Essentials of Advanced Financial Accounting

ISBN: 0078025648
Author: Baker
Title: Essentials of Advanced Financial Accounting 1e
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ISBN: 0078025648
Author: Baker
Title: Essentials of Advanced Financial Accounting 1e
Front endsheets
Color: 4c
Pages: 4, Insert
Confirming Pages
Essentials of
Advanced
Financial
Accounting
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Essentials of
Advanced Financial
Accounting
Richard E. Baker
Northern Illinois University
Theodore E. Christensen
Brigham Young University
David M. Cottrell
Brigham Young University
With contributions from:
Valdean C. Lembke
Professor Emeritus
University of Iowa
Thomas E. King
Professor Emeritus
Southern Illinois University, Edwardsville
Cynthia G. Jeffrey
Iowa State University
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ESSENTIALS OF ADVANCED FINANCIAL ACCOUNTING
Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue
of the Americas, New York, NY, 10020. Copyright © 2012 by The McGraw-Hill Companies, Inc. All
rights reserved. No part of this publication may be reproduced or distributed in any form or by any
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Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission,
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Some ancillaries, including electronic and print components, may not be available to customers outside
the United States.
This book is printed on acid-free paper.
1 2 3 4 5 6 7 8 9 0 QDB/QDB 1 0 9 8 7 6 5 4 3 2 1
ISBN 978-0-07-802564-8
MHID 0-07-802564-8
Vice president and editor-in-chief: Brent Gordon
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Library of Congress Cataloging-in-Publication Data
Baker, Richard E.
Essentials of advanced financial accounting / Richard E. Baker, Theodore E. Christensen,
David M. Cottrell; with contributions from Valdean C. Lembke, Thomas E. King, Cynthia
G. Jeffrey.—1st ed.
p. cm.
Includes index.
ISBN-13: 978-0-07-802564-8 (alk. paper)
ISBN-10: 0-07-802564-8 (alk. paper)
1. Accounting. I. Christensen, Theodore E. II. Cottrell, David M. III. Title.
HF5636.B35 2012
657’.046—dc22 2010053791
www.mhhe.com
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v
About the Authors
Richard E. Baker
Richard E. Baker was a member of the faculty of Northern Illinois University for
26 years. His academic recognitions include having been named the Ernst & Young Distinguished Professor of Accountancy at Northern Illinois University. In addition, he has
been recognized as an inaugural University Presidential Teaching Professor, the highest
teaching recognition of his university. He received his B.S. degree from the University
of Wisconsin at River Falls and his MBA and Ph.D. from the University of Wisconsin
at Madison. His activities in the American Accounting Association have been continuous over many years and include service on the AAA’s Executive Committee as the
Director of Education of the AAA; as a member of the AAA’s Council; as the Chair
of the Teaching and Curriculum Section; and as the President of the Midwest Region.
His lengthy service to the Federation of Schools of Accountancy (FSA) includes the
offices of the President, the Vice President, and the Secretary. Many of his extensive
professional and academic organization committee service efforts have involved research
in assessing teaching and learning outcomes, designing innovative curriculum models,
developing meaningful measurement criteria for evaluating accounting programs, and
continually integrating new electronic technology into the accounting classroom. Professor Baker has received numerous teaching awards at both the undergraduate and graduate
levels and has been selected as the Illinois CPA Society’s Outstanding Accounting Educator. His most recent published research studies have concentrated on ways to make the
learning/teaching experience as effective as possible.
Theodore E. Christensen
Ted Christensen has been a faculty member at Brigham Young University since 2000.
Prior to coming to BYU, he was on the faculty at Case Western Reserve University
for five years. He received a B.S. degree in accounting at San Jose State University,
a M.Acc. degree in tax at Brigham Young University, and a Ph.D. in accounting from
the University of Georgia. Professor Christensen has authored and coauthored articles
published in many journals including The Accounting Review, the Journal of Accounting and Economics, Accounting Organizations and Society, Review of Accounting Studies, the Journal of Business Finance & Accounting, Accounting Horizons, and Issues in
Accounting Education. Professor Christensen has taught financial accounting at all levels, financial statement analysis, both introductory and intermediate managerial accounting, and corporate taxation. He is the recipient of numerous awards for both teaching and
research. He has been active in serving on various committees of the American Accounting Association and is a CPA.
David M. Cottrell
Professor Cottrell joined the faculty at Brigham Young University in 1991. He currently
serves as the Associate Director of the School of Accountancy. Prior to coming to BYU
he spent five years at The Ohio State University, where he earned his Ph.D. Before pursuing a career in academics he worked as an auditor and consultant for the firm of Ernst
& Young in their San Francisco office. At BYU, Professor Cottrell has developed and
taught a case-based accounting and auditing research course in the graduate program,
and also has taught financial accounting and corporate financial reporting courses in
the School of Accountancy, the MBA program, and the Finance program. He has won
numerous awards from the alumni and faculty for his teaching and curriculum development. He has received the Outstanding Professor Award in the college of business as
selected by the students in the Finance Society; he has received the Outstanding Teaching Award as selected by the Marriott School of Management; and he is a four-time
winner of the collegewide Teaching Excellence Award for Management Skills, which is
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vi About the Authors
selected by the Alumni Board of the Marriott School of Management at BYU. In 2005
he was named as a University Faculty Fellow for Teaching and Learning with Technology. Professor Cottrell also has authored many articles about accounting and auditing
issues. His articles have been published in Issues in Accounting Education, The Journal
of Accounting Case Research, The Quarterly Review of Distance Education, Journal of
Accountancy, The CPA Journal, Internal Auditor, The Tax Executive, and The Journal of
International Taxation, among others.
NOTE FROM THE AUTHORS
Our objective in creating the “Essentials of Advanced Accounting” text was to give an
additional option to instructors and students who have only one term or one semester to
devote to advanced accounting topics. We have received several requests from Instructors and students for a resource which will help them cover in a single term or semester
the core elements of the advanced accounting material that is most frequently represented
on the CPA exam. Hence this text contains the essential information on consolidations,
multinational entities, partnerships, and governmental and not-for-profit entities.
The subject matter of advanced accounting is expanding at an unprecedented rate.
New topics are being added, and traditional topics require more extensive coverage. Most
one-term courses are unable to cover all the topics included in a traditional comprehensive advanced accounting text. In recognition of time constraints, this text is structured
to provide the most efficient use of the time available, while maintaining all the learning
support and ancillary materials that cover these essential topics. For students and instructors who would like to cover a wider set of topics, we invite you to examine our comprehensive text, Advanced Accounting, which is now in its ninth edition.
The new authors, Ted Christensen and David Cottrell, are excited to be involved with
this book and express their gratitude to Val Lembke, Tom King, and Cindy Jeffrey for
their many years of hard work to the previous editions of the comprehensive text.
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vii
Preface
Essentials of Advanced Financial Accounting is an up-to-date, comprehensive, and
highly illustrated presentation of the accounting and reporting principles and procedures
used in a variety of business entities. Every day, the business press carries stories about
the merger and acquisition mania, the complexities of modern business entities, new
organizational structures for conducting business, accounting scandals related to complex business transactions, the foreign activities of multinational firms, the operations of
governmental and not-for-profit entities, bankruptcies of major firms, and other topics
typically included in advanced accounting. Accountants must understand and know how
to deal with the accounting and reporting ramifications of these issues.
OVERVIEW
Essentials of Advanced Financial Accounting provides strong coverage of advanced
accounting topics, with clarity of presentation and integrated coverage based on continuous
case examples. The text is highly illustrated with complete presentations of worksheets,
schedules, and financial statements so that students can see the development of each topic.
Inclusion of all recent FASB and GASB pronouncements and the continuing deliberations
of the authoritative bodies provide a current and contemporary text for students preparing
for the CPA examination and current practice. This has become especially important given
the recent rapid pace of the authoritative bodies in dealing with major issues having farreaching implications. An overview of the contents and organization is illustrated below.
Multi-Corporate Entities
Business Combinations
1 Intercorporate Acquisitions and Investments in Other Entities
Consolidation Concepts and Procedures
2 Reporting Intercorporate Investments and Consolidation of Wholly Owned with
No Differential
3 The Reporting Entity and Consolidation of Less-than-Wholly-Owned with No Differential
4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value
5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than
Book Value
Intercompany Transfers
6 Intercompany Inventory Transactions
7 Intercompany Transfers of Services and Noncurrent Assets
Multinational Entities
Foreign Currency Transactions
8 Multinational Accounting: Foreign Currency Transactions and Financial Instruments
Translation of Foreign Statements
9 Multinational Accounting: Issues in Financial Reporting and Translation of Foreign
Entity Statements
Partnerships
Formation, Operation, Changes
10 Partnerships: Formation, Operation, and Changes in Membership
Liquidation
11 Partnerships: Liquidation
Governmental and Not-for-Profit Entities
Governmental Entities
12 Governmental Entities: Introduction and General Fund Accounting
Special Funds
13 Governmental Entities: Special Funds and Government-wide Financial Statements
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viii Preface
KEY FEATURES OF ESSENTIALS OF ADVANCED FINANCIAL ACCOUNTING
• Introductory vignettes. Each chapter begins with a brief story of a well-known company to illustrate why topics covered in that chapter are relevant in current practice.
Short descriptions of the vignettes and the featured companies are featured in the
Chapter-by-Chapter Changes section on page xvi.
• A building-block approach to consolidation. Virtually all advanced financial
accounting classes cover consolidation topics. While this topic is perhaps the most
important to instructors, students frequently struggle to gain a firm grasp of consolidation principles. Baker/Christensen/Cottrell 1e provides students with a learningfriendly framework to consolidations by introducing consolidation concepts and
procedures more gradually. This is accomplished by a building-block approach that
introduces consolidations earlier than in previous editions by beginning the consolidation discussion earlier in Chapters 2 and 3. The building-block approach can be summarized as follows:
• Chapter 2 begins with the most basic consolidation situation: the consolidation of
a wholly owned subsidiary that is either created or purchased at an amount equal to
the book value of net assets. Thus, students practice basic consolidation procedures
without having to worry about the complications associated with a differential or
noncontrolling shareholders.
• Chapter 3 introduces the notion of partial ownership of a subsidiary that is created
or acquired at an amount equal to the book value of net assets. In this way students
are exposed to the nuances associated with the existence of noncontrolling shareholders, but without the details associated with a differential.
• Chapter 4 exposes students to the intricacies of consolidation when the subsidiary
is acquired for an amount that exceeds the book value of net assets. In order to
isolate the new concepts and procedures that accompany the consolidation of a
subsidiary with a differential, this chapter focuses on wholly owned subsidiaries.
• Chapter 5 finally brings students full circle to the point where they are ready to
tackle more realistic situations where the parent company purchases a controlling interest in a subsidiary (but not 100% ownership) and the acquisition price
exceeds the book value of net assets. Thus, students learn how to simultaneously handle all of the details associated with a differential and noncontrolling
shareholders.
The overall coverage of the consolidation process by chapter is illustrated below:
No NCI
shareholders
NCI
shareholders
Differential
No
differential Investment = Book value
Wholly owned
subsidiary
Partially owned
subsidiary
Chapter 2
Chapter 4
Chapter 3
Investment > Book value Chapter 5
• Reorganization of consolidation elimination entries. Consistent with the buildingblock approach to consolidation, the text includes a slight reorganization of the elimination entries used in consolidation to facilitate the elimination of the investment
in a subsidiary in two steps: (1) first the book value portion of the investment and
income from the subsidiary are eliminated and (2) then the differential portion of the
investment and income from the subsidiary are eliminated with separate entries. This
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Preface ix
approach facilitates the building-block approach in Chapters 2–5. The text also uses
frequent illustrations to help students visualize the steps in the elimination process.
• Presentation of intercompany transactions. Intercompany inventory transfers
are presented before fixed-asset transfers. Inventory transfers are (1) far more common than fixed-asset transfers and (2) easier for students to understand. The fully
adjusted equity method is presented in Chapters 6 and 7. This method links back to the
building-block approach in Chapters 2–5.
• New FASB codification. All authoritative citations to U.S. GAAP include secondary
citations to the new FASB codification. We also maintain the authoritative citations
for clarity during this period of transition.
• IFRS comparisons. As the FASB and IASB work toward convergence to a single
set of global accounting standards, the SEC is debating the wholesale introduction of
international financial reporting standards (IFRS). The text summarizes key differences between current U.S. GAAP and IFRS to make students aware of changes that
will likely occur if the SEC adopts IFRS in the near future.
• AdvancedStudyGuide.com. See page xv for details.
• The use of a continuous case for each major subject-matter area. This textbook
presents the complete story of a company, Peerless Products Corporation, from its
beginning, through its growth to a multinational consolidated entity, and finally to its
end. At each stage of the entity’s development, including the acquisition of a subsidiary, Special Foods Inc., the text presents comprehensive examples and discussions of
the accounting and financial reporting issues that accountants face. The discussions
tied to the Peerless Products continuous case are easily identified by the company
logos in the margin:

The comprehensive case of Peerless Products Corporation and its subsidiary, Special
Foods Inc., is used throughout the for-profit chapters. For the governmental chapters,
the Sol City case has been used to facilitate the development of governmental accounting and reporting concepts and procedures. Using a continuous case provides several
benefits. First, students need only become familiar with one set of data and can then
move more quickly through the subsequent discussion and illustrations without having to absorb a new set of data. Second, the case adds realism to the study of advanced
accounting and permits students to see the effects of each successive step on the
financial reports of an entity. Finally, comparing and contrasting alternative methods
using a continuous case allows students to evaluate different methods and outcomes
more readily.
• Extensive illustrations of key concepts. The book is heavily illustrated with complete, not partial, workpapers, financial statements, and other computations and comparisons useful for demonstrating each topic. The illustrations are cross-referenced to
the relevant text discussion. In the consolidations portion of the text, the focus is on
the fully adjusted equity method of accounting for an investment in a subsidiary, but
two other methods—the cost method and the modified equity method—are also discussed and illustrated in chapter appendices.
• Comprehensive coverage with significant flexibility. The self-contained units of
subject matter allow for substantial flexibility in sequencing the course materials.
In addition, individual chapters are organized to allow for going into greater depth
on some topics through the use of the “Additional Considerations” sections. Several
chapters include appendices containing discussions of alternative accounting procedures or illustrations of procedures or concepts that are of a supplemental nature.
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x Preface
• Contemporary topical coverage. The dynamic business environment requires
accountants to continually learn about new types of transactions, new technologies
available to the profession, and new requirements and standards for accounting and
financial reporting. This textbook integrates the most recent professional standards
and includes cases and examples from current practice. For example, the importance
in recent years of topics such as the Sarbanes-Oxley Act, special-purpose entities
(SPEs), variable interest entities (VIEs), derivatives, fair value reporting, and international financial reporting standards (IFRS) has led to significant coverage of these
topics in the current and recent editions of the text. The GASB’s recent focus on
enhanced financial statement disclosures for governmental entities is discussed and
illustrated. Students are presented with an abundance of current information and learning opportunities to see that the topics in their advanced financial accounting courses
are a significant part of today’s profession of accountancy.
• Extensive end-of-chapter materials. A large number of questions, cases, exercises,
and problems at the end of each chapter provide the opportunity to solidify understanding of the chapter material and assess mastery of the subject matter. The end-ofchapter materials progress from simple focused exercises to more complex integrated
problems. Cases provide opportunities for extending thought, gaining exposure to
different sources of accounting-related information, and applying the course material to real-world situations. These cases include research cases where students are
referred to authoritative pronouncements, and Kaplan CPA Review simulations. The
American Institute of CPAs has identified five skills to be examined as part of the
CPA exam: ( a ) analysis, ( b ) judgment, ( c ) communication, ( d ) research, and ( e ) understanding. The end-of-chapter materials provide abundant opportunities for students to
enhance those skills with realistic and real-world applications of advanced financial
accounting topics. Cases and exercises identified with a world globe icon provide special opportunities for students to access real-world data by using electronic databases,
Internet search engines, or other inquiry processes to answer the questions presented
on the topics in the chapters.
MCGRAW-HILL’S CONNECT ™ACCOUNTING
Less Managing. More Teaching. Greater Learning.
McGraw-Hill’s Connect ™ Accounting is an online assignment and assessment solution
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McGraw-Hill’s Connect ™ Accounting Features
McGraw-Hill’s Connect ™ Accounting offers a number of powerful tools and features
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McGraw-Hill’s Connect ™ Accounting, students can engage with their coursework anytime and anywhere, making the learning process more accessible and efficient. McGrawHill’s Connect ™ Accounting offers you the features described below.
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Preface xi
Smart Grading
When it comes to studying, time is precious. McGraw-Hill’s Connect ™ Accounting
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McGraw-Hill’s Connect ™ Accounting keeps instructors informed about how each student, section, and class is performing, allowing for more productive use of lecture and
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McGraw-Hill reinvents the textbook learning experience for the modern student
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xii Preface
eBook and McGraw-Hill’s Connect ™ Accounting, McGraw-Hill’s Connect ™ Plus
Accounting provides all of the McGraw-Hill’s Connect ™ Accounting features plus
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In short, McGraw-Hill’s Connect ™ Accounting offers you and your students powerful tools and features that optimize your time and energies, enabling you to focus on
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For more information about McGraw-Hill’s Connect ™ Accounting, go to www
.mcgrawhillconnect.com, or contact your local McGraw-Hill sales representative.
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MCGRAW-HILL/IRWIN CUSTOMER CARE
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TEGRITY CAMPUS: LECTURES 24/7
Tegrity Campus is a service that makes class time available 24/7 by automatically capturing every lecture. With a simple one-click start-and-stop
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Preface xiii
MCGRAW-HILL HIGHER EDUCATION AND BLACKBOARD HAVE
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SUPPLEMENTS FOR INSTRUCTORS
• Online Learning Center (OLC). We offer an Online Learning Center (OLC) that follows Essentials of Advanced Financial Accounting chapter by chapter. It doesn’t
require any building or maintenance on your part. It’s ready to go the moment you and
your students type in the URL: www.mhhe.com/baker1e .
The OLC includes
• Interactive chapter quizzes
• PowerPoint® presentations
• Excel worksheets
• Check figures
• Supplemental chapters
• Supplemental problems
• Instructor PowerPoints. The authors have developed a comprehensive set of
PowerPoint slides designed to accompany the text. These slides do much more than
simply summarize the topics in each chapter. They illustrate key concepts but also
include group exercises and practice quiz questions to give students hands-on practice in class to better prepare them for future homework and assessment experiences.
Instructors benefit from proven interactive class discussions and exercises fully
annotated by the authors.
• Solutions Manual. Created by the authors, solutions are provided for all questions,
cases, exercises, and problems in the text. Solutions are carefully explained and logically presented. Answers for many of the multiple-choice questions include computations and explanations.
• Test Bank. Prepared by the authors, this comprehensive collection of both conceptual and procedural test items is organized by chapter and includes a large variety
of multiple-choice questions, exercises, and problems that can be used to measure
student achievement in the topics in each chapter. The test items are closely coordinated with the text to ensure consistency.
• Instructors’ Resource Manual. The Instructor’s Resource Manual includes chapter outlines, additional examples, teaching suggestions, and other materials to assist
instructors in making the most effective use of the text.
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xiv Preface
ASSURANCE OF LEARNING READY
Many educational institutions today are focused on the notion of assurance of learning,
an important element of some accreditation standards. Essentials of Advanced Financial
Accounting is designed specifically to support your assurance of learning initiatives with
a simple, yet powerful solution.
Each test bank question for Essentials of Advanced Financial Accounting maps to a
specific chapter learning outcome/objective listed in the text. You can use our test bank
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easily query for learning outcomes/objectives that directly relate to the learning objectives for your course. You can then use the reporting features of EZ Test to aggregate
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of learning data simple and easy.
AACSB STATEMENT
The McGraw-Hill Companies is a proud corporate member of AACSB International.
Understanding the importance and value of AACSB accreditation, Essentials of Advanced
Financial Accounting recognizes the curricula guidelines detailed in the AACSB standards for business accreditation by connecting selected questions in the text and the test
bank to the six general knowledge and skill guidelines in the AACSB standards.
The statements contained in Essentials of Advanced Financial Accounting are provided only as a guide for the users of this textbook. The AACSB leaves content coverage
and assessment within the purview of individual schools, the mission of the school, and
the faculty. While Essentials of Advanced Financial Accounting and the teaching package make no claim of any specific AACSB qualification or evaluation, we have within
Essentials of Advanced Financial Accounting labeled selected questions according to the
six general knowledge and skills areas.
• McGraw-Hill’s Connect ™ Plus Accounting
This integrates all of the text’s multimedia resources. Students can obtain state-of-theart study aids, including an online version of the text.
• McGraw-Hill’s Connect ™ Accounting
This Web-based software duplicates problem structures directly from the end-ofchapter material in the textbook. It shows students where they made errors. All applicable exercises and problems are available with McGraw-Hill’s Connect ™ Accounting.
Available on the Online Learning Center at www.mhhe.com/baker9e
• Online Quizzes. Interactive quizzes give students a variety of multiple-choice and
true/false questions related to the text for self-evaluation.
• Excel Worksheets. These worksheets for use with Excel are provided to facilitate completion of problems requiring numerous mechanical computations.
SUPPLEMENTS FOR STUDENTS
accounting
• Supplemental Problems. Downloadable additional exercises and problems are provided for a number of chapters. Instructors can assign these additional exercises and
problems to broaden their students’ understanding of the topics in the chapters. The
instructor side of the OLC includes downloadable solutions to those supplemental
exercises and problems.
• Supplemental Chapters. Two chapters are available online: ( a ) accounting for home
office and branch operations and ( b ) accounting and reporting for estates and trusts.
Cases, exercises, and problems are also available for these two chapters and the
Instructor Edition includes solutions to those end-of-chapter items.
• Instructor Updates. Contains timely discussions and illustrations of major accounting
or financial reporting issues under deliberation by standard-setting bodies. Instructors
can choose to share them with their students.
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Preface xv
• Check Figures. Prepared by the text authors, a list of answers is provided separately
for many of the end-of-chapter materials in the text.
• Microsoft PowerPoint Slides® . Available by chapter to facilitate note taking and review.
• Supplemental Problems. Additional problem materials for a number of the chapters are
available online to enhance students’ learning of the topics in the chapters. These supplemental problems tend to be longer problems that present a more comprehensive fact
situation and can extend understanding of the topics in the chapters to a broader scope.
• Supplemental Chapters. Two chapters are available online for those persons wishing extended learning: ( a ) accounting for home office and branch operations and
( b ) accounting and reporting for estates and trusts. Cases, exercises, and problems are
also available for these two chapters.
HIGH TECH: ESSENTIALS OF ADVANCED FINANCIAL ACCOUNTING HAS KEY
TECHNOLOGY RESOURCES TO BENEFIT BOTH STUDENTS AND INSTRUCTORS
Essentials of Advanced Financial Accounting introduces the most cutting-edge technology supplement ever delivered in the advanced accounting market. AdvancedStudyGuide.com is a product created exclusively by the authors of the text that represents a
new generation in study resources available to students as well as a new direction and
options in the resources instructors can use to help their students and elevate their classroom experiences.
Traditional study guides offer students a resource similar to the text itself. That is
more discussion like the text accompanied by more problems and exercises like the ones
in the text, all of this at a fairly costly price to just give students the same type of materials that they already received with the text.
At its core AdvancedStudyGuide.com (ASG) offers materials that go beyond
what a printed text can possibly deliver. The ASG contains dozens of narrated, animated discussions and explanations of materials aligned to key points in the chapter.
Not only that, the ASG also contains animated problems just like key problems in the
exercises and problems at the end of each chapter. For the student who would like a
little help with Essentials of Advanced Financial Accounting, the ASG is like having
private tutoring sessions from the authors who wrote the book (not a class TA) any
time, day or night. This also can provide tremendous benefits for instructors, as outlined below.
The Questions
• Have you ever had to miss a class and were then confused about what the book was
trying to say about a topic?
• Even when you were in class, do things sometimes not make as much sense when you
are reviewing on your own?
• Do you ever feel stuck when it comes to doing homework problems, even though you
read the chapter?
• When the exam is a few weeks after you covered the material in class, do you ever
wish someone could walk you through a few examples as you review for the exam?
• Have you ever purchased a study guide for a text and found it was very expensive and
did not give the additional study help you needed?
The ASG Answer
• The Answer, at least in part, is the ASG: a new type of study guide designed for the
way you like to study and the way that you learn best.
• It is our attempt as authors to really discuss the material in a way that a text-only
approach cannot do.
• AND we can discuss your questions with you 24/7, anytime—day or night, at times
when your regular instructor is not around.
For Students:
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xvi Preface
CHAPTER-BY-CHAPTER COVERAGE
• Chapter 1 emphasizes the importance of business acquisitions and combinations based
on the January 2010 acquisition of Cadbury PLC by Kraft Foods, Inc. The business
world is complex, and frequent business combinations will continue to increase the
complex nature of the business environment in the future. An understanding of the
accounting treatment of mergers, acquisitions, and other intercorporate investments is
an invaluable asset in our ever-changing markets.
• Chapter 2 summarizes the different types of intercorporate investments based on
the 2009 investment portfolio of Berkshire Hathaway. This vignette also discusses issues such as ownership and control that are related to the accounting for
investments.
• Through the ASG, we will bring you streaming media discussions where the authors
of the book (not a class TA) explain key points of each chapter.
• The ASG will also show, explain, and illustrate for you the approach to solving key
homework problems in the text. These explanations are Like Problems; that is, they
are problems “just like” some in the text that you were assigned for homework.
The ASG Benefit
AdvancedStudyGuide.combrings you discussion and examples worked out in streaming
video. While traditional study guides can Tell you what to do, the ASG will Show You
What to Do AND HOW to Do It.
See the student page at AdvancedStudyGuide.com .
The Questions
• Have you ever had a student miss class and then come to your office and ask you to go
over the topics that were discussed in class the day the student was absent?
• Even when a student is in class, does he or she sometimes come to your office and ask
you to repeat the discussion?
• Even when you have discussed the chapter concepts, do you have students who still
get stuck when it comes to doing homework problems?
• When exams are approaching, do students sometimes ask you to go back over material
you taught days or weeks before?
• Would it be helpful to you if, on occasion, the authors of the text offered to hold
“office hours” with your students for you?
The ASG Answer
• The Answer, at least in part, is the ASG: the authors’ attempt to partner with you in
helping to better serve students’ needs in some of the common situations where questions arise, without using more of your scarce time.
• The ASG will allow you to refer to streaming media discussions where the authors
explain key points of each chapter.
• The ASG will show, explain, and illustrate for students the approach to solving key
homework problems in the text. These explanations are Like Problems; that is they are
problems “just like” some in the text that you can assign for homework.
The ASG Benefit
AdvancedStudyGuide.com (ASG) is a great tool to let the authors of the text partner
with you, the instructor, in helping students learn Essentials of Advanced Financial
Accounting. The ASG will (1) help your students learn more effectively, (2) improve
your class discussions, and (3) make your student contact hours more efficient.
See the instructor page at AdvancedStudyGuide.com .
For Instructors:
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• Chapter 3 introduces the notion of special-purpose entities and accounting standards
related to variable interest entities by discussing the well-known collapse of Enron
Corporation. New accounting rules for determining when a business entity must be
consolidated resulted from this and other scandals. We also explore how the basic
consolidation process differs when a subsidiary is only partially owned.
• Chapter 4 gives a “behind the scenes” look at the work that goes into the consolidation process based on Disney Corporation. We learn about value-added activities
during the consolidation process. In addition, we introduce issues such as when a differential occurs when the acquiring company pays more than the book value of the
acquired company’s net assets.
• Chapter 5 discusses majority ownership of subsidiaries based on the 80 percent acquisition of Nuova Systems by Cisco Systems, Inc. in 2006. We further the discussion
of acquisitions with a differential with the added complexity of noncontrolling interest
shareholders when they purchase less than 100 percent of the outstanding common
stock.
• Chapter 6 introduces intercompany inventory transfers based on Toys R Us and
its 100 percent owned subsidiary Toysrus.com. Transactions between the two are
related-party transactions; therefore, the profit from intercompany inventory transfers
is eliminated in preparing consolidated finanial statements. This elimination process
can become complicated. Therefore, this chapter examines intercompany inventory
transactions and the consolidated procedures associated with them.
• Chapter 7 presents a real fixed-asset transfer that took place in 2009 between two of
Mircon subsidiaries.This chapter explores the accounting for both depreciable and
nondepreciable asset transfers among affiliated companies.
• Chapter 8 discusses the accounting issues affecting companies like Microsoft that
have international operations. Specifically, we discuss foreign currency transactions,
financial instruments, and the effects that changes in exchange rates can have on
reported results.
• Chapter 9 resumes the discussion of international accounting by looking at
McDonald’s global empire and how differences in accounting standards across countries and jurisdictions can cause significant difficulties for multinational firms. This
chapter summarizes current efforts to develop a global set of high-quality accounting
standards and explores the translation of financial statements of a foreign business
entity into U.S. dollars.
• Chapter 10 summarizes the evolution of the large accounting firms with an emphasis on partnerships. This chapter focuses on the formation and operation of partnerships, including accounting for the addition of new partners and the retirement of a
present partner.
• Chapter 11 illustrates the dissolution of partnerships with the example of Laventhol
& Horwath, the seventh largest accounting firm in 1990. We present the concepts that
accountants must know if they offer professional services to partnerships undergoing
liquidation.
CISCO
NuOVA SYSTEMS
80% 20%
NCI
100%
Asset
$
49% 51% 100%
R
LAVENTHOL & HORWATH
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xviii Preface
• Chapter 12 introduces the topic of accounting for government entities by examining the complexity of the operations of San Diego, California. The chapter has
two parts: the accounting and reporting requirements for state and local governmental units and a comprehensive illustration of accounting for the general fund
of a city.
• Chapter 13 resumes the discussion of accounting for governmental entities by specifically examining special funds and government-wide financial statements using the
example of the state of Maryland. We present the accounting and financial reporting
requirements for four remaining governmental fund types, two proprietary fund types,
and the four fiduciary fund types.
City of
San Diego
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Acknowledgments
We are grateful for the assistance and direction of the McGraw-Hill/Irwin team:
Stewart Mattson, Tim Vertovec, Dana Woo, Katie Jones, Alice Harra, Pat Frederickson, Michelle Gardner, Dean Karampelas, Matt Baldwin, Greg Bates, Carol Bielski, and
Suresh Babu, who all worked hard to champion our book through the production process .
Permission has been received from the Institute of Certified Management Accountants of
the Institute of Management Accountants to use questions and/or unofficial answers from
past CMA examinations. We appreciate the cooperation of the American Institute of Certified Public Accountants for providing permission to adapt and use materials from past
Uniform CPA Examinations. And we thank Kaplan CPA Review for providing their online
framework for Essentials of Advanced Financial Accounting students to gain important
experience with the types of simulations that are included on the Uniform CPA Examination.
Above all, we extend our deepest appreciation to our families who continue to provide
the encouragement and support necessary for this project.
Richard E. Baker
Theodore E. Christensen
David M. Cottrell
Alexander K. Buchholz
Brooklyn College of the City University
of New York
Mary Burnell
Fairmont State University
Steve Fabian
New Jersey City University
Earl Godfrey
Gardner-Webb University
Joshua Herbold
University of Montana
Mallory McWilliams
San Jose State University/University of
California, Santa Cruz
Abe Qastin
Lakeland College
Chantal Rowat
Bentley University
Margaret Shelton
University of Houston, Downtown
Frank Shuman
Utah State University
Nathan Slavin
Hofstra University
James Yang
Montclair State University
Jian Zhou
Binghamton University
This text includes the thoughts and contributions of many individuals, and we wish to
express our sincere appreciation to them. First and foremost, we thank all the students in
our advanced accounting classes, from whom we have learned so much. In many respects,
this text is an outcome of the learning experiences we have shared with our students. Second, we wish to thank the many outstanding teachers we have had in our own educational
programs, from whom we learned the joy of learning. We are indebted to our colleagues
in advanced accounting for helping us reach our goal of writing the best possible essentials of advanced financial accounting text. We appreciate the many valuable comments
and suggestions from the faculty who used recent editions of the text. Their comments
and suggestions have contributed to making this text a more effective learning tool. We
especially wish to thank Jane Ou from Santa Clara University, Mallory McWilliams from
San Jose State University, Mary Callegari from San Jose State University, Pam Smith
from Northern Illinois University, Larry Walther from Utah State University, and Han
Stice, Cameron Flanders, and Melissa Larson, all from Brigham Young University.
We express our sincere thanks to the following individuals who provided reviews on
the full version of the text:
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Brief Table of Contents
PREFACE vii
1 Intercorporate Acquisitions and
Investments in Other Entities 1
2 Reporting Intercorporate Investments
and Consolidation of Wholly Owned
Subsidiaries with No Differential 53
3 The Reporting Entity and Consolidation of
Less-than-Wholly-Owned Subsidiaries with
No Differential 107
4 Consolidation of Wholly Owned Subsidiaries
Acquired at More than Book Value 157
5 Consolidation of Less-than-WhollyOwned Subsidiaries Acquired at More
than Book Value 206
6 Intercompany Inventory Transactions 254
7 Intercompany Transfers of Services and
Noncurrent Assets 306
8 Multinational Accounting: Foreign
Currency Transactions and Financial
Instruments 373
9 Multinational Accounting: Issues in
Financial Reporting and Translation of
Foreign Entity Statements 444
10 Partnerships: Formation, Operation, and
Changes in Membership 506
11 Partnerships: Liquidation 561
12 Governmental Entities: Introduction and
General Fund Accounting 599
13 Governmental Entities: Special Funds
and Government-wide Financial
Statements 658
INDEX 727
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Table of Contents
ABOUT THE AUTHORSv
PREFACEvii
Chapter 1
Intercorporate Acquisitions and Investments
in Other Entities 1
Kraft’s Acquisition of Cadbury 1
A Brief Introduction 2
The Development of Complex Business Structures 4
Enterprise Expansion 5
Organizational Structure and Business Objectives 5
Organizational Structure, Acquisitions, and Ethical
Considerations 6
Business Expansion and Forms of Organizational
Structure 6
Internal Expansion 6
External Expansion through Business Combinations 7
Frequency of Business Combinations 8
Complex Organizational Structures 9
Organizational Structure and Financial Reporting 10
Creating Business Entities 10
Business Combinations 12
Forms of Business Combinations 12
Methods of Effecting Business Combinations 12
Valuation of Business Entities 14
Accounting for Business Combinations 15
Acquisition Accounting 16
Fair Value Measurements 16
Applying the Acquisition Method 16
Goodwill 17
Combination Effected through the Acquisition of Net Assets 18
Combination Effected through Acquisition of Stock 22
Financial Reporting Subsequent to a Business
Combination 23
Disclosure Requirements 24
Additional Considerations in Accounting for Business
Combinations 24
Uncertainty in Business Combinations 24
In-Process Research and Development 26
Noncontrolling Equity Held Prior to Combination 26
Acquisitions by Contract Alone 26
Summary of Key Concepts 26
Key Terms 27
APPENDIX 1A
Methods of Accounting for Business
Combinations 27
Questions 28
Cases 29
Exercises 32
Problems 43
Chapter 2
Reporting Intercorporate Investments and
Consolidation of Wholly Owned Subsidiaries
with No Differential 53
Berkshire Hathaway’s Many Investments 53
Accounting for Investments in Common Stock 54
Reasons for Investing in Common Stock 56
The Cost Method 57
Accounting Procedures under the Cost Method 57
Declaration of Dividends in Excess of Earnings since
Acquisition 57
Acquisition at Interim Date 59
Changes in the Number of Shares Held 59
The Equity Method 59
Use of the Equity Method 60
Investor’s Equity in the Investee 60
Recognition of Income 60
Recognition of Dividends 61
Comparison of the Carrying Amount of the Investment
under the Cost and Equity Methods 62
Acquisition at Interim Date 62
Changes in the Number of Shares Held 63
Comparison of the Cost and Equity Methods 65
The Fair Value Option 66
Overview of the Consolidation Process 66
Consolidation Procedures for Wholly Owned
Subsidiaries That Are Created or Purchased at Book
Value 67
Consolidation Worksheets 67
Worksheet Format 67
Nature of Eliminating Entries 69
Consolidated Balance Sheet with Wholly Owned
Subsidiary 69
100 Percent Ownership Acquired at Book Value 70
Consolidation Subsequent to Acquisition 73
Consolidated Net Income 74
Consolidated Retained Earnings 75
Consolidated Financial Statements—100 Percent
Ownership, Created or Acquired at Book Value 76
Initial Year of Ownership 77
Second and Subsequent Years of Ownership 81
Consolidated Net Income and Retained Earnings 83
Summary of Key Concepts 84
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Key Terms 85
APPENDIX 2A
Additional Considerations Relating to the
Equity Method 85
APPENDIX 2B
Consolidation and the Cost Method 88
Questions 90
Cases 92
Exercises 94
Problems 100
Chapter 3
The Reporting Entity and Consolidation of
Less-than-Wholly-Owned Subsidiaries with
No Differential 107
The Collapse of Enron and the Birth of a New
Paradigm 107
The Usefulness of Consolidated Financial
Statements 109
Limitations of Consolidated Financial Statements 109
Subsidiary Financial Statements 110
Consolidated Financial Statements: Concepts and
Standards 110
Traditional View of Control 110
Indirect Control 111
Ability to Exercise Control 111
Differences in Fiscal Periods 112
Changing Concept of the Reporting Entity 112
Special-Purpose and Variable Interest Entities 113
Off-Balance Sheet Financing 113
Variable Interest Entities 114
IFRS Differences in Determining Control of VIEs
and SPEs 116
Noncontrolling Interest 116
Computation of Noncontrolling Interest 116
Presentation of Noncontrolling Interest 116
Combined Financial Statements 118
Additional Considerations—Different Approaches to
Consolidation 119
Theories of Consolidation 119
Comparison of Alternative Theories 119
Current Practice 122
The Effect of a Noncontrolling Interest 122
Consolidated Net Income 122
Consolidated Retained Earnings 123
Worksheet Format 124
Consolidated Balance Sheet with a Less-than-WhollyOwned Subsidiary 124
80 Percent Ownership Acquired at Book Value 125
Consolidation Subsequent to Acquisition—80 Percent
Ownership Acquired at Book Value 127
Initial Year of Ownership 127
Second and Subsequent Years of Ownership 131
Summary of Key Concepts 133
Key Terms 134
APPENDIX 3A
Consolidation of Variable Interest Entities 134
Questions 135
Cases 136
Exercises 139
Problems 147
Chapter 4
Consolidation of Wholly Owned Subsidiaries
Acquired at More than Book Value 157
How Much Work Does It Really Take to Consolidate?
Ask the People Who Do It at Disney 157
Dealing with the Differential 158
The Difference between Acquisition Price and
Underlying Book Value 159
Consolidation Procedures for Wholly Owned
Subsidiaries Acquired at More than Book Value 162
Treatment of a Positive Differential 165
Illustration of Treatment of a Complex Differential 166
100 Percent Ownership Acquired at Less than Fair
Value of Net Assets 169
Illustration of Treatment of Bargain-Purchase
Differential 169
Consolidated Financial Statements—100 Percent
Ownership Acquired at More than Book Value 171
Initial Year of Ownership 171
Second Year of Ownership 176
Intercompany Receivables and Payables 180
Push-Down Accounting 180
Summary of Key Concepts 181
Key Terms 181
APPENDIX 4A
Push-Down Accounting Illustrated 181
Questions 184
Cases 184
Exercises 186
Problems 197
Chapter 5
Consolidation of Less-than-Wholly-Owned
Subsidiaries Acquired at More than Book
Value 206
Cisco Acquires a Controlling Interest in Nuova 206
A Noncontrolling Interest in Conjunction with
a Differential 207
Consolidated Balance Sheet with Majority-Owned
Subsidiary 207
Consolidated Financial Statements with a
Majority-Owned Subsidiary 210
Initial Year of Ownership 210
Second Year of Ownership 214
Discontinuance of Consolidation 217
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Treatment of Other Comprehensive Income 220
Modification of the Consolidation Worksheet 220
Adjusting Entry Recorded by Subsidiary 220
Adjusting Entry Recorded by Parent Company 220
Consolidation Worksheet—Second Year Following
Combination 221
Consolidation Procedures 221
Consolidation Worksheet—Comprehensive Income
in Subsequent Years 224
Additional Considerations 224
Subsidiary Valuation Accounts at Acquisition 224
Negative Retained Earnings of Subsidiary at
Acquisition 225
Other Stockholders’ Equity Accounts 225
Subsidiary’s Disposal of Differential-Related Assets 225
Summary of Key Concepts 227
Key Terms 227
Questions 227
Cases 228
Exercises 229
Problems 239
Chapter 6
Intercompany Inventory Transactions 254
Inventory Transfers at Toys R Us 254
Overview of the Consolidated Entity and
Intercompany Transactions 255
Elimination of Intercompany Transfers 256
Elimination of Unrealized Profits and Losses 256
Inventory Transactions 256
Transfers at Cost 257
Transfers at a Profit or Loss 257
Effect of Type of Inventory System 257
Downstream Sale of Inventory 258
Resale in Period of Intercorporate Transfer 259
Resale in Period following Intercorporate Transfer 260
Inventory Held for Two or More Periods 266
Upstream Sale of Inventory 267
Equity-Method Entries—20X1 267
Consolidation Worksheet—20X1 268
Consolidated Net Income—20X1 269
Equity-Method Entries—20X2 270
Consolidation Worksheet—20X2 270
Consolidated Net Income—20X2 272
Additional Considerations 272
Sale from One Subsidiary to Another 272
Costs Associated with Transfers 273
Lower of Cost or Market 273
Sales and Purchases before Affiliation 273
Summary of Key Concepts 274
Key Terms 274
APPENDIX 6A
Intercompany Inventory Transactions—Modified
Equity Method and Cost Method 274
Questions 281
Cases 282
Exercises 284
Problems 292
Chapter 7
Intercompany Transfers of Services and
Noncurrent Assets 306
Micron’s Intercompany Fixed Asset Sale 306
Intercompany Long-Term Asset Transfers 307
Intercompany Transfers of Services 309
Intercompany Land Transfers 309
Overview of the Profit Elimination Process 309
Assignment of Unrealized Profit Elimination 311
Downstream Sale of Land 313
Upstream Sale of Land 317
Eliminating the Unrealized Gain after the
First Year 321
Subsequent Disposition of the Asset 321
Intercompany Transfers of Depreciable
Assets 323
Downstream Sale 323
Change in Estimated Life of Asset upon Transfer 331
Upstream Sale 331
Asset Transfers before Year-End 341
Intercompany Transfers of Amortizable
Assets 341
Summary of Key Concepts 341
Key Terms 341
APPENDIX 7A
Intercompany Noncurrent Asset Transactions—
Modified Equity Method and Cost Method 342
Questions 349
Cases 350
Exercises 352
Problems 360
Chapter 8
Multinational Accounting: Foreign
Currency Transactions and Financial
Instruments 373
Microsoft’s Multinational Business 373
Doing Business in a Global Market 374
The Accounting Issues 375
Foreign Currency Exchange Rates 376
The Determination of Exchange Rates 376
Direct versus Indirect Exchange Rates 376
Changes in Exchange Rates 378
Spot Rates versus Current Rates 381
Forward Exchange Rates 381
Foreign Currency Transactions 381
Foreign Currency Import and Export
Transactions 383
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Managing International Currency Risk with
Foreign Currency Forward Exchange Financial
Instruments 386
Derivatives Designated as Hedges 387
Forward Exchange Contracts 389
Case 1: Managing an Exposed Foreign Currency Net
Asset or Liability Position: Not a Designated
Hedging Instrument 391
Case 2: Hedging an Unrecognized Foreign Currency
Firm Commitment: A Foreign Currency Fair Value
Hedge 396
Case 3: Hedging a Forecasted Foreign Currency
Transaction: A Foreign Currency Cash Flow
Hedge 399
Case 4: Speculation in Foreign Currency
Markets 403
Foreign Exchange Matrix 405
Additional Considerations 405
A Note on Measuring Hedge Effectiveness 405
Interperiod Tax Allocation for Foreign Currency
Gains (Losses) 406
Hedges of a Net Investment in a Foreign Entity 406
Summary of Key Concepts 406
Key Terms 406
APPENDIX 8A
Illustration of Valuing Forward Exchange
Contracts with Recognition for the Time Value
of Money 407
APPENDIX 8B
Use of Other Financial Instruments by
Multinational Companies 410
Questions 422
Cases 423
Exercises 425
Problems 436
Chapter 9
Multinational Accounting: Issues in
Financial Reporting and Translation of
Foreign Entity Statements 444
McDonald’s—The World’s Fast Food
Favorite 444
Differences in Accounting Principles 446
Determining the Functional Currency 449
Functional Currency Designation in Highly
Inflationary Economies 451
Translation versus Remeasurement of Foreign
Financial Statements 451
Translation of Functional Currency Statements into
the Reporting Currency of the U.S. Company 453
Financial Statement Presentation of Translation
Adjustment 454
Illustration of Translation and Consolidation of a
Foreign Subsidiary 455
Noncontrolling Interest of a Foreign
Subsidiary 464
Remeasurement of the Books of Record into the
Functional Currency 466
Statement Presentation of Remeasurement Gain
or Loss 467
Illustration of Remeasurement of a Foreign
Subsidiary 468
Proof of Remeasurement Exchange Gain 469
Remeasurement Case: Subsequent Consolidation
Worksheet 470
Summary of Translation versus
Remeasurement 473
Additional Considerations in Accounting for Foreign
Operations and Entities 473
Foreign Investments and Unconsolidated
Subsidiaries 474
Liquidation of a Foreign Investment 474
Hedge of a Net Investment in a Foreign
Subsidiary 475
Disclosure Requirements 476
Statement of Cash Flows 476
Lower-of-Cost-or-Market Inventory Valuation
under Remeasurement 477
Intercompany Transactions 477
Income Taxes 479
Translation When a Third Currency Is the Functional
Currency 479
Summary of Key Concepts 479
Key Terms 480
Questions 480
Cases 481
Exercises 485
Problems 494
Chapter 10
Partnerships: Formation, Operation, and
Changes in Membership 506
The Evolution of PricewaterhouseCoopers
(PwC) 506
The Nature of the Partnership Entity 507
Legal Regulation of Partnerships 507
Definition of a Partnership 508
Formation of a Partnership 508
Other Major Characteristics of Partnerships 509
Accounting and Financial Reporting Requirements
for Partnerships 511
International Financial Reporting Standards for
Small and Medium-Sized Entities and Joint
Ventures 512
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Table of Contents xxvii
Accounting for the Formation of a Partnership 512
Illustration of Accounting for Partnership
Formation 513
Accounting for the Operations of a
Partnership 514
Partners’ Accounts 514
Allocating Profit or Loss to Partners 515
Illustrations of Profit Allocation 516
Multiple Bases of Profit Allocation 519
Special Profit Allocation Methods 520
Partnership Financial Statements 520
Changes in Membership 521
General Concepts to Account for a Change in
Membership in the Partnership 521
New Partner Purchases an Interest 523
New Partner Invests in Partnership 525
Determining a New Partner’s Investment Cost 538
Dissociation of a Partner from the Partnership 538
Summary of Key Concepts 541
Key Terms 541
APPENDIX 10A
Tax Aspects of a Partnership 541
APPENDIX 10B
Joint Ventures 543
Questions 545
Cases 545
Exercises 548
Problems 554
Chapter 11
Partnerships: Liquidation 561
The Demise of Laventhol & Horwath 561
Overview of Partnership Liquidations 562
Dissociation, Dissolution, Winding Up, and Liquidation
of a Partnership 562
Lump-Sum Liquidations 564
Realization of Assets 564
Expenses of Liquidation 564
Illustration of Lump-Sum Liquidation 564
Installment Liquidations 569
Illustration of Installment Liquidation 570
Cash Distribution Plan 573
Additional Considerations 576
Incorporation of a Partnership 576
Summary of Key Concepts 577
Key Terms 578
APPENDIX 11A
Partners’ Personal Financial Statements 578
Questions 581
Cases 582
Exercises 584
Problems 593
Chapter 12
Governmental Entities: Introduction and
General Fund Accounting 599
Accounting for the Bustling City of San Diego 599
Differences between Governmental and Private Sector
Accounting 600
History of Governmental Accounting 601
Major Concepts of Governmental Accounting 602
Elements of Financial Statements 602
Expendability of Resources versus Capital Maintenance
Objectives 603
Definitions and Types of Funds 603
Financial Reporting of Governmental Entities 605
Fund-Based Financial Statements: Governmental
Funds 606
Measurement Focus and Basis of Accounting
(MFBA) 609
Basis of Accounting—Governmental Funds 610
Basis of Accounting—Proprietary Funds 613
Basis of Accounting—Fiduciary Funds 613
Budgetary Aspects of Governmental
Operations 614
Recording the Operating Budget 614
Accounting for Expenditures 615
The Expenditure Process 615
Classification of Expenditure Transactions and
Accounts 617
Outstanding Encumbrances at the End of the Fiscal
Period 617
Expenditures for Inventory 621
Accounting for Fixed Assets 623
Long-Term Debt and Capital Leases 624
Investments 624
Interfund Activities 625
(1) Interfund Loans 625
(2) Interfund Services Provided and Used 626
(3) Interfund Transfers 626
(4) Interfund Reimbursements 627
Overview of Accounting and Financial Reporting for
the General Fund 627
Comprehensive Illustration of Accounting for the
General Fund 628
Adoption of the Budget 628
Property Tax Levy and Collection 630
Other Revenue 631
Expenditures 632
Acquisition of Capital Asset 632
Interfund Activities 633
Adjusting Entries 633
Closing Entries 634
General Fund Financial Statement Information 635
Summary of Key Concepts 638
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xxviii Table of Contents
Key Terms 638
Questions 639
Cases 639
Exercises 642
Problems 650
Chapter 13
Governmental Entities: Special Funds
and Government-wide Financial
Statements 658
Governmental Accounting in Maryland 658
Summary of Governmental Fund Types 660
Governmental Funds Worksheets 661
Special Revenue Funds 661
Capital Projects Funds 665
Illustration of Transactions 665
Financial Statement Information for the Capital
Projects Fund 668
Debt Service Funds 668
Illustration of Transactions 669
Financial Statement Information for the Debt Service
Fund 671
Permanent Funds 671
Illustration of Transactions 671
Governmental Funds Financial Statements 672
Enterprise Funds 675
Illustration of Transactions 676
Financial Statements for the Proprietary Funds 678
Internal Service Funds 680
Illustration of Transactions 681
Financial Statements for Internal Service Funds 683
Trust Funds 683
Illustration of Private-Purpose Trust Fund 684
Agency Funds 685
Illustration of Transactions in an Agency Fund 686
The Government Reporting Model 686
Four Major Issues 686
Government Financial Reports 688
Government-wide Financial Statements 689
Reconciliation Schedules 691
Budgetary Comparison Schedule 693
Management’s Discussion and Analysis 695
Notes to the Government-wide Financial Statements 695
Other Financial Report Items 696
Interim Reporting 696
Auditing Governmental Entities 696
Additional Considerations 697
Special-Purpose Governmental Entities 697
Financial Reporting for Pensions and OPEB Plans 698
Summary of Key Concepts 699
Key Terms 700
APPENDIX 13A
Other Governmental Entities—Public School
Systems and the Federal Government 700
Questions 702
Cases 702
Exercises 704
Problems 715
INDEX727
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1
Chapter One
Intercorporate
Acquisitions and
Investments in Other
Entities
KRAFT’S ACQUISITION OF CADBURY
In recent years as well as during the past several decades, the business world has witnessed many corporate acquisitions and combinations, often involving some of the
world’s largest and best-known companies. Some of these combinations have captured
public attention because of the personalities involved, the daring strategies employed,
and the huge sums of money at stake. In January 2010 Kraft Foods Inc. finalized a deal
to acquire Cadbury PLC for $19.4 billion to form the second-largest confectionery, food,
and beverage company in the world. At the time of the acquisition, Cadbury’s net assets
were only worth around $5 billion. During the three months preceding Kraft’s final bid,
rumors circulated of a potential counterbid by Hershey. While a bidding war seemed
likely, Hershey decided not to counterbid when Kraft produced a “winning” offer. This
highly visible transaction was really the next step in more than a century of regular
acquisitions.
In 1896, inspired in part by his time in the Kellogg brothers’ Battle Creek Sanitarium,
C.W. Post founded Postum Cereal Company, Ltd. The following year he introduced
Grape-Nuts brand cereal. Within five years, Postum employed 2,500 people and its Battle
Creek facility was the largest of its kind in the world.
In 1903, James L. Kraft started selling cheese door to door from the back of a horsedrawn wagon. Although not immediately successful, he continued operations and was
eventually joined by four of his brothers in 1909. By 1914 Kraft & Bros. Company (later
Kraft Foods Inc.) had opened its first cheese manufacturing plant and in 1916 patented a
new process for pasteurizing cheese, making the cheese resistant to spoilage and allowing it to be transported over long distances.
These two start-up companies (Kraft and Postum) continued to grow independently.
Postum went public in 1922, followed by Kraft in 1924. In 1925 Postum acquired Jell-O
Company and in 1928 Maxwell House Coffee. That same year (1928) Kraft merged with
Phenix Cheese, maker of Philadelphia Brand cream cheese.
In 1929, Postum changed its name to General Foods Corporation and in 1930 Kraft was
acquired by National Dairy Products. In 1937 Kraft launched its well-known macaroni
and cheese dinners. By 1953 business was booming for General Foods and they acquired
Perkins Products, maker of Kool-Aid. In 1981 General Foods made another acquisition,
this time acquiring Oscar Mayer & Co.
Philip Morris acquired General Foods in 1985 and Kraft in 1988. A year later General
Foods and Kraft were combined to form Kraft General Foods Inc., which was renamed
Business
Combinations
Consolidation
Concepts and Procedures
Intercompany Transfers
Multinational
Entities
Multi-Corporate
Entities
Partnerships
Governmental
Entities
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2 Chapter 1 Intercorporate Acquisitions and Investments in Other Entities
Kraft Foods Inc. in 1995. In 2000, Philip Morris acquired Nabisco Holdings and began
integrating Nabisco and Kraft. The story does not end here. In August 2008 the Post
Cereal portion of Kraft was spun off and merged with Ralcorp Holdings. The remaining portion of Kraft Foods Inc. is the company that took part in the 2010 acquisition of
Cadbury PLC.
Of course, this is only half of the story. Cadbury took its own journey. It took
104 years and dozens of mergers and acquisitions to finally end up with the companies
that took part in the 2010 acquisition. The business world is complex and frequent
business combinations will continue to increase the complex nature of the business
environment in the future. An understanding of the accounting treatment of mergers,
acquisitions, and other intercorporate investments is an invaluable asset in our everchanging markets. This chapter introduces the key concepts associated with business
combinations.
LEARNING OBJECTIVES
When you finish studying this chapter, you should be able to:
LO1 Understand and explain different methods of business expansion, types of
organizational structures, and types of acquisitions.
LO2 Make calculations and prepare journal entries for the creation and purchase of
a business entity.
LO3 Understand and explain the differences between different forms of business
combinations.
LO4 Make calculations and prepare journal entries for different types of business
combinations through the acquisition of stock or assets.
LO5 Make calculations and business combination journal entries in the presence of
a differential, goodwill, or a bargain purchase element.
LO6 Understand additional considerations associated with business combinations.
A BRIEF INTRODUCTION
Before launching into our discussion of business combinations, we pause to provide
a brief overview of the text. First, we note that the book’s title does not necessarily
describe the level of difficulty of topics covered in the text. The concepts covered here
are not necessarily harder to grasp than those covered in your intermediate-level financial accounting courses. This course introduces financial accounting topics associated
with many different topics that are typically not covered in intermediate-level texts.
It may be more accurate to simply say that the term “advanced” means that the text
covers topics that are more appropriately introduced after you’ve established a solid
foundation in your intermediate courses. While the topics covered here will probably
not be more difficult than those covered in previous courses, they have been saved to
help you to build on what you’ve learned in prior courses. They will certainly help you
transition from simple, contrived accounting examples to more realistic settings found
in real-world situations.
Figure 1–1 summarizes the six major sections of this text. Chapters 1–7 comprise
the first major section of the text on multi-corporate entities. In this chapter, we introduce major topics related to business combinations, as illustrated with the Kraft-Cadbury
example. Chapters 2–5 explain the basic concepts and procedures for preparing consolidated financial statements, the required financial reporting method of affiliated corporate
groups. Chapters 6–7 describe the intricacies of preparing consolidated financial statements in the presence of intercompany asset or debt transfers within a controlled group
of companies. This major portion of the book on multi-corporate entities comprises the
first half of the text.
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FIGURE 1–1 Topical Overview
Advanced Financial Accounting Overview
Section Major Topic Chapter # Chapter Title
Multi-Corporate Entities
Business Combinations
1 Intercorporate Acquisitions and Investments in Other Entities
Consolidation Concepts
and Procedures
2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with
No Differential
3 The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential
4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value
5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value
Intercompany Transfers
6 Intercompany Inventory Transactions
7 Intercompany Transfers of Services and Noncurrent Assets
Multinational Entities
Foreign Currency Transactions
8 Multinational Accounting: Foreign Currency Transactions and Financial Instruments
Translation of Foreign Statements
9 Multinational Accounting: Issues in Financial Reporting and Translation of Foreign Entity Statements
Partnerships
Formation, Operation, Changes
10 Partnerships: Formation, Operation, and Changes in Membership
Liquidation
11 Partnerships: Liquidation
Governmental Entities
Governmental Entities
12 Governmental Entities: Introduction and General Fund Accounting
Special Funds
13 Governmental Entities: Special Funds and Government-Wide Financial Statements
3
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4 Chapter 1 Intercorporate Acquisitions and Investments in Other Entities
The next major section of the text on multinational entities introduces two
main topics. Chapter 8 explains the accounting for foreign currency transactions,
which are increasingly becoming more common in today’s global economy. Then,
Chapter 9 explains the translation of financial statements of foreign entities into
U.S. dollars.
The subsequent major section of this text introduces the accounting for partnerships.
In particular, Chapter 10 covers the accounting for the formation and normal operation of
a partnership as well as the nuances of accounting for changes in ownership. Chapter 11
explores the winding-up process of partnership liquidation.
The next major section of the text provides a brief overview of accounting for
governmental entities. In particular, Chapter 12 introduces basic concepts related
to governmental accounting and the notion of fund accounting. Chapter 12 uses the
general fund to illustrate these basic accounting principles. Chapter 13 concludes
the discussion of governmental accounting by explaining the accounting for special
funds.
The locator bar at the beginning of each chapter will remind you of where you are relative to the topical overview illustrated in Figure 1–1 .
THE DEVELOPMENT OF COMPLEX BUSINESS STRUCTURES
The business environment in the United States is perhaps the most dynamic and vibrant
in the world. Each day, new companies and new products enter the marketplace, and
others are forced to leave or to change substantially in order to survive. In this setting,
existing companies often find it necessary to combine their operations with those of other
companies or to establish new operating units in emerging areas of business activity.
Recent business practice has also experienced the creation of numerous less traditional
types of enterprise structures and new, sometimes novel, entities for carrying out the
enterprise’s operating and financing activities. The creation of new structures and special
entities is often a response to today’s current operating environment, with its abundant
operating risks, global considerations, and tax complexities. In some cases, however,
as evidenced by numerous lawsuits, criminal investigations, congressional actions, and
corporate bankruptcies, the legitimacy of the use of some of these structures and special
entities has been questioned. The adequacy of some of the accounting methods has also
been questioned.
Overall, today’s business environment is one of the most exciting and challenging
in history, characterized by rapid change and exceptional complexity. In this environment, regulators such as the Securities and Exchange Commission (SEC), the
Financial Accounting Standards Board (FASB), and the Public Company Accounting
Oversight Board (PCAOB) are scrambling to respond to the rapid-paced changes in
a manner that ensures the continued usefulness of accounting reports to reflect economic reality.
A number of accounting and reporting issues arise when two or more companies
join under common ownership or a company creates a complex organizational structure involving any of a variety of forms of new financing or operating entities. The
first seven chapters of this text focus on a number of these issues. Chapter 1 lays
the foundation by describing some of the factors that have led to corporate expansion and some of the types of complex organizational structures and relationships
that have evolved. Then, it describes the accounting and reporting issues related
to formal business combinations. Chapter 2 focuses on investments in the common
stock of other companies and on selected other types of investments in and relationships with other entities. Moreover, it introduces basic concepts associated with
the preparation of consolidated financial statements that portray the related companies as if they were actually a single company . The next six chapters systematically
LO1
Understand and explain
different methods of business expansion, types of
organizational structures,
and types of acquisitions.
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Chapter 1 Intercorporate Acquisitions and Investments in Other Entities 5
explain additional details related to the preparation and use of consolidated financial
statements.
Today’s business environment is complex. This complexity arises when companies
do business across state and national boundaries. Each state and country has its own set
of laws, tax provisions, and risks. Moreover, each jurisdiction has a myriad of different
types of common business transactions and financial instruments, and various other factors that require unique managerial expertise. The simple business setting in which one
company has two or three manufacturing plants and produces products for a local or
regional market is much less common now than it was several decades ago. As companies grow in size and respond to their unique business environment, they often develop
complex organizational and ownership structures.
Enterprise Expansion
Most business enterprises seek to expand over time in order to survive and become profitable. Both the owners and managers of a business enterprise have an interest in seeing a
company grow in size. Increased size often allows economies of scale in both production
and distribution. By expanding into new markets or acquiring other companies already in
those markets, companies can develop new earning potential and those in cyclical industries can add greater stability to earnings through diversification. For example, in 1997,
Boeing, a company very strong in commercial aviation, acquired McDonnell Douglas,
a company weak in commercial aviation but very strong in military aviation and other
defense and space applications. When orders for commercial airliners plummeted following a precipitous decline in air travel, increased defense spending, partially related to the
war in Iraq, helped level out Boeing’s earnings.
Corporate managers are often rewarded with higher salaries as their companies
increase in size. In addition, prestige frequently increases with the size of a company
and with a reputation for the successful acquisition of other companies. As a result,
corporate managers often find it personally advantageous to increase company size.
For instance, Bernard Ebbers started his telecommunications career as the head of a
small discount long-distance telephone service company and built it into one of the
world’s largest corporations, WorldCom. In the process, Ebbers became well known
for his acquisition prowess and grew tremendously wealthy—until WorldCom was
racked by accounting scandals and declared bankruptcy and Ebbers was sentenced to
prison in 2003.
Organizational Structure and Business Objectives
Complex organizational structures often evolve to help achieve a business’s objectives, such as increasing profitability or reducing risk. For example, many companies
establish subsidiaries to conduct certain business activities. A subsidiary is a corporation that is controlled by another corporation, referred to as a parent company,
usually through majority ownership of its common stock. Because a subsidiary is a
separate legal entity, the parent’s risk associated with the subsidiary’s activities is
limited. There are many reasons for creating or acquiring a subsidiary. For example,
companies often transfer their receivables to subsidiaries or special-purpose entities
that use the receivables as collateral for bonds issued to other entities (securitization).
External parties may hold partial or complete ownership of those entities, allowing
the transferring company to share its risk associated with the receivables. In some
situations, companies can realize tax benefits by conducting certain activities through
a separate entity. Bank of America, for example, established a subsidiary to which
it transferred bank-originated loans and was able to save $418 million in quarterly
taxes. 1

1 “PNC Shakes Up Banking Sector; Investors Exit,” The Wall Street Journal, January 30, 2002, p. C2.
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6 Chapter 1 Intercorporate Acquisitions and Investments in Other Entities
Organizational Structure, Acquisitions, and Ethical Considerations
Acquisitions and complex organizational structures have sometimes been used to manipulate financial reporting with the aim of enhancing or enriching managers. Many major
corporations, taking advantage of loopholes or laxness in financial reporting requirements, have used subsidiaries or other entities to borrow large amounts of money without
reporting the debt on their balance sheets. Some companies have created special entities
that have then been used to manipulate profits.
The term special-purpose entity has become well known in recent years because of the
egregious abuse of these entities by companies such as Enron. A special-purpose entity
(SPE) is, in general, a financing vehicle that is not a substantive operating entity, usually
one created for a single specified purpose. An SPE may be in the form of a corporation,
trust, or partnership. Enron Corp., one of the world’s largest companies prior to its collapse in 2001, established many SPEs, at least some of which were intended to manipulate financial reporting. Some of Enron’s SPEs apparently were created primarily to
hide debt while others were used to create fictional transactions or to convert borrowings
into reported revenues.
Accounting for mergers and acquisitions also is an area that can lend itself to manipulation. Arthur Levitt, former chairman of the SEC, referred to some of the accounting
practices that have been used in accounting for mergers and acquisitions as “creative acquisition accounting” or “merger magic.” For example, a previously widely used method of
accounting for business combinations, pooling-of-interests, sometimes created earnings
and, in the view of many, provided misleading financial reporting subsequent to a combination. WorldCom was a company built through acquisitions, many of which were accounted
for using the pooling-of-interests method. Another approach used by many companies in
accounting for their acquisitions was to assign a large portion of the purchase price of an
acquired company to its in-process research and development, immediately expensing the
full amount and freeing financial reporting in future periods from the burden of those costs.
These practices have since been eliminated by the FASB. However, the frequency and
size of business combinations, the complexity of acquisition accounting, and the potential impact on financial statements of the accounting methods employed mean that the
issues surrounding the accounting for business combinations are of critical importance.
The scandals and massive accounting failures at companies such as Enron, WorldCom,
and Tyco, leading to heavy losses suffered by creditors, investors, employees, and others,
focused considerable attention on weaknesses in accounting and the accounting profession. In the past several years, Congress, the SEC, and the FASB have taken actions to
strengthen the financial reporting process and to clarify the accounting rules relating to
special entities and to acquisitions.
BUSINESS EXPANSION AND FORMS OF ORGANIZATIONAL STRUCTURE
Historically, businesses have expanded by internal growth through new product development and expansion of existing product lines into new markets. In recent decades,
however, many companies have chosen to expand by combining with or acquiring other
companies. Either approach may lead to a change in organizational structure.
Internal Expansion
As companies expand from within, they often find it advantageous to conduct their
expanded operations through new subsidiaries or other entities such as partnerships, joint
ventures, or special entities. In most of these situations, an identifiable segment of the
company’s existing assets is transferred to the new entity, and, in exchange, the transferring company receives equity ownership (as illustrated in the diagram on the next page).
Companies may be motivated to establish new subsidiaries or other entities for a variety of reasons. Broadly diversified companies may place unrelated operations in separate
subsidiaries to establish clear lines of control and facilitate the evaluation of operating
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Chapter 1 Intercorporate Acquisitions and Investments in Other Entities 7
results. In some cases, an entity that specializes in a particular type of activity or has its
operations in a particular country may qualify for special tax incentives. Of particular
importance in some industries is the fact that a separate legal entity may be permitted
to operate in a regulatory environment without subjecting the entire entity to regulatory
control. Also, by creating a separate legal entity, a parent company may be able to protect
itself from exposing the entire company’s assets to legal liability that may stem from a
new product line or entry into a higher-risk form of business activity.
Companies also might establish new subsidiaries or other entities, not as a means of
expansion, but as a means of disposing of a portion of their existing operations through
outright sale or a transfer of ownership to existing shareholders or others. In some cases,
companies have used this approach in disposing of a segment of operations that no longer fits well with the overall mission of the company. In other cases, this approach has
been used as a means of disposing of unprofitable operations or to gain regulatory or
shareholder approval of a proposed merger with another company. A spin-off occurs
when the ownership of a newly created or existing subsidiary is distributed to the parent’s stockholders without the stockholders surrendering any of their stock in the parent
company. Thus, the company divests itself of the subsidiary since it is owned by the company’s shareholders after the spin-off. A split-off occurs when the subsidiary’s shares
are exchanged for shares of the parent, thereby leading to a reduction in the outstanding
shares of the parent company. While the two divestiture types are similar, the split-off
could result in one set of the former parent shareholders exchanging their shares for those
of the divested subsidiary. Although a transfer of ownership to one or more unrelated
parties normally results in a taxable transaction, properly designed transfers of ownership
to existing shareholders generally qualify as nontaxable exchanges.
External Expansion through Business Combinations
Many times companies find that entry into new product areas or geographic regions is
more easily accomplished by acquiring or combining with other companies than through
internal expansion. For example, SBC Communications, a major telecommunications
company and one of the “Baby Bells,” significantly increased its service area by combining with Pacific Telesis and Ameritech, later acquiring AT&T (and adopting its name), and
subsequently combining with BellSouth. Similarly, since the state of Florida has traditionally been very reluctant to issue new bank charters, bank corporations wishing to establish
operations in Florida have had to acquire an existing bank to obtain a charter in the state.
A business combination occurs when “. . . an acquirer obtains control of one or more
businesses.” 2
The diagram on the next page illustrates a typical acquisition. The concept of control relates to the ability to direct policies and management. Traditionally,
control over a company has been gained by acquiring a majority of the company’s common stock. However, the diversity of financial and operating arrangements employed in
recent years also raises the possibility of gaining control with less than majority ownership or, in some cases, with no ownership at all through other contractual arrangements.
The types of business combinations found in today’s business environment and the
terms of the combination agreements are as diverse as the firms involved. Companies
Internal
expansion S Stock
P
S
Assets
2
Financial Accounting Standards Board Statement No. 141 (revised 2007), “Business Combinations,”
December 2007, para. 3e. (ASC 805-10-65-1)
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8 Chapter 1 Intercorporate Acquisitions and Investments in Other Entities
enter into various types of formal and informal arrangements that may have at least some
of the characteristics of a business combination. Most companies tend to avoid recording
informal agreements on their books because of the potential difficulty of enforcing them.
In fact, some types of informal arrangements, such as those aimed at fixing prices or
apportioning potential customers, are illegal. Formal agreements generally are enforceable and are more likely to be recognized on the books of the participants.
Informal Arrangements
Informal arrangements take many different forms. A simple gentlemen’s agreement may
be all that is needed to establish an amiable long-term relationship in a joint business venture. In other cases, companies with complementary products or services develop implicit
working relationships. For example, a building contractor might always use a particular
electrical or plumbing subcontractor. Some companies form strategic alliances for working
together on a somewhat more formal basis. For example, Washington Mutual, the country’s largest thrift organization, formed a strategic alliance with SAFECO Corporation to
distribute SAFECO annuities through Washington Mutual’s multistate branch network.
Many airlines, such as American with Qantas and Delta with Air France-KLM, routinely
enter into route-sharing or code-sharing agreements with one another, and many other
well-known companies have entered into strategic agreements, such as Microsoft with Sun
Microsystems, Microsoft with Nortel, eBay with VeriSign, Boeing with IBM, and AOL
with Google. Companies that partially depend on each other may use interlocking directorates, in which one or more members serve on the boards of directors of both companies, as a
means of providing a degree of mutual direction without taking formal steps to join together.
The informality and freedom that make informal arrangements workable also are
strong factors against combining financial statements and treating the companies as if
they were a single entity. Another key factor in most informal arrangements is the continuing separation of ownership and the ease with which the informal arrangements can
be terminated. Without some type of combined ownership, the essentials of a business
combination generally are absent.
Formal Agreements
Formal business combinations usually are accompanied by written agreements. These
agreements specify the terms of the combination, including the form of the combined
company, the consideration to be exchanged, the disposition of outstanding securities,
and the rights and responsibilities of the participants. Consummation of such an agreement requires recognition on the books of one or more of the companies that are a party
to the combination.
In some cases, a formal agreement may be equivalent in substance to a business combination, yet different in form. For example, a company entering into an agreement to
lease all of another company’s assets for a period of several decades is, in effect, acquiring the other company. Similarly, an operating agreement giving to one company full
management authority over the operations of another company for an extended period of
time may be viewed as a means of effecting a business combination.
Frequency of Business Combinations
Very few major companies function as single legal entities in our modern business environment. Virtually all major companies have at least one subsidiary, with more than a
$
S Stock
S
P
External
expansion
S Shareholders
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few broadly diversified companies having several hundred subsidiaries. In some cases,
subsidiaries are created to incorporate separately part of the ongoing operations previously conducted within the parent company. Other subsidiaries are acquired through
business combinations.
Business combinations are a continuing and frequent part of the business environment. A merger boom occurred in the 1960s. This period was characterized by frantic
and, in some cases, disorganized merger binges, resulting in creation of a large number
of conglomerates, or companies operating in many different industries. Because many of
the resulting companies lacked coherence in their operations, they often were less successful than anticipated, and many of the acquisitions of the 1960s have since been sold
or abandoned. In the 1980s, the number of business combinations again increased. That
period saw many leveraged buyouts, but the resulting debt has plagued many of those
companies over the years.
The number of business combinations through the 1990s dwarfed previous merger
booms, with all records for merger activity shattered. This pace continued into the new
century, with a record-setting $3.3 trillion in deals closed in 2000. 3
However, with the
downturn in the economy in the early 2000s, the number of mergers declined significantly. Many companies put their expansion plans on hold, and a number of the mergers
that did occur were aimed at survival. Toward the middle of 2003, merger activity again
increased and accelerated significantly through the middle of the decade. During one
period of less than 100 hours in 2006, “around $110 billion in acquisition deals were
sealed worldwide in sectors ranging from natural gas, to copper, to mouthwash to steel,
linking investors and industrialists from India, to Canada, to Luxembourg to the U.S.” 4
Through much of the middle of the last decade, merger activity was fueled by a new
phenomenon, the use of private equity money. Rather than the traditional merger activity
that typically involves one publicly held company acquiring another, groups of investors,
such as wealthy individuals, pension and endowment funds, and mutual funds, pooled
their money to make acquisitions. Most of these acquisitions did not result in lasting
ownership relationships, with the private equity companies usually attempting to realize
a return by selling their investments in a relatively short time. This activity was slowed
dramatically by the credit crunch of 2007–2008. Nevertheless, business combinations
will continue to be an important business activity into the foreseeable future.
Aside from private-equity acquisitions, business combinations have been common
in telecommunications, defense, banking and financial services, information technology, energy and natural resources, entertainment, pharmaceuticals, and manufacturing. Some of the world’s largest companies and best-known names have been involved
in recent major acquisitions, such as Procter & Gamble, Gillette, Citicorp, Bank of
America, AT&T, Whirlpool, Sprint, Verizon, Adobe Systems, Chrysler, Daimler-Benz,
ConocoPhillips, British Petroleum, and Exxon.
Complex Organizational Structures
While a parent-subsidiary structure has been standard for major corporations for a number of decades, more complex structures have started to become common in recent years.
Many companies now conduct at least part of their operations through entities other than
subsidiaries. As is discussed in Chapter 3, special-purpose and variable interest entities, including trusts, have gained widespread use as financing vehicles. Corporate joint
ventures and partnerships are commonly found in energy development and distribution,
construction, motion picture production, and various other industries. For example, Cingular Wireless, the largest provider of mobile wireless communications in the United
States and now part of AT&T, was operated as a joint venture of AT&T and BellSouth
prior to AT&T’s acquisition of BellSouth. The adoption of less traditional, innovative
organizational structures provides many challenges for financial reporting.
3 Dennis K. Berman and Jason Singer, “Big Mergers Are Making a Comeback as Companies, Investors Seek
Growth,” The Wall Street Journal, November 5, 2005, p. A1.
4 Dennis K. Berman and Jason Singer, “Blizzard of Deals Heralds an Era of Megamergers,” The Wall Street
Journal, June 27, 2006, p. A1.
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10 Chapter 1 Intercorporate Acquisitions and Investments in Other Entities
Organizational Structure and Financial Reporting
When companies expand or change organizational structure by acquiring other companies or through internal division, the new structure must be examined to determine the
appropriate financial reporting procedures. Several approaches are possible, depending
on the circumstances:
1. Merger A merger is a business combination in which the acquired company’s assets
and liabilities are combined with those of the acquiring company. Thus, two companies are merged into a single entity. In essence, the acquiring company “swallows” the
acquired company.
2. Controlling ownership A business combination in which the acquired company
remains as a separate legal entity with a majority of its common stock owned by the
purchasing company leads to a parent–subsidiary relationship. Accounting standards
normally require that the financial statements of the parent and subsidiary be consolidated for general-purpose reporting so the companies appear as a single company. The
treatment is the same if the subsidiary is created rather than purchased. The treatment
is also the same when the other entity is unincorporated and the investor company has
control and majority ownership. 5
3. Noncontrolling ownership The purchase of a less-than-majority interest in another
corporation does not usually result in a business combination or controlling situation.
A similar situation arises when a company creates another entity and holds less than
a controlling position in it or purchases a less-than-controlling interest in an existing
partnership. In its financial statements, the investor company reports its interest in the
investee as an investment with the specific method of accounting for the investment
dictated by the circumstances.
4. Other beneficial interest One company may have a beneficial interest in another
entity even without a direct ownership interest. The beneficial interest may be defined by
the agreement establishing the entity or by an operating or financing agreement. When
the beneficial interest is based on contractual arrangements instead of majority stock
ownership, the reporting rules may be complex and depend on the circumstances. In general, a company that has the ability to make decisions significantly affecting the results of
another entity’s activities or is expected to receive a majority of the other entity’s profits
and losses is considered to be that entity’s primary beneficiary. Normally, that entity’s
financial statements would be consolidated with those of the primary beneficiary.
These different situations, and the related accounting and reporting procedures, will be
discussed throughout the first seven chapters of the text. The primary focus will be on the
first three situations, especially the purchase of all or part of another company’s stock.
The discussion of the fourth situation in Chapter 3 will be limited because of its complexity and the diversity of these contractual arrangements.
CREATING BUSINESS ENTITIES 6
Companies that choose to conduct a portion of their operations through separate business
entities usually do so through corporate subsidiaries, corporate joint ventures, or partnerships. The ongoing accounting and reporting for investments in corporate joint ventures
and subsidiaries are discussed in Chapters 2 through 7. This section discusses the origination of these entities when the parent or investor creates them rather than purchases an
interest in an existing corporation or partnership.
LO2
Make calculations and prepare journal entries for the
creation and purchase of a
business entity.
5 Majority ownership is generally a sufficient but not a necessary condition for the indicated treatment.
Unlike the corporate case, percentage ownership does not fully describe the nature of a beneficial interest in
a partnership. Investments in partnerships are discussed in later chapters.
6 To view a video explanationof this topic, visit advancedstudyguide.com.
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Chapter 1 Intercorporate Acquisitions and Investments in Other Entities 11
When a company transfers assets or operations to another entity that it has created, a vast number of variations in the types of entities and the types of agreements
between the creating company and the created entity are possible. Accordingly, it is
impossible to establish a single set of rules and procedures that will suffice in all situations. The discussion here focuses on the most straightforward and common cases in
which the transferring company creates a subsidiary or partnership that it owns and
controls, including cases in which the company intends to transfer ownership to its
stockholders through a spin-off or split-off. In simple cases, the company transfers
assets, and perhaps liabilities, to an entity that the company has created and controls
and in which it holds majority ownership. The company transfers assets and liabilities to the created entity at book value, and the transferring company recognizes an
ownership interest in the newly created entity equal to the book value of the net assets
transferred. Recognition of fair values of the assets transferred in excess of their carrying values on the books of the transferring company normally is not appropriate in
the absence of an arm’s-length transaction. Thus, no gains or losses are recognized on
the transfer by the transferring company. However, if the value of an asset transferred
to a newly created entity has been impaired prior to the transfer and its fair value is
less than the carrying value on the transferring company’s books, the transferring
company should recognize an impairment loss and transfer the asset to the new entity
at the lower fair value.
The created entity begins accounting for the transferred assets and liabilities in the
normal manner based on their book values at the time of transfer. Subsequent financial
reporting involves consolidating the created entity’s financial statements with those of
the parent company. Overall, the consolidated financial statements appear the same as if
the transfer had not taken place.
As an illustration of a created entity, assume that Allen Company creates a subsidiary,
Blaine Company, and transfers the following assets to Blaine in exchange for all 100,000
shares of Blaine’s $2 par common stock:
Item Cost Book Value
Cash $ 70,000
Inventory $ 50,000 50,000
Land 75,000 75,000
Building 100,000 80,000
Equipment 250,000 160,000
$435,000
Allen records the transfer with the following entry: 7
7 Journal entries used in the text to illustrate the various accounting procedures are numbered sequentially
within individual chapters for easy reference. Each journal entry number appears only once in a chapter.
(1) Investment in Blaine Company Common Stock 435,000
Accumulated Depreciation* 110,000
Cash 70,000
Inventory 50,000
Land 75,000
Building 100,000
Equipment 250,000
Record the creation of Blaine Company.
*$110,000 = ($100,000 − $80,000) + ($250,000 − $160,000)
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12 Chapter 1 Intercorporate Acquisitions and Investments in Other Entities
Blaine Company records the transfer of assets and the issuance of stock (at the book
value of the assets), as follows:
BUSINESS COMBINATIONS
A business combination occurs when one party acquires control over one or more businesses. This usually involves two or more separate businesses being joined together
under common control. The acquirer may obtain control by paying cash, transferring
other assets, issuing debt, or issuing stock. In rare cases, the acquirer might obtain control
by agreement or through other means without an exchange taking place. Business combinations can take one of several different forms and can be effected in different ways.
Forms of Business Combinations
Figure 1–2 illustrates the three primary legal forms of business combinations. A statutory
merger is a type of business combination in which only one of the combining companies
survives and the other loses its separate identity. The acquired company’s assets and
liabilities are transferred to the acquiring company, and the acquired company is dissolved, or liquidated. The operations of the previously separate companies are carried on
in a single legal entity following the merger.
A statutory consolidation is a business combination in which both combining companies are dissolved and the assets and liabilities of both companies are transferred to
a newly created corporation. The operations of the previously separate companies are
carried on in a single legal entity, and neither of the combining companies remains in
existence after a statutory consolidation. In many situations, however, the resulting corporation is new in form only, and in substance it actually is one of the combining companies reincorporated with a new name. A stock acquisition occurs when one company
acquires the voting shares of another company and the two companies continue to operate as separate, but related, legal entities. Because neither of the combining companies is
liquidated, the acquiring company accounts for its ownership interest in the other company as an investment. In a stock acquisition, the acquiring company need not acquire all
the other company’s stock to gain control.
The relationship that is created in a stock acquisition is referred to as a parent–
subsidiary relationship. A parent company is one that controls another company, referred
to as a subsidiary, usually through majority ownership of common stock. For generalpurpose financial reporting, a parent company and its subsidiaries present consolidated
financial statements that appear largely as if the companies had actually merged into one.
The legal form of a business combination, the substance of the combination agreement, and
the circumstances surrounding the combination all affect how the combination is recorded
initially and the accounting and reporting procedures used subsequent to the combination.
Methods of Effecting Business Combinations
Business combinations can be characterized as either friendly or unfriendly. In a friendly
combination, the managements of the companies involved come to agreement on the
terms of the combination and recommend approval by the stockholders. Such combinations usually are effected in a single transaction involving an exchange of assets or
LO3
Understand and explain
the differences between
different forms of business
combinations.
(2) Cash 70,000
Inventory 50,000
Land 75,000
Building 100,000
Equipment 250,000
Accumulated Depreciation 110,000
Common Stock, $2 par 200,000
Additional Paid-In Capital 235,000
Record the receipt of assets and the issuance of $2 par common stock.
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Chapter 1 Intercorporate Acquisitions and Investments in Other Entities 13
voting shares. In an unfriendly combination, or “hostile takeover,” the managements of
the companies involved are unable to agree on the terms of a combination, and the management of one of the companies makes a tender offer directly to the shareholders of the
other company. A tender offer invites the shareholders of the other company to “tender,”
or exchange, their shares for securities or assets of the acquiring company. If sufficient
shares are tendered, the acquiring company gains voting control of the other company
and can install its own management by exercising its voting rights.
The specific procedures to be used in accounting for a business combination depend
on whether the combination is effected through an acquisition of assets or an acquisition
of stock.
Acquisition of Assets
Sometimes one company acquires another company’s assets through direct negotiations
with its management. The agreement also may involve the acquiring company’s assuming the other company’s liabilities. Combinations of this sort normally take form ( a ) or
form ( b ) in Figure 1–2 . The selling company generally distributes to its stockholders the
assets or securities received in the combination from the acquiring company and liquidates, leaving only the acquiring company as the surviving legal entity.
FIGURE 1–2
Types of Business
Combinations
(a) Statutory Merger
(b) Statutory Consolidation
(c) Stock Acquisition
AA Company
AA Company
AA Company
AA Company
AA Company
BB Company
BB Company
BB Company
BB Company
CC Company
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14 Chapter 1 Intercorporate Acquisitions and Investments in Other Entities
The acquiring company accounts for the combination by recording each asset acquired,
each liability assumed, and the consideration given in exchange.
Acquisition of Stock
A business combination effected through a stock acquisition does not necessarily have
to involve the acquisition of all of a company’s outstanding voting shares. For one company to gain control over another through stock ownership, a majority (i.e., more than
50 percent) of the outstanding voting shares usually is required unless other factors lead
to the acquirer gaining control. The total of the shares of an acquired company not held
by the controlling shareholder is called the noncontrolling interest. In the past, the noncontrolling interest was referred to as the minority interest.
In those cases when control of another company is acquired and both companies
remain in existence as separate legal entities following the business combination, the
stock of the acquired company is recorded on the books of the acquiring company as an
investment. Alternatively, the acquired company may be liquidated and its assets and
liabilities transferred to the acquiring company or a newly created company. To do so, all
or substantially all of the acquired company’s voting stock must be obtained. An acquisition of stock and subsequent liquidation of the acquired company is equivalent to an
acquisition of assets.
Acquisition by Other Means
Occasionally, a business combination may be effected without an exchange of assets or
equities and without a change in ownership. In some cases, control might be acquired
through agreement alone, or in rare cases, by other contractual arrangements.
Valuation of Business Entities
All parties involved in a business combination must believe they have an opportunity to
benefit before they will agree to participate. Determining whether a particular combination proposal is advantageous can be difficult. Both the value of a company’s assets and
its future earning potential are important in assessing the value of the company. Tax
laws also influence investment decisions. For example, the existence of accumulated net
operating losses that can be used under U.S. tax law to shelter future income from taxes
increases the value of a potential acquiree.
Value of Individual Assets and Liabilities
The value of a company’s individual assets and liabilities is usually determined by
appraisal. For some items, the value may be determined with relative ease, such as investments that are traded actively in the securities markets, or short-term payables. For other
items, the appraisal may be much more subjective, such as the value of land located in an
area where few recent sales have occurred. In addition, certain intangibles typically are
not reported on the balance sheet. For example, the costs of developing new ideas, new
products, and new production methods normally are expensed as research and development costs in the period incurred.
Current liabilities are often viewed as having fair values equal to their book values
because they will be paid at face amount within a short time. Long-term liabilities, however, must be valued based on current interest rates if different from the effective rates
at the issue dates of the liabilities. For example, if $100,000 of 10-year, 6 percent bonds,
paying interest annually, had been issued at par three years ago, and the current market
rate of interest for the same type of security is 10 percent, the value of the liability currently is computed as follows:
Present value for 7 years at 10% of principal payment of $100,000 $51,316
Present value at 10% of 7 interest payments of $6,000 29,211
Present value of bond $80,527
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Chapter 1 Intercorporate Acquisitions and Investments in Other Entities 15
Although accurate assessments of the value of assets and liabilities may be difficult,
they form an important part of the overall determination of the value of an enterprise.
Value of Potential Earnings
In many cases, assets operated together as a group have a value that exceeds the sum
of their individual values. This “going-concern value” makes it desirable to operate the
assets as an ongoing entity rather than sell them individually. A company’s earning power
as an ongoing enterprise is of obvious importance in valuing that company.
There are different approaches to measuring the value of a company’s future earnings. Sometimes companies are valued based on a multiple of their current earnings. For
example, if Bargain Company reports earnings of $35,000 for the current year, the company’s value based on a multiple of 10 times current earnings is $350,000. The appropriate multiple to use is a matter of judgment and is based on factors such as the riskiness
and variability of the earnings and the anticipated degree of growth.
Another method of valuing a company is to compute the present value of the anticipated future net cash flows generated by the company. This requires assessing the amount
and timing of future cash flows and discounting them back to the present value at the discount rate determined to be appropriate for the type of enterprise. For example, if Bargain
Company is expected to generate cash flows of $35,000 for each of the next 25 years,
the present value of the firm at a discount rate of 10 percent is $317,696. Estimating the
potential for future earnings requires numerous assumptions and estimates. Not surprisingly, the buyer and seller often have difficulty agreeing on the value of a company’s
expected earnings.
