Chapter 1: The Equity Method of Accounting for Investments, Chapter 2: Consolidation of Financial Information, Ch. 3 Consolidations - Subsequent to Acquisition, LS Ch. 1, LS Ch.2

The FASB Accounting Standards Codification (ASC) contains the current accounting standards for business combinations under the following topics:

-"Business Combinations" (Topic 805) -"Consolidation" (Topic 810)

Legal and accounting distinctions divide business combinations into separate categories. Various procedures are utilized in this process according to the following sequence:

-Acquisition method when dissolution takes place. -Acquisition method when separate incorporation is maintained.

Significant differences are evident in combinations in which each company remains a legally incorporated separate entity.

-Consolidation of the financial information is only simulated. -Acquiring company does not physically record the acquired assets and liabilities. -Dissolution does not occur; each company maintains independent record-keeping. -To facilitate the preparation of consolidated financial statements, a worksheet and consolidation entries are employed using data gathered from these separate companies although neither company ever records consolidation worksheet entries in its journals.

Acquisition Method When Dissolution Takes Place The continuing firm prepares a journal entry to record

-Fair value of the consideration transferred to acquire the dissolved firm. -Identified assets acquired and liabilities assumed at their individual fair values.

When one company gains control over another, a business combination is created, and a single set of consolidate financial statements must be prepared. How?

-Parent's and subsidiary's financial data are brought together. -Financial position, results of operations, and cash flows are reported for the combined entity. -Reciprocal accounts and intra-entity transactions are adjusted or eliminated to ensure reported balances represent the single entity.

dividends declared amount

the parent company balance only because the subsidiary's dividends are attributable intra-entity to the parent, not to an outside party

Recording Fair-Value Method Initial investments in equity securities when significant influence and control are not present are:

-Recorded at cost. -Changes in fair values are recognized as income. -Dividends declared on the securities are recognized as income.

Upstream Sales of Inventory—Investee Sales to Investor

-Upstream sales of inventory are reported in the same manner as downstream sales. -Profit recognition is delayed until buyer disposes of the goods. -Investor decreases current equity income to reflect the deferred portion of the intra-entity profit. -The investor's own inventory account contains the deferred gross profit. Recognition of profit is deferred by decreasing the investment account rather than the inventory balance. -When this inventory is eventually consumed or sold to unrelated parties, the deferral is reversed.

What Is to Be Consolidated and When? If separate incorporation is maintained:

Only the financial statement information (on work papers, not the actual records) is consolidated. The consolidation process is carried out at regular intervals whenever financial statements are to be prepared.

Entry A

recognizes the unamortized allocations as of the beginning of the current year associated with the original adjustments to fair value

Equity method accounting requires that

the investor record its share of investee OCI and irregular items traditionally found in net income.

WOTF is a characteristic of the partial equity method of accounting for a parent company's investment in a subsidiary company?

the parent company accrues income as reported by the subsidiary

Initial value method

the parent recognizes income from its share of any subsidiary dividends when declared

Partial equity method

the parent recognizes the reported income accruing from the subsidiary; subsidiary dividends declared reduce the investment balance; no other equity adjustments (amortization or deferral of unrealized gains) are recorded

Upstream Sales of Inventory—Investee Sales to Investor Journal Entries Suppose the investee sells merchandise costing $40,000 to the investor for $60,000, and at year's end, the investor still retains $15,000 of the goods. The investee reports net income of $120,000 for the year. The investor records a journal entry to reflect the basic accrual of the investee's earnings. A second entry is required of the investor at year-end. Income accrual is reduced, and the investor defers its portion of the intra-entity gross profit. *Intra-Entity Gross Profit Deferral JE's*

(Dr.) Equity in Investee Income -> 2,000 (Cr.) Investment in Minor Company -> 2,000 To defer recognition of intra-entity gross profit until inventory is used or sold to unrelated parties.

