For WizardKim-PP

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chapter

In 1996, Berkshire Hathaway, Inc., acquired all of the outstanding stock of Geico, Inc., an insurance company. Although this transaction involved well-known companies, it was not unique; mergers and acquisitions have long been common in the business world.

Berkshire Hathaway’s current financial statements indicate that Geico

is still a component of this economic entity. However, Geico, Inc., con-

tinues as a separate legally incorporated concern long after its acquisi-

tion. As discussed in Chapter 2, a parent will often maintain separate legal

status for a subsidiary corporation to better utilize its inherent value as a

going concern.

For external reporting purposes, maintenance of incorporation cre-

ates an ongoing challenge for the accountant. In each subsequent period,

consolidation must be simulated anew through the use of a worksheet and

consolidation entries. Thus, for many years, the financial data for Berkshire

Hathaway and Geico (along with dozens of other subsidiaries) have been

brought together periodically to provide figures for the financial statements

that represent this business combination.

As also discussed in Chapter 2, the acquisition method governs the

way we initially record a business combination. In periods subsequent to

acquisition, the fair-value bases (established at the acquisition date) for sub-

sidiary assets acquired and liabilities assumed will be amortized (or tested

for possible impairment) for proper income recognition. Additionally, some

combinations require accounting for the eventual disposition of contingent

consideration, which, as presented later in this chapter, continues to follow a

fair-value model.

In the next several sections of this chapter, we present the procedures

to prepare consolidated financial statements in the years subsequent to

acquisition. We start by analyzing the relation between the parent’s inter-

nal accounting method for its subsidiary investment and the adjustments

required in consolidation. We also examine the specific procedures for

amortizing the acquisition-date fair-value adjustments to the subsidiary’s

assets and liabilities. We then cover testing for goodwill impairment and

post-acquisition accounting for contingent consideration. Finally, an appen-

dix presents the alternative goodwill model available as a reporting option

for private companies.

3 Consolidations— Subsequent to the Date of Acquisition

Learning Objectives After studying this chapter, you should be able to:

LO 3-1 Recognize the complexities in preparing consolidated financial reports that emerge from the passage of time.

LO 3-2 Identify and describe the various methods available to a parent company in order to maintain its investment in subsidiary account in its internal records.

LO 3-3 Prepare consolidated financial statements subsequent to acquisition when the parent has applied in its internal records:

a. The equity method. b. The initial value method. c. The partial equity method.

LO 3-4 Understand that a parent’s internal accounting method for its subsidiary investments has no effect on the resulting consolidated financial statements.

LO 3-5 Discuss the rationale for the goodwill impairment testing approach.

LO 3-6 Describe the procedures for conducting a goodwill impairment test.

LO 3-7 Describe the rationale and procedures for impairment testing for intangible assets other than goodwill.

LO 3-8 Understand the accounting and reporting for contingent consideration subsequent to a business acquisition.

LO 3-9 Appendix: Describe the alternative accounting treatments for goodwill and other intangible assets available for business combinations by private companies.

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Consolidation—The Effects Created by the Passage of Time In Chapter 2, consolidation accounting is analyzed at the date that a combination is created. The present chapter carries this process one step further by examining the consolidation pro- cedures that must be followed in subsequent periods whenever separate incorporation of the subsidiary is maintained.

Despite complexities created by the passage of time, the basic objective of all consolida- tions remains the same: to combine asset, liability, revenue, expense, and equity accounts of a parent and its subsidiaries. From a mechanical perspective, a worksheet and consolidation entries continue to provide structure for the production of a single set of financial statements for the combined business entity.

Consolidated Net Income Determination Subsequent to an acquisition, the parent company must report consolidated net income. Con- solidated income determination involves first combining the separately recorded revenues and expenses of the parent with those of the subsidiary on a consolidated worksheet. Because of separate record-keeping systems, however, the subsidiary’s expenses typically are based on their original book values and not the acquisition-date values the parent must recognize. Consequently, adjustments are made that reflect the amortization of the excess of the par- ent’s consideration transferred over the subsidiary book value. Additionally, the effects of any intra-entity transactions are removed.

The Parent’s Choice of Investment Accounting The time factor introduces other complications into the consolidation process as well. For internal record-keeping purposes, the parent must select and apply an accounting method to monitor the relationship between the two companies. The investment balance recorded by the parent varies over time as a result of the method chosen, as does the income subsequently rec- ognized. These differences affect the periodic consolidation process but not the figures to be reported by the combined entity. Regardless of the amount, the parent’s investment account is eliminated (brought to a zero balance) on the worksheet so that the subsidiary’s actual assets and liabilities can be consolidated. Likewise, the income figure accrued by the parent is removed each period so that the subsidiary’s revenues and expenses can be included when creating an income statement for the combined business entity.

Investment Accounting by the Acquiring Company For a parent company’s external financial reporting, consolidation of a subsidiary becomes necessary whenever control exists. For internal record-keeping, though, the parent has a choice for monitoring the activities of its subsidiaries. Although several variations occur in practice, three methods have emerged as the most prominent: the equity method, the initial value method,1 and the partial equity method.

At the acquisition date, each investment accounting method (equity, initial value, and par- tial equity) begins with an identical value recorded in an investment account. Typically the fair value of the consideration transferred by the parent will serve as the recorded valuation basis on the parent’s books.2

Subsequent to the acquisition date, the three methods produce different account balances for the parent’s investment in subsidiary, income recognized from the subsidiary’s activi- ties, and retained earnings accounts. Importantly, the selection of a particular method does not affect the totals ultimately reported for the combined companies. However, the parent’s

LO 3-2

Identify and describe the various methods available to a parent company in order to maintain its investment in subsidiary account in its internal records.

1 The initial value method is sometimes referred to as the cost method. 2 In the unusual case of a bargain purchase, the valuation basis for the investment account is the fair value of the net amount of the assets acquired and liabilities assumed.

LO 3-1

Recognize the complexities in preparing consolidated financial reports that emerge from the pas- sage of time.

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choice of an internal accounting method does lead to distinct procedures for consolidating the financial information from the separate organizations.

Internal Investment Accounting Alternatives—The Equity Method, Initial Value Method, and Partial Equity Method The internal reporting philosophy of the acquiring company often determines the accounting method choice for its subsidiary investment. Depending on the measures a company uses to assess the ongoing performances of its subsidiaries, parent companies may choose their own preferred internal reporting method. Regardless of this choice, however, the investment bal- ance will be eliminated in preparing consolidated financial statements for external reporting.

The Equity Method The equity method embraces full accrual accounting in maintaining the investment account and related income over time. Under the equity method, the acquiring company accrues income when the subsidiary earns it. To match the additional fair value recorded in the com- bination against income, amortization expense stemming from the original excess fair-value allocations is recognized through periodic adjusting entries. Unrealized gains on intra-entity transactions are deferred; subsidiary dividends serve to reduce the investment balance. As discussed in Chapter 1, the equity method creates a parallel between the parent’s investment accounts and changes in the underlying equity of the acquired company.3

When the parent has complete ownership, equity method earnings from the subsidiary, combined with the parent’s other income sources, create a total income figure reflective of the entire combined business entity. Consequently, the equity method often is referred to as a single-line consolidation. The equity method is especially popular in companies where management periodically (e.g., monthly or quarterly) measures each subsidiary’s profitability using accrual-based income figures.

The Initial Value Method Under the initial value method, the parent recognizes income from its share of any subsidiary dividends when declared. Because little time typically elapses between dividend declaration and cash distribution, the initial value method frequently reflects the cash basis for income recognition. No recognition is given to the income earned by the subsidiary. The investment balance remains on the parent’s financial records at the initial fair value assigned at the acqui- sition date.

The initial value method might be selected because the parent does not require an accrual- based income measure of subsidiary performance. For example, the parent may wish to assess subsidiary performance on its ability to generate cash flows, on revenues generated, or some other nonincome basis. Also, some firms may find the initial value method’s ease of applica- tion attractive. Because the investment account is eliminated in consolidation, and the actual subsidiary revenues and expenses are eventually combined, firms may avoid the complexity of the equity method unless they need the specific information provided by the equity income measure for internal decision making.

The Partial Equity Method A third method available to the acquiring company is a partial application of the equity method. Under this approach, the parent recognizes the reported income accruing from the subsidiary. Subsidiary dividends declared reduce the investment balance. However, no other equity adjustments (amortization or deferral of unrealized gains) are recorded. Thus, in many cases, earnings figures on the parent’s books approximate consolidated totals but without the effort associated with a full application of the equity method.

3 In Chapter 1, the equity method was introduced in connection with the external reporting of investments in which the owner held the ability to apply significant influence over the investee (usually by possessing 20 to 50 percent of the company’s voting stock). Here, the equity method is utilized for the internal report- ing of the parent for investments in which control is maintained. Although the accounting procedures are similar, the reason for using the equity method is different.

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Moreover, some parent companies rely on internally designed performance measures (rather than GAAP net income) to evaluate subsidiary management or make resource alloca- tion decisions. For such companies, a full equity method application may be unnecessary for internal purposes. In these cases, the partial equity method, although only approximating the GAAP income measure, may be sufficient for decision making.

Summary of Internal Investment Accounting Methods Exhibit 3.1 provides a summary of these three internal accounting techniques. Importantly, the method the acquiring company adopts affects only its separate financial records and has no impact on the subsidiary’s balances. Regardless of how the parent chooses to  account inter- nally for its subsidiary, the selection of a particular method (i.e., initial value, equity, or partial equity) does not affect the amounts ultimately reported on consolidated financial statements to external users.

Because specific worksheet procedures differ based on the investment method utilized by the parent, the consolidation process subsequent to the date of combination will be intro- duced twice. First, we review consolidations in which the acquiring company uses the equity method. Then we redevelop all procedures when the investment is recorded by one of the alternative methods.

Subsequent Consolidation—Investment Recorded by the Equity Method Acquisition Made during the Current Year As a basis for this illustration, assume that Parrot Company obtains all of the outstanding common stock of Sun Company on January 1, 2017. Parrot acquires this stock for $800,000 in cash.

The book values as well as the appraised fair values of Sun’s accounts follow:

LO 3-3a

Prepare consolidated financial statements subsequent to acquisi- tion when the parent has applied the equity method in its internal records.

Method Investment Account Income Account Advantages

Equity Continually adjusted to reflect current owner’s equity of acquired company.

Income accrued as earned; amortization and other adjustments are recognized.

Acquiring company totals give a true representation of consolida- tion figures.

Initial value Remains at acquisition-date value assigned.

Dividends declared recorded as Dividend Income.

It is easy to apply; it often reflects cash flows from the subsidiary.

Partial equity

Adjusted only for accrued income and dividends declared by the acquired company.

Income accrued as earned; no other adjustments recognized.

It usually gives balances approxi- mating consolidation figures, but it is easier to apply than equity method.

EXHIBIT 3.1 Internal Reporting of Investment Accounts by Acquiring Company

Book Values 1/1/17

Fair Values 1/1/17 Difference

Current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 320,000 $ 320,000 $ –0– Trademarks (indefinite life) . . . . . . . . . . . . . . . . . 200,000 220,000 + 20,000 Patented technology (10-year remaining life) . . . . . . . . . . . . . . . . . . . .

320,000 450,000 +130,000

Equipment (5-year remaining life) . . . . . . . . . . . 180,000 150,000   (30,000) Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    (420,000) (420,000) –0–

Net book value . . . . . . . . . . . . . . . . . . . . . . . . . $  600,000   $ 720,000 $ 120,000

Common stock—$40 par value . . . . . . . . . . . . . $ (200,000)  Additional paid-in capital . . . . . . . . . . . . . . . . . . .  (20,000) Retained earnings, 1/1/17. . . . . . . . . . . . . . . . . . (380,000) 

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Parrot considers the economic life of Sun’s trademarks as extending beyond the foresee- able future and thus having an indefinite life. Such assets are not amortized but are subject to periodic impairment testing.4 For the definite lived assets acquired in the combination (pat- ented technology and equipment), we assume that straight-line amortization and depreciation with no salvage value is appropriate.5

Parrot paid $800,000 cash to acquire Sun Company, clear evidence of the fair value of the consideration transferred. As shown in Exhibit 3.2, individual allocations are used to adjust Sun’s accounts from their book values to their acquisition-date fair values. Because the total value of these assets and liabilities was only $720,000, goodwill of $80,000 must be recog- nized for consolidation purposes.

Each of these allocated amounts (other than the $20,000 attributed to trademarks and the $80,000 for goodwill) represents a valuation associated with a definite life. As discussed in Chapter 1, Parrot must amortize each allocation over its expected life. The expense recogni- tion necessitated by this fair-value allocation is calculated in Exhibit 3.3.

Two aspects of this amortization schedule warrant further explanation. First, we use the term amortization in a generic sense to include both the amortization of definite-lived intan- gibles and depreciation of tangible assets. Second, the acquisition-date fair value of Sun’s equipment is $30,000 less than its book value. Therefore, instead of attributing an additional amount to this asset, the $30,000 allocation actually reflects a fair-value reduction. As such, the amortization shown in Exhibit 3.3 relating to Equipment is not an additional expense but instead is an expense reduction.

4 In other cases, trademarks can have a definite life and thus would be subject to regular amortization. 5 Unless otherwise stated, all amortization and depreciation expense computations in this textbook are based on the straight-line method with no salvage value.

PARROT COMPANY 100 Percent Acquisition of Sun Company

Allocation of Acquisition-Date Subsidiary Fair Value January 1, 2017

Sun Company fair value (consideration transferred by Parrot Company) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $800,000 Book value of Sun Company: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $200,000 Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   20,000 Retained earnings, 1/1/17 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380,000 (600,000)

Excess of fair value over book value. . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000 Allocation to specific accounts based on fair values:. . . . . . . . . . . . . . Trademarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,000 Patented technology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130,000 Equipment (overvalued) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    (30,000) 120,000

Excess fair value not identified with specific accounts—goodwill . . . $ 80,000

EXHIBIT 3.2 Excess Fair-Value Allocation

PARROT COMPANY 100 Percent Acquisition of Sun Company

Excess Amortization Schedule—Allocation of Acquisition-Date Fair Values

Account Allocation Remaining Useful Life

Annual Excess Amortizations

Trademarks $ 20,000  Indefinite $   –0– Patented technology 130,000 10 years 13,000 Equipment (30,000) 5 years (6,000) Goodwill 80,000 Indefinite     –0–

  $   7,000*

*Total excess amortizations will be $7,000 annually for five years until the equipment allocation is fully removed. At the end of each asset’s life, future amortizations will change.

EXHIBIT 3.3 Annual Excess Amortization

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Having determined the allocation of the acquisition-date fair value in the previous example as well as the associated amortization, the parent’s separate record-keeping for its first year of Sun Company ownership can be constructed. Assume that Sun earns income of $100,000 dur- ing the year, declares a $40,000 cash dividend on August 1, and pays the dividend on August 8.

In this first illustration, Parrot has adopted the equity method. Apparently, this company believes that the information derived from using the equity method is useful in its evaluation of Sun.

Application of the Equity Method

Parrot’s Financial Records 1/1/17 Investment in Sun Company . . . . . . . . . . . . . . . . . . . . . . . . . . . 800,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800,000  To record the acquisition of Sun Company.

8/1/17 Dividend Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 Investment in Sun Company. . . . . . . . . . . . . . . . . . . . . . .  40,000 To record cash dividend declaration from subsidiary.

8/8/17 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 Dividend Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  40,000 To record receipt of the subsidiary cash dividend.

12/31/17 Investment in Sun Company . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 Equity in Subsidiary Earnings . . . . . . . . . . . . . . . . . . . . . . 100,000  To accrue income earned by 100 percent owned subsidiary.

12/31/17 Equity in Subsidiary Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000 Investment in Sun Company. . . . . . . . . . . . . . . . . . . . . . .    7,000 To recognize amortizations on allocations made in acqui- sition of subsidiary (see Exhibit 3.3).

Parrot’s application of the equity method, as shown in this series of entries, causes the Investment in Sun Company account balance to rise from $800,000 to $853,000 ($800,000 − $40,000 + $100,000 − $7,000). During the same period the parent recognizes a $93,000 equity income figure (the $100,000 earnings accrual less the $7,000 excess amortization expenses).

The consolidation procedures for Parrot and Sun one year after the date of acquisition are illustrated next. For this purpose, Exhibit 3.4 presents the separate 2017 financial statements for these two companies. Parrot recorded both investment-related accounts (the $853,000 asset balance and the $93,000 income accrual) based on applying the equity method.

Determination of Consolidated Totals Before becoming immersed in the mechanical aspects of a consolidation, the objective of this process should be understood. As indicated in Chapter 2, in the preparation of consolidated financial reports, the subsidiary’s revenue, expense, asset, and liability accounts are added to the parent company balances. Within this procedure, several important guidelines must be followed:

∙ Sun’s assets and liabilities are adjusted to reflect the allocations originating from their acquisition-date fair values.

∙ Because of the passage of time, the income effects (e.g., amortizations) of these allocations must also be recognized within the consolidation process.

∙ Any reciprocal or intra-entity6 accounts must be offset. If, for example, one of the compa- nies owes money to the other, the receivable and the payable balances have no connection with an outside party.  Thus, when the companies are viewed as a single consolidated entity, the receivable and the payable represent intra-entity balances that should be elimi- nated for external reporting purposes.

6 The FASB Accounting Standards Codification (ASC) uses the term intra-entity to describe transfers of assets across business entities affiliated though common stock ownership or other control mechanisms. The phrase indicates that although such transfers occur across separate legal entities, they are nonetheless made within a commonly controlled entity. Prior to the use of the term intra-entity, such amounts were rou- tinely referred to as intercompany balances.

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The consolidation of the two sets of financial information in Exhibit 3.4 is a relatively uncom- plicated task and can even be carried out without the use of a worksheet. Understanding the origin of each reported figure is the first step in gaining a knowledge of this process.

∙ Revenues = $1,900,000. The revenues of the parent and the subsidiary are added together. ∙ Cost of goods sold = $932,000. The cost of goods sold of the parent and subsidiary are

added together. ∙ Amortization expense = $165,000. The balances of the parent and of the subsidiary are

combined along with the $13,000 additional amortization from the recognition of the excess fair value over book value attributed to the subsidiary’s patented technology, as shown in Exhibit 3.3.

∙ Depreciation expense = $110,000. The depreciation expenses of the parent and subsidiary are added together along with the $6,000 reduction in equipment depreciation, as indicated in Exhibit 3.3.

∙ Equity in subsidiary earnings = –0–. The investment income recorded by the parent is eliminated and replaced by adding across the subsidiary’s revenues and expenses to the consolidated totals.

∙ Net income = $693,000. Consolidated revenues less consolidated expenses. ∙ Retained earnings, 1/1/17 = $840,000. The parent figure only. This acquisition-date

parent’s balance has yet to be affected by any equity method adjustments.

PARROT COMPANY AND SUN COMPANY Financial Statements

For Year Ending December 31, 2017

Parrot Company

Sun Company

Income Statement Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (1,500,000)  $   (400,000) Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  700,000 232,000 Amortization expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000 32,000 Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000     36,000 Equity in subsidiary earnings . . . . . . . . . . . . . . . . . . . . . . (93,000)              –0–

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (693,000)  $    (100,000)

Statement of Retained Earnings Retained earnings, 1/1/17 . . . . . . . . . . . . . . . . . . . . . . . . $ (840,000)  $    (380,000) Net income (above) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   (693,000) (100,000) Dividends declared* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000          40,000

Retained earnings, 12/31/17 . . . . . . . . . . . . . . . . . . . $ (1,413,000) $   (440,000)

Balance Sheet Current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $  1,040,000 $  400,000 Investment in Sun Company (at equity) . . . . . . . . . . . . . 853,000  –0– Trademarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000  200,000 Patented technology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 370,000  288,000 Equipment (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000    220,000 

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $  3,113,000 $ 1,108,000   

Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $     (980,000) $   (448,000) Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (600,000)   (200,000) Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . .  (120,000)    (20,000) Retained earnings, 12/31/17 (above) . . . . . . . . . . . . . . (1,413,000)   (440,000)

Total liabilities and equity . . . . . . . . . . . . . . . . . . . . . . . $   (3,113,000) $ (1,108,000)  

Note: Parentheses indicate a credit balance. *Dividends declared, whether currently paid or not, provide the appropriate amount to include in a statement of retained earnings. To help keep the number of worksheet rows (i.e., dividends payable and receivable) at a minimum, throughout this text we assume that dividends are declared and paid in the same period.

EXHIBIT 3.4 Separate Records—Equity Method Applied

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∙ Dividends declared = $120,000. The parent company balance only because the subsid- iary’s dividends are attributable intra-entity to the parent, not to an outside party.

∙ Retained earnings, 12/31/17 = $1,413,000. Consolidated retained earnings as of the begin- ning of the year plus consolidated net income less consolidated dividends declared.

∙ Current assets = $1,440,000. The parent’s book value plus the subsidiary’s book value. ∙ Investment in Sun Company = –0–. The asset recorded by the parent is eliminated and

replaced by adding the subsidiary’s assets and liabilities across to the consolidated totals. ∙ Trademarks = $820,000. The parent’s book value plus the subsidiary’s book value plus

the $20,000 acquisition-date fair-value allocation. Note that the trademark has an indefi- nite life and therefore is not amortized.

∙ Patented technology = $775,000. The parent’s book value plus the subsidiary’s book value plus the $130,000 acquisition-date fair-value allocation less current year amortization of $13,000.

∙ Equipment = $446,000. The parent’s book value plus the subsidiary’s book value less the $30,000 fair-value reduction allocation plus the current year expense reduction of $6,000.

∙ Goodwill = $80,000. The residual allocation shown in Exhibit 3.2. Note that goodwill is considered to have an indefinite life and thus is not amortized.

∙ Total assets = $3,561,000. A vertical summation of consolidated assets. ∙ Liabilities = $1,428,000. The parent’s book value plus the subsidiary’s book value. ∙ Common stock = $600,000. The parent’s book value. Subsidiary shares owned by the par-

ent are treated as if they are no longer outstanding. ∙ Additional paid-in capital = $120,000. The parent’s book value. Subsidiary shares owned

by the parent are treated as if they are no longer outstanding. ∙ Retained earnings, 12/31/17 = $1,413,000. Computed previously. ∙ Total liabilities and equities = $3,561,000. A vertical summation of consolidated liabili-

ties and equities.

Consolidation Worksheet Although the consolidated figures to be reported can be computed as just shown, accountants normally prefer to use a worksheet. A worksheet provides an organized structure for this process, a benefit that becomes especially important in consolidating complex combinations.

For Parrot and Sun, only five consolidation entries are needed to arrive at the same fig- ures previously derived for this business combination. As discussed in Chapter 2, worksheet entries are the catalyst for developing totals to be reported by the entity but are not physically recorded in the individual account balances of either company.

Consolidation Entry S

Common Stock (Sun Company) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000 Additional Paid-In Capital (Sun Company) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Retained Earnings, 1/1/17 (Sun Company) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380,000 Investment in Sun Company. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000

As shown in Exhibit 3.2, Parrot’s $800,000 Investment account balance at January 1, 2017, reflects two components: (1) a $600,000 amount equal to Sun’s book value and (2) a $200,000 figure attributed to the acquisition-date difference between the book value and fair value of Sun’s assets and liabilities (with a residual allocation made to goodwill). Entry S removes the $600,000 component of the Investment in Sun Company account which is then replaced by add- ing the book values of each subsidiary asset and liability across to the consolidated figures. A second worksheet entry (Entry A) eliminates the remaining $200,000 portion of the January 1, 2017 Investment in Sun account and replaces it with the specific acquisition-date excess fair over book value allocations along with any goodwill. Importantly, worksheet entries S and A are part of the sequence of worksheet adjustments that bring the investment account to zero.

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Entry S also removes Sun’s stockholders’ equity accounts as of the beginning of the year. Because consolidated statements are prepared for the parent company owners, the subsid- iary equity accounts are not relevant to the business combination and should be eliminated for consolidation purposes. The elimination is made through this entry because the equity accounts and the $600,000 component of the investment account represent reciprocal bal- ances: Both provide a measure of Sun’s book value as of January 1, 2017.

