Chapter 4 - Consolidation of Non-Wholly Owned Subsidiaries PDF

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Chapter 4 - Consolidation of Non-Wholly Owned Subsidiaries ...

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Chapter 4 Consolidation of Non-Wholly Owned Subsidiaries

A brief description of the major points covered in each case and problem. CASES Case 4-1 Management of the parent company wants to compare goodwill and non-controlling interest under three theories of reporting a 60%-owned subsidiary and wants to know whether the subsidiary must be remeasured to fair value annually and which theory best reflects the economic reality of the business combination. Case 4-2 This case, adapted from a past UFE, questions the allocation of the acquisition cost and involves loss carryforwards and unrecognized intangible assets. Case 4-3

(prepared by J. C. (Jan) Thatcher, Lakehead University, and Margaret Forbes,

formerly University of Saskatchewan). This case requires students to analyze the clauses of a franchise agreement to determine whether or not control exists because of the agreement. Case 4-4 (prepared by Peter Secord, Saint Mary’s University) In this real life business combination, students are directed to identify all of the intangible assets acquired and to discuss the valuation problems associated with them.

Case 4-5 This case, adapted from a past UFE, involves a company operating an amusement park and golf course. It buys a sport franchise, builds a new arena and acquires the net assets of another amusement park. The student must assess a variety of capitalize versus expense issues, revenue recognition issues and how to account for the business combinations. Case 4-6 This case, adapted from a past UFE, involves the acquisition of a sports equipment wholesaler. The case contains issues related to accounts receivable, inventory, accounts payable, revenue recognition, intangible assets and goodwill.

PROBLEMS Problem 4-1 (35 min) This problem requires the preparation of a consolidated statement of financial position under the entity theory subsequent to the acquisition of a 70% interest in a subsidiary, and the calculation of goodwill and NCI under the parent company extension theory. Problem 4-2 (90 min.) Five separate cases are presented requiring the preparation of a consolidated balance sheet involving the same parent and subsidiary company. The cases vary as to the percentage of voting shares acquired and the price paid. Cases 1 and 2 are proportional and can be used as a classroom illustration to show that if the goodwill for a 100% owned subsidiary is $15,000, then the goodwill for an 80% owned subsidiary should be $12,000. The remaining cases involve goodwill of zero or negative goodwill. Problem 4-3 (50 min.) This problem requires the preparation of the parent’s separate entity balance sheet and a consolidated balance sheet of a parent and its 90%-owned subsidiary in which the allocation of the acquisition differential results in negative goodwill. Part of the acquisition cost needs to be allocated to an unrecorded customer supply contract. Problem 4-4 (30 min.) In this problem, a parent purchases 80% of the common shares of a subsidiary whose balance sheet contains the asset goodwill. The student is required to prepare a consolidated balance sheet. Problem 4-5 (20 min.) The parent’s and subsidiary’s statements of financial position are presented along with the consolidated statement of financial position. The ownership percentage has to be determined along with particular fair values of the subsidiary’s assets and liabilities. Problem 4-6 (40 min.) The preparation of a consolidated balance sheet under two theories of consolidation immediately after a parent company issues shares for a 70% interest in a subsidiary. Other

acquisition costs and share issue costs are involved as well as negative goodwill. Problem 4-7 (50 min.) This problem involves preparing a consolidated statement of financial position using two theories of consolidation. The student must also calculate and interpret the current ratio and debt-to-equity ratio and calculate goodwill under the proprietary theory. Problem 4-8 (40 min.) A parent has a 90% owned subsidiary. Unconsolidated and consolidated balance sheets are presented and the problem requires the preparation of the subsidiary’s balance sheet. Problem 4-9 (35 min.) A parent acquires 70% of the common shares of a subsidiary. The preparation of a consolidated balance sheet is required using the trading price of the subsidiary’s shares to value the non-controlling interest. Part of the acquisition cost needs to be allocated to an unrecorded taxi license. Problem 4-10 (45 min.) A consolidated balance sheet and the parent’s separate entity balance sheet are to be prepared after an 80%-owned subsidiary has been acquired. Part of the acquisition cost needs to be allocated to unrecorded Internet domain names. Problem 4-11 (40 min.) This problem involves preparing a consolidated statement of financial position using two theories of consolidation and stating which theory is required under IFRS. Problem 4-12 (30 min.) Selected account balances for the consolidated balance sheet are required to be calculated for a 90%-owned subsidiary. Problem 4-13 (45 min.) Journal entries are to be prepared for the acquisition of an 80%-owned subsidiary and other direct costs involved with the acquisition. A consolidated balance sheet is to be prepared. Part of the acquisition cost needs to be allocated to unrecorded in-process research and development.

