FA4 Class notes
Barbara Wyntjes, B.Sc., CGA.
Module 4: Consolidation subsequent to acquisition:
Part 1:
Three methods an investor can use to REPORT its investment in an investee:
• At each balance sheet date, the investor must decide how to present the investment on
its financial statements, according to the level of influence that the parent has over the
investee.
• If the investor has no significant influence over its investment, this passive type of
investment would be reported using the fair value method (or cost method if qualify
for differential reporting or no fair value available for AFS).
• If the investor had significant influence, the investment would be reported using the
equity method (one line, ‘the investment account’, on the balance sheet (B/S) and
one line, ‘investment income’, on the income statement (I/S). The impact on the
investor’s net asset position is identical to consolidation.
• If the investor controls the investee (creating a parent-subsidiary relationship), the
investment would be reported using Consolidation (cost or equity method if qualify
for differential reporting).
Parent can use 2 methods to RECORD its investments in a subsidiary:
1. The Cost method: records the initial acquisition at the purchase cost in the investment
account, and dividend payments are treated as revenue when they are declared by the
investee. The investment account is only adjusted for subsequent changes in the parent’s
ownership interest, permanent impairment or if the investee pays a liquidating dividend.
2. The equity method: records the initial purchase at the purchase cost in the investment
account and adjusts it each subsequent year for the parent’s share of the investee’s net
income, dividends and consolidation-type adjustments (purchase discrepancy
amortization, goodwill impairments and unrealized profits on intercompany transactions).
‘One line’ consolidation – parent’s net income and retained earnings equal consolidated
totals because of the adjustment in one line on the parent’s balance sheet (investment
account) and one line on the income statement (investment revenue).
•
•
•
Parent company would use the cost method to record its investments because it is
simple to use and simple for users to understand, the parent’s separate financial
statements report only the results of its operation and financial users may require non
consolidated statements.
Parent company would use the equity method to record its investments because
adjustments for consolidation are recorded in the parent’s books and provides
retained earnings and income figures to be the same as consolidated income and
retained earnings. Thus, it facilities the preparation of consolidated statements each
year.
The following parent’s financial statements account balances differ depending on
which method is used: Investment in subsidiary, retained earnings, dividends income
(used for cost method) and investment income (used for equity method).
1
FA4 Class notes
Barbara Wyntjes, B.Sc., CGA.
Purchase discrepancy amortization and goodwill impairment schedule:
• Each year, the purchase discrepancy must be amortized to reflect the use of the
subsidiary’s assets and liabilities, as if these assets and liabilities had been acquired
directly by the parent.The investment revenue and account is reduced (or increased if
NBV>FMV) by yearly amortization amounts of the purchase discrepancy as the
subsidiary's amortization is based on NBV and thus the FMV is not reflected in
subsidiary's books resulting in subsidiary's amortization expense too low (or too high
if NBV>FMV).The investment revenue and investment account is also reduced by
any goodwill impairment loss.To prepare a purchase discrepancy amortization and
goodwill impairment schedule, all the fair value increments (FVIs) and goodwill at
acquisition are listed in the first column and the total equals purchase discrepancy
amount.
• Second column all FVIs amortization and goodwill impairment loss up to the current
year adjusted to opening consolidated retained earnings, third column all current year
FVIs amortization and goodwill impairment loss adjusted on the consolidated income
statement and fourth column, remaining balances of FVIs and goodwill adjusted on
the consolidated balance sheet.
• Assumptions are made as to the remaining life of the item, the period to maturity, or
when the underlying item will be used by the subsidiary.
• Review Exhibit 4.2-1. Current assets/liabilities = 1 year; Capital assets/Intangibles
with finite life = useful life; Long-term debt = years to maturity;
Goodwill/Intangibles with indefinite life = impairment loss.
• Inventory is normally amortized within 1 year unless the subsidiary uses LIFO then
the Purchase discrepancy FVI may remain for a longer period until the beginning
inventory from acquisition date is used up and then it will be adjusted thru CGS on
the consolidated income statement (see Question 3, December 2005 exam).
• Unamortizable assets (i.e. land) are not subject to amortization and the original fair
value increment (FVI) remains until the asset is sold to an outside party.