Before moving to the next consolidation entry, a clarification point should be made. In actual practice, worksheet entries are usually identified numerically. However, as in the pre- vious chapter, the label “Entry S” used in this example refers to the elimination of Sun’s beginning Stockholders’ Equity. As a reminder of the purpose being served, all worksheet entries are identified in a similar fashion. Thus, throughout this textbook, “Entry S” always refers to the removal of the subsidiary’s beginning stockholders’ equity balances for the year against the book value portion of the investment account.

Consolidation Entry A

Trademarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Patented Technology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130,000 Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 Investment in Sun Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000

Equity in Subsidiary Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93,000 Investment in Sun Company. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93,000

Investment in Sun Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 Dividends Declared . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000

Consolidation Entry A adjusts the subsidiary balances from their book values to acquisition-date fair values (see Exhibit 3.2) and includes goodwill created by the acquisition. This entry is labeled “Entry A” to indicate that it represents the Allocations made in connection with the excess of the subsidiary’s fair values over its book values. Sun’s accounts are adjusted collectively by the $200,000 excess of Sun’s $800,000 acquisition-date fair value over its $600,000 book value.

Consolidation Entry I

“Entry I” (for Income) removes from the worksheet the subsidiary income recognized by Par- rot during the year. For reporting purposes, we must add the subsidiary’s individual revenue and expense accounts (and the current excess amortization expenses) to the parent’s respec- tive amounts to arrive at consolidated totals. Worksheet entry I thus effectively removes the one-line Equity in Subsidiary Earnings which is then replaced with the addition of the sub- sidiary’s separate revenues and expenses (already listed on the worksheet in the subsidiary’s balances). The $93,000 figure eliminated here represents the $100,000 income accrual rec- ognized by Parrot, reduced by the $7,000 in excess amortizations.   Observe that the entry originally recorded by the parent is simply reversed on the worksheet to remove its impact.

Consolidation Entry D

The dividends declared by the subsidiary during the year also must be eliminated from the consolidated totals. The entire $40,000 dividend goes to the parent, which from the viewpoint of the consolidated entity is simply an intra-entity transfer. The dividend declaration did not affect any outside party. Therefore, “Entry D” (for Dividends) is designed to offset the impact of this transaction by removing the subsidiary’s Dividends Declared account. Because the equity method has been applied, Parrot originally recorded these dividends as a decrease in the Investment in Sun Company account. To eliminate the impact of this reduction, the investment account is increased.

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Consolidation Entry E

Amortization Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,000 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 Patented Technology. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,000 Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

This final worksheet entry recognizes the current year’s excess amortization expenses relat- ing to the adjustments of Sun’s assets to acquisition-date fair values. Because the equity method amortization was eliminated within Entry I, “Entry E” (for Expense) now enters on the worksheet the current year expense attributed to each of the specific account allocations (see Exhibit 3.3). Note that we adjust depreciation expense for the tangible asset equipment and we adjust amortization expense for the intangible asset patented technology. As men- tioned earlier, we refer to the adjustments to all expenses resulting from excess acquisition- date fair-value allocations collectively as excess amortization expenses.

Thus, the worksheet entries necessary for consolidation when the parent has applied the equity method are as follows:

Entry S—Eliminates the subsidiary’s stockholders’ equity accounts as of the beginning of the current year along with the equivalent book value component within the parent’s investment account. Entry A—Recognizes the unamortized allocations as of the beginning of the current year associated with the original adjustments to fair value. Entry I—Eliminates the impact of intra-entity subsidiary income accrued by the parent. Entry D—Eliminates the impact of intra-entity subsidiary dividends. Entry E—Recognizes excess amortization expenses for the current period on the alloca- tions from the original adjustments to fair value.

Exhibit 3.5 provides a complete presentation of the December 31, 2017, consolidation worksheet for Parrot Company and Sun Company. The series of entries just described brings together the separate financial statements of these two organizations. Note that the consoli- dated totals are the same as those computed previously for this combination.

Observe that Parrot separately reports net income of $693,000 as well as ending retained earnings of $1,413,000, figures that are identical to the totals generated for the consolidated entity. However, subsidiary income earned after the date of acquisition is to be added to that of the parent. Thus, a question arises in this example as to why the parent company figures alone equal the consolidated balances of both operations.

In reality, Sun’s income for this period is contained in both Parrot’s reported balances and the consolidated totals. Through the application of the equity method, the current year earn- ings of the subsidiary have already been accrued by Parrot along with the appropriate amorti- zation expense. The parent’s Equity in Subsidiary Earnings account is, therefore, an accurate representation of Sun’s effect on consolidated net income. If the equity method is employed properly, the worksheet process simply replaces this single $93,000 balance with the specific revenue and expense accounts that it represents. Consequently, when the parent employs the equity method, its net income and retained earnings mirror consolidated totals.

Consolidation Subsequent to Year of Acquisition—Equity Method In many ways, every consolidation of Parrot and Sun prepared after the date of acquisition incorporates the same basic procedures outlined in the previous section. However, the con- tinual financial evolution undergone by the companies prohibits an exact repetition of the consolidation entries demonstrated in Exhibit 3.5.

As a basis for analyzing the procedural changes necessitated by the passage of time, assume that Parrot Company continues to hold its ownership of Sun Company as of December 31, 2020. This date was selected at random; any date subsequent to 2017 would serve equally well to illustrate this process. As an additional factor, assume that Sun now has a $40,000 liability that is payable to Parrot.

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For this consolidation, assume that the January 1, 2020, Sun Company’s Retained Earn- ings balance has risen to $600,000. Because that account had a reported total of only $380,000 on January 1, 2017, Sun’s book value apparently has increased by $220,000 during the 2017–2019 period. Although knowledge of individual operating figures in the past is not required, Sun’s reported totals help to clarify the consolidation procedures.

Year Sun Company

Net Income Dividends Declared

Increase in Book Value

Ending Retained Earnings

2017 $100,000 $  40,000 $  60,000 $ 440,000 2018 140,000   50,000   90,000 530,000 2019 90,000 20,000 70,000 600,000

$330,000 $110,000 $220,000

Investment: Equity Method

PARROT COMPANY AND SUN COMPANY Consolidation Worksheet

For Year Ending December 31, 2017

Accounts Parrot

Company Sun

Company

Consolidation Entries Consolidated

TotalsDebit Credit

Income Statement Revenues (1,500,000) (400,000) (1,900,000) Cost of goods sold 700,000 232,000 932,000 Amortization expense 120,000 32,000 (E) 13,000 165,000 Depreciation expense 80,000 36,000 (E)       6,000 110,000 Equity in subsidiary earnings   (93,000)    –0–  (I)  93,000   –0–

Net income (693,000) (100,000) (693,000)

Statement of Retained Earnings Retained earnings, 1/1/17 (840,000) (380,000) (S)  380,000 (840,000) Net income (above) (693,000) (100,000) (693,000) Dividends declared 120,000 40,000 (D)    40,000 120,000

Retained earnings, 12/31/17 (1,413,000) (440,000) (1,413,000)

Balance Sheet Current assets 1,040,000 400,000 1,440,000 Investment in Sun Company 853,000 –0– (D)   40,000 (S) 600,000 –0–

(A)  200,000 (I)   93,000 

Trademarks 600,000 200,000 (A)   20,000 820,000 Patented technology 370,000 288,000 (A)  130,000 (E) 13,000 775,000 Equipment (net) 250,000 220,000 (E)      6,000 (A)    30,000 446,000 Goodwill    –0–    –0– (A)   80,000 80,000

Total assets 3,113,000 1,108,000 3,561,000

Liabilities (980,000) (448,000)  (1,428,000) Common stock (600,000) (200,000)  (S)  200,000 (600,000) Additional paid-in capital (120,000) (20,000) (S)   20,000 (120,000) Retained earnings, 12/31/17 (above) (1,413,000) (440,000)  (1,413,000)

Total liabilities and equities (3,113,000) (1,108,000)    982,000 982,000 (3,561,000)

EXHIBIT 3.5 Consolidation Worksheet—Equity Method Applied

Note: Parentheses indicate a credit balance. Consolidation entries: (S) Elimination of Sun’s stockholders’ equity January 1 balances and the book value portion of the investment account. (A) Allocation of Sun’s acquisition-date excess fair values over book values. (I) Elimination of parent’s equity in subsidiary earnings accrual. (D) Elimination of intra-entity dividends. (E) Recognition of current year excess fair-value amortization and depreciation expenses.

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For 2020, the current year, we assume that Sun reports net income of $160,000 and declares and pays cash dividends of $70,000. Because it applies the equity method, Parrot recognizes earnings of $160,000. Furthermore, as shown in Exhibit 3.3, amortization expense of $7,000 applies to 2020 and must also be recorded by the parent. Consequently, Parrot reports an Equity in Subsidiary Earnings balance for the year of $153,000 ($160,000 − $7,000).

Although this income figure can be reconstructed with little difficulty, the current balance in the Investment in Sun Company account is more complicated. Over the years, the initial $800,000 acquisition price has been subjected to adjustments for

1. The annual accrual of Sun’s income. 2. The receipt of dividends from Sun. 3. The recognition of annual excess amortization expenses.

Exhibit 3.6 analyzes these changes and shows the components of the Investment in Sun Com- pany account balance as of December 31, 2020.

Following the construction of the Investment in Sun Company account, the consolida- tion worksheet developed in Exhibit 3.7 should be easier to understand. Current figures for both companies appear in the first two columns. The parent’s investment balance and equity income accrual as well as Sun’s income and stockholders’ equity accounts correspond to the information given previously. Worksheet entries (lettered to agree with the previous illustra- tion) are then utilized to consolidate all balances.

Several steps are necessary to arrive at these reported totals. The subsidiary’s assets, lia- bilities, revenues, and expenses are added to those same accounts of the parent. The unam- ortized portion of the original acquisition-date fair-value allocations are included along with current excess amortization expenses. The investment and equity income balances are both eliminated as are the subsidiary’s stockholders’ equity accounts. Intra-entity dividends are removed as are the existing receivable and payable balances between the two companies.

Consolidation Entry S Once again, this first consolidation entry offsets reciprocal amounts representing the subsid- iary’s book value as of the beginning of the current year. Sun’s January 1, 2020, stockholders’

PARROT COMPANY Investment in Sun Company Account

As of December 31, 2020 Equity Method Applied

Fair value of consideration transferred at date of acquisition $ 800,000 Entries recorded in prior years: Accrual of Sun Company’s income 2017 $100,000 2018 140,000 2019 90,000 330,000 Sun Company—Dividends declared 2017 $ (40,000) 2018 (50,000) 2019 (20,000) (110,000) Excess amortization expenses 2017 $   (7,000) 2018 (7,000) 2019    (7,000) (21,000) Entries recorded in current year—2020 Accrual of Sun Company’s income $160,000 Sun Company—Dividends declared (70,000) Excess amortization expenses    (7,000)    83,000

Investment in Sun Company, 12/31/20 $1,082,000

EXHIBIT 3.6 Investment Account under Equity Method

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equity accounts are eliminated against the book value portion of the parent’s investment account. Here, though, the amount eliminated is $820,000 rather than the $600,000 shown in Exhibit 3.5 for 2017. Both balances have changed during the 2017–2019 period. Sun’s operations caused a $220,000 increase in retained earnings. Parrot’s application of the equity method created a parallel effect on its Investment in Sun Company account (the income accrual of $330,000 less dividends collected of $110,000).

Although Sun’s Retained Earnings balance is removed in this entry, the income this com- pany earned since the acquisition date is still included in the consolidated figures. Parrot accrues these profits annually through application of the equity method. Thus, elimination of the subsidiary’s entire Retained Earnings is necessary; a portion was earned prior to the acquisition and the remainder has already been recorded by the parent.

Investment: Equity Method

PARROT COMPANY AND SUN COMPANY Consolidation Worksheet

For Year Ending December 31, 2020

Accounts Parrot

Company Sun

Company

Consolidation Entries Consolidation

TotalsDebit Credit

Income Statement Revenues (2,100,000) (600,000) (2,700,000) Cost of goods sold 1,000,000 380,000 1,380,000 Amortization expense 200,000 20,000 (E)  13,000  233,000 Depreciation expense 100,000 40,000 (E)     6,000 134,000 Equity in subsidiary earnings (153,000)    –0– (I) 153,000    –0–

Net income (953,000) (160,000) (953,000)

Statement of Retained Earnings Retained earnings, 1/1/20 (2,044,000) (600,000) (S)  600,000 (2,044,000) Net income (above) (953,000) (160,000) (953,000) Dividends declared 420,000 70,000 (D)   70,000 420,000

Retained earnings, 12/31/20 (2,577,000) (690,000)  (2,577,000)

Balance Sheet Current assets 1,705,000 500,000 (P)   40,000 2,165,000 Investment in Sun Company 1,082,000 –0– (D)  70,000 (S) 820,000 –0–

(A) 179,000 (I) 153,000

Trademarks 600,000 240,000 (A) 20,000 860,000 Patented technology 540,000 420,000 (A)  91,000 (E)   13,000 1,038,000 Equipment (net) 420,000 210,000 (E) 6,000 (A)   12,000 624,000 Goodwill    –0– –0– (A) 80,000 80,000

Total assets 4,347,000 1,370,000 4,767,000

Liabilities (1,050,000) (460,000) (P) 40,000 (1,470,000) Common stock (600,000) (200,000) (S) 200,000 (600,000) Additional paid-in capital (120,000) (20,000) (S) 20,000 (120,000) Retained earnings, 12/31/20 (above) (2,577,000) (690,000) (2,577,000)

Total liabilities and equities (4,347,000) (1,370,000)    1,293,000 1,293,000 (4,767,000)

Note: Parentheses indicate a credit balance. Consolidation entries: (S) Elimination of Sun’s stockholders’ equity January 1 balances and the book value portion of the investment account. (A) Allocation of Sun’s acquisition-date excess fair values over book values, unamortized balance as of beginning of year. (I) Elimination of parent’s equity in subsidiary earnings accrual. (D) Elimination of intra-entity dividends. (E) Recognition of current year excess fair-value amortization and depreciation expenses.    (P) Elimination of intra-entity receivable/payable.

EXHIBIT 3.7 Consolidation Worksheet Subsequent to Year of Acquisition—Equity Method Applied

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Entry S removes these balances as of the first day of 2020 rather than at the end of the year. The consolidation process is made a bit simpler by segregating the effect of preceding opera- tions from the transactions of the current year. Thus, all worksheet entries relate specifically to either the previous years (S and A) or the current period (I, D, E, and P).

Consolidation Entry A In the initial consolidation (2017), fair-value allocations amounting to $200,000 were entered, but these balances have now undergone three years of amortization. As computed in Exhibit 3.8, expenses for these prior years totaled $21,000, leaving a balance of $179,000. Allocation of this amount to the individual accounts is also determined in Exhibit 3.8 and reflected in worksheet Entry A. As with Entry S, these balances are calculated as of January 1, 2020, and replaced by current year expenses as shown in Entry E.

Consolidation Entry I As before, this entry eliminates the equity income recorded currently by Parrot ($153,000) in connection with its ownership of Sun. The subsidiary’s revenue and expense accounts are left intact so they can be included in the consolidated figures.

Consolidation Entry D This worksheet entry offsets the $70,000 intra-entity dividends (from Sun to Parrot) during the current period.

Consolidation Entry E Excess amortization expenses relating to acquisition-date fair-value adjustments are individu- ally recorded for the current period.

Before progressing to the final worksheet entry, note the close similarity of these entries with the five entries incorporated in the 2017 consolidation (Exhibit 3.5). Except for the numerical changes created by the passage of time, the entries are identical.

Consolidation Entry P This last entry (labeled “Entry P” because it eliminates an intra-entity Payable) introduces a new element to the consolidation process. As noted earlier, intra-entity reciprocal accounts do not relate to outside parties. Therefore, Sun’s $40,000 payable and Parrot’s $40,000 receivable must be removed on the worksheet because the companies are being reported as a single entity.

In reviewing Exhibit 3.7, note several aspects of the consolidation process:

∙ The stockholders’ equity accounts of the subsidiary are removed. ∙ The Investment in Sun Company and the Equity in Subsidiary Earnings are both removed. ∙ The parent’s Retained Earnings balance is not adjusted. Because the parent applies the

equity method this account should be correct. ∙ The acquisition-date fair-value adjustments to the subsidiary’s assets are recognized but

only after adjustment for prior periods’ annual excess amortization expenses. ∙ Intra-entity balances such as dividends and receivables/payables are offset.

Annual Excess Amortizations

Accounts Original Allocation 2017 2018 2019 Balance 1/1/20

Trademarks $ 20,000  $ –0– $     –0– $ –0–  $  20,000 Patented technology 130,000 13,000  13,000 13,000 91,000 Equipment (30,000) (6,000)  (6,000) (6,000) (12,000)  Goodwill 80,000       –0–       –0–        –0–     80,000

 $200,000  $  7,000 $  7,000 $  7,000 $179,000

$21,000

EXHIBIT 3.8 Excess Amortizations Relating to Individual Accounts as of January 1, 2020

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Subsequent Consolidations—Investment Recorded Using Initial Value or Partial Equity Method Acquisition Made during the Current Year As discussed at the beginning of this chapter, the parent company may opt to use the initial value method or the partial equity method for internal record-keeping rather than the equity method. Application of either alternative changes the balances recorded by the parent over time and, thus, the procedures followed in creating consolidations. However, choosing one of these other approaches does not affect any of the final consolidated figures to be reported.

When a company utilizes the equity method, it eliminates all reciprocal accounts, assigns unamortized fair-value allocations to specific accounts, and records amortization expense for the current year. Application of either the initial value method or the partial equity method has no effect on this basic process. For this reason, a number of the consolidation entries remain the same regardless of the parent’s investment accounting method.

In reality, just three of the parent’s accounts actually vary because of the method applied:

∙ The investment account. ∙ The income recognized from the subsidiary. ∙ The parent’s retained earnings (in periods after the initial year of the combination).

Only the differences found in these balances affect the consolidation process when another method is applied. Thus, any time after the acquisition date, accounting for these three bal- ances is of special importance.

To illustrate the modifications required by the adoption of an alternative accounting method, the consolidation of Parrot and Sun as of December 31, 2017, is reconstructed. Only one differing factor is introduced: the method by which Parrot accounts for its invest- ment. Exhibit 3.9 presents the 2017 consolidation based on Parrot’s use of the initial value method. Exhibit 3.10 demonstrates this same process assuming that the parent applied the partial equity method. Each entry on these worksheets is labeled to correspond with the 2017 consolidation in which the parent used the equity method (Exhibit 3.5). Furthermore, differ- ences with the equity method (both on the parent company records and with the consolidation entries) are highlighted on each of the worksheets.

Initial Value Method Applied—2017 Consolidation Although the initial value method theoretically stands in marked contrast to the equity method, few reporting differences actually exist. In the year of acquisition, Parrot’s income and investment accounts relating to the subsidiary are the only accounts affected.

Under the initial value method, income recognition in 2017 is limited to the $40,000 divi- dend received by the parent; no equity income accrual is made. At the same time, the invest- ment account retains its $800,000 initial value. Unlike the equity method, no adjustments are recorded in the parent’s investment account in connection with the current year operations, subsidiary dividends, or amortization of any fair-value allocations.

After the composition of the dividend income and investment accounts has been estab- lished, worksheet entries can be used to produce the consolidated figures found in Exhibit 3.9 as of December 31, 2017.

Consolidation Entry S As with the previous Entry S in Exhibit 3.5, the $600,000 component of the investment account is eliminated against the beginning stockholders’ equity account of the subsidiary. Both are equivalent to Sun’s net assets at January 1, 2017, and are, therefore, reciprocal bal- ances that must be offset. This entry is not affected by the accounting method in use.

Consolidation Entry A Sun’s $200,000 excess acquisition-date fair value over book value is allocated to Sun’s assets and liabilities based on their fair values at the date of acquisition. The $80,000 residual is

LO 3-3b

Prepare consolidated financial statements subsequent to acquisi- tion when the parent has applied the initial value method in its internal records.

LO 3-3c

Prepare consolidated financial statements subsequent to acquisi- tion when the parent has applied the partial equity method in its internal records.

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attributed to goodwill. This procedure is identical to the corresponding entry in Exhibit 3.5 in which the equity method was applied.

Consolidation Entry I Under the initial value method, the parent records dividends declared by the subsidiary as income. Entry I removes this Dividend Income account along with Sun’s Dividends Declared. From a consolidated perspective, these two $40,000 balances represent an intra-entity transfer that had no financial impact outside of the entity. In contrast to the equity method, Parrot has not accrued subsidiary income, nor has amortization been recorded; thus, no further income elimination is needed.

Investment: Initial Value Method

PARROT COMPANY AND SUN COMPANY Consolidation Worksheet

For Year Ending December 31, 2017

Accounts Parrot

Company Sun

Company

Consolidation Entries Consolidation

TotalsDebit Credit

Income Statement Revenues (1,500,000) (400,000)  (1,900,000) Cost of goods sold 700,000  232,000 932,000 Amortization expense 120,000  32,000 (E)    13,000 165,000 Depreciation expense 80,000  36,000 (E)      6,000 110,000 Dividend income    (40,000) *   –0– (I)     40,000 * –0–

Net income (640,000)  (100,000) (693,000)

Statement of Retained Earnings Retained earnings, 1/1/17 (840,000) (380,000) (S)  380,000 (840,000) Net income (above) (640,000) (100,000) (693,000) Dividends declared 120,000 40,000 (I)    40,000 * 120,000

Retained earnings, 12/31/17 (1,360,000)  (440,000) (1,413,000) 

Balance Sheet Current assets 1,040,000  400,000  1,440,000 Investment in Sun Company 800,000 *   –0– (S)  600,000 –0–

(A)  200,000 Trademarks 600,000 200,000 (A)  20,000 820,000 Patented technology 370,000 288,000 (A) 130,000   (E)    13,000 775,000 Equipment (net) 250,000 220,000 (E)   6,000 (A)    30,000 446,000 Goodwill –0–  –0– (A)  80,000 80,000

Total assets 3,060,000  1,108,000 3,561,000

Liabilities (980,000) (448,000)  (1,428,000)   Common stock (600,000) (200,000)  (S)  200,000 (600,000) Additional paid-in capital (120,000) (20,000)  (S)    20,000 (120,000)   Retained earnings, 12/31/17 (above) (1,360,000) (440,000)  (1,413,000)   

Total liabilities and equities (3,060,000) (1,108,000)    889,000 889,000 (3,561,000)   

Note: Parentheses indicate a credit balance. *Boxed items highlight differences with consolidation in Exhibit 3.5. Consolidation entries: (S) Elimination of Sun’s stockholders’ equity January 1 balances and the book value portion of the investment account. (A) Allocation of Sun’s acquisition-date excess fair values over book values. (I) Elimination of intra-entity dividend income and dividends declared by Sun. (E) Recognition of current year excess fair-value amortization and depreciation expenses. Note: Consolidation entry (D) is not needed when the parent applies the initial value method because entry (I) eliminates the intra-entity dividend effects.

EXHIBIT 3.9 Consolidation Worksheet—Initial Value Method Applied

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Dividend Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 Dividends Declared . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 To eliminate intra-entity income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Consolidation Entry D When the initial value method is applied, the parent records intra-entity dividends as income. Because these dividends were already removed from the consolidated totals by Entry I, no separate Entry D is required.

