Advanced Exam 2

Consolidation

Combining financial statements of a parent and subsidiary into one set for a single economic entity

When is consolidation required?

When one company has a controlling financial interest (usually more than 50%) in another entity

Purpose of consolidation

To present the parent and subsidiary as one economic entity to external users

Controlling financial interest

Ownership or control over another company’s decision-making, usually via majority voting stock

Separate incorporation advantage

Maintains the subsidiary’s legal identity, reputation, licenses, and employee loyalty

Fair value of consideration transferred

Total value paid by parent to acquire subsidiary, including cash, stock, and contingent payments

In-process research and development (IPR&D)

Recorded as an intangible asset at fair value and tested annually for impairment

Accounting for in-process R&D after acquisition

Expense future R&D costs as incurred

Contingent consideration

Future payment based on eventsrecognized at fair value on acquisition date

How to account for contingent consideration liability

Revalue through income as fair value changes over time

How to account for contingent consideration equity

Record at fair value on acquisition date, no later revaluation

Acquisition method steps

1) Determine consideration transferred

2) Identify assets/liabilities at fair value

3) Recognize goodwill or gain on bargain purchase

Book value of net assets (BVNA)

Subsidiary’s total assets minus liabilities at book value

Fair value of net assets (FVNA)

Subsidiary’s total assets minus liabilities at fair value

Goodwill

Excess of consideration over fair value of identifiable net assets not amortized and tested for impairment annually.

Bargain purchase

When fair value of net assets exceeds the purchase price record gain on acquisition

What is a statutory consolidation?

Two or more companies legally merge into a new entity, dissolving originals

Legal merger vs. legal consolidation

Merger: one company survives

Consolidation: both dissolve into new company

Parent company

The acquirer that gains control over the subsidiary

Subsidiary

The company acquired or controlled by the parent

Worksheet

Used to simulate consolidation without changing individual company books

Why use a worksheet?

To combine parent and subsidiary financials and record elimination entries

Are consolidation entries recorded in company books?

No, they appear only on the consolidation worksheet

Entry S

Eliminates subsidiary’s beginning stockholders’ equity (Common Stock, APIC, Retained Earnings) against parent’s investment

Purpose of Entry S

To remove subsidiary’s equity accounts so only assets and liabilities remain in consolidation

Entry A

Assigns excess purchase price to specific accounts based on fair value allocation, including goodwill

Purpose of Entry A

To adjust subsidiary’s book values to fair values in consolidation

Entry I

Eliminates parent’s equity in subsidiary income recognized during the year

Entry D

Eliminates intra-entity dividends declared by subsidiary to parent

Entry E

Recognizes amortization expense for excess fair value allocations

Entry *C

Converts balances to equity method if parent uses initial or partial equity methods

When is Entry *C used?

When the parent does not use the equity method but consolidation requires equity-equivalent adjustments

Initial value method

Investment recorded at cost, dividends recognized as income, no adjustments for subsidiary income or amortization

Partial equity method

Adjust investment for subsidiary income and dividends but not for amortization

Equity method

Full accrual method: adjusts for subsidiary income, dividends, and amortization

Which method provides full accrual information?

The equity method

Which method is easiest to apply?

The initial value method

Effect of parent’s method on consolidated results

No effect, consolidated financials are the same regardless of parent’s method

Fair value allocation schedule

Table showing how excess of purchase price over BVNA is assigned to assets, liabilities, or goodwill

Amortization schedule

Shows how fair value adjustments are expensed over time for definite-life assets

What is amortization expense in consolidation?

Expense for fair value adjustments of finite-life assets recognized each period

Calculation of goodwill

Goodwill = Purchase price – Fair value of identifiable net assets

How to test goodwill for impairment

Compare fair value of reporting unit to carrying amount, impairment if carrying > fair value

How to record goodwill impairment

Debit Loss on Impairment, Credit Goodwill

Intangible assets with indefinite lives

Not amortized, tested annually for impairment

Intangible assets with finite lives

Amortized over useful life, usually straight-line

Why maintain separate incorporation?

