Class Notes For Advanced Accounting, 4th Edition

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Chapter 11CHAPTER ONE–INTRODUCTION TO BUSINESS COMBINATIONSI.BUSINESS COMBINATIONSAbusiness combinationoccurs when the operations of two or more companiesare brought under common control.While merger activity (business combinations) experienced a slowdown in theeconomic decline of 2002 through mid-2003,byJuly of 2003,evidence ofrenewed interestwas obvious.This trend continued, and global merger activitypassed the one trillion dollar mark for the first quarter of 2007, the greatestactivity on record according to CNN.II.NATURE OF THE COMBINATIONA.Nature of the combination1.In afriendly combination, the boards of directors of the potentialcombining companies negotiate mutually agreeable terms of aproposed combination. The proposal is then submitted to thestockholders of the involved companies for approval.2.Anunfriendly (hostile) combinationresults when the board ofdirectors of a company targeted for acquisition resists thecombination. A formaltenderofferenables the acquiring firm todeal directly with individual shareholders.B.Defense tacticsResistance often involves various moves by the target company. Whetheror not such defenses are ultimately beneficial to shareholders remains acontroversial issue.1.Poison pill:Issuing stock rights to existing shareholdersenabling them to purchase additional shares at a price belowmarket value, but exercisable only in the event of a potentialtakeover.Example:Cisco creates "poison pill" to block takeoversby James Niccolaihttp://www.computerworld.com/home/news.nsf/all/9806125poisonCisco Systems, Inc. said yesterday that its board of directors has approved ashareholder rights plan designed to protect the networking company's investorsin the event of a hostile takeover bid.Known in the business world as a "poison pill," the plan is a strategic maneuverto make the company's stock less attractive to potential bidders and to encouragebidders to solicit offerings through the company's board of directors, the SanJose, Calif., company said. A company spokeswoman said Cisco isn't currently

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Chapter 12the target of a takeover bid, but added that such plans aren't uncommon at largecorporations.Under the plan, Cisco shareholders would have the right to acquire for half priceone share in the company for each share held as of June 22. The plan would kickin if a person or company acquires or announces an offer to acquire 15% ormore of the company's common stock, Cisco said.2.Greenmail:The purchase of any shares held by the would-beacquiring company at a price substantially in excess of their fairvalue. The purchased shares are then held as treasury stock orretired.3.White knight or white squire:Encouraging a third firm moreacceptable to the target company management to acquire or mergewith the target company.4.Pac-man defense: Attempting an unfriendly takeover of the would-be acquiring company.5.Selling the crown jewels: The sale of valuable assets to others tomake the firm less attractive to the would-be acquirer. Thenegative aspect is that the firm, if it survives, is left without someimportant assets.6.Leveraged buyouts: The purchase of a controlling interest in thetarget firm by its managers and third party investors, who usuallyincur substantial debt in the process and subsequently take the firmprivate. The bonds issued often take the form of high interest, highrisk “junk” bonds.III.BUSINESS COMBINATIONS: WHY? WHY NOT?A.A company may expand in several ways. Some firms concentrate oninternalexpansion. For other firmsexternalexpansion is the goal; acompany may achieve significant cost savings as a result of externalexpansion. In addition to rapid expansion, the business combinationmethod, or external expansion, has several other potential advantages overinternal expansion:1.Operating synergiesmay take a variety of forms. In the case ofvertical mergers(a merger between a supplier and a customer),synergies may result from the elimination of certain costs related tonegotiation, bargaining, and coordination between the parties. Inthe case of ahorizontalmerger(a merger between competitors),potential synergies include the combination of sales forces,facilities, outlets, etc., and the elimination of unnecessaryduplication in costs.

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Chapter 132.Combination may enable a company to compete more effectivelyin theinternational marketplace.3.Business combinations are sometimes entered into to takeadvantage ofincometaxlaws. The opportunity to file aconsolidated tax return may allow profitable corporations’ taxliability to be reduced by the losses of unprofitable affiliates.4.Diversificationresulting from a merger offers a number ofadvantages, including increased flexibility, an internal capitalmarket, an increase in the firm’s debt capacity, more protectionfrom competitors over proprietary information, and sometimes amore effective utilization of the organization’s resources.5.Divestituresaccounted for over 30% of the merger andacquisitions activity in each quarter from 1995 into mid-1998.Shedding divisions that are not part of a company’s core businessbecame common during this period. In some cases the divestituresmay be viewed as “undoing” or “redoing” past acquisitions.B.Notwithstanding its apparent advantages, business combination may notalways be the best means of expansion.1.An overriding emphasis on rapid growth may result in thepyramiding of one company on another without sufficientmanagement control over the resulting conglomerate.Unsuccessful or incompatible combinations may lead to futuredivestitures.2.In order to avoid large dilutions of equity, some companies haverelied on the use of various debt and preferred stock instruments tofinance expansion, only to find themselves unable to provide therequired debt service during a period of decreasing economicactivity. The junk bond market used to finance many of themergers in the 1980s had essentially collapsed by the end of thatdecade.3.Business combinations may destroy, rather than create, value insome instances.IV.BUSINESS COMBINATIONS--AN HISTORICAL PERSPECTIVEA.In the United States there have been three fairly distinct periodscharacterized by many business mergers, consolidations, and other formsof combinations: 1880-1904; 1905-1930; and 1945-present.

