CH 5 Consolidated Financial Statements PDF

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Chapter 5 Consolidated Financial Statements The accounting concept of a business combination includes combinations in which one or more companies become subsidiaries of a parent corporation. A corporation becomes a subsidiary when another corporation acquires a controlling interest in its outstanding voting stock. Ordinarily, one company gains control of another directly by acquiring a majority (more than 50 percent) of its voting stock. Once a parent–subsidiary relationship is established, the purchase of additional subsidiary stock is not a business combination. In other words, separate entities can combine only once. Increasing a controlling interest is the same as simply making an additional investment. Acquisition of additional subsidiary stock is recorded by increasing the investment account and reducing the non-controlling interest, based on the carrying amount of the non-controlling interest at the additional acquisition date. (The increase in the investment account presumes that the fair value of the subsidiary increases after the additional investment). Any difference between the acquisition price and the carrying amount of the non-controlling interest plus the increase in the investment account is an adjustment to additional paid-in capital of the parent company. A company will commonly purchase a large enough interest in another company’s voting common stock to obtain control of operations. The company owning the controlling interest is termed the parent, while the controlled company is termed the subsidiary. Legally, the parent company has only an investment in the stock of the subsidiary and will only record an investment account in its accounting records. The subsidiary will continue to prepare its own financial statements. However, accounting principles require that when one company has effective control over another, a single set of consolidated statements must be prepared for the companies under common control. The consolidated statements present the financial statements of the parent and its subsidiaries as those of a single economic entity. Worksheets are prepared to merge the separate statements of the parent and its subsidiary(s) into a single set of consolidated statements. The separate financial statements of the companies involved serve as the starting point each time consolidated statements are prepared. These separate statements are added together, after some adjustments and eliminations, to generate consolidated financial statements. The adjustments and eliminations relate to intercompany transactions and holdings. Although the individual companies within a consolidated entity may legitimately report sales and receivables or payables to one another, the consolidated entity as a whole must report transactions only with parties outside the consolidated entity and receivables from or payables to external parties. Thus, the adjustments and eliminations required as part of the consolidation process aim at ensuring that the consolidated financial statements are presented as if they were the statements of a single enterprise. The Concept of Consolidation

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A consolidated financial statement for a parent company and its subsidiaries is a financial statement prepared by combining the individual statements of the affiliated companies. The purpose of consolidated financial statements is to show the financial position and results of operations of separate but affiliated companies as if they were a single company. This approach is in accordance with the economic entity concept. Under the economic entity concept, a single set of financial statements be prepared for each economic entity. When an entity consists of more than one corporation, consolidated financial statements are required. Consolidated financial statements present the financial position and results of operations of the economic entity that consists of two or more legal entities. These legal entities-the parent company and the subsidiaries-continue to exist as separate legal entities. The Reporting Entity A business combination brings two previously separate corporations under the control of a single management team (the officers and directors of the parent). Although both corporations continue to exist as separate legal entities, the acquisition creates a new reporting entity that encompasses all operations controlled by the management of the parent. When an investment in voting stock creates a parent–subsidiary relationship, the purchasing entity (parent) and the entity acquired (subsidiary) continue to function as separate entities and maintain accounting records on a separate basis. Separate parent and subsidiary financial statements are converted into consolidated financial statements that reflect the financial position and the results of operations of the combined entity. The new reporting entity is responsible for reporting to the stockholders and creditors of the parent and to other interested parties. Consolidated financial statements are designed to present the results of operations, cash flow, and the balance sheet of both the parent and its subsidiaries as if they were a single company. Generally, consolidated statements are the most informative to the stockholders of the controlling company. Yet, consolidated statements do have their shortcomings. The rights of the noncontrolling shareholders are limited to only the company they own, and, therefore, they get little value from consolidated statements. They really need the separate statements of the subsidiary. Similarly, creditors of the subsidiary need its separate statements, because they may look only to the legal entity that is indebted to them for satisfaction of their claims. The parent’s creditors should be content with the consolidated statements, since the investment in the subsidiary will produce cash flows that can be used to satisfy their claims. The purpose of consolidated financial statements is to present, primarily for the benefit of the owners and creditors of the parent company, the results of operations and the financial position of a parent and all its subsidiaries as if the consolidated group were a single economic entity. There is a presumption that consolidated financial statements are more meaningful than separate financial statements and that they are usually necessary for a fair presentation when one of the entities in the consolidated group directly or indirectly has a controlling financial interest in the other entities. Consolidated statements are intended primarily for the parent’s investors, rather than for the non-controlling stockholders and subsidiary creditors. The subsidiary, as a separate Page 2 of 17