• Each year, goodwill and other intangible assets with indefinite useful lives remaining
must be tested for impairment.
• Any resulting impairment loss is recorded in the consolidated income statement.
• The yearly amortization or impairment loss for each item is calculated to determine
the annual adjustment to investment income and the unamortized or unimpaired
balance of each asset or liability at the end of the year. The unamortized or
unimpaired balance of each asset or liability at the end of the year balances is
reported on the consolidated balance sheet.
• NCI is not affected by the purchase discrepancy amortization (NCI is not part of the
purchase transaction so they do not participate in the FVIs of the subsidiary's assets
and liabilities).
2
FA4 Class notes
Barbara Wyntjes, B.Sc., CGA.
Part 2:
How to account for goodwill and other intangible assets:In July 2001, CICA
handbook approved the replacement of Section 3060 with Section 3061 & Section
3062. Section 3062 must be applied by most organizations for fiscal year beginning
on or after January 1, 2002.
• Section 3062 distinguishes between intangible assets, other than goodwill, that have a
defined (or limited) life and those whose useful life is considered to be indefinite.
• The cost of intangible assets with a limited life, other than goodwill, is to be
amortized in a systematic and rational manner similar to other amortizable assets (i.e.
building)
• Section 3062 requires that the estimated useful life and method of amortization be
• Intangibles with indefinite lives and goodwill are subject to an annual impairment test
(no longer amortized).
• Section 3062 has introduced the concept of recording a loss when the fair value of
these assets are less than their carrying value. Impairment test determines the lossIn
December 2002, Section 3063 “Impairment of long-lived assets” was approved. It
addresses measurement, recognition and disclosure issues for assets with finite
limited lives (i.e. applies to tangible assets). The important features of the impairment
test are:
o It is either a one-part or two-part test (intangible assets are only subject to the
first part whereas goodwill is subject to the second part if its carrying
value>fair value).
o The first part of the test compares the carrying value of the asset to its fair
value.
o The fair value of an intangible asset is determined by reference to its expected
value in the market.
o The test is to be conducted annually for each intangible asset (Exception: if
qualify for differential reporting, under certain circumstances qualifying
enterprises may elect to do so only when an event or circumstance occurs that
indicates that the fair value of a reporting unit may be less than its carrying
value).Process to determine if Goodwill is impaired:
• Goodwill derives its value from all aspects of the firm. Thus, in order to determine its
fair value, we have to determine the fair value of the firm.To determine if goodwill is
impaired:
o The fair value of goodwill is calculated in the same manner as goodwill is
calculated in a business combination; purchase price minus fair market value.
(Problem: determining the “purchase price” when there is no offer to purchase
can be difficult but using share value or a business valuator may help).
o Next, the fair market value of the goodwill is compared to its carrying value.
o If fair value is less than carrying value, the difference is reported as a goodwill
impairment loss on the consolidated income statement before extraordinary
items and discontinued operations.
3
FA4 Class notes
Barbara Wyntjes, B.Sc., CGA.
Part 3:
Class example 1:Pa Co. purchased 75% of the outstanding common shares of Son Co. on
January 1, 2002 for $630,000. Son’s common shares were $500,000 and retained
earnings were $300,000 at this time. Son’s assets and liabilities had fair values equal to
book values. On January 1, 2004, Son Co. was valued at $800,000. At this time Son’s
Retained earnings were $290,000. All Son’s assets and liabilities were equal to their fair
value. No new shares have been issued since the acquisition date. No goodwill
impairments have been recorded to date.
Required:
Determine the amount of goodwill impairment to be recognized by Pa Co. on its 2004
consolidated income statement.
January 1, 2002 – acquisition date:
Calculation and allocation of purchase discrepancy:
Cost of 75% of Son
$
Book value of Son:
Common shares
$ 500,000
Retained earnings
300,000
800,000
Pa’s ownership
75%
Purchase discrepancy = goodwill
January 1, 2004
Calculation and allocation of purchase discrepancy:
FMV of Son
FMV of Pa’s 75%
Book value of Son:
Common shares
Retained earnings
Pa’s ownership
Purchase discrepancy = goodwill
$
630,000
600,000
30,000
800,000
600,000
$ 500,000
290,000
790,000
75%
592,500
7,500
Impairment loss = carrying value less fair market value
= $30,000 – $7,500 = $22,500
Goodwill impairment loss of $22,500 should be reported on Pa’s 2004 consolidated
income statement.