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Chapter 141.1880-1904, huge holding companies or trusts were created byinvestment bankers seeking to establish monopoly control overcertain industries. This type of combination is generally calledhorizontal integrationbecause it involves the combination ofcompanies within the same industry.2.1905-1930, business combination activity of this period, fosteredby the federal government during World War I, was encouraged toobtain greater standardization of materials and parts and todiscourage price competition. After the war, these combinationswere efforts to obtain better integration of operations, reduce costs,and improve competitive positions rather than attempts to establishmonopoly control over an industry. This type of combination iscalledvertical integrationbecause it involves the combination ofa company with its suppliers or customers.3.1945-present, the third period has exhibited rapid growth in mergeractivity since the mid-1960s, and even more rapid since the 1980s.Some observers have called this activity "merger mania.''Illustration 1-1 presents a rough graph of the level of mergeractivity from 1972 to 2005in numberof deals, and from 1979 to12005in dollar volume. Illustration 1-2 presents summarystatistics on the level of activity for the year 2005by industrysector for acquisitions with purchase prices valued in excess of $10million.B.This most recent period can be further subdivided to focus on trends ofparticular decades or subperiods.1.From the 1950s to the 1970s most mergers wereconglomeratemergers. Here the primary motivation for combination was often todiversify business risk2.The 1980s were characterized by a relaxation in antitrustenforcement during the Reagan administration and by theemergence of high-yield junk bonds to finance acquisitions. Thedominant type of acquisition during this period and into the 1990shas beenstrategic acquisitionsclaiming to benefit fromoperating synergies. A temporary decline in activity near the endof the 1980s may be traced to the collapse of the junk bond marketand to an economic recession.3.By the mid-1990s the credit markets had recovered, and theupsurge in mergers renewed to greater levels than ever before.Deregulation undoubtedly played a role in the popularity of

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Chapter 15combinations in the 1990s. Although recent years have witnessedfew deals blocked due to antitrust enforcement. On May 13, 1998,the United States government announced its intent to appoint apanel of economic advisors to evaluate the impact of mergeractivity on the economy.V.TERMINOLOGY AND TYPES OF COMBINATIONSA.From an accounting perspective, the distinction that is most important atthis stage is between anasset acquisitionand astock acquisition. Anasset acquisition involves the purchase of all of the acquired company’snet assets, whereas a stock acquisition involves the attainment of controlvia purchase of a controlling interest in the stock of the acquired company.B.Astatutory mergerresults when one company acquires all the net assetsof one or more other companies through an exchange of stock, payment ofcash or other property, or the issue of debt instruments (or a combinationof these methods). Thus, if A Company acquires B Company in a statutorymerger, the combination is often expressed asStatutory Merger+=C.Astatutory consolidationresults when a new corporation is formed toacquire two or more other corporations through an exchange of votingstock; the acquired corporations then cease to exist as separate legalentities. Thus, if C Company is formed to consolidate A Company and BCompany, the combination is generally expressed asStatutory Consolidation+=D.Astock acquisitionoccurs when one corporation pays cash or issuesstock or debt for all or part of the voting stock of another company, andthe acquired company remains intact as a separate legal entity. Thus, if ACompany acquires 50% of the voting stock of B Company), a parent-subsidiary relationship results. Consolidated financial statements(explained in later chapters) are prepared and the business combination isoften expressed asA CompanyB CompanyA CompanyA CompanyB CompanyC Company

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Chapter 16Consolidated Financial Statements+=VII. TAKEOVER PREMIUMSAtakeover premiumis the term applied to the excess of the amount offered, oragreed upon, in an acquisition over the prior stock price of the acquired firm.VIII.AVOIDING THE PITFALLS BEFORE THE DEALTo consider the potential impact on a firm’s earnings realistically, the acquiringfirm’s managers and advisors must exercisedue diligencein considering theinformation presented to them. Some of the factors to beware include:A.Be cautious in interpreting anypercentagespresented by the sellingcompany.B.Don’t neglect to includeassumed liabilitiesin the assessment of the costof the merger. In addition to liabilities that are on the books of theacquired firm, be aware of the possibility of less obvious liabilities.C.Watch out for the impact on earnings of theallocation of expensesand theeffects of production increases, standard cost variances, LIFO liquidations,and by-product sales.D.Note anynonrecurring itemswhich may have artificially or temporarilyboosted earnings. In addition to nonrecurring gains or revenues, look forrecentchanges in estimates, accrual levels, and methods.E.Be careful ofCEO egos.IX.DETERMINING PRICE AND METHOD OF PAYMENT IN BUSINESSCOMBINATIONSWhether an acquisition is structured as an asset acquisition or a stock acquisition,the acquiring firm must choose to finance the combination with cash, stock, ordebt (or some combination).FinancialStatements ofA CompanyFinancialStatements ofB CompanyConsolidatedFinancialStatements ofA Company andB Company

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Chapter 17A.When a business combination is effected through an open-marketacquisition of stock, no particular problems arise in connection withdetermining price or method of payment. Price is determined by thenormal functioning of the stock market, and payment is generally in cash,although some or all of the cash may have to be raised by the acquiringcompany through debt or equity issues.B.When a business combination is effected by a stock swap, or exchange ofsecurities, both price and method of payment problems arise. In this case,the price is expressed in terms of astock exchange ratio, which isgenerally defined as the number of shares of the acquiring company to beexchanged for each share of the acquired company, and constitutes anegotiated price. It is important to understand that each constituent of thecombination makes two kinds of contributions to the new entity--netassets and future earnings. The accountant often becomes deeply involvedin the determination of the values of these contributions.X.NET ASSET AND FUTURE EARNINGS CONTRIBUTIONSA.Determination of an equitable price for each constituent company, and ofthe resulting exchange ratio, requires the valuation of each company's netassets, as well as their expected contribution to the future earnings of thenew entity. To estimate current replacement costs of real estate and otheritems of plant and equipment, the services of appraisal firms may beneeded.B.Estimation of the value of goodwill to be included in an offering price issubjective. A number of alternative methods are available, usuallyinvolving the discounting of expected future cash flows (or free cashflows), earnings, or excess earnings over some period of years. Generally,the use of free cash flows or earnings yields an estimate of the entire firmvalue (including goodwill), whereas the use of excess earnings yields anestimate of the goodwill component of total firm value.C.Steps in the excess earnings approach:Excess Earnings Approach to Estimating Goodwill1.Identify a normal rate of return on assets for firms similar to thecompany being targeted.2.Apply the rate of return identified in step 1 to the level ofidentifiable assets (or net assets) of the target to approximate whatthe “normal” firm in this industry might generate with the samelevel of resources. We will refer to the product as “normalearnings.”3.Estimate the expected future earnings of the target.4.Subtract the normal earnings calculated in step 2 from the expectedtarget earnings from step 3. The difference is “excess earnings.”