legal entity, continues to report the results of its own operations to the non-controlling shareholders. Consolidation Policy Consolidated financial statements provide much information that is not included in the separate statements of the parent, and are usually required for fair presentation of the financial position and results of operations for a group of affiliated companies. The usual condition for consolidation is ownership of more than 50 percent of the voting stock of another company. However, even though such a common stock ownership exists, other circumstances may negate the parent company’s actual control of the subsidiary and a subsidiary can be excluded from consolidation in some situations: (1) when control does not rest with the majority owner, (2) formation of joint ventures, (3) the acquisition of an asset or group of assets that does not constitute a business, (4) a combination between entities under common control, and (5) a combination between not-for-profit entities or the acquisition of a for-profit business by a notfor-profit entity. Control does not rest with the majority owner if the subsidiary is in legal reorganization or bankruptcy or is operating under severe foreign-exchange restrictions, controls, or other governmentally-imposed uncertainties. The Parent–Subsidiary Relationship We presume that a corporation that owns more than 50 percent of the voting stock of another corporation controls that corporation through its stock ownership, and a parent–subsidiary relationship exists between the two corporations. When parent–subsidiary relationships exist, the companies are affiliated. The outside stockholders are the non-controlling stockholders, and their interest is referred to as a non-controlling interest. Consolidated Balance Sheet Immediately Following Acquisition of Full Ownership A consolidated entity is a fictitious (conceptual) reporting entity. It is based on the assumption that the separate legal and accounting entities of a parent and its subsidiaries can be combined into a single meaningful set of financial statements for external reporting purposes. Note that the consolidated entity does not have transactions and does not maintain a consolidated ledger of accounts. Parent Acquires 100 Percent of Subsidiary at Book Value Illustration 1 On December 31, year 2, Pop Company issued 8,000 shares of its $10 par common stock with current fair values of $45 per share to stockholders of Sis Company for all outstanding $5 par common stock of Sis. There was no contingent consideration. Out-off pocket costs of the business combination paid by Pop on December 31, year 2 consisted of the finders and legal fees related to business combination, $20,000 and stock issue cost of $15,000. Assume also that Sis Company was to continue its corporate existence as a wholly owned subsidiary of Pop. Both Companies had a December 31 fiscal year and used the same accounting principles and procedures. Financial statement of Pop Company and Sis Company for the year ended December 31, year 2, prior to business combination as follows: Page 3 of 17

Pop and Sis Company Separate balance sheets For the year ended December 31, year 2 Pop Company Assets Cash …………………………………..…….. Inventories ………………………………….. Other assets …………………………………. Receivables from Sis Company …………..... Plant assets (net) ………………………....…. Patent (net) ………………………………….. Total assets …………………………………. Liabilities and SHE Payables to Pop Company …………...……... Income-tax payable ………………………… Other liabilities ………………………….….. Common stock, $10 par value ………….…... Common stock, $5 par value ……………….. Additional Paid in capital ……………….….. Retained earnings …………….……………... Total liability and SHE ……….....…..……..

