NON-PROFIT ACCOUNTING HW

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Chapter Two

Consolidation of Financial Information

Current Accounting Standards for Business Combinations

The FASB Accounting Standards Codification (ASC) contains the current accounting standards for business combinations under the following topics:

“Business Combinations” (Topic 805)

“Consolidation” (Topic 810)

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The FASB Accounting Standards Codification (ASC) contains the current accounting standards for business combinations under the following topics:

“Business Combinations” (Topic 805)

“Consolidation” (Topic 810)

FASB ASC Topics 805 and 810

FASB Accounting Standards Codification (ASC) “Business Combinations” (Topic 805) and “Consolidation” (Topic 810) provide guidance using the acquisition method.

The acquisition method embraces the fair-value measurement for measuring and assessing business activity.

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The ASC “Business Combinations” topic provides guidance on the accounting and reporting for business combinations using the acquisition method. The acquisition method embraces a fair-value measurement attribute. Adoption of this attribute reflects the FASB’s increasing emphasis on fair value for measuring and assessing business activity.

The ASC “Consolidation” topic provides guidance on circumstances that require a firm to prepare consolidated financial reports and various other related reporting issues.

Learning Objective 2-1

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Discuss the motives for business combinations.

LO 2-1: Discuss the motives for business combinations.

Reasons for Firms to Combine

No two business combinations are exactly alike, but they share one or more of the following characteristics that potentially enhance profitability:

Vertical integration.

Cost savings.

Quick entry for products into markets.

Economies of scale.

More attractive financing opportunities.

Diversification of business risk.

Business expansion.

Increasingly competitive environment.

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Although no two business combinations are exactly alike, many share one or more of the following characteristics that potentially enhance profitability:

Vertical integration of one firm’s output and another firm’s distribution or further processing.

Cost savings through elimination of duplicate facilities and staff.

Quick entry for new and existing products into domestic and foreign markets.

Economies of scale allowing greater efficiency and negotiating power.

The ability to access financing at more attractive rates. As firm size increases, negotiating power with financial institutions can increase also.

Diversification of business risk.

Business combinations also occur because many firms seek the continuous expansion of their organizations, often into diversified areas.

Recent Notable Business Combinations

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EXHIBIT 2.1 Recent Notable Business Combinations

A frequent economic phenomenon is the combining of two or more businesses into a single entity under common management and control. During recent decades, the United States and the rest of the world have experienced an enormous number of corporate mergers and takeovers, transactions in which one company gains control over another. According to Thomson Reuters, the number of mergers and acquisitions globally in 2015 exceeded 42,300, with a total value of more than $4.7 trillion. Of these deals, more than $2.3 trillion involved a U.S. firm.

Learning Objective 2-2

Recognize when consolidation of financial information into a single set of statements is necessary.

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LO 2-2: Recognize when consolidation of financial information into a single set of statements is necessary.

Consolidated Financial Reporting

Why consolidate financial information when two or more companies combine to create a single economic entity? According to FASB ASC (810-10-10-1):

Consolidated financial statements provide more meaningful information than separate statements.

Consolidated financial statements more fairly present the activities of the consolidated companies.

Consolidated companies may retain their legal identities as separate corporations.

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The consolidation of financial information into a single set of statements becomes necessary when the business combination of two or more companies creates a single economic entity. As stated in FASB ASC (810-10-10-1): “There is a presumption that consolidated financial statements are more meaningful than separate financial statements and that they are usually necessary for a fair presentation when one of the entities in the consolidated group directly or indirectly has a controlling financial interest in the other entities.”

Consolidated Financial Reporting (continued)

To explain the process of preparing consolidated financial statements for a business combination, we address three questions:

How is a business combination formed?

What constitutes a controlling financial interest?

How is the consolidation process carried out?

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To explain the process of preparing consolidated financial statements for a business combination, we address three questions:

How is a business combination formed?

What constitutes a controlling financial interest?

How is the consolidation process carried out?

Learning Objective 2-3

Define the term business combination and differentiate across various forms of business combinations.

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LO 2-3: Define the term business combination and differentiate across various forms of business combinations.

Business Combinations

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A business combination:

Refers to a transaction or other event in which an acquirer obtains control over one or more businesses.

Is formed by a wide variety of transactions or events with various formats.

Can differ widely in legal form.

Unites two or more enterprises into a single economic entity that requires consolidated financial statements.

A business combination refers to a transaction or other event in which an acquirer obtains control over one or more businesses.

Business combinations are formed by a wide variety of transactions or events with various formats. For example, each of the transactions on the following slides is identified as a business combination although it differs widely in legal form. In every case, two or more enterprises are being united into a single economic entity so that consolidated financial statements are required.

Types of Business Combinations – Statutory Mergers

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Statutory merger: Any business combination in which only one of the original companies continues to exist. The two types of statutory mergers are:

A business combination in which one company obtains all of the assets, and often the liabilities, of another company.

A business combination in which one company obtains all of the capital stock of another company. The acquiring company must gain 100 percent control of all shares of stock before legally dissolving the company.

