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03 Chapter - Consolidations--Subsequent to the Date of Acquisition 1 Answers to Discussion Questions How Does a Company Really Decide which Investment Method to Apply? Students can come up with literally dozens of factors that should be considered by Pilgrim in making the decision as to the method of accounting for its subsidiary, Crestwood Corporation. The following is simply a partial list of possible points to consider. Use of the information. If Pilgrim does not monitor its own income levels closely, applying the equity method would seem to be a waste of time and energy. A company must plan to use the additional data before the task of accumulation becomes worthwhile. Size of the subsidiary. If the subsidiary is large in comparison to Pilgrim, the effort required of the equity method may be important. Income levels would probably be significant. However, if the subsidiary is actually quite small in relation to the parent, the impact might not be material enough to warrant the extra effort. Size of dividend payments. If Crestwood pays out most of its earnings each period as dividends, that figure will approximate equity income. Little additional information would be accrued by applying the equity method. In contrast, if dividends are small or not paid on a regular basis, a Dividend Income balance might vastly understate the profits to be recognized by the business combination. Amount of excess amortizations. If Pilgrim has paid a significant amount in excess of book value so that annual amortization charges are quite high, use of the equity method might be preferred to show the effect of this expense each month (or whenever internal reporting is made). In this case, waiting until the end of the year and recording all of the expense at one time through a worksheet entry might not be the best way to reflect the impact of the expense. Amount of intercompany transactions. As with amortization, the volume of transfers can be an important element in deciding which accounting method to use. If few intercompany sales are made, monitoring the subsidiary through the application of the equity method is less essential. Conversely, if the amount of these transactions IS significant, the added data can be helpful to company administrators evaluating operations. Sophistication of accounting systems. If Pilgrim and Crestwood both have advanced accounting systems, application of the equity method may be relatively simple. Unfortunately, if these systems are primitive, the cost and effort necessary to apply the equity method may outweigh any potential benefits. The timeliness and accuracy of income figures generated by Crestwood. If the subsidiary reports operating results on a regular basis (such as weekly or monthly) and these figures prove to be reliable, equity totals recorded by Pilgrim may serve as valuable information to the parent. However, if Crestwood's reports are slow and often require later adjustment, Pilgrim's use of the equity method will provide only questionable results. 3-1 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition Answers to Questions 1. a. CCES Corp., for its own recordkeeping, may apply the equity method to the investment in Schmaling. Under this approach, the parent's records parallel the activities of the subsidiary. The parent accrues income as it is earned by the subsidiary. Dividends paid by Schmaling reduce its book value; therefore, the CCES reduces the investment account. In addition, any excess amortization expense associated with the allocation of CCES's purchase price is recognized through a periodic adjustment. By applying the equity method, both the parent's income and investment balances accurately reflect consolidated totals. The equity method is especially helpful in monitoring the income of the business combination. This method can be, however, rather difficult to apply and a time-consuming process. b. The initial value method. The initial value method can also be utilized by CCES Corporation. Any dividends received are recognized as income but no other investment entries are made. Thus, the initial value method is easy to apply. However, the resulting account balances of the parent may not provide a reasonable representation of the totals that result from consolidating the two companies. c. The partial equity method combines the advantages of the previous two techniques. Income is accrued as earned by the subsidiary as under the equity method. Similarly, dividends reduce the investment account. However, no other entries are recorded; more specifically, amortization is not recognized by the parent. The method is, therefore, easier to apply than the equity method but the subsidiary's individual totals will still frequently approximate consolidated balances. 2. a. The consolidated total for equipment is made up of the sum of Maguire's book value, Williams' book value, and any unamortized excess acquisition-date fair value over book value attributable to Williams' equipment. b. Although an Investment in Williams account is appropriately maintained by the parent, from a consolidation perspective the balance is intercompany in nature. Thus, the entire amount is eliminated in arriving at consolidated financial statements. c. Only dividends paid to outside parties are included in consolidated statements. Because Maguire owns 100 percent of Williams, all of the subsidiary's dividends are intercompany. Consequently, only the dividends paid by the parent company will be reported in the financial statements for this business combination. d. Any acquisition-date goodwill must still be reported for consolidation purposes. Reductions to goodwill are made if goodwill is determined to be impaired. e. Unless intercompany revenues have been recorded, consolidation is achieved in subsequent periods by adding the two book values together. f. Consolidated expenses are determined by combining the parent's and subsidiary amounts and then including any amortization expense associated with the purchase price. As will be discussed in detail in Chapter Five, intercompany expenses can also be present which require elimination in arriving at consolidated figures. g. Only the parent's common stock outstanding is included in consolidated totals. h. The net income for a business combination is calculated as the difference between consolidated revenues and consolidated expenses. 3-2 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition 3. Under the equity method, the parent accrues subsidiary earnings and amortization expense (associated with the acquisition price in a purchase) in the same manner as in the consolidation process. The equity method parallels consolidation. Thus, the parent's net income and retained earnings each year will equal the consolidated totals. In the consolidation process, excess amortizations must be recorded annually for any portion of the purchase price that is allocated to specific accounts (other than land or to goodwill). Although this expense can be simulated in total on the parent's books by an equity method entry, the actual amortization of each allocated fair value adjustment is appropriate for consolidation. Hence, the effect of the parent's equity method amortization entry is removed as part of Entry I so that the amortization of specific accounts (e.g., depreciation) can be recorded (in consolidation Entry E). When the initial value method is applied by the parent company, no accrual is recorded to reflect the subsidiary's change in book value during the years following acquisition. Furthermore, recognition of excess amortizations relating to the acquisition price is also omitted by the parent. The partial equity method, in contrast, records the subsidiary's book value increases and decreases but not amortizations. Consequently, for both of these methods, a technique must be established within the consolidation process to record the omitted figures. Entry *C simply brings the parent's records (more specifically, the beginning retained earnings balance and the investment account) up-to-date as of the first day of the current year. If the initial value method has been applied by the acquiring company, any changes in the subsidiary's book value in previous years must be recognized on the worksheet along with the appropriate amount of amortization expense. For the partial equity method, only the amortization relating to these prior years needs to be recognized. No similar entry is needed if the equity method has been applied; changes in the subsidiary's book value as well as excess amortization expense will be recorded each year by the parent. Thus, under the equity method, the parent's investment and beginning retained earnings balances are both correctly established without further adjustment. 4. 5. 6. Lambert's loan payable and the receivable held by Jenkins are intercompany accounts. As such, the reciprocal balances should be offset in the consolidation process. The $100,000 is not a debt to or a receivable from an unrelated (or outside) party and should, therefore, not be reported in consolidated financial statements. Additionally any interest income/expense recognized on this loan is also intercompany in nature and must likewise be eliminated. Because Benns applies the equity method, the $920,000 is composed of four balances: a. The original consideration transferred by the parent; b. The annual accruals made by Benns to recognize income as it is earned by the subsidiary; c. The reductions that are created by the subsidiary's payment of dividends; d. The periodic amortization recognized by Benns in connection with the allocations identified with its purchase price. 7. 8. The $100,000 attributed to goodwill is reported at its original amount unless a portion of goodwill is impaired or a unit of the business where goodwill resides is sold. 3-3 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition 9. 10. A parent should consider recognizing an impairment loss for goodwill associated with a purchased subsidiary when, at the reporting unit level, the fair value is less than its carrying amount. Goodwill is reduced when its carrying value is less than its fair value. To compute fair value for goodwill, its implied value is calculated by subtracting the fair values of the reporting unit's identifiable net assets from its total fair value. The impairment is recognized as a loss from continuing operations. The acquisition-date fair value of the contingent payment is part of the consideration transferred by Reimers to acquire Rollins and thus is part of the overall fair value assigned to the acquisition. If the contingency is a liability (to be settled in cash or other assets) then the liability is adjusted to fair value through time. If the contingency is a component of equity (e.g., to be settled by the parent issuing equity shares), then the equity instrument is not adjusted to fair value over time. At present, the Securities and Exchange Commission requires the use of push-down accounting for the separate financial statements of a subsidiary where no substantial outside ownership exists. Thus, if Company A owns all of Company B, the push-down method of accounting is appropriate for the separately issued statements of Company B. The SEC normally requires push-down accounting where 95 percent of a subsidiary is acquired and the company has no outstanding public debt or preferred stock. Push-down accounting may be required if 80-95 percent of the outstanding voting stock is purchased. Push-down accounting is justified in that the consideration transferred by provides the valuation basis for the subsidiary in consolidated reports. For example, if a piece of land costs Company B $10,000 but Company A pays $13,000 for the land when acquiring Company B, the land has a basis to the current owners of B of $13,000. If B's financial records had been united with A at the time of the acquisition, the land would have been reported at $13,000. Thus, leaving the $10,000 figure simply because separate incorporation is maintained is viewed, by proponents of push-down accounting, as unjustified. 11. 12. When push-down accounting is applied, the subsidiary adjusts the book value of its assets and liabilities based on the acquisition-date fair value allocations. The subsidiary then recognizes eriodic amortization expense on those allocations with definite lives. Therefore, the income recorded by the subsidiary represents its impact on consolidated earnings. The parent uses no special procedures when push-down accounting is being applied. However, if the equity method is in use, amortization need not be recognized by the parent since that expense is included in the figure reported by the subsidiary. 13. Push-down accounting has become popular for the parent's internal reporting purposes for two reasons. First, this method simplifies the consolidation process each year. If acquisition-date fair value allocations and subsequent amortizations are recorded by the subsidiary, they do not need to be repeated each year on a consolidation worksheet. Second, when the subsidiary records amortization, it provides a good representation of the impact that the acquisition has on the consolidated earnings. For example, if the subsidiary earns $100,000 each year but annual amortization is $80,000, the acquisition is only adding $20,000 to consolidated income each year rather than the $100,000 that is reported by the subsidiary in the absence of push-down accounting. 