CHAPTER ONE
BUSINESS COMBINATION
Definition of Business Combination
A business combination is defined in International Financial Reporting Standard 3 (IFRS 3) as a
transaction or other event in which an acquirer obtains control of one or more businesses.
Business combinations may be divided into two classes: friendly takeovers and hostile takeovers.
In a friendly takeover, the boards of directors of the constituent companies generally work out the
terms of the business combination amicably and submit the proposal to stockholders of all
constituent companies for approval. A target acquiree in a hostile takeover typically resists the
proposed business combination by resorting to one or more defensive tactics with the following
colorful designations:
 Pac-man defense: A threat to undertake a hostile takeover of the prospective acquirer.
 White knight: A search for a candidate to be the acquirer in a friendly takeover.
 Scorched earth: The disposal, by sale or by a spin-off to stockholders, of one or more
profitable business segments.
 Shark repellent: An acquisition of substantial amounts of outstanding common stock for
the treasury or for retirement, or the incurring of substantial long-term debt in exchange
for outstanding common stock.
 Poison pill: An amendment of the articles of incorporation or bylaws to make it more
difficult to obtain stockholder approval for a takeover.
 Greenmail: An acquisition of common stock presently owned by the prospective acquirer
at a price substantially in excess of the prospective acquirer’s cost, with the stock thus
acquired placed in the treasury or retired.
Reasons for Business Combination
Why do business enterprises enter into a business combination? Although a number of reasons can
be given, probably the overriding one for acquirers in recent years has been growth. Business
enterprises have major operating objectives other than growth, but that goal increasingly has
motivated acquirer managements to undertake business combinations. Advocates of this external
method of achieving growth point out that it is much more rapid than growth through internal
means. There is no question that expansion and diversification of product lines, or enlarging the
market share for current products, is achieved readily through a business combination with another
1|Page
enterprise. However, the disappointing experiences of many acquirers engaging in business
combinations suggest that much may be said in favor of more gradual and reasoned growth through
internal means, using available management and financial resources. Other reasons often advanced
in support of business combinations are obtaining new management strength or better use of
existing management and achieving manufacturing or other operating economies. In addition, a
business combination may be undertaken for the income tax advantages available to one or more
parties to the combination.
The rationales for business combination is said to include the following as well:
 Cost advantage
 Acquisition of intangible assets
 Lower risk
 Other: business and other tax advantages,
 Fewer operating delays
 Avoidance of takeovers
personal reasons
 ‘Empire building’
Critics have alleged that the foregoing reasons attributed to the “urge to merge” (business
combinations) do not apply to hostile takeovers. These critics complain that the “sharks” who
engage in hostile takeovers, and the investment bankers and attorneys who counsel them, are
motivated by the prospect of substantial gains resulting from the sale of business segments of a
acquiree following the business combination.
Types of Business Combinations
 Horizontal: a combination involving enterprises in the same industry.
 Vertical: a Combination involving an enterprise and its customers or suppliers.
 Conglomerate: a combination between enterprises in unrelated industries or markets.
Methods for Arranging Business Combinations
The three common methods for carrying out a business combination are statutory merger, statutory
consolidation and acquisition of common stock.
2|Page
Statutory merger
As its name implies, a statutory merger is executed under provisions of applicable state laws. In a
statutory merger, the boards of directors of the constituent companies approve a plan for the
exchange of voting common stock (and perhaps some preferred stock, cash, or long-term debt) of
one of the corporations (the survivor) for all the outstanding voting common stock of the other
corporations. Stockholders of all constituent companies must approve the terms of the merger;
some states require approval by two-thirds of the stockholders. The survivor corporation issues its
common stock or other consideration to the stockholders of the other corporations in exchange for
all their holdings, thus acquiring ownership of those corporations. The other corporations then are
dissolved and liquidated and thus cease to exist as separate legal entities, and their activities often
are continued as divisions of the survivor, which now owns the net assets (assets minus liabilities),
rather than the outstanding common stock, of the liquidated corporations.
To summarize, the procedures in a statutory merger are:
 The boards of directors of the constituent companies work out the terms of the merger.
 Stockholders of the constituent companies approve the terms of the merger, in accordance
with applicable corporate bylaws and state laws.
 The survivor issues its common stock or other consideration to the stockholders of the other
constituent companies in exchange for all their outstanding voting common stock of those
companies.
 The survivor dissolves and liquidates the other constituent companies, receiving in
exchange for its common stock investments the net assets of those companies.
Diagrammatically statutory merger can be expressed as;
Company AA
(Surviving Entity)
3|Page
Net assets of B
Company BB
(Dissolved Entity)
As you can understand from the above diagram, company AA may acquire the net assets of
Company BB by issuing debt or equity securities or assets directly to Company BB for B's net
assets or to B's stockholders equity for all of BB's outstanding stock. In either case, Company BB
is dissolved and Company AA takes over the net assets of Company BB.
This can be expressed as: AA + BB = AA
Statutory Consolidation
A statutory consolidation also is consummated in accordance with applicable state laws. However,
in a consolidation a new corporation is formed to issue its common stock for the outstanding
common stock of two or more existing corporations, which then go out of existence. The new
corporation thus acquires the net assets of the defunct corporations, whose activities may be
continued as divisions of the new corporation.
To summarize, the procedures in a statutory consolidation are:
 The boards of directors of the constituent companies work out the terms of the
consolidation.
 Stockholders of the constituent companies approve the terms of the consolidation, in
accordance with applicable corporate bylaws and state laws.
 A new corporation is formed to issue its common stock to the stockholders of the
constituent companies in exchange for all their outstanding voting common stock of those
companies.
 The new corporation dissolves and liquidates the constituent companies, receiving in
exchange for its common stock investments the net assets of those companies.
Diagrammatical form of statutory consolidation is:
Net Assets of AA
Company AA
(Dissolved Entity)
Company CC
(A new entity)
Net Assets of BB
4|Page
Company BB
(Dissolved entity)
From the diagram you can understand that, company CC may acquire the net assets of Company
BB and Company AA by issuing stock directly to Companies AA and BB for their net assets or to
the stockholders of Companies AA and BB for all of their stock. In either case, Companies AA
and BB are dissolved and Company CC takes over their assets.
Mathematically it can be expressed as: AA+BB=CC
Acquisition of Common Stock
One corporation (the investor) may issue preferred or common stock, cash, debt instruments, or a
combination thereof, to acquire from present stockholders a controlling interest in the voting
common stock of another corporation (the investee). This stock acquisition program may be
accomplished through direct acquisition in the stock market, through negotiations with the
principal stockholders of a closely held corporation, or through a tender offer to stockholders of a
publicly owned corporation. A tender offer is a publicly announced intention to acquire, for a
stated amount of consideration, a maximum number of shares of the acquiree’s common stock
“tendered” by holders thereof to an agent, such as an investment banker or a commercial bank.
The price per share stated in the tender offer usually is well above the prevailing market price of
the acquiree’s common stock. If a controlling interest in the acquiree’s voting common stock is
acquired, that corporation becomes affiliated with the acquirer parent company as a subsidiary,
but is not dissolved and liquidated and remains a separate legal entity. Business combinations
arranged through common stock acquisitions require authorization by the acquirer’s board of
directors and may require ratification by the acquiree’s stockholders. Most hostile takeovers are
accomplished by this means. Diagrammatically it can be expressed as follows:
5|Page
(Parent-Subsidiary operations and consolidated financial statements)
Over 50% of Stock of B
Company A
Company B
(Parent)
(Subsidiary)
Dear learner! Acquisition of common stock is similar to a merger or consolidation except that
Company AA receives a majority of the outstanding voting stock of Company BB by issuing debt
or equity securities or assets to the stockholders of Company BB. Company BB continues to exist
as a separate legal entity and to operate in a parent subsidiary relationship with Company AA.
