Electronic
Presentations
in Microsoft®
PowerPoint®
Prepared by
James Myers,
C.A.
University of
Toronto
© 2010 McGraw-Hill
Ryerson Limited
Chapter 5, Slide 1
© 2010 McGraw-Hill Ryerson Limited
Chapter 5
Consolidation Subsequent to
Acquisition Date
Chapter 5, Slide 2
© 2010 McGraw-Hill Ryerson Limited
Learning Objectives
1.
2.
3.
4.
5.
6.
7.
Explain the basic differences between the cost and equity
methods of recording investments
Explain how impairment tests are performed on long-lived
assets, other intangibles, and goodwill
Calculate the amortization and/or impairment of acquisition
differential on both an annual and cumulative basis
Calculate consolidated net income attributable to the parent’s
shareholders and consolidated retained earnings
Explain how the matching principle is applied when amortizing
or writing off the acquisition differential
Prepare consolidated financial statements in years subsequent
to acquisition
Prepare journal entries under the equity method to report
changes in the investment account during the year
Chapter 5, Slide 3
© 2010 McGraw-Hill Ryerson Limited
Method of Accounting for an Investment in a Subsidiary

The investment account in the parent’s books
may be maintained by the cost method, or the
equity method

LO 1
The choice of method to employ is entirely at the
discretion of the company involved, as this is a matter
of internal accounting policy, not external reporting there are no strong conceptual arguments in favour of
either approach since they both produce exactly the
same consolidated financial statements
Chapter 5, Slide 4
© 2010 McGraw-Hill Ryerson Limited
Method of Accounting for an Investment in a Subsidiary

The equity method provides more detailed information
to management but the cost method is easier to apply.



IAS 28 defines equity method as one under which the investment
is initially recorded at cost and adjusted thereafter for the postacquisition change in the investor’s share of net assets and other
comprehensive income of the investee
Distributions (e.g. dividends) from the investee reduce the
carrying amount of the investment
Under the cost method, the investment is initially
recorded at cost and earnings from the investment are
recognized only to the extent received or receivable.
Occasionally an entry may be required to record
impairment of the investment, if such occurs
LO 1
Chapter 5, Slide 5
© 2010 McGraw-Hill Ryerson Limited
Accounting With the Equity Method
Investment in Subsidiary
Original Cost Dividends received
Income earned
Acquisition Differential Amortization
Other adjustments*
Balance
*In later chapters
LO 1
Chapter 5, Slide 6
© 2010 McGraw-Hill Ryerson Limited
Equity Method of Accounting

Since the equity method includes the parent’s pro-rata
share of the subsidiary’s post-acquisition retained
earnings it produces the same net income and retained
earnings on the parent’s separate entity financial
statements as reported on the consolidated financial
statements


This provides more information, more readily, to management
The equity method is often referred to as a “one-line
consolidation”, because it aggregates all consolidation
adjustments in the parent’s investment revenue account,
with offsetting entries to the parent’s investment in
subsidiary account. It does not produce consolidated
balances for every account
LO 1
Chapter 5, Slide 7
© 2010 McGraw-Hill Ryerson Limited
Equity Method of Accounting

When the investment account for the subsidiary is
maintained under the equity method which reflects all
consolidation adjustments, we know the following:



Parent’s net income equals consolidated net income
Parent’s retained earnings equals consolidated retained
earnings
To produce consolidated financial statements, replace
the parent’s investment account with the individual
assets and liabilities of the subsidiary adjusted for the
acquisition differential, and replace the parent’s
investment income account with the subsidiary’s
individual income and expense accounts.
LO 1
Chapter 5, Slide 8
© 2010 McGraw-Hill Ryerson Limited
Method of Accounting for an Investment in a Subsidiary



When a company buys the shares of another
company, the cost of these shares is recorded in
an “investment account” in the parent’s general
ledger
Parent and subsidiary remain separate legal
entities each with their own accounting records
and separate entity financial statements for
income tax filing and other purposes
Since the parent controls the subsidiary,
consolidated financial statements are required in
addition to the separate entity financial
statements
LO 1
Chapter 5, Slide 9
© 2010 McGraw-Hill Ryerson Limited
Consolidated income and retained earnings