Working paper JE: Impairment loss
22,500
Goodwill
22,500
If parent used equity method for recording:
DR Investment income (loss)
22,500
CR Investment in Son
22,500
4
FA4 Class notes
Barbara Wyntjes, B.Sc., CGA.
Part 4:
Consolidated financial statements for the first and subsequent year ends after
acquisition when a parent uses the equity method of recording:
• Consolidated net income will be equal to reported net income on the parent’s separate
entity income statement prepared under the equity method.
• Consolidated retained earnings will be equal to retained earnings on the parent’s own
separate entity balance sheet prepared under the equity method.
• When preparing consolidated financial statements, first determine what the final
account balances should be on the consolidated financial statement.
• Consolidated financial statements should be a straight add of the financial statements
of the parent and subsidiary plus or minus the consolidation adjustments.
Approach for preparing consolidated financial statements:
• Prepare schedules in the following order to determine the consolidation adjustments:
• Calculation and allocation of purchase discrepancy
• Purchase discrepancy amortization and goodwill impairment schedule
• Intercompany sales, receivables and payables
• Intercompany profits, gains and losses
• Calculation of the noncontrolling interest
• Prepare consolidated financial statements using the schedules previously prepared.
• Intercompany payables or receivables are not reported, as they do not represent an
obligation outside the economic entity (seen by the consolidated entity as inter-branch
transfers). Also offsetting accounts need to be removed to avoid double counting and
distorting the financial ratios. Since there is no economic effect (net assets are not
changed), the eliminations of these items have no impact on retained earnings, NCI or
shareholders’ equity.
Working paper approach when a parent uses the equity method of recording:
• The working paper approach when the equity method has been used requires that you
make the following entries:
1. Remove the subsidiary’s current-year equity-based net income and dividends,
reducing the investment account to its balance at the beginning of the year.
2. Eliminate the subsidiary’s beginning of the year retained earnings and common
shares, set up the opening balance of the NCI, and reverse the balance of the
investment account. At the same time, record the total purchase discrepancy
amortization and impairment losses for the current year (including write-offs to
cost of goods sold and interest expense) and set up the unamortized and
unimpaired balances of the FVIs and unimpaired goodwill at the end of the year
according to the purchase discrepancy amortization and impairment schedule.3.
Allocate to the NCI its share of the subsidiary’s separate entity current-year net
income. Reduce the NCI by its percentage of the subsidiary’s current-year
dividends.
4. Eliminate any intercompany sales, payables, receivables, profits, gains and
losses.
5
FA4 Class notes
Barbara Wyntjes, B.Sc., CGA.
Part 5:
Prepare consolidated financial statements for the first and subsequent year after
acquisition when a parent uses the cost method of recording:
• Final balances on the consolidated statements will be exactly the same regardless of
whether the cost method or equity method was used in preparing the parent’s separate
entity statements.
• Since the starting position is different, the consolidation adjustments must be different
between the cost method and equity method in order to end at the same consolidated
statements.
Working paper approach under cost method:
• Initial adjusting entries on the working paper are:
1. Adjust the parent’s investment account and retained earnings at the beginning
of the year to the balances they would have been if parent used the equity method.
2. Replace dividends revenue from the subsidiary for the current year with the
equity method income. Difference is reflected in an entry to the investment
account.
Steps to prepare consolidated financial statements when the cost method was used
in the parent’s general ledger:
•
•
•
•
•
Prepare schedules to convert the parent’s records from the cost method to the equity
method. In addition to those prepared when the equity method is used, calculate the
consolidated net income and consolidated opening retained earnings.
Perform the same procedures as when the equity method of recording has been used,
with some differences.
Note: Three (3) main differences between cost and equity method: When the parent
uses the cost method for recording, you need to calculate consolidated net income,
calculate consolidated retained earnings and prepare adjusting entries before
eliminating entries.