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Chapter 18If thenormal earnings are greater than the target’s expectedearnings, then no goodwill is implied under this approach.5.To compute estimated goodwill from “excess earnings,” we mustassume an appropriate time period and a discount rate. The shorterthe time period and the higher the discount rate, the moreconservative the estimate. Because of the assumptions needed instep 5, a range of goodwill estimates may be obtained simply byvarying the assumed discount rate and/or the assumed discountperiod.6.Add the estimated goodwill from step 5 to the fair value of thefirm’s net identifiable assets to arrive at a possible offering price.XI.ALTERNATIVE CONCEPTS OF CONSOLIDATED FINANCIALSTATEMENTSA.Parent Company Concept:The parent company concept emphasizesthe interests of the parent'sshareholders. As a result, the consolidated financial statements reflectedthose stockholder interests in the parent itself, plus their undividedinterests in the net assets of the parent's subsidiaries.B.Economic Unit Concept:Theeconomic unit concept emphasizescontrol of the whole by a singlemanagement. As a result, under this concept, consolidated financialstatementsareintended to provide information about a group of legalentities-a parent company and its subsidiaries-operating as a single unit.In its most recent pronouncements,FASB hasopted to adoptthisconcept, and the4thedition chapters (2 through 9) are based ontheeconomic unitconcept.C.Noncontrolling Interest1.Under theeconomic unitconcept, a noncontrolling interest is apart of the ownership equity in the entire economic unit.2.Under theparent companyconcept, the nature and classificationof a noncontrolling interest are unclear.D.Consolidated Net Income1.Undertheparentcompanyconcept,consolidatednetincomeconsists of the realized combined income of the parent companyanditssubsidiariesafterdeductingnoncontrollinginterestinincome; that is, the noncontrolling interest in income is deductedas an expense item in determining consolidated net income.

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Chapter 192.Undertheeconomicunitconcept,consolidatednetincomeconsists ofthetotalrealizedcombinedincome oftheparentcompany and its subsidiaries. The total combined income is thenallocated proportionately to the noncontrolling interest and thecontrollinginterest.Noncontrollinginterestinincomeisconsidered an allocated portion of consolidated net income, ratherthan an element in the determination of consolidated net income.E.Consolidated Balance Sheet Values1.Under the parent company concept, the value assigned to the netassets should not exceed cost to the parent company.2.Under the economic unit concept, on the date of acquisition, thenetassetsofthesubsidiaryareincludedintheconsolidatedfinancial statements at their book value plus the entire differencebetween their fair value and their book value.F.Elimination of Unrealized Intercompany ProfitThe elimination methods associated with these two points of view aregenerally referred to as total (100%) elimination and partial elimination.Note: this issue is unlikely to mean much to students at this point in theirstudy, and may be returned to after chapter 6.It is included here,nonetheless, for the sake of thoroughness and because the discussion isfairly intuitive.1.Partial elimination is consistent with theparent companyconcept.2.Total elimination is consistent with theeconomic unitconcept.3.Currentand PastPracticea.Current(andpast)practicefollowsneithertheparentcompanynortheeconomicunitconceptentirely.Thedifferences in practice relate primarily to the classificationofnoncontrollinginterestandthetotaleliminationofunrealized intercompany profits in assets acquired from anaffiliate.However, as previously stated, the expectation isthat the economic entity concept will be followed in thefuture.b.Current accounting standards require the total eliminationof unrealized intercompany profit in assets acquired fromaffiliated companies, regardless of the percentage ofownership.

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Chapter 110

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Chapter 21CHAPTER TWO–ACCOUNTING FOR BUSINESS COMBINATIONSI.METHODOF ACCOUNTING FORNET ASSET ACQUISITIONS:PURCHASEOR ACQUISITION ACCOUNTINGA.Accounting standards now mandate the use of theacquisition (purchase)method for accounting for mergers &acquisitions.Until2001, companieshadachoice, albeit strictly regulated, between these two methods:1.Pooling ofinterests–previous standards clearly definedthecriteria necessaryto qualify for this accounting treatment, and theSEC was involved in its enforcement.2.Acquisition (Purchase)-all other combinations(i.e, those notqualifying for pooling treatment) were alwaysaccounted for bythepurchasemethod, as all combinations are currently.II.PRO FORMA STATEMENTS AND DISCLOSURE REQUIREMENTA.Pro forma statementshave historicallyservedtwo functions in relation tobusiness combinations:1.To provide information in theplanningstages of the combination,and2.Todiscloserelevant information subsequent to the combination.Note: This aspect was particularly important prior to theelimination of the pooling method, as a means of enabling users tocompare mergers despite the dissimilarity on the face of theprincipal statements between those accounted for under purchaseand pooling.B.The term “pro forma” is also frequently used, aside from mergers, toindicate any calculations which are computed “as if” alternative rules orstandards had been applied. For example, a firm may disclose in its pressreleases that earnings excluding certain one-time charges reflect a morepositive trend than the GAAP-reported EPS. However, the SEC hasrecently cracked down on the extent to which these types of pro formacalculations may be presented, and the details that should be included insuch announcements.C.The notes to the statements contain useful information to facilitatecomparison between periods.III.EXPLANATION AND ILLUSTRATION OFACQUISITIONACCOUNTING