Mathematically it can be expressed as: AA + BB = AA + BB
Methods of Accounting for Business Combinations
There are three methods of accounting for business combinations that have either been recently
used in practice or discussed in theory:
•
Purchase method
•
Acquisition method
•
New-entity method
These methods differ in how identifiable net assets of the acquiring company and acquired
company are measured at the date of a business combination. The following table indicates the
measurement basis and the current status and effective usage dates for these three methods:
6|Page
Method
Purchase method
Acquisition
method
New-entity
method
Measurement basis for net assets
of
Status
Acquiring
Acquired
company
company
Allocation
Was required prior to adoption of
Carrying amount
of purchase
acquisition method
price
Carrying amount Fair value
Was required starting in 2011
Fair value
Fair value
Never achieved status as an
acceptable method, but worthy of
future consideration
Prior to 2011, the purchase method was used to account for the combination. Under this method,
the acquiring company’s net assets are measured at their carrying amount and the acquired
company’s net assets are measured at the price paid for the assets by the acquiring company. This
price included any cash payment, the fair value of any shares issued, and the present value of any
promises to pay cash in the future. Any excess of the price paid over the fair value of the acquired
company’s identifiable net assets was recorded as goodwill. This method of accounting was
consistent with the historical cost principle of accounting for any assets acquired by a company.
Such assets were initially recorded at the price paid for them, and subsequently their cost was
charged against earnings over their useful lives.
Starting in 2011, the acquisition method must be used to account for business combinations. Under
this method, the acquiring company reports the identifiable net assets being acquired at the fair
value of these net assets, regardless of the amount paid for them. When the purchase price is greater
than the fair value of identifiable net assets, the excess is reported as goodwill, similar to the
purchase method. When the purchase price is less than the fair value of identifiable net assets, the
identifiable net assets are still reported at fair value and the deficiency in purchase price is reported
as a gain on purchase. This practice is not consistent with the historical cost principle, where assets
are reported at the amount paid for the assets. However, it is consistent with the general trend in
financial reporting to use fair value more and more often to report assets and liabilities. Fair value
is viewed as a relevant benchmark to help investors and creditors assess the success or failure of
business activity. Fair value of the investee is likely to be readily available since the investor likely
determined fair value when deciding on the price to be paid in acquiring the investee. Therefore,
the cost involved in determining the fair value of the investee’s assets and liabilities is more than
offset by the benefits of the more relevant information.
7|Page
The third method, the new-entity method, has been proposed in the past by proponents of fair value
accounting. It has been suggested that a new entity has been created when two companies combine
by the joining together of two ownership groups. As a result, the assets and liabilities contributed
by the two combining companies should be reported by this new entity at their fair values. This
would make the relevant contributions by the combining companies more comparable because the
net assets are measured on the same basis. However, this method has received virtually no support
in the accounting profession because of the additional revaluation difficulties and costs that would
result. Furthermore, it has been argued that if the owners were simply combining their interests,
there would be no new invested capital and, therefore, no new entity created.
The Acquisition Method
A business combination must be accounted for by applying the acquisition method, unless it is a
combination involving entities or businesses under common control or the acquiree is a subsidiary
of an investment entity, as defined in IFRS 10 Consolidated Financial Statements, which is
required to be measured at fair value through profit or loss. One of the parties to a business
combination can always be identified as the acquirer, being the entity that obtains control of the
other business (the acquiree). Formations of a joint venture or the acquisition of an asset or a group
of assets that does not constitute a business are not business combinations. The acquisition method
requires all of the following steps:
a. Identifying the acquirer
b. Determining the acquisition date
c. Recognizing and measuring the identifiable assets acquired, the liabilities assumed, and
any non-controlling interest in the acquire
d. Recognizing and measuring goodwill or a gain from a bargain purchase.
Identifying the Acquirer and Date of Acquisition
The acquirer is the entity that obtains control of one or more businesses in a business combination.
It is important to determine who has control because this determines whose net assets are reported
at carrying amount and whose assets are reported at fair value at the date of acquisition. The date
of acquisition is the date that one entity obtains control of one or more businesses.
8|Page
Acquisition Cost
The acquisition cost is made up of the following:
•
Any cash paid
•
Fair value of assets transferred by the acquirer
•
Present value of any promises by the acquirer to pay cash in the future
•
Fair value of any shares issued the value of shares is based on the market price of the
shares on the acquisition date
•
Fair value of contingent consideration
Under acquisition method, acquisition cost does not include costs such as fees for consultants,
accountants, and lawyers as these costs do not increase the fair value of the acquired company.
These costs should be expensed in the period of acquisition. This treatment differs from the
treatment under the purchase method (historical cost accounting) where these costs would be
capitalized as a cost of the purchase.
Costs incurred in issuing debt or shares are also not considered part of the acquisition cost. These
costs should be deducted from the amount recorded for the proceeds received for the debt or share
issue; for example, deducted from loan payable or common shares as applicable. The deduction
from loan payable would be treated like a discount on notes payable and would be amortized into
income over the life of the loan using the effective interest method.
Recognition and Measurement of Net Assets Acquired
The acquirer should recognize and measure the identifiable assets acquired and the liabilities
assumed at fair value and report them separately from goodwill. An identifiable asset is not
necessarily one that is presently recorded in the records of the acquiree company. For example, the
acquiree company may have patent rights that have a fair value but are not shown on its balance
sheet because the rights had been developed internally. Or the acquiree’s balance sheet may show
a pension asset, though an up-to-date actuarial valuation may indicate a net pension obligation.
IAS 38 defines an identifiable asset if it either
a. Is separable; that is, is capable of being separated or divided from the entity and sold,
transferred, licensed, rented, or exchanged, either individually or together with a related
contract, identifiable asset, or liability, regardless of whether the entity intends to do so; or
9|Page
b. Arises from contractual or other legal rights, regardless of whether those rights are
transferable or separable from the entity or from other rights and obligations.
Recognition of Goodwill
If the total consideration given by the controlling and non-controlling shareholders is greater than
the fair value of identifiable assets and liabilities acquired, the excess is recorded in the acquirer’s
financial statements as goodwill. Goodwill represents the amount paid for excess earning power
plus the value of other benefits that did not meet the criteria for recognition as an identifiable asset.
If the total consideration given is less than the fair value of the identifiable net assets acquired, we
have what is sometimes described as a “negative goodwill” situation. This negative goodwill is
recognized as a gain attributable to the acquirer on the acquisition date.
Illustration: Statutory Merger with Goodwill
On December 31, 2021, ABC Company (the acquiree) was merged into XYZ Company (the
acquirer or survivor). Both companies used the same accounting principles for assets, liabilities,
revenue, and expenses and both had a December 31 fiscal year. XYZ Company issued 150,000
shares of its Br. 10 par common stock (current fair value Br. 25 a share) to ABC Company
stockholders for all 100,000 issued and outstanding shares of ABC Company’s no-Par Br. 10 stated
value common stock.
There was no contingent consideration in the merger contract. Immediately prior to the merger, ABC
Company’s condensed balance sheet was as follows:
ABC Company (Acquiree)
Balance Sheet (prior to business combination)
December 31, 2021
Assets
Current assets
Plant assets (net)
Other assets
Total assets
10 | P a g e
Br. 1,000,000
3,000,000
600,000
Br. 4,600,000
Liabilities and Stockholders' Equity
Br.
Current liabilities
500,000
Long-term debt
1,000,000
Common stock, no par, Br. 10 stated value
1,000,000
700,000
Additional paid-in capital
1,400,000
Retained earnings
Total liabilities and stockholders’ equity
Br. 4,600,000
To be in line with IFRS 3, we have to use the fair value of the assets acquired and liabilities
assumed. For this illustration purpose the following figures have been assumed about:
Current assets
Plant assets
Other assets
Current liabilities
Long-term debt (present value)
Identifiable net assets of acquiree
Current Fair Values
Br. 1,150,000
3,400,000
600,000
(500,000)
(950,000)
Br.3,700,000
The condensed journal entries that follow are required for XYZ Company (the acquirer) to record
the merger with ABC Company on December 31, 2021, as a business combination. XYZ Company
uses an investment ledger account to accumulate the total cost of ABC Company prior to assigning
the cost to identifiable net assets and goodwill.
XYZ Company (Acquirer)
Journal Entries
December 31, 2021
Investment in ABC Company Common Stock (150,000 × Br. 25)…………………
3,750,000
Common Stock (150,000 × Br. 10) …………………………………………………..
1,500,000
Paid-in Capital in Excess of Par………………………………………………………
2,250,000
Current Assets……………………………………………………………………………..