3-4 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition Answers to Problems 1. A 2. B 3. A 4. D Willkom's equipment book value--12/31/12....................... Szabo's equipment book value--12/31/12 .......................... Original purchase price allocation to Szabo's equipment ($300,000 $200,000) ........................................................... Amortization of allocation ($100,000 10 years for 3 years) ................................... Consolidated equipment ...................................................... 5. A 6. B 7. D 8. B 9. B 10. C 11. C The $60,000 excess acquisition-date fair value allocation to equipment is "pushed-down" to the subsidiary and increases its balance from $330,000 to $390,000. The consolidated balance is $810,000 ($420,000 plus $390,000). 12. (35 Minutes) (Determine consolidated retained earnings when parent uses various accounting methods. Determine Entry *C for each of these methods) a. CONSOLIDATED RETAINED EARNINGS EQUITY METHOD Herbert (parent) balance--1/1/11 .................................. $400,000 Herbert income--2011 ................................................... 40,000 Herbert dividends--2011 (subsidiary dividends are intercompany and, thus, eliminated) ....................... (10,000) Rambis income--2011 (not included in parent's income) 20,000 Amortization--2011 ........................................................ (12,000) Herbert income--2012 ................................................... 50,000 Herbert dividends--2012 ................................................ (10,000) Rambis income--2012 ................................................... 30,000 Amortization--2012 ....................................................... (12,000) 3-5 $210,000 140,000 100,000 (30,000) $420,000 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition Consolidated Retained Earnings, 12/31/12 ................... $496,000 PARTIAL EQUITY METHOD AND INITIAL VALUE METHOD Consolidated retained earnings are the same regardless of the method in use: the beginning balance plus the income of the parent less the dividends of the parent plus the income of the subsidiary less amortization expense. Thus, consolidated retained earnings on December 31, 2012 are $496,000 as computed above. b. Investment in Rambis--equity method Rambis fair value 1/1/11............................................................. $574,000 Rambis income 2011 .................................................................. 20,000 Rambis dividends 2011.............................................................. (5,000) Herbert's 2011 excess fair over book value amortization ...... (12,000) Investment account balance 1/1/12 .......................................... $577,000 Investment in Rambis--partial equity method Rambis fair value 1/1/11............................................................. $574,000 Rambis income 2011 .................................................................. 20,000 Rambis dividends 2011.............................................................. (5,000) Investment account balance 1/1/12 .......................................... $589,000 Investment in Rambis--Initial value method Rambis fair value 1/1/11............................................................. $574,000 Investment account balance 1/1/12 .......................................... $574,000 12. (continued) c. ENTRY *C No entry is needed to convert the past figures to the equity method since that method has already been applied. PARTIAL EQUITY METHOD EQUITY METHOD Amortization for the prior years (only 2011 in this case) has not been recorded and must be brought into the consolidation through worksheet entry *C: ENTRY *C Retained Earnings, 1/1/12 (Parent) .................... 12,000 Investment in Rambis .................................... 12,000 (To record 2011 amortization in consolidated figures. Expense was omitted because of application of partial equity method.) INITIAL VALUE METHOD 3-6 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition Amortization for the prior years (only 2011 in this case) has not been recorded and must be brought into the consolidation through worksheet entry *C. In addition, only dividend income has been recorded by the parent ($5,000 in 2011). In this prior year, Rambis reported net income of $20,000. Thus, the parent has not recorded the $15,000 income in excess of dividends. That amount must also be included in the consolidation through entry *C: ENTRY *C Investment in Rambis ......................................... 3,000 Retained Earnings, 1/1/12 (Parent) ............... 3,000 (To record 2011 unrecognized subsidiary earnings as part of the parent's retained earnings. $15,000 income of subsidiary was not recorded by parent (income in excess of dividends). Amortization expense of $12,000 was not recorded under the initial value method. Note that *C adjustments bring the parent's January 1, 2012 Retained Earnings balance equal to that of the equity method. 13. (30 Minutes) (A variety of questions on equity method, initial value method, and partial equity method.) a. An allocation of the acquisition price (based on the fair value of the shares Issued) must be made first. Acquisition fair value (consideration paid by Haynes) Book value equivalency ................................................. Excess of Turner fair value over book value ............... Excess fair value assigned to specific accounts based on fair value Equipment ......................... $5,000 Customer List ...................... 30,000 Life 5 yrs. 10 yrs. $135,000 (100,000) $35,000 Annual Excess Amortizations $1,000 3,000 $4,000 $135,000 110,000 (50,000) (4,000) 130,000 (40,000) (4,000) $277,000 $240,000 130,000 (1,000) Acquisition fair value ...................................................... 2011 Income accrual ...................................................... 2011 Dividends paid by Turner ..................................... 2011 Amortizations (above) ........................................... 2012 Income accrual ...................................................... 2012 Dividends paid by Turner ..................................... 2012 Amortizations ........................................................ Investment in Turner account balance ......................... b. Net income of Haynes .................................................... Net Income of Turner ..................................................... Depreciation expense ..................................................... 3-7 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition Amortization expense ..................................................... Consolidated net income 2012 ................................ c. Equipment balance Haynes ........................................... Equipment balance Turner ............................................ Allocation based on fair value (above) ......................... Depreciation for 2011-2012 ............................................ Consolidated equipment--December 31, 2012............. (3,000) $366,000 $500,000 300,000 5,000 (2,000) $803,000 Parent's choice of an investment method has no impact on consolidated totals. 13. (continued) d. If the initial value method was applied during 2011, the parent would have recorded dividend income of $50,000 rather than $110,000 (as equity income). Income is, therefore, understated by $60,000. In addition, amortization expense of $4,000 was not recorded. Thus, the January 1, 2012, retained earnings is understated by $56,000 ($60,000 $4,000). An Entry *C is necessary on the worksheet to correct this equity figure: Investment in Turner ........................................... Retained Earnings, 1/1/12 (Haynes) ............. 56,000 56,000 If the partial equity method was applied during 2011, the parent would have failed to record amortization expense of $4,000. Retained earnings are overstated by $4,000 and are corrected through Entry *C: Retained Earnings, 1/1/12 (Haynes) ................... Investment in Turner ..................................... 4,000 4,000 If the equity method was applied during 2011, the parent's retained earnings are the same as the consolidated figure so that no adjustment is necessary. 14. (20 minutes) (Record a merger combination with subsequent testing for goodwill impairment). a. In accounting for the combination, the total fair value of Beltran (consideration transferred) is allocated to each identifiable asset acquired and liability assumed with any remaining excess as goodwill. Cash paid Fair value of shares issued 3-8 $450,000 1,248,000 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition Fair value transferred Fair value transferred (above) Fair value of net assets acquired and liabilities assumed Goodwill recognized in the combination $1,698,000 $1,698,000 1,298,000 $400,000 Entry by Francisco to record assets acquired and liabilities assumed in the combination with Beltran: Cash 75,000 Receivables 193,000 Inventory 281,000 Patents 525,000 Customer relationships 500,000 Equipment 295,000 Goodwill 400,000 Accounts payable Long-term liabilities Cash Common stock (Francisco Co., par value) Additional paid-in capital b. Step one in goodwill impairment test: Fair value of reporting unit as a whole Book value of reporting unit's net assets 121,000 450,000 450,000 104,000 1,144,000 1,425,000 1,585,000 Because the total fair value of the reporting unit is less than its carrying value, a potential goodwill impairment loss exists, step two is performed: Fair value of reporting unit as a whole $1,425,000 Fair values of reporting unit's net assets (excluding goodwill) 1,325,000 Implied fair value of goodwill 100,000 Book value of goodwill 400,000 Goodwill impairment loss $300,000 15. (20 minutes) (Goodwill impairment testing.) a. Goodwill Impairment Step 1 Fair value of reporting unit = Carrying value of reporting unit = $650 780 Because fair value < carrying value, there is a potential goodwill impairment loss. 3-9 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition Step 2 Fair value of reporting unit $650 Fair value of net assets excluding goodwill Tangible assets $110 Recognized intangibles 230 Unrecognized intangibles 200 540 Implied value of goodwill 110 Carrying value of goodwill 500 Goodwill impairment loss $390 b. Tangible assets, net Goodwill Customer list Patent $80 110 -0-0- 16. (30 minutes) (Goodwill impairment and intangible assets.) Part a Goodwill Impairment Test--Step 1 Total fair value $510,000 580,000 560,000 Carrying Potential goodwill value impairment? $530,000 yes 610,000 yes 280,000 no Sand Dollar Salty Dog Baytowne Part b < < > Goodwill Impairment Test--Step 2 (Sand Dollar and Salty Dog only) Sand Dollar--total fair value Fair values of identifiable net assets Tangible assets Trademark Customer list Liabilities Implied value of goodwill Carrying value of goodwill Impairment loss Salty Dog--total fair value Fair values of identifiable net assets Tangible assets Unpatented technology Licenses 3-10 $510,000 $190,000 150,000 100,000 (30,000) 410,000 100,000 120,000 $20,000 $580,000 $200,000 125,000 100,000 425,000 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition Implied value of goodwill Carrying value of goodwill No impairment--implied value > carry value Part c 155,000 150,000 -0- No changes in tangible assets or identifiable intangibles are reported based on goodwill impairment testing. The sole purpose of the valuation exercise is to estimate an implied value for goodwill. Destin will report a goodwill impairment loss of $20,000, which will reduce the amount of goodwill allocated to Sand Dollar. However, because the fair value of Sand Dollar's trademarks is less than its carrying amount, the account should be subjected to a separate impairment testing procedure to see if the carrying value is "recoverable" in future estimated cash flows. 17. (30 Minutes) (Consolidation entries for two years. Parent uses equity method.) Fair Value Allocation and Annual Amortization: Acquisition fair value (consideration transferred) . $490,000 Book value (assets minus liabilities or total stockholders' equity) .................................................................. (400,000) Excess fair value over book value .......................... $90,000 Excess fair value assigned to specific accounts based on individual fair values Annual Excess Life Amortizations Land .................................... $10,000 --Buildings ............................. 40,000 4 yrs. $10,000 Equipment ........................... (20,000) 5 yrs. (4,000) Total assigned to specific accounts ........................ Goodwill .............................. Total .................................... 30,000 60,000 $90,000 Indefinite -0$6,000 Consolidation Entries as of December 31, 2011 Entry S Common Stock--Abernethy................................ 250,000 Additional Paid-in Capital ................................... 50,000 Retained Earnings--1/1/11 ................................. 100,000 Investment in Abernethy ............................... (To eliminate stockholders' equity accounts of subsidiary) Entry A 3-11 400,000 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition Land ..................................................................... 10,000 Buildings .............................................................. 40,000 Goodwill ............................................................... 60,000 Equipment ...................................................... 20,000 Investment in Abernethy ............................... 90,000 (To recognize allocations attributed to fair value of specific accounts at acquisition date with residual fair value recognized as goodwill). Entry I Equity in Subsidiary Earnings ........................... 