Investment: Partial Equity Method

PARROT COMPANY AND SUN COMPANY Consolidation Worksheet

For Year Ending December 31, 2017

Accounts Parrot

Company Sun

Company

Consolidation Entries Consolidation

TotalsDebit Credit

Income Statement Revenues (1,500,000)  (400,000) (1,900,000) Cost of goods sold 700,000 232,000 932,000 Amortization expense 120,000 32,000 (E)    13,000 165,000 Depreciation expense 80,000 36,000 (E)      6,000 110,000 Equity in subsidiary earnings (100,000) * –0–    (I)  100,000 * –0–

Net income (700,000)  (100,000)  (693,000)

Statement of Retained Earnings Retained earnings, 1/1/17 (840,000) (380,000) (S)  380,000  (840,000) Net income (above) (700,000) (100,000)  (693,000) Dividends declared 120,000 40,000 (D)    40,000 120,000

Retained earnings, 12/31/17  (1,420,000) (440,000)  (1,413,000)

Balance Sheet Current assets 1,040,000  400,000 1,440,000  Investment in Sun Company 860,000 *   –0– (D)    40,000 (S)  600,000 –0–  

(A)  200,000 (I)  100,000 *

Trademarks 600,000 200,000 (A)    20,000 820,000 Patented technology 370,000 288,000 (A)  130,000 (E)    13,000 775,000 Equipment (net) 250,000 220,000 (E)      6,000 (A)    30,000 446,000 Goodwill –0–   –0– (A)    80,000   80,000

Total assets 3,120,000 1,108,000  3,561,000

Liabilities (980,000) (448,000)   (1,428,000) Common stock (600,000) (200,000)   (S)  200,000  (600,000) Additional paid-in capital (120,000) (20,000) (S)    20,000  (120,000) Retained earnings, 12/31/17 (above)  (1,420,000) (440,000)   (1,413,000)

Total liabilities and equities  (3,120,000)  (1,108,000) 989,000 989,000 (3,561,000)

Note: Parentheses indicate a credit balance. *Boxed items highlight differences with consolidation in Exhibit 3.5. Consolidation entries: (S) Elimination of Sun’s stockholders’ equity January 1 balances and the book value portion of the investment account. (A) Allocation of Sun’s acquisition-date excess fair values over book values. (I) Elimination of parent’s equity in subsidiary earnings accrual. (D) Elimination of intra-entity dividends. (E) Recognition of current year excess fair-value amortization and depreciation expenses.

EXHIBIT 3.10 Consolidation Worksheet—Partial Equity Method Applied

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Consolidation Entry E Regardless of the parent’s method of accounting, the reporting entity must recognize excess amortizations for the current year in connection with the original fair-value allocations. Thus, Entry E serves to bring the current year expenses into the consolidated financial statements.

Consequently, using the initial value method rather than the equity method changes only Entries I and D in the year of acquisition. Despite the change in methods, reported figures are still derived by (1) eliminating all reciprocals, (2) allocating the excess portion of the acquisition-date fair values, and (3) recording amortizations on these allocations. As indicated previously, the consolidated totals appearing in Exhibit 3.9 are identical to the figures produced previously in Exhibit 3.5. Although the income and the investment accounts on the parent company’s separate statements vary, the consolidated balances are not affected.

One significant difference between the initial value method and equity method does exist: The parent’s separate statements do not reflect consolidated income totals when the initial value method is used. Because equity adjustments (such as excess amortizations) are not recorded, neither Parrot’s reported net income of $640,000 nor its retained earnings of $1,360,000 provides an accurate portrayal of consolidated figures.

Partial Equity Method Applied—2017 Consolidation Exhibit 3.10 presents a worksheet to consolidate these two companies for 2017 (the year of acquisition) based on the assumption that Parrot applied the partial equity method. Again, the only changes from previous examples are found in (1) the parent’s separate records for this investment and its related income and (2) worksheet Entries I and D.

As discussed earlier, under the partial equity approach, the parent’s record-keeping is lim- ited to two periodic journal entries: the annual accrual of subsidiary income and the recogni- tion of dividends. Hence, within the parent’s records, only a few differences exist when the partial equity method is applied rather than the initial value method. The entries recorded by Parrot in connection with Sun’s 2017 operations illustrate both of these approaches.

Therefore, by applying the partial equity method, the investment account on the parent’s balance sheet rises to $860,000 by the end of 2017. This total is composed of the original $800,000 acquisition-date fair value for Sun adjusted for the $100,000 income recognition and the $40,000 cash dividend. The same $100,000 equity income figure appears within the parent’s income statement. These two balances are appropriately found in Parrot’s records in Exhibit 3.10.

Because of differences in income recognition and the effects of subsidiary dividends, Entries I and D again differ on the worksheet. For the partial equity method, the $100,000 equity income is eliminated (Entry I) by reversing the parent’s entry. Removing this accrual allows the individual revenue and expense accounts of the subsidiary to be reported without double-counting. The $40,000 intra-entity dividend must also be removed (Entry D). The Dividends Declared account is simply deleted. However, elimination of the dividend from the

Parrot Company Initial Value Method 2017

Parrot Company Partial Equity Method 2017

Dividend Receivable . . . . . . 40,000 Dividend Receivable . . . . . . 40,000 Dividend Income. . . . . . 40,000 Investment in Sun

Company . . . . . . . . . . . 40,000 Subsidiary dividends declared. Subsidiary dividends declared. Cash . . . . . . . . . . . . . . . . . . . . 40,000 Cash . . . . . . . . . . . . . . . . . . . . 40,000 Dividend Receivable . . 40,000 Dividend Receivable . . 40,000 To record the receipt of the cash dividend.

To record the receipt of the cash dividend.

Investment in Sun Company 100,000 Equity in Subsidiary

Earnings . . . . . . . . . . . . 100,000 Accrual of subsidiary income.

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Investment in Sun Company actually causes an increase because the dividend was recorded by Parrot as a reduction in that account. All other consolidation entries (Entries S, A, and E) are the same for all three methods.

Comparisons across Internal Investment Methods Consolidated financial worksheets have now been completed when the parent uses the equity, initial value, and partial equity methods. At this point it is instructive to compare the final con- solidated balances in Exhibits 3.5, 3.9, and 3.10. Note the identical final consolidated column balances across the three internal methods of investment accounting. Thus, the parent’s inter- nal investment method choice has no effect on the resulting consolidated financial statements.

Consolidation Subsequent to Year of Acquisition—Initial Value and Partial Equity Methods By again incorporating the December 31, 2020, financial data for Parrot and Sun (presented in Exhibit 3.7), consolidation procedures for the initial value method and the partial equity method are examined for years subsequent to the date of acquisition. In both cases, establishment of an appropriate beginning retained earnings figure becomes a significant goal of the consolidation.

Conversion of the Parent’s Retained Earnings to a Full-Accrual (Equity) Basis Consolidated financial statements require a full accrual-based measurement of both income and retained earnings. The initial value method, however, recognizes income when the sub- sidiary declares a dividend thus ignoring when the underlying income was earned. The partial equity method only partially accrues subsidiary income. Thus, neither provides a full accrual- based measure of the subsidiary activities on the parent’s income. As a result, over time the parent’s retained earnings account fails to show a full accrual-based amount. Therefore, new worksheet adjustments are required to convert the parent’s beginning of the year retained earnings balance to a full-accrual basis. These adjustments are made to beginning of the year retained earnings because current year earnings are readily converted to full-accrual basis by simply combining current year revenue and expenses. The resulting current year combined income figure is then added to the adjusted beginning of the year retained earnings to arrive at a full-accrual ending retained earnings balance.

This concern was not faced previously when the equity method was adopted. Under that approach, the parent’s Retained Earnings account balance already reflects a full-accrual basis so that no adjustment is necessary. In the earlier illustration, the $330,000 income accrual for the 2017–2019 period as well as the $21,000 amortization expense was recognized by the parent in applying the equity method (see Exhibit 3.6). Having been recorded in this man- ner, these two balances form a permanent part of Parrot’s retained earnings and are included automatically in the consolidated total. Consequently, if the equity method is applied, the pro- cess is simplified; no worksheet entries are needed to adjust the parent’s Retained Earnings account to record subsidiary operations or amortization for past years.

Conversely, if a method other than the equity method is used, a worksheet change must be made to the parent’s beginning Retained Earnings account (in every subsequent year) to equate this balance with a full-accrual amount. To quantify this adjustment, the parent’s recog- nized income for these past three years under each method is first determined (Exhibit 3.11). For consolidation purposes, the beginning retained earnings account must then be increased or decreased to create the same effect as the equity method.

LO 3-4

Understand that a parent’s inter- nal accounting method for its subsidiary investments has no effect on the resulting consoli- dated financial statements.

PARROT COMPANY AND SUN COMPANY Previous Years—2017–2019

Equity Method

Initial Value Method

Partial Equity Method

Equity accrual $330,000  $        –0– $330,000 Dividend income –0–  110,000 –0– Excess amortization expenses     ( 21,000)         –0–         –0–

Increase in parent’s retained earnings $309,000  $110,000 $330,000

EXHIBIT 3.11 Retained Earnings Differences

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Initial Value Method Applied—Subsequent Consolidation As shown in Exhibit 3.11, if Parrot applied the initial value method during the 2017–2019 period, it recognizes $199,000 less income than under the equity method ($309,000 − $110,000). Two items cause this difference. First, Parrot has not accrued the $220,000 increase in the subsidiary’s book value across the periods prior to the current year. Although the $110,000 in dividends was recorded as income, the parent never recognized the remainder of the $330,000 earned by the subsidiary.7 Second, no accounting has been made of the $21,000 excess amortization expenses. Thus, the parent’s beginning Retained Earnings account is $199,000 ($220,000 − $21,000) below the appropriate consolidated total and must be adjusted.8

To simulate the equity method so that the parent’s beginning Retained Earnings account reflects a full-accrual basis, this $199,000 increase is recorded through a worksheet entry. The initial value method figures reported by the parent effectively are converted into equity method balances.

7 Two different calculations are available for determining the $220,000 in nonrecorded income for prior years: (1) subsidiary income less dividends declared and (2) the change in the subsidiary’s book value as of the first day of the current year. The second method works only if the subsidiary has had no other equity transactions such as the issuance of new stock or the purchase of treasury shares. Unless otherwise stated, the assumption is made that no such transactions have occurred. 8 Because neither the income in excess of dividends nor excess amortization is recorded by the parent under the initial value method, its beginning Retained Earnings account is $199,000 less than the $2,044,000 reported under the equity method ( Exhibit 3.7 ). Thus, a $1,845,000 balance is shown in Exhibit 3.12 ($2,044,000 less $199,000). Conversely, if the partial equity method had been applied, Parrot’s absence of amortization would cause the Retained Earnings account to be $21,000 higher than the figure derived by the equity method. For this reason, Exhibit 3.13 shows the parent with a beginning Retained Earnings account of $2,065,000 rather than $2,044,000.

Investment in Sun Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199,000 Retained Earnings, 1/1/20 (Parrot Company) . . . . . . . . . . . . . . . . . . . . . . 199,000 To convert parent’s beginning retained earnings from the initial value method to equity method.

This adjustment is labeled Entry *C. The C refers to the conversion being made to equity method (full-accrual) totals. The asterisk indicates that this equity simulation relates solely to transactions of prior periods. Thus, Entry *C should be recorded before the other worksheet entries to align the beginning balances for the year.

Exhibit 3.12 provides a complete presentation of the consolidation of Parrot and Sun as of December 31, 2020, based on the parent’s application of the initial value method. After Entry *C has been recorded on the worksheet, the remainder of this consolidation follows the same pattern as previous examples. Sun’s stockholders’ equity accounts are eliminated (Entry S) while the allocations stemming from the $800,000 initial fair value are recorded (Entry A) at their unamortized balances as of January 1, 2020 (see Exhibit 3.8). Intra-entity dividend income is removed (Entry I) and current year excess amortization expenses are recognized (Entry E). To complete this process, the intra-entity receivable and payable of $40,000 are offset (Entry P).

In retrospect, the only new element introduced here is the adjustment of the parent’s begin- ning Retained Earnings. For a consolidation produced after the initial year of acquisition, an Entry *C is required if the parent has not applied the equity method.

Partial Equity Method Applied—Subsequent Consolidation Exhibit 3.13 demonstrates the worksheet consolidation of Parrot and Sun as of December 31, 2020, when the investment accounts have been recorded by the parent using the partial equity method. This approach accrues subsidiary income each year but records no other equity adjustments. Therefore, as of December 31, 2020, Parrot’s Investment in Sun Company account has a balance of $1,110,000:

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Fair value of consideration transferred for Sun Company 1/1/17 $   800,000 Sun Company’s 2017–2019 increase in book value: Accrual of Sun Company’s income $ 330,000 Sun Company’s dividends   (110,000) 220,000

Sun Company’s 2020 operations: Accrual of Sun Company’s income $ 160,000  Sun Company’s dividends     (70,000)        90,000

Investment in Sun Company, 12/31/20 (Partial equity method) $1,110,000

Investment: Initial Value Method

PARROT COMPANY AND SUN COMPANY Consolidation Worksheet

For Year Ending December 31, 2020

Accounts Parrot

Company Sun

Company

Consolidation Entries Consolidation

TotalsDebit Credit

Income Statement Revenues (2,100,000) (600,000) (2,700,000) Cost of goods sold 1,000,000 380,000 1,380,000 Amortization expense   200,000  20,000 (E)    13,000    233,000  Depreciation expense   100,000  40,000 (E)        6,000   134,000  Dividend income   (70,000) *  –0– (I)     70,000 *    –0–

Net income  (870,000) (160,000)  (953,000)

Statement of Retained Earnings Retained earnings, 1/1/20 Parrot Company  (1,845,000)† * (*C)  199,000 * (2,044,000) Sun Company (600,000) (S)  600,000 –0– Net income (above) (870,000) (160,000)   (953,000)  Dividends declared 420,000   70,000 (I)       70,000 * 420,000

Retained earnings, 12/31/20 (2,295,000) (690,000) (2,577,000)

Balance Sheet Current assets 1,705,000 500,000 (P)     40,000 2,165,000 Investment in Sun Company 800,000* –0– (*C)  199,000   (S)   820,000 –0–

(A)   179,000 Trademarks 600,000 240,000 (A)    20,000    860,000  Patented technology 540,000 420,000 (A)    91,000  (E)      13,000 1,038,000 Equipment (net) 420,000 210,000 (E)      6,000 (A)      12,000   624,000  Goodwill –0–  –0–  (A)    80,000   80,000 

Total assets 4,065,000  1,370,000  4,767,000

Liabilities (1,050,000) (460,000) (P)    40,000 (1,470,000) Common stock  (600,000) (200,000) (S)  200,000   (600,000)  Additional paid-in capital   (120,000)  (20,000)   (S)    20,000   (120,000)  Retained earnings, 12/31/20 (above) (2,295,000) (690,000) (2,577,000)

Total liabilities and equities (4,065,000) (1,370,000)  1,339,000   1,339,000   (4,767,000)

Note: Parentheses indicate a credit balance. *Boxed items highlight differences with consolidation in Exhibit 3.7. †See footnote 8. Consolidation entries:     (*C) To convert parent’s beginning retained earnings to full accrual basis.     (S) Elimination of Sun’s stockholders’ equity January 1 balances and the book value portion of investment account.     (A) Allocation of Sun’s excess acquisition-date fair value over book value, unamortized balance as of beginning of year.     (I) Elimination of intra-entity dividend income and dividends declared by Sun.     (E) Recognition of current year excess fair-value amortization and depreciation expenses.     (P) Elimination of intra-entity receivable/payable. Note: Consolidation entry (D) is not needed when the parent applies the initial value method because entry (I) eliminates the intra-entity dividend effects.

EXHIBIT 3.12 Consolidation Worksheet Subsequent to Year of Acquisition—Initial Value Method Applied

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As indicated here and in Exhibit 3.11, Parrot has recognized the yearly equity income accrual but not amortization. When the parent employs the partial equity method, the parent’s beginning Retained Earnings account must be adjusted to include this expense. Therefore, Entry *C provides the three-year $21,000 amortization  total to simulate the equity method and, hence, consolidated totals.

Investment: Partial Equity Method

PARROT COMPANY AND SUN COMPANY Consolidation Worksheet

For Year Ending December 31, 2020

Accounts Parrot

Company Sun

Company

Consolidation Entries Consolidation

TotalsDebit Credit

Income Statement Revenues (2,100,000)  (600,000) (2,700,000) Cost of goods sold 1,000,000  380,000 1,380,000 Amortization expense 200,000   20,000 (E)    13,000   233,000  Depreciation expense 100,000   40,000 (E)        6,000   134,000  Equity in subsidiary earnings (160,000) *  –0–   (I)  160,000 *   –0–

Net income (960,000)   (160,000)     (953,000) 

Statement of Retained Earnings Retained earnings, 1/1/20 Parrot Company  (2,065,000)† * (*C)   21,000 * (2,044,000) Sun Company   (600,000)   (S)  600,000   –0– Net income (above)  (960,000)    (160,000)     (953,000) Dividends declared   420,000     70,000 (D)      70,000*   420,000

Retained earnings, 12/31/20 (2,605,000)    (690,000)   (2,577,000)

Balance Sheet Current assets 1,705,000    500,000   (P)      40,000 2,165,000 Investment in Sun Company  1,110,000 *  –0– (D)    70,000 (*C)    21,000 *   –0–

 (S)   820,000  (A)   179,000 (I)     160,000 *

Trademarks 600,000   240,000   (A)    20,000   860,000 Patented technology 540,000   420,000   (A)    91,000 (E)     13,000  1,038,000 Equipment (net) 420,000   210,000   (E)      6,000 (A)     12,000   624,000 Goodwill –0– –0– (A)    80,000   80,000

Total assets 4,375,000  1,370,000     4,767,000

Liabilities (1,050,000)    (460,000)   (P)    40,000 (1,470,000) Common stock  (600,000)    (200,000)   (S)  200,000   (600,000)  Additional paid-in capital  (120,000)    (20,000) (S)    20,000   (120,000)  Retained earnings, 12/31/20 (above)  (2,605,000)   (690,000)   (2,577,000)

Total liabilities and equities (4,375,000)  (1,370,000)      1,321,000   1,321,000 (4,767,000)

Note: Parentheses indicate a credit balance. *Boxed items highlight differences with consolidation in Exhibit 3.7. †See footnote 8. Consolidation entries: (*C) To convert parent’s beginning retained earnings to full accrual basis. (S) Elimination of Sun’s stockholders’ equity January 1 balances and the book value portion of investment account. (A) Allocation of Sun’s excess acquisition-date fair over book value, unamortized balance as of beginning of year. (I) Elimination of parent’s equity in subsidiary earnings accrual. (D) Elimination of intra-entity dividends. (E) Recognition of current year excess fair-value amortization and depreciation expenses. (P) Elimination of intra-entity receivable/payable.

EXHIBIT 3.13 Consolidation Worksheet Subsequent to Year of Acquisition—Partial Equity Method Applied

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Consolidation Entry *C

Retained Earnings, 1/1/20 (Parrot Company). . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000 Investment in Sun Company. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000 To convert parent’s beginning Retained Earnings from partial equity method to equity method by including excess amortizations.

By recording Entry *C on the worksheet, all of the subsidiary’s operational results for the 2017–2019 period are included in the consolidation. As shown in Exhibit 3.13, the remainder of the worksheet entries follow the same basic pattern as that illustrated previously for the year of acquisition (Exhibit 3.10).

Summary of Worksheet Procedures Having three investment methods available to the parent means that three sets of entries must be understood to arrive at reported figures appropriate for a business combination. The pro- cess can initially seem to be a confusing overlap of procedures. However, at this point in the coverage, only three worksheet entries actually are affected by the choice of either the equity method, partial equity method, or initial value method: Entries *C, I, and D. Furthermore, accountants should never get so involved with a worksheet and its entries that they lose sight of the balances that this process is designed to calculate. Exhibit 3.14 provides a summary of the final consolidated totals and how they are calculated. These figures are never affected by the parent’s choice of an accounting method.

After the appropriate balance for each account is understood, worksheet entries assist the accountant in deriving these figures. To help clarify the consolidation process required under each of the three accounting methods, Exhibit 3.14 describes the purpose of each worksheet entry: first during the year of acquisition and second for any period following the year of acquisition.

Discussion Question

In consolidation worksheet entry *C,  we adjust the parent’s beginning of the year retained earnings to a full accrual basis. Why don’t we adjust to the parent’s end of the year retained earnings balance on the consolidated worksheet?

Clearly, in a consolidated balance sheet, we wish to report the parent’s end-of-period consolidated retained earnings at its full accrual GAAP basis. To accomplish this goal, we utilize the following sep- arate individual components of end-of-period retained earnings available on the worksheet.

Beginning of the year balance (after *C adjustment if parent does not employ equity method) + Net income (parent’s share of consolidated net income adjusted to full accrual by combining revenues and expenses—including excess acquisition-date fair value amortizations) −  Dividends (parent’s dividends) =  End of the year balance   The worksheet provides for the computation of current year full accrual consolidated net

income via the income statement section.  Dividends are already provided in the retained earn- ings section of the consolidated worksheet. The only component of the ending balance of retained earnings that requires a special adjustment (*C) is the beginning balance.

How does the consolidation worksheet entry *C differ when the parent uses the initial value method versus the partial equity method?  Why is no *C adjustment needed when consolidated statements are prepared for the first fiscal year-end after the business combination?

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Current revenues Parent revenues are included. Subsidiary revenues are included but only for the period since the acquisition.

Current expenses Parent expenses are included. Subsidiary expenses are included but only for the period since the acquisition. Amortization expenses of the excess fair-value allocations are included by recognition on the worksheet.

Investment (or dividend) income

Income recognized by parent is eliminated and effectively replaced by the subsidiary’s revenues and expenses.

Retained earnings, beginning balance

Parent balance is included. The change in the subsidiary balance since acquisition is included either as a regular accrual by the parent or through a worksheet entry to increase parent balance. Past amortization expenses of the excess fair-value allocations are included either as a part of parent balance or through a work- sheet entry.

Assets and liabilities Parent balances are included. Subsidiary balances are included after adjusting for acquisition- date fair values less amortization to beginning of current period. Intra-entity receivable/payable balances are eliminated.

Goodwill Investment in subsidiary

Original fair-value allocation is included unless reduced by impairment. Asset account recorded by parent is eliminated on the worksheet so that the balance is not included in consolidated figures.

Capital stock and addi- tional paid-in capital

Parent balances only are included although they will have been adjusted at acquisition date if stock was issued.

*The next few chapters discuss the necessity of altering some of these balances for consolidation purposes. Thus, this table is not definitive but is included only to provide a basic overview of the consolidation process as it has been described to this point.

EXHIBIT 3.14 Consolidated Totals Subsequent to Acquisition*

Discussion Question

HOW DOES A COMPANY REALLY DECIDE WHICH INVESTMENT METHOD TO APPLY?

Pilgrim Products, Inc., buys a controlling interest in the common stock of Crestwood Corpora- tion. Shortly after the acquisition, a meeting of Pilgrim’s accounting department is convened to discuss the internal reporting procedures required by the ownership of this subsidiary. Each member of the staff has a definite opinion as to whether the equity method, initial value method, or partial equity method should be adopted. To resolve this issue, Pilgrim’s chief financial officer outlines several of her concerns about the decision.

I already understand how each method works. I know the general advantages and disad- vantages of all three. I realize, for example, that the equity method provides more detailed information whereas the initial value method is much easier to apply. What I  need to know are the factors specific to our situation that should be considered in deciding which method to adopt. I must make a recommendation to the president on this matter, and he will want firm reasons for my favoring a particular approach. I don’t want us to select a method and then find out in six months that the information is not adequate for our needs or that the cost of adapting our system to monitor Crestwood outweighs the benefits derived from the data.

What are the factors that Pilgrim’s officials should evaluate when making this decision?

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Equity Method Applied Initial Value Method Applied Partial Equity Method Applied

Any Time during Year of Acquisition

Entry S Beginning stockholders’ equity of sub- sidiary is eliminated against book value portion of investment account. Same as equity method. Same as equity method.

Entry A Excess fair value is allocated to assets and liabilities based on difference in book values and fair values; residual is assigned to goodwill. Same as equity method. Same as equity method.

Entry I Equity income accrual (including amorti- zation expense) is eliminated. Dividend income is eliminated.

Equity income accrual is eliminated.

Entry D Intra-entity dividends declared by subsid- iary are eliminated.

No entry—intra-entity dividends are eliminated in Entry I. Same as equity method.