Any business combination in which only one of the original companies continues to exist is referred to in legal terms as a statutory merger. One company company obtains the assets, and often the liabilities, of another company in exchange for cash, other assets, liabilities, stock, or a combination of these. The second organization normally dissolves itself as a legal corporation. Thus, only the acquiring company remains in existence, having absorbed the acquired net assets directly into its own operations.

Another type of statutory merger is when one company obtains all of the capital stock of another in exchange for cash, other assets, liabilities, stock, or a combination of these. After gaining control, the acquiring company can decide to transfer all assets and liabilities to its own financial records with the second company being dissolved as a separate corporation. The business combination is, once again, a statutory merger because only one of the companies maintains legal existence. This statutory merger, however, is achieved by obtaining equity securities rather than by buying the target company’s assets. Because stock is obtained, the acquiring company must gain 100 percent control of all shares before legally dissolving the subsidiary.

Types of Business Combinations—Other Models

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Statutory consolidation: A specific type of business combination that unites two or more companies under the ownership of a newly created company. Two or more companies transfer either their assets or their capital stock to a newly formed corporation.

Control without dissolution: When one company achieves legal control over another by acquiring a majority of voting stock, although control is present, no dissolution takes place. Each company remains in existence as an incorporated operation.

A statutory consolidation occurs when two or more companies transfer either their assets or their capital stock to a newly formed corporation. Both original companies are dissolved, leaving only the new organization in existence. A business combination effected in this manner is a statutory consolidation. The use here of the term consolidation should not be confused with the accounting meaning of that same word. In accounting, consolidation refers to the mechanical process of bringing together the financial records of two or more organizations to form a single set of statements. A statutory consolidation denotes a specific type of business combination that has united two or more existing companies under the ownership of a newly created company.

Another type of business combination is when one company achieves legal control over another by acquiring a majority of voting stock. Although control is present, no dissolution takes place; each company remains in existence as an incorporated operation. NBC Universal, as an example, continues to retain its legal status as a corporation after being acquired by Comcast Corporation. Separate incorporation is frequently preferred to take full advantage of any intangible benefits accruing to the acquired company as a going concern. Better utilization of such factors as licenses, trade names, employee loyalty, and the company’s reputation can be possible when the subsidiary maintains its own legal identity. Moreover, maintaining an independent information system for a subsidiary often enhances its market value for an eventual sale or initial public offering as a stand-alone entity.

Because the asset and liability account balances are not physically combined as in statutory mergers and consolidations, each company continues to maintain an independent accounting system. To reflect the combination, the acquiring company enters the takeover transaction into its own records by establishing a single investment asset account. However, the newly acquired subsidiary omits any recording of this event; its stock is simply transferred to the parent from the subsidiary’s shareholders. Thus, the subsidiary’s financial records are not directly affected by a takeover.

Types of Business Combinations—Variable Interest Entity (VIE)

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Variable interest entity (VIE): Vehicle for control exercised through contractual arrangements with a sponsoring firm that may not own the VIE but becomes its “primary beneficiary” with rights to its residual profits.

Contract forms include leases, participation rights, guarantees, or other interests. Criticized in the past for providing sponsoring firms with off-balance-sheet financing and sometimes questionable profits.

Current GAAP expands the notion of control and thus requires consolidation of VIEs by their primary beneficiary.

A final vehicle for control of another business entity does not involve a majority voting stock interest or direct ownership of assets. Control of a variable interest entity (VIE) by design often does not rest with its equity holders. Instead, control is exercised through contractual arrangements with a sponsoring firm that, although it technically may not own the VIE, becomes its “primary beneficiary” with rights to its residual profits. These contracts can take the form of leases, participation rights, guarantees, or other interests. Past use of VIEs was criticized because these structures provided sponsoring firms with off-balance-sheet financing and sometimes questionable profits on sales to their VIEs. Prior to 2004, many sponsoring entities of VIEs did not technically meet the definition of a controlling financial interest (i.e., majority voting stock ownership) and thus did not consolidate their VIEs. Current GAAP, however, expands the notion of control and thus requires consolidation of VIEs by their primary beneficiary.

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Formats of Business Combinations

EXHIBIT 2.2 Business Combinations

Business combinations are created in many distinct forms. The specific format is a critical factor in the subsequent consolidation of financial information. Exhibit 2.2 provides an overview of the various combinations.

FASB Control Model

The FASB ASC (810-10-15-8) provides guidance and describes control as follows:

The usual condition for a controlling financial interest is ownership of a majority voting interest, and, therefore, as a general rule ownership by one reporting entity, directly or indirectly, of more than 50 percent of the outstanding voting shares of another entity is a

condition pointing toward consolidation.

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The definition of control is central to determining when two or more entities become one economic entity and therefore one reporting entity. Control of one firm by another is most often achieved through the acquisition of voting shares. The ASC (810-10-15-8) describes control as follows:

By exercising majority voting power, one firm can literally dictate the financing and operating activities of another firm. Accordingly, U.S. GAAP traditionally has pointed to a majority voting share ownership as a controlling financial interest that requires consolidation.

Notably, the power to control may also exist with less than 50 percent of the outstanding shares of another entity. The ASC (810-10-15-8) goes on to observe that:

The power to control may also exist with a lesser percentage of ownership, for example, by contract, lease, agreement with other stockholders, or by court decree.

