hoyle advanced accounting powerpoin

Chapter Two

Consolidation of Financial

Information

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Business Combinations

Most organizations, large and small, hold ownership in other companies.

FASB Accounting Standards Codification (ASC) Business Combinations (Topic 805) and Consolidation (Topic 810) provide guidance using the “acquisition method”.

The acquisition method embraces the fair value measurement for measuring and assessing business activity.

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Business Combinations

Financial statements that represent a parent and its subsidiaries as a SINGLE ENTITY are known as “consolidated” financial statements.

Ownership can exist through a majority voting interest or with a lesser percentage of ownership through governance contracts, leases, or agreements with other stockholders.

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Reasons Firms Combine

Vertical integration Cost savings Quick entry into new markets Economies of scale More attractive financing opportunities Diversification of business risk Business Expansion Increasingly competitive environment

LO 1

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Recent Notable Business Combinations

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The Consolidation Process

Consolidated financial statements provide more meaningful information than separate statements.

Consolidated financial statements more fairly present the activities of the consolidated companies.

Yet, consolidated companies may retain their legal identities as separate corporations.

“There is a presumption that consolidated statements are more meaningful.. and that they are usually necessary for a fair presentation when one of the companies in the group… has a controlling financial interest..” FASB ASC (810-10-10-1)

LO 2

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Business Combinations

Business combinations . . . can be achieved through transactions or events in which an acquirer obtains control over one or more businesses. Create single economic entities.

Can be formed by a variety of events but can differ widely in legal form.

Require consolidated financial statements.

LO 3

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Business Combinations

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FASB Control Model

The FASB provides guidance and defines control when accounting for business combinations with this control model:

“A reporting entity has the power to direct the activities of another entity when it has the current ability to direct the activities of the entity that significantly affect the entity's returns.”

The power criterion defines control both operationally through “majority voting shares” and conceptually through contractual rights.

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Subsidiaries’ financial data

Prepare a single set of consolidated financial statements.

Parent’s financial data

Consolidation of Financial Information

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To report the financial position, results of operations, and cash flows for the combined entity.

Reciprocal accounts and intra-entity transactions are adjusted or eliminated to. . .

brought together

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What is to be consolidated?

If dissolution occurs:All account balances are actually consolidated in the financial records of the survivor.

If separate incorporation maintained:Financial statement information (on work papers, not the actual records) is consolidated.

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When does consolidation occur?

If dissolution occurs:Permanent consolidation occurs at the combination date.

If separate incorporation maintained:Consolidation occurs at regular intervals, whenever financial statements are prepared.

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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 all balances of the dissolved company.

If separate incorporation is maintained:Each company continues to retain its own records.

worksheets facilitates the periodic consolidation process without disturbing individual accounting systems.

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The Acquisition Method

Used to account for business combinations.

Requires recognizing and measuring at fair value: Consideration transferred for the acquired

business Noncontrolling interest Separately identified assets and liabilities Goodwill or gain from a bargain purchase Any contingent considerations.

LO 4

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Fair Value

Asset valuations established using… The Market Approach – fair value can be

estimated referencing similar market trades.

The Income Approach – fair value can be estimated using the discounted future cash flows of the asset.

The Cost Approach – estimates fair values by reference to the current cost of replacing an asset with another of comparable economic utility.

LO 5

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Acquisition Method

What if the consideration transferred does NOT EQUAL the Fair Value of the Assets acquired?

If the consideration is LESS than the Fair Value of the Assets acquired, we got a BARGAIN!! And we will record a GAIN on the acquisition!!

If the consideration is MORE than the Fair Value of the Assets acquired, the difference is attributed to GOODWILL

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Acquisition Method Example Purchase Price = Fair Value

BigNet pays $2,550,000 ($550,000 cash and 20,000 unissued shares of its $10 par value common stock that is currently selling for $100 per share) for all of Smallport’s assets and liabilities.

Smallport then dissolves as a legal entity. As is typical, the $2,550,000 fair value of the consideration transferred by BigNet represents the fair value of the acquired Smallport business.

Dissolution of Subsidiary

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Consideration Transferred = Net Identified Asset Fair Values

BigNet Company’s Financial Records—December 31Current Assets . . . . . . . . . . . . . . . . . . . . . . . 300,000Computers and Equipment . . . . . . . . . . . . . 600,000Capitalized Software . . . . . . . . . . . . . . . . .1,200,000Customer Contracts . . . . . . . . . . . . . . . . . . . 700,000Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000Cash (paid by BigNet) . . . . . . . . . . . . . . . . . . . . . . . . . . 550,000Common Stock (20,000 shares issued at $10 par value) 200,000Additional Paid-In Capital . . . . . . . . . . . . . . . . . . . . . . 1,800,000To record acquisition of Smallport Company. Assets acquired and liabilities assumed are recorded at fair value.

Dissolution of Subsidiary

LO 6

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Acquisition Method Example Purchase Price > Fair Value

BigNet pays $3,000,000 ($1,000,000 cash and 20,000 unissued shares of its $10 par value common stock that is currently selling for $100 per share) for all of Smallport’s assets and liabilities.