To preserve subsidiary’s brand, legal status, and potential resale value

Consolidation when separate incorporation maintained

Simulated on worksheet, no actual journal entries in either company’s books

Purpose of consolidation entries

To eliminate intra-entity effects and adjust to fair value for combined presentation

Parent’s investment account

Represents parent’s ownership in subsidiary, eliminated during consolidation

Subsidiary equity accounts

Eliminated during consolidation since they’re replaced by parent’s ownership

Consolidation entry order

Typically S, A, I, D, E (and *C if applicable)

Which entry removes subsidiary equity?

Entry S

Which entry recognizes excess fair value allocations?

Entry A

Which entry eliminates intra-entity dividends?

Entry D

Which entry eliminates parent’s investment income?

Entry I

Which entry records amortization of fair value differences?

Entry E

When is consolidation performed?

At each reporting date when consolidated statements are prepared

Does consolidation affect separate company records?

No, only worksheet adjustments

Consolidation goal

To report financial position, results, and cash flows as if companies were one

What are reciprocal accounts?

Intercompany accounts like receivables/payables that must be eliminated in consolidation

What is intra-entity transaction elimination?

Removing effects of transactions between parent and subsidiary to avoid double counting

Example of intra-entity elimination

Parent’s receivable from subsidiary and subsidiary’s payable to parent

If parent pays stock to acquire subsidiary

Record at fair value of stock issued

Stock issuance costs

Reduce parent’s Additional Paid-In Capital

Direct combination costs (legal, accounting)

Expensed as incurred

Fair value of stock issued

Used to measure part of total consideration transferred

Noncontrolling interest

Portion of subsidiary not owned by parent, not applicable when 100% owned

Bargain purchase gain

Recorded when FV of net assets exceeds consideration transferred

Where to record bargain purchase gain

Income statement, as a gain on acquisition

Impairment vs. amortization

Impairment reduces asset to fair value, amortization allocates cost over life

When to perform goodwill impairment test

Annually or when negative events indicate possible impairment

Qualitative goodwill assessment

Optional step to decide if quantitative impairment test is needed

Quantitative goodwill test

Compare carrying value of reporting unit to fair value

Consolidated assets

Sum of parent’s and subsidiary’s assets minus eliminations

Consolidated liabilities

Sum of parent’s and subsidiary’s liabilities minus intra-entity eliminations

Consolidated equity

Parent’s equity only, subsidiary equity eliminated

Journal entry for acquisition

Debit Investment in Subsidiary, Credit Cash or Common Stock issued

Acquisition-related expenses

Debited to Expense (not to Investment account)

What happens to the subsidiary’s Common Stock in consolidation?

Eliminated through Entry S

What happens to Additional Paid-In Capital in consolidation?

Eliminated through Entry S

What happens to subsidiary’s Retained Earnings in consolidation?

Eliminated through Entry S

What happens to the Investment in Subsidiary account?

Eliminated during consolidation through Entries S and A

Parent’s accounting for dividends from sub under equity method

Reduces Investment in Subsidiary

Parent’s accounting for dividends under initial value method

Recognized as Dividend Income

Parent’s accounting for dividends under partial equity method

Reduces Investment in Subsidiary

Effect of amortization on investment account

Reduces parent’s Investment balance and increases expense

What is Entry P?

Eliminates intra-entity payables/receivables

Order of consolidation entries

S → A → I → D → E (and P if needed)

Which consolidation entry simulates amortization?

Entry E

How to compute excess fair value allocation

Excess = Purchase Price – Book Value of Net Assets, assign to undervalued assets or goodwill

How to compute amortization

Amortization = Excess allocated / Useful life

Amortization of goodwill

None, goodwill is indefinite-lived

Amortization of definite-life intangibles

Recorded periodically as expense

Impairment of definite-life intangibles

Test when events indicate carrying value may not be recoverable

Impairment of indefinite-life intangibles

Test at least annually

Investment income under equity method

Parent’s share of subsidiary’s net income adjusted for amortization

Investment income under initial value method

Recognized only for dividends received

Investment income under partial equity method

Recognized for subsidiary net income, not amortization

Amortization impact on consolidated net income

Decreases consolidated income