Ch 3: Consolidated Financial Statements Subsequent to the Date of Acquisition

Review of Equity Method of Accounting

• Goal: replace equity investment with the assets and liab of the subsidiary

• ex. Assumptions:

  • Parent purchases for $1,500,000 of a subsidiary with a BV of SE of $1,000,000

  • Parent issues 50,000 shares of $1 CS with MV of $30/s w the subsidiary’s Stockholders for all the subsidiary’s voting shares they own

  • JE to Record the acquisition of the sibsidiary: DR Equity Investment 1500000 CR CS 50000 APIC 1450000

  • The equity investment on the acquisition date has two components: $1000000 BV of the sub’s SE and $500,000 AAP assets relating to the undervalued PPE, the unrecorded patent asset, and the goodwill asset

• Assume that during the 1st yr following the acquisition the sub earns a profit of 210,000 during the yr, pays a dividends of 31,500 to the parent, the parent records amort of the AAP in the amnt of 27,500

  • Parent JE:

  • a. To record the recognition of equity earnings: DR Equity Investment CR Equity income 210000

  • b. To record the receipt of dividends: DR Cash CR Equity Investment 31500

  • c: To record the 10000 depr of the PPE asset and the 17500 amort of the patent asset: DR Equity Income CR Equity Investment 27500

LO2 Describe the consolidation process subsequent to the date of acquisition when the parent uses the equity method to account for its Equity Investment.

Three New Consolidation JE

1. C: the elimination of the changes in the Equity Investment account during the accounting period

2. D: to recognize the current period AAP depreciation and amort of the AAP in the consolidated IS

3. I: to eliminate the intercompany transaction during the period and balances remaining at the end of the period

The entries correspond to activities of the subsidiary during the period

LO2 Describe the consolidation process subsequent to the date of acquisition when the parent uses the equity method to account for its Equity Investment.

EOY Consolidation Ex Continued

• Recap: $1,500,000 acquisition, subsid earns profit during yr of $210,000, pays div of $31,500 to the parent, parent records amort of the aap in amnt of $27500

  • Parent JE: a. To record the recognition of equity earnings: DR Equity Investment CR Equity income 210000; b. To record the receipt of dividends: DR Cash CR Equity Investment 31500; c: To record the 10000 depr of the PPE asset and the 17500 amort of the patent asset: DR Equity Income CR Equity Investment 27500

• Consolidation Entries: Eliminate the changes in Eq Inv account during the period (C), Eliminate the beg bal of the Equity Inv account (E) and (A) and Record the depr &/ amort of the AAP (D)

• the consolidation JE are made only in our spreadsheet. They do NOT affect the accounting records of either the parent of the sub

LO2 Describe the consolidation process subsequent to the date of acquisition when the parent uses the equity method to account for its Equity Investment.

Consolidation at the End of Second Yr following the Acquisition

• Consolidated Statement of Cash Flows: Not the sum of the statement of cash flows of the indiv comps in the consolidated group

  • prepared from the consolidated IS and a comparative consolidated BS

  • add back the noncash exp relating to the depr and amort of the aap

  • In the yr of acquisition: the net cash paid for an acquisition is recorded in the investing section and the changes in working capital accounts are computed based on amounts excluding the effects of the acquisition

• Required footnote disclosures: name and descrip of the acquiree, the acq date, the percentage of voting equity interest acquired, the primary reasons for the business combo and how the acquirer obtained control of the acquiree

LO2 Describe the consolidation process subsequent to the date of acquisition when the parent uses the equity method to account for its Equity Investment.

Summary of Post-Acquisition Consolidation: Parent uses the Equity Method of investment Bookkeeping

LO3 Describe the consolidation process subsequent to the date of acquisition when the parent uses the cost method to account for its Equity Investment

Post-Acquisition Consideration Parent Uses the Cost Method

• The consolidated fin st will look the same, regardless of the pre-consolidation method of equity investment bookkeeping applied by the parent company

• bc the parent comps pre consolidation fin st will be different under the cost method vs the equity, the consolidation entries will be different

• the equity investment balance always remains unchanged at the og acquisition date amnt

• any dividend received by the parent is dividend income

LO3 Describe the consolidation process subsequent to the date of acquisition when the parent uses the cost method to account for its Equity Investment

Cost Method Vs Equity Method

Assumptions:

• the parent purchases the sub for $500,000 on jan 1 2016 (recorded as inc to Equity Inv under cost and equity)