Valuation of Consideration Exchanged
When one company acquires another, the acquiring company must place a value on the
consideration given in the exchange. Little difficulty is encountered when the acquiring company gives cash in an acquisition, but valuation may be more difficult when
the acquiring company gives securities, particularly new untraded securities or securities
with unusual features. For example, General Motors completed an acquisition a number
of years ago using a new Series B common stock that paid dividends based on subsequent earnings of the acquired company rather than on the earnings of General Motors
as a whole. Some companies have used non-interest-bearing bonds (zero coupon bonds),
which have a fair value sufficiently below par value to compensate the holder for interest.
Other companies have used various types of convertible securities. Unless these securities, or others that are considered equivalent, are being traded in the market, estimates of
their value must be made. The approach generally followed is to use the value of some
similar security with a determinable market value and adjust for the estimated value of
the differences in the features of the two securities.
ACCOUNTING FOR BUSINESS COMBINATIONS
For over half a century, accounting for business combinations remained largely
unchanged. Two methods of accounting for business combinations, the purchase method
and the pooling-of-interests method, were acceptable during that time. However, major
changes in accounting for business combinations have occurred over the past decade.
First, the FASB eliminated the pooling-of-interests method in 2001, leaving only a single method, purchase accounting. Then, in 2007, the FASB issued the revised version
of FASB Statement No. 141, “Business Combinations (revised 2007)” (FASB 141R,
ASC 805), that replaced the purchase method with the acquisition method, now the only
acceptable method of accounting for business combinations. The acquisition method
must be used to account for all business combinations for which the acquisition date is in
fiscal years beginning on or after December 15, 2008. FASB 141R (ASC 805) may not
be applied retroactively.
LO4
Make calculations and
prepare journal entries for
different types of business
combinations through the
acquisition of stock or
assets.
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16 Chapter 1 Intercorporate Acquisitions and Investments in Other Entities
Although all business combinations must now be accounted for using the acquisition method, many companies’ financial statements will continue to include the effects
of previous business combinations recorded using the purchase and pooling-of-interests
methods. Thus, a general understanding of those methods can be helpful. Appendix 1A
presents a numerical comparison of the three methods.
The idea behind a pooling-of-interests was that no change in ownership had actually occurred in the business combination, often a questionable premise. Based on this
idea, the book values of the combining companies were carried forward to the combined
company and no revaluations to fair value were made. Managers often preferred pooling accounting because it did not result in asset write-ups or goodwill that might burden
future earnings with additional depreciation or write-offs. Also, reporting practices often
made acquisitions appear better than they would have appeared if purchase accounting
had been used.
Purchase accounting treated the purchase of a business much like the purchase of
any asset. The acquired company was recorded based on the purchase price paid by the
acquirer. Individual assets and liabilities of the acquired company were valued at their
fair values, and the difference between the total purchase price and the fair value of the
net identifiable assets acquired was recorded as goodwill. All direct costs of bringing
about and consummating the combination were included in the total purchase price.
Acquisition accounting is consistent with the FASB’s intention to move accounting in
general more toward recognizing fair values. Under acquisition accounting, the acquirer
in a business combination, in effect, values the acquired company based on the fair value
of the consideration given in the combination and the fair value of any noncontrolling
interest not acquired by the acquirer.
ACQUISITION ACCOUNTING
As of the end of 2007, the FASB significantly changed the method of accounting for
business combinations, requiring the use of the acquisition method. Under the acquisition method , the acquirer recognizes all assets acquired and liabilities assumed in a
business combination and measures them at their acquisition-date fair values. If less than
100 percent of the acquiree is acquired, the noncontrolling interest also is measured at its
acquisition-date fair value. Note that a business combination does not affect the amounts
at which the assets and liabilities of the acquirer are valued.
Fair Value Measurements
Because accounting for business combinations is now based on fair values, the measurement of fair values takes on added importance. The acquirer must value at fair value
(1) the consideration it exchanges in a business combination, (2) each of the individual
assets and liabilities acquired, and (3) any noncontrolling interest in the acquiree. Normally, a business combination involves an arm’s-length exchange between two unrelated
parties. The value of the consideration given in the exchange is usually the best measure
of the value received and, therefore, reflects the value of the acquirer’s interest in the
acquiree. However, the FASB decided in FASB 141R (ASC 805) to focus directly on
the value of the consideration given rather than just using it to impute a fair value for the
acquiree as a whole. In some cases, the value of the consideration given may be difficult
to determine, or there may be no exchange, and valuation is better based on the value of
the acquirer’s interest in the acquiree or other valuation techniques. FASB Statement
No. 157, “Fair Value Measurements” (FASB 157, ASC 820), provides a framework for
applying fair value measurements in accounting.
Applying the Acquisition Method
For all business combinations, an acquirer must be identified, and that party is the one
gaining control over the other. In the past, some business combinations occurred under
the dubious assertion that neither party acquired the other. In addition, an acquisition date
LO5
Make calculations and business combination journal
entries in the presence of a
differential, goodwill, or a
bargain purchase element.
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Chapter 1 Intercorporate Acquisitions and Investments in Other Entities 17
must be determined. That date is usually the closing date when the exchange transaction actually occurs. However, in rare cases control may be acquired on a different date
or without an exchange, so the circumstances must be examined to determine precisely
when the acquirer gains control.
Under the acquisition method, the full acquisition-date fair values of the individual
assets acquired, both tangible and intangible, and liabilities assumed in a business combination are recognized. This is true regardless of the percentage ownership acquired by the
controlling entity. If the acquirer acquires all of the assets and liabilities of the acquiree in
a merger, these assets and liabilities are recorded on the books of the acquiring company
at their acquisition-date fair values. If the acquiring company acquires partial ownership
of the acquiree in a stock acquisition, the assets acquired and liabilities assumed appear
at their full acquisition-date fair values in a consolidated balance sheet prepared immediately after the combination.
Several other points to remember related to assets and liabilities acquired in a business
combination are as follows:
1. No separate asset valuation accounts related to assets acquired are recognized.
2. Long-lived assets classified at the acquisition date as held for sale are valued at fair
value less cost to sell.
3. Deferred income taxes related to the business combination and assets and liabilities
related to an acquiree’s employee benefit plans are valued in accordance with the specific FASB standards relating to those topics.
Any excess of (1) the sum of the fair value of the consideration given by the acquirer
in a business combination 8
and the acquisition-date fair value of any noncontrolling
interest over (2) the acquisition-date fair value of the net identifiable assets acquired in a
business combination is considered goodwill. The amount of goodwill arising in a business combination is unaffected by the percentage of the acquiree acquired.
All costs of bringing about and consummating a business combination are charged to
an acquisition expense as incurred. The costs of issuing equity securities used to acquire
the acquiree are treated in the same manner as stock issues costs are normally treated, as
a reduction in the paid-in capital associated with the securities.
Goodwill
Conceptually, goodwill as it relates to business combinations consists of all those intangible factors that allow a business to earn above-average profits. From an accounting perspective, the FASB has stated that goodwill “is an asset representing the future economic
benefits arising from other assets acquired in a business combination that are not individually identified and separately recognized.” 9
An asset is considered to be identifiable,
and therefore must be separately recognized, if it is separable (can be separated from the
business) or arises from a contractual or other right.
Under the acquisition method, an acquirer measures and recognizes goodwill from a
business combination based on the difference between the total fair value of the acquired
company and the fair value of its net identifiable assets. However, the FASB decided, for
several reasons, not to focus directly on the total fair value of the acquiree, but rather on
the components that provide an indication of that fair value. The FASB identified three
components that should be measured and summed for the total amount to be used in
determining the amount of goodwill recognized in a business combination:
1. The fair value of the consideration given by the acquirer.
2. The fair value of any interest in the acquiree already held by the acquirer.
3. The fair value of the noncontrolling interest in the acquiree, if any.
8 The fair value of any interest in the acquiree already held by the acquirer would also be included in this
calculation.
9
FASB 141R, para. 3j. (ASC 805-10-65-1)
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18 Chapter 1 Intercorporate Acquisitions and Investments in Other Entities
Note that the total amount of goodwill is not affected by whether 100 percent of the
acquiree is acquired or less than that. However, the fair value of the noncontrolling interest does have an effect on the amount of goodwill recognized. In the example given,
the fair values of the controlling and noncontrolling interests are proportional (each is
valued at an amount equal to its proportionate ownership share of the total) and imply
a total fair value of the acquired company of $400,000. This is frequently the case and
will always be assumed throughout the text unless indicated otherwise. However, that
may not always be the case in practice. Situations might arise in a stock acquisition, for
example, where the per-share value of the controlling interest is greater than that of the
noncontrolling interest because of a premium associated with gaining control.
Combination Effected through the Acquisition of Net Assets
When one company acquires all the net assets of another in a business combination, the
acquirer records on its books the individual assets acquired and liabilities assumed in the
combination and the consideration given in exchange. Each identifiable asset and liability
acquired (with minor exceptions) is recorded by the acquirer at its acquisition-date fair
value. Any excess of the fair value of the consideration exchanged over the fair value of
the acquiree’s net identifiable assets is recorded as goodwill by the acquiring company.
To illustrate the application of the acquisition method of accounting to a business
combination effected through the acquisition of the acquiree’s net assets, assume that
Point Corporation acquires all of the assets and assumes all of the liabilities of Sharp
Company in a statutory merger by issuing 10,000 shares of $10 par common stock to
Sharp. The shares issued have a total market value of $610,000. Point incurs legal and
appraisal fees of $40,000 in connection with the combination and stock issue costs of
$25,000. Figure 1–3 shows the book values and fair values of Sharp’s individual assets
and liabilities on the date of combination.
The relationships among the fair value of the consideration exchanged, the fair value
of Sharp’s net assets, and the book value of Sharp’s net assets are illustrated in the following diagram:
The total of these three amounts, all measured at the acquisition date, is then compared
with the acquisition-date fair value of the acquiree’s net identifiable assets, and the difference is goodwill.
As an example of the computation of goodwill, assume that Albert Company acquires all
of the assets of Zanfor Company for $400,000 when the fair value of Zanfor’s net identifiable assets is $380,000. Goodwill is recognized for the $20,000 difference between the total
consideration given and the fair value of the net identifiable assets acquired. If, instead of an
acquisition of assets, Albert acquires 75 percent of the common stock of Zanfor for $300,000,
and the fair value of the noncontrolling interest is $100,000, goodwill is computed as follows:
Fair value of consideration given by Albert $300,000
+ Fair value of noncontrolling interest 100,000
Total fair value of Zanfor Company $400,000
– Fair value of net identifiable assets acquired (380,000)
Goodwill $ 20,000
Total
differential
$310,000
Fair value of consideration
$610,000
Fair value of net identifiable assets
$510,000
Book value of net identifiable assets
$300,000
Goodwill $100,000
Book value of net identifiable
assets $300,000
Excess fair value of
net identifiable assets $210,000
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Chapter 1 Intercorporate Acquisitions and Investments in Other Entities 19
The total difference at the acquisition date between the fair value of the consideration
exchanged and the book value of the net identifiable assets acquired is referred to as the
differential. In more complex situations, the differential is equal to the difference between
(1) the acquisition-date fair value of the consideration transferred by the acquirer, plus
the acquisition-date fair value of any equity interest in the acquiree previously held by
the acquirer, plus the fair value of any noncontrolling interest in the acquiree and (2) the
acquisition-date book values of the identifiable assets acquired and liabilities assumed.
In the Point/Sharp merger, the total differential of $310,000 reflects the difference
between the total fair value of the shares issued by Point and the carrying amount of
Sharp’s net assets reflected on its books at the date of combination. A portion of that difference ($210,000) is attributable to the increased value of Sharp’s net assets over book
value. The remainder of the difference ($100,000) is considered to be goodwill.
The $40,000 of acquisition costs incurred by Point in carrying out the acquisition are
expensed as incurred:
FIGURE 1–3
Sharp Company
Balance Sheet
Information,
December 31, 20X0
Assets, Liabilities and Equities Book Value Fair Value
Cash and Receivables $ 45,000 $ 45,000
Inventory 65,000 75,000
Land 40,000 70,000
Buildings and Equipment 400,000 350,000
Accumulated Depreciation (150,000)
Patent 80,000
Total Assets $400,000 $620,000
Current Liabilities $100,000 110,000
Common Stock ($5 par) 100,000
Additional Paid-In Captial 50,000
Retained Earnings 150,000
Total Liabilities and Equities $400,000
Fair Value of Net Assets $510,000
Portions of the $25,000 of stock issue costs related to the shares issued to acquire
Sharp may be incurred at various times. To facilitate accumulating these amounts before
recording the combination, Point may record them in a separate temporary “suspense”
account as incurred:
On the date of combination, Point records the acquisition of Sharp with the following
entry:
(3) Acquisition Expense 40,000
Cash 40,000
Record costs related to acquisition of Sharp Company.
(4) Deferred Stock Issue Costs 25,000
Cash 25,000
Record costs related to issuance of common stock.
(5) Cash and Receivables 45,000
Inventory 75,000
Land 70,000
Buildings and Equipment 350,000
Patent 80,000
Goodwill 100,000
Current Liabilities 110,000
Common Stock 100,000
Additional Paid-In Capital 485,000
Deferred Stock Issue Costs 25,000
Record acquisition of Sharp Company.
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20 Chapter 1 Intercorporate Acquisitions and Investments in Other Entities
Entry (5) records all of Sharp’s individual assets and liabilities, both tangible and
intangible, on Point’s books at their fair values on the date of combination. The fair value
of Sharp’s net assets recorded is $510,000 ($620,000 − $110,000). The $100,000 difference between the fair value of the shares given by Point ($610,000) and the fair value of
Sharp’s net assets is recorded as goodwill.
In recording the business combination, Sharp’s book values are not relevant to Point;
only the fair values are recorded. Because a change in ownership has occurred, the basis
of accounting used by the acquired company is not relevant to the acquirer. Consistent
with this view, accumulated depreciation recorded by Sharp on its buildings and equipment is not relevant to Point and is not recorded.
The stock issue costs incurred by Point in connection with Sharp’s acquisition are
initially recorded in a temporary account as incurred. They are then treated in the normal
manner as a reduction in the proceeds received from the issuance of the stock. Thus,
these costs are transferred from the temporary account to Additional Paid-In Capital as
a reduction. Point records the $610,000 of stock issued at its value minus the stock issue
costs, or $585,000. Of this amount, the $100,000 par value is recorded in the Common
Stock account and the remainder in Additional Paid-In Capital.
Entries Recorded by Acquired Company
On the date of the combination, Sharp records the following entry to recognize receipt of
the Point shares and the transfer of all individual assets and liabilities to Point:
Sharp recognizes the fair value of Point Corporation shares at the time of the exchange
and records a gain of $310,000. The distribution of Point shares and the liquidation of
Sharp are recorded on Sharp’s books with the following entry:
Subsequent Accounting for Goodwill by Acquirer
Goodwill arising in a merger is recorded by the acquirer for the difference between the
fair value of the consideration exchanged and the fair value of the identifiable net assets
acquired, as illustrated in entry (5). Once goodwill has been recorded by the acquirer,
it must be accounted for in accordance with FASB Statement No. 142, “Goodwill and
Other Intangible Assets” (FASB 142, ASC 350). Goodwill is carried forward at the originally recorded amount unless it becomes impaired. Goodwill must be reported as a separate line item in the balance sheet. A goodwill impairment loss that occurs subsequent to
recording goodwill must be reported as a separate line item within income from continuing operations in the income statement unless the loss relates to discontinued operations,
in which case the loss is reported within the discontinued operations section.
Goodwill must be tested for impairment at least annually, at the same time each year,
and more frequently if events that are likely to impair the value of the goodwill occur.
(6) Investment in Point Stock 610,000
Current Liabilities 100,000
Accumulated Depreciation 150,000
Cash and Receivables 45,000
Inventory 65,000
Land 40,000
Buildings and Equipment 400,000
Gain on Sale of Net Assets 310,000
Record transfer of assets to Point Corporation.
(7) Common Stock 100,000
Additional Paid-In Capital 50,000
Retained Earnings 150,000
Gain on Sale of Net Assets 310,000
Investment in Point Stock 610,000
Record distribution of Point Corporation stock.
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Chapter 1 Intercorporate Acquisitions and Investments in Other Entities 21
The process of testing goodwill for impairment is complex. It involves examining potential goodwill impairment by each of the company’s reporting units, where a reporting
unit is an operating segment 10 or a component of an operating segment that is a business for which management regularly reviews financial information from that component. When goodwill arises in a business combination, it must be assigned to individual
reporting units. The goodwill is assigned to units that are expected to benefit from the
combination, even if no other assets or liabilities of the acquired company are assigned to
those units. To test for the impairment of goodwill, the fair value of the reporting unit is
compared with its carrying amount. If the fair value of the reporting unit exceeds its carrying amount, the goodwill of that reporting unit is considered unimpaired. On the other
hand, if the carrying amount of the reporting unit exceeds its fair value, an impairment of
the reporting unit’s goodwill is implied. 11
The amount of the reporting unit’s goodwill impairment is measured as the excess of
the carrying amount of the unit’s goodwill over the implied value of its goodwill. The
implied value of its goodwill is determined as the excess of the fair value of the reporting
unit over the fair value of its net assets excluding goodwill. Goodwill impairment losses
are recognized in income from continuing operations or income before extraordinary
gains and losses.
As an example of goodwill impairment, assume that Reporting Unit A is assigned
$100,000 of goodwill arising from a recent business combination. The following assets
and liabilities are assigned to Reporting Unit A:
10 An operating segment is defined in Financial Accounting Standards Board Statement No. 131, “Disclosures
about Segments of an Enterprise and Related Information,” June 1997 (ASC 280-10-50). Whereas U.S. GAAP
assigns goodwill to reporting units, IFRS assigns goodwill to cash-generating units (GCU).
11 The one-step impairment test for goodwill under IFRS is slightly different. The recoverable amount of
the cash-generating-unit (GCU) is compared with its carrying amount. Any impairment loss is recognized
in operating results as the excess of the carrying amount over the recoverable amount. Impairment losses
are recognized in operating results. If the impairment loss exceeds the book value of goodwill, the loss is
allocated first to goodwill and then on a pro rata basis to the other assets of the CGU.
Item Carrying Amount Fair Value
Cash and receivables $ 50,000 $ 50,000
Inventory 80,000 90,000
Equipment 120,000 150,000
Goodwill 100,000
Total assets $350,000 $290,000
Current payables (10,000) (10,000)
Net assets $340,000 $280,000
By summing the carrying amounts of the assets and subtracting the carrying amount of
the payables, the carrying amount of the reporting unit, including the goodwill, is determined to be $340,000. If the fair value of the reporting unit is estimated to be $360,000,
no impairment of goodwill is indicated. On the other hand, if the fair value of the reporting unit is estimated to be $320,000, a second comparison must be made to determine
the amount of any impairment loss. The implied value of Reporting Unit A’s goodwill is
determined by deducting the $280,000 fair value of the net assets, excluding goodwill,
from the unit’s $320,000 fair value. The $40,000 difference ($320,000 − $280,000) represents Reporting Unit A’s implied goodwill. The impairment loss is measured as the
excess of the carrying amount of the unit’s goodwill ($100,000) over the implied value
of the goodwill ($40,000), or $60,000. This goodwill impairment loss is combined with
any impairment losses from other reporting units to determine the total impairment loss
to be reported by the company as a whole. Goodwill is written down by the amount of
the impairment loss. Once written down, goodwill may not be written up for recoveries.
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22 Chapter 1 Intercorporate Acquisitions and Investments in Other Entities
Bargain Purchase
Occasionally, the fair value of the consideration given in a business combination, along
with the fair value of any equity interest in the acquiree already held and the fair value
of any noncontrolling interest in the acquiree, may be less than the fair value of the
acquiree’s net identifiable assets, resulting in a bargain purchase. This might occur, for
example, with a forced sale.
When a bargain purchase occurs (rarely), the acquirer must take steps to ensure that all
acquisition-date valuations are appropriate. If they are, the acquirer recognizes a gain at
the date of acquisition for the excess of the amount of the net identifiable assets acquired
and liabilities assumed as valued under FASB 141R (ASC 805), usually at fair value,
over the sum of the fair value of the consideration given in the exchange, the fair value of
any equity interest in the acquiree held by the acquirer at the date of acquisition, and the
fair value of any noncontrolling interest. Along with the amount of the gain, companies
must disclose the operating segment where the gain is reported and the factors that led to
the gain.
To illustrate accounting for a bargain purchase, assume that in the previous example of Point and Sharp, Point is able to acquire Sharp for $500,000 cash even though
the fair value of Sharp’s net identifiable assets is estimated to be $510,000. In this
simple bargain-purchase case without an equity interest already held or a noncontrolling interest, the fair value of Sharp’s net identifiable assets exceeds the consideration exchanged by Point, and, accordingly, a $10,000 gain attributable to Point is
recognized.
In accounting for the bargain purchase (for cash) on Point’s books, the following entry
replaces previous entry (5):
This treatment is rather unusual because it recognizes a gain on an acquisition and, thus,
represents an exception to the realization concept.
FASB 141R (ASC 805) does not state a treatment for the situation opposite to that
of a bargain purchase, that is, an overpayment. Acquirers do not knowingly overpay for
an acquisition. Any overpayment presumably would be the result of misinformation,
and the overpayment would not be discovered until a later time. The FASB avoided
this issue by basing the computation of goodwill on the consideration given by the
acquirer rather than the acquiree’s total fair value. Thus, any overpayment would be
included in goodwill and presumably eliminated in future periods by testing for goodwill impairment.
Combination Effected through Acquisition of Stock
Many business combinations are effected by acquiring the voting stock of another company rather than by acquiring its net assets. In such a situation, the acquired company
continues to exist, and the acquirer records an investment in the common stock of the
acquiree rather than its individual assets and liabilities. The acquirer records its investment in the acquiree’s common stock at the total fair value of the consideration given
in exchange. For example, if Point Corporation ( a ) exchanges 10,000 shares of its stock
with a total market value of $610,000 for all of Sharp Company’s shares and ( b ) incurs
(8) Cash and Receivables 45,000
Inventory 75,000
Land 70,000
Buildings and Equipment 350,000
Patent 80,000
Cash 500,000
Current Liabilities 110,000
Gain on Bargain Purchase of Sharp Company 10,000
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Chapter 1 Intercorporate Acquisitions and Investments in Other Entities 23
merger costs of $40,000 and stock issue costs of $25,000, Point records the following
entries upon receipt of the Sharp stock:
When a business combination is effected through a stock acquisition, the acquiree
may continue to operate as a separate company, or it may lose its separate identity and be
merged into the acquiring company. The accounting and reporting procedures for intercorporate investments in common stock when the acquiree continues in existence are
discussed in the next six chapters. If the acquired company is liquidated and its assets
and liabilities are transferred to the acquirer, the dollar amounts recorded are identical to
those in entry (5).
Financial Reporting Subsequent to a Business Combination
Financial statements prepared subsequent to a business combination reflect the combined entity only from the date of combination. When a combination occurs during a
fiscal period, income earned by the acquiree prior to the combination is not reported in
the income of the combined enterprise. If the combined company presents comparative
financial statements that include statements for periods before the combination, those
statements include only the activities and financial position of the acquiring company,
not those of the acquiree.
To illustrate financial reporting subsequent to a business combination, assume the following information for Point Corporation and Sharp Company:
20X0 20X1
Point Corporation:
Separate income (excluding any income from Sharp) $300,000 $300,000
Shares outstanding, December 31 30,000 40,000
Sharp Company:
Net income $ 60,000 $ 60,000
Point Corporation acquires all of Sharp Company’s stock at book value on January 1,
20X1, by issuing 10,000 shares of common stock. Subsequently, Point Corporation presents comparative financial statements for the years 20X0 and 20X1. The net income and
earnings per share that Point presents in its comparative financial statements for the two
years are as follows:
20X0:
Net Income $300,000
Earnings per Share ($300,000/30,000 shares) $10.00
20X1:
Net Income ($300,000 + $60,000) $360,000
Earnings per Share ($360,000/40,000 shares) $9.00
If Point Corporation had acquired Sharp Company in the middle of 20X1 instead of at
the beginning, Point would include only Sharp’s earnings subsequent to acquisition in its
(10) Investment in Sharp Stock 610,000
Common Stock 100,000
Additional Paid-In Capital 485,000
Deferred Stock Issue Costs 25,000
Record acquisition of Sharp Company stock.
(9) Acquisition Expense 40,000
Deferred Stock Issue Costs 25,000
Cash 65,000
Record merger and stock issue costs related
to acquisition of Sharp Company.
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24 Chapter 1 Intercorporate Acquisitions and Investments in Other Entities
20X1 income statement. If Sharp earned $25,000 in 20X1 before acquisition by Point and
$35,000 after the combination, Point would report total net income for 20X1 of $335,000
($300,000 + $35,000).
Disclosure Requirements
FASB 141R (ASC 810)12 requires extensive disclosures relating to a company’s business combinations so that financial statement users may assess the impact of the combinations. These disclosures include, among others items:
1. Identification and description of the acquired company, the acquisition date, and the
percentage ownership acquired.
2. The main reasons for the acquisition and a description of the factors that led to the
recognition of goodwill.
3. The acquisition-date fair value of the consideration transferred, the fair value of each
component of the consideration, and a description of any contingent consideration.
4. The acquisition-date amounts recognized for each major class of assets acquired and
liabilities assumed.
5. The business combination–related costs incurred, the amount expensed, and where
they were reported, along with any issue costs not expensed and how they were
recognized.
6. The acquiree’s revenue and net income included in the consolidated income statement for the period since acquisition, and the results of operations for the combined
company as if the business combination had occurred at the beginning of the reporting
period.
7. The total amount of goodwill, the amount expected to be deductible for tax purposes,
changes in goodwill during each subsequent period, and, if the company is required to
report segment information, the amount of goodwill assigned to each segment.
8. For less-than-100-percent acquisitions, the acquisition-date fair value of the noncontrolling interest and the valuation method used.
ADDITIONAL CONSIDERATIONS IN ACCOUNTING
FOR BUSINESS COMBINATIONS
FASB 141R (ASC 805) includes a number of requirements relating to specific items
or aspects encountered in business combinations. A discussion of several of the more
important situations follows.
Uncertainty in Business Combinations
Uncertainty affects much of accounting measurement but is especially prevalent in business combinations. Although uncertainty relates to many aspects of business combination, three aspects of accounting for business combinations deserve particular attention:
the measurement period, contingent consideration, and acquiree contingencies.
Measurement Period
One type of uncertainty in business combinations arises from the requirement to value at
acquisition-date fair value the assets and liabilities acquired in a business combination,
the acquirer’s interest in the acquiree, any noncontrolling interest, and the consideration
given. Because the acquirer may not have sufficient information available immediately to
properly ascertain fair values, FASB 141R (ASC 805) allows for a period of time, called
the measurement period, to acquire the necessary information. The measurement period
ends once the acquirer obtains the necessary information about the facts as of the acquisition date, but may not exceed one year.
12 FASB 141R, para. 68. (ASC 810-10-50-1 through ASC 810-10-50-2)
LO6
Understand additional considerations associated with
business combinations.
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Chapter 1 Intercorporate Acquisitions and Investments in Other Entities 25
Assets that have been provisionally recorded as of the acquisition date are retrospectively adjusted in value during the measurement period for new information that clarifies the acquisition-date value. Usually, the offsetting entry is to goodwill. Retrospective
adjustments may not be made for changes in value that occur subsequent to the acquisition date.
As an illustration, assume that Baine Company acquires land in a business combination and provisionally records the land at its estimated fair value of $100,000. During the
measurement period, Baine receives a reliable appraisal that the land was worth $110,000
at the acquisition date. Subsequently, during the same accounting period, a change in the
zoning of a neighboring parcel of land reduces the value of the land acquired by Baine to
$75,000. Baine records the clarification of the acquisition-date fair value of the land and
the subsequent impairment of value with the following entries:
Contingent Consideration
Sometimes the consideration exchanged by the acquirer in a business combination is
not fixed in amount, but rather is contingent on future events. For example, the acquiree
and acquirer may enter into a contingent-share agreement whereby, in addition to an
initial issuance of shares, the acquirer may agree to issue a certain number of additional
shares for each percentage point by which the earnings number exceeds a set amount
over the next five years. Thus, total consideration exchanged in the business combination
is not known within the measurement period because the number of shares to be issued is
dependent on future events.
FASB 141R (ASC 805) requires contingent consideration in a business combination
to be valued at fair value as of the acquisition date and classified as either a liability or
equity. The right to require the return of consideration given that it is dependent on future
events is classified as an asset. Contingent consideration classified as an asset or liability
is remeasured each period to fair value and the change is recognized in income. 13 Contingent consideration classified as equity is not remeasured.
Acquiree Contingencies
Certain contingencies may relate to an acquiree in a business combination, such as pending
lawsuits or loan guarantees made by the acquiree. Certainly, the acquirer considers such
contingencies when entering into an acquisition agreement, and the accounting must also
consider such contingencies. Under FASB 141R (ASC 805), the acquirer must recognize
all contingencies that arise from contractual rights or obligations and other contingencies
if it is more likely than not that they meet the definition of an asset or liability at the acquisition date. These contingencies are recorded by the acquirer at acquisition-date fair value.
For all acquired contingencies, the acquirer should provide a description of each, disclose the amount recognized at the acquisition date, and describe the estimated range of
possible undiscounted outcomes. Subsequently, the acquirer should disclose changes in
the amounts recognized and in the range of possible outcomes.
13 Treatment of contingent consideration under IFRS is slightly different. While contingent consideration
classified as an asset or liability will likely be a financial instrument measured at fair value with gains or
losses recognized in profit or loss (or OCI, as appropriate), if the asset or liability is not a financial instrument,
it is accounted for in accordance with the standard provisions for that class of asset or liability (i.e., not
necessarily at fair value).
(12) Impairment Loss 35,000
Land 35,000
Recognize decline in value of land held.
(11) Land 10,000
Goodwill 10,000
Adjust acquisition-date value of land acquired in business
combination.
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26 Chapter 1 Intercorporate Acquisitions and Investments in Other Entities
Business combinations and complex organizational structures are an important part of the global
business scene. Many companies add organizational components by creating new corporations or
partnerships through which to carry out a portion of their operations. In other cases, companies
may enter into business combinations to acquire other companies through which to further their
objectives.
When a company creates another corporation or a partnership through a transfer of assets, the
book values of those assets are transferred to the new entity and no gain or loss is recognized. The
creating company and the new entity will combine their financial statements for general-purpose
In-Process Research and Development
In normal operations, research and development costs are required to be expensed as
incurred, except under certain limited conditions. When a company acquires valuable
ongoing research and development projects from an acquiree in a business combination,
a question arises as to whether these should be recorded as assets. The FASB concluded
in FASB 141R (ASC 805) that these projects are assets and should be recorded at their
acquisition-date fair values, even if they have no alternative use. These projects should
be classified as having indefinite lives and, therefore, should not be amortized until completed or abandoned. They should be tested for impairment in accordance with current
standards. Subsequent expenditures for the previously acquired research and development projects would normally be expensed as incurred.
Noncontrolling Equity Held Prior to Combination
In some cases an acquirer may hold an equity interest in an acquiree prior to obtaining
control through a business combination. The total amount of the acquirer’s investment
in the acquiree subsequent to the combination is equal to the acquisition-date fair value
of the equity interest previously held and the fair value of the consideration given in the
business combination. For example, if Lemon Company held 10 percent of Aide Company’s stock with a fair value of $500,000 and Lemon acquired the remaining shares of
Aide for $4,500,000 cash, Lemon’s total investment is considered to be $5,000,000.
An acquirer that held an equity position in an acquiree immediately prior to the acquisition date must revalue that equity position to its fair value at the acquisition date and
recognize a gain or loss on the revaluation. Suppose that Lemon’s 10 percent investment
in Aide has a book value of $300,000 and fair value of $500,000 at the date Lemon
acquires the remaining 90 percent of Aide’s stock. Lemon revalues its original investment in Aide to its $500,000 fair value and recognizes a $200,000 gain on the revaluation
at the date it acquires the remaining shares of Aide. Lemon records the following entries
on its books in connection with the acquisition of Aide:
Acquisitions by Contract Alone
In rare instances, an acquirer may obtain control of an acquiree without transferring consideration or receiving an equity interest in the acquiree. Control is achieved by contract
alone. In such cases, the amount of the acquiree’s net assets at the date of acquisition
is attributed to the noncontrolling interest and included in the noncontrolling interest
reported in subsequent consolidated financial statements.
Summary of
Key Concepts
(14) Investment in Aide Company Stock 4,500,000
Cash 4,500,000
Acquire controlling interest in Aide Company.
(13) Investment in Aide Company Stock 200,000
Gain on revaluation of Aide Company Stock 200,000
Revalue Aide Company stock to fair value at date of business
combination.
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Chapter 1 Intercorporate Acquisitions and Investments in Other Entities 27
financial reporting to appear as if they were a single company as long as the creating company
continues to control the new entity.
Over the decades, business combinations have been occurring with increasing frequency.
A business combination occurs when an acquirer obtains control of one or more other businesses.
The three types of business combination that are commonly found are: ( a ) statutory mergers, where
the acquiree loses its separate identity and the acquirer continues with the assets and liabilities of
both companies; ( b ) statutory consolidations, where both combining companies join to form a new
company; and ( c ) stock acquisitions, where both combining companies maintain their separate
identities, with the acquirer owning the stock of the acquiree.
The FASB recently issued FASB 141R (ASC 805), which requires the acquisition method be
used to account for business combinations. Under the acquisition method, all of the assets acquired
and liabilities assumed by the acquirer in a business combination are valued at their fair values.
The excess of the sum of the fair value of the acquirer’s consideration transferred, the fair value
of any equity interest in the acquiree already held, and the fair value of any noncontrolling interest
in the acquiree over the fair value of the net identifiable assets acquired is goodwill. In subsequent
financial statements, goodwill must be reported separately. Goodwill is not amortized, but it must
be tested for impairment at least annually. If goodwill is impaired, it is written down to its new fair
value and a loss recognized for the amount of the impairment. If the fair value of the consideration
transferred by the acquirer in a business combination, along with the fair value of an equity interest
already held, and the noncontrolling interest is less than the fair value of the acquiree’s net identifiable assets, a situation referred to as a bargain purchase, the difference is recognized as a gain
attributable to the acquirer.
All costs associated with a business combination are expensed as incurred. Any stock issue
costs incurred in connection with a business combination are treated as a reduction in paid-in
capital. A business combination is given effect as of the acquisition date for subsequent financial
reporting.
acquisition method, 16
bargain purchase, 22
business combination, 7
consolidated financial
statements, 4
control, 7
differential, 19
goodwill, 17
liquidated, 12
measurement period, 24
minority interest, 14
noncontrolling
interest, 14
parent company, 5
parent–subsidiary
relationship, 12
pooling-of-interests, 6
primary beneficiary, 10
special-purpose
entity, 6
spin-off, 7
split-off, 7
statutory consolidation, 12
statutory merger, 12
stock acquisition, 12
subsidiary, 5
tender offer, 13
Key Terms
Appendix 1A Methods of Accounting for Business Combinations
As discussed in the chapter, several different methods of accounting for business combinations
have been acceptable over the years. While acquisition accounting is the only method acceptable
for business combinations occurring after 2008, many companies’ financial statements include the
results of past business combinations recorded using either the purchase or pooling-of-interests
method. Thus, accountants should understand the effects of these earlier methods even though they
are no longer acceptable.
We use the example presented earlier in the chapter to illustrate the differences between the
methods of accounting for business combinations. Point Corporation acquires all of the assets and
assumes all of the liabilities of Sharp Company in a merger by issuing to Sharp 10,000 shares of
$10 par common stock. The shares issued have a total market value of $610,000. Point incurs legal
and appraisal fees of $40,000 in connection with the combination and stock issue costs of $25,000.
As discussed previously, Figure 1–3 gives the book values and fair values of Sharp’s individual
assets and liabilities on the date of combination.
Figure 1– 4 shows the journal entries on Point’s books to record the business combination
under the acquisition, purchase, and pooling-of-interests methods. Under the acquisition method,
Point records the identifiable assets and liabilities acquired in the business combination at their fair
values and records goodwill for the $100,000 difference between the $610,000 fair value of the
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28 Chapter 1 Intercorporate Acquisitions and Investments in Other Entities
consideration transferred by Point and the $510,000 fair value of Sharp’s net identifiable assets.
Expenses related to the business combination are expensed, and the stock issue costs are treated as
a reduction in the issue price of Point’s stock.
The purchase method called for recording the acquired company at the amount of the total
purchase price paid by the acquirer, including associated costs. Point records the identifiable assets
and liabilities acquired at their fair values, as under the acquisition method. Point then records
goodwill for the difference between the total purchase price paid for Sharp and the fair value of
its net identifiable assets. The purchase method based the calculation of goodwill on the total
purchase price while the acquisition method is based on the fair value of the consideration given.
Also, the purchase method viewed the costs associated with bringing about the business combination as being part of the total purchase price, while the acquisition method expenses all such costs.
The $140,000 of goodwill is calculated under the purchase method as the sum of the fair value of
the consideration given by Point ($610,000) and the merger costs ($40,000), less the fair value of
Sharp’s net identifiable assets ($510,000).
The pooling-of-interests method assumed the view that the two companies were joining together
and pooling their resources without either company acquiring the other and with a continuity of
ownership. Thus, the book values of assets, liabilities, and equity were carried forward without
adjustment to fair value. Consistent with the idea of the owners of both companies continuing as
owners of the combined company, poolings could occur only when one company issued its common stock for the other combining company so that substantially all stockholders of both companies
continued as owners. The issuing company recorded equity equal to that of the other combining
company. The stock issued in the combination was recorded at the total amount of the other combining company’s stock that it replaced, and the retained earnings of the other combining company was
recorded on the books of the issuing company. All merger and stock issue costs were expensed. No
goodwill was ever recorded in poolings, but unlike under purchase accounting, the retained earnings
balances of both companies were carried forward. In this example, Point records on its books all of
Sharp’s recorded assets and liabilities at their book values from Sharp’s books. Point records the
stock it issues in the combination at the same total amount as Sharp’s stock ($150,000, including
both the par value and additional paid-in capital), and records Sharp’s retained earnings ($150,000).
Questions
LO1 Q1-1 What types of circumstances would encourage management to establish a complex organizational
structure?
LO1 Q1-2 How would the decision to dispose of a segment of operations using a split-off rather than a spinoff impact the financial statements of the company making the distribution?
LO1 Q1-3 Why did companies such as Enron find the use of special-purpose entities to be advantageous?
LO3 Q1-4 Describe each of the three legal forms that a business combination might take.
FIGURE 1–4 Different Methods of Accounting for Business Combinations
Acquisition Accounting Purchase Accounting Pooling Accounting
Merger Expenses 40,000 Deferred Merger Costs 40,000 Merger Expenses 65,000
Deferred Stock Issue
Costs 25,000
Deferred Stock Issue
Costs 25,000
Cash 65,000
Cash 65,000 Cash 65,000
Cash and Receivables 45,000 Cash and Receivables 45,000 Cash and Receivables 45,000
Inventory 75,000 Inventory 75,000 Inventory 65,000
Land 70,000 Land 70,000 Land 40,000
Buildings and
Equipment 350,000
Buildings and
Equipment 350,000
Buildings and
Equipment 400,000
Patent 80,000 Patent 80,000 Accumulated Depreciation 150,000
Goodwill 100,000 Goodwill 140,000 Current Liabilities 100,000
Current Liabilities 110,000 Current Liabilities 110,000 Common Stock 100,000
Common Stock 100,000 Common Stock 100,000 Additional Capital 50,000
Additional Capital 485,000 Additional Capital 485,000 Retained Earnings 150,000
Deferred Stock Issue
Costs 25,000
Deferred Merger Costs
Deferred Stock Issue Costs
40,000
25,000
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Chapter 1 Intercorporate Acquisitions and Investments in Other Entities 29
LO2 Q1-5 What basis of accounting normally is used in recording the assets and liabilities transferred to a
new wholly owned subsidiary?
LO1 Q1-6 How might the concept of a beneficial interest impact the reporting of an interest in another company?
LO1 Q1-7 When does a noncontrolling interest arise in a business combination?
LO1 Q1-8 Why did corporate management often prefer pooling-of-interests accounting in recording business
combinations?
LO5 Q1-9 How is the amount reported as goodwill determined under the acquisition method?
LO5 Q1-10 What impact does the level of ownership have on the amount of goodwill reported under the acquisition method?
LO5 Q1-11 How is the amount of goodwill assigned to the noncontrolling interest determined when less than
full ownership is acquired?
LO5 Q1-12 What is a differential?
LO4, LO5 Q1-13 When a business combination occurs after the beginning of the year, the income earned by the
acquired company between the beginning of the year and the date of combination is excluded from
the net income reported by the combined entity for the year. Why?
LO4 Q1-14 What is the maximum balance in retained earnings that can be reported by the combined entity
following a business combination?
LO4 Q1-15 How is the amount of additional paid-in capital determined when recording a business combination?
LO4, LO5 Q1-16 Which of the costs incurred in completing a business combination are capitalized under the acquisition method?
LO4 Q1-17 Which of the costs incurred in completing a business combination should be treated as a reduction
of additional paid-in capital?
LO5 Q1-18 When is goodwill considered impaired following a business combination?
LO5 Q1-19 When does a bargain purchase occur?
LO5 Q1-20 * Within the measurement period following a business combination, the acquisition-date fair value
of buildings acquired is determined to be less than initially recorded. How is the reduction in value
recognized?
LO4 Q1-21 * P Company reports its 10,000 shares of S Company at $40 per share. P Company then purchases
an additional 60,000 shares of S Company for $65 each and gains control of S Company. What
must be done with respect to the valuation of the shares previously owned?
LO5 Q1-22A P Company purchased 80 percent of the shares of S Company in 20X6 under the purchase method.
How would the amount of goodwill reported under the purchase method differ from the amount to
be reported under the acquisition method?
LO4 Q1-23A What major differences occur between using pooling-of-interests accounting for a business combination and using the acquisition method?
Cases
LO5 C1-1 Reporting Alternatives and International Harmonization
Accounting procedures for business combinations historically have differed across countries.
Pooling-of-interests, for many years a preferred method in the United States, was not acceptable in
most countries. In some countries, accounting standards permit goodwill to be written off directly
against stockholders’ equity at the time of a business combination.
Required
a. Over the years, many U.S. companies complained they were at a disadvantage when competing
against foreign companies in purchasing other business enterprises because, unlike U.S. companies, many foreign companies either did not have to capitalize goodwill or could write it off
immediately against stockholders’ equity. Historically, why were U.S. companies opposed to
Understanding
* Indicates that the item relates to “Additional Consideration.”
“A” indicates that the item relates to “Appendix A.”
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30 Chapter 1 Intercorporate Acquisitions and Investments in Other Entities
capitalizing goodwill? What happened during the past decade to improve the situation from the
perspective of U.S. companies?
b. Should U.S. companies care about accounting standards other than those that are generally
accepted in the United States? Explain.
LO4, LO5 C1-2 Assignment of Acquisition Costs
Troy Company notified Kline Company’s shareholders that it was interested in purchasing controlling ownership of Kline and offered to exchange one share of Troy’s common stock for each
share of Kline Company submitted by July 31, 20X7. At the time of the offer, Troy’s shares were
trading for $35 per share and Kline’s shares were trading at $28. Troy acquired all of the shares of
Kline prior to December 31, 20X7, and transferred the assets and liabilities of Kline to its books.
In addition to issuing its shares, Troy paid a finder’s fee of $200,000, stock registration and audit
fees of $60,000, legal fees of $90,000 for transferring Kline’s assets and liabilities to Troy, and
$370,000 in legal fees to settle litigation brought by Kline’s shareholders who alleged that the
offering price was below the per share fair value of Kline’s net assets.
Troy is currently negotiating to purchase Lad Company through an exchange of common stock
and expects to incur additional costs comparable to those involved in the acquisition of Kline. The
acquisition of Lad is expected to close sometime late in 20X9.
Required
Troy Company’s vice president of finance has asked you to review the current accounting literature, including authoritative pronouncements, and prepare a memo reporting the required
treatment of the additional costs at the time Kline Company was acquired and the current
requirements for reporting the additional costs of acquiring Lad Company. Support your recommendations with citations and quotations from the authoritative financial reporting standards or
other literature.
LO1, LO2C1-3 Evaluation of Merger
One company may acquire another for a number of different reasons. The acquisition often has a
significant impact on the financial statements. In 2005, 3M Corporation acquired CUNO Incorporated. Obtain a copy of the 3M 10-K filing for 2005. The 10-K reports the annual results for a
company and is often available on the Investor Relations section of a company’s Web site. It is
also available on the SEC’s Web site at www.SEC.gov .
Required
Use the 10-K for 2005 to find the answers to the following questions about 3M’s acquisition of
CUNO Inc. ( Hint: You can search on the term CUNO once you have accessed the 10-K online.)
a. Provide at least one reason why 3M acquired CUNO.
b. How was the acquisition funded?
c. What was the impact of the CUNO acquisition on net accounts receivable?
d. What was the impact of the CUNO acquisition on inventories?
LO3C1-4 Business Combinations
A merger boom comparable to those of the 1960s and mid-1980s occurred in the 1990s and
into the new century. The merger activity of the 1960s was associated with increasing stock
prices and heavy use of pooling-of-interests accounting. The mid-1980s activity was associated with a number of leveraged buyouts and acquisitions involving junk bonds. Merger
activity in the early 1990s, on the other hand, appeared to involve primarily purchases with
cash and standard debt instruments. By the mid-1990s, however, many business combinations
were being effected through exchanges of stock. In the first decade of the new century, the
nature of many business acquisitions changed, and by late 2008, the merger boom had slowed
dramatically.
a. Which factors do you believe were the most prominent in encouraging business combinations
in the 1990s? Which of these was the most important? Explain why.
b. Why were so many of the business combinations in the middle and late 1990s effected through
exchanges of stock?
c. What factors had a heavy influence on mergers during the mid-2000s? How did many of the
business combinations of this period differ from earlier combinations? Why did the merger
boom slow so dramatically late in 2008 and in 2009?
Research
Research
Analysis
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d. If a major review of the tax laws were undertaken, would it be wise or unwise public policy to
establish greater tax incentives for corporate mergers? Propose three incentives that might be used.
e. If the FASB were interested in encouraging more mergers, what action should it take with
regard to revising or eliminating existing accounting standards? Explain.
LO5C1-5 Determination of Goodwill Impairment
Plush Corporation purchased 100 percent of Common Corporation’s common stock on January 1,
20X3, and paid $450,000. The fair value of Common’s identifiable net assets at that date was
$430,000. By the end of 20X5, the fair value of Common, which Plush considers to be a reporting
unit, had increased to $485,000; however, Plush’s external auditor made a passing comment to the
company’s chief accountant that Plush may need to recognize impairment of goodwill on one or
more of its investments.
Required
Prepare a memo to Plush’s chief accountant indicating the tests used in determining whether goodwill has been impaired. Include in your discussion one or more possible conditions under which
Plush may be required to recognize impairment of goodwill on its investment in Common Corporation. In preparing your memo, review the current accounting literature, including authoritative
pronouncements of the FASB and other appropriate bodies. Support your discussion with citations
and quotations from the applicable literature.
LO1C1-6 Risks Associated with Acquisitions
Not all business combinations are successful, and many entail substantial risk. Acquiring another
company may involve a number of different types of risk. Obtain a copy of the 10-K report for
Google, Inc., for the year ended December 31, 2006, available at the SEC’s Web site ( www.sec.gov ).
The report also can be accessed through Yahoo Finance or the company’s Investor Relations page.
Required
On page 21 of the 10-K report, Google provides information to investors about its motivation for
acquiring companies and the possible risks associated with such acquisitions. Briefly discuss the
risks that Google sees inherent in potential acquisitions.
LO1C1-7 Numbers Game
Arthur Levitt’s speech, “The Numbers Game,” is available on the SEC’s Web site at www.sec.gov/
news/speech/speecharchive/1998/spch220.txt . Read the speech, and then answer the following
questions.
Required
a. Briefly explain what motivations Levitt discusses for earnings management.
b. What specific techniques for earnings management does Levitt discuss?
c. According to Levitt, why is the issue of earnings management important?
LO1, LO3C1-8 MCI: A Succession of Mergers
MCI WorldCom, Inc. (later MCI), was known as a high-flying company, having had its roots in
a small local company and rising to one of the world’s largest communications giants. The company’s spectacular growth was accomplished through a string of business combinations. However,
not all went as planned, and MCI is no longer an independent company.
Required
Provide a brief history of, and indicate subsequent events related to, MCI WorldCom. Include in
your discussion the following:
a. Trace the major acquisitions leading to MCI WorldCom and indicate the type of consideration
used in the acquisitions.
b. Who is Bernard Ebbers, and where is he now?
c. What happened to MCI WorldCom, and where is it now?
LO3 C1-9 Leveraged Buyouts
A type of acquisition that was not discussed in the chapter is the leveraged buyout. Many experts
argue that a leveraged buyout (LBO) is not a type of business combination but rather just a
restructuring of ownership. Yet some would see an LBO as having many of the characteristics of a
Research
Analysis
Communication
Research
Analysis
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32 Chapter 1 Intercorporate Acquisitions and Investments in Other Entities
business combination. The number of LBOs in recent years has grown dramatically and, therefore,
accounting for these transactions is of increased importance.
Required
a. What is a leveraged buyout? How does an LBO compare with a management buyout (MBO)?
b. What authoritative pronouncements, if any, deal with leveraged buyouts?
c. Is a leveraged buyout a type of business combination? Explain.
d. What is the major issue in determining the proper basis for an interest in a company purchased
through a leveraged buyout?
LO5C1-10 Curtiss-Wright and Goodwill
Accounting standards continually evolve. One area where significant change has occurred over the
past decade is in recording and accounting for goodwill. Prior to 2002, companies were required to
amortize goodwill over its useful life, not to exceed 17 years. Beginning in 2002, goodwill was no
longer required to be amortized. One company that has been affected by the changes in accounting
for goodwill is Curtiss-Wright.
Required
a. By what amounts did Curtiss-Wright’s goodwill increase in 2001 and 2002, and what amounts did
the company report at December 31, 2001 and 2002? What percentage of Curtis-Wright’s total
assets does goodwill represent at December 31, 2002? How does this compare to other companies?
b. What is the fair-value amount of assets Curtiss-Wright acquired in 2006 through business
combinations? By what dollar amount did goodwill increase during 2006? What percentage
increase does this represent? What percentage of Curtiss-Wright’s total assets does goodwill
represent at December 31, 2006?
c. What amount of goodwill impairment losses did Curtiss-Wright recognize for 2006 and 2005?
What change did Curtiss-Wright make during 2006 in its goodwill impairment testing? Why
was this change made? What effect did this change have on the financial statements for 2006
and prior years?
d. Do you think the management of Curtiss-Wright prefers the treatment that was required for
goodwill before 2002 or the current treatment? Explain.
LO1C1-11 Sears and Kmart: The Joining Together of Two of America’s Oldest Retailers
Kmart started in 1899 as the S. S. Kresge Company, better known as the five-and-dime store. Sears
has its roots in the 1880s and incorporated as Sears, Roebuck and Company in 1893. In 2005, the
two companies joined together in a business combination.
Required
a. What major event for Kmart occurred in 2002? How was that issued resolved?
b. What form of business combination brought Sears and Kmart together, and what was the resulting corporate structure?
c. In the business combination involving Sears and Kmart, which company acquired the other?
On what basis was this determination made? What accounting implications did the choice of
acquirer have?
Exercises
LO1, LO3 E1-1 Multiple-Choice Questions on Complex Organizations
Select the correct answer for each of the following questions.
1. Growth in the complexity of the U.S. business environment
a. Has led to increased use of partnerships to avoid legal liability.
b. Has led to increasingly complex organizational structures as management has attempted to
achieve its business objectives.
c. Has encouraged companies to reduce the number of operating divisions and product lines so
they may better control those they retain.
d. Has had no particular impact on the organizational structures or the way in which companies are
managed.
Research
Analysis
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2. Which of the following is not an appropriate reason for establishing a subsidiary?
a. The parent wishes to protect existing operations by shifting new activities with greater risk
to a newly created subsidiary.
b. The parent wishes to avoid subjecting all of its operations to regulatory control by establishing a subsidiary that focuses its operations in regulated industries.
c. The parent wishes to reduce its taxes by establishing a subsidiary that focuses its operations
in areas where special tax benefits are available.
d. The parent wishes to be able to increase its reported sales by transferring products to the subsidiary at the end of the fiscal year.
3. Which of the following actions is likely to result in recording goodwill on Randolph Company’s
books?
a. Randolph acquires Penn Corporation in a business combination recorded as a merger.
b. Randolph acquires a majority of Penn’s common stock in a business combination and
continues to operate it as a subsidiary.
c. Randolph distributes ownership of a newly created subsidiary in a distribution considered to
be a spin-off.
d. Randolph distributes ownership of a newly created subsidiary in a distribution considered to be
a split-off.
4. When an existing company creates a new subsidiary and transfers a portion of its assets and
liabilities to the new entity
a. The new entity records both the assets and liabilities it received at fair values.
b. The new entity records both the assets and liabilities it received at the carrying values of the
original company.
c. The original company records a gain or loss on the difference between its carrying values
and the fair values of the assets transferred to the new entity.
d. The original company records the difference between the carrying values and the fair values of
the assets transferred to the new entity as goodwill.
5. When a company assigns goodwill to a reporting unit acquired in a business combination, it
must record an impairment loss if
a. The fair value of the net identifiable assets held by a reporting unit decreases.
b. The fair value of the reporting unit decreases.
c. The carrying value of the reporting unit is less than the fair value of the reporting unit.
d. The fair value of the reporting unit is less than its carrying value and the carrying value of goodwill is more than the implied value of its goodwill.
LO4, LO5E1-2 Multiple-Choice Questions on Recording Business Combinations [AICPA Adapted]
Select the correct answer for each of the following questions.
1. Goodwill represents the excess of the sum of the consideration given over the
a. Sum of the fair values assigned to identifiable assets acquired less liabilities assumed.
b. Sum of the fair values assigned to tangible assets acquired less liabilities assumed.
c. Sum of the fair values assigned to intangible assets acquired less liabilities assumed.
d. Book value of an acquired company.
2. In a business combination, costs of registering equity securities to be issued by the acquiring
company are a(n)
a. Expense of the combined company for the period in which the costs were incurred.
b. Direct addition to stockholders’ equity of the combined company.
c. Reduction of the otherwise determinable fair value of the securities.
d. Addition to goodwill.
3. Which of the following is the appropriate basis for valuing fixed assets acquired in a business
combination carried out by exchanging cash for common stock?
a. Historical cost.
b. Book value.
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34 Chapter 1 Intercorporate Acquisitions and Investments in Other Entities
c. Cost plus any excess of purchase price over book value of assets acquired.
d. Fair value.
4. In a business combination, the fair value of the net identifiable assets acquired exceeds the fair
value of the consideration given. The excess should be reported as a
a. Deferred credit.
b. Reduction of the values assigned to current assets and a deferred credit for any unallocated
portion.
c. Pro rata reduction of the values assigned to current and noncurrent assets and a deferred
credit for any unallocated portion.
d. No answer listed is correct.
5. A and B Companies have been operating separately for five years. Each company has a minimal
amount of liabilities and a simple capital structure consisting solely of voting common stock.
A Company, in exchange for 40 percent of its voting stock, acquires 80 percent of the common stock
of B Company. This is a “tax-free” stock-for-stock (type B) exchange for tax purposes. B Company assets have a total net fair market value of $800,000 and a total net book value of $580,000.
The fair market value of the A stock used in the exchange is $700,000 and the fair value of the
noncontrolling interest is $175,000. The goodwill reported following the acquisition would be
a. Zero.
b. $60,000.
c. $75,000.
d. $295,000.
LO4, LO5E1-3 Multiple-Choice Questions on Reported Balances [AICPA Adapted]
Select the correct answer for each of the following questions.
1. On December 31, 20X3, Saxe Corporation was merged into Poe Corporation. In the business
combination, Poe issued 200,000 shares of its $10 par common stock, with a market price of
$18 a share, for all of Saxe’s common stock. The stockholders’ equity section of each company’s balance sheet immediately before the combination was:
Poe Saxe
Common Stock $3,000,000 $1,500,000
Additional Paid-In Capital 1,300,000 150,000
Retained Earnings 2,500,000 850,000
$6,800,000 $2,500,000
In the December 31, 20X3, consolidated balance sheet, additional paid-in capital should be
reported at
a. $950,000.
b. $1,300,000.
c. $1,450,000.
d. $2,900,000.
2. On January 1, 20X1, Rolan Corporation issued 10,000 shares of common stock in exchange for
all of Sandin Corporation’s outstanding stock. Condensed balance sheets of Rolan and Sandin
immediately before the combination follow:
Rolan Sandin
Total Assets $1,000,000 $500,000
Liabilities $ 300,000 $150,000
Common Stock ($10 par) 200,000 100,000
Retained Earnings 500,000 250,000
Total Liabilities and Equities $1,000,000 $500,000
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Rolan’s common stock had a market price of $60 per share on January 1, 20X1. The market
price of Sandin’s stock was not readily determinable. The fair value of Sandin’s net identifiable
assets was determined to be $570,000. Rolan’s investment in Sandin’s stock will be stated in
Rolan’s balance sheet immediately after the combination in the amount of
a. $350,000.
b. $500,000.
c. $570,000.
d. $600,000.
3. On April 1, 20X2, Jack Company paid $800,000 for all of Ann Corporation’s issued and
outstanding common stock. Ann’s recorded assets and liabilities on April 1, 20X2, were as
follows:
Cash $ 80,000
Inventory 240,000
Property and equipment (net of accumulated depreciation of $320,000) 480,000
Liabilities (180,000)
On April 1, 20X2, Ann’s inventory was determined to have a fair value of $190,000 and the
property and equipment had a fair value of $560,000. What is the amount of goodwill resulting
from the business combination?
a. $0.
b. $50,000.
c. $150,000.
d. $180,000.
4. Action Corporation issued nonvoting preferred stock with a fair market value of $4,000,000
in exchange for all the outstanding common stock of Master Corporation. On the date of the
exchange, Master had tangible net assets with a book value of $2,000,000 and a fair value of
$2,500,000. In addition, Action issued preferred stock valued at $400,000 to an individual as a
finder’s fee in arranging the transaction. As a result of this transaction, Action should record an
increase in net assets of
a. $2,000,000.
b. $2,500,000.
c. $4,000,000.
d. $4,400,000.
LO4, LO5E1-4 Multiple-Choice Questions Involving Account Balances
Select the correct answer for each of the following questions.
1. Topper Company established a subsidiary and transferred equipment with a fair value of
$72,000 to the subsidiary. Topper had purchased the equipment with an expected life of
10 years four years earlier for $100,000 and has used straight-line depreciation with no expected
residual value. At the time of the transfer, the subsidiary should record
a. Equipment at $72,000 and no accumulated depreciation.
b. Equipment at $60,000 and no accumulated depreciation.
c. Equipment at $100,000 and accumulated depreciation of $40,000.
d. Equipment at $120,000 and accumulated depreciation of $48,000.
2. Lead Corporation established a new subsidiary and transferred to it assets with a cost of $90,000
and a book value of $75,000. The assets had a fair value of $100,000 at the time of transfer. The
transfer will result in
a. A reduction of net assets reported by Lead Corporation of $90,000.
b. A reduction of net assets reported by Lead Corporation of $75,000.
c. No change in the reported net assets of Lead Corporation.
d. An increase in the net assets reported by Lead Corporation of $25,000.
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36 Chapter 1 Intercorporate Acquisitions and Investments in Other Entities
3. Tear Company, a newly established subsidiary of Stern Corporation, received assets with an
original cost of $260,000, a fair value of $200,000, and a book value of $140,000 from the parent in exchange for 7,000 shares of Tear’s $8 par value common stock. Tear should record
a. Additional paid-in capital of $0.
b. Additional paid-in capital of $84,000.
c. Additional paid-in capital of $144,000.
d. Additional paid-in capital of $204,000.
4. Grout Company reports assets with a carrying value of $420,000 (including goodwill with a
carrying value of $35,000) assigned to an identifiable reporting unit purchased at the end of the
prior year. The fair value of the net assets held by the reporting unit is currently $350,000, and
the fair value of the reporting unit is $395,000. At the end of the current period, Grout should
report goodwill of
a. $45,000.
b. $35,000.
c. $25,000.
d. $10,000.
5. Twill Company has a reporting unit with the fair value of its net identifiable assets of $500,000.
The carrying value of the reporting unit’s net assets on Twill’s books is $575,000, which
includes $90,000 of goodwill. The fair value of the reporting unit is $560,000. Twill should
report impairment of goodwill of
a. $60,000.
b. $30,000.
c. $15,000.
d. $0.
LO2E1-5 Asset Transfer to Subsidiary
Pale Company was established on January 1, 20X1. Along with other assets, it immediately purchased land for $80,000, a building for $240,000, and equipment for $90,000. On January 1, 20X5,
Pale transferred these assets, cash of $21,000, and inventory costing $37,000 to a newly created
subsidiary, Bright Company, in exchange for 10,000 shares of Bright’s $6 par value stock. Pale
uses straight-line depreciation and useful lives of 40 years and 10 years for the building and equipment, respectively, with no estimated residual values.
Required
a. Give the journal entry that Pale recorded when it transferred the assets to Bright.
b. Give the journal entry that Bright recorded for the receipt of assets and issuance of common
stock to Pale.
LO2E1-6 Creation of New Subsidiary
Lester Company transferred the following assets to a newly created subsidiary, Mumby Corporation, in exchange for 40,000 shares of its $3 par value stock:
Cost Book Value
Cash $ 40,000 $ 40,000
Accounts Receivable 75,000 68,000
Inventory 50,000 50,000
Land 35,000 35,000
Buildings 160,000 125,000
Equipment 240,000 180,000
Required
a. Give the journal entry in which Lester recorded the transfer of assets to Mumby Corporation.
b. Give the journal entry in which Mumby recorded the receipt of assets and issuance of common
stock to Lester.
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Chapter 1 Intercorporate Acquisitions and Investments in Other Entities 37
LO2, LO4 E1-7 Balance Sheet Totals of Parent Company
Foster Corporation established Kline Company as a wholly owned subsidiary. Foster reported
the following balance sheet amounts immediately before and after it transferred assets and
accounts payable to Kline Company in exchange for 4,000 shares of $12 par value common
stock:
Amount Reported
Before Transfer After Transfer
Cash $ 40,000 $ 25,000
Accounts Receivable 65,000 41,000
Inventory 30,000 21,000
Investment in Kline Company 66,000
Land 15,000 12,000
Depreciable Assets $180,000 $115,000
Accumulated Depreciation 75,000 105,000 47,000 68,000
Total Assets $255,000 $233,000
Accounts Payable $ 40,000 $ 18,000
Bonds Payable 80,000 80,000
Common Stock 60,000 60,000
Retained Earnings 75,000 75,000
Total Liabilities and Equities $255,000 $233,000
Required
a. Give the journal entry that Foster recorded when it transferred its assets and accounts payable
to Kline.
b. Give the journal entry that Kline recorded upon receipt of the assets and accounts payable from
Foster.
LO2E1-8 Creation of Partnership
Glover Corporation entered into an agreement with Renfro Company to establish G&R Partnership. Glover agreed to transfer the following assets to G&R for 90 percent ownership, and Renfro
agreed to transfer $50,000 cash to the partnership for 10 percent ownership.
Cost Book Value
Cash $ 10,000 $ 10,000
Accounts Receivable 19,000 19,000
Inventory 35,000 35,000
Land 16,000 16,000
Buildings 260,000 200,000
Equipment 210,000 170,000
Required
a. Give the journal entry that Glover recorded at the time of its transfer of assets to G&R.
b. Give the journal entry that Renfro recorded at the time of its transfer of cash to G&R.
c. Give the journal entry that G&R recorded upon the receipt of assets from Glover and Renfro.
LO4, LO5E1-9 Acquisition of Net Assets
Sun Corporation concluded the fair value of Tender Company was $60,000 and paid that amount
to acquire its net assets. Tender reported assets with a book value of $55,000 and fair value of
$71,000 and liabilities with a book value and fair value of $20,000 on the date of combination. Sun
also paid $4,000 to a search firm for finder’s fees related to the acquisition.
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38 Chapter 1 Intercorporate Acquisitions and Investments in Other Entities
Required
Give the journal entries to be made by Sun to record its investment in Tender and its payment of
the finder’s fees.
LO5E1-10 Reporting Goodwill
Samper Company reported the book value of its net assets at $160,000 when Public Corporation
acquired 100 percent ownership for $310,000. The fair value of Samper’s net assets was determined to be $190,000 on that date.
Required
Determine the amount of goodwill to be reported in consolidated financial statements presented
immediately following the combination and the amount at which Public will record its investment
in Samper if the amount paid by Public is
a. $310,000.
b. $196,000.
c. $150,000.
LO4E1-11 Stock Acquisition
McDermott Corporation has been in the midst of a major expansion program. Much of its
growth had been internal, but in 20X1 McDermott decided to continue its expansion through
the acquisition of other companies. The first company acquired was Tippy Inc., a small manufacturer of inertial guidance systems for aircraft and missiles. On June 10, 20X1, McDermott
issued 17,000 shares of its $25 par common stock for all 40,000 of Tippy’s $10 par common
shares. At the date of combination, Tippy reported additional paid-in capital of $100,000 and
retained earnings of $350,000. McDermott’s stock was selling for $58 per share immediately
prior to the combination. Subsequent to the combination, Tippy operated as a subsidiary of
McDermott.
Required
Present the journal entry or entries that McDermott would make to record the business combination with Tippy.
LO4, LO5E1-12 Balances Reported Following Combination
Elm Corporation and Maple Company have announced terms of an exchange agreement under
which Elm will issue 8,000 shares of its $10 par value common stock to acquire all of Maple
Company’s assets. Elm shares currently are trading at $50, and Maple $5 par value shares are
trading at $18 each. Historical cost and fair value balance sheet data on January 1, 20X2, are as
follows:
Elm Corporation Maple Company
Balance Sheet Item Book Value Fair Value Book Value Fair Value
Cash and Receivables $150,000 $150,000 $ 40,000 $ 40,000
Land 100,000 170,000 50,000 85,000
Buildings and Equipment (net) 300,000 400,000 160,000 230,000
Total Assets $550,000 $720,000 $250,000 $355,000
Common Stock $200,000 $100,000
Additional Paid-In Capital 20,000 10,000
Retained Earnings 330,000 140,000
Total Equities $550,000 $250,000
Required
What amount will be reported immediately following the business combination for each of the following items in the combined company’s balance sheet?
a. Common Stock.
b. Cash and Receivables.
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Chapter 1 Intercorporate Acquisitions and Investments in Other Entities 39
c. Land.
d. Buildings and Equipment (net).
e. Goodwill.
f. Additional Paid-In Capital.
g. Retained Earnings.
LO5E1-13 Goodwill Recognition
Spur Corporation reported the following balance sheet amounts on December 31, 20X1:
Balance Sheet Item Historical Cost Fair Value
Cash and Receivables $ 50,000 $ 40,000
Inventory 100,000 150,000
Land 40,000 30,000
Plant and Equipment 400,000 350,000
Less: Accumulated Depreciation (150,000)
Patent 130,000
Total Assets $440,000 $700,000
Accounts Payable $ 80,000 $ 85,000
Common Stock 200,000
Additional Paid-In Capital 20,000
Retained Earnings 140,000
Total Liabilities and Equities $440,000
Required
Blanket acquired Spur Corporation’s assets and liabilities for $670,000 cash on December 31,
20X1. Give the entry that Blanket made to record the purchase.
LO4E1-14 Acquisition Using Debentures
Fortune Corporation used debentures with a par value of $625,000 to acquire 100 percent
of Sorden Company’s net assets on January 1, 20X2. On that date, the fair value of the
bonds issued by Fortune was $608,000. The following balance sheet data were reported by
Sorden:
Balance Sheet Item Historical Cost Fair Value
Cash and Receivables $ 55,000 $ 50,000
Inventory 105,000 200,000
Land 60,000 100,000
Plant and Equipment 400,000 300,000
Less: Accumulated Depreciation (150,000)
Goodwill 10,000
Total Assets $480,000 $650,000
Accounts Payable $ 50,000 $ 50,000
Common Stock 100,000
Additional Paid-In Capital 60,000
Retained Earnings 270,000
Total Liabilities and Equities $480,000
Required
Give the journal entry that Fortune recorded at the time of exchange.
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40 Chapter 1 Intercorporate Acquisitions and Investments in Other Entities
LO5 E1-15 Bargain Purchase
Using the data presented in E1-14 determine the amount Fortune Corporation would record as a
gain on bargain purchase and prepare the journal entry Fortune would record at the time of the
exchange if Fortune issued bonds with a par value of $580,000 and a fair value of $564,000 in
completing the acquisition of Sorden.
LO5E1-16 Impairment of Goodwill
Mesa Corporation purchased Kwick Company’s net assets and assigned goodwill of $80,000
to Reporting Division K. The following assets and liabilities are assigned to Reporting
Division K:
Carrying Amount Fair Value
Cash $ 14,000 $ 14,000
Inventory 56,000 71,000
Equipment 170,000 190,000
Goodwill 80,000
Accounts Payable 30,000 30,000
Required
Determine the amount of goodwill to be reported for Division K and the amount of goodwill
impairment to be recognized, if any, if Division K’s fair value is determined to be
a. $340,000.
b. $280,000.
c. $260,000.
LO5E1-17 Assignment of Goodwill
Double Corporation acquired all of the common stock of Simple Company for $450,000 on January 1, 20X4. On that date, Simple’s identifiable net assets had a fair value of $390,000. The assets
acquired in the purchase of Simple are considered to be a separate reporting unit of Double. The
carrying value of Double’s investment at December 31, 20X4, is $500,000.
Required
Determine the amount of goodwill impairment, if any, that should be recognized at December 31,
20X4, if the fair value of the net assets (excluding goodwill) at that date is $440,000 and the fair
value of the reporting unit is determined to be
a. $530,000.
b. $485,000.
c. $450,000.
LO5E1-18 Goodwill Assigned to Reporting Units
Groft Company purchased Strobe Company’s net assets and assigned them to four separate reporting units. Total goodwill of $186,000 is assigned to the reporting units as indicated:
Reporting Unit
ABCD
Carrying value of investment $700,000 $330,000 $380,000 $520,000
Goodwill included in carrying value 60,000 48,000 28,000 50,000
Fair value of net identifiable assets
at year-end 600,000 300,000 400,000 500,000
Fair value of reporting unit at year-end 690,000 335,000 370,000 585,000
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Chapter 1 Intercorporate Acquisitions and Investments in Other Entities 41
Required
Determine the amount of goodwill that Groft should report at year-end. Show how you computed it.
LO5E1-19 Goodwill Measurement
Washer Company has a reporting unit resulting from an earlier business combination. The reporting unit’s current assets and liabilities are
Carrying Amount Fair Value
Cash $ 30,000 $ 30,000
Inventory 70,000 100,000
Land 30,000 60,000
Buildings 210,000 230,000
Equipment 160,000 170,000
Goodwill 150,000
Notes Payable 100,000 100,000
Required
Determine the amount of goodwill to be reported and the amount of goodwill impairment, if any,
if the fair value of the reporting unit is determined to be
a. $580,000.
b. $540,000.
c. $500,000.
d. $460,000.
LO4, LO5E1-20 Computation of Fair Value
Grant Company acquired all of Bedford Corporation’s assets and liabilities on January 1,
20X2, in a business combination. At that date, Bedford reported assets with a book value
of $624,000 and liabilities of $356,000. Grant noted that Bedford had $40,000 of research
and development costs on its books at the acquisition date that did not appear to be of value.
Grant also determined that patents developed by Bedford had a fair value of $120,000 but
had not been recorded by Bedford. Except for buildings and equipment, Grant determined the
fair value of all other assets and liabilities reported by Bedford approximated the recorded
amounts. In recording the transfer of assets and liabilities to its books, Grant recorded goodwill of $93,000. Grant paid $517,000 to acquire Bedford’s assets and liabilities. If the book
value of Bedford’s buildings and equipment was $341,000 at the date of acquisition, what was
their fair value?
LO4, LO5E1-21 Computation of Shares Issued and Goodwill
Dunyain Company acquired Allsap Corporation on January 1, 20X1, through an exchange of
common shares. All of Allsap’s assets and liabilities were immediately transferred to Dunyain,
which reported total par value of shares outstanding of $218,400 and $327,600 and additional
paid-in capital of $370,000 and $650,800 immediately before and after the business combination,
respectively.
Required
a. Assuming that Dunyain’s common stock had a market value of $25 per share at the time of
exchange, what number of shares was issued?
b. What is the par value per share of Dunyain’s common stock?
c. Assuming that Allsap’s identifiable assets had a fair value of $476,000 and its liabilities had a
fair value of $120,000, what amount of goodwill did Dunyain record at the time of the business
combination?
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42 Chapter 1 Intercorporate Acquisitions and Investments in Other Entities
LO4E1-22 Combined Balance Sheet
The following balance sheets were prepared for Adam Corporation and Best Company on January 1,
20X2, just before they entered into a business combination:
Adam Corporation Best Company
Item Book Value Fair Value Book Value Fair Value
Cash and Receivables $150,000 $150,000 $ 90,000 $ 90,000
Inventory 300,000 380,000 70,000 160,000
Buildings and Equipment 600,000 430,000 250,000 240,000
Less: Accumulated Depreciation (250,000) (80,000)
Total Assets $800,000 $960,000 $330,000 $490,000
Accounts Payable $ 75,000 $ 75,000 $ 50,000 $ 50,000
Notes Payable 200,000 215,000 30,000 35,000
Common Stock:
$8 par value 180,000
$6 par value 90,000
Additional Paid-In Capital 140,000 55,000
Retained Earnings 205,000 105,000
Total Liabilities and Equities $800,000 $330,000
Adam acquired all of Best Company’s assets and liabilities on January 1, 20X2, in exchange for its
common shares. Adam issued 8,000 shares of stock to complete the business combination.
Required
Prepare a balance sheet of the combined company immediately following the acquisition, assuming Adam’s shares were trading at $60 each.
LO4E1-23 Recording a Business Combination
The following financial statement information was prepared for Blue Corporation and Sparse
Company at December 31, 20X2:
Balance Sheets
December 31, 20X2
Blue Corporation Sparse Company
Cash $ 140,000 $ 70,000
Accounts Receivable 170,000 110,000
Inventory 250,000 180,000
Land 80,000 100,000
Buildings and Equipment $ 680,000 $ 450,000
Less: Accumulated Depreciation (320,000) 360,000 (230,000) 220,000
Goodwill 70,000 20,000
Total Assets $1,070,000 $700,000
Accounts Payable $ 70,000 $195,000
Bonds Payable 320,000 100,000
Bond Premium 10,000
Common Stock 120,000 150,000
Additional Paid-In Capital 170,000 60,000
Retained Earnings 390,000 185,000
Total Liabilities and Equities $1,070,000 $700,000
Blue and Sparse agreed to combine as of January 1, 20X3. To effect the merger, Blue paid
finder’s fees of $30,000 and legal fees of $24,000. Blue also paid $15,000 of audit fees related
to the issuance of stock, stock registration fees of $8,000, and stock listing application fees
of $6,000.
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At January 1, 20X3, book values of Sparse Company’s assets and liabilities approximated market value except for inventory with a market value of $200,000, buildings and equipment with
a market value of $350,000, and bonds payable with a market value of $105,000. All assets and
liabilities were immediately recorded on Blue’s books.
Required
Give all journal entries that Blue recorded assuming Blue issued 40,000 shares of $8 par value
common stock to acquire all of Sparse’s assets and liabilities in a business combination. Blue common stock was trading at $14 per share on January 1, 20X3.
LO4E1-24 Reporting Income
On July 1, 20X2, Alan Enterprises merged with Cherry Corporation through an exchange of stock
and the subsequent liquidation of Cherry. Alan issued 200,000 shares of its stock to effect the
combination. The book values of Cherry’s assets and liabilities were equal to their fair values at
the date of combination, and the value of the shares exchanged was equal to Cherry’s book value.
Information relating to income for the companies is as follows:
20X1 Jan. 1–June 30, 20X2 July 1–Dec. 31, 20X2
Net Income:
Alan Enterprises $4,460,000 $2,500,000 $3,528,000
Cherry Corporation 1,300,000 692,000 —
Alan Enterprises had 1,000,000 shares of stock outstanding prior to the combination.
Required
Compute the net income and earnings-per-share amounts that would be reported in Alan’s 20X2
comparative income statements for both 20X2 and 20X1.
Problems
LO2 P1-25 Assets and Accounts Payable Transferred to Subsidiary
Tab Corporation decided to establish Collon Company as a wholly owned subsidiary by transferring some of its existing assets and liabilities to the new entity. In exchange, Collon issued Tab
30,000 shares of $6 par value common stock. The following information is provided on the assets
and accounts payable transferred:
Cost Book Value Fair Value
Cash $ 25,000 $ 25,000 $ 25,000
Inventory 70,000 70,000 70,000
Land 60,000 60,000 90,000
Buildings 170,000 130,000 240,000
Equipment 90,000 80,000 105,000
Accounts Payable 45,000 45,000 45,000
Required
a. Give the journal entry that Tab recorded for the transfer of assets and accounts payable to Collon.
b. Give the journal entry that Collon recorded for the receipt of assets and accounts payable from Tab.
LO2P1-26 Creation of New Subsidiary
Eagle Corporation established a subsidiary to enter into a new line of business considered to be
substantially more risky than Eagle’s current business. Eagle transferred the following assets and
accounts payable to Sand Corporation in exchange for 5,000 shares of $10 par value stock of Sand:
Cost Book Value
Cash $ 30,000 $ 30,000
Accounts Receivable 45,000 40,000
Inventory 60,000 60,000
Land 20,000 20,000
Buildings and Equipment 300,000 260,000
Accounts Payable 10,000 10,000
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44 Chapter 1 Intercorporate Acquisitions and Investments in Other Entities
Required
a. Give the journal entry that Eagle recorded for the transfer of assets and accounts payable to
Sand.
b. Give the journal entry that Sand recorded for receipt of the assets and accounts payable from
Eagle.
LO2P1-27 Incomplete Data on Creation of Subsidiary
Thumb Company created New Company as a wholly owned subsidiary by transferring assets and
accounts payable to New in exchange for its common stock. New recorded the following entry
when it received the assets and accounts payable:
Cash 3,000
Accounts Receivable 16,000
Inventory 27,000
Land 9,000
Buildings 70,000
Equipment 60,000
Accounts Payable 14,000
Accumulated Depreciation—Buildings 21,000
Accumulated Depreciation—Equipment 12,000
Common Stock 40,000
Additional Paid-In Capital 98,000
Required
a. What was Thumb’s book value of the total assets transferred to New Company?
b. What amount did Thumb report as its investment in New after the transfer?
c. What number of shares of $5 par value stock did New issue to Thumb?
d. What impact did the transfer of assets and accounts payable have on the amount reported by
Thumb as total assets?
e. What impact did the transfer of assets and accounts payable have on the amount that Thumb
and the consolidated entity reported as shares outstanding?
LO2 P1-28 Establishing a Partnership
Krantz Company and Dull Corporation decided to form a partnership. Krantz agreed to transfer the following assets and accounts payable to K&D Partnership in exchange for 60 percent
ownership:
Cost Book Value
Cash $ 10,000 $ 10,000
Inventory 30,000 30,000
Land 70,000 70,000
Buildings 200,000 150,000
Equipment 120,000 90,000
Accounts Payable 50,000 50,000
Dull agreed to contribute cash of $200,000 to K&D Partnership.
Required
a. Give the journal entries that K&D recorded for its receipt of assets and accounts payable from
Krantz and Dull.
b. Give the journal entries that Krantz and Dull recorded for their transfer of assets and accounts
payable to K&D Partnership.
LO2P1-29 Balance Sheet Data for Companies Establishing a Partnership
Good Corporation and Nevall Company formed G&W Partnership in which Good received 75 percent ownership and Nevall received 25 percent ownership. The following assets were transferred
by Good and Nevall:
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Required
a. Give the journal entry that Good recorded for its transfer of assets to G&W Partnership.
b. Give the journal entry that Nevall recorded for its transfer of assets to G&W Partnership.
c. Give the journal entry that G&W recorded for its receipt of assets from Good and Nevall.
LO4P1-30 Acquisition in Multiple Steps
Deal Corporation issued 4,000 shares of its $10 par value stock with a market value of $85,000 to
acquire 85 percent ownership of Mead Company on August 31, 20X3. The fair value of Mead was
determined to be $100,000 on that date. Deal had earlier purchased 15 percent of Mead’s shares
for $9,000 and used the cost method in accounting for its investment in Mead. Deal later paid
appraisal fees of $3,500 and stock issue costs of $2,000 incurred in completing the acquisition of
the additional shares.
Required
Give the journal entries to be recorded by Deal in completing the acquisition of the additional
shares of Mead.
LO4P1-31 Journal Entries to Record a Business Combination
On January 1, 20X2, Frost Company acquired all of TKK Corporation’s assets and liabilities by
issuing 24,000 shares of its $4 par value common stock. At that date, Frost shares were selling at
$22 per share. Historical cost and fair value balance sheet data for TKK at the time of acquisition
were as follows:
Good Corporation Nevall Company
Cost Book Value Cost Book Value
Cash $ 21,000 $21,000 $ 3,000 $ 3,000
Inventory 4,000 4,000 25,000 25,000
Land 15,000 15,000
Buildings 100,000 70,000
Equipment 60,000 40,000 36,000 22,000
Balance Sheet Item Historical Cost Fair Value
Cash and Receivables $ 28,000 $ 28,000
Inventory 94,000 122,000
Buildings and Equipment 600,000 470,000
Less: Accumulated Depreciation (240,000)
Total Assets $ 482,000 $620,000
Accounts Payable $ 41,000 $ 41,000
Notes Payable 65,000 63,000
Common Stock ($10 par value) 160,000
Retained Earnings 216,000
Total Liabilities and Equities $ 482,000
Frost paid legal fees for the transfer of assets and liabilities of $14,000. Frost also paid
audit fees of $21,000 and listing application fees of $7,000, both related to the issuance of new
shares.
Required
Prepare the journal entries made by Frost to record the business combination.
LO4P1-32 Recording Business Combinations
Flint Corporation exchanged shares of its $2 par common stock for all of Mark Company’s assets
and liabilities in a planned merger. Immediately prior to the combination, Mark’s assets and liabilities were as follows:
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46 Chapter 1 Intercorporate Acquisitions and Investments in Other Entities
Immediately prior to the combination, Flint reported $250,000 additional paid-in capital and
$1,350,000 retained earnings. The fair values of Mark’s assets and liabilities were equal to their
book values on the date of combination except that Mark’s buildings were worth $1,500,000 and
its equipment was worth $300,000. Costs associated with planning and completing the business
combination totaled $38,000, and stock issue costs totaled $22,000. The market value of Flint’s
stock at the date of combination was $4 per share.
Required
Prepare the journal entries that would appear on Flint’s books to record the combination if Flint
issued 450,000 shares.
LO4, LO5P1-33 Business Combination with Goodwill
Anchor Corporation paid cash of $178,000 to acquire Zink Company’s net assets on February 1,
20X3. The balance sheet data for the two companies and fair value information for Zink immediately before the business combination were:
Assets
Cash and Equivalents $ 41,000
Accounts Receivable 73,000
Inventory 144,000
Land 200,000
Buildings 1,520,000
Equipment 638,000
Accumulated Depreciation (431,000)
Total Assets $2,185,000
Liabilities and Equities
Accounts Payable $ 35,000
Short-Term Notes Payable 50,000
Bonds Payable 500,000
Common Stock ($10 par) 1,000,000
Additional Paid-In Capital 325,000
Retained Earnings 275,000
Total Liabilities and Equities $2,185,000
Anchor Corporation Zink Company
Balance Sheet Item Book Value Book Value Fair Value
Cash $ 240,000 $ 20,000 $ 20,000
Accounts Receivable 140,000 35,000 35,000
Inventory 170,000 30,000 50,000
Patents 80,000 40,000 60,000
Buildings and Equipment 380,000 310,000 150,000
Less: Accumulated Depreciation (190,000) (200,000)
Total Assets $ 820,000 $ 235,000 $315,000
Accounts Payable $ 85,000 $ 55,000 $ 55,000
Notes Payable 150,000 120,000 120,000
Common Stock:
$10 par value 200,000
$6 par value 18,000
Additional Paid-In Capital 160,000 10,000
Retained Earnings 225,000 32,000
Total Liabilities and Equities $ 820,000 $ 235,000
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Required
a. Give the journal entry recorded by Anchor Corporation when it acquired Zink’s net assets.
b. Prepare a balance sheet for Anchor immediately following the acquisition.
c. Give the journal entry to be recorded by Anchor if it acquires all of Zink’s common stock for
$178,000.
LO4, LO5P1-34 Bargain Purchase
Bower Company purchased Lark Corporation’s net assets on January 3, 20X2, for $625,000 cash.
In addition, $5,000 of direct costs were incurred in consummating the combination. At the time of
acquisition, Lark reported the following historical cost and current market data:
Balance Sheet Item Book Value Fair Value
Cash and Receivables $ 50,000 $ 50,000
Inventory 100,000 150,000
Buildings and Equipment (net) 200,000 300,000
Patent — 200,000
Total Assets $350,000 $700,000
Accounts Payable $ 30,000 $ 30,000
Common Stock 100,000
Additional Paid-In Capital 80,000
Retained Earnings 140,000
Total Liabilities and Equities $350,000
Required
Give the journal entry or entries with which Bower recorded its acquisition of Lark’s net assets.
LO4, LO5P1-35 Computation of Account Balances
Aspro Division is considered to be an individual reporting unit of Tabor Company. Tabor acquired
the division by issuing 100,000 shares of its common stock with a market price of $7.60 each. Tabor
management was able to identify assets with fair values of $810,000 and liabilities of $190,000 at
the date of acquisition. At the end of the first year, the reporting unit had assets with a fair value of
$950,000, and the fair value of the reporting entity was $930,000. Tabor’s accountants concluded it
must recognize impairment of goodwill in the amount of $30,000 at the end of the first year.
Required
a. Determine the fair value of the reporting unit’s liabilities at the end of the first year. Show your
computation.
b. If the reporting unit’s liabilities at the end of the period had been $70,000, what would the fair
value of the reporting unit have to have been to avoid recognizing an impairment of goodwill?
Show your computation.
LO5P1-36 Goodwill Assigned to Multiple Reporting Units
The fair values of assets and liabilities held by three reporting units and other information related
to the reporting units owned by Rover Company are as follows:
Reporting Unit
ABC
Cash and Receivables $ 30,000 $ 80,000 $ 20,000
Inventory 60,000 100,000 40,000
Land 20,000 30,000 10,000
Buildings 100,000 150,000 80,000
Equipment 140,000 90,000 50,000
Accounts Payable 40,000 60,000 10,000
Fair Value of Reporting Unit 400,000 440,000 265,000
Carrying Value of Investment 420,000 500,000 290,000
Goodwill Included in Carrying Value 70,000 80,000 40,000
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48 Chapter 1 Intercorporate Acquisitions and Investments in Other Entities
Required
a. Determine the amount of goodwill that Rover should report in its current financial statements.
b. Determine the amount, if any, that Rover should report as impairment of goodwill for the current period.
LO4P1-37 Journal Entries
On January 1, 20X3, PURE Products Corporation issued 12,000 shares of its $10 par value stock
to acquire the net assets of Light Steel Company. Underlying book value and fair value information for the balance sheet items of Light Steel at the time of acquisition follow:
Balance Sheet Item Book Value Fair Value
Cash $ 60,000 $ 60,000
Accounts Receivable 100,000 100,000
Inventory (LIFO basis) 60,000 115,000
Land 50,000 70,000
Buildings and Equipment 400,000 350,000
Less: Accumulated Depreciation (150,000) —
Total Assets $ 520,000 $695,000
Accounts Payable $ 10,000 $ 10,000
Bonds Payable 200,000 180,000
Common Stock ($5 par value) 150,000
Additional Paid-In Capital 70,000
Retained Earnings 90,000
Total Liabilities and Equities $ 520,000
Light Steel shares were selling at $18 and PURE Products shares were selling at $50 just before
the merger announcement. Additional cash payments made by PURE Products in completing the
acquisition were
Finder’s fee paid to firm that located Light Steel $10,000
Audit fee for stock issued by PURE Products 3,000
Stock registration fee for new shares of PURE Products 5,000
Legal fees paid to assist in transfer of net assets 9,000
Cost of SEC registration of PURE Products shares 1,000
Required
Prepare all journal entries to record the business combination on PURE Products’ books.