Entry E Current year excess amortization expenses of fair-value allocations are recorded. Same as equity method. Same as equity method.

Entry P Intra-entity payable/receivable balances are offset. Same as equity method. Same as equity method.

Any Time Following Year of Acquisition

Entry *C

No entry—equity income for prior years has already been recognized along with amortization expenses.

Increase in subsidiary’s book value during prior years and excess amortization expenses are recognized (conversion is made to equity method).

Excess amortization expenses for prior years are recognized (conversion is made to equity method).

Entry S Same as initial year. Same as initial year. Same as initial year.

Entry A Unamortized excess fair value at begin- ning of year is allocated to specific accounts and to goodwill. Same as equity method. Same as equity method.

Entry I Same as initial year. Same as initial year. Same as initial year.

Entry D Same as initial year. Same as initial year. Same as initial year.

Entry E Same as initial year. Same as initial year. Same as initial year.

Entry P Same as initial year. Same as initial year. Same as initial year.

EXHIBIT 3.15  Consolidation Worksheet Entries

Excess Fair Value Attributable to Subsidiary Long- Term Debt: Post-Acquisition Procedures In the previous consolidation examples for Parrot and Sun Company, the acquisition-date excess fair values were attributed solely to long-term assets. Similarly, however, the acquisition-date fair value of subsidiary long-term debt may also differ from its carrying amount. Although the long-term debt adjustment to fair value is relatively straightforward, the adjustments to interest expense in periods subsequent to acquisition require additional analysis.

In subsequent periods, the acquisition-date fair value adjustment to long-term debt is amor- tized to interest expense over the remaining life of the debt. When the acquisition-date fair value of subsidiary long-term debt exceeds its carrying amount on the subsidiary’s books, the parent increases the value of the debt reported on its consolidated balance sheet (and vice-versa). Conse- quently, when the parent reflects the increased value of the subsidiary’s long-term debt valuation, it must reduce interest expense recognized on the consolidated income statement over the debt’s remaining life. When the long-term debt valuation is decreased, interest expense increases.

Exhibit 3.16 summarizes the worksheet effects when acquisition-date long-term debt’s carrying amount differs from its fair value.

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At first glance, it may seem counterintuitive that when long-term debt is increased, inter- est expense is decreased. Certainly for plant assets like equipment, when we increase their carrying amounts to acquisition-date fair values on the worksheet, we increase the related depreciation expense. Why do we seem to do the opposite for long-term liabilities?

The answer can be seen in the fact that even though the acquisition-date value of the subsid- iary’s long-term debt exceeds its carrying amount, the acquisition does not affect the subsidiary’s contractual obligation for repaying the debt. The ultimate amount of debt to be repaid at maturity remains the same. For example, assume Pax Company acquires Sax Company on January 1, 2017. Exhibit 3.17 provides information about Sax Company’s long-term debt:

December 31, 2017, Consolidation Worksheet Consolidation Entry A Investment in Sax Company 5,000 Long-term debt 5,000 To adjust the subsidiary’s long-term debt to acquisition-date fair value.

Consolidation Entry E Long-term debt 1,000 Interest expense 1,000 To recognize the reduction in current year interest expense

December 31, 2018, Consolidation Worksheet Consolidation Entry A Investment in Sax Company 4,000 Long-term debt 4,000 To adjust the subsidiary’s long-term debt to unamortized balance as of the beginning of the year ($5,000 – $1,000 from year 2017). Consolidation Entry E Long-term debt 1,000 Interest expense 1,000 To recognize the reduction in current year interest expense

EXHIBIT 3.18 Worksheet Adjustments for Excess Acquisition-Date Fair Value Attributable to Subsidiary Long-Term Debt

Long-Term Debt January 1, 2017

Long-Term Debt Maturity Value

January 1, 2022

Fair value  $105,000 $100,000 Carrying amount  100,000 100,000

EXHIBIT 3.17 Acquisition-Date Long- Term Debt Valuation

Long-Term Debt Valuation at Acquisition Date

Worksheet Adjustment to Long-Term Debt

Worksheet Adjustment to Interest Expense

Fair value > Carrying amount Increase long-term debt to adjust to fair value (less previous periods interest amortization)

Debit Long-Term Debt and credit Interest Expense

Fair value < Carrying amount Decrease long-term debt to adjust to fair value (less previous periods interest amortization)

Debit Interest Expense and credit Long-Term Debt

EXHIBIT 3.16 Long-Term Debt: Consolidation Worksheet Adjustments

By acquiring Sax, Pax has taken on $105,000 of fair value debt, but will only have to pay back $100,000 at the debt’s maturity date. As shown in Exhibit 3.18, the additional $5,000 excess fair over book value (that will not be repaid) is recognized as a reduction in overall inter- est expense, similar to amortizing a bond premium. Therefore, when consolidated statements are prepared, interest expense is reduced over the life of the long-term debt.

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Microsoft $5.1 billion Yahoo! 4.5 billion Devon Energy 1.9 billion Rent-a-Center 1.2 billion Time, Inc. 952 million J. Crew 676 million Staples 410 million The Hershey Company 31 million Pep Boys 23.9 million

EXHIBIT 3.19 Recent Goodwill Impairments

To complete this example, we assume the sole acquistion-date excess fair value adjust- ment made by Pax Company is to long-term debt, and straight-line amortization is used for the interest adjustments.

Finally, the carrying amount of a subsidiary’s long-term debt may exceed its fair value. In that case, a consolidation entry is required to decrease the long-term debt reported in the con- solidated balance sheet. Then, in periods subsequent to acquisition, worksheet entries are also needed to increase the amount of interest expense to be recognized in the consolidated income statement.

Goodwill Impairment FASB ASC Topic 350, “Intangibles—Goodwill and Other,” provides accounting standards for determining, measuring, and reporting goodwill impairment losses. Because goodwill is considered to have an indefinite life, an impairment approach is used rather than amortization. The FASB reasoned that although goodwill can decrease over time, it does not do so in the “rational and systematic” manner that periodic amortization suggests. Only upon recognition of an impairment loss (or partial sale of a subsidiary) will goodwill decline from one period to the next. Goodwill impairment losses are reported as operating items in the consolidated income statement.

The notion of an indefinite life allows many firms to report the original amount of good- will recognized in a business combination. However, goodwill can become impaired, requir- ing loss recognition and a reduction in the amount reported in the consolidated balance sheet. Evidence shows that goodwill impairment losses can be substantial. Exhibit 3.19 provides examples of some recent goodwill impairment losses. Unlike amortization, which periodi- cally reduces asset values, impairment must first be revealed before a write-down is justified. Accounting standards therefore require periodic tests for goodwill impairment.

Goodwill impairment tests are performed at the reporting unit level within a combined entity. As discussed next, all assets acquired (including goodwill) and liabilities assumed in a business combination must be assigned to reporting units within a consolidated enterprise. The goodwill residing in each reporting unit is then separately subjected to periodic impair- ment reviews. Current financial reporting standards require, at a minimum, an annual assess- ment for potential goodwill impairment.

Because impairment testing procedures can be costly, the FASB provides firms the option to first conduct a qualitative analysis to assess whether further testing procedures are appro- priate. If circumstances indicate a potential decline in the fair value of a reporting unit below its carrying amount, then further tests are required to see if goodwill is the source of the decline. Our coverage of goodwill impairment addresses the following:

∙ The assignment of acquired goodwill to reporting units. ∙ The option to conduct an annual qualitative test for potential goodwill impairment. ∙ Goodwill impairment testing procedures. ∙ A FASB proposal to simplify goodwill impairment testing. ∙ Comparison with international accounting standards.

LO 3-5

Discuss the rationale for the goodwill impairment testing approach.

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Assigning Goodwill to Reporting Units Combined companies typically organize themselves into separate units along distinct operat- ing lines. Each individual operating unit has responsibility for managing its assets and liabili- ties to earn profits for the combined entity. These operating units report information about their earnings activities to top management to support decision making. Such operating units are known as reporting units.

Following a business combination, the identifiable assets and liabilities acquired are assigned to the firm’s reporting units based on where they will be employed. Any amount assigned to goodwill also is assigned to reporting units expected to benefit from the synergies of the combination. Thus, any individual reporting unit where goodwill resides is the appro- priate level for goodwill impairment testing.

In practice, firms often assign goodwill to reporting units either at the level of a reporting segment—as described in ASC Topic 280, “Segment Reporting”—or at a lower level within a segment of a combined enterprise. Reporting units may thus include the following:

∙ A component of an operating segment at a level below that operating segment. Segment management should review and assess performance at this level. Also, the component should be a business in which discrete financial information is available and should differ economically from other components of the operating segment.

∙ The segments of an enterprise. ∙ The entire enterprise.

For example, Qorvo, Inc. is a wireless technology firm serving the mobile device, net- works infrastructure, and defense and aerospace markets. In its recent annual report Qorvo identified its two business segments, MP and IDP (Mobile Products and Infrastructure and Defense Products), as its reporting units:

For fiscal 2015, we have determined that our reporting units are MP and IDP for purposes of allo- cating and testing goodwill. . .Goodwill is allocated to our reporting units based on the expected benefit from the synergies of the business combinations generating the underlying goodwill.

Thus, all goodwill impairment testing is performed at the reporting unit level, rather than collectively at the combined entity level. Separate testing of goodwill within individual reporting units also prevents the masking of goodwill impairment in one reporting unit with contemporaneous increases in the value of goodwill in other reporting units.

Qualitative Assessment Option Because goodwill impairment tests require firms to calculate fair values for their reporting units each year, such a comprehensive measurement exercise can be costly. To help reduce costs, FASB ASC Topic 305 allows an entity the option to first assess qualitative factors to determine whether more rigorous testing for goodwill impairment is needed. The qualitative approach assesses the likelihood that a reporting unit’s fair value is less than its carrying amount. The more-likely-than-not threshold is defined as having a likelihood of more than 50 percent.

In assessing whether a reporting unit’s fair value exceeds its carrying amount, a firm must examine all relevant facts and circumstances, including

∙ Macroeconomic conditions such as a deterioration in general economic conditions, limita- tions on accessing capital, fluctuations in foreign exchange rates, or other developments in equity and credit markets.

∙ Industry and market considerations such as a deterioration in the environment in which an entity operates, an increased competitive environment, a decline (both absolute and rela- tive to its peers) in market-dependent multiples or metrics, a change in the market for an entity’s products or services, or a regulatory or political development.

∙ Cost factors such as increases in raw materials, labor, or other costs that have a negative effect on earnings.

∙ Overall financial performance such as negative or declining cash flows or a decline in actual or planned revenue or earnings.

LO 3-6

Describe the procedures for conducting a goodwill impair- ment test.

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∙ Other relevant entity-specific events such as changes in management, key personnel, strat- egy, or customers; contemplation of bankruptcy; or litigation.

∙ Events affecting a reporting unit such as a change in the carrying amount of its net assets, a more-likely-than-not expectation of selling or disposing all, or a portion of, a reporting unit, the testing for recoverability of a significant asset group within a reporting unit, or recognition of a goodwill impairment loss in the financial statements of a subsidiary that is a component of a reporting unit.

∙ If applicable, a sustained decrease (both absolute and relative to its peers) in share price. (FASB ASC para. 350-20-35-3C)

The underlying rationale for comparing a reporting unit’s fair value and carrying amount is as follows. If a reporting unit’s fair value is deemed greater than its carrying amount, then its col- lective net assets are maintaining their value. It then can be argued that a decline in any particular asset (i.e., goodwill) within the reporting unit is also unlikely and no further impairment tests are necessary. On the other hand, if the relevant facts and circumstances listed above suggest that a reporting unit’s fair value is likely less than its carrying amount, then more rigorous testing for goodwill impairment is appropriate. Nonetheless, a qualitative assessment of a sufficient fair value for a reporting unit circumvents further goodwill impairment testing.

The FASB ASC (paragraph 350-20-35-28) requires an entity to assess its goodwill for impairment annually for each of its reporting units where goodwill resides. Moreover, more frequent impairment assessment is required if events or circumstances change that make it more likely than not that a reporting unit’s fair value has fallen below its carrying amount.

Testing Goodwill for Impairment Goodwill impairment testing and measurement involves a two-step process.9 In contrast to the qualitative assessment, Steps 1 and 2 rely on quantitative fair-value measures for report- ing units as a whole and for their underlying individual assets and liabilities. If, after perform- ing the qualitative assessment described above, an entity concludes that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, then the entity is required to proceed to the first step of the two-step impairment test.10

Step 1: Is the Carrying Amount of a Reporting Unit More Than Its Fair Value? In the first step of impairment testing, the consolidated entity calculates fair values for each of its reporting units with allocated goodwill. Each reporting unit’s fair value is then compared with its carrying amount (including goodwill). If an individual reporting unit’s fair value exceeds its carrying amount, its goodwill is not considered impaired, and the second step in testing is not performed—goodwill remains at its current carrying amount. However, if the fair value of a reporting unit has fallen below its carrying amount, a potential for goodwill impairment exists. In this case, a second step must be performed to determine whether good- will has been impaired and to measure the amount of impairment.

Step 2: Is Goodwill’s Implied Value Less Than Its Carrying Amount? If Step 1 indicates potential goodwill impairment, Step 2 then compares the fair value of goodwill to its carrying amount. Because, by definition, goodwill is not separable from other assets, it is not possible to directly observe its fair value. Therefore, an implied fair value for goodwill is calculated in a similar manner to the determination of goodwill in a business com- bination. As stated in the FASB ASC (para. 350-20-35-14):

The implied fair value of goodwill shall be determined in the same manner as the amount of goodwill recognized in a business combination . . . That is, an entity shall assign the fair value of a reporting unit to all of the assets and liabilities of that unit (including any unrecognized intangible assets) as if the reporting unit had been acquired in a business combination . . .

9 As discussed later in this chapter, FASB has proposed the elimination of step 2 of the goodwill impairment measurement procedure. 10 An entity, on the basis of its discretion, may bypass the qualitative assessment for any reporting unit in any period and proceed directly to performing the first step of the impairment test. An entity may resume per- forming the qualitative assessment in any subsequent period (FASB ASC para. 350-20-35-3B).

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Newcall’s Reporting Units Goodwill

Acquisition-Date Fair Values January 1, 2017

DSM Wired $22,000,000 $950,000,000 DSM Wireless 155,000,000 748,000,000 VisionTalk 38,000,000 502,000,000

DSM Wireless December 31, 2017, fair value $600,000,000 Fair values of DSM Wireless net assets at December 31, 2017: Current assets $  50,000,000 Property 125,000,000 Equipment 265,000,000 Subscriber list 140,000,000 Patented technology 185,000,000 Current liabilities (44,000,000) Long-term debt (125,000,000)

Value assigned to identifiable net assets $596,000,000

Implied fair value of goodwill $    4,000,000 Goodwill carrying amount before impairment 155,000,000

Impairment loss $151,000,000

The current fair value of the reporting unit is allocated across that unit’s identifiable assets and liabilities with any remaining excess considered as the implied value of goodwill.11 If the implied value of goodwill is less than its carrying amount, impairment has occurred and a loss is recognized. The loss equals the excess of the carrying amount of the reporting unit’s good- will over its implied fair value.12

Illustration—Accounting and Reporting for a Goodwill Impairment Loss To illustrate the testing procedures for goodwill impairment, assume that on January 1, 2017, investors form Newcall Corporation to consolidate the telecommunications operations of DSM, Inc., and VisionTalk Company in a deal valued at $2.2 billion. Newcall organizes each former firm as an operating segment. Additionally, DSM comprises two divisions—DSM Wired and DSM Wireless—that along with VisionTalk are treated as independent report- ing units for internal performance evaluation and management reviews. Newcall recognizes $215 million as goodwill at the merger date and allocates this entire amount to its reporting units. That information and each reporting unit’s acquisition-date fair values are as follows:

11 This procedure serves only to measure an implied fair value for goodwill. None of the other values allo- cated to assets and liabilities in the testing comparison are used to adjust their reported amounts. 12 The loss cannot exceed the carrying amount of goodwill.

In December 2017, Newcall performs a qualitative analysis for each of its three reporting units to assess potential goodwill impairment. Accordingly, Newcall examines the relevant events and circumstances that may affect the fair values of its reporting units. The analysis reveals that the fair value of each reporting unit likely exceeds its carrying amount except for DSM Wireless. Step 1 of the goodwill impairment test then reveals that DSM Wireless’s fair value has fallen to $600 million, well below its current carrying amount. Newcall attributes the decline in value to a failure to realize expected cost-saving synergies with VisionTalk. Then, in Step 2, Newcall compares the implied fair value of the DSM Wireless goodwill to its carrying amount. Newcall derived the implied fair value of goodwill through the following allocation of the December 31, 2017, fair value of DSM Wireless:

Thus, Newcall reports a $151,000,000 goodwill impairment loss as a separate line item in the operating section of its consolidated income statement. Additional disclosures are required describing (1) the facts and circumstances leading to the impairment and (2) the method of determining the fair value of the associated reporting unit (e.g., market prices, comparable business, present value technique, etc.). The reported amounts for the other

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assets and liabilities of DSM Wireless remain the same and are not changed based on the goodwill testing procedure.

Reporting Units with Zero or Negative Carrying Amounts One final issue regarding goodwill impairment testing deserves mentioning. When a report- ing unit has a zero or negative carrying amount, the ASC requires a special application of the testing procedure. An exception is needed because a zero or negative carrying amount for a reporting unit accompanied by a positive fair value would always permit an entity to forgo Step 2 of the impairment test even though its underlying goodwill might be impaired. There- fore, in such circumstances, the ASC requires an entity to perform Step 2 of the impairment test when it is more likely than not that a goodwill impairment exists. In judging the likeli- hood of goodwill impairment, an entity must consider the same factors as in the qualitative assessment for individual reporting units.

Goodwill Impairment Simplified—Proposed Accounting Standards Update (ASU) In May, 2016, the FASB issued a proposed ASU entitled, “Simplifying the Accounting for Goodwill Impairment.”13 The stated objective of the proposed ASU was “to remove Step 2 from the goodwill impairment test, which includes determining the implied fair value of goodwill and comparing it with the carrying amount of that goodwill.” The proposed changes would greatly simplify the accounting procedures previously described. The changes would also save companies the cost involved in determining fair values for each of the assets and liabilities residing in their reporting units. However, the FASB would continue to require a determination of the fair value of its reporting units, should any fail (or elect to forego) the qualitative goodwill impairment assessment.

The FASB’s recommendation partially stems from a post-implementation review of accounting for business combinations. That review concluded that current goodwill account- ing produces more complexity and costs than the FASB anticipated. Further, the board con- cluded that eliminating Step 2 would not significantly reduce the usefulness of the goodwill impairment information provided to users of financial statements.

The proposed ASU changes accounting for goodwill impairment as follows:

. . .an entity would perform its annual, or any interim, goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An entity generally would recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value. However, that amount should not exceed the carrying amount of goodwill allocated to that reporting unit. An entity would still have the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary.14

Thus, assuming a reporting unit failed (or elected to forego) the qualitative assessment (a likelihood of more than 50 percent that a reporting unit’s fair value is less than its carrying amount), a quantitative comparison would be employed to measure the amount of goodwill impairment. For example, assume the following December 31, 2018 values for Quality Road Company’s RNT reporting unit:

December 31, 2018 Fair Value Carrying Amount

RNT reporting unit as a whole $1,500,000 $1,625,000* Goodwill ? 148,000

* Reporting unit’s assets (including goodwill) – liabilities.

The December 31, 2018 goodwill impairment loss would be measured simply as follows:

RNT reporting unit fair value $1,500,000 –RNT reporting unit carrying amount 1,625,000 Goodwill impairment loss $ 125,000

13 Financial Accounting Standards Board, Exposure Draft: Proposed Accounting Standards Update, Intangibles— Goodwill and Other (Topic 350), “Simplifying the Accounting for Goodwill Impairment,” May 12, 2016. 14 Ibid.

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By eliminating Step 2 of the impairment test, Quality Road Company would benefit by avoiding costs of determining fair values for the RNT reporting unit’s identifiable assets and liabilities. Moreover, no fair values would need to be determined for any unrecorded intan- gibles of the reporting unit.

The only exception to the previously mentioned impairment measurement occurs when the ini- tially computed goodwill impairment loss exceeds the carrying amount of goodwill. In the earlier example, the RNT reporting unit’s goodwill carrying amount is $148,000, sufficient to absorb the $125,000 impairment. However, if the reporting unit’s goodwill carrying amount was less than $125,000, the goodwill impairment loss would be limited to the lower carrying amount. Thus, the impairment loss cannot exceed the carrying amount of any particular reporting unit’s goodwill.

Another change to goodwill accounting would be the elimination of the differential impair- ment analysis required for reporting units with zero or negative carrying amounts. According to the proposed ASU, “the same impairment assessment would apply to all reporting units. An entity would be required to disclose the existence of any reporting units with zero or negative carrying amounts and the amount of goodwill allocated to those reporting units.”15 Therefore, if the proposed ASU is ultimately approved, all reporting units would follow an identical model for assessing goodwill impairment.

Comparisons with International Accounting Standards International Financial Reporting Standards (IFRS) and U.S. GAAP both require goodwill recognition in a business combination when the fair value of the consideration transferred exceeds the net fair values of the assets acquired and liabilities assumed. Subsequent to acqui- sition, both IFRS and U.S. GAAP require an assessment for goodwill impairment at least annually and more frequently in the presence of indicators of possible impairment. Also for both sets of standards, goodwill impairments, once recognized, are not recoverable. However, differences exist across the two sets of standards in the way goodwill impairment is tested for and recognized. In particular, goodwill allocation, impairment testing, and determination of the impairment loss differ across the two reporting regimes and are discussed below.

Goodwill Allocation

∙ U.S. GAAP. Goodwill acquired in a business combination is allocated to reporting units expected to benefit from the goodwill. Reporting units are operating segments or a busi- ness component one level below an operating segment.

∙ IFRS. International Accounting Standard (IAS) 36 requires goodwill acquired in a business combination to be allocated to cash-generating units or groups of cash-generating units that are expected to benefit from the synergies of the business combination. Cash-generat- ing groups represent the lowest level within the entity at which the goodwill is monitored for internal management purposes and are not to be larger than an operating segment or determined in accordance with IFRS 8, “Operating Segments.”

Impairment Testing

∙ U.S. GAAP. Firms have the option to perform a qualitative assessment to evaluate possible goodwill impairment based on a greater than 50 percent likelihood that a reporting unit’s fair value is less than its carrying amount. If such a likelihood exists, then a two-step test- ing procedure is performed. In step one, a reporting unit’s total fair value is compared to its carrying amount. If the carrying amount exceeds fair value, then a second step comparing goodwill’s implied fair value to its carrying amount is performed.

∙ IFRS. A one-step approach compares the fair and carrying amounts of each cash-generating unit with goodwill. If the carrying amount exceeds the fair value of the cash-generating unit, then goodwill (and possibly other assets of the cash-generating unit) is considered impaired.

Determination of the Impairment Loss

∙ U.S. GAAP. In step two, a reporting unit’s implied fair value for goodwill is computed as the excess of the reporting unit’s fair value over the fair value of its identifiable net assets.

15 Ibid.

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If the carrying amount of goodwill is greater than its implied fair value, an impairment loss is recognized for the difference.

∙ IFRS. Any excess carrying amount over fair value for a cash-generating unit is first assigned to reduce goodwill. If goodwill is reduced to zero, then the other assets of the cash-generating unit are reduced pro-rata based on the carrying amounts of the assets.

Finally, the FASB and IASB have agreed to include impairment recognition and reporting as one of their future convergence projects.

Amortization and Impairment of Other Intangibles As discussed in Chapter 2, the acquisition method governs how we initially consolidate the assets acquired and liabilities assumed in a business combination. Subsequent to acquisition, income determination becomes a regular part of the consolidation process. The fair-value bases (established at the acquisition date) for definite-lived subsidiary assets acquired and liabilities assumed will be amortized over their remaining lives for income recognition. For indefinite-lived assets (e.g., goodwill, certain other intangibles), an impairment model is used to assess whether asset write-downs are appropriate.