Smallport then dissolves as a legal entity. The $3,000,000 fair value of the consideration transferred by BigNet is greater than the fair value of the acquired Smallport business.

Dissolution of Subsidiary

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Acquisition Method ExamplePurchase Price > Fair Value

BigNet Company’s Financial Records—December 31Current Assets . . . . . . . . . . . . . . . . . . . . . 300,000Computers and Equipment . . . . . . . . . . . 600,000Capitalized Software . . . . . . . . . . . . . . .1,200,000Customer Contracts . . . . . . . . . . . . . . . . . 700,000Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . .450,000Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000Cash (paid by BigNet) . . . . . . . . . . . . . . . . . . . . . . 1,000,000Common Stock (20,000 shares at $10 par value) . . . . 200,000Additional Paid-In Capital . . . . . . . . . . . . . . . . . . . . 1,800,000To record acquisition of Smallport Company. Assets acquired and liabilities assumed are recorded at fair value.

Dissolution of Subsidiary

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Acquisition Method Example Purchase Price < Fair Value

BigNet pays $2,000,000 by issuing 20,000 unissued shares of its $10 par value common stock that is currently selling for $100 per share for all of Smallport’s assets and liabilities.

Smallport then dissolves as a legal entity. The $2,000,000 fair value of the consideration transferred by BigNet is less than the fair value of the acquired Smallport business.

Dissolution of Subsidiary

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Acquisition Method – ExamplePurchase Price < Fair Value

BigNet Company’s Financial Records—December 31Current Assets . . . . . . . . . . . . . . . . . . . . . . . 300,000Computers and Equipment . . . . . . . . . . . . . 600,000Capitalized Software . . . . . . . . . . . . . . . . .1,200,000Customer Contracts . . . . . . . . . . . . . . . . . . . 700,000Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000Common Stock (20,000 shares issued at $10 par value) 200,000Additional Paid-In Capital . . . . . . . . . . . . . . . . . . . . . . 1,800,000Gain on Bargain Purchase . . . . . . . . . . . . . . . . . . . . . . 550,000To record acquisition of Smallport Company. Assets acquired and liabilities assumed are recorded at fair value.

Dissolution of Subsidiary

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Related Costs of Business Combinations

Direct Costs of the acquisition (attorneys, appraisers, accountants, investment bankers, etc.) are NOT part of the fair value received, and are immediately expensed.

Indirect or Internal Costs of acquisition (secretarial and management time) are period costs expensed as incurred.

Costs to register and issue securities related to the acquisition reduce their fair value.

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Acquisition Method

Separate Incorporation MaintainedDissolution does not occur.Consolidation process is similar to previous example.Fair value is the basis for initial consolidation of

subsidiary’s net assets. Subsidiary is a legally incorporated separate entity.Consolidation of financial information is simulated.Acquiring company does not physically record the

transaction.

LO 7

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The Consolidation Worksheet

Consolidation worksheet entries (adjustments and eliminations) are entered on the worksheet only.

Steps in the process:

1.Prior to constructing a worksheet, the parent prepares a formal allocation of the acquisition date fair value

similar to the equity method procedures.

2.Financial information for Parent and Sub is recorded in the first two columns of the worksheet (with Sub’s

prior revenue and expense already closed).

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The Consolidation Worksheetcontinued. . .

3. Remove the Sub’s equity account balances.

4. Remove the Investment in Sub balance.

5. Allocate Sub’s Fair Values, including any excess of cost over Book Value to identifiable assets or goodwill.

6. Combine all account balances and extend into the Consolidated totals column.

7. Subtract consolidated expenses from revenues to arrive at net income.

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Acquisition Method – Consolidation Workpaper Example

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Acquisition Date Fair-Value Allocations – Additional Issues

Intangibles are assets that: Lack physical substance (excluding financial

instruments) Arise from contractual or other legal rights Can be sold or otherwise separated from the acquired

enterprise

Preexisting goodwill recorded in the acquired company’s accounts is ignored in the allocation of the purchase price.

IPR&D that has reached technological feasibility is capitalized as an intangible asset at fair value with an indefinite life that is reviewed for impairment.

Ongoing R&D is expensed as incurred.

LO 8

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Convergence between U. S. and International Standards

IASB International Financial Reporting Standard 3 (IFRS 3) Revised and FASB ASC topics 805, Business Combinations, and 810, Consolidation, effectively converged accounting for business combinations.

In 2011, the IASB issued IFRS 10 Consolidated Financial Statements and IFRS 12 Disclosure

of Interests in Other Entities - effective beginning in 2013.

New definition of control focuses on the power to direct the activities of an entity, exposure to variable returns, and a linkage between power and returns.

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Summary

Consolidation of financial information is required when one firm gains control of another.Current financial reporting standards require the acquisition method to be used in accounting for business combinations. Recognize Goodwill if the purchase price > fair value of net assets acquired; recognize a gain if purchase price < fair value of net assets. Particular attention should be paid to the recognition of intangible assets in business combinations.

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