$50,000

Sis Company

80,000 20,000 220,000 480,000

$20,000 65,000 55,000 125,000 8,000 273,000

15,000 85,000 200,000 60,000 120,000 480,000

20,000 5,000 40,000 100,000 43,000 65,000 273,000

110,000

The December 31, current fair values of Sis company’s identifiable assets and liabilities were the same as their carrying amount except the Sis assets listed below: Inventories ………………………………..…….. $100000 Plant assets (net) ……………………………….. 210000 Patent (net) ……………………………………… 15000 Required: 1. Record the journal entries of a business combination 2. Prepare consolidated balance sheet on December 31, year 2 

Pop records the issuance of the 8,000 shares on its books as follows: Investment in Sad Company (+A) ………………… 360,000 Common stock, $10 par (+SE) ………….……….. 80,000 Additional paid-in capital (+SE) ………...………...280,000

To record issuance of 8,000 shares of $10 par common with a market value of $45 in a business combination with Sis Company. 

Pop records additional direct costs of the business combination as follows: Acquisition expense (E, –SE) ……………….…...… 20,000 Additional paid-in capital (–SE) ………………..….. 15,000 Cash (or other net assets) (–A) ………….…… 35,000

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To record additional direct costs of combining with Sis Company: $20,000 for finders and legal fees and $15,000 for registering and issuing equity securities 

Purchase consideration: Amount of shares issued to Sis Company …………….. 360,000



Shareholders' equity of Sis Company: Common stock ………………..…. 100,000 Additional Paid in Capital ……..... 43,000 Retained earnings …………….…. 65,000 ………….. (208,000) Excess of cost over book value …………..…… 152,000

Allocation: Inventories- Undervalued ……………………….. Plant assets-Undervalued ……………….. Patent-Undervalued ……………………………... Goodwill …………………………………….……. Excess of cost over book value …………...…..….

35000 85000 7000 25000 152000

Pop Company acquires 100 percent of Sis Company at its fair value of $360,000 in an acquisition on December 31, year 2. Pop’s “Investment in Sis” appears in the separate balance sheet of Pop, but not in the consolidated balance sheet for Pop and Subsidiary. When preparing the balance sheet, we eliminate the Investment in Sis account (Pop’s books) and the stockholders’ equity accounts (Sis’s books) because they are reciprocal—both representing the net assets of Sis at December 31, year 2. We combine the nonreciprocal accounts of Pop and Sis and include them in the consolidated balance sheet of Pop Company and Subsidiary. Note that the consolidated balance sheet is not merely a summation of account balances of the affiliates. We eliminate reciprocal accounts in the process of consolidation and combine only nonreciprocal accounts. The capital stock that appears in a consolidated balance sheet is the capital stock of the parent, and the consolidated retained earnings are the retained earnings of the parent company. Consolidated balance sheet on December 31, year 2 without the use of the working paper: 

The parent company investment account and the subsidiary stockholders equity account do not appear in the consolidated balance sheet because they are essentially reciprocal/intercompany accounts



The parent company assets and liabilities (other than intercompany accounts) are reflected at carrying amount and the subsidiary assets and liabilities (other than intercompany accounts) are reflected at current fair values in the consolidated balance sheet.



Goodwill is recognized

Consolidated balance sheet on December 31, year 2 with the use of the working paper:

