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1. © The McGraw-Hill Companies, Inc., 2004
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Chapter Two
ConsolidationConsolidation
of Financialof Financial
InformationInformation

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Why do Firms Combine?
 Vertical integration.
 Cost savings.
 Quick access to new
markets.
 Economies of scale.
 More attractive
financing opportunities.
 Diversification of
business risk.
 Vertical integration.
 Cost savings.
 Quick access to new
markets.
 Economies of scale.
 More attractive
financing opportunities.
 Diversification of
business risk.

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The Consolidation Process
Why Consolidated Statements?
 They are presumed to be more meaningful
that separate statements.
 They are considered necessary for a fair
presentation.
The consolidation of financial information into a
single set of statements becomes necessary
whenever a single economic entity is created by
the business combination of two or more
companies. - - ARB No. 51
The consolidation of financial information into a
single set of statements becomes necessary
whenever a single economic entity is created by
the business combination of two or more
companies. - - ARB No. 51

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Business Combinations
A business combination
occurs when an enterprise
acquires net assets that
constitute a business or equity
interests of one or more other
enterprises and obtains
control over that enterprise or
enterprises. - - SFAS No. 141
A business combination
occurs when an enterprise
acquires net assets that
constitute a business or equity
interests of one or more other
enterprises and obtains
control over that enterprise or
enterprises. - - SFAS No. 141

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Business Combinations
Exh.
2-2
ContinueContinue

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Business Combinations – Cont.
Exh.
2-2

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Parent Subsidiary
The Sub still prepares
separate financial
statements
Consolidated
financial statements
are prepared.
The parent does not
prepare separate
financial statements
Consolidation of Financial
Information

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GAAP Accounting Methods

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If the acquisition is
made by issuing
stock, the cost of
the acquisition is
equal to the
MARKET VALUE
of the stock
issued.
If the acquisition is
made by issuing
stock, the cost of
the acquisition is
equal to the
MARKET VALUE
of the stock
issued.
Purchase Method – SFAS 141
 Used when when
there is a change in
ownership that
results in control of
one enterprise by
another enterprise.
 The appropriate
valuation basis for
any purchase
transaction is “cost”.

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Purchase Method Situations
Dissolution of the
acquired company:
Cost = FMV
Cost > FMV
Cost < FMV
Separate
incorporation is
maintained.
Dissolution of the
acquired company:
Cost = FMV
Cost > FMV
Cost < FMV
Separate
incorporation is
maintained.

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Purchase Method - Dissolution
Cost = FMV
 Ignore the Equity and Nominal
accounts of the acquired
company.
 Determine FMV of the acquired
company’s assets and liabilities.
 Prepare a journal entry to
 recognize cost of the acquisition
 incorporate the FMV of acquired
company’s assets and liabilities
into acquiring company’s books.

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Prepare the entry to record Large’s
purchase.
Purchase Method - Dissolution
Cost = FMV
On 1/1/04, Large acquired 100% of Tiny
for $300,000 cash.

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Purchase Method - Dissolution
Cost = FMV
Tiny’s fair market value was $300,000 which is
equal to the price paid by Large. Record the
purchased assets at their market value.

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Purchase Method - Dissolution
Cost > FMV
 At date of acquisition:
 Acquired company should
prepare a Balance Sheet as of
the date of acquisition.
 Acquired company’s income
prior to acquisition is irrelevant
to the acquiring company.
 FMV of acquired company’s
assets and liabilities is added
to acquiring company’s
books.
 Difference between Cost and
FMV is allocated to
identifiable intangible assets
and to goodwill.
Note: Goodwill
should be viewed
as a residual
amount
remaining after
all other
identifiable and
separable
intangible assets
have been
identified.
Note: Goodwill
should be viewed
as a residual
amount
remaining after
all other
identifiable and
separable
intangible assets
have been
identified.

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Small has no identifiable, separable intangible
assets.
Purchase Method - Dissolution
Cost > FMV
On 1/1/04, Huge acquires 100% of Small
for $250,000 cash.

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Goodwill will be recorded as an intangible asset
on Huge’s books, but will not be amortized.
Purchase Method - Dissolution
Cost > FMV

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Purchase Method - Dissolution
Cost > FMV
Prepare Large’s journal entry for this
acquisition. Remember to record the
$33,000 of Goodwill.

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Purchase Method - Dissolution
Cost < FMV
 When FMV exceeds cost, we
have a Bargain Purchase.
 Current assets and liabilities
should be consolidated at
their FMV.
 Non-current assets should
be recorded at a value
between FMV and BV.
 i.e. each non-current asset’s
(including in-process R&D)
FMV should be reduced by a
proportionate share of the
excess of FMV over cost.