  • All three of these reflected in equity method but not cost

    • the sub reports $100,000 of NI during 2016

    • the sub pays $20,000 of dividends to the parent during 2016

    • the parent’s investment in the sub includes AAP. during 2016, aap amort is $5,000

• Equity Method Equity Income: 100,000 - 5000 = 95000

• Cost Method Dividend Income: 20000

LO3 Describe the consolidation process subsequent to the date of acquisition when the parent uses the cost method to account for its Equity Investment

Consolidations: Cost Method: The ADJ Entry

• New: ADJ: E A D, and I entries are identical to the equity method consolidation entries. Bc of the ADJ entry causes the parents Equity investment and retained earnings account to equal their beg period balances as if the parent comp always used the equity method. then perform consolidation like normal

  • C entry will change since the parent has recognized dividend income in place of equity income. But the concept to back out that income is the same

    • DR Dividend Income (Parent) Cr Dividends (Subsid)

• The ADJ entry backs out the cumulative cost method activity that has been recorded in the parents RE account since acquisition and inserts the cumulative RE activity that would have been recorded if the parent comp used the equity method

LO3 Describe the consolidation process subsequent to the date of acquisition when the parent uses the cost method to account for its Equity Investment

The ADJ Example

• assume Jan 1, 2011: parent comp purchased a subsidiary for $1,000,000 and recognized AAP of $40,000 w a UL of 10 yrs

• each yr btwn Jan 1, 2011 and Dec 31, 2015 the sub reported NI of $20,000 and paid div of $10,000

• Picture: diff btwn the income that the parent has recognized and what it would have recognized if it used the equity method all along

  • the cumulative diff is what we would need to adjust the cost method equity investment account by to bring it to the bal that would have been reported if the parent has always used the equity method

  • Adjusting Entry: DR Equity Investment CR RE (parent) 30,000 (brings equity inv up to 80

LO4 Describe the accounting for Goodwill and Bargain Acquisition Gains.

Accounting for Goodwill

• Goodwill: an asset that must meet the conceptual def of an asset in order to be recognized on the BS

  • Does the parent comp control the Goodwill asset?

  • Will the Goodwill asset provide future benefits?

• The second question must be answered each yr

• Goodwill must be tested annually for impairment and written down if impaired

LO4 Describe the accounting for Goodwill and Bargain Acquisition Gains.

Amortization of Goodwill depends on two factors:

• Amortization of Goodwill depends on two factors:

  • whether the aquiring company qualifies as a “private company” (entities that are not public, not for profit, or employee benefit plans)

  • whether the acquiring (private) comp elects to adopt the Goodwill amort exception available to private comps

  • If the acquiring comp satisfies both of these conditions, then the acquiring comp is req to amortize the goodwill on a straight line basis over 10 yrs or less than 10 if the entity demonstrates that another UL is more appropriate

  • if a private comp attempts to transition to being a public business entity then the comp will be req to retroactively restate its fin st w/o the private comp exeption included in the fin st

LO4 Describe the accounting for Goodwill and Bargain Acquisition Gains.

Test of Goodwill Impairment

• for public comps, goodwill is not amortized like most identifiable intang assets

• Along w goodwill, all indefinite lived intangible assets must be evaluated, at least annually, for impairment

• companies must conduct this annual evaluation during the same time of year

• Impairment: the condition that exists when the carrying amnt of a long lived asset exceeds its FV

• If its impaired: DR Equity Income CR Equity Investment To write down the BV of Goodwill

LO4 Describe the accounting for Goodwill and Bargain Acquisition Gains.

Reporting Units

• If a Private comp chooses to adopt the goodwill amort exception then the comp must make a policy election of whether to test Goodwill for impairment at the entire company level or at the reporting unit level

• for all public comps (and private that do not adopt the goodwill amort exception) all goodwill impairment tests are performed at the reporting unit level

• For the purposes of testing goodwill for impairment, acquired assets and assumed liab must be assigned to indiv reporting units as of the acquisition date if both:

  • the asset will be employed in or the liab related to the operations of a reporting unit

  • the asset or liab will be considered in determining the FV of the reporting unit

• after the identifiable assets and liab are assigned to the reporting unit, then the acquiring comp must calculate the amnt of goodwill assigned to each reporting unit

LO4 Describe the accounting for Goodwill and Bargain Acquisition Gains.