When one company gains control over another, a business combination is created, and a single set of consolidate financial statements must be prepared. How?

Parent’s and subsidiary’s financial data are brought together.

Financial position, results of operations, and cash flows are reported for the combined entity.

Reciprocal accounts and intra-entity transactions are adjusted or eliminated to ensure reported balances represent the single entity.

Consolidation of Financial Information

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When one company gains control over another, a business combination is established. Financial data gathered from the individual companies are then brought together to form a single set of consolidated statements. Although this process can be complicated, the objectives of a consolidation are straightforward—to report the financial position, results of operations, and cash flows for the combined entity. As a part of this process, reciprocal accounts and intra-entity transactions must be adjusted or eliminated to ensure that all reported balances truly represent the single entity. Applicable consolidation procedures vary significantly depending on the legal format employed in creating a business combination.

What Is to Be Consolidated and When?

If dissolution occurs: All appropriate account balances are physically consolidated in the financial records of the survivor. Permanent consolidation occurs at the combination date.

If separate incorporation is maintained: Only the financial statement information (on work papers, not the actual records) is consolidated. The consolidation process is carried out at regular intervals whenever financial statements are to be prepared.

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What is to be consolidated?

If dissolution takes place, appropriate account balances are physically consolidated in the surviving company’s financial records.

If separate incorporation is maintained, only the financial statement information (not the actual records) is consolidated

When does the consolidation take place?

If dissolution occurs, a permanent consolidation occurs at the combination date.

If separate incorporation is maintained, the consolidation process is carried out at regular intervals whenever financial statements are to be prepared.

How Does Consolidation Affect the Accounting Records?

If dissolution occurs:

Dissolved company’s records are closed out. Surviving company’s accounts are adjusted to include appropriate balances of the dissolved company.

If separate incorporation is maintained:

Each company continues to retain its own records. Worksheets facilitate the periodic consolidation process without disturbing individual accounting systems.

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How does consolidation affect the accounting records?

If dissolution takes place, the surviving company’s accounts are adjusted to include appropriate balances of the dissolved company. The dissolved company’s records are closed out.

If separate incorporation is maintained, each company continues to retain its own records. Using worksheets facilitates the periodic consolidation process without disturbing individual accounting systems.

Learning Objective 2-4

Describe the valuation principles of the acquisition method.

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LO 2-4: Describe the valuation principles of the acquisition method.

The Acquisition Method

The acquisition method is required to account for a business combination. It embraces the fair value in measuring the acquirer’s interest in the acquired business.

Applying the acquisition method involves using fair value to recognize and measure:

The consideration transferred for the acquired business and any noncontrolling interest.

Separately identified assets acquired and liabilities assumed.

Goodwill, or a gain from a bargain purchase.

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Regardless of whether the acquired firm maintains its separate incorporation or dissolution takes place, current standards require the acquisition method to account for business combinations. Applying the acquisition method involves recognizing and measuring

The consideration transferred for the acquired business and any noncontrolling interest.

The separately identified assets acquired and liabilities assumed.

Goodwill, or a gain from a bargain purchase.

Fair value is the measurement attribute used to recognize these and other aspects of a business combination.

Fair Value

GAAP requires that fair value of assets acquired and liabilities assumed in a business combination be determined at the acquisition date.

Fair value: The price that would be received from selling an asset or paid for transferring a liability in an orderly transaction between market participants at the measurement date.

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LO 5

Fair value, as defined by GAAP, is the price that would be received from selling an asset or paid for transferring a liability in an orderly transaction between market participants at the measurement date. However, determining the acquisition-date fair values of the individual assets acquired and liabilities assumed can prove challenging.

Valuation Techniques

ASC (820-10-35-28) identifies three valuation techniques:

The market approach estimates fair values using other market transactions involving similar assets or liabilities.

The income approach relies on multi-period estimates of future cash flows projected to be generated by an asset.

The cost approach estimates fair values by reference to the current cost of replacing an asset with another of comparable economic utility.

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LO 5

The ASC (820-10-35-28) points to three sets of valuation techniques typically employed: the market approach, the income approach, and the cost approach.

The market approach estimates fair values using other market transactions involving similar assets or liabilities. In a business combination, assets acquired such as marketable securities and some tangible assets may have established markets that can provide comparable market values for estimating fair values. Similarly, the fair values of many liabilities assumed can be determined by reference to market trades for similar debt instruments.

The income approach relies on multi-period estimates of future cash flows projected to be generated by an asset. These projected cash flows are then discounted at a required rate of return that reflects the time value of money and the risk associated with realizing the future estimated cash flows. The multi-period income approach is often useful for obtaining fair value estimates of intangible assets and acquired in-process research and development.

The cost approach estimates fair values by reference to the current cost of replacing an asset with another of comparable economic utility. Used assets can present a particular valuation challenge if active markets only exist for newer versions of the asset. Thus, the cost to replace a particular asset reflects both its estimated replacement cost and the effects of obsolescence. In this sense, obsolescence is meant to capture economic declines in value including both technological obsolescence and physical deterioration. The cost approach is widely used to estimate fair values for many tangible assets acquired in business combinations such as property, plant, and equipment.

