Chapter Two

Consolidation of Financial Information

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

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Business Combinations
A business combination refers to a transaction or other event in which an acquirer obtains control over one or more businesses. There are five types of combinations that are required to prepare consolidated statements.

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Statutory Merger (Through Asset Acquisition)

Investor acquires assets (and often liabilities) of the Investee Investee dissolves and goes out of business Investees books are permanently closed and the Investors books are adjusted at the acquisition date for the newly acquired accounts One entity survives and moves forward

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Statutory Merger (Through Capital Stock Acquisition)

Investor acquires all stock of the Investee, and then transfers assets and liabilities of the Investee to its own books. Investee dissolves as a separate company but often remains as a division of the Investor. One entity survives and moves forward

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Statutory Consolidation
A newly created company receives all assets or stock of the original companies. Original companies dissolve, but often remain as divisions of the new company.

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Acquisition of Majority of Shares

Investor acquires the majority of voting stock of another company, and is able to control their decisions. Investor records the investment in the stock of the Investee. Investee remains in existence as a separate company, but as a subsidiary of the Investor, or parent company.

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Control Through Ownership of Variable Interests

Sponsoring Firm creates a Special Purpose Entity (SPE) intended to engage in a specific activity Investor may be different than the Sponsoring Firm SPE is a separate legal entity whose risks and rewards may flow to Sponsoring Firm instead of to the equity investors. Control is established by agreement, not ownership.

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The Acquisition Method EFFECTIVE IN 2009

Used when there is a change in ownership, resulting in control of one enterprise by another Requires accounting for the fair value of the acquired business as a whole by recognizing and measuring: Consideration transferred The fair value of each asset acquired and liability assumed Effectively converged with International Standards

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Acquisition Method (Continued)

What must be determined at the date of acquisition?
The Fair Value of assets and liabilities acquired, including the value of purchased In-Process Research and Development (and ignoring equity accounts) The value of consideration transferred The fair value of any contingent consideration given, based on risk and probability of payment

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Acquisition Method (Continued)

But what if the consideration transferred does NOT EQUAL the Fair Value of the Assets acquired?? If the Consideration is MORE than the Fair Value of the Assets acquired, the difference is attributed to GOODWILL

If the Consideration is LESS than the Fair Value of the Assets acquired, we got a BARGAIN!! And we will record a GAIN on the acquisition!!

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Acquisition Method Related Costs of Business Combinations

Direct Costs of the acquisition (attorneys, appraisers, accountants, investment bankers, etc.) are NOT part of the fair value received, and so are immediately expensed Indirect or Internal Costs of acquisition (secretarial and management time) are expensed as incurred. Costs to register and issue securities related to the acquisition reduce their fair value

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Acquisition Method No Dissolution

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

Separate records for each company are still maintained.

The acquired company is reported on the Parents books (Investment in Subsidiary account). The adjusted balances for Parent and Subsidiary are consolidated using a worksheet only (no formal journal entries!)

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The Consolidation Worksheet

1. Parent prepares the allocation of the FV, including calculation of gain or goodwill. 2. 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). 3. Remove the Subs equity account balances. 4. Remove the Investment in Sub balance. 5. Allocate Subs Fair Values, including any excess of cost over Book Value to identifiable assets or goodwill. 6. Combine all account balances.

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Purchase Price Allocations Additional Issues

Intangibles are 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

Note: If there was goodwill already recorded in the acquired companys accounts, it is ignored in the allocation of the purchase price.

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Purchase Price Allocations Additional Issues

In-Process R&D IPR&D is capitalized as an intangible asset
Determination of fair value is critical

IPR&D is considered to have an indefinite life, and is reviewed for impairment. Ongoing R&D is expensed as incurred.

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Legacy Methods Purchase and Pooling of Interests Methods

Since the ACQUISITION METHOD is applied only to business combinations occurring in 2009 and after, the two prior methods are still in use.

2002 to 2008: PURCHASE METHOD Prior to 2002: PURCHASE METHOD or the POOLING OF INTERESTS METHOD

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Purchase Method Differences from the Acquisition Method

Valuation basis is cost

The value of the consideration

transferred, PLUS the direct costs of the acquisition, IGNORING any indirect costs of the acquisition, IGNORING any contingent payments.

The total cost of the acquisition is allocated proportionately to the net assets based on their fair values, with any excess going to goodwill.

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Pooling of Interests Historical Review

The larger company records an Investment in Sub account. Consolidation is done on a worksheet only, eliminating Investment account and Subs equity accounts. The remaining Book Values of the combining companies are simply added together. No goodwill is recorded. Revenues and expenses are combined retrospectively, and prospectively.