The Annual Evaluation of Goodwill Impairment

• if after evaluating, a comp determines that it is more likely than not that the FV of a reporting unit is greater than its carrying amnt, then no further evaluation is needed

• if a cmp determines that it is more likely than not that the FV of a reporting unit is less than its carrying amnt then the comp is req to proceed thru the quantitative impairment test

LO4 Describe the accounting for Goodwill and Bargain Acquisition Gains.

Goodwill Impairment Testing and Measurement

• comps are req to estimate the FV of each of its reporting units in which goodwill has been recorded

• The comp compares the est FV of each reporting unit to the recorded CV of each reporting unit (including goodwill)

  • CV > FV: goodwill in the reporting unit is IMPAIRED

  • CV <= FV: Goodwill in the reporting unit is NOT impaired

• the amnt of the recorded goodwill impairment is the amnt by which the FV of the entire reporting unit is less than the carrying value of the entire reporting unit

• for each reporting unit, the recorded goodwill impairment for a given reporting unit cannot be greater than the current carrying value of the goodwill asset in that reporting unit. Excess impairment over the current CV is ignored

LO4 Describe the accounting for Goodwill and Bargain Acquisition Gains.

Goodwill Impairment Example

• Assume: the CV of the equity investment: $1,848,053; CV of Goodwill: $125,000; FV of reporting unit (the subsidiary): 1,700,000

• the potential impairment is the 148,053 diff btwn the FV of the reporting unit and its CV

• The goodwill balance is only 125,000, so the impairment is capped at that amount

• Goodwill must be written down to a zero balance:

  • DR Equity Income CR Equity Investment 125,000 Made by parent comp on its books bc they are reporting the goodwill asset

LO4 Describe the accounting for Goodwill and Bargain Acquisition Gains.

When should Goodwill be Evaluated for Impairment?

• Comps are req to test goodwill for impairment every yr

• goodwill must be tested btwn the annual eval dates if an event occurs or circumstances change that would more likely than not reduce the FV of a reporting unit below its CV (macrecon factors, industry considerations, cost factors)

LO4 Describe the accounting for Goodwill and Bargain Acquisition Gains.

Accounting for Bargain Acquisition

• a bargain acquisition occurs if the total FV of the investee comp is less than the acquisition date amnts of the identifiable assets acquired and the liabs assumed (the amount computed for goodwill is neg)

  • investor recognized neg goodwill as an ordinary gain in its IS on the acquisition date

• Ex: Assume purch price for subsidiary is 200 and FV of subs net assets is 250

  • 200- 250 = (50) unexplained negative residual (bargain purch gain)

  • DR Equity Investment 250 CR Cash 200 CR Gain on bargain purchase 50

• Consolidation Entries:

  • E: DR SE of Subsidiary 100 CR Equity Investment 100

  • A: DR Net Assets (broken out into indiv A&L account) CR Equity Investment 150

  • the net result is that the gain on the bargain acquisition is recognized in the consolidation IS immediately upon acquisition

Completed

Appendix 3A: Complete Listing of Required Disclosures

Required Disclosures

• the name and description of the acquiree

• the acquisition date

• the % of voting equity interests acquired

• the primary reasons for the business combo and a description of how the acquirer obtained control of the business

• for transactions that are recognized separately from the acquisition of assets and assumptions of liab in the business combo all of the following:

  • a description of each transaction, how the acquirer accounted for each transaction, the amnts recognized for each transaction and the line item in the fin st in which each amnt is recognized, if the transaction is the effective settlement of a preexisting relationship the method used to determine the settlement amount
    
    

  • if the

LO5 Describe the accounting for common control business combinations and the pooling-of-interests method

• Pooling of interest method: NOT USED

• REQATCH IF IN PPT

COST METHOD

Chapter 3

Parent’s Ownership Accounting

The use of the Equity Method has been concentrated on as:

1. Consolidated Net Income will equal Parent Company’s pre-consolidation net

income.

2. Consolidated Owner’s Equity will equal parent’s pre-consolidation owner’s

equity.

Due to many of the complexities that we have already covered, you can see why

many companies may opt to use the cost method for bookkeeping purposes.

Regardless of the bookkeeping approach chosen by the Parent, consolidated

financial statements will look the same.

Post-Acquisition Consolidation Parent Uses the Cost Method

The consolidated financial statements will look the same, regardless of the pre-consolidation method of Equity Investment bookkeeping applied by the parent company.

Because parent company’s pre-consolidation financial statements will be different under the cost method versus the equity method, the consolidation entries will (out of necessity) be slightly different.