Current accounting standards suggest categories of intangible assets for possible recog- nition when one business acquires another. Examples include noncompetition agreements, customer lists, patents, subscriber lists, databases, trademarks, lease agreements, licenses, and many others. All identified intangible assets should be amortized over their economic use- ful life unless such life is considered indefinite. The term indefinite life is defined as a life that extends beyond the foreseeable future. A recognized intangible asset with an indefinite life should not be amortized unless and until its life is determined to be finite. Importantly, indefinite does not mean “infinite.” Also, the useful life of an intangible asset should not be considered indefinite because a precise finite life is not known.

For intangible assets with finite lives, the amortization method should reflect the pattern of decline in the economic usefulness of the asset. If no such pattern is apparent, the straight- line method of amortization should be used. The amount to be amortized should be the value assigned to the intangible asset less any residual value. In most cases, the residual value is presumed to be zero. However, that presumption can be overcome if the acquiring enterprise has a commitment from a third party to purchase the intangible at the end of its useful life or an observable market exists for the intangible asset.

The length of the amortization period for identifiable intangibles (i.e., those not included in goodwill) depends primarily on the assumed economic life of the asset. Factors that should be considered in determining the useful life of an intangible asset include

∙ Legal, regulatory, or contractual provisions. ∙ The effects of obsolescence, demand, competition, industry stability, rate of technological

change, and expected changes in distribution channels. ∙ The enterprise’s expected use of the intangible asset. ∙ The level of maintenance expenditure required to obtain the asset’s expected future benefits.

Any recognized intangible assets considered to possess indefinite lives are not amortized but instead are assessed for impairment on an annual basis.16 Similar to goodwill impairment assessment, an entity has the option to first perform qualitative assessments for its indefinite- lived intangibles to see if further quantitative tests are necessary. According to the FASB ASC (350-30-65-3), if an entity elects to perform a qualitative assessment, it examines events and circumstances to determine whether it is more likely than not (that is, a likelihood of more than 50 percent) that an indefinite-lived intangible asset is impaired. Qualitative fac- tors include costs of using the intangible, legal and regulatory factors, industry and market considerations, and other. If the qualitative assessment indicates impairment is unlikely, no additional tests are needed.

LO 3-7

Describe the rationale and pro- cedures for impairment testing for intangible assets other than goodwill.

16 An entity has an unconditional option to bypass the qualitative assessment for any indefinite-lived intan- gible asset in any period and proceed directly to performing the quantitative impairment test.

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If the qualitative assessment indicates that impairment is likely, the entity then must per- form a quantitative test to determine if a loss has occurred. To test an indefinite-lived intan- gible asset for impairment, its carrying amount is compared to its fair value. If the fair value is less than the carrying amount, then the intangible asset is considered impaired and an impair- ment loss is recognized. The asset’s carrying amount is reduced accordingly for the excess of its carrying amount over its fair value.

Contingent Consideration Contingency agreements frequently accompany business combinations. In many cases, the target firm asks for consideration based on projections of its future performance. The acquir- ing firm, however, may not share the projections and, thus, may be unwilling to pay now for uncertain future performance. To close the deal, agreements for the acquirer’s future pay- ments to the former owners of the target are common. Alternatively, when the acquirer’s stock comprises the consideration transferred, the sellers of the target firm may request a guaranteed minimum market value of the stock for a period of time to ensure a fair price.

Accounting for Contingent Consideration in Business Combinations As an illustration, assume that Skeptical, Inc., acquires 100 percent of the voting stock of Rosy Pictures Company on January 1, 2017, for the following consideration:

∙ $550,000 market value of 10,000 shares of its $5-par common stock. ∙ A contingent payment of $80,000 cash if Rosy Pictures generates cash flows from opera-

tions of $20,000 or more in 2017. ∙ A payment of sufficient shares of Skeptical common stock to ensure a total value of

$550,000 if the price per share is less than $55 on January 1, 2018.

Under the acquisition method, each of the three elements of consideration represents a portion of the negotiated fair value of Rosy Pictures and therefore must be included in the recorded value entered on Skeptical’s accounting records. For the cash contingency, Skeptical esti- mates that there is a 30 percent chance that the $80,000 payment will be required. For the stock contingency, Skeptical estimates that there is a 20 percent probability that the 10,000 shares issued will have a market value of $540,000 on January 1, 2018, and an 80 percent probability that the market value of the 10,000 shares will exceed $550,000. Skeptical uses an interest rate of 4 percent to incorporate the time value of money.

To determine the fair values of the contingent consideration, Skeptical computes the pres- ent value of the expected payments as follows:

∙ Cash contingency = $80,000 × 30% × [1/(1 + .04)] = $23,077 ∙ Stock contingency = $10,000 × 20% × [1/(1 + .04)] = $1,923

Skeptical then records in its accounting records the acquisition of Rosy Pictures as follows:

LO 3-8

Understand the accounting and reporting for contingent consid- eration subsequent to a business acquisition.

Investment in Rosy Pictures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 575,000 Common Stock ($5 par). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 Additional Paid-in Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000 Contingent Performance Obligation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,077 Additional Paid-in Capital—Contingent Equity Outstanding . . . . . . . . . . 1,923 To record acquisition of Rosy Pictures at fair value of consideration trans- ferred including performance and stock contingencies.

Skeptical will report the contingent cash payment under its liabilities and the contingent stock payment as a component of stockholders’ equity. In periods subsequent to acquisition, obligations for contingent consideration that meet the definition of a liability will continue to be measured at fair value with adjustments recognized in income. Those obligations classified as equity are not subsequently remeasured at fair value, consistent with other equity issues (e.g., common stock).

To continue the preceding example, assume that in 2017 Rosy Pictures exceeds the cash flow from operations threshold of $20,000, thus requiring an additional payment of $80,000. Also, Skeptical’s stock price had fallen to $54.45 at January 1, 2018. Because the acquisition

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Contingent Performance Obligation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,077 Loss from Revaluation of Contingent Performance Obligation. . . . . . . . . . . . 56,923 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 To record contingent cash payment required by original Rosy Pictures acquisition agreement.

Additional Paid-in Capital—Contingent Equity Outstanding . . . . . . . . . . . . . . 1,923 Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505 Additional Paid-in Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,418 To record contingent stock issue required by original Rosy Pictures acquisi- tion agreement.

The loss from revaluation of the contingent performance obligation is reported in Skepti- cal’s consolidated income statement as a component of ordinary income. Regarding the addi- tional required stock issue, note that Skeptical’s total paid-in capital remains unchanged from the total $551,923 recorded at the acquisition date.

1. The procedures used to consolidate financial information generated by the separate companies in a business combination are affected by both the passage of time and the method applied by the parent in accounting for the subsidiary. Thus, no single consolidation process that is applicable to all busi- ness combinations can be described.

2. The parent might elect to utilize the equity method to account for a subsidiary. As discussed in Chapter 1, the parent accrues income when earned by the subsidiary. The parent records dividend declarations by the subsidiary as reductions in the investment account. The effects of excess fair- value amortizations or any intra-entity transactions also are reflected within the parent’s financial records. The equity method provides the parent with accurate information concerning the subsid- iary’s impact on consolidated totals; however, it is usually somewhat complicated to apply.

3. The initial value method and the partial equity method are two alternatives to the equity method. The initial value method recognizes only the subsidiary’s dividends as income while the asset balance remains at the acquisition-date fair value. This approach is simple and typically reflects cash flows between the two companies. Under the partial equity method, the parent accrues the subsidiary’s income as earned but does not record adjustments that might be required by excess fair-value amor- tizations or intra-entity transfers. The partial equity method is easier to apply than the equity method, and, in many cases, the parent’s income is a reasonable approximation of the consolidated total.

4. For a consolidation in any subsequent period, all reciprocal balances must be eliminated. Thus, the subsidiary’s equity accounts, the parent’s investment balance, intra-entity income, dividends, and liabilities are removed. In addition, the remaining unamortized portions of the fair-value allocations are recognized along with excess amortization expenses for the period. If the equity method has not been applied, the parent’s beginning Retained Earnings account also must be adjusted for any previ- ous income or excess amortizations that have not yet been recorded.

5. For each subsidiary acquisition, the parent must assign the acquired assets and liabilities (includ- ing goodwill) to individual reporting units of the combined entity. The reporting units should be at operating segment level or lower and serve as the basis for future assessments of fair value. Any value assigned to goodwill is not amortized but instead is tested annually for impairment. Firms have the option to perform a qualitative assessment to evaluate whether a reporting unit’s fair value more likely than not exceeds its carrying amount. If the assessment shows excess fair value over carrying amount for the reporting unit, a firm can forgo further testing. Otherwise, a two-step test is performed. First, if the fair value of any reporting unit below its carrying amount, then the implied value of the associated goodwill is recomputed. Second, the recomputed implied value of goodwill is compared to its carrying amount. An impairment loss must then be recognized if the carrying amount of goodwill exceeds its implied value.17

6. Subsequent to a business combination, any newly recognized subsidiary identifiable intangible assets (i.e., other than goodwill) considered to possess indefinite lives are not amortized but instead are assessed for impairment on an annual basis.  Similar to goodwill impairment assessment, an

17 A proposed FASB Accounting Standards Update would eliminate the second step of the impairment test. Goodwill would simply be the excess of a reporting unit’s carrying amount over its fair value (loss not to exceed goodwill’s carrying amount).

Summary

agreement called for a $550,000 total value at January 1, 2018, Skeptical must issue an addi- tional 101 shares ($5,500 shortfall/$54.45 per share) to the former owners of Rosy Pictures.

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entity has the option to first perform qualitative assessments for its indefinite-lived intangibles to see if further quantitative tests are necessary. For intangible assets with finite lives, amortization expense is recognized over the intangible asset’s useful life. The amortization method should reflect the pat- tern of decline in the economic usefulness of the asset. If no such pattern is apparent, the straight-line method of amortization should be used.

7. The acquisition-date fair value assigned to a subsidiary can be based, at least in part, on the fair value of any contingent consideration. For contingent obligations that meet the definition of a liability, the obligation is adjusted for changes in fair value over time with corresponding recognition of gains or losses from the revaluation. For contingent obligations classified as equity, no remeasurement to fair value takes place. In either case the initial value recognized in the combination does not change regardless of whether the contingency is eventually paid or not.

(Estimated Time: 40 to 65 Minutes) On January 1, 2016, Top Company acquired all of Bottom Com- pany’s outstanding common stock for $842,000 in cash. As of that date, one of Bottom’s buildings with a 12-year remaining life was undervalued on its financial records by $72,000. Equipment with a 10-year remaining life was undervalued, but only by $10,000. The book values of all of Bottom’s other assets and liabilities were equal to their fair values at that time except for an unrecorded licensing agreement with an assessed value of $40,000 and a 20-year remaining useful life. Bottom’s book value at the acqui- sition date was $720,000.

During 2016, Bottom reported net income of $100,000 and declared $30,000 in dividends. Earnings were $120,000 in 2017 with $20,000 in dividends distributed by the subsidiary. As of December 31, 2018, the companies reported the following selected balances, which include all revenues and expenses for the year:

Comprehensive Illustration

Problem

Required a. If Top applies the equity method, what is its investment account balance as of December 31, 2018? b. If Top applies the initial value method, what is its investment account balance as of December 31,

2018? c. Regardless of the accounting method in use by Top, what are the consolidated totals as of December 31,

2018, for each of the following accounts?

Top Company December 31, 2018

Bottom Company December 31, 2018

Debit Credit Debit Credit

Buildings . . . . . . . . . . . . . . . $1,540,000 $460,000 Cash and receivables. . . . 50,000 90,000 Common stock . . . . . . . . . $  900,000 $400,000 Dividends declared. . . . . . 70,000 10,000 Equipment . . . . . . . . . . . . . 280,000 200,000 Cost of goods sold . . . . . . 500,000 120,000 Depreciation expense . . . 100,000 60,000 Inventory . . . . . . . . . . . . . . . 280,000 260,000 Land. . . . . . . . . . . . . . . . . . . 330,000 250,000 Liabilities . . . . . . . . . . . . . . . 480,000 260,000 Retained earnings, 1/1/18 1,360,000 490,000 Revenues . . . . . . . . . . . . . . 900,000 300,000

Buildings Revenues Equipment Net Income Land Investment in Bottom Depreciation Expense Dividends Declared Amortization Expense Cost of Goods Sold

d. Prepare the worksheet entries required on December 31, 2018, to consolidate the financial records of these two companies. Assume that Top applied the equity method to its investment account.

e. How would the worksheet entries in requirement (d) be altered if Top has used the initial value method?

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Initial value (fair value of consideration transferred by Top) . . . . . $   842,000 Bottom Company’s 2016–2017 increase in book value (income

less dividends). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170,000

Excess amortizations for 2016–2017 ($9,000 per year for two years). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

(18,000) 

Current year recognition (2018): Equity income accrual (Bottom’s revenues less its expenses) . . . $120,000 Excess amortization expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . (9,000) Dividends from Bottom . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    (10,000)      101,000

Investment in Bottom Company, 12/31/18 . . . . . . . . . . . . . . . . . . . $1,095,000  

Fair value of consideration transferred by Top Company . . $ 842,000 Book value of Bottom Company, 1/1/16 . . . . . . . . . . . . . . . .   (720,000)

Excess fair value over book value . . . . . . . . . . . . . . . . . . . . $ 122,000 

Remaining Life (years)

Annual Amortization

Buildings . . . . . . . . . . . . . . . . . . . $  72,000 12 $6,000 Equipment . . . . . . . . . . . . . . . . . 10,000 10 1,000 Licensing agreement . . . . . . . . 40,000 20 2,000

Totals. . . . . . . . . . . . . . . . . . . . $122,000 $9,000  

Adjustments to specific accounts based on fair values:

Thus, if Top adopts the equity method to account for this subsidiary, the Investment in Bottom account shows a December 31, 2018, balance of $1,095,000, computed as follows:

Solution a. To determine the investment balances under the equity method, four items must be determined: the initial value assigned, the income accrual, dividends and amortization of excess acquisition-date fair value over book value. Although the first three are indicated in the problem, amortizations must be calculated separately.

An allocation of Bottom’s acquisition-date fair values as well as the related amortization expense follows.

The $120,000 income accrual and the $9,000 excess amortization expenses indicate that an Equity in Subsidiary Earnings balance of $111,000 appears in Top’s income statement for the current period.

b. If Top Company applies the initial value method, the Investment in Bottom Company account per- manently retains its original $842,000 balance, and the parent recognizes only the intra-entity divi- dend of $10,000 as income in 2018.

c. ∙ The consolidated Buildings account as of December 31, 2018, has a balance of $2,054,000. Although the two book value figures total only $2 million, a $72,000 allocation was made to this account based on fair value at the date of acquisition. Because this amount is being depreciated at the rate of $6,000 per year, the original allocation will have been reduced by $18,000 by the end of 2018, leaving only a $54,000 increase.

∙ On December 31, 2018, the consolidated Equipment account amounts to $487,000. The book values found in the financial records of Top and Bottom provide a total of $480,000. Once again, the allocation ($10,000) established by the acquisition-date fair value must be included in the consolidated balance after being adjusted for three years of depreciation ($1,000 × 3 years, or $3,000).

∙ Land has a consolidated total of $580,000. Because the book value and fair value of Bottom’s land were in agreement at the date of acquisition, no additional allocation was made to this account. Thus, the book values are simply added together to derive a consolidated figure.

∙ Cost of goods sold = $620,000. The cost of goods sold of the parent and subsidiary are added together.

∙ Depreciation expense = $167,000. The depreciation expenses of the parent and subsidiary are added together along with the $6,000 additional building depreciation and the $1,000 additional equipment depreciation as presented in the fair-value allocation schedule.

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∙ Amortization expense = $2,000. An additional expense of $2,000 is recognized from the amorti- zation of the licensing agreement acquired in the business combination.

∙ The Revenues account appears as $1.2 million in the consolidated income statement. None of the worksheet entries in this example affects the individual balances of either company. Consolida- tion results merely from the addition of the two book values.

∙ Net income for this business combination is $411,000: consolidated expenses of $789,000 sub- tracted from revenues of $1.2 million.

∙ The parent’s Investment in Bottom account is removed entirely on the worksheet so that no bal- ance is reported. For consolidation purposes, this account is always eliminated so that the indi- vidual assets and liabilities of the subsidiary can be included.

∙ Dividends declared for the consolidated entity should be reported as $70,000, the amount Top distributed. Because Bottom’s dividends are entirely intra-entity, they are deleted in arriving at consolidated figures.

d. Consolidation Entries Assuming Equity Method Used by Parent

Entry S Common Stock (Bottom Company) . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000 Retained Earnings, 1/1/18. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (Bottom Company) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 490,000 Investment in Bottom Company. . . . . . . . . . . . . . . . . . . . . . . . . 890,000 Elimination of subsidiary’s beginning stockholders’ equity accounts against book value portion of investment account.

Entry A Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  60,000 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    8,000 Licensing Agreement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  36,000 Investment in Bottom Company. . . . . . . . . . . . . . . . . . . . . . . . . 104,000 To recognize fair-value allocations to the subsidiary’s assets in excess of book value. Balances represent original allocations less two years of amortization for the 2016–2017 period.

Entry I Equity in Subsidiary Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111,000 Investment in Bottom Company. . . . . . . . . . . . . . . . . . . . . . . . . 111,000 To eliminate parent’s equity income accrual, balance is computed in requirement (a).

Entry D Investment in Bottom . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  10,000 Dividends Declared . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  10,000 To eliminate intra-entity dividends from the subsidiary to the parent (and recorded as a reduction in the investment account because the equity method is in use).

Entry E Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    7,000 Amortization Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    2,000 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    1,000 Buildings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    6,000 Licensing Agreement. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    2,000 To recognize excess fair-value depreciation and amortization for 2018.

e. If Top utilizes the initial value method rather than the equity method, three changes are required in the development of consolidation entries:

(1) An Entry *C is required to update the parent’s beginning Retained Earnings account as if the equity method had been applied. Both an income accrual as well as excess amortizations for the prior two years must be recognized because these balances were not recorded by the parent.

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Entry I Dividend Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Dividends Declared . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 To eliminate intra-entity dividends recorded by parent as income.

Entry *C Investment in Bottom Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152,000 Retained Earnings, 1/1/18 (Top Company) . . . . . . . . . . . . . . . 152,000 To convert to the equity method by accruing the net effect of the subsidiary’s operations (income less dividends) for the prior two years ($170,000) along with excess amortization expenses ($18,000) for this same period.

(2) An alteration is needed in Entry I because, under the initial value method, only dividends are recorded by the parent as income.

(3) Finally, because the intra-entity dividends have been eliminated in Entry I, no separate Entry D is needed.

Appendix: Private Company Accounting for Business Combinations

External Reporting Option for Private Company Goodwill Accounting 

In January 2014, the Financial Accounting Standards Board (FASB) approved an Accounting Stan- dards Update (ASU 2014-02) to Topic 350, “Intangibles—Goodwill and Other, on Accounting for Goodwill.” This ASU emerged as a consensus of the FASB’s Private Company Council (PCC) and gives private companies an option to apply a simplified alternative to the more complex goodwill accounting model required of public companies. As discussed below, the new standard allows a private company both to amortize goodwill and to apply a simplified impairment test at either the reporting unit or entity level.

The private company standards apply only to businesses that do not meet the definition of a public business entity or a not-for-profit entity. In general, business is a public entity if the Securities and Exchange Commission (or a foreign or other domestic regulatory agency) requires the business to fur- nish financial statements (ASU 2013-12). In this textbook, our focus is squarely on public business entities. Nonetheless, the goodwill accounting option for private companies provides an interesting alternative that the FASB may someday consider for public entities as well.18

The new standard allows a private company to elect to amortize goodwill over a 10-year period.19 The amortization process effectively treats goodwill as a definite-lived intangible asset. This approach, of course, stands in marked contrast to the goodwill accounting for public companies which treats goodwill as an indefinite-lived asset, prohibits amortization, and requires annual impairment testing for goodwill. In justifying the differential treatment for private companies, the FASB  reasoned that, based on research by the PCC, goodwill impairment tests provided

limited decision-useful information because most users of private company financial statement generally dis- regard goodwill and goodwill impairment losses in their analysis of a private company’s financial condition and operating  performance. (ASU 2014-02, Summary)

Equally important, the PCC expressed concerns about the cost and complexity of goodwill impair- ment tests, especially for private companies. The cost and complexity arise in large part from the efforts required in determining fair values for a company’s reporting units and their identifiable assets and liabilities.

In many cases, goodwill amortization will replace the need to periodically assess and, when deemed necessary, write-down goodwill through the recognition of impairment losses. Private companies who elect the alternative goodwill accounting, however, will still be required to test goodwill balances for impairment in some circumstances, although a simplified approach is employed.

18  In November 2014, the FASB directed its staff to extend its research on goodwill amortization to public companies, focusing on the most appropriate useful life if goodwill were amortized and simplifying the goodwill impairment test.   19  A less-than-10-year amortization period is available if it can be shown to be appropriate (ASC 350-20-35-63).

LO 3-9:

Describe the alternative account- ing treatments for goodwill and other intangible assets available for business combinations by private companies.

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The goodwill impairment process is simplified in two respects for private companies. First, if a trig- gering event occurs (i.e., any event or change in circumstances that may have caused the fair value of the acquired entity—or the reporting unit—to fall below its carrying amount), then the unamortized balance of goodwill must be assessed for impairment.20 However, to save costs and streamline the pro- cess, there is no requirement (as exists for public companies) to remeasure each of the entity’s (or reporting unit’s) separate assets and liabilities at current fair values to compute a residual implied value for goodwill. The measurement of the goodwill impairment loss simply equals the excess (if any) of the fair value of the acquired entity (or reporting unit) over its total carrying amount. The amount of the impairment loss, however, is limited to the remaining unamortized balance in the goodwill account.

Unlike public companies, a private company also has the option to designate and test goodwill for impairment either at the entity level or the reporting unit level—a policy election made at the adoption of the alternative goodwill method. Thus the accounting for goodwill impairment is simplified by both the ability to assess goodwill at the entity level and the use of a single-step test that compares the fair value of the entity to its carrying amount. Similar to public companies, a private company may skip the qualitative assessment. Unlike public companies, a private company can then go directly to a single-step quantitative impairment test.

External Reporting Option for Private Company Accounting for Other Intangible Assets in a Business Combination

In addition to the private company separate guidance for goodwill, the FASB in December 2014 issued ASU 2014-18, “Accounting for Identifiable Intangible Assets in a Business Combination (a consensus of the Private Company Council),” an amendment of Business Combinations (Topic 805). The new standard allows private companies an option to simplify their accounting by recognizing fewer intan- gible assets in future business combinations. Private companies can now elect to (1) limit the customer- related intangibles it recognizes separately to those capable of being sold or licensed independently from the other assets of the business, and (2) avoid separate recognition of noncompetition agreements.

By limiting the separate recognition of customer-related intangibles (e.g., customer lists, customer relationships, commodity supply contracts, etc.) and noncompetition agreements, the value of these intangible assets is effectively subsumed into goodwill. As with other private company financial report- ing options, the FASB cites cost/benefit considerations.

By providing an accounting alternative, this Update reduces the cost and complexity associated with the measurement of certain identifiable intangible assets without significantly diminishing decision-useful information to users of private company financial statements (ASU 2014-18, Summary).

A private company may elect this alternative only if it also elects the private company goodwill accounting alternative which includes goodwill amortization—thus ensuring that any non-recognized intangibles subsumed into goodwill are also subject to amortization. Companies that choose the goodwill accounting alternative, however, are not required to elect the intangible assets accounting alternative.

20 Distinct from public company requirements, no annual assessment for goodwill impairment is required for private companies.

Questions 1. CCES Corporation acquires a controlling interest in Schmaling, Inc. CCES may utilize any one of three methods to internally account for this investment. Describe each of these methods, and indicate their advantages and disadvantages.