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Purchase Method - Dissolution
Cost < FMV
In the event that the difference is
substantial enough to eliminate all
the non-current asset balances of
the acquired company . . .
. . . The remainder is to be
reported as an extraordinary gain
(SFAS 141)
In the event that the difference is
substantial enough to eliminate all
the non-current asset balances of
the acquired company . . .
. . . The remainder is to be
reported as an extraordinary gain
(SFAS 141)

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Let’s see what happensLet’s see what happens
when the acquired companywhen the acquired company
is not dissolved.is not dissolved.

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Purchase Method
No Dissolution
 The acquired company
continues as a separate entity.
 The acquisition shows up on the
Parent’s books in the Investment
in Subsidiary account.
 Separate records for each
company are still maintained.
 The adjusted balances for the
Parent and the Subsidiary are
consolidated using a
worksheet.
 The acquired company
continues as a separate entity.
 The acquisition shows up on the
Parent’s books in the Investment
in Subsidiary account.
 Separate records for each
company are still maintained.
 The adjusted balances for the
Parent and the Subsidiary are
consolidated using a
worksheet.

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Steps for Consolidation
1. Record the financial information for
both Parent and Sub on the worksheet.
1. Record the financial information for
both Parent and Sub on the worksheet.
2. Remove the Investment in Sub balance.2. Remove the Investment in Sub balance.
3. Remove the Sub’s equity account
balances.
3. Remove the Sub’s equity account
balances.
4. Adjust the Sub’s net assets to FMV.4. Adjust the Sub’s net assets to FMV.
5. Allocate any excess of cost over BV to
identifiable, separable intangible assets
or goodwill.
5. Allocate any excess of cost over BV to
identifiable, separable intangible assets
or goodwill.
6. Combine all account balances.6. Combine all account balances.

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No Dissolution
Example
On 1/1/05, Huge acquires 100% of Small
for $250,000 cash.
Small holds a trademark that is valued at
$25,000.

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1. Record the
balances for
each company
in the
worksheet.
1. Record the
balances for
each company
in the
worksheet.

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2. Remove the
investment
account from
the worksheet.
2. Remove the
investment
account from
the worksheet.

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3. Remove the
subsidiary’s
equity account
balances.
3. Remove the
subsidiary’s
equity account
balances.
Let’s look at
the
computation
of Goodwill.
Let’s look at
the
computation
of Goodwill.

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Goodwill Computation for Huge’s
Acquisition of Small
We use these numbers
for steps #4 & #5.
We use these numbers
for steps #4 & #5.

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4. Adjust the
subsidiary’s
balances to
FMV.
4. Adjust the
subsidiary’s
balances to
FMV.

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5. Record the
trademark and
the Goodwill.
5. Record the
trademark and
the Goodwill.

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6. Add the balances
across the page.
6. Add the balances
across the page.

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Purchase Price Allocations -
Additional Issues
 Consolidation Costs
 Legal Fees, Direct Costs
of Combination
 Increase the Investment in
Subsidiary account.
 Stock Issuance Costs
 Broker Fees, Registration
Fees, etc.
 Decrease the Parent’s
Paid-In Capital account.
 Consolidation Costs
 Legal Fees, Direct Costs
of Combination
 Increase the Investment in
Subsidiary account.
 Stock Issuance Costs
 Broker Fees, Registration
Fees, etc.
 Decrease the Parent’s
Paid-In Capital account.

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Purchase Price Allocations -
Additional Issues, SFAS No. 141
 Intangibles
 Current and noncurrent assets
that lack physical substance.
 Do not include financial
instruments.
 When should an Intangible
be recognized?
 Does it arise from contractual
or other legal rights?
 Can it be sold or otherwise
separated from the acquired
enterprise?
 Intangibles
 Current and noncurrent assets
that lack physical substance.
 Do not include financial
instruments.
 When should an Intangible
be recognized?
 Does it arise from contractual
or other legal rights?
 Can it be sold or otherwise
separated from the acquired
enterprise?