LO4, LO5P1-38 Purchase at More than Book Value
Ramrod Manufacturing acquired all the assets and liabilities of Stafford Industries on January 1,
20X2, in exchange for 4,000 shares of Ramrod’s $20 par value common stock. Balance sheet data
for both companies just before the merger are given as follows:
Ramrod Manufacturing Stafford Industries
Balance Sheet Items Book Value Fair Value Book Value Fair Value
Cash $ 70,000 $ 70,000 $ 30,000 $ 30,000
Accounts Receivable 100,000 100,000 60,000 60,000
Inventory 200,000 375,000 100,000 160,000
Land 50,000 80,000 40,000 30,000
Buildings and Equipment 600,000 540,000 400,000 350,000
Less: Accumulated Depreciation (250,000) (150,000)
Total Assets $ 770,000 $1,165,000 $ 480,000 $630,000
Accounts Payable $ 50,000 $ 50,000 $ 10,000 $ 10,000
Bonds Payable 300,000 310,000 150,000 145,000
(continued)
} }
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Chapter 1 Intercorporate Acquisitions and Investments in Other Entities 49
Ramrod shares were selling for $150 on the date of acquisition.
Required
Prepare the following:
a. Journal entries to record the acquisition on Ramrod’s books.
b. A balance sheet for the combined enterprise immediately following the business combination.
LO4 P1-39 Business Combination
Following are the balance sheets of Boogie Musical Corporation and Toot-Toot Tuba Company as
of December 31, 20X5.
Common Stock:
$20 par value 200,000
$5 par value 100,000
Additional Paid-In Capital 40,000 20,000
Retained Earnings 180,000 200,000
Total Liabilities and Equities $ 770,000 $ 480,000
BOOGIE MUSICAL CORPORATION
Balance Sheet
December 31, 20X5
Assets Liabilities and Equities
Cash $ 23,000 Accounts Payable $ 48,000
Accounts Receivable 85,000 Notes Payable 65,000
Allowance for Uncollectible Accounts (1,200) Mortgage Payable 200,000
Inventory 192,000 Bonds Payable 200,000
Plant and Equipment 980,000 Capital Stock ($10 par) 500,000
Accumulated Depreciation (160,000) Premium on Capital Stock 1,000
Other Assets 14,000 Retained Earnings 118,800
Total Assets $1,132,800 Total Liabilities and Equities $1,132,800
TOOT-TOOT TUBA COMPANY
Balance Sheet
December 31, 20X5
Assets Liabilities and Equities
Cash $ 300 Accounts Payable $ 8,200
Accounts Receivable 17,000 Notes Payable 10,000
Allowance for Uncollectible Accounts (600) Mortgage Payable 50,000
Inventory 78,500 Bonds Payable 100,000
Plant and Equipment 451,000 Capital Stock ($50 par) 100,000
Accumulated Depreciation (225,000) Premium on Capital Stock 150,000
Other Assets 25,800 Retained Earnings (71,200)
Total Assets $347,000 Total Liabilities and Equities $347,000
In preparation for a possible business combination, a team of experts from Boogie Musical made
a thorough examination and audit of Toot-Toot Tuba. They found that Toot-Toot’s assets and
liabilities were correctly stated except that they estimated uncollectible accounts at $1,400. The
experts also estimated the market value of the inventory at $35,000 and the market value of the
plant and equipment at $500,000. The business combination took place on January 1, 20X6, and
on that date Boogie Musical acquired all the assets and liabilities of Toot-Toot Tuba. On that date,
Boogie’s common stock was selling for $55 per share.
Required
Record the combination on Boogie’s books assuming that Boogie issued 9,000 of its $10 par common shares in exchange for Toot-Toot’s assets and liabilities.
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50 Chapter 1 Intercorporate Acquisitions and Investments in Other Entities
LO4 P1-40 Combined Balance Sheet
Bilge Pumpworks and Seaworthy Rope Company agreed to merge on January 1, 20X3. On the
date of the merger agreement, the companies reported the following data:
Bilge
Pumpworks
Seaworthy
Rope Company
Balance Sheet Items Book Value Fair Value Book Value Fair Value
Cash and Receivables $ 90,000 $ 90,000 $ 20,000 $ 20,000
Inventory 100,000 150,000 30,000 42,000
Land 100,000 140,000 10,000 15,000
Plant and Equipment 400,000 300,000 200,000 140,000
Less: Accumulated Depreciation (150,000) (80,000)
Total Assets $ 540,000 $680,000 $180,000 $217,000
Current Liabilities $ 80,000 $ 80,000 $ 20,000 $ 20,000
Capital Stock 200,000 20,000
Capital in Excess of Par Value 20,000 5,000
Retained Earnings 240,000 135,000
Total Liabilities and Equities $ 540,000 $180,000
Bilge Pumpworks has 10,000 shares of its $20 par value shares outstanding on January 1, 20X3,
and Seaworthy has 4,000 shares of $5 par value stock outstanding. The market values of the shares
are $300 and $50, respectively.
Required
a. Bilge issues 700 shares of stock in exchange for all of Seaworthy’s net assets. Prepare a balance
sheet for the combined entity immediately following the merger.
b. Prepare the stockholders’ equity section of the combined company’s balance sheet, assuming
Bilge acquires all of Seaworthy’s net assets by issuing:
1. 1,100 shares of common.
2. 1,800 shares of common.
3. 3,000 shares of common.
LO4, LO5P1-41 Incomplete Data Problem
On January 1, 20X2, End Corporation acquired all of Cork Corporation’s assets and liabilities by
issuing shares of its common stock. Partial balance sheet data for the companies prior to the business combination and immediately following the combination are as follows:
End Corp. Cork Corp.
Book Value Book Value Combined Entity
Cash $ 40,000 $ 10,000 $ 50,000
Accounts Receivable 60,000 30,000 88,000
Inventory 50,000 35,000 96,000
Buildings and Equipment (net) 300,000 110,000 430,000
Goodwill ?
Total Assets $450,000 $185,000 $ ?
Accounts Payable $ 32,000 $ 14,000 $ 46,000
Bonds Payable 150,000 70,000 220,000
Bond Premium 6,000 6,000
Common Stock, $5 par 100,000 40,000 126,000
Additional Paid-In Capital 65,000 28,000 247,000
Retained Earnings 97,000 33,000 ?
Total Liabilities and Equities $450,000 $185,000 $ ?
} }
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Chapter 1 Intercorporate Acquisitions and Investments in Other Entities 51
Required
a. What number of shares did End issue to acquire Cork’s assets and liabilities?
b. What was the market value of the shares issued by End?
c. What was the fair value of the inventory held by Cork at the date of combination?
d. What was the fair value of the net assets held by Cork at the date of combination?
e. What amount of goodwill, if any, will be reported by the combined entity immediately following the combination?
f. What balance in retained earnings will the combined entity report immediately following the
combination?
g. If the depreciable assets held by Cork had an average remaining life of 10 years at the date of
acquisition, what amount of depreciation expense will be reported on those assets in 20X2?
LO4, LO5P1-42 Incomplete Data Following Purchase
On January 1, 20X1, Alpha Corporation acquired all of Bravo Company’s assets and liabilities by
issuing shares of its $3 par value stock to the owners of Bravo Company in a business combination. Alpha also made a cash payment to Banker Corporation for stock issue costs. Partial balance
sheet data for Alpha and Bravo, before the cash payment and issuance of shares, and a combined
balance sheet following the business combination are as follows:
Alpha
Corporation
Bravo
Company
Book Value Book Value Fair Value Combined Entity
Cash $ 65,000 $ 15,000 $ 15,000 $ 56,000
Accounts Receivable 105,000 30,000 30,000 135,000
Inventory 210,000 90,000 ? 320,000
Buildings and Equipment (net) 400,000 210,000 293,000 693,000
Goodwill ?
Total Assets $780,000 $345,000 $448,000 $ ?
Accounts Payable $ 56,000 $ 22,000 $ 22,000 $ 78,000
Bonds Payable 200,000 120,000 120,000 320,000
Common Stock 96,000 70,000 117,000
Additional Paid-In Capital 234,000 42,000 553,000
Retained Earnings 194,000 91,000 ?
Total Liabilities and Equities $780,000 $345,000 $142,000 $ ?
Required
a. What number of its $5 par value shares did Bravo have outstanding at January 1, 20X1?
b. Assuming that all of Bravo’s shares were issued when the company was started, what was the
price per share received at the time of issue?
c. How many shares of Alpha were issued at the date of combination?
d. What amount of cash did Alpha pay as stock issue costs?
e. What was the market value of Alpha’s shares issued at the date of combination?
f. What was the fair value of Bravo’s inventory at the date of combination?
g. What was the fair value of Bravo’s net assets at the date of combination?
h. What amount of goodwill, if any, will be reported in the combined balance sheet following the
combination?
LO4, LO5P1-43 Comprehensive Business Combination Problem
Bigtime Industries Inc. entered into a business combination agreement with Hydrolized Chemical
Corporation (HCC) to ensure an uninterrupted supply of key raw materials and to realize certain
economies from combining the operating processes and the marketing efforts of the two companies. Under the terms of the agreement, Bigtime issued 180,000 shares of its $1 par common stock
in exchange for all of HCC’s assets and liabilities. The Bigtime shares then were distributed to
HCC’s shareholders, and HCC was liquidated.
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52 Chapter 1 Intercorporate Acquisitions and Investments in Other Entities
Immediately prior to the combination, HCC’s balance sheet appeared as follows, with fair values also indicated:
Book Values Fair Values
Assets
Cash $ 28,000 $ 28,000
Accounts Receivable 258,000 251,500
Less: Allowance for Bad Debts (6,500)
Inventory 381,000 395,000
Long-Term Investments 150,000 175,000
Land 55,000 100,000
Rolling Stock 130,000 63,000
Plant and Equipment 2,425,000 2,500,000
Less: Accumulated Depreciation (614,000)
Patents 125,000 500,000
Special Licenses 95,800 100,000
Total Assets $3,027,300 $4,112,500
Liabilities
Current Payables $ 137,200 $ 137,200
Mortgages Payable 500,000 520,000
Equipment Trust Notes 100,000 95,000
Debentures Payable 1,000,000 950,000
Less: Discount on Debentures (40,000)
Total Liabilities $1,697,200 $1,702,200
Stockholders’ Equity
Common Stock ($5 par) 600,000
Additional Paid-In Capital from Common Stock 500,000
Additional Paid-In Capital from
Retirement of Preferred Stock 22,000
Retained Earnings 220,100
Less: Treasury Stock (1,500 shares) (12,000)
Total Liabilities and Equity $3,027,300
Immediately prior to the combination, Bigtime’s common stock was selling for $14 per share. Bigtime incurred direct costs of $135,000 in arranging the business combination and $42,000 of costs
associated with registering and issuing the common stock used in the combination.
Required
a. Prepare all journal entries that Bigtime should have entered on its books to record the business
combination.
b. Present all journal entries that should have been entered on HCC’s books to record the combination and the distribution of the stock received.
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53
Chapter Two
Reporting Intercorporate
Investments and
Consolidation of Wholly
Owned Subsidiaries with
No Differential
BERKSHIRE HATHAWAY’S MANY INVESTMENTS
As of this writing (March 2010), Warren Buffett is the third richest man in the world,
worth a staggering $47 billion. He is also the chairman, CEO, and primary shareholder of
Berkshire Hathaway Inc. Over the past 44 years, Berkshire has grown at an average rate
of 20.3 percent annually. Warren Buffett has achieved this success through his unparalleled business sense regarding investments and acquisitions of other companies.
Berkshire Hathaway was originally a textile manufacturing company. In 1962, Warren
Buffett and his partners began buying large blocks of Berkshire stock. Within five years,
Buffett began expanding into the insurance industry, and in 1985 the last of Berkshire’s
textile operations was shut down. In the late 1970s Berkshire began acquiring stock in
GEICO insurance and in January 1996 bought GEICO outright. While Berkshire has
extensive insurance holdings, it has not focused its investment activities solely on insurance. Since Buffett took the helm in the 1960s, Berkshire has made many acquisitions.
Look at the list of selected Berkshire holdings as of the end of 2009 (on the next page).
Do you recognize any of these companies?
Each item in Berkshire’s portfolio has to be accounted for individually. For example,
Wesco Financial and Comdisco Holdings are accounted for as equity method investments, while Wal-Mart, American Express, and Nike are classified as available-forsale investments. Berkshire consolidates the fully owned companies as well as Wesco
Financial. In addition, companies like GEICO have many subsidiaries of their own. As
you can imagine, accounting for investments at Berkshire can be very complex. This
chapter focuses on issues related to the accounting for investments.
Multi-Corporate
Entities
Business
Combinations
Consolidation Concepts
and Procedures
Intercompany
Transfers
Multinational
Entities
Partnerships
Governmental
Entities
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54 Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential
LEARNING OBJECTIVES
When you finish studying this chapter, you should be able to:
LO1 Understand and explain how ownership and control can influence the accounting
for investments in common stock.
LO2 Prepare journal entries using the cost method for accounting for investments.
LO3 Prepare journal entries using the equity method for accounting for investments.
LO4 Understand and explain differences between the cost and equity methods.
LO5 Prepare journal entries using the fair value option.
LO6 Make calculations and prepare basic elimination entries for a simple
consolidation.
LO7 Prepare a consolidation worksheet.
ACCOUNTING FOR INVESTMENTS IN COMMON STOCK
The method used to account for investments in common stock depends, in part,
on the level of influence or control that the investor is able to exercise over the investee.
The investment must be reported on the investor’s balance sheet using the cost method
(adjusted to market value, if appropriate), the equity method, or the fair value option.
Note that, while use of the cost or equity method is dictated by the level of influence, the
investor can elect the fair value option in place of either method. Figure 2–1 summarizes
the relationship between methods used to report intercorporate investments in common
stock and levels of ownership and influence.
The cost method is used for reporting investments in equity securities when both consolidation and equity-method reporting are inappropriate. If cost-method equity securities have
readily determinable fair values, they must be adjusted to market value at year-end under
BERKSHIRE HATHAWAY SELECTED HOLDINGS
(as of 12/31/2009)
Fully owned subsidiaries:
Geico
Dairy Queen
See’s Candies
Fruit of the Loom
The Pampered Chef
Partially owned companies: Ticker Holding Value Stake
Wesco Financial Corporation WSC $ 2,235,610,104 80.1%
Comdisco Holdings Company CDCO $ 13,076,204 38.2%
The Washington Post Company WPO $ 774,038,720 18.4%
Moody’s MCO $ 943,437,410 13.4%
American Express AXP $ 6,114,459,531 12.7%
Kraft Foods KFT $ 4,097,014,175 9.4%
The Coca-Cola Company KO $10,950,000,000 8.7%
Wells Fargo WFC $ 9,724,285,136 6.2%
Procter & Gamble PG $ 5,586,217,758 3.0%
Nike Inc. NKE $ 561,766,320 1.6%
Costco COST $ 319,022,880 1.2%
Walmart WMT $ 2,160,315,438 1.0%
Lowes Companies Inc. LOW $ 161,070,000 0.4%
United Parcel Service Inc. UPS $ 91,940,436 0.1%
General Electric GE $ 140,546,653 0.1%
Bank of America Corp. BAC $ 84,100,000 0.1%
LO1
Understand and explain
how ownership and control
can influence the accounting for investments in common stock.
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Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential 55
FASB Statement 1151
(ASC 320). Under the cost method, the investor recognizes income
from the investment when the income is distributed by the investee as dividends.
The equity method is used for external reporting when the investor exercises significant influence over the operating and financial policies of the investee and consolidation is not appropriate. This method is used most often when one company holds
20 percent or more of another company’s common stock. Under the equity method,
the investor recognizes income from the investment as the investee earns the income.
Instead of combining the individual assets, liabilities, revenues, and expenses of the
investee with those of the investor, as in consolidation, the investment is reported as
one line in the investor’s balance sheet, and income recognized from the investee is
reported as one line in the investor’s income statement. The investment represents the
investor’s share of the investee’s net assets, and the income recognized is the investor’s share of the investee’s net income.
For financial reporting, consolidated financial statements that include both the investor
and the investee must be presented if the investor can exercise control over the investee.
Consolidation involves combining for financial reporting the individual assets, liabilities, revenues, and expenses of two or more related companies as if they were part of a
single company. This process includes the elimination of all intercompany ownership
and activities. Consolidation normally is appropriate when one company, referred to as
the parent, controls another company, referred to as a subsidiary. We discuss the specific
requirements for consolidation later in this chapter. A subsidiary that is not consolidated
with the parent is referred to as an unconsolidated subsidiary and is shown as an investment on the parent’s balance sheet. Under current accounting standards, most subsidiaries are consolidated. When intercorporate investments are consolidated for financial
reporting, the investment and related income accounts are eliminated in preparing the
1
Financial Accounting Standards Board Statement No. 115, “Accounting for Certain Investments in Debt
and Equity Securities,” May 1993. Because the provisions of FASB 115 (ASC 320) are normally discussed
in Intermediate Accounting, detailed coverage is not provided here. Note, however, that equity investments
accounted for using the cost method are accounted for as discussed in this chapter, with the provisions of
FASB 115 (ASC 320) applied as end-of-period adjustments. FASB 115 (ASC 320) is not applicable to
equity-method investments.
FIGURE 2–1
Financial Reporting
Basis by Level of
Common Stock
Ownership
Summary of Accounting for Equity Investment Securities
(based on the normal level of stock ownership)
0% 20%* 50% 100%
* The threshold for “significant influence” is normally considered to be 20%, but it may vary
depending on circumstances.
** Investor may choose the fair value option instead.
*** Appendix 2B illustrates how the cost method can be used under consolidation.
Insignificant
influence
Cost method**
(Investments not
intended to be held
long term are markedto-market as trading or
available-for-sale
securities.)
Equity method**
Significant
influence
Control
Equity method
(or cost method***)
+ consolidation
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56 Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential
consolidated statements. Nevertheless, the parent must still account for the investments
on its books. Parent companies normally account for investments in consolidated subsidiaries on their books using the equity method. 2
Under the FASB’s recently effective fair value option, 3
companies have the choice
of using traditional methods, such as the cost and equity methods, to report financial
assets and liabilities, or they can elect to report at fair value some or all of their financial assets and liabilities. Under the fair value option, intercorporate investments in
common stock are remeasured to fair value at the end of each period and the unrealized
gain or loss is recognized in income. The fair value option does not apply to intercorporate investments that must be consolidated.
This chapter follows Figure 2–1 in summarizing the accounting for investments in other
companies. It first discusses the cost and equity methods for accounting for investments. It
then summarizes the fair value option. Finally, it introduces the preparation of consolidated
financial statements using the most simple consolidation scenario (when a subsidiary is
wholly owned and it is either created or purchased for an amount exactly equal to the book
value of the subsidiary’s net assets). Since consolidation is a major topic of this textbook,
we use a building block approach to our coverage of consolidation in Chapters 2 through 5.
Chapter 3 explains how the basic consolidation process changes when the parent company
owns less than 100 percent of the subsidiary. Chapter 4 shows how the consolidation process differs when the parent company acquires the subsidiary for an amount greater (or
less) than the book value of the subsidiary’s net assets. Finally, Chapter 5 presents the most
complex consolidation scenario (where the parent owns less than 100 percent of the subsidiary’s outstanding voting stock and the acquisition price is not equal to the book value of the
subsidiary’s net assets). Chapters 6 and 7 delve into asset transfers among members of the
same consolidated group of companies.
REASONS FOR INVESTING IN COMMON STOCK
Companies acquire ownership interests in other companies for a variety of reasons. For
example, some companies invest in other companies simply to earn a favorable return
by taking advantage of the future earnings potential of their investees. Other reasons for
acquiring interests in other entities include (1) gaining voting control, (2) entering new
product markets by purchasing companies already established in those areas, (3) ensuring a supply of raw materials or other production inputs, (4) ensuring a customer for
production output, (5) gaining economies associated with greater size, (6) diversifying
operations, (7) obtaining new technology, (8) lessening competition, and (9) limiting
risk. Examples of intercorporate investments include IBM’s acquisition of a sizable portion of Intel’s stock to ensure a supply of computer components, AT&T’s purchase of
the stock of McCaw Cellular Communications to gain a foothold in the cellular phone
market, and Texaco’s acquisition of Getty Oil’s stock to acquire oil and gas reserves.
Summary of Consolidation Coverage in Chapters 2–5
Investment = Book value
Wholly Owned
Subsidiary
Partially Owned
Subsidiary
Chapter 2
Chapter 4
Chapter 3
Investment > Book value Chapter 5
2 The cost method is also allowed for consolidated investments since (as explained later in this chapter) the
investment account is eliminated in the consolidated financial statements.
3 Financial Accounting Standards Board Statement No. 159, “The Fair Value Option for Financial Assets and
Liabilities,” February 2007.
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Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential 57
THE COST METHOD
Intercorporate investments reported on the balance sheet using the cost method are carried by the investor at historical cost. Income is recorded by the investor as dividends are
declared by the investee. The cost method is used when the investor lacks the ability either
to control or to exercise significant influence over the investee. The inability of an investor
to exercise either control or significant influence over an investee may result from the size
of the investment, usually at common stock ownership levels of less than 20 percent. In
some situations, other factors, such as the bankruptcy of the investee, prevent the investor
from exercising control or significant influence regardless of the size of the investment.
Accounting Procedures under the Cost Method
The cost method is consistent with the treatment normally accorded noncurrent assets.
At the time of purchase, the investor records its investment in common stock at the total
cost incurred in making the purchase. Subsequently, the carrying amount of the investment remains unchanged under the cost method; the investment continues to be carried
at its original cost until the time of sale. Income from the investment is recognized by the
investor as dividends are declared by the investee. Once the investee declares a dividend,
the investor has a legal claim against the investee for a proportionate share of the dividend, and realization of the income is considered certain enough to be recognized. Recognition of investment income before a dividend declaration is considered inappropriate
because the investee’s income is not available to the owners until a dividend is declared.
To illustrate the cost method, assume that ABC Company purchases 20 percent of
XYZ Company’s common stock for $100,000 at the beginning of the year but does not
gain significant influence over XYZ. During the year, XYZ has net income of $60,000
and pays dividends of $20,000. ABC Company records the following entries relating to
its investment in XYZ:
LO2
Prepare journal entries
using the cost method for
accounting for investments.
Note that ABC records only its share of the distributed earnings of XYZ and makes no
entry regarding the undistributed portion. The carrying amount of the investment remains
at its original cost of $100,000.
Declaration of Dividends in Excess of Earnings since Acquisition
A special treatment is required under the cost method in situations in which an investor
holds common stock in a company that declares dividends in excess of the income it has
earned since the investor acquired its stock. The dividends received are viewed first as
representing earnings of the investee from the purchase date of the investment to the declaration date of the dividend. All dividends declared by the investee in excess of its earnings since acquisition by the investor are viewed by the investor as liquidating dividends.
The investor’s share of these liquidating dividends is treated as a return of capital, and
the investment account balance is reduced by that amount. Blocks of an investee’s stock
acquired at different times should be treated separately for purposes of computing liquidating dividends.
Liquidating Dividends Example
To illustrate the computation of liquidating dividends received by the investor, assume
that Investor Company purchases 10 percent of the common stock of Investee Company
(1) Investment in XYZ Company Stock 100,000
Cash 100,000
Record purchase of XYZ Company stock.
(2) Dividends Receivable 4,000
Dividend Income 4,000
Record dividend from XYZ Company ($20,000 × 0.20)
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58 Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential
on January 2, 20X1. The annual income and dividends of Investee, the amount of dividend income recognized by Investor each year under the cost method, and the reduction
of the carrying amount of Investor’s investment in Investee when appropriate are as
follows:
Investee Company Investor Company
Year
Net
Income Dividends
Cumulative
Undistributed
Income
Cash
Received
Dividend
Income
Reduction
of
Investment
20X1 $100,000 $ 70,000 $30,000 $ 7,000 $ 7,000
20X2 100,000 120,000 10,000 12,000 12,000
20X3 100,000 120,000 –0– 12,000 11,000 $1,000
20X4 100,000 120,000 –0– 12,000 10,000 2,000
20X5 100,000 70,000 30,000 7,000 7,000
Once the investor has recorded a liquidating dividend, the comparison in future periods between cumulative earnings and dividends of the investee should be based on the
date of the last liquidating dividend rather than the date the investor acquired the investee’s stock. In this example, Investor Company records liquidating dividends in 20X3 and
20X4. In years after 20X4, Investor compares earnings and dividends of Investee from
the date of the most recent liquidating dividend in 20X4 rather than comparing from
January 2, 20X1. The entire dividend paid in 20X5 is considered by Investor to be a distribution of earnings.
Liquidating Dividends following Switch from Equity Method
If the investor previously carried the investment using the equity method and, because
of the sale of a portion of the investment, switches to the cost method, the date of the
switch in methods replaces the date of acquisition as the reference date for distinguishing
liquidating dividends. From that point forward, the investor should compare earnings and
dividends of the investee starting at the date of the switch to the cost method.
Investee’s View of Liquidating Dividends
Dividends received by an investor in excess of earnings since acquisition, while viewed
as liquidating dividends by the investor, usually are not liquidating dividends from the
Investor Company records its 10 percent share of Investee’s dividend as income in
20X1 because the income of Investee exceeds its dividend. In 20X2, Investee’s dividend exceeds earnings for the year, but the cumulative dividends declared since January 2, 20X1, the date Investor acquired Investee’s stock, do not exceed Investee’s
earnings since that date. Hence, Investor again records its 10 percent share of the dividend as income. By the end of 20X3, dividends declared by Investee since January 2,
20X1, total $310,000, while Investee’s income since that date totals only $300,000.
Thus, from Investor’s point of view, $10,000 of the 20X3 dividend represents a return
of capital while the remaining $110,000 represents a distribution of earnings. Investor’s
share of each amount is 10 percent. The entry to record the 20X3 dividend on Investor’s
books is:
(3) Cash 12,000
Investment in Investee 1,000
Dividend Income 11,000
Record receipt of 20X3 dividend from Investee
$12,000 = $120,000 × 0.10
$1,000 = ($310,000 – $300,000) × 0.10
$11,000 = ($120,000 – $10,000) × 0.10
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Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential 59
investee’s point of view. This type of dividend might occur, for example, when an investee’s stock is acquired shortly before a dividend is declared. The investee does not consider a dividend to be a liquidating dividend unless the investee’s retained earnings are
insufficient or the investee specifically declares a liquidating dividend for all common
shareholders.
Acquisition at Interim Date
The acquisition of an investment at other than the beginning or end of a fiscal period generally does not create any major problems when the cost method is used to account for
the investment. The only potential difficulty involves determining whether some part of
the payment received by the investor is a liquidating dividend when the investee declares
a dividend soon after the investor purchases stock in the investee. In this situation, the
investor must estimate the amount of the investee’s earnings for the portion of the period
during which the investor held the investee’s stock and may record dividend income only
on that portion.
Changes in the Number of Shares Held
Changes in the number of investment shares resulting from stock dividends, stock splits,
or reverse splits receive no formal recognition in the accounts of the investor. The carrying value of the investment before the stock dividend or split becomes the carrying
amount of the new, greater or lesser number of shares. Purchases and sales of shares, of
course, do require journal entries but do not result in any unusual difficulties under the
cost method.
Purchases of Additional Shares
The purchase of additional shares of a company already held is recorded at cost in the
same way as an initial purchase of shares. The investor’s new percentage ownership of
the investee then is calculated, and other evidence, if available, is evaluated to determine
whether the total investment still should be carried at cost or if the investor should switch
to the equity method. When the additional shares give the investor the ability to exercise
significant influence over the investee, the equity method should be applied retroactively
from the date of the original investment, as illustrated later in this chapter.
Sales of Shares
If all or part of an intercorporate investment in stock is sold, the transaction is accounted
for in the same manner as the sale of any other noncurrent asset. A gain or loss on the sale
is recognized for the difference between the proceeds received and the carrying amount
of the investment sold.
If shares of the stock have been purchased at more than one price, a determination
must be made at the time of sale as to which of the shares have been sold. The specific
shares sold may be identified through segregation, numbered stock certificates, or other
means. When specific identification is impractical, either a FIFO or weighted-average
cost flow assumption may be used. However, the weighted-average method seldom is
used in practice because it is not acceptable for tax purposes.
THE EQUITY METHOD
The equity method of accounting for intercorporate investments in common stock is
intended to reflect the investor’s changing equity or interest in the investee. This method
is a rather curious one in that the balance in the investment account generally does not
reflect either cost or market value, and it does not necessarily represent a pro rata share of
the investee’s book value. Instead, the investment is recorded at the initial purchase price
and adjusted each period for the investor’s share of the investee’s profits or losses and the
dividends declared by the investee.
LO3
Prepare journal entries
using the equity method for
accounting for investments.
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60 Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential
Use of the Equity Method
APB Opinion No. 18 (as amended, ASC 323 and 325), “The Equity Method of Accounting for Investments in Common Stock” (APB 18), requires that the equity method be
used for reporting investments in common stock of the following: 4
1. Corporate joint ventures. A corporate joint venture is a corporation owned and operated by a small group of businesses, none of which owns a majority of the joint venture’s common stock.
2. Companies in which the investor’s voting stock interest gives the investor the “ability to exercise significant influence over operating and financial policies” of that
company.
The second condition is the broader of the two and establishes the “significant influence” criterion. Because assessing the degree of influence may be difficult in some cases,
APB 18 (ASC 323 and 325) establishes a 20 percent rule. 5
In the absence of evidence to
the contrary, an investor holding 20 percent or more of an investee’s voting stock is presumed to have the ability to exercise significant influence over the investee. On the other
hand, an investor holding less than 20 percent of an investee’s voting stock is presumed
not to have the ability to exercise significant influence in the absence of evidence to the
contrary.
In most cases, an investment of 20 percent or more in another company’s voting stock
is reported under the equity method. Notice, however, that the 20 percent rule does not
apply if other evidence is available that provides a better indication of the ability or inability of the investor to significantly influence the investee.
Regardless of the level of ownership, the equity method is not appropriate if the
investor’s influence is limited by circumstances other than stock ownership, such as
bankruptcy of the investee or severe restrictions placed on the availability of a foreign
investee’s earnings or assets by a foreign government.
Investor’s Equity in the Investee
Under the equity method, the investor records its investment at the original cost. This
amount is adjusted periodically for changes in the investee’s stockholders’ equity occasioned by the investee’s profits, losses, and dividend declarations. The effect of the
investee’s income, losses, and dividends on the investor’s investment account and other
accounts can be summarized as follows:
Reported by Investee Effect on Investor’s Accounts
Net income Record income from investment
Increase investment account
Net loss Record loss from investment
Decrease investment account
Dividend declaration Record asset (cash or receivable)
Decrease investment account
4 Accounting Principles Board Opinion No. 18, “The Equity Method of Accounting for Investments in
Common Stock,” March 1971, para. 16.
5 Ibid., para. 17.
Recognition of Income
Under the equity method, the investor’s income statement includes the investor’s proportionate share of the investee’s income or loss each period. The carrying amount of the
investment is adjusted by the same amount to reflect the change in the net assets of the
investee resulting from the investee’s income.
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To illustrate, assume ABC Company acquires significant influence over XYZ Company by purchasing 20 percent of the common stock of the XYZ Company for $100,000
at the beginning of the year.
XYZ reports income of $60,000 for the year. ABC records its 20 percent share of
XYZ’s income ($12,000) in an account called “Income from XYZ Company” or “Equity
in Net Income of XYZ Company” as follows:
This entry may be referred to as the equity accrual and normally is made as an adjusting entry at the end of the period. If the investee reports a loss for the period, the investor
recognizes its share of the loss and reduces the carrying amount of the investment by that
amount.
Because of the ability to exercise significant influence over the policies of the investee,
realization of income from the investment is considered to be sufficiently ensured to
warrant recognition by the investor as the income is earned by the investee. This differs
from the case in which the investor does not have the ability to significantly influence
the investee and the investment must be reported using the cost method; in that case,
income from the investment is recognized only upon declaration of a dividend by the
investee.
Recognition of Dividends
Dividends from an investment are not recognized as income under the equity method
because the investor’s share of the investee’s income is recognized as it is earned by
the investee. Instead, dividends of the investee are viewed as distributions of previously
recognized income that already has been capitalized in the carrying amount of the investment. The investor must consider investee dividends declared as a reduction in its equity
in the investee and, accordingly, reduce the carrying amount of its investment. In effect,
all dividends from the investee are treated as liquidating dividends under the equity
method. Thus, if ABC Company owns 20 percent of XYZ Company’s common stock and
XYZ declares and pays a $20,000 dividend, the following entry is recorded on the books
of ABC to record its share of the dividend:
The following T-accounts summarize all of the normal equity method entries (journal
entries 4–6) on the investor company’s books:
(4) Investment in XYZ Company Stock 100,000
Cash 100,000
Record purchase of XYZ Company stock.
(5) Investment in XYZ Company Stock 12,000
Income from XYZ Co. 12,000
Record income from XYZ Company ($60,000 × 0.20)
(6) Dividends Receivable 4,000
Investment in XYZ Company Stock 4,000
Record dividend from XYZ Company ($20,000 × 0.20)
Investment in
XYZ Co.
Income from
XYZ
Purchase 100,000
20% of NI 12,000 12,000 20% of NI
4,000 20% of Dividend
Ending Balance 108,000 12,000 Ending Balance
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62 Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential
While the “Investment in XYZ Company” account summarizes ABC’s ownership of the
net assets of XYZ Company, the “Income from XYZ” account summarizes ABC’s share
of XYZ Company’s income.
Comparison of the Carrying Amount of the Investment
under the Cost and Equity Methods
Because the investment account on the investor’s books under the equity method is
adjusted for the investor’s share of the investee’s income or losses and dividends, the carrying amount of the investment usually is not the same as the original cost to the investor.
Only if the investee pays dividends in the exact amount of its earnings will the carrying
amount of the investment subsequent to acquisition be equal to its original cost. If the
earnings of the investee subsequent to investment by the investor exceed the investee’s
dividends during that time, the carrying amount of the investment will be greater than its
original cost. On the other hand, if the investee’s dividends exceed its income, the carrying amount of the investment will be less than its original cost.
To compare the change in the carrying amount of the investment under the equity
method relative to the cost method, assume the same facts listed previously for ABC’s
20 percent acquisition of XYZ’s common stock. Recall that during the year XYZ earns
income of $60,000 and pays dividends of $20,000. Under the equity method, the carrying amount of the investment starts with the original cost of $100,000 and is increased
by ABC’s share of XYZ’s income ($12,000). The carrying amount is reduced by ABC’s
share of XYZ’s dividends ($4,000). Thus, the carrying amount of the investment using
the equity method at the end of the period is $108,000 ($100,000 + $12,000 – $4,000),
compared to the original acquisition price of $100,000 under the cost method.
Investment income under the equity method (the balance in the “Equity in Net Income
from XYZ” account) is $12,000 while investment income under the cost method is equal
to dividend income, $4,000.
Acquisition at Interim Date
When an investment is purchased, the investor begins accruing income from the investee
under the equity method at the date of acquisition. No income earned by the investee
before the date of acquisition of the investment may be accrued by the investor. When
the purchase occurs between balance sheet dates, the amount of income earned by the
investee from the date of acquisition to the end of the fiscal period may need to be estimated by the investor in recording the equity accrual.
To illustrate, assume that ABC acquires 20 percent of XYZ’s common stock on
October 1 for $100,000. XYZ earns income of $60,000 uniformly throughout the year
and declares dividends of $20,000 on December 20 (paid on December 31). The carrying amount of the investment is increased by $3,000, which represents ABC’s share of
XYZ’s net income earned between October 1 and December 31 (1/4 of the year), and
is decreased by $4,000 as a result of dividends declared at year end (resulting in a net
decrease of $1,000 since the time of the stock purchase). 6
6
Note that we assume the entire dividend ($20,000) was declared and paid at the end of the year. If
dividends had been declared and paid quarterly, we would only record dividends declared after ABC’s
acquisition of the XYZ shares.
Equity Method: Cost Method:
Investment in
XYZ Co.
Investment in
XYZ Co.
Acquisition: Purchase 100,000 Purchase 100,000
Share of Income: 20% NI 12,000
Share of Dividends: 4,000 20% of Dividend
EB 108,000
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Changes in the Number of Shares Held
Some changes in the number of common shares held by an investor are handled easily under the equity method, but others require a bit more attention. A change resulting
from a stock dividend, split, or reverse split is treated in the same way as under the cost
method. No formal accounting recognition is required on the books of the investor. On
the other hand, purchases and sales of shares do require formal recognition.
Purchases of Additional Shares
A purchase of additional shares of a common stock already held by an investor and
accounted for using the equity method simply involves adding the cost of the new shares
to the investment account and applying the equity method in the normal manner from the
date of acquisition forward. The new and old investments in the same stock are combined
for financial reporting purposes. Income accruing to the new shares can be recognized by
the investor only from the date of acquisition forward.
To illustrate, assume that ABC Company purchases 20 percent of XYZ Company’s
common stock on January 2, 20X1, for $100,000, and another 10 percent on July 1,
20X1, for $50,000, and that the stock purchases represent 20 percent and 30 percent
respectively of the book value of XYZ’s net assets. If XYZ earns income of $25,000
from January 2 to June 30 and earns $35,000 from July 1 to December 31, the total
income recognized in 20X1 by ABC from its investment in XYZ is $15,500, computed
as follows:
Income, January 2 to June 30: $25,000 × 0.20 $ 5,000
Income, July 1 to December 31: $35,000 × 0.30 10,500
Investment Income, 20X1 $15,500
If XYZ declares and pays a $10,000 dividend on January 15 and again on July 15, ABC
reduces its investment account by $2,000 ($10,000 × 0.20) on January 15 and by $3,000
($10,000 × 0.30) on July 15. Thus, the ending balance in the investment account at the
end of the year is $160,500, computed as follows:
When an investment in common stock is carried using the cost method and purchases
of additional shares give the investor the ability to significantly influence the investee,
a retroactive switch from the cost method to the equity method is required. This change
Investment in
XYZ Co.
Stock Purchase 100,000
20% × NI × 1/4 3,000
4,000 20% Dividends
Ending Balance 99,000
Investment in
XYZ Co.
Income from
XYZ Co.
1/2/X1 Purchase 100,000
20% NI to 6/30 5,000 2,000 5,000 20% NI to 6/30
7/1/X1 Purchase 50,000 20% Div. to 6/30
30% NI from 7/1 10,500 3,000 30% Div. from 7/1 10,500 30% NI from 7/1
Ending Balance 160,500 15,500 Ending Balance
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64 Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential
to the equity method must be applied retroactively to the date of the first acquisition of
the investee’s stock.
To illustrate a change to the equity method, assume that Aron Corporation purchases 15 percent of Zenon Company’s common stock on January 2, 20X1, and another
10 percent on January 2, 20X4. Furthermore, assume that Aron switches to the equity
method on January 2, 20X4, because it gains the ability to significantly influence Zenon.
Given the following income and dividend data for Zenon, and assuming the purchases of
stock are at book value, the investment income figures reported by Aron originally and
as restated are as follows:
Zenon Aron’s Reported Investment Income
Year
Net
Income Dividends
Originally under
Cost a
Restated under
Equity b
20X1 $15,000 $10,000 $1,500 $2,250
20X2 18,000 10,000 1,500 2,700
20X3 22,000 10,000 1,500 3,300
$55,000 $30,000 $4,500 $8,250
a15 percent of Zenon’s dividends for the year.
b
15 percent of Zenon’s net income for the year.
Thus, in Aron’s 20X4 financial report, the comparative statements for 20X1, 20X2,
and 20X3 are restated to include Aron’s 15 percent share of Zenon’s profit and to
exclude from income Aron’s share of dividends recognized under the cost method. In
addition, the investment account and retained earnings of Aron are restated as if the
equity method had been applied from the date of the original acquisition. This restatement is accomplished on Aron’s books with the following journal entry on January 2,
20X4:
In 20X4, if Zenon reports net income of $30,000, Aron’s investment income is $7,500
(25 percent of Zenon’s net income).
Sales of Shares
The sale of all or part of an investment in common stock carried using the equity method
is treated the same as the sale of any noncurrent asset. First, the investment account is
adjusted to the date of sale for the investor’s share of the investee’s current earnings.
Then, a gain or loss is recognized for the difference between the proceeds received and
the carrying amount of the shares sold.
If only part of the investment is sold, the investor must decide whether to continue
using the equity method to account for the remaining shares or to change to the cost
method. The choice is based on evidence available after the sale as to whether the investor still is able to exercise significant influence over the investee. If the equity method no
longer is appropriate after the date of sale, the carrying value of the remaining investment
is treated as the cost of that investment, and the cost method is applied in the normal manner from the date of sale forward. No retroactive restatement of the investment to actual
cost is made.
(7) Investment in Zenon Company Stock 3,750
Retained Earnings 3,750
Restate investment account from cost to equity method:
$8,250 – $4,500
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COMPARISON OF THE COST AND EQUITY METHODS 7
Figure 2–2 summarizes some of the key features of the cost and equity methods of
accounting for intercorporate investments. The cost method is consistent with the
historical cost basis for most other assets. This method is subject to the usual criticisms leveled against historical cost. In particular, questions arise as to the relevance
of reporting the purchase price of an investment acquired some years earlier. The cost
method conforms more closely to the traditional accounting and legal views of the
realization of income in that the investee’s earnings are not available to the investor
until transferred as dividends. However, income based on dividend distributions can
sometimes be manipulated. The significant influence criterion required for the equity
method considers that the declaration of dividends by the investee can be influenced by
the investor. Recognizing equity-method income from the investee without regard to
investee dividends provides protection against manipulating the investor’s net income
by influencing investee dividend declarations. On the other hand, the equity method
is sometimes criticized because the asset valuation departs from historical cost but stops
short of a market value approach. Instead, the carrying amount of the investment is composed of a number of components and is not similar to the valuation of any other assets.
Over the years there has been considerable criticism of the use of the equity method
as a substitute for the consolidation of certain types of subsidiaries. Although the equity
method has been viewed as a one-line consolidation, the amount of detail reported is
considerably different under the equity method than with consolidation. For example, an
investor would report the same equity-method income from the following two investees
even though their income statements are quite different in composition:
LO4
Understand and explain differences between the cost
and equity methods.
FIGURE 2–2
Summary Comparison
of the Cost and Equity
Methods
Item Cost Method Equity Method
Recorded amount of invest-
ment at date of acquisition
Original cost Original cost
Usual carrying amount of
investment subsequent to
acquisition
Original cost Original cost increased (decreased)
by investor’s share of investee’s
income (loss) and decreased
by investor’s share of investee’s
dividends
Income recognition by investor Investor’s share of
investee’s dividends
declared from earnings
since acquisition
Investor’s share of investee’s
earnings since acquisition,
whether distributed or not
Investee dividends from
earnings since acquisition by
investor
Income Reduction of investment
Investee dividends in excess of
earnings since acquisition by
investor
Reduction of
investment
Reduction of investment
Investee 1 Investee 2
Sales $ 50,000 $ 500,000
Operating Expenses (30,000) (620,000)
Operating Income (Loss) $ 20,000 $(120,000)
Gain on Sale of Land 140,000
Net Income $ 20,000 $ 20,000
7
To view a video explanation of this topic, visit advancedstudyguide.com.
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66 Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential
Similarly, an investment in the stock of another company is reported under the equity
method as a single amount in the balance sheet of the investor regardless of the asset and
capital structure of the investee. In the past, some companies borrowed heavily through
unconsolidated subsidiaries and reported their investments in the subsidiaries using the
equity method. Because the debt was not reported in these situations, concerns were
raised over the use of the equity method to facilitate “off-balance sheet” financing.
As a result of these concerns, the Financial Accounting Standards Board eliminated
the use of the equity method for reporting investments in subsidiaries by requiring the
consolidation of virtually all majority-owned subsidiaries.
THE FAIR VALUE OPTION
FASB 159 (ASC 825) permits, but does not require, companies to measure many financial assets and liabilities at fair value. Companies holding investments in the common
stock of other companies have this option for investments that are not required to be
consolidated. Thus, rather than using the cost or equity method to report nonsubsidiary
investments in common stock, investors may report those investments at fair value.
Under the fair value option, the investor remeasures the investment to its fair value at
the end of each period. The change in value is then recognized in income for the period.
Although the FASB does not specify how to account for dividends received from the
investment, normally the investor recognizes dividend income in the same manner as
under the cost method.
To illustrate the use of the fair value method, assume that Ajax Corporation purchases
40 percent of Barclay Company’s common stock on January 1, 20X1, for $200,000. Ajax
prepares financial statements at the end of each calendar quarter. On March 1, 20X1, Ajax
receives a cash dividend of $1,500 from Barclay. On March 31, 20X1, Ajax determines the
fair value of its investment in Barclay to be $207,000. During the first quarter of 20X1, Ajax
records the following entries on its books in relation to its investment in Barclay:
LO6
Make calculations and
prepare basic elimination entries for a simple
consolidation.
LO5
Prepare journal entries
using the fair value option.
OVERVIEW OF THE CONSOLIDATION PROCESS
The consolidation process adds together the financial statements of two or more legally
separate companies, creating a single set of financial statements. Chapters 2 through 5
discuss the specific procedures used to produce consolidated financial statements in considerable detail. An understanding of the procedures is important because they facilitate
the accurate and efficient preparation of consolidated statements. However, the focus
should continue to be on the end product—the financial statements. The procedures are
intended to produce financial statements that appear as if the consolidated companies are
actually a single company.
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
(8) Investment in Barclay Stock 200,000
Cash 200,000
Record purchase of Barclay Company stock.
(10) Investment in Barclay Stock 7,000
Unrealized Gain on Barclay Stock 7,000
Record increase in fair value of Barclay stock.
(9) Cash 1,500
Dividend Income 1,500
Record dividend income from Barclay Company.
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Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential 67
holdings. While 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 only transactions 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.
CONSOLIDATION PROCEDURES FOR WHOLLY OWNED SUBSIDIARIES
THAT ARE CREATED OR PURCHASED AT BOOK VALUE
We begin preparing consolidated financial statements with the books of the individual
companies that are to be consolidated. Because the consolidated entity has no books, all
amounts in the consolidated financial statements originate on the books of the parent or a
subsidiary or in the consolidation worksheet.
The term subsidiary has been defined as “an entity . . . in which another entity, known
as its parent, holds a controlling financial interest.” 8
A parent company may hold all or
less than all of a corporate subsidiary’s common stock, but at least majority ownership is
normally required for the presentation of consolidated financial statements. Most, but not
all, corporate subsidiaries are wholly owned by their parents.
Because most subsidiaries are wholly owned, this chapter begins the in-depth examination of consolidation procedures for wholly owned subsidiaries. Moreover, we begin
with the most basic consolidation scenario when the subsidiary is either created by the
parent or purchased for an amount exactly equal to the book value of the subsidiary’s net
assets. This assumption simplifies the consolidation because there is no differential. We
start with basic consolidation procedures applied to the preparation of a consolidated balance sheet immediately following the establishment of a parent–subsidiary relationship,
either through creation or acquisition of the subsidiary. Then, we introduce the use of a
simple consolidation worksheet for the balance sheet only. The chapter then moves to the
preparation of a full set of consolidated financial statements in subsequent periods and
the use of a three-part worksheet designed to facilitate the preparation of a consolidated
income statement, retained earnings statement, and balance sheet. Chapter 3 extends the
discussion by dealing with the preparation of consolidated financial statements for lessthan-wholly-owned subsidiaries that are created or purchased at book value.
CONSOLIDATION WORKSHEETS
The consolidation worksheet provides a mechanism for efficiently combining the
accounts of the separate companies involved in the consolidation and for adjusting the
combined balances to the amounts that would be reported if all consolidating companies
were actually a single company. Keep in mind that no set of books exists for the consolidated entity. The parent and its subsidiaries, as separate legal and accounting entities, maintain their own books. When consolidated financial statements are prepared, the
account balances are taken from the separate books of the parent and each subsidiary and
placed in the consolidation worksheet. The consolidated statements are prepared, after
adjustments and eliminations, from the amounts in the consolidation worksheet.
Worksheet Format
Several different worksheet formats for preparing consolidated financial statements
are used in practice. One of the most widely used formats is the three-part worksheet,
consisting of one part for each of three financial statements: (1) the income statement,
(2) the statement of retained earnings, and (3) the balance sheet. In recent years, the
LO7
Prepare a consolidation
worksheet.
8 Financial Accounting Standards Board Statement No. 160, “Noncontrolling Interests in Consolidated
Financial Statements, an amendment of ARB No. 51,” December 2007, para. B1. (ASC 810)
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68 Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential
retained earnings statement has been dropped by many companies in favor of the
statement of changes in stockholders’ equity. Nevertheless, the information normally
found in a retained earnings statement is included in the statement of stockholders’
equity, along with additional information, and so the three-part worksheet described
continues to provide a useful format. Figure 2–3 presents the format for the comprehensive three-part consolidation worksheet. Specifically, Figure 2–3 illustrates the
basic form of a consolidation worksheet. The titles of the accounts of the consolidating companies are listed in the first column of the worksheet. The account balances
from the books or trial balances of the individual companies are listed in the next set
of columns, with a separate column for each company included in the consolidation.
Entries are made in the columns labeled Elimination Entries to adjust or eliminate
balances so that the resulting amounts are those that would appear in the financial
statements if all the consolidating companies actually formed a single company. The
balances in the last column are obtained by summing all amounts algebraically across
the worksheet by account. These are the balances that appear in the consolidated
financial statements.
The top portion of the worksheet is used in preparing the consolidated income statement. All income statement accounts are listed in the order they normally appear in an
income statement. 9
When the income statement portion of the worksheet is completed,
a total for each column is entered at the bottom of the income statement portion of the
worksheet. The bottom line in this part of the worksheet shows the parent’s net income,
the subsidiary’s net income, the totals of the debit and credit eliminations for this section
of the worksheet, and consolidated net income. The entire bottom line is carried down to
the “net income” line in the retained earnings statement portion of the worksheet immediately below.
The retained earnings statement section of the worksheet is in the same format as a
retained earnings statement, or the retained earnings section of a statement of stockholders’ equity. Net income and the other totals from the bottom line of the income statement
FIGURE 2–3
Format for
Consolidation
Worksheet
9 An optional format lists accounts with credit balance accounts first and those having debit balances listed
next.
Income Statement
Revenues
Expense
Expense
Net Income
Statement of Retained Earnings
Retained Earnings (1/1)
Add: Net Income
Less: Dividends
Retained Earnings (12/31)
Balance Sheet
Assets
Total Assets
Liabilities
Equity
Common Stcok
Retained Earnings
Total Liabilities and Equity
Parent Subsidiary DR
Elimination Entries
CR Consolidated
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Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential 69
portion of the worksheet are brought down from above. Similarly, the final line in the
retained earnings statement section of the worksheet is carried down in its entirety to the
retained earnings line in the balance sheet section.
The bottom portion of the worksheet reflects the balance sheet amounts at the end of
the period. 10 The retained earnings amounts appearing in the balance sheet section of the
worksheet are the totals carried forward from the bottom line of the retained earnings
statement section. The examples in the following sections of this chapter demonstrate the
use of the comprehensive three-part consolidation worksheet.
Nature of Eliminating Entries
Eliminating entries are used in the consolidation worksheet to adjust the totals of
the individual account balances of the separate consolidating companies to reflect the
amounts that would appear if all the legally separate companies were actually a single
company. Eliminating entries appear only in the consolidating worksheets and do not
affect the books of the separate companies.
For the most part, companies that are to be consolidated record their transactions during the period without regard to the consolidated entity. Transactions with related companies tend to be recorded in the same manner as those with unrelated parties, although
intercompany transactions may be recorded in separate accounts or other records may be
kept to facilitate the later elimination of intercompany transactions. Each of the consolidating companies also prepares its adjusting and closing entries at the end of the period
in the normal manner. The resulting balances are entered in the consolidation worksheet
and combined to arrive at the consolidated totals. Eliminating entries are used in the
worksheet to increase or decrease the combined totals for individual accounts so that only
transactions with external parties are reflected in the consolidated amounts.
Some eliminating entries are required at the end of one period but not at the end of
subsequent periods. For example, a loan from a parent to a subsidiary in December 20X1,
repaid in February 20X2, requires an entry to eliminate the intercompany receivable and
payable on December 31, 20X1, but not at the end of 20X2. Some other eliminating
entries need to be placed in the consolidation worksheets each time consolidated statements are prepared for a period of years. For example, if a parent company sells land to a
subsidiary for $5,000 above the cost to the parent, a worksheet entry is needed to reduce
the land amount by $5,000 each time consolidated statements are prepared for as long as
an affiliate holds the land. It is important to remember that because eliminating entries
are not made on the books of any company, they do not carry over from period to period.
CONSOLIDATED BALANCE SHEET WITH WHOLLY OWNED SUBSIDIARY
The simplest consolidation setting occurs when the financial statements of related companies are consolidated immediately after a parent–subsidiary relationship is established
through a business combination or creation of a new subsidiary. We present a series
of examples to illustrate the preparation of a consolidated balance sheet. Consolidation
procedures are the same whether a subsidiary is created or acquired. We use the case of
an acquired subsidiary to illustrate the consolidation procedures in the examples that follow. In each example, Peerless Products Corporation purchases all or part of the common
stock of Special Foods Inc. on January 1, 20X1, and immediately prepares a consolidated
balance sheet. Figure 2–4 presents the separate balance sheets of the two companies
immediately before the combination.
In the discussion that follows, we discuss all journal entries and worksheet eliminating
entries in the text of the chapter. To avoid confusing the eliminating entries with journal
entries that appear on the separate books of the parent or subsidiary, all worksheet eliminating entries appearing in the text are shaded while journal entries recorded in the books
of the parent company are not shaded.
10 Optionally, accounts can be separated and listed with debits first and then credits.
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70 Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential
100 Percent Ownership Acquired at Book Value
In the first example, Peerless acquires all of Special Foods’ outstanding common stock
for $300,000, an amount equal to the fair value of Special Foods as a whole. On the date
of combination, the fair values of Special Foods’ individual assets and liabilities are equal
to their book values shown in Figure 2–4 . Because Peerless acquires all of Special Foods’
common stock and because Special Foods has only the one class of stock outstanding,
the total book value of the shares acquired equals the total stockholders’ equity of Special
Foods ($200,000 + $100,000). The $300,000 of consideration exchanged is equal to the
book value of the shares acquired. This ownership situation can be characterized as follows:
FIGURE 2–4
Balance Sheets of
Peerless Products and
Special Foods, January
1, 20X1, Immediately
before Combination
Peerless Products Special Foods
Assets
Cash $ 350,000 $ 50,000
Accounts Receivable 75,000 50,000
Inventory 100,000 60,000
Land 175,000 40,000
Buildings and Equipment 800,000 600,000
Accumulated Depreciation (400,000) (300,000)
Total Assets $1,100,000 $500,000
Liabilities and Stockholders’ Equity
Accounts Payable $ 100,000 $100,000
Bonds Payable 200,000 100,000
Common Stock 500,000 200,000
Retained Earnings 300,000 100,000
Total Liabilities and Equity $1,100,000 $500,000
Fair value of consideration $300,000
Book value of shares acquired
Common stock—Special Foods $200,000
Retained earnings—Special Foods 100,000
300,000
Difference between fair value and book value $ 0
P
S
1/1/X1
100%
Peerless records the stock acquisition on its books with the following entry on the date
of combination:
Figure 2–5 presents the separate financial statements of Peerless and Special Foods
immediately after the combination. Special Foods’ balance sheet in Figure 2–5 is the
same as in Figure 2–4 , but Peerless’ balance sheet has changed to reflect the $300,000
reduction in cash and the recording of the investment in Special Foods stock for the same
amount. Note that the $300,000 of cash was paid to the former stockholders of Special
Foods and not to the company itself. Accordingly, that cash is no longer in the consolidated entity. Instead, Peerless’ balance sheet now reflects a $300,000 Investment in Special Foods Stock account.
Investment Elimination Entry
Figure 2–6 presents a basic example of a consolidation worksheet. The only eliminating
entry in the worksheet in Figure 2–6 removes the Investment in Special Foods Stock
(11) Investment in Special Foods 300,000
Cash 300,000
Record purchase of Special Foods stock.
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Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential 71
account and the subsidiary’s stockholders’ equity accounts. While this elimination entry
is very simple, to be consistent with the discussion of more complicated examples later
in the chapter, we illustrate the thought process in developing the worksheet entry. In
this example, Peerless’ investment is exactly equal to the book value of equity of Special
Foods. Therefore, no goodwill is recorded and all assets and liabilities are simply combined from Special Foods’ financial statements at their current book values. In Chapters
4 and 5, we will explore situations where the acquiring company pays more than the book
value of the acquired company’s net assets (i.e., when there is a positive differential).
However, in Chapters 2 and 3, the excess value of identifiable net assets and goodwill
will always be equal to zero. To maintain a consistent approach through all four chapters,
we always illustrate the components of the acquiring company’s investment, even though
the acquiring company’s investment will always be exactly equal to its share of the book
value of net assets in Chapters 2 and 3. Therefore, the relationship between the fair value
of the consideration given to acquire Special Foods, the fair value of Special Foods’ net
assets, and the book value of Special Foods’ net assets can be illustrated as follows:
FIGURE 2–5
Balance Sheets of
Peerless Products and
Special Foods,
January 1, 20X1,
Immediately after
Combination
Peerless Products Special Foods
Assets
Cash $ 50,000 $ 50,000
Accounts Receivable 75,000 50,000
Inventory 100,000 60,000
Land 175,000 40,000
Buildings and Equipment 800,000 600,000
Accumulated Depreciation (400,000) (300,000)
Investment in Special Foods Stock 300,000
Total Assets $1,100,000 $500,000
Liabilities and Stockholders’ Equity
Accounts Payable $ 100,000 $100,000
Bonds Payable 200,000 100,000
Common Stock 500,000 200,000
Retained Earnings 300,000 100,000
Total Liabilities and Equity $1,100,000 $500,000
Goodwill = 0
1/1/X1
$300,000
Initial
investment
in Special
Foods
Identifiable
excess = 0
Book value =
CS + RE =
300,000
The book value of Special Foods’ equity as of the acquisition date is equal to the sum of
common stock and retained earnings:
Book Value Calculations:
Total Investment = Common Stock + Retained Earnings
Original book value 300,000 200,000 100,000
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72 Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential
Therefore, the elimination entry simply credits the Investment in Special Foods Stock
account (for the original acquisition price, $300,000) from Peerless’ balance sheet. In
this and all future examples, we use blue lettering to highlight the numbers from the book
value analysis that appear in the basic elimination entry:
The corresponding debits eliminate the beginning balances in the equity accounts of Special Foods:
Remember that this entry is made in the consolidation worksheet, not on the books of
either the parent or the subsidiary, and is presented here in general journal form only for
instructional purposes.
The investment account must be eliminated because, from a single entity viewpoint,
a company cannot hold an investment in itself. The subsidiary’s stock and the related
stockholders’ equity accounts must be eliminated because the subsidiary’s stock is held
entirely within the consolidated entity and none represents claims by outsiders.
From a somewhat different viewpoint, the investment account on the parent’s books
can be thought of as a single account representing the parent’s investment in the net assets
of the subsidiary, a so-called one-line consolidation. In a full consolidation, the subsidiary’s individual assets and liabilities are combined with those of the parent. Including
both the net assets of the subsidiary, as represented by the balance in the investment
account, and the subsidiary’s individual assets and liabilities would double-count the
same set of assets. Therefore, the investment account is eliminated and not carried to the
consolidated balance sheet.
In this example, the acquisition price of the stock acquired by Peerless is equal to the
fair value of Special Foods as a whole. This reflects the normal situation where the acquisition price paid by the parent is equal to the fair value of its proportionate share of the
subsidiary. In addition, this example assumes that the subsidiary’s fair value is equal to
its book value, a generally unrealistic assumption. Given this assumption, however, the
balance of Peerless’ investment account is equal to Special Foods’ stockholders’ equity
accounts, so this worksheet entry fully eliminates Peerless’ investment account against
Special Foods’ stockholders’ equity accounts.
Consolidation Worksheet
We present the worksheet for the preparation of a consolidated balance sheet immediately following the acquisition in Figure 2–6 . The first two columns of the worksheet in
Figure 2–6 are the account balances taken from the books of Peerless and Special Foods,
as shown in Figure 2–5 . The balances of like accounts are placed side by side so that they
may be added together. If more than two companies were to be consolidated, a separate
column would be included in the worksheet for each additional subsidiary.
Investment in
Special Foods
Acquisition
Price 300,000
300,000 Basic elimination entry
0
Basic elimination entry:
Common stock 200,000 Original amount invested (100%)
Retained earnings 100,000 Beginning balance in ret. earnings
Investment in Special Foods 300,000 Book value in investment account
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Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential 73
The accounts are placed in the worksheet in the order they would normally appear
in the companies’ financial statements. The two columns labeled Elimination Entries
in Figure 2–6 are used to adjust the amounts reported by the individual companies to
the amounts appropriate for the consolidated statement. All eliminations made in the
worksheets are made in double-entry form. Thus, when the worksheet is completed, total
debits entered in the Debit Eliminations column must equal total credits entered in the
Credit Eliminations column. We highlight all parts of each eliminating entry with the
same color so that the reader can identify the individual elimination entries in the worksheet. After the appropriate eliminating entries have been entered in the Elimination
Entries columns, summing algebraically across the individual accounts provides the consolidated totals.
The Consolidated Balance Sheet
The consolidated balance sheet presented in Figure 2–7 comes directly from the last
column of the consolidation worksheet in Figure 2–6 . Because no operations occurred
between the date of combination and the preparation of the consolidated balance sheet,
the stockholders’ equity section of the consolidated balance sheet is identical to that of
Peerless in Figure 2–5 .
CONSOLIDATION SUBSEQUENT TO ACQUISITION
The preceding section introduced the procedures used to prepare a consolidated balance
sheet as of the acquisition date. More than a consolidated balance sheet, however, is
needed to provide a comprehensive picture of the consolidated entity’s activities following acquisition. As with a single company, the set of basic financial statements for a consolidated entity consists of a balance sheet, an income statement, a statement of changes
in retained earnings, and a statement of cash flows.
This section of the chapter presents the procedures used to prepare an income statement, statement of retained earnings, and consolidated balance sheet subsequent to the
acquisition date.
The discussion that follows first deals with the important concepts of consolidated net
income and consolidated retained earnings, followed by a description of the worksheet
FIGURE 2–6 Worksheet for Consolidated Balance Sheet, January 1, 20X1, Date of Combination; 100 Percent
Acquisition at Book Value
Peerless
Products
Special
Foods
Elimination Entries
DR CR Consolidated
Balance Sheet
Cash $ 50,000 $ 50,000 $ 100,000
Accounts Receivable 75,000 50,000 125,000
Inventory 100,000 60,000 160,000
Investment in Special Foods 300,000 $300,000 0
Land 175,000 40,000 215,000
Buildings & Equipment 800,000 600,000 1,400,000
Less: Accumulated Depreciation (400,000) (300,000) (700,000)
Total Assets $1,100,000 $500,000 $ 0 $300,000 $1,300,000
Accounts Payable 100,000 100,000 200,000
Bonds Payable 200,000 100,000 300,000
Common Stock 500,000 200,000 200,000 500,000
Retained Earnings 300,000 100,000 100,000 300,000
Total Liabilities & Equity $1,100,000 $500,000 $300,000 $ 0 $1,300,000
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74 Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential
format used to facilitate the preparation of a full set of consolidated financial statements.
We then discuss the specific procedures used to prepare consolidated financial statements subsequent to the date of combination.
This and subsequent chapters focus on procedures for consolidation when the parent
company accounts for its investment in subsidiary stock using the equity method. If the
parent accounts for its investment using the cost method, the general approach to the
preparation of consolidated financial statements is the same, but the specific elimination
entries differ. Appendix 2B summarizes consolidation procedures using the cost method.
Regardless of the method the parent uses to account for its subsidiary investment, however, the consolidated statements will be the same because the investment and related
accounts are eliminated in the consolidation process.
The approach followed to prepare a complete set of consolidated financial statements
subsequent to a business combination is quite similar to that used to prepare a consolidated balance sheet as of the date of combination. However, in addition to the assets and
liabilities, the revenues and expenses of the consolidating companies must be combined.
As the accounts are combined, eliminations must be made in the consolidation worksheet
so that the consolidated financial statements appear as if they are the financial statements
of a single company.
When a full set of consolidated financial statements is prepared subsequent to the date
of combination, two of the important concepts affecting the statements are those of consolidated net income and consolidated retained earnings.
Consolidated Net Income
All revenues and expenses of the individual consolidating companies arising from transactions with unaffiliated companies are included in the consolidated financial statements. The consolidated income statement includes 100 percent of the revenues and
expenses regardless of the parent’s percentage ownership. Similar to single-company
financial statements, where the difference between revenues and expenses equals net
income, revenues minus expenses in the consolidated financial statements equals consolidated net income. Consolidated net income is equal to the parent’s income from
its own operations, excluding any investment income from consolidated subsidiaries,
plus the net income from each of the consolidated subsidiaries, adjusted for any differential write-off (which is zero in this chapter). Intercorporate investment income
from consolidated subsidiaries included in the parent’s net income under either the cost
or equity method must be eliminated in computing consolidated net income to avoid
double-counting.
If all subsidiaries are wholly owned, all of the consolidated net income accrues to the
parent company, or the controlling interest. If one or more of the consolidated subsidiaries
FIGURE 2–7 Consolidated Balance Sheet, January 1, 20X1, Date of Combination; 100 Percent Acquisition
at Book Value
PEERLESS PRODUCTS CORPORATION AND SUBSIDIARY
Consolidated Balance Sheet
January 1, 20X1
Assets Liabilities
Cash $ 100,000 Accounts Payable $ 200,000
Accounts Receivable 125,000 Bonds Payable 300,000
Inventory 160,000
Land 215,000 Stockholders’ Equity
Buildings and Equipment $1,400,000 Common Stock 500,000
Accumulated Depreciation (700,000) 700,000 Retained Earnings 300,000
Total Assets $1,300,000 Total Liabilities and Equity $1,300,000
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Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential 75
is less than wholly owned, a portion of the consolidated net income accrues to the noncontrolling shareholders (as explained in Chapter 3). In that case, the income attributable
to the noncontrolling interest is deducted from consolidated net income on the face of
the income statement to arrive at consolidated net income attributable to the controlling
interest.
Consolidated net income and consolidated net income attributable to the controlling
interest are the same when all consolidated subsidiaries are wholly owned. For example,
assume that Push Corporation purchases all of the stock of Shove Company at an amount
equal to its book value. During 20X1, Shove reports net income of $25,000, while Push
reports net income of $125,000, including equity-method income from Shove of $25,000.
Consolidated net income for 20X1 is computed as follows:
Push’s net income $125,000
Less: Equity-method income from Shove (25,000)
Shove’s net income 25,000
Consolidated net income $125,000
Note that when the parent company properly applies the equity method, consolidated net
income is always equal to the parent’s equity-method net income.
Consolidated Retained Earnings
The retained earnings figure reported in the consolidated balance sheet is the retained
earnings attributable to the controlling interest. For subsidiaries that are not wholly
owned, the noncontrolling stockholders’ share of subsidiary retained earnings is included
in the noncontrolling interest amount reported in the equity section of the consolidated
balance sheet.
Consolidated retained earnings, as it appears in the consolidated balance sheet, is
that portion of the consolidated enterprise’s undistributed earnings accruing to the parent company shareholders. Consolidated retained earnings at the end of the period is
equal to the beginning consolidated retained earnings balance plus consolidated net
income attributable to the controlling interest, less dividends declared by the parent
company.
Computing Consolidated Retained Earnings
Consolidated retained earnings is computed by adding together the parent’s retained
earnings from its own operations (excluding any income from consolidated subsidiaries recognized by the parent) and the parent’s proportionate share of the net income of
each subsidiary since the date of acquisition, adjusted for differential write-off and goodwill impairment. Consolidated retained earnings should be equal to the parent’s equitymethod retained earnings.
If the parent accounts for subsidiaries using the equity method on its books, the retained
earnings of each subsidiary is completely eliminated when the subsidiary is consolidated.
This is necessary because (1) retained earnings cannot be purchased, and so subsidiary
retained earnings at the date of a business combination cannot be included in the combined company’s retained earnings; (2) the parent’s share of the subsidiary’s income
since acquisition is already included in the parent’s equity-method retained earnings; and
(3) the noncontrolling interest’s share (if any) of the subsidiary’s retained earnings is not
included in consolidated retained earnings.
In the simple example given previously, assume that on the date of combination,
January 1, 20X1, Push’s retained earnings balance is $400,000 and Shove’s is $250,000.
During 20X1, Shove reports $25,000 of net income and declares $10,000 of dividends.
Push reports $100,000 of separate operating earnings plus $25,000 of equity-method
income from its 100 percent interest in Shove; Push declares dividends of $30,000. Based
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76 Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential
on this information, the retained earnings balances for Push and Shove on December 31,
20X1, are computed as follows:
Fair value of consideration $300,000
Book value of shares acquired
Common stock—Special Foods $200,000
Retained earnings—Special Foods 100,000
300,000
Difference between fair value and book value $ 0
P
S
1/1/X1
100%
Consolidated retained earnings is computed by first determining the parent’s retained
earnings from its own operations. This computation involves removing from the parent’s retained earnings the $25,000 of subsidiary income since acquisition recognized
by the parent, leaving $470,000 ($495,000 – $25,000) of retained earnings resulting
from the parent’s own operations. The parent’s 100 percent share of the subsidiary’s
net income since the date of acquisition is then added to this number, resulting in consolidated retained earnings of $495,000. We note that since this is the first year since
the acquisition, the net income since the date of acquisition is just this year’s income.
Subsequent examples will illustrate how this calculation differs in later years. We also
emphasize that since Push uses the fully adjusted equity method, this number is the same
as the parent’s equity-method retained earnings.
CONSOLIDATED FINANCIAL STATEMENTS—100 PERCENT OWNERSHIP,
CREATED OR ACQUIRED AT BOOK VALUE
Each of the consolidated financial statements is prepared as if it is taken from a single
set of books that is being used to account for the overall consolidated entity. There is,
of course, no set of books for the consolidated entity, and as in the preparation of the
consolidated balance sheet, the consolidation process starts with the data recorded on the
books of the individual consolidating companies. The account balances from the books
of the individual companies are placed in the three-part worksheet, and entries are made
to eliminate the effects of intercorporate ownership and transactions. The consolidation
approach and procedures are the same whether the subsidiary being consolidated was
acquired or created.
To understand the process of consolidation subsequent to the start of a parent–subsidiary
relationship, assume that on January 1, 20X1, Peerless Products Corporation acquires all of
the common stock of Special Foods Inc. for $300,000, an amount equal to the book value
of Special Foods on that date. At that time, Special Foods has $200,000 of common stock
outstanding and retained earnings of $100,000, summarized as follows:
Push Shove
Balance, January 1, 20X1 $400,000 $250,000
Net income, 20X1 125,000 25,000
Dividends declared in 20X1 (30,000) (10,000)
Balance, December 31, 20X1 $495,000 $265,000
Peerless accounts for its investment in Special Foods stock using the equity method.
Information about Peerless and Special Foods as of the date of combination and for the
years 20X1 and 20X2 appears in Figure 2–8 .
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Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential 77
Initial Year of Ownership
On January 1, 20X1, Peerless records its purchase of Special Foods common stock with
the following entry:
FIGURE 2–8
Selected Information
about Peerless
Products and Special
Foods on January 1,
20X1, and for the
Years 20X1 and 20X2
Peerless
Products
Special
Foods
Common Stock, January 1, 20X1 $500,000 $200,000
Retained Earnings, January 1, 20X1 300,000 100,000
20X1:
Separate Operating Income, Peerless 140,000
Net Income, Special Foods 50,000
Dividends 60,000 30,000
20X2:
Separate Operating Income, Peerless 160,000
Net Income, Special Foods 75,000
Dividends 60,000 40,000
During 20X1, Peerless records operating earnings of $140,000, excluding its income
from investing in Special Foods, and declares dividends of $60,000. Special Foods
reports 20X1 net income of $50,000 and declares dividends of $30,000.
Parent Company Entries
Peerless records its 20X1 income and dividends from Special Foods under the equity
method as follows:
Consolidation Worksheet—Initial Year of Ownership
After all appropriate entries, including year-end adjustments, have been made on
the books of Peerless and Special Foods, a consolidation worksheet is prepared as in
Figure 2–9 . The adjusted account balances from the books of Peerless and Special Foods
are placed in the first two columns of the worksheet. Then all amounts that reflect intercorporate transactions or ownership are eliminated in the consolidation process.
The distinction between journal entries recorded on the books of the individual companies and the eliminating entries recorded only on the consolidation worksheet is an
important one. Book entries affect balances on the books and the amounts that are carried
to the consolidation worksheet; worksheet eliminating entries affect only those balances
carried to the consolidated financial statements in the period. As mentioned previously,
the eliminating entries presented in this text are shaded both when presented in journal
entry form in the text and in the worksheet.
In this example, the accounts that must be eliminated because of intercorporate
ownership are the stockholders’ equity accounts of Special Foods, including dividends
declared, Peerless’ investment in Special Foods stock, and Peerless’ income from Special
Foods. However, different from previous examples, the book value portion of Peerless’
(12) Investment in Special Foods 300,000
Cash 300,000
Record purchase of Special Foods stock.
(13) Investment in Special Foods 50,000
Income from Special Foods 50,000
Record Peerless’ 100% share of Special Foods’ 20X1 income.
(14) Cash 30,000
Investment in Special Foods 30,000
Record Peerless’ 100% share of Special Foods’ 20X1 dividend.
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78 Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential
investment has changed because earnings and dividends have adjusted the investment
account balance. The book value portion of the investment account can be summarized
as follows:
Goodwill = 0
1/1/X1
$300,000
Initial
investment
in Special
Foods
Identifiable
excess = 0
Book value =
CS + RE =
300,000
Goodwill = 0
12/31/X1
$320,000
Net
investment
in Special
Foods
Excess = 0
Book value =
CS + RE =
320,000
The beginning and ending balances in the investment account can be illustrated as
follows:
Under the equity method, Peerless recognizes its share (100 percent) of Special
Foods’ reported income. In the consolidated income statement, however, Special
Foods’ individual revenue and expense accounts are combined with Peerless’ accounts.
Peerless’ equity method income from Special Foods, therefore, must be eliminated to
avoid double-counting. Special Foods’ dividends paid to the Peerless must be eliminated when consolidated statements are prepared so that only dividend declarations
related to the parent’s shareholders are treated as dividends of the consolidated entity.
Thus, the basic eliminating entry removes both the equity method Income from Special
Foods and Special Foods’ dividends declared during the period:
The book value calculations in the chart above help to facilitate preparation of the
basic elimination entry. Thus, the basic eliminating entry removes (1) Special Foods’
equity accounts, (2) Special Foods’ dividends declared, (3) Peerless’ Income from
Special Foods account, and (4) Peerless’ Investment in Special Foods account. Note
that we use blue shading in the numbers in the book value analysis that appear in
Book Value Calculations:
Total Investment = Common Stock + Retained Earnings
Original book value 300,000 200,000 100,000
+ Net income 50,000 50,000
− Dividends (30,000) (30,000)
Ending book value 320,000 200,000 120,000
Basic elimination entry:
Common stock 200,000 Original amount invested (100%)
Retained earnings 100,000 Beginning balance in RE
Income from Special Foods 50,000 Special Foods’ reported income
Dividends declared 30,000 100% of Special Foods’ dividends
Investment in Special Foods 320,000 Net BV in investment account
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Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential 79
the basic elimination entry. Since there is no differential in this example, the basic
elimination entry completely eliminates the balance in Peerless’ investment account
on the balance sheet as well as the Income from Special Foods account on the income
statement. Additional elimination entries will be necessary when there is a differential
in Chapters 4 and 5.
We now introduce one final elimination entry that is optional but that provides for
a more “correct” consolidation. When the parent company acquires the subsidiary, the
consolidated financial statements should appear as if all of the subsidiary’s assets and
liabilities were acquired at fair value as of the acquisition date. For example, if the
acquisition were to be exercised as an acquisition of the assets instead of the stock of
the company, each individual asset would be recorded by the acquiring company with
a new basis equal to its fair value (and zero accumulated depreciation) on that date.
Old book value and accumulated depreciation numbers from the seller would be disregarded. In the same way, when a company’s stock is acquired in an acquisition, the
consolidated financial statements should appear with all assets and liabilities recorded
at their current fair market values. Thus, eliminating the old accumulated depreciation
of the subsidiary as of the acquisition date and netting it out against the historical cost
gives the appearance that the depreciable assets have been newly recorded at their fair
value as of the acquisition date. In this example, the fair value of Special Foods’ buildings and equipment is equal to their current book values. Special Foods’ books indicate accumulated depreciation on the acquisition date of $300,000. Thus, the following
elimination entry nets this accumulated depreciation out against the cost of the building
and equipment.
Note that this worksheet elimination entry does not change the net buildings and equipment balance. Netting the pre-acquisition accumulated depreciation out against the cost
basis of the corresponding assets merely causes the buildings and equipment to appear in
the consolidated financial statements as if they had been revalued to their fair values on the
acquisition date. This same entry would be included in each succeeding consolidation as
long as the assets remain on Special Foods’ books (always based on the acquisition date
accumulated depreciation balance).
Worksheet Relationships
Both of the eliminating entries are entered in Figure 2–9 and the amounts totaled across
each row and down each column to complete the worksheet. Some specific points to recognize with respect to the full worksheet are as follows:
Investment in
Special Foods
Income from
Special Foods
Acquisition Price 300,000
Net Income 50,000 50,000 Net Income
30,000 Dividends
Ending Balance 320,000 50,000 Ending Balance
320,000 Basic 50,000
0 0
Optional accumulated depreciation elimination entry:
Accumulated depreciation 300,000 Original depreciation at the time of
Building and equipment 300,000 the acquisition netted against cost
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80 Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential
1. Because of the normal articulation among the financial statements, the bottom-line
number from each of the first two sections of the worksheet carries down to the next
financial statement in a logical progression. As part of the normal accounting cycle,
net income is closed to retained earnings, and retained earnings is reflected in the
balance sheet. Therefore, in the consolidation worksheet, the net income is carried
down to the retained earnings statement section of the worksheet, and the ending
retained earnings line is carried down to the balance sheet section of the worksheet. Note that in both cases the entire line, including total eliminations, is carried
forward.
2. Double-entry bookkeeping requires total debits to equal total credits for any single
eliminating entry and for the worksheet as a whole. Because some eliminating entries
extend to more than one section of the worksheet, however, the totals of the debit and
credit eliminations are not likely to be equal in either of the first two sections of the
worksheet. The totals of all debits and credits at the bottom of the balance sheet section are equal because the cumulative balances from the two upper sections are carried
forward to the balance sheet section.
3. In the balance sheet portion of the worksheet, total debit balances must equal total
credit balances for each company and the consolidated entity.
4. When the parent uses the full equity method of accounting for the investment, consolidated net income should equal the parent’s net income and consolidated retained
FIGURE 2–9 December 31, 20X1, Equity-Method Worksheet for Consolidated Financial Statements, Initial Year of
Ownership; 100 Percent Acquisition at Book Value
Peerless
Products
Special
Foods
Elimination Entries
DR CR Consolidated
Income Statement
Sales $ 400,000 $200,000 $ 600,000
Less: COGS (170,000) (115,000) (285,000)
Less: Depreciation Expense (50,000) (20,000) (70,000)
Less: Other Expenses (40,000) (15,000) (55,000)
Income from Special Foods 50,000 $ 50,000 0
Net Income $ 190,000 $ 50,000 $ 50,000 $ 0 $ 190,000
Statement of Retained Earnings
Beginning Balance $ 300,000 $100,000 $100,000 $ 300,000
Net Income 190,000 50,000 50,000 $ 0 190,000
Less: Dividends Declared (60,000) (30,000) 30,000 (60,000)
Ending Balance $ 430,000 $120,000 $150,000 $ 30,000 $ 430,000
Balance Sheet
Cash $ 210,000 $ 75,000 $ 285,000
Accounts Receivable 75,000 50,000 125,000
Inventory 100,000 75,000 175,000
Investment in Special Foods 320,000 $320,000 0
Land 175,000 40,000 215,000
Buildings & Equipment 800,000 600,000 300,000 1,100,000
Less: Accumulated Depreciation (450,000) (320,000) $300,000 (470,000)
Total Assets $1,230,000 $520,000 $300,000 $620,000 $1,430,000
Accounts Payable $ 100,000 $100,000 $ 200,000
Bonds Payable 200,000 100,000 300,000
Common Stock 500,000 200,000 $200,000 500,000
Retained Earnings 430,000 120,000 150,000 $ 30,000 430,000
Total Liabilities & Equity $1,230,000 $520,000 $350,000 $ 30,000 $1,430,000
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Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential 81
earnings should equal the parent’s retained earnings. This means the existing balance
in subsidiary retained earnings must be eliminated to avoid double counting.
5. Certain other clerical safeguards are incorporated into the worksheet. The amounts
reflected in the bottom line of the income statement section, when summed (algebraically) across, must equal the number reported as consolidated net income. Similarly,
the amounts in the last line of the retained earnings statement section must equal consolidated retained earnings when summed across.
Second and Subsequent Years of Ownership
The consolidation procedures employed at the end of the second and subsequent years
are basically the same as those used at the end of the first year. Adjusted trial balance
data of the individual companies are used as the starting point each time consolidated
statements are prepared because no separate books are kept for the consolidated entity.
An additional check is needed in each period following acquisition to ensure that the
beginning balance of consolidated retained earnings shown in the completed worksheet equals the balance reported at the end of the prior period. In all other respects,
the eliminating entries and worksheet are comparable with those shown for the first
year.
Parent Company Entries
We illustrate consolidation after two years of ownership by continuing the example of
Peerless Products and Special Foods, based on the data in Figure 2–8 . Peerless’ separate
income from its own operations for 20X2 is $160,000, and its dividends total $60,000.
Special Foods reports net income of $75,000 in 20X2 and pays dividends of $40,000.
Peerless records the following equity-method entries in 20X2:
The balance in the investment account reported by Peerless increases from $320,000 on
January 1, 20X2, to $355,000 on December 31, 20X2, and reported net income of Peerless totals $235,000 ($160,000 + $75,000).
Consolidation Worksheet—Second Year of Ownership
Figure 2–10 illustrates the worksheet to prepare consolidated statements for 20X2. The
book value of Peerless’ investment in Special Foods (which is equal to the book value of
Special Foods’ equity accounts) can be analyzed and summarized as follows:
(15) Investment in Special Foods 75,000
Income from Special Foods 75,000
Record Peerless’ 100% share of Special Foods’ 20X2 income.
(16) Cash 40,000
Investment in Special Foods 40,000
Record Peerless’ 100% share of Special Foods’ 20X2 dividend.
Book Value Calculations:
Total Investment = Common Stock + Retained Earnings
Original book value 320,000 200,000 120,000
+ Net income 75,000 75,000
− Dividends (40,000) (40,000)
Ending book value 355,000 200,000 155,000
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82 Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential
The beginning and ending balances in the investment account can be illustrated as
follows:
Again, the basic eliminating entry removes (1) Special Foods’ equity accounts,
(2) Special Foods’ dividends declared, (3) Peerless’ Income from Special Foods account,
and (4) Peerless’ Investment in Special Foods account:
As explained previously, since there is no differential in this example, the basic elimination entry completely eliminates the balance in Peerless’ investment account on
the balance sheet as well as the Income from Special Foods account on the income
statement.
In this example, Special Foods had accumulated depreciation on the acquisition date
of $300,000. Thus, we repeat the same accumulated depreciation elimination entry this
year (and every year as long as Special Foods owns the assets) that we used in the initial
year.
Goodwill = 0
1/1/X2
$320,000
Net
investment
in Special
Foods
Excess = 0
Book value =
CS + RE =
320,000
Goodwill = 0
12/31/X2
$355,000
Net
investment
in Special
Foods
Excess = 0
Book value =
CS + RE =
355,000
Basic elimination entry:
Common stock 200,000 Original amount invested (100%)
Retained earnings 120,000 Beginning balance in RE
Income from Special Foods 75,000 Special Foods’ reported income
Dividends declared 40,000 100% of Special Foods’ dividends
Investment in Special Foods 355,000 Net BV in investment account
Investment in
Special Foods
Income from
Special Foods
Beginning Balance 320,000
Net Income 75,000 75,000 Net Income
40,000 Dividends
Ending Balance 355,000 75,000 Ending Balance
355,000 Basic 75,000
0 0
Optional accumulated depreciation elimination entry:
Accumulated depreciation 300,000 Original depreciation at the time of
Building and equipment 300,000 the acquisition netted against cost
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Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential 83
After placing the two elimination entries in the consolidation worksheet, it is completed in the normal manner as illustrated in Figure 2–10 . All worksheet relationships
discussed in conjunction with Figure 2–9 continue in the second year as well. The beginning consolidated retained earnings balance for 20X2, as shown in Figure 2–10 , should
be compared with the ending consolidated retained earnings balance for 20X1, as shown
in Figure 2–9 , to ensure that they are the same.
Consolidated Net Income and Retained Earnings
In the consolidation worksheets illustrated in Figures 2–9 and 2–10 , consolidated net income
for 20X1 and 20X2 appears as the last number in the income statement section of the worksheets in the Consolidated column on the far right. The numbers can be computed as follows:
FIGURE 2–10 December 31, 20X2, Equity-Method Worksheet for Consolidated Financial Statements, Second Year
of Ownership; 100 Percent Acquisition at Book Value
20X1 20X2
Peerless’ net income $190,000 $235,000
Peerless’ equity income from Special Foods (50,000) (75,000)
Special Foods’ net income 50,000 75,000
Consolidated net income $190,000 $235,000
In this simple illustration, consolidated net income is the same as Peerless’ equitymethod net income. Had Peerless used the cost method to account for its investment
Peerless
Products
Special
Foods
Eliminating Entries
DR CR Consolidated
Income Statement
Sales $ 450,000 $300,000 $ 750,000
Less: COGS (180,000) (160,000) (340,000)
Less: Depreciation Expense (50,000) (20,000) (70,000)
Less: Other Expenses (60,000) (45,000) (105,000)
Income from Special Foods 75,000 $ 75,000 0
Net Income $ 235,000 $ 75,000 $ 75,000 $ 0 $ 235,000
Statement of Retained Earnings
Beginning Balance $ 430,000 $120,000 $120,000 $ 430,000
Net Income 235,000 75,000 75,000 $ 0 235,000
Less: Dividends Declared (60,000) (40,000) 40,000 (60,000)
Ending Balance $ 605,000 $155,000 $195,000 $ 40,000 $ 605,000
Balance Sheet
Cash $ 245,000 $ 85,000 $ 330,000
Accounts Receivable 150,000 80,000 230,000
Inventory 180,000 90,000 270,000
Investment in Special Foods 355,000 $355,000 0
Land 175,000 40,000 215,000
Buildings & Equipment 800,000 600,000 300,000 1,100,000
Less: Accumulated Depreciation (500,000) (340,000) $300,000 (540,000)
Total Assets $1,405,000 $555,000 $300,000 $655,000 $1,605,000
Accounts Payable $ 100,000 $100,000 $ 200,000
Bonds Payable 200,000 100,000 300,000
Common Stock 500,000 200,000 $200,000 500,000
Retained Earnings 605,000 155,000 195,000 $ 40,000 605,000
Total Liabilities & Equity $1,405,000 $555,000 $395,000 $ 40,000 $1,605,000
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84 Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential
Companies owning investments in the common stock of other companies generally report those
investments by consolidating them or reporting them using the cost method (adjusted to market, if
appropriate) or equity method, depending on the circumstances. Consolidation generally is appropriate if one entity controls the investee, usually through majority ownership of the investee’s
voting stock. The equity method is required when an investor has sufficient stock ownership in an
investee to significantly influence the operating and financial policies of the investee but owns less
than a majority of the investee’s stock. In the absence of other evidence, ownership of 20 percent
or more of an investee’s voting stock is viewed as giving the investor the ability to exercise significant influence over the investee. The cost method is used when consolidation and the equity
method are not appropriate, usually when the investor is unable to exercise significant influence
over the investee. If the cost method is used in reporting an investment in common stock and the
common stock is marketable, an adjustment to market is required for financial reporting purposes.