1,150,000
Plant Assets………………………………………………………………………………..
3,400,000
Other Assets……………………………………………………………………………….
600,000
11 | P a g e
Discount on long-Term Debt………………………………………………………………
50,000
Goodwill…………………………………………………………………………………...
50,000
Current Liabilities…………………………………………………………………….
500,000
Long-Term Debt………………………………………………………………………
1,000,000
Investment in ABC Company Stock……………………………………………………
3,750,000
To allocate total cost of liquidated ABC Company to identifiable assets and liabilities, with the remainder to goodwill .
Amount of goodwill is computed as follows:
Br. 3,750,000
Total cost of ABC Company …………………………………………………………
Less: Carrying amount of ABC Company identifiable net Assets
(Br. 4,600,000 - Br. 1,500,000)…………………………………………………….
Br. 3,100,000
Excess (deficiency) of Current fair values of Identifiable net assets Over carrying
amounts:
Current assets…………………………………………………………………..
150,000
Plant assets……………………………………………………………………..
400,000
Long-term debt…………………………………………………………………
50,000
3,700,000
Amount of goodwill………………………………………………………….......
Br.50,000
Note that no adjustments are made in the foregoing journal entries to reflect the current fair values
of ABC Company’s identifiable net assets or goodwill, because XYZ Company is the acquirer in
the business combination. The acquiree on the other hand has to record the above transaction in a
way that reflects the liquidation.
ABC Company (Acquiree)
Journal Entries
December 31, 2021
Current Liabilities………………………………………………………………………..…
500,000
Long-Term Debt……………………………………………………………………………
1,000,000
Common Stock, Br. 10 stated value ……………………………………………………….
1,000,000
Paid-in Capital in Excess of Stated Value………………………………………………….
700,000
Retained Earnings…………………………………………………………………………..
1,400,000
Current Assets…………………………………………………………………………
1,000,000
Plant Assets (net)……………………………………………………………………...
3,000,000
Other Assets…………………………………………………………………………...
600,000
12 | P a g e
To record liquidation of company in conjunction with merger with XYZ Company.
The above entry wipes out the records of ABC Company (the acquiree) as posting the above entry
to the respective accounts makes their balances zero.
Illustration: Acquisition of Net Assets, with Bargain-Purchase
The foregoing illustration assumes that the acquirer paid more than the net asset value and the
difference is assigned to unidentified intangible assets; a goodwill as commonly practiced. It is
also possible for the acquirer to pay less than the net asset value of the acquiree.
Assume that on December 31, 2020, Star Company acquired all the net assets of Moon Company
directly from Moon Company for $440,000 cash, in a business combination. The condensed
balance sheet of Moon Company prior to the business combination, with related current fair value
data, is presented below:
Moon Company (acquiree)
Balance Sheet (prior to business combination)
December 31, 2020
Carrying
Current
Amounts
Fair Values
$
$
Assets
Current assets
Investment in marketable debt securities(held to maturity)
200,000
50,000
60,000
870,000
900,000
90,000
100,000
$1,200,000
$1,260,000
$240,000
$ 240,000
500,000
520,000
740,000
$ 760,000
Plant assets (net)
Intangible assets(net)
Total assets
190,000
Liabilities and Stockholders' Equity
Current liabilities
Long-term debt
Total liabilities
13 | P a g e
$
Common stock, Br.1 par
$
Deficit
600,000
(140,000)
Total stockholders’ equity
$
Total liabilities and stockholders’ equity
460,000
$1,200,000
Thus, Star Company acquired identifiable net assets with a current fair value of $500,000
($1,260,000 – $760,000 = $500,000) for a total cost of $440,000. The $60,000 excess of current
fair value of the net assets over their cost ($500, 000 – $440, 000 = $60,000) is prorated to the
plant assets and intangible assets in the ratio of their respective current fair values, as follows:
Allocation of Excess of Current Fair Value over Cost of Identifiable Net Assets of acquiree
To plant assets:
$ 60, 000 × ($ 900,000 ÷ $1,000, 000)
=
$ 54,000
To Intangible assets:
$60, 000 × ($100,000 ÷ $1,000, 000)
=
6,000
Total excess of current fair value of identifiable net assets over cost acquirer’s cost
$60,000
Remember that no part of the $60,000 bargain-purchase excess is allocated to current assets or to
the investment in marketable securities.
Star Company (acquirer)
Journal Entries
December 31, 2020
Investment in Net Assets of Moon Company ………………………………………...
440,000
Cash …………………………………………………..……………………………….
440,000
To record acquisition of net assets of Moon Company.
To record payment of legal fees incurred in acquisition of net assets of Moon Company.
Current Assets……………………………………………………………………………...
200,000
Investments in marketable Debt securities…………………………………………………
60,000
Plant Assets ($900,000 – $54,000)……………………………………………………….
846,000
Intangible Assets ($100,000 – $ 6,000)
……………………………………………..
94,000
Current Liabilities …………………………………………………………………….
240,000
Long-Term Debt ………………………………………………………………………
500,000
Premium on long-Term Debt ($520,000 – $500,000) ………………………………..
20,000
Investment is net Assets of Moon company…………………………………………..………….
440,000
To allocate total cost of net assets acquired to identifiable net assets, with excess of current fair value of net assets
over their cost prorated to noncurrent assets other than investment in marketable debt securities. (Income tax effects
are disregarded.)
14 | P a g e
The above two consecutive illustrations must have given you the basics of what will be done on
date of business combination. Beyond the complexity of computations it is worth taking note of
the following:
a) Distinction of who is the acquirer and acquiree company.
b) The carrying amounts and the current fair values of the assets and liabilities.
c) The cost of combination (Consideration given up) for the business combination.
d) Determining whether the net asset fair value amounts is equal, less or greater the
consideration given up.
e) Determining the amount of goodwill, amount of gain on business combinations.
CHAPTER TWO
CONSOLIDATED FINANCIAL STATEMENTS: ON DATE OF BUSINESS COMBINATION
Definition of consolidation, subsidiaries and control.
The following definitions are provided in IFRS 10:
(a) Consolidated financial statements: The financial statements of a group in which the assets,
liabilities, equity, income, expenses, and cash flows of the parent and its subsidiaries are
presented as those of a single economic entity
(b) Group: A parent and its subsidiaries
(c) Parent: An entity that controls one or more entities
(d) Subsidiary: An entity that is controlled by another entity
(e) Non-controlling interest: Equity in a subsidiary not attributable, directly or indirectly, to a
parent.
As per IFRS 10, consolidated financial statements are where the company presents all assets,
liabilities, equity, revenues, expenses, and cash flows of the parent company and all its subsidiaries
as if the group was a single entity.
Consolidation of financial statements requires the parent company to integrate and combine all its
15 | P a g e
financials to create a standard-form income statement, balance sheet, and cash flow statement, as
part of a set of consolidated financial statements.
IFRS Definition of subsidiaries:
Subsidiary is an entity which is controlled by another entity. The control means that the parent
company can govern the financial and operating policies of its subsidiaries to gain benefits from
the operations of subsidiary. Control can be gained if more than 50% of the voting rights are
acquired by the parent.
The objective of IFRS 10 is to establish principles for the presentation and preparation of
consolidated financial statements when an entity controls one or more other entities.
The Standard: [IFRS 10:1]

requires a parent entity (an entity that controls one or more other entities) to present
consolidated financial statements

defines the principle of control, and establishes control as the basis for consolidation

set out how to apply the principle of control to identify whether an investor controls an
investee and therefore must consolidate the investee

sets out the accounting requirements for the preparation of consolidated financial
statements

defines an investment entity and sets out an exception to consolidating particular
subsidiaries of an investment entity.
Definition of Consolidation
The financial statements of a group in which the assets, liabilities, equity, income, expenses and
cash flows of the parent and its subsidiaries are presented as those of a single economic entity.
An investor controls an investee when the investor is exposed, or has rights, to variable returns
from its involvement with the investee and has the ability to affect those returns through its power
over the investee.
