ACC 424 Financial Reporting II Lecture 5 Introduction to consolidations
Dec 16, 2015
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Agenda
• Nature of consolidated financial statements
• Why consolidate?
• Who has to consolidate?
• Consolidation at acquisition
• Consolidation after acquisition
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Nature of consolidation• Consolidated financial statements report the financial affairs of affiliated
corporations as though they are a single firm
– A parent corporation & its subsidiaries are often referred to as affiliated corporations
• No separate books for the consolidated entity. Each affiliated corporation has
its own set of books & financial statements – The statements are prepared using working papers (spreadsheets)
• Intercompany transactions are eliminated:
– e.g., revenues are the revenues from sales of the group to outside customers
• Intercompany receivables & payables are also eliminated
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Nature of consolidation• Consolidation’s effect on financial statements can be
significant• Prior to FAS 94 (1987) corporations did not have to consolidate
financial subsidiaries. If the big 3 US automakers had consolidated their financial subsidiaries in 1986, the effects would have been substantial:
Return on Assets Debt/Equity
Unconsolidated Consolidated Unconsolidated Consolidated
Ford 9% 4% 1.6 5.4
GM 4% 2% 1.4 3.9
Chrysler 10% 5% 1.7 5.2
Average Impact -52% +207%
Source: Seidler (1987)
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Why consolidate?• Rationale for required consolidation
– Information motivation• Consolidations required to avoid “fooling” investors & creditors (e.g., financial
subsidiaries used to keep debt off balance sheets) • Current concern that joint ventures and other devices used for the same purpose• Among informed users (banks & securities firms) who lobbied on FAS 94 there was
little support for the standard (Mian & Smith, 1990)
• Evidence from voluntary consolidations– Australia in 1930s & 1950s (Whittred)– Of financial, insurance & real estate subsidiaries in the US prior to FAS 94
(Mian & Smith)
• Evidence from insurance company debt contracts– Contracts undo the equity method of accounting for unconsolidated subsidiaries
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Who has to consolidate?Current standards
A parent owning >50% of the voting stock (legal control) except:
i) if control is temporary; or
ii) control does not rest with the majority owner (legal reorganization, bankruptcy, severe foreign exchange restrictions, controls or government imposed uncertainties)
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Who has to consolidate?Exposure Draft, February, 1999
as modified to 12/31/99
• A parent must consolidate each subsidiary that it controls.
• Once a subsidiary is consolidated must be consolidated until parent ceases to control it
• Control involves 2 essential characteristics– A parent’s non-shared decision-making ability
– A parent’s ability to use that power to increase to increase the benefits it derives & limit the losses it suffers from the subsidiary’s activities
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Who has to consolidate?Exposure Draft, February, 1999
as modified to 12/31/99
Control is presumed if an entity (including its subsidiaries):– Has majority voting interest in the election of a corporation’s governing body or a
right to appoint a majority of the members of that body– Has a large minority voting interest in the election of the governing body and no
other party or organized group of parties has a significant voting interest– Has a unilateral ability to
• Obtain a majority voting interest in the election of the governing body or• Obtain a right to appoint a majority of the governing body via currently
exercisable rights and expected benefits of exercising rights exceeds expected cost
– Is the only general partner in a limited partnership
A minority interest is large if it exceeds 50% of votes typically cast in a corporation’s election of directorsFor example, if only 60% of eligible votes are typically cast, 35% would be deemed large
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Consolidation at acquisitionE3.4
1. Give the journal entry to record the business combination as a purchase & elimination entries necessary to prepare a consolidated balance sheet at the business combination date assuming the purchase method is used.2. Give the journal entry to record the business combination as a pooling of interests & elimination entries necessary to prepare a consolidated balance sheet at the business combination date assuming the pooling of interests method is used.
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Consolidation at acquisitionE3.4 - Purchase
First determine the differential between price & book value (premium or discount)
Market value of shares issued $2,000,000
Accountants’ & attorneys’ fees 100,000
Total acquisition cost $2,100,000
Net book value acquired .9 $2,000,000 $1,800,000
Differential (premium) $ 300,000
Allocation to fair market values of assets & liabilities and goodwill
Increase in the value of inventory .9 $100,000 $ 90,000
Increase in net plant assets .9 $200,000 180,000
Increase in LT marketable securities .9 $20,000 18,000
$288,000
Less Increase in LT debt .9 $100,000 90,000
Share of value increase of identifiable net assets $198,000
Goodwill 102,000
Differential (premium) $300,000
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Consolidation at acquisitionE3.4 - Purchase
Journal entry in Giant’s books to record combinationInvestment in Small $2,100,000
Common stock & Additional PIC $2,000,000
Cash 100,000
Elimination entries in consolidated statement working papers(1) Purchase premium $ 300,000
Investment in Small $ 300,000
To reclassify the purchase premium
(2) Inventories $ 90,000
Plant assets (net) 180,000
Long-term marketable securities 18,000
Goodwill 102,000
Long-term Debt $ 90,000
Purchase premium 300,000
To allocate purchase premium
(3) Capital stock - Small $ 400,000
Retained earnings - Small 1,600,000
Investment in Small $1,800,000
Minority interest in Small 200,000
To eliminate the Investment in Small & establish Minority Interest
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Consolidation at acquisitionE3.4 - points on purchase
– The individual assets & liabilities of Small replace the Giant’s Investment in Small in the consolidated financial statements
– To that end Investment in Small is eliminated against Small’s stockholders’ equity and the purchase premium leaving minority interest
– Small’s individual assets & liabilities are increased by 90% of valuation difference and goodwill is included at 90% of its value
– The exposure draft would increase individual assets & liabilities by 100% of the valuation difference by increasing minority interest for its share of the write-up
– As of January, 1997, the board has also decided to increase goodwill to 100% of its value by including the minority share
– Note minority interest in subsidiary would be called noncontrolling interest in subsidiary under the exposure draft
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Consolidation at acquisition E3.4 - pooling
Journal entry in Giant’s books to record combination
Investment in Small $1,800,000
Expenses of business combination 100,000
Stockholders’ equity $1,800,000
Cash 100,000
Elimination in consolidated statement working papers
Capital stock - Small $ 400,000
Retained earnings - Small 1,600,000
Investment in Small $1,800,000
Minority interest in Small 200,000