Consolidated Financial Statements

1
Chapter 5

• Consolidated Financial Statements
• Subsequent to Acquisition Date
• Equity Method

2
Learning Objectives

• To explain how impairment tests are performed
• on long-lived assets and other intangibles
• on goodwill
• To describe the composition of yearly
  consolidated net income
• To prepare consolidated financial statements in
  years subsequent to acquisition date when the
  parent has used the equity method to account for
  its investment
• Balance sheet
• Income statement

3
IMPAIRMENT TESTS ON GOODWILL
4
Goodwill and Other Intangibles

• The purchase discrepancy (ie. the difference
  between the cost and underlying book value) must
  be allocated in order that the fair values at the
  date of the business combination are recognized
  in the accounts
• The purchase discrepancy relates mostly to
  goodwill and different FMV of assets (from book
  values)

5
Goodwill and Other Intangibles

• Since July 2001, goodwill, long-lived assets and
  other intangibles need to be reviewed and tested
  periodically for impairment
• (Prior to 2001, goodwill was amortized over max
  40 years.)

6
Recognition of Acquired Identifiable Intangible
Assets

• Rule for identifying Goodwill and other
  intangibles separately
• An intangible asset should be recognized apart
  from goodwill when
• The asset results from contractual or other legal
  rights (regardless of whether those rights are
  transferable or separable from the acquired
  enterprise or from other rights and obligations)
• The asset is capable of being separated or
  divided from the acquired enterprise and sold,
  transferred, licensed, rented, or exchanged
  (regardless of whether there is an intent to do
  so)
• Otherwise it is goodwill

7
Recognition of Acquired Identifiable Intangible
Assets

• Any intangible assets that cannot be isolated are
  included in the amount assigned to goodwill
• Intangible assets should be amortized over their
  useful lives unless their lives are considered to
  be indefinite
• Intangible assets that are subject to
  amortization are periodically reviewed for
  impairment in accordance with Handbook Section
  3063, Impairment of Long-Lived Assets

8
Tests for Impairment

• 3 Levels of tests for impairment
• Tests for Long-lived Assets (sec 3063)
• Tests for other intangibles (sec 3062)
• Tests for goodwill (sec 3062)

9
Testing Long-Lived Assets

• Applies to long-lived, non-monetary assets and
  intangible assets with finite useful lives
• Impairment testing means estimating of future net
  cash flows associated with the assets
• In many instances it is impossible to associate
  cash flows with a single asset so use asset
  groups
• the lowest level (smallest combination) of
  assets and liabilities for which identifiable
  cash flows are largely independent of the cash
  flows of other assets or groups of assets and
  liabilities.

10
Testing Long-Lived Assets

• The test has two stages as follows
• A test is performed to see whether the carrying
  amount of an asset (or asset group) is
  recoverable
• (ie. Sum of undiscounted future CF gt BV)
• If Yes , then no impairment exists
• If NO The second stage requires comparing the
  carrying value of the asset (or group) with its
  fair market value, and if the fair value is the
  lower amount an impairment loss is recognized for
  the difference

11
Testing Long-Lived Assets
Is sum of undiscounted future CF gt BV?
For each asset group
NO
YES
Is BV gt FMV of asset?
No impairment No further action
NO
YES
No impairment No further action
Record impairment loss
12
Testing Long-Lived Assets for Impairment, Section
3063

• Fair value is defined as the amount of
  consideration between knowledgeable, willing
  parties who are under no compulsion to act
  3063.03(b)
• Fair value can be determined by using quoted
  market prices, if available, or by making
  comparisons with the prices of other similar
  assets

13
Testing Long-Lived Assets for Impairment, Section
3063

• The asset group may contain current assets such
  as receivables and inventory, and also
  liabilities associated with it
• These current assets would be evaluated in
  accordance with other Handbook section before
  being included in the group

14
Testing other intangibles and Goodwill

• Tests apply to intangibles with indefinite lives
• Tests are done after tests on other assets
• Goodwill is tested yearly
• If FV lt BV then it is written down and a loss is
  reported in income
• How?
• By comparing the FMV of the company to its
  carrying value
• (ie. Recalculating goodwill amount each year)

