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Prepared by
Peter Secord
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© 2003 McGraw-Hill
Ryerson Limited
Chapter 4
Consolidated Statements
on
Date of Acquisition
Chapter 4
© 2003 McGraw-Hill Ryerson Limited
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Consolidated Statements at Acquisition
• Outline
– Consolidation at acquisition
– Consolidation theories
• Proprietary
• Entity
• Parent company
– Examples
– International view
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Consolidated Statements at Acquisition
• At the time an intercorporate investment is made,
there is generally a difference between the cost of
the investment and the underlying book value
(shareholders’ equity) of the company acquired
• This difference, the purchase discrepancy, must
be allocated to the various assets and liabilities of
the acquired company, with any residual allocated
to goodwill arising on acquisition
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Consolidated Statements at Acquisition
• Whether the acquirer has purchased 100% of the
company or not, the process of allocation of the
purchase discrepancy must be addressed
• We often require a complex series of appraisals
and allocations, in order for both balance sheet
and income statement amounts to be presented
fairly after the acquisition is consummated
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Consolidated Statements at Acquisition
• We must initially compute the aggregate value of
the consideration paid (Handbook s. 1581.22):
– The cost of the purchase to the acquirer should be
determined by the fair value of the consideration given
or the acquirer's share of the fair value of the net assets
or equity interests acquired, whichever is more reliably
measurable, except when the transaction does not
represent the culmination of the earnings process.
– The cost includes the direct costs of the business
combination. Costs of registering and issuing shares
issued should be treated as a capital transaction.
Indirect expenses are expensed when incurred.
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Consolidated Statements at Acquisition
• In accounting for a business combination effected by
issuing shares, the quoted market price of the shares
issued generally is used to estimate the fair value of the
acquired enterprise after recognizing possible effects of
price fluctuations, quantities traded, issue costs, and
similar items. The value of the shares is based on their
market price over a reasonable period before and after the
date the terms of the business combination are agreed to
and announced.
– When the quoted market price of shares issued to effect a
business combination is not representative of their fair value, the
net assets received, including goodwill, and the extent of the
adjustment of the quoted market price of the shares issued, are
assessed to determine the amount to be recorded.
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Consolidated Statements at Acquisition
• We then compare the consideration given up to
the (acquirer’s percent of the) underlying book
value of the company acquired.
• The difference between the cost and underlying
book value, the purchase discrepancy, must be
allocated in order that the fair values at the date of
the business combination are recognized in the
accounts.
• Fair values are recognized at that time, as a new
basis of accountability is established by the terms
of the purchase and the business combination.
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Consolidated Statements at Acquisition
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Consolidated Statements at Acquisition
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Consolidated Statements at Acquisition
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Allocation of the Purchase Price
Example:
On December 31, 2001, the balance sheets of the
Power Company and the Pro Company are as follows:
Cash
Accounts Receivable
Inventories
Plant & Equipment (net)
Total Assets
Current liabilities
Long term liabilities
Common shares
Retained earnings
Total Equities
Power
$ 500
1,500
2,000
2,500
$6,500
$ 700
800
3,300
1,700
$6,500
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Pro
Pro (FV)
$ 800
1,700
1,500
4,000 $4,300
$8,000
$ 400
500 $ 400
2,500
4,600
$8,000
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Allocation of the Purchase Price
• Power Company has 100,000 shares of common stock
outstanding; Pro Company has 45,000 shares.
• On January 1, 2002 Power issued an additional 90,000
shares of common stock in exchange for all the outstanding
shares of Pro.
• All assets and liabilities have book values equal to fair
values, except as noted.
• Market value of the new shares issued was $90 per share.
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Allocation of the Purchase Price
• To prepare consolidated financial statements, we first calculate and
allocate the purchase price discrepancy:
Purchase Price (90,000 shares @ $90)
Less: Book value acquired:
Common shares
2,500
Retained earnings
4,600
7,100 x 100%
Purchase price discrepancy:
Allocated to (amounts in thousands):
Item
(Fair Value - Book Value) (x %)
Plant & Equipment (4,300 - 4,000) x 100%
Long term liabilities (400 - 500) x 100%
Total allocated to Identifiable Net Assets
Remainder: Allocated to Goodwill
$8,100 Dr
Total Allocated
$1,000 Dr
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© 2003 McGraw-Hill Ryerson Limited
7,100 Cr
$1,000 Dr
$ 300 Dr
100 Dr
$ 400 Dr
600 Dr
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Allocation of the Purchase Price
• The basic process of consolidation of financial
statements involves adding together the amounts
recorded on the books of the parent and subsidiary, with
certain adjustments and eliminations
• This allocation of the purchase price discrepancy may
easily be stated as a journal entry, which serves to
eliminate the investment account of the parent against
the shareholders’ equity of the subsidiary, as well as
recording the allocation of the purchase discrepancy
• Further, all significant intercompany balances,
transactions and profits are eliminated in
consolidation.