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Chapter 22A.If cash is used, payment equals cost; if debt securities are used, presentvalue of future payments represents cost.B.Assets acquired via issued shares are recorded at fair values of the stockgiven or the assets received whichever is more clearly evident.C.If stock is actively traded, market price is a better estimate of fair valuethan appraisal values.D.Goodwill (GW) is recorded as any excess of total cost over the sum ofamounts assigned to identifiable assets and liabilities and, underSFAS No.142[ASC350]is no longer amortized.E.Goodwillmustbe tested for impairment at a level referred to as areporting unit–generally a level lower than that of the entire entity. If theimplied fair value of the reporting unit’s goodwill is less than its carryingamount, goodwillisconsidered impaired.F.Goodwill impairment lossesshould be aggregated and presented as aseparate line item in the operating section of the income statement.G.Bargain acquisition—whenthenet amount of fair values of identifiableassets less liabilitiesexceedsthe total cost of the acquired company—again is recognized in the period of the acquisition undercurrent GAAP.H.When S Company acquires P Company with stock, common stock iscredited for the par value of the shares issued, with the remainder creditedto other contributed capital. Individual assets acquired and liabilitiesassumed are recorded at their fair values. Plant assetsand other long-livedassetsare recorded at their fair valuesunless a bargain has occurred, inwhich case their values are reduced below fair value to the extent of thebargain.When the cost exceeds the fair value of identifiable net assets,any excess of cost over the fair value is recorded asgoodwill.I.Income Tax Consequences ofAcquisitionMethod BusinessCombinations: deferred tax assetsand/or liabilitiesmust be recognized fordifferences between the assigned values and tax bases of the assets andliabilitiesacquired.Such differences are likely when the combination istax-free to the sellers.

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Chapter 23IV.CONTINGENT CONSIDERATION IN A PURCHASEA.Contingency—transferof assetssubsequent to acquisition from parent tosubsidiary, generally dependent of some measure of performance.B.Contingency based on earningsis probably the most common, but it maycreate conflicts upon implementation because of measures which are outof the control of certain managers after the merger, as well as creatingpossible incentives for manipulation of earnings numbers (and may lead todecisions which are short-term rather than long-term focused).C.Contingency based on security pricesserves to correct some of theshortcomings of contingency calculations based on earnings (manipulationof numbers, for example), but leads to its own set of problems; forexample, market prices fluctuate in response to many economy-widefactors that are almost completely outside the managers’ control.V.LEVERAGED BUYOUTSA.Group of employees/management createsanew company to acquire allthe outstanding shares of employer/original company.B.Consensus position is that only portion of the net assets acquired withborrowed funds have actually been purchased and therefore recorded atcost.APPENDIXA: Deferred Taxes in Business CombinationsA.Motivation for selling firm: structure the deal so that any gain resulting istax-free at the time of the combination.B.Deferred tax liability(or asset)needs to be recognized by purchaser whenthe book value of the assets is used (inherited) for tax purposes, but thefair value is recognized in the accounting books under purchaseaccounting rules.

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Chapter 24APPENDIXB:Did Firms Prefer Pooling; And, If So, Why?I.A. Some facts about pooling1.Majority of US mergers did not meet pooling criteria. Thereforethe purchase method was more widely used, but firms (especiallyin large mergers) sometimes went to great lengths to qualify forpooling treatment. Furthermore, when the elimination of thepooling method was proposed, it meant with vehement protestsfrom a number of fronts.2.Why did firms care? The two methods resulted in a substantialdifference in the way the combined financial statements appeared.3.Pooling—neither of the two firms was considered dominant. Theacquiring firm was termed the “issuer” and the other firm was the“non-issuer.” Assets, liabilities, and retained earnings were takenforward at their previous carrying amounts. Operating results ofthe two companies were combined for the entire period beingpresented, regardless of the date of acquisition. Previously issuedstatements (when presented) were restated as if the companies hadalways been combined.4.Pooling--income statements subsequent to the transaction did notinclude goodwill amortization, excess depreciation, or othercharges due to asset revaluing.5.Purchase accounting yields a generally lower net income dividedby a larger base of assets, and therefore a substantially decreasedreturn on assets (ROA) in most cases relative to pooling.However, this effect has been lessened by another FASB changewhich essentially eliminates the amortization of goodwill.6.Pooling required review of prior year statements which facilitatedtrend analysis.7.See Illustration 2-1 for comparison of the two methods8.Balance sheet differences—Purchase accounting reflects morecurrent values for the combining firm’s assets and liabilites.Pooling combined retained earnings of the two firms (in mostcases), leading to generally greater retained earnings balances forthe combined entity relative to purhase. Purchase, on the otherhand, does not reflect any retained earnings from the acquiredentity.

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Chapter 25B.Treatment of Acquisition Expenses Contrasted1.Pooling—all types of expenses (direct, indirect, and security issuecosts) were expensed in the period incurred.2.Purchase—each category of expenses is treated differently, asshown below.PoolingPurchaseDirect ExpensesExpense (IS)Capitalize (GW or PPE)Indirect ExpenseExpense (IS)ExpenseSecurity Issue CostsExpense (IS)Adjust additional PICC.PURCHASE VERSUS POOLING--AUTHORITATIVE POSITION (ANDHISTORICAL PERSPECTIVE)1. The Financial Accounting Standards Board (FASB) has recentlyeliminated the pooling method. As a result, all acquisitions are nowaccounted for by the purchase method.2. Prior to the issuance of APBOpinion No. 16, “Business Combinations,”the pooling method was widely used and abused. This opinion delineatedthe specific conditions under which pooling was required; all othercombinations had to be accounted for as purchases.a.Paragraphs 45--48 ofOpinion No. 16spelled out the specific conditionsunder which pooling was required.b.Twelve conditions inOpinion No. 16were specified to meet requirementsfor pooling.c.Opinion No. 16attempted to define criteria clearly, remove any choice ofmethod (other than that provided by judicious planning of a combination'sterms), and prohibit partial pooling.3.Advantages and disadvantages, both theoretical and practical, were notedfor both methods.4.Opinion No. 16, issued in 1970, significantly reduced the proportion ofbusiness combinations accounted for as poolings of interests and improvedbusiness combination accounting and reporting to a large extent. However,pooling remained a popular and controversial method for very largemergers untilFASB eliminated it in 2001.