15
Testing Goodwill
Is FMV of company gt BV?
NO
Redo Goodwill calculation
YES
Is FMV of company gt FMV of identifiable assets?
No impairment No further action
YES
NO
No impairment No further action
Record impairment loss
16
Testing Goodwill for Impairment, Section 3062

• The excess of cost over fair value is recorded as
  goodwill
• In order to be able to conduct future goodwill
  impairment testing, this goodwill is allocated to
  the reporting units of the subsidiary as of this
  date
• The process is as follows
• The total purchased price is allocated to each
  reporting unit
• For each reporting unit, the allocated purchase
  price is compared with the parents share of the
  fair value of the units net assets

17
Testing Goodwill for Impairment, Section 3062

• The fair value of the subsidiarys individual net
  assets is also allocated to each reporting unit
• This will become carrying value (amortized) when
  impairment tests are performed later
• The difference is the goodwill of the reporting
  unit
• The sum of each reporting units goodwill equals
  the total acquisition goodwill
• Each year thereafter this goodwill is tested for
  impairment

18
Goodwill Impairment Tests

• The goodwill impairment test is a two stage
  process
• First, the fair value of a reporting unit should
  be compared with its carrying amount, including
  goodwill, in order to identify a potential
  impairment. When the fair value of a reporting
  unit exceeds its carrying amount, goodwill of the
  reporting unit is considered not to be impaired
  and the second step of the impairment test is
  unnecessary

19
Goodwill Impairment Tests

• Second, when the carrying amount of a reporting
  unit exceeds its fair value, the fair value of
  the reporting unit's goodwill should be compared
  with its carrying amount to measure the amount of
  the impairment loss, if any
• The fair value of goodwill is determined in
  accordance with the guidance in paragraph 3062.32
  
• When the carrying amount of reporting unit
  goodwill exceeds the fair value of the goodwill,
  an impairment loss should be recognized in an
  amount equal to the excess

20
ACCOUNTING FOR INVESTMENTS IN SUBSIDIARY
21
Method of Accounting for an Investment in a
Subsidiary

• At the date of acquisition, the financial
  statements (especially the balance sheet) may be
  prepared as a snapshot at a point in time
• After acquisition, the consolidated financial
  statements must include the accounts of both the
  parent and the subsidiary, reported as one
  economic entity

22
Method of Accounting for an Investment in a
Subsidiary

• Two methods
• Cost method
• Equity method
• Parent chooses the method it prefers
• Consolidated statements are identical
• Approach to statement preparation differs

23
Method of Accounting for an Investment in a
Subsidiary

• The investment account may be maintained by the
  cost method, or the equity method
• The choice of method to employ is entirely at the
  discretion of the company involved, as this is a
  matter of internal accounting policy, not
  external reporting - there are no strong
  conceptual arguments in favour of either approach
  
• Virtually all external reporting will include
  consolidated financial statements, so we are
  concerned with background for consolidation -
  preparation of these statements

24
Method of Accounting for an Investment in a
Subsidiary

• When a company buys the shares of another
  company, the cost of these shares is recorded in
  an investment account
• When the intercorporate investment is a
  subsidiary, the external financial reporting will
  nearly always be through the presentation of
  consolidated financial statements
• However, the parent company must continue to
  maintain the investment account for the
  subsidiary, as the actual companies generally
  remain as separate legal entities

25
Method of Accounting for an Investment in a
Subsidiary

• Parents journal entries
• Cost method
• Parent makes one entry each year to record
  dividends received from sub
• Cash xxx
• Dividend revenue xxx
• Easier method

26
Method of Accounting for an Investment in a
Subsidiary

• Parents journal entries
• Equity method
• Parent makes 3 entries
• to record its share of net income
• Investment in sub xx
• Investment income xx
• Parent makes an entry to record dividends
  received from sub
• Cash xxx
• Investment in sub xxx

27
Method of Accounting for an Investment in a
Subsidiary

• 3. Amortize purchase discrepancy by reducing
  investment income
• Investment income xxx
• Investment in S xxx

28
Main Consolidation process

• Parent makes certain entries in its books bec it
  is a separate legal entity
• Parents entries related to the sub must be
  eliminated
• Reduce investment revenue by amortization and
  write-offs associated with the purchase
  discrepancy
• Eliminate any intercompany profits (because
  profits are not realized until items are sold to
  outsiders)