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Allocation of the Purchase Price
• This entry would have been made by Power to record the investment:
Investment in Pro
8,100
Common Shares
8,100
• The working paper entry required to perform the allocation and
elimination is:
Common Shares - Pro
Retained earnings - Pro
Plant & Equipment
Long Term Liabilities - Discount
Goodwill
Investment in Pro
2,500
4,600
300
100
600
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8,100
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Acquisitions: International View
• In Canada and the United States, Goodwill
arising in a business combination is
recognized as an asset in the consolidated
financial statements, and is subject to
periodic review of the recorded value
• There are many other possible treatments of
the amount we refer to as Goodwill.
• These include asset with amortization, debit
to reserve (equity) accounts, and immediate
write off to expense in the period of
acquisition.
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Acquisitions: International View
The financial statements of Bayer AG, a German
company which reports under International
Accounting Standards, included the following note
Intangible assets
– Goodwill,including that resulting from capital
consolidation, is capitalized in accordance with
IAS 22 and amortized on a straight-line basis over
a maximum estimated useful life of 20 years.The
value of goodwill is reassessed regularly and
written down if necessary.
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Acquisitions: International View
Heineken of the Netherlands included this note on
newly acquired companies; accounting policies
employed are very different from those used in Canada
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Push Down Accounting
• The practice of push down accounting may
be used in Canada, if the parent company
owns 90% or more of the subsidiary
• The amounts to be presented on the
consolidated financial statements are unlikely
to be different when push down accounting is
used, as the use of push down accounting
does not change the fair values to be
presented in the financial statements - it
causes them to be recorded in the books of
account, not just on the working papers.
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Conceptual Alternatives
• The acquisition of less than 100% of the
shares of a subsidiary company introduces the
possibility of a variety of conceptual
approaches to consolidation which do not arise
with a 100% acquisition
• The most important of these approaches are
– The Parent Company approach
– The Entity approach
– The Proprietary Approach
• Parent Company approach is GAAP in Canada
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The Parent Company Approach
• Under the Parent Company approach, the fair
values of the assets acquired and liabilities
assumed in the consolidation are adopted for
the consolidated statements, but only to the
extent of the proportionate interest acquired
• Accordingly, the value of assets acquired and
liabilities assumed is a hybid: book value on
the subsidiary’s books plus the parent’s share
of the fair value increment
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The Parent Company Approach
• The generally accepted "parent company"
approach requires that fair values be recognized
only to the extent of the proportion confirmed by
the purchase. That is, with a 90% purchase of a
subsidiary, full book value is recorded for each
asset, plus a fair value increment based on 90%
of the difference between fair and book values.
• Consolidated amounts are the sum of the:
• Book value of Parent Company's Net Assets
• Book value of Subsidiary Company Net Assets, and
• Excess of fair value over book value of Sub assets,
for the percentage acquired only.
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The Parent Company Approach
• The Noncontrolling (Minority) interest is
valued on the basis of the book value
reported by the subsidiary company
• The shares owned by the minority were not a
part of the business combination transaction,
and accordingly have not been revalued as a
part of the business combination process
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The Entity Approach
• Although the Parent Company approach is
GAAP in Canada, the Entity approach is an
important conceptual alternative
• The key distinctions have to do with how the
purchase discrepancy is computed and
allocated, and how minority interest is valued
• Under the entity approach, the cost paid by
the parent in the acquisition is assumed to be
representative of the fair value of the entire
company
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The Entity Approach
• Accordingly, the price per share paid by the
parent is effectively extrapolated to the
shares not acquired, to establish a fair value
for the entire company.