74,000 Investment in Abernethy ............................... 74,000 (To eliminate $80,000 income accrual for 2011 less $6,000 amortization recorded by parent using equity method) 17. (continued) Entry D Investment in Abernethy .................................... Dividends Paid ............................................... (To eliminate intercompany dividend transfers) Entry E Depreciation expense .......................................... Equipment............................................................. Buildings ......................................................... (To record current year amortization expense) Consolidation Entries as of December 31, 2012 Entry S Common Stock--Abernethy ............................... 250,000 Additional Paid-in Capital ................................... 50,000 Retained Earnings--1/1/12 .................................. 170,000 Investment in Abernethy ............................... 470,000 (To eliminate beginning stockholders' equity of subsidiary--the Retained Earnings account has been adjusted for 2011 income and dividends. Entry *C is not needed because equity method was applied.) Entry A Land ..................................................................... Buildings .............................................................. Goodwill ............................................................... Equipment ...................................................... Investment in Abernethy ............................... 10,000 10,000 6,000 4,000 10,000 10,000 30,000 60,000 16,000 84,000 3-12 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition (To recognize allocations relating to investment--balances shown here are as of beginning of current year [original allocation less excess amortizations for the prior period]) Entry I Equity in Subsidiary Earnings ........................... 104,000 Investment in Abernethy ............................... 104,000 (To eliminate $110,000 income accrual less $6,000 amortization recorded by parent during 2012 using equity method) Entry D Investment in Abernethy .................................... Dividends Paid ............................................... (To eliminate intercompany dividend transfers) Entry E Same as Entry E for 2011 18. (35 Minutes) (Consolidation entries for two years. Parent uses initial value method.) Purchase Price Allocation and Annual Excess Amortizations: Acquisition date value (consideration paid) ..... $500,000 Book value ........................................................... (400,000) Excess price paid over book value .................... $100,000 Excess price paid assigned to specific accounts based on fair values Equipment Long-term liabilities Goodwill Total $20,000 30,000 $50,000 $100,000 Life 5 yrs. 4 yrs. Indefinite Annual Excess Amortizations $4,000 7,500 -0$11,500 30,000 30,000 Consolidation Entries as of December 31, 2011 Entry S Common Stock--Abernethy .............................. 250,000 Additional Paid-in Capital .................................. 50,000 Retained Earnings--1/1/11 ................................ 100,000 Investment in Abernethy ............................... (To eliminate stockholders' equity accounts of subsidiary) 400,000 Entry A Equipment ........................................................... 20,000 Long-term Liabilities .......................................... 30,000 Goodwill .............................................................. 50,000 Investment in Abernethy .............................. 100,000 (To recognize allocations determined above in connection with acquisition-date fair values) 3-13 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition Entry I Dividend Income ................................................ 10,000 Dividends Paid .............................................. 10,000 (To eliminate intercompany dividend payments recorded by parent as income) Entry E Depreciation expense ........................................ Interest expense .................................................. Equipment ...................................................... Long-term liabilities ....................................... (To record 2011 amortization expense) 18. (continued) Consolidation Entries as of December 31, 2012 Entry *C Investment in Abernethy ................................... 58,500 Retained Earnings--1/1/12 (Chapman) ....... 58,500 (To convert parent company figures to equity method by recognizing subsidiary's increase in book value for prior year [$80,000 net income less $10,000 dividend payment] and excess amortizations for that period [$11,500]) Entry S Common Stock--Abernethy .............................. 250,000 Additional Paid-in Capital .................................. 50,000 Retained Earnings--1/1/12 ................................ 170,000 Investment in Abernethy .............................. 470,000 (To eliminate beginning of year stockholders' equity accounts of subsidiary. The retained earnings balance has been adjusted for 2011 income and dividends) Entry A Equipment ........................................................... 16,000 Long-term Liabilities .......................................... 22,500 Goodwill .............................................................. 50,000 Investment in Abernethy .............................. 88,500 (To recognize allocations relating to investment--balances shown here are as of the beginning of the current year [original allocation less excess amortizations for the prior period]) Entry I Dividend Income ................................................ 30,000 Dividends Paid ......................................... 30,000 (To eliminate intercompany dividend payments recorded by parent as income) Entry E Same as Entry E for 2011 3-14 4,000 7,500 4,000 7,500 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition 19. (20 Minutes) (Consolidation entries for two years. Parent uses partial equity method.) Fair Value Allocation and Annual Excess Amortizations: Abernethy fair value (consideration paid) .............. Book value ................................................................ Excess fair value over book value (all goodwill) ... Life assigned to goodwill ......................................... Annual excess amortizations .................................. Consolidation Entries as of December 31, 2011 Entry S Common Stock--Abernethy ............................... 250,000 Additional Paid-in Capital ................................... 50,000 Retained Earnings--Abernethy--1/1/11 ............ 100,000 Investment in Abernethy ............................... (To eliminate stockholders' equity accounts of subsidiary) $520,000 (400,000) $120,000 Indefinite -0- 400,000 Entry A Goodwill ............................................................... 120,000 Investment in Abernethy ............................... 120,000 (To recognize goodwill portion of the original acquisition fair value) Entry I Equity in Earnings of Subsidiary ........................ 80,000 Investment in Abernethy ............................... 80,000 (To eliminate intercompany income accrual for the current year based on the parent's usage of the partial equity method) Entry D Investment in Abernethy .................................... Dividends Paid ............................................... (To eliminate intercompany dividend transfers) Entry E--Not needed. Goodwill is not amortized. Consolidation Entries as of December 31, 2012 Entry *C--Not needed. Goodwill is not amortized. Entry S Common Stock--Abernethy................................ Additional Paid-in Capital--Abernethy .............. Retained Earnings--Abernethy--1/1/12 ............ Investment in Abernethy ............................... 10,000 10,000 250,000 50,000 170,000 470,000 19. (continued) 3-15 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition (To eliminate beginning of year stockholders' equity accounts of subsidiary--the retained earnings balance has been adjusted for 2011 income and dividends.) Entry A Goodwill ............................................................... Investment in Abernethy ............................... (To recognize original goodwill balance.) 120,000 120,000 Entry I Equity in Earnings of Subsidiary ........................ 110,000 Investment in Abernethy ............................... 110,000 (To eliminate Intercompany Income accrual for the current year.) Entry D Investment in Abernethy .................................... Dividends Paid ............................................... (To eliminate Intercompany dividend transfers.) Equity E--not needed 30,000 30,000 20. (45 Minutes) (Variety of questions about the three methods of recording an Investment in a subsidiary for internal reporting purposes.) a. Purchase Price Allocation and Annual Amortization: Clay's acquisition-date fair value ............ $510,000 Book value (assets minus liabilities or stockholders' equity) ...................... 450,000 Fair value in excess of book value .......... 60,000 Annual Excess Allocation to equipment based on Life Amortizations difference between fair and book value .. 50,000 5 yrs. $10,000 Goodwill ..................................................... $10,000 indefinite -0Total .......................................................... $10,000 EQUITY METHOD Investment Income--2011: Equity accrual (based on Clay's income) .................... Amortization (above) ..................................................... Investment income for 2011 ................................................ $55,000 (10,000) $45,000 20. (continued) Investment in Clay--December 31, 2011: 3-16 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition Consideration transferred for Clay ............................... 2010: Equity accrual (based on Clay's Income) ............... Excess amortizations (above) ................................. Dividends received ................................................... 2011: Equity accrual (based on Clay's Income) ................ Excess amortizations ............................................... Dividends received ................................................... Total ................................................................................ INITIAL VALUE METHOD Investment Income--2011: Dividend Income ........................................................... Investment in Clay--December 31, 2011: Consideration transferred for Clay ............................... $510,000 55,000 (10,000) (5,000) 60,000 (10,000) (8,000) $592,000 $8,000 $510,000 b. The reported consolidated balances are not affected by the parent's investment accounting method. Thus, consolidated expenses ($480,000 or $290,000 + $180,000 + amortizations of $10,000) are the same regardless of whether the equity method, the partial equity method, or the initial value method is applied by Adams. c. The reported consolidated balances are not affected by the parent's investment accounting method. Thus, consolidated equipment ($970,000 or $520,000 + $420,000 + allocation of $50,000 two years of excess depreciation totaling $20,000) is the same regardless of whether the equity method or the initial value method is applied by Adams. d. Adams Retained Earnings--Equity Method Adams Retained Earnings--1/1/10 ..................................... Adams income 2010 ............................................................. 2010 equity accrual for Clay income .................................. 2010 excess amortization .................................................... Adams Retained Earnings--1/1/11 ..................................... Adams Retained Earnings--Initial value method Adams Retained Earnings--1/1/10 ..................................... Adams income 2010 ............................................................. 2010 dividend income from Clay ........................................ Adams Retained Earnings--1/1/11 ..................................... 20. (continued) 3-17 $860,000 125,000 55,000 (10,000) $1,030,000 $860,000 125,000 5,000 $990,000 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition e. EQUITY METHOD--Entry *C is not utilized since parent's retained earnings balance is correct. INITIAL VALUE METHOD--Entry *C is needed to record increase in subsidiary's book value ($55,000 income less 5,000 dividends) and amortization ($10,000) for prior year. Investment in Clay .............................................. Retained earnings, 1/1/11 (parent) ................ f. Consolidated worksheet entry S for 2011: Common stock (Clay) .................................... Retained earnings, 1/1/11 (Clay) .................... Investment in Clay .................................... g. Consolidated revenues (combined) .................. Consolidated expenses (combined plus excess amortization) ..................................... Consolidated net income .................................... 21. (15 Minutes) (Consolidated accounts one year after acquisition) Stanza acquisition fair value ($10,000 in stock issue costs reduce additional paid-in capital) .................... $680,000 Book value of subsidiary (1/1/12 stockholders' equity balances) ..... (480,000) Fair value in excess of book value .......... $200,000 Excess fair value allocated to copyrights based on fair value .............................. Goodwill ..................................................... Total ...................................................... 