29
Method of Accounting for an Investment in a
Subsidiary

• The Handbook describes the cost method as
• A basis of accounting for long-term investment
  whereby the investment is initially recorded at
  cost earnings from such investments are
  recognized only to the extent received or
  receivable
• When the investment is in the form of shares,
  dividends received in excess of the investors
  pro rata share of post acquisition income are
  recorded as a reduction of the amount of the
  investment

30
Method of Accounting for an Investment in a
Subsidiary

• The equity method is described as
• A basis of accounting for long-term investments
  whereby the investment is initially recorded at
  cost and the carrying value adjusted thereafter
  to include the investors pro-rata share of post
  acquisition retained earnings of the investee,
  computed by the consolidation method

31
Method of Accounting for an Investment in a
Subsidiary

• The amount of the adjustment is included in the
  determination of net income by the investor and
  the investment account is also increased or
  decreased to reflect the investors share of
  capital transactions and changes in accounting
  policies and corrections of errors relating to
  prior period financial statements applicable to
  post acquisition period
• Profit distributions received or receivable from
  an investee reduce the carrying amount of the
  investment

32
Method of Accounting for an Investment in a
Subsidiary

• This chapter is concerned with the EQUITY METHOD

33
Consolidation from the Equity Method

• Investment in Subsidiary

Original Cost
34
Consolidation from the Equity Method

• Investment in Subsidiary

Original Cost Income earned
35
Consolidation from the Equity Method

• Investment in Subsidiary

Original Cost Income earned
Dividends received
36
Consolidation from the Equity Method

• Investment in Subsidiary

Original Cost Income earned
Dividends received P.D. Amortization
37
Consolidation from the Equity Method

• Investment in Subsidiary

Original Cost Income earned
Dividends received P.D. Amortization Other
adjustments
Balance
In later chapters
38
Consolidated income and retained earnings

• Consolidated income consists of
• Net income of the parent from its own operations
• Excludes dividends and other income from
  subsidiary
• Plus Parents share of net income from
  subsidiary
• Less Amortization of the purchase discrepancy
• This approach can always be used to compute the
  value of consolidated net income, whether or not
  an income statement is to be prepared

39
Consolidations Direct Approach

• Worksheet method is easier and less prone to
  errors direct approach method is faster
• When the investment account for the subsidiary is
  maintained under the equity method
• Parents net income equals consolidated net
  income
• Parents retained earnings equals consolidated
  retained earnings

40
Consolidations Direct Approach

• KEY POINTS
• For the Consolidated Income Statement
• The account investment income (under the equity
  method) is replaced by the reported revenues and
  expenses of the subsidiary, adjusted for the
  amortization of the purchase discrepancy (and
  intercompany transactions, if any)
• These adjustments are on working papers only
• For Consolidated Retained Earnings
• No adjustments are necessary

41
Consolidations Direct Approach

• For the Consolidated Balance Sheet
• The investment account is replaced by the
  individual assets and liabilities of the
  subsidiary in the consolidated balance sheet,
  restated by the unamortized purchase discrepancy
  (and intercompany balances, if any)
• These adjustments are on working papers only, and
  are not posted to the general ledger
• Consolidated retained earnings does not have to
  be restated, as this amount equals the retained
  earnings of the parent company (determined using
  the equity method)

42
Consolidations Direct Approach

• The direct approach to the preparation of
  statements relies on supporting calculations
• The calculation and allocation of the purchase
  discrepancy
• An amortization schedule for the purchase
  discrepancy
• Annual amortization amounts for the income
  statement
• Unamortized amounts for the balance sheet
• Careful determination of any intercompany
  revenues and expenses, and receivables and
  payables (if applicable)

43
Worksheet Approach

• 100 owned sub
• lt 100 owned sub

44
100 owned sub

• Example P purchases 100 of S on Jan 1, 2001 for
  19M. Ss common stock is 10M and Retained
  Earnings is 6M. Inventory of S has a FMV that is
  2000 greater than BV. All other assets and
  liabilities have FMV equal to their BV.

