Chapter One

Consolidation of
Financial Information
2

Business Combinations
Separate organizations tied together through common
control
Financial statements which represent more than one
corporation are known as “consolidated” financial
statements.
The company which exerts control is known as the
“parent.”
The separate controlled companies whose
information is consolidated are known as
“subsidiaries.”
 Why do Firms
Combine?
i. Part of mgt strategy to maximize SH value.
ii. For growth and competitiveness-size & scale
are becoming critical as firm compete in today’s
market. If large firms can be more efficient in
delivering goods & services, they gain a
competitive advantage & become more
profitable for the owners.
iii. Operative synergies and cost savings
4
Why do Firms
Combine?
iv.
iv. Vertical
Verticalintegration
integrationof offirm’s
firm’sout
output
put&&other
otherfirm’s
firm’s
distribution
distributionor orfurther
furtherprocessing.
processing.
v.v. Cost
Costsavings
savingsthrough
throughelimination
eliminationof ofduplicate
duplicatefacilities
facilities
and
andstaff.
staff.
vi.
vi. Quick
Quick(entry)
(entry)access
accessfor
fornew
newand
andexisting
existingproducts
products
into
intodomestic
domestic&&foreign
foreignmarkets.
markets.
vii.
vii. Economies
Economiesof ofscale
scaleallowing
allowinggreater
greaterefficiency
efficiency&&
negotiating
negotiatingpower.
power.
viii.The
viii.Theability
abilityto
toaccess
accessfinancing
financingat atmore
moreattractive
attractive
rates.
rates.
ix.
ix. Diversification
Diversificationof ofbusiness
businessrisk
risk
5
The Consolidation
Process
“The
“Thepurpose
purposeof ofconsolidated
consolidatedfinancial
financialstatements
statementsisisto
topresent,
present,
primarily
primarilyfor
forthe
thebenefit
benefitof
ofthe
theowners
ownersand andcreditors
creditorsof
ofthe
theparent,
parent,
the
theresults
resultsof
ofoperations
operationsandandthe
thefinancial
financialposition
positionof
ofaaparent
parent
company
companyandandallallits
itssubsidiaries
subsidiariesas
asififthe
theconsolidated
consolidatedgroup
groupwere
wereaa
single
singleeconomic
economicentity
entitywith
withone
oneor
ormore
morebranches
branchesorordivisions.”
divisions.”
Why Consolidated Statements?
i.They are presumed to be more meaningful than separate
statements.
ii.They are considered necessary for fair presentation,
when One of the companies in the group directly or
indirectly has a controlling financial interest in the other
companies.
6

Business Combinations
The usual condition for a controlling financial
interest is ownership of a majority voting
interest, and, therefore,
as a general rule ownership by one entity,
directly or indirectly, of more than 50 per cent of
the outstanding voting shares of another entity is
a condition pointing toward consolidation (as per
GAAP)
 Cont…
Thus, in producing FSs for external distribution, the
reporting entity transcends the boundaries of
incorporation to encompass all companies for
which control is present.
Even though the various companies may retain their
legal identities as separate corporations, the
resulting information is more meaningful to outside
parties when consolidated into a single set of FSs.
Business Combinations-
Crating a single economic
entity
A BC refers to any set of conditions in which two
or more organizations are joined together through
common control.
BC are formed by wide variety of transaction or
events with various formats.
Fore example, each of the ff is identified as BC
although it differ widely in legal form.
9 Exh.

Business Combinations
2-2

Continued
10 Exh.
2-2

Cont…
 Cont…
In accounting, consolidation refers to the mechanical
process of bringing together the financial records of
two or more organisations to form a single set of
statements.
Separate incorporation is frequently preferred to
take full advantage of any intangible benefits accruing
to the acquired company as a going concern.
Better utilisation of licenses, trade names, employee
loyalty, and the company’s reputation can be possible.
Enhance its market value for an eventual sale or
initial public offering as a stand alone entity.
12