Traditionally, an investor’s direct or indirect ownership of more than 50% of an investee’s
outstanding common stock has been required to evidence the controlling interest underlying a
parent-subsidiary relationship. However, even though such a common stock ownership exists,
other circumstances may negate the parent company’s actual control of the subsidiary. For
16 | P a g e
example, a subsidiary that is in liquidation or reorganization in court-supervised bankruptcy
proceedings is not controlled by its parent company. Moreover, a foreign subsidiary in a country
having severe production, monetary, or income tax restrictions may be subject to the authority of
the foreign country rather than of the parent company. Further, if Non-controlling shareholders of
a subsidiary have the right effectively to participate in the financial and operating activities of the
subsidiary in the ordinary course of business, the subsidiary’s financial statements should not be
consolidated with those of the parent company.
An investor determines whether it is a parent by assessing whether it controls one or more
investees. An investor considers all relevant facts and circumstances when assessing whether it
controls an investee.
It is important to recognize that a parent company’s control of a subsidiary may be achieved
indirectly. For example, if P Corporation owns 85% of the outstanding common stock of S
Company and 45% of T Company’s common stock, and S Company also owns 45% of T
Company’s common stock, both S Company and T Company are controlled by P Corporation,
because it effectively controls 90% of T Company. This effective control consists of 45% owned
directly and 45% indirectly.
Preparation of Consolidated Financial Statements
A parent prepares consolidated financial statements using uniform accounting policies for like
transactions and other events in similar circumstances.
Consolidation Procedures
Consolidated financial statements:
 combine like items of assets, liabilities, equity, income, expenses and cash flows of the
parent with those of its subsidiaries
 Offset (eliminate) the carrying amount of the parent's investment in each subsidiary and
the parent's portion of equity of each subsidiary.
 Eliminate in full intragroup assets and liabilities, equity, income, expenses and cash flows
relating to transactions between entities of the group (profits or losses resulting from
intragroup transactions that are recognized in assets, such as inventory and fixed assets, are
eliminated in full).
17 | P a g e
A reporting entity includes the income and expenses of a subsidiary in the consolidated financial
statements from the date it gains control until the date when the reporting entity ceases to control
the subsidiary. Income and expenses of the subsidiary are based on the amounts of the assets and
liabilities recognized in the consolidated financial statements at the acquisition date.
The parent and subsidiaries are required to have the same reporting dates, or consolidation based
on additional financial information prepared by subsidiary, unless impracticable. Where
impracticable, the most recent financial statements of the subsidiary are used, adjusted for the
effects of significant transactions or events between the reporting dates of the subsidiary and
consolidated financial statements. The difference between the date of the subsidiary's financial
statements and that of the consolidated financial statements shall be no more than three months.
Changes in Ownership Interests
Changes in a parent's ownership interest in a subsidiary that do not result in the parent losing
control of the subsidiary are equity transactions (i.e. transactions with owners in their capacity as
owners). When the proportion of the equity held by Non-controlling interests changes, the carrying
amounts of the controlling and Non-controlling interests are adjusted to reflect the changes in their
relative interests in the subsidiary. Any difference between the amount by which the Noncontrolling interests are adjusted and the fair value of the consideration paid or received is
recognized directly in equity and attributed to the owners of the parent.
If a parent loses control of a subsidiary, the parent

derecognizes the assets and liabilities of the former subsidiary from the consolidated
statement of financial position

Recognizes any investment retained in the former subsidiary when control is lost and
subsequently accounts for it and for any amounts owed by or to the former subsidiary in
accordance with relevant IFRSs. That retained interest is premeasured and the re-measured
value is regarded as the fair value on initial recognition of a financial asset in accordance.

Recognizes the gain or loss associated with the loss of control attributable to the former
controlling interest.
18 | P a g e
Assessing Control
“The IFRS defines the principle of control and establishes control as the basis for determining
which entities are consolidated in the consolidated financial statements. The IFRS also sets out the
accounting requirements for the preparation of consolidated financial statements”. In the face of
strenuous objections by financial statement preparers to the foregoing definition,
An investor controls an investee when it is exposed, or has rights, to variable returns from its
involvement with the investee and has the ability to affect those returns through its power over the
investee; thus, the principle of control sets out the following three elements of control:
(a) Power over the investee;
(b) Exposure, or rights, to variable returns from involvement with the investee; and
(c) The ability to use power over the investee to affect the amount of the investor’s returns.
Accounting Requirements
The 2008 amendments to IAS 27 changed the term ‘minority interest’ to ‘Non-controlling interest’.
The change in terminology reflects the fact that the owner of a minority interest in an entity might
control that entity and, conversely, that the owners of a majority interest in an entity might not
control the entity. ‘Non-controlling interest’ is a more accurate description than ‘minority interest’
of the interest of those owners who do not have a controlling interest in an entity.
As part of its revision of IAS 27 in 2003, the Board amended this requirement to require minority
(non-controlling) interests to be presented in the consolidated statement of financial position
within equity, separately from the equity of the shareholders of the parent.
Definition and Presentation of Non-controlling Interests
A parent presents non-controlling interests in its consolidated statement of financial position
within equity, separately from the equity of the owners of the parent.
A reporting entity attributes the profit or loss and each component of other comprehensive income
to the owners of the parent and to the non-controlling interests. The proportion allocated to the
parent and non-controlling interests are determined on the basis of present ownership interests.
The reporting entity also attributes total comprehensive income to the owners of the parent and to
the Non-controlling interests even if this results in the Non-controlling interests having a deficit
balance.
19 | P a g e
The IFRS Sets out Requirements on how to apply the Control Principle:
(a) In circumstances when voting rights or similar rights give an investor power, including
situations where the investor holds less than a majority of voting rights and in
circumstances involving potential voting rights.
(b) In circumstances when an investee is designed so that voting rights are not the dominant
factor in deciding who controls the investee, such as when any voting rights relate to
administrative tasks only and the relevant activities are directed by means of contractual
arrangements.
(c) In circumstances involving agency relationships.
(d) In circumstances when the investor has control over specified assets of an investee.
Consolidation of wholly owned subsidiary on date of business combination
Illustration: assume that on December 31, 2020, Palm Corporation issued 10,000 shares of its $10
par common stock (current fair value $45 a share) to stockholders of Starr Company for all the
outstanding $5 par common stock of Starr. There was no contingent consideration. Out-of-pocket
costs of the business combination paid by Palm on December 31, 2020, consisted of the following:
Finder’s and legal fees relating to business combination
$50,000
Costs associated with SEC registration Statement for Palm common stock
35,000
Total out-of-pocket costs of business combination
$85,000
Assume also that Starr Company was to continue its corporate existence as a wholly owned
subsidiary of Palm Corporation. Both constituent companies had a December 31 fiscal year and
used the same accounting principles and procedures; thus, no adjusting entries were required for
either company prior to the combination. The income tax rate for each company was 40%.
Financial statements of Palm Corporation and Starr Company for the year ended December 31,
2020, prior to consummation of the business combination, follow:
20 | P a g e
PALM CORPORATION AND STARR COMPANY
Separate Financial Statements (prior to business combination)
For Year Ended December 31, 2020
Palm
Starr
Corporation
Company
Income Statements
Revenue:
Net Sales
$ 990,000
$600,000
Interest revenue
10,000
0
Total revenue
$ 1,000,000
$600,000
Costs and expenses:
Cost of goods sold
$635,000
$410,000
Operating expenses
158,333
73,333
Interest expense
50,000
30,000
Income taxes expense
62,667
34,667
Total costs and expense
$906,000
$548,000
Net income
$ 94,000
$ 52,000
Statement of Retained Earnings
Retained earnings, beginning of year
$ 65,000
$100,000
Add: Net income
94,000
52,000
Sub total
$ 159,000
$152,000
Less: Dividends
25,000
20,000
Retained earnings, end of year
$134,000
$132,000
Balance Sheets
Assets
Cash
$100,000
$ 40,000
Inventories
150,000
110,000
Other current assets
110,000
70,000
Receivables from Starr Company
25,000
0
Plant assets (net)
450,000
300,000
Patent (net)
0
20,000
Total assets
$835,000
$540,000
Liabilities and Stockholders’ Equity
Payables to Palm Corporation
$25,000
Income taxes payable
$26,000
10,000
Other liabilities
325,000
115,000
Common stock, $10 par
300,000
Common stock, $5 par
200,000
Additional paid in capital
50,000
58,000
Retained earnings
134,000
132,000
Total Liabilities and Stockholders’ equity
$835,000
$540,000
The December 31, 2020, current fair values of Starr Company’s identifiable assets and liabilities
were the same as their carrying amounts, except for the three assets listed below:
21 | P a g e
Current Fair Values, Dec. 31,2020
Inventories
$135,000
Plant assets (net)
365,000
Patent (net)
25,000
Since Starr was to continue as a separate corporation and current generally accepted accounting
principles do not sanction write-ups of assets of a going concern, Starr did not prepare journal
entries for the business combination. Palm Corporation recorded the combination on December
31, 2020, with the following journal entries:
PALM CORPORATION (ACQUIRER)
Journal Entries
December 31, 2020
Investment in Starr Company Common Stock (10,000*$45)
450,000
Common Stock (10,000*$10)
100,000
Paid-in Capital in Excess of Par
350,000
To record issuance of 10,000 shares of common stock for all the outstanding common stock of
Starr Company in a business combination.
