1. Chapter Two Consolidation of Financial Information McGraw-Hill/Irwin Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Business Combinations

Separate organizations may be tied together throughcommon control

The company which exerts control is known as the parent.

The separate controlled companies are known as subsidiaries.

Financial statements which represent a parent and its subsidiaries are known as consolidated financial statements prepared as though the companies were aSINGLE ENTITY .

2- 3. Why do Organizations Combine?

Vertical integration

Cost savings

Quick access to new markets

Economies of scale

More attractive financing opportunities

Diversification of business risk

2- 4. Scale of Recent Combinations 2- ACQUIRER TARGET COST (in $ billions) Pfizer Wyeth $67.3 InBev Anheuser-Busch 52.0 Bank of America Merrill Lynch 29.1 Verizon Wireless Alltel 28.1 Mars Candy Wm. Wrigley, Jr 23.2 Delta Airlines Northwest Airlines 3.4 5. The Consolidation Process

Why Consolidated Statements?

• They providemore meaningful informationthan separate statements.

• Theymore fairly presentthe activities of the consolidated companies.

There is a presumption that consolidated statements are more meaningful.. and that they are usually necessary for a fair presentation when one of the companies in the group has a controlling financial interests.. - - FASB ASC (810-10-10-1) 2- 6. Business Combinations Abusiness combinationrefers to a transaction or other event in which an acquirer obtainscontrol over one or more businesses.There arefive typesof combinations that are required to prepare consolidated statements. 2- 7. Statutory Merger (ThroughAsset Acquisition)

Investoracquires assets(and often liabilities) of the Investee

Investeedissolvesand goes out of business

Investees books arepermanently closedand the Investors books areadjustedat the acquisition date for the newly acquired accounts

One entitysurvives and moves forward

2- 8. Statutory Merger (ThroughCapital Stock Acquisition)

Investoracquiresallstock of the Investee, andthen transfers assets and liabilities of the Investee to its own books.

Investeedissolvesas a separate company but often remains as a division of the Investor.

One entitysurvives and moves forward

2- 9. Statutory Consolidation

Anewly createdcompany receives all assets or stock of theoriginal companies.

Original companiesdissolve , but often remain as divisions of the new company.

2- 10. Acquisition of Majority of Shares

Investor acquires themajorityof voting stock of another company, and is able tocontrol itsdecisions.

Investor records theinvestmentin the stock of the Investee.

Investee remains in existence as a separate company, but as asubsidiaryof the Investor, orparentcompany.

2- 11. Control Through Ownership ofVariable Interests

Sponsoring Firm creates aSpecial Purpose Entity(SPE) intended to engage in a specific activity

Investor may bedifferent thanthe Sponsoring Firm

SPE is aseparate legal entitywhose risks and rewards may flow to Sponsoring Firm instead of to the equity investors.

Control is established by

agreement , not ownership.

2- 12. A Control Issue SPEs

Special Purpose Entities (a popular type of variable interest entity) were misused to hide debt and manipulate earnings.

As a result, the FASB expanded the definition of control to include these entities.

The following indicate a controlling financial interest in a variable interest entity:

• Ability to make decisions about the entitys activities

• Obligation to cover any expected losses of the entity

• The right to receive any expected residuals of the entity

2- 13. Consolidation of Financial Information 2- Parent Subsidiary The Sub still prepares separate financial statements Consolidated financial statements are prepared. The parent does not prepare separate financial statements 14. What is to be consolidated?

If dissolution occurs :

• All account balances areactuallyconsolidatedin the financial recordsof the survivor.

If separate incorporation maintained :

• Financial statement information is consolidated onwork papersand not in the actual records

2- 15. When does consolidation occur?

If dissolution occurs:

• Permanentconsolidation occurs at the combination date.

If separate incorporation maintained:

• Consolidation (on work papers,notin the actual records!!) occurs regularly,whenever financial statements are prepared.

2- 16. How does consolidation affect the accounting records?

If dissolution occurs:

• Dissolved companys records areclosed out .

• Surviving companys accounts are adjusted toincludeall balances of the dissolved company.

If separate incorporation maintained:

• Each company continues to maintain itsown records .

2- 17. Reminder: GAAP Accounting Methods 2- 18. The Acquisition Method EFFECTIVE IN 2009

Used when there is a change in ownership, resulting incontrolof one enterprise by another

Requires accounting for the fair value of the acquired businessas a wholeby recognizing and measuring:

• Considerationtransferred

• The fair value ofeach asset acquired andliability assumed

Effectively converged withInternational Standards

2- 19. Acquisition Method (Continued)

What must be determined atthe date of acquisition?

