1
Reporting Business Combinations
Operations are accounted for as
separate entities throughout the year
Parent
Subsidiary
Acquirer
Acquired company
Year-end Reporting Purposes
Consolidated Entity
This chapter is limited to wholly-owned subsidiaries.
©Cambridge Business Publishing, 2010
Purpose of Consolidated Financial
Statements
 To present results of operations and the
financial position of a parent and all its
subsidiaries as if the consolidated group
were a single economic entity
 Primarily for the benefit of owners and
creditors of the parent
Presumption Consolidated financial statements are more
meaningful than separate statements when one entity in
the consolidated group directly or indirectly has a
controlling financial interest in the other entity
©Cambridge Business Publishing, 2010
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3
Concept of Control
 Requires ownership of a majority voting
interest, by one entity, directly or indirectly,
of more than 50 percent of the outstanding
voting shares of another entity
 SFAS 94 requirements
 Consolidate majority-owned entities
 Except when
 Control is temporary, or
 Control is not present
 Nonhomogeneity exception eliminated to avoid
‘off-balance-sheet financing’
©Cambridge Business Publishing, 2010
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Financial Effects of Consolidation
Manufacturing Company plans to buy the stock of
Finance Corporation for $10 million cash. Balance
sheets before Manufacturing Company acquires stock of
Finance Corporation:
Manufacturing Co. Finance Corp.
Total assets
$220,000,000 $110,000,000
Total liabilities
Stockholders' equity
Total liabilities and equity
$115,000,000 $100,000,000
105,000,000
10,000,000
$220,000,000 $110,000,000
Entry to record statutory merger of Finance Corp. by
Manufacturing Company:
Total assets
Total liabilities
Cash
©Cambridge Business Publishing, 2010
110,000,000
100,000,000
10,000,000
5
Financial Effects of Equity Method
Suppose the equity method is used. Balance sheets
before Manufacturing Company acquires stock of
Finance Corporation:
Manufacturing Co. Finance Corp.
Total assets
$220,000,000 $110,000,000
Total liabilities
Stockholders' equity
Total liabilities and equity
$115,000,000 $100,000,000
105,000,000
10,000,000
$220,000,000 $110,000,000
Entry to record equity method acquisition of
Finance Corporation:
Investment in Finance Corp.
Cash
©Cambridge Business Publishing, 2010
10,000,000
10,000,000
Comparing Consolidation and Equity
Method Leverage
Consolidated Balance Sheet of Manufacturing
Company and Subsidiary
Total assets
$320,000,000
Total liabilities
Stockholders' equity
Total liabilities and equity
$215,000,000
105,000,000
$320,000,000
Balance Sheet of Manufacturing Company
using Equity Method
Other assets
$210,000,000
Investment in Finance Corp.
10,000,000
Total assets
$220,000,000
Total liabilities
Stockholders' equity
Total liabilities and equity
©Cambridge Business Publishing, 2010
$115,000,000
105,000,000
$220,000,000
As a Consolidated
Entity
Total liabilities/
Total assets = 0.67
Total liabilities/
Total equity = 2.05
Using Equity
Method Accounting
Total liabilities/
Total assets = 0.52
Total liabilities/
Total equity = 1.10
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Control and Consolidation
 Control exists for
 Investments in over 50% of the voting stock of
another company
 Consolidation required unless unusual
circumstances prevent control
 Consolidation is allowed if investment is less
than 50%
Virtually all consolidated subsidiaries
involving equity ownership have U.S.
parents with majority ownership.
©Cambridge Business Publishing, 2010
8
Special Purpose Entities (SPEs)
 Legal structures formed for specific
business activities
 Control may be obtained
 Without paying consideration, or
 With little or no equity investment
 Frequently have no separate management
or employees
 Often obtain financing from debt
 Have small outside equity interest that
obtains a secure return with little or no risk
©Cambridge Business Publishing, 2010
9
Examples of SPEs
Securitizations
Provide the
opportunity to hide
debt and losses
from investors
Leasing
Joint Ventures
©Cambridge Business Publishing, 2010
ARB 51 and
SFAS 94 do
not apply.
10
Securitizations
Set up by a financial services company to buy loan
or customer receivables from clients
SPE uses the
money to buy
the receivables
Allows clients to obtain
immediate cash for
receivables
©Cambridge Business Publishing, 2010
SPE issues debt securities
backed by the receivables
SPE uses the collection
proceeds to pay principal
and interest
11
Leasing
 Created by a company to purchase longterm assets
 Funding for purchases obtained through
loans
 SPE leases assets to the company
 SPE uses lease payments to pay interest
and principal on the debt
Lease terms usually allow lessee to
report the lease as an operating lease.