Goodwill and Gains on Bargain Purchases

What if the consideration transferred does NOT equal the fair value of the assets acquired?

If the consideration transferred exceeds the net amount of the assets acquired and liabilities assumed, the difference is attributed to the asset goodwill by the acquiring company.

If the fair value of the assets acquired and liabilities assumed exceeds the consideration transferred, a “gain on bargain purchase” is recognized by the acquiring business.

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When the consideration transferred exceeds the acquisition-date net amount of the identified assets acquired and the liabilities assumed, the acquirer recognizes the asset goodwill for the excess. Goodwill is defined as an asset representing the future economic benefits arising in a business combination that are not individually identified and separately recognized. Goodwill often embodies the expected synergies that the acquirer expects to achieve through control of the acquired firm’s assets. Goodwill may also capture non-recognized intangibles of the acquired firm such as employee expertise.

Conversely, if the collective fair value of the net identified assets acquired and liabilities assumed exceeds the consideration transferred, the acquirer recognizes a “gain on bargain purchase.” In such cases, the fair value of the net assets acquired replaces the consideration transferred as the valuation basis for the acquired firm. Bargain purchases can result from business divestitures forced by regulatory agencies or other types of distress sales. Before recognizing a gain on bargain purchase, however, the acquirer must reassess whether it has correctly identified and measured all of the acquired assets and liabilities.

Learning Objective 2-5

Determine the total fair value of the consideration transferred for an acquisition and allocate that fair value to specific subsidiary assets acquired

(including goodwill) and liabilities assumed or to a gain on bargain purchase.

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LO 2-5: Determine the total fair value of the consideration transferred for an acquisition and allocate that fair value to specific subsidiary assets acquired (including goodwill) and liabilities assumed or to a gain on bargain purchase.

Consideration Transferred = Fair Value of Net Assets Acquired Example

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Assume that BigNet agrees to pay cash of $550,000 and to issue 20,000 previously unissued shares of its $10 par value common stock (currently selling for $100 per share) for all of Smallport’s assets and liabilities.

Following the acquisition, Smallport then dissolves itself as a legal entity. The consideration transferred from BigNet to Smallport exactly equals the collective fair values of Smallport’s assets less liabilities.

Assume that after negotiations with the owners of Smallport, BigNet Company agrees to pay cash of $550,000 and to issue 20,000 previously unissued shares of its $10 par value common stock (currently selling for $100 per share) for all of Smallport’s assets and liabilities. Following the acquisition, Smallport then dissolves itself as a legal entity. The consideration transferred from BigNet to Smallport exactly equals the collective fair values of Smallport’s assets less liabilities.

Procedures for Consolidating Financial Information

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The $2,550,000 fair value of the consideration transferred by BigNet equals the collective fair values of Smallport’s assets less liabilities and serves as the basis for recording the combination.

The $2,550,000 fair value of the consideration transferred by BigNet represents the fair value of the acquired Smallport business and serves as the basis for recording the combination in total.

Procedures for Consolidating Financial Information (continued)

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Legal and accounting distinctions divide business combinations into separate categories. Various procedures are utilized in this process according to the following sequence:

Acquisition method when dissolution takes place.

Acquisition method when separate incorporation is maintained.

When an acquired firm’s legal status is dissolved in a business combination, the continuing firm owns the former firm’s net assets.

Legal as well as accounting distinctions divide business combinations into several separate categories. To facilitate the introduction of consolidation accounting, we present the various procedures utilized in this process according to the following sequence:

Acquisition method when dissolution takes place.

Acquisition method when separate incorporation is maintained.

When an acquired firm’s legal status is dissolved in a business combination, the continuing firm owns the former firm’s net assets.

Acquisition Method When Dissolution Takes Place

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The continuing firm prepares a journal entry to record

Fair value of the consideration transferred to acquire the dissolved firm.

Identified assets acquired and liabilities assumed at their individual fair values.

The entry to record the fair value of the combination depends on whether the consideration transferred is equal to, exceeds, or is less than the fair value of the net assets of the firm dissolved.

When the acquired firm’s legal status is dissolved in a business combination, the continuing firm takes direct ownership of the former firm’s assets and assumes its liabilities. Thus, the continuing firm will prepare a journal entry to record

The fair value of the consideration transferred by the acquiring firm to the former owners of the acquiree and

The identified assets acquired and liabilities assumed at their individual fair values.

However, the entry to record the combination further depends on the relation between the consideration transferred and the net amount of the fair values assigned to the identified assets acquired and liabilities assumed.

Learning Objective 2-6a

Prepare the journal entry to consolidate the accounts of a subsidiary if dissolution

takes place.

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LO 2-6a: Prepare the journal entry to consolidate the accounts of a subsidiary if dissolution takes place.

Consideration Transferred = Fair Values of Net Assets Acquired—Subsidiary Dissolved

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Under the acquisition method, BigNet records Smallport’s assets and liabilities at fair value, ignoring original book values. Revenue, expense, dividend, and equity accounts cannot be transferred to a parent and are not included.