Investment in Starr Company Common Stock
50,000
Paid-in Capital in Excess of Par
35,000
Cash
85,000
To record payment of out-of-pocket costs of business combination with Starr Company. Finder’s
and legal fees relating to the combination are recorded as additional costs of the investment;
costs associated with the SEC registration statement are recorded as an offset to the previously
recorded proceeds from the issuance of common stock.
An Investment in Common Stock ledger account is debited with the current fair value of the
Acquirer’s common stock issued to affect the business combination, and the paid-in capital
accounts are credited in the usual manner for any common stock issuance. In the second journal
entry, the direct out-of-pocket costs of the business combination are debited to the Investment in
Common Stock ledger account, and the costs that are associated with the SEC registration
statement, being costs of issuing the common stock, are applied to reduce the proceeds of the
common stock issuance.
22 | P a g e
After the foregoing journal entries have been posted, the affected ledger accounts of Palm
Corporation (the Acquirer) are as follows:
Cash
Date
2020
Dec. 31
Explanation
Debit
Balance forward
Out-of-pocket costs of business combination
Credit
85,000
Balance
100,000 dr.
15,000 dr.
31
Date
2020
Dec. 31
31
Date
2020
Dec. 31
31
Date
2020
Dec. 31
31
Investment in Starr Company Common Stock
Explanation
Debit
Credit
Issuance of common stock in
business combination
Direct out-of-pocket costs of
business combination
Explanation
450,000
450,000 dr.
50,000
500,000 dr.
Common Stock, $10 Par
Debit
Balance forward
Issuance of common stock in
business combination
Explanation
Credit
Balance
300,000 cr.
Paid-in Capital in Excess of Par
Debit
Balance forward
Issuance of common stock in
business combination
Costs of issuing common stock in
business combination
Balance
100,000
400,000 cr.
Credit
Balance
50,000 cr.
350,000
35,000
400,000 cr.
365,000 cr.
31
Preparation of consolidated balance sheet without a working paper
Accounting for the business combination of Palm Corporation and Starr Company requires a fresh
start for the consolidated entity. This reflects the theory that a business combination that involves
a parent company–subsidiary relationship is an acquisition of the Acquiree’s net assets (assets
23 | P a g e
less liabilities) by the Acquirer. The operating results of Palm and Starr prior to the date of their
business combination are those of two separate economic as well as legal entities. Accordingly, a
consolidated balance sheet is the only consolidated financial statement issued by Palm on
December 31, 2020, the date of the business combination of Palm and Starr.
The preparation of a consolidated balance sheet for a parent company and its wholly owned
subsidiary may be accomplished without the use of a supporting working paper. The parent
company’s investment account and the subsidiary’s stockholder’s equity accounts do not appear
in the consolidated balance sheet because they are essentially reciprocal (intercompany) accounts.
The parent company (Acquirer ) assets and liabilities (other than intercompany ones) are reflected
at carrying amounts, and the subsidiary (Acquiree ) assets and liabilities (other than intercompany
ones) are reflected at current fair values, in the consolidated balance sheet. Goodwill is recognized
to the extent the cost of the parent’s investment in 100% of the subsidiary’s outstanding common
stock exceeds the current fair value of the subsidiary’s identifiable net assets, both tangible and
intangible.
Applying the foregoing principles to the Palm Corporation and Starr Company’s parent–subsidiary
relationship, the following consolidated balance sheet is produced:
PALM CORPORATION AND SUBSIDIARY
Consolidated Balance Sheet
December 31, 2020
Assets
Current assets:
Cash ($15,000 + $40,000)
Inventories ($150,000 + $135,000)
Other ($110,000 + $70,000)
Total current assets
Plant assets (net) ($450,000 + $365,000)
Intangible assets
Patent (net) ($0 + $25,000)
Goodwill
Total assets
$ 55,000
$285,000
$180,000
$520,000
$815,000
$25,000
15,000
$40,000
$1,375,000
Liabilities and Stockholders’ Equity
Liabilities:
Income taxes payable ($26,000 + $10,000)
24 | P a g e
$ 36,000
Other ($325,000 + $115,000)
Total liabilities
Stockholders’ equity:
Common stock, $10 par
Additional paid-in capital
Retained earnings
Total liabilities and stockholders’ equity
$440,000
$476,000
$400,000
365,000
134,000
899,000
$1,375,000
The following are significant aspects of the consolidated balance sheet:
i.
The first amounts in the computations of consolidated assets and liabilities (except goodwill)
are the parent company’s carrying amounts; the second amounts are the subsidiary’s current
fair values.
ii.
Intercompany accounts (parent’s investment, subsidiary’s stockholders’ equity, and
intercompany receivable/payable) are excluded from the consolidated balance sheet.
iii.
Goodwill in the consolidated balance sheet is the cost of the parent company’s investment
($500,000) less the current fair value of the subsidiary’s identifiable net assets ($485,000), or
$15,000. The $485,000 current fair value of the subsidiary’s identifiable net assets is computed
as follows: $40,000 + $135,000 + $70,000 + $365,000 + $25,000 - $25,000 - $10,000 $115,000 = $485,000.
Working paper for consolidated balance sheet
The preparation of a consolidated balance sheet on the date of a business combination usually
requires the use of a working paper for consolidated balance sheet, even for a parent company
and a wholly owned subsidiary. The format of the working paper, with the individual balance sheet
amounts included for both Palm Corporation and Starr Company, is shown below.
PALM CORPORATION AND SUBSIDIARY
Working Paper for Consolidated Balance Sheet
December 31, 2020
Eliminations
Palm
Starr
Increase
Corporation Company (Decrease)
Assets
Cash
Inventories
Other current assets
Intercompany receivable (payable)
Investment in Starr Company
25 | P a g e
15,000
150,000
110,000
25,000
500,0000
40,000
110,000
70,000
(25,000)
Consolidated
common stock
Plant assets (net)
Patent (net)
Goodwill
Total assets
Liabilities and Stockholders’ Equity
Income taxes payable
Other liabilities
Common stock, $10 par
Common stock, $5 par
Additional paid in capital
Retained earnings
Total liabilities and
stockholders’ equity
450,000
300,000
20,000
1,250,000
515,000
26,000
325,000
400,000
10,000
115,000
365,000
134,000
1,250,000
200,000
58,000
132,000
515,000
Developing the elimination
Palm Corporation’s Investment in Starr Company Common Stock ledger account in the working
paper for consolidated balance sheet is similar to a home office’s Investment in Branch account.
However, Starr Company is a separate corporation, not a branch; therefore, Starr has the three
conventional stockholders’ equity accounts rather than the single Home Office reciprocal account
used by a branch. Accordingly, the elimination for the intercompany accounts of Palm and Starr
must decrease to zero the Investment in Starr Company Common Stock account of Palm and the
three stockholder’s equity accounts of Starr. Decreases in assets are affected by credits, and
decreases in stockholder’s equity accounts are affected by debits; therefore, the elimination for
Palm Corporation and subsidiary on December 31, 2020 (the date of the business combination), is
begun as shown in the below (a journal entry format is used to facilitate review of the elimination):
Elimination Entry
(a) Common Stock—Starr
200,000
Additional Paid-in Capital—Starr
58,000
Retained Earnings—Starr
132,000
Inventories—Starr ($135,000 - $110,000)
25,000
Plant Assets (net)—Starr ($365,000 - $300,000)
65,000
Patent (net)—Starr ($25,000 - $20,000)
5,000
Goodwill—Starr ($500,000 - $485,000)
15,000
Investment in Starr Company Common Stock—Palm
26 | P a g e
500,000
To eliminate intercompany investment and equity accounts of subsidiary on date of business
combination; and to allocate excess of cost over carrying amount of identifiable assets acquired,
with remainder to goodwill. (Income tax effects are disregarded.)