The Reporting of Investments in Corporate Equity Securities GAAP recognizes four methods to report investments in other companies:

-Fair-value method -Cost method for equity securities without readily determinable fair values -Consolidation of financial statements -Equity method The method selected depends upon the degree of influence the investor (stockholder) has over the investee

What if the consideration transferred does NOT equal the fair value of the assets acquired?

-If the consideration transferred exceeds the net amount of the assets acquired and liabilities assumed, the difference is attributed to the asset goodwill by the acquiring company. -If the fair value of the assets acquired and liabilities assumed exceeds the consideration transferred, a "gain on bargain purchase" is recognized by the acquiring business.

Acquisition-Date Fair-Value Allocations—Additional Issues

-Preexisting goodwill recorded in the acquired company's accounts is ignored in the acquisition-date fair value. Goodwill is recognized only if excess remains after recognizing fair values of net identified assets. -Acquired IPR&D (acquired businesses to in-process research and development) is measured at acquisition-date fair value, recognized as an asset, and tested for impairment. It is not amortized until its useful life is determined to be no longer indefinite.

At the acquisition date, each investment accounting method (equity, initial value, and partial equity) begins:

with an identical value recorded in an investment account

In conjunction with combining a subsidiary's assets and liabilities with those of the parent company, the investment in subsidiary account is brought to a ________ balance as part of the consolidation process.

zero

Upstream Sales of Inventory—Investee Sales to Investor Journal Entries Suppose the investee sells merchandise costing $40,000 to the investor for $60,000, and at year's end, the investor still retains $15,000 of the goods. The investee reports net income of $120,000 for the year. The investor records a journal entry to reflect the basic accrual of the investee's earnings. *Income Accrual JE's*

(Dr.) Investment in Minor Company -> 48,000 (Cr.) Equity in Investee Income- > 48,000 To accure income from 40% owned investee ($120,000 x 40%)

*Type of Combination*: Statutory merger though capital stock acquisition *Action of Acquiring Company*: *Action of Acquired Company*:

*Action of Acquiring Company*: Acquires all stock and then transfers assets and liabilities to its own books. *Action of Acquired Company*: Dissolves as a separate corporation, often remaining as a division of the acquiring comapny.

*Type of Combination*: Acquisition of more than 50 percent of the voting stock. *Action of Acquiring Company*: *Action of Acquired Company*:

*Action of Acquiring Company*: Acquires stock that is recorded as an investment; controls decision making of the acquired company. *Action of Acquired Company*: Remains in existence as a legal corporation, although now a subsidiary of the acquering company.

*Type of Combination*: Control though ownership of variable interests. Risks and rewards often flow to a sponsoring firm that may or may not hold equity shares. *Action of Acquiring Company*: *Action of Acquired Company*:

*Action of Acquiring Company*: Establishes contractual control over a variable interest entity to engage in a specific activity. *Action of Acquired Company*: Remains in existence as a separate legal entity - often a trust or partnership

*Type of Combination*: Statutory consolidation through capital stock or asset acquisition. *Action of Acquiring Company*: *Action of Acquired Company*:

*Action of Acquiring Company*: Newly created entity receives assets or capital stock of original companies. *Action of Acquired Company*: Original companies may dissolve while remaining as separate divisions of newly created companies.

Fair-Value Method andImpairment Assessment GAAP allows for two fair value assessments that may affect cost method amounts reported on the financial statements:

1.Periodic assessment for impairment to determine if the fair value of the investment is less than its carrying amount. 2.Recognition of "observable price changes in orderly transactions for the identical or a similar investment of the same issuer" as unrealized holding gains (or losses).

Why consolidate financial information when two or more companies combine to create a single economic entity? According to FASB ASC (810-10-10-1):

-Consolidated financial statements provide more meaningful information than separate statements. -Consolidated financial statements more fairly present the activities of the consolidated companies. -Consolidated companies may retain their legal identities as separate corporations.

Use the Fair-Value Method when:

-Investor holds a small percentage of equity securities of investee. -Investor cannot significantly affect investee's operations. -Investment is made in anticipation of dividends or market appreciation.