• As a result:
– Assets acquired and liabilities assumed are valued
at their total fair value at the date of acquisition
– Non-controlling interest is valued on the basis of
the market value of the company acquired, not the
underlying book value
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The Proprietary Approach
• Although the parent company approach is
GAAP for virtually all consolidations in
Canada, the proprietary appoach might be
said to have a niche market in Canada
• The proprietary appoach, also known as
proportionate consolidation, is the manner in
which joint ventures are consolidated with the
accounts of the parent company, the venturer
• In the broader framework of consolidations,
this approach is not GAAP, yet is a valid
approach with sound underlying reasoning
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The Proprietary Approach
• The proprietary approach incorporates the
amounts recorded by the subsidiary into the
consolidated financial statements at fair value
at the date of acquisition, but only to the
extent of the proportion acquired
• The basis of the inclusion in this manner is
that the investor shares in the risks and
rewards of ownership in direct proportion to
the shareholding percentage
• With a joint venture, joint control of the
venture makes this treatment appropriate
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The Proprietary Approach
• This approach is not generally accepted in
Canada for subsidiaries, as consolidation
practices are based on the concept of control
– if the parent controls the subsidiary company, then
all the assets and related liabilities are included in
the consolidated statements (and the contribution
of non-controlling interests is acknowledged)
– With the characteristic formal agreement of a joint
venture, the extent of participation only is
consolidated, as this portrays the real economic
value of the relationship
– A joint venture is distinct from a parent - subsidiary
relationship, both conceptually and managerially
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Contingent Consideration
• Generally, the values established in a
business combination are established on a
“once and for ever” basis
• However, what happens when a portion of the
total cost of the acquisition is variable, so the
eventual total cost is not known with certainty
at the date of acquisition of the subsidiary?
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Contingent Consideration
• When the amount of any contingent consideration
can be reasonably estimated at the date of
acquisition and the outcome of the contingency can
be determined beyond reasonable doubt, the
contingent consideration should be recognized at that
date as part of the cost of the purchase.
• When the amount of contingent consideration cannot
be reasonably estimated or the outcome of the
contingency cannot be determined without
reasonable doubt, details of the contingency should
be disclosed. Neither a liability nor outstanding equity
instruments are recognized until the contingency is
resolved and consideration is issued or becomes
issuable.
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Contingent Consideration
Contingent consideration arises in a variety of
circumstances, and leads to adjustments to the
purchase price and it’s allocation, and ultimately
the value of goodwill to be recognized.
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Reverse Takeovers
• A reverse takeover arises when one company
issues so many shares in a business
combination that the control of the group
passes to the company (or new shareholders)
which have received the newly issued shares
– Although this may be generally infrequent in
practice, it is a common way for companies to
obtain a listing on a stock exchange or to take
advantage of existing brand names held by a
smaller company - it rarely happens by accident!!
– The accounting treatment must reflect the
economic substance of the business combination
transaction
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Reverse Takeovers
This reverse takeover is the subject of case 4-5
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International View
• What conceptual approaches to preparation
of consolidated financial statements are seen
in Canada?
• The Handbook is clear that the parent
company approach is to be used:
– The non-controlling interest in the subsidiary's
assets and liabilities should be reflected in terms
of carrying values recorded in the accounting
records of the subsidiary company (s. 1600.15).
• There is rarely, if ever, disclosure of this
aspect of consolidation, as there is no
accounting policy choice permitted.
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International View
• What conceptual approaches to preparation
of consolidated financial statements are used
in other countries?
– Rules and practices vary widely.
– The permitted approaches differ somewhat in the
manner that they are described in the notes to the
financial statements. Although proportionate
consolidation (proprietary theory) is often noted, it
is rare for a company to state unequivocally that
the “entity” approach has been used, rather that
the “parent company” approach.
• The notes to the statements must be studied!!
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International View
• In consolidated statements in Canada, the
minority (non- controlling) interest consists of all
“outside equity” interest in consolidated
subsidiaries. These interests would include
both common and preferred shares.
• Disclosure of aggregate non-controlling interest
is required, as is the allocation of subsidiary
income, but without details.
• Notes to the financial statements may include
further details, but additional disclosure
requirements are not specified in the Handbook.
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International View
• In Britain, it is common to present “capital and
reserves” (shareholders’ equity), then minority
interest, distinguishing between common (equity) and
preferred (non-equity) shares (further detail in notes)
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