Consolidated income consists of:
Net income of the parent from its own operations

Excludes dividends and other income from subsidiary
Plus: net income from subsidiary
Less: acquisition differential amortization


The amortization of the acquisition differential is reflected
on the consolidated financial statements, not the
subsidiary’s financial statements
The acquisition differential is amortized or written off on
consolidation as if the parent had purchased the related
net assets directly
LO 1
Chapter 5, Slide 10
© 2010 McGraw-Hill Ryerson Limited
Testing Goodwill and Other Intangibles for Impairment

Before July 1, 2001 Canadian GAAP required
goodwill to be amortized over its useful life not to
exceed 40 years


This often resulted in substantial reductions to postacquisition consolidated income, particularly when the
amount of goodwill was significant
In 2001 new rules were provided with guidelines
for the recognition and measurement of
intangibles other than goodwill and, in addition,
replaced the annual amortization of goodwill with
periodic reviews for impairment
LO 2
Chapter 5, Slide 11
© 2010 McGraw-Hill Ryerson Limited
Testing Long-Lived Assets for Impairment

In 2011, unless adopted earlier, IAS 36:
Impairment of Assets, will apply to the valuation
of all assets unless specifically excluded in
another standard



LO 2
Assets are required to be carried at no more than their
recoverable amount
An asset, or a group of similar assets (i.e. a “cashgenerating unit”), should be written down if its carrying
amount exceeds the amount to be recovered through
use or sale of the assets
This write-down is an “impairment loss” to be reported
in net income (unless the asset has previously been
reflected at a revalued amount)
Chapter 5, Slide 12
© 2010 McGraw-Hill Ryerson Limited
Testing Long-Lived Assets for Impairment

Recoverable amount is the higher of (i) fair value less
costs to sell and (ii) value in use



If either (i) or (ii) exceeds carrying amount then the asset is not
impaired and the other value need not be determined
If there is no available market for the asset it may be difficult to
determine (i), in which case the value from (ii) is acceptable for
recoverable amount
Determining recoverable amount requires estimating
future cash flows associated with an individual asset
which is sometimes impossible to do and in such cases
the amount can be determined for the cash-generating
unit (i.e. the smallest group of assets with independent
cash flows) that includes the particular asset
LO 2
Chapter 5, Slide 13
© 2010 McGraw-Hill Ryerson Limited
Testing Long-Lived Assets for Impairment

IAS 36 establishes different rules and
procedures for impairment testing for each of the
following types of intangible assets:



LO 2
Intangible assets with definite useful lives
Intangible assets with indefinite useful lives or not yet
available for use
Cash-generating units and goodwill
Chapter 5, Slide 14
© 2010 McGraw-Hill Ryerson Limited
Intangible Assets with Definite Useful Lives

The recoverable amount needs to be determined only if
there is an indication of impairment. At a minimum the
following factors should be considered:
LO 2
Chapter 5, Slide 15
© 2010 McGraw-Hill Ryerson Limited
Intangible Assets with Indefinite Useful Lives

Indefinite-life intangible assets are not amortized
but must be assessed for impairment at the
same time every year, regardless of whether
there is any indication of impairment
LO 2
Chapter 5, Slide 16
© 2010 McGraw-Hill Ryerson Limited
Intangible Assets with Indefinite Useful Lives

As a cost-saving measure the recoverable amount from
a preceding period can be used in the impairment test
for the indefinite life intangible asset if all of the following
three conditions are met:



LO 2
If the asset does not generate its own cash inflows and is
therefore tested as part of a larger cash-generating unit, the
assets and liabilities of the cash-generating unit to which it
belongs have not changed significantly since the last recoverable
amount calculation; and
The most recent recoverable amount calculation resulted in a
substantial excess over carrying amount; and
No changes in events or circumstances indicate that the current
recoverable amount would be less than the asset’s carrying value
Chapter 5, Slide 17
© 2010 McGraw-Hill Ryerson Limited
Cash-Generating Units and Goodwill