Consolidation of Financial
Information

Parent Subsidiary

The parent does not Consolidated The Sub still prepares

prepare separate financial statements separate financial
financial statements are prepared. statements
 A Control Issue – SPE’s
Traditionally control is considered to exist if one
company holds more than 50 % of other company’s
voting stock. (As per GAAP)
Thus, control has been tied directly to ownership
The difficulty in defining control is exemplified in
FASB Interpretation 46B “Consolidation of Variable
Interest Entities,”
One popular type of variable interest entities has
become widely as a special purpose entity (SPE).
 A Control Issue – SPE’s
SPEs typically take the form of trust, partnership, joint
venture, or corporation.
Fore example, a business may create an SPE to finance its
acquisition of a large asset.
The SPE purchase the asset using debt & equity financing &
then leases the asset back to the sponsoring firm.
If their activities are strictly limited & the asset is pledged
as collateral, lenders often view SPEs as less risky than their
sponsoring firm.
 A Control Issue –
SPE’s
As a result, such arrangement can allow financing at lower
interest rates than would otherwise be available to the
sponsor.
Control of an SPE by design does not rest with its equity
holders.
Instead, control is exercised through contractual
arrangements with the sponsoring firm who may become
the “primary beneficiary” of the entity.
These contract can take the form of leases, participation
rights, guarantees, or other residual interest
 A Control Issue –
SPE’s
Through contracting, the primary beneficiary
bears a majority of the entity’s risks & receives a
majority of its rewards often without owning
any voting shares.
Consequently, an exclusive examination of
voting interests can fail to identify the firm with
the controlling financial interest in an SPE or
similar entity.
17

A Control Issue – SPE’s

Special Purpose Entities (a popular type of “variable interest
entity”) were misused to hide debt and manipulate earnings
As a result, the FASB (in FIN 46R) expanded the definition of
“control” beyond just the holding of a majority share position.
An entity whose control rests with a primary beneficiary is
referred to as a variable interest entity.
The following indicate a controlling financial interest in a
variable interest entity:
◦ Direct or indirect ability to make decisions about the entity’s activities
◦ Obligation to absorb any expected losses of the entity
◦ The right to receive any expected residuals of the entity
 Consolidation of financial
statement
The A, L, E, R, & E accounts of the companies simply are
combined.
As part of this process, reciprocal accounts &
intercompany transactions must be adjusted or eliminated
to ensure that all reported balances truly represent the
single entity.
Applicable consolidation procedures vary significantly
depending on the legal format employed in creating a BC.
SM & SC: one accounting consolidation ever occurs.
19 What is to be
consolidated?
If dissolution occurs:
All account balances are actually or physically
consolidated in the financial records of the survivor.
If separate incorporation is maintained:
Only the financial statement information
is consolidated on work papers and not
in the actual records
20
When does consolidation
occur?
If dissolution occurs:
A permanent consolidation occurs at the date of the
combination only.

If separate incorporation is maintained:

Consolidation (on work papers, not in the actual
records!!) occurs regularly, whenever financial
statements are prepared
21
How does consolidation affect the accounting
records?
If dissolution occurs:
Dissolved company’s records are closed out.
Surviving company’s accounts are adjusted to
include all balances of the dissolved company
If separate incorporation maintained:
Each company continues to maintain its own
records.
Using worksheets facilitates the periodic
consolidation process without disturbing the
individual accounting system.
22
Acquisition Method – SFAS 141R (effective for all
combinations beginning in 2009) as per GAAP

The fundamental characteristic of any asset acquisition is a

change in ownership.
Following a BC, accounting & financial reporting require that
the new owner (acquirer) record appropriate values for the
items received in the transaction.
In a BC, fair values for both the items exchanged & received
can enter into the determination of the acquirer’s accounting
valuation of the acquired firm.
SFAS141R requires the acquisition method to account for BCs
replacing the SFAS141 purchase method.
 Acquisition Method – SFAS 141R (effective for all
combinations beginning in 2009)

Applying the acquisition method typically involves recognizing &

measuring:
◦ The consideration transferred for the acquired business.
◦ The separately identified assets acquired, liabilities assumed, & any
noncontrolling interest.
◦ Goodwill or gain from a bargain purchase.

SFAS 141R’s emphasis on fair value as a measurement attribute for

an acquired firm represent a distinct departure from the cost-based
provision of SFAS 141.
Consideration transferred includes
◦ Cash paid or fair value of stock issued
◦ Fair value of any contingent consideration
◦ Fair value of any other property transferred
 Consideration
Transferred
The fair value of the consideration transferred to acquire a
business from its former owner is the starting point in
valuing & recording a BCs.
The consideration transferred in a BC shall be measured at
fair value, which shall be calculated as the sum of the
acquisition-date fair value of the asset transferred, the
liability incurred, and the equity interest issued by the
acquirer.
 Consideration Transferred
“Fair value is defined as the price that would be received to
sell an asset or paid to transfer a liability in orderly
transaction between market participants at the
measurement date (SFAS 157).
Thus, market values are often the best source of evidence
of the fair value of consideration transferred in a BC.
Contingent consideration can also serve as an additional
element of consideration transferred.
 Consideration
Transferred
Combination agreement often contain provision to
compensate former owners upon achievement of specified
future performance measures.
A fundamental principle of the acquisition method is that:
a.An acquirer must recognise the identifiable assets acquired &
the liabilities assumed in BC.
b.Further, once recognised, the acquirer measures the
identifiable assets acquired & liabilities assumed at their
acquisition-date fair values.
27 Acquisition Method
Situations
Dissolution
Dissolutionof
ofthe
theacquired
acquiredcompany:
company:
◦◦ Consideration
Considerationtransferred
transferred==
Collective
Collectivefair
fairvalues
valuesof
ofthe
theindividual
individualasset
assetacquired
acquiredand
and
liabilities
liabilitiesassumed
assumed(FV)
(FV)
◦◦ Consideration
Considerationtransferred
transferred==FVFV
◦◦ Consideration
Considerationtransferred
transferred>>FVFV
◦◦ Consideration
Considerationtransferred
transferred<<FVFV