Under the cost method, consolidation-type adjustments are recorded on a
consolidated worksheet and are NEVER recorded in the parent’s separate entity
books.
Net income represents results for one reporting period. When calculating consolidated
net income, only make adjustments applicable to the reporting period.When
calculating consolidated retained earnings, include the cumulative effect of all
consolidation adjustments made from the acquisition date to the end of the reporting
period. NCI on the income statement represents the NCI’s share of the subsidiary’s
net income for one reporting period. When calculating NCI on the income statement,
only include adjustments applicable to the reporting period.
6
FA4 Class notes
•
Barbara Wyntjes, B.Sc., CGA.
NCI on the balance sheet represents NCI’s share of the subsidiary’s shareholders’
equity at the reporting date. When calculating NCI, include the cumulative effect of
all adjustments made to the end of the reporting period.
Direct approach:The direct approach requires the following:
o Replace the investment income account with 100% of the subsidiary’s
revenue and expenses adjusted for the current year’s purchase discrepancy
amortizations and impairment losses.
o Eliminate any intercompany payables or receivables.
o The investment account is replaced with goodwill and the subsidiary’s assets
and liabilities, adjusted for purchase discrepancy amortization and impairment
loss.
• Add NBV of parent and subsidiary plus or minus FVIs and consolidation adjustments
• The NCI’s portion of the subsidiary’s separate entity net income and net assets will
have to be deducted on the income statement and included on the balance sheet
between liabilities and shareholders’ equity.
NOTE the starting point when adding line by line the separate legal financial statements of the
parent and subsidiary. Both are at book value and since legally they are outsiders to each other,
they must report gains, losses, profits, revenues, expenses, payables, receivables, sales and
purchases between them. This is why we have to adjust:
1: FVIs as if legal title transferred at acquisition and thus the assets and liabilities of the
subsidiary would have been recorded in the books at FMV. Then amortization would have
been based on FMV, goodwill would have been recorded and the balances would show up on
the subsidiary’s balance sheet.
2: For all intercompany transactions.
Part 6:
Class example 2:
On January 1, 2001, Pal Ltd. purchased 80% of the outstanding shares of Son Company
for $1,000,000 in cash. On the date of the purchase, Son’s balance sheet and fair values
were as follows:
SON COMPANY
Balance Sheet
At January 1, 2001
Book value
Fair value
Assets
Cash
$
40,000
$ 40,000
Accounts receivable
100,000
95,000
Inventory
180,000
200,000
Equipment — net
500,000
450,000
Land
300,000
450,000
$ 1,120,000
7
FA4 Class notes
Liabilities
Accounts payable
Bonds payable
Shareholders’ equity
Common shares
Retained earnings
Barbara Wyntjes, B.Sc., CGA.
$
110,000
360,000
594,000
115,000
360,000
450,000
200,000
650,000
$ 1,120,000
Son has a new patent that is not recorded in its books but has a fair value of $250,000.
The patent rights extend for another 20 years. The equipment in Son’s books has an
expected remaining useful life of 10 years. Due to economic changes the annual goodwill
impairment tests resulted in a $9,600 loss in 2001 and 2002.
At December 31, 2002, Son owed Pal $80,000 in a non-interest bearing current note.
During 2002, Pal paid $200,000 in dividends and Son paid $100,000 in dividends.
The income statements and balance sheets for both companies for the year ended 2002
are as follows:
Balance Sheets
At December 31, 2002
Pal Ltd.
Son Company
Assets
Cash
$
50,000
$
35,000
Accounts receivable
200,000
40,000
Notes receivable
120,000
Inventory
900,000
150,000
Land
1,000,000
900,000
Equipment
3,500,000
490,000
Investment in Son (cost basis)
1,000,000
—
$ 6,770,000
$ 1,615,000
Liabilities
Accounts payable
$
70,000
$ 150,000
Notes payable
80,000
Bonds payable
200,000
360,000
270,000
590,000
Shareholders’ equity
Common shares
Retained earnings
2,000,000
4,500,000
6,500,000
$ 6,770,000
450,000
575,000
1,025,000
$ 1,615,000
8
FA4 Class notes
Barbara Wyntjes, B.Sc., CGA.