Cost Method for Equity Investment

Under the cost method, the Equity Investment balance always remains unchanged at its original acquisition-date amount. Any dividends received by the parent are recorded as dividend income and thus included in Parent’s Retained Earnings

Cost Method: Beg Bal → Ending Balance

Equity Method: Beg Bal + Equity Income - Div Rec - AAP Amort = End Bal

Cost Vs Equity Method

Assumptions:

1. The parent purchases the subsidiary for $500,000 on January 1, 2022.

2. The subsidiary reports $100,000 of net income during 2022.

3. The subsidiary pays $20,000 of dividends to the parent during 2022.

4. The parent’s investment in the subsidiary includes AAP. During 2022, AAP

amortization is $5,000.

Equity Investment

Cost Method: Beg (500,000) = End (500,000)

Equity Method: Beg Bal (500,000) + Equity Income (100,000) - Div Rec (20,000) - AAP Amort (5,000) = End Bal (575,000)

Cost Vs Equity Method

Under the equity method

The parent reports equity income of $100,000 - $5,000 (AAP adjustment) = $95,000

Under the cost method

The parent reports dividend income of $20,000

Cost Method	Equity Method
Effect on Net Income during 2022: Dividend income + $20,000</span></p><p><br><br></p><p>Net effect <span>$\dots\dots\dots\dots\dots\dots\dots\dots\dots\dots$</span> <span>$+\$20,000$	Effect on Net Income during 2022: Subsidiary income $\dots\dots\dots\dots\dots\dots\dots\dots$ $+\$100,000$</span></p><p><br></p><p>AAP amortization <span>$\dots\dots\dots\dots\dots\dots\dots\dots$</span> <span>$-\ \ \ 5,000$</span></p><p><br></p><p>Net effect <span>$\dots\dots\dots\dots\dots\dots\dots\dots\dots\dots$</span> <span>$+\$95,000$
Effect on Ret. Earn. through 12/31/22: Net effect $\dots\dots\dots\dots\dots\dots\dots\dots\dots\dots$ $+\$20,000$</span></p></td><td colspan="1" rowspan="1" style="border: 1px solid rgb(196, 199, 197); padding: 8px 12px;"><p><strong>Effect on Ret. Earn. through 12/31/22:</strong></p><p><br></p><p>Net effect <span>$\dots\dots\dots\dots\dots\dots\dots\dots\dots\dots$</span> <span>$+\$95,000$

• Difference = $\$75,000$ (between the Retained Earnings effects of the two methods)

To convert from Cost to Equity:

Equity Investment $75,000

Retained Earnings (Parent) $75,000

CEADI

• [ADJ]: Changes the Equity Investment account and the parent company's retained earnings account to an "as-if-equity-method" basis as of the beginning of the accounting period.

• [C]: Eliminates all changes in the parent's books caused by investment bookkeeping during the year. When the parent uses the cost method to account for the pre-consolidation Equity Investment account it eliminates dividend income.

• [E]: Eliminates the portion of the investment account related to the book value of the subsidiary's Stockholders' Equity at the beginning of the accounting period. (After this entry, the investment account should equal the beginning of period unamortized AAP, on an "as-if-equity-method" basis.)

• [A]: Assigns the remaining Equity Investment account (i.e., unamortized beginning of period AAP) to appropriate asset and liability accounts as of the beginning of the accounting period.

• [D]: Depreciates/amortizes AAP so that the income statement includes the activity and the balance sheet accounts include ending AAP allocated to the appropriate accounts.

• [I]: Eliminates intercompany activity (e.g., sales between parent and subsidiary) and/or intercompany balances (e.g., account payable and account receivable between parent and subsidiary). (This will be covered in Chapter 4.)

Entries [E], [A], [D], and [I] are identical to the equity method consolidation entries. This occurs because the consolidation entry [ADJ] causes the parent's Equity Investment account and Retained Earnings account to equal their beginning of period balances as if the parent company always used the equity method.

The [ADJ] Entry

The [ADJ] entry: Will convert the Parent’s Equity Investment account and Retained Earnings to the Equity Method (assuming 100% ownership of subsidiary)

Retained Earnings of Subsidiary @ Beg. Of Year to be Consolidated less Retained Earnings at Date of Acquisition less AAP Amortization/Depreciation through Beg. Of Year to be Consolidated

This adjusts the Parent’s retained earnings to an as-if equity method or consolidated basis to provide consolidated financial statements. Adjustment is made only on the consolidated worksheet and not to the parent’s actual books.