Separate
Separateincorporation
incorporation maintained
maintained. .
28 Acquisition Method: Dissolution
Consideration transferred = Fair
value
Ignore the equity and nominal accounts of the
acquired company.
Determine fair values of the acquired company’s
assets and liabilities.
Prepare a journal entry to
◦ recognize the fair value of the consideration
transferred in the acquisition
◦ incorporate the fair value of the acquired company’s
identifiable assets and liabilities into the acquiring
company’s books.
 Acquisition Method: Dissolution
Consideration transferred = Fair
29

value

EXHIBIT 2.3.doc BigNet agrees to pay

$2,550,000 (cash of $550,000 and 20,000 unissued
shares of its $10 par value common stock that is
currently selling for $100 per share) for all of
Smallport’s assets and liabilities.
Smallport then dissolves itself as 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.
30

Acquisition Method: Dissolution

Consideration transferred = Fair value
 Acquisition Method: Dissolution
31
Consideration transferred > Fair
value
FV of acquired company’s assets and
liabilities is added to acquiring company’s
Note: Goodwill
books.
should be viewed
Difference between consideration as a residual
transferred & FV of identifiable assets amount remaining
acquired and liabilities assumed is after all other
allocated to goodwill. (unidentifiable identifiable assets
assets) acquired and
liabilities assumed
are recognized.
 Acquisition Method: Dissolution
Consideration transferred > Fair
value
Assume that BigNet agrees to pay $3,000,000 in exchange for all of
Smallport’s assets and liabilities.
BigNet transfers to the former owners of Smallport consideration of
$1,000,000 in cash plus 20,000 shares of common stock with a fair
value of $100 per share.
The resulting consideration paid is $450,000 more than the 2,550,000
fair value of Smallport’s net assets.
Synergy effect, history of profitability, reputation, quality of its
personnel, e.t.c
 Acquisition Method: Dissolution
33

Consideration transferred > Fair value

34 Acquisition Method: Dissolution
Consideration transferred < Fair
value
In rare circumstances, the FV of the identifiable
assets acquired and liabilities assumed may exceed
the consideration transferred.
This excess FV is recognized as an ordinary gain on a
bargain purchase.
The FV of the identifiable assets acquired and
liabilities assumed then becomes the valuation
basis of the acquisition.
 Acquisition Method: Dissolution
Consideration transferred < Fair
35

value

At
At acquisition
acquisition date,
date, each
each subsidiary
subsidiary
asset
asset and
and liability
liability is
is reported
reported at
at its
its fair
fair
value.
value. .. ..

.. .. .. The
The remainder
remainder is
is to
to be
be reported
reported as
as an
an
ordinary
ordinary gain gain on
on bargain
bargain purchase
purchase (SFAS
(SFAS
141R)
141R)
 Cont…
A consequence of implementing a fair-value concept to
acquisition accounting is the recognition of an unrealised
gain on the bargain purchase.

A criticism of the gain recognition is that the acquirer

recognizes profit from a buying activity that occurs prior to
traditional accrual measures of earned income (i.e selling
activity).
 Cont….
Nonetheless, SFAS 141R requires an exception to the
general rule of recording business acquisitions at fair value
of the consideration transferred in a rare circumstances of a
bargain purchase.
Thus, in a bargain purchase, the fair value of the assets
received & all liabilities assumed in a BC are considered
more relevant for asset valuation than the consideration
transferred.
 Acquisition Method: Dissolution
Consideration transferred < Fair value
Assume that BigNet agrees to pay $2,000,000 to the owners of
Smallport in exchange for their business.
BigNet conveys no cash and issues 20,000 shares of common stock
having a $100 per share fair value.
$2,000,000 consideration transferred
$2,550,000 net amount of fair values individually assigned to the
assets acquired and liabilities assumed.
The gain on bargain purchase is 550,000
Illustrations\Acquisition method.doc
39

Accounting for Additional Costs Associated with

Business Combinations (SFAS 141R) as per GAAP
Direct combination costs Expense as incurred
(Accounting, legal,
investment banking and
appraisal fees, etc.)