Income Statements
For the year ended December 31, 2002
Sales
Cost of goods sold
Amortization expense
Administration expense
Other expenses
Investment income (100,000 x 80%)
Net income before taxes
Income tax
Net income
Pal Ltd.
$ 8,000,000
5,500,000
2,500,000
Son
Company
$ 5,000,000
2,900,000
2,100,000
300,000
400,000
600,000
1,300,000
110,000
400,000
910,000
1,420,000
80,000
—
1,280,000
576,000
$ 704,000
680,000
306,000
374,000
$
Required:
a. Calculate the purchase discrepancy amortization schedule for 2001 and 2002.
b. Calculate the consolidated net income for 2002, and indicate the non-controlling
interest claim on Son’s 2002 income.
c. Calculate the consolidated retained earnings at January 1, 2002.
d. Prepare the consolidated financial statements (balance sheet and statement of income
and retained earnings) for Pal at December 31, 2002, using the direct method.
e. Prepare the adjusting and eliminating journal entries for 2002.
Class example 2 Solution:
a) Calculation and allocation of purchase discrepancy:
Cost of 80% of Son
$
Book value of Son:
Common shares
$ 450,000
Retained earnings
200,000
650,000
80%
Purchase discrepancy
Allocated:
(FV – BV) × %
Accounts receivable – 5,000 × 80%
– 4,000
Inventory
20,000 × 80%
16,000
Equipment
–50,000 × 80%
–40,000
Land
150,000 x 80%
120,000
Patent rights
250,000 × 80%
200,000
Accounts payable
-5,000 × 80%
–4,000
Balance — goodwill
1,000,000
520,000
480,000
288,000
$ 192,000
9
FA4 Class notes
Barbara Wyntjes, B.Sc., CGA.
Calculation of noncontrolling interest
Shareholders’ equity, Son
Noncontrolling interest’s ownership
Noncontrolling interest
$ 650,000
20%
$ 130,000
Purchase discrepancy amortization and impairment schedule:
Balance at
Amortization/ Amortization/
Acquisition
Impairment Impairment
Jan. 1, 2001
2001
2002
Accounts receivable
–4,000
–4,000
—
Inventory
16,000
16,000
—
Equipment (10 years)
–40,000
–4,000
–4,000
Land
120,000
—
—
Patent rights (20 years)
200,000
10,000
10,000
Accounts payable
–4,000
–4,000
—
Goodwill
192,000
9,600
9,600
480,000
23,600
15,600
* $32,000: CV in excess over FV (Online lecture – said opposite)
Remaining
at
Dec. 31, 2002
—
—
–32,000*
120,000
180,000
—
172,800
440,800
b) Calculation of consolidated net income — 2002
Pal’s net income — cost method
Less: Dividend income from Son ($100,000 × 80%)
Pal’s net income, own operations
Son net income
$ 374,000
Pal’s ownership
80%
299,200
Less: Purchase discrepancy amortization/impairment
15,600
Pal’s net income — equity method
$ 704,000
80,000
624,000
Noncontrolling interest ($374,000 × 20%)
$ 74,800b
283,600g
$ 907,600a
c) Calculation of consolidated retained earnings at January 1, 2002
Pal’s R/E at January 1, 2002
(4,500,000 – 704,000 + 200,000)
Son’s R/E at December 31, 2001
(575,000 – 374,000 + 100,000)
Son’s R/E at January 1, 2001
Increase since acquisition
Pal’s ownership
Less: Purchase discrepancy amortization/impairment
to the end of 2001
Consolidated R/E at January 1, 2002
$3,996,000
$ 301,000h
(200,000)
101,000
80%
80,800
23,600
57,200f
$4,053,200c
10
FA4 Class notes
Barbara Wyntjes, B.Sc., CGA.