Special procedures are required in accounting for each of the following:

-Reporting a change to the equity method. -Reporting investee income from sources other than continuing operations. -Reporting investee losses. -Reporting the sale of an equity investment.

Downstream Sale

Investor -> Investee

Upstream Sale

Investor <- Investee

As compared to acquisition-date accounting for business combinations, subsequent to an acquisition the parent company must additionally report consolidated:

net income, revenues, and expenses

Trademarks that have an economic life that is seen as extending beyond the foreseeable future and having an indefinite life are:

not amortized but are subject to periodic impairment testing

Because consolidate statements are prepared for the ________ company owners, the __________ equity accounts are not relevant to the business combination and should be ___________ for consolidation purposes.

parent; subsidiary; eliminated

Some parent companies rely on internally designed performance measures (rather than GAAP net income) to evaluate subsidiary management or make resource allocation decisions, in which case the __________ _________ method may be sufficient for decision making.

partial equity

When a depreciable asset acquired in a business combination has an acquisition-date book value in excess of its fair value, the excess will be allocated over time as a __________ to consolidated depreciation expense.

reduction

acquisition method

required to account for a business combination. It embraces the fair value in measuring the acquirer's interest in the acquired business.

FASB ASC (para. 323-10-35-32)

requires that a loss in value of an investment which is other than a temporary decline shall be recognized.

Revenue amount

revenues of the parent and the subsidiary are added together

Other Comprehensive Income (OCI) is defined as

revenues, expenses, gains, and losses that under GAAP are included in comprehensive income but excluded from net income.

The equity method is often referred to as a

single-line consolidation

Under the initial value method, no recognition is given to the income earned by the

subsidiary

Consolidation accounting is analyzed at the date:

that a combination is created

When an acquired firm's legal status is dissolved in a business combination

the continuing firm owns the former firm's net assets.

cost of goods sold amount

the cost of goods sold of the parent and subsidiary are added together

Three methods available to a parent company in order to maintain its investment in subsidiary account in its internal records

the equity method, the initial value method, and the partial equity method

In the preparation of consolidated financial reports:

the subsidiary's revenue, expense, asset, and liability accounts are added to the parent company balances

The selection of a particular method does not affect the _______ ultimately reported for the combined companies.

totals

The entry to record the fair value of the combination depends on

whether the consideration transferred is equal to, exceeds, or is less than the fair value of the net assets of the firm dissolved.

How Does Consolidation Affect the Accounting Records? If dissolution occurs:

Dissolved company's records are closed out. Surviving company's accounts are adjusted to include appropriate balances of the dissolved company.

Deferral of Intra-Entity Gross Profits in Inventory

Many equity acquisitions establish ties between companies to facilitate the direct purchase and sale of inventory items. Such intra-entity transactions can occur either on a regular basis or sporadically.

*Type of Combination*: Statutory merger through asset acquisition. *Action of Acquiring Company*: *Action of Acquired Company*:

*Action of Acquiring Company*: Acquires assets and often liabilities. *Action of Acquired Company*: Dissolves and goes out of business.

Recorded at cost

-Adjusted to fair value if fair value is determinable. -If fair value not determinable, remains at cost.

Limitations of Equity Method Applicability Regardless of investor's degree of ownership, the equity method is not appropriate if investments demonstrate:

-An agreement exists between investor and investee by which the investor surrenders significant rights as a shareholder. -A concentration of ownership operates the investee without regard for the views of the investor. -The investor attempts but fails to obtain representation on the investee's board of directors. If an entity can exercise control over investee, regardless of ownership level, consolidation is required.

Report a change to the equity method if:

-An investment that was recorded using the cost or fair-value method reaches the point where significant influence is established. -When an investment qualifies for use of the equity method, the investor adds the cost of acquiring additional interest in the investee to the current basis and adopts the equity method of accounting [(FASB ASC (para. 323-10-35-33)]. -This prospective approach avoids the complexity of restating prior period amounts.