Because Smallport Company will be dissolved, BigNet (the surviving company) enters a journal entry in its financial records to record the combination. BigNet has directly acquired the assets and assumed the liabilities of Smallport. Under the acquisition method, BigNet records Smallport’s assets and liabilities at fair value, ignoring original book values. Revenue, expense, dividend, and equity accounts cannot be transferred to a parent and are not included in recording the business combination.

Consideration Transferred Exceeds Fair Values of Net Assets Acquired and Liabilities Assumed

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BigNet transfers to the owners of Smallport consideration of $1,000,000 in cash plus 20,000 shares of common stock with a fair value of $100 per share in exchange for ownership of the company. The $3,000,000 consideration transferred from BigNet to Smallport results in an excess amount exchanged over the fair value of the net assets acquired.

When the consideration transferred in an acquisition exceeds total net fair value of the identified assets and liabilities, the excess ($450,000 in this case) is allocated to an unidentifiable asset known as goodwill.

BigNet transfers to the owners of Smallport consideration of $1,000,000 in cash plus 20,000 shares of common stock with a fair value of $100 per share in exchange for ownership of the company. The consideration transferred from BigNet to Smallport results in an excess amount exchanged over the fair value of the net assets acquired.

Journal Entry to Record an Acquisition Resulting in Goodwill

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BigNet’s $3,000,000 consideration results in $450,000 in excess of the fair value of Smallport’s net assets. BigNet records $450,000 in goodwill and the fair value of each asset and liability in the following journal entry at the acquisition date.

Returning to BigNet’s $3,000,000 consideration, $450,000 is in excess of the fair value of Smallport’s net assets. Thus, goodwill of that amount is entered into BigNet’s accounting system along with the fair value of each individual asset and liability. BigNet makes the journal entry at the date of acquisition as shown.

Consideration Transferred Is Less Than Net Identified Asset Fair Values

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An exception to the general rule of recording business acquisitions at fair value of the consideration transferred occurs in the rare circumstance of a bargain purchase.

Bargain purchase: The fair value of the consideration transferred by the acquirer is less than the fair value received in an acquisition, which is considered more relevant for asset valuation than the consideration transferred.

A bargain purchase is when the fair value of the consideration transferred by the acquirer is less than the fair value received in an acquisition.

A consequence of implementing a fair-value concept to acquisition accounting is the recognition of an unrealized gain on the bargain purchase. A criticism of the gain recognition is that the acquirer recognizes profit from a buying activity that occurs prior to traditional accrual measures of earned income (i.e., selling activity). Nonetheless, an exception to the general rule of recording business acquisitions at fair value of the consideration transferred occurs in the rare circumstance of a bargain purchase. Thus, in a bargain purchase, the fair values of the assets received and all liabilities assumed in a business combination are considered more relevant for asset valuation than the consideration transferred.

Journal Entry to Record a Bargain Purchase

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BigNet transfers consideration of $2,000,000 to the owners of Smallport in exchange for their business. BigNet conveys no cash and issues 20,000 shares of $10 par common stock that has a $100 per share fair value. The consideration transferred from BigNet to Smallport results in a gain on bargain purchase.

Learning Objective 2-6b

Prepare the journal entry to record the various related costs involved in a business combination.

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LO 2-6b: Prepare the journal entry to record the various related costs involved in a business combination.

Related Costs of Business Combinations

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Three additional categories of costs are incurred in business combinations, regardless of whether dissolution takes place:

Attorneys, accountants, investment bankers, and other professionals engaged for combination-related services. These service fees are expensed in the period incurred.

An acquiring firm’s internal costs (secretarial and management time allocated to the acquisition activity). Such indirect costs are reported as current year expenses, too.

Amounts incurred to register and issue securities in connection with a business combination simply reduce the otherwise determinable fair value of those securities.

Three additional categories of costs typically accompany business combinations, regardless of whether dissolution takes place. First, firms often engage attorneys, accountants, investment bankers, and other professionals for combination-related services. The acquisition method does not consider such expenditures as part of the fair value received by the acquirer. Therefore, professional service fees are expensed in the period incurred. The second category concerns an acquiring firm’s internal costs. Examples include secretarial and management time allocated to the acquisition activity. Such indirect costs are reported as current year expenses, too. Finally, amounts incurred to register and issue securities in connection with a business combination simply reduce the otherwise determinable fair value of those securities. Exhibit 2.5 summarizes the three categories of related payments that accompany a business combination and their respective accounting treatments.

Journal Entry to Record Related Costs of Business Combinations

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Regardless of whether dissolution occurs or separate incorporation is maintained, BigNet records these transactions as follows:

Following the acquisition method, regardless of whether dissolution occurs or separate incorporation is maintained, BigNet would record these transactions as shown.

Learning Objective 2-6c

Prepare the journal entry to record a business combination when the acquired firm retains its separate existence.

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LO 2-6c: Prepare the journal entry to record a business combination when the acquired firm retains its separate existence.

The Acquisition Method When Separate Incorporation Is Maintained

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Significant differences are evident in combinations in which each company remains a legally incorporated separate entity.

Consolidation of the financial information is only simulated.

Acquiring company does not physically record the acquired assets and liabilities.

Dissolution does not occur; each company maintains independent record-keeping.

To facilitate the preparation of consolidated financial statements, a worksheet and consolidation entries are employed using data gathered from these separate companies although neither company ever records consolidation worksheet entries in its journals.