2. Maguire Company obtains 100 percent control over Williams Company. Several years after the takeover, consolidated financial statements are being produced. For each of the following accounts, briefly describe the values that should be included in consolidated totals. a. Equipment. b. Investment in Williams Company. c. Dividends Declared. d. Goodwill. e. Revenues. f. Expenses. g. Common Stock. h. Net Income.

3. When a parent company uses the equity method to account for an investment in a subsidiary, why do both the parent’s Net Income and Retained Earnings account balances agree with the consolidated totals?

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4. When a parent company uses the equity method to account for investment in a subsidiary, the amortization expense entry recorded during the year is eliminated on a consolidation worksheet as a component of Entry I. What is the necessity of removing this amortization?

5. When a parent company applies the initial value method or the partial equity method to an invest- ment, a worksheet adjustment must be made to the parent’s beginning Retained Earnings account (Entry *C) in every period after the year of acquisition. What is the necessity for this entry? Why is no similar entry found when the parent utilizes the equity method?

6. Several years ago, Jenkins Company acquired a controlling interest in Lambert Company. Lambert recently borrowed $100,000 from Jenkins. In consolidating the financial records of these two com- panies, how will this debt be handled?

7. Benns adopts the equity method for its 100 percent investment in Waters. At the end of six years, Benns reports an investment in Waters of $920,000. What figures constitute this balance?

8. One company acquired another in a transaction in which $100,000 of the acquisition price is assigned to goodwill. Several years later, a worksheet is being produced to consolidate these two companies. How is the reported value of the goodwill determined at this date?

9. When should a parent consider recognizing an impairment loss for goodwill associated with a sub- sidiary? How should the loss be reported in the financial statements?

10. Reimers Company acquires Rollins Corporation on January 1, 2017. As part of the agreement, the parent states that an additional $100,000 payment to the former owners of Rollins will be made in 2018, if Rollins achieves certain income thresholds during the first two years following the acquisition. How should Reimers account for this contingency in its 2017 consolidated financial statements?

1. A company acquires a subsidiary and will prepare consolidated financial statements for external reporting purposes. For internal reporting purposes, the company has decided to apply the initial value method. Why might the company have made this decision? a. It is a relatively easy method to apply. b. Operating results appearing on the parent’s financial records reflect consolidated totals. c. GAAP now requires the use of this particular method for internal reporting purposes. d. Consolidation is not required when the parent uses the initial value method.

2. A company acquires a subsidiary and will prepare consolidated financial statements for external reporting purposes. For internal reporting purposes, the company has decided to apply the equity method. Why might the company have made this decision? a. It is a relatively easy method to apply. b. Operating results appearing on the parent’s financial records reflect consolidated totals. c. GAAP now requires the use of this particular method for internal reporting purposes. d. Consolidation is not required when the parent uses the equity method.

3. On January 1, 2018, Jay Company acquired all the outstanding ownership shares of Zee Company. In assessing Zee’s acquisition-date fair values, Jay concluded that the carrying value of Zee’s long-term debt (8-year remaining life) was less than its fair value by $20,000. At December 31, 2018, Zee Company’s accounts show interest expense of $12,000 and long-term debt of $250,000. What amounts of interest expense and long-term debt should appear on the December 31, 2018, consolidated financial statements of Jay and its subsidiary Zee?

LO 3-2

LO 3-2

LO 3-4

Problems

Interest expense Long-term debt a. $14,500 $270,000 b. $14,500 $267,500 c. $9,500 $270,000 d. $9,500 $267,500

4. When should a consolidated entity recognize a goodwill impairment loss? a. If both the fair value of a reporting unit and its associated implied goodwill fall below their

respective carrying amounts. b. Whenever the entity’s fair value declines significantly. c. If the fair value of a reporting unit with goodwill fall below its carrying amount. d. Annually on a systematic and rational basis.

LO 3-5

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5. Paar Corporation bought 100 percent of Kimmel, Inc., on January 1, 2015. On that date, Paar’s equipment (10-year remaining life) has a book value of $420,000 but a fair value of $520,000. Kimmel has equipment (10-year remaining life) with a book value of $272,000 but a fair value of $400,000. Paar uses the equity method to record its investment in Kimmel. On December 31, 2017, Paar has equipment with a book value of $294,000 but a fair value of $445,200. Kimmel has equip- ment with a book value of $190,400 but a fair value of $357,000. What is the consolidated balance for the Equipment account as of December 31, 2017? a. $574,000 b. $802,200 c. $612,600 d. $484,400

6. How would the answer to problem (5) have been affected if the parent had applied the initial value method rather than the equity method? a. No effect: The method the parent uses is for internal reporting purposes only and has no impact

on consolidated totals. b. The consolidated Equipment account would have a higher reported balance. c. The consolidated Equipment account would have a lower reported balance. d. The balance in the consolidated Equipment account cannot be determined for the initial value

method using the information given. 7. Goodwill recognized in a business combination must be allocated among a firm’s identified report-

ing units. If the fair value of a particular reporting unit with recognized goodwill falls below its carrying amount, which of the following is true? a. No goodwill impairment loss is recognized unless the implied value for goodwill exceeds its

carrying amount. b. A goodwill impairment loss is recognized if the carrying amount for goodwill exceeds its

implied value. c. A goodwill impairment loss is recognized for the excess of a reporting unit’s carrying amount

over its fair value, not to exceed the carrying amount of goodwill. d. The reporting unit reduces the values assigned to its long-term assets (including any unrecog-

nized intangibles) to reflect its fair value. 8. If no legal, regulatory, contractual, competitive, economic, or other factors limit the life of an intan-

gible asset, the asset’s assigned value is allocated to expense over which of the following? a. 20 years. b. 20 years with an annual impairment review. c. Infinitely. d. Indefinitely (no amortization) with an annual impairment review until its life becomes finite.

9. Dosmann, Inc., bought all outstanding shares of Lizzi Corporation on January 1, 2016, for $700,000 in cash. This portion of the consideration transferred results in a fair-value allocation of $35,000 to equipment and goodwill of $88,000. At the acquisition date, Dosmann also agrees to pay Lizzi’s previous owners an additional $110,000 on January 1, 2018, if Lizzi earns a 10 percent return on the fair value of its assets in 2016 and 2017. Lizzi’s profits exceed this threshold in both years. Which of the following is true? a. The additional $110,000 payment is a reduction in consolidated retained earnings. b. The fair value of the expected contingent payment increases goodwill at the acquisition date. c. Consolidated goodwill as of January 1, 2018, increases by $110,000. d. The $110,000 is recorded as an expense in 2018.

Problems 10, 11, and 12 relate to the following: On January 1, 2016, Phoenix Co. acquired 100 percent of the outstanding voting shares of Sedona Inc., for $600,000 cash. At January 1, 2016, Sedona’s net assets had a total carrying amount of $420,000. Equipment (eight-year remaining life) was undervalued on Sedona’s financial records by $80,000. Any remaining excess fair over book value was attributed to a customer list developed by Sedona (four-year remaining life), but not recorded on its books. Phoenix applies the equity method to account for its investment in Sedona. Each year since the acquisition, Sedona has declared a $20,000 dividend. Sedona recorded net income of $70,000 in 2016 and $80,000 in 2017.

LO 3-1

LO 3-4

LO 3-5

LO 3-7

LO 3-7

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Selected account balances from the two companies’ individual records were as follows:

Phoenix Sedona

2018 Revenues $498,000 $285,000 2018 Expenses 350,000 195,000 2018 Income from Sedona 55,000 Retained earnings 12/31/18 250,000 175,000

10. What is consolidated net income for Phoenix and Sedona for 2018? a. $148,000 b. $203,000 c. $228,000 d. $238,000

11. What is Phoenix’s consolidated retained earnings balance at December 31, 2018? a. $250,000 b. $290,000 c. $330,000 d. $360,000

12. On its December 31, 2018, consolidated balance sheet, what amount should Phoenix report for Sedona’s customer list? a. $10,000 b. $20,000 c. $25,000 d. $50,000

13. Kaplan Corporation acquired Star, Inc., on January 1, 2017, by issuing 13,000 shares of common stock with a $10 per share par value and a $23 market value. This transaction resulted in recogniz- ing $62,000 of goodwill. Kaplan also agreed to compensate Star’s former owners for any difference if Kaplan’s stock is worth less than $23 on January 1, 2018. On January 1, 2018, Kaplan issues an additional 3,000 shares to Star’s former owners to honor the contingent consideration agreement. Which of the following is true? a. The fair value of the number of shares issued for the contingency increases the Goodwill

account at January 1, 2018. b. The parent’s additional paid-in capital from the contingent equity recorded at the acquisition

date is reclassified as a regular common stock issue on January 1, 2018. c. All of the subsidiary’s asset and liability accounts must be revalued for consolidation purposes

based on their fair values as of January 1, 2018. d. The additional shares are assumed to have been issued on January 1, 2017, so that a retrospec-

tive adjustment is required. 14. Herbert, Inc., acquired all of Rambis Company’s outstanding stock on January 1, 2017, for $574,000

in cash. Annual excess amortization of $12,000 results from this transaction. On the date of the takeover, Herbert reported retained earnings of $400,000, and Rambis reported a $200,000 balance. Herbert reported internal net income of $40,000 in 2017 and $50,000 in 2018 and declared $10,000 in dividends each year. Rambis reported net income of $20,000 in 2017 and $30,000 in 2018 and declared $5,000 in dividends each year. a. Assume that Herbert’s internal net income figures above do not include any income from the subsidiary.

∙ If the parent uses the equity method, what is the amount reported as consolidated retained earnings on December 31, 2018?

∙ Would the amount of consolidated retained earnings change if the parent had applied either the initial value or partial equity method for internal accounting purposes?

b. Under each of the following situations, what is the Investment in Rambis account balance on Herbert’s books on January 1, 2018? ∙ The parent uses the equity method. ∙ The parent uses the partial equity method. ∙ The parent uses the initial value method.

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c. Under each of the following situations, what is Entry *C on a 2018 consolidation worksheet? ∙ The parent uses the equity method. ∙ The parent uses the partial equity method. ∙ The parent uses the initial value method.

15. Haynes, Inc., obtained 100 percent of Turner Company’s common stock on January 1, 2017, by issu- ing 9,000 shares of $10 par value common stock. Haynes’s shares had a $15 per share fair value. On that date, Turner reported a net book value of $100,000. However, its equipment (with a five-year remaining life) was undervalued by $5,000 in the company’s accounting records. Also, Turner had developed a customer list with an assessed value of $30,000, although no value had been recorded on Turner’s books. The customer list had an estimated remaining useful life of 10 years.

The following balances come from the individual accounting records of these two companies as of December 31, 2017:

LO 3-3, 3-4

Haynes Turner

Revenues $(600,000) $(230,000) Expenses 440,000 120,000 Investment income Not given  –0– Dividends declared 80,000 50,000

Beltran Reporting Unit Fair Values

1/1/17 Fair Values

12/31/18 Book Values

12/31/18

Cash $   75,000 $   50,000 $  50,000 Receivables 193,000 225,000 225,000 Inventory 281,000 305,000 300,000 Patents 525,000 600,000 500,000 Customer relationships 500,000 480,000 450,000 Equipment (net) 295,000 240,000 235,000 Goodwill ? ? 400,000 Accounts payable (121,000) (175,000) (175,000) Long-term liabilities (450,000) (400,000) (400,000)

Haynes Turner

Revenues $(700,000) $(280,000) Expenses 460,000 150,000 Investment income Not given  –0– Dividends declared 90,000 40,000 Equipment 500,000 300,000

The following balances come from the individual accounting records of these two companies as of December 31, 2018:

a. What balance does Haynes’s Investment in Turner account show on December 31, 2018, when the equity method is applied?

b. What is the consolidated net income for the year ending December 31, 2018? c. What is the consolidated equipment balance as of December 31, 2018? How would this answer

be affected by the investment method applied by the parent? d. If Haynes has applied the initial value method to account for its investment, what adjustment is

needed to the beginning of the Retained Earnings account on a December 31, 2018, consolida- tion worksheet? How would this answer change if the partial equity method had been in use? How would this answer change if the equity method had been in use?

16. Francisco Inc. acquired 100 percent of the voting shares of Beltran Company on January 1, 2017. In exchange, Francisco paid $450,000 in cash and issued 104,000 shares of its own $1 par value common stock. On this date, Francisco’s stock had a fair value of $12 per share. The combination is a statutory merger with Beltran subsequently dissolved as a legal corporation. Beltran’s assets and liabilities are assigned to a new reporting unit.

The following reports the fair values for the Beltran reporting unit for January 1, 2017, and December 31, 2018, along with their respective book values on December 31, 2018.

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a. Prepare Francisco’s journal entry to record the assets acquired and the liabilities assumed in the Beltran merger on January 1, 2017.

b. On December 31, 2018, Francisco opts to forgo any goodwill impairment qualitative assessment and estimates that the total fair value of the entire Beltran reporting unit is $1,425,000. What amount of goodwill impairment, if any, should Francisco recognize on its 2018 income statement?

17. Alomar Co., a consolidated enterprise, conducted an impairment review for each of its reporting units. In its qualitative assessment, one particular reporting unit, Sellers, emerged as a candidate for possible goodwill impairment. Sellers has recognized net assets of $1,094, including goodwill of $755. Seller’s fair value is assessed at $1,028 and includes two internally developed unrecognized intangible assets (a patent and a customer list with fair values of $199 and $56, respectively). The following table summarizes current financial information for the Sellers reporting unit:

LO 3-6

Carrying Amounts

Fair Values

Tangible assets, net $     84 $   137 Recognized intangible assets, net 255 326 Goodwill 755 ? Unrecognized intangible assets          0      255 Total $1,094 $1,028

a. Determine the amount of any goodwill impairment for Alomar’s Sellers reporting unit. b. After recognition of any goodwill impairment loss, what are the reported carrying amounts for

the following assets of Alomar’s reporting unit Sellers? ∙ Tangible assets, net. ∙ Goodwill. ∙ Patent. ∙ Customer list.

18. Destin Company recently acquired several businesses and recognized goodwill in each acquisition. Destin has allocated the resulting goodwill to its three reporting units: Sand Dollar, Salty Dog, and Baytowne. Destin opts to skip the qualitative assessment and therefore performs a quantitative goodwill impairment review annually.

In its current year assessment of goodwill, Destin provides the following individual asset and liability values for each reporting unit:

Carrying Amounts

Fair Values

Sand Dollar Tangible assets $180,000 $190,000 Trademark 170,000 150,000 Customer list 90,000 100,000 Goodwill 120,000 ? Liabilities (30,000) (30,000) Salty Dog Tangible assets $200,000 $200,000 Unpatented technology 170,000 125,000 Licenses 90,000 100,000 Goodwill 150,000 ? Baytowne Tangible assets $140,000 $150,000 Unpatented technology –0– 100,000 Copyrights 50,000 80,000 Goodwill 90,000 ?

The fair values for each reporting unit (including goodwill) are $510,000 for Sand Dollar, $580,000 for Salty Dog, and $560,000 for Baytowne. To date, Destin has reported no goodwill impairments. a. How much goodwill impairment should Destin report this year? b. What changes to the valuations of Destin’s tangible assets and identified intangible assets

should be reported based on the goodwill impairment tests?

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Problems 19 through 21 should be viewed as independent situations. They are based on the following data: Chapman Company obtains 100 percent of Abernethy Company’s stock on January 1, 2017. As of that date, Abernethy has the following trial balance:

Debit Credit

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $  50,000 Accounts receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $  40,000 Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 Buildings (net) (4-year remaining life) . . . . . . . . . . . . . . . . . . . . . 120,000 Cash and short-term investments . . . . . . . . . . . . . . . . . . . . . . . . 60,000 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000 Equipment (net) (5-year remaining life) . . . . . . . . . . . . . . . . . . . . 200,000 Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000 Land. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 Long-term liabilities (mature 12/31/20) . . . . . . . . . . . . . . . . . . . 150,000 Retained earnings, 1/1/17. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     10,000                  Totals. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $600,000 $600,000

During 2017, Abernethy reported net income of $80,000 while declaring and paying dividends of $10,000. During 2018, Abernethy reported net income of $110,000 while declaring and paying dividends of $30,000.

19. Assume that Chapman Company acquired Abernethy’s common stock for $490,000 in cash. As of January 1, 2017, Abernethy’s land had a fair value of $90,000, its buildings were valued at $160,000, and its equipment was appraised at $180,000. Chapman uses the equity method for this investment. Prepare consolidation worksheet entries for December 31, 2017, and December 31, 2018.

20. Assume that Chapman Company acquired Abernethy’s common stock for $500,000 in cash. Assume that the equipment and long-term liabilities had fair values of $220,000 and $120,000, respectively, on the acquisition date. Chapman uses the initial value method to account for its investment. Prepare consolidation worksheet entries for December 31, 2017, and December 31, 2018.

21. Assume that Chapman Company acquired Abernethy’s common stock by paying $520,000 in cash. All of Abernethy’s accounts are estimated to have a fair value approximately equal to present book values. Chapman uses the partial equity method to account for its investment. Prepare the consoli- dation worksheet entries for December 31, 2017, and December 31, 2018.

22. Adams, Inc., acquires Clay Corporation on January 1, 2017, in exchange for $510,000 cash. Immediately after the acquisition, the two companies have the following account balances. Clay’s equipment (with a five-year remaining life) is actually worth $440,000. Credit balances are indicated by parentheses.

Adams Clay

Current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 300,000 $ 220,000 Investment in Clay. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 510,000 –0– Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000 390,000 Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (200,000) (160,000) Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (350,000) (150,000) Retained earnings, 1/1/17. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (860,000) (300,000)

In 2017, Clay earns a net income of $55,000 and declares and pays a $5,000 cash dividend. In 2017, Adams reports net income from its own operations (exclusive of any income from Clay) of $125,000 and declares no dividends. At the end of 2018, selected account balances for the two companies are as follows:

Adams Clay

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(400,000) $(240,000) Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  290,000 180,000 Investment income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Not given    –0– Retained earnings, 1/1/18. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Not given (350,000)

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LO 3-3b

LO 3-3c

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Adams Clay

Dividends declared. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . –0– 8,000 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (350,000) (150,000) Current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 580,000 262,000 Investment in Clay. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Not given  –0– Equipment 520,000 420,000 Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (152,000) (130,000)

a. What are the December 31, 2018, Investment Income and Investment in Clay account balances assuming Adams uses the: ∙ Equity method. ∙ Initial value method.

b. How does the parent’s internal investment accounting method choice affect the amount reported for expenses in its December 31, 2018, consolidated income statement?

c. How does the parent’s internal investment accounting method choice affect the amount reported for equipment in its December 31, 2018, consolidated balance sheet?

d. What is Adams’s January 1, 2018, Retained Earnings account balance assuming Adams accounts for its investment in Clay using the: ∙ Equity value method. ∙ Initial value method.

e. What worksheet adjustment to Adams’s January 1, 2018, Retained Earnings account balance is required if Adams accounts for its investment in Clay using the initial value method?

f. Prepare the worksheet entry to eliminate Clay’s stockholders’ equity. g. What is consolidated net income for 2018?

23. Following are selected account balances from Penske Company and Stanza Corporation as of December 31, 2018:

Penske Stanza

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . $(700,000) $(400,000) Cost of goods sold . . . . . . . . . . . . . . . . . . . 250,000 100,000 Depreciation expense . . . . . . . . . . . . . . . . 150,000 200,000 Investment income . . . . . . . . . . . . . . . . . . . Not given –0– Dividends declared. . . . . . . . . . . . . . . . . . . 80,000 60,000 Retained earnings, 1/1/18. . . . . . . . . . . . . (600,000) (200,000) Current assets . . . . . . . . . . . . . . . . . . . . . . . 400,000 500,000 Copyrights . . . . . . . . . . . . . . . . . . . . . . . . . . 900,000 400,000 Royalty agreements . . . . . . . . . . . . . . . . . . 600,000  1,000,000 Investment in Stanza . . . . . . . . . . . . . . . . . Not given –0– Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . (500,000) (1,380,000) Common stock . . . . . . . . . . . . . . . . . . . . . . (600,000) ($20 par) (200,000) ($10 par) Additional paid-in capital . . . . . . . . . . . . . . (150,000) (80,000)

On January 1, 2018, Penske acquired all of Stanza’s outstanding stock for $680,000 fair value in cash and common stock. Penske also paid $10,000 in stock issuance costs. At the date of acquisition, copyrights (with a six-year remaining life) have a $440,000 book value but a fair value of $560,000. a. As of December 31, 2018, what is the consolidated copyrights balance? b. For the year ending December 31, 2018, what is consolidated net income? c. As of December 31, 2018, what is the consolidated retained earnings balance? d. As of December 31, 2018, what is the consolidated balance to be reported for goodwill?

24. Foxx Corporation acquired all of Greenburg Company’s outstanding stock on January 1, 2016, for $600,000 cash. Greenburg’s accounting records showed net assets on that date of $470,000, although equipment with a 10-year remaining life was undervalued on the records by $90,000. Any recognized goodwill is considered to have an indefinite life.

Greenburg reports net income in 2016 of $90,000 and $100,000 in 2017. The subsidiary declared dividends of $20,000 in each of these two years.

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Account balances for the year ending December 31, 2018, follow. Credit balances are indicated by parentheses.

Foxx Greenburg

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $   (800,000) $   (600,000) Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 150,000 Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000 350,000 Investment income . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        (20,000)               –0–

Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $   (420,000) $   (100,000)

Retained earnings, 1/1/18. . . . . . . . . . . . . . . . . . . . . . . $(1,100,000) $   (320,000) Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  (420,000) (100,000) Dividends declared. . . . . . . . . . . . . . . . . . . . . . . . . . . . .       120,000         20,000

Retained earnings, 12/31/18 . . . . . . . . . . . . . . . . . . $(1,400,000) $   (400,000)

Current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $    300,000 $    100,000 Investment in subsidiary . . . . . . . . . . . . . . . . . . . . . . . .  600,000  –0– Equipment (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  900,000 600,000 Buildings (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  800,000 400,000 Land. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       600,000       100,000

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,200,000 $ 1,200,000

Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $   (900,000) $   (500,000) Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (900,000) (300,000) Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   (1,400,000)      (400,000)

Total liabilities and equity . . . . . . . . . . . . . . . . . . . . . $(3,200,000) $(1,200,000)

a. Determine the December 31, 2018, consolidated balance for each of the following accounts:

Depreciation Expense Dividends Declared Revenues Equipment

Buildings Goodwill Common Stock

b. How does the parent’s choice of an accounting method for its investment affect the balances computed in requirement (a)?

c. Which method of accounting for this subsidiary is the parent actually using for internal report- ing purposes?

d. If the parent company had used a different method of accounting for this investment, how could that method have been identified?

e. What would be Foxx’s balance for retained earnings as of January 1, 2018, if each of the follow- ing methods had been in use? ∙ Initial value method. ∙ Partial equity method. ∙ Equity method.

25. Allison Corporation acquired all of the outstanding voting stock of Mathias, Inc., on January 1, 2017, in exchange for $5,875,000 in cash. Allison intends to maintain Mathias as a wholly owned subsidiary. Both companies have December 31 fiscal year-ends. At the acquisition date, Mathias’s stockholders’ equity was $2,000,000 including retained earnings of $1,500,000.

At the acquisition date, Allison prepared the following fair value allocation schedule for its newly acquired subsidiary:

Consideration transferred . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,875,000 Mathias stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000,000 Excess fair over book value . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,875,000 to unpatented technology (8-year remaining life) . . . . . . . . . . $ 800,000 to patents (10-year remaining life) . . . . . . . . . . . . . . . . . . . . . . . 2,500,000 to increase long-term debt (undervalued, 5-year

remaining life) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (100,000) 3,200,000

Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $   675,000

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Post-acquisition, Allison employs the equity method to account for its investment in Mathias. During the two years following the business combination, Mathias reports the following income and dividends:

Income Dividends

2017 $480,000  $25,000 2018   960,000  50,000

No asset impairments have occurred since the acquisition date. Individual financial statements for each company as of December 31, 2018, appear below.