Problem 4-14 (45 min.) This problem involves preparing a consolidated statement of financial position using two theories of consolidation when the market value of NCI is known at the date of acquisition. The student must also calculate goodwill under the proprietary theory. Problem 4-15 (45 min.) Journal entries are to be prepared to record contingent consideration pertaining to an earnout and a guarantee valued for share price in one year’s time both at the date of acquisition and at the end of the first year.

SOLUTIONS TO REVIEW QUESTIONS 1. No, it is not the same. A negative acquisition differential exists if the implied value for a 100% acquisition is less than the carrying amount of the subsidiary's net assets. Negative goodwill exists if the implied acquisition cost is less than the fair value of the subsidiary's identifiable net assets. It is possible to have a negative acquisition differential and end up with positive goodwill.

2. Proprietary theory requires consolidation of the parent's share of the subsidiary's net assets, therefore giving no recognition to the non-controlling interest at all. Entity theory views the consolidated entity as being owned by two groups of shareholders, the parent and the noncontrolling interest, and views the purchase transaction to have revalued both parties' ownership. Thus, the entity theory requires the non-controlling interest to be recorded at its percentage share of the fair value of the subsidiary's net assets (including goodwill) at the date that the parent acquired its controlling interest. Parent company extension theory also gives attention to NCI as one of the shareholders groups; Under this theory, non-controlling interest is to be recorded at its percentage share of the fair value of the subsidiary's identifiable net assets (excluding goodwill).

3. Goodwill of this nature is treated as if it does not exist at the date of acquisition. A new goodwill figure is calculated based on the acquisition cost at the date of acquisition. When preparing the schedule to allocate the acquisition differential, we assume that the goodwill

had been written off by the subsidiary just before the parent acquired its controlling interest in the subsidiary. When calculating goodwill and goodwill impairment in subsequent years, we must make adjustments on consolidation based on the goodwill calculated at the date of acquisition

4. If 80% of a subsidiary cost $80,000, it is inferred that 100% would have cost $100,000. The fair value of 100% of the subsidiary's net assets is subtracted from this implied acquisition cost and the difference is goodwill. The amount of the non-controlling interest is determined based on the subsidiary's fair values and goodwill arising from the purchase. With a small ownership percentage (e.g., 52%), or when majority ownership is reached through a series of small step acquisitions, this inference as to what 100% would cost is significantly less reliable than at higher ownership percentages.

5. Non-controlling interest represents the equity interest of the non-controlling shareholders in the fair value of the subsidiary. IFRS 10 requires that it be shown in shareholders' equity in the consolidated balance sheet under both the parent company extension and entity theories.

6. Goodwill and non-controlling interest differ under the two consolidation theories. Under the parent company extension theory, only the parent’s share of the subsidiary’s goodwill is reported because it is too difficult or subjective to measure the total goodwill of the subsidiary. Since the non-controlling interest’s share of the subsidiary’s goodwill is not included on the consolidated balance sheet, the value for non-controlling does not include a share of the subsidiary’s goodwill. Therefore, both goodwill and non-controlling interest are smaller amounts under the parent company extension theory in comparison to the entity theory.