©Cambridge Business Publishing, 2010
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Joint Ventures
 Formed by two or more companies for
specialized projects
 Often requires large amounts of
specialized skill and financing
 Structure legally separates the projects’
risk from that of the sponsors
 Allows financing to be obtained at a lower
cost
©Cambridge Business Publishing, 2010
13
Consolidation at Date of Acquisition
When the companies remain as separate
legal entities:
Acquiring
Company
Reports investment as one
line on its balance sheet
Acquired
Company
Makes no entry;
Stock is owned by new
shareholders
©Cambridge Business Publishing, 2010
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Objectives of Consolidation
 To report the affairs of a group of affiliated
corporations as a single economic entity
 Procedures designed to
 Remove the effects of reported transactions
and relationships between components of the
reporting entity
 Ensure that information reflects transactions
with outside parties
©Cambridge Business Publishing, 2010
15
Consolidation Process
 Assets and liabilities of the acquired
company
 Revalued to fair value
 Combined with assets and liabilities of parent
 Intercompany transactions and account
balances are removed
Process occurs each time financial
statements are prepared
©Cambridge Business Publishing, 2010
16
Consolidation Working Paper
 Three elements
 Accounts of the parent company
 Accounts of the subsidiary company
 Eliminating entries to consolidate the accounts
 Eliminate the investment account on the parent
company’s books
 Eliminate the stockholders’ equity accounts on the
subsidiary’s books
 Revalue subsidiary’s assets and liabilities from book
value to fair value
©Cambridge Business Publishing, 2010
17
Consolidation Example
Assume General Motors pays $35 million cash for all of the
stock of Automagic Parts, Inc. on January 1, 2011. Balance
sheets prior to acquisition are:
Current assets
Plant and equipment, net
Patents and copyrights
General Motors
Book Value
Dr(Cr)
$100,000,000
400,000,000
10,000,000
Current liabilities
Long-term debt
Common stock, $1 par
Additional paid-in capital
Retained earnings
(120,000,000)
(300,000,000)
(10,000,000)
(60,000,000)
(20,000,000)
Automagic Parts, Inc.
Book Value
Fair Value
Dr(Cr)
Dr(Cr)
$ 2,000,000 $ 1,800,000
50,000,000
80,000,000
1,000,000
3,200,000
(10,000,000)
(38,000,000)
(500,000)
(2,000,000)
(2,500,000)
(10,000,000)
(40,000,000)
To record investment in the stock of Automagic Parts, Inc.:
Investment in Automagic Parts
Cash
©Cambridge Business Publishing, 2010
35,000,000
35,000,000
18
Consolidation Example
continued
Calculate goodwill:
Acquisition cost
$35,000,000.
Book value of Automagic
(5,000,000)
Cost in excess of Automagic's book value
30,000,000.
Differences between fair value and book value :
Current assets
$ (200,000)
Plant and equipment, net
30,000,000.
Patents and copyrights
2,200,000.
Long-term debt
(2,000,000) (30,000,000)
Goodwill
$
0.
Because the acquisition cost is equal to
the fair value of the identifiable net
assets, there is no goodwill.