Parentheses indicate credit balances. Dividends declared were paid in the same period.

Income Statement Allison Mathias

Sales (6,400,000) (3,900,000) Cost of goods sold 4,500,000 2,500,000 Depreciation expense    875,000    277,000 Amortization expense    430,000    103,000 Interest expense      55,000      60,000 Equity earnings in Mathias (630,000)         –0–

Net income (1,170,000) (960,000)

Statement of Retained Earnings Retained earnings 1/1 (5,340,000) (1,955,000) Net income (above) (1,170,000)    (960,000) Dividends declared 560,000       50,000

Retained earnings 12/31 (5,950,000) (2,865,000)

Balance Sheet Cash      75,000    143,000 Accounts receivable    950,000    225,000 Inventories 1,700,000    785,000 Investment in Mathias 6,580,000            –0– Equipment (net) 3,700,000 2,052,000 Patents      95,000            –0– Unpatented technology 2,125,000 1,450,000 Goodwill 425,000         –0–

Total assets 15,650,000   4,655,000

Accounts payable    (500,000)      (90,000) Long-term debt (1,000,000) (1,200,000) Common stock (8,200,000)    (500,000) Retained earnings 12/31 (5,950,000) (2,865,000)

Total liabilities and equity (15,650,000)   (4,655,000)

Required:

a. Show how Allison determined its December 31, 2018, Investment in Mathias balance. b. Prepare a worksheet to determine the consolidated values to be reported on Allison’s financial

statements. 26. On January 3, 2016, Persoff Corporation acquired all of the outstanding voting stock of Sea Cliff,

Inc., in exchange for $6,000,000 in cash. Persoff elected to exercise control over Sea Cliff as a wholly owned subsidiary with an independent accounting system. Both companies have December 31 fiscal year-ends. At the acquisition date, Sea Cliff’s stockholders’ equity was $2,500,000 includ- ing retained earnings of $1,700,000.

Persoff pursued the acquisition, in part, to utilize Sea Cliff’s technology and computer software. These items had fair values that differed from their values on Sea Cliff’s books as follows:

Asset Book Value

Fair Value

Remaining Useful Life

Patented technology $140,000 $2,240,000 7 years Computer software $  60,000 $1,260,000 12 years

LO 3-1, 3-3a

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Sea Cliff’s remaining identifiable assets and liabilities had acquisition-date book values that closely approximated fair values. Since acquisition, no assets have been impaired. During the next three years, Sea Cliff reported the following income and dividends:

Net Income Dividends

2016 $900,000 $150,000 2017 940,000 150,000 2018 975,000 150,000

December 31, 2018, financial statements for each company appear below. Parentheses indicate credit balances. Dividends declared were paid in the same period.

Income Statement Persoff Sea Cliff

Revenues $ (2,720,000) $(2,250,000)  Cost of goods sold 1,350,000 870,000 Depreciation expense 275,000 380,000 Amortization expense 370,000  25,000 Equity earnings in Sea Cliff        (575,000)              –0–

Net income $  (1,300,000) $   (975,000)

Statement of Retained Earnings Retained earnings 1/1 $  (7,470,000) $(3,240,000) Net income (above) (1,300,000) (975,000)  Dividends declared         600,000      150,000

Retained earnings 12/31 $  (8,170,000) $(4,065,000)

Balance Sheet Current assets $      490,000 $    375,000 Investment in Sea Cliff 7,165,000 –0– Computer software 300,000  45,000 Patented technology 800,000  80,000 Goodwill 100,000  –0– Equipment   1,835,000 4,500,000 

Total assets $ 10,690,000 $ 5,000,000

Liabilities $     (520,000) $   (135,000) Common stock (2,000,000) (800,000) Retained earnings 12/31 (8,170,000)    (4,065,000)

Total liabilities and equity $(10,690,000) $(5,000,000)

a. Construct Persoff’s acquisition-date fair-value allocation schedule for its investment in Sea Cliff. b. Show how Persoff determined its Equity earnings in Sea Cliff balance for the year ended

December 31, 2018. c. Show how Persoff determined its December 31, 2018, Investment in Sea Cliff balance. d. Prepare a worksheet to determine the consolidated values to be reported on Persoff’s financial

statements. 27. On January 1, 2017, Prestige Corporation acquired 100 percent of the voting stock of Stylene Cor-

poration in exchange for $2,030,000 in cash and securities. On the acquisition date, Stylene had the following balance sheet:

Cash $     23,000 Accounts payable $1,050,000 Accounts receivable   97,000     Inventory   140,000  Equipment (net)   1,490,000   Common stock    800,000   Trademarks      850,000 Retained earnings      750,000

$2,600,000 $2,600,000

LO 3-1, 3-3a

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At the acquisition date, the book values of Stylene’s assets and liabilities were generally equivalent to their fair values except for the following assets:

Asset Book Value Fair Value Remaining Useful Life

Equipment $1,490,000 $1,610,000 8 years Customer lists –0–  160,000 4 years Trademarks 850,000  900,000 Indefinite

During the next two years, Stylene has the following income and dividends in its own separately prepared financial reports to its parent.

Net Income Dividends

2017 $175,000 $25,000   2018   375,000 45,000

Dividends are declared and paid in the same period. The December 31, 2018, separate financial statements for each company appear below. Parentheses indicate credit balances.

Income Statement Prestige Stylene

Revenues $ (4,200,000) $ (2,200,000)  Cost of goods sold   2,300,000    1,550,000  Depreciation expense     495,000  275,000 Amortization expense   105,000              –0– Equity earnings in Stylene        (320,000)               –0–

Net income $ (1,620,000)  $    (375,000)  

Statement of Retained Earnings Retained earnings 1/1 $   (2,900,000)  $    (900,000)  Net income (above)  (1,620,000)    (375,000) Dividends declared         150,000           45,000  

Retained earnings 12/31 $  (4,370,000) $ (1,230,000)

Balance Sheet Cash $      430,000  $   35,000   Accounts receivable     693,000   75,000   Inventory     890,000   420,000 Investment in Stylene   2,400,000  –0– Equipment   6,000,000   1,400,000 Customer lists     115,000 –0– Trademarks    2,500,000   850,000 Goodwill   172,000             –0–

Total assets $ 13,200,000   $ 2,780,000  

Accounts payable $     (330,000)   $   (750,000) Common stock    (8,500,000)    (800,000)  Retained earnings 12/31 (4,370,000)     (1,230,000)

Total liabilities and equity $(13,200,000) $ (2,780,000) 

a. Prepare Prestige’s acquisition-date fair-value allocation schedule for its investment in Stylene.

b. Show how Prestige determined its December 31, 2018, Investment in Stylene balance. c. Prepare a worksheet to determine the balances for Prestige’s December 31, 2018, consolidated

financial statements.

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28. Patrick Corporation acquired 100 percent of O’Brien Company’s outstanding common stock on January 1, for $550,000 in cash. O’Brien reported net assets with a carrying amount of $350,000 at that time. Some of O’Brien’s assets either were unrecorded (having been internally developed) or had fair values that differed from book values as follows:

Book Values

Fair Values

Trademarks (indefinite life) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $  60,000 $160,000 Customer relationships (5-year remaining life) . . . . . . . . . . . . . –0– 75,000  Equipment (10-year remaining life) . . . . . . . . . . . . . . . . . . . . . . . 342,000 312,000

Any goodwill is considered to have an indefinite life with no impairment charges during the year.

Following are financial statements at the end of the first year for these two companies prepared from their separately maintained accounting systems. O’Brien declared and paid dividends in the same period. Credit balances are indicated by parentheses.

Patrick O’Brien

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $    (1,125,000)  $    (520,000) Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . .      300,000      228,000 Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . .        75,000      70,000 Amortization expense . . . . . . . . . . . . . . . . . . . . . . . . .        25,000       –0– Income from O’Brien . . . . . . . . . . . . . . . . . . . . . . . . . .     (210,000) –0–

Net Income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $    (935,000)   $    (222,000)

Retained earnings 1/1 . . . . . . . . . . . . . . . . . . . . . . . . . $    (700,000) $    (250,000) Net Income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       (935,000)      (222,000) Dividends declared. . . . . . . . . . . . . . . . . . . . . . . . . . . .    142,000     80,000

Retained earnings 12/31. . . . . . . . . . . . . . . . . . . . . $    (1,493,000)  $     (392,000)

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $     185,000 $      105,000  Receivables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       225,000       56,000 Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       175,000       135,000 Investment in O’Brien . . . . . . . . . . . . . . . . . . . . . . . . . .       680,000         –0– Trademarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       474,000        60,000 Customer relationships . . . . . . . . . . . . . . . . . . . . . . . .         –0–          –0– Equipment (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       925,000        272,000 Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         –0–       –0–

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $      2,664,000   $      628,000 

Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $        (771,000) $    (136,000)  Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        (400,000)       (100,000) Retained earnings 12/31. . . . . . . . . . . . . . . . . . . . . . .       (1,493,000)        (392,000)

Total liabilities and equity . . . . . . . . . . . . . . . . . . . . $    (2,664,000) $    (628,000) 

a. Show how Patrick computed the $210,000 Income of O’Brien balance. Discuss how you deter- mined which accounting method Patrick uses for its investment in O’Brien.

b. Without preparing a worksheet or consolidation entries, determine and explain the totals to be reported for this business combination for the year ending December 31.

c. Verify the totals determined in part (b) by producing a consolidation worksheet for Patrick and O’Brien for the year ending December 31.

29. Following are separate financial statements of Michael Company and Aaron Company as of December 31, 2018 (credit balances indicated by parentheses). Michael acquired all of Aaron’s outstanding voting stock on January 1, 2014, by issuing 20,000 shares of its own $1 par common  stock. On the acquisition date, Michael Company’s stock actively traded at $23.50 per share.

LO 3-1, 3-3a

LO 3-1, 3-3a, 3-3b, 3-4

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Michael Company 12/31/18

Aaron Company 12/31/18

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $  (610,000) $ (370,000) Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   270,000 140,000 Amortization expense . . . . . . . . . . . . . . . . . . . . . . . . . .   115,000 80,000 Dividend income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         (5,000)            –0–

Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (230,000)  $  (150,000)  

Retained earnings, 1/1/18. . . . . . . . . . . . . . . . . . . . . . . $ (880,000) $  (490,000)    Net income (above) . . . . . . . . . . . . . . . . . . . . . . . . . . . . (230,000)   (150,000) Dividends declared. . . . . . . . . . . . . . . . . . . . . . . . . . . . .    90,000      5,000

Retained earnings, 12/31/18 . . . . . . . . . . . . . . . . . . $ (1,020,000)  $ (635,000)

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $   110,000    $ 15,000  Receivables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380,000 220,000  Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 560,000 280,000  Investment in Aaron Company . . . . . . . . . . . . . . . . . . . 470,000 –0– Copyrights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 460,000 340,000 Royalty agreements . . . . . . . . . . . . . . . . . . . . . . . . . . . .       920,000  380,000 

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,900,000    $ 1,235,000

Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $  (780,000)    $ (470,000) Preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  (300,000) –0– Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  (500,000) (100,000) Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . .  (300,000) (30,000) Retained earnings, 12/31/18 . . . . . . . . . . . . . . . . . . . .   (1,020,000)   (635,000)  

Total liabilities and equity . . . . . . . . . . . . . . . . . . . . . $ (2,900,000)   $(1,235,000) 

On the date of acquisition, Aaron reported retained earnings of $230,000 and a total book value of $360,000. At that time, its royalty agreements were undervalued by $60,000. This intangible was assumed to have a six-year remaining life with no residual value. Additionally, Aaron owned a trademark with a fair value of $50,000 and a 10-year remaining life that was not reflected on its books. Aaron declared and paid dividends in the same period. a. Using the preceding information, prepare a consolidation worksheet for these two companies as

of December 31, 2018. b. Instead of the initial value method, assume now that Michael applies the equity method to its

Investment in Aaron account. What account balances would the parent’s individual financial statements then show for the Equity in Subsidiary Earnings, Retained Earnings, and Investment in Aaron accounts?

c. Assuming that Michael applied the equity method to this investment, how would the consolida- tion entries differ on a December 31, 2018, worksheet?

d. Assuming that Michael applied the equity method to this investment, how would the December 31, 2018, reported consolidated balances differ?

30. Giant acquired all of Small’s common stock on January 1, 2014, in exchange for cash of $770,000. On that day, Small reported common stock of $170,000 and retained earnings of $400,000. At the acquisition date, $90,000 of the fair-value price was attributed to undervalued land while $50,000 was assigned to undervalued equipment having a 10-year remaining life. The $60,000 unallocated portion of the acquisition-date excess fair value over book value was viewed as goodwill. Over the next few years, Giant applied the equity method to the recording of this investment.

Following are individual financial statements for the year ending December 31, 2018. On that date, Small owes Giant $10,000. Small declared and paid dividends in the same period. Credits are indicated by parentheses. a. How was the $135,000 Equity in Income of Small balance computed? b. Without preparing a worksheet or consolidation entries, determine and explain the totals to be

reported by this business combination for the year ending December 31, 2018. c. Verify the amounts determined in part (b) by producing a consolidation worksheet for Giant and

Small for the year ending December 31, 2018.

LO 3-1, 3-3, 3-6

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d. If Giant determined that the entire amount of goodwill from its investment in Small was impaired in 2018, how would the parent’s accounts reflect the impairment loss? How would the worksheet process change? What impact does an impairment loss have on consolidated finan- cial statements?

Giant Small

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(1,175,000) $ (360,000) Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 550,000   90,000 Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . 172,000    130,000 Equity in income of Small. . . . . . . . . . . . . . . . . . . . . . . .      (135,000) –0–

Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $   (588,000)   $ (140,000)

Retained earnings, 1/1/18. . . . . . . . . . . . . . . . . . . . . . . $(1,417,000)  $  (620,000) Net income (above) . . . . . . . . . . . . . . . . . . . . . . . . . . . . (588,000) (140,000) Dividends declared. . . . . . . . . . . . . . . . . . . . . . . . . . . . .      310,000   110,000

Retained earnings, 12/31/18 . . . . . . . . . . . . . . . . . . $(1,695,000) $ (650,000)   

Current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $   398,000    $ 318,000  Investment in Small. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 995,000  –0– Land. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 440,000     165,000  Buildings (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304,000   419,000 Equipment (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 648,000 286,000 Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          –0–   –0–

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,785,000 $ 1,188,000 

Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (840,000)   $ (368,000)  Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (250,000)  (170,000) Retained earnings (above). . . . . . . . . . . . . . . . . . . . . . .   (1,695,000)      (650,000)

Total liabilities and equity . . . . . . . . . . . . . . . . . . . . . $(2,785,000)  $(1,188,000

31. On January 1, 2017, Pinnacle Corporation exchanged $3,200,000 cash for 100 percent of the out- standing voting stock of Strata Corporation. On the acquisition date, Strata had the following bal- ance sheet:

Cash . . . . . . . . . . . . . . . . . . . . $   122,000 Accounts payable . . . . . . . . $   375,000 Accounts receivable. . . . . . . 283,000 Long-term debt . . . . . . . . . . 2,655,000 Inventory . . . . . . . . . . . . . . . . . 350,000 Common stock . . . . . . . . . . 1,500,000 Buildings (net) . . . . . . . . . . . . 1,875,000 Retained earnings. . . . . . . .   1,100,000

Licensing agreements . . . . .    3,000,000 $5,630,000

$5,630,000

Pinnacle prepared the following fair-value allocation:

Fair value of Strata (consideration transferred) . . . . . . . . . . . . $3,200,000 Carrying amount acquired. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   2,600,000

Excess fair value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000 to buildings (undervalued). . . . . . . . . . . . . . . . . . . . . . . . . . . . $300,000 to licensing agreements (overvalued) . . . . . . . . . . . . . . . . . . (100,000)      200,000

to goodwill (indefinite life) . . . . . . . . . . . . . . . . . . . . . . . . . . . . $   400,000

At the acquisition date, Strata’s buildings had a 10-year remaining life and its licensing agree- ments were due to expire in 5 years. At December 31, 2018, Strata’s accounts payable included an $85,000 current liability owed to Pinnacle. Strata Corporation continues its separate legal existence as a wholly owned subsidiary of Pinnacle with independent accounting records. Pinnacle employs the initial value method in its internal accounting for its investment in Strata.

The separate financial statements for the two companies for the year ending December 31, 2018, follow. Credit balances are indicated by parentheses.

LO 3-1, 3-3a, 3-3b, 3-4

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Pinnacle Strata

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (7,000,000) $(3,000,000) Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  4,650,000    1,700,000 Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  255,000  160,000 Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . .  585,000  350,000 Amortization expense . . . . . . . . . . . . . . . . . . . . . . . . . .  600,000 Dividend income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .      (50,000)

Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (1,560,000) $ (190,000) 

Retained earnings 1/1/18 . . . . . . . . . . . . . . . . . . . . . . . $  (5,000,000) $(1,350,000) Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,560,000)  (190,000) Dividends declared. . . . . . . . . . . . . . . . . . . . . . . . . . . . .    560,000 50,000

Retained earnings 12/31/18 . . . . . . . . . . . . . . . . . . $  (6,000,000) $(1,490,000)

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $      433,000 $    165,000    Accounts receivable  1,210,000 200,000 Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  1,235,000 1,500,000  Investment in Strata . . . . . . . . . . . . . . . . . . . . . . . . . . . .  3,200,000 Buildings (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  5,572,000 2,040,000  Licensing agreements . . . . . . . . . . . . . . . . . . . . . . . . . .  1,800,000   Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350,000

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 12,000,000 $ 5,705,000

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $     (300,000) $   (715,000)  Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,700,000) (2,000,000)   Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,000,000)  (1,500,000)    Retained earnings 12/31/18. . . . . . . . . . . . . . . . . . . . .    (6,000,000)    (1,490,000)    

Total liabilities and OE . . . . . . . . . . . . . . . . . . . . . . . . $(12,000,000)  $(5,705,000) 

a. Prepare a worksheet to consolidate the financial information for these two companies. b. Compute the following amounts that would appear on Pinnacle’s 2018 separate (nonconsoli-

dated) financial records if Pinnacle’s investment accounting was based on the equity method. ∙ Subsidiary income. ∙ Retained earnings, 1/1/18. ∙ Investment in Strata.

c. What effect does the parent’s internal investment accounting method have on its consolidated financial statements?

32. Following are selected accounts for Mergaronite Company and Hill, Inc., as of December 31, 2018. Several of Mergaronite’s accounts have been omitted. Credit balances are indicated by parentheses. Dividends were declared and paid in the same period.

Mergaronite Hill

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(600,000) $(250,000) Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280,000 100,000 Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000 50,000 Investment income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Not given NA Retained earnings, 1/1/18. . . . . . . . . . . . . . . . . . . . . . . . (900,000) (600,000) Dividends declared. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130,000 40,000 Current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000 690,000 Land. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000 90,000 Buildings (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000 140,000 Equipment (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000 250,000 Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (400,000) (310,000) Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (300,000) (40,000) Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . (50,000) (160,000)

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Assume that Mergaronite took over Hill on January 1, 2014, by issuing 7,000 shares of common stock having a par value of $10 per share but a fair value of $100 each. On January 1, 2014, Hill’s land was undervalued by $20,000, its buildings were overvalued by $30,000, and equipment was undervalued by $60,000. The buildings had a 10-year remaining life; the equipment had a 5-year remaining life. A customer list with an appraised value of $100,000 was developed internally by Hill and was to be written off over a 20-year period. a. Determine and explain the December 31, 2018, consolidated totals for the following accounts:

Revenues Amortization Expense Customer List Cost of Goods Sold Buildings Common Stock Depreciation Expense Equipment Additional Paid-In Capital

b. In requirement (a), why can the consolidated totals be determined without knowing which method the parent used to account for the subsidiary?

c. If the parent uses the equity method, what consolidation entries would be used on a 2018 worksheet?

33. On January 1, 2018, Brooks Corporation exchanged $1,183,000 fair-value consideration for all of the outstanding voting stock of Chandler, Inc. At the acquisition date, Chandler had a book value equal to $1,105,000. Chandler’s individual assets and liabilities had fair values equal to their respec- tive book values except for the patented technology account, which was undervalued by $204,000 with an estimated remaining life of six years. The Chandler acquisition was Brooks’s only business combination for the year.

In case expected synergies did not materialize, Brooks Corporation wished to prepare for a potential future spin-off of Chandler, Inc. Therefore, Brooks had Chandler maintain its separate incorporation and independent accounting information system as elements of continuing value.

On December 31, 2018, each company submitted the following financial statements for consoli- dation. Dividends were declared and paid in the same period. Parentheses indicated credit balances.

Brooks Corp. Chandler Inc.

Income Statement Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (640,000) $ (587,000) Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  255,000 203,000 Gain on bargain purchase . . . . . . . . . . . . . . . . . . . . . . . . . (126,000) –0– Depreciation and amortization . . . . . . . . . . . . . . . . . . . . . 150,000 151,000 Equity earnings from Chandler . . . . . . . . . . . . . . . . . . . . .      (199,000)          –0–

Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (560,000) $ (233,000)

Statement of Retained Earnings Retained earnings, 1/1. . . . . . . . . . . . . . . . . . . . . . . . . . . . $(1,835,000) $  (805,000)  Net income (above) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (560,000)  (233,000) Dividends declared. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       100,000    40,000

Retained earnings, 12/31 . . . . . . . . . . . . . . . . . . . . . . . $(2,295,000)  $ (998,000)

Balance Sheet Current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $    343,000    $    432,000 Investment in Chandler . . . . . . . . . . . . . . . . . . . . . . . . . . .  1,468,000 –0– Trademarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134,000 221,000 Patented technology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 395,000 410,000 Equipment   693,000   341,000

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,033,000 $ 1,404,000 

Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $  (203,000) $   (106,000) Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (535,000) (300,000) Retained earnings, 12/31   (2,295,000) (998,000)

Total liabilities and equity . . . . . . . . . . . . . . . . . . . . . . . $(3,033,000) $(1,404,000) 

a. Show how Brooks determined the following account balances: ∙ Gain on bargain purchase. ∙ Earnings from Chandler. ∙ Investment in Chandler.

b. Prepare a December 31, 2018, consolidated worksheet for Brooks and Chandler.

LO 3-3, 3-4, 3-6

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34. Branson paid $465,000 cash for all of the outstanding common stock of Wolfpack, Inc., on January 1, 2017. On that date, the subsidiary had a book value of $340,000 (common stock of $200,000 and retained earnings of $140,000), although various unrecorded royalty agreements (10-year remaining life) were assessed at a $100,000 fair value. Any remaining excess fair value was considered goodwill.

In negotiating the acquisition price, Branson also promised to pay Wolfpack’s former owners an additional $50,000 if Wolfpack’s income exceeded $120,000 total over the first two years after the acquisition. At the acquisition date, Branson estimated the probability-adjusted present value of this contingent consideration at $35,000. On December 31, 2017, based on Wolfpack’s earnings to date, Branson increased the value of the contingency to $40,000.

During the subsequent two years, Wolfpack reported the following amounts for income and dividends:

Net Income Dividends Declared

2017 $65,000 $25,000 2018 75,000 35,000

In keeping with the original acquisition agreement, on December 31, 2018, Branson paid the additional $50,000 performance fee to Wolfpack’s previous owners.

Prepare each of the following: a. Branson’s entry to record the acquisition of the shares of its Wolfpack subsidiary. b. Branson’s entries at the end of 2017 and 2018 to adjust its contingent performance obligation

for changes in fair value and the December 31, 2018, payment. c. Consolidation worksheet entries as of December 31, 2018, assuming that Branson has applied

the equity method. d. Consolidation worksheet entries as of December 31, 2018, assuming that Branson has applied

the initial value method. 35. Allen Company acquired 100 percent of Bradford Company’s voting stock on January 1, 2014,

by issuing 10,000 shares of its $10 par value common stock (having a fair value of $14 per share). As of that date, Bradford had stockholders’ equity totaling $105,000. Land shown on Bradford’s accounting records was undervalued by $10,000. Equipment (with a five-year remaining life) was undervalued by $5,000. A secret formula developed by Bradford was appraised at $20,000 with an estimated life of 20 years.