The cost method is similar to the approach used in accounting for other noncurrent assets. The
investment is carried at its original cost to the investor. Consistent with the realization concept,
income from the investment is recognized when distributed by the investee in the form of dividends.
The equity method is unique in that the carrying value of the investment is adjusted periodically
to reflect the investor’s changing equity in the underlying investee. Income from the investment is
recognized by the investor under the equity method as the investee reports the income rather than
when it is distributed.
Companies also have the choice of reporting nonconsolidated investments using the fair value
option instead of the cost or equity method. Under the fair value option, the investment is remeasured to fair value at the end of each reporting period and the change in value recognized as an
unrealized gain or loss in income.
Consolidated financial statements present the financial position and results of operations of
two or more separate legal entities as if they were a single company. A consolidated balance sheet
prepared on the date a parent acquires a subsidiary appears the same as if the acquired company
had been merged into the parent.
A consolidation worksheet provides a means of efficiently developing the data needed to prepare consolidated financial statements. The worksheet includes a separate column for the trial balance data of each of the consolidating companies, a debit and a credit column for the elimination
entries, and a column for the consolidated totals that appear in the consolidated financial statements. A three-part consolidation worksheet facilitates preparation of a consolidated income statement, retained earnings statement, and balance sheet, and it includes a section for each statement.
Eliminating entries are needed in the worksheet to remove the effects of intercompany ownership
and intercompany transactions so the consolidated financial statements appear as if the separate
companies are actually one.
in Special Foods, the consolidated net income would not be the same as Peerless’ net
income.
In Figures 2–9 and 2–10 , the ending consolidated retained earnings number is equal
to the beginning balance of consolidated retained earnings plus consolidated net income,
less dividends declared on the parent’s common stock. It also can be computed as
follows:
20X1 20X2
Peerless’ beginning retained earnings from its own operations $300,000 $380,000
Peerless’ income from its own operations 140,000 160,000
Peerless’ income from Special Foods since acquisition (cumulative) 50,000 125,000
Peerless’ dividends declared (60,000) (60,000)
Consolidated retained earnings $430,000 $605,000
As with income, consolidated retained earnings is the same as the parent’s equity-method
retained earnings if the parent company uses the equity method. We note that the second
year of this calculation illustrates how cumulative income from Special Foods (since the
acquisition date) can be used to calculate ending retained earnings.
Summary of
Key Concepts
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Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential 85
Appendix 2A Additional Considerations Relating to the Equity
Method
Determination of Significant Influence
The general rule established in APB 18 (ASC 323 and 325) is that the equity method is appropriate
when the investor, by virtue of its common stock interest in an investee, is able to exercise significant influence over the operating and financial policies of the investee. In the absence of other
evidence, common stock ownership of 20 percent or more is viewed as indicating that the investor
is able to exercise significant influence over the investee. However, the APB also stated a number of
factors that could constitute other evidence of the ability to exercise significant influence: 11
1. Representation on board of directors.
2. Participation in policy making.
3. Material intercompany transactions.
4. Interchange of managerial personnel.
5. Technological dependency.
6. Size of investment in relation to concentration of other shareholdings.
Conversely, the FASB provides in FASB Interpretation No. 35 (ASC 323) some examples
of evidence that an investor is unable to exercise significant influence over an investee. 12 These
situations include legal or regulatory challenges to the investor’s influence by the investee, agreement by the investor to give up important shareholder rights, concentration of majority ownership
among a small group of owners who disregard the views of the investor, and unsuccessful attempts
by the investor to obtain information from the investee or representation on the investee’s board
of directors.
Alternative Versions of the Equity Method of Accounting for
Investments in Subsidiaries
Companies are free to adopt whatever procedures they wish in accounting for investments in controlled subsidiaries on their books. Because investments in consolidated subsidiaries are eliminated when consolidated statements are prepared, the consolidated statements are not affected by
the procedures used to account for the investments on the parent’s books.
In practice, companies follow three different approaches in accounting for their consolidated
subsidiaries:
1. Cost method.
2. Fully adjusted equity method.
3. Modified version of the equity method.
Several modified versions of the equity method are found in practice, and all usually are
referred to as the modified equity method. Some companies apply the equity method without
making adjustments for unrealized intercompany profits and the amortization of the differential.
consolidated net income, 74
consolidated retained
earnings, 75
consolidation, 55
consolidation worksheet, 67
corporate joint venture, 60
cost method, 54
eliminating entries, 69
equity accrual, 61
equity method, 55
fully adjusted equity
method, 86
liquidating dividends, 57
modified equity method, 85
one-line consolidation, 65, 86
parent, 55, 67
significant influence, 55
subsidiary, 55, 67
unconsolidated subsidiary, 55
11 APB 18, para. 17. (ASC 323-10-15-6)
12 Financial Accounting Standards Board Interpretation No. 35, “Criteria for Applying the Equity Method of
Accounting for Investments in Common Stock,” May 1981, para. 4. (ASC 323-10-15-10)
Key Terms
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86 Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential
Total intercompany profit $10,000 – $7,000 = $3,000
Unrealized portion $3,000 × 2/3 = $2,000
Others adjust for the amortization of the differential but omit the adjustments for unrealized intercompany profits. While modified versions of the equity method are not acceptable for financial
reporting purposes, they may provide some clerical savings for the parent if used on the books
when consolidation of the subsidiary is required.
Unrealized Intercompany Profits
The equity method as applied under APB 18 (ASC 323 and 325) often is referred to as a one-line
consolidation because ( a ) the investor’s income and stockholders’ equity are the same as if the
investee were consolidated and ( b ) all equity method adjustments are made through the investment
and related income accounts, which are reported in only a single line in the balance sheet and a
single line in the income statement. 13 The view currently taken in consolidation is that intercompany sales do not result in the realization of income until the intercompany profit is confirmed in
some way, usually through a transaction with an unrelated third party. For example, if a parent
company sells inventory to a subsidiary at a profit, that profit cannot be recognized in the consolidated financial statements until it is confirmed by resale of the inventory to an external party.
Because profits from sales to related companies are viewed from a consolidated perspective as
being unrealized until there is a resale to unrelated parties, such profits must be eliminated when
preparing consolidated financial statements.
The consolidated financial statements are not the only ones affected, however, because
APB 18 (ASC 323 and 325) requires that the income of an investor that reports an investment
using the equity method must be the same as if the investee were consolidated. Therefore, the
investor’s equity-method income from the investee must be adjusted for unconfirmed profits on
intercompany sales as well. The term for the application of the equity method that includes the
adjustment for unrealized profit on sales to affiliates is fully adjusted equity method.
Adjusting for Unrealized Intercompany Profits
An intercompany sale normally is recorded on the books of the selling affiliate in the same manner
as any other sale, including the recognition of profit. In applying the equity method, any intercompany profit remaining unrealized at the end of the period must be deducted from the amount of
income that otherwise would be reported.
Under the one-line consolidation approach, the income recognized from the investment and the
carrying amount of the investment are reduced to remove the effects of the unrealized intercompany
profits. In future periods when the intercompany profit actually is realized, the entry is reversed.
Unrealized Profit Adjustments Illustrated
To illustrate the adjustment for unrealized intercompany profits under the equity method, assume
that Palit Corporation owns 40 percent of the common stock of Label Manufacturing. During
20X1, Palit sells inventory to Label for $10,000; the inventory originally cost Palit $7,000. Label
resells one-third of the inventory to outsiders during 20X1 and retains the other two-thirds in its
ending inventory. The amount of unrealized profit is computed as follows:
13 Although APB 18 (ASC 323 and 325) established the requirement for an equity-method investor’s income
and stockholders’ equity to be the same as if the investee were consolidated, the FASB’s recent decision
to not permit the write-off of equity-method goodwill may lead to differences in situations in which such
goodwill has been impaired.
Assuming that Label reports net income of $60,000 for 20X1 and declares no dividends, the following entries are recorded on Palit’s books at the end of 20X1:
(17) Investment in Label Manufacturing 24,000
Income from Label Manufacturing 24,000
Record equity-method income: $60,000 × 0.40
(18) Income from Label Manufacturing 2,000
Investment in Label Manufacturing 2,000
Remove unrealized intercompany profit.
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If all the remaining inventory is sold in 20X2, the following entry is made on Palit’s books at the
end of 20X2 to record the realization of the previously unrealized intercompany profit:
Additional Requirements of APB 18 (ASC 323 and 325)
APB 18 (ASC 323 and 325), the main pronouncement on equity-method reporting, includes several additional requirements:
1. The investor’s share of the investee’s extraordinary items and prior-period adjustments should
be reported as such by the investor, if material.
2. If an investor’s share of investee losses exceeds the carrying amount of the investment, the
equity method should be discontinued once the investment has been reduced to zero. No further losses are to be recognized by the investor unless the investor is committed to provide
further financial support for the investee or unless the investee’s imminent return to profitability appears assured. If, after the equity method has been suspended, the investee reports net
income, the investor again should apply the equity method, but only after the investor’s share of
net income equals its share of losses not previously recognized.
3. Preferred dividends of the investee should be deducted from the investee’s net income if
declared or, whether declared or not, if the preferred stock is cumulative, before the investor
computes its share of investee earnings.
APB 18 (ASC 323 and 325) also includes a number of required financial statement disclosures.
When using the equity method, the investor must disclose 14
1. The name and percentage ownership of each investee.
2. The investor’s accounting policies with respect to its investments in common stock, including
the reasons for any departures from the 20 percent criterion established by APB 18 (ASC 323
and 325).
3. The amount and accounting treatment of any differential.
4. The aggregate market value of each identified nonsubsidiary investment where a quoted market
price is available.
5. Either separate statements for or summarized information as to assets, liabilities, and results of
operations of corporate joint ventures of the investor, if material in the aggregate.
Investor’s Share of Other Comprehensive Income
When an investor uses the equity method to account for its investment in another company, the
investor’s comprehensive income should include its proportionate share of each of the amounts
reported as “Other Comprehensive Income” by the investee. For example, assume that Ajax Corporation purchases 40 percent of the common stock of Barclay Company on January 1, 20X1. For
the year 20X1, Barclay reports net income of $80,000 and comprehensive income of $115,000,
which includes other comprehensive income (in addition to net income) of $35,000. This other
comprehensive income (OCI) reflects an unrealized $35,000 gain (net of tax) resulting from an
increase in the fair value of an investment in stock classified as available-for-sale under the criteria
established by FASB 115. In addition to recording the normal equity-method entries, Ajax recognizes its proportionate share of the unrealized gain on available-for-sale securities reported by
Barclay during 20X1 with the following entry:
14 FASB 159 (ASC 825) requires most of the same disclosures for investments in common stock reported
under the fair value option that otherwise would have been reported using the equity method.
(19) Investment in Label Manufacturing Stock 2,000
Income from Label Manufacturing 2,000
Recognize realized intercompany profit.
(20) Investment in Barclay Stock 14,000
Unrealized Gain on Investee OCI Investments 14,000
Recognize share of investee’s unrealized gain on available-for-sale
securities.
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Entry (20) has no effect on Ajax’s net income for 20X1, but it does increase Ajax’s other comprehensive income, and thus its total comprehensive income, by $14,000. Ajax will make a similar
entry at the end of each period for its proportionate share of any increase or decrease in Barclay’s
accumulated unrealized holding gain.
Appendix 2B Consolidation and the Cost Method
Not all parent companies use the equity method to account for their subsidiary investments that are
to be consolidated. The choice of the cost or equity method has no effect on the consolidated financial statements. This is true because the balance in the parent’s investment account, the parent’s
income from the subsidiary, and related items are eliminated in preparing the consolidated statements. Thus, the parent is free to use either the cost method or some version of the equity method
on its separate books in accounting for investments in subsidiaries that are to be consolidated.
Because the cost method uses different parent-company entries than the equity method, it also
requires different eliminating entries in preparing the consolidation worksheet. Keep in mind that
the consolidated financial statements appear the same regardless of whether the parent uses the
cost or the equity method on its separate books.
CONSOLIDATION—YEAR OF COMBINATION
To illustrate the preparation of consolidated financial statements when the parent company carries
its subsidiary investment using the cost method, refer again to the Peerless Products and Special Foods example. Assume that Peerless purchases 100 percent of the common stock of Special
Foods on January 1, 20X1, for $300,000. At that date, the book value of Special Foods as a whole
is $300,000. All other data are the same as presented in Figures 2–4 and 2–5 .
Parent Company Cost-Method Entries
When the parent company uses the cost method, only two journal entries are recorded by
Peerless during 20X1 related to its investment in Special Foods. Entry (21) records Peerless’
purchase of Special Foods stock; entry (22) recognizes dividend income based on the $30,000
($30,000 × 100%) of dividends received during the period:
No entries are made on the parent’s books with respect to Special Foods income in 20X1, as
would be done under the equity method.
Consolidation Worksheet—Year of Combination
Figure 2–11 illustrates the worksheet to prepare consolidated financial statements for December
31, 20X1, using the cost method. The trial balance data for Peerless and Special Foods included in
the worksheet in Figure 2–11 differ from those presented in Figure 2–9 only by the effects of using
the cost method rather than the equity method on Peerless’ books. Note that all of the amounts
in the Consolidated column are the same as in Figure 2–9 because the method used by the parent
to account for its subsidiary investment on its books has no effect on the consolidated financial
statements.
When a company uses the cost method, the basic elimination entry can be divided into two
parts. The first eliminates the investment account. The investment elimination entry eliminates the
balances in the stockholders’ equity accounts of Special Foods and the balance in Peerless’ investment account as of the date of combination. This elimination entry is the same each year (assuming
there is no impairment of the investment account) since it relates to the original acquisition price
and the original balances in Special Foods’ equity accounts.
(21) Investment in Special Foods 300,000
Cash 300,000
Record the initial investment in Special Foods.
(22) Cash 30,000
Dividend Income 30,000
Record Peerless’ 100% share of Special Foods’ 20X1 dividend.
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The dividend elimination entry eliminates the dividend income recorded by Peerless during the
period along with Special Foods’ dividend declaration related to the stockholdings of Peerless.
Finally, the accumulated depreciation elimination entry is the same as under the equity method.
FIGURE 2–11 December 31, 20X1, Cost-Method Worksheet for Consolidated Financial Statements, Initial Year of
Ownership; 100 Percent Acquisition at Book Value
Peerless
Products
Special
Foods
Elimination Entries
DR CR Consolidated
Income Statement
Sales $ 400,000 $200,000 $ 600,000
Less: COGS (170,000) (115,000) (285,000)
Less: Depreciation Expense (50,000) (20,000) (70,000)
Less: Other Expenses (40,000) (15,000) (55,000)
Dividend Income 30,000 $ 30,000 0
Net Income $ 170,000 $ 50,000 $ 30,000 $ 0 $ 190,000
Statement of Retained Earnings
Beginning Balance $ 300,000 $100,000 $100,000 $ 300,000
Net Income 170,000 50,000 30,000 $ 0 190,000
Less: Dividends Declared (60,000) (30,000) 30,000 (60,000)
Ending Balance $ 410,000 $120,000 $130,000 $ 30,000 $ 430,000
Balance Sheet
Cash $ 210,000 $ 75,000 $ 285,000
Accounts Receivable 75,000 50,000 125,000
Inventory 100,000 75,000 175,000
Investment in Special Foods 300,000 $300,000 0
Land 175,000 40,000 215,000
Buildings & Equipment 800,000 600,000 300,000 1,100,000
Less: Accumulated Depreciation (450,000) (320,000) $300,000 (470,000)
Total Assets $1,210,000 $520,000 $300,000 $600,000 $1,430,000
Accounts Payable $ 100,000 $100,000 $ 200,000
Bonds Payable 200,000 100,000 300,000
Common Stock 500,000 200,000 $200,000 500,000
Retained Earnings 410,000 120,000 130,000 $ 30,000 430,000
Total Liabilities & Equity $1,210,000 $520,000 $330,000 $ 30,000 $1,430,000
Common stock 200,000
Retained earnings 100,000
Investment in Special Foods 300,000
Investment elimination entry:
Dividend income 30,000
Dividends declared 30,000
Dividend elimination entry:
Optional accumulated depreciation elimination entry:
Accumulated depreciation 300,000
Building and equipment 300,000
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As mentioned previously, the amounts in the Consolidated column of the worksheet in
Figure 2–11 are the same as those in Figure 2–9 because the method used on the parent’s books to
account for the subsidiary investment does not affect the consolidated financial statements.
CONSOLIDATION—SECOND YEAR OF OWNERSHIP
Consolidation differences between cost-method accounting and equity-method accounting tend to
be more evident in the second year of ownership simply because the equity method entries change
every year while the cost method entries are generally the same (with the exception of recording
the initial investment).
Parent Company Cost-Method Entry
Peerless only records a single entry on its books in 20X2 related to its investment in Special Foods:
Consolidation Worksheet—Second Year Following Combination
The worksheet elimination entries are identical to those used in the first year except that the
amount of dividends declared by Special Foods in the second year is $40,000 instead of $30,000.
Under the cost method, Peerless has not recognized any portion of the undistributed earnings
of Special Foods on its parent company books. Therefore, Peerless’ retained earnings at the beginning of the second year are less than consolidated retained earnings. Also, Peerless’ Investment in
Special Foods account balance is less than its 100% share of Special Foods’ net assets at that date.
The consolidation worksheet in Figure 2–12 demonstrates how the worksheet entries eliminate the
balances reported by Peerless under the cost method.
Note that while the Consolidated column yields identical numbers to those found in Figure 2–10 ,
the cost method does not maintain the favorable properties that exist when the equity method is
employed. Specifically, the parent’s net income no longer equals consolidated net income and the
parent’s retained earnings no longer equals consolidated retained earnings balance. Hence, while
the procedures used under the cost method require less work, the parent company does not enjoy
some of the favorable relationships among parent and consolidated numbers that exist under the
equity method.
Questions
LO1 Q2-1 What types of investments in common stock normally are accounted for using ( a ) the equity
method and ( b ) the cost method?
LO1 Q2-2 How is the ability to significantly influence the operating and financial policies of a company normally demonstrated?
(23) Cash 40,000
Dividend Income 40,000
Record Peerless’ 100% share of Special Foods’ 20X2 dividend.
Common stock 200,000
Retained earnings 100,000
Investment in Special Foods 300,000
Investment elimination entry:
Dividend income 40,000
Dividends declared 40,000
Dividend elimination entry:
Optional accumulated depreciation elimination entry:
Accumulated depreciation 300,000
Building and equipment 300,000
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LO3 Q2-3* When is equity-method reporting considered inappropriate even though sufficient common shares
are owned to allow the exercise of significant influence?
LO4 Q2-4 When will the balance in the intercorporate investment account be the same under the cost method
and the equity method?
LO2, LO3 Q2-5 Describe an investor’s treatment of an investee’s prior-period dividends and earnings when the
investor acquires significant influence through a purchase of additional stock.
LO2, LO3 Q2-6 From the point of view of an investor in common stock, what is a liquidating dividend? Is a liquidating dividend viewed in the same way by the investee?
LO2, LO3 Q2-7 What effect does a liquidating dividend have on the balance in the investment account under the
cost method and the equity method?
LO2, LO3 Q2-8 How is the receipt of a dividend recorded under the equity method? Under the cost method?
LO5 Q2-9 How does the fair value method differ from the cost method and equity method in reporting income
from nonsubsidiary investments?
LO3 Q2-10 * How does the fully adjusted equity method differ from the modified equity method?
LO4 Q2-11 Explain the concept of a one-line consolidation.
LO3 Q2-12 * What is the modified equity method? When might a company choose to use the modified equity
method rather than the fully adjusted equity method?
LO3 Q2-13 * How are extraordinary items of the investee disclosed by the investor under equity-method reporting?
FIGURE 2-12 December 31, 20X1, Cost-Method Worksheet for Consolidated Financial Statements, Second Year of
Ownership; 100 Percent Acquisition at Book Value
Peerless
Products
Special
Foods
Elimination Entries
DR CR Consolidated
Income Statement
Sales $ 450,000 $300,000 $ 750,000
Less: COGS (180,000) (160,000) (340,000)
Less: Depreciation Expense (50,000) (20,000) (70,000)
Less: Other Expenses (60,000) (45,000) (105,000)
Income from Special Foods 40,000 $ 40,000 0
Net Income $ 200,000 $ 75,000 $ 40,000 $ 0 $ 235,000
Statement of Retained Earnings
Beginning Balance $ 410,000 $120,000 $100,000 $ 430,000
Net Income 200,000 75,000 40,000 $ 0 235,000
Less: Dividends Declared (60,000) (40,000) 40,000 (60,000)
Ending Balance $ 550,000 $155,000 $140,000 $ 40,000 $ 605,000
Balance Sheet
Cash $ 245,000 $ 85,000 $ 330,000
Accounts Receivable 150,000 80,000 230,000
Inventory 180,000 90,000 270,000
Investment in Special Foods 300,000 $300,000 0
Land 175,000 40,000 215,000
Buildings & Equipment 800,000 600,000 300,000 1,100,000
Less: Accumulated Depreciation (500,000) (340,000) $300,000 (540,000)
Total Assets $1,350,000 $555,000 $300,000 $600,000 $1,605,000
Accounts Payable $ 100,000 $100,000 $ 200,000
Bonds Payable 200,000 100,000 300,000
Common Stock 500,000 200,000 $200,000 500,000
Retained Earnings 550,000 155,000 140,000 $ 40,000 605,000
Total Liabilities & Equity $1,350,000 $555,000 $340,000 $ 40,000 $1,605,000
*Indicates that the item relates to material in the appendices.
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LO6 Q2-14 How does an eliminating entry differ from an adjusting entry?
LO6, LO7 Q2-15 What portion of the balances of subsidiary stockholders’ equity accounts is included in the consolidated balance sheet?
LO6 Q2-16 How does the elimination process change when consolidated statements are prepared after—rather
than at—the date of acquisition?
LO7 Q2-17 What are the three parts of the consolidation worksheet, and what sequence is used in completing
the worksheet parts?
LO6 Q2-18 How are a subsidiary’s dividend declarations reported in the consolidated retained earnings
statement?
LO7 Q2-19 How is consolidated net income computed in a consolidation worksheet?
LO6 Q2-20 Give a definition of consolidated retained earnings.
LO6, LO7 Q2-21 How is the amount reported as consolidated retained earnings determined?
LO7 Q2-22 Why is the beginning retained earnings balance for each company entered in the three-part
consolidation worksheet rather than just the ending balance?
Cases
LO2, LO3 C2-1 Choice of Accounting Method
Slanted Building Supplies purchased 32 percent of the voting shares of Flat Flooring Company
in March 20X3. On December 31, 20X3, the officers of Slanted Building Supplies indicated they
needed advice on whether to use the equity method or cost method in reporting their ownership in
Flat Flooring.
Required
a. What factors should be considered in determining whether equity-method reporting is
appropriate?
b. Which of the two methods is likely to show the larger reported contribution to Slanted’s earnings in 20X4? Explain.
c. Why might the use of the equity method become more appropriate as the percentage of ownership increases?
LO2, LO3 C2-2 Intercorporate Ownership
Most Company purchased 90 percent of the voting common stock of Port Company on January 1,
20X4, and 15 percent of the voting common stock of Adams Company on July 1, 20X4. In preparing the financial statements for Most Company at December 31, 20X4, you discover that Port
Company purchased 10 percent of the common stock of Adams Company in 20X2 and continues
to hold those shares. Adams Company reported net income of $200,000 for 20X4 and paid a dividend of $70,000 on December 20, 20X4.
Required
Most Company’s chief accountant instructs you to review the current accounting literature, including pronouncements of the FASB and other appropriate bodies, and prepare a memo discussing
whether the cost or equity method should be used in reporting the investment in Adams Company
in Most’s consolidated statements prepared at December 31, 20X4. Support your recommendations with citations and quotations from the authoritative financial reporting standards or other
literature.
LO2 C2-3 Application of the Equity Method
Forth Company owned 85,000 of Brown Company’s 100,000 shares of common stock until
January 1, 20X2, at which time it sold 70,000 of the shares to a group of seven investors, each of
whom purchased 10,000 shares. On December 3, 20X2, Forth received a dividend of $9,000 from
Brown. Forth continues to purchase a substantial portion of Brown’s output under a contract that
runs until the end of 20X9. Because of this arrangement, Forth is permitted to place two of its
employees on the board of directors of Brown.
Understanding
Research
Research
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Required
Forth Company’s controller is not sure whether the company should use the cost or equity method
in accounting for its investment in Brown Company. The controller asked you to review the relevant accounting literature and prepare a memo containing your recommendations. Support your
recommendations with citations and quotations from the appropriate authoritative financial reporting standards or other literature.
LO6 C2-4 Need for Consolidation Process
At a recent staff meeting, the vice president of marketing appeared confused. The controller had
assured him that the parent company and each of the subsidiary companies had properly accounted
for all transactions during the year. After several other questions, he finally asked, “If it has been
done properly, then why must you spend so much time and make so many changes to the amounts
reported by the individual companies when you prepare the consolidated financial statements each
month? You should be able to just add the reported balances together.”
Required
Prepare an appropriate response to help the controller answer the marketing vice president’s
question.
LO1 C2-5 Account Presentation
Prime Company has been expanding rapidly and is now an extremely diversified company for its
size. It currently owns three companies with manufacturing facilities, two companies primarily in
retail sales, a consumer finance company, and two natural gas pipeline companies. This has led to
some conflict between the company’s chief accountant and its treasurer. The treasurer advocates
presenting no more than five assets and three liabilities on its balance sheet. The chief accountant
has resisted combining balances from substantially different subsidiaries and has asked for your
assistance.
Required
Review the appropriate authoritative pronouncements or other relevant accounting literature to see
what guidance is provided and prepare a memo to the chief accountant with your findings. Include
citations to and quotations from the most relevant references. Include in your memo at least two
examples of situations in which it may be inappropriate to combine similar-appearing accounts of
two subsidiaries.
LO6 C2-6 Consolidating an Unprofitable Subsidiary
Amazing Chemical Corporation’s president had always wanted his own yacht and crew and concluded that Amazing Chemical should diversify its investments by purchasing an existing boatyard
and repair facility on the lake-shore near his summer home. He could then purchase a yacht and
have a convenient place to store it and have it repaired. Although the board of directors was never
formally asked to approve this new venture, the president moved forward with optimism and a
rather substantial amount of corporate money to purchase full ownership of the boatyard, which
had lost rather significant amounts of money each of the five prior years and had never reported a
profit for the original owners.
Not surprisingly, the boatyard continued to lose money after Amazing Chemical purchased
it, and the losses grew larger each month. Amazing Chemical, a very profitable chemical
company, reported net income of $780,000 in 20X2 and $850,000 in 20X3 even though
the boatyard reported net losses of $160,000 in 20X2 and $210,000 in 20X3 and was fully
consolidated.
Required
Amazing Chemical’s chief accountant has become concerned that members of the board of
directors or company shareholders will accuse him of improperly preparing the consolidated
statements. The president does not plan to tell anyone about the losses, which do not show up in
the consolidated income statement that the chief accountant prepared. You have been asked to
prepare a memo to the chief accountant indicating the way to include subsidiaries in the consolidated income statement and to provide citations to or quotations from the authoritative accounting literature that would assist the chief accountant in dealing with this matter. You have also
been asked to search the accounting literature to see whether any reporting requirements require
disclosure of the boatyard in notes to the financial statements or in management’s discussion
and analysis.
Communication
Research
Research
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94 Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential
2. In 20X0, Neil Company held the following investments in common stock:
• 25,000 shares of B&K Inc.’s 100,000 outstanding shares. Neil’s level of ownership gives it
the ability to exercise significant influence over the financial and operating policies of B&K.
• 6,000 shares of Amal Corporation’s 309,000 outstanding shares.
During 20X0, Neil received the following distributions from its common stock investments:
Exercises
LO2, LO3 E2-1 Multiple-Choice Questions on Use of Cost and Equity Methods [AICPA Adapted]
Select the correct answer for each of the following questions.
1. Peel Company received a cash dividend from a common stock investment. Should Peel report
an increase in the investment account if it uses the cost method or equity method of accounting?
Cost Equity
a. No No
b. Yes Yes
c. Yes No
d. No Yes
November 6 $30,000 cash dividend from B&K
November 11 $1,500 cash dividend from Amal
December 26 3 percent common stock dividend from Amal
The closing price of this stock was $115 per share.
What amount of dividend revenue should Neil report for 20X0?
a. $1,500.
b. $4,200.
c. $31,500.
d. $34,200.
3. What is the most appropriate basis for recording the acquisition of 100 percent of the stock in
another company if the acquisition was a noncash transaction?
a. At the book value of the consideration given.
b. At the par value of the stock acquired.
c. At the book value of the stock acquired.
d. At the fair value of the consideration given.
4. An investor uses the equity method to account for an investment in common stock. Assume that
(1) the investor owns more than 50 percent of the outstanding common stock of the investee,
(2) the investee company reports net income and declares dividends during the year, and (3) the
investee’s net income is greater than the dividends it declares. How would the investor’s investment in the common stock of the investee company under the equity method differ at year end from
what it would have been if the investor had accounted for the investment under the cost method?
a. The balance under the equity method is higher than it would have been under the cost method.
b. The balance under the equity method is lower than it would have been under the cost method.
c. The balance under the equity method is higher than it would have been under the cost
method, but only if the investee company actually paid the dividends before year end.
d. The balance under the equity method is lower than it would have been under the cost method,
but only if the investee company actually paid the dividends before year end.
5. A corporation exercises significant influence over an affiliate in which it holds a 40 percent
common stock interest. If its affiliate completed a fiscal year profitably but paid no dividends,
how would this affect the investor corporation?
a. Result in an increased current ratio.
b. Result in increased earnings per share.
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7. An investor uses the cost method to account for an investment in common stock. A portion of
the dividends received this year was in excess of the investor’s share of investee’s earnings
subsequent to the date of investment. The amount of dividend revenue that should be reported
in the investor’s income statement for this year would be
a. Zero.
b. The total amount of dividends received this year.
c. The portion of the dividends received this year that was in excess of the investor’s share of
investee’s earnings subsequent to the date of investment.
d. The portion of the dividends received this year that was not in excess of the investor’s share
of investee’s earnings subsequent to the date of investment.
LO4 E2-2 Multiple-Choice Questions on Intercorporate Investments
Select the correct answer for each of the following questions.
1. Companies often acquire ownership in other companies using a variety of ownership arrangements. Equity-method reporting should be used by the investor whenever
a. The investor purchases voting common stock of the investee.
b. The investor has significant influence over the operating and financing decisions of the
investee.
c. The investor purchases goods and services from the investee.
d. The carrying value of the investment is less than the market value of the investee’s shares
held by the investor.
2. The carrying amount of an investment in stock accounted for under the equity method is equal to
a. The original price paid to purchase the investment.
b. The original price paid to purchase the investment plus cumulative net income plus cumulative dividends declared by the investee since the date the investment was acquired.
c. The original price paid to purchase the investment plus cumulative net income minus cumulative dividends declared by the investee since the date the investment was acquired.
d. The original price paid to purchase the investment minus cumulative net income minus
cumulative dividends declared by the investee since the date the investment was acquired.
LO3E2-3 Multiple-Choice Questions on Applying Equity Method [AICPA Adapted]
Select the correct answer for each of the following questions.
1. Green Corporation owns 30 percent of the outstanding common stock and 100 percent of the
outstanding noncumulative nonvoting preferred stock of Axel Corporation. In 20X1, Axel
declared dividends of $100,000 on its common stock and $60,000 on its preferred stock. Green
exercises significant influence over Axel’s operations. What amount of dividend revenue
should Green report in its income statement for the year ended December 31, 20X1?
a. $0.
b. $30,000.
c. $60,000.
d. $90,000.
c. Increase several turnover ratios.
d. Decrease book value per share.
6. An investor in common stock received dividends in excess of the investor’s share of investee’s
earnings subsequent to the date of the investment. How will the investor’s investment account
be affected by those dividends under each of the following methods?
Cost Method Equity Method
a. No effect No effect
b. Decrease No effect
c. No effect Decrease
d. Decrease Decrease
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96 Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential
2. On January 2, 20X3, Kean Company purchased a 30 percent interest in Pod Company for
$250,000. Pod reported net income of $100,000 for 20X3 and paid a dividend of $10,000. Kean
accounts for this investment using the equity method. In its December 31, 20X3, balance sheet,
what amount should Kean report as its investment in Pod?
a. $160,000.
b. $223,000.
c. $340,000.
d. $277,000.
3. On January 1, 20X8, Mega Corporation acquired 10 percent of the outstanding voting stock
of Penny Inc. On January 2, 20X9, Mega gained the ability to exercise significant influence
over Penny’s financial and operating decisions by acquiring an additional 20 percent of Penny’s
outstanding stock. The two purchases were made at prices proportionate to the value assigned
to Penny’s net assets, which equaled their carrying amounts. For the years ended December 31,
20X8 and 20X9, Penny reported the following:
20X8 20X9
Dividends Paid $200,000 $300,000
Net Income 600,000 650,000
20X9 Investment
Income
Adjustment to 20X8
Investment Income
a. $195,000 $160,000
b. $195,000 $100,000
c. $195,000 $ 40,000
d. $105,000 $ 40,000
Investment in Investee 8,000
Equity in Earnings of Investee 8,000
Cash 2,000
Dividend Revenue 2,000
In 20X9, what amounts should Mega report as current year investment income and as an adjustment, before income taxes, to 20X8 investment income?
4. Investor Inc. owns 40 percent of Alimand Corporation. During the calendar year 20X5,
Alimand had net earnings of $100,000 and paid dividends of $10,000. Investor mistakenly
recorded these transactions using the cost method rather than the equity method of accounting.
What effect would this have on the investment account, net earnings, and retained earnings,
respectively?
a. Understate, overstate, overstate.
b. Overstate, understate, understate.
c. Overstate, overstate, overstate.
d. Understate, understate, understate.
5. A corporation using the equity method of accounting for its investment in a 40 percent–owned
investee, which earned $20,000 and paid $5,000 in dividends, made the following entries:
What effect will these entries have on the investor’s statement of financial position?
a. Financial position will be fairly stated.
b. Investment in the investee will be overstated, retained earnings understated.
c. Investment in the investee will be understated, retained earnings understated.
d. Investment in the investee will be overstated, retained earnings overstated.
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Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential 97
Required
Compute the net income reported by Winston for each of the three years, assuming it accounts for
its investment in Fullbright using ( a ) the cost method and ( b ) the equity method.
LO2, LO3 E2-5 Acquisition Price
Phillips Company bought 40 percent ownership in Jones Bag Company on January 1, 20X1, at
underlying book value. In 20X1, 20X2, and 20X3, Jones Bag reported net income of $8,000,
$12,000, and $20,000, and dividends of $15,000, $10,000, and $10,000, respectively. The balance
in Phillips Company’s investment account on December 31, 20X3, was $54,000.
Required
In each of the following independent cases, determine the amount that Phillips paid for its investment in Jones Bag stock assuming that Phillips accounted for its investment using the ( a ) cost
method and ( b ) equity method.
LO2, LO3 E2-6 Investment Income
Ravine Corporation purchased 30 percent ownership of Valley Industries for $90,000 on January 1,
20X6, when Valley had capital stock of $240,000 and retained earnings of $60,000. The following
data were reported by the companies for the years 20X6 through 20X9:
LO4 E2-4 Cost versus Equity Reporting
Winston Corporation purchased 40 percent of the stock of Fullbright Company on January 1,
20X2, at underlying book value. The companies reported the following operating results and dividend payments during the first three years of intercorporate ownership:
Winston Corporation Fullbright Company
Year Operating Income Dividends Net Income Dividends
20X2 $100,000 $ 40,000 $70,000 $30,000
20X3 60,000 80,000 40,000 60,000
20X4 250,000 120,000 25,000 50,000
Year
Operating Income,
Ravine Corporation
Net Income,
Valley Industries
Dividends Declared
Ravine Valley
20X6 $140,000 $30,000 $ 70,000 $20,000
20X7 80,000 50,000 70,000 40,000
20X8 220,000 10,000 90,000 40,000
20X9 160,000 40,000 100,000 20,000
Required
a. What net income would Ravine Corporation have reported for each of the years, assuming
Ravine accounts for the intercorporate investment using (1) the cost method and (2) the equity
method?
b. Give all appropriate journal entries for 20X8 that Ravine made under both the cost and the
equity methods.
LO5 E2-7 Investment Value
Port Company purchased 30,000 of the 100,000 outstanding shares of Sund Company common
stock on January 1, 20X2, for $180,000. The purchase price was equal to the book value of the
shares purchased. Sund reported net income of $40,000, $30,000, and $5,000 for 20X2, 20X3, and
20X4, respectively. It paid a dividend of $25,000 in 20X2, but paid no dividends in 20X3 and 20X4.
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98 Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential
Required
Prepare all journal entries on Grandview’s books for 20X9 to account for its investment in
Spinet.
LO5 E2-9 Fair Value Method
Small Company reported 20X7 net income of $40,000 and paid dividends of $15,000 during the
year. Mock Corporation acquired 20 percent of Small’s shares on January 1, 20X7, for $105,000.
At December 31, 20X7, Mock determined the fair value of the shares of Small to be $121,000.
Mock reported operating income of $90,000 for 20X7.
Required
Compute Mock’s net income for 20X7 assuming it uses
a. The cost method in accounting for its investment in Small.
b. The equity method in accounting for its investment in Small.
c. The fair value method in accounting for its investment in Small.
LO4, LO5 E2-10 Fair Value Recognition
Kent Company purchased 35 percent ownership of Lomm Company on January 1, 20X8,
for $140,000. Lomm reported 20X8 net income of $80,000 and paid dividends of $20,000. At
December 31, 20X8, Kent determined the fair value of its investment in Lomm to be $174,000.
Required
Give all journal entries recorded by Kent with respect to its investment in Lomm in 20X8 assuming it uses
a. The equity method.
b. The fair value method.
LO2, LO3 E2-11 * Investee with Preferred Stock Outstanding
Reden Corporation purchased 45 percent of Montgomery Company’s common stock on January 1,
20X9, at underlying book value of $288,000. Montgomery’s balance sheet contained the following
stockholders’ equity balances:
Required
Compute the amounts Port Company should report as the carrying values of its investment in Sund
Company at December 31, 20X2, 20X3, and 20X4.
LO2, LO3 E2-8* Income Reporting
Grandview Company purchased 40 percent of the stock of Spinet Corporation on January 1, 20X8,
at underlying book value. Spinet recorded the following income for 20X9:
Income before Extraordinary Gain $60,000
Extraordinary Gain 30,000
Net Income $90,000
Preferred Stock ($5 par value, 50,000 shares issued and outstanding) $250,000
Common Stock ($1 par value, 150,000 shares issued and outstanding) 150,000
Additional Paid-In Capital 180,000
Retained Earnings 310,000
Total Stockholders’ Equity $890,000
Montgomery’s preferred stock is cumulative and pays a 10 percent annual dividend. Montgomery
reported net income of $95,000 for 20X9 and paid total dividends of $40,000.
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Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential 99
At the date of the business combination, the book values of Faith’s net assets and liabilities
approximated fair value. Assume Faith Corporation’s accumulated depreciation on buildings and
equipment on the acquisition date was $30,000.
Required
Give the journal entries recorded by Reden Corporation for 20X9 related to its investment in
Montgomery Company common stock.
LO2, LO3 E2-12 * Other Comprehensive Income Reported by Investee
Callas Corporation paid $380,000 to acquire 40 percent ownership of Thinbill Company on
January 1, 20X9. The amount paid was equal to underlying book value. During 20X9, Thinbill
reported operating income of $45,000, an increase of $10,000 in the market value of trading securities held for the year, and an increase of $20,000 in the market value of available-for-sale securities held for the year. Thinbill paid dividends of $9,000 on December 10, 20X9.
Required
Give all journal entries that Callas Corporation recorded in 20X9, including closing entries at
December 31, 20X9, associated with its investment in Thinbill Company.
LO2, LO3 E2-13 * Other Comprehensive Income Reported by Investee
Baldwin Corporation purchased 25 percent of Gwin Company’s common stock on January 1,
20X8, at underlying book value. In 20X8, Gwin reported a net loss of $20,000 and paid dividends of $10,000, and in 20X9 the company reported net income of $68,000 and paid dividends of
$16,000. Gwin also purchased marketable securities classified as available-for-sale on February 8,
20X9, and reported an increase of $12,000 in their fair value at December 31, 20X9. Baldwin
reported a balance of $67,000 in its investment in Gwin at December 31, 20X9.
Required
Compute the amount paid by Baldwin Corporation to purchase the shares of Gwin Company.
LO6 E2-14 Basic Elimination Entry
On December 31, 20X3, Broadway Corporation reported common stock outstanding of $200,000,
additional paid-in capital of $300,000, and retained earnings of $100,000. On January 1, 20X4,
Johe Company acquired control of Broadway in a business combination.
Required
Give the eliminating entry that would be needed in preparing a consolidated balance sheet immediately following the combination if Johe acquired all of Broadway’s outstanding common stock
for $600,000.
LO6, LO7 E2-15 Balance Sheet Worksheet
Blank Corporation acquired 100 percent of Faith Corporation’s common stock on December 31,
20X2, for $150,000. Data from the balance sheets of the two companies included the following
amounts as of the date of acquisition:
Item
Blank
Corporation
Faith
Corporation
Cash $ 65,000 $ 18,000
Accounts Receivable 87,000 37,000
Inventory 110,000 60,000
Buildings and Equipment (net) 220,000 150,000
Investment in Faith Corporation Stock 150,000
Total Assets $632,000 $265,000
Accounts Payable $ 92,000 $ 35,000
Notes Payable 150,000 80,000
Common Stock 100,000 60,000
Retained Earnings 290,000 90,000
Total Liabilities and Stockholders’ Equity $632,000 $265,000
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100 Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential
Round reported net income of $80,000 for 20X2 and paid dividends of $25,000.
Required
a. Give the journal entries recorded by Trim Corporation during 20X2 on its books if Trim
accounts for its investment in Round using the equity method.
b. Give the eliminating entries needed at December 31, 20X2, to prepare consolidated financial
statements.
LO3, LO6 E2-17 Basic Consolidation Entries for Fully Owned Subsidiary
Amber Corporation reported the following summarized balance sheet data on December 31, 20X6:
Required
a. Give the eliminating entry or entries needed to prepare a consolidated balance sheet immediately following the business combination.
b. Prepare a consolidated balance sheet worksheet.
LO3, LO6 E2-16 Consolidation Entries for Wholly Owned Subsidiary
Trim Corporation acquired 100 percent of Round Corporation’s voting common stock on January 1,
20X2, for $400,000. At that date, the book values and fair values of Round’s assets and liabilities
were equal. Round reported the following summarized balance sheet data:
Assets $700,000 Accounts Payable $100,000
Bonds Payable 200,000
Common Stock 120,000
Retained Earnings 280,000
Total $700,000 Total $700,000
Assets $600,000 Liabilities $100,000
Common Stock 300,000
Retained Earnings 200,000
Total $600,000 Total $600,000
On January 1, 20X7, Purple Company acquired 100 percent of Amber’s stock for $500,000. At
the acquisition date, the book values and fair values of Amber’s assets and liabilities were equal.
Amber reported net income of $50,000 for 20X7 and paid dividends of $20,000.
Required
a. Give the journal entries recorded by Purple on its books during 20X7 if it accounts for its
investment in Amber using the equity method.
b. Give the eliminating entries needed on December 31, 20X7, to prepare consolidated financial
statements.
Problems
LO2, LO3 P2-18 Retroactive Recognition
Idle Corporation has been acquiring shares of Fast Track Enterprises at book value for the last
several years. Data provided by Fast Track included the following:
20X2 20X3 20X4 20X5
Net Income $40,000 $60,000 $40,000 $50,000
Dividends 20,000 20,000 10,000 20,000
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Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential 101
Required
Determine the amounts reported by Gant as income from its investment in Temp for each year and
the balance in Gant’s investment in Temp at the end of each year assuming Gant uses the following methods in accounting for its investment in Temp:
a. Cost method.
b. Equity method
c. Fair value method.
LO5 P2-20 Fair Value Journal Entries
Marlow Company acquired 40 percent of the voting shares of Brown Company on January 1,
20X8, for $85,000. The following results are reported for Brown Company:
Required
Give the journal entries to be recorded on Idle’s books in 20X5 related to its investment in Fast
Track.
LO5 P2-19 Fair Value Method
Gant Company purchased 20 percent of the outstanding shares of Temp Company for $70,000 on
January 1, 20X6. The following results are reported for Temp Company:
Fast Track declares and pays its annual dividend on November 15 each year. Its net book value on
January 1, 20X2, was $250,000. Idle purchased shares of Fast Track on three occasions:
Date
Percent of Ownership
Purchased
Amount
Paid
January 1, 20X2 10% $25,000
July 1, 20X3 5 15,000
January 1, 20X5 10 34,000
20X6 20X7 20X8
Net income $40,000 $35,000 $60,000
Dividends paid 15,000 30,000 20,000
Fair value of shares held by Gant:
January 1 70,000 89,000 86,000
December 31 89,000 86,000 97,000
20X8 20X9
Net income $20,000 $30,000
Dividends paid 10,000 15,000
Fair value of shares held by Marlow:
January 1 85,000 97,000
December 31 97,000 92,000
Required
Give all journal entries recorded by Marlow for 20X8 and 20X9 assuming it uses the fair value
method in accounting for its investment in Brown.
LO3 P2-21 * Other Comprehensive Income Reported by Investee
Dewey Corporation owns 30 percent of the common stock of Jimm Company, which it purchased at underlying book value on January 1, 20X5. Dewey reported a balance of $245,000
for its investment in Jimm Company on January 1, 20X5, and $276,800 at December 31, 20X5.
During 20X5, Dewey and Jimm Company reported operating income of $340,000 and $70,000,
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102 Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential
Wealthy Manufacturing uses the equity method in accounting for its investment in Diversified
Products. The controller was also aware of the following specific transactions for Diversified
Products in 20X8, which were not included in the preceding data:
1. On June 30, 20X8, Diversified incurred a $5,000 extraordinary loss from a volcanic eruption
near its Greenland facility.
2. Diversified sold its entire Health Technologies division on September 30, 20X8, for $375,000.
The book value of Health Technologies division’s net assets on that date was $331,000. The
division incurred an operating loss of $15,000 in the first nine months of 20X8.
3. On January 1, 20X8, Diversified switched from FIFO inventory costing to the weighted-average
method. Had Diversified always used the weighted-average method, prior years’ income would
have been lower by $20,000.
4. During 20X8, Diversified sold one of its delivery trucks after it was involved in an accident and
recorded a gain of $10,000.
Required
a. Prepare an income statement and retained earnings statement for Diversified Products for
20X8.
b. Prepare an income statement and retained earnings statement for Wealthy Manufacturing for
20X8.
LO3, LO6, P2-23 Consolidated Worksheet at End of the First Year of Ownership (Equity Method)
Peanut Company acquired 100 percent of Snoopy Company’s outstanding common stock for
$300,000 on January 1, 20X8, when the book value of Snoopy’s net assets was equal to $300,000.
Peanut uses the equity method to account for investments. Trial balance data for Peanut and
Snoopy as of December 31, 20X8, are as follows:
respectively. Jimm received dividends from investments in marketable equity securities in the
amount of $7,000 during 20X5. It also reported an increase of $18,000 in the market value of its
portfolio of trading securities and an increase in the value of its portfolio of securities classified as
available-for-sale. Jimm paid dividends of $20,000 in 20X5. Ignore income taxes in determining
your solution.
Required
a. Assuming that Dewey uses the equity method in accounting for its investment in Jimm, compute the amount of income from Jimm recorded by Dewey in 20X5.
b. Compute the amount added to the investment account during 20X5.
c. Compute the amount reported by Jimm as other comprehensive income in 20X5.
d. If all of Jimm’s other comprehensive income arose solely from its investment in available-forsale securities purchased on March 10, 20X5, for $130,000, what was the market value of those
securities at December 31, 20X5?
LO3, LO6 P2-22 * Equity-Method Income Statement
Wealthy Manufacturing Company purchased 40 percent of the voting shares of Diversified Products Corporation on March 23, 20X4. On December 31, 20X8, Wealthy Manufacturing’s controller attempted to prepare income statements and retained earnings statements for the two companies
using the following summarized 20X8 data:
Wealthy
Manufacturing
Diversifi ed
Products
Net Sales $850,000 $400,000
Cost of Goods Sold 670,000 320,000
Other Expenses 90,000 25,000
Dividends Paid 30,000 10,000
Retained Earnings, 1/1/X8 420,000 260,000
LO7
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Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential 103
Required
a. Prepare the journal entries on Peanut’s books for the acquisition of Snoopy on January 1, 20X8,
as well as any normal equity method entry(ies) related to the investment in Snoopy Company
during 20X8.
b. Prepare a consolidation worksheet for 20X8 in good form.
LO3, LO6, P2-24 Consolidated Worksheet at End of the Second Year of Ownership (Equity Method)
Peanut Company acquired 100 percent of Snoopy Company’s outstanding common stock for
$300,000 on January 1, 20X8, when the book value of Snoopy’s net assets was equal to $300,000.
Problem 2-23 summarizes the first year of Peanut’s ownership of Snoopy. Peanut uses the equity
method to account for investments. The following trial balance summarizes the financial position
and operations for Peanut and Snoopy as of December 31, 20X9:
Peanut Company Snoopy Company
Debit Credit Debit Credit
Cash $ 130,000 $ 80,000
Accounts Receivable 165,000 65,000
Inventory 200,000 75,000
Investment in Snoopy Stock 355,000 0
Land 200,000 100,000
Buildings and Equipment 700,000 200,000
Cost of Goods Sold 200,000 125,000
Depreciation Expense 50,000 10,000
Selling & Administrative
Expense
225,000 40,000
Dividends Declared 100,000 20,000
Accumulated Depreciation $ 450,000 $ 20,000
Accounts Payable 75,000 60,000
Bonds Payable 200,000 85,000
Common Stock 500,000 200,000
Retained Earnings 225,000 100,000
Sales 800,000 250,000
Income from Snoopy 75,000 0
Total $2,325,000 $2,325,000 $715,000 $715,000
Peanut Company Snoopy Company
Debit Credit Debit Credit
Cash $ 230,000 $ 75,000
Accounts Receivable 190,000 80,000
Inventory 180,000 100,000
Investment in Snoopy Stock 405,000 0
Land 200,000 100,000
Buildings and Equipment 700,000 200,000
Cost of Goods Sold 270,000 150,000
Depreciation Expense 50,000 10,000
Selling & Administrative Expense 230,000 60,000
Dividends Declared 225,000 30,000
Accumulated Depreciation $ 500,000 $ 30,000
Accounts Payable 75,000 35,000
Bonds Payable 150,000 85,000
Common Stock 500,000 200,000
Retained Earnings 525,000 155,000
Sales 850,000 300,000
Income from Snoopy 80,000 0
Total $2,680,000 $2,680,000 $805,000 $805,000
LO7
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104 Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential
Required
a. Prepare the journal entries on Paper’s books for the acquisition of Scissor on January 1, 20X8
as well as any normal equity method entry(ies) related to the investment in Scissor Company
during 20X8.
b. Prepare a consolidation worksheet for 20X8 in good form.
LO3, LO6, P2-26 Consolidated Worksheet at End of the Second Year of Ownership
(Equity Method)
Paper Company acquired 100 percent of Scissor Company’s outstanding common stock for
$370,000 on January 1, 20X8, when the book value of Scissor’s net assets was equal to $370,000.
Problem 2-25 summarizes the first year of Paper’s ownership of Scissor. Paper uses the equity
method to account for investments. The following trial balance summarizes the financial position
and operations for Paper and Scissor as of December 31, 20X9:
Required
a. Prepare any equity method journal entry(ies) related to the investment in Snoopy Company
during 20X9.
b. Prepare a consolidation worksheet for 20X9 in good form.
LO3, LO6, P2-25 Consolidated Worksheet at End of the First Year of Ownership (Equity Method)
Paper Company acquired 100 percent of Scissor Company’s outstanding common stock for
$370,000 on January 1, 20X8, when the book value of Scissor’s net assets was equal to $370,000.
Paper uses the equity method to account for investments. Trial balance data for Paper and Scissor
as of December 31, 20X8, are as follows:
Paper Company Scissor Company
Debit Credit Debit Credit
Cash $ 122,000 $ 46,000
Accounts Receivable 140,000 60,000
Inventory 190,000 120,000
Investment in Scissor Stock 438,000 0
Land 250,000 125,000
Buildings and Equipment 875,000 250,000
Cost of Goods Sold 250,000 155,000
Depreciation Expense 65,000 12,000
Selling & Administrative Expense 280,000 50,000
Dividends Declared 80,000 25,000
Accumulated Depreciation $ 565,000 $ 36,000
Accounts Payable 77,000 27,000
Bonds Payable 250,000 100,000
Common Stock 625,000 250,000
Retained Earnings 280,000 120,000
Sales 800,000 310,000
Income from Scissor 93,000 0
Total $2,690,000 $2,690,000 $843,000 $843,000
LO7
LO7
Paper Company Scissor Company
Debit Credit Debit Credit
Cash $232,000 $116,000
Accounts Receivable 165,000 97,000
Inventory 193,000 115,000
Investment in Scissor Stock 515,000 0
Land 250,000 125,000
Buildings and Equipment 875,000 250,000
(continued)
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Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential 105
Required
a. Prepare any equity method journal entry(ies) related to the investment in Scissor Company during 20X9.
b. Prepare a consolidation worksheet for 20X9 in good form.
LO2, LO6, P2-27 * Consolidated Worksheet at End of the First Year of Ownership (Cost Method)
Peanut Company acquired 100 percent of Snoopy Company’s outstanding common stock for
$300,000 on January 1, 20X8, when the book value of Snoopy’s net assets was equal to $300,000.
Peanut uses the cost method to account for investments. Trial balance data for Peanut and Snoopy
as of December 31, 20X8, are as follows:
Peanut Company Snoopy Company
Debit Credit Debit Credit
Cash $ 130,000 $ 80,000
Accounts Receivable 165,000 65,000
Inventory 200,000 75,000
Investment in Snoopy Stock 300,000 0
Land 200,000 100,000
Buildings and Equipment 700,000 200,000
Cost of Goods Sold 200,000 125,000
Depreciation Expense 50,000 10,000
Selling & Administrative Expense 225,000 40,000
Dividends Declared 100,000 20,000
Accumulated Depreciation $ 450,000 $ 20,000
Accounts Payable 75,000 60,000
Bonds Payable 200,000 85,000
Common Stock 500,000 200,000
Retained Earnings 225,000 100,000
Sales 800,000 250,000
Dividend Income 20,000 0
Total $2,270,000 $2,270,000 $715,000 $715,000
Cost of Goods Sold $ 278,000 $178,000
Depreciation Expense 65,000 12,000
Selling & Administrative Expense 312,000 58,000
Dividends Declared 90,000 30,000
Accumulated Depreciation $ 630,000 $ 48,000
Accounts Payable 85,000 40,000
Bonds Payable 150,000 100,000
Common Stock 625,000 250,000
Retained Earnings 498,000 188,000
Sales 880,000 355,000
Income from Scissor 107,000 0
Total $2,975,000 $2,975,000 $981,000 $981,000
Required
a. Prepare the journal entries on Peanut’s books for the acquisition of Snoopy on January 1, 20X8
as well as any normal cost method entry(ies) related to the investment in Snoopy Company during 20X8.
b. Prepare a consolidation worksheet for 20X8 in good form.
LO2, LO6, P2-28 * Consolidated Worksheet at End of the Second Year of Ownership
(Cost Method)
Peanut Company acquired 100 percent of Snoopy Company’s outstanding common stock for
$300,000 on January 1, 20X8, when the book value of Snoopy’s net assets was equal to $300,000.
LO7
LO7
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106 Chapter 2 Reporting Intercorporate Investments and Consolidation of Wholly Owned Subsidiaries with No Differential
Problem 2-25 summarizes the first year of Peanut’s ownership of Snoopy. Peanut uses the cost
method to account for investments. The following trial balance summarizes the financial position
and operations for Peanut and Snoopy as of December 31, 20X9:
Peanut Company Snoopy Company
Debit Credit Debit Credit
Cash $ 230,000 $ 75,000
Accounts Receivable 190,000 80,000
Inventory 180,000 100,000
Investment in Snoopy Stock 300,000 0
Land 200,000 100,000
Buildings and Equipment 700,000 200,000
Cost of Goods Sold 270,000 150,000
Depreciation Expense 50,000 10,000
Selling & Administrative Expense 230,000 60,000
Dividends Declared 225,000 30,000
Accumulated Depreciation $ 500,000 $ 30,000
Accounts Payable 75,000 35,000
Bonds Payable 150,000 85,000
Common Stock 500,000 200,000
Retained Earnings 470,000 155,000
Sales 850,000 300,000
Dividend Income 30,000 0
Total $2,575,000 $2,575,000 $805,000 $805,000
Required
a. Prepare any cost method journal entry(ies) related to the investment in Snoopy Company during 20X9.
b. Prepare a consolidation worksheet for 20X9 in good form.
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107
The Reporting Entity
and Consolidation of
Less-than-WhollyOwned Subsidiaries with
No Differential
THE COLLAPSE OF ENRON AND THE BIRTH OF A NEW
PARADIGM
In February 2001 Fortune magazine named Enron the most innovative company in
America for the sixth year in a row. Ten months later on December 2, 2001, Enron filed
for bankruptcy, making it, at that time, the largest bankruptcy in history. What was the
cause of this drastic turnaround? Did Enron just throw in the towel after six years of
“innovation” and decide to call it quits? Sadly, this was not the case; something much
more serious caused Enron’s historic fall.
Enron came into being in 1985 when InterNorth acquired Houston Natural Gas. Originally, the company was headquarted in Omaha, but shortly after Kenneth Lay took over
as CEO of the company, he moved its headquarters to Houston. Enron was originally
in the business of transmitting electricity and natural gas throughout the United States,
which it accomplished through its extensive network of pipelines and power plants.
These types of services made up the bulk of Enron’s revenues until management decided
to branch out. In 1990, Enron began to serve as an intermediary for gas contracts.
Energy and gas prices have traditionally been extremely volatile. Companies didn’t
want to sign long-term contracts because of the large fluctuations in these prices. Enron
would buy 30-day gas contracts from a variety of suppliers and then bundle these contracts to offer long-term prices to local utility companies. Basically, Enron accepted the
price risk in exchange for a fee. Over time, the wholesale trading of energy contracts
became an increasingly important part of Enron’s business, as illustrated in the figure on
the next page. For the 2000 fiscal year, Enron reported revenues of $93 billion from these
“wholesale” activities and only $2.7 billion from its traditional piping business.
Even with these extreme revenues, Enron was forced to file for bankruptcy at the end
of 2001. How did this happen? Enron used two clever accounting tricks to inflate its
performance. First, managers used Special Purpose Entities (SPEs) to hide losses and
move liabilities and impaired assets off Enron’s books. We discuss SPEs in detail in this
chapter. Second, they “grossed” up their revenues to make their performance look better
than it actually was. That is, Enron reported the total value of the trades it facilitated not
just its fee for its wholesale services.
Chapter Three
Business
Combinations
Consolidation Concepts
and Procedures
Intercompany Transfers
Multinational
Entities
Multi-Corporate
Entities
Partnerships
Governmental
Entities
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108 Chapter 3 The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential
As a result of Enron’s bankruptcy and the demise of its auditor, Arthur Andersen,
over 100,000 jobs were lost (85,000 from Enron and 22,000 from Arthur Andersen),
along with billions of dollars of investors’ money. Accounting policies can have a significant influence on the economy. As Enron showed, careful manipulation of even a
few simple rules can have catastrophic effects on individuals and the global economy.
This chapter introduces new accounting rules for determining when a business entity
must be consolidated that resulted from this and other accounting scandals. It also
explores how the basic consolidation process differs when a subsidiary is only partially
owned.
LEARNING OBJECTIVES
When you finish studying this chapter, you should be able to:
LO1 Understand and explain the usefulness and limitations of consolidated
financial statements.
LO2 Understand and explain how direct and indirect control influence the
consolidation of a subsidiary.
LO3 Understand and explain rules related to the consolidation of variable interest
entities.
LO4 Understand and explain differences in consolidation rules under U.S. GAAP
and IFRS.
LO5 Understand and explain differences in the consolidation process when the
subsidiary is not wholly owned.
LO6 Understand and explain the differences in theories of consolidation.
LO7 Make calculations and prepare basic elimination entries for the consolidation
of a less-than-wholly-owned subsidiary.
LO8 Prepare a consolidation worksheet for a less-than-wholly-owned
consolidation.
Wholesale
Traditional Piping
Enron’s Revenues 1993–2000
$-
$10,000.00
$20,000.00
$30,000.00
$40,000.00
$50,000.00
$60,000.00
$70,000.00
$80,000.00
$90,000.00
$100,000.00
Dollars (in millions)
1993 1994 1995 1996 1997 1998 1999 2000
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Chapter 3 The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential 109
THE USEFULNESS OF CONSOLIDATED FINANCIAL STATEMENTS
Chapter 2 introduced an example of a basic consolidation. We now provide more background. Consolidated financial statements are presented primarily for those parties
having a long-run interest in the parent company, including the parent’s shareholders,
creditors, and other resource providers. Consolidated statements often provide the only
means of obtaining a clear picture of the total resources of the combined entity that are
under the parent’s control and the results of employing those resources. Especially when
the number of related companies is substantial, consolidated statements may provide the
only means of conveniently summarizing the vast amount of information relating to the
individual companies and how the positions and operations of the individual companies
affect the overall consolidated entity.
Current and prospective stockholders of the parent company are usually more interested in the consolidated financial statements than those of the individual companies
because the well-being of the parent company is affected by its subsidiaries’ operations.
When subsidiaries are profitable, profits accrue to the parent. However, the parent cannot
escape the ill effects of unprofitable subsidiaries. By examining the consolidated statements, owners and potential owners are better able to assess how effectively management
employs all the resources under its control.
The parent’s long-term creditors also find the consolidated statements useful because
the effects of subsidiary operations on the overall health and future of the parent are relevant to their decisions. In addition, although the parent and its subsidiaries are separate
companies, the parent’s creditors have an indirect claim on the subsidiaries’ assets. The
parent’s short-term creditors, however, even though they also have an indirect claim on
the subsidiaries’ assets, are usually more interested in the parent’s immediate solvency
rather than its long-term profitability. Accordingly, they tend to rely more on the parent’s
separate financial statements, especially the balance sheet.
The parent company’s management has a continuing need for current information
both about the combined operations of the consolidated entity and about the individual
companies forming the consolidated entity. For example, individual subsidiaries might
have substantial volatility in their operations, and not until operating results and balance
sheets are combined can the manager understand the overall impact of the activities for
the period. On the other hand, information about individual companies within the consolidated entity also may be useful. For example, it may allow a manager to offset a cash
shortfall in one subsidiary with excess cash from another without resorting to costly outside borrowing. The parent company’s management may be particularly concerned with
the consolidated financial statements because top management generally is evaluated,
and sometimes compensated, based on the overall performance of the entity as reflected
in the consolidated statements.
The creditors and any outside stockholders of subsidiaries generally are most interested in the separate financial statements of those subsidiaries. Subsidiary resource providers have no claim on the parent company unless the parent has provided guarantees or
entered into other arrangements for the benefit of the subsidiaries.
LIMITATIONS OF CONSOLIDATED FINANCIAL STATEMENTS
While consolidated financial statements are useful, their limitations also must be kept in
mind. Some information is lost any time data sets are aggregated; this is particularly true
when the information involves an aggregation across companies that have substantially
different operating characteristics. Some of the more important limitations of consolidated financial statements are as follows:
1. Because the operating results and financial position of individual companies included
in the consolidation are not disclosed, the poor performance or position of one or more
companies may be hidden by the good performance and position of others.
LO1
Understand and explain the
usefulness and limitations
of consolidated financial
statements.
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110 Chapter 3 The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential
2. Not all the consolidated retained earnings balance is necessarily available for dividends of the parent because a portion may represent the parent’s share of undistributed subsidiary earnings. Similarly, because the consolidated statements include the
subsidiary’s assets, not all assets shown are available for dividend distributions of the
parent company.
3. Because financial ratios based on the consolidated statements are calculated on aggregated information, they are not necessarily representative of any single company in
the consolidation, including the parent.
4. Similar accounts of different companies that are combined in the consolidation may
not be entirely comparable. For example, the length of operating cycles of different
companies may vary, causing receivables of similar length to be classified differently.
5. Additional information about individual companies or groups of companies included
in the consolidation often is necessary for a fair presentation; such additional disclosures may require voluminous footnotes.
SUBSIDIARY FINANCIAL STATEMENTS
Some financial statement users may be interested in the separate financial statements of
individual subsidiaries, either instead of or in addition to consolidated financial statements.
While the parent company’s management is concerned with the entire consolidated entity
as well as individual subsidiaries, the creditors, preferred stockholders, and noncontrolling
common stockholders of subsidiary companies are most interested in the separate financial statements of the subsidiaries in which they have an interest. Because subsidiaries are
legally separate from their parents, a subsidiary’s creditors and stockholders generally have
no claim on the parent and the subsidiary’s stockholders do not share in the parent’s profits. Therefore, consolidated financial statements usually are of little use to those interested
in obtaining information about the assets, capital, or income of individual subsidiaries.
CONSOLIDATED FINANCIAL STATEMENTS: CONCEPTS AND STANDARDS
Consolidated financial statements are intended to provide a meaningful representation
of the overall position and activities of a single economic entity comprising a number of
related companies. Current consolidation standards have been established by Accounting
Research Bulletin No. 51 (ASC 810), “Consolidated Financial Statements” (ARB 51), 1
issued in 1959; FASB Statement No. 94 (ASC 840 and 810), “Consolidation of All
Majority-Owned Subsidiaries” (FASB 94), 2
issued in 1987; and FASB Statement No.
160 (ASC 810), “Noncontrolling Interests in Consolidated Financial Statements, an
amendment of ARB No. 51 (ASC 810)” (FASB 160, ASC 810), 3
issued in 2007. 4
Under
current standards, subsidiaries must be consolidated unless the parent is precluded from
exercising control. When it is not appropriate to consolidate a subsidiary, it is reported as
an intercorporate investment.
Traditional View of Control
Over the years, the single most important criterion for determining when an individual
subsidiary should be consolidated has been that of control. ARB 51 (ASC 810) indicates
LO2
Understand and explain
how direct and indirect control influence the consolidation of a subsidiary.
1
Accounting Research Bulletin No. 51(ASC 810), “Consolidated Financial Statements,” Committee on
Accounting Procedure, American Institute of Certified Public Accountants, August 1959.
2
Financial Accounting Standards Board Statement No. 94 (ASC 840 and 810), “Consolidation of All
Majority-Owned Subsidiaries,” October 1987.
3
Financial Accounting Standards Board Statement No. 160 (ASC 810), “Noncontrolling Interests in
Consolidated Financial Statements, an amendment of ARB No. 51 (ASC 810),” December 2007.
4
FASB 141R (ASC 805), “Business Combinations,” does not deal directly with consolidation standards, but
many of its requirements have a significant impact on consolidated financial statements.
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Chapter 3 The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential 111
that consolidated financial statements normally are appropriate for a group of companies when one company “has a controlling financial interest in the other companies.” It
also states that “the usual condition for a controlling financial interest is ownership of a
majority voting interest. . . .” In practice, control has been determined by the proportion
of voting shares of a company’s stock owned directly or indirectly by another company.
This criterion was formalized by FASB 94 (ASC 840 and 810), which requires consolidation of all majority-owned subsidiaries unless the parent is unable to exercise control.
Although majority ownership is the most common means of acquiring control, a company may be able to direct the operating and financing policies of another with less than
majority ownership, such as when the remainder of the stock is widely held. FASB 94
(ASC 840 and 810) does not preclude consolidation with less than majority ownership,
but such consolidations have seldom been found in practice. More directly, FASB 141R
(ASC 805) indicates that control can be obtained without majority ownership of a company’s common stock.
Indirect Control 5
The traditional view of control includes both direct and indirect control. Direct control
typically occurs when one company owns a majority of another company’s common stock.
Indirect control or pyramiding occurs when a company’s common stock is owned by one
or more other companies that are all under common control. In each of the following examples, P Company controls Z Company. However, in each case, P Company does not own a
direct interest in Z. Instead, P controls Z indirectly through ownership of other companies.
(1) (2) (3)
PP P
X
Z
0.60
0.80
X Y
Z
0.40
0.90
0.30
0.70
X
Z
W Y
0.80
0.30 0.15 0.15
0.90 0.80
In (1), P owns 80 percent of X, which owns 60 percent of Z. Since P controls X and X
controls Z, P indirectly controls Z. In (2), P owns 90 percent of X and 70 percent of Y;
X owns 40 percent of Z; Y owns 30 percent of Z. Since P controls both X and Y and they,
in turn, jointly control Z (with a combined ownership of 70 percent), P effectively controls Z through its two subsidiaries. In (3), P owns 90 percent of X and 80 percent of Y;
X owns 80 percent of W and 30 percent of Z; Y owns 15 percent of Z; W owns 15 percent
of Z. Since P controls both X and Y and they, in turn, jointly control Z (with a combined
control of 60 percent—15 percent of which comes through X’s subsidiary W), P effectively controls Z through its two subsidiaries. In each case, P controls Z either solely or in
conjunction with other entities. As a result, P controls Z through its subsidiaries.
Ability to Exercise Control
Under certain circumstances, a subsidiary’s majority stockholders may not be able to
exercise control even though they hold more than 50 percent of its outstanding voting
stock. This might occur, for instance, if the subsidiary was in legal reorganization or in
bankruptcy; while the parent might hold majority ownership, control would rest with
5 To view a video explanationof this topic, visit advancedstudyguide.com.
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112 Chapter 3 The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential
the courts or a court-appointed trustee. Similarly, if the subsidiary were located in a foreign country and that country had placed restrictions on the subsidiary that prevented
the remittance of profits or assets back to the parent company, consolidation of that subsidiary would not be appropriate because of the parent’s inability to control important
aspects of the subsidiary’s operations.
Differences in Fiscal Periods
A difference in the fiscal periods of a parent and subsidiary should not preclude consolidation of that subsidiary. Often the subsidiary’s fiscal period, if different from the
parent’s, is changed to coincide with that of the parent. Another alternative is to adjust
the financial statement data of the subsidiary each period to place the data on a basis consistent with the fiscal period of the parent. Both the Securities and Exchange Commission and current accounting standards permit the consolidation of a subsidiary’s financial
statements without adjusting the fiscal period of the subsidiary if that period does not differ from the parent’s by more than three months and if recognition is given to intervening
events that have a material effect on financial position or results of operations.
Changing Concept of the Reporting Entity
For nearly three decades, ARB 51 (ASC 810) served without significant revision as
the primary source of consolidation policy. Over those years, many changes occurred
in the business environment, including widespread diversification of companies and the
increased emphasis on financial services by manufacturing and merchandising companies such as General Electric and Harley-Davidson.
In addition, the criteria used in determining whether to consolidate specific subsidiaries were subject to varying interpretations. Companies exercised great latitude in selecting which subsidiaries to consolidate and which to report as intercorporate investments.
The lack of consistency in consolidation policy became of increasing concern as many
manufacturing and merchandising companies engaged in “off-balance sheet financing”
by borrowing heavily through finance subsidiaries and then excluding those subsidiaries
from consolidation.
In 1982, the FASB began a project aimed at developing a comprehensive consolidation policy. In 1987, FASB 94 (ASC 840 and 810), requiring consolidation of all
majority-owned subsidiaries, was issued to eliminate the inconsistencies found in practice until a more comprehensive standard could be issued. Unfortunately, the issues have
been more difficult to resolve than anticipated. After grappling with these issues for more
than two decades, the FASB has still been unable to provide a comprehensive consolidation policy.
Completion of the FASB’s consolidation project has been hampered by, among other
things, the inability to resolve issues related to two important concepts: (1) control and
(2) the reporting entity. Regarding the first issue, the FASB has been attempting to move
beyond the traditional notion of control based on majority ownership of common stock to
requiring consolidation of entities under effective control. This idea reflects the ability to
direct the policies of another entity even though majority ownership is lacking. Adopting
the concept of effective control can lead to the consolidation of companies in which little,
or even no, ownership is held and to the consolidation of entities other than corporations,
such as partnerships and trusts. Although the FASB has indicated in its new standard on
business combinations, FASB 141R (ASC 805), that control can be achieved without
majority ownership, a comprehensive consolidation policy has yet to be achieved.
With respect to the second issue, defining the accounting entity would go a long way
toward resolving the issue of when to prepare consolidated financial statements and
what entities should be included. Unfortunately, the FASB has found both the entity
and control issues so complex that they are not easily resolved and require further study.
Accordingly, the FASB issued FASB 160 (ASC 810), which deals only with selected
issues related to consolidated financial statements, leaving a comprehensive consolidation policy until a later time.
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SPECIAL-PURPOSE AND VARIABLE INTEREST ENTITIES
While consolidation standards pertaining to related corporations have at times lacked
clarity and needed updating, consolidation standards relating to partnerships or other
types of entities such as trusts have been virtually nonexistent. Even corporate consolidation standards have not been adequate in situations in which other relationships such as
guarantees and operating agreements overshadow the lack of a significant ownership element. As a result, companies such as Enron have taken advantage of the lack of standards
to avoid reporting debt or losses by hiding them in special entities that were not consolidated. Although many companies have used special entities for legitimate purposes,
financial reporting has not always captured the economic substance of the relationships.
Only in the past few years have consolidation standards for these special entities started
to provide some uniformity in the financial reporting for corporations having relationships with such entities.
ARB 51 (ASC 810) establishes consolidation standards in terms of one company
controlling another and set majority voting interest as the usual condition leading to
consolidation. Similarly, FASB 94 (ASC 840 and 810) requires consolidation for
majority-owned subsidiaries. In recent years, however, new types of relationships have
been established between corporations and other entities that often are difficult to characterize in terms of voting, controlling, or ownership interests. Such entities often are
structured to provide financing and/or control through forms other than those used by
traditional operating companies. Some entities have no governing boards, or they may
have boards or managers with only a limited ability to direct the entity’s activities. Such
entities may be governed instead by their incorporation or partnership documents, or by
other agreements or documents. Some entities may have little equity investment, and the
equity investors may have little or no control over the entity. For these special types of
entities, ARB 51 (ASC 810) does not provide a clear basis for consolidation.
These special types of entities have generally been referred to as special-purpose
entities (SPEs). In general, SPEs are corporations, trusts, or partnerships created for a
single specified purpose. They usually have no substantive operations and are used only
for financing purposes. SPEs have been used for several decades for asset securitization, risk sharing, and taking advantage of tax statutes. Prior to 2003, no comprehensive
reporting framework had been established for SPEs. Several different pronouncements
from various bodies dealt with selected issues or types of SPEs, but the guidance provided by these issuances was incomplete, vague, and not always correctly interpreted in
practice.
Off-Balance Sheet Financing
Imagine that Genergy, Inc., needs $1 billion to finance building a gas pipeline in central Asia. Potential investors may want their risk/reward exposure limited to the pipeline
without other aspects of Genergy’s business. They might also want the pipeline to be
a self-supporting independent entity with cash flows that are separate from Genergy’s
other business activities, and they may want to eliminate the possibility that Genergy
will sell the pipeline. These objectives might be achieved by forming an SPE or what
the FASB refers to as a variable interest entity (VIE), with a charter that specifies these
limited operating activities.
Once the VIE is established, the pipeline assets and the debt used to finance the pipeline may, under certain circumstances, be excluded from Genergy’s balance sheet. In
this manner, Genergy has achieved off-balance sheet financing of the pipeline. As long
as the VIE is not consolidated, Genergy’s financial statements will not reflect the assets,
liabilities, cash flows, revenues, and expenses associated with owning and operating the
pipeline. Further, any transactions between Genergy and the pipeline entity are not eliminated in preparing Genergy’s financial statements.
Some estimates suggest that well over half of American companies use some type of
off-balance sheet financing, involving perhaps trillions of dollars. These transactions are
LO3
Understand and explain
rules related to the consolidation of variable interest
entities.
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114 Chapter 3 The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential
often facilitated by the use of some type of special entity, such as a VIE. There is concern
that VIEs can be motivated either by a genuine business purpose, such as risk sharing
among investors and isolation of project risk from company risk, or by a desire to meet
specific financial reporting goals that may or may not be supported by the underlying
economic substance of the transactions.
Companies might prefer to keep debt and the related assets financed by that debt off
the balance sheet for a number of reasons, but the main one often has to do with making
the company appear better to investors. One effect is to reduce the company’s leverage and debt/equity ratios. Net income also may be increased as neither the interest on
the debt nor the depreciation on the related assets is included in expenses. Further, the
smaller asset base, because the assets are not shown on the balance sheet, combined with
the higher net income produces a higher calculated return on assets.
Several means of keeping debt and related assets off a company’s balance sheet have
become common in practice. A company may lease assets from a third party such as a
VIE, which borrows the money to buy the assets. Careful engineering of the lease terms
so that it qualifies for treatment as an operating rather than a capital lease avoids recognition of the asset and lease obligation. Another possibility is for a company to sell assets
such as accounts receivable outright rather than borrowing against them. A third option
found with increasing frequency is for a company to create a new VIE and transfer both
assets and liabilities to it. Not only does this allow the sponsoring corporation to remove
the asset and related debt from its balance sheet, but the company also may be able to
recognize a gain on the disposal of the asset.
Complex organizational structures increase the need for accounting standards aimed at
ensuring that financial statements reflect the economic substance of those structures and
the related transactions. However, the very complexity of these organizational structures
makes the development of these standards a challenging endeavor.
Variable Interest Entities
In January 2003, the FASB issued FASB Interpretation No. 46 (ASC 810), “ Consolidation of Variable Interest Entities,an interpretation of ARB No. 51 (ASC 810),” with
a revised version issued in December 2003 (FIN 46R, ASC 810).6
For clarification, the
interpretation uses the term variable interest entities to encompass SPEs and any other
entities falling within its conditions.
A variable interest entity (VIE) is a legal structure used for business purposes, usually
a corporation, trust, or partnership, that either (1) does not have equity investors that have
voting rights and share in all of the entity’s profits and losses or (2) has equity investors that do not provide sufficient financial resources to support the entity’s activities.
In a variable interest entity, specific agreements may limit the extent to which the equity
investors, if any, share in the entity’s profits or losses, and the agreements may limit the
control that equity investors have over the entity’s activities. For the equity investment to
be considered sufficient financial support for the entity’s activities (condition 2), it must
be able to absorb the entity’s expected future losses. A total equity investment that is less
than 10 percent of the entity’s total assets is, in general, considered to be insufficient by
itself to allow the entity to finance its activities, and an investment of more than 10 percent might be needed, depending on the circumstances.
A typical variable interest entity might be created (or sponsored) by a corporation for
a particular purpose, such as purchasing the sponsoring company’s receivables or leasing facilities to the sponsoring company. The sponsoring company may acquire little
or no stock in the VIE. Instead, the sponsoring company may enlist another party to
purchase most or all of the common stock. The majority of the VIE’s capital, however,
normally comes from borrowing. Because lenders may be reluctant to lend (at least at
reasonable interest rates) to an entity with only a small amount of equity, the sponsoring
6 Financial Accounting Standards Board Interpretation No. 46 (ASC 810) (revised December 2003),
“Consolidation of Variable Interest Entities, an interpretation of ARB No. 51 (ASC 810),” December 2003.
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company often guarantees the VIE’s loans. Thus, the sponsoring company may have
little or no equity investment in the VIE, but the loan guarantees represent a type of
interest in the VIE.
A corporation having an interest in a VIE cannot simply rely on its percentage stock
ownership, if any, to determine whether to consolidate the entity. Instead each party having a variable interest in the VIE must determine the extent to which it shares in the VIE’s
expected profits and losses. FIN 46R (ASC 810, para. 2c) defines a variable interest in
a VIE as a contractual, ownership (with or without voting rights), or other money-related
interest in an entity that changes with changes in the fair value of the entity’s net assets
exclusive of variable interests. In other words, variable interests increase with the VIE’s
profits and decrease with its losses. The VIE’s variable interests will absorb portions of
the losses, if they occur, or receive portions of the residual returns.
There are several different types of variable interests, some of which can be summarized as follows:
Type of Interest Variable Interest?
Common stock, with no special features or provisions Yes
Common stock, with loss protection or other provisions Maybe
Senior debt Usually not
Subordinated debt Yes
Loan or asset guarantees Yes
Common stock that places the owners’ investment at risk is a variable interest. In
some cases, certain common stock may have, by agreement, special provisions that
protect the investor against losses or provide a fixed return. These special types of
shares may not involve significant risk on the part of the investor and might, depending on the provisions, result in an interest that is not a variable interest. Senior debt
usually carries a fixed return and is protected against loss by subordinated interests.
Subordinated debt represents a variable interest because, if the entity’s cash flows
are insufficient to pay off the subordinated debt, the holders of that debt will sustain
losses. They do not have the same protection against loss that holders of the senior
debt have. Parties that guarantee the value of assets or liabilities can sustain losses
if they are called on to make good on their guarantees, and, therefore, the guarantees
represent variable interests.
The nature of each party’s variable interest determines whether consolidation by that
party is appropriate. An enterprise that will absorb a majority of the VIE’s expected
losses, receive a majority of the VIE’s expected residual returns, or both, is called the
primary beneficiary of the variable interest entity. The primary beneficiary must consolidate the VIE. If the entity’s profits and losses are divided differently, the enterprise
absorbing a majority of the losses will consolidate the VIE.
As an example of the financial reporting determinations of parties with an interest in a
VIE, suppose that Young Company and Zebra Corporation, both financially stable companies, create YZ Corporation to lease equipment to Young and other companies. Zebra
purchases all of YZ’s common stock. Young guarantees Zebra a 7 percent dividend on
its stock, agrees to absorb all of YZ’s losses, and guarantees fixed-rate bank loans that
are made to YZ. All profits in excess of the 7 percent payout to Zebra are split evenly
between Young and Zebra.
In this case, the bank loans are not variable interests because they carry a fixed interest
rate and are guaranteed by Young, a company capable of honoring the guarantee. Common stock of a VIE is a variable interest if the investment is at risk. In this case, Zebra’s
investment is not at risk, but it does share in the profits of YZ, and the amount of profits
is not fixed. Therefore, the common stock is a variable interest. However, Zebra will not
consolidate YZ because Zebra does not share in the losses, all of which Young will bear.
Young would consolidate YZ because Young’s guarantees represent a variable interest
and it will absorb a majority (all) of the losses.
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116 Chapter 3 The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential
If consolidation of a VIE is appropriate, the amounts to be consolidated with those of
the primary beneficiary are based on fair values at the date the enterprise first becomes the
primary beneficiary. However, assets and liabilities transferred to a VIE by its primary
beneficiary are valued at their book values, with no gain or loss recognized on the transfer. Subsequent to the initial determination of consolidation values, a VIE is accounted
for in consolidated financial statements in accordance with ARB 51 (ASC 810) in the
same manner as if it were consolidated based on voting interests. Intercompany balances
and transactions are eliminated so the resulting consolidated financial statements appear
as if there were just a single entity. These procedures are consistent with those used when
consolidating parent and subsidiary corporations. Appendix 3A at the end of the chapter
presents a simple illustration of the consolidation of a VIE.
IFRS Differences in Determining Control of VIEs and SPEs
Although rules under international financial reporting standards (IFRS) for consolidation
are generally very similar to those under U.S. GAAP, there are some important differences. The SEC’s February 2010 working plan toward convergence in global accounting
standards suggests that U.S. registrants could potentially be required to begin reporting under IFRS as early as 2015 or 2016. Therefore, understanding these differences is
very important because students beginning their careers in the accounting profession will
likely face this transition in the near future. In the meantime, the FASB and the IASB
are working toward convergence of differences in existing rules within the consolidation area with an exposure draft on consolidation expected in the second quarter of 2010.
While the proposed standard will remove many of these differences related to VIEs and
SPEs, there are differences under the current standards. Figure 3–1 provides a summary
of the main differences.
NONCONTROLLING INTEREST
A parent company does not always own 100 percent of a subsidiary’s outstanding common stock. The parent may have acquired less than 100 percent of a company’s stock in
a business combination, or it may originally have held 100 percent but sold or awarded
some shares to others. For the parent to consolidate the subsidiary, only a controlling
interest is needed. Those shareholders of the subsidiary other than the parent are referred
to as “noncontrolling” or “minority” shareholders. The claim of these shareholders on the
income and net assets of the subsidiary is referred to as the noncontrolling interest or
the minority interest. Throughout this chapter and in subsequent chapters, whenever the
acquired company is less-than-wholly-owned, we will frequently refer to the noncontrolling interest shareholders as the “NCI shareholders.” The NCI shareholders clearly have
a claim on the subsidiary’s assets and earnings through their stock ownership. Because
100 percent of a subsidiary’s assets, liabilities, and earnings is included in the consolidated financial statements, regardless of the parent’s percentage ownership, the NCI
shareholders’ claim on these items must be reported.
Computation of Noncontrolling Interest
In uncomplicated situations, the noncontrolling interest’s share of consolidated net
income is a simple proportionate share of the subsidiary’s net income. For example, if a
subsidiary has net income of $150,000 and the NCI shareholders own 10 percent of the
subsidiary’s common stock, their share of income is $15,000 ($150,000 × 0.10).
The NCI shareholders’ claim on the net assets of the subsidiary is based on the acquisition-date fair value of the noncontrolling interest, adjusted over time for a proportionate
share of the subsidiary’s income and dividends. The noncontrolling interest is discussed
in more detail in Chapter 5.
Presentation of Noncontrolling Interest
Historically, the portion of the subsidiary’s net income assigned to the noncontrolling
interest normally has been deducted from the combined earnings of the entire entity
LO4
Understand and explain
differences in consolidation
rules under U.S. GAAP and
IFRS.
LO5
Understand and explain
differences in the consolidation process when
the subsidiary is not wholly
owned.
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Chapter 3 The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential 117
(including both the parent and subsidiary) to arrive at consolidated net income in the
consolidated income statement. The label “consolidated net income” has sometimes been
used in the past to refer to the parent’s share of the consolidated entity’s income. Even
though income assigned to the noncontrolling interest does not meet the definition of
an expense, it normally has been accorded this expense-type treatment. For example,
Century Telephone generally has referred to the minority interest’s share of income as an
expense in the notes to its consolidated financial statements.
The FASB’s new standard on reporting noncontrolling interests, FASB 160 (ASC
810), requires that the term “consolidated net income” be applied to the income available to all stockholders, with the allocation of that income between the controlling and
noncontrolling stockholders shown. For example, assume that Parent Company owns
FIGURE 3–1 Summary of Differences between IFRS and U.S. GAAP related to Control and VIEs
Topic U.S. GAAP IFRS
Determination of Control • Normally, control is determined by majority
ownership of voting shares.
• However, majority ownership may not
indicate control of a VIE.
• Thus, VIE rules must be evaluated first in all
situations.
• The primary beneficiary must consolidate
a VIE.
• The majority shareholder consolidates most
non-VIEs.
• Control is based on direct or indirect voting
interests.
• An entity with less than 50 percent
ownership may have “effective control”
through other contractual arrangements.
• Normally, control is determined by majority
ownership of voting shares.
• In addition to voting shares, convertible
instruments and other contractual rights
that could affect control are considered.
• A parent with less than 50 percent of the
voting shares could have control through
contractual arrangements allowing control
of votes or the board of directors.
• Control over SPEs is determined based on
judgment and relevant facts.
• Substance over form considered in
determining whether an SPE should be
consolidated.
Related Parties • Interests held by related parties and
“de facto” agents may be considered in
determining control of a VIE.
• There is no specific provision for related
parties or de facto agents.
Definitions of VIEs
versus SPEs
• SPEs can be VIEs.
• Consolidation rules focus on whether an
entity is a VIE (regardless of whether or not
it is an SPE).
• This guidance applies only to legal entities.
• Considers specific indicators of whether an
entity has control of an SPE: (1) whether
the SPE conducts activities for the entity,
(2) whether the entity has decision-making
power to obtain majority of benefits from
the SPE, (3) whether the entity has the
right to majority of benefits from the SPE,
and (4) whether entity has majority of the
SPE’s residual or risks.
