Chapter 7
 Consolidated
Financial Statements :
Subsequent to Date of Business
Combination
© 2003 The McGraw-Hill
Companies, Inc., All Rights
Reserved
Scope of Chapter
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2
The accounting for operating results of both
wholly owned and partially owned subsidiaries
is described and illustrated.
Accounting for inter-company transactions not
involving a profit (gain) or a loss, as well as
those involving a profit or a loss, are dealt with.
Accounting For Operating Results
Of Wholly Owned Subsidiaries
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3
In accounting for operating results of
consolidated subsidiaries, a parent
company may choose either of the two
methods:
– Equity Method of Accounting
– Cost Method of Accounting
Equity Method
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4
The parent company recognizes its share of
the subsidiary’s net income or net loss,
adjusted for depreciation and amortization
of differences between current fair values
and carrying amounts of a subsidiary’s
identifiable net assets on the date of
business combination , as well as its share
of dividends declared by the subsidiary.
Equity Method
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5
The equity method of accounting is quite
similar to home office accounting for a
branch’s operations.
The proponents claim that equity method
stresses the economic substance of the
parent-subsidiary relationship.
Dividends declared by a subsidiary do not
constitute revenue to the parent company.
Equity Method
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6
Proponents of the method maintain that the
method is consistent with the accrual basis
of accounting because it recognizes
increases or decreases in the carrying
amount of the parent company’s investment
in the subsidiary when they are realized by
the subsidiary as net income or net loss, not
when they are paid by the subsidiary as
dividends.
Cost Method
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7
The parent company accounts for the
operations of a subsidiary only to the extent
that dividends are declared by the subsidiary.
Net income or net loss of the subsidiary is not
recognized by the parent company.
Supporters of the method contend that the
method appropriately recognizes the legal form
of parent – subsidiary relationship.
Cost Method
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8
The dividends declared by subsidiary are
recognized as revenue by the parent
company.
The dividends declared by subsidiary in
excess of post-combination net income
constitute a reduction of the carrying
amount of the parent company’s investment
in the subsidiary.
Cost Method
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9
According to the proponents of the cost
method, a parent company realizes revenue
from an investment in a subsidiary when the
subsidiary declares dividend, not when the
subsidiary reports net income.
Choosing Between Equity Method
And Cost Method
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10
The consolidated financial statement amounts
are the same, regardless of which method is
used to account for subsidiary’s operations.
Working paper eliminations used in the two
methods are different.
Working Paper Eliminations for
Equity Method
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11
Three components of the subsidiary’s stock
holders’ equity are reciprocal to the parent
company’s Investment Ledger Account.
The subsidiary’s beginning-of-year
retained earnings amount is eliminated.
Subsidiary’s dividends are an offset to the
subsidiary’s retained earnings.
Working Paper Eliminations for
Equity Method
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12
The balance of the parent company’s
Investment Ledger Account is net of the
dividends received from the subsidiary.
The elimination of the subsidiary’s
beginning-of-year retained earnings makes
beginning-of-year consolidated retained
earnings identical to the end-of-previousyear consolidated retained earnings.
Working Paper Eliminations for
Equity Method
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13
The debits to the subsidiary’s plant
assets, patent, and goodwill bring into the
consolidated balance sheet the unamortized differences between current
fair values and carrying amounts of the
subsidiary’s assets on the date of the
business combination.
Working Paper Eliminations for
Equity Method
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14
The amount of the parent company’s
inter-company investment income is an
element of the balance of the parent’s
Investment Ledger Account.
Working Paper Eliminations for
Equity Method
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15
In effect, the elimination of the intercompany investment income comprises a
reclassification of the inter-company
investment income to the adjusted
components of the subsidiary’s net
income in the consolidated income
statement.
Working Paper Eliminations for
Equity Method
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16
The increases in the subsidiary’s cost of
goods sold and operating expenses, in
effect, reclassify the comparable
decrease in the parent company’s
Investment ledger account under the
equity method of accounting.
Emphasized Aspects of
Working Paper
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17
The inter-company receivable and payable,
placed in adjacent columns on the same
line, are offset without a formal elimination.
The elimination cancels all inter-company
transactions and balances not dealt with by
the offset described above.
Emphasized Aspects of
Working Paper
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18
The elimination cancels the subsidiary’s
retained earnings balance at the beginning-ofyear, so that each of the three basic financial
statements may be consolidated in turn.
The first-in, first-out method is used by
subsidiary to account for inventories; thus the
difference attributable to subsidiary’s beginning
inventories is allocated to cost of goods sold
for the year ended.
Emphasized Aspects of
Working Paper
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19
Income tax effects of the elimination’s
increase in subsidiary’s expenses are not
included in the elimination.
One of the effects of the elimination is to
reduce the differences between the current
fair values and the carrying amounts of the
subsidiary’s net assets, excepting land and
goodwill, on the business combination date.
Emphasized Aspects of
Working Paper
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The parent company’s use of the equity method of
accounting results in the equalities described
below:
–
–
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20
Parent Company Net Income = Consolidated Net Income.
Parent Company Retained Earnings = Consolidated Retained Earnings.
Despite the equalities, consolidated financial
statements are superior to parent company
financial statements for the presentation of
financial position and operating results of parent
and subsidiary companies.
Closing Entries
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21
After consolidated financial statements have
been completed, both the parent and its
subsidiary companies prepare and post closing
entries, to complete the accounting cycle for
the year.
The subsidiary’s closing entries are prepared in
the usual fashion. However, the parent
company’s use of equity method of accounting
necessitates specialized closing entries.
Closing Entries
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22
The equity method of accounting disregards
legal form in favor of economic substance.
However, state corporation laws generally
require separate accounting for retained
earnings available for dividends to
stockholders.
Accounting for Operating Results
of Partially Owned Subsidiaries
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23
Accounting for the operating results of a
partially owned subsidiary requires the
computation of the minority interest in net
income or net losses of the subsidiary.
Accounting for Operating Results
of Partially Owned Subsidiaries
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24
Thus under the economic unit concept,
the consolidated income statement of a
parent company and its partially owned
subsidiaries includes an allocation of total
consolidated income to the parent
company and the minority interest.
Concluding Comments
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In today’s financial accounting
environment, the equity method of
accounting for a subsidiary’s operations
is preferable to the cost method for the
following reasons:
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25
The equity method, which is consistent with the
accrual basis of accounting, emphasizes economic
substance of the parent company – subsidiary
relationship, while the cost method emphasizes
legal form.
Concluding Comments
–
–
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26
The equity method permits the use of parent
company journal entries to reflect many items that
must be included in working paper eliminations in
the cost method. Formal journal entries in the
accounting records provide a better record than do
working paper eliminations.
The equity method facilitates issuance of separate
financial statements, if required by SEC regulations
or other considerations.
The equity method provides a useful self checking
technique.