Part 7:
Calculation of NCI at December 31, 2002
Son’s common shares at December 31, 2002
Son’s retained earnings at December 31, 2002
$ 450,000
575,000
NCI
$1,025,000
20%
$ 205,000e
d)
PAL CORPORATION
Consolidated Balance Sheet
At December 31, 2002
Cash (50,000 + 35,000)
Accounts receivable (200,000 + 40,000)
Note receivable (120,000 + 0 – 80,000)
Inventory (900,000 + 150,000)
Land (1,000,000 + 900,000 +120,000)
Equipment (3,500,000 + 490,000 –32,000)
Patent rights
Goodwill
$
85,000
240,000
40,000
1,050,000
2,020,000
3,958,000
180,000
172,800
$7,745,800
Accounts payable (70,000 + 150,000)
Note payable (0 + 80,000 – 80 000)
Bond payable (200,000 + 360,000)
Noncontrolling interest
Common shares
Retained earnings (4,053,200c + 907,600a – 200,000)
$ 220,000
—
560,000
205,000e
2,000,000
4,760,800d
$7,745,800
11
FA4 Class notes
Barbara Wyntjes, B.Sc., CGA.
Consolidated Statement of Income and Retained Earnings
For the year ended December 31, 2002
Sales (8,000,000 + 5,000,000)
COGS (5,500,000 + 2,900,000)
$13,000,000
8,400,000
4,600,000
406,000
800,000
10,000
1,510,000
2,726,000
9,600
Amortization (300,000 + 110,000 – 4,000)
Administration (400,000 + 400,000)
Patent amortization
Other expenses (600,000 + 910,000)
Loss due to goodwill impairment
Net income before tax
Less: Income tax (576,000 + 306,000)
Net income — entity
Less: Noncontrolling interest (374,000 x 20%)
Net income
1,864,400
882,000
982,400
74,800b
907,600a
Consolidated retained earnings at January 1
Less: Dividends declared
4,053,200c
200,000
Consolidated retained earnings at December 31, 2002
$4,760,800d
e) Adjusting entries 2002:
a. Investment in Son
Retained earnings, Jan. 1’02
57,200f
57,200
To adjust the investment account and opening retained earnings of Pal to the equity
basis at Dec. 31, 2001 (See calculations of cons. opening retained earnings for
amounts). Recall not recorded in book so must make this adjustment.
b. Dividend income
Investment in Son
Investment income
80,000
203,600
283,600g
To reverse dividends income from Son recorded by Pal, and record equity basis net
investment income (see calculations of cons. NI for amounts).
12
FA4 Class notes
Barbara Wyntjes, B.Sc., CGA.
Eliminating entries for 2002:
1. Investment income
283,600
Investment in Son
203,600
Dividend income
80,000
To eliminate investment income and Pal’s percentage of Son’s dividends against the
investment account. (Note: reverse of b. adjusting JE)
2. Common shares – Son’s
450,000
Retained earnings, Jan. 1’02 – Son’s
301,000h
Purchase discrepancy (480,000-23,600)
456,400
Investment in Son (1,000,000 + 57,200)
1,057,200
Noncontrolling interest – B/S[(450,000 + 301,000)20%]
150,200
To eliminate Son’s beginning of the year common shares and retained earnings against the
start of the year investment account, and set up purchase discrepancy and
noncontrolling at the beginning of the year.
3. Patent
180,000
Goodwill
172,800
Land
120,000
Patent amortization
Goodwill impairment
10,000
9,600
Equipment
32,000
Amortization exp (equip)
4,000
Purchase discrepancy
456,400
To allocate purchase discrepancy at the beginning of the year, record current year
amortization expense and impairment loss, and set up unamortized purchase
discrepancy and unimpairment balances at the end of 2002.
4. Noncontrolling interest – I/S
74,800b
Noncontrolling interest – B/S
74,800b
To allocate noncontrolling share of Son’s 2002 net income.
13
FA4 Class notes
Barbara Wyntjes, B.Sc., CGA.
5. Noncontrolling interest - B/S
20,000
Dividends – Son.
20,000
To reverse noncontrolling percentage of dividends declared by Son (100,000 x 20%).
6. Note payable
80,000
Note receivable
80,000
To eliminate intercompany receivable/payable.
Note: NCI – BS = 150,200 + 74,800 – 20,000 = 205,000
THE END
14