A business divides itself into separate cash-generating
units, each of which has cash inflows from an asset or a
group of assets that are largely independent of the cash
inflows from other assets or asset groups


Management often monitors the entity’s operations by cashgenerating units, which are separated for example by product
lines, businesses, geographical locations, or different internal
management authorities
Goodwill resulting from a business combination should
be divided among each cash-generating unit that will
benefit from the goodwill

LO 2
Each unit to which goodwill is so allocated shall represent the
lowest level applicable and will not be larger than an operating
segment determined in accordance with IFRS 8
Chapter 5, Slide 18
© 2010 McGraw-Hill Ryerson Limited
Cash-Generating Units and Goodwill

Goodwill is allocated to cash-generating units as
follows:





LO 2
The total value of the subsidiary is allocated to each
cash-generating unit
The FV of the subsidiary’s individual net assets is also
allocated to each cash-generating unit
For each cash-generating unit, the allocated value is
compared with the fair value of the unit’s identifiable
net assets
The difference = goodwill of the cash-generating unit
Sum of each cash-generating unit’s goodwill = total
acquisition goodwill of the subsidiary
Chapter 5, Slide 19
© 2010 McGraw-Hill Ryerson Limited
Cash-Generating Units and Goodwill



The goodwill impairment test is complex and
often requires significant professional judgment
Before goodwill impairment is tested, individual
assets should be tested for impairment and any
losses recorded
Then the recoverable amount of each cashgenerating unit is compared to its carrying
amount, including goodwill. If recoverable
amount > carrying amount then no goodwill
impairment
LO 2
Chapter 5, Slide 20
© 2010 McGraw-Hill Ryerson Limited
Cash-Generating Units and Goodwill

When the carrying amount of the cash-generating unit
goodwill exceeds the recoverable amount of the
goodwill, an impairment loss should be recognized in
an amount equal to the excess and should be
allocated to the assets of the unit in the following
order:


First, to reduce the carrying amount of any goodwill allocated
to cash-generating unit, and
Second, to the other assets of the unit pro rata based on the
carrying amount of each

LO 2
if such allocation should be greater than the carrying amount of
the asset the excess is further re-allocated to the other assets pro
rata
Chapter 5, Slide 21
© 2010 McGraw-Hill Ryerson Limited
Cash-Generating Units and Goodwill

LO 2
The most recent previously calculated recoverable amount of a
cash-generating unit can be used if there are clear indications no
impairment has occurred, such as:
 Very little change in the composition of assets and liabilities of
the cash-generating unit since the most recent recoverable
amount calculation; and
 The most recent recoverable amount determination yielded a
fair value that substantially exceed the carrying amount of the
cash-generating unit; and
 The likelihood of changes in events or circumstances that
indicate the current recoverable amount would be less than
the carrying amount of the unit is remote
Chapter 5, Slide 22
© 2010 McGraw-Hill Ryerson Limited
Reversing an Impairment Loss

Impairment losses on intangible assets other than
goodwill can be reversed only to the extent of the preloss carrying amount of the intangible asset





LO 2
In the first step, the entity assesses whether there are any
indications that the impairment loss either decreased or no longer
exists
If decrease is indicated in the first step, in the second step the
recoverable amount is determined
Impairment loss is reversed only if there has been a change in
the estimates used to determine the asset’s recoverable amount,
not if the present value of future cash inflows has increased
solely from the passage of time
Report reversal in net income
Allocate reversal to the assets of the cash-generating unit pro
rata based on carrying amounts
Chapter 5, Slide 23
© 2010 McGraw-Hill Ryerson Limited
Disclosure

Extensive disclosure requirements are required for
impairment of assets:



