Advanced Accounting Chapter 4

Subsequent Disposition of Asset

o For consolidation purposes, the gain or loss recognized by the affiliate selling to the external party must be adjusted for the previously unrealized intercompany gain or loss. o While the seller's reported profit on the external sale is based on the affiliate's cost, the gain or loss reported by the consolidated entity is based on the cost of the asset to the consolidated entity, which is the cost incurred by the affiliate that purchased the asset originally from an outside party. o At the time of realization, the full amount of the deferred intercompany profit is added back into the consolidated income computation and assigned to the shareholder interest from which it originally was eliminated. Example 1: P (parent) acquires land for $20K on 1/1/x0 and sells to S (sub) on 7/1/x1 for $35K. An A/R and A/P is established for the sale.

Elimination after the First Year

o In the period in which unrealized profit arises from an intercompany sale, workpaper elimination entries are used in the process to remove the gain or loss recorded by the seller and to adjust the reported amount of the assets back to the price originally paid by the selling affiliate. o Each period thereafter while the assets are held by purchasing affiliate, the reported asset balance and the shareholder claims of the selling affiliate are adjusted to remove the effects of unrealized gain or loss. Income in those subsequent periods is not affected. o In the upstream case, the intercompany profit is recognized by the subsidiary, the parent recognized its proportionate share of the gain, and that amount is included in the parent's beginning R/E in the subsequent years (i.e., Chapter 5) o In the case of a downstream sale, the profit on the intercompany transfer is recognized entirely by the parent and is included in the parent's R/E in subsequent years.

Consolidated R/E

o Portion of the consolidated company's undistributed earnings accruing to the parent company shareholders. o Consolidated R/E at end of period equals the beginning consolidated R/E plus consolidated NI attributable to the controlling interest, less dividends declared by the parent company.

Noncontrolling Interest or Minority Interest:

• The shareholders who own the shares of the subsidiary not held by the parent. • When a subsidiary is less than wholly owned, the general approach to consolidation is the same as Chapters 2-4, but the consolidation procedures must be modified slightly to recognize the noncontrolling interest. • The computation of consolidated NI and R/E must allow for the claim of the noncontrolling interest. • Consolidated assets and liabilities remain unchanged in the presence of noncontrolling shareholders.

Bargain Purchase

• The total FV of the investee company is less than the acquisition-date amounts of the identifiable net assets (i.e., negative goodwill). • Recognized as an ordinary gain in the I/S at acquisition date. [A] Elimination entry: Net assets-various Equity Investment Bargain purchase gain

Deconsolidation of the Subsidiary

• Upon loss of control o The earnings process with respect to that Equity Investment has been completed, and o The parent recognizes a gain or loss on the deconsolidation

Profit Elimination for Upstream Inventory Sales:

• When inventory is resold by the parent to a nonaffiliated during the same period. All the eliminating entries are identical to the downstream case. When not resold in same period, eliminating entries are different from the downstream case only by the apportionment of the unrealized intercompany profit to both the controlling and noncontrolling interest. The elimination of the unrealized intercompany profit must reduce the interest of both ownership groups each period until the profit is confirmed by resale of the inventory to a nonaffiliated party.

3 new consolidation journal entries (correspond to activities of the subsidiary during the period):

• [C] entry relating to the elimination of the changes in the Equity Investment account during the accounting period. • [D] entry to recognize the current-period AAP depreciation and amortization of the AAP in the consolidated income statement. • [I] entry to eliminate intercompany transactions during the period and balances remaining at the end of the period.

Transfers at a Profit or Loss

Companies use many different approaches in setting intercorporate transfer prices. o The sale price to an affiliate is the same as the price to any other customer o Some companies routinely mark-up inventory transferred to affiliates by a certain percentage of cost. Regardless of method used, the elimination process must remove the effects of such sales from the consolidated statements. When intercorporate sales include profits or losses, there are two aspects of the W/P eliminations needed in the period of transfer to prepare consolidated financial statements 1. I/S Focus: o The sales revenue from the intercompany sales and related COGS recorded by the transferring affiliate must be removed. 2. B/S Focus: o Profit or loss on the intercompany sale must be removed so the inventory is reported at the cost of the consolidated entity.

Consolidation W/P - Second and Subsequent Years of Ownership

The consolidation procedures employed at the end of the second and subsequent years are basically the same as those used at the end of the first year. 2. Adjusted trial balance data of the individual companies are used as the starting point each time consolidated statements are prepared because no separate books are kept for the consolidated entity.

Consolidation Subsequent to Acquisition

1. More than a consolidated B/S is needed to provide a comprehensive picture of the consolidated company's activities following acquisition. 2. Approach used is similar to that used to prepare a consolidated balance sheet as of date of acquisition.