©Cambridge Business Publishing, 2010
19
Consolidation Example
continued
(E) Eliminate the subsidiary’s acquisition date
equity balances:
Common stock, $1 par
Additional paid-in capital
Retained earnings
Investment in Automagic Parts
500,000
2,000,000
2,500,000
5,000,000
(R)Recognize acquisition date fair value revaluations:
Plant and equipment, net
Patents and copyrights
Current assets
Long-term debt
Investment in Automagic Parts
©Cambridge Business Publishing, 2010
30,000,000
2,200,000
200,000
2,000,000
30,000,000
20
Consolidation Working Paper
for GM and Automagic
Eliminating entries appear
in the Eliminations column
Current assets
Plant and equipment, net
Patents and copyrights
Investment in Automagic
Total assets
Accounts from Books
GM
Automagic
$65,000,000 $2,000,000
400,000,000 50,000,000
10,000,000 1,000,000
35,000,000
Exhibit 3.3
Eliminations
Dr
Cr
$200,000 (R)
(R) $30,000,000
(R)
2,200,000
Consolidated
Balances
$ 66,800,000
480,000,000
13,200,000
5,000,000 (E)
30,000,000 (R)
$510,000,000 $53,000,000
$560,000,000
Current liabilities
$120,000,000 $10,000,000
$130,000,000
Long-term debt
300,000,000 38,000,000
2,000,000 (R) 340,000,000
Common stock, $1 par
10,000,000
500,000 (E)
500,000
10,000,000
Additional paid-in capital
60,000,000 2,000,000 (E) 2,000,000
60,000,000
Retained earnings
20,000,000 2,500,000 (E) 2,500,000
20,000,000
Total liabilities and equity $510,000,000 $53,000,000 $37,200,000 $37,200,000 $560,000,000
Elimination debits =
Elimination credits
©Cambridge Business Publishing, 2010
Consolidation with Goodwill and Previously
Unreported Intangibles Example
IBM pays $25,000,000 in cash to acquire DataFile,
Inc. on July 1, 2010. Fair values of DataFile's assets
and liabilities are as follows:
Exhibit 3.4
DataFile’s accounts:
Current assets
Plant and equipment
Patents and copyrights
Current liabilities
Long-term debt
Fair values of previously unreported intangible assets:
Brand names
Favorable lease agreements
Assembled workforce
In-process contracts with potential customers
Contractual customer relationships
©Cambridge Business Publishing, 2010
Fair Value
$2,000,000
60,000,000
5,000,000
10,000,000
40,000,000
$1,000,000
600,000
5,000,000
2,000,000
3,000,000
21
Consolidation with Goodwill and Previously
Unreported Intangibles Example
continued
IBM and DataFile, Inc.’s balance sheets
immediately prior to acquisition on July 1, 2010:
Current assets
Plant and equipment, net
Patents and copyrights
Total assets
IBM
$ 40,000,000
150,000,000
3,000,000
$193,000,000
DataFile
$ 2,300,000
50,000,000
1,000,000
$53,300,000
Current liabilities
Long-term debt
Common stock, $0.50 par
Additional paid-in capital
Retained earnings
Total liabilities and equity
$ 15,000,000
100,000,000
2,000,000
60,000,000
16,000,000
$193,000,000
$10,000,000
38,000,000
500,000
2,000,000
2,800,000
$53,300,000
©Cambridge Business Publishing, 2010
Exhibit 3.5
22
Consolidation with Goodwill and Previously
Unreported Intangibles Example
continued
IBM’s entry to record the stock acquisition:
Investment in DataFile
Cash
25,000,000
25,000,000
Calculate goodwill:
Acquisition cost
$25,000,000.
Book value of DataFile
(5,300,000)
Cost in excess of DataFile's book value
$19,700,000.
Differences between fair value and book value:
Current assets
$ (300,000)
Plant and equipment, net
10,000,000.
Patents and copyrights
4,000,000.
Brand names
1,000,000.
Favorable lease agreements
600,000.
Contractual customer relationships
3,000,000.
Long-term debt
(2,000,000) 16,300,000.
Goodwill
$ 3,400,000.
©Cambridge Business Publishing, 2010
23
Consolidation with Goodwill and Previously
Unreported Intangibles Example
continued
(E) Eliminate DataFile’s equity balances:
Common stock, $0.50 par
Additional paid-in capital
Retained earnings
Investment in DataFile
500,000
2,000,000
2,800,000
5,300,000
(R) Eliminate excess paid over book value and revalue
DataFile’s assets and liabilities to fair value:
Plant and equipment, net
10,000,000
Patents and copyrights
4,000,000
Brand names
1,000,000
Favorable lease agreements
600,000
Contractual customer relationships 3,000,000
Goodwill
3,400,000
Current assets
300,000
Long-term debt
2,000,000
Investment in DataFile
19,700,000
©Cambridge Business Publishing, 2010
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25
Consolidation Working Paper
Accounts Taken from Books
IBM
DataFile
Exhibit 3.6
Current assets
Plant and equipment, net
Patents and copyrights
Investment in DataFile
$15,000,000
150,000,000
3,000,000
25,000,000
Eliminations
Dr
$2,300,000
50,000,000 (R) $10,000,000
1,000,000 (R) 4,000,000
Brand names
Favorable lease agreements
Contractual customer relationships
(R)
Goodwill
Total assets
(R)
$193,000,000 $53,300,000
(R)
(R)
1,000,000
600,000
3,000,000
3,400,000
Cr
Consolidated
Balances
$300,000 (R) $ 17,000,000
210,000,000
8,000,000
5,300,000 (E)
19,700,000 (R)
1,000,000
600,000
3,000,000
3,400,000
$243,000,000
Current liabilities
$15,000,000 $10,000,000
$25,000,000
Long-term debt
100,000,000 38,000,000
2,000,000 (R) 140,000,000
Common stock, $0.50 par
2,000,000
500,000 (E)
500,000
2,000,000
Additional paid-in capital
60,000,000
2,000,000 (E) 2,000,000
60,000,000
Retained earnings
16,000,000
2,800,000 (E) 2,800,000
16,000,000
Total liabilities and equity $193,000,000 $53,300,000 $27,300,000 $27,300,000 $243,000,000
Consolidated balance sheet at date of acquisition
©Cambridge Business Publishing, 2010
26
Consolidation with Bargain Purchase
 Occurs when the fair values of the
identifiable net assets of the acquired
company total more than the acquisition
price
 Parent company reports the difference as a
gain on acquisition
 No goodwill reported in consolidation
©Cambridge Business Publishing, 2010
Consolidation with Bargain Purchase
Example
Assume that IBM pays only $20 million in cash for all the
stock of DataFile.