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Chapter 26II.A LOOK BACK: EXPLANATION AND ILLUSTRATION OF POOLING OFINTERESTSA.Business combination process in which two or more groups ofstockholders united their ownership interests by an exchange of commonstock.B.Owners retained proprietary rightsC.Fair value of assets and liabilities were ignored except in thedetermination of an equitable exchange ratio of common stock. Assetsand liabilities were carried forward at book value.D.Equity allocation to common stock, to other contributed capital and toretained earnings:1.If par value of shares issued equals par value of existing shares onbooks of the combining firm—show addition of all othercontributed capital and retained earnings.2.If par value of shares issued exceeds par value of existing shares—equity transfer rule—when the par (or stated) value of the sharesissued by the issuing firm exceeds the total par or stated value ofthe combining company'’ stock, the excess should be deducted firstfrom the combined other contributed capital and then fromcombined retained earnings (RE).3.If par value of shares issued is less than par value of existingshares on books of the combining firm—show addition of othercontributed capital and retained earnings plus additional “othercontributed capital” for the difference between par values.4.Results of operations for that period were the sum of the results of:(1)Operations of the separate companies as if they had beencombined from the beginning of the fiscal period to thedate the combination is consummated.(2)The combined operations from that date to the end of theperiod.III.FINANCIAL STATEMENT DIFFERENCES BETWEEN ACCOUNTINGMETHODSA.Purchase and pooling of interest methods were not intended to beconsidered as alternatives in accounting for a specific businesscombination. Nonetheless business managers often regarded them as suchin the planning stages of an acquisition. Furthermore, those acquisitionsthat were initially recorded under the pooling rules remain on the booksunder those rules; i.e.the elimination wasnot retroactive. Thus, it is

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Chapter 27important to realize that so long as those companies do not unwind or spinoff such prior acquisitions, the “old” pooling rules will continue to affectthe appearance of financial statements for years to come.B.Purchase accounting tends to report higher asset values but lower earnings(due to excess depreciation and amortization) versus pooling of interest.C.Bargain purchases—purchase price below fair value of identifiable netassets—will yield ordinary gain under acquisition (purchase) rules. (In thepast, extraordinary gains were sometimes recorded.)

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Chapter 31CHAPTERTHREE–CONSOLIDATED FINANCIAL STATEMENTSI.DEFINITIONS OF SUBSIDIARY AND CONTROLA.Subsidiary:Situation wherein a parent company (and/or parent’s othersubsidiaries) owns a controlling interest in the voting shares of another company, usuallymore than 50% of the voting shares.B.Control: The ability of an entity to direct the policies and management that guide theongoing activities of another entity so as to increase its benefits and limit its losses fromthat other entity’s activities. For purposes of consolidated financial statements, controlinvolves decision-making ability that is not shared with others. It stresses the need toprepare consolidated financial statements whenever control exists, even in the absence of amajority ownership.C.Parent:Whenastock acquisitionoccurs, the acquiring company is generally referred toas theparent.D.Noncontrolling (minority) interest:Shareholders holding theremaining stock in asubsidiaryoutside of that held by the parent company.E.Affiliated companies:The related companieshavingajoint relationship. Each of theaffiliated companies continues its separate legal existence.II.REQUIREMENTS FOR THE INCLUSION OF SUBSIDIARIESIN THE CONSOLIDATED FINANCIAL STATEMENTSA.Given the purposethatconsolidated statements is to present for a single accounting entitythe net resources and operating results of a group of companies under common control,also considering theproblems related to off-balance-sheet financing, the FASB has takenthe position that essentially all controlled corporations should be consolidated.B.Under some circumstances, majority-owned subsidiaries should be excluded from theconsolidated statements. Those circumstances include:1.Control does not rest with the majority owner–e.g. as when the firm is inbankruptcy.2.A foreign company is domiciled in a country with foreign exchange restrictions,controls, or governmentally imposed uncertainties that cast significant doubt on theparent’s ability to control the subsidiary.3.Majority owned investments that are not consolidated for one of the above reasonsare normally reported as investments using the cost method (with fair valueadjustments, if needed) because the subsidiaries are not controlled nor significantlyinfluenced by the parent company.III.REASONS FOR SUBSIDIARY COMPANIES

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Chapter 32A.Stock acquisition is relatively simple in some cases. Mechanisms such as open marketpurchases and cash tenderoffers help avoid the often long & difficult negotiations of stockfor stock exchange in complete takeovers.B.Control of subsidiary’s operations can be accomplished with smaller investment–not allof the subsidiary’s stock must be acquired, but only a sufficient portion to achieve control.C.Limited liability-separate legal existence of individual affiliates provides an element ofprotection of the parent’s assets from creditors of the subsidiary.D.In some cases, one of the entities may be subject to regulation while others are not.In a stock acquisition, the other entities may maintain their unregulated status.IV.CONSOLIDATED FINANCIAL STATEMENTSA.Statements prepared for a parent company and its subsidiaries. They represent the sum ofassets, liabilities, revenues, and expenses of the affiliates after eliminating the effect of anytransactions among the affiliated companies.B.When a parent acquires controlling interest in a subsidiary, the parent makes an entry todebit Investment in Subsidiary and credit either cash, debt, or stock (or combination)depending on medium of exchange. Assume the acquisition has a cash purchase price of$5 million. Entry in parent’s books is:C.Investment in Subsidiary$5,000,000Cash$5,000,00C.The investment account represents the parent’s investment in the different asset andliability accounts of the subsidiary. The subsidiary continues to maintain detailed booksbased on historical book values, which are not as current as the market values assessed bythe parent at the date of acquisition but are detailed as to classification. Consolidationprocess summarization:Investment Account onthe Parent’s BooksAsset and LiabilityAccounts on theSubsidiary’s BooksValuation in thefinancial statementsMARKET VALUEHISTORICAL VALUEClassification in thefinancial statementsONE ACCOUNTMULTIPLEACCOUNTSD.Process of preparing consolidated financial statements aims to achieve market value andmultiple accounts characteristics (items in the diagonal in part C above). Consolidatedstatements ignore the legal aspects of the separate entities and focus on the economicentity under the control of management, and thus focus on substance rather than form.Consolidated statements are not to be used as substitutes for the statements prepared bythe separate subsidiaries.