LO 2
For each class of assets, the amount of impairment losses and
reversals of impairment losses segregated by amounts
recognized in net income and amounts recognized in OCI
The events and circumstances that led to the recognition or
reversal of an impairment loss for individual assets, the basis of
recoverable amount, the basis used to determine fair value less
costs to sell, and the discount rate used
For cash-generating units or indefinite-life intangible assets, the
carrying amount of goodwill and of indefinite-life intangibles
allocated to the unit, the basis of recoverable amount, description
of key cash flow projection assumptions, and the methodology to
determine fair value less costs to sell
Chapter 5, Slide 24
© 2010 McGraw-Hill Ryerson Limited
Consolidation of 100%-Owned Subsidiary

The investment account is replaced by the
carrying value of the subsidiary’s assets and
liabilities plus the acquisition differential


Purchase price consists of carrying value of the
subsidiary’s assets and liabilities plus the acquisition
differential
Dividends received or receivable from subsidiary
are recorded in parent’s income when the cost
method is used

LO 6
These dividends are eliminated on consolidation
Chapter 5, Slide 25
© 2010 McGraw-Hill Ryerson Limited
Consolidation of 100%-Owned Subsidiary

The amortization and impairment of the acquisition
differential is recorded on the consolidated financial
statements, in order to match the expense to the
revenue generated by the net assets acquired. Example
of amortization and impairment schedule:
LO 3, 5
Chapter 5, Slide 26
© 2010 McGraw-Hill Ryerson Limited
Consolidation of 100%-Owned Subsidiary

When the parent uses the cost method to
account for the subsidiary, consolidated net
income has to be calculated, by converting to
equity-method net income since the equity
method reflects all consolidation adjustments.
Example (Exhibit 5.4):
LO 4
Chapter 5, Slide 27
© 2010 McGraw-Hill Ryerson Limited
Consolidation of 100%-Owned Subsidiary

The consolidated financial statements are prepared,
account-by-account, starting with the consolidated
income statement, then consolidated statement of
retained earnings, and finally the consolidated balance
sheet. (Exhibit 5.5 next slide)




LO 6
Consolidated net income, and the consolidated balance sheet
accounts, are the same regardless of whether the parent used
equity or cost method
Dividends on the consolidated statement of retained earnings are
the dividends of the parent
Consolidated retained earnings reflect the cumulative effect of all
adjustments to that time
The consolidated financial statements presents the combined
position of parent and subsidiary as if the parent had acquired the
subsidiary’s assets and liabilities directly
Chapter 5, Slide 28
© 2010 McGraw-Hill Ryerson Limited
Consolidation of 100%-Owned Subsidiary
LO 6
Chapter 5, Slide 29
© 2010 McGraw-Hill Ryerson Limited
Consolidation of 80%-Owned Subsidiary

It is necessary to calculate non-controlling
interest that will appear on the consolidated
balance sheet
LO 6
Chapter 5, Slide 30
© 2010 McGraw-Hill Ryerson Limited
Consolidation of 80%-Owned Subsidiary


Although the parent owns <100% of the
subsidiary, 100% of the subsidiary’s individual
assets and liabilities are still reported on the
consolidated balance sheet since they are
controlled by the parent
Non-controlling interest is the balance that
appears in consolidated equity that reflects the
portion of the subsidiary that the parent does not
own
LO 6
Chapter 5, Slide 31
© 2010 McGraw-Hill Ryerson Limited
Consolidation of 80%-Owned Subsidiary

When the parent uses the cost method to
account for the subsidiary, consolidated net
income needs to be calculated and then
allocated between parent and non-controlling
shareholders. Example (Exhibit 5.11):
LO 5
Chapter 5, Slide 32
© 2010 McGraw-Hill Ryerson Limited
Consolidation of 80%-Owned Subsidiary

The consolidated financial statements are
prepared, account-by-account, starting with the
consolidated income statement, then
consolidated statement of retained earnings,
and finally the consolidated balance sheet.
(Exhibit 5.12 next slide)


