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Prepared by
Peter Secord
Saint Mary’s
University
© 2003 McGraw-Hill
Ryerson Limited
Chapter 5
Consolidated Financial Statements
Subsequent to Acquisition Date:
Equity Method
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Consolidation from the Equity Method
• Outline
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Goodwill and other Intangibles
Goodwill impairment tests
Transitional Provisions
Consolidated income and retained earnings
Consolidation practices subsequent to acquisition
Examples
International View
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Goodwill and other Intangibles
• As discussed in prior chapters, when an
intercorporate investment is made, 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.
• In many cases, a significant proportion of the
purchase price relates to intangible assets,
including goodwill, acquired.
• This amount is recognized in the statements.
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Goodwill and other Intangibles
• The cost of the purchase should be allocated
as follows:
– all assets acquired and liabilities assumed in a
business combination, whether or not recognized
in the financial statements of the acquired
enterprise (except goodwill and future income
taxes recognized by an acquired enterprise before
its acquisition) should be assigned a portion of the
total cost of the purchase based on their fair
values at the date of acquisition; and
– the excess of the cost of the purchase over the net
of the amounts assigned … should be recognized
as an asset referred to as goodwill.
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Goodwill and other Intangibles
• These Handbook provisions include two
important aspects of the process of
accounting for business combinations:
– There must be an examination of the assets
actually owned, including intangibles, with
particular regard to the need for identification and
valuation of unrecorded intangible assets
– The residual amount in a business combination is
allocated to Goodwill, which represents the
unallocated excess of the purchase price over the
identifiable assets acquired
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Goodwill and other Intangibles
• There has been significant debate on the
appropriate accounting treatment for intangible
assets arising in business combinations, in part
because of large variations internationally in the
permissible treatment of these items
• The “playing field” was perceived to be uneven
• In the interest of international harmonization,
and perhaps as a result of extensive “lobbying”
by the business community, recent changes in
the CICA Handbook attempt to resolve the
debate and guide practice
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International View
• There were simultaneous changes in the United
States and Mexico which have the same effect
on accounting practices in those countries
• Concurrently, the pooling of interest approach
(as discussed in Chapter 4) was abolished, and
many changes were introduced to unify (if not
standardize completely) accounting for
intangible assets arising from business
combinations in North America
• Beyond North America, there remains
significant diversity in rules and practices
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Goodwill and other Intangibles
• The implications of these rules are that much
effort must be devoted to the identification of
the many potential assets which make up the
value of a firm and the price paid
– Prior rules allowed essentially all the residual
value, after tangible assets and high profile
intangibles (such as patents) were assigned value,
to be allocated to goodwill
– The new rules appear to require somewhat more
care in the identification and assignment of values
and provide extensive, detailed guidance in this
area
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Goodwill and other Intangibles
• Under the new Handbook provisions (s.1581.48),
an intangible asset should be recognized
apart from goodwill when:
– the asset results from contractual or other legal
rights (regardless of whether those rights are
transferable or separable from the acquired
enterprise or from other rights and obligations); or
– the asset is capable of being separated or divided
from the acquired enterprise and sold, transferred,
licensed, rented, or exchanged (regardless of
whether there is an intent to do so).
– Otherwise it should be included in the amount
recognized as goodwill.
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Goodwill and other Intangibles
• When amounts assigned to intangible assets
are significant, required disclosure includes:
– for intangible assets subject to amortization, the
total amount assigned and the amount assigned to
each major intangible asset class;
– for intangible assets not subject to amortization,
the total amount assigned and the amount
assigned to each major intangible asset class; and
– for goodwill:
• total goodwill and tax deductible amount; and
• amount of goodwill by reportable segment.
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Goodwill and other Intangibles
• Identifiable intangible assets are either
– Of limited life
– Of indefinite (and perhaps infinite) life
• Assets with limited life should be amortized
over the best estimate of the economic life,
and are subject to a periodic review for
impairment of value, under s. 3061, in the
same manner as property, plant and
equipment must be reviewed
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Goodwill and other Intangibles
• Intangible assets not subject to amortization
should be tested for impairment annually or
more frequently if events or changes in
circumstances indicate that the asset might
be impaired.
