McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc. All rights reserved.

4

Consolidation of Wholly Owned Subsidiaries

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Consolidation Procedures

• The starting point for preparing consolidated financial statements is the books of the separate consolidating companies.

• Because the consolidated entity has no books, all amounts in the consolidated financial statements originate on the books of the parent or a subsidiary or in the consolidation workpaper.

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Consolidation Procedures

• The term subsidiary has been defined as “an entity . . . in which another entity known as its parent holds a controlling financial interest.”

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Consolidation Workpapers

• The consolidation 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 amounts that would be reported if all consolidating companies were actually a single company.

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Nature of Eliminating Entries

• Eliminating entries are used in the consolidation workpaper to adjust the totals of the individual account balances of the separate consolidating companies to reflect the amounts that would appear if all the legally separate companies were actually a single company.

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Nature of Eliminating Entries

• Eliminating entries appear only in the consolidating workpapers and do not affect the books of the separate companies.

• Some eliminating entries are required at the end of one period but not at the end of subsequent periods.

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Full Ownership Purchased at Book Value

• The purchase price of $300,000 is equal to the book value of the shares acquired. This ownership situation can be characterized as follows:

• Investment cost $300,000• Book value 1/1/X1 Common stock —Special Foods $200,000• 100% Retained earnings—Special Foods 100,000

$300,000• Peerless’ s share 1.00 (300,000)• Difference between cost and book value $ -0-

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Full Ownership Purchased at Book Value

Peerless records the stock acquisition on its books with the following entry on the date of

combination:

January 1, 20X1

Investment in Special Foods Stock 300,000

Cash 300,000

Record purchase of Special Foods stock.

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Investment Elimination Entry

The only eliminating entry in the workpaper is one needed to eliminate the Investment in Special Foods Stock account and the subsidiary’s stockholders’ equity accounts.

Common Stock—Special Foods 200,000

Retained Earnings 100,000

Inv in Special Foods Stock 300,000

Eliminate investment balance.

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Full Ownership Purchased at More than Book Value

• A company’s stock price is influenced by many factors, including net asset values, enterprise earning power, and general market conditions.

• When one company purchases another, there is no reason to expect that the purchase price necessarily will be equal to the acquired stock’s book value.

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Full Ownership Purchased at More than Book Value

• The process used to prepare the consolidated balance sheet is complicated only slightly when 100 percent of a company’s stock is purchased at a price different from its book value.

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Treatment of a Positive Differential

• There are several reasons that the purchase price of a company’s stock might exceed the stock’s book value:1. Errors or omissions on the books of the

subsidiary.

2. Excess of fair value over the book value of the subsidiary’s net identifiable assets.

3. Existence of goodwill.

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Excess of Fair Value over Book Value of Subsidiary’s Net Identifiable Assets

• The fair value of a company’s assets is an important factor in the overall determination of the company’s purchase price.

• In many cases, the fair value of an acquired company’s net assets exceeds the book value.

• Revaluing the assets and liabilities on the subsidiary’s books generally is the simplest approach if all of the subsidiary’s common stock is acquired.

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Existence of Goodwill

• If a company purchases a subsidiary at a price in excess of the total of the fair values of the subsidiary’s net identifiable assets, the additional amount generally is considered to be a payment for the excess earning power of the acquired company, referred to as goodwill .

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Existence of Goodwill

• In the past, some companies have included in goodwill the portion of the purchase price related to certain identifiable intangible assets.

• This treatment is not acceptable.

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Full Ownership Purchased at Less than Book Value

• Numerous cases of companies with common stock trading in the market at prices less than book value.

• Often the companies are singled out as prime acquisition targets.

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Full Ownership Purchased at Less than Book Value

• Differential may include:• 1. Errors or omissions on the books of the

subsidiary.• 2. Excess of book value over the fair value of the

subsidiary’s net identifiable assets.• 3. Diminution of previously recorded goodwill.• 4. Bargain purchase.

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Bargain Purchase

• The existence of “negative goodwill,” indicating that the subsidiary’s net assets are worth less as a going concern than if they were sold individually.

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Illustration of Treatment of Credit Differential

• Peerless purchases all of Special Foods’ stock for $260,000. The resulting ownership situation is as follows:

Investment cost $260,000Book valueCommon stock—Special Foods $200,000Retained earnings—Special Foods 100,000

$300,000S Peerless’s share 1.00

(300,000)Differential (credit) $

(40,000)

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CONSOLIDATION SUBSEQUENT TO ACQUISITION

• More than a consolidated balance sheet, however, is needed to provide a comprehensive picture of the consolidated entity’s activities following acquisition.