In determining whether to recognize an intangible asset in a business combination, two specific criteria are essential. Intangible assets:

-Arise from contractual or other legal rights (most intangibles in business combinations meet the contractual-legal criterion). -Are capable of being sold or otherwise separated from the acquired enterprise.

Criticisms of the Equity Method

-Emphasizing the 20-50 percent of voting stock in determining significant influence versus control. -Allowing off-balance-sheet financing. -Potentially biasing performance ratios.

Reported figures are affected by the accounting methods selected and lead to different book values; for example:

-Inventory costing methods (LIFO and FIFO). -Acceptable depreciation methods (straight-line, units of production).

If part of an equity investment is sold during the period:

-The equity method is applied up to the transaction date. -At the transaction date, the Investment account balance is reduced by the percentage of shares sold. -If significant influence is lost, *NO RETROACTIVE ADJUSTMENT* is recorded if the investor is required to change *FROM* the equity method to the fair-value method. -Note: A change *TO* the equity method is also treated prospectively.

Assets may be undervalued on the investee's books because:

-The fair values (FV) of some assets and liabilities are different from their book values (BV). -The investor may be willing to pay extra because future benefits are expected to accrue from the investment.

ASC (820-10-35-28) identifies three valuation techniques to determine fair value:

-The market approach estimates fair values using other market transactions involving similar assets or liabilities. -The income approach relies on multi-period estimates of future cash flows projected to be generated by an asset. -The cost approach estimates fair values by reference to the current cost of replacing an asset with another of comparable economic utility.

No two business combinations are exactly alike, but they share one or more of the following characteristics that potentially enhance profitability:

-Vertical integration. -Cost savings. -Quick entry for products into markets. -Economies of scale. -More attractive financing opportunities. -Diversification of business risk. -Business expansion. -Increasingly competitive environment.

Items included in AOCI (Accumulated Other Comprehensive Income) on the balance sheet are

-accumulated derivative net gains and losses -foreign currency translation adjustments -certain pension adjustments.

Bargain purchase:

The fair value of the consideration transferred by the acquirer is less than the fair value received in an acquisition, which is considered more relevant for asset valuation than the consideration transferred.

retained earnings amount

consolidated retained earnings as of the beginning of the year plus consolidated net income less consolidated dividends declared

Typically the _________ value of the consideration transferred by the parent will serve as the recorded valuation basis on the parent's books.

fair

AOCI is reported

in stockholders' equity and represents a source of change in investee company net assets that is recognized under the equity method.

Because the investment account is eliminated in consolidation for the initial value method, and the actual subsidiary revenues and expenses are eventually combined, firms:

may avoid the complexity of the equity method unless they need the specific information provided by the equity income measure for internal decision making

The equity method is popular in companies where management ________________ measures each ______________'s profitability using accrual-based income figures.

periodically (i.e. monthly or quarterly); subsidiary

Under the equity method, the acquiring company accrues income when:

the subsidiary earns it

How Does Consolidation Affect the Accounting Records? If separate incorporation is maintained:

Each company continues to retain its own records. Worksheets facilitate the periodic consolidation process without disturbing individual accounting systems.

*goodwill*

Extra payment that cannot be attributed to a specific asset or liability is assigned to the intangible asset

FASB ASC Section 810-10-05, Variable Interest Entities

•Includes entities controlled through special contractual arrangements (not through voting stock interests). •Intended to combat misuse of SPE's (special purpose entities) to keep large amounts of assets and liabilities off the balance sheet known as "off-balance-sheet financing."

As of December 15, 2017

available-for-sale category with fair value changes recorded in other comprehensive income will no longer be available.

Entry I

eliminates the impact of intra-entity subsidiary income accrued by the parent

Entry S

eliminates the subsidiary's stockholders' equity accounts as of the beginning of the current year along with the equivalent book value component within the parent's investment account

Equity method

embraces full accrual accounting in maintaining the investment account and related income over time

Declines in investment value can result due to

-a loss of major customers -changes in economic conditions -loss of a significant patent or other legal right -damage to the company's reputation A temporary drop in the fair value of an investment is simply ignored.