Following are the separate financial statements for the two companies for the year ending December 31, 2018. There were no intra-entity payables on that date. Credit balances are indicated by parentheses.

Allen Company

Bradford Company

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $   (485,000) $(190,000) Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160,000   70,000 Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130,000  52,000 Subsidiary earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (66,000)   –0–  

Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $   (261,000)  $  (68,000)

Retained earnings, 1/1/18. . . . . . . . . . . . . . . . . . . . . . . . . . $   (659,000)   $  (98,000) Net income (above) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (261,000) (68,000) Dividends declared. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       175,500        40,000

Retained earnings, 12/31/18 . . . . . . . . . . . . . . . . . . . . . $   (744,500)  $(126,000)

Current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $    268,000    $   75,000   Investment in Bradford Company . . . . . . . . . . . . . . . . . . .  216,000 –0– Land. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  427,500   58,000  Buildings and equipment (net) . . . . . . . . . . . . . . . . . . . . . .      713,000       161,000

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,624,500    $ 294,000  

Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $   (190,000) $(103,000) Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (600,000) (60,000) Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . .   (90,000) (5,000)   Retained earnings, 12/31/18 . . . . . . . . . . . . . . . . . . . . . . .     (744,500)     (126,000)

Total liabilities and equity . . . . . . . . . . . . . . . . . . . . . . . . $(1,624,500)  $(294,000)

LO 3-3a, 3-3b, 3-7

LO 3-3, 3-8

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a. Explain how Allen derived the $66,000 balance in the Subsidiary Earnings account. b. Prepare a worksheet to consolidate the financial information for these two companies.

36. Tyler Company acquired all of Jasmine Company’s outstanding stock on January 1, 2016, for $206,000 in cash. Jasmine had a book value of only $140,000 on that date. However, equipment (having an eight-year remaining life) was undervalued by $54,400 on Jasmine’s financial records. A building with a 20-year remaining life was overvalued by $10,000. Subsequent to the acquisition, Jasmine reported the following:

Net Income

Dividends Declared

2016 $50,000 $10,000 2017 60,000 40,000 2018 30,000 20,000

In accounting for this investment, Tyler has used the equity method. Selected accounts taken from the financial records of these two companies as of December 31, 2018, follow:

Tyler Company

Jasmine Company

Revenues—operating. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(310,000)   $(104,000) Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198,000 74,000 Equipment (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320,000 50,000 Buildings (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220,000 68,000 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (290,000) (50,000) Retained earnings, 12/31/18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . (410,000) (160,000)  

Determine and explain the following account balances as of December 31, 2018: a. Investment in Jasmine Company (on Tyler’s individual financial records). b. Equity in Subsidiary Earnings (on Tyler’s individual financial records). c. Consolidated Net Income. d. Consolidated Equipment (net). e. Consolidated Buildings (net). f. Consolidated Goodwill (net). g. Consolidated Common Stock. h. Consolidated Retained Earnings, 12/31/18.

37. On January 1, 2017, Procise Corporation acquired 100 percent of the outstanding voting stock of GaugeRite Corporation for $1,980,000 cash. On the acquisition date, GaugeRite had the following balance sheet:

Cash . . . . . . . . . . . . . . . . . . $     14,000 Accounts payable . . . . . . . $ 120,000  Accounts receivable. . . . . 100,000 Long-term debt . . . . . . . . . 930,000 Land. . . . . . . . . . . . . . . . . . . 700,000 Common stock . . . . . . . . . 1,000,000 Equipment (net) . . . . . . . . .   1,886,000 Retained earnings. . . . . . .     650,000

$2,700,000 $2,700,000  

At the acquisition date, the following allocation was prepared:

Fair value of consideration transferred . . . . . . . . . . . . . . . . . . . . . . . $1,980,000 Book value acquired . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   1,650,000 Excess fair value over book value . . . . . . . . . . . . . . . . . . . . . . . . . . . 330,000 To in-process research and development . . . . . . . . . . . . . . . . . . $44,000 To equipment (8-year remaining life) . . . . . . . . . . . . . . . . . . . . . .   56,000      100,000

To goodwill (indefinite life) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $   230,000

Although at acquisition date Procise had expected $44,000 in future benefits from GaugeRite’s in-process research and development project, by the end of 2017 it was apparent that the research project was a failure with no future economic benefits.

LO 3-3a

LO 3-3

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On December 31, 2018, Procise and GaugeRite submitted the following trial balances for con- solidation. There were no intra-entity payables on that date.

Procise GaugeRite

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (3,500,000) $ (1,000,000) Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,600,000 630,000  Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . .  350,000  130,000 Other operating expenses . . . . . . . . . . . . . . . . . . . . . . .  190,000  30,000 Subsidiary income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       (203,000)      –0–

Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (1,563,000) $   (210,000) 

Retained earnings 1/1/18 . . . . . . . . . . . . . . . . . . . . . . . . $ (3,000,000) $   (800,000) Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,563,000) (210,000) Dividends declared. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   200,000       25,000    

Retained earnings 12/31/18 . . . . . . . . . . . . . . . . . . . $ (4,363,000)  $   (985,000)  

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $     228,000 $      50,000  Accounts receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . .  840,000  155,000 Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  900,000  580,000 Investment in GaugeRite . . . . . . . . . . . . . . . . . . . . . . . . . 2,257,000  –0– Land. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,500,000   700,000 Equipment (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,785,000   1,700,000 Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     290,000       –0–

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 12,800,000 $  3,185,000 

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $    (193,000)     $    (400,000)  Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,094,000)   (800,000) Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (5,150,000)   (1,000,000) Retained earnings 12/31/18. . . . . . . . . . . . . . . . . . . . . .     (4,363,000)       (985,000) 

Total liabilities and equities. . . . . . . . . . . . . . . . . . . . . $(12,800,000) $ (3,185,000) 

a. Show how Procise derived its December 31, 2018, Investment in GaugeRite account balance. b. Explain the treatment of the acquired in-process research and development. c. Prepare a consolidated worksheet for Procise and GaugeRite as of December 31, 2018.

38. On January 1, Prine, Inc., acquired 100 percent of Lydia Company’s common stock for a fair value of $120,000,000 in cash and stock. Lydia’s assets and liabilities equaled their fair values except for its equipment, which was undervalued by $500,000 and had a 10-year remaining life.

Prine specializes in media distribution and viewed its acquisition of Lydia as a strategic move into content ownership and creation. Prine expected both cost and revenue synergies from control- ling Lydia’s artistic content (a large library of classic movies) and its sports programming specialty video operation. Accordingly, Prine allocated Lydia’s assets and liabilities (including $50,000,000 of goodwill) to a newly formed operating segment appropriately designated as a reporting unit.

The fair values of the reporting unit’s identifiable assets and liabilities through the first year of operations were as follows.

Fair Values

Account 1/1 12/31

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $    215,000 $    109,000 Receivables (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525,000  897,000 Movie library (25-year remaining life) . . . . . . . . . . . 40,000,000  60,000,000 Broadcast licenses (indefinite life) . . . . . . . . . . . . . . 15,000,000  20,000,000 Equipment (10-year remaining life) . . . . . . . . . . . . . 20,750,000  19,000,000 Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (490,000) (650,000) Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (6,000,000) (6,250,000)

However, Lydia’s assets have taken longer than anticipated to produce the expected synergies with Prine’s operations. Accordingly, Prine reviewed events and circumstances and concluded that Lydia’s fair value was likely less than its carrying amount. At year-end, Prine reduced its assess- ment of the Lydia reporting unit’s fair value to $110,000,000.

LO 3-4a, 3-6

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At December 31, Prine and Lydia submitted the following balances for consolidation. There were no intra-entity payables on that date.

Prine, Inc. Lydia Co.

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $  (18,000,000) $(12,000,000) Operating expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . 10,350,000 11,800,000 Equity in Lydia earnings . . . . . . . . . . . . . . . . . . . . . . . . (150,000) Dividends declared. . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000 80,000 Retained earnings, 1/1. . . . . . . . . . . . . . . . . . . . . . . . . (52,000,000) (2,000,000) Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260,000 109,000 Receivables (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210,000 897,000 Investment in Lydia . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,070,000 Broadcast licenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350,000 14,014,000 Movie library. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 365,000 45,000,000 Equipment (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136,000,000 17,500,000 Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (755,000) (650,000) Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (22,000,000) (7,250,000) Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (175,000,000) (67,500,000)

a. What is the relevant initial test to determine whether goodwill could be impaired? b. At what amount should Prine record an impairment loss for its Lydia reporting unit for the year? c. What is consolidated net income for the year? d. What is the December 31 consolidated balance for goodwill? e. What is the December 31 consolidated balance for broadcast licenses? f. Prepare a consolidated worksheet for Prine and Lydia (Prine’s trial balance should first be

adjusted for any appropriate impairment loss).

Appendix Problems 39. Briefly discuss the cost savings that may result from a private company electing to amortize good-

will as opposed to annual impairment testing. 40. Angela Corporation (a private company) acquired all of the outstanding voting stock of Eddy Tech,

Inc., on January 1, 2018, in exchange for $9,000,000 in cash. At the acquisition date, Eddy Tech’s stockholders’ equity was $7,200,000 including retained earnings of $3,000,000.

At the acquisition date, Angela prepared the following fair value allocation schedule for its newly acquired subsidiary:

Consideration transferred . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $9,000,000 Eddy’s stockholder’s equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   7,200,000 Excess fair over book value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,800,000 to patented technology (5-year remaining life) . . . . . . . . . . . $ 150,000 to trade names (indefinite remaining life) . . . . . . . . . . . . . . . . 500,000 to equipment (8-year remaining life) . . . . . . . . . . . . . . . . . . . . 50,000      700,000 Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,100,000

At the end of 2018, Angela and Eddy Tech report the following amounts from their individually maintained account balances, before consideration of their parent-subsidiary relationship. Parenthe- ses indicate a credit balance.

Angela Eddy Tech

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (7,850,000) (2,400,000) Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,200,000 1,300,000 Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    425,000      48,000 Amortization expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    250,000      12,000 Other operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . .      75,000      53,750 Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2,900,000)    (986,250)

Required: Prepare a 2018 consolidated income statement for Angela and its subsidiary Eddy Tech. Assume that Angela, as a private company, elects to amortize goodwill over a 10-year period.

LO 3-8

LO 3-8

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Develop Your Skills

RESEARCH CASE

Jonas Tech Corporation recently acquired Innovation Plus Company. The combined firm consists of three related businesses that will serve as reporting units. In connection with the acquisition, Jonas requests your help with the following asset valuation and allocation issues. Support your answers with references to FASB ASC as appropriate.

Jonas recognizes several identifiable intangibles from its acquisition of Innovation Plus. It expresses the desire to have these intangible assets written down to zero in the acquisition period.

The price Jonas paid for Innovation Plus indicates that it paid a large amount for goodwill. However, Jonas worries that any future goodwill impairment may send the wrong signal to its investors about the wisdom of the Innovation Plus acquisition. Jonas thus wishes to allocate the combined goodwill of all of its reporting units 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 could be offset by an increase in the value of goodwill in another business unit.

Required

1. Advise Jonas on the acceptability of its suggested immediate write-off of its identifiable intangibles. 2. Indicate the relevant factors to consider in allocating the value assigned to identifiable intangibles

acquired in a business combination to expense over time. 3. Advise Jonas on the acceptability of its suggested treatment of goodwill. 4. Indicate the relevant factors to consider in allocating goodwill across an enterprise’s business units.

MICROSOFT IMPAIRMENT ANALYSIS CASE

In 2015 Microsoft Corporation reported a $5.1 billion charge for the impairment of goodwill and a $2.2 billion charge for the impairment of intangible assets in one of its reporting units (segments) in its 10-K annual report. Referring to Microsoft’s 2015 financial statements and any other information from the media, address the following: 1. Microsoft’s segments serve as its reporting units for assessing goodwill for potential impairments.

Which segment suffered a 2015 impairment? Describe the revenue model for this segment. 2. What were the underlying business reasons that required Microsoft to record a goodwill impairment

in 2015? 3. How did Microsoft reflect the 2015 goodwill impairment in its income statement and cash flow

statement? 4. Describe in your own words the goodwill impairment testing steps performed by Microsoft in 2015

and the consequent loss measurement.

FASB ASC AND IASB RESEARCH CASE

A vice president for operations at Poncho Platforms asks for your help on a financial reporting issue con- cerning goodwill. Two years ago, the company suffered a goodwill impairment loss for its Chip Integra- tion reporting unit. Since that time, however, the Chip Integration unit has recovered nicely and its current cash flows (and projected cash flows) are at an all-time high. The vice president now asks whether the goodwill loss can be reversed given the reversal of fortunes for the Chip Integration reporting unit. 1. Is impairment of goodwill reversible under U.S. GAAP? How about under IFRS? (Refer to FASB

Topic 350, “Intangibles—Goodwill and Other,” and IAS 36, “Impairment of Assets.”) 2. Are goodwill impairment testing procedures the same under IFRS and U.S. GAAP? If not, how is

goodwill tested for impairment under IFRS? (Refer to IAS 36, “Impairment of Assets.”)

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On January 1, 2017, Innovus, Inc., acquired 100 percent of the common stock of ChipTech Company for $670,000 in cash and other fair-value consideration. ChipTech’s fair value was allocated among its net assets as follows:

Fair value of consideration transferred for ChipTech $670,000 Book value of ChipTech: Common stock and Additional Paid-In Capital (APIC) $130,000 Retained earnings 370,000 500,000 Excess fair value over book value to 170,000 Trademark (10-year remaining life) $ 40,000 Existing technology (5-year remaining life) 80,000 120,000 Goodwill $ 50,000

The December 31, 2018, trial balances for the parent and subsidiary follow (there were no intra- entity payables on that date):

Innovus ChipTech

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $   (990,000) $ (210,000)  Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        500,000        90,000  Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        100,000          5,000  Amortization expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          55,000        18,000  Dividend income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        (40,000)     –0–

Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $    (375,000) $   (97,000)

Retained earnings 1/1/18 . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (1,555,000) $ (450,000) Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        (375,000)        (97,000) Dividends declared. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     250,000     40,000

Retained earnings 12/31/18 . . . . . . . . . . . . . . . . . . . . . . $ (1,680,000) $ (507,000)

Current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $      960,000  $ 355,000   Investment in ChipTech . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        670,000 Equipment (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        765,000       225,000  Trademark . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        235,000       100,000  Existing technology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                –0–         45,000  Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450,000         –0–

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $  3,080,000 $ 725,000

Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $    (780,000)         (88,000)  Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        (500,000)      (100,000) Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . .        (120,000)        (30,000) Retained earnings 12/31/18. . . . . . . . . . . . . . . . . . . . . . . . .   (1,680,000)    (507,000)

Total liabilities and equity . . . . . . . . . . . . . . . . . . . . . . . . . $ (3,080,000) $ (725,000)

Required a. Using Excel, compute consolidated balances for Innovus and ChipTech. Either use a worksheet

approach or compute the balances directly. b. Prepare a second spreadsheet that shows a 2018 impairment loss for the entire amount of goodwill

from the ChipTech acquisition.

EXCEL CASE 1

EXCEL CASE 2

On January 1, 2017, Hi-Speed.com acquired 100 percent of the common stock of Wi-Free Co. for cash of $730,000. The consideration transferred was allocated among Wi-Free’s net assets as follows:

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Wi-Free fair value (cash paid by Hi-Speed) $730,000 Book value of Wi-Free: Common stock and additional paid-in capital (APIC) $130,000  Retained earnings 370,000  500,000 Excess fair value over book value to 230,000 In-process R&D $ 75,000  Computer software (overvalued) (30,000) Internet domain name 120,000  165,000 Goodwill $ 65,000

At the acquisition date, the computer software had a 4-year remaining life, and the Internet domain name was estimated to have a 10-year remaining life. By the end of 2017, it became clear that the acquired in- process research and development would yield no economic benefits and Hi-Speed.com recognized an impairment loss. At December 31, 2018, Wi-Free’s accounts payable included a $30,000 amount owed to Hi-Speed.

The December 31, 2018, trial balances for the parent and subsidiary follow:

Hi-Speed.com Wi-Free Co.

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (1,100,000) $ (325,000) Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       625,000  122,000 Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . .       140,000  12,000 Amortization expense . . . . . . . . . . . . . . . . . . . . . . . . . .         50,000  11,000 Equity in subsidiary earnings . . . . . . . . . . . . . . . . . . . .     (175,500) –0–

Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (460,500) $ (180,000)

Retained earnings 1/1/18 . . . . . . . . . . . . . . . . . . . . . . . $ (1,552,500) $ (450,000) Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         (460,500)      (180,000) Dividends declared. . . . . . . . . . . . . . . . . . . . . . . . . . . . .     250,000       50,000

Retained earnings 12/31/18 $ (1,763,000) $ (580,000)

Current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,034,000  $ 345,000 Investment in Wi-Free . . . . . . . . . . . . . . . . . . . . . . . . . .  856,000              –0– Equipment (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   713,000       305,000 Computer software . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   650,000       130,000 Internet domain name . . . . . . . . . . . . . . . . . . . . . . . . . .  –0–       100,000 Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   –0–   –0–

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,253,000 $ 880,000

Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (870,000) $ (170,000) Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   (500,000) (110,000) Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . .  (120,000) (20,000) Retained earnings 12/31/18. . . . . . . . . . . . . . . . . . . . .   (1,763,000)   (580,000)

Total liabilities and equity . . . . . . . . . . . . . . . . . . . . . $ (3,253,000) $ (880,000)

Required a. Using Excel, prepare calculations showing how Hi-Speed derived the $856,000 amount for its

investment in Wi-Free. b. Using Excel, compute consolidated balances for Hi-Speed and Wi-Free. Either use a worksheet

approach or compute the balances directly.

Computer Project Alternative Investment Methods, Goodwill Impairment, and Consolidated Financial Statements In this project, you are to provide an analysis of alternative accounting methods for controlling interest investments and subsequent effects on consolidated reporting. The project requires the use of a com- puter and a spreadsheet software package (e.g., Microsoft Excel, etc.). The use of these tools allows you

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to assess the sensitivity of alternative accounting methods on consolidated financial reporting without preparing several similar worksheets by hand. Also, by modeling a worksheet process, you can develop a better understanding of accounting for combined reporting entities.

Consolidated Worksheet Preparation

You will be creating and entering formulas to complete four worksheets. The first objective is to dem- onstrate the effect of different methods of accounting for the investments (equity, initial value, and partial equity) on the parent company’s trial balance and on the consolidated worksheet subsequent to acquisition. The second objective is to show the effect on consolidated balances and key financial ratios of recognizing a goodwill impairment loss.

The project requires preparation of the following four separate worksheets:

a. Consolidated information worksheet (follows). b. Equity method consolidation worksheet. c. Initial value method consolidation worksheet. d. Partial equity method consolidation worksheet.

If your spreadsheet package has multiple worksheet capabilities (e.g., Excel), you can use separate worksheets; otherwise, each of the four worksheets can reside in a separate area of a single spreadsheet.

In formulating your solution, each worksheet should link directly to the first worksheet. Also, feel free to create supplemental schedules to enhance the capabilities of your worksheet.

Project Scenario

Pecos Company acquired 100 percent of Suaro’s outstanding stock for $1,450,000 cash on January 1, 2017, when Suaro had the following balance sheet:

Assets Liabilities and Equity

Cash . . . . . . . . . . . . . . . . . . . . . . . $ 37,000 Liabilities . . . . . . . . . . . . . . . . . . . . $(422,000) Receivables . . . . . . . . . . . . . . . . . 82,000 Inventory . . . . . . . . . . . . . . . . . . . . 149,000 Common stock . . . . . . . . . . . . . . (350,000) Land. . . . . . . . . . . . . . . . . . . . . . . . 90,000 Retained earnings. . . . . . . . . . . . (126,000) Equipment (net) . . . . . . . . . . . . . . 225,000 Software . . . . . . . . . . . . . . . . . . . . 315,000 Total assets . . . . . . . . . . . . . . . $898,000 Total liabilities and equity . . . $(898,000)

At the acquisition date, the fair values of each identifiable asset and liability that differed from book value were as follows:

Land $  80,000 Brand name 60,000 (indefinite life—unrecognized on Suaro’s books) Software 415,000 (2-year estimated remaining useful life) In-process R&D 300,000

Additional Information ∙ Although at acquisition date Pecos expected future benefits from Suaro’s in-process research and

development (R&D), by the end of 2017 it became clear that the research project was a failure with no future economic benefits.

∙ During 2017, Suaro earns $75,000 and pays no dividends. ∙ Selected amounts from Pecos and Suaro’s separate financial statements at December 31, 2018, are

presented in the consolidated information worksheet. All consolidated worksheets are to be prepared as of December 31, 2018, two years subsequent to acquisition.

∙ Pecos’s January 1, 2018, Retained Earnings balance—before any effect from Suaro’s 2017 income— is $(930,000) (credit balance).

∙ Pecos has 500,000 common shares outstanding for EPS calculations and reported $2,943,100 for consolidated assets at the beginning of the period.

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Following is the consolidated information worksheet.

A B C D

1 December 31, 2018, trial balances

2

3 Pecos Suaro

4 Revenues $ (1,052,000) $ (427,000)

5 Operating expenses 821,000   262,000

6 Goodwill impairment loss ?

7 Income of Suaro ?

8 Net income ? $ (165,000) 

9

10 Retained earnings—Pecos 1/1/18 ?

11 Retained earnings—Suaro 1/1/18 (201,000)

12 Net income (above) ? (165,000)

13 Dividends declared   200,000 35,000

14 Retained earnings 12/31/18 ? $ (331,000)

15

16 Cash 195,000   95,000 

17 Receivables 247,000    143,000 

18 Inventory 415,000    197,000 

19 Investment in Suaro ?

20

21

22

23 Land          341,000    85,000 

24 Equipment (net)          240,100    100,000 

25 Software  312,000 

26 Other intangibles          145,000  

27 Goodwill

28 Total assets ? $ 932,000

29

30 Liabilities     (1,537,100)  (251,000)

31 Common stock        (500,000)  (350,000)

32 Retained earnings (above) ?   (331,000)

33 Total liabilities and equity ? $ (932,000)

34

35 Fair-value allocation schedule

36 Price paid       1,450,000  

37 Book value     476,000

38 Excess initial value     974,000   Amortizations

39 to land     (10,000)  2017 2018

40 to brand name         60,000   ? ?

(continued )

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A B C D

41 to software     100,000 ? ?

42 to IPR&D     300,000 ? ?

43 to goodwill     524,000   ? ?

44

45 Suaro’s RE changes Income Dividends

46 2017        75,000   0

47 2018       165,000    35,000

Project Requirements Complete the four worksheets as follows: 1. Input the consolidated information worksheet provided and complete the fair-value allocation

schedule by computing the excess amortizations for 2017 and 2018. 2. Using separate worksheets, prepare Pecos’s trial balances for each of the indicated accounting meth-

ods (equity, initial value, and partial equity). Use only formulas for the Investment in Suaro, the Income of Suaro, and Retained Earnings accounts.

3. Using references to other cells only (either from the consolidated information worksheet or from the separate method sheets), prepare for each of the three consolidation worksheets: ∙ Adjustments and eliminations. ∙ Consolidated balances.

4. Calculate and present the effects of a 2018 total goodwill impairment loss on the following ratios for the consolidated entity: ∙ Earnings per share (EPS). ∙ Return on assets. ∙ Return on equity. ∙ Debt to equity.

Your worksheets should have the capability to adjust immediately for the possibility that all acquisi- tion goodwill can be considered impaired in 2018.

5. Prepare a word-processed report that describes and discusses the following worksheet results: a. The effects of alternative investment accounting methods on the parent’s trial balances and the

final consolidation figures. b. The relation between consolidated retained earnings and the parent’s retained earnings under

each of the three (equity, initial value, partial equity) investment accounting methods. c. The effect on EPS, return on assets, return on equity, and debt-to-equity ratios of the recognition

that all acquisition-related goodwill is considered impaired in 2018.

(continued )

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