150,000 350,000 500,000 $640,000 (480,000) $160,000 40,000 40,000 Annual Excess Life Amortizations 120,000 6 yrs. $20,000 $80,000 indefinite -0$20,000 a. Consolidated copyrights Penske (book value) ...................................... $900,000 Stanza (book value) ....................................... 400,000 Allocation (above) .......................................... 120,000 Excess amortizations, 2012 .......................... (20,000) Total ........................................................... $1,400,000 21. (continued) b. Consolidated net income, 2012 Revenues (add book values) ........................ Expenses: Add book values ....................................... Excess amortizations ............................... Consolidated net income ............................... c. Consolidated retained earnings, 12/31/12 3-18 $1,100,000 $700,000 20,000 720,000 $380,000 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition Retained earnings 1/1/12 (Penske) ............... Net income 2012 (above) ............................... Dividends paid 2012 (Penske) ...................... Total ........................................................... $600,000 380,000 (80,000) $900,000 Stanza's retained earnings balance as of January 1, 2011, is not included because these operations occurred prior to the purchase. Stanza's dividends were paid to Penske and therefore are excluded because they are intercompany in nature. d. Consolidated goodwill, 12/31/12 Allocation (above) .......................................... 22. $80,000 (30 Minutes) (Consolidated balances three years after the date of acquisition. Includes questions about parent's method of recording investment for internal reporting purposes.) a. Acquisition-Date Fair Value Allocation and Amortization: Consideration transferred 1/1/11 ............. Book value (given) .................................... Fair value in excess of book value ..... Allocation to equipment based on difference in fair value and book value ............................................ Goodwill ..................................................... Total ...................................................... CONSOLIDATED BALANCES Depreciation expense = $659,000 (book values plus $9,000 excess depreciation) Dividends Paid = $120,000 (parent balance only. Subsidiary's dividends are eliminated as intercompany transfer) Revenues = $1,400,000 (add book values) Equipment = $1,563,000 (add book values plus $90,000 allocation less three years of excess depreciation [$27,000]) $600,000 (470,000) 130,000 Annual Excess Life Amortizations $9,000 -0$9,000 90,000 10 yrs. $40,000 indefinite 22. (continued) Buildings = $1,200,000 (add book values) Goodwill = $40,000 (original residual allocation) Common Stock = $900,000 (parent balance only) b. The parent's choice of an investment method has no impact on the consolidated totals. The choice of an investment method only affects the internal reporting of the parent. 3-19 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition c. The initial value method is used. The parent's Investment in Subsidiary account still retains the original consideration transferred of $600,000. In addition, the Investment Income account equals the amount of dividends paid by the subsidiary. d. If the partial equity method had been utilized, the investment income account would have shown an equity accrual of $100,000. If the equity method had been applied, the Investment Income account would have included both the equity accrual of $100,000 and excess amortizations of $9,000 for a balance of $91,000. e. Initial Value Method--Foxx's Retained Earnings--1/1/13 Foxx's 1/1/13 balance (initial value method was employed) $1,100,000 Partial Equity Method--Foxx's Retained Earnings--1/1/13 Foxx's 1/1/13 balance (initial value method) ..................... $1,100,000 2011 net equity accrual for Greenburg (90,000 20,000).. 70,000 2012 net equity accrual for Greenburg (100,000 20,000) 80,000 Foxx's 1/1/13 Retained Earnings ........................................ $1,250,000 Equity Method--Foxx's Retained Earnings--1/1/13 Foxx's 1/1/13 balance (initial value method) ..................... 2011 net equity accrual for Greenburg (90,000 20,000).. 2011 excess fair over book value amortization ................. 2012 net equity accrual for Greenburg (100,000 20,000) 2012 excess fair over book value amortization ................. Foxx's 1/1/13 Retained Earnings ........................................ 23. $1,100,000 70,000 (9,000) 80,000 (9,000) $1,232,000 (50 Minutes) (Consolidated totals for an acquisition. Worksheet is produced as a separate requirement.) a. O'Brien acquisition-date fair value .................... O'Brien book value ............................................. Fair value in excess of book value .................... Excess assigned to specific accounts based on fair value Trademarks .............................. Customer relationships ........... Equipment ................................ Goodwill ................................... Total .......................................... $550,000 (350,000) $200,000 Annual Life Excess Amortizations 100,000 indefinite -075,000 5 yrs. $15,000 (30,000) 10 yrs. (3,000) 55,000 indefinite -0$200,000 $12,000 If the partial equity method were in use, the Income of O'Brien account would have had a balance of $222,000 (100% of O'Brien's reported income for the period). If the initial value method were in use, the Income of O'Brien account would have had a balance of $80,000 (100% of the dividends paid by O'Brien). 3-20 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition The Income of O'Brien balance is an equity accrual of $222,000 (100% of O'Brien's reported income) less excess amortizations of $12,000 (as computed above). Thus, the equity method must be in use. b. Students can develop consolidated figures conceptually, without relying on a worksheet or consolidation entries. Thus, part b. asks students to determine independently each balance to be reported by the business combination. Revenues = $1,645,000 (the accounts of both companies combined) Cost of Goods Sold = 528,000 (the accounts of both companies combined) Amortization Expense = $40,000 (the accounts of both companies and the acquisition-related adjustment of $15,000) Depreciation Expense = $142,000 (the accounts for both companies and the acquisition-related depreciation adjustment of $3,000) Income of O'Brien = $0 (the balance reported by the parent is removed and replaced with the subsidiary's individual revenue and expense accounts) Net Income = 935,000 (consolidated revenues less expenses) Retained Earnings, 1/1 = $700,000 (only the parent's retained earnings figure is included) Dividends Paid = $142,000 (the subsidiary's dividends were paid to the parent and, thus, as an intercompany transfer are eliminated) Retained Earnings, 12/31 = $1,493,000 (the beginning balance for the parent plus consolidated net income less consolidated [parent] dividends) 23. (continued) Cash = $290,000 (the accounts of both companies are added together) Receivables = $281,000 (the accounts of both companies are combined) Inventory = $310,000 (the accounts of both companies are combined) Investment in O'Brien = $0 (the parent's balance is removed and replaced with the subsidiary's individual asset and liability accounts) Trademarks = $634,000 (the accounts of both companies are added together plus the 100,000 fair value adjustment) Customer relationships = $60,000 (the initial $75,000 fair value adjustment less $15,000 amortization expense) Equipment = $1,170,000 (both company's balances less the $30,000 fair value adjustment net of $3,000 in depreciation expense reduction) Goodwill = $55,000 (the original allocation) Total Assets = $2,800,000 (summation of consolidated balances) 3-21 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition Liabilities = $907,000 (the accounts of both companies are combined) Common Stock = $400,000 (parent balance only) Retained Earnings, 12/31 = $1,493,000 (computed above) Total Liabilities and Equities = 2,800,000 (summation of consolidated balances) 3-22 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition 23. (Continued) c. PATRICK COMPANY AND CONSOLIDATED SUBSIDIARY Consolidation Worksheet For Year Ending December 31 Consolidation Entries Patrick O'Brien Debit Credit (1,125,000) (520,000) 300,000 228,000 75,000 70,000 (E) 3,000 25,000 -0(E) 15,000 (210,000) -0(I) 210,000 (935,000) (222,000) (700,000) (935,000) 142,000 (1,493,000) 185,000 225,000 175,000 680,000 (250,000) (222,000) 80,000 (392,000) 105,000 56,000 135,000 (D) 80,000 (S) 350,000 (A) 200,000 (I) 210,000 (E) 15,000 (A) 30,000 (S)250,000 (D) 80,000 Accounts Revenues Cost of goods sold Depreciation expense Amortization expense Income of O'Brien Net income Retained earnings, 1/1 Net income (above) Dividends paid Retained earnings, 12/31 Cash Receivables Inventory Investment in O'Brien Consolidated Totals (1,645,000) 528,000 142,000 40,000 -0(935,000) (700,000) (935,000) 142,000 (1,493,000) 290,000 281,000 310,000 -0634,000 60,000 1,170,000 55,000 2,800,000 (907,000) (400,000) (1,493,000)) (2,800,000) Trademarks Customer relationships Equipment (net) Goodwill Total assets Liabilities Common stock Retained earnings (above) Total liabilities and equity 474,000 -0925,000 -02,664,000 (771,000) (400,000) (1,493,000) (2,664,000) 60,000 -0272,000 -0628,000 (136,000) (100,000) (392,000) (628,000) (A) 100,000 (A) 75,000 (E) 3,000 (A) 55,000 (S)100,000 3-23 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition 24. (60 Minutes) (Consolidation worksheet five years after acquisition with parent using initial value method. Effects of using equity method also included) Acquisition-Date Fair Value Allocation and Annual Amortization: a. Aaron fair value (stock exchanged at fair value) ....................................... Book value of subsidiary ....................... Excess fair value over book value ........ Excess assigned to specific accounts based on fair values Life $470,000 (360,000) $110,000 Annual Excess Amortizations Royalty agreements Trademark Total $60,000 6 yrs. 50,000 10 yrs. $110,000 $10,000 5,000 $15,000 The parent company is apparently applying the initial value method: only dividend income is recognized during the current year and the investment account retains its original $470,000 balance. Therefore, both the subsidiary's change in retained earnings during 20092012 as well as the amortization for that period must be brought into the consolidation. Aaron' retained earnings January 1, 2013 ......................... Retained earnings at date of purchase ............................. Increase since date of purchase ........................................ Excess amortization expenses ($15,000 x 4 years) .......... Conversion to equity method for years prior to 2013 (Entry *C) ................................................................... Explanation of Consolidation Entries Found on Worksheet Entry*C: Converts 1/1/13 figures from initial value method to equity method as per computation above. Entry S: Eliminates stockholders' equity accounts of subsidiary as of the beginning of current year. Entry A: Recognizes allocations to royalty agreements and trademark. This entry establishes unamortized balances as of the beginning of the current year. Entry I: Eliminates intercompany dividends. Entry E: Records excess amortization expenses for the current year. See next page for worksheet. $490,000 (230,000) $260,000 (60,000) $200,000 3-24 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition 24. a. (continued) MICHAEL COMPANY AND CONSOLIDATED SUBSIDIARY Consolidation Worksheet For Year Ending December 31, 2013 Consolidation Entries Michael Aaron Debit Credit $(610,000) $(370,000) 270,000 140,000 115,000 80,000 (E) 15,000 (5,000) -0(I) 5,000 $(230,000) $(150,000) $(880,000) (230,000) 90,000 $(1,020,000) $110,000 380,000 560,000 470,000 460,000 920,000 -0$2,900,000 $(780,000) (300,000) (500,000) (300,000) (1,020,000) $(2,900,000) (490,000) (150,000) 5,000 $(635,000) $15,000 220,000 280,000 -0340,000 380,000 -0$1,235,000 $(470,000) -0(100,000) (30,000) (635,000) $(1,235,000) (S) 490,000 (I) 5,000 (*C) 200,000 Accounts Revenues Cost of goods sold Amortization expense Dividend income Net income Retained earnings 1/1 Net income (above) Dividends paid Retained earnings 12/31 Cash Receivables Inventory Investment in Aaron Co. Copyrights Royalty agreements Trademark Total assets Liabilities Preferred stock Common stock Additional paid-in capital Retained earnings 12/31 Total liabilities and equity Consolidated Totals $(980,000) 410,000 210,000 -0$(360,000) $(1,080,000) -0(360,000) 90,000 $(1,350,000) $125,000 600,000 840,000 -0800,000 1,310,000 25,000 $3,700,000 $(1,250,000) (300,000) (500,000) (300,000) (1,350,000) $(3,700,000) (*C) 200,000 (A) (A) 20,000 30,000 (S) 620,000 (A) 50,000 (E) 10,000 (E) 5,000 (S) 100,000 (S) 30,000 Parentheses indicate a credit balance. 3-25 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition 24. (continued) b. If the equity method had been applied by Michael, three figures on that company's financial records would be different: Equity in Earnings of Aaron, Retained Earnings--1/1/13, and Investment in Aaron Co. Equity in Earnings of Aaron: $135,000 (the parent would accrue 100% of Aaron's $150,000 income but must also recognize $15,000 in amortization expense.) Retained Earnings, 1/1/13: $1,080,000 (increases by $200,000--the parent would have recognized the $260,000 increment in the subsidiary's book value during previous years as well as $60,000 in excess amortization expenses for these same four years [see Part a.]) Investment in Aaron: $800,000 (increases by $330,000--the parent would have recognized the $260,000 increment in the subsidiary's book value during previous years as well as $60,000 in excess amortization expenses for these same four years [see Part a.]