The following features of the working paper for consolidated balance sheet on the date of the
business combination should emphasize that:
i.
The elimination is not entered in either the parent company’s or the subsidiary’s
accounting records; it is only a part of the working paper for preparation of the
consolidated balance sheet.
ii.
The elimination is used to reflect differences between current fair values and carrying
amounts of the subsidiary’s identifiable net assets because the subsidiary did not write-up
its assets to current fair values on the date of the business combination.
iii.
The Eliminations column in the working paper for consolidated balance sheet reflects
increases and decreases, rather than debits and credits. Debits and credits are not
appropriate in a working paper dealing with financial statements rather than trial
balances.
iv.
Intercompany receivables and payables are placed on the same line of the working paper
for consolidated balance sheet and are combined to produce a consolidated amount of
zero.
v.
The respective corporations are identified in the working paper elimination.
vi.
The consolidated paid-in capital amounts are those of the parent company only.
Subsidiaries’ paid-in capital amounts always are eliminated in the process of
consolidation.
vii.
Consolidated retained earnings on the date of a business combination include only the
retained earnings of the parent company. This treatment is consistent with the theory that
purchase accounting reflects a fresh start in an acquisition of net assets (assets less
liabilities).
viii.
The amounts in the consolidated column of the working paper for consolidated balance
sheet reflect the financial position of a single economic entity comprising two legal
entities, with all intercompany balances of the two entities eliminated.
27 | P a g e
Consolidated balance sheet
The amounts in the consolidated column of the working paper for consolidated balance sheet are
presented in the customary fashion in the consolidated balance sheet of Palm Corporation and
subsidiary that follows.
PALM CORPORATION AND SUBSIDIARY
Consolidated Balance Sheet
December 31, 2020
Assets
Current assets:
Cash ($15,000 + $40,000)
Inventories ($150,000 + $135,000)
Other ($110,000 + $70,000)
Total current assets
Plant assets (net) ($450,000 + $365,000)
Intangible assets
Patent (net) ($0 + $25,000)
Goodwill
Total assets
$ 55,000
$285,000
$180,000
$520,000
$815,000
$25,000
15,000
$40,000
$1,375,000
Liabilities and Stockholders’ Equity
Liabilities:
Income taxes payable ($26,000 + $10,000)
Other ($325,000 + $115,000)
Total liabilities
Stockholders’ equity:
Common stock, $10 par
Additional paid-in capital
Retained earnings
Total liabilities and stockholders’ equity
$ 36,000
$440,000
$476,000
$400,000
365,000
134,000
899,000
$1,375,000
Consolidation of Partially owned Subsidiary on date of Business Combination
If parent company purchased less than 100% net asset of subsidiary, the subsidiary is known as
partially owned subsidiary. The shares not acquired by the parent are owned by other shareholders,
who are referred to as the non-controlling shareholders. The value of the shares attributed to the
non-controlling shareholders, when presented on the consolidated financial statements, is referred
to as non-controlling interests, abbreviated as NCI.
28 | P a g e
Illustration: On June 30, Year 1, P Ltd. obtains control over S Ltd. by paying cash to the
shareholders of S Ltd. for a portion of that company’s outstanding common shares. No additional
transactions take place on this date. Immediately after the share acquisition, P Ltd. prepares a
consolidated balance sheet.
Assume that on June 30, Year 1, S Ltd. had 10,000 shares outstanding and P Ltd. purchases 8,000
shares (80%) of S Ltd. for a total cost of $72,000.
Three questions arise when preparing consolidated financial statements for less-than-100%-owned
subsidiaries:
1.
How should the portion of the subsidiary’s assets and liabilities that was not acquired by the
parent be measured on the consolidated financial statements?
2.
How should NCI be measured on the consolidated financial statements?
3.
How should NCI be presented on the consolidated financial statements?
The following theories have developed over time and have been proposed as solutions to preparing
consolidated financial statements for non–wholly owned subsidiaries:
1) Proprietary theory
29 | P a g e
2) Parent company theory
3) Parent company extension theory
4) Entity theory
The entity theory is sometimes referred to as the fair value of subsidiary method.
1) Proprietary theory
Proprietary theory views the consolidated entity from the standpoint of the share-holders of the
parent company. The consolidated statements do not acknowledge or show the equity of the noncontrolling shareholders. The consolidated balance sheet on the date of acquisition reflects only
the parent’s share of the assets and liabilities of the subsidiary, based on their fair values, and the
resultant goodwill from the combination.
Using the direct approach, the consolidated balance sheet is prepared by combining, on an itemby-item basis, the carrying amounts of the parent with the parent’s share of the fair values of the
subsidiary, which is derived by using the parent’s share of the carrying amount of the subsidiary
plus the acquisition differential.
30 | P a g e
2) Parent Company Theory
Parent company theory is similar to proprietary theory in that the focus of the consolidated
statements is directed toward the shareholders of the parent company. However, NCI is recognized
and reflected as a liability in the consolidated balance sheet; its amount is based on the carrying
amounts of the net assets of the subsidiary.
NCI is calculated as follows:
Carrying amount of S Ltd.’s net assets
Assets
Liabilities
$100,000
(30,000)
70,000
Non-controlling ownership percentage
20%
Non-controlling interest
$ 14,000
The consolidated balance sheet is prepared by combining, on an item-by-item basis, the carrying
amount of the parent with 100% of the carrying amount of the subsidiary plus the parent’s share
of the acquisition differential.
Under this theory, the parent’s share of the subsidiary is measured at fair value, whereas the NCI’s
share is based on the subsidiary’s carrying amount on the consolidated balance sheet.
31 | P a g e
3) Entity Theory
Entity theory views the consolidated entity as having two distinct groups of shareholders the
controlling shareholders and the non-controlling shareholders. NCI is presented as a separate
component of shareholders’ equity on the consolidated balance sheet.
In acquiring a controlling interest, a parent company becomes responsible for managing all the
subsidiary’s assets and liabilities, even though it may own only a partial interest. If a parent can
control the business activities of its subsidiary, it directly follows that the parent is accountable to
its investors and creditors for all of the subsidiary’s assets, liabilities, and profits.
The full fair value of the subsidiary is typically determined by combining the fair value of the
controlling interest and the fair value of the NCI. Measurement of the controlling interest’s fair
value is straightforward in the vast majority of cases. The consideration paid by the parent typically
provides the best evidence of fair value of the acquirer’s interest. However, there is no parallel
consideration transferred by the NCI to value the NCI. Therefore, the parent must employ other
valuation techniques to estimate the fair value of the non-controlling interest at the acquisition
date.
32 | P a g e
33 | P a g e
4) Parent Company Extension Theory
Parent company extension theory was invented to address the concerns about goodwill valuation
under entity theory. Parent company extension theory does just that it values both the parent’s
share and the NCI’s share of identifiable net assets at fair value.
Under parent company extension theory, NCI is recognized in shareholders’ equity in the
consolidated balance sheet, similar to entity theory. Its amount is based on the fair values of
the identifiable net assets of the subsidiary; it excludes any value pertaining to the subsidiary’s
goodwill.
The consolidated balance sheet is prepared by combining, on an item-by-item basis, the carrying
amount of the parent with the fair value of the subsidiary’s identifiable net assets plus the parent’s
share of the subsidiary’s goodwill.
34 | P a g e
Either entity theory or parent company extension theory can be used under IFRSs. It is an
accounting policy choice. However, IFRS 3 does not use the term parent company extension
theory.
For each business combination, the acquirer shall measure any Non-controlling interest in the
acquiree either at fair value or at the Non-controlling interest’s proportionate share of the
acquiree’s identifiable net assets.