[Adj] DR Equity Investment(P) at Beg. Of Year CR Retained Earnings(P) at Beg. Of Year

Accounting for Goodwill

Goodwill is an asset and must meet the conceptual definition of an asset in order to be recognized on the balance sheet.

1. Does the parent company control the Goodwill asset?

2. Will the Goodwill asset provide future benefits?

 The second question must be answered each year.

 Goodwill must be tested annually for impairment and written

down if impaired.

Goodwill Amortization - Private Companies

The amortization of Goodwill depends on two factors:

1. Whether the acquiring company qualifies as a “private company” (i.e., entities that are not public business entities, not- for-profit entities, or employee benefit plans), and

2. Whether the acquiring (private) company elects to adopt the Goodwill amortization exception available to private companies.

If the acquiring company satisfies both of these conditions, then the acquiring company is required to amortize the Goodwill “on a straight-line basis over 10 years, or less than 10 years if the entity demonstrates that another useful life is more appropriate.”

 However, if a private company attempts to transition to being a public business entity (e.g., by registering its common stock with the SEC and issuing the shares to investors via an Initial Public Offering), then the company will be required to retroactively restate its financial statements without the private-company exception included in the financial statements.

Goodwill - Public Companies

For public companies, Goodwill is not amortized like most identifiable intangible assets.

 Along with Goodwill, all indefinite-lived intangible assets must be evaluated, at least annually, for impairment.

 Further, companies must conduct this annual evaluation during the same time of year

Impairment Journal Entry

Impairment is the condition that exists when the carrying amount of a long-lived asset (asset group) exceeds its fair value.”

 If we test Goodwill for impairment and find it to be impaired, we must write it down with a journal entry similar to the following (assuming the parent uses the equity method):

DR Equity Income CR Equity Investment

Assigning Goodwill to Reporting Units

For the purpose of testing Goodwill for impairment, acquired assets and assumed liabilities must be assigned to individual reporting units as of the acquisition date if both

a. The asset will be employed in or the liability relates to the operations of a

reporting unit, and

b. The asset or liability will be considered in determining the fair value of the

reporting unit.

After the identifiable assets and liabilities are assigned to the reporting unit, then the acquiring company must calculate the amount of Goodwill assigned to each reporting unit.

Goodwill Impairment Testing and Measurement

Companies are required to estimate the fair value of each of its reporting units in which Goodwill has been recorded.

The company compares the estimated fair value of each reporting unit to the recorded carrying value of each reporting unit (i.e., including goodwill).

 If carrying value > fair value, then goodwill in the reporting unit is impaired.

 If carrying value ≤ fair value, then goodwill in the reporting unit is not impaired.

 Companies are required to test Goodwill for impairment every year

Goodwill Impairment Example

Assume:

The carrying value of the Equity Investment is $1,848,500.

The carrying value of Goodwill is $125,000.

The fair value of the reporting unit (the subsidiary) is $1,800,000.

The potential impairment is equal to the $48,500 difference between the fair value of the reporting unit and its carrying value.

The Goodwill balance is $125,000, so the impairment loss amount = $48,500

As a result of this computation, Goodwill must be written down with the following journal entry in the parent’s books:

DR Equity Income $48,500 CR Equity Investment $48,500

Bargain Purchase Accounting

A bargain acquisition is said to occur if the total fair value of the investee company is less than the acquisition-date amounts of the identifiable assets acquired and the liabilities assumed (i.e., the amount computed for Goodwill is negative).

 In that case, the investor recognizes the negative Goodwill as an ordinary gain in its income statement on the acquisition date

Example of a Bargain Acquisition

Assume:

Purchase Price of Subsidiary is $200,000

Fair value of the sub’s net assets is $250,000

Bargain Purchase $ 50,000

Journal Entry at Acquisition on Parent’s Books

DR Equity Investment $250,000 CR Cash $200,000 CR Gain On Bargain Purchase 50,000

Gain will appear on Income Statement of Parent; never attribute any of it to sub

Consolidation Entries for Bargain Purchase

E] DR Stockholder’s Equity (S) 100,000 CR Equity Investment 100,000

eliminates acquisition date Sub. Equity against investment account

[A] DR Net Assets 150,000 CR Equity Investment 150,000

eliminates remaining equity investment/reclassifies AAP

The net result is that the gain on the bargain acquisition is

recognized in the consolidated income statement immediately

upon acquisition.