What Is to Be Consolidated and When? If dissolution occurs:

All appropriate account balances are physically consolidated in the financial records of the survivor. Permanent consolidation occurs at the combination date.

Consideration Transferred Is Less Than Net Identified Asset Fair Values

An exception to the general rule of recording business acquisitions at fair value of the consideration transferred occurs in the rare circumstance of a bargain purchase.

The equity method creates:

a parallel between the parent's investment accounts and changes in the underlying equity of the acquired company

A permanent decline in the investee's fair market value is recorded as

an impairment loss and the investment account is reduced to the fair value.

The FASB ASC (810-10-15-8) provides guidance and describes *control* as follows:

The usual condition for a controlling financial interest is ownership of a majority voting interest, and, therefore, as a general rule ownership by one reporting entity, directly or indirectly, of more than 50 percent of the outstanding voting shares of another entity is a condition pointing toward consolidation.

Initial value method frequently reflects ________ basis for income recognition because little time typically elapses between dividend ______________ and _________ distribution.

cash; declaration; cash

Worksheet

provides an organized structure for the consolidation process, a benefit that becomes especially important in consolidating complex combinations

Downstream Sales of Inventory—Investor Sales to Investee Journal Entries If gross profit on an original intra-entity sale is 30 percent of $10,000 in sales, investor profit associated with the sale is $3,000. If 40 percent of investee's stock is held, just $1,200 of the profit is deferred. Current equity income decreases by $1,200 to defer the intra-entity profit and temporarily remove 30 percent of the profit from the investor's books in 2018 until the investee disposes of the inventory in 2019. *Intra-Entity Gross Profit Deferral JE's*

(Dr.) Equity in Investee Income -> 1,200 (Cr.) Investment in Minor Company -> 1,200 To defer gross profit on sale of inventory to Minor Company.

Downstream Sales of Inventory—Investor Sales to Investee Journal Entries If gross profit on an original intra-entity sale is 30 percent of $10,000 in sales, investor profit associated with the sale is $3,000. If 40 percent of investee's stock is held, just $1,200 of the profit is deferred. Current equity income decreases by $1,200 to defer the intra-entity profit and temporarily remove 30 percent of the profit from the investor's books in 2018 until the investee disposes of the inventory in 2019. Reverse the preceding deferral entry to move the profit into the year of sale to outside customers. *Subsequent Recognition of Intra-Entity Gross Profit JE's*

(Dr.) Investment in Minor Comapny -> 1,200 (Cr.) Equity in Investee Income -> 1,200 To recognize income on intra-entity sale that now can be recognized after sales to outsiders.

Three additional categories of costs are incurred in business combinations, regardless of whether dissolution takes place:

-Attorneys, accountants, investment bankers, and other professionals engaged for combination-related services. These service fees are expensed in the period incurred. -An acquiring firm's internal costs (secretarial and management time allocated to the acquisition activity). Such indirect costs are reported as current year expenses, too. -Amounts incurred to register and issue securities in connection with a business combination simply reduce the otherwise determinable fair value of those securities.

Convergence between U.S. and International Accounting Standards

-FASB Project Updates: Business Combinations: Applying the Acquisition Method—Joint Project of the IASB and FASB: October 25, 2007) goal was to develop a standard with a common set of principles and guidance. -ASB International Financial Reporting Standard 3 (IFRS 3) Revised and FASB ASC Topics 805, "Business Combinations," and 810, "Consolidation," effectively converged accounting for business combinations.