Calculate gain:
Acquisition cost
Book value of DataFile
Cost in excess of DataFile's book value
Differences between fair value and book value
Gain on acquisition
$20,000,000.
(5,300,000)
14,700,000.
16,300,000.
$1,600,000.
IBM’s entry to record the stock acquisition:
Investment in DataFile
Gain on acquisition
Cash
©Cambridge Business Publishing, 2010
21,600,000
1,600,000
20,000,000
27
Consolidation with Bargain Purchase
Example
28
continued
Exhibit 3.7
Current assets
Plant and equipment, net
Patents and copyrights
Investment in DataFile
Accounts from Books
IBM
DataFile
$20,000,000 $2,300,000
150,000,000 50,000,000
3,000,000 1,000,000
21,600,000
Brand names
Favorable lease agreements
Contractual customer relationships
Total assets
$194,600,000 $53,300,000
Eliminations
Dr
Cr
$ 300,000 (R)
(R) $10,000,000
(R)
4,000,000
Consolidated
Balances
$ 22,000,000
210,000,000
8,000,000
5,300,000 (E)
16,300,000 (R)
(R)
(R)
(R)
1,000,000
600,000
3,000,000
1,000,000
600,000
3,000,000
$244,600,000
Current liabilities
$ 15,000,000 $10,000,000
$25,000,000
Long-term debt
100,000,000 38,000,000
2,000,000 (R) 140,000,000
Common stock, $0.50 par
2,000,000
500,000 (E)
500,000
2,000,000
Additional paid-in capital
60,000,000 2,000,000 (E) 2,000,000
60,000,000
Retained earnings
17,600,000 2,800,000 (E) 2,800,000
17,600,000
Total liabilities and equity $194,600,000 $53,300,000 $23,900,000 $23,900,000 $244,600,000
Gain becomes part of parent’s retained earnings
©Cambridge Business Publishing, 2010
29
Special Issue: Depreciable Assets
 Acquiring company reports acquired assets
at fair value
 Fair value at date of acquisition = original
cost to acquiring company for consolidation
purposes
 Original cost and related accumulated
depreciation on books of subsidiary are not
relevant to acquiring company
©Cambridge Business Publishing, 2010
Special Issue: Previously Reported
Goodwill
 May exist on subsidiary’s books if another
company had previously been acquired by
the subsidiary
 Acquiring company assigns a zero value to
goodwill acquired
 Not an identifiable asset
©Cambridge Business Publishing, 2010
30
Consolidating a Subsidiary Reporting
Goodwill
Assume General Motors acquires Powerdown, Inc. for $40
million. Powerdown’s balance sheet:
Various identifiable assets
Goodwill
Total assets
Book Value
Fair Value
$50,000,000 $80,000,000
10,000,000
9,000,000
$60,000,000
Liabilities
Stockholders' equity
Total liabilities and equity
$55,000,000 $55,000,000
5,000,000
$60,000,000
Calculation of goodwill:
Acquisition cost
Book value of Powerdown
Cost in excess of Powerdown's book value
Differences between fair value and book value:
Various identifiable assets
Previously recorded goodwill
Goodwill
©Cambridge Business Publishing, 2010
$40,000,000.
(5,000,000)
$35,000,000.
$30,000,000.
(10,000,000) 20,000,000.
$15,000,000.
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32
IFRS for Consolidations
 Principles-based application of control
concept
 Conditions leading to consolidation
 Control over more than half the voting rights
 Power to control major decisions due to statute
or agreement
 Power to appoint or remove the majority of
board members
 Power to cast the majority of votes at board
meetings
 Requires consideration of potential voting
rights
©Cambridge Business Publishing, 2010