Several significant differences are evident in combinations in which each company remains a legally incorporated separate entity. Most noticeably, the consolidation of the financial information is only simulated; the acquiring company does not physically record the acquired assets and liabilities. Because dissolution does not occur, each company maintains independent record-keeping. To facilitate the preparation of consolidated financial statements, a worksheet and consolidation entries are employed using data gathered from these separate companies.

A worksheet provides the structure for generating financial reports for the single economic entity. An integral part of this process employs consolidation worksheet entries that either adjust or eliminate various account balances of the parent and subsidiary. These adjustments and eliminations are entered on the worksheet to produce consolidated statements as if the financial records had been physically combined. Because no actual union occurs, neither company ever records consolidation worksheet entries in its journals. Instead, these adjustments and eliminations appear solely on the worksheet to derive consolidated balances for financial reporting purposes.

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BigNet acquires Smallport Company on December 31 by issuing 26,000 shares of $10 par value common stock valued at $100 per share. BigNet pays fees of $40,000 to a third party for its assistance.

BigNet promises to pay an additional $83,200 to the former owners if Smallport’s earnings exceed $300,000 during the next annual period, with an expected present value of $20,000 for the contingent liability as shown below.

Acquisition Method—Subsidiary Is Not Dissolved

Assume that BigNet acquires Smallport Company on December 31 by issuing 26,000 shares of $10 par value common stock valued at $100 per share (or $2,600,000 in total). BigNet pays fees of $40,000 to a third party for its assistance in arranging the transaction.

Then, to settle a difference of opinion regarding Smallport’s fair value, BigNet promises to pay an additional $83,200 to the former owners if Smallport’s earnings exceed $300,000 during the next annual period. BigNet estimates a 25 percent probability that the $83,200 contingent payment will be required. A discount rate of 4 percent (to represent the time value of money) yields an expected present value of $20,000 for the contingent liability ($83,200 × 25% × 0.961538). The fair-value approach of the acquisition method views such contingent payments as part of the consideration transferred. According to this view, contingencies have value to those who receive the consideration and represent measurable obligations of the acquirer. (The ASC [805-30-35-1] notes several reasons for contingent consideration including meeting an earnings target, reaching a specified share price, or reaching a milestone on a research and development project.) Therefore, the fair value of the consideration transferred in this example consists of the following two elements:

Fair value of securities issued by BigNet..................... $2,600,000

Fair value of contingent performance liability ............. 20,000

Total fair value of consideration transferred................. $2,620,000

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When the subsidiary remains separate, the parent establishes an investment account that initially reflects the acquired firm’s acquisition-date fair value. Because Smallport maintains its separate identity, BigNet prepares the following journal entries on its books to record the business combination.

Acquisition Method—Subsidiary Is Not Dissolved (continued)

Although the assets and liabilities are not transferred, BigNet must still record the consideration provided to Smallport’s owners. When the subsidiary remains separate, the parent establishes an investment account that initially reflects the acquired firm’s acquisition-date fair value. Because Smallport maintains its separate identity, BigNet prepares the journal entries on its books to record the business combination as shown.

Learning Objective 2-7

Prepare a worksheet to consolidate the financial statements of two companies that form a business combination in the absence of dissolution.

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LO 2-7: Prepare a worksheet to consolidate the financial statements of two companies that form a business combination in the absence of dissolution.

Acquisition Method—Consolidation Workpaper Example

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A worksheet can be prepared on the date of acquisition to arrive at consolidated totals for this combination. The entire process consists of six steps.

Consolidation Worksheet Entries

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Consolidation worksheet entries (adjustments and eliminations) are entered on the worksheet only.

Steps in the process:

Prior to constructing a worksheet, the parent prepares a formal allocation of the acquisition-date fair value similar to the equity method procedures.

Consolidation worksheet entries (adjustments and eliminations) are entered on the worksheet only.

Steps in the process:

Prior to constructing a worksheet, the parent prepares a formal allocation of the acquisition-date fair value similar to the equity method procedures.

Consolidation Worksheet Entries (continued)

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Acquisition-date financial information for parent (after journal entry for the investment and combination costs) and sub is recorded in the first two columns of the worksheet (sub’s prior revenue and expense already closed).

Remove the sub’s equity account balances and remove the Investment in Sub balance (Entry S).

Remove the excess payment in the investment account at acquisition date and assign it to the specific accounts indicated by the fair-value allocation schedule (Entry A).

The consolidation process begins with preparing the first two columns of the worksheet (see Exhibit 2.6) containing the separate companies’ acquisition-date book value financial figures (see Exhibit 2.3). BigNet’s accounts have been adjusted for the journal entries recorded earlier for the investment and the combination costs. As another preliminary step, Smallport’s revenue, expense, and dividend accounts have been closed into its Retained Earnings account. The subsidiary’s operations prior to the December 31 takeover have no direct bearing on the operating results of the business combination. These activities occurred before Smallport was acquired; thus, the new owner should not include any precombination subsidiary revenues or expenses in the consolidated statements.

