being applied. However, if the equity method is in use, amortization need not be recognized by the parent since that expense is included in the figure reported by the subsidiary.
LO1: Recognize the complexities in preparing consolidated financial reports that emerge from the passage of time?
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LO2: Identify and describe the various methods available to a parent company in order to maintain its investment in subsidiary account in its internal records.
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LO3: Understand that a parent’s internal accounting method for its subsidiary investments has no effect on the resulting consolidated financial statements.
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