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Development of elimination entry (determination of items of accounted to be considered in the elimination column (increase or decrease the balance)) The working paper for consolidated balance sheet on the date of purchase-type business combination has the following features:  The elimination is not entered in either the parent company’s or the subsidiary’s accounting records; it is only a part of the working paper for preparation of the consolidated balance sheet.  The elimination is used to eliminate the parent company investment account and the subsidiary stockholders’ equity account in the consolidated balance sheet because they are essentially reciprocal/intercompany accounts  The elimination is used to reflect differences between current fair values and carrying amounts of the subsidiary’s identifiable net assets because the subsidiary did not write up its assets to current fair values on the date of the business combination.  The elimination is used to recognize goodwill if cost greater than current fair values of net asset  The Elimination column in the working paper for consolidated balance sheet reflects increases and decreases, rather than debits and credits.  Intercompany receivables and payables are placed on the same line of the working paper for consolidated balance sheet and are combined to produce a consolidated amount of zero.  The respective corporations are identified in the working paper elimination. The reason for precise identification is to deal with the eliminations of intercompany profits (or gains).  The consolidated paid-in capital amounts are those of the parent company only. Subsidiaries Paid-in capital amounts always are eliminated in the process of consolidation.  Consolidated retained earnings on the date of purchase-type business combination include only the retained earnings of the parent company. This treatment is consistent with the theory that acquisition accounting reflects a fresh start in an acquisition of net assets, not a combining of existing stockholder interest.  The amounts in the consolidated column of the working paper for consolidated balance sheet reflects the financial position of a single economic entity comprising two legal entities, with all intercompany balances of the two entities eliminated. Thus, the elimination entry is: Common stock, $5 par …………………………………

100,000

Additional Paid-in Capital ……………………….……..

43,000

Retained earnings …………………………………….…

65,000

Inventory ………………………………….………….…

35,000

Plant assets ……………………………………………… 85,000 Patent ……………………………………………..…….. 7,000 Page 6 of 17

Goodwill ………………………………………………… 25,000 Investment in Sis Company common stock ……...…… 360,000 Pop and Sis Company Working paper to Consolidated Balance Sheet December 31, year 2 Item

Pop Company

Sis Compan y

Elimination

Consolidated Amount

Asset Cash Inventory

15,000 110,000

20,000 65,000

35,000

Other asset Intercompany accounts Investment in Sis co. Plant asset Patent Goodwill Total asset

80,000 20,000 360,000 220,000 805,000

55,000 (20,000) 125,000 8,000 253,000

(360,000) 85,000 7,000 25,000 (208,000)

430,000 15,000 25,000 850,000

Liabilities and Equity Income tax payable Other liabilities Common stock

15,000 85,000 280,000

5,000 40,000 100,000

(100,000)

20,000 125,000 280,000

Paid in capital

325,000

43,000

(43,000)

325,000

Retained earnings

100,000

65,000

(65,000)

100,000

Total Liabilities and Equity

805,000

253,000

(208,000)

850,000

35,000 210,000 135,000 -

Consolidation of Partially Owned Subsidiary at the Date of Business Combination Consolidation Theory The purchase method of accounting requires reporting the assets and liabilities of a subsidiary in the consolidated financial statements on the date of acquisition at fair market values. When the subsidiary is less than 100% owned, a question arises regarding the values to be assigned to consolidated subsidiary assets and liabilities whose book value and fair market value differ on the acquisition date. Two alternative practices exist: The parent company approach: under this approach, the assets and liabilities of the subsidiary are consolidated at the amount equal to their book value plus the controlling interest share of the amount by which fair market value exceeds book value on the date of acquisition. For example, Page 7 of 17

assume an 80% owned subsidiary had buildings with a book value of $100,000 and a fair market value of $200,000 on the acquisition date. The consolidated balance sheet as of the date of acquisition would report these building at $180,000 (historical book value plus 80% of the fair value-book value differential = $100,000 + (($200,000 - $100,000) x 80%), following the parent company approach. The argument in favor of this approach is that the acquisition transaction by the parent company involves only the controlling interest share of the fair market value-book value differential. While this argument may be valid on strict technical grounds, it is not consistent with economic reality. Economic unit approach: under this approach, subsidiary assets and liabilities would be consolidated at the same values for both wholly owned and less than 100% owned subsidiaries. All assets and liabilities would be consolidated at fair market value on the date of acquisition. In the above example, subsidiary buildings with a book value of $100,000 and a fair market value of $200,000 on the acquisition date would be consolidated at $200,000. The existence of a noncontrolling interest wou...