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Chapter 33V.INVESTMENTS AT THE DATE OF ACQUISITIONA.Recording Investments at Cost (Parent’s Books)1.Purchase method–stock investment is recorded at its cost as measured by the fairvalue of the consideration given or received, whichever is more clearly evident.2.Both direct and indirectcosts(costs of maintaining an M&A dept, for example)should be expensed as incurred.B.If cash is used for the acquisition, the investment is recorded at its cash cost, includingbroker's fees and other direct costs of the investment.C.Ifthe company acquires onlypart of shares and pays an acquisition fee, the investment isrecorded at itscost of purchasing shares and other direct costs of investment.D.Ifthecompany issues stock in the acquisition, the investment is recorded at the fair valueof the stock issued, giving effect to any costs of registering the stock issue.E.Ifthecompany paysadditionalfees, such asa finder’s fee,the cost ofthatfee should beexpensed under Exposure Draft No. 1204-001.VI.CONSOLIDATED BALANCE SHEETS: THE USE OF WORKPAPERSA.Theuse ofworkpapers1.Consolidated balance sheet reports the sum of the assets and liabilities of a parentand its subsidiaries as if they constituted a single company.2.Assets and liabilities are summed in their entirety (whether 100% ownership ornot).3.Noncontrolling interests are reflected as a component of owner’s equity.4.Eliminations must be made to cancel effects of transactions among the parent andits subsidiaries, as shown in the table below.5.A workpaper is used to summarize the effects of the various additions,eliminations, etc.Intercompany Accounts to be EliminatedParent’s AccountsSubsidiary’s AccountsInvestment in SubsidiaryAgainstEquity AccountsIntercompany receivable(payable)AgainstIntercompany payable(receivable)Advances to subsidiary (fromsubsidiary)AgainstAdvances to parent (to parent)Interest revenue (interestexpense)AgainstInterest expense (interestrevenue)Dividend revenue (dividendsdeclared)AgainstDividends declared (dividendrevenue)Management fee received fromAgainstManagement fee paid to

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Chapter 34subsidiarysubsidiarySales to subsidiary (purchases ofinventory from subsidiary)AgainstPurchases of inventory fromparent (sales to parent)B.Investment elimination1.An important basic elimination in the preparation of consolidated statements is theelimination of the investment account and the related subsidiary's stockholders'equity.2.To start the process of combining the individual assets and liabilities of a parentcompany and its subsidiary at the date of acquisition, the first step is to prepare a“Computation and Allocation of Difference betweenImpliedand Book Value”schedule (CAD). Preparation of this schedule requires us to address two basicissues.a.Determine the percentage of stock acquired in the subsidiary (Is it a 100%acquisition, or a smaller percentage?)and calculate Implied Value (IV) bydividing the purchase price by the percentage acquired.b.Compare theIVto the book value of the equityof the target. If a differencebetweenimpliedand book value exists, we must then allocate that difference toadjust the underlying assets and/or liabilities of the acquired company.c.Book value of the equity= Assets of S Company minus Liabilities of SCompany, or recorded values of all S Company equity accounts summed.d.Note that the comparison isimplied value (IV)tobookvalue, rather thanmarketvalue of the acquired entity.e.The steps above lead to the following possible cases:CASE 1. Thevalue of the subsidiary (IV), as implied by the purchase price,isequalto the book value of the subsidiary company's equity, and(a) The parent company acquires 100% of the subsidiarycompany's stock; or(b) The parent company acquires less than 100% of thesubsidiary company's stock.CASE 2. TheIVexceedsthe book value of the subsidiary company's equity, and(a) The parent company acquires 100% of the subsidiarycompany's stock; or(b) The parent company acquires less than 100% of thesubsidiary company's stock.CASE 3. TheIVislessthan the book value of the subsidiary company's equity,and(a) The parent company acquires 100% of the subsidiarycompany's stock; or(b) The parent company acquires less than 100% of thesubsidiary company's stock.D.Illustration of the alternatives1.Case1(a):IV (implied value)Is Equal to Book Value of Subsidiary Stock–TotalOwnership (100% of Subsidiary Stock Acquired)

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Chapter 35P acquires all outstanding stock (5,000 shares) of S Company for a cash paymentof $80,000Journal entry:Investment in S Company$80,000Cash$80,000P company's cash balance drops to $20,000 and an investment of $80,000 isrecognizedComputation and allocation of difference betweenimpliedand book value:Cost of investment (purchase price)= IV$80,000Book value of equity$80,000Difference betweenimpliedand book value0Note: Eliminating entries are made to cancel the effects of intercompanytransactions and are madeon workpapers onlyEliminating entry in this example:Common Stock-S Company$50,000Other Contributed Capital-S Company$10,000Retained Earnings-S Company$20,000Investment in S Company$80,000A workpaper for the preparation of a consolidated balance sheet for P and SCompanies on January 1, 2007, the date of acquisition, is presented in Illustration3-2.2.CASE 1(b):IVIs Equal to Book Value of Subsidiary Company's Stock–PartialOwnership (Less than 100% of Subsidiary Stock Acquired)P acquires 90% of outstanding stock (4,500 shares) of S Company for a cashpayment of $72,000In this case, consideration must be given to a noncontrolling interest because Powns less than 100% of S Company.Journal entry:Investment in S Company$72,000Cash$72,000P Company's cash balance drops to $28,000 and an investment of $72,000 isrecognized