• This guidance applies whether or not
conducted by a legal entity.
Disclosure • Disclosures required for determining
control of a VIE.
• Entities must disclose whether or not they
are the primary beneficiary of related VIEs.
• No SPE-specific disclosure requirements.
• There are specific disclosure requirements
related to consolidation in general.
Accounting for Joint
Ventures
• Owners typically share control (often with
50-50 ownership).
• If the joint venture is a VIE, contracts
must be considered to determine whether
consolidation is required.
• If the joint venture is not a VIE, venturers
use the equity method.
• Proportional consolidation generally not
permitted.
• Joint ventures can be accounted for using
either proportionate consolidation or the
equity method.
• Proportionate consolidation reports the
venturer’s share of the assets, liabilities,
income, and expenses on a line-by-line
basis based on the venturer’s financial
statement line items.
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118 Chapter 3 The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential
90 percent of Sub Company’s stock, acquired without a differential, and that the two
companies report revenues and expenses as follows:
Parent Sub
Revenues $300,000 $100,000
Expenses 225,000 65,000
An abbreviated consolidated income statement for Parent and its subsidiary would appear
as follows:
Revenues $ 400,000
Expenses (290,000)
Consolidated net income $ 110,000
Less consolidated net income attributable to
noncontrolling interest in subsidiary (3,500)
Consolidated net income attributable to
controlling interest $ 106,500
The noncontrolling interest’s claim on the net assets of the subsidiary was previously
reported in the balance sheet most frequently in the “mezzanine” between liabilities
and stockholders’ equity. Some companies reported the minority interest as a liability,
although it clearly did not meet the definition of a liability. FASB 160 (ASC 810) makes
clear that the noncontrolling interest’s claim on net assets is an element of equity, not
a liability. It requires reporting the noncontrolling interest in equity, in the following
manner:
Controlling interest:
Common stock $700,000
Additional paid-in capital 50,000
Retained earnings 80,000
Total controlling interest $830,000
Noncontrolling interest in subsidiary 75,000
Total stockholders’ equity $905,000
Several different consolidation theories that affect the computation and treatment of
the noncontrolling interest have been proposed. These theories are discussed briefly later
in the chapter.
COMBINED FINANCIAL STATEMENTS
Financial statements are sometimes prepared for a group of companies when no one company in the group owns a majority of the common stock of any other company in the
group. Financial statements that include a group of related companies without including
the parent company or other owner are referred to as combined financial statements.
Combined financial statements are commonly prepared when an individual, rather
than a corporation, owns or controls a number of companies and wishes to include them
all in a single set of financial statements. In some cases, a parent company may prepare financial statements that include only its subsidiaries, not the parent. In other cases,
a parent may prepare financial statements for its subsidiaries by operating group, with all
the subsidiaries engaged in a particular type of operation, or those located in a particular
geographical region, reported together.
The procedures used to prepare combined financial statements are essentially the
same as those used in preparing consolidated financial statements. All intercompany
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Chapter 3 The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential 119
receivables and payables, intercompany transactions, and unrealized intercompany profits and losses must be eliminated in the same manner as in the preparation of consolidated statements. Although no parent company is included in the reporting entity, any
intercompany ownership, and the associated portion of stockholders’ equity, must be
eliminated in the same way as the parent’s investment in a subsidiary is eliminated in
preparing consolidated financial statements. The remaining stockholders’ equity of the
companies in the reporting entity is divided into the portions accruing to the controlling
and noncontrolling interests.
ADDITIONAL CONSIDERATIONS—DIFFERENT APPROACHES
TO CONSOLIDATION
Several different accounting theories have been suggested that might serve as a basis for
preparing consolidated financial statements. The choice of theory can have a significant
impact on the consolidated financial statements in cases when the parent company owns
less than 100 percent of the subsidiary’s common stock. This discussion focuses on three
alternative theories of consolidation: (1) proprietary, (2) parent company, and (3) entity.
The proprietary and entity theories may be viewed as falling near opposite ends of a spectrum, with the parent company theory falling somewhere in between. Until recently, the
accounting profession had not adopted any of the three theories in its entirety, although
practice was most closely aligned with the parent company approach. With the issuance
of FASB 141R (ASC 805) in 2007, however, the FASB adopted the entity theory.
Theories of Consolidation
The proprietary theory of accounting views the firm as an extension of the owners. The
firm’s assets, liabilities, revenues, and expenses are viewed as those of the owners themselves. When applied to consolidated financial statements, the proprietary concept results
in a pro rata consolidation in which the parent company consolidates only its proportionate share of a less-than-wholly-owned subsidiary’s assets, liabilities, revenues, and
expenses.
The parent company theory is perhaps better suited to the modern corporation and
the preparation of consolidated financial statements than is the proprietary approach. The
parent company theory recognizes that the parent has the ability to effectively control
all of the assets and liabilities of a majority-owned subsidiary, not just a proportionate share, even though the parent does not actually own the subsidiary’s assets or have
any obligation for its liabilities. The consolidated financial statements include all of the
subsidiary’s assets, liabilities, revenues, and expenses. Separate recognition is given in
the consolidated balance sheet to the noncontrolling interest’s claim on the subsidiary’s
net assets and in the consolidated income statement to the earnings assigned to the NCI
shareholders.
As a general ownership theory, the entity theory focuses on the firm as a separate economic entity rather than on the ownership rights of the shareholders. Emphasis under the
entity approach is on the consolidated entity itself, with the controlling and NCI shareholders viewed as two separate groups, each having an equity interest in the consolidated
entity. Neither of the two groups is emphasized over the other or over the consolidated
entity. Accordingly, all of the assets, liabilities, revenues, and expenses of a less-thanwholly-owned subsidiary are included in the consolidated financial statements, with no
special treatment accorded either the controlling or noncontrolling interest.
Comparison of Alternative Theories
Figure 3–2 provides a comparison of the amounts included in a consolidated balance
sheet (lined areas) for a parent and less-than-wholly-owned subsidiary under the different approaches to consolidation. With the proprietary theory, only the parent’s share of
a subsidiary’s assets and liabilities is included in the consolidated balance sheet, with
LO6
Understand and explain the
differences in theories of
consolidation.
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120 Chapter 3 The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential
the amount based on the fair values of those assets and liabilities on the date majority
ownership in the subsidiary is acquired. Goodwill is included for the excess of the purchase price over the fair value of the parent’s share of the subsidiary’s net identifiable
assets. The portion of the subsidiary’s identifiable assets and liabilities claimed by the
noncontrolling interest is excluded from the consolidated balance sheet, as is any implied
goodwill assignable to the noncontrolling interest.
The parent company approach includes all of the subsidiary’s assets and liabilities
in the consolidated balance sheet, as can be seen from the lined areas in Figure 3–2 .
However, only the parent’s share of any fair value increment and goodwill is included.
As a result, subsidiary assets are included at their full fair values only when the parent
purchases full ownership of the subsidiary. The noncontrolling shareholders’ claim is
reported in the consolidated balance sheet based on a proportionate share of the book
value of the subsidiary’s net assets.
All subsidiary assets and liabilities are also included in the consolidated balance sheet
under the entity approach. However, the amounts included are based on the full fair values at the date of combination, and the full amount of any goodwill is included regardless
of the percentage ownership held by the parent. The amount of noncontrolling interest
reported in the consolidated balance sheet is based on a proportionate share of the total
amount of subsidiary net assets, including goodwill.
Figure 3–3 provides a comparison of amounts included in the consolidated income
statement under the different approaches when a less-than-wholly-owned subsidiary is
consolidated. In general, the income statement treatment is consistent with the balance
sheet treatment shown in Figure 3–2 under each theory. As can be seen from the lined
areas, the proprietary theory results in consolidation of just the parent’s share of the revenues, expenses, and net income of the subsidiary. On the other hand, both the parent
company and entity theories result in consolidation of all of the subsidiary’s revenues
and expenses, regardless of degree of majority ownership. Under the parent company
theory, however, the noncontrolling interest’s share of income is deducted to arrive at
consolidated net income.
FIGURE 3–2
Recognition of
Subsidiary Net Assets
Goodwill
Fair value
increment
Book value
Parent’s
share
Noncontrolling
interest’s share
Parent’s
share
Noncontrolling
interest’s share
Proprietary Parent Company
Element Theory
Entity
Portion included in consolidated financial statements.
Noncontrolling
interest’s share
Parent’s
share
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Figure 3–4 provides a numerical comparison of the different consolidation approaches.
The example assumes that P Company acquires 80 percent of the stock of S Company on
January 1, 20X1, for $96,000. On that date, S Company has a total fair value of $120,000
and the 20 percent noncontrolling interest has a fair value of $24,000. S Company holds
assets with a book value of $100,000 and fair value of $120,000. The $20,000 fair value
increment relates entirely to S Company’s buildings and equipment, with a remaining
life of 10 years. Straight-line depreciation is used. For the year 20X1, P Company reports
FIGURE 3–3
Recognition of
Subsidiary Income
Revenues
Expenses
Net income
Parent’s
share
Noncontrolling
interest’s share
Noncontrolling
interest’s share
Parent’s
share
Proprietary Parent Company
Element Theory
Entity
Portion included in consolidated financial statements.
Noncontrolling
interest’s share
Parent’s
share
FIGURE 3–4
Illustration of the
Effects of Different
Approaches to the
Preparation of
Consolidated Financial
Statements
Theory
Item Proprietary Parent Company Entity
Value of subsidiary net assets recognized
at acquisition:
Book value:
$100,000 × 0.80 $ 80,000
$100,000 × 1.00 $100,000 $100,000
Fair value increment:
$20,000 × 0.80 16,000 16,000
$20,000 × 1.00 20,000
Total net assets $ 96,000 $116,000 $120,000
Amount of noncontrolling interest
recognized at acquisition $ 20,000 $ 24,000
Amount of fair value increment amortized* $ 1,600 $ 1,600 $ 2,000
Consolidated net income $222,400a $222,400a $228,000b
Income assigned to noncontrolling interest $ 6,000c $ 5,600d
a
$222,400 = $200,000 + ($30,000 × 0.80) − $1,600 * b
$228,000 = $200,000 + $30,000 − $2,000 * c
$6,000 = $30,000 × 0.20 d
$5,600 = ($30,000 − $2,000) × 0.20
* Amortization of fair value increment using straight-line basis over 10 years.
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122 Chapter 3 The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential
income from its own operations of $200,000, and S Company reports net income of
$30,000. The example assumes the income includes no unrealized profits from intercompany sales. If unrealized intercompany profits were included in income, additional
differences between the approaches could be seen.
Current Practice
FASB 141R (ASC 805) has significantly changed the preparation of consolidated financial statements subsequent to the acquisition of less-than-wholly-owned subsidiaries. In
the past, only the parent’s share of a subsidiary’s fair value increment and goodwill at the
date of combination was recognized, consistent with a parent company approach. Now,
under FASB 141R (ASC 805), consolidation follows largely an entity-theory approach.
Accordingly, the full entity fair value increment and the full amount of goodwill are
recognized.
Current practice follows the entity approach in most important aspects, but it does
deviate in certain respects. In the income statement, consolidated net income refers to the
income of the consolidated entity as a whole, rather than just the parent’s share as in the
past. Still, more emphasis continues to be placed on the parent’s share of consolidated net
income than on the noncontrolling interest’s share. For example, only the parent’s portion of consolidated net income is included in the computation of consolidated earnings
per share. In addition, the only retained earnings figure reported in the consolidated balance sheet is that related to the controlling interest, with all amounts relating to the noncontrolling interest’s share of equity reported in a single figure. If a strict entity approach
were followed, the emphasis would be on the entire entity without emphasizing either the
controlling or noncontrolling interest over the other. Nevertheless, the current approach
clearly follows the entity theory with minor modifications aimed at the practical reality that consolidated financial statements are used primarily by those having a long-run
interest in the parent company.
THE EFFECT OF A NONCONTROLLING INTEREST
When a subsidiary is less than wholly owned, the general approach to consolidation is
the same as discussed in Chapter 2, but the consolidation procedures must be modified
slightly to recognize the noncontrolling interest. Thus, the difference between the consolidation procedures illustrated in Chapter 2 and what we will demonstrate here is that we
now have to account for the NCI shareholders’ ownership in the income and net assets
of the acquired company. Before examining the specific procedures used in consolidating a less-than-wholly-owned subsidiary, we discuss the computation of consolidated
net income, consolidated retained earnings, and the noncontrolling interest’s claim on
income and net assets. We also discuss modifications to the consolidation worksheet.
LO7
Make calculations and
prepare basic elimination
entries for the consolidation of a less-than-whollyowned subsidiary.
No NCI
shareholders
NCI
shareholders
Investment = Book value
Wholly owned
subsidiary
Partially owned
subsidiary
Chapter 2
Chapter 4
Chapter 3
Investment > Book value Chapter 5
Consolidated Net Income
Consolidated net income, as it appears in the consolidated income statement, is the
difference between consolidated revenues and expenses. In the absence of transactions
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between companies included in the consolidation, consolidated net income is equal
to the parent’s income from its own operations, excluding any investment income
from consolidated subsidiaries, plus the net income from each of the consolidated
subsidiaries.
When all subsidiaries are wholly owned, all of the consolidated net income accrues to
the parent company, or the controlling interest. If one or more of the consolidated subsidiaries is less than wholly owned, a portion of the consolidated net income accrues to the
NCI shareholders. In that case, the income attributable to the subsidiary noncontrolling
interest is deducted from consolidated net income on the face of the income statement to
arrive at consolidated net income attributable to the controlling interest.
Income attributable to a noncontrolling interest in a subsidiary is based on a proportionate share of that subsidiary’s net income. The subsidiary’s net income available to
common shareholders is divided between the parent and noncontrolling stockholders
based on their relative common stock ownership of the subsidiary. Note that the NCI
shareholders in a particular subsidiary have a proportionate claim only on the income of
that subsidiary and not on the income of the parent or any other subsidiary.
As an example of the computation and allocation of consolidated net income, assume
that Push Corporation purchases 80 percent of the stock of Shove Company for an
amount equal to 80 percent of Shove’s total book value. During 20X1, Shove reports net
income of $25,000, while Push reports net income of $120,000, including equity-method
income from Shove of $20,000 ($25,000 × 0.80). Consolidated net income for 20X1 is
computed and allocated as follows:
Push’s net income $120,000
Less: Equity-method income from Shove (20,000)
Shove’s net income 25,000
Consolidated net income $125,000
Income attributable to noncontrolling interest (5,000)
Income attributable to controlling interest $120,000
Consolidated net income is equal to the separate income of Push from its own operations
($100,000) plus Shove’s net income ($25,000). The $20,000 of equity-method income
from Shove that had been recognized by Push must be excluded from the computation
to avoid double-counting the same income. Consolidated net income is allocated to the
noncontrolling stockholders based on their 20 percent share of Shove’s net income. The
amount of income allocated to the controlling interest is equal to the parent’s income
from its own operations ($100,000) and the parent’s 80 percent share of Shove’s income
($20,000).
Consolidated Retained Earnings
The only retained earnings figure reported in the consolidated balance sheet is not
entirely consistent with the computation of consolidated net income. Retained earnings
in the consolidated balance sheet is that portion of the consolidated entity’s undistributed earnings accruing to the parent’s stockholders. It is calculated by adding the parent’s share of subsidiary cumulative net income since acquisition to the parent’s retained
earnings from its own operations (excluding any income from the subsidiary included
in the parent’s retained earnings) and subtracting the parent’s share of any differential
write-off. Any retained earnings related to subsidiary NCI shareholders is included in the
Noncontrolling Interest in Net Assets of Subsidiary amount reported in the equity section
of the consolidated balance sheet. Thus, the consolidated retained earnings figure is more
consistent with the parent company theory rather than the entity approach assumed in the
computation of consolidated net income.
To illustrate the computation of consolidated retained earnings when a noncontrolling
interest exists, assume that Push purchases 80 percent of Shove’s stock on January 1,
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124 Chapter 3 The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential
20X1, and accounts for the investment using the equity method. Assume net income and
dividends as follows during the two years following the acquisition:
Push Shove
Retained earnings, January 1, 20X1 $400,000 $250,000
Net income, 20X1 120,000 25,000
Dividends, 20X1 (30,000) (10,000)
Retained earnings, December 31, 20X1 $490,000 $265,000
Net income, 20X2 148,000 35,000
Dividends, 20X2 (30,000) (10,000)
Retained earnings, December 31, 20X2 $608,000 $290,000
Consolidated retained earnings at two years after the date of combination is computed as
follows
Push’s retained earnings, December 31, 20X2 $608,000
Equity accrual from Shove since acquisition ($25,000 + $35,000) × 0.80 (48,000)
Push’s retained earnings from its own operations, December 31, 20X2 $560,000
Push’s share of Shove’s net income since acquisition ($60,000 × 0.80) 48,000
Consolidated retained earnings, December 31, 20X2 $608,000
We note several important points from the example. First, the subsidiary’s retained
earnings are not combined with the parent’s retained earnings. Only the parent’s share of
the subsidiary’s cumulative net income since the date of combination is included. Second,
consolidated retained earnings are equal to the parent’s retained earnings because the parent uses the equity method to account for its investment in the subsidiary. If the parent
accounted for the investment using the cost method, the parent’s retained earnings and consolidated retained earnings would differ. Finally, the cumulative income from the subsidiary
recognized by the parent on its books must be removed from the parent’s retained earnings
to arrive at retained earnings from the parent’s own operations so that all or part (depending
on whether the equity or cost method is used) of the same income will not be included twice.
Worksheet Format
The same three-part worksheet described in Chapter 2 can be used when consolidating less-than-wholly-owned subsidiaries, with only minor modifications. The worksheet
must allow for including the noncontrolling interest’s claim on the income and net assets
of the subsidiaries. The noncontrolling interest’s claim on the income of a subsidiary is
deducted from consolidated net income at the bottom of the worksheet’s income statement section in the Consolidated column to arrive at consolidated net income attributable
to the controlling interest. The noncontrolling interest’s claim on the subsidiary’s net
assets is placed at the bottom of the worksheet’s balance sheet section. The noncontrolling interest’s claims on both income and net assets are entered in the worksheet through
eliminating entries and then carried over to the Consolidated column. As discussed in
Chapter 2, the amounts in the Consolidated column are used to prepare the consolidated
financial statements.
CONSOLIDATED BALANCE SHEET WITH A
LESS-THAN-WHOLLY-OWNED SUBSIDIARY
In order to illustrate the consolidation process for a less-than-wholly-owned subsidiary,
we use the Peerless-Special Foods example from Chapter 2. The only difference is that
we assume that instead of acquiring all of the common stock of Special Foods, Peerless
only buys 80 percent of the shares. Thus, we assume that the other 20 percent of the
shares are widely held by other shareholders (the NCI shareholders).
LO8
Prepare a consolidation worksheet for a
less-than-wholly-owned
consolidation.
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Chapter 3 The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential 125
80 Percent Ownership Acquired at Book Value
Peerless acquires 80 percent of Special Foods’ outstanding common stock for $240,000,
an amount equal to 80 percent of the fair value of Special Foods’ net assets on January 1,
20X1. On this date, the fair values of Special Foods’ individual assets and liabilities are
equal to their book values. Because Peerless acquires only 80 percent of Special Foods’
common stock, the Investment in Special Foods equals 80 percent of the total stockholders’ equity of Special Foods ($200,000 + $100,000). We can summarize Special
Foods’ ownership as follows:
Total fair value of consideration 300,000
Book value of Special Foods’ net assets
Common stock—Special Foods 200,000
Retained earnings—Special Foods 100,000
300,000
Difference between fair value and book value $ 0
P Add the fair value of the NCI interest 60,000
S NCI
1/1/X1
80%
20%
Fair value of Peerless’s consideration $240,000
Peerless records the 80 percent stock acquisition on its books with the following entry on
January 1, 20X1:
(1) Investment in Special Foods 240,000
Cash 240,000
Record purchase of Special Foods stock.
The Basic Investment Elimination Entry
The basic elimination on the date of acquisition would be the same as the one illustrated
in Chapter 2 except that the $300,000 book value of net assets is now jointly owned by
Peerless (80 percent) and the NCI shareholders (20 percent). Thus, the original $300,000
credit to the Investment in Special Foods account from the wholly owned example in
Chapter 2 is now “shared” with the NCI shareholders as shown in the breakdown of the
book value of Special Foods:
Thus, the only eliminating entry in the worksheet removes the Investment in Special
Foods Stock account and the subsidiary’s stockholders’ equity accounts and records the
$60,000 NCI interest in the net assets of Special Foods.
In this example, Peerless’ investment is exactly equal to its 80 percent share of the book
value of net assets of Special Foods. Therefore, no goodwill is recorded and all assets and
liabilities are simply combined from Special Foods’ financial statements at their current
book values. Again, in Chapters 4 and 5 we will explore situations where the acquiring
company pays more than the book value of the acquired company’s net assets. However, in Chapters 2 and 3, the excess value of identifiable net assets and goodwill will
Book Value Calculations:
NCI 20%+Peerless 80% = Common Stock +Retained Earnings
Original book value 60,000 240,000 200,000 100,000
Basic elimination entry:
Common stock 200,000 Original amount invested
Retained earnings 100,000 Beginning balance in RE
Investment in Special Foods 240,000 Peerless’ share of “book value”
NCI in NA of Special Foods 60,000 NCI’s share of “book value”
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126 Chapter 3 The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential
always be equal to zero. To maintain a consistent approach through all four chapters, we
always illustrate the components of the acquiring company’s investment, even though
the acquiring company’s investment will always be exactly equal to its share of the book
value of net assets in Chapters 2 and 3. Therefore, the relationship between the fair value
of the consideration given to acquire Special Foods, the fair value of Special Foods’ net
assets, and the book value of Special Foods’ net assets can be illustrated as follows:
Goodwill = 0
1/1/X1
$240,000
Initial
investment
in Special
Foods
Identifiable
excess = 0
80%
Book value =
240,000
Therefore, the elimination entry simply credits the Investment in Special Foods Stock
account (for the original acquisition price, $240,000), eliminating this account from Peerless’ balance sheet.
Investment in
Special Foods
Acquisition Price 240,000
240,000 Basic elimination entry
0
Remember that this entry is made in the consolidation worksheet, not on the books of
either the parent or the subsidiary, and is presented here in T-account form for instructional purposes only. The investment account must be eliminated because, as explained in
Chapter 2, from a single-entity viewpoint, a company cannot hold an investment in itself.
FIGURE 3–5 Worksheet for Consolidated Balance Sheet, January 1, 20X1, Date of Combination; 80 Percent
Acquisition at Book Value
Peerless
Products
Special
Foods
Elimination Entries
DR CR Consolidated
Balance Sheet
Cash 110,000 50,000 160,000
Accounts Receivable 75,000 50,000 125,000
Inventory 100,000 60,000 160,000
Investment in Special Foods 240,000 240,000 0
Land 175,000 40,000 215,000
Buildings & Equipment 800,000 600,000 1,400,000
Less Accumulated Depreciation (400,000) (300,000) (700,000)
Total Assets 1,100,000 500,000 0 240,000 1,360,000
Accounts Payable 100,000 100,000 200,000
Bonds Payable 200,000 100,000 300,000
Common Stock 500,000 200,000 200,000 500,000
Retained Earnings 300,000 100,000 100,000 300,000
NCI in NA of Special Foods 60,000 60,000
Total Liabilities & Equity 1,100,000 500,000 300,000 60,000 1,360,000
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Chapter 3 The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential 127
Consolidation Worksheet
Figure 3–5 presents the consolidation worksheet. As explained previously in Chapter 2,
the investment account on the parent’s books can be thought of as a single account representing the parent’s investment in the net assets of the subsidiary, a one-line consolidation.
In a full consolidation, the subsidiary’s individual assets and liabilities are combined with
those of the parent. Including both the net assets of the subsidiary, as represented by the
balance in the investment account, and the subsidiary’s individual assets and liabilities
would double count the same set of assets. Therefore, the investment account is eliminated and not carried to the consolidated balance sheet.
The Consolidated Balance Sheet
Figure 3–6 presents the consolidated balance sheet as of the date of acquisition.
Because no operations occurred between the date of combination and the preparation
of the consolidated balance sheet, there is no income statement or statement of retained
earnings.
CONSOLIDATION SUBSEQUENT TO ACQUISITION—
80 PERCENT OWNERSHIP ACQUIRED AT BOOK VALUE
Chapter 2 explains the procedures used to prepare a consolidated balance sheet as
of the acquisition date. More than a consolidated balance sheet, however, is needed
to provide a comprehensive picture of the consolidated entity’s activities following acquisition. As with a single company, the set of basic financial statements for a
consolidated entity consists of a balance sheet, an income statement, a statement of
changes in retained earnings, and a statement of cash flows. Each of the consolidated
financial statements is prepared as if it is taken from a single set of books that is being
used to account for the overall consolidated entity. There is, of course, no set of books
for the consolidated entity, and as in the preparation of the consolidated balance sheet,
the consolidation process starts with the data recorded on the books of the individual
consolidating companies. The account balances from the books of the individual companies are placed in the three-part worksheet, and entries are made to eliminate the
effects of intercorporate ownership and transactions. The consolidation approach and
procedures are the same whether the subsidiary being consolidated was acquired or
created.
Initial Year of Ownership
Assume that Peerless has already recorded the acquisition on January 1, 20X1, and that
during 20X1, Peerless records operating earnings of $140,000, excluding its income from
investing in Special Foods, and declares dividends of $60,000. Special Foods reports
20X1 net income of $50,000 and declares dividends of $30,000.
FIGURE 3–6
Consolidated Balance
Sheet, January 1, 20X1,
Date of Combination;
80 Percent Acquisition
at Book Value
PEERLESS PRODUCTS CORPORATION AND SUBSIDIARY
Consolidated Balance Sheet
January 1, 20X1
Assets Liabilities
Cash 160,000 Accounts Payable 200,000
Accounts Receivable 125,000 Bonds Payable 300,000
Inventory 160,000 Stockholders’ Equity
Land 215,000 Common Stock 500,000
Buildings and Equipment 1,400,000 Retained Earnings 300,000
Accumulated Depreciation (700,000) 700,000 NCI in NA of Special Foods 60,000
Total Assets 1,360,000 Total Liabilities and Equity 1,360,000
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128 Chapter 3 The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential
Parent Company Entries
Peerless records its 20X1 income and dividends from Special Foods under the equity
method as follows:
(3) Cash 24,000
Investment in Special Foods 24,000
Record Peerless’ 80% share of Special Foods’ 20X1 dividend.
(2) Investment in Special Foods 40,000
Income from Special Foods 40,000
Record Peerless’ 80% share of Special Foods’ 20X1 income.
Consolidation Worksheet—Initial Year of Ownership
After all appropriate equity method entries have been made on Peerless’ books, the company can prepare a consolidation worksheet. Peerless begins the worksheet by placing
the adjusted account balances from the books of Peerless and Special Foods in the first
two columns of the worksheet. Then all amounts that reflect intercorporate transactions
or ownership are eliminated in the consolidation process.
The distinction between journal entries recorded on the books of the individual companies and the eliminating entries recorded only on the consolidation worksheet is an
important one. Book entries affect balances on the books and the amounts that are carried
to the consolidation worksheet; worksheet eliminating entries affect only those balances
carried to the consolidated financial statements in the period. As mentioned previously,
the eliminating entries presented in this text are shaded when presented both in journal
entry form in the text and in the worksheet.
In this example, the accounts that must be eliminated because of intercorporate ownership are the stockholders’ equity accounts of Special Foods, including dividends declared,
Peerless’ investment in Special Foods stock, and Peerless’ income from Special Foods.
However, the book value portion of Peerless’ investment has changed since the January 1 acquisition date because under the equity method, Peerless has adjusted the investment account balance for its share of earnings and dividends. The book value portion of
the investment account can be summarized as follows:
Book Value Calculations:
NCI 20%+Peerless 80% = Common Stock+Retained Earnings
Original book value 60,000 240,000 200,000 100,000
+ Net income 10,000 40,000 50,000
− Dividends (6,000) (24,000) (30,000)
Ending book value 64,000 256,000 200,000 120,000
Note that we shade the amounts in the book value analysis that appear in the basic elimination entry with a lighter font. The beginning and ending balances in the investment
account can be illustrated as follows:
Goodwill = 0
1/1/X1
$240,000
Initial
investment
in Special
Foods
Identifiable
excess = 0
80%
Book value =
240,000
Goodwill = 0
12/31/X1
$256,000
Net
investment
in Special
Foods
Excess = 0
80%
Book value =
256,000
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Chapter 3 The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential 129
Under the equity method, the parent recognized on its separate books its share
(80 percent) of the subsidiary’s income. In the consolidated income statement, however,
the individual revenue and expense accounts of the subsidiary are combined with those
of the parent. Income recognized by the parent from all consolidated subsidiaries, therefore, must be eliminated to avoid double-counting. The subsidiary’s dividends paid to the
parent company must be eliminated when consolidated statements are prepared so that
only dividend declarations related to the parent’s shareholders are treated as dividends of
the consolidated entity. Thus, the basic eliminating entry removes both the investment
income reflected in the parent’s income statement and any dividends declared by the
subsidiary during the period:
Basic elimination entry:
Common stock 200,000 Original amount invested
Retained earnings 100,000 Beginning RE from trial balance
Income from Special Foods 40,000 Peerless’ share of Special Foods’ NI
NCI in NI of Special Foods 10,000 NCI share of Special Foods’ reported NI
Dividends declared 30,000 100% of sub’s dividends declared
Investment in Special Foods 256,000 Peerless’ share of BV of net assets
NCI in NA of Special Foods 64,000 NCI share of BV of net assets
Since there is no differential in this example, the basic elimination entry completely
eliminates the balance in Peerless’ investment account on the balance sheet as well as
the Income from Special Foods account on the income statement. Note again that the
parent’s investment in the stock of a consolidated subsidiary never appears in the consolidated balance sheet and the income from subsidiary account never appears on the
consolidated income statement.
Investment in
Special Foods
Income from
Special Foods
Acquisition Price 240,000
80% of Net Income 40,000 40,000 80% Net Income
24,000 80% Dividends
Ending Balance 256,000 40,000 Ending Balance
256,000 Basic entry 40,000
0 0
As explained in Chapter 2, when the parent company acquires the subsidiary, the
consolidated financial statements should appear as if all of the subsidiary’s assets and
liabilities were acquired at fair value as of the acquisition date. If Peerless had purchased
Special Foods’ assets instead of its stock, the book value and accumulated depreciation
amounts would have been ignored and the assets would have been recorded in Peerless’
books at their current fair values as of the acquisition date. Following this logic, since
Peerless did acquire Special Foods’ stock, the consolidated financial statements should
present all of Special Foods’ assets and liabilities as if they had been recorded at their
current fair market values on the acquisition date and then depreciated from that date
forward. Thus, eliminating the old accumulated depreciation of the subsidiary as of the
acquisition date and netting it out against the historical cost gives the appearance that the
depreciable assets have been newly recorded at their fair value as of the acquisition date.
In this example, Special Foods had accumulated depreciation on the acquisition date of
$300,000. Thus, as explained in Chapter 2, the following elimination entry nets this accumulated depreciation out against the cost of the building and equipment.
Optional accumulated depreciation elimination entry:
Accumulated depreciation 300,000 Original depreciation at the time of
Building and equipment 300,000 the acquisition netted against cost
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130 Chapter 3 The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential
Also as explained in Chapter 2, this worksheet elimination entry does not change
the net buildings and equipment balance. Netting the pre-acquisition accumulated
depreciation out against the cost basis of the corresponding assets merely causes the
buildings and equipment to appear in the consolidated financial statements as if they
had been revalued to their fair values on the acquisition date. This same entry would
be included in each succeeding consolidation as long as the assets remain on Special
Foods’ books (always based on the accumulated depreciation balance as of the acquisition date).
We note that the only two changes on the worksheet when the subsidiary is only
partially owned are that the income statement first calculates the consolidated net
income ($190,000 in this example) and then deducts the portion attributable to the
NCI shareholders to arrive at the portion attributable to the parent (controlling interest) as demonstrated in Figure 3–7 . In this example, the final line of the income statement presents Peerless’ share of the consolidated net income, $180,000. This amount
should always equal the parent’s net income in the first column of the worksheet
FIGURE 3–7 December 31, 20X1, Equity-Method Worksheet for Consolidated Financial Statements, Initial Year
of Ownership; 80 percent Acquisition at Book Value
Peerless
Products
Special
Foods
Elimination Entries
DR CR Consolidated
Income Statement
Sales 400,000 200,000 600,000
Less COGS (170,000) (115,000) (285,000)
Less Depreciation Expense (50,000) (20,000) (70,000)
Less Other Expenses (40,000) (15,000) (55,000)
Income from Special Foods 40,000 40,000 0
Consolidated Net Income 180,000 50,000 40,000 0 190,000
NCI in Net Income 10,000 (10,000)
Controlling Interest in Net Income 180,000 50,000 50,000 0 180,000
Statement of Retained Earnings
Beginning Balance 300,000 100,000 100,000 300,000
Net Income 180,000 50,000 50,000 0 180,000
Less Dividends Declared (60,000) (30,000) 30,000 (60,000)
Ending Balance 420,000 120,000 150,000 30,000 420,000
Balance Sheet
Cash 264,000 75,000 339,000
Accounts Receivable 75,000 50,000 125,000
Inventory 100,000 75,000 175,000
Investment in Special Foods 256,000 256,000 0
Land 175,000 40,000 215,000
Buildings & Equipment 800,000 600,000 300,000 1,100,000
Less Accumulated Depreciation (450,000) (320,000) 300,000 (470,000)
Total Assets 1,220,000 520,000 300,000 556,000 1,484,000
Accounts Payable 100,000 100,000 200,000
Bonds Payable 200,000 100,000 300,000
Common Stock 500,000 200,000 200,000 500,000
Retained Earnings 420,000 120,000 150,000 30,000 420,000
NCI in NA of Special Foods 64,000 64,000
Total Liabilities & Equity 1,220,000 520,000 350,000 94,000 1,484,000
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Chapter 3 The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential 131
(if the parent properly accounts for the investment in the subsidiary using the equity
method on its own books). 7

Second and Subsequent Years of Ownership
The consolidation procedures employed at the end of the second and subsequent years
are basically the same as those used at the end of the first year. Adjusted trial balance data
of the individual companies are used as the starting point each time consolidated statements are prepared because no separate books are kept for the consolidated entity. An
additional check is needed in each period following acquisition to ensure that the beginning balance of consolidated retained earnings shown in the completed worksheet equals
the balance reported at the end of the prior period. In all other respects the eliminating
entries and worksheet are comparable with those shown for the first year.
Parent Company Entries
Consolidation after two years of ownership is illustrated by continuing the example of
Peerless Products and Special Foods. Peerless’ separate income from its own operations
for 20X2 is $160,000, and its dividends total $60,000. Special Foods reports net income
of $75,000 in 20X2 and pays dividends of $40,000. Equity-method entries recorded by
Peerless in 20X2 are as follows:
(5) Cash 32,000
Investment in Special Foods 32,000
Record Peerless’ 80% share of Special Foods’ 20X2 dividend.
(4) Investment in Special Foods 60,000
Income from Special Foods 60,000
Record Peerless’ 80% share of Special Foods’ 20X2 income.
Peerless’ reported net income totals $220,000 ($160,000 from separate operations
+ $60,000 from Special Foods).
Consolidation Worksheet—Second Year of Ownership
In order to complete the worksheet, Peerless must calculate the worksheet elimination
entries using the following process. The book value of equity can be analyzed and summarized as follows:
Book Value Calculations:
NCI 20%+Peerless 80%=Common Stock+Retained Earnings
Beginning book value 64,000 256,000 200,000 120,000
+ Net income 15,000 60,000 75,000
− Dividends (8,000) (32,000) (40,000)
Ending book value 71,000 284,000 200,000 155,000
7 Note that the “Consolidated Net Income” line properly adds Peerless’ reported net income, $180,000, to
Special Foods’ net income, $50,000, and eliminates Peerless’ share of Special Foods’ net income such that
the total consolidated net income is equal to Peerless’ income from separate operations ($140,000) plus
Special Foods’ reported net income ($50,000). On the other hand, the “Controlling Interest in Net Income”
line indicates that Peerless’ true income can be calculated in two ways. Either start with total “Consolidated
Net Income” and deduct the portion that belongs to the NCI shareholders in the far right column or simply
use Peerless’ correctly calculated equity method net income, $180,000, which is its income from separate
operations ($140,000) plus its share of Special Foods’ net income ($40,000). The controlling interest in
net income line starts with this correctly calculated number from Peerless’ income statement (in the first
column) adds it to Special Foods’ reported income (in the second column), but then eliminates Special Foods’
reported income in the eliminations column. Thus, the controlling interest in net income in the consolidation
column equals Peerless’ reported net income under the equity method.
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132 Chapter 3 The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential
Thus, the balance in Peerless’ Investment in Special Foods account increases from
$256,000 to $284,000 in 20X2:
Goodwill = 0
1/1/X2
$256,000
Net
investment
in Special
Foods
Excess = 0
80%
Book value =
256,000
Goodwill = 0
12/31/X2
$284,000
Net
investment
in Special
Foods
Excess = 0
80%
Book value =
284,000
Thus, the basic eliminating entry removes both the investment income reflected in
the parent’s income statement and any dividends declared by the subsidiary during the
period:
Since there is no differential in this example, the basic elimination entry completely eliminates the balance in Peerless’ investment account on the balance sheet as well as the
Income from Special Foods account on the income statement.
Investment in
Special Foods
Income from
Special Foods
Beginning Balance 256,000
80% of Net Income 60,000 60,000 80% of Net Income
32,000 80% Dividends
Ending Balance 284,000 60,000 Ending Balance
284,000 Basic entry 60,000
0 0
In this example, Special Foods had accumulated depreciation on the acquisition date of
$300,000. Thus, we repeat the same accumulated depreciation elimination entry this year
(and every year as long as Special Foods owns the assets) that we used in the initial year.
Optional accumulated depreciation elimination entry:
Accumulated depreciation 300,000 Original depreciation at the time of
Building and equipment 300,000 the acquisition netted against cost
After placement of the two elimination entries in the consolidation worksheet, the
worksheet is completed in the normal manner as shown in Figure 3–8 .
Basic elimination entry:
Common stock 200,000 Original amount invested
Retained earnings 120,000 RE from trial balance.
Income from Special Foods 60,000 Peerless’ share of Special Foods’ NI
NCI in NI of Special Foods 15,000 NCI share of Special Foods’ reported NI
Dividends declared 40,000 100% of sub’s dividends declared
Investment in Special Foods 284,000 Peerless’ share of BV of net assets
NCI in NA of Special Foods 71,000 NCI share of BV of net assets
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Chapter 3 The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential 133
Consolidated financial statements present the financial position and results of operations of a parent and one or more subsidiaries as if they were actually a single company. As a result, a group of
legally separate companies is portrayed as a single economic entity by the consolidated financial
statements. All indications of intercorporate ownership and the effects of all intercompany transactions are excluded from the consolidated statements. The basic approach to the preparation of
consolidated financial statements is to combine the separate financial statements of the individual
consolidating companies and then to eliminate or adjust those items that would not appear, or that
would appear differently, if the companies actually were one.
Current consolidation standards require that the consolidated financial statements include all
companies under common control unless control is questionable. Consolidated financial statements are prepared primarily for those with a long-run interest in the parent company, especially
the parent’s stockholders and long-term creditors. While consolidated financial statements allow
interested parties to view a group of related companies as a single economic entity, such statements have some limitations. In particular, information about the characteristics and operations
of the individual companies within the consolidated entity is lost in the process of combining
financial statements.
New types of business arrangements have proved troublesome for financial reporting. In particular, special types of entities, called special-purpose entities and variable interest entities, have
Summary of
Key Concepts
Peerless
Products
Special
Foods
Elimination Entries
DR CR Consolidated
Income Statement
Sales 450,000 300,000 750,000
Less COGS (180,000) (160,000) (340,000)
Less Depreciation Expense (50,000) (20,000) (70,000)
Less Other Expenses (60,000) (45,000) (105,000)
Income from Special Foods 60,000 60,000 0
Consolidated Net Income 220,000 75,000 60,000 0 235,000
NCI in Net Income 15,000 (15,000)
Controlling Interest Net Income 220,000 75,000 75,000 0 220,000
Statement of Retained Earnings
Beginning Balance 420,000 120,000 120,000 420,000
Net Income 220,000 75,000 75,000 0 220,000
Less Dividends Declared (60,000) (40,000) 40,000 (60,000)
Ending Balance 580,000 155,000 195,000 40,000 580,000
Balance Sheet
Cash 291,000 85,000 376,000
Accounts Receivable 150,000 80,000 230,000
Inventory 180,000 90,000 270,000
Investment in Special Foods 284,000 284,000 0
Land 175,000 40,000 215,000
Buildings & Equipment 800,000 600,000 300,000 1,100,000
Less Accumulated Depreciation (500,000) (340,000) 300,000 (540,000)
Total Assets 1,380,000 555,000 300,000 584,000 1,651,000
Accounts Payable 100,000 100,000 200,000
Bonds Payable 200,000 100,000 300,000
Common Stock 500,000 200,000 200,000 500,000
Retained Earnings 580,000 155,000 195,000 40,000 580,000
NCI in NA of Special Foods 71,000 71,000
Total Liabilities & Equity 1,380,000 555,000 395,000 111,000 1,651,000
FIGURE 3–8 December 31, 20X2, Equity-Method Worksheet for Consolidated Financial Statements, Second Year
of Ownership; 80 percent Acquisition at Book Value
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134 Chapter 3 The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential
been used to hide or transform various types of transactions, in addition to being used for many
legitimate purposes such as risk sharing. Often these entities were disclosed only through vague
notes to the financial statements. Reporting standards now require that the party that is the primary
beneficiary of a variable interest entity consolidate that entity.
Several different theories or approaches underlie the preparation of consolidated financial statements, and the approach used can significantly affect the consolidated statements when the subsidiaries are not wholly owned. The proprietary and entity theories can be viewed as lying at opposite
ends of a spectrum, with the parent company theory in the middle. Until recently, practice largely
followed the parent company approach. Now, following issuance of FASB 141R (ASC 805) and
FASB 160 (ASC 810), practice conforms most closely with the entity approach, but with a greater
emphasis on the controlling interest than on the noncontrolling interest.
combined financial
statements, 118
consolidated net income, 123
direct control, 111
effective control, 112
entity theory, 119
indirect control, 111
minority interest, 116
noncontrolling interest, 116
parent company theory, 119
primary beneficiary, 115
proprietary theory, 119
pro rata consolidation, 119
special-purpose entities
(SPEs), 113
variable interest entity
(VIE), 114
Key Terms
Appendix 3A Consolidation of Variable Interest Entities
The standards for determining whether a party with an interest in a variable interest entity (VIE)
should consolidate the VIE were discussed earlier in the chapter. Once a party has determined that
it must consolidate a VIE, the consolidation procedures are similar to those used when consolidating a subsidiary. As an illustration, assume that Ignition Petroleum Company joins with Mammoth
Financial Corporation to create a special corporation, Exploration Equipment Company, that
would lease equipment to Ignition and other companies. Ignition purchases 10 percent of Exploration’s stock for $1,000,000, and Mammoth purchases the other 90 percent for $9,000,000. Profits
are to be split equally between the two owners, but Ignition agrees to absorb the first $500,000 of
annual losses. Immediately after incorporation, Exploration borrows $120,000,000 from a syndicate of banks, and Ignition guarantees the loan. Exploration then purchases plant, equipment,
and supplies for its own use and equipment for lease to others. The balance sheets of Ignition and
Exploration appear as follows just prior to the start of Exploration’s operations:
Item Ignition Exploration
Cash and Receivables $100,000,000 $ 23,500,000
Inventory and Supplies 50,000,000 200,000
Equipment Held for Lease 105,000,000
Investment in Exploration Equipment Co. 1,000,000
Plant and Equipment (net) 180,000,000 1,350,000
Total Assets $331,000,000 $130,050,000
Accounts Payable $ 900,000 $ 50,000
Bank Loans Payable 30,000,000 120,000,000
Common Stock Issued and Outstanding 200,000,000 10,000,000
Retained Earnings 100,100,000
Total Liabilities and Equity $331,000,000 $130,050,000
Both Ignition and Mammoth hold variable interests in Exploration. Ignition’s variable interests
include both its common stock and its guarantees. Ignition is the primary beneficiary of Exploration because it shares equally in the profits with Mammoth but must absorb a larger share of the
expected losses than Mammoth, through both its profit-and-loss-sharing agreement with Mammoth and its loan guarantee. Accordingly, Ignition must consolidate Exploration.
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Ignition’s consolidated balance sheet that includes Exploration appears as in Figure 3–9 . The
balances in Exploration’s asset and liability accounts are added to the balances of Ignition’s like
accounts. Ignition’s investment in Exploration is eliminated against the common stock of Exploration, and Exploration’s remaining common stock is labeled as noncontrolling interest and reported
within the equity section of the consolidated balance sheet.
Questions
LO1 Q3-1 What is the basic idea underlying the preparation of consolidated financial statements?
LO1 Q3-2 How might consolidated statements help an investor assess the desirability of purchasing shares
of the parent company?
LO1 Q3-3 Are consolidated financial statements likely to be more useful to the owners of the parent company
or to the noncontrolling owners of the subsidiaries? Why?
LO2 Q3-4 What is meant by “parent company”? When is a company considered to be a parent?
LO1 Q3-5 Are consolidated financial statements likely to be more useful to the creditors of the parent company or the creditors of the subsidiaries? Why?
LO2 Q3-6 Why is ownership of a majority of the common stock of another company considered important
in consolidation?
LO2 Q3-7 What major criteria must be met before a company is consolidated?
LO3 Q3-8 When is consolidation considered inappropriate even though the parent holds a majority of the
voting common shares of another company?
LO3 Q3-9 How has reliance on legal control as a consolidation criterion led to off-balance sheet financing?
LO3 Q3-10 What types of entities are referred to as special-purpose entities, and how have they generally been
used?
LO3 Q3-11 How does a variable interest entity typically differ from a traditional corporate business entity?
LO3 Q3-12 What characteristics are normally examined in determining whether a company is a primary
beneficiary of a variable interest entity?
LO2 Q3-13 What is meant by “indirect control”? Give an illustration.
LO4 Q3-14 What means other than majority ownership might be used to gain control over a company? Can
consolidation occur if control is gained by other means?
FIGURE 3–9
Balance Sheet
Consolidating a
Variable Interest
Entity
IGNITION PETROLEUM COMPANY
Consolidated Balance Sheet
Assets
Cash and Receivables $123,500,000
Inventory and Supplies 50,200,000
Equipment Held for Lease 105,000,000
Plant and Equipment (net) 181,350,000
Total Assets $460,050,000
Liabilities
Accounts Payable $ 950,000
Bank Loans Payable 150,000,000
Total Liabilities $150,950,000
Stockholders’ Equity
Common Stock $200,000,000
Retained Earnings 100,100,000
Noncontrolling Interest 9,000,000
Total Stockholders’ Equity 309,100,000
Total Liabilities and Stockholders’ Equity $460,050,000
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136 Chapter 3 The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential
LO5 Q3-15 Why must intercompany receivables and payables be eliminated when consolidated financial
statements are prepared?
LO7 Q3-16 Why are subsidiary shares not reported as stock outstanding in the consolidated balance sheet?
LO8 Q3-17 What must be done if the fiscal periods of the parent and its subsidiary are not the same?
LO7 Q3-18 What is the noncontrolling interest in a subsidiary?
LO6 Q3-19 What is the difference between consolidated and combined financial statements?
LO6 Q3-20 How does the proprietary theory of consolidation differ from current accounting practice?
LO6 Q3-21 How does the entity theory of consolidation differ from current accounting practice?
LO6 Q3-22 Which theory of consolidation is closest to current accounting practice?
Cases
LO3, LO5 C3-1 Computation of Total Asset Values
A reader of Gigantic Company’s consolidated financial statements received from another source
copies of the financial statements of the individual companies included in the consolidation. He is
confused by the fact that the total assets in the consolidated balance sheet differ rather substantially
from the sum of the asset totals reported by the individual companies.
Required
Will this relationship always be true? What factors may cause this difference to occur?
LO3 C3-2 Accounting Entity [AICPA Adapted]
The concept of the accounting entity often is considered to be the most fundamental of accounting
concepts, one that pervades all of accounting.
Required
a. (1) What is an accounting entity? Explain.
(2) Explain why the accounting entity concept is so fundamental that it pervades all of
accounting.
b. For each of the following, indicate whether the entity concept is applicable; discuss and give
illustrations.
(1) A unit created by or under law.
(2) The product-line segment of an enterprise.
(3) A combination of legal units.
(4) All the activities of an owner or a group of owners.
(5) The economy of the United States.
LO5 C3-3 Recognition of Fair Value and Goodwill
March Corporation acquired 65 percent of Ember Corporation’s ownership on January 2, 2008, for
$708,500. At that time, Ember’s net assets had a book value of $810,000 and a fair value of $960,000.
The difference between the book value and fair value of Ember’s net assets all related to depreciable
assets. The total fair value of Ember’s shares not acquired by March Corporation was $381,500.
FASB Statement No. 141R (ASC 805), which was not in effect at the time of Ember’s acquisition, requires recognition of 100 percent of the fair value of the assets and liabilities of an acquired
company and 100 percent of the implied goodwill, even in less-than-100-percent acquisitions.
Because March’s top managers are considering additional acquisitions, they are concerned with
how to account for those acquisitions under the FASB’s current standards.
Required
Analyze how March’s consolidated financial statements would have been different if March had
acquired Ember after FASB Statement No. 141R (ASC 805) became effective. Prepare a memo
to Mr. R. U. Cleer, CFO of March Corporation, explaining how the amounts appearing in the consolidated financial statements relating to Ember would differ between the prior reporting standards
and those established by FASB No. 141R (ASC 805). Include in your memo citations to and quotations from the appropriate accounting literature.
Understanding
Understanding
Research
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LO5 C3-4 Joint Venture Investment
Dell Computer Corp. and CIT Group, Inc., established Dell Financial Services L.P. (DFS) as a
joint venture to provide financing services for Dell customers. Dell originally purchased 70 percent
of the equity of DFS and CIT purchased 30 percent. In the initial agreement, losses were allocated
entirely to CIT, although CIT would recoup any losses before any future income was allocated.
At the time the joint venture was formed, both Dell and CIT indicated that they had no plans to
consolidate DFS.
Required
a. How could both Dell and CIT avoid consolidating DFS?
b. Does Dell currently employ off-balance sheet financing? Explain.
LO5 C3-5 Need for Consolidation [AICPA Adapted]
Sharp Company will acquire 90 percent of Moore Company in a business combination. The total
consideration has been agreed on, but the nature of Sharp’s payment has not. It is expected that on
the date the business combination is to be consummated, the fair value will exceed the book value
of Moore’s assets minus liabilities. Sharp desires to prepare consolidated financial statements that
will include Moore’s financial statements.
Required
a. Explain how the amount of goodwill is determined.
b. From a theoretical standpoint, why should consolidated financial statements be prepared?
c. From a theoretical standpoint, what is usually the first necessary condition to be met before
consolidated financial statements can be prepared?
LO1 C3-6 What Company Is That?
Many well-known products and names come from companies that may be less well known or
may be known for other reasons. In some cases, an obscure parent company may have wellknown subsidiaries, and often familiar but diverse products may be produced under common
ownership.
Required
a. Viacom is not necessarily a common name easily identified because it operates through numerous subsidiaries, but its brand names are seen every day. What are some of the well-known
brand names from Viacom’s subsidiaries? What changes occurred in its organizational structure in 2006? Who is Sumner Redstone?
b. ConAgra Foods, Inc., is one of the world’s largest food processors and distributors. Although
it produces many products with familiar names, the company’s name generally is not well
known. What are some of ConAgra’s brand names?
c. What type of company is Yum! Brands, Inc.? What are some of its well-known brands? What
is the origin of the company, and what was its previous name?
LO1 C3-7 Subsidiaries and Core Businesses
During previous merger booms, a number of companies acquired many subsidiaries that often
were in businesses unrelated to the acquiring company’s central operations. In many cases, the
acquiring company’s management was unable to manage effectively the many diverse types of
operations found in the numerous subsidiaries. More recently, many of these subsidiaries have
been sold or, in a few cases, liquidated so the parent companies could concentrate on their core
businesses.
Required
a. In 1986, General Electric acquired nearly all of the common stock of the large brokerage firm
Kidder, Peabody Inc. Unfortunately, the newly acquired subsidiary’s performance was very
poor. What ultimately happened to this subsidiary of General Electric?
b. What major business has Sears, Roebuck been in for many decades? What other businesses
was it in during the 1980s and early 1990s? What were some of its best-known subsidiaries
during that time? Does Sears still own those subsidiaries? What additional acquisitions have
occurred?
Research
Analysis
Analysis
Analysis
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c. PepsiCo is best known as a soft-drink company. What well-known subsidiaries did PepsiCo
own during the mid-1990s? Does PepsiCo still own them?
d. When a parent company and its subsidiaries are in businesses that are considerably different in
nature, such as retailing and financial services, how meaningful are their consolidated financial statements in your opinion? Explain. How might financial reporting be improved in such
situations?
LO4 C3-8 International Consolidation Issues
The International Accounting Standards Board (IASB) is charged with developing a set of highquality standards and encouraging their adoption globally. Standards promulgated by the IASB
are called International Financial Reporting Standards (IFRS). The European Union (EU) requires
statements prepared using IFRS for all companies that list on the EU stock exchanges. While the
United States does not yet accept IFRS, the SEC has indicated that it is working toward allowing international companies that list on U.S. exchanges to use IFRS for financial reporting in the
United States.
The differences between U.S. GAAP and IFRS are described in many different publications.
For example, PricewaterhouseCoopers has a publication available for download on its Web site
( http://www.pwc.com/us/en/issues/ifrs-reporting/publications/ifrs-and-us-gaap-similarities-anddifferences-september-2009.jhtml ) entitled “IFRS and U.S. GAAP: Similarities and Differences:
September 2009” that provides a topic-based comparison. Based on the information in this publication or others, answer the following questions about the preparation of consolidated financial
statements.
Required
a. Under U.S. GAAP, a two-tiered consolidation model is applied, one focused on voting rights
and the second based on a party’s exposure to risks and rewards associated with the entity’s
activities (the VIE model). Upon what is the IFRS framework based?
b. U.S. GAAP requires a two-step process to evaluate goodwill for potential impairment (as discussed in Chapter 1). What is required by IFRS with respect to goodwill impairment?
c. Under U.S. GAAP, noncontrolling interests are measured at fair value. What is required by
IFRS?
LO3 C3-9 Off-Balance Sheet Financing and VIEs
A variable interest entity (VIE) is a structure frequently used for off-balance sheet financing. VIEs
have become quite numerous in recent years and have been the subject of some controversy.
Required
a. Briefly explain what is meant by off-balance sheet financing.
b. What are three techniques used to keep debt off the balance sheet?
c. What are some legitimate uses of VIEs?
d. How can VIEs be used to manage earnings to meet financial reporting goals? How does this
relate to the importance of following the intent of the guidelines for consolidations?
LO6 C3-10 Alternative Accounting Methods
The use of proportionate or pro rata consolidation generally has not been acceptable in the United
States. Normally, a significant investment in the common stock of another company must be either
fully consolidated or reported using the equity method.
Required
a. What method does Amerada Hess use to account for its investments in affiliates and joint
ventures?
b. What method does EnCana Corporation use to account for its investments in jointly controlled
ventures? In what country is EnCana based? Does this make a difference?
c. Should the method used to account for investments in affiliates be different depending on
whether the affiliate is a corporation or an unincorporated partnership? Explain.
LO5 C3-11 Consolidation Differences among Major Companies
A variety of organizational structures are used by major companies, and different approaches to
consolidation are sometimes found. Two large and familiar U.S. corporations are Union Pacific
and ExxonMobil.
Research
Understanding
Analysis
Research
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Required
a. Many large companies have tens or even hundreds of subsidiaries. List the significant subsidiaries of Union Pacific Corporation.
b. Exxon Mobil Corporation is a major energy company. Does Exxon Mobil consolidate all of its
majority-owned subsidiaries? Explain. Does Exxon Mobil consolidate any entities in which it
does not hold majority ownership? Explain. What methods does Exxon Mobil use to account for
investments in the common stock of companies in which it holds less than majority ownership?
Exercises
LO1 E3-1 Multiple-Choice Questions on Consolidation Overview [AICPA Adapted]
Select the correct answer for each of the following questions.
1. When a parent–subsidiary relationship exists, consolidated financial statements are prepared in
recognition of the accounting concept of
a. Reliability.
b. Materiality.
c. Legal entity.
d. Economic entity.
2. Consolidated financial statements are typically prepared when one company has a controlling
interest in another unless
a. The subsidiary is a finance company.
b. The fiscal year-ends of the two companies are more than three months apart.
c. Circumstances prevent the exercise of control.
d. The two companies are in unrelated industries, such as real estate and manufacturing.
3. Penn Inc., a manufacturing company, owns 75 percent of the common stock of Sell Inc., an
investment company. Sell owns 60 percent of the common stock of Vane Inc., an insurance
company. In Penn’s consolidated statements, should consolidation accounting or equitymethod accounting be used for Sell and Vane?
a. Consolidation used for Sell and equity method used for Vane.
b. Consolidation used for both Sell and Vane.
c. Equity method used for Sell and consolidation used for Vane.
d. Equity method used for both Sell and Vane.
4. Shep Company has a receivable from its parent, Pep Company. Should this receivable be separately reported on Shep’s balance sheet and in Pep’s consolidated balance sheet?
Shep’s
Balance Sheet
Pep’s Consolidated
Balance Sheet
a. Yes No
b. Yes Yes
c. No No
d. No Yes
5. Which of the following is the best theoretical justification for consolidated financial statements?
a. In form the companies are one entity; in substance they are separate.
b. In form the companies are separate; in substance they are one entity.
c. In form and substance the companies are one entity.
d. In form and substance the companies are separate.
LO3 E3-2 Multiple-Choice Questions on Variable Interest Entities
Select the correct answer for each of the following questions.
1. Special-purpose entities generally
a. Have a much larger portion of assets financed by equity shareholders than do companies
such as General Motors.
b. Have relatively large amounts of preferred stock and convertible securities outstanding.
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c. Have a much smaller portion of their assets financed by equity shareholders than do companies such as General Motors.
d. Pay out a relatively high percentage of their earnings as dividends to facilitate the sale of
additional shares.
2. Variable interest entities may be established as
a. Corporations.
b. Trusts.
c. Partnerships.
d. All of the above.
3. An enterprise that will absorb a majority of a variable interest entity’s expected losses is called the
a. Primary beneficiary.
b. Qualified owner.
c. Major facilitator.
d. Critical management director.
4. In determining whether or not a variable interest entity is to be consolidated, the FASB focused on
a. Legal control.
b. Share of profits and obligation to absorb losses.
c. Frequency of intercompany transfers.
d. Proportionate size of the two entities.
LO5 E3-3 Multiple-Choice Questions on Consolidated Balances [AICPA Adapted]
Select the correct answer for each of the following questions.
1. Par Corporation owns 60 percent of Sub Corporation’s outstanding capital stock. On May 1,
20X8, Par advanced Sub $70,000 in cash, which was still outstanding at December 31, 20X8.
What portion of this advance should be eliminated in the preparation of the December 31,
20X8, consolidated balance sheet?
a. $70,000.
b. $42,000.
c. $28,000.
d. $0.
Items 2 and 3 are based on the following:
On January 2, 20X8, Pare Company acquired 75 percent of Kidd Company’s outstanding common stock. Selected balance sheet data at December 31, 20X8, are as follows:
Pare Company Kidd Company
Total Assets $420,000 $180,000
Liabilities $120,000 $ 60,000
Common Stock 100,000 50,000
Retained Earnings 200,000 70,000
$420,000 $180,000
2. In Pare’s December 31, 20X8, consolidated balance sheet, what amount should be reported as
minority interest in net assets?
a. $0.
b. $30,000.
c. $45,000.
d. $105,000.
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3. In its consolidated balance sheet at December 31, 20X8, what amount should Pare report as
common stock outstanding?
a. $50,000.
b. $100,000.
c. $137,500.
d. $150,000.
4. At the time Hyman Corporation became a subsidiary of Duane Corporation, Hyman switched
depreciation of its plant assets from the straight-line method to the sum-of-the-years’-digits
method used by Duane. As to Hyman, this change was a
a. Change in an accounting estimate.
b. Correction of an error.
c. Change of accounting principle.
d. Change in the reporting entity.
5. Consolidated statements are proper for Neely Inc., Randle Inc., and Walker Inc., if
a. Neely owns 80 percent of the outstanding common stock of Randle and 40 percent of
Walker; Randle owns 30 percent of Walker.
b. Neely owns 100 percent of the outstanding common stock of Randle and 90 percent
of Walker; Neely bought the Walker stock one month before the foreign country in
which Walker is based imposed restrictions preventing Walker from remitting profits to
Neely.
c. Neely owns 100 percent of the outstanding common stock of Randle and Walker; Walker is
in legal reorganization.
d. Neely owns 80 percent of the outstanding common stock of Randle and 40 percent of
Walker; Reeves Inc. owns 55 percent of Walker.
LO2, LO5 E3-4 Multiple-Choice Questions on Consolidation Overview [AICPA Adapted]
Select the correct answer for each of the following questions.
1. Consolidated financial statements are typically prepared when one company has
a. Accounted for its investment in another company by the equity method.
b. Accounted for its investment in another company by the cost method.
c. Significant influence over the operating and financial policies of another company.
d. The controlling financial interest in another company.
2. Aaron Inc. owns 80 percent of the outstanding stock of Belle Inc. Compare the consolidated
net earnings of Aaron and Belle (X) and Aaron’s net earnings if it does not consolidate
Belle (Y).
a. X is greater than Y.
b. X is equal to Y.
c. X is less than Y.
d. Cannot be determined.
3. On October 1, X Company acquired for cash all of Y Company’s outstanding common
stock. Both companies have a December 31 year-end and have been in business for
many years. Consolidated net income for the year ended December 31 should include net
income of
a. X Company for three months and Y Company for three months.
b. X Company for 12 months and Y Company for 3 months.
c. X Company for 12 months and Y Company for 12 months.
d. X Company for 12 months, but no income from Y Company until Y Company distributes a
dividend.
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4. Ownership of 51 percent of the outstanding voting stock of a company would usually result in
a. The use of the cost method.
b. The use of the lower-of-cost-or-market method.
c. The use of the equity method.
d. A consolidation.
LO7 E3-5 Balance Sheet Consolidation
On January 1, 20X3, Guild Corporation reported total assets of $470,000, liabilities of $270,000,
and stockholders’ equity of $200,000. At that date, Bristol Corporation reported total assets of
$190,000, liabilities of $135,000, and stockholders’ equity of $55,000. Following lengthy negotiations, Guild paid Bristol’s existing shareholders $44,000 in cash for 80 percent of the voting common shares of Bristol.
Required
Immediately after Guild purchased the Bristol shares
a. What amount of total assets did Guild report in its balance sheet?
b. What amount of total assets was reported in the consolidated balance sheet?
c. What amount of total liabilities was reported in the consolidated balance sheet?
d. What amount of stockholders’ equity was reported in the consolidated balance sheet?
LO7 E3-6 Balance Sheet Consolidation with Intercompany Transfer
Potter Company acquired 90 percent of the voting common shares of Stately Corporation by issuing bonds with a par value and fair value of $121,500 to Stately’s existing shareholders. Immediately prior to the acquisition, Potter reported total assets of $510,000, liabilities of $320,000,
and stockholders’ equity of $190,000. At that date, Stately reported total assets of $350,000,
liabilities of $215,000, and stockholders’ equity of $135,000. Included in Stately’s liabilities
was an account payable to Potter in the amount of $15,000, which Potter included in its accounts
receivable.
Required
Immediately after Potter acquired Stately’s shares
a. What amount of total assets did Potter report in its balance sheet?
b. What amount of total assets was reported in the consolidated balance sheet?
c. What amount of total liabilities was reported in the consolidated balance sheet?
d. What amount of stockholders’ equity was reported in the consolidated balance sheet?
LO7 E3-7 Subsidiary Acquired for Cash
Fineline Pencil Company acquired 80 percent of Smudge Eraser Corporation’s stock on January 2,
20X3, for $72,000 cash. Summarized balance sheet data for the companies on December 31,
20X2, are as follows:
Fineline Pencil
Company
Smudge Eraser
Corporation
Book Value Fair Value Book Value Fair Value
Cash $200,000 $200,000 $ 50,000 $ 50,000
Other Assets 400,000 400,000 120,000 120,000
Total Debits $600,000 $170,000
Current Liabilities $100,000 100,000 $ 80,000 80,000
Common Stock 300,000 50,000
Retained Earnings 200,000 40,000
Total Credits $600,000 $170,000
Required
Prepare a consolidated balance sheet immediately following the acquisition.
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LO7 E3-8 Subsidiary Acquired with Bonds
Byte Computer Corporation acquired 75 percent of Nofail Software Company’s stock on January 2,
20X3, by issuing bonds with a par value of $50,000 and a fair value of $67,500 in exchange for
the shares. Summarized balance sheet data presented for the companies just before the acquisition
are as follows:
Byte Computer
Corporation
Nofail Software
Company
Book Value Fair Value Book Value Fair Value
Cash $200,000 $200,000 $ 50,000 $ 50,000
Other Assets 400,000 400,000 120,000 120,000
Total Debits $600,000 $170,000
Current Liabilities $100,000 100,000 $ 80,000 80,000
Common Stock 300,000 50,000
Retained Earnings 200,000 40,000
Total Credits $600,000 $170,000
Required
Prepare a consolidated balance sheet immediately following the acquisition.
LO7 E3-9 Subsidiary Acquired by Issuing Preferred Stock
Byte Computer Corporation acquired 90 percent of Nofail Software Company’s common
stock on January 2, 20X3, by issuing preferred stock with a par value of $6 per share and
a market value of $8.10 per share. A total of 10,000 shares of preferred stock was issued.
Balance sheet data for the two companies immediately before the business combination are
presented in E3-8.
Required
Prepare a consolidated balance sheet for the companies immediately after Byte obtains ownership
of Nofail by issuing the preferred stock.
LO3 E3-10 Reporting for a Variable Interest Entity
Gamble Company convinced Conservative Corporation that the two companies should establish
Simpletown Corporation to build a new gambling casino in Simpletown Corner. Although chances
for the casino’s success were relatively low, a local bank loaned $140,000,000 to the new corporation, which built the casino at a cost of $130,000,000. Conservative purchased 100 percent of the
initial capital stock offering for $5,600,000, and Gamble agreed to supply 100 percent of the management and guarantee the bank loan. Gamble also guaranteed a 20 percent return to Conservative
on its investment for the first 10 years. Gamble will receive all profits in excess of the 20 percent
return to Conservative. Immediately after the casino’s construction, Gamble reported the following
amounts:
Cash $ 3,000,000
Buildings and Equipment 240,600,000
Accumulated Depreciation 10,100,000
Accounts Payable 5,000,000
Bonds Payable 20,300,000
Common Stock 103,000,000
Retained Earnings 105,200,000
The only disclosure that Gamble currently provides in its financial reports about its relationships to
Conservative and Simpletown is a brief footnote indicating that a contingent liability exists on its
guarantee of Simpletown Corporation’s debt.
Required
Prepare a balance sheet in good form for Gamble immediately following the casino’s construction.
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LO7 E3-11 Consolidation of a Variable Interest Entity
Teal Corporation is the primary beneficiary of a variable interest entity with total assets of
$500,000, liabilities of $470,000, and owners’ equity of $30,000. Because Teal owns 25 percent
of the VIE’s voting stock, it reported a $7,500 investment in the VIE in its balance sheet. Teal
reported total assets of $190,000 (including its investment in the VIE), liabilities of $80,000, common stock of $15,000, and retained earnings of $95,000 in its balance sheet.
Required
Prepare a condensed balance sheet in good form for Teal, taking into consideration that it is the
primary beneficiary of the variable interest entity.
LO5, LO7 E3-12 Computation of Subsidiary Net Income
Frazer Corporation owns 70 percent of Messer Company’s stock. In the 20X9 consolidated income
statement, the noncontrolling interest was assigned $18,000 of income.
Required
What amount of net income did Messer Company report for 20X9?
LO5, LO7 E3-13 Incomplete Consolidation
Belchfi re Motors’ accountant was called away after completing only half of the consolidated statements at the end of 20X4. The data left behind included the following:
Item
Belchfire
Motors
Premium
Body Shop Consolidated
Cash $ 40,000 $ 20,000 $ 60,000
Accounts Receivable 180,000 30,000 200,000
Inventory 220,000 50,000 270,000
Buildings and Equipment (net) 300,000 290,000 590,000
Investment in Premium Body Shop 150,000
Total Debits $890,000 $390,000 $1,120,000
Accounts Payable $ 30,000 $ 40,000
Bonds Payable 400,000 200,000
Common Stock 200,000 100,000
Retained Earnings 260,000 50,000
Total Credits $890,000 $390,000
Required
a. Belchfire Motors acquired shares of Premium Body Shop at underlying book value on
January 1, 20X1. What portion of the ownership of Premium Body Shop does Belchfire apparently hold?
b. Compute the consolidated totals for each of the remaining balance sheet items.
LO5, LO7 E3-14 Noncontrolling Interest
Sanderson Corporation acquired 70 percent of Kline Corporation’s common stock on January 1,
20X7, for $294,000 in cash. At the acquisition date, the book values and fair values of Kline’s
assets and liabilities were equal, and the fair value of the noncontrolling interest was equal to
30 percent of the total book value of Kline. The stockholders’ equity accounts of the two companies
at the date of purchase are:
Sanderson
Corporation
Kline
Corporation
Common Stock ($10 par value) $400,000 $ 180,000
Additional Paid-In Capital 222,000 65,000
Retained Earnings 358,000 175,000
Total Stockholders’ Equity $980,000 $420,000
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Required
a. What amount will be assigned to the noncontrolling interest on January 1, 20X7, in the consolidated balance sheet?
b. Prepare the stockholders’ equity section of Sanderson and Kline’s consolidated balance sheet
as of January 1, 20X7.
c. Sanderson acquired ownership of Kline to ensure a constant supply of electronic switches,
which it purchases regularly from Kline. Why might Sanderson not feel compelled to purchase
all of Kline’s shares?
LO7 E3-15 Computation of Consolidated Net Income
Ambrose Corporation owns 75 percent of Kroop Company’s common stock, acquired at underlying book value on January 1, 20X4. At the acquisition date, the book values and fair values of
Kroop’s assets and liabilities were equal, and the fair value of the noncontrolling interest was equal
to 25 percent of the total book value of Kroop. The income statements for Ambrose and Kroop for
20X4 include the following amounts:
Ambrose
Corporation
Kroop
Company
Sales $528,000 $150,000
Dividend Income 9,000
Total Income $537,000 $150,000
Less: Cost of Goods Sold $380,000 $ 87,000
Depreciation Expense 32,000 20,000
Other Expenses 66,000 23,000
Total Expenses $478,000 $130,000
Net Income $ 59,000 $ 20,000
Ambrose uses the cost method in accounting for its ownership of Kroop. Kroop paid dividends of
$12,000 in 20X4.
Required
a. What amount should Ambrose report in its income statement as income from its investment in
Kroop using equity-method accounting?
b. What amount of income should be assigned to noncontrolling interest in the consolidated
income statement for 20X4?
c. What amount should Ambrose report as consolidated net income for 20X4?
d. Why should Ambrose not report consolidated net income of $79,000 ($59,000 + $20,000) for
20X4?
LO7 E3-16 Computation of Subsidiary Balances
Tall Corporation acquired 75 percent of Light Corporation’s voting common stock on January 1,
20X2, at underlying book value. At the acquisition date, the book values and fair values of
Light’s assets and liabilities were equal, and the fair value of the noncontrolling interest was
equal to 25 percent of the total book value of Light. Noncontrolling interest was assigned income
of $8,000 in Tall’s consolidated income statement for 20X2 and a balance of $65,500 in Tall’s
consolidated balance sheet at December 31, 20X2. Light reported retained earnings of $70,000
and additional paid-in capital of $40,000 on January 1, 20X2. Light did not pay dividends or
issue stock in 20X2.
Required
a. Compute the amount of net income reported by Light for 20X2.
b. Prepare the stockholders’ equity section of Light’s balance sheet at December 31, 20X2.
LO7, LO8 E3-17 Subsidiary Acquired at Net Book Value
On December 31, 20X8, Banner Corporation acquired 80 percent of Dwyer Company’s common
stock for $136,000. At the acquisition date, the book values and fair values of all of Dwyer’s assets
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and liabilities were equal. Banner uses the equity method in accounting for its investment. Balance
sheet information provided by the companies at December 31, 20X8, is as follows:
Banner
Corporation
Dwyer
Company
Cash $ 74,000 $ 20,000
Accounts Receivable 120,000 70,000
Inventory 180,000 90,000
Fixed Assets (net) 350,000 240,000
Investment in Dwyer Company Stock 136,000
Total Debits $860,000 $420,000
Accounts Payable $ 65,000 $ 30,000
Notes Payable 350,000 220,000
Common Stock 150,000 90,000
Retained Earnings 295,000 80,000
Total Credits $860,000 $420,000
Required
Prepare a consolidated balance sheet for Banner at December 31, 20X8.
LO6 E3-18 Applying Alternative Accounting Theories
Noway Manufacturing owns 75 percent of Positive Piston Corporation’s stock. During 20X9,
Noway and Positive Piston reported sales of $400,000 and $200,000 and expenses of $280,000
and $160,000, respectively.
Required
Compute the amount of total revenue, total expenses, and net income to be reported in the 20X9
consolidated income statement under the following alternative approaches:
a. Proprietary theory.
b. Parent company theory.
c. Entity theory.
d. Current accounting practice.
LO6 E3-19 Measurement of Goodwill
Rank Corporation acquired 60 percent of Fresh Company’s stock on December 31, 20X4. In preparing the consolidated financial statements at December 31, 20X4, goodwill of $240,000 was
reported. The goodwill is attributable to Rank’s purchase of Fresh shares, and the parent company
approach was used in determining the amount of goodwill reported.
Required
Determine the amount of goodwill to be reported under each of the following consolidation
alternatives:
a. Proprietary theory.
b. Entity theory.
c. Current accounting practice.
LO6 E3-20 Assets under Alternative Accounting Theories
Garwood Corporation acquired 75 percent of Zorn Company’s voting common stock on January 1,
20X4. At the time of acquisition, Zorn reported buildings and equipment at book value of $240,000;
however, an appraisal indicated a fair value of $290,000.
Required
If consolidated statements are prepared, determine the amount at which buildings and equipment
will be reported using the following consolidation alternatives:
a. Entity theory.
b. Parent company theory.
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c. Proprietary theory.
d. Current accounting practice.
LO6 E3-21 Reported Income under Alternative Accounting Theories
Placer Corporation acquired 80 percent of Billings Company’s voting common stock on January 1,
20X4. Placer and Billings reported total revenue of $410,000 and $200,000 and total expenses of
$320,000 and $150,000, respectively, for the year ended December 31, 20X4.
Required
Determine the amount of total revenue, total expense, and net income to be reported in the consolidated income statement for 20X4 under the following consolidation alternatives:
a. Entity theory.
b. Parent company theory.
c. Proprietary theory.
d. Current accounting practice.
LO7 E3-22 Acquisition of Majority Ownership
Lang Company reports net assets with a book value and fair value of $200,000 Pace Corporation
acquires 75 percent ownership for $150,000. Pace reports net assets with a book value of $520,000
and a fair value of $640,000 at that time, excluding its investment in Lang.
Required
For each of the following, compute the amounts that would be reported immediately after the combination under current accounting practice:
a. Consolidated net identifiable assets.
b. Noncontrolling interest.
Problems
LO7 P3-23 Multiple-Choice Questions on Consolidated and Combined Financial
Statements [AICPA Adapted]
Select the correct answer for each of the following questions.
1. What is the theoretically preferred method of presenting a noncontrolling interest in a consolidated balance sheet?
a. As a separate item within the liability section.
b. As a deduction from (contra to) goodwill from consolidation, if any.
c. By means of notes or footnotes to the balance sheet.
d. As a separate item within the stockholders’ equity section.
2. Presenting consolidated financial statements this year when statements of individual companies
were presented last year is
a. The correction of an error.
b. An accounting change that should be reported prospectively.
c. An accounting change that should be reported by restating the financial statements of all
prior periods presented.
d. Not an accounting change.
3. A subsidiary, acquired for cash in a business combination, owned equipment with a market
value in excess of book value as of the date of combination. A consolidated balance sheet prepared immediately after the acquisition would treat this excess as
a. Goodwill.
b. Plant and equipment.
c. Retained earnings.
d. Deferred credit.
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4. Mr. Cord owns four corporations. Combined financial statements are being prepared for
these corporations, which have intercompany loans of $200,000 and intercompany profits of
$500,000. What amount of these intercompany loans and profits should be included in the combined financial statements?
Intercompany
Loans Profits
a. $200,000 $ 0
b. $200,000 $500,000
c. $ 0 $ 0
d. $ 0 $500,000
LO7 P3-24 Determining Net Income of Parent Company
Tally Corporation and its subsidiary reported consolidated net income of $164,300 for 20X2. Tally
owns 60 percent of the common shares of its subsidiary, acquired at book value. Noncontrolling
interest was assigned income of $15,200 in the consolidated income statement for 20X2.
Required
Determine the amount of separate operating income reported by Tally for 20X2.
LO7 P3-25 Reported Balances
Roof Corporation acquired 80 percent of the stock of Gable Company by issuing shares of its common stock with a fair value of $192,000. At that time, the fair value of the noncontrolling interest
was estimated to be $48,000 and the fair values of Gable’s identifiable assets and liabilities were
$310,000 and $95,000, respectively. Gable’s assets and liabilities had book values of $220,000
and $95,000, respectively.
Required
Compute the following amounts to be reported immediately after the combination
a. Investment in Gable reported by Roof.
b. Increase in identifiable assets of the combined entity.
c. Increase in total liabilities of the combined entity.
d. Goodwill for the combined entity.
e. Noncontrolling interest reported in the consolidated balance sheet.
LO7 P3-26 Acquisition Price
Darwin Company holds assets with a fair value of $120,000 and a book value of $90,000 and
liabilities with a book value and fair value of $25,000.
Required
Compute the following amounts if Brad Corporation acquires 60 percent ownership of Darwin:
a. What amount did Brad pay for the shares if no goodwill and no gain on a bargain purchase are
reported?
b. What amount did Brad pay for the shares if the fair value of the noncontrolling interest at acquisition is $54,000 and goodwill of $40,000 is reported?
c. What balance will be assigned to the noncontrolling interest in the consolidated balance sheet if
Brad pays $73,200 to acquire its ownership and goodwill of $27,000 is reported?
LO3 P3-27 Consolidation of a Variable Interest Entity
On December 28, 20X3, Stern Corporation and Ram Company established S&R Partnership, with
cash contributions of $10,000 and $40,000, respectively. The partnership’s purpose is to purchase
from Stern accounts receivable that have an average collection period of 80 days and hold them
to collection. The partnership borrows cash from Midtown Bank and purchases the receivables
without recourse but at an amount equal to the expected percent to be collected, less a financing
fee of 3 percent of the gross receivables. Stern and Ram hold 20 percent and 80 percent of the
ownership of the partnership, respectively, and Stern guarantees both the bank loan made to the
partnership and a 15 percent annual return on the investment made by Ram. Stern receives any
income in excess of the 15 percent return guaranteed to Ram. The partnership agreement provides
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Stern total control over the partnership’s activities. On December 31, 20X3, Stern sold $8,000,000
of accounts receivable to the partnership. The partnership immediately borrowed $7,500,000 from
the bank and paid Stern $7,360,000. Prior to the sale, Stern had established a $400,000 allowance
for uncollectibles on the receivables sold to the partnership. The balance sheets of Stern and S&R
immediately after the sale of receivables to the partnership contained the following:
Stern
Corporation
S&R
Partnership
Cash $7,960,000 $ 190,000
Accounts Receivable 4,200,000 8,000,000
Allowance for Uncollectible Accounts (210,000) (400,000)
Other Assets 5,400,000
Prepaid Finance Charges 240,000
Investment in S&R Partnership 10,000
Accounts Payable 950,000
Deferred Revenue 240,000
Bank Notes Payable 7,500,000
Bonds Payable 9,800,000
Common Stock 700,000
Retained Earnings 6,150,000
Capital, Stern Corporation 10,000
Capital, Ram Company 40,000
Required
Assuming that Stern is S&R’s primary beneficiary, prepare a consolidated balance sheet in good
form for Stern at January 1, 20X4.
LO3 P3-28 Reporting for Variable Interest Entities
Purified Oil Company and Midwest Pipeline Corporation established Venture Company to conduct oil exploration activities in North America to reduce their dependence on imported crude oil.
Midwest Pipeline purchased all 20,000 shares of the newly created company for $10 each. Purified Oil agreed to purchase all of Venture’s output at market price, guarantee up to $5,000,000 of
debt for Venture, and absorb all losses if the company proved unsuccessful. Purified and Midwest
agreed to share equally the profits up to $80,000 per year and to allocate 70 percent of those in
excess of $80,000 to Purified and 30 percent to Midwest.
Venture immediately borrowed $3,000,000 from Second National Bank and purchased land,
drilling equipment, and supplies to start its operations. Following these asset purchases, Venture
and Purified Oil reported the following balances:
Venture
Company
Purified Oil
Company
Cash $ 230,000 $ 410,000
Drilling Supplies 420,000
Accounts Receivable 640,000
Equipment (net) 1,800,000 6,700,000
Land 900,000 4,200,000
Accounts Payable 150,000 440,000
Bank Loans Payable 3,000,000 8,800,000
Common Stock 200,000 560,000
Retained Earnings 2,150,000
The only disclosure that Purified Oil currently provides in its financial statements with respect
to its relationship with Midwest Pipeline and Venture is a brief note indicating that a contingent
liability exists on the guarantee of Venture Company debt.
Required
Assuming that Venture is considered to be a variable interest entity and Purified Oil is the primary
beneficiary, prepare a balance sheet in good form for Purified Oil.
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LO7 P3-29 Consolidated Income Statement Data
Master Products acquired 80 percent ownership of LoCal Bakeries on January 1, 20X3, when the
fair value of LoCal’s depreciable assets was equal to book value.
Master Products LoCal Bakeries
Sales $ 300,000 $ 200,000
Cost of Goods Sold $200,000 $130,000
Depreciation Expense 40,000 (240,000) 30,000 (160,000)
Income before Income from Subsidiary $ 60,000
Net Income $ 40,000
During 20X3, Master Products purchased a special imported yeast for $35,000 and resold it to
LoCal for $50,000. LoCal did not resell any of the yeast before year-end.
Required
Determine the amounts to be reported for each of the following items in the consolidated income
statement for 20X3:
a. Sales.
b. Investment income from LoCal Bakeries.
c. Cost of goods sold.
d. Depreciation expense.
LO7 P3-30 Parent Company and Consolidated Amounts
Quoton Corporation acquired 80 percent of Tempro Company’s common stock on December 31,
20X5, at underlying book value. The book values and fair values of Tempro’s assets and liabilities
were equal, and the fair value of the noncontrolling interest was equal to 20 percent of the total
book value of Tempro. Tempro provided the following trial balance data at December 31, 20X5:
Debit Credit
Cash $ 28,000
Accounts Receivable 65,000
Inventory 90,000
Buildings and Equipment (net) 210,000
Cost of Goods Sold 105,000
Depreciation Expense 24,000
Other Operating Expenses 31,000
Dividends Declared 15,000
Accounts Payable $ 33,000
Notes Payable 120,000
Common Stock 90,000
Retained Earnings 130,000
Sales 195,000
Total $568,000 $568,000
Required
a. How much did Quoton pay to purchase its shares of Tempro?
b. If consolidated financial statements are prepared at December 31, 20X5, what amount will be
assigned to the noncontrolling interest in the consolidated balance sheet?
c. If Quoton reported income of $143,000 from its separate operations for 20X5, what amount of
consolidated net income will be reported for 20X5?
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d. If Quoton had purchased its ownership of Tempro on January 1, 20X5, at underlying book
value and Quoton reported income of $143,000 from its separate operations for 20X5, what
amount of consolidated net income would be reported for 20X5?
LO7 P3-31 Parent Company and Consolidated Balances
Exacto Company reported the following net income and dividends for the years indicated:
Year Net Income Dividends
20X5 $35,000 $12,000
20X6 45,000 20,000
20X7 30,000 14,000
True Corporation acquired 75 percent of Exacto’s common stock on January 1, 20X5. On that
date, the fair value of Exacto’s net assets was equal to the book value. True uses the equity method
in accounting for its ownership in Exacto and reported a balance of $259,800 in its investment
account on December 31, 20X7.
Required
a. What amount did True pay when it purchased Exacto’s shares?
b. What was the fair value of Exacto’s net assets on January 1, 20X5?
c. What amount was assigned to the NCI shareholders on January 1, 20X5?
d. What amount will be assigned to the NCI shareholders in the consolidated balance sheet prepared at December 31, 20X7?
LO2, LO7 P3-32 Indirect Ownership
Purple Corporation recently attempted to expand by acquiring ownership in Green Company. The
following ownership structure was reported on December 31, 20X9:
Investor Investee
Percentage of
Ownership Held
Purple Corporation Green Company 70
Green Company Orange Corporation 10
Orange Corporation Blue Company 60
Green Company Yellow Company 40
The following income from operations (excluding investment income) and dividend payments
were reported by the companies during 20X9:
Company
Operating
Income
Dividends
Paid
Purple Corporation $ 90,000 $60,000
Green Company 20,000 10,000
Orange Corporation 40,000 30,000
Blue Company 100,000 80,000
Yellow Company 60,000 40,000
Required
Compute the amount reported as consolidated net income for 20X9.
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LO6 P3-33 Balance Sheet Amounts under Alternative Accounting Theories
Parsons Corporation purchased 75 percent ownership of Tumble Company on December 31, 20X7,
for $210,000. Summarized balance sheet amounts for the companies on December 31, 20X7, prior
to the purchase, were as follows:
Parsons
Corporation
Tumble Company
Book Value Fair Value
Cash and Inventory $300,000 $ 80,000 $ 80,000
Buildings and Equipment (net) 400,000 120,000 180,000
Total Assets $700,000 $200,000 $260,000
Common Stock $380,000 $ 90,000
Retained Earnings 320,000 110,000
Total Liabilities and Stockholders’ Equity $700,000 $200,000
Required
If consolidated financial statements are prepared, determine the amounts that would be reported as cash
and inventory, buildings and equipment (net), and goodwill using the following consolidation alternatives:
a. Proprietary theory.
b. Parent company theory.
c. Entity theory.
d. Current accounting practice.
LO7, LO8 P3-34 Consolidated Worksheet and Balance Sheet on the Acquisition Date
(Equity Method)
Peanut Company acquired 90 percent of Snoopy Company’s outstanding common stock for
$270,000 on January 1, 20X8, when the book value of Snoopy’s net assets was equal to $300,000.
Peanut uses the equity method to account for investments. Trial balance data for Peanut and
Snoopy as of January 1, 20X8, are as follows:
Peanut
Company
Snoopy
Company
Assets
Cash 55,000 20,000
Accounts Receivable 50,000 30,000
Inventory 100,000 60,000
Investment in Snoopy Stock 270,000
Land 225,000 100,000
Buildings and Equipment 700,000 200,000
Accumulated Depreciation (400,000) (10,000)
Total Assets 1,000,000 400,000
Liabilities and Stockholders’ Equity
Accounts Payable 75,000 25,000
Bonds Payable 200,000 75,000
Common Stock 500,000 200,000
Retained Earnings 225,000 100,000
Total Liabilities and Equity 1,000,000 400,000
Required
a. Prepare the journal entry on Peanut’s books for the acquisition of Snoopy on January 1, 20X8.
b. Prepare a consolidation worksheet on the acquisition date, January 1, 20X8, in good form.
c. Prepare a consolidated balance sheet on the acquisition date, January 1, 20X8, in good form.
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LO7, LO8 P3-35 Consolidated Worksheet at End of the First Year of Ownership (Equity Method)
Peanut Company acquired 90 percent of Snoopy Company’s outstanding common stock for
$270,000 on January 1, 20X8, when the book value of Snoopy’s net assets was equal to $300,000.