• The approach followed to prepare a complete set of consolidated financial statements subsequent to a business combination is quite similar to that used to prepare a consolidated balance sheet as of the date of combination.

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Consolidated Net Income

• All revenues and expenses of the individual consolidating companies arising from transactions with nonaffiliated companies are included in the consolidated income statement.

• The amount reported as consolidated net income is that part of the total enterprise’s income that is assigned to the parent company’s shareholders.

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Consolidated Net Income

• Consolidated net income is computed by adding the parent’s proportionate share of the income of all subsidiaries, adjusted for any differential write-off or goodwill impairment, to the parent’s income from its own separate operations (parent’s net income less investment income from the subsidiaries under either the cost or equity method).

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Consolidated Retained Earnings

• Consolidated retained earnings must be measured on a basis consistent with that used in determining consolidated net income.

• Consolidated retained earnings is that portion of the consolidated enterprise’s undistributed earnings accruing to the parent company shareholders.

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CONSOLIDATION SUBSEQUENT TO ACQUISITION— 100 PERCENT OWNERSHIP

PURCHASED AT BOOK VALUE

• Each of the consolidated financial statements is prepared as if it is taken from a single set of books that is being used to account for the overall consolidated entity.

• As in the preparation of the consolidated balance sheet, the consolidation process starts with the data recorded on the books of the individual consolidating companies.

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Consolidation Workpaper—Year of Combination

• After all appropriate entries, including year-end adjustments, have been made on the books a consolidation workpaper is prepared.

• Then all amounts that reflect intercorporate transactions or ownership are eliminated in the consolidation process.

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Consolidation Workpaper—Year of Combination

• Book entries affect balances on the books and the amounts that are carried to the consolidation workpaper; workpaper eliminating entries affect only those balances carried to the consolidated financial statements in the period.

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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.

• 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.

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Second and Subsequent Years of Ownership

• An additional check is needed in each period following acquisition to ensure that the beginning balance of consolidated retained earnings shown in the completed workpaper equals the balance reported at the end of the prior period.

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100 PERCENT OWNERSHIP PURCHASED AT MORE THAN BOOK VALUE

• The excess of the purchase price over the book value of the net identifiable assets purchased must be allocated to those assets and liabilities acquired, including any purchased goodwill.

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100 PERCENT OWNERSHIP PURCHASED AT MORE THAN BOOK VALUE

• In consolidation, the purchase differential is assigned to the appropriate asset and liability balances, and consolidated income is adjusted for the amounts expiring during the period by assigning them to the related expense items (e.g., depreciation expense).

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INTERCOMPANY RECEIVABLES AND PAYABLES

• All forms of intercompany receivables and payables need to be eliminated when consolidated financial statements are prepared.

• From a single-company viewpoint, a company cannot owe itself money.

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INTERCOMPANY RECEIVABLES AND PAYABLES

• When consolidated financial statements are prepared, the following elimination entry is needed in the consolidation workpaper:

Accounts Payable 1,000

Accounts Receivable 1,000

Eliminate intercompany receivable/payable.

• If no eliminating entry is made, both the consolidated assets and liabilities are overstated by an equal amount.

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PUSH-DOWN ACCOUNTING

• The term push-down accounting refers to the practice of revaluing the assets and liabilities of a purchased subsidiary directly on that subsidiary’s books at the date of acquisition.

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PUSH-DOWN ACCOUNTING

• Those who favor push-down accounting argue that the change in the subsidiary’s ownership in an acquisition is reason for adopting a new basis of accounting for the subsidiary’s assets and liabilities, and this new basis of accounting should be reflected directly on the subsidiary’s books.

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PUSH-DOWN ACCOUNTING

• SEC Staff Accounting Bulletin No. 54 requires push-down accounting whenever a business combination results in the acquired subsidiary becoming substantially wholly owned.

• The revaluation of assets and liabilities on a subsidiary’s books involves making an entry to debit or credit each asset and liability account to be revalued, with the balancing entry to a revaluation capital account.

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You Will Survive This Chapter !!!

Now this is Advanced Accounting !!!

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc. All rights reserved.

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Consolidation of Wholly Owned Subsidiaries

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