Advanced Financial Accounting I
ADMS 4520 – Winter 2012 – Patrice Gelinas
Lecture 4 – Consolidation Subsequent to Acquisition Date – Jan 27
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
o 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
- The equity method provides more detailed information to management but the cost
method is easier to apply.
o IAS 28 defines equity method as one under which the investment is initially
recorded at cost and adjusted thereafter for the post-acquisition change in
the investor’s share of net assets and other comprehensive income of the
investee
o 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
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
o 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
- When the investment account for the subsidiary is maintained under the equity
method which reflects all consolidation adjustments, we know the following:
o Parent’s net income equals consolidated net income
o 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.
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
Consolidated Income and Retained Earnings
- Consolidated income consists of:
o Net income of the parent from its own operations
 Excludes dividends and other income from subsidiary
o Plus: net income from subsidiary
o 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
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
o This often resulted in substantial reductions to post-acquisition 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.
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
o Assets are required to be carried at no more than their recoverable amount
o An asset, or a group of similar assets (i.e. a “cash-generating unit”), should be
written down if its carrying amount exceeds the amount to be recovered
through use or sale of the assets
o This write-down is an “impairment loss” to be reported in net income (unless
the asset has previously been reflected at a revalued amount)
- Recoverable amount is the higher of (i) fair value less costs to sell and (ii) value in
use
o If either (i) or (ii) exceeds carrying amount then the asset is not impaired and
the other value need not be determined
o 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
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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
IAS 36 establishes different rules and procedures for impairment testing for each of
the following types of intangible assets:
o Intangible assets with definite useful lives
o Intangible assets with indefinite useful lives or not yet available for use
o Cash-generating units and goodwill
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:
- External factors:
o An asset’s market value has declined significantly.
o Significant adverse changes in the technological, market, economic, or legal
environment of the entity have occurred.
o A significant increase in market rates of return has occurred that will cause a
reduction to value in use.
o The carrying amount of the net assets of the entity is more than its market
capitalization.
- Internal factors
o There is evidence of obsolescence or physical damage of an asset.
o There have been significant adverse changes in how an asset is used or
expected to be used.
o Evidence has arisen that the economic performance of an asset is, or will be,
worse than expected.
o The carrying amount of the investment in subsidiary in the separate-entity
financial statements exceeds the carrying amount in the consolidated
financial statements of the investee’s net assets, including associated
goodwill.
o The dividend from the subsidiary exceeds the total comprehensive income of
the subsidiary.
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
- 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:
o 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 cashgenerating unit to which it belongs have not changed significantly since the
last recoverable amount calculation; and
o The most recent recoverable amount calculation resulted in a substantial
excess over carrying amount; and
o No changes in events or circumstances indicate that the current recoverable
amount would be less than the asset’s carrying value
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
o Management often monitors the entity’s operations by cash-generating 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 cashgenerating unit that will benefit from the goodwill
o 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
- Goodwill is allocated to cash-generating units as follows:
o The total value of the subsidiary is allocated to each cash-generating unit
o The FV of the subsidiary’s individual net assets is also allocated to each cashgenerating unit
o For each cash-generating unit, the allocated value is compared with the fair
value of the unit’s identifiable net assets
o The difference = goodwill of the cash-generating unit
o Sum of each cash-generating unit’s goodwill = total acquisition goodwill of
the subsidiary
- 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 cash-generating unit is compared to its
carrying amount, including goodwill. If recoverable amount > carrying amount then
no goodwill impairment
o 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:
o First, to reduce the carrying amount of any goodwill allocated to cashgenerating unit, and
o Second, to the other assets of the unit pro rata based on the carrying amount
of each
 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
o The most recent previously calculated recoverable amount of a cashgenerating unit can be used if there are clear indications no impairment has
occurred, such as:
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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 cashgenerating 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
Reversing and Impairment Loss
- Impairment losses on intangible assets other than goodwill can be reversed only to
the extent of the pre-loss carrying amount of the intangible asset
o In the first step, the entity assesses whether there are any indications that
the impairment loss either decreased or no longer exists
o If decrease is indicated in the first step, in the second step the recoverable
amount is determined
o 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
o Report reversal in net income
o Allocate reversal to the assets of the cash-generating unit pro rata based on
carrying amounts
Disclosure
- Extensive disclosure requirements are required for impairment of assets:
o 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
o 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
o 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
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
o 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
o These dividends are eliminated on consolidation
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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.
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.
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)
o Consolidated net income, and the consolidated balance sheet accounts, are
the same regardless of whether the parent used equity or cost method
o Dividends on the consolidated statement of retained earnings are the
dividends of the parent
o Consolidated retained earnings reflect the cumulative effect of all
adjustments to that time
o 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
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
- 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 noncontrolling shareholders.
- 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.
o Consolidated net income is attributed to the controlling shareholders and
non-controlling interest
o 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
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
o Reflecting the cumulative increase or decrease in subsidiary’s retained
earnings since acquisition
o 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
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.
o The text uses straight-line as well as effective interest method. Only the
effective interest method is permitted in practice.
Intercompany Receivables and Payables
- Related companies often have extensive transactions within the group
o Some companies have the vast majority of their purchases or sales (or both)
to a related company
o 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
o This is discussed in the next several chapters
Subsidiary Acquired During the Year
- The consolidated financial statements should include only the subsidiary’s net
income from the date of acquisition
- 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
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