Peanut uses the equity method to account for investments. Trial balance data for Peanut and
Snoopy as of December 31, 20X8, are as follows:
Peanut Company Snoopy Company
Debit Credit Debit Credit
Cash 158,000 80,000
Accounts Receivable 165,000 65,000
Inventory 200,000 75,000
Investment in Snoopy Stock 319,500 0
Land 200,000 100,000
Buildings and Equipment 700,000 200,000
Cost of Goods Sold 200,000 125,000
Depreciation Expense 50,000 10,000
Selling & Administrative Expense 225,000 40,000
Dividends Declared 100,000 20,000
Accumulated Depreciation 450,000 20,000
Accounts Payable 75,000 60,000
Bonds Payable 200,000 85,000
Common Stock 500,000 200,000
Retained Earnings 225,000 100,000
Sales 800,000 250,000
Income from Snoopy 67,500 0
Total 2,317,500 2,317,500 715,000 715,000
(continued)
Peanut Company Snoopy Company
Debit Credit Debit Credit
Cash 255,000 75,000
Accounts Receivable 190,000 80,000
Inventory 180,000 100,000
Investment in Snoopy Stock 364,500 0
Land 200,000 100,000
Buildings and Equipment 700,000 200,000
Cost of Goods Sold 270,000 150,000
Depreciation Expense 50,000 10,000
Selling & Administrative Expense 230,000 60,000
Required
a. Prepare any equity method journal entry(ies) related to the investment in Snoopy Company for
20X8.
b. Prepare a consolidation worksheet for 20X8 in good form.
LO7, LO8 P3-36 Consolidated Worksheet at End of the Second Year of Ownership
(Equity Method)
Peanut Company acquired 90 percent of Snoopy Company’s outstanding common stock for
$270,000 on January 1, 20X8, when the book value of Snoopy’s net assets was equal to $300,000.
Problem 3-36 summarizes the first year of Peanut’s ownership of Snoopy. Peanut uses the equity
method to account for investments. The following trial balance summarizes the financial position
and operations for Peanut and Snoopy as of December 31, 20X9:
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Required
a. Prepare any equity method journal entry(ies) related to the investment in Snoopy Company
during 20X9.
b. Prepare a consolidation worksheet for 20X9 in good form.
LO7, LO8 P3-37 Consolidated Worksheet and Balance Sheet on the Acquisition Date
(Equity Method)
Paper Company acquired 80 percent of Scissor Company’s outstanding common stock for
$296,000 on January 1, 20X8, when the book value of Scissor’s net assets was equal to $370,000.
Paper uses the equity method to account for investments. Trial balance data for Paper and Scissor
as of January 1, 20X8, are as follows:
Peanut Company Snoopy Company
Debit Credit Debit Credit
Dividends Declared 225,000 30,000
Accumulated Depreciation 500,000 30,000
Accounts Payable 75,000 35,000
Bonds Payable 150,000 85,000
Common Stock 500,000 200,000
Retained Earnings 517,500 155,000
Sales 850,000 300,000
Income from Snoopy 72,000 0
Total 2,664,500 2,664,500 805,000 805,000
Paper
Company
Scissor
Company
Assets
Cash 109,000 25,000
Accounts Receivable 65,000 37,000
Inventory 125,000 87,000
Investment in Scissor Stock 296,000
Land 280,000 125,000
Buildings and Equipment 875,000 250,000
Accumulated Depreciation (500,000) (24,000)
Total Assets 1,250,000 500,000
Liabilities and Stockholders’ Equity
Accounts Payable 95,000 30,000
Bonds Payable 250,000 100,000
Common Stock 625,000 250,000
Retained Earnings 280,000 120,000
Total Liabilities and Equity 1,250,000 500,000
Required
a. Prepare the journal entry on Paper’s books for the acquisition of Scissor Co. on January
1, 20X8.
b. Prepare a consolidation worksheet on the acquisition date, January 1, 20X8, in good form.
c. Prepare a consolidated balance sheet on the acquisition date, January 1, 20X8, in good form.
LO7, LO8 P3-38 Consolidated Worksheet at End of the First Year of Ownership
(Equity Method)
Paper Company acquired 80 percent of Scissor Company’s outstanding common stock for
$296,000 on January 1, 20X8, when the book value of Scissor’s net assets was equal to $370,000.
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Paper uses the equity method to account for investments. Trial balance data for Paper and Scissor
as of December 31, 20X8, are as follows:
Paper Company Scissor Company
Debit Credit Debit Credit
Cash 191,000 46,000
Accounts Receivable 140,000 60,000
Inventory 190,000 120,000
Investment in Scissor Stock 350,400 0
Land 250,000 125,000
Buildings and Equipment 875,000 250,000
Cost of Goods Sold 250,000 155,000
Depreciation Expense 65,000 12,000
Selling & Administrative Expense 280,000 50,000
Dividends Declared 80,000 25,000
Accumulated Depreciation 565,000 36,000
Accounts Payable 77,000 27,000
Bonds Payable 250,000 100,000
Common Stock 625,000 250,000
Retained Earnings 280,000 120,000
Sales 800,000 310,000
Income from Scissor 74,400 0
Total 2,671,400 2,671,400 843,000 843,000
(continued)
Paper Company Scissor Company
Debit Credit Debit Credit
Cash 295,000 116,000
Accounts Receivable 165,000 97,000
Inventory 193,000 115,000
Investment in Scissor Stock 412,000 0
Land 250,000 125,000
Buildings and Equipment 875,000 250,000
Cost of Goods Sold 278,000 178,000
Depreciation Expense 65,000 12,000
Selling & Administrative Expense 312,000 58,000
Dividends Declared 90,000 30,000
Accumulated Depreciation 630,000 48,000
Accounts Payable 85,000 40,000
Required
a. Prepare any equity method journal entry(ies) related to the investment in Scissor Company for
20X8.
b. Prepare a consolidation worksheet for 20X8 in good form.
LO7, LO8 P3-39 Consolidated Worksheet at End of the Second Year of Ownership
(Equity Method)
Paper Company acquired 80 percent of Scissor Company’s outstanding common stock for $296,000
on January 1, 20X8, when the book value of Scissor’s net assets was equal to $370,000. Problem
3-36 summarizes the first year of Paper’s ownership of Scissor. Paper uses the equity method to
account for investments. The following trial balance summarizes the financial position and operations for Paper and Scissor as of December 31, 20X9:
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156 Chapter 3 The Reporting Entity and Consolidation of Less-than-Wholly-Owned Subsidiaries with No Differential
Required
a. Prepare any equity method journal entry(ies) related to the investment in Scissor Company during 20X9.
b. Prepare a consolidation worksheet for 20X9 in good form.
Paper Company Scissor Company
Debit Credit Debit Credit
Bonds Payable 150,000 100,000
Common Stock 625,000 250,000
Retained Earnings 479,400 188,000
Sales 880,000 355,000
Income from Scissor 85,600 0
Total 2,935,000 2,935,000 981,000 981,000
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157
Consolidation of Wholly
Owned Subsidiaries
Acquired at More than
Book Value
HOW MUCH WORK DOES IT REALLY TAKE
TO CONSOLIDATE? ASK THE PEOPLE WHO DO
IT AT DISNEY
The Walt Disney Company, whose history goes back to 1923, is parent company to
some of the most well-known businesses in the world. Best known for Walt Disney
Studios, its world famous parks and resorts, its media operations, like the Disney
Channel, and its consumer products, Disney is a widely diversified company. For
example, did you know that Disney owns the ABC Television Network and is the
majority owner of ESPN? While the consolidation examples you’re working in class
usually involve a parent company and a single subsidiary, Disney employs a dedicated staff at its Burbank, California headquarters each quarter to complete the consolidation of its five segments, each comprised of many subsidiaries, in preparation
for its quarterly 10-Q and annual 10-K filings with the SEC. Preparation for the
actual consolidation begins before the end of the fiscal period and soon after the end
of the period each segment closes its books, including performing its own subsidiaryconsolidations, works with the independent auditors, and prepares for the roll-up to
the overall company consolidation. The work continues as the finance and accounting staff of approximately 100 men and women at the corporate offices review and
analyze the results from the individual segments and work with segment financial
staff to prepare what becomes the publicly disclosed set of consolidated financial
statements.
However, the work doesn’t all take place at the end of the fiscal period. The accounting system also tracks intercompany transactions throughout the period. The consolidation process requires the elimination of intercompany sales and asset transfers among
others cost allocations (as discussed in Chapters 6 and 7). Tracking these transactions
involves ongoing efforts throughout the period.
Finally, you may have read recently about Disney’s acquisition of Marvel Entertainment in 2009 and its acquisition of Pixar Animation Studios in 2006. In these and
other well-known acquisitions, Disney paid more than the book value of each acquired
company’s net assets to acquire them. Acquisition accounting rules require Disney to
account for the full acquisition price—even though the acquired companies may continue to report their assets and liabilities on their separate books at their historical book
Governmental
Entities
Business
Combinations
Consolidation Concepts
and Procedures
Intercompany Transfers
Multinational
Entities
Multi-Corporate
Entities
Partnerships
Chapter Four
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158 Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value
values. Thus, acquisition accounting requires Disney to essentially re-value the balance
sheets of these companies to their amortized fair values in the consolidation process
each period.
The bottom line is that preparation of Disney’s publicly disclosed financial statements is the culmination of a lot of work by the segment and corporate accounting
and finance staff. The issues mentioned here illustrate the complexity of a process
that requires substantial team work and effort to produce audited financial statements
that are valuable to an investor or interested accounting student. You’ll learn in this
chapter about the value-added activities during the consolidation process performed
by the accounting staff at any well-known public company. This chapter also introduces differences in the consolidation process when there is a differential (i.e., the
acquiring company pays more than the book value of the acquired company’s net
assets).
LEARNING OBJECTIVES
When you finish studying this chapter, you should be able to:
LO1 Understand and make equity-method journal entries related to the differential.
LO2 Understand and explain how consolidation procedures differ when there is a
differential.
LO3 Make calculations and prepare elimination entries for the consolidation of a
wholly owned subsidiary when there is a complex positive differential at the
acquisition date.
LO4 Make calculations and prepare elimination entries for the consolidation
of a wholly owned subsidiary when there is a complex bargain-purchase
differential.
LO5 Prepare equity-method journal entries, elimination entries, and the consolidation worksheet for a wholly owned subsidiary when there is a complex positive
differential.
LO6 Understand and explain the elimination of basic intercompany transactions.
LO7 Understand and explain the basics of push-down accounting.
DEALING WITH THE DIFFERENTIAL
This chapter continues to build upon the foundation established in Chapters 2 and 3
related to the consolidation of majority-owned subsidiaries. In Chapters 2 and 3, we
focus on relatively simple situations where the acquisition price is exactly equal to the
parent’s share of the book value of the subsidiary’s net assets. In Chapter 4, we relax this
assumption and allow the acquisition price to differ from book value. As explained in
Chapter 1, this allows for a “differential.”
No NCI
shareholders
NCI
shareholders
Differential
No
differential Investment = Book value
Wholly owned
subsidiary
Partially owned
subsidiary
Chapter 2
Chapter 4
Chapter 3
Investment > Book value Chapter 5
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Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value 159
The Difference between Acquisition Price
and Underlying Book Value
When an investor purchases the common stock of another company, the purchase price
normally is based on the market value of the shares acquired rather than the book value
of the investee’s assets and liabilities. Not surprisingly, the acquisition price is usually
different from the book value of the investor’s proportionate share of the investee’s
net assets. This difference is referred to as a differential. The differential is frequently
positive, meaning the acquiring company pays more than their share of the book value of
the subsidiary’s net assets. Note that in the case of an equity-method investment, the differential on the parent’s books relates only to the parent’s share of any difference between
total investee’s fair value and book value. The differential in the case of an equity-method
investment is implicit in the investment account on the parent’s books and is not recorded
separately.
The cost of an investment might exceed the book value of the underlying net assets,
giving rise to a positive differential, for any of several reasons. One reason is that the
investee’s assets may be worth more than their book values. Another reason could be
the existence of unrecorded goodwill associated with the excess earning power of the
investee. In either case, the portion of the differential pertaining to each asset of the
investee, including goodwill, must be ascertained. When the parent company uses
the equity-method, that portion of the differential pertaining to limited-life assets of
the investee, including identifiable intangibles, must be amortized over the remaining
economic lives of those assets. Any portion of the differential that represents goodwill
(referred to as equity-method goodwill ) is not amortized or written off because of impairment. However, an impairment loss on the investment itself should be recognized if it
suffers a material decline in value that is other than temporary.
Amortization or Write-Off of the Differential 1
When the equity-method is used, each portion of the differential must be treated in
the same manner as the investee treats the assets or liabilities to which the differential relates. Thus, any portion of the differential related to depreciable or amortizable
assets of the investee should be amortized over the remaining time that the cost of the
asset is being allocated by the investee. Amortization of the differential associated
with depreciable or amortizable assets of the investee is necessary on the investor’s
books to reflect the decline in the future benefits the investor expects from that portion
of the investment cost associated with those assets. The investee recognizes the reduction in service potential of assets with limited lives as depreciation or amortization
expense based on the amount it has invested in those assets. This reduction, in turn,
is recognized by the investor through its share of the investee’s net income. When the
cost of the investor’s interest in the investee’s assets is greater than the investee’s cost
(as reflected in a positive differential), the additional cost must be amortized as well.
The approach to amortizing the differential that is most consistent with the idea of
reflecting all aspects of the investment in just one line on the balance sheet and one line
on the income statement is to reduce the income recognized by the investor from the
investee and the balance of the investment account:
LO1
Understand and make
equity-method journal
entries related to the
differential.
Income from Investee XXXX
Investment in Common Stock of Investee XXX
The differential represents the amount paid by the investor in excess of the book value
of the investment and is included in the investment amount. Hence, the amortization or
reduction of the differential involves the reduction of the investment account. At the
same time, the investor’s net income must be reduced by an equal amount to recognize
that a portion of the amount paid for the investment has expired.
1 To view a video explanation of this topic, visit advancedstudyguide.com.
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160 Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value
Cost of investment to Ajax $200,000
Book value of Ajax’s share of Barclay’s net assets (160,000)
Differential $ 40,000
Total Increase Ajax’s 40% Share
Land $15,000 6,000
Equipment 50,000 20,000
$65,000 $26,000
Treatment of the Differential Illustrated
To illustrate the equity-method when the cost of the investment exceeds the book value
of the underlying net assets, assume that Ajax Corporation purchases 40 percent of the
common stock of Barclay Company on January 1, 20X1, for $200,000. Barclay has net
assets on that date with a book value of $400,000 and fair value of $465,000. Ajax’s share
of the book value of Barclay’s net assets at acquisition is $160,000 ($400,000 × 0.40).
A $40,000 differential is computed as follows:
The $65,000 excess of the fair value over the book value of Barclay’s net assets consists
of a $15,000 increase in the value of Barclay’s land and a $50,000 increase in the value
of Barclay’s equipment. Ajax’s 40 percent share of the increase in the value of Barclay’s
assets is as follows:
Thus, $26,000 of the differential is assigned to land and equipment, with the remaining
$14,000 attributed to goodwill. The allocation of the differential can be illustrated as
shown in the diagram.
Although the differential relates to assets of Barclay, the additional cost incurred
by Ajax to acquire a claim on the assets of Barclay is reflected in Ajax’s investment
in Barclay. No separate differential account is established, and no separate accounts are
recorded on Ajax’s books to reflect the apportionment of the differential to specific assets.
Similarly, no separate expense account is established on Ajax’s books. Amortization or
write-off of the differential is accomplished by reducing Ajax’s investment account and
the income Ajax recognizes from its investment in Barclay.
Because land has an unlimited economic life, the portion of the differential related to
land is not amortized. The $20,000 portion of the differential related to Barclay’s equipment is amortized over the equipment’s remaining life. If the equipment’s remaining life
is five years, Ajax’s annual amortization of the differential is $4,000 ($20,000 ÷ 5).
Beginning in 1970, financial reporting standards required that goodwill be amortized over its useful life, not to exceed 40 years. In 2001, however, the FASB issued
Statement No. 142 (ASC 350), “Goodwill and Other Intangible Assets,” under which
equity-method goodwill is neither amortized nor written off. That portion of the differential remains imbedded in the investment account. Thus, in this example, the only
amortization of the differential is the $4,000 related to Barclay’s equipment.
Barclay reports net income of $80,000 at year end and declares dividends of $20,000
during 20X1. Using the equity-method, Ajax records the following entries on its books
during 20X1:
(2) Investment in Barclay Stock 32,000
Income from Investee 32,000
Record equity-method income: $80,000 × 0.40
(1) Investment in Barclay Stock 200,000
Cash 200,000
Record purchase of Barclay stock.
Goodwill = 14,000
1/1/X1
$200,000
Investment
in Barclay
Company
Identifiable
excess =
26,000
Book value =
CS + RE =
160,000
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Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value 161
With these entries, Ajax recognizes $28,000 of income from Barclay and adjusts its
investment in Barclay to an ending balance of $220,000.
The amortization on Ajax’s books of the portion of the differential related to Barclay’s
equipment is the same ($4,000) for each of the first five years (20X1 through 20X5). This
amortization stops after 20X5 because this portion of the differential is fully amortized
after five years.
Notice that no special accounts are established on the books of the investor with regard
to the differential or the amortization of the differential. The only two accounts involved
are “Income from Investee” and “Investment in Barclay Stock.” As the Investment in
Barclay Stock account is amortized, the differential between the carrying amount of the
investment and the book value of the underlying net assets decreases.
Disposal of Differential-Related Assets
Although the differential is included on the books of the investor as part of the investment
account, it relates to specific assets of the investee. Thus, if the investee disposes of any
asset to which the differential relates, that portion of the differential must be removed
from the investment account on the investor’s books. When this is done, the investor’s
share of the investee’s gain or loss on disposal of the asset must be adjusted to reflect
the fact that the investor paid more for its proportionate share of that asset than did the
investee. For example, if in the previous illustration Barclay Company sells the land to
which $6,000 of Ajax’s differential relates, Ajax does not recognize a full 40 percent of
the gain or loss on the sale. Assume that Barclay originally had purchased the land in
20X0 for $75,000 and sells the land in 20X2 for $125,000. Barclay recognizes a gain on
the sale of $50,000, and Ajax’s share of that gain is 40 percent, or $20,000. The portion of
the gain actually recognized by Ajax, however, must be adjusted as follows because of the
amount in excess of book value paid by Ajax for its investment in Barclay:
Ajax’s share of Barclay’s reported gain $20,000
Portion of Ajax’s differential related to the land (6,000)
Gain to be recognized by Ajax $14,000
Thus, if Barclay reports net income (including the gain on the sale of land) of $150,000
for 20X2, Ajax records the following entries (disregarding dividends and amortization of
the differential relating to equipment):
(4) Income from Investee 4,000
Investment in Barclay Stock 4,000
Amortize differential related to equipment.
(3) Cash 8,000
Investment in Barclay Stock 8,000
Record dividend from Barclay: $20,000 × 0.40
(6) Income from Investee 6,000
Investment in Barclay Stock 6,000
Remove differential related to Barclay’s land that was sold.
(5) Investment in Barclay Stock 60,000
Income from Investee 60,000
Record equity-method income: $150,000 × 0.40
The same approach applies when dealing with a limited-life asset. The unamortized
portion of the original differential relating to the asset sold is removed from the investment account, and the investor’s share of the investee’s income is adjusted by that amount.
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162 Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value
Note that the investor does not separately report its share of ordinary gains or losses
included in the investee’s net income, such as the gain on the sale of the fixed asset or the
write-off of the unamortized differential. Consistent with the idea of using only a single
line in the income statement to report the impact of the investee’s activities on the investor, all such items are included in the Income from Investee account. Current standards
do require the investor to report its share of an investee’s extraordinary gains and losses,
prior-period adjustments, and elements of other comprehensive income, if material to the
investor, as separate items in the same manner as the investor reports its own.
Impairment of Investment Value
As with many assets, accounting standards require that equity-method investments be
written down if their value is impaired. If the market value of the investment declines
materially below its equity-method carrying amount, and the decline in value is considered other than temporary, the carrying amount of the investment should be written down
to the market value and a loss recognized. The new lower value serves as a starting point
for continued application of the equity-method. Subsequent recoveries in the value of the
investment may not be recognized.
CONSOLIDATION PROCEDURES FOR WHOLLY OWNED SUBSIDIARIES
ACQUIRED AT MORE THAN BOOK VALUE
Many factors have an effect on the fair value of a company and its stock price, including
its asset values, its earning power, and general market conditions. When one company
acquires another, the acquiree’s fair value usually differs from its book value, and so
the consideration given by the acquirer does as well. As discussed in Chapter 1, this
difference between the fair value of the consideration given and the book value of the
acquiree’s net identifiable assets is referred to as a differential.
The process of preparing a consolidated balance sheet immediately after a business
combination is complicated only slightly when 100 percent of a company’s stock is
acquired at a price that differs from the acquiree’s book value. To illustrate the acquisition of a subsidiary when the consideration given is greater than the book value of the
acquiree, we use the Peerless-Special Foods example from Chapter 2. We assume that
Peerless Products acquires all of Special Foods’ outstanding stock on January 1, 20X1,
by paying $340,000 cash, an amount equal to Special Foods’ fair value as a whole. The
consideration given by Peerless is $40,000 in excess of Special Foods’ book value of
$300,000. The resulting ownership situation can be viewed as follows:
LO2
Understand and explain
how consolidation procedures differ when there is a
differential.
Fair value of consideration $340,000
Book value of Special Foods’ net assets
Common stock—Special Foods 200,000
Retained earnings—Special Foods 100,000
300,000
Difference between fair value and book value $ 40,000
P
S
1/1/X1
100%
Peerless records the stock acquisition with the following entry:
(7) Investment in Special Foods 340,000
Cash 340,000
Record purchase of Special Foods stock.
In a business combination, and therefore in a consolidation following a business combination, the full amount of the consideration given by the acquirer must be assigned to
the individual assets and liabilities acquired and to goodwill. In this example, the fair
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Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value 163
value of consideration given (the acquisition price) includes an extra $40,000 for appreciation in the value of the land since it was originally acquired by Special Foods. The
relationship between the fair value of the consideration given for Special Foods, the fair
value of Special Foods’ net assets, and the book value of Special Foods’ net assets can be
illustrated as follows:
Goodwill = 0
1/1/X1
$340,000
Initial
Investment
Special
Foods
Identifiable
excess =
40,000
Book value =
CS + RE =
300,000
The consolidation worksheet procedures used in adjusting to the proper consolidated
amounts follow a consistent pattern. The first worksheet entry (often referred to as the
“basic” elimination entry) eliminates the book value portion of the parent’s investment
account and each of the subsidiary’s stockholders’ equity accounts. It is useful to analyze
the investment account and the subsidiary’s equity accounts as follows:
The worksheet entry to eliminate the book value portion of Peerless’ investment
account and the stockholders’ equity accounts of Special Foods is as follows:
2 Alternatively, a separate clearing account titled Excess of Acquisition Consideration over Acquiree Book
Value , or just Differential can be debited for this excess amount. A subsequent entry can be used to
reclassify the differential to the various accounts on the balance sheet that need to be re-valued to their
acquisition date amounts. Note that the Differential account is simply a worksheet clearing account and
is not found on the books of the parent or subsidiary and does not appear in the consolidated financial
statements.
Book Value Calculations:
Total Investment = Common Stock + Retained Earnings
Original book value 300,000 200,000 100,000
When the acquisition-date fair value of the consideration is more than the acquiree’s
book value at that date, the second eliminating entry reclassifies the excess acquisition price to the specific accounts on the balance sheet for which the book values are
not the same as their fair values on the acquisition date. 2
The differential represents
(in simple situations involving a 100 percent acquisition) the total difference between
the acquisition-date fair value of the consideration given by the acquirer and the
acquiree’s book value. In this example, the differential is the additional $40,000 paid
by Peerless to acquire Special Foods because its land was worth $40,000 more than its
book value as of the acquisition date. In preparing a consolidated balance sheet immediately after acquisition (on January 1, 20X1), the second elimination entry appearing
Basic elimination entry:
Common stock 200,000 Original amount invested (100%)
Retained earnings 100,000 Beginning balance in RE
Investment in Special Foods 300,000 Net BV in investment account
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164 Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value
in the consolidation worksheet simply re-assigns this $40,000 from the investment
account to the land account so that: (a) the Land account fully reflects the fair value of
this asset as of the acquisition date and (b) the investment account is fully eliminated
from Peerless’ books:
Thus, these two elimination entries completely eliminate the balance in Peerless’
investment account and the second entry assigns the differential to the land account.
FIGURE 4–1 Worksheet for Consolidated Balance Sheet, January 1, 20X1, Date of Combination; 100 Percent
Acquisition at More than Book Value
Peerless
Products
Special
Foods
Elimination Entries
DR CR Consolidated
Balance Sheet
Cash 10,000 50,000 60,000
Accounts Receivable 75,000 50,000 125,000
Inventory 100,000 60,000 160,000
Investment in Special Foods 340,000 300,000 0
40,000
Land 175,000 40,000 40,000 255,000
Buildings & Equipment 800,000 600,000 1,400,000
Less Accumulated Depreciation (400,000) (300,000) (700,000)
Total Assets 1,100,000 500,000 40,000 340,000 1,300,000
Accounts Payable 100,000 100,000 200,000
Bonds Payable 300,000 100,000 300,000
Common Stock 500,000 200,000 200,000 500,000
Retained Earnings 300,000 100,000 100,000 300,000
Total Liabilities & Equity 1,100,000 500,000 300,000 0 1,300,000
Excess value reclassification entry:
Land 40,000 Excess value assigned to land
Investment in Special Foods 40,000 Reclassify excess acquisition price
Investment in
Special Foods
Acquisition Price 340,000
300,000 Basic elimination entry
40,000 Excess value reclassification entry
0
In more complicated examples where the fair values of various balance sheet accounts
differ from book values, the excess value reclassification entry reassigns the differential
to adjust various account balances to reflect the fair values of the subsidiary’s assets
and liabilities at the time the parent acquired the subsidiary and to establish goodwill, if
appropriate.
Figure 4–1 illustrates the consolidation worksheet reflecting the allocation of the differential to the subsidiary’s land.
The amounts reported in the consolidated balance sheet are those in the Consolidated
column of the worksheet in Figure 4–1 . Land would be included in the consolidated
balance sheet at $255,000, the amount carried on Peerless’ books ($175,000) plus the
amount carried on Special Foods’ books ($40,000) plus the differential reflecting the
increased value of Special Foods’ land ($40,000).
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Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value 165
This example is sufficiently simple that the assignment of the differential to land could
be made directly in the basic eliminating entry rather than through the use of a separate
entry. In practice, however, the differential often relates to more than a single asset, and
the allocation of the differential may be considerably more complex than in this example.
The possibilities for clerical errors are reduced in complex situations by making two
separate entries rather than one complicated entry.
Treatment of a Positive Differential
The fair value, and hence acquisition price, of a subsidiary might exceed the book value
for several reasons, such as the following:
1. Errors or omissions on the books of the subsidiary.
2. Excess of fair value over the book value of the subsidiary’s net identifiable assets.
3. Existence of goodwill.
Errors or Omissions on the Books of the Subsidiary
An examination of an acquired company’s books may reveal material errors. In some
cases, the acquired company may have expensed rather than capitalized assets or, for
other reasons, omitted them from the books. An acquired company that previously had
been closely held may not have followed generally accepted accounting principles in
maintaining its accounting records. In some cases, the recordkeeping may have simply
been inadequate.
Where errors or omissions occur, corrections should be made directly on the subsidiary’s books as of the date of acquisition. These corrections are treated as prior-period
adjustments in accordance with FASB Statement No. 16 (ASC 250), “Prior Period
Adjustments” (FASB 16, ASC 250). Once the subsidiary’s books are stated in accordance
with generally accepted accounting principles, that portion of the differential attributable
to errors or omissions will no longer exist.
Excess of Fair Value over Book Value of Subsidiary’s Net Identifiable Assets
The fair value of a company’s assets is an important factor in the overall determination
of the company’s fair value. In many cases, the fair value of an acquired company’s net
assets exceeds the book value. Consequently, the consideration given by an acquirer may
exceed the acquiree’s book value. The procedures used in preparing the consolidated
balance sheet should lead to reporting all of the acquired company’s assets and liabilities
based on their fair values on the date of combination. This valuation may be accomplished in one of two ways: (1) the assets and liabilities of the subsidiary may be revalued
directly on the books of the subsidiary or (2) the accounting basis of the subsidiary may
be maintained and the revaluations made each period in the consolidation worksheet.
Revaluing the assets and liabilities on the subsidiary’s books generally is the simplest approach if all of the subsidiary’s common stock is acquired. On the other hand,
it generally is not appropriate to revalue the assets and liabilities on the subsidiary’s
books if there is a significant noncontrolling interest in that subsidiary. From a noncontrolling shareholder’s point of view, the subsidiary is a continuing company, and
the basis of accounting should not change. More difficult to resolve is the situation in
which the parent acquires all of the subsidiary’s common stock but continues to issue
separate financial statements of the subsidiary to holders of the subsidiary’s bonds or
preferred stock. Revaluing the assets and liabilities of the subsidiary directly on the
subsidiary’s books is referred to as push-down accounting and is discussed later in this
chapter.
When the assets and liabilities are revalued directly on the subsidiary’s books, that
portion of the differential then no longer exists. However, if the assets and liabilities are
not revalued on the subsidiary’s books, an entry to revalue those assets and allocate the
differential is needed in the consolidation worksheet each time consolidated financial
statements are prepared, for as long as the related assets are held.
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166 Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value
Existence of Goodwill
If the acquisition-date fair value of the consideration exchanged for an acquired subsidiary is greater than the total fair value of the subsidiary’s net identifiable assets, the difference is considered to be related to the future economic benefits associated with other
assets of the subsidiary that are not separately identified and recognized and is referred
to as goodwill. Thus, once a subsidiary’s identifiable assets and liabilities are revalued
to their fair values, any remaining debit differential is normally allocated to goodwill.
For example, assuming that in the Peerless Products and Special Foods illustration the
acquisition-date fair values of Special Foods’ assets and liabilities are equal to their book
values, then the $40,000 difference between the $340,000 consideration exchanged and
the $300,000 fair value of the subsidiary’s net identifiable assets should be attributed to
goodwill. The following entry to assign the differential is needed in the consolidation
worksheet prepared immediately after the combination:
The consolidation worksheet is similar to Figure 4–1 except that the debit in the excess
value reclassification worksheet entry would be to goodwill instead of land. Goodwill,
which does not appear on the books of either Peerless or Special Foods, would appear at
$40,000 in the consolidated balance sheet prepared immediately after acquisition.
In the past, some companies have included the fair-value increment related to certain
identifiable assets of the subsidiary in goodwill rather than separately recognizing those
assets. This treatment is not acceptable, and any fair-value increment related to an intangible asset that arises from a contractual or legal right or that is separable from the entity
must be allocated to that asset.
Illustration of Treatment of a Complex Differential
In many situations, the differential relates to a number of different assets and liabilities.
As a means of illustrating the allocation of the differential to various assets and liabilities,
assume that the acquisition-date book values and fair values of Special Foods’ assets and
liabilities are as shown in Figure 4–2 . The inventory and land have fair values in excess of
their book values, while the buildings and equipment are worth less than their book values.
Bond prices fluctuate as interest rates change. In this example, the value of Special
Foods’ bonds payable is higher than the book value. This indicates that the nominal interest rate on the bonds is higher than the current market rate of interest, and, therefore,
investors are willing to pay a price higher than par for the bonds. In determining the value
of Special Foods, Peerless must recognize that it is assuming a liability that pays an interest rate higher than the current market rate. Accordingly, Special Foods’ value will be
less than if the liability carried a lower interest rate. The resulting consolidated financial
statements must recognize the acquisition-date fair values of Special Foods’ liabilities as
well as its assets.
Assume that Peerless Products acquires all of Special Foods’ capital stock for
$400,000 on January 1, 20X1, by issuing $100,000 of 9 percent bonds, with a fair value
of $100,000, and paying cash of $300,000. The resulting ownership situation can be pictured as follows with a $100,000 differential:
LO3
Make calculations and
prepare elimination entries
for the consolidation of a
wholly owned subsidiary
when there is a complex
positive differential at the
acquisition date.
Fair value of consideration $400,000
Book value of Special Foods’ net assets
Common stock—Special Foods 200,000
Retained earnings—Special Foods 100,000
300,000
Difference between fair value and book value $100,000
P
S
1/1/X1
100%
Excess value reclassification entry:
Goodwill 40,000 Excess value assigned to goodwill
Investment in Special Foods 40,000 Reassign excess acquisition price
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Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value 167
Peerless records the investment on its books with the following entry:
FIGURE 4–2
Differences between
Book and Fair Values
of Special Foods’
Identifiable Assets
and Liabilities as of
January 1, 20X1, the
Date of Combination

Book
Value
Fair
Value
Difference
between Fair
Value and
Book Value
Cash $ 50,000 $ 50,000
Accounts Receivable 50,000 50,000
Inventory 60,000 75,000 $15,000
Land 40,000 100,000 60,000
Buildings and Equipment 600,000
Accumulated Depreciation (300,000) 300,000 290,000 (10,000)
$500,000 $565,000
Accounts Payable $100,000 $100,000
Bonds Payable 100,000 135,000 (35,000)
Common Stock 200,000
Retained Earnings 100,000
$500,000 $235,000 $30,000
Goodwill =
70,000
1/1/X1
$400,000
Initial
Investment
Special
Foods
Identifiable
excess =
30,000
Book value =
CS + RE =
300,000
The fair value of the consideration that Peerless gave to acquire Special Foods’ stock
($400,000) can be divided between the fair value of Special Foods’ net assets ($330,000)
and goodwill ($70,000), illustrated as follows:
The total $400,000 consideration exceeds the book value of Special Foods’ net
assets by $100,000 (assets of $500,000 less liabilities of $200,000). Thus, the total
differential is $100,000. The total fair value of the net identifiable assets acquired in
the combination is $330,000 ($565,000 − $235,000), based on the data in Figure 4–2 .
The amount by which the total consideration of $400,000 exceeds the $330,000 fair
value of the net identifiable assets is $70,000, and that amount is assigned to goodwill
in the consolidated balance sheet. The book value portion of the acquisition price is
$300,000:
(8) Investment in Special Foods 400,000
Bonds Payable 100,000
Cash 300,000
Record purchase of Special Foods stock.
Book Value Calculations:
Total Investment = Common Stock + Retained Earnings
Original book value 300,000 200,000 100,000
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168 Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value
Thus, the basic elimination entry is as follows:
Excess Value (Differential) Calculations:
Total Differential = Inventory + Land + Building + Goodwill + Bonds Payable
100,000 15,000 60,000 (10,000) 70,000 (35,000)
The reclassification of the differential to the various accounts that are either over- or
under-valued on Special Foods’ balance sheet as of the acquisition date is more complicated than in the previous example. Thus, it is helpful to analyze the differential as
follows:
This analysis leads to the following reclassification entry to assign the $100,000 differential to the specific accounts that need to be “revalued” to reflect their fair values as
of the acquisition date. Moreover, this entry completes the elimination of the investment
account from Peerless’ books.
In summary, these two elimination entries completely eliminate the balance in Peerless’ investment account and the second entry assigns the differential to various balance
sheet accounts. As in previous examples, it is helpful to visualize how the two elimination entries “zero out” the investment account:
Excess value (differential) reclassification entry:
Inventory 15,000 Excess value assigned to inventory
Land 60,000 Excess value assigned to land
Building 10,000 Under-valuation assigned to building
Goodwill 70,000 Excess value assigned to goodwill
Bonds Payable 35,000 Excess liability associated with the bonds
Investment in Special Foods 100,000 Re-assign excess acquisition price
Investment in
Special Foods
Acquisition Price 400,000
300,000 Basic elimination entry
100,000 Excess value reclassification entry
0
These entries are reflected in the worksheet in Figure 4–3 . While the reclassification
entry is somewhat more complex than in the previous example, the differential allocation is conceptually the same in both cases. In each case, the end result is a consolidated
balance sheet with the subsidiary’s assets and liabilities valued at their fair values at the
date of combination.
Basic elimination entry:
Common stock 200,000 Original amount invested (100%)
Retained earnings 100,000 Beginning balance in RE
Investment in Special Foods 300,000 Net BV in investment account
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Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value 169
FIGURE 4–3 Worksheet for Consolidated Balance Sheet, January 1, 20X1, Date of Combination; 100 Percent
Acquisition at More than Book Value
Fair value of consideration $310,000
Book value of Special Foods’ net assets
Common stock—Special Foods 200,000
Retained earnings—Special Foods 100,000
300,000
Difference between fair value and book value $ 10,000
P
S
1/1/X1
100%
100 Percent Ownership Acquired at Less than Fair Value
of Net Assets
It is not uncommon for companies’ stock to trade at prices that are lower than the fair
value of their net assets. These companies are often singled out as prime acquisition targets. The acquisition price of an acquired company may be less than the fair value of its
net assets because some of the Acquiree’s assets or liabilities may have been incorrectly
specified or because the transaction reflects a forced sale where the seller was required to
sell quickly and was unable to fully market the sale.
Obviously, if assets or liabilities acquired in a business combination have been incorrectly specified, the errors must be corrected and the assets and liabilities valued at their
fair values. Once this is done, if the fair value of the consideration given is still less than
the fair value of the net assets acquired, a gain attributable to the acquirer is recognized
for the difference. In general, as discussed in Chapter 1, a business combination where
(1) the sum of the acquisition-date fair values of the consideration given, any equity
interest already held by the acquirer, and any noncontrolling interest is less than (2) the
amounts at which the identifiable net assets must be valued at the acquisition date as specified by FASB 141R (ASC 805) (usually fair values) is considered a bargain purchase,
and a gain attributable to the acquirer is recognized for the difference.
Illustration of Treatment of Bargain-Purchase Differential
Using the example of Peerless Products and Special Foods, assume that the acquisitiondate book values and fair values of Special Foods’ assets and liabilities are equal except
that the fair value of Special Foods’ land is $40,000 greater than its book value. On
January 1, 20X1, Peerless acquires all of Special Foods’ common stock for $310,000,
resulting in a bargain purchase. The resulting ownership situation is as follows:
LO4
Make calculations and
prepare elimination
entries for the consolidation of a wholly owned
subsidiary when there is a
complex bargain-purchase
differential.
Peerless
Products
Special
Foods
Elimination Entries
DR CR Consolidated
Balance Sheet
Cash 50,000 50,000 100,000
Accounts Receivable 75,000 50,000 125,000
Inventory 100,000 60,000 15,000 175,000
Investment in Special Foods 400,000 300,000 0
100,000
Land 175,000 40,000 60,000 275,000
Buildings & Equipment 800,000 600,000 10,000 1,390,000
Less Accumulated Depreciation (400,000) (300,000) (700,000)
Goodwill 70,000 70,000
Total Assets 1,200,000 500,000 145,000 410,000 1,435,000
Accounts Payable 100,000 100,000 200,000
Bonds Payable 300,000 100,000 400,000
Premium on Bonds Payable 35,000 35,000
Common Stock 500,000 200,000 200,000 500,000
Retained Earnings 300,000 100,000 100,000 300,000
Total Liabilities & Equity 1,200,000 500,000 300,000 35,000 1,435,000
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170 Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value
Peerless records its investment in Special Foods with the following entry on its books:
In this example, the acquisition-date fair value of Special Foods’ net assets is greater
than their book value by $40,000. However, the purchase price exceeds Special Foods’
book value by only $10,000 and, thus, is less than the fair value of the net identifiable
assets acquired. This business combination, therefore, represents a bargain purchase. All
of the acquiree’s assets and liabilities must be valued at fair value, which in this case
requires only Special Foods’ land to be revalued. Assuming push-down accounting is
not employed, this revaluation is accomplished in the consolidation worksheet. The book
value portion of the acquisition price is $300,000:
Excess Value (Differential) Calculations:
Net Differential = Land – Gain
10,000 40,000 (30,000)
Thus, the basic elimination entry is the same as in previous examples:
The reclassification of the net differential to the accounts that are either over- or
under-valued on Special Foods’ financial statements as of the acquisition date can be
summarized as follows:
(9) Investment in Special Foods 310,000
Cash 310,000
Record purchase of Special Foods stock.
In concept, this analysis leads to the following reclassification entry to assign the
$10,000 net differential to the Land and Gain on Bargain Purchase accounts.
If the consolidation worksheet were prepared at the end of the year, the notion of recognizing a gain for the $30,000 excess of the $340,000 fair value of Special Foods’ net
assets over the $310,000 fair value of the consideration given by Peerless in the exchange
would be correct. However, assuming the consolidation worksheet is prepared on the
acquisition date (January 1, 20X1), the gain is carried directly to Retained Earnings
Book Value Calculations:
Total Investment = Common Stock + Retained Earnings
Original book value 300,000 200,000 100,000
Excess value (differential) reclassification entry:
Land 40,000 Excess value assigned to land
Gain on Bargain Purchase 30,000 Gain on bargain purchase
Investment in Special Foods 10,000 Reclassify excess value portion of
the investment account to
specific accounts
Basic elimination entry:
Common stock 200,000 Original amount invested (100%)
Retained earnings 100,000 Beginning balance in RE
Investment in Special Foods 300,000 Net BV in investment account
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Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value 171
3 Note that if the acquisition were to take place at the end of the year, the gain would appear on the
consolidated income statement in the acquisition year. In subsequent years, the credit for $30,000 would be
assigned to retained earnings.
because an income statement is not prepared on the acquisition date, only a balance sheet
(since it is the first day of the year). 3
In summary, these two elimination entries effectively eliminate the balance in Peerless’ investment account and assign the net differential to the Land and Gain (or Retained
Earnings) accounts. As in previous examples, it is helpful to visualize how the two elimination entries “zero out” the investment account:
LO5
Prepare equity-method
journal entries, elimination
entries, and the consolidation worksheet for a wholly
owned subsidiary when
there is a complex positive
differential.
Investment in
Special Foods
Acquisition Price 310,000
300,000 Basic elimination entry
10,000 Excess value reclassification
0
If the consideration given in the exchange had been less than the book value of Special Foods, the same procedures would be followed except the differential would have a
credit balance.
CONSOLIDATED FINANCIAL STATEMENTS—100 PERCENT OWNERSHIP
ACQUIRED AT MORE THAN BOOK VALUE
Most frequently, an investment in a subsidiary is acquired at a price that is in excess of the
acquiree’s book value. In consolidation, the excess or differential must be allocated to specific assets and liabilities, with the identifiable assets and liabilities revalued based on their
acquisition-date fair values and any excess recognized as goodwill. If this revaluation is not
accomplished on the separate books of the subsidiary through the use of push-down accounting, as illustrated in Appendix 4A, it must be made in the consolidation worksheet each time
consolidated statements are prepared. In addition, if the revaluations relate to assets or liabilities that must be depreciated, amortized, or otherwise written off, appropriate entries must be
made in the consolidation worksheet to reduce consolidated net income accordingly.
When an investor company accounts for an investment using the equity-method, as
illustrated in Chapter 2, it records the amount of differential viewed as expiring during
the period as a reduction of the income recognized from the investee. In consolidation,
the differential is assigned to the appropriate asset and liability balances, and consolidated income is adjusted for the amounts expiring during the period by assigning them to
the related expense items (e.g., depreciation expense).
Initial Year of Ownership
As an illustration of the acquisition of 100 percent ownership acquired at an amount
greater than book value, assume that Peerless Products acquires all of Special Foods’
common stock on January 1, 20X1, for $387,500, an amount $87,500 in excess of the
book value. The acquisition price includes cash of $300,000 and a 60-day note for $87,500
(paid at maturity during 20X1). At the date of combination, Special Foods is holding the
assets and liabilities shown in Figure 4–2 . The resulting ownership situation is as follows:
Fair value of consideration $387,500
Book value of Special Foods’ net assets
Common stock—Special Foods 200,000
Retained earnings—Special Foods 100,000
300,000
Difference between fair value and book value $ 87,500
P
S
1/1/X1
100%
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172 Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value
On the date of combination, all of Special Foods’ assets and liabilities have fair values
equal to their book values, except as follows:
Book
Value
Fair
Value
Fair Value
Increment
Inventory $ 60,000 $ 65,000 $ 5,000
Land 40,000 50,000 10,000
Buildings and Equipment 300,000 360,000 60,000
$400,000 $475,000 $75,000
(11) Investment in Special Foods 50,000
Income from Special Foods 50,000
Record Peerless’ 100% share of Special Foods’ 20X1 income.
(12) Cash 30,000
Investment in Special Foods 30,000
Record Peerless’ 100% share of Special Foods’ 20X1 dividend.
(10) Investment in Special Foods 387,500
Cash 300,000
Notes Payable 87,500
Record the initial investment in Special Foods.
In this case, Peerless paid an amount for its investment that was $87,500 in excess
of the book value of the shares acquired. As discussed previously, this difference is a
differential that is implicit in the amount recorded in the investment account on Peerless’ books. Because Peerless acquired 100 percent of Special Foods’ stock, Peerless’
differential included in its investment account is equal to the total differential arising
from the business combination. However, while the differential arising from the business combination must be allocated to specific assets and liabilities in consolidation,
the differential on Peerless’ books does not appear separate from the Investment in
Special Foods account. A portion of the differential ($5,000) in the investment account
on Peerless’ books relates to a portion of Special Foods’ inventory that is sold during
20X1. Because the asset to which that portion of the differential relates is no longer held
by Special Foods at year-end, that portion of the differential is written off by reducing the investment account and Peerless’ income from Special Foods. An additional
$60,000 of the differential is attributable to the excess of the acquisition-date fair value
over book value of Special Foods’ buildings and equipment. As the service potential
of the underlying assets expires, Peerless must amortize the additional cost it incurred
Of the $87,500 total differential, $75,000 relates to identifiable assets of Special Foods. The
remaining $12,500 is attributable to goodwill. The apportionment of the differential appears as
follows: The entire amount of inventory to which the differential relates is sold during 20X1;
none is left in ending inventory. The buildings and equipment have a remaining economic
life of 10 years from the date of combination, and Special Foods uses straight-line depreciation. At the end of 20X1, Peerless’ management determines that the goodwill acquired in the
combination with Special Foods has been impaired. Management determines that a $3,000
goodwill impairment loss should be recognized in the consolidated income statement.
For the first year immediately after the date of combination, 20X1, Peerless Products earns income from its own separate operations of $140,000 and pays dividends of
$60,000. Special Foods reports net income of $50,000 and pays dividends of $30,000.
Parent Company Entries
During 20X1, Peerless makes the normal equity-method entries on its books to record its
purchase of Special Foods stock and its income and dividends from Special Foods:
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Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value 173
because of the higher fair value of those assets. This is accomplished through annual
amortization of $6,000 ($60,000 ÷ 10) over the remaining 10-year life beginning in
20X1. Finally, the goodwill is deemed to be impaired by $3,000 and is also adjusted
on Peerless’ books. 4
Thus, the differential must be written off on Peerless’ books to
recognize the cost expiration related to the service expiration of Special Foods’ assets
to which it relates. Under the full equity-method, the differential is written off periodically from the investment account to Income from Special Foods to reflect these
changes in the differential ($5,000 inventory + $6,000 depreciation + $3,000 goodwill impairment = $14,000):
4 Although the goodwill will be written down and a goodwill impairment loss recognized when preparing
consolidated financial statements, the FASB has indicated that no equity-method adjustment should be
made to reflect this impairment of goodwill. Some would argue that it would be inappropriate to treat the
goodwill impairment in the same way as the other excess value components. However, for simplicity, since
the investment account is eliminated in consolidation anyway, we choose to treat goodwill impairment like
all other excess value components.
Goodwill =
9,500
12/31/X1
$393,500
Net
Investment
in Special
Foods
Identifiable
excess =
64,000
Book value =
CS + RE =
320,000
Goodwill =
12,500
1/1/X1
$387,500
Initial
Investment
Special
Foods
Identifiable
excess =
75,000
Book value =
CS + RE =
300,000
Book Value Calculations:
Total Investment = Common Stock + Retained Earnings
Original book value 300,000 200,000 100,000
+ Net Income 50,000 50,000
– Dividends (30,000) (30,000)
Ending book value 320,000 200,000 120,000
(13) Income from Special Foods 14,000
Investment in Special Foods 14,000
Record amortization of excess acquisition price.
Consolidation Worksheet—Year of Combination
The following diagrams illustrate the breakdown of the book value and excess value
components of the investment account at the beginning and end of the year.
The book value component can be summarized as follows:
This chart leads to the basic elimination entry. Note that we shade the numbers that appear
in the elimination entry with a lighter font color to help the reader see how to construct
the elimination entry.
Basic elimination entry:
Common stock 200,000 Original amount invested (100%)
Retained earnings 100,000 Beginning balance in RE
Income from Special Foods 50,000 Special Foods’ reported income
Dividends declared 30,000 100% of Special Foods’ dividends
Investment in Special Foods 320,000 Net BV in investment account
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174 Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value
We then analyze the differential and its changes during the period:
Finally, the remaining unamortized differential is reclassified to the correct accounts
based on the ending balances in the chart above:
In sum, these worksheet entries (1) eliminate the balances in the Investment in Special
Foods and Income from Special Foods accounts, (2) reclassify the amortization of excess
Excess Value (Differential) Calculations:
Total = Inventory + Land + Building + Acc. Depr. + Goodwill
Beginning balance 87,500 5,000 10,000 60,000 0 12,500
− Changes (14,000) (5,000) (6,000) (3,000)
Ending balance 73,500 0 10,000 60,000 (6,000) 9,500
Excess value (differential) reclassification entry:
Land 10,000 Original calculated excess value.
Building 60,000 Original calculated excess value.
Goodwill 9,500 Calculated value from acquisition.
Accumulated depreciation 6,000 = 60,000 ÷ 10 years
Investment in Special Foods 73,500 Remaining balance in differential
Inv. in
Special Foods
Inc. from
Special Foods
Acquisition Price 387,500
Net Income 50,000 50,000 80% Net Income
30,000 Dividends
14,000 Excess Value 14,000
Amortization
Ending Balance 393,500 36,000 Ending Balance
320,000 Basic 50,000
73,500 Excess Reclass. 14,000 Excess Value
0 0
The entire differential amount assigned to the inventory already passed through cost of
goods sold during the year. The only other amortization item—the excess value assigned
to the building—is amortized over a 10-year period ($60,000 ÷ 10 = $6,000 per year).
Finally, the goodwill is deemed to be impaired and worth only $9,500. Since the amortization of the differential was already written off from the investment account against
the Income from Special Foods account, the changes are simply reclassified from the
Income from Special Foods account to the various income statement accounts to which
they apply during the consolidation process:
Amortized excess value reclassification entry:
Cost of goods sold 5,000 Extra cost of goods sold
Depreciation expense 6,000 Depreciation of excess building value
Goodwill impairment loss 3,000 Goodwill impairment
Income from Special Foods 14,000 See calculation above
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Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value 175
FIGURE 4–4 December 31, 20X1, Equity-Method Worksheet for Consolidated Financial Statements, Initial Year
of Ownership; 100 Percent Acquisition at More than Book Value
Peerless
Products
Special
Foods
Elimination Entries
DR CR Consolidated
Income Statement
Sales 400,000 200,000 600,000
Less: COGS (170,000) (115,000) 5,000 (290,000)
Less: Depreciation Expense (50,000) (20,000) 6,000 (76,000)
Less: Other Expenses (40,000) (15,000) (55,000)
Less: Impairment Loss 3,000 (3,000)
Income from Special Foods 36,000 50,000 14,000 0
Net Income 176,000 50,000 64,000 14,000 176,000
Statement of Retained Earnings
Beginning Balance 300,000 100,000 100,000 300,000
Net Income 176,000 50,000 64,000 14,000 176,000
Less Dividends Declared (60,000) (30,000) 30,000 (60,000)
Ending Balance 416,000 120,000 164,000 44,000 416,000
Balance Sheet
Cash 122,500 75,000 197,500
Accounts Receivable 75,000 50,000 125,000
Inventory 100,000 75,000 175,000
Investment in Special Foods 393,500 320,000 0
73,500
Land 175,000 40,000 10,000 225,000
Buildings & Equipment 800,000 600,000 60,000 300,000 1,160,000
Less Accumulated Depreciation (450,000) (320,000) 300,000 6,000 (476,000)
Goodwill 9,500 9,500
Total Assets 1,216,000 520,000 379,500 699,500 1,416,000
Accounts Payable 100,000 100,000 200,000
Bonds Payable 200,000 100,000 300,000
Common Stock 500,000 200,000 200,000 500,000
Retained Earnings 416,000 120,000 164,000 44,000 416,000
Total Liabilities & Equity 1,216,000 520,000 364,000 44,000 1,416,000
Optional accumulated depreciation elimination entry:
Accumulated depreciation 300,000 Original depreciation at the time of
Building and equipment 300,000 the acquisition netted against cost
value to the proper income statement accounts, and (3) reclassify the remaining differential to the appropriate balance sheet accounts as of the end of the period.
As usual, we eliminate Special Foods’ acquisition date accumulated depreciation
against the Buildings and Equipment balance so that it will appear as if these fixed assets
were recorded at their acquisition date fair values.
After the subsidiary income accruals are entered on Peerless’ books, the adjusted
trial balance data of the consolidating companies are entered in the three-part consolidation worksheet as shown in Figure 4–4 . We note that because all inventory on hand
on the date of combination has been sold during the year, the $5,000 of differential
applicable to inventory is allocated directly to cost of goods sold. The cost of goods sold
recorded on the books of Special Foods is correct for that company’s separate financial
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176 Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value
statements. However, the cost of the inventory to the consolidated entity is viewed as
being $5,000 higher, and this additional cost must be included in consolidated cost of
goods sold. No worksheet entry is needed in future periods with respect to the inventory
because the inventory has been expensed and no longer is on the subsidiary’s books.
The portion of the differential related to the inventory no longer exists on Peerless’
books after 20X1 because it is removed from the investment account by the second
elimination entry.
The differential assigned to depreciable assets must be charged to depreciation expense
over the remaining lives of those assets. From a consolidated viewpoint, the acquisitiondate fair value increment associated with the depreciable assets acquired becomes part of
the assets’ depreciation base. Depreciation already is recorded on the subsidiary’s books
based on the original cost of the assets to the subsidiary, and these amounts are carried to
the consolidation worksheet as depreciation expense.
The difference between the $387,500 fair value of the consideration exchanged and
the $375,000 fair value of Special Foods’ net identifiable assets is assumed to be related
to the excess earning power of Special Foods. This difference is entered in the worksheet in Figure 4–4 . A distinction must be made between journal entries recorded on
the parent’s books under equity-method reporting and the eliminating entries needed in
the worksheet to prepare the consolidated financial statements. Again, we distinguish
between actual equity-method journal entries on the parent’s books (not shaded) and
worksheet elimination entries (shaded).
Consolidated Net Income and Retained Earnings
As can be seen from the worksheet in Figure 4–4 , consolidated net income for 20X1 is
$176,000 and consolidated retained earnings on December 31, 20X1, is $416,000. These
amounts can be computed as shown in Figure 4–5 .
Second Year of Ownership
The consolidation procedures employed at the end of the second year, and in periods
thereafter, are basically the same as those used at the end of the first year. Consolidation
two years after acquisition is illustrated by continuing the example used for 20X1. During 20X2, Peerless Products earns income from its own separate operations of $160,000
and pays dividends of $60,000; Special Foods reports net income of $75,000 and pays
dividends of $40,000. No further impairment of the goodwill from the business combination occurs during 20X2.
FIGURE 4–5
Consolidated Net
Income and Retained
Earnings, 20X1; 100
Percent Acquisition at
More than Book Value
Consolidated net income, 20X1:
Peerless’ separate operating income $140,000
Special Foods’ net income 50,000
Write-off of differential related to inventory sold during 20X1 (5,000)
Amortization of differential related to buildings and equipment in 20X1 (6,000)
Goodwill impairment loss (3,000)
Consolidated net income, 20X1 $176,000
Consolidated retained earnings, December 31, 20X1:
Peerless’ retained earnings on date of combination, January 1, 20X1 $300,000
Peerless’ separate operating income, 20X1 140,000
Special Foods’ 20X1 net income 50,000
Write-off of differential related to inventory sold during 20X1 (5,000)
Amortization of differential related to buildings and equipment in 20X1 (6,000)
Goodwill impairment loss (3,000)
Dividends declared by Peerless, 20X1 (60,000)
Consolidated retained earnings, December 31, 20X1 $416,000
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Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value 177
Goodwill =
9,500
12/31/X2
$422,500
Net
Investment
in Special
Foods
Identifiable
excess =
58,000
Book value =
CS + RE =
355,000
Parent Company Entries
Peerless Products records the following entries on its separate books during 20X2:
Goodwill =
9,500
1/1/X2
$393,500
12/31/X1
Investment
in Special
Foods
Balance
Identifiable
excess =
64,000
Book value =
CS + RE =
320,000
(15) Cash 40,000
Investment in Special Foods 40,000
Record Peerless’ 100% share of Special Foods’ 20X2 dividend.
(16) Income from Special Foods 6,000
Investment in Special Foods 6,000
Record amortization of excess acquisition price.
(14) Investment in Special Foods 75,000
Income from Special Foods 75,000
Record Peerless’ 100% share of Special Foods’ 20X2 income.
The changes in the parent’s investment account during 20X2 can be summarized as
follows:
The book value component can be summarized as follows:
The light-shaded numbers in this chart determine the basic elimination entry:
The entire differential amount assigned to the inventory already passed through cost of
goods sold during the prior year period. The only other amortization item is the excess
value assigned to the building, which continues to be written off over a 10-year period
($60,000 ÷ 10 = $6,000) as illustrated in the following chart.
Book Value Calculations:
Total Investment = Common Stock + Retained Earnings
Original book value 320,000 200,000 120,000
+ Net Income 75,000 75,000
– Dividends (40,000) (40,000)
Ending book value 355,000 200,000 155,000
Basic elimination entry:
Common stock 200,000 Original amount invested (100%)
Retained earnings 120,000 Beginning balance in RE
Income from Special Foods 75,000 Special Foods’ reported income
Dividends declared 40,000 100% of Special Foods’ dividends
Investment in Special Foods 355,000 Net BV in investment account
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178 Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value
Since the amortization of the differential was already written off from the investment
account against the Income from Special Foods account, the change to the differential
is simply reclassified from the Income from Special Foods account to the income statement account to which it applies during the consolidation process. Then, the remaining
amount of the differential at year end is reclassified to the various balance sheet accounts
to which they apply:
These elimination entries, (1) eliminate the balances in the Investment in Special Foods
and Income from Special Foods accounts, (2) reclassify the amortization of excess value
to the proper income statement accounts, and (3) reclassify the remaining differential
to the appropriate balance sheet accounts as of the end of the accounting period. The
following T-accounts illustrate how the three elimination entries “zero out” the equitymethod investment and income accounts:
Again, we repeat the same accumulated depreciation elimination entry this year (and
every year as long as Special Foods owns the assets) that we used in the initial year.
Excess Value (Differential) Calculations:
Total = Land + Building + Acc. Depr. + Goodwill
Beginning balance 73,500 10,000 60,000 (6,000) 9,500
Changes (6,000) (6,000)
Ending balance 67,500 10,000 60,000 (12,000) 9,500
Amortized excess value reclassification entry:
Depreciation expense 6,000 Extra depreciation expense
Income from Special Foods 6,000 See calculation above.
Excess value (differential) reclassification entry:
Land 10,000 Original calculated excess value.
Building 60,000 Original calculated excess value.
Goodwill 9,500 Calculated value from acquisition.
Accumulated depreciation 12,000 = (60,000 ÷ 10 years) × 2 years
Investment in Special Foods 67,500 Remaining balance in differential
Inv. in
Special Foods
Inc. from
Special Foods
Acquisition Price 393,500
Net Income 75,000 75,000 Net Income
40,000 Dividends
6,000 Excess Price 6,000
Amortization
Ending Balance 422,500 69,000 Ending Balance
355,000 Basic 75,000
67,500 Excess Reclass. 6,000 Excess Value
0 0
Optional accumulated depreciation elimination entry:
Accumulated depreciation 300,000 Original depreciation at the time of
Building and equipment 300,000 the acquisition netted against cost
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Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value 179
FIGURE 4–7
Consolidated Net
Income and Retained
Earnings, 20X2; 100
Percent Acquisition at
More than Book Value
Consolidated net income, 20X2:
Peerless’ separate operating income $160,000
Special Foods’ net income 75,000
Amortization of differential related to buildings and equipment in 20X2 (6,000)
Consolidated net income, 20X2 $229,000
Consolidated retained earnings, December 31, 20X2:
Consolidated retained earnings, December 31, 20X1 $416,000
Peerless’ separate operating income, 20X2 160,000
Special Foods’ 20X2 net income 75,000
Amortization of differential related to buildings and equipment in 20X2 (6,000)
Dividends declared by Peerless, 20X2 (60,000)
Consolidated retained earnings, December 31, 20X2 $585,000
Consolidation Worksheet—Second Year Following Combination
The worksheet for the second year, 20X2, completes the two-year cycle as illustrated in
Figure 4–6 . Moreover, as can be seen from the worksheet, consolidated net income for
20X2 is $229,000 and consolidated retained earnings on December 31, 20X2, is $585,000
as illustrated in Figure 4–7 .
FIGURE 4–6 December 31, 20X2, Equity-Method Worksheet for Consolidated Financial Statements, Second Year
of Ownership; 100 Percent Acquisition at More than Book Value
Peerless
Products
Special
Foods
Elimination Entries
DR CR Consolidated
Income Statement
Sales 450,000 300,000 750,000
Less: COGS (180,000) (160,000) (340,000)
Less: Depreciation Expense (50,000) (20,000) 6,000 (76,000)
Less: Other Expenses (60,000) (45,000) (105,000)
Less: Impairment Loss 0
Income from Special Foods 69,000 75,000 6,000 0
Net Income 229,000 75,000 81,000 6,000 229,000
Statement of Retained Earnings
Beginning Balance 416,000 120,000 120,000 416,000
Net Income 229,000 75,000 81,000 6,000 229,000
Less Dividends Declared (60,000) (40,000) 40,000 (60,000)
Ending Balance 585,000 155,000 201,000 46,000 585,000
Balance Sheet
Cash 157,500 85,000 242,500
Accounts Receivable 150,000 80,000 230,000
Inventory 180,000 90,000 270,000
Investment in Special Foods 422,500 355,000 0
67,500
Land 175,000 40,000 10,000 225,000
Buildings & Equipment 800,000 600,000 60,000 300,000 1,160,000
Less Accumulated Depreciation (500,000) (340,000) 300,000 12,000 (552,000)
Goodwill 9,500 9,500
Total Assets 1,385,000 555,000 379,500 734,500 1,585,000
Accounts Payable 100,000 100,000 200,000
Bonds Payable 200,000 100,000 300,000
Common Stock 500,000 200,000 200,000 500,000
Retained Earnings 585,000 155,000 201,000 46,000 585,000
Total Liabilities & Equity 1,385,000 555,000 401,000 46,000 1,585,000
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180 Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value
INTERCOMPANY RECEIVABLES AND PAYABLES
All forms of intercompany receivables and payables need to be eliminated when consolidated financial statements are prepared. From a single-company viewpoint, a company
cannot owe itself money. If a company owes an affiliate $1,000 on account, one company
carries a $1,000 receivable on its separate books and the other has a payable for the same
amount. When consolidated financial statements are prepared, the following elimination
entry is needed in the consolidation worksheet:
LO7
Understand and explain
the basics of push-down
accounting.
LO6
Understand and explain the
elimination of basic intercompany transactions.
Accounts Payable 1,000
Accounts Receivable 1,000
Eliminate intercompany receivable/payable.
If no eliminating entry is made, both the consolidated assets and liabilities are overstated
by an equal amount.
If the intercompany receivable/payable bears interest, all accounts related to the intercompany claim must be eliminated in the preparation of consolidated statements, including the receivable/payable, interest income, interest expense, and any accrued interest
on the intercompany claim. Other forms of intercorporate claims, such as bonds, are discussed in subsequent chapters. In all cases, failure to eliminate these claims can distort
consolidated balances. As a result, the magnitude of debt of the combined entity may
appear to be greater than it is, working capital ratios may be incorrect, and other types of
comparisons may be distorted.
PUSH-DOWN ACCOUNTING
The term push-down accounting refers to the practice of revaluing an acquired subsidiary’s assets and liabilities to their fair values directly on that subsidiary’s books at the
date of acquisition. If this practice is followed, the revaluations are recorded once on the
subsidiary’s books at the date of acquisition and, therefore, are not made in the consolidation worksheets each time consolidated statements are prepared.
Those who favor push-down accounting argue that the change in the subsidiary’s
ownership in an acquisition is reason for adopting a new basis of accounting for the
subsidiary’s assets and liabilities, and this new basis of accounting should be reflected
directly on the subsidiary’s books. This argument is most persuasive when the subsidiary
is wholly owned, is consolidated, or has its separate financial statements included with
the parent’s statements.
On the other hand, when a subsidiary has a significant noncontrolling interest or the
subsidiary has bonds or preferred stock held by the public, push-down accounting may
be inappropriate. The use of push-down accounting in the financial statements issued to
the noncontrolling shareholders or to those holding bonds or preferred stock results in
a new basis of accounting even though, from the perspective of those statement users,
the entity has not changed. From their viewpoint, push-down accounting results in the
revaluation of the assets and liabilities of a continuing enterprise, a practice that normally
is not acceptable.
SEC Staff Accounting Bulletin No. 54 requires push-down accounting whenever a
business combination results in the acquired subsidiary becoming substantially wholly
owned. The staff accounting bulletin encourages but does not require the use of pushdown accounting in situations in which the subsidiary is less than wholly owned or the
subsidiary has outstanding debt or preferred stock held by the public.
The revaluation of assets and liabilities on a subsidiary’s books involves making an
entry to debit or credit each asset and liability account to be revalued, with the balancing entry to a revaluation capital account. The revaluation capital account is part of the
subsidiary’s stockholders’ equity. Once the revaluations are made on the books of the
subsidiary, the new book values of the subsidiary’s assets, including goodwill, are equal
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Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value 181
to the acquisition cost of the subsidiary. Thus, no differential arises in the consolidation
process. The investment elimination entry in a consolidation worksheet prepared immediately after acquisition of a subsidiary and revaluation of its assets on its books might
appear as follows:
Key Terms
Summary of
Key Concepts
Capital Stock—Subsidiary XXX
Retained Earnings XXX
Revaluation Capital XXX
Investment in Subsidiary Stock XXX
Eliminate investment balance.
Note that the Revaluation Capital account, as part of the subsidiary’s stockholders’
equity, is eliminated in preparing consolidated statements. We provide a more detailed
example of push-down accounting in Appendix 4A.
Eliminating entries are needed in the worksheet to remove the effects of intercompany ownership
and intercompany transactions so the consolidated financial statements appear as if the separate
companies are actually one. Worksheet eliminating entries are needed to (1) eliminate the book value
portion of the parent’s subsidiary investment and the subsidiary’s stockholders’ equity accounts,
(2) reclassify the amortization of excess value from the parent’s income from subsidiary account to
the correct income statement line items, (3) assign any remaining differential to specific assets and
liabilities, and (4) net the original accumulated depreciation of the subsidiary as of the acquisition
date against the historical cost of property, plant, and equipment.
Consolidated net income is computed in simple cases for a parent and a wholly owned subsidiary as the total of the parent’s income from its own operations and the subsidiary’s net income,
adjusted for the write-off of differential, if appropriate. In this situation, consolidated retained
earnings is computed as the total of the parent’s retained earnings, excluding any income from the
subsidiary, plus the subsidiary’s cumulative net income since acquisition.
When a subsidiary is acquired for an amount greater than its book value, some parents may
prefer to assign the differential to individual assets and liabilities directly on the books of the
subsidiary at the time of acquisition, thereby eliminating the need for revaluation entries in the
consolidation worksheet each period. This procedure is called push-down accounting.
bargain purchase, 169
differential, 159
goodwill, 166 push-down accounting, 165
Appendix 4A Push-Down Accounting Illustrated
When a subsidiary is acquired in a business combination, its assets and liabilities must be revalued to their fair values as of the date of combination for consolidated reporting. If push-down
accounting is employed, the revaluations are made as of the date of combination directly on the
books of the subsidiary and no eliminating entries related to the differential are needed in the
worksheets.
The following example illustrates the consolidation process when assets and liabilities are
revalued directly on a subsidiary’s books rather than using consolidation worksheet entries to
accomplish the revaluation. Assume that Peerless Products purchases all of Special Foods’ common stock on January 1, 20X1, for $370,000 cash. The purchase price is $70,000 in excess of Special Foods’ book value. Of the $70,000 total differential, $10,000 is related to land held by Special
Foods and $60,000 is related to buildings and equipment having a 10-year remaining life. Peerless
accounts for its investment in Special Foods stock using the equity-method.
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182 Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value
In contrast to a worksheet revaluation, the use of push-down accounting involves the revaluation of the assets on the separate books of Special Foods and alleviates the need for revaluation
entries in the consolidation worksheet each period. If push-down accounting is used to revalue
Special Foods’ assets, the following entry is made directly on Special Foods’ books:
Peerless records the acquisition of stock on its books with the following entry:
Book Value Calculations:
Total
Investment =
Common
Stock +
Retained
Earnings +
Revaluation
Capital
Original book value 370,000 200,000 100,000 70,000
+ Net Income 44,000 44,000
– Dividends (30,000) (30,000)
Ending book value 384,000 200,000 114,000 70,000
This entry increases the amount at which the land and the buildings and equipment are shown
in Special Foods’ separate financial statements and gives rise to a revaluation capital account
that is shown in the stockholders’ equity section of Special Foods’ balance sheet. Special Foods
records $6,000 additional depreciation on its books to reflect the amortization over 10 years of
the $60,000 write-up of buildings and equipment. This additional depreciation decreases Special
Foods’ reported net income for 20X1 from $50,000 to $44,000.
Peerless records its income and dividends from Special Foods on its parent-company books:
The equity-method income recorded by Peerless is less than had push-down accounting not
been employed because Special Foods’ income is reduced by the additional depreciation on the
write-up of the buildings and equipment recorded on Special Foods’ books. Because the revaluation is recorded on the subsidiary’s books, Special Foods’ book value is then equal to the fair
value of the consideration given in the combination. Therefore, no differential exists, and Peerless
need not record any amortization associated with the investment. The net amount of income from
Special Foods recorded by Peerless is the same regardless of whether or not push-down accounting is employed. The book value portion of the investment account can be summarized as follows:
The basic elimination entry is very similar to the original example presented previously except
that it must also eliminate Special Foods’ revaluation capital account and the income from Special
Foods is $6,000 lower due to the extra depreciation on the revalued building:
(18) Land 10,000
Buildings and Equipment 60,000
Revaluation Capital 70,000
Record the increase in fair value of land and buildings.
(17) Investment in Special Foods 370,000
Cash 370,000
Record the initial investment in Special Foods.
(20) Cash 30,000
Investment in Special Foods 30,000
Record Peerless’ 100% share of Special Foods’ 20X1 dividend.
(19) Investment in Special Foods 44,000
Income from Special Foods 44,000
Record Peerless’ 100% share of Special Foods’ 20X1 income.
Basic elimination entry:
Common stock 200,000
Retained earnings 100,000
Revaluation Capital 70,000
Income from Special Foods 44,000
Dividends declared 30,000
Investment in Special Foods 384,000
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Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value 183
FIGURE 4–8 December 31, 20X1, Equity-Method Worksheet for Consolidated Financial Statements, Initial Year
of Ownership; 100 Percent Acquisition at More than Book Value; Push-Down Accounting
Peerless
Products
Special
Foods
Eliminating Entries
DR CR Consolidated
Income Statement
Sales 400,000 200,000 600,000
Less: COGS (170,000) (115,000) (285,000)
Less: Depreciation Expense (50,000) (26,000) (76,000)
Less: Other Expenses (40,000) (15,000) (55,000)
Income from Special Foods 44,000 44,000 0
Net Income 184,000 44,000 44,000 0 184,000
Statement of Retained Earnings
Beginning Balance 300,000 100,000 100,000 300,000
Net Income 184,000 44,000 44,000 0 184,000
Less: Dividends Declared (60,000) (30,000) 30,000 (60,000)
Ending Balance 424,000 114,000 144,000 30,000 424,000
Balance Sheet
Cash 140,000 75,000 215,000
Accounts Receivable 75,000 50,000 125,000
Inventory 100,000 75,000 175,000
Investment in Special Foods 384,000 384,000 0
Land 175,000 50,000 225,000
Buildings & Equipment 800,000 660,000 300,000 1,160,000
Less: Accumulated Depreciation (450,000) (326,000) 300,000 (476,000)
Total Assets 1,224,000 584,000 300,000 684,000 1,424,000
Accounts Payable 100,000 100,000 200,000
Bonds Payable 200,000 100,000 300,000
Common Stock 500,000 200,000 200,000 500,000
Retained Earnings 424,000 114,000 144,000 30,000 424,000
Revaluation Capital 70,000 70,000 0
Total Liabilities & Equity 1,224,000 584,000 414,000 30,000 1,424,000
Again, since there is no differential in this example, the basic elimination entry completely eliminates the balance in Peerless’ investment account on the balance sheet as well as the Income from
Special Foods account on the income statement.
Investment in
Special Foods
Income from
Special Foods
Acquisition Price 370,000
Net Income 44,000 44,000 Net Income
30,000 Dividends
Ending Balance 384,000 44,000 Ending Balance
384,000 Basic 44,000
0 0
In addition, we include the normal accumulated depreciation elimination entry:
Optional accumulated depreciation elimination entry:
Accumulated depreciation 300,000
Building and equipment 300,000
Figure 4–8 shows the consolidation worksheet prepared at the end of 20X1 and includes the
effects of revaluing Special Foods’ assets. Note that Special Foods’ Land and Buildings and
Equipment have been increased by $10,000 and $60,000, respectively. Also note the Revaluation
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184 Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value
Capital account in Special Foods’ stockholders’ equity. Because the revaluation was accomplished
directly on the books of Special Foods, only the basic and the accumulated depreciation elimination entries are needed in the worksheet illustrated in Figure 4–8 .
Questions
LO1 Q4-1 When is the carrying value of the investment account reduced under equity-method reporting?
LO1 Q4-2 What is a differential? How is a differential treated by an investor in computing income from an
investee under ( a ) cost-method and ( b ) equity-method reporting?
LO1 Q4-3 Turner Manufacturing Corporation owns 100 percent of the common shares of Straight Lace Company. If Straight Lace reports net income of $100,000 for 20X5, what factors may cause Turner to
report less than $100,000 of income from the investee?
LO1 Q4-4 What is the term differential used to indicate?
LO1 Q4-5 What conditions must exist for a negative differential to occur?
LO2 Q4-6 What portion of the book value of the net assets held by a subsidiary at acquisition is included in
the consolidated balance sheet?
LO2 Q4-7 What portion of the fair value of a subsidiary’s net assets normally is included in the consolidated
balance sheet following a business combination?
LO3 Q4-8 What happens to the differential in the consolidation worksheet prepared as of the date of combination? How is it reestablished so that the proper balances can be reported the following year?
LO2 Q4-9 Explain why consolidated financial statements become increasingly important when the differential is very large.
LO3 Q4-10 Give a definition of consolidated net income.
LO5 Q4-11 When Ajax was preparing its consolidation worksheet, the differential was properly assigned to
buildings and equipment. What additional entry generally must be made in the worksheet?
LO3, LO4 Q4-12 What determines whether the balance assigned to the differential remains constant or decreases
each period?
LO7 Q4-13 What does the term push-down accounting mean?
LO7 Q4-14 Under what conditions is push-down accounting considered appropriate?
LO7 Q4-15 What happens to the differential when push-down accounting is used following a business
combination?
Cases
LO1 C4-1 Reporting Significant Investments in Common Stock
The reporting treatment for investments in common stock depends on the level of ownership and
the ability to influence policies of the investee. The reporting treatment may even change over
time as ownership levels or other factors change. When investees are not consolidated, the investments typically are reported in the Investments section of the investor’s balance sheet. However,
the investor’s income from those investments is not always easy to find in the investor’s income
statement.
Required
a. Harley-Davidson, Inc., holds an investment in the common stock of Buell Motorcycle
Company. How did Harley-Davidson report this investment before 1998? How does it
report the investment now? Why did Harley change its method of reporting its investment
in Buell?
b. How does Chevron Corporation account for its investments in affiliated companies? How does
the company account for issuances of additional stock by affiliates that change the company’s
proportionate dollar share of the affiliates’ equity? How does Chevron treat a differential associated with an equity-method investment? How does Chevron account for the impairment of an
equity investment?
Analysis
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Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value 185
c. Prior to 1999, where did PepsiCo report its share of the net income or loss of its unconsolidated
affiliates over which it exercised significant influence but not control? What rationale might be
given for this treatment? How does PepsiCo now report this type of income?
d. Does Sears have any investments in companies that it accounts for using the equity-method?
Where are these investments reported in the balance sheet, and where is the income from these
investments reported in the income statement?
LO2C4-2 Assigning an Acquisition Differential
Ball Corporation’s owners recently offered to sell 100 percent of their ownership to Timber Corporation for $450,000. Timber’s business manager was told that Ball’s book value was $300,000,
and she estimates the fair value of its net assets at approximately $600,000. Ball has relatively old
equipment and manufacturing facilities and uses a LIFO basis for inventory valuation of some
items and a FIFO basis for others.
Required
If Timber accepts the offer and acquires a controlling interest in Ball, what difficulties are likely to
be encountered in assigning the differential?
LO2C4-3 Negative Retained Earnings
Although Sloan Company had good earnings reports in 20X5 and 20X6, it had a negative retained
earnings balance on December 31, 20X6. Jacobs Corporation purchased 100 percent of Sloan’s
common stock on January 1, 20X7.
Required
a. Explain how Sloan’s negative retained earnings balance is reflected in the consolidated balance
sheet immediately following the acquisition.
b. Explain how the existence of negative retained earnings changes the consolidation worksheet
entries.
c. Can goodwill be recorded if Jacobs pays more than book value for Sloan’s shares? Explain.
LO1C4-4 Balance Sheet Reporting Issues
Crumple Car Rentals is planning to expand into the western part of the United States and needs
to acquire approximately 400 additional automobiles for rental purposes. Because Crumple’s cash
reserves were substantially depleted in replacing the bumpers on existing automobiles with new
“fashion plate” bumpers, the expansion funds must be acquired through other means. Crumple’s
management has identified three options:
1. Issue additional debt.
2. Create a wholly owned leasing subsidiary that would borrow the money with a guarantee for
payment from Crumple. The subsidiary would then lease the cars to the parent.
3. Create a trust that would borrow the money with a guarantee for repayment from Crumple and
lease the cars to it. In the event of liquidation, the residual value of the trust would go to the
Historical Preservation Society of Pleasantville.
The acquisition price of the cars is approximately the same under all three alternatives.
Required
a. You have been asked to compare and contrast the three alternatives from the perspective of
(1) The impact on Crumple’s consolidated balance sheet.
(2) Their legal ramifications.
(3) The ability to control the maintenance, repair, and replacement of automobiles.
b. You are to consider any alternatives that might be used in acquiring the required automobiles.
c. You are to select the preferred alternative and show why it is the best choice.
LO1C4-5 Subsidiary Ownership: AMR Corporation and International Lease
Most subsidiaries are wholly owned, although only majority ownership is usually all that is
required for consolidation. The parent’s ownership may be direct or indirect. Frequently, a
parent’s direct subsidiaries have subsidiaries of their own, thus providing the parent with indirect
ownership of the subsidiary’s subsidiaries.
Analysis
Understanding
Judgment
Research
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186 Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value
Required
a. AMR Corporation is one of the largest corporations in the United States, with significant
visibility.
(1) What is AMR Corporation’s principal business?
(2) What is the name of AMR’s principal directly owned subsidiary?
(3) In what city is AMR headquartered?
(4) In what state is AMR incorporated?
(5) Where are most of AMR’s subsidiaries incorporated?
(6) Where is AMR’s common stock traded?
(7) How many subsidiaries, if any, does AMR’s principal subsidiary have?
(8) Approximately what percentage of AMR’s subsidiaries are wholly owned?
b. International Lease Finance Corporation is a very large leasing company. It leases equipment
that everyone is familiar with and many have used.
(1) Specifically, what is the principal business of International Lease Finance Corporation?
(2) Who are the direct owners of International Lease?
(3) In what city is International Lease headquartered?
(4) In what state is International Lease incorporated?
(5) Where is International Lease’s common stock traded?
(6) What company is the parent in the consolidated financial statements in which International
Lease is included, and what is that company’s principal business?
Exercises
LO1 E4-1 Cost versus Equity Reporting
Roller Corporation purchased 100 percent ownership of Steam Company on January
1, 20X5, for $270,000. On that date, the book value of Steam’s reported net assets was
$200,000. The excess over book value paid is attributable to depreciable assets with a
remaining useful life of 10 years. Net income and dividend payments of Steam in the following periods were
Year Net Income Dividends
20X5 $20,000 $ 5,000
20X6 40,000 15,000
20X7 20,000 35,000
Required
Prepare journal entries on Roller Corporation’s books relating to its investment in Steam Company
for each of the three years, assuming it accounts for the investment using ( a ) the cost method and
( b ) the equity-method.
LO1E4-2 Differential Assigned to Patents
Power Corporation purchased 100 percent of the common stock of Snow Corporation on January 1,
20X2, by issuing 45,000 shares of its $6 par value common stock. The market price of Power’s
shares at the date of issue was $24. Snow reported net assets with a book value of $980,000 on
that date. The amount paid in excess of the book value of Snow’s net assets was attributed to the
increased value of patents held by Snow with a remaining useful life of eight years. Snow reported
net income of $56,000 and paid dividends of $20,000 in 20X2 and reported a net loss of $44,000
and paid dividends of $10,000 in 20X3.
Required
Assuming that Power Corporation uses the equity-method in accounting for its investment in
Snow Corporation, prepare all journal entries for Power for 20X2 and 20X3.
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Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value 187
LO1E4-3 Differential Assigned to Copyrights
Best Corporation acquired 100 percent of the voting common stock of Flair Company on January 1,
20X7, by issuing bonds with a par value and fair value of $670,000 and making a cash payment of
$24,000. At the date of acquisition, Flair reported assets of $740,000 and liabilities of $140,000.
The book values and fair values of Flair’s net assets were equal except for land and copyrights.
Flair’s land had a fair value $16,000 greater than its book value. All of the remaining purchase
price was attributable to the increased value of Flair’s copyrights with a remaining useful life of
eight years. Flair Company reported a loss of $88,000 in 20X7 and net income of $120,000 in
20X8. Flair paid dividends of $24,000 each year.
Required
Assuming that Best Corporation uses the equity-method in accounting for its investment in Flair
Company, prepare all journal entries for Best for 20X7 and 20X8.
LO1E4-4 Differential Attributable to Depreciable Assets
Capital Corporation purchased 100 percent of Cook Company’s stock on January 1, 20X4, for
$340,000. On that date, Cook reported net assets of $300,000 valued at historical cost and $340,000
stated at fair value. The difference was due to the increased value of buildings with a remaining
life of 10 years. During 20X4 and 20X5 Cook reported net income of $10,000 and $20,000 and
paid dividends of $6,000 and $9,000, respectively.
Required
Assuming that Capital Corporation uses ( a ) the equity-method and ( b ) the cost method in accounting
for its ownership of Cook Company, give the journal entries that Capital recorded in 20X4 and 20X5.
LO1E4-5 Investment Income
Brindle Company purchased 100 percent of Monroe Company’s voting common stock for
$648,000 on January 1, 20X4. At that date, Monroe reported assets of $690,000 and liabilities
of $230,000. The book values and fair values of Monroe’s assets were equal except for land,
which had a fair value $108,000 greater than book value, and equipment, which had a fair value
$80,000 greater than book value. The remaining economic life of all depreciable assets at January 1, 20X4, was five years. The amount of the differential assigned to goodwill is not impaired.
Monroe reported net income of $68,000 and paid dividends of $34,000 in 20X4.
Required
Compute the amount of investment income to be reported by Brindle for 20X4.
LO1E4-6 Determination of Purchase Price
Branch Corporation purchased 100 percent of Hardy Company’s common stock on January 1,
20X5, and paid $28,000 above book value. The full amount of the additional payment was attributed to amortizable assets with a life of eight years remaining at January 1, 20X5. During 20X5
and 20X6, Hardy reported net income of $33,000 and $6,000 and paid dividends of $15,000 and
$12,000, respectively. Branch uses the equity-method in accounting for its investment in Hardy
and reported a balance in its investment account of $161,000 on December 31, 20X6.
Required
Compute the amount paid by Branch to purchase Hardy shares.
LO1E4-7 Correction of Error
During review of the adjusting entries to be recorded on December 31, 20X8, Grand Corporation
discovered that it had inappropriately been using the cost method in accounting for its investment
in Case Products Corporation. Grand purchased 100 percent ownership of Case Products on January 1, 20X6, for $56,000, at which time Case Products reported retained earnings of $10,000 and
capital stock outstanding of $30,000. The differential was attributable to patents with a life of eight
years. Income and dividends of Case Products were:
Year Net Income Dividends
20X6 $16,000 $6,000
20X7 24,000 8,000
20X8 32,000 8,000
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188 Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value
Required
Give the correcting entry required on December 31, 20X8, to properly report the investment under
the equity-method, assuming the books have not been closed. Case Products’ dividends were
declared in early November and paid in early December each year.
LO1E4-8 Differential Assigned to Land and Equipment
Rod Corporation purchased 100 percent ownership of Stafford Corporation on January 1, 20X4,
for $65,000, which was $10,000 above the underlying book value. Half the additional amount
was attributable to an increase in the value of land held by Stafford, and half was due to an
increase in the value of equipment. The equipment had a remaining economic life of five years
on January 1, 20X4. During 20X4, Stafford reported net income of $12,000 and paid dividends
of $4,500.
Required
Give the journal entries that Rod Corporation recorded during 20X4 related to its investment in Stafford Corporation, assuming Rod uses the equity-method in accounting for its
investment.
LO1 E4-9 Equity Entries with Goodwill
Turner Corporation reported the following balances at January 1, 20X9:
Item Book Value Fair Value
Cash $ 45,000 $ 45,000
Accounts Receivable 60,000 60,000
Inventory 120,000 130,000
Buildings and Equipment 300,000 240,000
Less: Accumulated Depreciation (150,000)
Total Assets $375,000 $475,000
Accounts Payable $ 75,000 $ 75,000
Common Stock ($10 par value) 100,000
Additional Paid-In Capital 30,000
Retained Earnings 170,000
Total Liabilities and Equities $375,000
On January 1, 20X9, Gross Corporation purchased 100 percent of Turner’s stock. All tangible
assets had a remaining economic life of 10 years at January 1, 20X9. Both companies use the FIFO
inventory method. Turner reported net income of $16,000 in 20X9 and paid dividends of $3,200.
Gross uses the equity-method in accounting for its investment in Turner.
Required
Give all journal entries that Gross recorded during 20X9 with respect to its investment assuming
Gross paid $437,500 for the ownership of Turner on January 1, 20X9. The amount of the differential assigned to goodwill is not impaired.
LO1, LO6E4-10 Multiple-Choice Questions on Consolidation Process
Select the most appropriate answer for each of the following questions.
1. Goodwill is
a. Seldom reported because it is too difficult to measure.
b. Reported when more than book value is paid in purchasing another company.
c. Reported when the fair value of the acquiree is greater than the fair value of the net identifiable assets acquired.
d. Generally smaller for small companies and increases in amount as the companies acquired
increase in size.
2. [AICPA Adapted] Wright Corporation includes several subsidiaries in its consolidated financial statements. In its December 31, 20X2, trial balance, Wright had the following intercompany balances before eliminations:
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Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value 189
Debit Credit
Current receivable due from Main Company $ 32,000
Noncurrent receivable from Main Company 114,000
Cash advance to Corn Corporation 6,000
Cash advance from King Company $ 15,000
Intercompany payable to King Company 101,000
Beni Carr
Assets $2,000,000 $750,000
Liabilities $ 750,000 $400,000
Common Stock 1,000,000 310,000
Retained Earnings 250,000 40,000
Liabilities and Stockholders’ Equity $2,000,000 $750,000
Assets Liabilities and Stockholders’ Equity
Cash $ 100,000 Current Liabilities $ 300,000
Accounts Receivable 200,000 Long-Term Debt 500,000
Inventories 500,000 Common Stock (par $1 per share) 100,000
Property, Plant, and Equipment (net) 900,000 Additional Paid-In Capital 200,000
Retained Earnings 600,000
Total Assets $1,700,000 Total Liabilities and Stockholders’ Equity $1,700,000
In its December 31, 20X2, consolidated balance sheet, what amount should Wright report as
intercompany receivables?
a. $152,000.
b. $146,000.
c. $36,000.
d. $0.