• The impairment test should consist of a
comparison of the fair value of the intangible
asset with its carrying amount. When the
carrying amount of the intangible asset
exceeds its fair value, an impairment loss
should be recognized in an amount equal to
the excess.
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Goodwill Impairment Tests
• Goodwill is not to be amortized under the new
provisions, so is subject to special tests to
determine if any impairment has occurred
• These impairment tests are carried out at the
level of the “reporting unit”
– The reporting unit is either a segment (s. 1701),
where the components have similar economic
characteristics, or
– A segment component (a business for which
discrete financial information is available and for
which segment management may regularly review
operating results)
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Goodwill Impairment Tests
• A goodwill impairment loss should be
recognized when the carrying amount of the
goodwill of a reporting unit exceeds the fair
value of the goodwill.
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Goodwill Impairment Tests
• A goodwill impairment loss should be
recognized when the carrying amount of the
goodwill of a reporting unit exceeds the fair
value of the goodwill.
• An impairment loss should not be reversed if
the fair value subsequently increases.
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Goodwill Impairment Tests
• A goodwill impairment loss should be
recognized when the carrying amount of the
goodwill of a reporting unit exceeds the fair
value of the goodwill.
• An impairment loss should not be reversed if
the fair value subsequently increases.
• The fair value of goodwill can be measured
only as a residual, not directly, in the same
manner that it was initially computed at the
time of the business combination which gave
rise to recognition
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Goodwill Impairment Tests
• The goodwill impairment test is a two stage
process:
– First, the fair value of a reporting unit should be
compared with its carrying amount, including
goodwill, in order to identify a potential
impairment. When the fair value of a reporting unit
exceeds its carrying amount, goodwill of the
reporting unit is considered not to be impaired and
the second step of the impairment test is
unnecessary.
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Goodwill Impairment Tests
– Second, when the carrying amount of a reporting
unit exceeds its fair value, the fair value of the
reporting unit's goodwill should be compared with
its carrying amount to measure the amount of the
impairment loss, if any.
– The fair value of goodwill is determined in
accordance with the guidance in paragraph
3062.32.
– When the carrying amount of reporting unit
goodwill exceeds the fair value of the goodwill, an
impairment loss should be recognized in an
amount equal to the excess.
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Goodwill Impairment Tests
• The fair value of goodwill is determined in the
same manner as the determination of the
value of goodwill in a business combination.
• An enterprise allocates the fair value of a
reporting unit to all of the assets and liabilities
of the unit, whether or not recognized
separately, as if the reporting unit had been
acquired in a business combination and the
fair value of the reporting unit was the price
paid to acquire the reporting unit.
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Goodwill Impairment Tests
• The excess of total fair value over assigned
amounts is the fair value of goodwill.
• Although amounts are assigned to intangible
assets in this process, additional intangible
assets are not recognized
• This allocation process is performed only for
purposes of testing goodwill for impairment
and does not cause an enterprise to write up
or write down a recognized asset or liability or
to recognize a previously unrecognized asset
as a result of this allocation process.
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International View
There is significant variation internationally in the
determination of the value of intangible assets
and their treatment in the financial statements
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Transitional Provisions
• Goodwill Impairment Test
– In accordance with the transitional provisions
contained in Section 3062 of the CICA Handbook,
an impairment loss recognized during the financial
year in which the new recommendations are
initially applied is recognized as the effect of a
change in accounting policy and charged to
opening retained earnings, without restatement of
prior periods.