. In the current year, of income $135,000 would have been recognized [see above] along with a reduction of $5,000 for dividends received). c. No Entry *C is needed on the worksheet if the equity method is applied. Both the investment account as well as beginning retained earnings would be stated appropriately. Entry I would have been used to eliminate the $135,000 Equity in Earnings of Aaron from the parent's income statement and from the Investment in Aaron Co. account. Entry D would eliminate the $5,000 current year dividend from Dividends Paid and the Investment in Aaron account balances. d. Consolidated figures are not affected by the investment method used by the parent. The parent company balances would differ and changes would be required in the worksheet entries. However, the figures to be reported do not depend on the parent's selection of a method. 25. (65 Minutes) (Consolidated totals and worksheet five years after acquisition. Parent uses equity method. Includes goodwill impairment.) a. Acquisition-date fair value allocations (given) Land Equipment Goodwill Total $90,000 50,000 60,000 $200,000 Excess Amortizations --10 yrs. $5,000 indefinite -0$5,000 Life 3-26 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition Because Giant uses the equity method, the $135,000 "Equity in Income of Small" reflects a $140,000 equity accrual (100% of Small's reported earnings) less $5,000 in amortization expense computed above. b. Revenues = $1,535,000 (both balances are added together) Cost of Goods Sold = $640,000 (both balances are added) Depreciation Expense = $307,000 (both balances are added along with excess equipment depreciation) Equity in Income of Small = $0 (the parent's income balance is removed and replaced with Small's individual revenue and expense accounts) Net Income = $588,000 (consolidated expenses are subtracted from consolidated revenues) Retained Earnings, 1/1/13 = $1,417,000 (the parent's balance) Dividends Paid = $310,000 (the parent number alone because the subsidiary's dividends are intercompany, paid to Giant) Retained Earnings, 12/31/13 = $1,695,000 (the parent's balance at beginning of the year plus consolidated net income less consolidated dividends paid) Current Assets = $706,000 (both book balances are added together while the $10,000 intercompany receivable is eliminated) Investment in Small = $0 (the parent's asset is removed so that Small's individual asset and liability accounts can be brought into the consolidation) Land = $695,000 (both book balances are added together along with the purchase price allocation of $90,000) Buildings = $723,000 (both book balances are added together) Equipment = $959,000 (both book balances are added plus the unamortized portion of the purchase price allocation [$50,000 less $25,000 after 5 years of excess depreciation]) 25. b. (continued) Goodwill = $60,000 (represents the original price allocation) Total Assets = $3,143,000 (summation of all consolidated assets) Liabilities = $1,198,000 (both balances are added together while the $10,000 intercompany payable is eliminated) Common Stock = $250,000 (parent balance only) Retained Earnings, 12/31/13 = $1,695,000 (see above) 3-27 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition Total Liabilities and Equity = $3,143,000 (summation of all consolidated liabilities and equity) a. Worksheet is presented on following page. b. If all goodwill from the Small investment was determined to be impaired, Giant would make the following journal entry on its books: Goodwill impairment loss Investment in Small 60,000 60,000 After this entry, the worksheet process would no longer require an adjustment in Entry (A) to recognize goodwill. The impairment loss would simply carry over to the consolidated income column. The impairment loss would be reported as a separate line item in the operating section of the consolidated income statement. 3-28 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition 25. c. (continued) GIANT COMPANY AND SMALL COMPANY Consolidation Worksheet For Year Ending December 31, 2013 Accounts Revenues ............................................................ Cost of goods sold............................................. Depreciation expense ........................................ Equity income of Small...................................... Net income .................................................... Retained earnings 1/1 ........................................ Net income (above) ............................................ Dividends paid ................................................... Retained earnings 12/31 .............................. Current assets .................................................... Investment in Small ........................................... Giant (1,175,000) 550,000 172,000 (135,000) (588,000) (1,417,000) (588,000) 310,000 (1,695,000) 398,000 995,000 Small (360,000) 90,000 130,000 -0(140,000) (620,000) (140,000) 110,000 (650,000) 318,000 -0Consolidation Entries Debit Credit Consolidated Totals (1,535,000) 640,000 307,000 -0(588,000) (1,417,000) (588,000) 310,000 (1,695,000) 706,000 -0- (E) 5,000 (I) 135,000 (S) 620,000 (D) 110,000 (D) 110,000 (P) 10,000 (S) 790,000 (A) 180,000 (I) 135,000 Land ................................................................. Buildings (net) .................................................... Equipment (net).................................................. Goodwill.............................................................. Total assets .................................................. Liabilities ............................................................ Common stock ................................................... Retained earnings (above) ................................ Total liabilities and equity............................ Parentheses indicate a credit balance. 440,000 304,000 648,000 -02,785,000 (840,000) (250,000) (1,695,000) (2,785,000) 165,000 419,000 286,000 -01,188,000 (368,000) (170,000) (650,000) (1,188,000) (A) 90,000 (A) 30,000 (A) 60,000 (E) 5,000 695,000 723,000 959,000 60,000 3,143,000 (1,198,000) (250,000) (1,695,000) (3,143,000) (P) 10,000 (S)170,000 3-29 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition 26. (30 Minutes) (Determine consolidated accounts and consolidation entries five years after purchase. Parent applies equity method.) a. Fair Value Allocation and Annual Amortization Allocation $20,000 (30,000) 60,000 100,000 Life 10 yrs. 5 yrs. 20 yrs. Annual Excess Amortizations $(3,000) 12,000 5,000 $14,000 Land ..................................... Buildings .............................. Equipment ............................ Customer List ...................... Total ..................................... CONSOLIDATED TOTALS Revenues = $850,000 (add the two book values) Cost of Goods Sold = $380,000 (the accounts of both companies are added together) Depreciation Expense = $179,000 (the accounts are added and include the excess depreciation adjustment of $9,000) Amortization Expense = $5,000 (current amortization for customer list recognized in acquisition) Buildings (net) = $625,000 (add the two book values less the purchase price allocation [a $30,000 reduction] after removing 5 years of amortization totaling $15,000) Equipment (net) = $450,000 (add the two book values. The purchase price allocation is completely amortized at end of current year) Customer List = $75,000 ($100,000 original allocation less $25,000 [5 years of amortization]) Common stock = $300,000 (parent company balance only) Additional paid-in capital = $50,000 (parent company balance only) b. The method used by the parent is only important in determining the parent's separate account balances (which are given here or are not needed) or consolidation worksheet entries (which are not required in a.) 3-30 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition 26. (continued) c. Consolidation Entry S Common Stock (Hill) ............................ 40,000 Additional paid-in capital (Hill) ........... 160,000 Retained Earnings 1/1 ......................... 600,000 Investment in Hill ............................ 800,000 (To eliminate beginning stockholders' equity of subsidiary) Consolidation Entry A Land ...................................................... 20,000 Equipment (net) ................................... 12,000 Customer List (net) .............................. 80,000 Buildings (net) ................................ 18,000 Investment in Hill ............................ 94,000 (To record unamortized allocation balances as of beginning of current year) Consolidation Entry I Investment Income .............................. 86,000 Investment in Hill ............................ 86,000 (To remove equity income recognized during year--equity method accrual of $100,000 [based on subsidiary's income] less amortization of $14,000 for the year) Consolidation Entry D Investment in Hill ................................. 40,000 Dividends Paid ................................ (To remove Intercompany dividend payments) 40,000 Consolidation Entry E Amortization expense........................... 5,000 Depreciation expense ........................... 9,000 Buildings .............................................. 3,000 Equipment ........................................ 12,000 Customer List .................................. 5,000 (To recognize excess acquisition-date fair-value amortizations for the period) 27. (30 Minutes) (Determine parent company and consolidated account balances for a bargain purchase combination. Parent applies equity method) Acquisition-Date Fair Value Allocation and Annual Excess Amortization Consideration transferred ............. Santiago book value (given) .......... Technology undervaluation (6 yr. life) $1,090,000 $950,000 240,000 a. 3-31 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition Acquisition fair value of net assets Gain on bargain purchase .............. Santiago income .............................. Technology amortization ................ Equity earnings in Santiago ........... Fair value of net assets at acquisition-date Equity earnings from Santiago....... Dividends received .......................... Investment in Santiago 12/31/11 .... 1,190,000 $(100,000) $(200,000) 40,000 $(160,000) $1,190,000 160,000 (50,000) $1,300,000 Because a bargain purchase occurred, Santiago's net asset fair value replaces the fair value of the consideration transferred as the initial value assigned to the subsidiary on Peterson's books.b. Income Statement Revenues Cost of goods sold Gain on bargain purchase Depreciation and amortization Equity earnings in Santiago Net income Statement of Retained Earnings Retained earnings, 1/1 Net income (above) Dividends paid Retained earnings, 12/31 Balance Sheet Current assets Investment in Santiago Peterson (535,000) 170,000 (100,000) 125,000 (160,000) (500,000) Santiago (495,000) 155,000 -0140,000 -0(200,000) Adj. & Elim. Consolidated (1,030,000) 325,000 (100,000) 305,000 -0(500,000) (E) 40,000 (I) 160,000 (1,500,000) (500,000) 200,000 (1,800,000) (650,000) (200,000) 50,000 (800,000) (S) 650,000 (D) 50,000 (1,500,000) (500,000) 200,000 (1,800,000) 190,000 1,300,000 300,000 -0- 490,000 (D) 50,000 (I) 160,000 (S) 950,000 (A) 240,000 (E) 40,000 -0- Trademarks Patented technology Equipment Total assets Liabilities Common stock Retained earnings, 12/31 Total liabilities and equity 100,000 300,000 610,000 2,500,000 (165,000) (535,000) (1,800,000) (2,500,000) 200,000 400,000 300,000 1,200,000 (100,000) (300,000) (800,000) (1,200,000) (A) 240,000 300,000 900,000 910,000 2,600,000 (265,000) (535,000) (1,800,000) (2,600,000) (S) 300,000 1,440,000 1,440,000 3-32 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition 28. (35 minutes) (Acquisition method: Contingent performance obligation and worksheet adjustments for equity and initial value methods.) a. Investment in Wolfpack, Inc. Contingent performance obligation Cash 500,000 35,000 465,000 b. 12/31/11 Loss from increase in contingent performance obligation Contingent performance obligation 5,000 5,000 12/31/12 Loss from increase in contingent performance obligation 10,000 Contingent performance obligation 10,000 12/31/12 Contingent performance obligation Cash c. Equity Method Common stock- Wolfpack Retained earnings-Wolfpack Investment in Wolfpack Royalty agreements Goodwill Investment in Wolfpack Equity earnings of Wolfpack Investment in Wolfpack Investment in Wolfpack Dividends paid Amortization expense Royalty agreements d. Initial Value Method Investment in Wolfpack Retained earnings-Branson Common stock Retained earnings-Wolfpack Investment in Wolfpack 28. (continued) 3-33 50,000 50,000 200,000 180,000 380,000 90,000 60,000 150,000 65,000 65,000 35,000 35,000 10,000 10,000 30,000 30,000 200,000 180,000 380,000 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition Royalty agreements Goodwill Investment in Wolfpack Dividend income Dividends paid Amortization expense Royalty agreements 90,000 60,000 150,000 35,000 35,000 10,000 10,000 29. (45 Minutes) (Prepare consolidation worksheet five years after purchase. Parent applies equity method. Includes question on push-down accounting.) a. Allocation of Acquisition-Date Fair Value and Determination of Amortization: Storm's acquisition-date fair value .................... Book value of Storm (acquisition date) ............. Fair value in excess of book value .................... Excess assigned to specific accounts: Life $140,000 (105,000) $35,000 Annual Excess Amortizations Land ........................................... Equipment ................................. Formula ...................................... Total ................................................ $10,000 5,000 20,000 $35,000 5 yrs. 20 yrs. $1,000 1,000 $2,000 The equity in subsidiary earnings account reflects the equity method. The initial value method would have recorded $40,000 (100% of dividend payments) as income while the partial equity method would have shown $68,000 (100% of the subsidiary's income). Under the equity method, an income accrual of $66,000 is recognized (100% of reported income less the $2,000 in excess amortization expenses computed above). b. Explanation of Consolidation Entries Found on Worksheet Entry S--Eliminates stockholders' equity accounts of the subsidiary as of the beginning of the current year. Entry A--Records remaining unamortized allocation from acquisitiondate fair value adjustments. As of the beginning of the current year, equipment and formula have undergone four years of amortization. Entry I--Eliminates intercompany income accrual for the current year. Entry D--Eliminates intercompany dividend transfers. Entry E--Recognizes excess amortization expenses for current year. 3-34 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition 2009 Consolidation Entries S Common Stock APIC 60,000 5,000 Retained earnings 40,000 Investment in Storm A Land Bld. & Equip. Formula 10,000 5,000 20,000 35,000 105,000 Investment in Storm 3-35 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition I Equity in Sub Earnings Investment in Storm D Investment in Storm Dividends Paid (Dividends paid) E Depreciation Expense 1000 Amortization Expense 1000 Bld. & Equip. Formula 1000 1000 3-36 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition 2013 Consolidation Entries S Common Stock APIC 60,000 5,000 Retained earnings 98,000 Investment in Storm 163,000 A Land 10,000 Bld. & Equip. 1,000 Formula 16,000 27,000 Investment in Storm 3-37 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition I Equity in Sub Earnings Investment in Storm D Investment in Storm Dividends Paid 40,000 40,000 66,000 66,000 E Depreciation Expense 1000 Amortization Expense 1000 Bld. & Equip. Formula 1000 1000 3-38 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition 29. (continued) Palm and Subsidiary Consolidated Worksheet for year ended December 31, 2013 Accounts Income Statement Revenues .......................................................... Cost of goods sold........................................... Depreciation expense ...................................... Amortization expense ...................................... Equity in subsidiary earnings ......................... Net income .................................................. Statement of Retained Earnings Retained earnings 1/1 ...................................... Net income (above) .......................................... Dividends paid ................................................. Retained earnings 12/31 ............................ Balance Sheet Current assets .................................................. Investment in Storm Co. .................................. Palm Co. (485,000) 160,000 130,000 -0(66,000) (261,000) Storm Co. Consolidation Entries Debit Credit Consolidated Totals (675,000) 230,000 183,000 1,000 -0(261,000) (190,000) 70,000 52,000 (E) 1,000 -0- (E) 1,000 -0- (I) 66,000 (68,000) (659,000) (261,000) 175,500 (744,500) (98,000) (S) 98,000 (68,000) 40,000 (126,000) (D) 40,000 (659,000) (261,000) 175,500 (744,500) 268,000 216,000 75,000 -0- (D) 40,000 (S) 163,000 (A) 27,000 (I) 66,000 (E) (E) 1,000 1,000 343,000 -0- Land ............................................................... Buildings and equipment (net) ........................ Formula............................................................. Total assets ................................................ Current liabilities.............................................. Long-term liabilities ......................................... Common stock ................................................. Additional paid-in capital................................. Retained earnings 12/31 .................................. Total liabilities and equity.......................... Parentheses indicate a credit balance. 3-39 427,500 713,000 -01,624,500 (110,000) (80,000) (600,000) (90,000) (744,500) (1,624,500) 58,000 161,000 -0294,000 (A) 10,000 (A) 1,000 (A) 16,000 495,500 874,000 15,000 1,727,500 (129,000) (164,000) (600,000) (90,000) (744,500) (1,727,500) (19,000) (84,000) (60,000) (S) 60,000 (5,000) (S) 5,000 (126,000) (294,000) Chapter 03 - Consolidations--Subsequent to the Date of Acquisition 29. (continued) c. If push-down accounting had been applied, the purchase price allocations to land ($10,000), equipment ($5,000), and formula ($20,000) would have been entered into the subsidiary's balances with an offsetting $35,000 increase in additional paid-in capital. The equipment and the formula would then have been amortized by the subsidiary as annual expenses of $1,000 each. For 2013, the subsidiary's expenses would have been $2,000 higher leaving reported net income at $66,000. At the end of 2013, land would still have been $10,000 higher because no amortization is recorded on that asset. Equipment would be no higher at this time since the $5,000 allocation is fully depreciated at the end of this fifth year. However, the secret formula would be recorded by the subsidiary as $15,000, the $20,000 allocation less five years of amortization at $1,000 per year. 30. (20 Minutes) (Consolidated balances three years after purchase. Parent has applied the equity method.) a. Schedule 1--Acquisition-Date Fair Value Allocation and Amortization Jasmine's acquisition-date fair value $206,000 Book value of Jasmine .................. (140,000) Fair value in excess of book value 66,000 Excess fair value assigned to specific accounts based on individual fair values Equipment ................................. Buildings (overvalued) ............. Goodwill ..................................... Total ........................................... Annual Excess Life Amortization 54,400 8 yrs. $6,800 (10,000) 20 yrs. (500) $21,600 indefinite -0$6,300 $206,000 40,000 (6,300) 20,000 (6,300) 10,000 (6,300) $257,100 Investment in Jasmine Company--12/31/11 Jasmine's acquisition-date fair value ............................ 2009 Increase in book value of subsidiary ................... 2009 Excess amortizations (Schedule 1) ..................... 2010 Increase in book value of subsidiary ................... 2010 Excess amortizations (Schedule 1) ..................... 2011 Increase in book value of subsidiary ................... 2011 Excess amortizations (Schedule 1) ..................... Investment in Jasmine Company ............................ 3-41 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition 30. (continued) b. Equity in Subsidiary Earnings Income accrual ................................................................ Excess amortizations (Schedule 1) .............................. Equity in subsidiary earnings .................................. c. Consolidated Net Income Consolidated revenues (add book values) .................. Consolidated expenses (add book values) .................. Excess amortization expenses (Schedule 1) ............... Consolidated net income ............................................... d. Consolidated Equipment Book values added together ......................................... Allocation of purchase price ......................................... Excess depreciation ($6,800 3) .................................. Consolidated equipment .......................................... e. Consolidated Buildings .................................................. Book values added together ......................................... Allocation of purchase price ......................................... Excess depreciation ($500 3) ..................................... Consolidated buildings ............................................. f. Consolidated goodwill Allocation of excess fair value to goodwill ................... g. Consolidated Common Stock ........................................ $414,000 (272,000) (6,300) $135,700 $370,000 54,400 (20,400) $404,000 $30,000 (6,300) $23,700 $288,000 (10,000) 1,500 $279,500 $21,600 $290,000 As a purchase, the parent's balance of $290,000 is used (the acquired company's common stock will be eliminated each year on the consolidation worksheet). h. Consolidated Retained Earnings ................................... $410,000 Tyler's balance of $410,000 is equal to the consolidated total because the equity method has been applied. 31. a. (35 minutes) (Consolidation with IPR&D, equity method) Consideration transferred 1/1/10 Increase in Salsa's RE to1/1/11 In-process R&D write-off in 2010 Amortizations 2010 Income 2011 Dividends paid 2011 Amortization 2011 Investment balance 12/31/11 3-42 $1,765,000 150,000 (44,000) (7,000) 210,000 (25,000) (7,000) $2,042,000 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition 31. (continued) b. Picante and Subsidiary Salsa Consolidated Worksheet for the year ended December 31, 2011 12/31/11 Picante (3,500,000) 1,600,000 540,000 (203,000) (1,563,000) (3,000,000) (1,563,000) 200,000 (4,363,000) 228,000 840,000 900,000 2,042,000 12/31/11 Salsa (1,000,000) 630,000 160,000 (210,000) (800,000) (210,000) 25,000 (985,000) 50,000 155,000 580,000 (D) 25,000 (S)1,800,000 (A) 64,000 (I) 203,000 (E) 7,000 (S) 800,000 (D) 25,000 Adjustments Consolidated (4,500,000) 2,230,000 707,000 -0(1,563,000) (3,000,000) (1,563,000) 200,000 (4,363,000) 278,000 995,000 1,480,000 -0- Accounts Sales Cost of Goods Sold Depreciation Expense Subsidiary Income Net Income Ret. Earnings 1/1/11 Net Income Dividends Paid Ret. Earnings 12/31/11 Cash Accounts Receivable Inventory Investment in Salsa (E) 7,000 (I) 203,000 Land Equipment (net) Goodwill Total Assets Accounts Payable Long-term Debt Common Stock--Picante Common Stock--Salsa Ret. Earnings 12/31/11 3,500,000 5,000,000 290,000 12,800,000 (193,000) (3,094,000) (5,150,000) (4,363,000) (12,800,000) 700,000 1,700,000 -03,185,000 (400,000) (800,000) (1,000,000) (985,000) (3,185,000) (A) 49,000 (A) 15,000 4,200,000 6,742,000 305,000 14,000,000 (593,000) (3,894,000) (5,150,000) (S)1,000,000 2,099,000 2,099,000 (4,363,000) (14,000,000) 32. (55 minutes) (Goodwill impairment test, consolidated balances, and worksheet) a. Prine should compare Lydia's total fair value to its carrying value, as follows: 12/31 Carrying value (equity method balance) $120,070,000 12/31 Fair value 110,000,000 Excess carrying value over fair value $10,070,000 3-43 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition Because fair value is less than carrying value, Prine is required to further test whether goodwill is impaired. b. 12/31 Fair value for Lydia Fair values of assets and liabilities Cash Receivables (net) Movie library Broadcast licenses Equipment Current liabilities Long-term debt Total net fair value Implied fair value for goodwill Carrying value for goodwill Impairment loss Journal Entry by Prine: Goodwill impairment loss Investment in Lydia Co. $110,000,000 $109,000 897,000 60,000,000 20,000,000 19,000,000 (650,000) (6,250,000) 93,106,000 16,894,000 50,000,000 $33,106,000 33,106,000 33,106,000 c. Combined revenues $30,000,000 Combined expenses (including excess amortization) 22,200,000 Income before impairment loss 7,800,000 Goodwill impairment loss--Lydia (33,106,000) Net loss $(25,306,000) d. Consolidated goodwill = $50,000,000 $33,106,000 = $16,894,000 32. (continued) e. Consolidated broadcast licenses = $350,000 + $14,014,000 = $14,364,000 The consolidated balance equals the sum of parent's book value plus the fair value of the subsidiary broadcast licenses at acquisition date adjusted for any changes since acquisition. Because the subsidiary's book value equaled fair value at acquisition date, no worksheet adjustment is needed. Because the broadcast licenses are considered to have indefinite lives, they are not amortized. Note that the 12/31 fair value, assessed for purposes of computing implied value for goodwill, is not used for financial reporting purposes. 3-44 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition 32. f. (continued) Prine and Lydia Consolidated Worksheet December 31 Prine, Inc. (18,000,000) 10,350,000 (150,000) 33,106,000 25,306,000 (52,000,000) 300,000 25,306,000 (26,394,000) 260,000 210,000 86,964,000 Lydia Co. (12,000,000) 11,800,000 (E) -0- (I) -0(200,000) Adjusting Entries Debit Credit 50,000 150,000 Consolidated Totals (30,000,000) 22,200,000 -033,106,000 25,306,000 (52,000,000) 300,000 25,306,000 (26,394,000) 369,000 1,107,000 -0- Accounts Revenues Expenses Equity in Lydia earnings Impairment loss Net income/loss Retained Earnings 1/1 Dividends paid Net income Retained earnings 12/31 Cash Receivables (net) Investment in Lydia, Co. (2,000,000) (S) 2,000,000 80,000 (200,000) (2,120,000) 109,000 897,000 -0- (D) (D) 80,000 80,000 (S)69,500,000 (A)17,394,000 (I) 150,000 Broadcast licenses Movie library Equipment (net) Goodwill Total assets Current Liabilities Long-term Debt Common stock Retained earnings 12/31 Total liabilities and equity 350,000 365,000 136,000,000 -0224,149,000 (755,000) (22,000,000) (175,000,000) (26,394,000) (224,149,000) 14,014,000 45,000,000 17,500,000 (A) 500,000 -0- (A)16,894,000 77,520,000 (650,000) (7,250,000) (67,500,000) (S)67,500,000 (2,120,000) (77,520,000) (E) 14,364,000 45,365,000 50,000 153,950,000 16,894,000 232,049,000 (1,405,000) (29,250,000) (175,000,000) (26,394,000) (232,049,000) 3-45 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition FARS Case Solution Jonas recognized several identifiable intangibles from its acquisition of Innovation+. Jonas expresses the desire to expense these intangible assets in the acquisition period. 