Consolidation Entry S eliminates Smallport’s stockholders’ equity accounts (S is a reference to beginning subsidiary stockholders’ equity). Consolidation Entry S is a worksheet entry and accordingly does not affect the financial records of either company. The subsidiary balances (Common Stock, Additional Paid-In Capital, and Retained Earnings) represent ownership interests held by the parent in their entirety and thus no longer are outstanding. By removing these account balances on the worksheet, only Smallport’s assets and liabilities remain to be combined with the parent company figures. Consolidation Entry S also removes the $600,000 component of the parent’s Investment in Smallport Company account balance that equates to the book value of the subsidiary’s net assets. For external reporting purposes, BigNet should include each of Smallport’s assets and liabilities rather than a single investment balance. In effect, this portion of the parent’s Investment in Smallport Company account balance is deleted and replaced by the specific subsidiary assets and liabilities that are already listed in the second column of the worksheet.

Consolidation Entry A removes the excess payment in the Investment in Smallport Company and assigns it to the specific accounts indicated by the fair-value allocation schedule. Consequently, Computers and Equipment is increased by $200,000 to agree with Smallport’s fair value: $1,100,000 is attributed to Capitalized Software, $700,000 to Customer Contracts, and $50,000 to Notes Payable. The unidentified excess of $70,000 is allocated to Goodwill. This consolidation worksheet entry is labeled Entry A to indicate that it represents the Allocations made in connection with Smallport’s acquisition-date fair value. It also completes the Investment in Smallport Company account balance elimination on the worksheet.

Acquisition Method—Consolidation Workpaper Journal Entries

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Consolidation Entry A

Consolidation Entry S

Consolidation Entry S eliminates Smallport’s stockholders’ equity accounts as shown.

Consolidation Entry A removes the $2,020,000 excess payment in the Investment in Smallport Company and assigns it to the specific accounts indicated by the fair-value allocation schedule as shown.

Consolidation Worksheet Entries (concluded)

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Combine all account balances and extend into the Consolidated Totals column.

Subtract consolidated expenses from revenues to arrive at net income.

All accounts are extended into the Consolidated Totals column. For accounts such as Current Assets, this process simply adds Smallport and BigNet book values. However, when applicable, this extension also includes any allocations to establish the acquisition-date fair values of Smallport’s assets and liabilities. Computers and Equipment, for example, is increased by $200,000. By increasing the subsidiary’s book value to fair value, the reported balances are the same as in the previous example when dissolution occurred. The use of a worksheet does not alter the consolidated figures but only the method of deriving those numbers.

We subtract consolidated expenses from revenues to arrive at net income. Note that because this is an acquisition-date worksheet, we consolidate no amounts for Smallport’s revenues and expenses. Having just been acquired, Smallport has not yet earned any income for BigNet owners. Consolidated revenues, expenses, and net income are identical to BigNet’s balances. Subsequent to acquisition, of course, Smallport’s revenue and expense accounts will be consolidated with BigNet’s

Learning Objective 2-8

Describe the accounting treatment for the various intangible assets often acquired in a business combination.

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LO 2-8: Describe the accounting treatment for the various intangible assets often acquired in a business combination.

Acquisition-Date Fair-Value Allocations

In determining whether to recognize an intangible

asset in a business combination, two specific criteria are essential. Intangible assets:

Arise from contractual or other legal rights (most intangibles in business combinations meet the contractual-legal criterion).

Are capable of being sold or otherwise separated from the acquired enterprise.

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Intangible assets include both current and noncurrent assets (not including financial instruments) that lack physical substance. In determining whether to recognize an intangible asset in a business combination, two specific criteria are essential.

Does the intangible asset arise from contractual or other legal rights?

Is the intangible asset capable of being sold or otherwise separated from the acquired enterprise?

Intangibles arising from contractual or legal rights are commonplace in business combinations. Often identified among the assets acquired are trademarks, patents, copyrights, franchise agreements, and a number of other intangibles that derive their value from governmental protection (or other contractual agreements) that allow a firm exclusive use of the asset. Most intangible assets recognized in business combinations meet the contractual-legal criterion.

Also seen in business combinations are intangible assets meeting the separability criterion. An acquired intangible asset is recognized if it is capable of being separated or divided from the acquiree and sold, transferred, licensed, rented, or exchanged individually or together with a related contract, identifiable asset, or liability. The acquirer is not required to have the intention to sell, license, or otherwise exchange the intangible in order to meet the separability criterion.

Intangible Assets That Meet the Criteria for Recognition Separately from Goodwill

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The intangible assets designated by the symbol (c) could meet the separability criterion. However, separability is not a necessary condition for an asset to meet the contractual-legal criterion.

Acquisition-Date Fair-Value Allocations—Additional Issues

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Preexisting goodwill recorded in the acquired company’s accounts is ignored in the acquisition-date fair value. Goodwill is recognized only if excess remains after recognizing fair values of net identified assets.

Acquired IPR&D (acquired businesses to in-process research and development) is measured at acquisition-date fair value, recognized as an asset, and tested for impairment. It is not amortized until its useful life is determined to be no longer indefinite.

By its very nature, preexisting goodwill is not considered identifiable by the parent. Therefore, the new owner simply ignores it in allocating the acquisition-date fair value. The logic is that the total business fair value is first allocated to the identified assets and liabilities. Only if an excess amount remains after recognizing the fair values of the net identified assets is any goodwill recognized.