7. Contingent consideration is the additional consideration that may be payable for the acquisition of a business. The additional consideration is dependent upon whether certain future events occur (or do not occur). For example, a further payment may be required if future net income reaches (or fails to reach) a certain level. The contingent consideration should be measured at fair value at the date of acquisition. To do so, the parent should assess the amount expected to be paid in the future under different scenarios, assign probabilities as to the likelihood of the scenarios occurring, derive an expected value of the

likely amount to be paid, and use a discount rate to derive the value of the expected payment in today’s dollars.

8. Changes in the fair value of contingent consideration that will be payable in cash should be recognized in net income at each reporting date with a corresponding adjustment to the contingent liability.

9. A private company may choose not to consolidate its subsidiaries and instead can report its investment in subsidiaries using the equity method or the cost method. All subsidiaries should be reported using the same method. However, if the entity would otherwise choose to use the cost method and the security is traded in an active market, it must report the investment at fair value.

10. Negative goodwill exists if the implied acquisition cost for a 100% investment is less than the fair value of the subsidiary's identifiable net assets. Negative goodwill is reported on the consolidated income statement as a gain on purchase.

11. No, the historical cost principle is not applied when accounting for negative goodwill. In fact, it is violated. The subsidiary’s identifiable net assets are reported at fair value on the consolidated balance sheet at the date of acquisition regardless of the amount paid by the parent. The negative goodwill is reported as a gain on purchase, which is not consistent with the historical cost principle.

12. Any income earned by the subsidiary subsequent to the date of acquisition is incorporated in the consolidated income statement on a line-by-line basis. Any income earned by the subsidiary prior to the date of acquisition is not incorporated in the consolidated income statement because the subsidiary was not part of the consolidated group prior to the date of acquisition.

13. The consolidation elimination entries are not recorded in the accounting records of either the parent or subsidiary unless the subsidiary applies push down accounting. The elimination entries are recorded on a consolidated working paper or consolidated worksheet, which is

used to facilitate the consolidation process.

14. Deferred charges do not meet the definition of an asset. Therefore, the deferred charge should not be reported on the consolidation balance sheet. In other words, the deferred charge should be measured at zero and would appear as a fair value deficiency on the schedule of acquisition differential.

15. A parent-founded subsidiary would not have any acquisition differential i.e., there would not be any difference between the fair value and carrying amount of assets and liabilities on the date of acquisition.

SOLUTIONS TO CASES Case 4-1 Under all theories of consolidation except for the entity theory, only the portion of Leafs’ goodwill purchased by Maple is reported on the consolidated balance sheet. Given an acquisition cost of $1,200,000, Maple paid $528,000 for its share of Leafs’ goodwill as shown in the first column of Exhibit I. Putting a value on 100% of Leafs’ goodwill is not an easy matter as there are different ways of determining this value. First, one could assume a linear relationship between the amount paid for 60% and the value of 100% of the subsidiary. In this case, if 60% of the shares were worth $1,200,000, then 100% of the shares should have been worth $2,000,000. In turn, 100% of goodwill would be measured at $880,000 as indicated in the second column of Exhibit I. (See below.) Secondly, one could listen to the argument made by the management of Maple and assume that there was not a linear relationship between the amount paid for 60% and the value of 100% of the subsidiary. Management stated that it was willing to pay a premium of $240,000 over and above the market price of the shares in order to gain control over Maple and the premium would be $240,000 regardless of the percentage of shares acquired. If this were the case, the total value of Leafs would be $1,840,000 of which $720,000 would be allocated to goodwill as indicated in the third column of Exhibit I.

The value assigned to goodwill will affect the value reported for non-controlling interest under the entity theory. When goodwill is measured at $880,000, non-controlling interest is reported at $800,000 as indicated in the fourth column in Exhibit II. When goodwill is measured at $720,000, non-controlling interest is reported at $640,000 as indicated in the fifth column in Exhibit II. The subsidiary’s assets and liabilities are brought on to the consolidated balance sheet at fair values only at the date of acquisition. These fair values become the historical values for reporting purposes subsequent to the date of acquisition. That is, the subsidiary’s assets and liabilities are not remeasured to fair value on each reporting date subsequent to the date of acquisition. The entity theory presents the fair value of the net assets of the subsidiary including goodwill at the date of acquisition. The entity theory probably best reflects the economic reality of the business combination since fair value is often a better reflection of economic reality. Since the entity theory presents the highest values for assets, it will produce the lowest percentage return on assets in subsequent periods because these assets need to be depreciated, expensed or written off at some point. For this reason, the management of Maple may probably prefer to not use the entity theory when preparing the consolidated financial statements. EXHIBIT I ALLOCATION OF ACQUISITION COST (In 000s) 60% Cost of 60% of Leafs