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Chapter 36Computation and Allocation of Difference ScheduleParentNon-TotalShareControllingValueSharePurchase price and implied value$72,0008,00080,000Less: Book value of equity acquired:Common stock45,0005,00050,000Other contributed capital9,0001,00010,000Retained earnings18,0002,00020,000Totalbook value72,0008,00080,000Difference between implied and book value000Eliminating entry in this example:Common Stock-S Company$50,000Other Contributed Capital-S Company$10,000Retained Earnings-S Company$20,000Investment in S Company$72,000Noncontrolling Interest in Equity (NCI)8,000Illustration 3 shows the balance sheets of S and P Company before theconsolidation, the eliminating entries, as well as the consolidated balance sheet.Note thatthe investment by P in S reflects only its percentage of S Company’sequity. Thus, when eliminating the equity accounts of S, we must recognize theemergence of a noncontrolling interest (NCI).Nonetheless, all the assets andliabilities of S Company and P Company are used to make up the consolidatedbalance sheet because the purpose of the latter is to show the resources that areundercontrolof a single management, notowned! The noncontrolling interestrepresents the ownership of other shareholders inthe net assets of S Company.Andlast, note that the assets are $8,000 greater than in the example before becauseP Company has $8,000 more left in cash (on the equity side of the balance sheetthis difference is made up by the noncontrolling interest).3.CASE 2(b):Implied Value (IV)Exceeds Book Value of Subsidiary Company'sStock Acquired–Partial Ownership (Less than 100% of the Subsidiary Company'sStock Acquired) [Note that Case 2(a) is omitted here, as it is relatively easy tounderstand once Case 2(b) is grasped.]P acquires 80% of outstanding stock (4,000 shares) of S Company for a cashpayment of $74,000Again, consideration must be given to a noncontrolling interest because P ownsless than 100% of S Company. At the same time, the amountby which IVexceedsthe book value ofS Companyequity must be allocated to an assetor assets in theworkpaper entries.

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Chapter 37Journal entry:Investment in S Company$74,000Cash$74,000P Company's cash balance is to $26,000 and an investment of $74,000 isrecognized. We assume in this case that the difference between the book value ofthe equity and theimplied valueis attributable to undervalued land.Computation and Allocation of Difference ScheduleParentNon-TotalShareControllingValueSharePurchase price and implied value$74,00018,50092,500Less: Book value of equity acquired:Common stock40,00010,00050,000Other contributed capital8,0002,00010,000Retained earnings16,0004,00020,000Totalbook value64,00016,00080,000Difference between implied and book value10,0002,50012,500Adjust land upward (mark to market)(10,000)(2,500)(12,500)Balance-0--0--0-Eliminating entry in this example:Common Stock-S Company$50,000Other Contributed Capital-S Company$10,000Retained Earnings-S Company$20,000Differencebetweenimpliedand book value$12,500Investment in S Company$74,000Noncontrolling Interest (NCI)18,500Land$12,500Difference betweenimplied and book value$12,500As one can see, the account “Difference betweenimpliedand book value” is only atemporary account; the debit to land could also have been made in the early journalentry when the equity accounts of S Company were eliminated.Illustration3-4 shows the balance sheets of S and P Company before theconsolidation, the eliminating entries, as well as the consolidated balance sheet.Note the adjustment of land.Reasons for paying for more than the book value:a.Conservative accounting principles were appliedb.Unrecorded goodwillc.Overvaluation of liabilities

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Chapter 38d.Bidding war over company to be acquired drives the price up4.CASE 3(b):Implied Value (IV)Is Less than Book Value of Subsidiary Stock–Partial Ownership (Less than 100% of Subsidiary Stock Acquired)[Note that Case3(a) is omitted here, as it is relatively easy to understand once Case 3(b) isgrasped.]P acquires 80% of outstanding stock (4,000 shares) of S Company for a cashpayment of $60,000Again, consideration must be given to a noncontrolling interest because P ownsless than 100% of S Company. At the same time, the amount that exceeds thebook value ofS Company equitymust be allocated to an asset(or a gain may berecognized, if no market value adjustments are warranted);however this time, thevalue of the assetiswrittendownrather than up.Journal entry:Investment in S Company$60,000Cash$60,000P Company's cash balance is to $40,000 and an investment of $60,000 isrecognized. We assume in this case that the difference between the book value ofthe equity and theimplied valueis attributable to overvalued land.Computation and Allocation of Difference ScheduleParentNon-TotalShareControllingValueSharePurchase price and implied value$60,00015,000$75,000Less: Book value of equity acquired:Common stock40,00010,00050,000Other contributed capital8,0002,00010,000Retained earnings16,0004,00020,000Total book value64,00016,000$80,000Difference between implied and book value(4,000)(1,000)(5,000)Land, adjust downward4,0001,0005,000Balance-0--0--0-Eliminating entry in this example:Common Stock-S Company$50,000Other Contributed Capital-S Company$10,000Retained Earnings-S Company$20,000Difference betweenimpliedand bookvalue$ 5,000Investment in S Company$60,000Noncontrolling Interest (NCI)$15,000

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Chapter 39Difference betweenimpliedand book value$5,000Land$5,000Illustration3-5 shows the balance sheets of S and P Company before theconsolidation, the eliminating entries, as well as the consolidated balance sheet.Note the (downward) adjustment of land.E.Subsidiary Treasury Stock HoldingsTreasury stock is excluded from the computation of the percentage of interest acquiredbecause the latter is based on stock outstandingExample: P Company acquires 18,000 of S Company’s shares for $320,000S Company’s equity section appears as follows:Common stock, $10 par, 25,000 shares issued$250,000Other contributed capital$50,000Retained Earnings$125,000$425,000Less: Treasury stock at cost, 1,000 shares$25,000$400,000P Company’s interest in SCompany is 18,000/24,000 = 75%. Implied Value (IV) =$320,000/75%, or $426,667. The NCI is 25% x $426,667, or $106,667.Since Treasury Stock is a contra account, P Company’s share must be reducedaccordingly.Eliminating entry:Common Stock-S Company$250,000Other Contributed Capital-S Company$50,000Retained Earnings-S Company$125,000Difference between IV and Book Value$26,667Treasury stock$25,000Investment in S Company$320,000Noncontrollling Interest in Equity (NCI)$106,667E.Other Intercompany Balance Sheet EliminationsAll receivables or payables as well as cash advances must be eliminated against thereciprocal accounts of the other company.A $5,000 cash advance by P Company to S Company:Advance from P Company$25,000Advance to S Company$25,000F.Adjusting Entries Prior to Eliminating EntriesIn case certain transactions are not completed, adjusting entries must bemade.VII.A COMPREHENSIVE ILLUSTRATION-MORE THAN ONESUBSIDIARY COMPANY(Illustration 3-6, 3-7)