A
45
100 owned sub

• Balance sheet at date of acquisition
• Exhibit 5.1

46
100 owned sub

• Balance sheet and income statement at the end of
  year 1
• Additional information
• S reports a net income of 7300 and pays
  dividends of 2500
• The inventory purchased with the company was sold
  during the year
• An impairment test on Goodwill on Dec 31 showed a
  50 loss
• The parent uses the equity method of accounting

47
100 owned sub

• Lets look at the journal entries the parent
  would make in its books
• Investment in S 7300
• Investment income 7300
• (to record share of net income of sub)
• Cash 2500
• Investment in S 2500
• (to record dividends)
• Investment Income 2050
• Investment in S 2050
• (to amortize purchase discrepancy)

B
48
100 owned sub

• Worksheet exhibit 5.4
• (notes on board)

49
100 owned sub

• Balance sheet and income statement at the end of
  Year 2
• Additional information on the example
• In year 2, S reports earnings of 10M and pays a
  dividend of 3M.
• An impairment test on goodwill shows it has a
  fair value of 870 therefore there is a 80 loss.

50
100 owned sub

• Lets look at the journal entries the parent
  would make in its books for year 2
• Investment in S 10,000
• Investment income 10,000
• (to record share of net income of sub)
• Cash 3000
• Investment in S 3000
• (to record dividends)
• Investment Income 80
• Investment in S 80
• (to amortize purchase discrepancy)

C
51
100 owned sub

• Worksheet exhibit 5.7
• (notes on board)

52
80 subsidiary

• P purchases 80 of S on Jan 1, 2001 for 15,200.
  Ss common stock is 10M and Retained Earnings is
  6M. Inventory of S has a FMV that is 2000
  greater than BV. All other assets and liabilities
  have FMV equal to their BV.

D
53
80 owned sub

• Balance sheet at date of acquisition
• Exhibit 5.8, page 181

54
80 owned sub

• Balance sheet and income statement at the end of
  year 1
• Additional information
• S reports a net income of 7300 and pays
  dividends of 2500
• The inventory purchased with the company was sold
  during the year
• An impairment test on Goodwill on Dec 31 showed a
  40 loss
• The parent uses the equity method of accounting

55
80 owned sub

• Lets look at the journal entries the parent
  would make in its books
• Investment in S 5840
• Investment income 5840
• (to record share of net income of sub 80 x
  7300)
• Cash 2000
• Investment in S 2000
• (to record dividends 80 x 2500)
• Investment Income 1640
• Investment in S 1640
• (to amortize purchase discrepancy inventory and
  goodwill)

56
80 owned sub

• Income statement
• All revenues and expenses of sub are combined
  with parent and a new expense noncontrolling
  interest is identified to define the portion of
  income which belongs to other shareholders
• Balance sheet
• Assets and liabilities are combined
• Noncontrolling interest defines the portion of
  assets that belong to other shareholders

E,F
57
80 owned sub

• Worksheet notes on board
• Exhibit 5.11

58
80 owned sub

• Balance sheet and income statement at the end of
  Year 2
• Additional information on the example
• In year 2, S reports earnings of 10M and pays a
  dividend of 3M.
• An impairment test on goodwill shows it has a
  fair value of 696 therefore there is a 64 loss.

59
80 owned sub

• Lets look at the journal entries the parent
  would make in its books for year 2
• Investment in S 8,000
• Investment income 8,000
• (to record share of net income of sub 80 x
  10,000)
• Cash 2400
• Investment in S 2400
• (to record dividends 80 x 3000)
• Investment Income 64
• Investment in S 64
• (to amortize purchase discrepancy)

G
60
80 owned sub

• Worksheet exhibit 5.14
• (notes on board)

61
Intercompany receivables and payables

• Related companies often have extensive
  transactions within the group
• Some companies have the vast majority of their
  purchases or sales (or both) to a related company
• Vertical integration is one of the principal
  reasons intercorporate investments are made
• All intercompany sales must be eliminated in
  consolidation, against the related purchase
• All intercompany balances (including receivables
  and payables) are eliminated
• This is discussed in the next several chapters

62
When control ceases?

• When control ceases, the investment will no
  longer be consolidated as a subsidiary
• The parent must determine how to account for
  the remaining investment, if any
• If a portfolio investment, using the cost method
• If significant influence exist, using the equity
  method
• As there is a change in circumstances, the new
  method does not lead to retroactive restatement