Consolidation W/P - Year of Combination

1. Prepared after all appropriate entries, including year-end adjustments, have been made on the books. 2. All amounts that reflect intercorporate transactions or ownership are eliminated in the consolidation process.

Intangible Assets Amortization

B. If intangible assets have an expected economic life, amortization must be taken.

Inventory

Reminder: The eliminations ensure that only the historical cost of the inventory to the consolidated entity is included in the consolidated B/S when the inventory is still on hand and is charge to COGS in the period the inventory is resold to nonaffiliates.

Eliminations

Since you can't own yourself, the investment account must be eliminated [E] • i.e., the subsidiary's S/E accounts must be eliminated because the stock of the subsidiary is held entirely within the consolidated entity and none represents claims by outsiders. 2. Acquisition Accounting Premium [A] • A positive, or debit differential occurs when one company acquires the stock of another company for more than book value.

Required Footnote Disclosures

• The name and a description of the acquiree. • The acquisition date. • The percentage of voting equity interests acquired. • The primary reasons for the business combination and a description of how the acquirer obtained control of the acquiree.

Downstream Sale - Perpetual System

For consolidation purposes, profits recorded on an intercorporate inventory sale are recognized in the period in which the inventory is resold to an unrelated party. Consolidate NI must be based on the realized income of the transferring affiliate. Because intercompany profits from downstream sales are on the books of the parent, consolidated NI and the overall claim of parent company shareholders must be reduced by the full amount of the unrealized profits. When a company sells an inventory item to an affiliate, one of three situations results: 1. The item is resold to a nonaffiliated during the same period. No elimination of intercompany profit is needed because all of the intercompany profit has been realized through resale of the inventory to the external party during the current period (Sales/COGS need adjusting). 2. The item is resold to a nonaffiliated during the next period. Appropriate adjustments are needed to prepare consolidated F/S in the period of the intercompany sale and in each subsequent period until the inventory is sold to a nonaffiliated. 3. The item is held for two or more periods by the purchasing affiliate. Prior to liquidation, an eliminating entry is needed in the consolidation W/P each time consolidated statements are prepared to restate the inventory to its cost.

Intercompany inventory transactions

Inventory transactions are the most common form of intercorporte exchange. o The sale can still occur (and is recognized in the separate accounting records of the affiliated companies). o All revenue and expense from the intercorporate sale must be eliminated fully in preparing the consolidated I/S, and all profits and losses recorded on the transfers are deferred until the items are sold to a nonaffiliated party. o The eliminations ensure that only the pre-intercompany-transaction carrying value of the inventory to the consolidated entity is included in the consolidated balance sheet when the inventory is still on hand and is charged to COGS in the period the inventory is resold to nonaffilliates.

Sale from one Subsidiary to Another:

The eliminating entries are identical to those presented earlier for sales from a subsidiary to its parent o The full amount of any unrealized intercompany profit is eliminated, with the profit elimination allocated proportionately against the ownership interest of the selling subsidiary.

Intercompany Transfers of Land:

Transfer of Land at BV: o No special adjustments or eliminations needed (i.e., no gain or loss is recorded by the seller, both income and assets are stated correctly from a consolidated viewpoint). Transfer of Land at a Gain or Loss: o Land must be reported at its original cost in the consolidated F/S. o The selling entity's gain/loss must be eliminated because the land is still held by the consolidated entity, and no gain or loss may be reported in the consolidated F/S until the land is sold to a party outside the consolidated entity. o Regardless of percentage of ownership, the full amount of any unrealized gain/loss bust be eliminated and excluded from consolidate NI.

Intercompany Sales of Noncurrent Assets

Unrealized Profits and Losses • Profit or loss from selling an item to a related party normally is considered realized at the time of the sale from the selling company's perspective, but it is not considered realized for consolidation purposes until confirmed (i.e., usually through resale to an unrelated party). • Unrealized intercompany profit is the unconfirmed profit from an intercompany transfer.

Intercompany Transfers of Depreciable Assets:

Unrealized intercompany profits on a depreciable or amortizable asset are viewed as being realized over the remaining economic life of the asset as it is used by the purchasing affiliate in generating revenue from unaffiliated parties. o From a consolidated viewpoint, depreciation must be based on the cost of the asset to the consolidated entity. Downstream Sale o As long as the subsidiary continues to hold and depreciate the equipment, consolidation procedures in subsequent years must include: 1. Restating the assets and accumulated depreciation balances. 2. Adjusting depreciation expense for the year. 3. Reducing beginning retained earnings y the amount of the intercompany gain unrealized at the beginning of the year. Upstream Sale o The treatment of unrealized profits is identical to that of downstream sales except that the unrealized profit, and subsequent realization, must be allocated between the controlling and noncontrolling interests (i.e., Chapter 5).