– This treatment is consistent with many other
changes in accounting policy arising from changes
in the provisions of the CICA Handbook
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Transitional Provisions
From the annual report, 2001
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Transitional Provisions
From the annual report, 2001
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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: Parent’s share of net income from subsidiary
– Less: Amortization of the purchase discrepancy
• This approach can always be used to
compute the value of consolidated net
income, whether or not an income statement
is to be prepared
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Consolidation from the Equity Method
• At the date of acquisition, the financial
statements (especially the balance sheet)
may be prepared as a “snapshot” at a point in
time
• After acquisition, the consolidated financial
statements must include the accounts of both
the parent and the subsidiary, reported as
one economic entity
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Consolidation from the Equity Method
• When a company buys the shares of another
company, the cost of these shares is recorded in
an “investment account”
• When the intercorporate investment is a
subsidiary, the external financial reporting will
nearly always be through the presentation of
consolidated financial statements
• However, the parent company must continue to
maintain the investment account for the
subsidiary, as the actual companies generally
remain as separate legal entities
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Consolidation from the Equity Method
• The investment account may be maintained by
the cost method, or the equity method (or by any
other systematic method)
– 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
• Virtually all external reporting will include
consolidated financial statements, so we are
concerned with background for consolidation preparation of these statements
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Consolidation from the Equity Method
• This chapter is concerned with the process of
consolidation when the “investment account” has
been maintained using the equity method
• Problem material illustrates this approach
• Use of the equity method by the parent generally
means that the original cost of the investment has
been periodically updated for
– Earnings and dividend distributions of the subsidiary
– Amortization of the purchase price discrepancy, as
applicable
– Other consolidation adjustments (such as unrealized
profits), as covered in later chapters
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Consolidation from the Equity Method
Investment in Subsidiary
Original Cost
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Consolidation from the Equity Method
Investment in Subsidiary
Original Cost
Income earned
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Consolidation from the Equity Method
Investment in Subsidiary
Original Cost
Income earned
Dividends received
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Consolidation from the Equity Method
Investment in Subsidiary
Original Cost
Income earned
Dividends received
P.D. Amortization
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Consolidation from the Equity Method
Investment in Subsidiary
Original Cost
Income earned
Dividends received
P.D. Amortization
Other adjustments*
Balance
*In later chapters
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Consolidations: Direct Approach
• Although working papers are preferred by
some, a direct approach to the preparation of
consolidated financial statements can be
significantly more efficient
• When the investment account for the
subsidiary is maintained under the equity
method:
– Parent’s net income equals consolidated net
income
– Parent’s retained earnings equals consolidated
retained earnings
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Consolidations: Direct Approach
• These true relationships assist greatly in the
preparation of consolidated financial
statements
• For the Consolidated Income Statement:
– The account investment income (under the equity
method) is replaced by the reported revenues and
expenses of the subsidiary, adjusted for the
amortization of the purchase discrepancy (and
intercompany transactions, if any)
– These adjustments are on working papers only
• For Consolidated Retained Earnings
– No adjustments are necessary
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Consolidations: Direct Approach
• For the Consolidated Balance Sheet
– The investment account is replaced by the
individual assets and liabilities of the subsidiary in
the consolidated balance sheet, restated by the
unamortized purchase discrepancy (and
intercompany balances, if any)
– These adjustments are on working papers only,
and are not posted to the general ledger
– Consolidated retained earnings does not have to
be restated, as this amount equals the retained
earnings of the parent company (determined using
the equity method)
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Consolidations: Direct Approach
• The direct approach to the preparation of
statements relies on supporting calculations:
– The calculation and allocation of the purchase
discrepancy
– An amortization schedule for the purchase
discrepancy
• Annual amortization amounts for the income
statement
• Unamortized amounts for the balance sheet
– Careful determination of any intercompany
revenues and expenses, and receivables and
payables (if applicable)
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When control ceases?
• When control ceases, the investment will no
longer be consolidated as a subsidiary
• The “parent” must determine how to account
for the remaining investment, if any:
– If a portfolio investment, using the cost method
– If significant influence exist, using the equity
method
– Discontinued operations, under Handbook s. 3475
• As there is a change in circumstances, the
new method does not lead to retroactive
restatement
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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 purchase
• All intercompany balances (including
receivables and payables) are eliminated
– This is discussed in the next several chapters
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