The Fair Value of assets and liabilities acquired, including the value of purchasedIn-Process Research and Development(and ignoring equity accounts)

The value ofconsiderationtransferred

The fair value of anycontingent considerationgiven, based on risk and probability of payment

2- 20. Acquisition Method Fair Value

Valuation of assets and liabilities is established using

TheMarketApproach what is thevalue in similar exchanges?

TheIncomeApproach what is the value of the discounted future cash flows of the asset?

TheCostApproach what wouldthe cost be to replace the assetor liability with one of similarutility (wear and age)

2- 21. Acquisition Method - In-Process Research and Development Costs

Recognized and measured atfair valueon the acquisition date

Reported as anintangible assetwith an indefinite life

Subject to periodic impairment reviews

2- 22. Acquisition Method (Continued)

But what if theconsiderationtransferred doesNOT EQUALtheFair Valueof the Assets acquired??

If the Consideration isLESSthan the Fair Value of the Assets acquired, we got aBARGAIN !!And we will record aGAINon the acquisition!! If the Consideration isMOREthan the Fair Value of the Assets acquired, the difference is attributed toGOODWILL 2- 23. Acquisition Method Example Purchase Price = Fair Value

Lets look at an example where the Purchase Price = the Fair Value of the Net Assets acquired.

Well use the financial information found in Exhibit 2.3 of the text 2- 24. Acquisition Method ExamplePurchase Price = Fair Value BigNetpays $2,550,000( $550,000cash and20,000unissued shares of its $10 par value common stock that is currently selling for$100per share) for all of Smallports assets and liabilities.Smallport thendissolvesas a legal entity. As is typical, the $2,550,000 fair value of the consideration transferred by BigNet represents the fair value of the acquired Smallport business. 2- 25. Acquisition Method - Example Purchase Price = Fair Value 2- BigNet Companys Financial RecordsDecember 31 Current Assets . . . . . . . . . . . . . . . . . . . . . . . 300,000 Computers and Equipment . . . . . . . . . . . . .600,000 Capitalized Software . . . . . . . . . . . . . . . . .1,200,000 Customer Contracts . . . . . . . . . . . . . . . . . . . 700,000 Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000 Cash (paid by BigNet) . . . . . . . . . . . . . . . . . . . . . . . . . .550,000 Common Stock (20,000 shares issued at $10 par value)200,000 Additional Paid-In Capital . . . . . . . . . . . . . . . . . . . . . . 1,800,000 To record acquisition of Smallport Company. Assets acquired and liabilities assumed are recorded at fair value. 26. Acquisition Method Example Purchase Price > Fair Value Use the same data as in the first example, but increase the amount that BigNetincreasedthe amount ofcashthey paid to$1,000,000 .Why would BigNet paymorethan the FV ofSmallPorts Net Assets?? 2- 27. Acquisition Method Example Purchase Price > Fair Value BigNet Companys Financial RecordsDecember 31 Current Assets . . . . . . . . . . . . . . . . . . . . . . . 300,000 Computers and Equipment . . . . . . . . . . . . .600,000 Capitalized Software . . . . . . . . . . . . . . . . .1,200,000 Customer Contracts . . . . . . . . . . . . . . . . . . . 700,000 Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . .450,000 Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000 Cash (paid by BigNet) . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000 Common Stock (20,000 shares issued at $10 par value)200,000 Additional Paid-In Capital . . . . . . . . . . . . . . . . . . . . . . 1,800,000 To record acquisition of Smallport Company. Assets acquired and liabilities assumed are recorded at fair value. 2- 28. Acquisition Method Example Purchase Price < Fair Value Lastly, lets use the same data as in the first example, but this time, assume that BigNet paysno cashconsideration, only the stock issuance is made.Why would BigNet paylessthanthe FV of SmallPortsNet Assets?? 2- 29. Acquisition Method Example Purchase Price < Fair Value BigNet Companys Financial RecordsDecember 31 Current Assets . . . . . . . . . . . . . . . . . . . . . . . 300,000 Computers and Equipment . . . . . . . . . . . . .600,000 Capitalized Software . . . . . . . . . . . . . . . . .1,200,000 Customer Contracts . . . . . . . . . . . . . . . . . . . 700,000 Notes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000 Common Stock (20,000 shares issued at $10 par value)200,000 Additional Paid-In Capital . . . . . . . . . . . . . . . . . . . . . . 1,800,000 Gain on Bargain Purchase . . . . . . . . . . . . . . . . . . . . . . 550,000 To record acquisition of Smallport Company. Assets acquired and liabilities assumed are recorded at fair value. 2- 30. Acquisition Method Related Costs of Business Combinations

Direct Costsof the acquisition (attorneys, appraisers, accountants, investment bankers, etc.) areNOTpart of the fair value received, and so areimmediately expensed

Indirect orInternal Costsof acquisition (secretarial and management time) areexpensed as incurred .