Change in Estimate Life of Asset:

When a change in the estimated life of a depreciable asset occurs at the time of an intercorporate transfer, the treatment is no different than if the change occurred while the asset remained on the books of the transferring affiliate. The new remaining useful life is used as a basis for depreciation both by the purchasing affiliate and for purposed of preparing consolidated F/S.

Upstream Sale - Perpetual System

When an upstream sale of inventory occurs and the inventory is resold by the parent to a nonaffiliated during the same period. • All the eliminating entries are identical to the downstream case. When not resold in same period, eliminating entries are different from the downstream case only by the apportionment of the unrealized intercompany profit to both the controlling and noncontrolling interest (Chapter 5).

Nature of Elimination Entries

1. Appear only in the workpapers and do not affect the books of the separate companies. 2. Companies that are to be consolidated record their transactions during the period without regard to the consolidated entity. 3. Transactions with related parties tend to be recorded in the same manner as those with unrelated parties. 4. Elimination entries are used to increase or decrease the combined totals for individual accounts so that only transactions with external parties are reflected in the consolidated amounts. 5. Some eliminating entries are required at the end of one period but not at the end of subsequent periods. 6. Some other eliminating entries need to be placed in the consolidated workpapers each time consolidation statements are prepared.

Consolidated NI (CH 5)

1. In the absence of transactions between companies included in the consolidation, consolidated NI is equal to: • the parent's income from its own operations, excluding any investment income from consolidated subsidiaries, plus the NI from each of the consolidated subsidiaries adjusted for any AAP amortization. • The income attributable to the subsidiary noncontrolling interest is deducted from consolidated NI on the face of the I/S to arrive at consolidated NI attributable to the controlling interest. o i.e., the income attributable to a noncontrolling interest in a subsidiary is based on a proportionate share of that subsidiary's NI.

Consolidation Subsequent to Acquisition (Ch. 5)

1. Involves the preparation of a complete set of consolidated F/S as discussed in Chapter 3 [C] Equity investment income Consol. NI attributable to NCI Dividends Equity investment Noncontrolling interest

Consolidation R/E

1. Stockholders' Equity section will clearly separate the interests of the two groups of shareholders: • Shareholders of the parent company who have a claim on the net assets of the total consolidated entity by virtue of their ownership of the parent company, and • Noncontrolling shareholders of the subsidiary who only have a claim on the net assets of the subsidiary (called noncontrolling interests or NCI). • Per-share fair values of the parent's interest in the subsidiary and the noncontrolling interest might differ. o The inclusion of a control premium in the per-share fair value of the parent's interest in the subsidiary or, conversely, o The inclusion of a discount for lack of control (i.e., noncontrolling interest discount) in the per-share fair value of the noncontrolling interest.

Consolidated Statements

1. The procedures used in accounting for intercorporate investments were discussed in Chapter 1 (i.e., Equity Method). • These procedures are important for the preparation of consolidation statements because the specific consolidation procedures depend on the way in which the parent accounts for its investment in a subsidiary. • The consolidated statements, however, are the same regardless of the method used by the parent company to account for the investment. 2. Consolidated Statements are GAAP

Consolidated B/S

1. The simplest consolidation situation occurs: • Immediately after the parent-subsidiary relationship is established. • When the subsidiary is wholly-owned by the parent. • When the subsidiary is purchased at BV and the FV of all of the individual accounts of the subsidiary are equal to their respective BV.

Consolidation Workpapers

1. The workpaper provides a mechanism for efficiently combining the accounts of the separate companies involved in the consolidation and for adjusting the combined balances to the amount that would be reported if all the consolidating companies were actually a single company. 2. There is no set of books for the consolidated entity (parent and subsidiary each maintain their own books).

Accounting for Changes in Ownership: 1. Step Acquisitions

• Both of the following occur on the acquisition date: 1. All of the Equity Investments made by the investor in the investee must be revalued, and any gain or loss as a result of the revaluation should be recognized currently in income. 2. Goodwill is measured (this only occurs on the date that the parent obtains control of the investee). • The revaluation gain is recognized by the parent in its income statement during the period in which the controlling interest in the subsidiary is obtained. • Inclusion of Sub's I/S following the acquisition of a controlling interest: o Include the subsidiary's revenues, expenses, gains, and losses only from the date the subsidiary is initially consolidated.

Consolidated NI

• Computation: In the absence of transactions among the consolidating companies, consolidated NI equals the parent's income from its operations, excluding any investment income from subsidiaries, plus the NI from each of the subsidiaries, adjusted for any AAP write-off. • Includes 100% of revenues and expenses regardless of the parent's percentage ownership.