Advantages and shortcomings of consolidated financial statements
Consolidated financial statements are useful principally to stockholders and prospective investors
of the parent company. These users of consolidated financial statements are provided with
comprehensive financial information for the economic chapter represented by the parent company
and its subsidiaries, without regard for legal separateness of the individual companies.
Creditors of each consolidated company and minority stockholders of subsidiaries have only
limited use for consolidated financial statements, because such statements do not show the
financial position or operating results of the individual companies comprising the consolidated
group. In addition, creditors of the constituent companies cannot ascertain the asset coverages for
their respective claims. But perhaps the most telling criticism of consolidated financial statements
has come from financial analysts. These critics have pointed out that consolidated financial
35 | P a g e
statements of diversified companies (conglomerates) are impossible to classify into a single
industry. Thus, say the financial analysts, consolidated financial statements of a conglomerate
cannot be used for comparative purposes.
CHAPTER THREE
Consolidated Financial Statements Subsequent to Date of Business Combination
In the equity method of accounting, 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 the business
combination, as well as its share of dividends declared by the subsidiary.
In the cost method of accounting, the parent company accounts for the operations of a subsidiary
only to the extent that dividends are declared by the subsidiary. Dividends declared by the
subsidiary from net income subsequent to the business combination are recognized as revenue by
the parent company; dividends declared by the subsidiary in excess of post combination net income
constitute a reduction of the carrying amount of the parent company's investment in the subsidiary.
Net income or net loss of the subsidiary is not recognized by the parent company when the cost
method of accounting is used.
Assume that Palm Corporation had appropriately accounted for the December 31, 2020, business
combination with its wholly owned subsidiary, Starr Company and that Starr had a net income of
Br. 60,000 for the year ended December 31, 2021. Assume further that on December 20, 2021,
Starr's board of directors declared a cash dividend of Br. 0.60 a share on the 40,000 outstanding
shares of common stock owned by Palm. The dividend was payable January 8, 2022, to
stockholders of record December 29, 2021.
Required: Under the equity method of accounting record the journal entries for Palm Corporation
Assume that the December 31, 2020 (date of business combination), differences between the
current fair values and carrying amounts of Starr Company's net assets were as follows:
Difference between
Inventories (first-in, first-out cost)
Current Fair Values
Plant assets (net):
and Carrying
Land
Br. 25,000
Br. 15,000
Amounts of Wholly
Building (economic File 15 years)
30,000
Owned Subsidiary’s
Machinery (economic life 10 years)
20,000
Assets on Date of
36 | P a g e
Patent (economic life 5 years)
65,000
5,000
Business
Goodwill (not impaired as of December 31, 2006)
Combination
Total
15,000
Br. 110,000
Required: Under the equity method record the entry to reflect the effects of depreciation and
amortization of the differences between the current fair values and carrying amounts of Starr
Company's identifiable net assets on Starr's net income for the year ended December 31, 2021:
In our Illustration, the investor, Palm Corporation's use of the equity method of accounting for its
Investment in Starr Company results in a balance in the Investment account that is a mixture of
two components:
1)
The carrying amount of Starr's identifiable net assets, and
2) The excess on the date of business combination of the current fair values of
the
of
subsidiary's net assets (including goodwill) over their carrying amounts, net
depreciation and amortization.
Working Paper for Consolidated Financial Statements
We continue to apply the equity method to illustrate the preparation of consolidated financial
statements using a work paper. The work paper follows the discussion of the components and their
computation. We start with the balance sheet of a year ago that we used form Palm Corporation
and Starr Company.
The intercompany receivable and payable is the Br. 24,000 dividend payable by Starr to Palm on
December 31, 2021. (The advances by Palm to Starr that were outstanding on December 31, 2020,
were repaid by Starr on January 2, 2021)
The following aspects of the working paper for consolidated financial statements of Palm
Corporation and subsidiary should be emphasized:
1. The intercompany receivable and payable, placed in adjacent columns on the same line, are
offset without a formal elimination.
2. The elimination cancels all intercompany transactions and balances not dealt with by the offset
described in number 1 above.
3. The elimination cancels the subsidiary's retained earnings balance at the beginning of the year
(the date of the business combination), so that each of the three basic financial statements may
37 | P a g e
be consolidated in turn. (All financial statements of a parent company and a subsidiary are
consolidated for accounting periods subsequent to the business combination.)
4. The first-in, first-out method is used by Starr Company to account for inventories; thus, the
Br. 25,000 difference attributable to Starr's beginning inventories is allocated to cost of goods
sold for the year ended December 31, 2021.
5.
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. The effect of the reduction is as follows:
Total difference on date of business combination (Dec. 31, 2020)
Br. 110,000
Less: Reduction in elimination (a) (Br. 25,000 + Br. 5,000)
Unamortized difference, Dec, 31, 2021 (Br. 61,000 + Br. 4,000 + Br. 15,000)
30,000
Br. 80,000
Remember that the Br. 15,000 balance applicable to Starr's land will not be extinguished; the
Br.15, 000 balance applicable to Starr's goodwill will be reduced only if the goodwill in
subsequently impaired.
The parent company's use of the equity method of accounting results in the equalities described
below:
Parent company net income = consolidated net income
Parent company retained earnings = consolidated retained earnings
6. The equalities exist when the equity method of accounting is used and intercompany profits
and sales are ignored. Despite the equalities indicated above, consolidated financial
statements are superior to parent company financial statements for the presentation of
financial position and operating results of parent and subsidiary companies. The effect of the
consolidation process for Palm Corporation and subsidiary is to reclassify Palm's Br. 30,000
share of its subsidiary's adjusted net income to the revenue and expense components of that
net income. Similarly, Palm's Br. 506,000 investment in the subsidiary is replaced by the
assets and liabilities comprising the subsidiary's net assets.
38 | P a g e
Equity Method: Wholly Owned Subsidiary Subsequent to Date of Business Combination
PALM CORPORATION AND SUBSIDIARY
Working Paper for Consolidated Financial Statements
For Year Ended December 31, 2021
Elimination
Palm
Starr
Increase
Corporation
Company
(Decrease)
Consolidated
Income Statement
Revenue:
Net sales
1,100,000
Inter-company Investment Income
Total revenue
680,000
30,000
(a)
----
1,780,000
(30,000)
----
(30,000)
1,780,000
1,130,000
680,000
Cost of Goods sold
700,000
450,000
(a)
25,000
1,175,000
Operating expenses
217,667
130,000
(a)
5,000
352,667
----
49,000
----
49,000
Costs and expenses:
Interest expense
Income taxes expense
53,333
Total costs and exp
1, 020,000
Net income
53,333
620,000
30,000*
1,670,000
(60,000)
110,000
(132,000)
134,000
110,000
60,000
Beginning Retained earnings
134,000
132,000
Net Income
110,000
60,000
(60,000)
110,000
Sub total
244,000
192,000
(192,000)
244,000
30,000
24,000
(a) (24,000)**
30,000
214,000
168,000
(168,000)
214,000
Cash
15,900
72,100
Intercompany receivable (payable)
24,000
(24,000)
136,000
115,000
Statement of Retained Earnings
Dividends declared
Ending Retained earnings
(a)
Balance Sheet
Assets
Inventories
39 | P a g e
88,000
----
---251,000
Other current assets
88,000
131,000
Investment in Starr Co. Common Stock
506,000
----
(a)
(506,000)
----
Plant assets (net)
440,000
340,000
(a)
61,000
841,000
16,000
(a)
4,000
20,000
(a)
15,000
15,000
Patent (net)
Goodwill
Total assets
219,000
1,209,900
650,100
(426,000)
1,434,000
40,000
20,000
----
60,000
Other liabilities
190,900
204,100
----
395,000
Common stock, Br. 10 par
400,000
Liabilities and Stockholder’s Equity
Income taxes payable
Common stock, Br. 5 par
400,000
200,000
(a)
(200,000)
(a)
(58,000)
365,000
Additional Paid-in Capital
365,000
58,000
Retained earnings
214,000
168,000
(168,000)
214 000
1,209,900
650,100
(426,000)
1,434,000
Total Liabilities and Stockholders’ Equity
* an increase in total costs and expenses and a decrease in net income
**a decrease in dividends and an increase in retained earnings
Required: based on the above working paper prepare consolidated financial statements
40 | P a g e
INTERCOMPANY REVENUE AND EXPENSES
Intercompany Sales and Purchases
Suppose the parent company lends $100,000 to the subsidiary company and receives a note
payable on demand with interest at 10% paid annually. The transactions would be recorded as
follows:
From the consolidated entity’s point of view, all that has happened is that cash has been transferred
from one bank account to another. No revenue has been earned, no expense has been incurred, and
there are no receivables or payables with parties outside the consolidated entity. The elimination
of $10,000 interest revenue and interest expense on the consolidated income statement does not
change the net income of the consolidated entity. If total net income is not affected, then the
amount allocated to the non-controlling and controlling interest is also not affected. On the
consolidated balance sheet, we eliminate $100,000 from notes receivable and notes payable. An
equal elimination of assets and liabilities on the balance sheet leaves the amounts of the two
equities (non-controlling interest and controlling interest) unchanged.