100%

$1,200

Implied value of 100% of Leafs (Note 1)

$2,000

Implied value of 100% of Leafs (Note 2)

$1,840

Carrying amount of Leafs’ net assets (60% x [2,000 –1,600]) Acquisition differential

100%

400

400

240

.

.

960

1,600

1,440 Allocated Fair value excess for identifiable assets

480

800

800

Fair value excess for liabilities

(48)

(80)

(80)

$528

$880

$720

Goodwill

Notes: 1. The implied value is calculated assuming a linear relationship between the value for 60% and the value of 100% i.e., if 60% is worth $1,200,000 then 100% is worth $1,200,000 / 0.6 = $2,000,000 2. The implied value is calculated assuming a non-linear relationship and assuming that each share is worth $40 and that a control premium of $240,000 is paid regardless of the number of shares purchased. Given that the total shares outstanding is 24,000 / 0.6 = 40,000, the total value of Leafs would be 40,000 shares x $40 + $240,000 = $1,840,000

EXHIBIT II Maple Company Consolidated Balance Sheet At December 31, Year 7 (In 000s) (See notes)

Identifiable assets Goodwill

Liabilities

Proprietary

Parent Co.

Parent Ex

Entity

Entity

(a)

(b)

(c)

(d1)

(d2)

$5,680

$6,480

$6,800

$6,800

$6,800

528

528

880

720

$6,208

$7,008

$7,328

$7,680

$7,520

$ 4,008

$4,648

$4,680

$4,680

$4,680

528

Non-controlling interest

160

Shareholders’ equity Controlling interest Non-controlling interest

2,200

2,200

2,200

2,200

2,200

.

.

448

800

640

$6,208

$7,008

$7,328

$7,680

$7,520

Notes: 1. The assets and liabilities are calculated as follows: (a)

Carrying amounts for Maple and 60% of fair values for Leafs

(b)

Carrying amounts for Maple and carrying amounts for Leafs plus 60% of fair value excess for Leafs’ identifiable assets and liabilities plus 60% of the value of Leafs’ goodwill

(c)

Carrying amounts for Maple and carrying amounts for Leafs plus 100% of fair value excess for Leafs’ identifiable assets and liabilities plus 60% of the value of Leafs’ goodwill

(d1)

Carrying amounts for Maple and carrying amounts for Leafs plus 100% of fair value excess for Leafs’ identifiable assets and liabilities plus 100% of the value of Leafs’ goodwill assuming a linear relationship between the value of 60% and the value of 100%

(d2)

Carrying amounts for Maple and carrying amounts for Leafs plus 100% of fair value excess for Leafs’ identifiable assets and liabilities plus 100% of the value of Leafs’ goodwill assuming a non-linear relationship and a control premium of $120,000

2. The non-controlling interest is calculated as follows: (b)

40% x carrying amount of Leafs’ shareholders’ equity

(c)

40% x fair value of Leafs’ identifiable assets and liabilities

(d1) 40% x fair value of Leafs’ identifiable assets, liabilities, and goodwill (d2) 40% x fair value of Leafs’ identifiable assets and liabilities and Leafs’ goodwill in total less goodwill purchased by Maple i.e., 40% x ((2,800,000 –1,680,000) + (720,000 – 528,000))

Case 4-2 Memo To:

Partner

From:

CPA

Subject:

Eternal Rest Engagement

As requested, I have reviewed the files and notes prepared for the Eternal Rest Limited (ERL) engagement. Below is my analysis and disposition of outstanding accounting issues.

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