1. Advise Jonas on the acceptability of its suggested immediate write-off. An intangible asset should not be written down or off in the period of acquisition unless it becomes impaired during that period. 2. Indicate the relevant factors to consider in allocating the values assigned to identifiable intangibles acquired in a business combination. The accounting for a recognized intangible asset is based on its useful life to the reporting entity. An intangible asset with a finite useful life is amortized; an intangible asset with an indefinite useful life is not amortized. The useful life of an intangible asset to an entity is the period over which the asset is expected to contribute directly or indirectly to the future cash flows of that entity. Other factors to be considered are legal, regulatory, or contractual provisions, effects of obsolescence, demand, competition, and other economic factors, and the level of maintenance expenditures required to obtain the expected future cash flows from the asset. (paragraph 11 SFAS 142) The price paid by Jonas for Innovation+ indicates a large amount was paid for goodwill. However, Jonas worries that any future goodwill impairment may send the wrong signal to its investors about the wisdom of the Innovation+ acquisition. Jonas thus wishes to allocate all the goodwill to one account called "enterprise goodwill." In this way, Jonas hopes to minimize the possibility of goodwill impairment because a decline in goodwill in one business unit may be offset by an increase in the value of goodwill in another business unit. 3. Jonas' suggested treatment of goodwill is inappropriate. To ensure that goodwill increases in one reporting unit do not offset decreases in others, goodwill acquired in a business combination is allocated across business units that benefit from the goodwill. Per the FASB ASC: For the purpose of testing goodwill for impairment, all goodwill acquired in a business combination shall be assigned to one or more reporting units as of the acquisition date. Goodwill shall be assigned to reporting units of the acquiring entity that are expected to benefit from the synergies of the combination even though other assets or liabilities of the acquired entity may not be assigned to that reporting unit. The total amount of acquired goodwill may be divided among a number of reporting units. The methodology used to determine the amount of goodwill to assign to a reporting unit shall be reasonable and supportable and shall be applied in a consistent manner. 3-46 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition Therefore, Jonas' desire to minimize the possibility of goodwill impairment should not be a factor in allocating goodwill to reporting units. Sprint Nextel Research Case Solution--Goodwill Impairment 1) Sprint reported a $29.7 billion non-cash goodwill impairment charge in 2007 2) Sprint wrote down their goodwill in 2007 because they experienced a sustained, significant decline in their stock price, which was due in large part to "fewer than expected net subscriber additions." The following examples are provided as possible interim triggering events in FASB ASC 350-20-35-30): A significant adverse change in legal factors or in the business climate An adverse action or assessment by a regulator Unanticipated competition A loss of key personnel A "more likely than not" expectation that a reporting unit or a significant portion of a reporting unit will be sold or otherwise disposed of The testing for recoverability under FAS 144 or a significant asset group within a reporting unit Recognition of a goodwill impairment loss in the standalone financial statements of a subsidiary that is a component of a reporting unit. 3) Consolidated Balance Sheets: Goodwill down from $30,904 in 2006 to $935 in 2007 (in millions) Consolidated Statement of Operations: Goodwill impairment: $29,729 million Consolidated Statement of Cash Flows: Goodwill impairment: $29,729 million 4) Sprint reviews their goodwill for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. Testing Steps: First step: compare the fair value of their wireless reporting unit with its net book value. If the fair value of the wireless reporting unit exceeds its net book value, goodwill is not impaired, and no further testing is necessary. If the net book value of the wireless reporting unit exceeds its fair value, a second test is performed. Second step: compare the implied fair value of goodwill with that recorded on the balance sheet. Implied fair value of goodwill is determined in the same manner as if the wireless reporting unit were being acquired in a business combination. Specifically, fair value of the wireless reporting unit is allocated to all of the assets and liabilities of that unit, including any unrecognized intangible assets, in a hypothetical calculation that would yield the implied fair value of goodwill. If the 3-47 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition implied fair value of goodwill is less than the goodwill recorded on their balance sheet, an impairment charge is recorded for the difference. 5) Sprint incurred a $163 million impairment charge for their long-lived assets in 2007, primarily attributable to their Wireless segment, which included the write-off of cell site development costs that they abandoned as the sites would not be used based on management's strategic network plans, the sale of Velocita Wireless, and the closing of retail stores due to integration efforts. There was no impairment charge for intangible assets both indefinite-lived and finite-lived. Sprint tests other indefinite-lived intangibles for impairment by comparing the asset's respective net book value to estimates of fair value. (One-step) The test is done annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. (Same as goodwill) Sprint reviews their long-lived assets (including intangible assets with a finite life) for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. The assets are impaired if the total of the expected undiscounted future cash flows is less than the carrying amount of their long-lived assets, a loss is recognized for the difference between the fair value and carrying value of the assets (Two-step). 6) GAAP prohibits reversal of impairment loss for goodwill. IFRS also prohibits reversal of impairment loss for goodwill 7) No, the requirement for goodwill impairment is different under IFRS. Under IFRS, Goodwill impairment testing is performed under a one-step approach: The recoverable amount of the CGU (cash-generating unit) or group of CGUs (i.e., the higher of its fair value minus costs to sell and its value in use) is compared with its carrying amount. Any impairment loss is recognized in operating results as the excess of the carrying amount over the recoverable amount. The impairment loss is allocated first to goodwill and then on a pro rata basis to the other assets of the CGU or group of CGUs to the extent that the impairment loss exceeds the book value of goodwill. IAS 36 Impairment of Assets: 88. When, as described in paragraph 81, goodwill relates to a cash-generating unit but has not been allocated to that unit, the unit shall be tested for impairment, whenever there is an indication that the unit may be impaired, by comparing the unit's carrying amount, excluding any goodwill, with its recoverable amount. Any impairment loss shall be recognised in accordance with paragraph 104. 90. A cash-generating unit to which goodwill has been allocated shall be tested for impairment annually, and whenever there is an indication that the 3-48 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition unit may be impaired, by comparing the carrying amount of the unit, including the goodwill, with the recoverable amount of the unit. If the recoverable amount of the unit exceeds the carrying amount of the unit, the unit and the goodwill allocated to that unit shall be regarded as not impaired. If the carrying amount of the unit exceeds the recoverable amount of the unit, the entity shall recognise the impairment loss in accordance with paragraph 104. 104. An impairment loss shall be recognised for a cash-generating unit (the smallest group of cash-generating units to which goodwill or a corporate asset has been allocated) if, and only if, the recoverable amount of the unit (group of units) is less than the carrying amount of the unit (group of units). The impairment loss shall be allocated to reduce the carrying amount of the assets of the unit (group of units) in the following order: (a) first, to reduce the carrying amount of any goodwill allocated to the cashgenerating unit (group of units); and (b) then, to the other assets of the unit (group of units) pro rata on the basis of the carrying amount of each asset in the unit (group of units). These reductions in carrying amounts shall be treated as impairment losses on individual assets and recognised in accordance with paragraph 60. AOL Time Warner Analysis Case Solution--Goodwill Impairment 1. How did AOL determine the initial amount of goodwill to recognize in its merger with Time Warner? The merger of America Online and Time Warner has been accounted for by AOL Time Warner as an acquisition of Time Warner under the purchase method of accounting for business combinations. Under the purchase method of accounting, the cost, including transaction costs, to acquire Time Warner was allocated to the underlying net assets, based on their respective estimated fair values. The excess of the purchase price over the estimated fair values of the net assets acquired was recorded as goodwill. 2. How did AOL Time Warner determine the $99 billion impairment charge to its goodwill? What procedures will Time Warner follow in the future to assess the value of its goodwill? AOL Time Warner determined the goodwill write-down by employing the twostep impairment test. In step one, the carrying value of each reporting unit was compared to its fair value. If the book value of the reporting unit exceeded the fair value, AOL employed step two by comparing goodwill's book value to its implied fair value. 3-49 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition From the 2002 annual report: The $54.199 billion goodwill impairment is associated entirely with goodwill resulting from the Merger. The amount of the impairment primarily reflects the decline in the Company's stock price since the Merger was announced and valued for accounting purposes in January of 2000. Prior to performing the review for impairment, FAS 142 required that all goodwill deemed to be related to the entity as a whole be assigned to all of the Company's reporting units, including the reporting units of the acquirer. This differs from the previous accounting rules where goodwill was assigned only to the businesses of the company acquired. As a result, a portion of the goodwill generated in the Merger has been reallocated to the AOL segment. During the fourth quarter of 2002, the Company performed its annual impairment review for goodwill and other intangible assets and recorded an additional charge of $45.538 billion, which is recorded as a component of operating income in the accompanying consolidated statement of operations. The $45.538 billion is reflective of the overall decline in market values and includes charges to reduce the carrying value of goodwill at the AOL segment ($33.489 billion), Cable segment ($10.550 billion) and Music segment ($646 million), as well as a charge to reduce the carrying value of brands and trademarks at the Music segment ($853 million). 3. What business areas has AOL designated as its reporting units? Why is it important to define the reporting unit? A reporting unit is an operating segment or a component. AOL's reporting units are consistent with its operating segments, which are classified based on different business interest areas as follows: 1ST quarter 2002 Reporting Units impairment loss AOL -0Cable $22,980 Filmed Entertainment 4,091 Networks 13,077 Music 4,796 Publishing 9,259 st Total 1 quarter 2002 impairment losses $54,203 Since the goodwill impairment test is dependent upon the fair value of a reporting unit, companies may prefer to aggregate operating segment 3-50 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition components when identifying reporting units so that they can reduce the probability of a goodwill impairment charge. 4. What effects did SFAS 142 have on AOL Time Warner's earnings performance both in the short term and in the long run? In the short term, the $54 billion directly reduced AOL Time Warner's net income and retained earnings, resulting in a net loss of $54.240 billion in the first quarter. Because this charge was recorded as "cumulative effect of accounting change," it didn't affect AOL's operating income. As a non-cash charge, it didn't affect cash flow either. However, the 4th quarter charge of $45.5 billion, was recorded as a component of operating income in the accompanying consolidated statement of operations. Only in the 1st quarter of 2002 were firm's allowed to avoid reporting goodwill impairment losses in operating income. In the long run, SFAS 142 eliminated the amortization of goodwill, but companies face the risk of further goodwill impairment. So, the rule may make Time Warner and other public companies more accountable for acquisition choices. 