Intercompany Rentals
Occasionally, buildings or equipment owned by one company are used by another company within
the group. Rather than transfer legal title, the companies agree on a yearly rental to be charged. In
such cases, intercompany rental revenues and expenses must be eliminated from the consolidated
income statement.
INTERCOMPANY PROFITS IN ASSETS
When one affiliated company sells assets to another affiliated company, it is possible that the profit
or loss recorded on the transaction has not been realized from the point of view of the consolidated
entity. If the purchasing affiliate has sold these assets outside the group, all profits (losses) recorded
are realized. If, however, all or a portion of these assets have not been sold outside the group, we
41 | P a g e
must eliminate the remaining intercompany profit and may need to eliminate the intercompany
loss from the consolidated statements. The intercompany profit (loss) will be realized for
consolidation purposes during the accounting period in which the particular asset is sold to
outsiders.
Upstream versus Downstream Transactions
When we talk about intercompany transactions, it is important to distinguish between downstream
and upstream transactions. When the parent sells to the subsidiary, the transaction is referred to
as a downstream transaction. When the subsidiary sells to the parent, it is referred to as an
upstream transaction. The name of the method is consistent with the common perception that the
parent is the head of the family and the subsidiary is the child of the parent. The parent looks down
to the child, while the child looks up to the parent.
The company doing the selling is the company recognizing the profit on the sale. When we
eliminate the profit from intercompany transactions, we should take it away from the selling
company, that is, from the company that recognized the profit in the first place. On downstream
transactions, we will eliminate the profit that the parent had recognized. On upstream transactions,
we will eliminate the profit that the subsidiary had recognized.
The name of the method is also based on which company was the selling company. When one
subsidiary sells to another subsidiary, the profit must also be eliminated because it is not realized
with an outside party.
Illustration: On January 1, Year 1, Parent Company acquired 90% of the common shares of Sub
Incorporated for $11,250. On that date, Sub had common shares of $8,000 and retained earnings
of $4,500, and there were no differences between the fair values and the carrying amounts of its
identifiable net assets. The acquisition differential was calculated as follows:
42 | P a g e
The financial statements of Parent and Sub as at December 31, Year 1, are presented as follows.
Intercompany Inventory Profits: Subsidiary Selling (Upstream Transactions)
The following intercompany transactions occurred during Year 1:
1. During Year 1, Sub made sales to Parent amounting to $5,000 at a gross profit rate of 30%.
2. At the end of Year 1, Parent’s inventory contained items purchased from Sub for $1,000.
3. Sub paid (or accrued) income tax on its taxable income at a rate of 40%.
43 | P a g e
To hold back the gross profit of $300 from the consolidated entity’s net income, cost of goods sold
increased by $300. The reasoning is as follows:
(a) Cost of goods sold is made up of opening inventory, plus purchases, less ending inventory.
(b) The ending inventory contains the $300 gross profit.
(c) If we subtract the $300 profit from the ending inventory on the balance sheet, the ending
inventory is now stated at cost to the consolidated entity.
(d) A reduction of $300 from ending inventory in the cost of goods sold calculation increases cost
of goods sold by $300.
(e) This increase to cost of goods sold reduces the before-tax net income earned by the entity by
$300.
(f) Because the entity’s before-tax net income has been reduced by $300, it is necessary to reduce
the income tax expense (the tax paid on the profit held back) by $120.
(g) A reduction of income tax expense increases the net income of the consolidated entity
(h) A $300 increase in cost of goods sold, together with a $120 reduction in income tax expense,
results in the after-tax profit of $180 being removed from consolidated net income.
If Parent was using the equity method, the following journal entries would be made on December
31, Year 1:
44 | P a g e
After these entries were posted, the two related equity method accounts of Parent would show the
following changes and balances:
Parent’s total income under the equity method would be $4,768, consisting of $3,400 from its own
operations, plus investment income of $1,368, as reported above. This income of $4,768 should
be and is equal to consolidated net income attributable to Parent’s shareholders.
Realization of Inventory Profits—Year 2
The previous example illustrated the holdback of an unrealized intercompany inventory profit in
Year 1. We will continue our example of Parent Company and Sub Inc. by looking at the events
of Year 2. On December 31, Year 2, Parent reported earnings from its own operations of $4,050
and declared dividends of $2,500. Sub reported a net income of $3,100 and, again, did not declare
a dividend.
During Year 2, there were no intercompany transactions, and at year-end, the inventory of Parent
contained no items purchased from Sub. In other words, the December 31, Year 1, inventory of
Parent was sold during Year 2, and the unrealized profit that was held back for consolidated
purposes in Year 1 will have to be released into in Year 2.
45 | P a g e

There were no intercompany sales or purchases in Year 2, and therefore no elimination is
required on the income statement.
 To realize the gross profit of $300 in Year 2, we decrease cost of goods sold by $300. The
reasoning behind this is as follows:
(a) Cost of goods sold is made up of opening inventory, plus purchases, less ending inventory.
(b) Parent’s opening inventory contains the $300 gross profit. After we reduce it by $300, the
opening inventory is at cost to the entity.
(c) A reduction of $300 from opening inventory decreases cost of goods sold by $300.
(d) This decrease in cost of goods sold increases the before-tax net income earned by the entity
by $300
46 | P a g e
If Parent had used the equity method, the following journal entries would have been made on
December 31, Year 2:
After these entries are posted, the two related equity method accounts of Parent show the following
changes and balances:
Note that the January 1 balance ($12,618) included the $162 holdback and that this amount was
realized during the year with a journal entry. It should be obvious that the December 31 balance
($15,570) does not contain any holdback.
Intercompany Inventory Profits: Parent Selling (Downstream Transactions)
In our previous example, the subsidiary was the selling company in the intercompany profit
transaction (an upstream transaction). This resulted in the $180 after-tax profit elimination being
allocated to the controlling and non-controlling equities.
Suppose we had assumed that it was the parent company that sold the inventory to the subsidiary
(a downstream transaction).
47 | P a g e
Note that the after-tax profit is deducted from the net income of Parent because it was the selling
company, and that Parent’s net income contains this profit being held back for consolidation
purposes.
The eliminations on the consolidated income statement for intercompany sales and purchases and
for unrealized profit in inventory, and the related adjustment to income tax expense would not
change. But the split of the consolidated net income between the shareholders of the parent and
the non-controlling interest is different, as indicated in the previous calculation. Because Parent
was the selling company, all of the $180 holdback was allocated to the parent and none was
allocated to the non-controlling interest.
The elimination entries on the Year 2 consolidated income statement would be the same as in the
previous illustration, but because the amount for non-controlling interest is $310, the consolidated
net income attributable to Parent’s shareholders is a higher amount, as indicated in the previous
calculations.
To summarize, the holdback and subsequent realization of intercompany profits in assets is
allocated to the non-controlling and controlling equities only if the subsidiary was the original
seller in the intercompany transaction. If the parent was the original seller, the allocation is entirely
to the controlling equity.
If Parent used the equity method to account for its investment, it would make the following entries
as at December 31, Year 1:
Rather than preparing two separate entries, the following entry could be made to capture the
overall impact of the two separate entries:
48 | P a g e
On December 31, Year 2, Parent would make the following journal entries if it used the equity
method:
Alternatively, the following entry could be made to capture the overall impact of the two separate
entries:
49 | P a g e