Indirect combination costs Expense as incurred

(additional internal costs
such as secretarial or
managerial time)
Costs to register and issue Reduce the value assigned
securities to the fair value of the
Illustrations\Example.doc securities issued (typically
as a debit to APIC)
40

Let’s see what happens

when the acquired company
is not dissolved.
41
Acquisition Method - No
Dissolution
The
Theacquired
acquiredcompany
companycontinues
continuesas
asaa
separate
separateentity.
entity.
◦◦Reported
Reportedon
onParent’s
Parent’sbooks
booksasasthe
the
Investment
InvestmentininSubsidiary
Subsidiaryaccount.
account.
Separate
Separaterecords
recordsfor
foreach
eachcompany
company
are
arestill
stillmaintained.
maintained.
The
Theadjusted
adjustedbalances
balancesfor
forthe
theParent
Parent
and
andthe
theSubsidiary
Subsidiaryare
areconsolidated
consolidated
using
usingaaworksheet
worksheet(no
(noformal
formaljournal
journal
entries!)
entries!)
 Acquisition Method - No
Dissolution
When each company retains separate incorporation in a BC,
many aspects of the consolidation process are identical to
those demonstrated in the previous section.
Several significant difference exist in BC in which each
company remains a legally incorporated entity. Most
noticeably:
◦ The consolidation of the financial information is only simulated.
◦ The acquiring company doesn’t physically record the acquired assets
& liabilities
 Acquisition Method - No
Dissolution
◦ B/c dissolution doesn’t occur, each company maintains independent
record keeping.
◦ To facilitate the preparation of consolidated FSs, a worksheet &
consolidation entries are employed using data gathered from these
separate companies.
A worksheet provides the stricture for gathering financial
reports for single economic entity.
The adjustment & eliminations are entered on the
worksheet & represent alteration that would be required if
the financial records were physically united.
 Acquisition Method - No
Dissolution
B/c no actual union occurs neither company ever records
consolidation entries in its journals.

Instead, they appear solely on the worksheet to derive

consolidated balances for financial reporting purposes.
 Acquisition Method - No
Dissolution
To illustrate using the Illustrations\EXHIBIT 2.3.doc
information, assume that BigNet acquires Smallport
company on December 31 by issuing 26,000 shares of $10
par value common stock valued at $100 per share (or
$2,600,000 in total).
BigNet pays fees of $40,000 to a third party for their
assistance in arranging the transaction.
 Acquisition Method - No Dissolution
Then to settle a difference of opinion regarding Smallport’s
fair value, BigNet promises to pay an additional $83,200 to
the former owners if Smallport’s earnings exceed $300,000
during the next annual period.
BigNet estimates a 25% probability that the $83,200
contingent payment will be required.
A discount rate of 4% (to represent the time value of
money) yields an expected present value of $20,000 for the
contingent liability(83200*25%*.961538)
 Acquisition Method - No Dissolution
Therefore the fair value of the consideration transferred in
this example consists of the following two elements:
FV of securities issued by BigNet = $2,600,000
FV of contingent performance liability = $20,000
Total FV of consideration transferred = $2,620,000
 Acquisition Method - No Dissolution
Although the assets and liabilities are not transferred, BigNet must
still record the payment made to Smallport’s owners.
When the subsidiary remains separate, the parent establishes an
investment account that initially reflects the acquired firm’s
acquisition date fair value.
Because Smallport maintain its separate identity, BigNet prepares
the ff journal entries on the books to record the BC.
Illustrations\Journal Entries.doc
 Steps for Consolidation
49

1.
1. Record
Record the
thefinancial
financialinformation
informationfor
for
both
both Parent
Parentand
andSub
Subon onthe
theworksheet.
worksheet.
2.
2. Remove
Removethe
theInvestment
Investment in
in Sub
Sub balance.
balance.
3.
3. Remove
RemovethetheSub’s
Sub’sequity
equityaccount
account
balances.
balances.
4.
4. Adjust
Adjustthe
theidentifiable
identifiable assets
assetsacquired
acquired
and
andliabilities
liabilitiesassumed
assumed to to FV.
FV.
5.
5. Allocate
Allocateany
anyremaining
remainingexcess
excessof of
consideration
consideration transferred
transferredover
over FV
FVtoto
goodwill.
goodwill.
6.
6. Combine
Combineall all account
account balances.
balances.
50
No Dissolution Example
51
Cont..
Note that this schedule initially subtracts Smallport's-
acquisition date book value.
The resulting $ 2,020,000 difference represents the total
amount needed on the worksheet to adjust Smallport’s
individual assets & liabilities from book value to fair value
(& to recognize goodwill).
Next the schedule shows how this $2,020,000 total is
allocated to adjust each individual item to fair value.
No part of the $2,020,000 excess fair value is attributed to
the current assets b/c the book value equals fair value.
The N/p account shows a negative allocation, b/c the
debt’s present value exceeds its book value.
53
54
55
TO BE CONTINUED