LO 6
Consolidated net income is attributed to the controlling
shareholders and non-controlling interest
Non-controlling interest is shown on the balance sheet
as a component of shareholders’ equity. This NCI
increases when the subsidiary earns income and
decreases when the subsidiary pays dividends
Chapter 5, Slide 33
© 2010 McGraw-Hill Ryerson Limited
Consolidation of 80%-Owned Subsidiary
LO 6
Chapter 5, Slide 34
© 2010 McGraw-Hill Ryerson Limited
Consolidation under equity and cost methods
LO 1, 6
Chapter 5, Slide 35
© 2010 McGraw-Hill Ryerson Limited
Consolidation in Subsequent Years

If the parent has used the cost method to record
the subsidiary, it is necessary to calculate
opening consolidated retained earnings




Reflecting the cumulative increase or decrease in
subsidiary’s retained earnings since acquisition
Reflecting cumulative consolidation adjustments to
that point (e.g. acquisition differential amortization)
When the subsidiary is less than 100% owned, it
is also necessary to calculate balance sheet NCI
See Example (Exhibit 5.14) next slide
LO 6
Chapter 5, Slide 36
© 2010 McGraw-Hill Ryerson Limited
Consolidation in Subsequent Years
LO 4, 6
Chapter 5, Slide 37
© 2010 McGraw-Hill Ryerson Limited
Acquisition Differential Assigned to Liabilities



Interest rate changes result in differences
between fair values and carrying values of
liabilities assumed in a business combination.
This difference is similar to a bond premium or
discount that must be amortized over its
remaining life.
The effective interest method of amortization is
required by IAS 39.

LO 3
The text uses straight-line as well as effective interest
method. Only the effective interest method is
permitted in practice.
Chapter 5, Slide 38
© 2010 McGraw-Hill Ryerson Limited
Acquisition Differential Assigned to Liabilities

Example: Subsidiary has outstanding 10% bonds with
face value of $100,000 maturing in 3 years. The market
interest rate is 8%. The fair value of the bonds based on
future cash flows discounted at 8% is $105,154,
reflecting a premium of $5,154 which is amortized as
follows:
LO 3
Chapter 5, Slide 39
© 2010 McGraw-Hill Ryerson Limited
Intercompany receivables and payables

Related companies often have extensive
transactions within the group




Some companies have the vast majority of their
purchases or sales (or both) to a related company
Vertical integration is one of the principal reasons
intercorporate investments are made
All intercompany sales must be eliminated in
consolidation, against the related purchases
All intercompany balances (including receivables
and payables) are eliminated

LO 6
This is discussed in the next several chapters
Chapter 5, Slide 40
© 2010 McGraw-Hill Ryerson Limited
Subsidiary Acquired During the Year

The consolidated financial statements should include
only the subsidiary’s net income from the date of
acquisition


Example: Parent and subsidiary both have year-ends of
December 31, Year 2. Parent acquires 80% of subsidiary on
September 30, Year 2, and therefore reports only the subsidiary’s
net income from October 1 to December 31, Year 2
To increase subsequent year financial statement
comparability, the consolidated financial statement
footnotes should include a pro forma consolidated
income statement prepared as if the subsidiary had been
acquired at the beginning of the year
LO 6
Chapter 5, Slide 41
© 2010 McGraw-Hill Ryerson Limited
Equity Method Recording

Refer to Chapter 2 slides and Chapter 5 for
examples of equity method journal entries that a
parent would record in its books when it uses the
equity method to record
LO 7
Chapter 5, Slide 42
© 2010 McGraw-Hill Ryerson Limited
GAAP for Private Enterprises





Private companies can either consolidate their
subsidiaries or report investments in subsidiaries using
the cost or equity method
All intangible assets and goodwill should be tested for
impairment when circumstances indicate that carrying
amount > FV
Record impairment loss on definite-life intangible assets
when both (i) carrying amount > recoverable amount and
(ii) carrying amount > FV
Record impairment losses on indefinite-life intangibles
and goodwill when carrying amount > FV
Impairment losses cannot be reversed
LO 6
Chapter 5, Slide 43
© 2010 McGraw-Hill Ryerson Limited