Profit Elimination for Downstream Inventory Sales:

• Consolidated NI must be based on the realized income of the transferring affiliate. • Because intercompany profits from downstream sales are on the books of the parent, consolidated NI and the overall claim of parent company shareholders must be reduced by the full amount of the unrealized profits. CONSOLIDATED NI Parent's NI + Unrealized intercompany profit on prior year inventory sale - Unrealized intercompany profit on current year inventory sale = Parent's Realized Income +Sub's NI = Consolidated NI Income to Noncontrolling Interest Income to Controlling Interest Eliminating Entries: Year 1: Year 2: Sales R/E, Parent (BOY) COGS COGS Inventory

A. Objective of Consolidated Statements

• Consolidated financial statements bring together the operating results and financial position of two or more separate legal entities into a single set of statements for the economic entity as a whole. • The process includes procedures that eliminate all effects of intercorporate ownership and intercompany transactions.

Accounting for Goodwill

• Goodwill is an asset and must meet the conceptual definition of an asset in order to be recognized on the B/S. o Does the parent company control the goodwill asset? o Will the goodwill asset provide future benefits? • The 2nd question must be answered each year. • Definition: an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognized. • Goodwill must be tested annually for impairment and written down if impaired.

Accounting for an Additional Purchase of Stock Subsequent to the Date on Which Control is Achieved

• If the parent subsequently purchases additional shares from the noncontrolling shareholders, o Reduce the noncontrolling interest and o Increase or decrease in APIC for the difference between the BV of the NCI purchased and the cash payment.

Cost of Goods Sold

• Inventory transactions and balances always affect COGS. • 3 questions: o Did the parent and/or subsidiaries have profits in beginning inventory that were the result of transactions with other companies in the affiliated group of companies? o Did the parent and/or subsidiaries engage in intercompany purchases during the period from other companies in the affiliated group of companies? o Did the parent and/or subsidiaries have profits in ending inventory that were the result of transactions with other companies in the affiliated group of companies? • If answered "yes" to Q1 or Q3, need to remove the deferred profit from COGS.

Transfers at Cost

• Merchandise sometimes is sold to related companies at the seller's cost or carrying value. • When an intercorporate sale includes no profit or loss, the balance sheet inventory amounts at the end of the period require no adjustment for consolidation. • An eliminating entry is needed to remove both the revenue from the intercorporate sale and the related COGS recorded by the seller. o Avoids overstating the two accounts o Consolidated NI is not affected

Consolidated Statement of Cash Flows

• Not the sum of the statements of cash flows of the individual companies in the consolidated group. • Prepared from the consolidated income statement and a comparative consolidated balance sheet. 1. Add back the noncash expense relating to the depreciation and amortization of the AAP. 2. In the year of acquisition, a. The net cash paid for an acquisition is recorded in the investing section. b. The changes in working capital accounts (current assets and liabilities) are computed based on amounts excluding the effects of the acquisition.

Sale of the Equity Investment by the Investor

• Sale is treated like the sale of any other asset. • If the parent sells a portion of the subsidiary stock that it owns, but retains control over the subsidiary, the sale is viewed as a transaction among owners and no gain or loss is recognized in the consolidated I/S.

Goodwill Impairment

• Since goodwill has an indefinite life, it cannot be amortized. • Therefore, must test for impairment (at the reporting unit level). o Definition: the condition that exists when the carrying amount of a long-lived asset exceeds its fair value. • Two-step Test (Exhibit 3.6) o Is the FV of the reporting unit < than its carrying value? o If yes, is carrying value of goodwill > implied value of goodwill? o If yes, recognize impairment loss equal to the excess. • Entry if impairment is recognized: Loss on write-down of goodwill Equity Investment • Additional circumstances for impairment test: o A significant adverse change in legal factors or in the business climate o An adverse action or assessment by a regulator o Unanticipated competition o A loss of key personnel o The reporting unit or a significant portion of a reporting unit will be sold. • No need for goodwill valuation if all of the following criteria have been met: o The assets and liabilities that make up the reporting unit have not changed significantly since the most recent FV determination. o The most recent F determination resulted in an amount that exceeded the carrying amount of the reporting unit by a substantial margin. o The likelihood that a current FV determination would be less than the current carrying amount of the reporting unit is remote.

Preparation of Consolidated B/S at date of acquisition

• The same as wholly-owned except the claims of the noncontrolling or minority interest must be included. [E] R/E - Subsidiary BOY C/S - Subsidiary BOY APIC - Subsidiary BOY Equity Investment (% of majority) Noncontrolling interest (% of minority) [A] AAP adjustments Equity investment Noncontrolling interest