5. The rationale is to improve the financial reporting. The accounting treatment for goodwill should better reflect the underlying economics of goodwill. Instead of regarding goodwill as a steadily "wasting" asset, the impairment method regards the goodwill as one that sporadically declines or even conceivably maintains its value in perpetuity, which is consistent with the concept of representational faithfulness. Excel Case 1 Solution a. Innovus employs initial value method to account for ChipTech. Innovus (990,000) 500,000 100,000 55,000 (40,000) (375,000) (1,555,000) (375,000) 250,000 (1,680,000) 960,000 ChipTech (210,000) 90,000 5,000 18,000 -0(97,000) (450,000) (97,000) 40,000 (507,000) 355,000 3-51 Adjustments Revenues Cost of good sold Depreciation expense Amortization expense Dividend income Net Income Retained earnings 1/1 Net income Dividends paid Retained earnings 12/31 Current assets (E) 20,000 (I) 40,000 Consolidated (1,200,000) 590,000 105,000 93,000 -0(412,000) (1,615,000) (412,000) 250,000 (1,777,000) 1,315,000 (S)450,000 (C*) 60,000 (I) 40,000 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition Investment in Chiptech 670,000 (C*) 60,000 (S) 580,000 (A) 150,000 -0990,000 367,000 93,000 500,000 3,265,000 (868,000) (500,000) (120,000) (1,777,000) (3,265,000) Equipment (net) Trademark Existing technology Goodwill Total assets Liabilities Common stock Additional paid-in capital Retained earnings 12/31 Total liabilities and equity 765,000 235,000 0 450,000 3,080,000 (780,000) (500,000) (120,000) (1,680,000) (3,080,000) 225,000 100,000 45,000 -0725,000 (88,000) (100,000) (30,000) (507,000) (725,000) (A) 36,000 (A) 64,000 (A) 50,000 (E) 4,000 (E) 16,000 (S)100,000 (S) 30,000 850,000 850,000 Excel Case 1 Solution (continued) b. Innovus employs initial value method to account for ChipTech and goodwill is impaired. Innovus (990,000) 500,000 100,000 55,000 50,000 (40,000) (325,000) (1,555,000) (325,000) 250,000 (1,630,000) 960,000 620,000 ChipTech (210,000) 90,000 5,000 18,000 -0(97,000) (450,000) (97,000) 40,000 (507,000) 355,000 (C) 60,000 (S)580,000 (S)150,000 Equipment (net) Trademark Existing technology Goodwill Total assets Liabilities Common stock Additional paid-in capital 765,000 235,000 -0450,000 3,030,000 (780,000) (500,000) (120,000) 3-52 Revenues Cost of good sold Depreciation expense Amortization expense Impairment loss Dividend income Net Income Retained earnings 1/1 Net income Dividends paid Retained earnings 12/31 Current assets Investment in Chiptech (E) 20,000 (E) 40,000 Consolidated (1,200,000) 590,000 105,000 93,000 50,000 -0(362,000) (C) 60,000 (D) 40,000 (1,615,000) (362,000) 250,000 (1,727,000) 1,315,000 (S)450,000 225,000 100,000 45,000 -0725,000 (88,000) (100,000) (30,000) (A) 36,000 (A )64,000 (A) 50,000 (E) 4,000 (E) 16,000 50,000 -0990,000 367,000 93,000 450,000 3,215,000 (868,000) (500,000) (120,000) (S)100,000 (S) 30,000 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition Retained earnings 12/31 Total liabilities and equity (1,630,000) (3,030,000) (507,000) (725,000) 900,000 900,000 (1,727,000) (3,215,000) Alternatively, the goodwill impairment loss could have been recorded as an adjustement on the worksheet. Excel Case 2 Solution Part a: Investment in Wi-Free account balance 12/31/11 Wi-Free's acquisition-date fair value Change in Wi-Free's retained earnings for 2010 2010 amortization 2010 in-process R&D write-off 2011 reported Wi-Free income 2011 Wi-Free dividend 2011 amortization Balance 12/31/11 Part b: Revenues Cost of good sold Depreciation expense Amortization expense Equity in subsidiary earnings Net Income Retained earnings 1/1 Net income Dividends paid Retained earnings 12/31 Current assets Investment in Wi-Free Hi-Speed (1,100,000) 625,000 140,000 50,000 (175,500) (460,500) (1,552,500) (460,500) 250,000 (1,763,000) 1,034,000 856,000 Wi-Free (325,000) 122,000 12,000 11,000 -0(180,000) (450,000) (180,000) 50,000 (580,000) 345,000 (D) 50,000 $730,000 80,000 (4,500) (75,000) 180,000 (50,000) (4,500) $856,000 Consolidation Entries Debit Credit Consolidated Totals (1,425,000) 747,000 152,000 (E) 7,500 65,500 -0(460,500) (1,552,500) (460,500) 250,000 (1,763,000) 1,349,000 (E) 12,000 (I)175,500 (S)450,000 (D) 50,000 (P) 30,000 (I) 175,500 (S)580,000 (A)150,500 (A) 22,500 (E) 12,000 Equipment (net) Computer software Internet domain name Goodwill Total assets Liabilities 713,000 650,000 0 -03,253,000 (870,000) 3-53 305,000 130,000 100,000 -0880,000 (170,000) (E) 7,500 (A)108,000 (A) 65,000 0 1,018,000 765,000 196,000 65,000 3,393,000 (1,010,000) (P) 30,000 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition Common stock Additional paid-in capital Retained earnings 12/31 Total liab. and equity (500,000) (120,000) (1,763,000) (3,253,000) (110,000) (20,000) (580,000) (880,000) (S)110,000 (S) 20,000 1,028,000 1,028,000 (500,000) (120,000) (1,763,000) (3,393,000) Chapter 3 - Computer Project PECOS COMPANY AND SUARO COMPANY Consolidated Information Worksheet Pecos (1,052,000) 821,000 Suaro (427,000) 262,000 0 0 0 (165,000) Revenues Operating expenses Amortization of intangibles Goodwill impairment loss Income of Suaro Net income Retained earnings--Pecos, 1/1 Retained earnings--Suaro, 1/1 Net income (above) Dividends paid Retained earnings, 12/31 Cash Receivables Inventory Investment in Suaro Land Equipment (net) Software Other intangibles Goodwill Total assets Liabilities Common stock Retained earnings (above) Total liabilities and equity 0 0 200,000 (201,000) (165,000) 35,000 (331,000) 195,000 247,000 415,000 341,000 240,100 0 145,000 0 95,000 143,000 197,000 0 85,000 100,000 312,000 0 0 932,000 (1,537,100) (500,000) (251,000) (350,000) (331,000) (932,000) 3-54 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition Consolidated Information Worksheet (continued) Fair Value Allocation Schedule Acquisition-date fair value 1,450,000 Book value 476,000 Excess fair value over book value 974,000 Amortizations and Write-off 2011 Land Brand Name Software IPR&D Goodwill Total (10,000) 60,000 100,000 300,000 524,000 974,000 0 0 50,000 300,000 0 350,000 2012 0 0 50,000 0 0 50,000 Suaro's Retained Earnings Changes Income Dividends 2011 75,000 0 2012 165,000 35,000 3-55 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition Chapter 3 - Computer Project Solution PECOS COMPANY AND SUARO COMPANY Consolidated Worksheet For the Year Ended December 31, 2012 EQUITY METHOD Consolidation Entries Pecos (1,052,000 ) 821,000 0 0 (115,000) (346,000) (655,000) 0 (346,000) 200,000 (801,000) 195,000 247,000 415,000 3-56 Consolidated Totals (1,479,000) 1,083,000 50,000 0 0 (346,000) (655,000) 0 (346,000) 200,000 (801,000) 290,000 390,000 612,000 Suaro (427,000) 262,000 0 0 0 (165,000) 0 (201,000) (165,000) 35,000 (331,000) 95,000 143,000 197,000 Debit Credit Revenues Operating expenses Amortization of intangibles Goodwill impairment loss Income of Suaro Net income Retained earnings--Pecos, 1/1 Retained earnings--Suaro, 1/1 Net income (above) Dividends paid Retained earnings, 12/31 Cash Receivables Inventory (E) (I) 50,000 115,000 (S) 201,000 (D) 35,000 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition Investment in Suaro 1,255,000 (A) (I) 0 (D) 35,000 (S) 551,000 624,000 115,000 0 Consolidated Worksheet (continued) Land Equipment (net) Software Other intangibles Brand name Goodwill Total assets Liabilities Common stock Retained earnings (above) Total liabilities and equity 341,000 240,100 0 145,000 0 0 2,838,100 (1,537,100) (500,000) (801,000) (2,838,100) 85,000 100,000 312,000 0 0 0 932,000 (251,000) (350,000) (331,000) (932,000) (A) (A) (A) (A) 50,000 (E) 60,000 524,000 10,000 50,000 416,000 340,100 312,000 145,000 60,000 524,000 3,089,100 (1,788,100) (500,000) (801,000) 1,385,000 (3,089,100) (S) 350,000 1,385,000 Shaded items were provided on the Consolidated Information Worksheet 3-57 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition Chapter 3 Computer Project Solution PECOS COMPANY AND SUARO COMPANY Consolidated Worksheet For the Year Ended December 31, 2012 PARTIAL EQUITY METHOD Consolidation Entries Revenues Operating expenses Amortization of intangibles Goodwill impairment loss Income of Suaro Net income Retained earnings--Pecos, 1/1 Retained earnings--Suaro, 1/1 Net income (above) Dividends paid Retained earnings, 12/31 Cash Receivables Inventory Investment in Suaro Pecos (1,052,000) 821,000 0 0 (165,000) (396,000) (1,005,000) 0 (396,000) 200,000 (1,201,000) 195,000 247,000 415,000 1,655,000 Suaro (427,000) 262,000 0 0 0 (165,000) 0 (201,000) (165,000) 35,000 (331,000) 95,000 143,000 197,000 0 (*C) (S) 350,000 201,000 (D) 35,000 Debit Credit Consolidated Totals (1,479,000) 1,083,000 50,000 0 0 (346,000) (655,000) 0 (346,000) 200,000 (801,000) 290,000 390,000 612,000 0 (E) (I) 50,000 165,000 (D) 35,000 (S) (A) 551,000 624,000 3-58 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition (I) (*C) onsolidated Worksheet (continued) Land Equipment (net) Software Other intangibles Brand name Goodwill Total assets Liabilities Common stock Retained earnings (above) Total liabilities and equity 341,000 240,100 0 145,000 0 0 3,238,100 (1,537,100) (500,000) (1,201,000) (3,238,100) 85,000 100,000 312,000 0 0 0 932,000 (251,000) (350,000) (331,000) (932,000) (A) (A) (A) (A) 50,000 (E) 60,000 524,000 165,000 350,000 10,000 50,000 416,000 340,100 312,000 145,000 60,000 524,000 3,089,100 (1,788,100) (500,000) (801,000) (S) 350,000 1,785,000 1,785,000 (3,089,100) Shaded items were provided on the Consolidated Information Worksheet 3-59 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition Chapter 3 Computer Project Solution PECOS COMPANY AND SUARO COMPANY Consolidated Worksheet For the Year Ended December 31, 2012 INITIAL VALUE METHOD Consolidation Entries Revenues Operating expenses Amortization of intangibles Goodwill impairment loss Income of Suaro Net income Retained earnings--Pecos, 1/1 Retained earnings--Suaro, 1/1 Net income (above) Dividends paid Retained earnings, 12/31 Cash Receivables Inventory Investment in Suaro Pecos (1,052,000) 821,000 0 0 (35,000) (266,000) (930,000) 0 (266,000) 200,000 (996,000) 195,000 247,000 415,000 1,450,000 Suaro (427,000) 262,000 0 0 0 (165,000) 0 (201,000) (165,000) 35,000 (331,000) 95,000 143,000 197,000 0 (*C) (S) 275,000 201,000 (I) 35,000 Debit Credit Consolidated Totals (1,479,000) 1,083,000 50,000 0 0 (346,000) (655,000) 0 (346,000) 200,000 (801,000) 290,000 390,000 612,000 0 (E) (I) 50,000 35,000 (S) (A) 551,000 624,000 3-60 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition (*C) Consolidated Worksheet (continued) 275,000 Land Equipment (net) Software Other intangibles Brand name Goodwill Total assets Liabilities Common stock Retained earnings (above) Total liabilities and equity 341,000 240,100 0 145,000 0 0 3,033,100 (1,537,100) (500,000) (996,000) (3,033,100) 85,000 100,000 312,000 0 0 0 932,000 (251,000) (350,000) (331,000) (932,000) (A) (A) (A) (A) 50,000 (E) 60,000 524,000 10,000 50,000 416,000 340,100 312,000 145,000 60,000 524,000 3,089,100 (1,788,100) (500,000) (801,000) (S) 350,000 1,545,000 1,545,000 (3,089,100) Shaded items were provided on the Consolidated Information Worksheet 3-61 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition Chapter 3 Computer Project PECOS COMPANY AND SUARO COMPANY Goodwill Impairment Loss Effects Without Impairment Common shares outstanding Consolidated net income/(loss) Consolidated assets, 1/1/12 Consolidated assets, 12/31/12 Consolidated equity, 1/1/12 Consolidated equity, 12/31/12 Consolidated liabilities 500,000 346,000 2,943,100 3,089,100 1,155,000 1,301,000 1,788,100 With Impairment 500,000 (178,000) 2,943,100 2,565,100 1,155,000 777,000 1,788,100 Earnings-per-share Return on assets Return on equity Debt-to-equity 0.69 11.47% 28.18% 1.37 -0.36 -6.46% -18.43% 2.30 3-62 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition Chapter 3 Computer Project Solution PECOS COMPANY AND SUARO COMPANY Consolidated Worksheet For the Year Ended December 31, 2012 EQUITY METHOD GOODWILL IMPAIRMENT LOSS Consolidation Entries Revenues Operating expenses Amortization of intangibles Goodwill impairment loss Income of Suaro Net income Retained earnings--Pecos, 1/1 Retained earnings--Suaro, 1/1 Net income (above) Dividends paid Retained earnings, 12/31 Cash Receivables Inventory Investment in Suaro Pecos (1,052,000) 821,000 0 524,000 (115,000) 178,000 (655,000) 0 178,000 200,000 (277,000) 195,000 247,000 415,000 731,000 Suaro (427,000) 262,000 0 0 0 (165,000) 0 (201,000) (165,000) 35,000 (331,000) 95,000 143,000 197,000 0 Debit Credit Consolidated Totals (1,479,000) 1,083,000 50,000 524,000 0 178,000 (655,000) 0 178,000 200,000 (277,000) 290,000 390,000 612,000 0 (E) (I) 50,000 115,000 (S) 201,000 (D) 35,000 (D) 35,000 (S) (A) 551,000 100,000 3-63 Chapter 03 - Consolidations--Subsequent to the Date of Acquisition (I) Consolidated Worksheet (continued) Land Equipment (net) Software Other intangibles Brand name Goodwill Total assets Liabilities Common stock Retained earnings (above) Total liabilities and equity 341,000 240,100 0 145,000 0 0 2,314,100 (1,537,100) (500,000) (277,000) (2,314,100) 85,000 100,000 312,000 0 0 0 932,000 (251,000) (350,000) (331,000) (932,000) (A) (A) (A) 50,000 (E) 60,000 115,000 10,000 50,000 416,000 340,100 312,000 145,000 60,000 0 2,565,100 (1,788,100) (500,000) (277,000) (S) 350,000 861,000 861,000 (2,565,100) Shaded items were provided on the Consolidated Information Worksheet 3-64 ... 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