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Purchase Price Allocations -
Additional Issues, SFAS No. 141
Intangible Asset Examples
 Customer Base
 Trademarked Brand
Names
 Customer Routes
 Effective Advertising
Programs
 Covenants
 Rights (broadcasting,
development, use,
etc.)
 Customer Base
 Trademarked Brand
Names
 Customer Routes
 Effective Advertising
Programs
 Covenants
 Rights (broadcasting,
development, use,
etc.)
 Databases
 Technological know-
how
 Patents & Copyrights
 Strong labor relations
 Assembled, trained
workforce
 Favorable government
relations
 Databases
 Technological know-
how
 Patents & Copyrights
 Strong labor relations
 Assembled, trained
workforce
 Favorable government
relations
Exh.
2-7

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Purchase Price Allocations -
Additional Issues, SFAS No. 141
 In-Process R&D
 Should be expensed immediately
upon acquisition, unless there
are alternative future uses.
• Dr. R&D Expense
• Cr. Investment in Investee
 It could also be written-off via
consolidation entries
 IPR&D that has reached
technological feasibility, can
be “capitalized”.
 Determination of fair value is
critical.
 In-Process R&D
 Should be expensed immediately
upon acquisition, unless there
are alternative future uses.
• Dr. R&D Expense
• Cr. Investment in Investee
 It could also be written-off via
consolidation entries
 IPR&D that has reached
technological feasibility, can
be “capitalized”.
 Determination of fair value is
critical.

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Unconsolidated Subsidiaries
S F A S N o . 9 4
W h e n c o n t r o l d o e s n o t
a c t u a ll y r e s t w i t h th e 5 0 %
o w n e r s .
W h e n c a n a P a r e n t e x c l u d e a 5 0 %
o w n e d s u b s i d i a r y f r o m c o n s o l i d a t i o n ?

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Pooling of Interests
Historically, many business
combinations have been
accounted for as “Pooling
of Interests.”
In its SFAS 141, “Business
Combinations”, the FASB
states that all business
combinations should be
accounted for using the
“Purchase MethodPurchase Method”.
Historically, many business
combinations have been
accounted for as “Pooling
of Interests.”
In its SFAS 141, “Business
Combinations”, the FASB
states that all business
combinations should be
accounted for using the
“Purchase MethodPurchase Method”.

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Pooling of Interests
According to SFAS No. 141, the
purchase method is to be
applied prospectively.
Past poolings of interests are
left intact by SFAS No. 141.
Therefore, it is important to
understand how to account
for PAST poolings.
According to SFAS No. 141, the
purchase method is to be
applied prospectively.
Past poolings of interests are
left intact by SFAS No. 141.
Therefore, it is important to
understand how to account
for PAST poolings.

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In a pooling, one
company obtained
essentially “all” of the
other company’s
stock.
In a pooling, one
company obtained
essentially “all” of the
other company’s
stock.
The transaction
involved the
exchange of common
stock. No exchange
of cash was allowed.
The transaction
involved the
exchange of common
stock. No exchange
of cash was allowed.
 The ownership interests of
two, or more, companies
were combined into one
new company.
 No single company was
dominant.
 Precise cost figures were
difficult to obtain.
 To use pooling of
interests, 12 strict criteria
had to be met.
Historical Review of Pooling of
Interests. Read the book for details!

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Historical Review of Pooling of
Interests
The Book Values of the two
combining companies were
joined. No Goodwill was
recorded.
The Book Values of the two
combining companies were
joined. No Goodwill was
recorded.
Revenues and expenses were
combined retroactively for the
two companies. This created
superior earnings, hence its
preference.
Revenues and expenses were
combined retroactively for the
two companies. This created
superior earnings, hence its
preference.

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Historical Review of Pooling of
Interests
 If both companies
continued to exist, an
Investment in Sub
account was recorded on
one company’s books
(usually the larger).
 No Goodwill was
recorded.
 Both companies were
combined at BV.
 If both companies
continued to exist, an
Investment in Sub
account was recorded on
one company’s books
(usually the larger).
 No Goodwill was
recorded.
 Both companies were
combined at BV.

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Historical Review of Pooling of
Interests
 Prior Period Adjustments were
made to account for
differences in the ways the two
companies accounted for
income.
 A journal entry was recorded
to recognize the Investment in
Subsidiary.
 The BV’s for both companies
were entered on a
consolidation worksheet.
 Prior Period Adjustments were
made to account for
differences in the ways the two
companies accounted for
income.
 A journal entry was recorded
to recognize the Investment in
Subsidiary.
 The BV’s for both companies
were entered on a
consolidation worksheet.

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Continued Accounting for Pooling
of Interests
 The Investment in Sub
account must be
eliminated.
 Also eliminate the Sub’s
Equity accounts to
prevent double-counting.
 They have already been
included in the original
Investment in Sub entry.
 Add together the BV’s of
the remaining accounts.
THE END OF CHAPTER 2