3. Beni Corporation acquired 100 percent of Carr Corporation’s outstanding capital stock for
$430,000 cash. Immediately before the purchase, the balance sheets of both corporations
reported the following:
At the date of purchase, the fair value of Carr’s assets was $50,000 more than the aggregate
carrying amounts. In the consolidated balance sheet prepared immediately after the purchase,
the consolidated stockholders’ equity should amount to
a. $1,680,000.
b. $1,650,000.
c. $1,600,000.
d. $1,250,000.
Note: Questions 4 and 5 are based on the following information:
Nugget Company’s balance sheet on December 31, 20X6, was as follows:
On December 31, 20X6, Gold Company acquired all of Nugget’s outstanding common stock for
$1,500,000 cash. On that date, the fair (market) value of Nugget’s inventories was $450,000, and
the fair value of Nugget’s property, plant, and equipment was $1,000,000. The fair values of all
other assets and liabilities of Nugget were equal to their book values.
4. As a result of Gold’s acquisition of Nugget, the consolidated balance sheet of Gold and Nugget
should reflect goodwill in the amount of
a. $500,000.
b. $550,000.
c. $600,000.
d. $650,000.
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190 Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value
5. Assuming that the balance sheet of Gold (unconsolidated) on December 31, 20X6, reflected
retained earnings of $2,000,000, what amount of retained earnings should be shown in the
December 31, 20X6, consolidated balance sheet of Gold and its new subsidiary, Nugget?
a. $2,000,000.
b. $2,600,000.
c. $2,800,000.
d. $3,150,000.
LO3, LO6E4-11 Multiple-Choice Questions on Consolidation [AICPA Adapted]
Select the correct answer for each of the following questions.
1. On January 1, 20X1, Prim Inc. acquired all of Scrap Inc.’s outstanding common shares for cash
equal to the stock’s book value. The carrying amounts of Scrap’s assets and liabilities approximated their fair values, except that the carrying amount of its building was more than fair value.
In preparing Prim’s 20X1 consolidated income statement, which of the following adjustments
would be made?
a. Decrease depreciation expense and recognize goodwill amortization.
b. Increase depreciation expense and recognize goodwill amortization.
c. Decrease depreciation expense and recognize no goodwill amortization.
d. Increase depreciation expense and recognize no goodwill amortization.
2. The first examination of Rudd Corporation’s financial statements was made for the year ended
December 31, 20X8. The auditor found that Rudd had acquired another company on January 1,
20X8, and had recorded goodwill of $100,000 in connection with this acquisition. Although a
friend of the auditor believes the goodwill will last no more than five years, Rudd’s management has found no impairment of goodwill during 20X8. In its 20X8 financial statements, Rudd
should report
Amortization
Expense
Goodwill
a. $ 0 $100,000
b. $100,000 $ 0
c. $ 20,000 $ 80,000
d. $ 0 $ 0
Intercompany
Loans Profits
a. $ 0 $ 0
b. $ 0 $300,000
c. $100,000 $ 0
d. $100,000 $300,000
Cost Fair Value
Cash $ 160,000 $ 160,000
Inventory 480,000 460,000
Property, plant and equipment (net) 980,000 1,040,000
Liabilities (360,000) (360,000)
Net assets $1,260,000 $1,300,000
3. Consolidated financial statements are being prepared for a parent and its four subsidiaries that
have intercompany loans of $100,000 and intercompany profits of $300,000. How much of
these intercompany loans and profits should be eliminated?
4. On April 1, 20X8, Plum Inc. paid $1,700,000 for all of Long Corp.’s issued and outstanding
common stock. On that date, the costs and fair values of Long’s recorded assets and liabilities
were as follows:
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Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value 191
In Plum’s March 31, 20X9, consolidated balance sheet, what amount of goodwill should be
reported as a result of this business combination?
a. $360,000.
b. $396,000.
c. $400,000.
d. $440,000.
LO3E4-12 Eliminating Entries with Differential
On June 10, 20X8, Tower Corporation acquired 100 percent of Brown Company’s common stock.
Summarized balance sheet data for the two companies immediately after the stock acquisition are
as follows:
Tower Corp. Brown Company
Item Book Value Fair Value
Cash $ 15,000 $ 5,000 $ 5,000
Accounts Receivable 30,000 10,000 10,000
Inventory 80,000 20,000 25,000
Buildings and Equipment (net) 120,000 50,000 70,000
Investment in Brown Stock 100,000
Total $345,000 $85,000 $110,000
Accounts Payable $ 25,000 $ 3,000 $ 3,000
Bonds Payable 150,000 25,000 25,000
Common Stock 55,000 20,000
Retained Earnings 115,000 37,000
Total $345,000 $85,000 $ 28,000
Cash $120,000 Current Liabilities $ 80,000
Inventory 100,000 Long-Term Liabilities 200,000
Buildings (net) 420,000 Common Stock 120,000
Retained Earnings 240,000
Total $640,000 Total $640,000
Required
a. Give the eliminating entries required to prepare a consolidated balance sheet immediately after
the acquisition of Brown Company shares.
b. Explain how eliminating entries differ from other types of journal entries recorded in the normal course of business.
LO5E4-13 Balance Sheet Consolidation
Reed Corporation acquired 100 percent of Thorne Corporation’s voting common stock on December 31, 20X4, for $395,000. At the date of combination, Thorne reported the following:
At December 31, 20X4, the book values of Thorne’s net assets and liabilities approximated their
fair values, except for buildings, which had a fair value of $20,000 less than book value, and
inventories, which had a fair value $36,000 more than book value.
Required
Reed Corporation wishes to prepare a consolidated balance sheet immediately following the business combination. Give the eliminating entry or entries needed to prepare a consolidated balance
sheet at December 31, 20X4.
LO3E4-14 Acquisition with Differential
Road Corporation acquired all of Conger Corporation’s voting shares on January 1, 20X2, for
$470,000. At that time Conger reported common stock outstanding of $80,000 and retained
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192 Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value
earnings of $130,000. The book values of Conger’s assets and liabilities approximated fair values,
except for land, which had a book value of $80,000 and a fair value of $100,000, and buildings,
which had a book value of $220,000 and a fair value of $400,000. Land and buildings are the only
noncurrent assets that Conger holds.
Required
a. Compute the amount of goodwill at the date of acquisition.
b. Give the eliminating entry or entries required immediately following the acquisition to prepare
a consolidated balance sheet.
LO5E4-15 Balance Sheet Worksheet with Differential
Blank Corporation acquired 100 percent of Faith Corporation’s common stock on December 31,
20X2, for $189,000. Data from the balance sheets of the two companies included the following
amounts as of the date of acquisition:
Item
Blank
Corporation
Faith
Corporation
Cash $ 26,000 $ 18,000
Accounts Receivable 87,000 37,000
Inventory 110,000 60,000
Buildings and Equipment (net) 220,000 150,000
Investment in Faith Corporation Stock 189,000
Total Assets $632,000 $265,000
Accounts Payable $ 92,000 $ 35,000
Notes Payable 150,000 80,000
Common Stock 100,000 60,000
Retained Earnings 290,000 90,000
Total Liabilities and Stockholders’ Equity $632,000 $265,000
Gold
Enterprises
Premium
Builders
Cash and Receivables $ 80,000 $ 30,000
Inventory 150,000 350,000
Buildings and Equipment (net) 430,000 80,000
Investment in Premium Stock 167,000
Total Assets $827,000 $460,000
Current Liabilities $100,000 $110,000
Long-Term Debt 400,000 200,000
Common Stock 200,000 140,000
Retained Earnings 127,000 10,000
Total Liabilities and Stockholders’ Equity $827,000 $460,000
At the date of the business combination, Faith’s net assets and liabilities approximated fair value
except for inventory, which had a fair value of $84,000, and buildings and equipment (net), which
had a fair value of $165,000.
Required
a. Give the eliminating entry or entries needed to prepare a consolidated balance sheet immediately following the business combination.
b. Prepare a consolidation balance sheet worksheet.
LO3E4-16 Worksheet for Wholly Owned Subsidiary
Gold Enterprises acquired 100 percent of Premium Builders’ stock on December 31, 20X4. Balance sheet data for Gold and Premium on January 1, 20X5, are as follows:
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Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value 193
At the date of the business combination, Premium’s cash and receivables had a fair value of
$28,000, inventory had a fair value of $357,000, and buildings and equipment had a fair value of
$92,000.
Required
a. Give all eliminating entries needed to prepare a consolidated balance sheet on January 1, 20X5.
b. Complete a consolidated balance sheet worksheet.
c. Prepare a consolidated balance sheet in good form.
LO3E4-17 Computation of Consolidated Balances
Astor Corporation’s balance sheet at January 1, 20X7, reflected the following balances:
Cash and Receivables $ 80,000 Accounts Payable $ 40,000
Inventory 120,000 Income Taxes Payable 60,000
Land 70,000 Bonds Payable 200,000
Buildings and Equipment (net) 480,000 Common Stock 250,000
Retained Earnings 200,000
Total Assets $750,000 Total Liabilities and Stockholders’ Equity $750,000
Book Value Fair Value
Inventory $120,000 $140,000
Land 70,000 60,000
Buildings and Equipment (net) 480,000 550,000
Item
Top
Corporation
Sun
Corporation
Cash $ 49,000 $ 30,000
Accounts Receivable 110,000 45,000
Inventory 130,000 70,000
Land 80,000 25,000
Buildings and Equipment 500,000 400,000
Less: Accumulated Depreciation (223,000) (165,000)
Investment in Sun Corporation Stock 198,000
Total Assets $844,000 $405,000
Accounts Payable $ 61,500 $ 28,000
Taxes Payable 95,000 37,000
Bonds Payable 280,000 200,000
Common Stock 150,000 50,000
Retained Earnings 257,500 90,000
Total Liabilities and Stockholders’ Equity $844,000 $405,000
Phel Corporation, which had just entered into an active acquisition program, acquired 100 percent
of Astor’s common stock on January 2, 20X7, for $576,000. A careful review of the fair value of
Astor’s assets and liabilities indicated the following:
Required
Compute the appropriate amount to be included in the consolidated balance sheet immediately following the acquisition for each of the following items:
a. Inventory.
b. Land.
c. Buildings and Equipment (net).
d. Goodwill.
e. Investment in Astor Corporation.
LO3, LO4E4-18 Multiple-Choice Questions on Balance Sheet Consolidation
Top Corporation acquired 100 percent of Sun Corporation’s common stock on December 31,
20X2. Balance sheet data for the two companies immediately following the acquisition follow:
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194 Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value
At the date of the business combination, the book values of Sun’s net assets and liabilities approximated fair value except for inventory, which had a fair value of $85,000, and land, which had a
fair value of $45,000.
Required
For each question, indicate the appropriate total that should appear in the consolidated balance
sheet prepared immediately after the business combination.
1. What amount of inventory will be reported?
a. $70,000.
b. $130,000.
c. $200,000.
d. $215,000.
2. What amount of goodwill will be reported?
a. $0.
b. $23,000.
c. $43,000.
d. $58,000.
3. What amount of total assets will be reported?
a. $84,400.
b. $1,051,000.
c. $1,109,000.
d. $1,249,000.
4. What amount of total liabilities will be reported?
a. $265,000.
b. $436,500.
c. $701,500.
d. $1,249,000.
5. What amount of consolidated retained earnings will be reported?
a. $547,500.
b. $397,500.
c. $347,500.
d. $257,500.
6. What amount of total stockholders’ equity will be reported?
a. $407,500.
b. $547,500.
c. $844,000.
d. $1,249,000.
LO3E4-19 Wholly Owned Subsidiary with Differential
Canton Corporation is a wholly owned subsidiary of Winston Corporation. Winston acquired ownership of Canton on January 1, 20X3, for $28,000 above Canton’s reported net assets. At that date,
Canton reported common stock outstanding of $60,000 and retained earnings of $90,000. The differential is assigned to equipment with an economic life of seven years at the date of the business
combination. Canton reported net income of $30,000 and paid dividends of $12,000 in 20X3.
Required
a. Give the journal entries recorded by Winston Corporation during 20X3 on its books if Winston
accounts for its investment in Canton using the equity-method.
b. Give the eliminating entries needed at December 31, 20X3, to prepare consolidated financial
statements.
LO5E4-20 Basic Consolidation Worksheet
Blake Corporation acquired 100 percent of Shaw Corporation’s voting shares on January 1, 20X3, at
underlying book value. At that date, the book values and fair values of Shaw’s assets and liabilities
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Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value 195
were equal. Blake uses the equity-method in accounting for its investment in Shaw. Adjusted trial
balances for Blake and Shaw on December 31, 20X3, are as follows:
Item
Blake Corporation Shaw Corporation
Debit Credit Debit Credit
Current Assets $145,000 $105,000
Depreciable Assets (net) 325,000 225,000
Investment in Shaw Corporation Stock 170,000
Depreciation Expense 25,000 15,000
Other Expenses 105,000 75,000
Dividends Declared 40,000 10,000
Current Liabilities $ 50,000 $ 40,000
Long-Term Debt 100,000 120,000
Common Stock 200,000 100,000
Retained Earnings 230,000 50,000
Sales 200,000 120,000
Income from Subsidiary 30,000
$810,000 $810,000 $430,000 $430,000
Item
Blake Corporation Shaw Corporation
Debit Credit Debit Credit
Current Assets $210,000 $150,000
Depreciable Assets (net) 300,000 210,000
Investment in Shaw Corporation Stock 190,000
Depreciation Expense 25,000 15,000
Other Expenses 150,000 90,000
Dividends Declared 50,000 15,000
Current Liabilities $ 70,000 $ 50,000
Long-Term Debt 100,000 120,000
Common Stock 200,000 100,000
Retained Earnings 290,000 70,000
Sales 230,000 140,000
Income from Subsidiary 35,000
$925,000 $925,000 $480,000 $480,000
Required
a. Give all eliminating entries required on December 31, 20X3, to prepare consolidated financial
statements.
b. Prepare a three-part consolidation worksheet as of December 31, 20X3.
LO5E4-21 Basic Consolidation Worksheet for Second Year
Blake Corporation acquired 100 percent of Shaw Corporation’s voting shares on January 1, 20X3,
at underlying book value. At that date, the book values and fair values of Shaw’s assets and liabilities were equal. Blake uses the equity-method in accounting for its investment in Shaw. Adjusted
trial balances for Blake and Shaw on December 31, 20X4, are as follows:
Required
a. Give all eliminating entries required on December 31, 20X4, to prepare consolidated financial
statements.
b. Prepare a three-part consolidation worksheet as of December 31, 20X4.
LO5E4-22 Consolidation Worksheet with Differential
Kennelly Corporation acquired all of Short Company’s common shares on January 1, 20X5, for
$180,000. On that date, the book value of the net assets reported by Short was $150,000. The entire
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196 Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value
differential was assigned to depreciable assets with a six-year remaining economic life from January
1, 20X5.
The adjusted trial balances for the two companies on December 31, 20X5, are as follows:
Item Land Corporation Growth Company
Debit Credit Debit Credit
Current Assets $ 238,000 $150,000
Depreciable Assets 500,000 300,000
Investment in Growth Company Stock 190,000
Depreciation Expense 25,000 15,000
Other Expenses 150,000 90,000
Dividends Declared 50,000 15,000
Accumulated Depreciation $ 200,000 $ 90,000
Current Liabilities 70,000 50,000
Long-Term Debt 100,000 120,000
Common Stock 200,000 100,000
Retained Earnings 318,000 70,000
Sales 230,000 140,000
Income from Subsidiary 35,000
$1,153,000 $1,153,000 $570,000 $570,000
Kennelly uses the equity-method in accounting for its investment in Short. Short declared and paid
dividends on December 31, 20X5.
Required
a. Prepare the eliminating entries needed as of December 31, 20X5, to complete a consolidation
worksheet.
b. Prepare a three-part consolidation worksheet as of December 31, 20X5.
LO5E4-23 Consolidation Worksheet for Subsidiary
Land Corporation acquired 100 percent of Growth Company’s voting stock on January 1, 20X4,
at underlying book value. Land uses the equity-method in accounting for its ownership of Growth.
On December 31, 20X4, the trial balances of the two companies are as follows:
Item
Kennelly Corporation Short Company
Debit Credit Debit Credit
Cash $ 15,000 $ 5,000
Accounts Receivable 30,000 40,000
Inventory 70,000 60,000
Depreciable Assets (net) 325,000 225,000
Investment in Short Company Stock 195,000
Depreciation Expense 25,000 15,000
Other Expenses 105,000 75,000
Dividends Declared 40,000 10,000
Accounts Payable $ 50,000 $ 40,000
Notes Payable 100,000 120,000
Common Stock 200,000 100,000
Retained Earnings 230,000 50,000
Sales 200,000 120,000
Income from Subsidiary 25,000
$805,000 $805,000 $430,000 $430,000
Required
a. Give all eliminating entries required on December 31, 20X4, to prepare consolidated financial
statements.
b. Prepare a three-part consolidation worksheet as of December 31, 20X4.
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Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value 197
LO7E4-24 Push-Down Accounting
Jefferson Company acquired all of Louis Corporation’s common shares on January 2, 20X3, for
$789,000. At the date of combination, Louis’s balance sheet appeared as follows:
Assets Liabilities
Cash and Receivables $ 34,000 Current Payables $ 25,000
Inventory 165,000 Notes Payable 100,000
Land 60,000 Stockholders’ Equity
Buildings (net) 250,000 Common Stock 200,000
Equipment (net) 320,000 Additional Capital 425,000
Retained Earnings 79,000
Total $829,000 Total $829,000
Teresa
Corporation
Sally
Enterprises
Cash and Receivables $ 40,000 $ 20,000
Inventory 95,000 40,000
Land 80,000 90,000
Buildings and Equipment 400,000 230,000
Investment in Sally Enterprises 290,000
Total Debits $905,000 $380,000
Accumulated Depreciation $175,000 $ 65,000
Accounts Payable 60,000 15,000
Notes Payable 100,000 50,000
Common Stock 300,000 100,000
Retained Earnings 270,000 150,000
Total Credits $905,000 $380,000
The fair values of all of Louis’s assets and liabilities were equal to their book values except for its
fixed assets. Louis’s land had a fair value of $75,000; the buildings, a fair value of $300,000; and
the equipment, a fair value of $340,000.
Jefferson Company decided to employ push-down accounting for the acquisition of Louis Corporation. Subsequent to the combination, Louis continued to operate as a separate company.
Required
a. Record the acquisition of Louis’s stock on Jefferson’s books.
b. Present any entries that would be made on Louis’s books related to the business combination,
assuming push-down accounting is used.
c. Present, in general journal form, all elimination entries that would appear in a consolidation
worksheet for Jefferson and its subsidiary prepared immediately following the combination.
Problems
LO5 P4-25 Assignment of Differential in Worksheet
Teresa Corporation acquired all the voting shares of Sally Enterprises on January 1, 20X4. Balance
sheet amounts for the companies on the date of acquisition were as follows:
Sally Enterprises’ buildings and equipment were estimated to have a market value of $175,000
on January 1, 20X4. All other items appeared to have market values approximating current book
values.
Required
a. Complete a consolidated balance sheet worksheet for January 1, 20X4.
b. Prepare a consolidated balance sheet in good form.
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198 Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value
LO3, LO4 P4-26 Computation of Consolidated Balances
Retail Records Inc. acquired all of Decibel Studios’ voting shares on January 1, 20X2, for $280,000.
Retail’s balance sheet immediately after the combination contained the following balances:
Decibel’s balance sheet at acquisition contained the following balances:
On the date of combination, the inventory held by Decibel had a fair value of $170,000, and
its buildings and recording equipment had a value of $375,000. Goodwill reported by Decibel
resulted from a purchase of Sound Stage Enterprises in 20X1. Sound Stage was liquidated and its
assets and liabilities were brought onto Decibel’s books.
Required
Compute the balances to be reported in the consolidated balance sheet immediately after the acquisition for:
a. Inventory.
b. Buildings and Equipment (net).
c. Investment in Decibel Stock.
d. Goodwill.
e. Common Stock.
f. Retained Earnings.
LO5 P4-27 Balance Sheet Consolidation [AICPA Adapted]
Case Inc. acquired all Frey Inc.’s outstanding $25 par common stock on December 31, 20X3, in
exchange for 40,000 shares of its $25 par common stock. Case’s common stock closed at $56.50 per
share on a national stock exchange on December 31, 20X3. Both corporations continued to operate
as separate businesses maintaining separate accounting records with years ending December 31.
On December 31, 20X4, after year-end adjustments and the closing of nominal accounts, the
companies had condensed balance sheet accounts (on the next page).
Additional Information
1. Case uses the equity-method of accounting for its investment in Frey.
2. On December 31, 20X3, Frey’s assets and liabilities had fair values equal to the book balances
with the exception of land, which had a fair value of $550,000. Frey had no land transactions in
20X4.
3. On June 15, 20X4, Frey paid a cash dividend of $4 per share on its common stock.
4. On December 10, 20X4, Case paid a cash dividend totaling $256,000 on its common stock.
RETAIL RECORDS INC.
Balance Sheet
January 1, 20X2
Cash and Receivables $120,000 Accounts Payable $ 75,000
Inventory 110,000 Taxes Payable 50,000
Land 70,000 Notes Payable 300,000
Buildings and Equipment (net) 350,000 Common Stock 400,000
Investment in Decibel Stock 280,000 Retained Earnings 105,000
Total Assets $930,000 Total Liabilities and Stockholders’ Equity $930,000
DECIBEL STUDIOS
Balance Sheet
January 1, 20X2
Cash and Receivables $ 40,000 Accounts Payable $ 90,000
Inventory 180,000 Notes Payable 250,000
Buildings and Equipment (net) 350,000 Common Stock 100,000
Goodwill 30,000 Additional Paid-In Capital 200,000
Retained Earnings (40,000)
Total Assets $600,000 Total Liabilities and Stockholders’ Equity $600,000
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Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value 199
Case Frey
Assets
Cash $ 825,000 $ 330,000
Accounts and Other Receivables 2,140,000 835,000
Inventories 2,310,000 1,045,000
Land 650,000 300,000
Depreciable Assets (net) 4,575,000 1,980,000
Investment in Frey Inc. 2,680,000
Long-Term Investments and Other Assets 865,000 385,000
Total Assets $14,045,000 $4,875,000
Liabilities and Stockholders’ Equity
Accounts Payable and Other Current Liabilities $ 2,465,000 $1,145,000
Long-Term Debt 1,900,000 1,300,000
Common Stock, $25 Par Value 3,200,000 1,000,000
Additional Paid-In Capital 2,100,000 190,000
Retained Earnings 4,380,000 1,240,000
Total Liabilities and Stockholders’ Equity $14,045,000 $4,875,000
Case Frey
Common Stock $2,200,000 $1,000,000
Additional Paid-In Capital 1,660,000 190,000
Retained Earnings 3,166,000 820,000
$7,026,000 $2,010,000
Thompson
Company
Lake
Corporation
Cash $ 30,000 $ 20,000
Accounts Receivable 100,000 40,000
Land 60,000 50,000
Buildings and Equipment 500,000 350,000
Less: Accumulated Depreciation (230,000) (75,000)
Investment in Lake Corporation 252,000
$712,000 $385,000
Accounts Payable $ 80,000 $ 10,000
Taxes Payable 40,000 70,000
Notes Payable 100,000 85,000
Common Stock 200,000 100,000
Retained Earnings 292,000 120,000
$712,000 $385,000
6. The 20X4 net income amounts according to the separate books of Case and Frey were $890,000
(exclusive of equity in Frey’s earnings) and $580,000, respectively.
Required
Prepare a consolidated balance sheet worksheet for Case and its subsidiary, Frey, for December
31, 20X4. A formal consolidated balance sheet is not required.
LO5 P4-28 Consolidated Balance Sheet
Thompson Company spent $240,000 to acquire all of Lake Corporation’s stock on January 1,
20X2. The balance sheets of the two companies on December 31, 20X3, showed the following
amounts:
Lake reported retained earnings of $100,000 at the date of acquisition. The difference between
the acquisition price and underlying book value is assigned to buildings and equipment with a
remaining economic life of 10 years from the date of acquisition.
5. On December 31, 20X3, immediately before the combination, the stockholders’ equity balance was:
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200 Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value
Required
a. Give the appropriate eliminating entry or entries needed to prepare a consolidated balance sheet
as of December 31, 20X3.
b. Prepare a consolidated balance sheet worksheet as of December 31, 20X3.
LO5, LO6 P4-29 Comprehensive Problem: Consolidation in Subsequent Period
Thompson Company spent $240,000 to acquire all of Lake Corporation’s stock on January 1,
20X2. On December 31, 20X4, the trial balances of the two companies were as follows:
Lake Corporation reported retained earnings of $100,000 at the date of acquisition. The difference
between the acquisition price and underlying book value is assigned to buildings and equipment
with a remaining economic life of 10 years from the date of acquisition. At December 31, 20X4,
Lake owed Thompson $2,500 for services provided.
Required
a. Give all journal entries recorded by Thompson with regard to its investment in Lake during
20X4.
b. Give all eliminating entries required on December 31, 20X4, to prepare consolidated financial
statements.
c. Prepare a three-part consolidation worksheet as of December 31, 20X4.
LO3, LO4 P4-30 Acquisition at Other than Fair Value of Net Assets
Mason Corporation acquired 100 percent ownership of Best Company on February 12, 20X9.
At the date of acquisition, Best Company reported assets and liabilities with book values of
$420,000 and $165,000, respectively, common stock outstanding of $80,000, and retained
earnings of $175,000. The book values and fair values of Best’s assets and liabilities were
identical except for land which had increased in value by $20,000 and inventories which had
decreased by $7,000. The estimated fair value of Best as a whole at the date of acquisition was
$295,000.
Required
Give the eliminating entries required to prepare a consolidated balance sheet immediately after the
business combination assuming Mason acquired its ownership of Best for:
a. $280,000.
b. $251,000.
Thompson Company Lake Corporation
Item Debit Credit Debit Credit
Cash $ 74,000 $ 42,000
Accounts Receivable 130,000 53,000
Land 60,000 50,000
Buildings and Equipment 500,000 350,000
Investment in Lake Corporation Stock 268,000
Cost of Services Provided 470,000 130,000
Depreciation Expense 35,000 18,000
Other Expenses 57,000 60,000
Dividends Declared 30,000 12,000
Accumulated Depreciation $ 265,000 $ 93,000
Accounts Payable 71,000 17,000
Taxes Payable 58,000 60,000
Notes Payable 100,000 85,000
Common Stock 200,000 100,000
Retained Earnings 292,000 120,000
Service Revenue 610,000 240,000
Income from Subsidiary 28,000
$1,624,000 $1,624,000 $715,000 $715,000
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Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value 201
LO6 P4-31 Intercorporate Receivables and Payables
Kim Corporation acquired 100 percent of Normal Company’s outstanding shares on January 1,
20X7. Balance sheet data for the two companies immediately after the purchase follow:
Kim
Corporation
Normal
Company
Cash $ 70,000 $ 35,000
Accounts Receivable 90,000 65,000
Inventory 84,000 80,000
Buildings and Equipment 400,000 300,000
Less: Accumulated Depreciation (160,000) (75,000)
Investment in Normal Company Stock 305,000
Investment in Normal Company Bonds 50,000
Total Assets $839,000 $405,000
Accounts Payable $ 50,000 $ 20,000
Bonds Payable 200,000 100,000
Common Stock 300,000 150,000
Capital in Excess of Par 140,000
Retained Earnings 289,000 (5,000)
Total Liabilities and Equities $839,000 $405,000
Primary Street
Book Value Fair Value Book Value Fair Value
Cash $ 12,000 $ 12,000 $ 9,000 $ 9,000
Receivables 41,000 39,000 31,000 30,000
Allowance for Bad Debts (2,000) (1,000)
Inventory 86,000 89,000 68,000 72,000
Land 55,000 200,000 50,000 70,000
Buildings and Equipment 960,000 650,000 670,000 500,000
Accumulated Depreciation (411,000) (220,000)
Patent 40,000
Total Assets $741,000 $990,000 $607,000 $721,000
Current Payables $ 38,000 $ 38,000 $ 29,000 $ 29,000
Bonds Payable 200,000 210,000 100,000 90,000
Common Stock 300,000 200,000
Additional Paid-In Capital 100,000 130,000
Retained Earnings 103,000 148,000
Total Liabilities and Equity $741,000 $607,000
As indicated in the parent company balance sheet, Kim purchased $50,000 of Normal’s bonds
from the subsidiary immediately after it acquired the stock. An analysis of intercompany receivables and payables also indicates that the subsidiary owes the parent $10,000. On the date of combination, the book values and fair values of Normal’s assets and liabilities were the same.
Required
a. Give all eliminating entries needed to prepare a consolidated balance sheet for January 1, 20X7.
b. Complete a consolidated balance sheet worksheet.
c. Prepare a consolidated balance sheet in good form.
LO5 P4-32 Balance Sheet Consolidation
On January 2, 20X8, Primary Corporation acquired 100 percent of Street Company’s outstanding
common stock. In exchange for Street’s stock, Primary issued bonds payable with a par and fair
value of $650,000 directly to the selling stockholders of Street. The two companies continued to
operate as separate entities subsequent to combination.
Immediately prior to the combination, the book values and fair values of the companies’ assets
and liabilities were as follows:
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202 Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value
Mill Corporation Roller Company
Item Debit Credit Debit Credit
Cash $ 19,500 $ 21,000
Accounts Receivable 70,000 12,000
Inventory 90,000 25,000
Land 30,000 15,000
Buildings and Equipment 350,000 150,000
Investment in Roller Co. Stock 128,500
Cost of Goods Sold 125,000 110,000
Wage Expense 42,000 27,000
Depreciation Expense 25,000 10,000
Interest Expense 12,000 4,000
Other Expenses 13,500 5,000
Dividends Declared 30,000 16,000
Accumulated Depreciation $145,000 $ 40,000
Accounts Payable 45,000 16,000
Wages Payable 17,000 9,000
Notes Payable 150,000 50,000
Common Stock 200,000 60,000
Retained Earnings 102,000 40,000
Sales 260,000 180,000
Income from Subsidiary 16,500
$935,500 $935,500 $395,000 $395,000
At the date of combination, Street owed Primary $6,000 plus accrued interest of $500 on a
short-term note. Both companies have properly recorded these amounts.
Required
a. Record the business combination on the books of Primary Corporation.
b. Present in general journal form all elimination entries needed in a worksheet to prepare a
consolidated balance sheet immediately following the business combination on January 2,
20X8.
c. Prepare and complete a consolidated balance sheet worksheet as of January 2, 20X8, immediately following the business combination.
d. Present a consolidated balance sheet for Primary and its subsidiary as of January 2, 20X8.
LO1 P4-33 Consolidation Worksheet at End of First Year of Ownership
Mill Corporation acquired 100 percent ownership of Roller Company on January 1, 20X8, for
$128,000. At that date, the fair value of Roller’s buildings and equipment was $20,000 more
than book value. Buildings and equipment are depreciated on a 10-year basis. Although goodwill is not amortized, the management of Mill concluded at December 31, 20X8, that goodwill
involved in its acquisition of Roller shares had been impaired and the correct carrying value
was $2,500.
Trial balance data for Mill and Roller on December 31, 20X8, are as follows:
Required
a. Give all eliminating entries needed to prepare a three-part consolidation worksheet as of
December 31, 20X8.
b. Prepare a three-part consolidation worksheet for 20X8 in good form.
LO5 P4-34 Consolidation Worksheet at End of Second Year of Ownership
Mill Corporation acquired 100 percent ownership of Roller Company on January 1, 20X8, for
$128,000. At that date, the fair value of Roller’s buildings and equipment was $20,000 more than
book value. Buildings and equipment are depreciated on a 10-year basis. Although goodwill is not
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Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value 203
amortized, the management of Mill concluded at December 31, 20X8, that goodwill involved in
its acquisition of Roller shares had been impaired and the correct carrying value was $2,500. No
additional impairment occurred in 20X9.
Trial balance data for Mill and Roller on December 31, 20X9, are as follows:
Mill Corporation Roller Company
Item Debit Credit Debit Credit
Cash $ 45,500 $ 32,000
Accounts Receivable 85,000 14,000
Inventory 97,000 24,000
Land 50,000 25,000
Buildings and Equipment 350,000 150,000
Investment in Roller Co. Stock 142,500
Cost of Goods Sold 145,000 114,000
Wage Expense 35,000 20,000
Depreciation Expense 25,000 10,000
Interest Expense 12,000 4,000
Other Expenses 23,000 16,000
Dividends Declared 30,000 20,000
Accumulated Depreciation $ 170,000 $ 50,000
Accounts Payable 51,000 15,000
Wages Payable 14,000 6,000
Notes Payable 150,000 50,000
Common Stock 200,000 60,000
Retained Earnings 131,000 48,000
Sales 290,000 200,000
Income from Subsidiary 34,000
$1,040,000 $1,040,000 $429,000 $429,000
Required
a. Give all eliminating entries needed to prepare a three-part consolidation worksheet as of
December 31, 20X9.
b. Prepare a three-part consolidation worksheet for 20X9 in good form.
c. Prepare a consolidated balance sheet, income statement, and retained earnings statement for
20X9.
LO5 P4-35 Comprehensive Problem: Wholly Owned Subsidiary
Power Corporation acquired 100 percent ownership of Upland Products Company on January 1,
20X1, for $200,000. On that date Upland reported retained earnings of $50,000 and had $100,000
of common stock outstanding. Power has used the equity-method in accounting for its investment in
Upland.
Trial balance data for the two companies on December 31, 20X5 (on the next page).
Additional Information
1. On the date of combination, the fair value of Upland’s depreciable assets was $50,000 more
than book value. The differential assigned to depreciable assets should be written off over the
following 10-year period.
2. There was $10,000 of intercorporate receivables and payables at the end of 20X5.
Required
a. Give all journal entries that Power recorded during 20X5 related to its investment in Upland.
b. Give all eliminating entries needed to prepare consolidated statements for 20X5.
c. Prepare a three-part worksheet as of December 31, 20X5.
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204 Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value
LO5 P4-36 Comprehensive Problem: Differential Apportionment
Jersey Corporation acquired 100 percent of Lime Company on January 1, 20X7, for $203,000.
The trial balances for the two companies on December 31, 20X7, included the following amounts:
Item
Power
Corporation
Upland
Products Company
Debit Credit Debit Credit
Cash and Receivables $ 43,000 $ 65,000
Inventory 260,000 90,000
Land 80,000 80,000
Buildings and Equipment 500,000 150,000
Investment in Upland Products Stock 235,000
Cost of Goods Sold 120,000 50,000
Depreciation Expense 25,000 15,000
Inventory Losses 15,000 5,000
Dividends Declared 30,000 10,000
Accumulated Depreciation $ 205,000 $105,000
Accounts Payable 60,000 20,000
Notes Payable 200,000 50,000
Common Stock 300,000 100,000
Retained Earnings 318,000 90,000
Sales 200,000 100,000
Income from Subsidiary 25,000
$1,308,000 $1,308,000 $465,000 $465,000
Jersey Corporation Lime Company
Item Debit Credit Debit Credit
Cash $ 82,000 $ 25,000
Accounts Receivable 50,000 55,000
Inventory 170,000 100,000
Land 80,000 20,000
Buildings and Equipment 500,000 150,000
Investment in Lime Company Stock 240,000
Cost of Goods Sold 500,000 250,000
Depreciation Expense 25,000 15,000
Other Expenses 75,000 75,000
Dividends Declared 50,000 20,000
Accumulated Depreciation $ 155,000 $ 75,000
Accounts Payable 70,000 35,000
Mortgages Payable 200,000 50,000
Common Stock 300,000 50,000
Retained Earnings 290,000 100,000
Sales 700,000 400,000
Income from Subsidiary 57,000
$1,772,000 $1,772,000 $710,000 $710,000
Additional Information
1. On January 1, 20X7, Lime reported net assets with a book value of $150,000. A total of $20,000
of the acquisition price is applied to goodwill, which was not impaired in 20X7.
2. Lime’s depreciable assets had an estimated economic life of 11 years on the date of combination. The difference between fair value and book value of tangible assets is related entirely to
buildings and equipment.
3. Jersey used the equity-method in accounting for its investment in Lime.
4. Detailed analysis of receivables and payables showed that Lime owed Jersey $16,000 on
December 31, 20X7.
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Chapter 4 Consolidation of Wholly Owned Subsidiaries Acquired at More than Book Value 205
Required
a. Give all journal entries recorded by Jersey with regard to its investment in Lime during 20X7.
b. Give all eliminating entries needed to prepare a full set of consolidated financial statements for 20X7.
c. Prepare a three-part consolidation worksheet as of December 31, 20X7.
LO7 P4-37A Push-Down Accounting
On December 31, 20X6, Greenly Corporation and Lindy Company entered into a business combination in which Greenly acquired all of Lindy’s common stock for $935,000. At the date of
combination, Lindy had common stock outstanding with a par value of $100,000, additional paidin capital of $400,000, and retained earnings of $175,000. The fair values and book values of all
Lindy’s assets and liabilities were equal at the date of combination, except for the following:
Book Value Fair Value
Inventory $ 50,000 $ 55,000
Land 75,000 160,000
Buildings 400,000 500,000
Equipment 500,000 570,000
The buildings had a remaining life of 20 years, and the equipment was expected to last another
10 years. In accounting for the business combination, Greenly decided to use push-down accounting on Lindy’s books.
During 20X7, Lindy earned net income of $88,000 and paid a dividend of $50,000. All of
the inventory on hand at the end of 20X6 was sold during 20X7. During 20X8, Lindy earned net
income of $90,000 and paid a dividend of $50,000.
Required
a. Record the acquisition of Lindy’s stock on Greenly’s books on December 31, 20X6.
b. Record any entries that would be made on December 31, 20X6, on Lindy’s books related to the
business combination if push-down accounting is employed.
c. Present all eliminating entries that would appear in the worksheet to prepare a consolidated balance sheet immediately after the combination.
d. Present all entries that Greenly would record during 20X7 related to its investment in Lindy if
Greenly uses the equity-method of accounting for its investment.
e. Present all eliminating entries that would appear in the worksheet to prepare a full set of consolidated financial statements for the year 20X7.
f. Present all eliminating entries that would appear in the worksheet to prepare a full set of consolidated financial statements for the year 20X8.
Review
Kaplan CPA Kaplan CPA Review Simulation on Comprehensive Consolidation Procedures
Access to the online CPA Simulation can be attained by visiting the text’s Web site:
www.mhhe.com/baker1e
Situation
On January 1, Year One, Big Corporation acquires for $700,000 in cash all of the outstanding
voting stock of Little Corporation. It was the first such acquisition for either company. On the day
prior to the transaction, Big and Little reported assets of $2 million and $800,000, liabilities of
$900,000 and $330,000, contributed capital of $300,000 and $100,000, and retained earnings of
$800,000 and $370,000, respectively. Unless otherwise stated, assume Little Corporation holds a
building with a book value of $200,000 but a fair value of $300,000. The building has a 10-year
remaining life. All of Little’s other assets and liabilities are fairly valued in its financial records.
Topics Covered in the Simulation
a. Computation of consolidated assets.
b. Goodwill measurement.
c. Computation of consolidated expenses.
d. Allocation of purchase differentials.
e. Equity-method reporting.
f. Valuation of other intangibles.
g. Determining when control exists.
h. Testing for goodwill impairment.
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206
Consolidation of Lessthan-Wholly-Owned
Subsidiaries Acquired at
More than Book Value
CISCO ACQUIRES A CONTROLLING INTEREST IN NUOVA
In many of the examples of corporate acquisitions discussed so far, the acquiring company has purchased 100 percent of the outstanding stock of the acquired company. However, the buyer doesn’t always acquire 100 percent ownership of the target company. For
example, in 2006 Cisco Systems Inc. acquired 80 percent of Nuova Systems in order to
take advantage of Nuova’s innovative data center technology. The remaining 20 percent
of the company was still held by individual investors. Cisco’s initial investment in Nuova
was $50 million. Accounting for this type of investment can be very complicated. First,
Cisco’s $50 million investment was not intended solely to purchase Nuova’s tangible
assets. Cisco also paid for Nuova’s potential future earnings, for its innovation, and for
the fair value of assets in excess of their book values as of the acquisition date. Because
Cisco did not purchase 100 percent of Nuova, the Cisco consolidated financial statements
in future years would have to account for the portion of the company owned by the noncontrolling interest (NCI) shareholders. This chapter explores the consolidation of lessthan-wholly-owned subsidiaries when there is a positive differential.
Chapter Five
Business
Combinations
Consolidation Concepts
and Procedures
Intercompany Transfers
Multinational
Entities
Multi-Corporate
Entities
Partnerships
Governmental
Entities
CISCO
NuOVA SYSTEMS
80% 20%
NCI
LEARNING OBJECTIVES
When you finish studying this chapter, you should be able to:
LO1 Understand and explain how the consolidation process differs when the subsidiary
is less-than-wholly owned and there is a differential.
LO2 Make calculations and prepare elimination entries for the consolidation of a
partially owned subsidiary when there is a complex positive differential.
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Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value 207
LO3 Understand and explain what happens when a parent company ceases to consolidate a subsidiary.
LO4 Make calculations and prepare elimination entries for the consolidation of a
partially owned subsidiary when there is a complex positive differential and other
comprehensive income.
LO5 Understand and explain additional considerations associated with consolidation.
A NONCONTROLLING INTEREST IN CONJUNCTION WITH A DIFFERENTIAL
This chapter continues to build upon the foundation established in Chapters 2 through 4
related to the consolidation of majority-owned subsidiaries. In fact, Chapter 5 represents
the culmination of our understanding of procedures associated with the consolidation
process. Chapter 5 combines the complexities introduced in Chapters 3 and 4. Specifically, Chapter 5 examines situations where the acquiring company purchases less than
100 percent of the outstanding stock of the acquired company (similar to Chapter 3) and
pays an amount greater than its proportionate share of the book value of net assets (resulting in a differential as introduced in Chapter 4). Once you master Chapter 5, you can
handle virtually any consolidation problem!
LO1
Understand and explain
how the consolidation
process differs when the
subsidiary is less-thanwholly owned and there is a
differential.
No NCI
shareholders
NCI
shareholders
Differential
No
differential Investment = Book value
Wholly owned
subsidiary
Partially owned
subsidiary
Chapter 2
Chapter 4
Chapter 3
Investment > Book value Chapter 5
CONSOLIDATED BALANCE SHEET WITH MAJORITY-OWNED SUBSIDIARY
The consolidation process for a less-than-wholly-owned subsidiary with a differential is the
same as the process for a wholly owned subsidiary with a differential except that the claims of
the noncontrolling interest must be included. The example of Peerless Products Corporation
and Special Foods Inc. from Chapter 4 will serve as a basis for illustrating consolidation procedures when the parent has less than full ownership of a subsidiary. Assume that on January
1, 20X1, Peerless acquires 80 percent of the common stock of Special Foods for $310,000. At
that date, the fair value of the noncontrolling interest is estimated to be $77,500. The ownership situation can be viewed as follows, where the total fair value indicated is equal to the sum
of the fair value of the consideration given and the fair value of the noncontrolling interest:
20%
Fair value of consideration $387,500
Book value of Special Foods’ net assets
Common stock—Special Foods 200,000
Retained earnings—Special Foods 100,000
300,000
Difference between fair value and book value 87,500
P
S
1/1/X1
80%
NCI
$
Peerless records the acquisition on its books with the following entry:
(1) Investment in Special Foods 310,000
Cash 310,000
Record purchase of Special Foods stock.
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208 Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value
The balance sheets of Peerless and Special Foods appear immediately after acquisition
as in Figure 5–1. The fair values of all of Special Foods’ assets and liabilities are equal to
their book values except as shown in Figure 5–2.
The excess of the $387,500 total fair value of the consideration given and the noncontrolling interest on the date of combination over the $300,000 book value of Special
Foods is $87,500. Of this total $87,500 differential, $75,000 relates to the excess of the
acquisition-date fair value over the book value of Special Foods’ net identifiable assets,
as can be seen from Figure 5–2. The remaining $12,500 of the differential, the excess
of the consideration given and the noncontrolling interest over the fair value of Special Foods’ net identifiable assets, is assigned to goodwill. Since Peerless only acquires
80 percent of Special Foods’ outstanding common stock, Peerless’ share of the total differential is $70,000 ($87,500 × 0.80). Specifically, Peerless’ share of the excess fair
value over book value of identifiable net assets is $60,000 ($75,000 × 0.80) and its share
of the goodwill is $10,000 ($12,500 × 0.80). As a result, Peerless’ acquisition price of
$310,000 applies to the book value and differential components of Special Foods’ fair
value as follows:

Peerless
Products
Special
Foods
Assets
Cash $ 40,000 $ 50,000
Accounts Receivable 75,000 50,000
Inventory 100,000 60,000
Land 175,000 40,000
Buildings and Equipment 800,000 600,000
Accumulated Depreciation (400,000) (300,000)
Investment in Special Foods Stock 310,000
Total Assets $1,100,000 $500,000
Liabilities and Stockholders’ Equity
Accounts Payable $ 100,000 $100,000
Bonds Payable 200,000 100,000
Common Stock 500,000 200,000
Retained Earnings 300,000 100,000
Total Liabilities and Equity $1,100,000 $500,000
FIGURE 5–1
Balance Sheets
of Peerless Products
and Special Foods,
January 1, 20X1,
Immediately after
Combination
Book Value Fair Value
Fair Value
Increment
Inventory $ 60,000 $ 65,000 $ 5,000
Land 40,000 50,000 10,000
Buildings and Equipment 300,000 360,000 60,000
$400,000 $475,000 $75,000
FIGURE 5–2
Values of Select Assets
of Special Foods
80% Goodwill =
10,000
1/1/X1
$310,000
Initial
investment
in Special
Foods
80% Identifiable
excess =
60,000
80% Book value =
240,000
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Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value 209
The book value component of the acquisition price is divided between Peerless and
the noncontrolling interest as follows:
Book Value Calculations:
NCI 20% Peerless 80% = Common Stock + Retained Earnings
Original book value 60,000 240,000 200,000 100,000
This analysis leads to the following basic elimination entry:
Basic investment account elimination entry:1
Common stock 200,000 Original amount invested (100%)
Retained earnings 100,000 Beginning balance in RE
Investment in Special Foods 240,000 Peerless’ share of Special Foods’ NA
NCI in NA of Special Foods 60,000 NCI’s share of BV
The differential can be allocated between Peerless and the noncontrolling interest as
follows:
Excess Value (Differential) Calculations:
NCI 20% + Peerless 80% = Inventory + Land + Building + Acc. Depr. + Goodwill
Beginning balance 17,500 70,000 5,000 10,000 60,000 0 12,500
From this analysis, we can construct the excess value reclassification entry:
Excess value (differential) reclassification entry:
Inventory 5,000 Original calculated excess value
Land 10,000 Original calculated excess value
Building 60,000 Original calculated excess value
Goodwill 12,500 Calculated value from acquisition
Investment in Special Foods 70,000 Peerless’ share of differential
NCI in NA of Special Foods 17,500 NCI’s share of differential
As explained in Chapter 4, Special Foods had accumulated depreciation on the acquisition date of $300,000. The following elimination entry nets this accumulated depreciation out against the cost of the building and equipment.
Optional accumulated depreciation elimination entry:
Accumulated depreciation 300,000 Original depreciation at the time of
Building and equipment 300,000 the acquisition netted against cost
Figure 5–3 illustrates Peerless’ consolidation worksheet on the date of acquisition at
January 1, 20X1. Once the eliminating entries are placed in the worksheet, each row is
summed across to get the consolidated totals. Note that the asset amounts included in the
Consolidated column, and thus in the consolidated balance sheet, consist of book values
for Peerless’ assets and liabilities, plus acquisition-date fair values for Special Foods’
assets and liabilities, plus goodwill.
1 To view a video explanation of this topic, visit advancedstudyguide.com.
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210 Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value
CONSOLIDATED FINANCIAL STATEMENTS WITH
A MAJORITY-OWNED SUBSIDIARY
Consolidation subsequent to acquisition involves the preparation of a complete set of
consolidated financial statements, as discussed in Chapter 4. To continue the illustration from the previous section beyond the date of acquisition, assume Peerless Products
and Special Foods report the income and dividends during 20X1 and 20X2 shown in
Figure 5–4. With respect to the assets to which the $87,500 differential relates, assume
that the entire inventory is sold during 20X1, the buildings and equipment have a remaining economic life of 10 years from the date of combination, and straight-line depreciation
is used. Further, assume that management determines at the end of 20X1 that the goodwill is impaired and should be written down by $3,125. Management has determined
that the goodwill arising in the acquisition of Special Foods relates proportionately to
the controlling and noncontrolling interests, as does the impairment. Finally, assume that
Peerless accounts for its investment in Special Foods using the equity method.
Initial Year of Ownership
The business combination of Peerless Products and Special Foods occurs at the beginning of 20X1. Accordingly, Peerless records the acquisition on the acquisition date and
recognizes income and dividends from Special Foods on its books for the entire year.
Thus, the consolidated statements portray the two companies as if they were one entity
for the entire year. The procedures are basically the same as those in Chapter 4 except
the parent claims only its share of the subsidiary’s income and dividends, and the consolidation procedures must allow for the claims of the noncontrolling shareholders as
illustrated in Chapter 3.
Parent Company Entries
During 20X1, Peerless makes the usual equity-method entries to record income and dividends from its subsidiary, but, unlike in Chapter 4, Peerless must share Special Foods’
income and dividends with the subsidiary’s noncontrolling stockholders. Accordingly,
Peerless
Products
Special
Foods
Elimination Entries
DR CR Consolidated
Balance Sheet
Cash 40,000 50,000 90,000
Accounts Receivable 75,000 50,000 125,000
Inventory 100,000 60,000 5,000 165,000
Investment in Special Foods 310,000 240,000 0
70,000
Land 175,000 40,000 10,000 225,000
Buildings & Equipment 800,000 600,000 60,000 300,000 1,160,000
Less: Accumulated Depreciation (400,000) (300,000) 300,000 (400,000)
Goodwill 12,500 12,500
Total Assets 1,100,000 500,000 387,500 610,000 1,377,500
Accounts Payable 100,000 100,000 200,000
Bonds Payable 200,000 100,000 300,000
Common Stock 500,000 200,000 200,000 500,000
Retained Earnings 300,000 100,000 100,000 300,000
NCI in NA of Special Foods 60,000 77,500
17,500
Total Liabilities & Equity 1,100,000 500,000 300,000 77,500 1,377,500
FIGURE 5–3 Worksheet for Consolidated Balance Sheet, January 1, 20X1, Date of Combination; 80 Percent
Acquisition at More than Book Value
LO2
Make calculations and
prepare elimination entries
for the consolidation of a
partially owned subsidiary
when there is a complex
positive differential.
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Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value 211
Peerless recognizes only its proportionate share of Special Foods’ net income and dividends. Peerless records the following entries during 20X1:

Peerless
Products
Special
Foods
20X1:
Separate operating income, Peerless $140,000
Net income, Special Foods $50,000
Dividends 60,000 30,000
20X2:
Separate operating income, Peerless 160,000
Net income, Special Foods 75,000
Dividends 60,000 40,000
FIGURE 5–4
Income and Dividend
Information about
Peerless Products and
Special Foods for the
Years 20X1 and 20X2
(2) Investment in Special Foods 40,000
Income from Special Foods 40,000
Record Peerless’ 80% share of Special Foods’ 20X1 income.
(3) Cash 24,000
Investment in Special Foods 24,000
Record Peerless’ 80% share of Special Foods’ 20X1 dividend.
(4) Income from Special Foods 11,300
Investment in Special Foods 11,300
Record amortization of excess acquisition price.
In addition, Peerless must write off a portion of the differential with the following entry:
Special Foods’ undervalued inventory, comprising $5,000 of the total differential,
was sold during the year. Therefore, Peerless’ $4,000 portion ($5,000 × 80%) must
be written off by taking it out of the investment account and reducing the parent’s
income from the subsidiary. Also, Peerless’ $48,000 portion of the excess fair value
of Special Foods’ buildings and equipment must be amortized at $4,800 per year
($48,000 ÷ 10) over the remaining 10-year life. Finally, Peerless’ portion of the
goodwill impairment is included in this adjustment. The calculation of Peerless’ share
of the differential amortization is illustrated below in the “Excess Value (Differential)
Calculations.”
The following diagrams illustrate the breakdown of the book value and excess value
components of the investment account at the beginning and end of the year.
80% Goodwill =
10,000
1/1/X1
$310,000
Beginning
investment
in Special
Foods
80% Identifiable
excess =
60,000
80% Book value =
240,000
80% Goodwill =
7,500
12/31/X1
$314,700
Ending
investment
in Special
Foods
80% Identifiable
excess =
51,200
80% Book value =
256,000
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212 Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value
The book value component can be summarized as follows:
Book Value Calculations:
NCI 20% Peerless 80% = Common Stock + Retained Earnings
Original book value 60,000 240,000 200,000 100,000
+ Net Income 10,000 40,000 50,000
− Dividends (6,000) (24,000) (30,000)
Ending book value 64,000 256,000 200,000 120,000
The lighter shaded numbers in this chart comprise the basic elimination entry:
Basic investment account elimination entry:
Common stock 200,000 Original amount invested (100%)
Retained earnings 100,000 Beginning balance in RE
Income from Special Foods 40,000 Peerless’ share of Special Foods’ NI
NCI in NI of Special Foods 10,000 NCI’s share of Special Foods’ NI
Dividends declared 30,000 100% of Special Foods’ dividends
Investment in Special Foods 256,000 Peerless’ share of Special Foods’ NA
NCI in NA of Special Foods 64,000 NCI’s share of net amount of BV
We then analyze the differential and its changes during the period:
Excess Value (Differential) Calculations:
NCI 20% + Peerless 80% = Inventory + Land + Building + Acc. Depr. + Goodwill
Beginning Balance 17,500 70,000 5,000 10,000 60,000 0 12,500
Amortization (2,825) (11,300) (5,000) (6,000) (3,125)
Ending Balance 14,675 58,700 0 10,000 60,000 (6,000) 9,375
The entire differential amount assigned to the inventory already passed
through cost of goods sold during the year. The only other amortization item
is the excess value assigned to the building, amortized over a 10-year period
($60,000 ÷ 10 = $6,000 per year). Finally, the goodwill is deemed to be impaired
and worth only $9,375.
Since the amortization of the differential was already written off from the investment
account against the Income from Special Foods account, the changes are simply reclassified from the Income from Special Foods account to the various income statement
accounts to which they apply using the following worksheet entry:
Amortized excess value reclassification entry:
Cost of goods sold 5,000 Extra cost of goods sold
Depreciation expense 6,000 Depreciation of excess building value
Goodwill impairment loss 3,125 Goodwill impairment
Income from Special Foods 11,300 Peerless’ share of amortization
NCI in NI of Special Foods 2,825 NCI’s share of amortization
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Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value 213
Finally, the remaining unamortized differential is reclassified to the correct accounts
based on the ending balances in the chart above:
Excess value (differential) reclassification entry:
Land 10,000 Original calculated excess value
Buiding 60,000 Original calculated excess value
Goodwill 9,375 Calculated value from acquisition
Accumulated depreciation 6,000 Excess building value ÷10 years
Investment in Special Foods 58,700 Peerless’ share of differential
NCI in NA of Special Foods 14,675 NCI’s share of differential
In sum, these worksheet entries (1) eliminate the balances in the Investment in Special Foods and Income from Special Foods accounts, (2) reclassify the amortization of
excess value to the proper income statement accounts, and (3) reclassify the remaining
differential to the appropriate balance sheet accounts as of the end of the accounting
period. The following T-accounts illustrate how Peerless’ equity method investmentrelated accounts are eliminated.
Investment in
Special Foods
Income from
Special Foods
Acquisition Price 310,000
80% of NI 40,000 40,000 80% of NI
24,000 80% of Div.
11,300 80% of Excess 11,300
Amortization
Ending Balance 314,700 28,700 Ending Balance
256,000 Basic 40,000
58,700 Excess Value 11,300 “Amort. Excess Value”
0 Reclassification 0
Again, we repeat the same accumulated depreciation elimination entry this year (and
every year as long as Special Foods owns the assets) that we used in the initial year.
Optional accumulated depreciation elimination entry:
Accumulated depreciation 300,000 Original depreciation at the time of
Building and equipment 300,000 the acquisition netted against cost
Consolidation Worksheet—Initial Year of Ownership
After the subsidiary income accruals are entered on Peerless’ books, the adjusted trial
balance data of the consolidating companies are entered in the three-part consolidation
worksheet as shown in Figure 5–5. The last column in the worksheet will serve as a basis
for preparing consolidated financial statements at the end of 20X1.
Once the appropriate eliminating entries are placed in the consolidation worksheet in
Figure 5–5, the worksheet is completed by summing each row across, taking into consideration the debit or credit effect of the eliminations.
Consolidated Net Income and Retained Earnings
As can be seen from the worksheet in Figure 5–5, consolidated net income for 20X1 is
$175,875 and the amount of that income accruing to the controlling interest, shown as
the last number in the income statement section of the worksheet in the Consolidated column, is $168,700. The amount of retained earnings reported in the consolidated balance
sheet at December 31, 20X1, shown as the last number in the retained earnings section of
the worksheet in the Consolidated column, is $408,700. Figure 5– 6 illustrates the computation of these amounts.
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214 Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value
Peerless
Products
Special
Foods
Elimination Entries
DR CR Consolidated
Income Statement
Sales 400,000 200,000 600,000
Less: COGS (170,000) (115,000) 5,000 (290,000)
Less: Depreciation Expense (50,000) (20,000) 6,000 (76,000)
Less: Other Expenses (40,000) (15,000) (55,000)
Less: Impairment Loss 3,125 3,125
Income from Special Foods 28,700 40,000 11,300 0
Consolidated Net Income 168,700 50,000 54,125 11,300 175,875
NCI in Net Income 10,000 2,825 (7,175)
Controlling Interest in Net Income 168,700 50,000 64,125 14,125 168,700
Statement of Retained Earnings
Beginning Balance 300,000 100,000 100,000 300,000
Net Income 168,700 50,000 64,125 14,125 168,700
Less: Dividends Declared (60,000) (30,000) 30,000 (60,000)
Ending Balance 408,700 120,000 164,125 44,125 408,700
Balance Sheet
Cash 194,000 75,000 269,000
Accounts Receivable 75,000 50,000 125,000
Inventory 100,000 75,000 175,000
Investment in Special Foods 314,700 256,000 0
58,700
Land 175,000 40,000 10,000 225,000
Buildings & Equipment 800,000 600,000 60,000 300,000 1,160,000
Less: Accumulated Depreciation (450,000) (320,000) 300,000 6,000(476,000)
Goodwill 9,375 9,375
Total Assets 1,208,700 520,000 379,375 620,700 1,487,375
Accounts Payable 100,000 100,000 200,000
Bonds Payable 200,000 100,000 300,000
Common Stock 500,000 200,000 200,000 500,000
Retained Earnings 408,700 120,000 164,125 44,125 408,700
NCI in NA of Special Foods 64,000 78,675
14,675
Total Liabilities & Equity 1,208,700 520,000 364,125 122,800 1,487,375
FIGURE 5–5 December 31, 20X1, Equity-Method Worksheet for Consolidated Financial Statements, Initial Year of
Ownership; 80 Percent Acquisition at More than Book Value
Second Year of Ownership
The equity-method and consolidation procedures employed during the second and
subsequent years of ownership are the same as those used during the first year and are
illustrated by continuing the Peerless Products and Special Foods example through
20X2. No further impairment of the goodwill arising from the business combination
occurs in 20X2.
Parent Company Entries
Given the income and dividends as shown in Figure 5–4, Peerless Products records the
following entries on its separate books during 20X2:
(5) Investment in Special Foods 60,000
Income from Special Foods 60,000
Record Peerless’ 80% share of Special Foods’ 20X2 income.
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Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value 215
Consolidated net income, 20X1:
Peerless’ separate operating income $140,000
Special Foods’ net income 50,000
Write-off of differential related to inventory sold in 20X1 (5,000)
Amortization of differential related to buildings and equipment in 20X1 (6,000)
Goodwill impairment loss (3,125)
Consolidated net income $175,875
Income to controlling interest, 20X1:
Consolidated net income $175,875
Income to noncontrolling interest (7,175)
Income to controlling interest $168,700
Consolidated retained earnings, December 31, 20X1:
Peerless’ retained earnings on date of combination, January 1, 20X1 $300,000
Income to controlling interest, 20X1 168,700
Dividends declared by Peerless, 20X1 (60,000)
Consolidated retained earnings $408,700
FIGURE 5–6
Consolidated Net
Income and Retained
Earnings, 20X1; 80
Percent Acquisition at
More than Book Value
(6) Cash 32,000
Investment in Special Foods 32,000
Record Peerless’ 80% share of Special Foods’ 20X2 dividend.
(7) Income from Special Foods 4,800
Investment in Special Foods 4,800
Record amortization of excess acquisition price.
Consolidation Worksheet—Second Year Following Combination
The consolidation procedures in the second year following the acquisition are very
similar to those in the first year. Consistent with the process illustrated in 20X1, we follow the same process for 20X2. In order to determine the worksheet entries for 20X2,
we first summarize the changes in the parent’s investment account during 20X2 as
follows:
80% Goodwill =
7,500
1/1/X2
$314,700
Beginning
investment
in Special
Foods
80% Identifiable
excess =
51,200
80% Book value =
256,000
80% Goodwill =
7,500
12/31/X2
$337,900
Ending
investment
in Special
Foods
80% Identifiable
excess =
46,400
80% Book value =
284,000
The book value component can be summarized as follows:
Book Value Calculations:
NCI 20%+Peerless 80%=Common Stock+Retained Earnings
Beginning book value 64,000 256,000 200,000 120,000
+ Net income 15,000 60,000 75,000
− Dividends (8,000) (32,000) (40,000)
Ending book value 71,000 284,000 200,000 155,000
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216 Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value
The lighter shaded numbers in this chart comprise the basic elimination entry:
Excess Value (Differential) Calculations:
NCI 20% + Peerless 80% = Land + Building + Acc. Depr. + Goodwill
Beginning Balances 14,675 58,700 10,000 60,000 (6,000) 9,375
Amortization (1,200) (4,800) (6,000)
Ending Balance 13,475 53,900 10,000 60,000 (12,000) 9,375
Since the amortization of the differential was already written off from the investment
account against the Income from Special Foods account, the change to the differential
is simply reclassified from the Income from Special Foods account to the income statement account to which it applies during the consolidation process. Then, the remaining
amount of the differential is reclassified to the various balance accounts to which they
apply:
Amortized excess value reclassification entry:
Depreciation expense 6,000 Depreciation of excess building value
Income from Special Foods 4,800 Peerless’ share of amortization of diff.
NCI in NI of Special Foods 1,200 NCI’s share of amortization of differential
Again, these worksheet entries (1) eliminate the balances in the Investment in Special
Foods and Income from Special Foods accounts, (2) reclassify the amortization of
excess value to the proper income statement accounts, and (3) reclassify the remaining differential to the appropriate balance sheet accounts at the end of the accounting
period. The following T-accounts illustrate how Peerless’ Investment in Special Foods
and Income from Special Foods accounts are eliminated.
The entire differential amount assigned to the inventory already passed through cost of
goods sold during the prior year period. The only other amortization item is the excess
value assigned to the building, which continues to be written off over a 10-year period
($60,000 ÷ 10 = $6,000).
Basic elimination entry:
Common stock 200,000 Original amount invested (100%)
Retained earnings 120,000 Beginning RE from trial balance
Income from Special Foods 60,000 Peerless’ share of reported income
NCI in NI of Special Foods 15,000 NCI’s share of reported income
Dividends declared 40,000 100% of sub’s dividends declared
Investment in Special Foods 284,000 Peerless’ share of Special Foods’ NA
NCI in NA of Special Foods 71,000 NCI’s share of net amount of BV
Excess value (differential) reclassification entry:
Land 10,000 Original calculated excess value
Building 60,000 Original calculated excess value
Goodwill 9,375 Calculated value from acquisition
Accumulated depreciation 12,000 = (Excess value ÷ 10 years) × 2 years
Investment in Special Foods 53,900 Peerless’ share of excess value
NCI in NA of Special Foods 13,475 NCI’s share of excess value
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Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value 217
Figure 5–7 illustrates the worksheet to prepare a complete set of consolidated financial
statements for the year 20X2.
Consolidated Net Income and Retained Earnings
Figure 5–8 shows the computation of 20X2 consolidated net income and consolidated
retained earnings at the end of 20X2.
Consolidated Financial Statements
Figure 5–9 presents a consolidated income statement and retained earnings statement for the year 20X2 and a consolidated balance sheet as of December 31,
20X2.
DISCONTINUANCE OF CONSOLIDATION
A parent that has been including a subsidiary in its consolidated financial statements
should exclude that company from future consolidation if the parent can no longer exercise control over it. Control might be lost for a number of reasons, such as the parent
sells some or all of its interest in the subsidiary, the subsidiary issues additional common
stock, the parent enters into an agreement to relinquish control, or the subsidiary comes
under the control of the government or other regulator.
If a parent loses control of a subsidiary and no longer holds an equity interest in the
former subsidiary, it recognizes a gain or loss for the difference between any proceeds
received from the event leading to loss of control (e.g., sale of interest, expropriation of
subsidiary) and the carrying amount of the parent’s equity interest. If the parent loses
control but maintains a noncontrolling equity interest in the former subsidiary, it must
recognize a gain or loss for the difference, at the date control is lost, between (1) the sum
of any proceeds received by the parent and the fair value of its remaining equity interest
in the former subsidiary and (2) the carrying amount of the parent’s total interest in the
subsidiary.
LO3
Understand and explain
what happens when a parent company ceases to consolidate a subsidiary.
Investment in
Special Foods
Income from
Special Foods
Beginning Balance 314,700
80% of NI 60,000 60,000 80% of NI
32,000 80% of Div.
4,800 80% of Excess 4,800
Amortization
Ending Balance 337,900 55,200 Ending Balance
284,000 Basic 60,000
53,900 Excess Reclass. 4,800 “Amort. Excess Value”
0 0
Optional accumulated depreciation elimination entry:
Accumulated depreciation 300,000 Original depreciation at the time of
Building and equipment 300,000 the acquisition netted against cost
Again, we repeat the same accumulated depreciation elimination entry this year
(and every year as long as Special Foods owns the assets) that we used in the initial
year.
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218
FIGURE 5–8
Consolidated Net
Income and Retained
Earnings, 20X2; 80
Percent Acquisition at
More than Book Value
Consolidated net income, 20X2:
Peerless’ separate operating income $160,000
Special Foods’ net income 75,000
Amortization of differential related to buildings and equipment in 20X2 (6,000)
Consolidated net income $229,000
Income to controlling interest, 20X2:
Consolidated net income $229,000
Income to noncontrolling interest (13,800)
Income to controlling interest $215,200
Consolidated retained earnings, December 31, 20X2:
Peerless’ retained earnings on date of combination, January 1, 20X1 $300,000
Income to controlling interest, 20X1 168,700
Dividends declared by Peerless, 20X1 (60,000)
Consolidated retained earnings, December 31, 20X1 $408,700
Income to controlling interest, 20X2 215,200
Dividends declared by Peerless, 20X2 (60,000)
Consolidated retained earnings, December 31, 20X2 $563,900
Peerless
Products
Special
Foods
Elimination Entries
DR CR Consolidated
Income Statement
Sales 450,000 300,000 750,000
Less: COGS (180,000) (160,000) (340,000)
Less: Depreciation Expense (50,000) (20,000) 6,000 (76,000)
Less: Other Expenses (60,000) (45,000) (105,000)
Less: Impairment Loss 0
Income from Special Foods 55,200 60,000 4,800 0
Consolidated Net Income 215,200 75,000 66,000 4,800 229,000
NCI in Net Income 15,000 1,200 (13,800)
Controlling Interest Net Income 215,200 75,000 81,000 6,000 215,200
Statement of Retained Earnings
Beginning Balance 408,700 120,000 120,000 408,700
Net Income 215,200 75,000 81,000 6,000 215,200
Less: Dividends Declared (60,000) (40,000) 40,000 (60,000)
Ending Balance 563,900 155,000 201,000 46,000 563,900
Balance Sheet
Cash 221,000 85,000 306,000
Accounts Receivable 150,000 80,000 230,000
Inventory 180,000 90,000 270,000
Investment in Special Foods 337,900 284,000 0
53,900
Land 175,000 40,000 10,000 225,000
Buildings & Equipment 800,000 600,000 60,000 300,000 1,160,000
Less: Accumulated Depreciation (500,000) (340,000) 300,000 12,000(552,000)
Goodwill 9,375 9,375
Total Assets 1,363,900 555,000 379,375 649,900 1,648,375
Accounts Payable 100,000 100,000 200,000
Bonds Payable 200,000 100,000 300,000
Common Stock 500,000 200,000 200,000 500,000
Retained Earnings 563,900 155,000 201,000 46,000 563,900
NCI in NA of Special Foods 71,000 84,475
13,475
Total Liabilities & Equity 1,363,900 555,000 401,000 130,475 1,648,375
FIGURE 5–7 December 31, 20X2, Equity-Method Worksheet for Consolidated Financial Statements, Second Year
of Ownership; 80 Percent Acquisition at More than Book Value
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Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value 219
FIGURE 5–9 Consolidated Financial Statements for Peerless Products Corporation and Special Foods Inc., 20X2
PEERLESS PRODUCTS CORPORATION AND SUBSIDIARY
Consolidated Income Statement
For the Year Ended December 31, 20X2
Sales $750,000
Cost of Goods Sold (340,000)
Gross Margin $410,000
Expences:
Depreciation and Amortization $ 76,000
Other Expenses 105,000
Total Expenses (181,000)
Consolidated Net Income $229,000
Income to Noncontrolling Interest (13,800)
Income to Controlling Interest $215,200
PEERLESS PRODUCTS CORPORATION AND SUBSIDIARY
Consolidated Retained Earnings Statement
For the Year Ended December 31, 20X2
Retained Earnings, January 1, 20X2 $408,700
Income to Controlling Interest, 20X2 215,200
Dividends Declared, 20X2 (60,000)
Retained Earnings, December 31, 20X2 $563,900
PEERLESS PRODUCTS CORPORATION AND SUBSIDIARY
Consolidated Balance Sheet
December 31, 20X2
Assets Liabilities
Cash $ 306,000 Accounts Payable $200,000
Accounts Receivable 230,000 Bonds Payable 300,000
Inventory 270,000 $500,000
Land 225,000 Stockholders’ Equity
Buildings and Equipment $1,160,000 Controling Interest
Accumulated Depreciation (552,000) Common Stock $500,000
608,000 Retained Earnings 563,900
Goodwill 9,375 Total Controling Interest 1,063,900
Noncontroling Interest 84,475
Total Assets $1,648,375 Total Liabilities and Equity $1,648,375
As an example, assume that Peerless Products sells three-quarters of its 80 percent
interest in Special Foods on January 1, 20X2, for $246,000, leaving it holding 20 percent
of Special Foods’ outstanding stock. On that date, assume that the fair value of Special
Foods as a whole is $410,000 and the carrying amount of Peerless’ 80 percent share of
Special Foods is $317,200 (as shown earlier in the chapter). Assume the fair value of
Peerless’ remaining 20 percent interest in Special Foods is $82,000. Peerless’ gain on the
sale of Special Foods stock is computed as follows:
Cash proceeds received $246,000
Fair value of Peerless’ remaining equity interest in Special Foods 82,000
$328,000
Peerless’ total interest in Special Foods at date of sale 314,700
Gain on sale of 60 percent interest in Special Foods $ 13,300
Peerless reports the $13,300 gain in 20X2 income.
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220 Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value
TREATMENT OF OTHER COMPREHENSIVE INCOME
FASB Statement No. 130 (ASC 220), “Reporting Comprehensive Income”, requires
that companies separately report other comprehensive income, which includes all revenues, expenses, gains, and losses that under generally accepted accounting principles
are excluded from net income.2
Comprehensive income is the sum of net income and
other comprehensive income. FASB 130 (ASC 220) permits several different options for
reporting comprehensive income, but the consolidation process is the same regardless of
the reporting format.
Other comprehensive income accounts are temporary accounts that are closed at the
end of each period. Instead of being closed to Retained Earnings as revenue and expense
accounts are, other comprehensive income accounts are closed to a special stockholders’
equity account, Accumulated Other Comprehensive Income.
Modification of the Consolidation Worksheet
When a parent or subsidiary has recorded other comprehensive income, the consolidation worksheet normally includes an additional section for other comprehensive income.
This section of the worksheet facilitates computation of the amount of other comprehensive income to be reported; the portion, if any, of other comprehensive income to be
assigned to the noncontrolling interest; and the amount of accumulated other comprehensive income to be reported in the consolidated balance sheet. Although this extra section
of the worksheet for comprehensive income could be placed after the income statement
section of the standard worksheet, the format used here is to place it at the bottom of the
worksheet. If neither the parent nor any subsidiary reports other comprehensive income,
the section can be omitted from the worksheet. When other comprehensive income is
reported, the worksheet is prepared in the normal manner, with the additional section
added to the bottom. The only modification within the standard worksheet is an additional stockholders’ equity account included in the balance sheet portion of the worksheet for the cumulative effects of the other comprehensive income.
To illustrate the consolidation process when a subsidiary reports other comprehensive income, assume that during 20X2 Special Foods purchases $20,000 of investments
classified as available-for-sale. By December 31, 20X2, the fair value of the securities
increases to $30,000. Other than the effects of accounting for Special Foods’ investment
in securities, the financial statement information reported by Peerless Products and Special Foods at December 31, 20X2, is identical to that presented in Figure 5–8.
Adjusting Entry Recorded by Subsidiary
At December 31, 20X2, Special Foods recognizes the increase in the fair value of its
available-for-sale securities by recording the following adjusting entry:
LO4
Make calculations and
prepare elimination entries
for the consolidation of a
partially owned subsidiary
when there is a complex
positive differential and
other comprehensive
income.
2 Other comprehensive income elements include foreign currency translation adjustments, unrealized gains
and losses on certain derivatives and investments in certain types of securities, and certain minimum pension
liability adjustments.
(8) Investment in Available-for-Sale Securities 10,000
Unrealized Gain on Investments (OCI) 10,000
Record the increase in fair value of available-for-sale securities.
The unrealized gain is not included in the subsidiary’s net income but is reported by the
subsidiary as an element of other comprehensive income (OCI).
Adjusting Entry Recorded by Parent Company
In 20X2, Peerless records all its normal entries relating to its investment in Special
Foods as if the subsidiary had not reported other comprehensive income. In addition, at
December 31, 20X2, Peerless Products separately recognizes its proportionate share of
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Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value 221
the subsidiary’s unrealized gain from the increase in the value of the available-for-sale
securities:
(9) Investment in Special Foods 8,000
Other Comprehensive Income from Special Foods 8,000
Record share of the increase in value of available-for-sale-securities
held by subsidiary.
Consolidation Worksheet—Second Year Following Combination
The worksheet to prepare a complete set of consolidated financial statements for the
year 20X2 is illustrated in Figure 5–10. In the worksheet, Peerless’ balance in the
Investment in Special Foods Stock account is greater than the balance in Figure 5–8.
Specifically, because of the adjusting entry just mentioned, Peerless’ $8,000 proportionate share of Special Foods’ unrealized gain is included in the separate section of
the worksheet for comprehensive income (Other Comprehensive Income from Subsidiary—Unrealized Gain on Investments). Special Foods’ trial balance has been changed
to reflect (1) the reduction in the cash balance resulting from the investment acquisition, (2) the investment in available-for-sale securities, and (3) an unrealized gain of
$10,000 on the investment.
Consolidation Procedures
The normal eliminating entries (the basic elimination entry, the amortized excess cost
reclassification entry, the differential reclassification entry, and the accumulated depreciation elimination entry) were used in preparing the consolidation worksheet for 20X2
presented in Figure 5–7. Although these entries remain unchanged in this example, they
would have included the elimination of the beginning balance of the subsidiary’s accumulated Other Comprehensive Income, if the subsidiary had had a balance as of the
beginning of the period because that account is properly included in the subsidiary’s
stockholders’ equity; further, a portion of the balance of that account would have been
allocated to the beginning noncontrolling interest, as with the other stockholders’ equity
accounts of the subsidiary.
One additional entry is needed for the treatment of the subsidiary’s other comprehensive income. First, the proportionate share of the subsidiary’s other comprehensive income recorded by the parent in the adjusting entry previously mentioned must
be eliminated to avoid double-counting the subsidiary’s other comprehensive income.
Thus, the adjusting entry is reversed in the worksheet. Moreover, a proportionate share
of the subsidiary’s other comprehensive income must be allocated to the noncontrolling interest:
Other comprehensive income entry:
OCI from Special Foods 8,000
OCI to the NCI 2,000
Investment in Special Foods 8,000
NCI in NA of Subsidiary 2,000
The amount of consolidated other comprehensive income reported in the consolidated
financial statements is equal to the subsidiary’s $10,000 amount. The noncontrolling
interest’s $2,000 proportionate share of the subsidiary’s other comprehensive income is
deducted to arrive at the $8,000 other comprehensive income allocated to the controlling
interest.
While consolidated net income is the same in Figure 5–10 as in Figure 5–7, the other
comprehensive income section of the worksheet in Figure 5–10 gives explicit recognition
to the unrealized gain on available-for-sale securities held by Special Foods. This permits
recognition in the consolidated financial statements under any of the alternative formats
permitted by the FASB.
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222 Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value
Peerless
Products
Special
Foods
Elimination Entries
DR CR Consolidated
Income Statement
Sales 450,000 300,000 750,000
Less: COGS (180,000) (160,000) (340,000)
Less: Depreciation Expense (50,000) (20,000) 6,000 (76,000)
Less: Other Expenses (60,000) (45,000) (105,000)
Less: Impairment Loss 0
Income from Special Foods 55,200 60,000 4,800 0
Consolidated Net Income 215,200 75,000 66,000 4,800 229,000
NCI in Net Income 15,000 1,200 (13,800)
Controlling Interest in Net Income 215,200 75,000 81,000 6,000 215,200
Statement of Retained Earnings
Beginning Balance 408,700 120,000 120,000 408,700
Add Net Income 215,200 75,000 81,000 6,000 215,200
Less: Dividends Declared (60,000) (40,000) 40,000 (60,000)
Ending Balance 563,900 155,000 201,000 46,000 563,900
Balance Sheet
Cash 221,000 65,000 286,000
Accounts Receivable 150,000 80,000 230,000
Inventory 180,000 90,000 270,000
Investment in Subsidiary 345,900 284,000 0
53,900
8,000
Investment in AFS Securities 30,000 30,000
Land 175,000 40,000 10,000 225,000
Buildings & Equipment 800,000 600,000 60,000 300,000 1,160,000
Less: Accumulated Depreciation (500,000) (340,000) 300,000 12,000(552,000)
Goodwill 9,375 9,375
Total Assets 1,371,900 565,000 379,375 657,900 1,658,375
Accounts Payable 100,000 100,000 200,000
Bonds Payable 200,000 100,000 300,000
Common Stock 500,000 200,000 200,000 500,000
Retained Earnings 563,900 155,000 201,000 46,000 563,900
Accumulated Other Comprehensive Income,
12/31/X2 8,000 10,000 10,000 0 8,000
NCI in NA of Special Foods 71,000 86,475
13,475
2,000
Total Liabilities & Equity 1,371,900 565,000 411,000 130,475 1,658,375
Other Comprehensive Income
Accumulated Other Comprehensive Income,
1/1/X2 0 0 0
Other Comprehensive Income from Special Foods 8,000 8,000 0
Unrealized Gain on Investments 10,000 10,000
Other Comprehensive Income to NCI 2,000 (2,000)
Accumulated Other Comprehensive
Income, 12/31/X2 8,000 10,000 10,000 0 8,000
FIGURE 5–10 December 31, 20X2, Comprehensive Income Illustration, Second Year of Ownership; 80 Percent
Acquisition at More than Book Value
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Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value 223
FIGURE 5–11
Consolidated Financial
Statements for Peerless
Products Corporation
and Special Foods Inc.,
20X2, Including Other
Comprehensive Income
PEERLESS PRODUCTS CORPORATION AND SUBSIDIARY
Consolidated Income Statement
For the Year Ended December 31, 20X2
Sales $750,000
Cost of Goods Sold (340,000)
Gross Margin $410,000
Expences:
Depreciation and Amortization $ 76,000
Other Expenses 105,000
Total Expenses (181,000)
Consolidated Net Income $229,000
Income to Noncontrolling Interest (13,800)
Income to Controlling Interest $215,200
PEERLESS PRODUCTS CORPORATION AND SUBSIDIARY
Consolidated Statement of Comprehensive Income
For the Year Ended December 31, 20X2
Consolidated Net Income $229,000
Other Comprehensive Income:
Unrealized Gain on Investments 10,000
Total Consolidated Comprehensive Income $239,000
Less: Comprehensive Income Attribute to Noncontrolling Interest 15,800
Comprehensive Income Attribute to Controlling Interest $223,200
PEERLESS PRODUCTS CORPORATION AND SUBSIDIARY
Consolidated Statement of Financial Position
December 31, 20X2
Assets
Cash $ 286,000
Accounts Receivable 230,000
Inventory 270,000
Investment in Available-for-Sale Securities 30,000
Land 225,000
Buildings and Equipment $1,160,000
Accumulated Depreciation (552,000)
608,000
Goodwill 9,375
Total Assets $1,658,375
Liabilities
Accounts Payable $ 200,000
Bonds Payable 300,000
Total Liabilities $ 500,000
Stockholders’ Equity
Controlling Interest:
Common Stock $ 500,000
Retained Earnings 563,900
Accumulated Other Comprehensive Income 8,000
Total Controlling Interest $1,071,900
Noncontrolling Interest 86,475
Total Stockholders’ Equity 1,158,375
Total Liabilities and Stockholders’ Equity $1,658,375
Consolidated financial statements for the other comprehensive income example are
presented in Figure 5–11. Note that consolidated other comprehensive income includes
the full $10,000 unrealized gain. The noncontrolling interest’s share is then deducted,
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224 Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value
ADDITIONAL CONSIDERATIONS
Chapters 3, 4, and 5 provide a conceptual foundation for preparing consolidated financial statements and a description of the basic procedures used in preparing consolidated
statements. Before moving on to intercompany transactions in Chapters 6 and 7, several
additional items should be considered to provide completeness and clarity.
Subsidiary Valuation Accounts at Acquisition
FASB 141R (ASC 805) indicates that all assets and liabilities acquired in a business combination should be valued at their acquisition-date fair values and no valuation accounts are to be carried over. While the application of this rule is clear-cut
in merger-type business combinations, its application in consolidation following a
stock acquisition is less clear. A subsidiary maintains an ongoing set of books and,
unless push-down accounting is employed, it will carry forward its accounts. For
some valuation accounts, such as accumulated depreciation, theory has dictated that
the acquisition-date amount of the valuation account should be offset against the
LO5
Understand and explain
additional considerations associated with
consolidation.
along with its share of consolidated net income, to arrive at the consolidated comprehensive income allocated to the controlling interest. The amount of other comprehensive
income allocated to the controlling interest is carried to the Accumulated Other Comprehensive Income that is reported in the consolidated balance sheet, while the noncontrolling interest’s share is included in the Noncontrolling Interest amount in the consolidated
balance sheet. The FASB requires that the amount of each other comprehensive income
element allocated to the controlling and noncontrolling interests be disclosed in the consolidated statements or notes.
Consolidation Worksheet—Comprehensive Income
in Subsequent Years
Each year following 20X2, Special Foods will adjust the unrealized gain on investments
on its books for the change in fair value of the available-for-sale securities. For example,
if Special Foods’ investment increased in value by an additional $5,000 during 20X3,
Special Foods would increase by $5,000 the carrying amount of its investment in securities and recognize as an element of 20X3’s other comprehensive income an unrealized
gain of $5,000. Under equity-method recording, Peerless would increase its Investment
in Special Foods Stock account and record its $4,000 share of the subsidiary’s other comprehensive income.
The eliminating entries required to prepare the consolidation worksheet at December
31, 20X3, would include the normal eliminating entries (the basic elimination entry, the
amortized excess cost reclassification entry, the differential reclassification entry, and
the accumulated depreciation elimination entry). In addition, the basic elimination entry
would be expanded to eliminate the subsidiary’s $10,000 beginning Accumulated Other
Comprehensive Income balance and to increase the noncontrolling interest by its proportionate share of the subsidiary’s beginning Accumulated Other Comprehensive Income
amount ($10,000 × 0.20). The Other Comprehensive Income eliminating entry allocates
the 20X3 other comprehensive income:
Other comprehensive income entry:
OCI from Special Foods 4,000
OCI to the NCI 1,000
Investment in Special Foods 4,000
NCI in NA of Subsidiary 1,000
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Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value 225
related asset account each time consolidated statements are prepared. Nevertheless,
as an expediency, and because of a lack of materiality, companies generally have not
made this offset, with no effect on the net amount of the asset. That is not expected to
change under FASB 141R (ASC 805). For some other valuation accounts, depending
on their nature and materiality, and how the amounts work out over time, they may
have to be offset each time consolidated statements are prepared, at least for some
number of periods. This is the reason for the optional accumulated depreciation elimination entry.
Negative Retained Earnings of Subsidiary at Acquisition
A parent company may acquire a subsidiary with a negative or debit balance in its retained
earnings account. An accumulated deficit of a subsidiary at acquisition causes no special
problems in the consolidation process. The basic investment account elimination entry is
the same in the consolidation worksheet except that the debit balance in the subsidiary’s
Retained Earnings account is eliminated with a credit entry. Thus, the basic investment
account elimination entry appears as follows:
Basic investment account elimination entry:
Common stock XX
Income from Special Foods XX
NCI in NI of Special Foods XX
Retained earnings XX
Dividends declared XX
Investment in Special Foods XX
NCI in NA of Special Foods XX
Other Stockholders’ Equity Accounts
The discussion of consolidated statements up to this point has dealt with companies having stockholders’ equity consisting only of retained earnings and a single class of capital stock issued at par. Typically, companies have more complex stockholders’ equity
structures, often including preferred stock and various types of additional contributed
capital. In general, all stockholders’ equity accounts accruing to the common shareholders receive the same treatment as common stock and are eliminated at the time common
stock is eliminated.
Subsidiary’s Disposal of Differential-Related Assets
The disposal of an asset usually has income statement implications. If the asset is held
by a subsidiary and is one to which a differential is assigned in the consolidation worksheet, both the parent’s equity-method income and consolidated net income are affected.
On the parent’s books, the portion of the differential included in the subsidiary investment account that relates to the asset sold must be written off by the parent under the
equity method as a reduction in both the income from the subsidiary and the investment
account. In consolidation, the portion of the differential related to the asset sold is treated
as an adjustment to consolidated income.
Inventory
Any inventory-related differential is assigned to inventory for as long as the subsidiary holds the inventory units. In the period in which the inventory units are sold, the
inventory-related differential is assigned to Cost of Goods Sold, as illustrated previously
in Figure 5–5.
The inventory costing method used by the subsidiary determines the period in
which the differential cost of goods sold is recognized. When the subsidiary uses
FIFO inventory costing, the inventory units on hand on the date of combination are
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226 Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value
viewed as being the first units sold after the combination. Therefore, the differential
normally is assigned to cost of goods sold in the period immediately after the combination. When the subsidiary uses LIFO inventory costing, the inventory units on
the date of combination are viewed as remaining in the subsidiary’s inventory. Thus,
when the subsidiary uses LIFO inventory costing, the differential is not assigned to
cost of goods sold unless the inventory level drops below its level at the date of
combination.
Fixed Assets
A differential related to land held by a subsidiary is added to the Land balance in the consolidation worksheet each time a consolidated balance sheet is prepared. If the subsidiary
sells the land to which the differential relates, the differential is treated in the consolidation worksheet as an adjustment to the gain or loss on the sale of the land in the period
of the sale.
To illustrate, assume that on January 1, 20X1, Pluto purchases all the common stock
of Star at $10,000 more than book value. All the differential relates to land that Star
had purchased earlier for $25,000. So long as Star continues to hold the land, the
$10,000 differential is assigned to Land in the consolidation worksheet. If Star sells
the land to an unrelated company for $40,000, the following entry is recorded on Star’s
books:
(10) Cash 40,000
Land 25,000
Gain on Sale of Land 15,000
Record sale of Land.