Costs to register andissuesecuritiesrelated to theacquisitionreducetheir fair value

2- 31. Acquisition Method No Dissolution

If the acquired company doesnt dissolve, but continues as aseparate entity :

Separate recordsfor each company are still maintained.

• The acquired company isreportedon the Parents books ( Investment in Subsidiaryaccount).

The adjusted balances for Parent andSubsidiary areconsolidatedusing aworksheet only( noformaljournal entries!)

2- 32. The Consolidation Worksheet 2-

Parent prepares the allocation of the FV, including calculation of gain or goodwill.

The financial information for Parent and Sub are recorded in the first two columns of the worksheet (with Subs prior revenue and expense already closed).

Remove theS ubs equity account balances.

Remove the Investment inS ub balance.

A llocate Subs Fair Values, including any excess of cost over Book Value to identifiable assets or goodwill.

Combine all account balances.

33. Acquisition Method Consolidation Workpaper Example 2- 34. Purchase Price Allocations Additional Issues

Intangiblesare assets that:

• Lack physical substance (excluding financial instruments)

• Arise from contractual or other legal rights

• Can be sold or otherwise separated from the acquired enterprise

2- Note:If there was goodwill already recorded in the acquired companys accounts, it is ignored in the allocation of the purchase price. 35. Purchase Price Allocations -Additional Issues

In-Process R&D

IPR&D that has reached technological feasibility, may be capitalized as anintangible asset

• Determination of fair value is critical

IPR&D is considered to have anindefinitelife, and is reviewed forimpairment.

Ongoing R&D isexpensedas incurred.

2- 36.

But if theAcquisition Methodis new in 2009,

what was theOLDmethod??

GAAP used to employTWOother methods, which were cost based

2- 37. Legacy Methods Purchase and Pooling of Interests Methods

2002 to 2008:PURCHASE METHOD

Prior to 2002:PURCHASE METHOD

or thePOOLING OF

INTERESTS METHOD

2- Since theACQUISITION METHODis applied only to business combinations occurring in 2009 and after, the two prior methods are still in use. 38. Purchase Method Differences from the Acquisition Method

Valuation basis is cost

• The value of theconsiderationtransferred,

• PLUS thedirect costsof the acquisition,

• IGNORING anyindirect costsof the acquisition,

• IGNORING anycontingentpayments.

The total cost of the acquisition isallocated proportionatelyto the net assets based on their fair values,with anyexcessgoing togoodwill .

2- 39. Purchase Method Purchase Price < Fair Value

Then current assets and liabilities are recorded atfair value , and non-current assets arereduced proportionately , with the followingexceptions :

• Financial assets other than equity method investments

• Assets to be disposed of by sale

• Deferred tax assets

• Prepaid assets related to pension or other post-retirement benefit plans

2-

BUT WHAT IF THE TOTALCOST ISLESS THANTHEFAIR VALUEOF THE NET ASSETS ACQUIRED?

40. Purchase Method Purchase Price < Fair Value If difference is substantial enough to eliminate all the non-current asset balances of the acquired company . . . . . . The remainder is reported as anextraordinary gain One other significantdifferencefrom theAcquisition Method :In-Process R&D isexpensedunder thePurchase Method , unless it has reached technological feasibility. 2- 41.

Prior to 2002, under certain criteria, combinations could be accounted for as Pooling of Interests when one company purchased all of another companys stock using its own stock as consideration (no cash!)

These Pooling combinations are leftintactgoing forward.

Pooling of Interests Historical Review 2- 42.

The larger company records anInvestment in Subaccount.

Consolidation is done on aworksheetonly, eliminating Investment account and Subs equity accounts.

The remainingBook Valuesof the combining companies are simplyadded together .

No goodwill is recorded.

Revenues and expenses are combinedretrospectively , and prospectively.

2- Pooling of Interests Historical Review 43. Summary

Consolidation of financial information is required when one organization gainscontrolof another.

Ifdissolutionoccurs, the consolidation is recorded at the date of acquisition and a single set of accounting records continues.

Ifseparate identities(and separate books) are maintained, consolidation is done on a worksheet,notinvolving journal entries.

TheAcquisition Methodis currently GAAP, although the two prior methods will continue in practice until those combinations are dissolved.

2- 44. Possible Criticisms

The Acquisition Method involves a departure from traditional cost-based measurement.This violates theHistoric CostPrinciple.

The capitalization of IPR&D departs from the traditional approach ofexpensingR&D as incurred.

WHAT DO YOU THINK?

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