Differences may exist between a company's book value and fair value because:

-Fair value is based on multiple factors, including but not limited to profitability, new products, expected dividend payments, projected operating results, and general economic conditions. -Stock prices are based, partially, on the perceived worth of a company's net assets, amounts that often vary from underlying book values. Asset and liability accounts on the balance sheet tend to measure historical costs rather than current value. -Reported figures are affected by the accounting methods selected and lead to different book values -When purchase price exceeds book value of an investment acquired, the difference must be identified. -Assets may be undervalued on the investee's books -Extra payment that cannot be attributed to a specific asset or liability is assigned to the intangible asset *goodwill*.

Consolidation worksheet entries (adjustments and eliminations) are entered on the worksheet only. Steps in the process:

-Prior to constructing a worksheet, the parent prepares a formal allocation of the acquisition-date fair value similar to the equity method procedures. -Acquisition-date financial information for parent (after journal entry for the investment and combination costs) and sub is recorded in the first two columns of the worksheet (sub's prior revenue and expense already closed). -Remove the sub's equity account balances and remove the Investment in Sub balance (Entry S). -Remove the excess payment in the investment account at acquisition date and assign it to the specific accounts indicated by the fair-value allocation schedule (Entry A). -Combine all account balances and extend into the Consolidated Totals column. -Subtract consolidated expenses from revenues to arrive at net income.

Downstream Sales of Inventory— Investor Sales to Investee

-Profit recognition is delayed until buyer disposes of the goods. -Investor decreases current equity income to reflect the deferred portion of the intra-entity profit. -When this inventory is eventually consumed or sold to unrelated parties, the deferral is no longer needed. -The investor should recognize the deferred intra-entity gross profit. Recognition shifts from the year of inventory transfer to the year in which the sale to unrelated customers occurred. -An alternative treatment would be the direct reduction of the investor's inventory balance as a means of accounting for this deferred amount.

A business combination:

-Refers to a transaction or other event in which an acquirer obtains control over one or more businesses. -Is formed by a wide variety of transactions or events with various formats. -Can differ widely in legal form. -Unites two or more enterprises into a single economic entity that requires consolidated financial statements.

Criteria for Utilizingthe Equity Method Significant Influence (FASB ASC Topic 323):

-Representation on the investee's board of directors. -Participation in the investee's policy-making process. -Material intra-entity transactions.Interchange of managerial personnel. -Technological dependency. -Other investee ownership percentages.

Applying the acquisition method involves using fair value to recognize and measure:

-The consideration transferred for the acquired business and any noncontrolling interest. -Separately identified assets acquired and liabilities assumed. -Goodwill, or a gain from a bargain purchase.

Equity Method Accounting for Decreases in an Investment

-The investor decreases its investment account's carrying value for its share of investee cash dividends. When the investee declares a cash dividend, its owners' equity decreases. -The investor shall recognize its share of the earnings or losses of an investee in the periods for which they are reported by the investee in its financial statements.

Equity Method Accounting for Increases in an Investment

-The investor increases the investment account as the investee earns and reports income. The investor uses the accrual method to record investment income—recognizing it in the same time period as the investee earns it. -Upward adjustments in the asset balance are recorded as soon as the investee makes a profit. The investor reduces the investment account if the investee reports a loss.

Investment Reduced to Zero

-When accumulated losses incurred and dividends paid by the investee reduce the investment account to $-0-, no further loss can be accrued. A temporary decline is ignored! -Once the original cost of the investment has been eliminated, no additional losses can accrue to the investor. -Future equity income will be offset by these losses prior to recording equity income in our results.

Use Equity Method when:

•Investor has the ability to exercise significant influence on investee operations (whether applied or not). •Ownership is between 20 percent and 50 percent. Significant influence might be present with much lower ownership percentages. Under the ______________________, investor's share of investee dividends declared are recorded as decreases in the investment account, not income.

Consolidation of Financial Statements

•Required when investor's ownership exceeds 50 percent of an organization's outstanding voting stock. •When a majority of voting stock is held, investor-investee relationship is so closely connected that the two corporations are viewed as a single entity. •One set of financial statements prepared to consolidate all accounts of the parent company and all of its controlled subsidiaries as a single entity.