While a gain of $15,000 is appropriate for Star to report, the accounting basis of the land
to the consolidated entity is $35,000 ($25,000 + $10,000). Therefore, the consolidated
enterprise must report a gain of only $5,000. To reduce the $15,000 gain reported by Star
to the $5,000 gain that should be reported by the consolidated entity, the following elimination is included in the consolidation worksheet for the year of the sale:
Eliminate gain on sale of land:
Gain on Sale of Land 10,000
Income from Star 10,000
If, instead, Star sells the land for $32,000, the $7,000 ($32,000 − $25,000) gain recorded
by Star is eliminated, and a loss of $3,000 ($32,000 − $35,000) is recognized in the consolidated income statement. The eliminating entry in this case is
Eliminate gain and record loss on sale of land:
Gain on Sale of Land 7,000
Loss on Sale of Land 3,000
Income from Star 10,000
When the equity method is used on the parent’s books, the parent must adjust the carrying amount of the investment and its equity-method income in the period of the sale to
write off the differential, as discussed in Chapter 2. Thereafter, the $10,000 differential
no longer exists.
The sale of differential-related equipment is treated in the same manner as land except
that the amortization for the current and previous periods must be considered.
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Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value 227
The procedures and worksheet for consolidating less-than-wholly-owned subsidiaries are the same
as discussed in Chapter 4 for wholly owned subsidiaries, with several modifications. The worksheet elimination entries are modified to include the noncontrolling shareholders’ claim on the
income and assets of the subsidiary. The noncontrolling interest has a claim on subsidiary assets
based on its acquisition-date fair value. If the acquisition-date fair value of the consideration given
in a business combination, plus the fair value of any noncontrolling interest, exceeds the book
value of the subsidiary, the difference is referred to as a differential and increases both the controlling and noncontrolling interests. The subsidiary’s assets and liabilities are valued in consolidation
based on their full acquisition-date fair values, with goodwill recognized at acquisition for the
difference between (1) the sum of the fair value of the consideration given in the combination and
the fair value of the noncontrolling interest and (2) the fair value of the subsidiary’s net identifiable
assets. Any subsequent write-off of the differential reduces both the controlling and noncontrolling
interests.
Consolidated net income is equal to the parent’s income from its own operations plus the subsidiary’s net income adjusted for any amortization or write-off of the differential. The amount of
consolidated net income attributable to the noncontrolling interest is equal to the noncontrolling
interest’s proportionate share of the subsidiary’s net income less a proportionate share of any differential write-off. The income attributable to the controlling interest is equal to consolidated net
income less the income attributable to the noncontrolling interest.
A subsidiary’s other comprehensive income for the period must be recognized in consolidated
other comprehensive income and allocated between the controlling and noncontrolling interests.
The consolidation worksheet is modified to accommodate the other comprehensive income items
by adding a special section at the bottom.
Summary of
Key Concepts
Key Term other comprehensive income, 220
Questions
LO1 Q5-1 Where is the balance assigned to the noncontrolling interest reported in the consolidated balance
sheet?
LO1 Q5-2 Why must a noncontrolling interest be reported in the consolidated balance sheet?
LO1 Q5-3 How does the introduction of noncontrolling shareholders change the consolidation worksheet?
LO1 Q5-4 How is the amount assigned to the noncontrolling interest normally determined when a consolidated balance sheet is prepared immediately after a business combination?
LO2 Q5-5 What portion of consolidated retained earnings is assigned to the noncontrolling interest in the
consolidated balance sheet?
LO2 Q5-6 When majority ownership is acquired, what portion of the fair value of assets held by the subsidiary at acquisition is reported in the consolidated balance sheet?
LO2 Q5-7 When majority ownership is acquired, what portion of the goodwill reported in the consolidated
balance sheet is assigned to the noncontrolling interest?
LO2 Q5-8 How is the income assigned to the noncontrolling interest normally computed?
LO2 Q5-9 How is income assigned to the noncontrolling interest shown in the consolidation worksheet?
LO2 Q5-10 How are dividends paid by a subsidiary to noncontrolling shareholders treated in the consolidation
worksheet?
LO5 Q5-11 Does a noncontrolling shareholder have access to any information other than the consolidated
financial statements to determine how well the subsidiary is doing? Explain.
LO4 Q5-12 How do other comprehensive income elements reported by a subsidiary affect the consolidated
financial statements?
LO4 Q5-13 What portion of other comprehensive income reported by a subsidiary is included in the consolidated statement of comprehensive income as accruing to parent company shareholders?
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228 Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value
LO5 Q5-14†
Prior to the adoption of FASB 141R (ASC 805), how was the amount of the differential
determined?
LO5 Q5-15†
Prior to the adoption of FASB 141R (ASC 805), how was the amount reported as goodwill determined when majority ownership was acquired at an amount greater than book value?
LO5 Q5-16†
Prior to the adoption of FASB 141R (ASC 805), how was the amount of consolidated net income
of a less-than-wholly-owned subsidiary determined?
LO5 Q5-17* What effect does a negative retained earnings balance on the subsidiary’s books have on consolidation procedures?
LO5 Q5-18* What type of adjustment must be made in the consolidation worksheet if a differential is assigned
to land and the subsidiary disposes of the land in the current period?
Cases
LO2 C5-1 Consolidation Worksheet Preparation
The newest clerk in the accounting office recently entered trial balance data for the parent company
and its subsidiaries in the company’s consolidation program. After a few minutes of additional
work needed to eliminate the intercompany investment account balances, he expressed his satisfaction at having completed the consolidation worksheet for 20X5. In reviewing the printout of the
consolidation worksheet, other employees raised several questions, and you are asked to respond.
Required
Indicate whether each of the following items can be answered by looking at the data in the consolidation worksheet (indicate why or why not):
a. Is it possible to tell if the parent is using the equity method in recording its ownership of each
subsidiary?
b. Is it possible to tell if the correct amount of consolidated net income has been reported?
c. One of the employees thought the parent company had paid well above the fair value of net
assets for a subsidiary purchased on January 1, 20X5. Is it possible to tell by reviewing the
consolidation worksheet?
d. Is it possible to determine from the worksheet the percentage ownership of a subsidiary held by
the parent?
LO2 C5-2 Consolidated Income Presentation
Standard Company has a relatively high profit margin on its sales, and Jewel Company has a substantially lower profit margin. Standard holds 55 percent of Jewel’s common stock and includes
Jewel in its consolidated statements. Standard and Jewel reported sales of $100,000 and $60,000,
respectively, in 20X4. Sales increased to $120,000 and $280,000 for the two companies in 20X5.
The average profit margins of the two companies remained constant over the two years at 60 percent
and 10 percent, respectively.
Standard’s treasurer was aware that the subsidiary was awarded a major new contract in 20X5
and anticipated a substantial increase in net income for the year. She was disappointed to learn
that consolidated net income allocated to the controlling interest had increased by only 38 percent
even though sales were 2.5 times higher than in 20X4. She is not trained in accounting and does
not understand the fundamental processes used in preparing Standard’s consolidated income statement. She does know, however, that the earnings per share figures reported in the consolidated
income statement are based on income allocated to the controlling interest and she wonders why
that number isn’t higher.
Required
As a member of the accounting department, you have been asked to prepare a memo to the treasurer explaining how consolidated net income is computed and the procedures used to allocate
income to the parent company and to the subsidiary’s noncontrolling shareholders. Include in your
memo citations to or quotations from the authoritative literature. To assist the treasurer in gaining a
better understanding, prepare an analysis showing the income statement amounts actually reported
for 20X4 and 20X5.
Analysis
Research
*Indicates that the item relates to “Additional Considerations.”
† These questions may require Internet research.
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Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value 229
LO1 C5-3 Pro Rata Consolidation
Rose Corporation and Krome Company established a joint venture to manufacture components
for both companies’ use on January 1, 20X1, and have operated it quite successfully for the past
four years. Rose and Krome both contributed 50 percent of the equity when the joint venture was
created. Rose purchases roughly 70 percent of the output of the joint venture and Krome purchases
30 percent. Rose and Krome have equal numbers of representatives on the joint venture’s board
of directors and participate equally in its management. Joint venture profits are distributed at yearend on the basis of total purchases by each company.
Required
Rose has been using the equity method to report its investment in the joint venture; however,
Rose’s financial vice president believes that each company should use pro rata consolidation. As a
senior accountant at Rose, you have been asked to prepare a memo discussing those situations in
which pro rata consolidation may be appropriate and to offer your recommendation as to whether
Rose should continue to use the equity method or switch to pro rata consolidation. Include in your
memo citations of and quotations from the authoritative literature to support your arguments.
LO1 C5-4 Elimination Procedures
A new employee has been given responsibility for preparing the consolidated financial statements
of Sample Company. After attempting to work alone for some time, the employee seeks assistance
in gaining a better overall understanding of the way in which the consolidation process works.
Required
You have been asked to provide assistance in explaining the consolidation process.
a. Why must the eliminating entries be entered in the consolidation worksheet each time consolidated statements are prepared?
b. How is the beginning-of-period noncontrolling interest balance determined?
c. How is the end-of-period noncontrolling interest balance determined?
d. Which of the subsidiary’s account balances must always be eliminated?
e. Which of the parent company’s account balances must always be eliminated?
LO1 C5-5 Changing Accounting Standards: Monsanto Company
Monsanto Company, a St. Louis–based company, is a leading provider of agricultural products for
farmers. It sells seeds, biotechnology trait products, and herbicides worldwide.
Required
a. How did Monsanto Company report its income to noncontrolling (minority) shareholders of
consolidated subsidiaries in its 2007 consolidated income statement?
b. How did Monsanto Company report its subsidiary noncontrolling (minority) interest in its 2007
consolidated balance sheet?
c. Comment on Monsanto’s treatment of its subsidiary noncontrolling interest.
d. In 2007, Monsanto had several affiliates that were special purpose or variable interest entities.
What level of ownership did Monsanto have in these entities? Were any of these consolidated?
Why?
Exercises
LO1, LO2 E5-1 Multiple-Choice Questions on Consolidation Process
Select the most appropriate answer for each of the following questions.
1. If A Company acquires 80 percent of the stock of B Company on January 1, 20X2, immediately
after the acquisition
a. Consolidated retained earnings will be equal to the combined retained earnings of the two
companies.
b. Goodwill will always be reported in the consolidated balance sheet.
c. A Company’s additional paid-in capital may be reduced to permit the carryforward of B
Company retained earnings.
d. Consolidated retained earnings and A Company retained earnings will be the same.
Research
Communication
Research
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230 Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value
2. Which of the following is correct?
a. The noncontrolling shareholders’ claim on the subsidiary’s net assets is based on the book
value of the subsidiary’s net assets.
b. Only the parent’s portion of the difference between book value and fair value of the subsidiary’s assets is assigned to those assets.
c. Goodwill represents the difference between the book value of the subsidiary’s net assets and
the amount paid by the parent to buy ownership.
d. Total assets reported by the parent generally will be less than total assets reported on the
consolidated balance sheet.
3. Which of the following statements is correct?
a. Foreign subsidiaries do not need to be consolidated if they are reported as a separate operating group under segment reporting.
b. Consolidated retained earnings do not include the noncontrolling interest’s claim on the
subsidiary’s retained earnings.
c. The noncontrolling shareholders’ claim should be adjusted for changes in the fair value of
the subsidiary assets but should not include goodwill.
d. Consolidation is expected any time the investor holds significant influence over the investee.
4. [AICPA Adapted] At December 31, 20X9, Grey Inc. owned 90 percent of Winn Corporation,
a consolidated subsidiary, and 20 percent of Carr Corporation, an investee in which Grey cannot exercise significant influence. On the same date, Grey had receivables of $300,000 from
Winn and $200,000 from Carr. In its December 31, 20X9, consolidated balance sheet, Grey
should report accounts receivable from its affiliates of
a. $500,000.
b. $340,000.
c. $230,000.
d. $200,000.
LO1, LO2 E5-2 Multiple-Choice Questions on Consolidation [AICPA Adapted]
Select the correct answer for each of the following questions.
1. A 70 percent owned subsidiary company declares and pays a cash dividend. What effect does
the dividend have on the retained earnings and minority interest balances in the parent company’s consolidated balance sheet?
a. No effect on either retained earnings or minority interest.
b. No effect on retained earnings and a decrease in minority interest.
c. Decreases in both retained earnings and minority interest.
d. A decrease in retained earnings and no effect on minority interest.
2. How is the portion of consolidated earnings to be assigned to the noncontrolling interest in
consolidated financial statements determined?
a. The parent’s net income is subtracted from the subsidiary’s net income to determine the
noncontrolling interest.
b. The subsidiary’s net income is extended to the noncontrolling interest.
c. The amount of the subsidiary’s earnings recognized for consolidation purposes is multiplied
by the noncontrolling interest’s percentage of ownership.
d. The amount of consolidated earnings on the consolidated worksheets is multiplied by the
noncontrolling interest percentage on the balance sheet date.
3. On January 1, 20X5, Post Company acquired an 80 percent investment in Stake Company.
The acquisition cost was equal to Post’s equity in Stake’s net assets at that date. On January
1, 20X5, Post and Stake had retained earnings of $500,000 and $100,000, respectively. During 20X5, Post had net income of $200,000, which included its equity in Stake’s earnings, and
declared dividends of $50,000; Stake had net income of $40,000 and declared dividends of
$20,000. There were no other intercompany transactions between the parent and subsidiary. On
December 31, 20X5, what should the consolidated retained earnings be?
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Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value 231
a. $650,000.
b. $666,000.
c. $766,000.
d. $770,000.
Note: Items 4 and 5 are based on the following information:
On January 1, 20X8, Ritt Corporation acquired 80 percent of Shaw Corporation’s $10 par common stock for $956,000. On this date, the fair value of the noncontrolling interest was $239,000,
and the carrying amount of Shaw’s net assets was $1,000,000. The fair values of Shaw’s identifi –
able assets and liabilities were the same as their carrying amounts except for plant assets (net) with
a remaining life of 20 years, which were $100,000 in excess of the carrying amount. For the year
ended December 31, 20X8, Shaw had net income of $190,000 and paid cash dividends totaling
$125,000.
4. In the January 1, 20X8, consolidated balance sheet, the amount of goodwill reported should be
a. $0.
b. $76,000.
c. $95,000.
d. $156,000.
5. In the December 31, 20X8, consolidated balance sheet, the amount of noncontrolling interest
reported should be
a. $200,000.
b. $239,000.
c. $251,000.
d. $252,000.
LO2 E5-3 Eliminating Entries with Differential
On June 10, 20X8, Game Corporation acquired 60 percent of Amber Company’s common stock.
The fair value of the noncontrolling interest was $32,800 on that date. Summarized balance sheet
data for the two companies immediately after the stock purchase are as follows:
Game Corp. Amber Company
Item Book Value Book Value Fair Value
Cash $ 25,800 $ 5,000 $ 5,000
Accounts Receivable 30,000 10,000 10,000
Inventory 80,000 20,000 25,000
Buildings and Equipment (net) 120,000 50,000 70,000
Investment in Amber Stock 49,200
Total $305,000 $85,000 $110,000
Accounts Payable $ 25,000 $ 3,000 $ 3,000
Bonds Payable 150,000 25,000 25,000
Common Stock 55,000 20,000
Retained Earnings 75,000 37,000
Total $305,000 $85,000 $ 28,000
Required
a. Give the eliminating entries required to prepare a consolidated balance sheet immediately after
the purchase of Amber Company shares.
b. Explain how eliminating entries differ from other types of journal entries recorded in the normal course of business.
LO2 E5-4 Computation of Consolidated Balances
Slim Corporation’s balance sheet at January 1, 20X7, reflected the following balances:
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232 Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value
Ford Corporation entered into an active acquisition program and acquired 80 percent of Slim’s
common stock on January 2, 20X7, for $470,000. The fair value of the noncontrolling interest at
that date was determined to be $117,500. A careful review of the fair value of Slim’s assets and
liabilities indicated the following:
Cash and Receivables $ 80,000 Accounts Payable $ 40,000
Inventory 120,000 Income Taxes Payable 60,000
Land 70,000 Bonds Payable 200,000
Buildings and Equipment (net) 480,000 Common Stock 250,000
Retained Earnings 200,000
Total Assets $750,000 Total Liabilities and Stockholders’ Equity $750,000
Book Value Fair Value
Inventory $120,000 $140,000
Land 70,000 60,000
Buildings and Equipment (net) 480,000 550,000
Goodwill is assigned proportionately to Ford and the noncontrolling shareholders.
Required
Compute the appropriate amount to be included in the consolidated balance sheet immediately following the acquisition for each of the following items:
a. Inventory.
b. Land.
c. Buildings and Equipment (net).
d. Goodwill.
e. Investment in Slim Corporation.
f. Noncontrolling Interest.
LO2 E5-5 Balance Sheet Worksheet
Power Company owns 90 percent of Pleasantdale Dairy’s stock. The balance sheets of the two
companies immediately after the Pleasantdale acquisition showed the following amounts:
Power
Company
Pleasantdale
Dairy
Cash and Receivables $ 130,000 $ 70,000
Inventory 210,000 90,000
Land 70,000 40,000
Buildings and Equipment (net) 390,000 220,000
Investment in Pleasantdale Stock 270,000
Total Assets $1,070,000 $420,000
Current Payables $ 80,000 $ 40,000
Long-Term Liabilities 200,000 100,000
Common Stock 400,000 60,000
Retained Earnings 390,000 220,000
Total Liabilities and Stockholders’ Equity $1,070,000 $420,000
The fair value of the noncontrolling interest at the date of acquisition was determined to be
$30,000. The full amount of the increase over book value is assigned to land held by Pleasantdale.
At the date of acquisition, Pleasantdale owed Power $8,000 plus $900 accrued interest. Pleasantdale had recorded the accrued interest, but Power had not.
Required
Prepare and complete a consolidated balance sheet worksheet.
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Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value 233
LO2 E5-6 Majority-Owned Subsidiary Acquired at Greater than Book Value
Zenith Corporation acquired 70 percent of Down Corporation’s common stock on December 31,
20X4, for $102,200. The fair value of the noncontrolling interest at that date was determined to be
$43,800. Data from the balance sheets of the two companies included the following amounts as of
the date of acquisition:
Item
Zenith
Corporation
Down
Corporation
Cash $ 50,300 $ 21,000
Accounts Receivable 90,000 44,000
Inventory 130,000 75,000
Land 60,000 30,000
Buildings and Equipment 410,000 250,000
Less: Accumulated Depreciation (150,000) (80,000)
Investment in Down Corporation Stock 102,200
Total Assets $692,500 $340,000
Accounts Payable $152,500 $ 35,000
Mortgage Payable 250,000 180,000
Common Stock 80,000 40,000
Retained Earnings 210,000 85,000
Total Liabilities and Stockholders’ Equity $692,500 $340,000
At the date of the business combination, the book values of Down’s assets and liabilities approximated fair value except for inventory, which had a fair value of $81,000, and buildings and equipment, which had a fair value of $185,000. At December 31, 20X4, Zenith reported accounts
payable of $12,500 to Down, which reported an equal amount in its accounts receivable.
Required
a. Give the eliminating entry or entries needed to prepare a consolidated balance sheet immediately following the business combination.
b. Prepare a consolidated balance sheet worksheet.
c. Prepare a consolidated balance sheet in good form.
LO2 E5-7 Consolidation with Minority Interest
Temple Corporation acquired 75 percent of Dynamic Corporation’s voting common stock on
December 31, 20X4, for $390,000. At the date of combination, Dynamic reported the following:
Current Assets $220,000 Current Liabilities $ 80,000
Long-Term Assets (net) 420,000 Long-Term Liabilities 200,000
Common Stock 120,000
Retained Earnings 240,000
Total $640,000 Total $640,000
At December 31, 20X4, the book values of Dynamic’s net assets and liabilities approximated their
fair values, except for buildings, which had a fair value of $80,000 more than book value, and
inventories, which had a fair value of $36,000 more than book value. The fair value of the noncontrolling interest was determined to be $130,000 at that date.
Required
Temple Corporation wishes to prepare a consolidated balance sheet immediately following the
business combination. Give the eliminating entry or entries needed to prepare a consolidated balance sheet at December 31, 20X4.
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234 Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value
LO2 E5-8 Worksheet for Majority-Owned Subsidiary
Glitter Enterprises acquired 60 percent of Lowtide Builders’ stock on December 31, 20X4. Glitter
acquired its shares for $90,000, the book value of the shares acquired. At that date, the fair value
of the noncontrolling interest was equal to 40 percent of the book value of Lowtide. Balance sheet
data for Glitter and Lowtide on January 1, 20X5, are as follows:
Glitter
Enterprises
Lowtide
Builders
Cash and Receivables $ 80,000 $ 30,000
Inventory 150,000 350,000
Buildings and Equipment (net) 430,000 80,000
Investment in Lowtide Stock 90,000
Total Assets $750,000 $460,000
Current Liabilities $100,000 $110,000
Long-Term Debt 400,000 200,000
Common Stock 200,000 140,000
Retained Earnings 50,000 10,000
Total Liabilities and Stockholders’ Equity $750,000 $460,000
Required
a. Give all eliminating entries needed to prepare a consolidated balance sheet on January 1, 20X5.
b. Complete a consolidated balance sheet worksheet.
c. Prepare a consolidated balance sheet in good form.
LO2 E5-9 Multiple-Choice Questions on Balance Sheet Consolidation
Power Corporation acquired 70 percent of Silk Corporation’s common stock on December 31,
20X2. Balance sheet data for the two companies immediately following the acquisition follow:
Item
Power
Corporation
Silk
Corporation
Cash $ 44,000 $ 30,000
Accounts Receivable 110,000 45,000
Inventory 130,000 70,000
Land 80,000 25,000
Buildings and Equipment 500,000 400,000
Less: Accumulated Depreciation (223,000) (165,000)
Investment in Silk Corporation Stock 150,500
Total Assets $ 791,500 $405,000
Accounts Payable $ 61,500 $ 28,000
Taxes Payable 95,000 37,000
Bonds Payable 280,000 200,000
Common Stock 150,000 50,000
Retained Earnings 205,000 90,000
Total Liabilities and Stockholders’ Equity $ 791,500 $405,000
At the date of the business combination, the book values of Silk’s net assets and liabilities approximated fair value except for inventory, which had a fair value of $85,000, and land, which had a
fair value of $45,000. The fair value of the noncontrolling interest was $64,500 on December 31,
20X2.
Required
For each question below, indicate the appropriate total that should appear in the consolidated balance sheet prepared immediately after the business combination.
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Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value 235
1. What amount of inventory will be reported?
a. $179,000.
b. $200,000.
c. $210,500.
d. $215,000.
2. What amount of goodwill will be reported?
a. $0.
b. $28,000.
c. $40,000.
d. $52,000.
3. What amount of total assets will be reported?
a. $1,081,000.
b. $1,121,000.
c. $1,196,500.
d. $1,231,500.
4. What amount of total liabilities will be reported?
a. $265,000.
b. $436,500.
c. $622,000.
d. $701,500.
5. What amount will be reported as noncontrolling interest?
a. $42,000.
b. $52,500.
c. $60,900.
d. $64,500.
6. What amount of consolidated retained earnings will be reported?
a. $295,000.
b. $268,000.
c. $232,000.
d. $205,000.
7. What amount of total stockholders’ equity will be reported?
a. $355,000.
b. $397,000.
c. $419,500.
d. $495,000.
LO2 E5-10 Basic Consolidation Entries for Majority-Owned Subsidiary
Farmstead Company reported the following summarized balance sheet data on December 31,
20X8:
Assets $350,000 Account Payable $ 50,000
Common Stock 100,000
Retained Earnings 200,000
Total $350,000 Total $350,000
On January 1, 20X9, Horrigan Corporation acquired 70 percent of Farmstead’s stock for $210,000,
the book value of the shares acquired. At that date the fair value of the noncontrolling interest was
equal to 30 percent of the book value of Farmstead. Farmstead reported net income of $20,000 for
20X9 and paid dividends of $5,000.
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236 Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value
Required
a. Give the equity-method journal entries recorded by Horrigan on its books during 20X9 related
to its ownership of Farmstead.
b. Give the eliminating entries needed on December 31, 20X9, to prepare consolidated financial
statements.
LO2 E5-11 Majority-Owned Subsidiary with Differential
Canton Corporation is a majority-owned subsidiary of West Corporation. West acquired 75 percent
ownership on January 1, 20X3, for $133,500. At that date, Canton reported common stock outstanding of $60,000 and retained earnings of $90,000, and the fair value of the noncontrolling interest was $44,500. The differential is assigned to equipment, which had a fair value $28,000 greater
than book value and a remaining economic life of seven years at the date of the business combination. Canton reported net income of $30,000 and paid dividends of $12,000 in 20X3.
Required
a. Give the journal entries recorded by West during 20X3 on its books if it accounts for its investment in Canton using the equity method.
b. Give the eliminating entries needed at December 31, 20X3, to prepare consolidated financial
statements.
LO2 E5-12 Differential Assigned to Amortizable Asset
Major Corporation acquired 90 percent of Lancaster Company’s voting common stock on
January 1, 20X1, for $486,000. At the time of the combination, Lancaster reported common stock
outstanding of $120,000 and retained earnings of $380,000, and the fair value of the noncontrolling interest was $54,000. The book value of Lancaster’s net assets approximated market value
except for patents that had a market value of $40,000 more than their book value. The patents
had a remaining economic life of five years at the date of the business combination. Lancaster
reported net income of $60,000 and paid dividends of $20,000 during 20X1.
Required
a. What balance did Major report as its investment in Lancaster at December 31, 20X1, assuming
Major uses the equity method in accounting for its investment?
b. Give the eliminating entry or entries needed to prepare consolidated financial statements at
December 31, 20X1.
LO2 E5-13 Consolidation after One Year of Ownership
Pioneer Corporation purchased 80 percent of Lowe Corporation’s stock on January 1, 20X2. At
that date Lowe reported retained earnings of $80,000 and had $120,000 of stock outstanding. The
fair value of its buildings was $32,000 more than the book value.
Pioneer paid $190,000 to acquire the Lowe shares. At that date, the noncontrolling interest had
a fair value of $47,500. The remaining economic life for all Lowe’s depreciable assets was eight
years on the date of combination. The amount of the differential assigned to goodwill is not impaired. Lowe reported net income of $40,000 in 20X2 and declared no dividends.
Required
a. Give the eliminating entries needed to prepare a consolidated balance sheet immediately after
Pioneer purchased Lowe stock.
b. Give all eliminating entries needed to prepare a full set of consolidated financial statements for
20X2.
LO2 E5-14 Consolidation Following Three Years of Ownership
Knox Corporation purchased 60 percent of Conway Company ownership on January 1, 20X7, for
$277,500. Conway reported the following net income and dividend payments:
Year Net Income Dividends Paid
20X7 $45,000 $25,000
20X8 55,000 35,000
20X9 30,000 10,000
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Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value 237
On January 1, 20X7, Conway had $250,000 of $5 par value common stock outstanding and
retained earnings of $150,000, and the fair value of the noncontrolling interest was $185,000. Conway held land with a book value of $22,500 and a market value of $30,000 and equipment with a
book value of $320,000 and a market value of $360,000 at the date of combination. The remainder
of the differential at acquisition was attributable to an increase in the value of patents, which had a
remaining useful life of 10 years. All depreciable assets held by Conway at the date of acquisition
had a remaining economic life of eight years.
Required
a. Compute the increase in the fair value of patents held by Conway.
b. Prepare the eliminating entries needed at January 1, 20X7, to prepare a consolidated balance
sheet.
c. Compute the balance reported by Knox as its investment in Conway at January 1, 20X9.
d. Prepare the journal entries recorded by Knox with regard to its investment in Conway during
20X9.
e. Prepare the eliminating entries needed at December 31, 20X9, to prepare a three-part consolidation worksheet.
LO2 E5-15 Consolidation Worksheet for Majority-Owned Subsidiary
Proud Corporation acquired 80 percent of Stergis Company’s voting stock on January 1, 20X3, at
underlying book value. The fair value of the noncontrolling interest was equal to 20 percent of the
book value of Stergis at that date. Proud uses the equity method in accounting for its ownership
of Stergis during 20X3. On December 31, 20X3, the trial balances of the two companies are as
follows:
Proud Corporation Stergis Company
Item Debit Credit Debit Credit
Current Assets $173,000 $105,000
Depreciable Assets 500,000 300,000
Investment in Stergis Company Stock 136,000
Depreciation Expense 25,000 15,000
Other Expenses 105,000 75,000
Dividends Declared 40,000 10,000
Accumulated Depreciation $175,000 $ 75,000
Current Liabilities 50,000 40,000
Long-Term Debt 100,000 120,000
Common Stock 200,000 100,000
Retained Earnings 230,000 50,000
Sales 200,000 120,000
Income from Subsidiary 24,000
$979,000 $979,000 $505,000 $505,000
Required
a. Give all eliminating entries required as of December 31, 20X3, to prepare consolidated financial statements.
b. Prepare a three-part consolidation worksheet.
c. Prepare a consolidated balance sheet, income statement, and retained earnings statement for
20X3.
LO2 E5-16 Consolidation Worksheet for Majority-Owned Subsidiary for Second Year
Proud Corporation acquired 80 percent of Stergis Company’s voting stock on January 1, 20X3,
at underlying book value. The fair value of the noncontrolling interest was equal to 20 percent
of the book value of Stergis at that date. Proud uses the equity method in accounting for its
ownership of Stergis. On December 31, 20X4, the trial balances of the two companies are as
follows:
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238 Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value
Required
a. Give all eliminating entries required on December 31, 20X4, to prepare consolidated financial
statements.
b. Prepare a three-part consolidation worksheet as of December 31, 20X4.
LO4 E5-17 Preparation of Stockholders’ Equity Section with Other Comprehensive Income
Broadmore Corporation acquired 75 percent of Stem Corporation’s common stock on January 1,
20X8, for $435,000. At that date, Stem reported common stock outstanding of $300,000 and
retained earnings of $200,000, and the fair value of the noncontrolling interest was $145,000. The
book values and fair values of Stem’s assets and liabilities were equal, except for other intangible
assets, which had a fair value $80,000 greater than book value and a 10-year remaining life. Broadmore and Stem reported the following data for 20X8 and 20X9:
Proud Corporation Stergis Company
Item Debit Credit Debit Credit
Current Assets $ 235,000 $150,000
Depreciable Assets 500,000 300,000
Investment in Stergis Company Stock 152,000
Depreciation Expense 25,000 15,000
Other Expenses 150,000 90,000
Dividends Declared 50,000 15,000
Accumulated Depreciation $ 200,000 $ 90,000
Current Liabilities 70,000 50,000
Long-Term Debt 100,000 120,000
Common Stock 200,000 100,000
Retained Earnings 284,000 70,000
Sales 230,000 140,000
Income from Subsidiary 28,000
$1,112,000 $1,112,000 $570,000 $570,000
Stem Corporation Broadmore Corporation
Year
Net
Income
Comprehensive
Income
Dividends
Paid
Operating
Income
Dividends
Paid
20X8 $40,000 $50,000 $15,000 $120,000 $70,000
20X9 60,000 65,000 30,000 140,000 70,000
Required
a. Compute consolidated comprehensive income for 20X8 and 20X9.
b. Compute comprehensive income attributable to the controlling interest for 20X8 and 20X9.
c. Assuming that Broadmore reported capital stock outstanding of $320,000 and retained earnings
of $430,000 at January 1, 20X8, prepare the stockholders’ equity section of the consolidated
balance sheet at December 31, 20X8 and 20X9.
LO4 E5-18 Eliminating Entries for Subsidiary with Other Comprehensive Income
Palmer Corporation acquired 70 percent of Krown Corporation’s ownership on January 1, 20X8,
for $140,000. At that date, Krown reported capital stock outstanding of $120,000 and retained
earnings of $80,000, and the fair value of the noncontrolling interest was equal to 30 percent of the
book value of Krown. During 20X8, Krown reported net income of $30,000 and comprehensive
income of $36,000 and paid dividends of $25,000.
Required
a. Present all equity-method entries that Palmer would have recorded in accounting for its investment in Krown during 20X8.
b. Present all eliminating entries needed at December 31, 20X8, to prepare a complete set of consolidated financial statements for Palmer Corporation and its subsidiary.
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Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value 239
LO5 E5-19* Consolidation of Subsidiary with Negative Retained Earnings
General Corporation acquired 80 percent of Strap Company’s voting common stock on January 1,
20X4, for $138,000. At that date, the fair value of the noncontrolling interest was $34,500. Strap’s
balance sheet at the date of acquisition contained the following balances:
STRAP COMPANY
Balance Sheet
January 1, 20X4
Cash $ 20,000 Accounts Payable $ 35,000
Accounts Receivable 35,000 Notes Payable 180,000
Land 90,000 Common Stock 100,000
Building and Equipment 300,000 Additional Paid-in Capital 75,000
Less: Accumulated Depreciation (85,000) Retained Earnings (30,000)
Total Assets $360,000 Total Liabilities and Stockholders’ Equity $360,000
At the date of acquisition, the reported book values of Strap’s assets and liabilities approximated
fair value.
Required
Give the eliminating entry or entries needed to prepare a consolidated balance sheet immediately
following the business combination.
LO5 E5-20* Complex Assignment of Differential
On December 31, 20X4, Worth Corporation acquired 90 percent of Brinker Inc.’s common
stock for $864,000. At that date, the fair value of the noncontrolling interest was $96,000. Of the
$240,000 differential, $5,000 related to the increased value of Brinker’s inventory, $75,000 related
to the increased value of its land, $60,000 related to the increased value of its equipment, and
$50,000 was associated with a change in the value of its notes payable due to increasing interest
rates. Brinker’s equipment had a remaining life of 15 years from the date of combination. Brinker
sold all inventory it held at the end of 20X4 during 20X5; the land to which the differential related also was sold during the year for a large gain. The amortization of the differential relating to
Brinker’s notes payable was $7,500 for 20X5.
At the date of combination, Brinker reported retained earnings of $120,000, common stock outstanding of $500,000, and premium on common stock of $100,000. For the year 20X5, it reported
net income of $150,000 but paid no dividends. Worth accounts for its investment in Brinker using
the equity method.
Required
a. Present all entries that Worth would have recorded during 20X5 with respect to its investment
in Brinker.
b. Present all elimination entries that would have been included in the worksheet to prepare a full
set of consolidated financial statements for the year 20X5.
Problems
LO1 P5-21 Multiple-Choice Questions on Applying the Equity Method [AICPA Adapted]
Select the correct answer for each of the following questions.
1. On July 1, 20X3, Barker Company purchased 20 percent of Acme Company’s outstanding
common stock for $400,000 when the fair value of Acme’s net assets was $2,000,000. Barker
does not have the ability to exercise significant influence over Acme’s operating and financial
policies. The following data concerning Acme are available for 20X3:
Twelve Months Ended
December 31, 20X3
Six Months Ended
December 31, 20X3
Net income $300,000 $160,000
Dividends declared and paid 190,000 100,000
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240 Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value
In its income statement for the year ended December 31, 20X3, how much income should
Barker report from this investment?
a. $20,000.
b. $32,000.
c. $38,000.
d. $60,000.
2. On January 1, 20X3, Miller Company purchased 25 percent of Wall Corporation’s common stock;
no goodwill resulted from the purchase. Miller appropriately carries this investment at equity, and
the balance in Miller’s investment account was $190,000 on December 31, 20X3. Wall reported
net income of $120,000 for the year ended December 31, 20X3, and paid dividends on its common
stock totaling $48,000 during 20X3. How much did Miller pay for its 25 percent interest in Wall?
a. $172,000.
b. $202,000.
c. $208,000.
d. $232,000.
3. On January 1, 20X7, Robohn Company purchased for cash 40 percent of Lowell Company’s
300,000 shares of voting common stock for $1,800,000 when 40 percent of the underlying equity
in Lowell’s net assets was $1,740,000. The payment in excess of underlying equity was assigned
to amortizable assets with a remaining life of six years. The amortization is not deductible for
income tax reporting. As a result of this transaction, Robohn has the ability to exercise significant influence over Lowell’s operating and financial policies. Lowell’s net income for the year
ended December 31, 20X7, was $600,000. During 20X7, Lowell paid $325,000 in dividends to
its shareholders. The income reported by Robohn for its investment in Lowell should be
a. $120,000.
b. $130,000.
c. $230,000.
d. $240,000.
4. In January 20X0, Farley Corporation acquired 20 percent of Davis Company’s outstanding common stock for $800,000. This investment gave Farley the ability to exercise significant influence
over Davis. The book value of the acquired shares was $600,000. The excess of cost over book
value was attributed to an identifiable intangible asset, which was undervalued on Davis’s balance sheet and had a remaining economic life of 10 years. For the year ended December 31,
20X0, Davis reported net income of $180,000 and paid cash dividends of $40,000 on its common
stock. What is the proper carrying value of Farley’s investment in Davis on December 31, 20X0?
a. $772,000.
b. $780,000.
c. $800,000.
d. $808,000.
LO1 P5-22 Amortization of Differential
Ball Corporation purchased 30 percent of Krown Company’s common stock on January 1, 20X5,
by issuing preferred stock with a par value of $50,000 and a market price of $120,000. The following amounts relate to Krown’s balance sheet items at that date:
Book Value Fair Value
Cash and Receivables $ 200,000 $200,000
Buildings and Equipment 400,000 360,000
Less: Accumulated Depreciation (100,000)
Total Assets $ 500,000
Accounts Payable $ 50,000 50,000
Bonds Payable 200,000 200,000
Common Stock 100,000
Retained Earnings 150,000
Total Liabilities and Equities $ 500,000
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Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value 241
Krown purchased buildings and equipment on January 1, 20X0, with an expected economic life
of 20 years. No change in overall expected economic life occurred as a result of the acquisition of
Ball’s stock. The amount paid in excess of the fair value of Krown’s reported net assets is attributed to unrecorded copyrights with a remaining useful life of eight years. During 20X5, Krown
reported net income of $40,000 and paid dividends of $10,000.
Required
Give all journal entries to be recorded on Ball Corporation’s books during 20X5, assuming it uses
the equity method in accounting for its ownership of Krown Company.
LO1 P5-23 Computation of Account Balances
Easy Chair Company purchased 40 percent ownership of Stuffy Sofa Corporation on January 1,
20X1, for $150,000. Stuffy Sofa’s balance sheet at the time of acquisition was as follows:
STUFFY SOFA CORPORATION
Balance Sheet
January 1, 20X1
Cash $ 30,000 Current Liabilities $ 40,000
Accounts Receivable 120,000 Bonds Payable 200,000
Inventory 80,000 Common Stock 200,000
Land 150,000 Additional Paid-In Capital 40,000
Buildings and Equipment $ 300,000
Less: Accumulated Depreciation (120,000) 180,000 Retained Earnings 80,000
Total Assets $560,000 Total Liabilities and Equities $560,000
During 20X1 Stuffy Sofa Corporation reported net income of $30,000 and paid dividends of
$9,000. The fair values of Stuffy Sofa’s assets and liabilities were equal to their book values at the
date of acquisition, with the exception of buildings and equipment, which had a fair value $35,000
above book value. All buildings and equipment had remaining lives of five years at the time of the
business combination. The amount attributed to goodwill as a result of its purchase of Stuffy Sofa
shares is not impaired.
Required
a. What amount of investment income will Easy Chair Company record during 20X1 under
equity-method accounting?
b. What amount of income will be reported under the cost method?
c. What will be the balance in the investment account on December 31, 20X1, under (1) costmethod and (2) equity-method accounting?
LO1 P5-24 Multistep Acquisition
Jackson Corporation purchased shares of Phillips Corporation in the following sequence:
Date
Number of Shares
Purchased
Amount
Paid
January 1, 20X6 1,000 shares $25,000
January 1, 20X8 500 shares 15,000
January 1, 20X9 2,000 shares 70,000
The book value of Phillips’s net assets at January 1, 20X6, was $200,000. Each year since Jackson
first purchased shares, Phillips has reported net income of $70,000 and paid dividends of $20,000.
The amount paid in excess of the book value of Phillips’s net assets was attributed to the increase
in the value of identifiable intangible assets with a remaining life of five years at the date the shares
of Phillips were purchased. Phillips has had 10,000 shares of voting common stock outstanding
throughout the four-year period.
Required
Give the journal entries recorded on Jackson Corporation’s books in 20X9 related to its investment
in Phillips Corporation.
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242 Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value
LO1 P5-25 Complex Differential
Essex Company issued common shares with a par value of $50,000 and a market value of
$165,000 in exchange for 30 percent ownership of Tolliver Corporation on January 1, 20X2. Tolliver reported the following balances on that date:
TOLLIVER CORPORATION
Balance Sheet
January 1, 20X2
Book Value Fair Value
Assets
Cash $ 40,000 $ 40,000
Accounts Receivable 80,000 80,000
Inventory (FIFO basis) 120,000 150,000
Land 50,000 65,000
Buildings and Equipment 500,000 320,000
Less: Accumulated Depreciation (240,000)
Patent 25,000
Total Assets $550,000 $680,000
Liabilities and Equities
Accounts Payable $ 30,000 $ 30,000
Bonds Payable 100,000 100,000
Common Stock 150,000
Additional Paid-In Capital 20,000
Retained Earnings 250,000
Total Liabilities and Equities $550,000
The estimated economic life of the patents held by Tolliver is 10 years. The buildings and equipment are expected to last 12 more years on average. Tolliver paid dividends of $9,000 during 20X2
and reported net income of $80,000 for the year.
Required
Compute the amount of investment income (loss) reported by Essex from its investment in Tolliver for 20X2 and the balance in the investment account on December 31, 20X2, assuming the
equity method is used in accounting for the investment.
LO1 P5-26 Equity Entries with Differential
On January 1, 20X0, Hunter Corporation issued 6,000 of its $10 par value shares to acquire 45 percent of the shares of Arrow Manufacturing. Arrow Manufacturing’s balance sheet immediately
before the acquisition contained the following items:
ARROW MANUFACTURING
Balance Sheet
January 1, 20X0
Book Value Fair Value
Assets
Cash and Receivables $ 30,000 $ 30,000
Land 70,000 80,000
Buildings and Equipment (net) 120,000 150,000
Patent 80,000 80,000
Total Assets $300,000
Liabilities and Equities
Accounts Payable $ 90,000 90,000
Common Stock 150,000
Retained Earnings 60,000
Total Liabilities and Equities $300,000
On the date of the stock acquisition, Hunter’s shares were selling at $35, and Arrow Manufacturing’s buildings and equipment had a remaining economic life of 10 years. The amount of the differential assigned to goodwill is not impaired.
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Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value 243
In the two years following the stock acquisition, Arrow Manufacturing reported net income of
$80,000 and $50,000 and paid dividends of $20,000 and $40,000, respectively. Hunter used the
equity method in accounting for its ownership of Arrow Manufacturing.
Required
a. Give the entry recorded by Hunter Corporation at the time of acquisition.
b. Give the journal entries recorded by Hunter during 20X0 and 20X1 related to its investment in
Arrow Manufacturing.
c. What balance will be reported in Hunter’s investment account on December 31, 20X1?
LO1 P5-27 Equity Entries with Differential
Ennis Corporation acquired 35 percent of Jackson Corporation’s stock on January 1, 20X8, by
issuing 25,000 shares of its $2 par value common stock. Jackson Corporation’s balance sheet
immediately before the acquisition contained the following items:
JACKSON CORPORATION
Balance Sheet
January 1, 20X8
Book Value Fair Value
Assets
Cash and Receivables $ 40,000 $ 40,000
Inventory (FIFO basis) 80,000 100,000
Land 50,000 70,000
Buildings and Equipment (net) 240,000 320,000
Total Assets $410,000 $530,000
Liabilities and Equities
Accounts Payable $ 70,000 $ 70,000
Common Stock 130,000
Retained Earnings 210,000
Total Liabilities and Equities $410,000
Shares of Ennis were selling at $8 at the time of the acquisition. On the date of acquisition, the
remaining economic life of buildings and equipment held by Jackson was 20 years. The amount
of the differential assigned to goodwill is not impaired. For the year 20X8, Jackson reported net
income of $70,000 and paid dividends of $10,000.
Required
a. Give the journal entries recorded by Ennis Corporation during 20X8 related to its investment in
Jackson Corporation.
b. What balance will Ennis report as its investment in Jackson at December 31, 20X8?
LO1 P5-28 Additional Ownership Level
Balance sheet and income and dividend data for Amber Corporation, Blair Corporation, and Carmen Corporation at January 1, 20X3, were as follows:
Account Balances
Amber
Corporation
Blair
Corporation
Carmen
Corporation
Cash $ 70,000 $ 60,000 $ 20,000
Accounts Receivable 120,000 80,000 40,000
Inventory 100,000 90,000 65,000
Fixed Assets (net) 450,000 350,000 240,000
Total Assets $740,000 $580,000 $365,000
Accounts Payable $105,000 $110,000 $ 45,000
Bonds Payable 300,000 200,000 120,000
Common Stock 150,000 75,000 90,000
Retained Earnings 185,000 195,000 110,000
Total Liabilities and Equity $740,000 $580,000 $365,000
Income from Operations in 20X3 $220,000 $100,000
Net Income for 20X3 $ 50,000
Dividends Declared and Paid 60,000 30,000 25,000
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244 Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value
On January 1, 20X3, Amber Corporation purchased 40 percent of the voting common stock
of Blair Corporation by issuing common stock with a par value of $40,000 and fair value of
$130,000. Immediately after this transaction, Blair purchased 25 percent of the voting common
stock of Carmen Corporation by issuing bonds payable with a par value and market value of
$51,500.
On January 1, 20X3, the book values of Blair’s net assets were equal to their fair values except
for equipment that had a fair value $30,000 greater than book value and patents that had a fair
value $25,000 greater than book value. At that date the equipment had a remaining economic life
of eight years and the patents had a remaining economic life of five years. The book values of
Carmen’s assets were equal to their fair values except for inventory that had a fair value $6,000 in
excess of book value and was accounted for on a FIFO basis.
Required
a. Compute the net income reported by Amber Corporation for 20X3, assuming the equity method
is used by Amber and Blair in accounting for their intercorporate investments.
b. Give all journal entries recorded by Amber relating to its investment in Blair during 20X3.
LO1 P5-29 Correction of Error
Hill Company paid $164,000 to acquire 40 percent ownership of Dale Company on January 1,
20X2. Net book value of Dale’s assets on that date was $300,000. Book values and fair values
of net assets held by Dale were the same except for equipment and patents. Equipment held by
Dale had a book value of $70,000 and fair value of $120,000. All of the remaining purchase price
was attributable to the increased value of patents with a remaining useful life of eight years. The
remaining economic life of all depreciable assets held by Dale was five years.
Dale Company’s net income and dividends for the three years immediately following the purchase of shares were
Year Net Income Dividends
20X2 $40,000 $15,000
20X3 60,000 20,000
20X4 70,000 25,000
The computation of Hill’s investment income for 20X4 and entries in its investment account
since the date of purchase were as follows:
20X4 Investment Income
Pro rata income accrual ($70,000 × 0.40) $28,000
Amortize patents ($44,000 ÷ 8 years) $5,500
Dividends received ($25,000 × 0.40) 10,000
20X4 investment income $32,500
Investment in Dale Company
1/1/X2 purchase price $164,000
20X2 income accrual 16,000
Amortize patents $5,500
20X3 income accrual 24,000
Amortize patents 5,500
20X4 income accrual 28,000
Amortize patents 5,500
12/31/X4 balance $215,500
Before making closing entries at the end of 20X4, Hill’s new controller reviewed the reports and
was convinced that both the balance in the investment account and the investment income that Hill
reported for 20X4 were in error.
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Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value 245
Required
Prepare a correcting entry, along with supporting computations, to properly state the balance in the
investment account and all related account balances at the end of 20X4.
LO2 P5-30 Majority-Owned Subsidiary Acquired at Book Value
Cameron Corporation acquired 70 percent of Darla Corporation’s common stock on December
31, 20X4, for $87,500. Data from the balance sheets of the two companies included the following
amounts as of the date of acquisition:
Item
Cameron
Corporation
Darla
Corporation
Cash $ 65,000 $ 21,000
Accounts Receivable 90,000 44,000
Inventory 130,000 75,000
Land 60,000 30,000
Buildings and Equipment 410,000 250,000
Less: Accumulated Depreciation (150,000) (80,000)
Investment in Darla Corporation Stock 87,500
Total Assets $692,500 $340,000
Accounts Payable $152,500 $ 35,000
Mortgage Payable 250,000 180,000
Common Stock 80,000 40,000
Retained Earnings 210,000 85,000
Total Liabilities and Stockholders’ Equity $692,500 $340,000
At the date of the business combination, the book values of Darla Corporation’s assets and liabilities approximated fair value, and the fair value of the noncontrolling interest was equal to 30 percent
of the book value of Darla Corporation. At December 31, 20X4, Cameron reported accounts payable of $12,500 to Darla, which reported an equal amount in its accounts receivable.
Required
a. Give the eliminating entry or entries needed to prepare a consolidated balance sheet immediately following the business combination.
b. Prepare a consolidated balance sheet worksheet.
c. Prepare a consolidated balance sheet in good form.
LO2 P5-31 Majority-Owned Subsidiary Acquired at Greater Than Book Value
Porter corporation acquired 70 percent of Darla Corporation’s common stock on December 31,
20X4, for $102,200. At that date, the fair value of the noncontrolling interest was $43,800. Data
from the balance sheets of the two companies included the following amounts as of the date of
acquisition:
Item
Porter
Corporation
Darla
Corporation
Cash $ 50,300 $ 21,000
Accounts Receivable 90,000 44,000
Inventory 130,000 75,000
Land 60,000 30,000
Buildings and Equipment 410,000 250,000
Less: Accumulated Depreciation (150,000) (80,000)
Investment in Darla Corporation Stock 102,200
Total Assets $692,500 $340,000
Accounts Payable $152,500 $ 35,000
Mortgage Payable 250,000 180,000
Common Stock 80,000 40,000
Retained Earnings 210,000 85,000
Total Liabilities and Stockholders’ Equity $692,500 $340,000
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246 Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value
At the date of the business combination, the book values of Darla’s assets and liabilities approximated fair value except for inventory, which had a fair value of $81,000, and buildings and equipment, which had a fair value of $185,000. At December 31, 20X4, Porter reported accounts payable
of $12,500 to Darla, which reported an equal amount in its accounts receivable.
Required
a. Give the eliminating entry or entries needed to prepare a consolidated balance sheet immediately following the business combination.
b. Prepare a consolidated balance sheet worksheet.
c. Prepare a consolidated balance sheet in good form.
LO2 P5-32 Balance Sheet Consolidation of Majority-Owned Subsidiary
On January 2, 20X8, Total Corporation acquired 75 percent of Ticken Tie Company’s outstanding
common stock. In exchange for Ticken Tie’s stock, Total issued bonds payable with a par value
of $500,000 and fair value of $510,000 directly to the selling stockholders of Ticken Tie. At that
date, the fair value of the noncontrolling interest was $170,000. The two companies continued to
operate as separate entities subsequent to the combination.
Immediately prior to the combination, the book values and fair values of the companies’ assets
and liabilities were as follows:
Total Ticken Tie
Book Value Fair Value Book Value Fair Value
Cash $ 12,000 $ 12,000 $ 9,000 $ 9,000
Receivables 41,000 39,000 31,000 30,000
Allowance for Bad Debts (2,000) (1,000)
Inventory 86,000 89,000 68,000 72,000
Land 55,000 200,000 50,000 70,000
Buildings and Equipment 960,000 650,000 670,000 500,000
Accumulated Depreciation (411,000) (220,000)
Patent 40,000
Total Assets $741,000 $990,000 $607,000 $721,000
Current Payables $ 38,000 $ 38,000 $ 29,000 $ 29,000
Bonds Payable 200,000 210,000 100,000 100,000
Common Stock 300,000 200,000
Additional Paid-in Capital 100,000 130,000
Retained Earnings 103,000 148,000
Total Liabilities and Equity $741,000 $607,000
At the date of combination, Ticken Tie owed Total $6,000 plus accrued interest of $500 on a shortterm note. Both companies have properly recorded these amounts.
Required
a. Record the business combination on the books of Total Corporation.
b. Present in general journal form all elimination entries needed in a worksheet to prepare a consolidated balance sheet immediately following the business combination on January 2, 20X8.
c. Prepare and complete a consolidated balance sheet worksheet as of January 2, 20X8, immediately following the business combination.
d. Present a consolidated balance sheet for Total and its subsidiary as of January 2, 20X8.
LO2 P5-33 Incomplete Data
Blue Corporation acquired controlling ownership of Skyler Corporation on December 31, 20X3,
and a consolidated balance sheet was prepared immediately. Partial balance sheet data for the two
companies and the consolidated entity at that date follow:
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Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value 247
BLUE CORPORATION AND SKYLER CORPORATION
Balance Sheet Data
December 31, 20X3
Item
Blue
Corporation
Skyler
Corporation
Consolidated
Entity
Cash $ 63,650 $ 35,000 $ 98,650
Accounts Receivable 98,000 ? 148,000
Inventory 105,000 80,000 195,000
Buildings and Equipment 400,000 340,000 780,000
Less: Accumulated Depreciation (215,000) (140,000) (355,000)
Investment in Skyler Corporation Stock ?
Goodwill 9,000
Total Assets $620,000 $380,000 $875,650
Accounts Payable $115,000 $ 46,000 $146,000
Wages Payable ? ? 94,000
Notes Payable 200,000 110,000 310,000
Common Stock 120,000 75,000 ?
Retained Earnings 115,000 125,000 ?
Noncontrolling Interest 90,650
Total Liabilities and Equities $ ? $380,000 $875,650
During 20X3, Blue provided engineering services to Skyler and has not yet been paid for
them. There were no other receivables or payables between Blue and Skyler at December 31,
20X3.
Required
a. What is the amount of unpaid engineering services at December 31, 20X3, on work done by
Blue for Skyler?
b. What balance in accounts receivable did Skyler report at December 31, 20X3?
c. What amounts of wages payable did Blue and Skyler report at December 31, 20X3?
d. What was the fair value of Skyler as a whole at the date of acquisition?
e. What percentage of Skyler’s shares were purchased by Blue?
f. What amounts of capital stock and retained earnings must be reported in the consolidated balance sheet?
LO2 P5-34 Income and Retained Earnings
Quill Corporation acquired 70 percent of North Company’s stock on January 1, 20X9, for
$105,000. At that date, the fair value of the noncontrolling interest was equal to 30 percent of the
book value of North Company. The companies reported the following stockholders’ equity balances immediately after the acquisition:
Quill
Corporation
North
Company
Common Stock $120,000 $ 30,000
Additional Paid-in Capital 230,000 80,000
Retained Earnings 290,000 40,000
Total $640,000 $150,000
Quill and North reported 20X9 operating incomes of $90,000 and $35,000 and dividend payments
of $30,000 and $10,000, respectively.
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248 Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value
Required
a. Compute the amount reported as net income by each company for 20X9, assuming Quill uses
equity-method accounting for its investment in North.
b. Compute consolidated net income for 20X9.
c. Compute the reported balance in retained earnings at December 31, 20X9, for both
companies.
d. Compute consolidated retained earnings at December 31, 20X9.
e. How would the computation of consolidated retained earnings at December 31, 20X9, change
if Quill uses the cost method in accounting for its investment in North?
LO2 P5-35 Consolidation Worksheet at End of First Year of Ownership
Power Corporation acquired 75 percent of Best Company’s ownership on January 1, 20X8,
for $96,000. At that date, the fair value of the noncontrolling interest was $32,000. The book
value of Best’s net assets at acquisition was $100,000. The book values and fair values of
Best’s assets and liabilities were equal, except for Best’s buildings and equipment, which
were worth $20,000 more than book value. Buildings and equipment are depreciated on a
10-year basis.
Although goodwill is not amortized, the management of Power concluded at December 31,
20X8, that goodwill from its purchase of Best shares had been impaired and the correct carrying
amount was $2,500. Goodwill and goodwill impairment were assigned proportionately to the controlling and noncontrolling shareholders.
Trial balance data for Power and Best on December 31, 20X8, are as follows:
Power Corporation Best Company
Item Debit Credit Debit Credit
Cash $ 47,500 $ 21,000
Accounts Receivable 70,000 12,000
Inventory 90,000 25,000
Land 30,000 15,000
Buildings and Equipment 350,000 150,000
Investment in Best Co. Stock 96,375
Cost of Goods Sold 125,000 110,000
Wage Expense 42,000 27,000
Depreciation Expense 25,000 10,000
Interest Expense 12,000 4,000
Other Expenses 13,500 5,000
Dividends Declared 30,000 16,000
Accumulated Depreciation $145,000 $ 40,000
Accounts Payable 45,000 16,000
Wages Payable 17,000 9,000
Notes Payable 150,000 50,000
Common Stock 200,000 60,000
Retained Earnings 102,000 40,000
Sales 260,000 180,000
Income from Subsidiary 12,375
$931,375 $931,375 $395,000 $395,000
Required
a. Give all eliminating entries needed to prepare a three-part consolidation worksheet as of
December 31, 20X8.
b. Prepare a three-part consolidation worksheet for 20X8 in good form.
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Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value 249
LO2 P5-36 Consolidation Worksheet at End of Second Year of Ownership
Power Corporation acquired 75 percent of Best Company’s ownership on January 1, 20X8,
for $96,000. At that date, the fair value of the noncontrolling interest was $32,000. The book
value of Best’s net assets at acquisition was $100,000. The book values and fair values of
Best’s assets and liabilities were equal, except for Best’s buildings and equipment, which
were worth $20,000 more than book value. Buildings and equipment are depreciated on a
10-year basis.
Although goodwill is not amortized, the management of Power concluded at December 31,
20X8, that goodwill from its purchase of Best shares had been impaired and the correct carrying
amount was $2,500. Goodwill and goodwill impairment were assigned proportionately to the controlling and noncontrolling shareholders. No additional impairment occurred in 20X9.
Trial balance data for Power and Best on December 31, 20X9, are as follows:
Required
a. Give all eliminating entries needed to prepare a three-part consolidation worksheet as of
December 31, 20X9.
b. Prepare a three-part consolidation worksheet for 20X9 in good form.
c. Prepare a consolidated balance sheet, income statement, and retained earnings statement for
20X9.
LO2, LO5 P5-37 Comprehensive Problem: Majority-Owned Subsidiary
Master Corporation acquired 80 percent ownership of Stanley Wood Products Company on
January 1, 20X1, for $160,000. On that date, the fair value of the noncontrolling interest was
$40,000, and Stanley reported retained earnings of $50,000 and had $100,000 of common
stock outstanding. Master has used the equity method in accounting for its investment in
Stanley.
Trial balance data for the two companies on December 31, 20X5, are as follows:
Power Corporation Best Company
Item Debit Credit Debit Credit
Cash $ 68,500 $ 32,000
Accounts Receivable 85,000 14,000
Inventory 97,000 24,000
Land 50,000 25,000
Buildings and Equipment 350,000 150,000
Investment in Best Co. Stock 106,875
Cost of Goods Sold 145,000 114,000
Wage Expense 35,000 20,000
Depreciation Expense 25,000 10,000
Interest Expense 12,000 4,000
Other Expenses 23,000 16,000
Dividends Declared 30,000 20,000
Accumulated Depreciation $ 170,000 $ 50,000
Accounts Payable 51,000 15,000
Wages Payable 14,000 6,000
Notes Payable 150,000 50,000
Common Stock 200,000 60,000
Retained Earnings 126,875 48,000
Sales 290,000 200,000
Income from Subsidiary 25,500
$1,027,375 $1,027,375 $429,000 $429,000
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250 Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value
Additional Information
1. On the date of combination, the fair value of Stanley’s depreciable assets was $50,000 more
than book value. The differential assigned to depreciable assets should be written off over the
following 10-year period.
2. There was $10,000 of intercorporate receivables and payables at the end of 20X5.
Required
a. Give all journal entries that Master recorded during 20X5 related to its investment in Stanley.
b. Give all eliminating entries needed to prepare consolidated statements for 20X5.
c. Prepare a three-part worksheet as of December 31, 20X5.
LO2 P5-38 Comprehensive Problem: Differential Apportionment
Mortar Corporation acquired 80 percent ownership of Granite Company on January 1, 20X7, for
$173,000. At that date, the fair value of the noncontrolling interest was $43,250. The trial balances
for the two companies on December 31, 20X7, included the following amounts:
Master
Corporation
Stanley Wood
Products Company
Item Debit Credit Debit Credit
Cash and Receivables $ 81,000 $ 65,000
Inventory 260,000 90,000
Land 80,000 80,000
Buildings and Equipment 500,000 150,000
Investment in Stanley Wood Products Stock 188,000
Cost of Goods Sold 120,000 50,000
Depreciation Expense 25,000 15,000
Inventory Losses 15,000 5,000
Dividends Declared 30,000 10,000
Accumulated Depreciation $ 205,000 $105,000
Accounts Payable 60,000 20,000
Notes Payable 200,000 50,000
Common Stock 300,000 100,000
Retained Earnings 314,000 90,000
Sales 200,000 100,000
Income from Subsidiary 20,000
$1,299,000 $1,299,000 $465,000 $465,000
Mortar Corporation Granite Company
Item Debit Credit Debit Credit
Cash $ 38,000 $ 25,000
Accounts Receivable 50,000 55,000
Inventory 240,000 100,000
Land 80,000 20,000
Buildings and Equipment 500,000 150,000
Investment in Granite Company Stock 202,000
Cost of Goods Sold 500,000 250,000
Depreciation Expense 25,000 15,000
Other Expenses 75,000 75,000
Dividends Declared 50,000 20,000
Accumulated Depreciation $ 155,000 $ 75,000
Accounts Payable 70,000 35,000
Mortgages Payable 200,000 50,000
Common Stock 300,000 50,000
Retained Earnings 290,000 100,000
Sales 700,000 400,000
Income from Subsidiary 45,000
$1,760,000 $1,760,000 $710,000 $710,000
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Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value 251
Additional Information
1. On January 1, 20X7, Granite reported net assets with a book value of $150,000 and a fair value
of $191,250.
2. Granite’s depreciable assets had an estimated economic life of 11 years on the date of combination. The difference between fair value and book value of Granite’s net assets is related entirely
to buildings and equipment.
3. Mortar used the equity method in accounting for its investment in Granite.
4. Detailed analysis of receivables and payables showed that Granite owed Mortar $16,000 on
December 31, 20X7.
5. Assume that any goodwill impairment should be recorded as an adjustment in Mortar’s equity
method accounts along with the amortization of other differential components.
Required
a. Give all journal entries recorded by Mortar with regard to its investment in Granite during
20X7.
b. Give all eliminating entries needed to prepare a full set of consolidated financial statements for
20X7.
c. Prepare a three-part consolidation worksheet as of December 31, 20X7.
LO2 P5-39 Comprehensive Problem: Differential Apportionment in Subsequent Period
Mortar Corporation acquired 80 percent ownership of Granite Company on January 1, 20X7, for
$173,000. At that date, the fair value of the noncontrolling interest was $43,250. The trial balances
for the two companies on December 31, 20X8, included the following amounts:
Mortar Corporation Granite Company
Item Debit Credit Debit Credit
Cash $ 59,000 $ 31,000
Accounts Receivable 83,000 71,000
Inventory 275,000 118,000
Land 80,000 30,000
Buildings and Equipment 500,000 150,000
Investment in Granite Company Stock 206,200
Cost of Goods Sold 490,000 310,000
Depreciation Expense 25,000 15,000
Other Expenses 62,000 100,000
Dividends Declared 45,000 25,000
Accumulated Depreciation $ 180,000 $ 90,000
Accounts Payable 86,000 30,000
Mortgages Payable 200,000 70,000
Common Stock 300,000 50,000
Retained Earnings 385,000 140,000
Sales 650,000 470,000
Income from Subsidiary 24,200
$1,825,200 $1,825,200 $850,000 $850,000
Additional Information
1. On January 1, 20X7, Granite reported net assets with a book value of $150,000 and a fair value
of $191,250. The difference between fair value and book value of Granite’s net assets is related
entirely to Buildings and Equipment. Granite’s depreciable assets had an estimated economic
life of 11 years on the date of combination.
2. At December 31, 20X8, Mortar’s management reviewed the amount attributed to goodwill
and concluded goodwill was impaired and should be reduced to $14,000. Goodwill and
goodwill impairment were assigned proportionately to the controlling and noncontrolling
shareholders.
3. Mortar used the equity method in accounting for its investment in Granite.
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252 Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value
4. Detailed analysis of receivables and payables showed that Mortar owed Granite $9,000 on
December 31, 20X8.
5. Assume the goodwill impairment from the previous year was recorded as an adjustment in Mortar’s equity method accounts along with the amortization of other differential
components.
Required
a. Give all journal entries recorded by Mortar with regard to its investment in Granite during
20X8.
b. Give all eliminating entries needed to prepare a full set of consolidated financial statements for
20X8.
c. Prepare a three-part consolidation worksheet as of December 31, 20X8.
LO5 P5-40 Subsidiary with Other Comprehensive Income in Year of Acquisition
Amber Corporation acquired 60 percent ownership of Sparta Company on January 1, 20X8, at
underlying book value. At that date, the fair value of the noncontrolling interest was equal to
40 percent of the book value of Sparta Company. Trial balance data at December 31, 20X8, for
Amber and Sparta are as follows:
Amber Corporation Sparta Company
Item Debit Credit Debit Credit
Cash $ 27,000 $ 8,000
Accounts Receivable 65,000 22,000
Inventory 40,000 30,000
Buildings and Equipment 500,000 235,000
Investment in Row Company Securities 40,000
Investment in Sparta Company 108,000
Cost of Goods Sold 150,000 110,000
Depreciation Expense 30,000 10,000
Interest Expense 8,000 3,000
Dividends Declared 24,000 15,000
Accumulated Depreciation $140,000 $ 85,000
Accounts Payable 63,000 20,000
Bonds Payable 100,000 50,000
Common Stock 200,000 100,000
Retained Earnings 208,000 60,000
Other Comprehensive Income from
Subsidiary (OCI)—Unrealized Gain
on Investments 6,000
Unrealized Gain on Investments (OCI) 10,000
Sales 220,000 148,000
Income from Subsidiary 15,000
$952,000 $952,000 $473,000 $473,000
Additional Information
Sparta purchased stock of Row Company on January 1, 20X8, for $30,000 and classified the
investment as available-for-sale securities. The value of Row’s securities increased to $40,000 at
December 31, 20X8.
Required
a. Give all eliminating entries needed to prepare a three-part consolidation worksheet as of
December 31, 20X8.
b. Prepare a three-part consolidation worksheet for 20X8 in good form.
c. Prepare a consolidated balance sheet, income statement, and statement of comprehensive
income for 20X8.
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Chapter 5 Consolidation of Less-than-Wholly-Owned Subsidiaries Acquired at More than Book Value 253
LO5 P5-41 Subsidiary with Other Comprehensive Income in Year Following Acquisition
Amber Corporation acquired 60 percent ownership of Sparta Company on January 1, 20X8, at
underlying book value. At that date, the fair value of the noncontrolling interest was equal to
40 percent of the book value of Sparta Company. Trial balance data at December 31, 20X9, for
Amber and Sparta are as follows:
Amber Corporation Sparta Company
Item Debit Credit Debit Credit
Cash $ 18,000 $ 11,000
Accounts Receivable 45,000 21,000
Inventory 40,000 30,000
Buildings and Equipment 585,000 257,000
Investment in Row Company Securities 44,000
Investment in Sparta Company 116,400
Cost of Goods Sold 170,000 97,000
Depreciation Expense 30,000 10,000
Interest Expense 8,000 3,000
Dividends Declared 40,000 20,000
Accumulated Depreciation $ 170,000 $ 95,000
Accounts Payable 75,000 24,000
Bonds Payable 100,000 50,000
Common Stock 200,000 100,000
Retained Earnings 231,000 70,000
Accumulated Other Comprehensive Income 6,000 10,000
Other Comprehensive Income from
Subsidiary (OCI)—Unrealized Gain on
Investments 2,400
Unrealized Gain on Investments (OCI) 4,000
Sales 250,000 140,000
Income from Subsidiary 18,000
$1,052,400 $1,052,400 $493,000 $493,000
Additional Information
Sparta purchased stock of Row Company on January 1, 20X8, for $30,000 and classified the
investment as available-for-sale securities. The value of Row’s securities increased to $40,000 and
$44,000, respectively, at December 31, 20X8, and 20X9.
Required
a. Give all eliminating entries needed to prepare a three-part consolidation worksheet as of
December 31, 20X9.
b. Prepare a three-part consolidation worksheet for 20X9 in good form.
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254
Intercompany Inventory
Transactions
INVENTORY TRANSFERS AT TOYS R US
Most people know the catchy jingle, “I don’t want to grow up; I’m a Toys R Us kid.”
Toys R Us was originally a simple baby furniture warehouse started by Charles Lazarus
in 1948. However, after a few years and numerous requests from customers, he expanded
his business into toys. Quickly, toys became his staple product and he adopted the name
“Toys R Us,” along with the supermarket model in 1957.
The business continued to expand and in 1978 Toys R Us went public. During the
1980s, in an effort to further expand its business, Toys R Us branched out into the
clothing market with Kids R Us stores (these stores were discontinued in 2003). It
also opened two international stores in Singapore and Canada. The 1990s saw further
expansion with the creation of the Babies R Us brand which has since grown to more
than 260 locations.
In its next effort to expand, Toys R Us Inc. launched a subsidiary, Toysrus.com, in
1999 to capture a portion of the growing online toy retail market. As a subsidiary of
Toys R Us Inc., Toysrus.com acts independently of the parent company. However, the
dotcom does not manufacture inventory or purchase it from outside sources; it receives
its entire inventory from Toys R Us Inc.
Because Toysrus.com is a wholly owned subsidiary of Toys R Us Inc., transactions
between the two companies are not considered “arm’s length.” They are related-party
transactions and must be eliminated. Thus, the profit from intercompany inventory transfers is eliminated in preparing consolidated financial statements. This elimination is
required because Toys R Us Inc. and Toysrus.com, in essence, are the same company
and a company cannot make a profit by selling inventory to itself. This elimination process becomes quite complicated and the procedures are slightly different for partially
owned companies when the transactions are “upstream” (from subsidiary to parent). This
chapter examines intercompany inventory transactions and the consolidation procedures
associated with them.
LEARNING OBJECTIVES
When you finish studying this chapter, you should be able to:
LO1 Understand and explain intercompany transfers and why they must be
eliminated.
LO2 Understand and explain concepts associated with inventory transfers and transfer
pricing.
LO3 Prepare equity-method journal entries and elimination entries for the consolidation of a subsidiary following downstream inventory transfers.
LO4 Prepare equity-method journal entries and elimination entries for the consolidation of a subsidiary following upstream inventory transfers.
LO5 Understand and explain additional considerations associated with consolidation.
Chapter Six
Business
Combinations
Consolidation Concepts
and Procedures
Intercompany Transfers
Multinational
Entities
Multi-Corporate
Entities
Partnerships
Governmental
Entities
100%
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Chapter 6 Intercompany Inventory Transactions 255
OVERVIEW OF THE CONSOLIDATED ENTITY AND
INTERCOMPANY TRANSACTIONS
The consolidated entity is an aggregation of a number of different companies. The financial statements prepared by the individual affiliates are consolidated into a single set of
financial statements representing the financial position and operating results of the entire
economic entity as if it were a single company.
A parent company and its subsidiaries often engage in a variety of transactions
among themselves. For example, manufacturing companies often have subsidiaries that
develop raw materials or produce components to be included in the products of affiliated companies. Some companies sell consulting or other services to affiliated companies. A number of major retailers, such as J. C. Penney Company, transfer receivables
to their credit subsidiaries in return for operating cash. United States Steel Corporation
and its subsidiaries engage in numerous transactions with one another, including sales
of raw materials, fabricated products, and transportation services. Such transactions
often are critical to the operations of the overall consolidated entity. These transactions between related companies are referred to as intercompany or intercorporate
transfers.
Figure 6–1 illustrates a consolidated entity with each of the affiliated companies
engaging in both intercompany transfers and transactions with external parties. From a
consolidated viewpoint, only transactions with parties outside the economic entity are
included in the income statement. Thus, the arrows crossing the perimeter of the consolidated entity in Figure 6–1 represent transactions that are included in the operating results
of the consolidated entity for the period. Transfers between the affiliated companies,
shown in Figure 6–1 as those arrows not crossing the boundary of the consolidated entity,
are equivalent to transfers between operating divisions of a single company and are not
reported in the consolidated statements.
LO1
Understand and explain
intercompany transfers
and why they must be
eliminated.
Parent Company
Subsidiary
A
Subsidiary
B
Consolidated Entity
FIGURE 6–1
Transactions of
Affiliated Companies
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256 Chapter 6 Intercompany Inventory Transactions
The central idea of consolidated financial statements is that they report on the activities of the consolidating affiliates as if the separate affiliates actually constitute a single
company. Because single companies are not permitted to reflect internal transactions
in their financial statements, consolidated entities also must exclude from their financial statements the effects of transactions that are totally within the consolidated entity.
Building on the basic consolidation procedures presented in earlier chapters, this chapter
and the next two deal with the effects of intercompany transfers. This chapter deals with
intercompany inventory sales, and Chapter 7 discusses intercompany services and fixed
asset sales.
Elimination of Intercompany Transfers
All aspects of intercompany transfers must be eliminated in preparing consolidated financial statements so that the statements appear as if they were those of a single company.
Accounting Research Bulletin No. 51, “Consolidated Financial Statements” (ARB 51,
ASC 810), mentions open account balances, security holdings, sales and purchases, and
interest and dividends as examples of the intercompany balances and transactions that
must be eliminated. 1
No distinction is made between wholly owned and less-than-wholly-owned subsidiaries with regard to the elimination of intercompany transfers. The focus in consolidation is
on the single-entity concept rather than on the percentage of ownership. Once the conditions for consolidation are met, a company becomes part of a single economic entity, and
all transactions with related companies become internal transfers that must be eliminated
fully, regardless of the level of ownership held.
Elimination of Unrealized Profits and Losses
Companies usually record transactions with affiliates on the same basis as transactions
with nonaffiliates, including recognition of profits and losses. Profit or loss from selling
an item to a related party normally is considered realized at the time of the sale from the
selling company’s perspective, but the profit is not considered realized for consolidation purposes until confirmed, usually through resale to an unrelated party. This unconfirmed profit from an intercompany transfer is referred to as unrealized intercompany
profit.
INVENTORY TRANSACTIONS
Inventory transactions are the most common form of intercompany exchange. Conceptually, the elimination of inventory transfers between related companies is no different than
for other types of intercompany transactions. All revenue and expense items recorded by
the participants must be eliminated fully in preparing the consolidated income statement,
and all profits and losses recorded on the transfers are deferred until the items are sold to
a nonaffiliate.
The recordkeeping process for intercompany transfers of inventory may be more complex than for other forms of transfers. Companies often have many different types of
inventory items, and some may be transferred from affiliate to affiliate. Also, the problems of keeping tabs on which items have been resold and which items are still on hand
are greater in the case of inventory transactions because part of a shipment may be sold
immediately by the purchasing company and other units may remain on hand for several
accounting periods.
The worksheet eliminating entries used in preparing consolidated financial statements
must eliminate fully the effects of all transactions between related companies. When
there have been intercompany inventory transactions, eliminating entries are needed to
remove the revenue and expenses related to the intercompany transfers recorded by the
individual companies. The eliminations ensure that only the cost of the inventory to the
LO2
Understand and explain
concepts associated with
inventory transfers and
transfer pricing.
1
Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” August 1959, para. 6. (ASC 810)
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Chapter 6 Intercompany Inventory Transactions 257
consolidated entity is included in the consolidated balance sheet when the inventory is
still on hand and is charged to cost of goods sold in the period the inventory is resold to
nonaffiliates.
Transfers at Cost
Merchandise sometimes is sold to related companies at the seller’s cost or carrying
value. When an intercorporate sale includes no profit or loss, the balance sheet inventory amounts at the end of the period require no adjustment for consolidation because the
purchasing affiliate’s inventory carrying amount is the same as the cost to the transferring
affiliate and the consolidated entity. At the time the inventory is resold to a nonaffiliate,
the amount recognized as cost of goods sold by the affiliate making the outside sale is the
cost to the consolidated entity.
Even when the intercorporate sale includes no profit or loss, however, an eliminating
entry is needed to remove both the revenue from the intercorporate sale and the related
cost of goods sold recorded by the seller. This avoids overstating these two accounts.
Consolidated net income is not affected by the eliminating entry when the transfer is
made at cost because both revenue and cost of goods sold are reduced by the same
amount.
Transfers at a Profit or Loss
Companies use many different approaches in setting intercorporate transfer prices. In
some companies, the sale price to an affiliate is the same as the price to any other customer. Some companies routinely mark up inventory transferred to affiliates by a certain
percentage of cost. Other companies have elaborate transfer pricing policies designed to
encourage internal sales. Regardless of the method used in setting intercorporate transfer
prices, the elimination process must remove the effects of such sales from the consolidated statements. Profit or loss from selling an item to a related party normally is considered realized at the time of the sale from the selling company’s perspective, but the profit
is not considered realized for consolidation purposes until confirmed, usually through
resale to an unrelated party. This unconfirmed profit from an intercompany transfer is
referred to as unrealized intercompany profit.
When intercompany sales include unrealized profits or losses, the worksheet eliminations needed for consolidation in the period of transfer must adjust accounts in both the
consolidated income statement and balance sheet:
Income statement: Sales and cost of goods sold. The sales revenue from the
intercompany sale and the related cost of goods sold recorded by the transferring
affiliate must be removed.
Balance sheet: Inventory. The profit or loss on the intercompany sale must be
removed so the inventory is reported at the cost to the consolidated entity.
The resulting financial statements appear as if the intercompany transfer had not occurred.
Effect of Type of Inventory System
Most companies use either a perpetual or a periodic inventory control system to keep
track of inventory and cost of goods sold. Under a perpetual inventory system, a purchase
of merchandise is debited directly to the Inventory account; a sale requires a debit to Cost
of Goods Sold and a credit to Inventory for the cost of the item. When a periodic system
is used, a purchase of merchandise is debited to a Purchases account rather than to Inventory, and no entry is made to recognize cost of goods sold until the end of the accounting
period.
The choice between periodic and perpetual inventory systems results in different
entries on the books of the individual companies and, therefore, slightly different worksheet eliminating entries in preparing consolidated financial statements. Because most
companies use perpetual inventory systems, the discussion in the chapter focuses on the
consolidation procedures used in connection with perpetual inventories.
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258 Chapter 6 Intercompany Inventory Transactions
DOWNSTREAM SALE OF INVENTORY2
For consolidation purposes, profits recorded on an intercorporate inventory sale are recognized in the period in which the inventory is resold to an unrelated party. Until the
point of resale, all intercorporate profits must be deferred. When a sale is from a parent
to a subsidiary, referred to as a downstream sale, any gain or loss on the transfer accrues
to the parent company’s stockholders. When the sale is from a subsidiary to its parent, an
upstream sale, any gain or loss accrues to the subsidiary’s stockholders. If the subsidiary
is wholly owned, all gain or loss ultimately accrues to the parent company as the sole
stockholder. If, however, the selling subsidiary is not wholly owned, the profit or loss
on the upstream sale is apportioned between the parent company and the noncontrolling
shareholders. Consolidated net income must be based on the realized income of the transferring affiliate. Because intercompany profits from downstream sales are on the parent’s
books, consolidated net income and the overall claim of parent company shareholders
must be reduced by the full amount of the unrealized profits.
When a company sells an inventory item to an affiliate, one of three situations results:
(1) the item is resold to a nonaffiliate during the same period, (2) the item is resold to a nonaffiliate during the next period, or (3) the item is held for two or more periods by the purchasing
affiliate. We use the continuing example of Peerless Products Corporation and Special Foods
Inc. to illustrate the consolidation process under each of the alternatives. Picking up with the
example in Chapter 3, to illustrate more fully the treatment of unrealized intercompany profits,
assume the following with respect to the Peerless and Special Foods example used previously:
1. Peerless Products Corporation purchases 80 percent of Special Foods Inc.’s stock on
December 31, 20X0, at the stock’s book value of $240,000. The fair value of Special
Foods’ noncontrolling interest on that date is $60,000, the book value of those shares.
2. During 20X1, Peerless reports separate income of $140,000 income from regular
operations and declares dividends of $60,000. Special Foods reports net income of
$50,000 and declares dividends of $30,000.
3. Peerless accounts for its investment in Special Foods using the equity method, under
which it records its share of Special Foods’ net income and dividends and also adjusts
for unrealized intercompany profits using the fully adjusted equity method.
As an illustration of the effects of a downstream inventory sale, assume that on March
1, 20X1, Peerless buys inventory for $7,000 and resells it to Special Foods for $10,000
on April 1. Peerless records the following entries on its books:
April 1, 20X1
(2) Cash 10,000
Sales 10,000
Record sale of inventory to Special Foods.
(3) Cost of Goods Sold 7,000
Inventory 7,000
Record cost of inventory sold to Special Foods.
March 1, 20X1
(1) Inventory 7,000
Cash 7,000
Record inventory purchase.
Special Foods records the purchase of the inventory from Peerless with the following entry:
April 1, 20X1
(4) Inventory 10,000
Cash 10,000
Record purchase of inventory from Peerless.
LO3
Prepare equity-method
journal entries and elimination entries for the consolidation of a subsidiary
following downstream
inventory transfers.
2 To view a video explanation of this topic, visit advancedstudyguide.com.
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Chapter 6 Intercompany Inventory Transactions 259
Resale in Period of Intercorporate Transfer
To illustrate consolidation when inventory is sold to an affiliate and then resold to a
nonaffiliate during the same period, assume that on November 5, 20X1, Special Foods
sells the inventory purchased from Peerless to Nonaffiliated Corporation for $15,000, as
follows:
Peerless
Products
Special
Foods November 5, 20X1
Sell inventory
for $15,000
Intercorporate
transfer of inventory
$10,000
Purchase inventory
for $7,000
March 1, 20X1 April 1, 20X1
Consolidated Entity
Special Foods records the sale to Nonaffiliated with the following entries:
November 5, 20X1
(5) Cash 15,000
Sales 15,000
Record sale of inventory to Nonaffiliated.
(6) Cost of Goods Sold 10,000
Inventory 10,000
Record cost of inventory sold to Nonaffiliated.
A review of all entries recorded by the individual companies indicates that incorrect balances will be reported in the consolidated income statement if the effects of the intercorporate sale are not removed:
Item
Peerless
Products
Special
Foods
Unadjusted
Totals
Consolidated
Amounts
Sales $10,000 $ 15,000 $ 25,000 $15,000
Cost of Goods Sold (7,000) (10,000) (17,000) (7,000)
Gross Profit $ 3,000 $ 5,000 $ 8,000 $ 8,000
Although consolidated gross profit is correct even if no adjustments are made, the
totals for sales and cost of goods sold derived by simply adding the amounts on the books
of Peerless and Special Foods are overstated for the consolidated entity. The selling price
of the inventory to Nonaffiliated Corporation is $15,000, and the original cost to Peerless
Products is $7,000. Thus, gross profit of $8,000 is correct from a consolidated viewpoint,
but consolidated sales and cost of goods sold should be $15,000 and $7,000, respectively,
rather than $25,000 and $17,000. In the consolidation worksheet, the amount of the intercompany sale must be eliminated from both sales and cost of goods sold to correctly state
the consolidated totals:
Sales 10,000
Cost of Goods Sold 10,000
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260 Chapter 6 Intercompany Inventory Transactions
Note that this entry does not affect consolidated net income because sales and cost of
goods sold both are reduced by the same amount. No elimination of intercompany profit
is needed because all the intercompany profit has been realized through resale of the
inventory to the external party during the current period.
Resale in Period following Intercorporate Transfer
When inventory is sold to an affiliate at a profit but is not resold during the same period,
appropriate adjustments are needed to prepare consolidated financial statements in the
period of the intercompany sale and in each subsequent period until the inventory is sold
to a nonaffiliate. By way of illustration, assume that Peerless Products purchases inventory on March 1, 20X1 for $7,000 and sells the inventory during the year (on April 1) to
Special Foods for $10,000. Special Foods sells the inventory to Nonaffiliated Corporation for $15,000 on January 2, 20X2, as follows:
Peerless
Products
Special
Foods January 2, 20X2
Sell inventory
for $15,000
Intercorporate
transfer of inventory
$10,000
Purchase inventory
for $7,000
March 1, 20X1 April 1, 20X1
Consolidated Entity
During 20X1, Peerless records the purchase of the inventory and the sale to Special Foods
with journal entries (1) through (3), given previously; Special Foods records the purchase
of the inventory from Peerless with entry (4). In 20X2, Special Foods records the sale of
the inventory to Nonaffiliated with entries (5) and (6), given earlier.
Equity-Method Entries—20X1
Using the equity method, Peerless records its share of Special Foods’ income and dividends for 20X1:
(7) Investment in Special Foods 40,000
Income from Special Foods 40,000
Record Peerless’ 80% share of Special Foods’ 20X1 income.
(8) Cash 24,000
Investment in Special Foods 24,000
Record Peerless’ 80% share of Special Foods’ 20X1 dividend.
As a result of these entries, the ending balance of the investment account is currently
$256,000 ($240,000 + $40,000 − $24,000). However, since the downstream sale of
inventory to Special Foods results in $3,000 of unrealized profits, Peerless makes an
adjustment in the equity accounts to reduce the income from Special Foods on the income
statement and Investment in Special Foods on the balance sheet by its share of the unrealized gross profit. Since this is a downstream transaction, the sale (and associated unrealized gross profit) resides on Peerless’ income statement. Since we assume the NCI
shareholders do not own Peerless stock, they do not share in the deferral of the unrealized
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Chapter 6 Intercompany Inventory Transactions 261
profit. Under the fully adjusted equity method, Peerless defers the entire $3,000 using the
following equity method entry:
(9) Income from Special Foods 3,000
Investment in Special Foods 3,000
Defer unrealized gross profit on inventory sales to Special Foods not yet resold.
Note that this entry accomplishes two important objectives. First, since Peerless
income is overstated by $3,000, the adjustment to Income from Special Foods offsets
this overstatement so that Peerless bottom-line net income is now correct. Second,
Special Foods’ inventory is currently overstated by $3,000. Since the Investment in
Special Foods account summarizes Peerless’ investment in Special Foods’ balance
sheet, this reduction to the investment account offsets the fact that Special Foods’
inventory (and thus entire balance sheet) is overstated by $3,000. Thus, after making
this equity-method adjustment to defer the unrealized gross profit, Peerless’ financial statements are now correctly stated. Therefore, Peerless’ reported income will be
exactly equal to the controlling interest in net income on the consolidated financial
statements.
Consolidation Worksheet—20X1
We present the consolidation worksheet prepared at the end of 20X1 in Figure 6–2 .
The first two elimination entries are the same as we calculated in Chapter 3 with one
minor exception. While the analysis of the “book value” portion of the investment
account is the same, in preparing the basic elimination entry, we reduce the amounts
in the Income from Special Foods and Investment in Special Foods by the $3,000
deferral.
Book Value Calculations:
NCI 20%+Peerless 80% = Common Stock+Retained Earnings
Original book value 60,000 240,000 200,000 100,000
+ Net income 10,000 40,000 50,000
− Dividends (6,000) (24,000) (30,000)
Ending book value 64,000 256,000 200,000 120,000
Basic investment account elimination entry:
Common stock 200,000 Original amount invested (100%)
Retained earnings 100,000 Beginning balance in RE
Income from Special Foods 37,000 Peerless’ % of NI − Deferred GP
NCI in NI of Special Foods 10,000 NCI share of Special Foods’ NI
Dividends declared 30,000 100% of sub’s dividends declared
Investment in Special Foods 253,000 Net BV in investment − Deferred GP
NCI in NA of Special Foods 64,000 NCI share of net amount of BV
20% 80%
NCI
Peerless
Products
Special
Foods
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262 Chapter 6 Intercompany Inventory Transactions
Optional accumulated depreciation elimination entry:
Accumulated depreciation 300,000 Original depreciation at the time of
Building and equipment 300,000 the acquisition netted against cost
Moreover, although Peerless recorded an equity-method entry to defer the unrealized gross profit, both the Income from Special Foods and Investment in Special Foods
accounts are eliminated with the basic elimination entry. Peerless’ Sales and Cost of
Goods Sold amounts are still