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Chapter 310Parent company owns a direct controlling interest in more than one subsidiaryA.Balance sheet of each affiliate is entered on the workpaper.B.Any adjustments are prepared.C.All related intercompany accounts, including those between subsidiary companies, areeliminated.D.Remaining balances are combined, constituting a consolidated balance sheet.E.Formal consolidated balance sheet is prepared from the detail in the consolidated balancesheet columns of the workpaper.F.Balance sheet data are classified according to normal balance sheet arrangements.G.Noncontrolling interest in consolidated net assets is reported as a component ofstockholders’ equity.VIII.LIMITATIONS OF CONSOLIDATED STATEMENTS:A.Noncontrolling stockholders and regulatory agencies–consolidated statements containinsufficient detail about individual subsidiaries.B.Creditors–have claims only against the resources of particular subsidiary, unless theparent guarantees the claims.C.Financial analysts–difficult to analyze or compare diversified companies operating acrossseveral industries.

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Chapter 311Appendix A:Deferred Taxes on the Date of AcquisitionA.If a purchase acquisition is tax-free to the seller, the tax bases of the acquired assets andliabilities are carried forward at book value.B.The assets and liabilities of the acquired company are recorded on the consolidated booksat adjusted fair value.C.The difference between the tax bases and the recorded values gives rise to deferred taxes.Appendix B:Consolidation ofVariable Interest Entities (VIEs)A.An entity is considered a VIE and is subject to consolidation under FASB Interpretation No.46 if:1.Its total equity at risk is not adequate to allow the entity to finance its own activitieswithout additional subordinated financial support,2.If the voting rights of the equity investors do not reflect their economic interests, or3.If the equity investors lack one or more of the following three characteristics:a.Direct or indirect ability to make decisions that control the entity,b.The obligation to absorb the expected losses of the entity, orc.The right to receive the expected residual returns of the entity.B.The primary beneficiary of a VIE must disclose:1.The nature, purpose, size, and activities of the VIE,2.The carrying amount and classification of consolidated assets that are collateral for theobligations of the VIE,3.Any lack of recourse by creditors of a consolidated VIE to the general credit of theprimary beneficiary.

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Chapter 41CHAPTER FOUR–CONSOLIDATED FINANCIAL STATEMENTS AFTER ACQUISITIONI.THREE METHODS OF REPORTING ON PARENT’S BOOKSA.Investments in voting stock of other companies may be consolidated, or they may beseparately reported in the financial statements at cost, at fair value, or at equity. Themethod of reporting adopted depends on a number of factors including the size of theinvestment, the extent to which the investor exercises control over the activities of theinvestee, and the marketability of the securities.B.Generally speaking, there are three levels of influence or control by an investor over aninvestee, which determine the appropriate accounting treatment. There are no absolutepercentages to distinguish among these levels, but there are guidelines. The three levelsand the corresponding accounting treatment are summarized as follows:LevelGuidelinePercentagesUsual Accounting TreatmentNo significantinfluenceLess than 20%Investment carried at fair value at current year-end (trading or available for sale securities)–method traditionally referred to as “Cost”method with an adjustment for market changes.Significantinfluence (nocontrol)20 to 50%Investment measured under the equity methodEffectivecontrolGreater than50%Consolidated statements required(investment eliminated, combined financialstatements): investment recorded under cost,partial equity, or complete equity method.C.Differences among the three methods in accounting for the investment on the books of theparent are also summarized in Figure 4-1.D.Cost Method on Books of InvestorP Company acquired 90% of the outstanding voting stock of S Company at the beginningof Year 1 for $800,000. Income (loss) of S Company and dividends declared by SCompany during the next three years were: During the third year, the firm pays aliquidating dividend (i.e. the cumulative dividends declared exceeds the cumulativeincome earned).YearIncome(Loss)DividendsDeclaredCumulative Income Over(Under) Dividends1$90,000$30,000$60,0002(20,000)30,00010,000310,00030,000(10,000)P’s booksYear 1–P’s BooksInvestment in S Company800,000Cash800,000

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Chapter 42To record the initial investmentCash7,000Dividend Income27,000To record dividends received .9($30,000).Year 2–P’s BooksCash7,000Dividend Income27,000To record dividends received .9($30,000).Year 3–P’s BooksCash7,000Dividend Income18,000Investment in S Company9,000To record dividends received, $9,000 of which represents a return of investment.After these entries are posted, the investment account will appear as follows:Investment in S company (Cost Method)Year 1 Cost800,000Year 3 Liquidating dividend9,000Year 3 Balance791,000Year 1 entries record the initial investment and the receipt of dividends from S Company.In Year 2, although S Company incurred a $20,000 loss, there was a $60,000 excess ofearnings over dividends in Year 1. Consequently, the dividends received are recognized asincome by P Company. In Year 3, however, aliquidating dividendoccurs. From the pointof view of a parent company, a purchased subsidiary is deemed to have distributed aliquidating dividend when the cumulative amount of its dividends declared exceeds itscumulative reported earnings after its acquisition. Such excess dividends are treated as areturn of capital, and are recorded as a reduction of the investment account rather than asdividend income. The liquidating dividend is 90% of the excess of dividends paid overcumulative earnings since acquisition (90% of $10,000).E.Partial Equity Method on Books of InvestorP Company has elected to use the partial equity method to record the investment in SCompany above. The entries for the first three years would appear as follows:Year 1–P’s BooksInvestment in S Company800,000Cash800,000To record the initial investment.Investment in S Company81,000Equity in Subsidiary Income.9($90,000)81,000

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