Accounting for a business combination begins with the identification of the tangible and intangible assets acquired and liabilities assumed by the acquirer. The fair values of the individual assets and liabilities then provide the basis for financial statement valuations. Many firms—especially those in pharmaceutical and high-tech industries—have allocated significant portions of acquired businesses to in-process research and development (IPR&D).

Current accounting standards require that acquired IPR&D be measured at acquisition-date fair value and recognized in consolidated financial statements as an asset. An acquired IPR&D asset is tested for impairment and is not amortized until its useful life is determined to be no longer indefinite.

Convergence between U.S. and International Accounting Standards

FASB Project Updates: Business Combinations: Applying the Acquisition Method—Joint Project of the IASB and FASB: October 25, 2007) goal was to develop a standard with a common set of principles and guidance.

IASB International Financial Reporting Standard 3 (IFRS 3) Revised and FASB ASC Topics 805, “Business Combinations,” and 810, “Consolidation,” effectively converged accounting for business combinations.

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The FASB ASC Topics “Business Combinations” (805) and “Consolidation” (810) represent outcomes of a joint project between the FASB and the International Accounting Standards Board (IASB). The primary objective of the project was stated as follows:

to develop a single high-quality standard for business combinations that can be used for both domestic and cross-border financial reporting. The goal is to develop a standard that includes a common set of principles and related guidance that produces decision-useful information and minimizes exceptions to those principles. The standard should improve the completeness, relevance, and comparability of financial information about business combinations. . . (FASB Project Updates: Business Combinations: Applying the Acquisition Method—Joint Project of the IASB and FASB: October 25, 2007)

The IASB subsequently issued International Financial Reporting Standard 3 (IFRS 3) Revised (effective July 2009), which along with FASB ASC Topics 805, “Business Combinations,” and 810, “Consolidation,” effectively converged the accounting for business combinations internationally.

Learning Objective 2-9

Appendix 2A: Identify the general characteristics of the legacy purchase and pooling of interest methods of accounting for past business combinations. Understand the effects that persist today in financial statements from the use of these legacy methods.

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LO 2-9: Appendix 2A: Identify the general characteristics of the legacy purchase and pooling of interest methods of accounting for past business combinations. Understand the effects that persist today in financial statements from the use of these legacy methods.

Appendix 2A: Legacy Methods of Accounting for Business Combinations

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

2002 to 2008: Purchase Method

Prior to 2002: Purchase Method or Pooling of Interests Method

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The acquisition method provides the accounting for business combinations occurring in 2009 and thereafter. However, for decades, business combinations were accounted for using either the purchase or pooling of interests method. From 2002 through 2008, the purchase method was used exclusively for business combinations. Prior to 2002, financial reporting standards allowed two alternatives: the purchase method and the pooling of interests method. Because the FASB required prospective application of the acquisition method for 2009 and beyond, the purchase and pooling of interests methods continue to provide the basis for financial reporting for pre-2009 business combinations and thus will remain relevant for many years. Literally tens of thousands of past business combinations will continue to be reported in future statements under one of these legacy methods.

Purchase Method: An Application of the Cost Principle

How the cost-based purchase method differs from the fair-value-based acquisition method:

Acquisition date allocations (including bargain purchases).

Direct combination costs.

Contingent consideration.

In-process R&D.

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A basic principle of the purchase method was to record a business combination at the cost to the new owners.

Several elements of the purchase method reflect a strict application of the cost principle. The following items represent examples of how the cost-based purchase method differs from the fair-value-based acquisition method.

Acquisition date allocations (including bargain purchases).

Direct combination costs.

Contingent consideration.

In-process research and development.

Purchase-Date Cost Allocations (Including Bargain Purchases)

The purchase method based its cost allocations on the combination-date fair values of the acquired assets and liabilities.

Excess of cost over the sum of the net identified asset fair values was attributed to goodwill.

A bargain purchase occurred when the sum of the individual fair values of the acquired net assets exceeded the purchase cost.

To record a bargain purchase at cost, however, the purchase method required that certain long-term assets be recorded at amounts below their assessed fair values.

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In pre-2009 business combinations, the application of the cost principle often was complicated because literally hundreds of separate assets and liabilities were acquired. Accordingly, for asset valuation and future income determination, firms needed a basis to allocate the total cost among the various assets and liabilities received in the bargained exchange. Similar to the acquisition method, the purchase method based its cost allocations on the combination-date fair values of the acquired assets and liabilities. Also closely related to the acquisition method procedures, any excess of cost over the sum of the net identified asset fair values was attributed to goodwill.

But the purchase method stands in marked contrast to the acquisition method in bargain purchase situations. Under the purchase method, a bargain purchase occurred when the sum of the individual fair values of the acquired net assets exceeded the purchase cost. To record a bargain purchase at cost, however, the purchase method required that certain long-term assets be recorded at amounts below their assessed fair values.

Acquirer measures and recognizes fair values of each of the assets acquired and liabilities assumed at the date of combination, regardless of consideration transferred. Therefore:

No assets are recorded at amounts below their assessed fair values, as is the case with bargain purchases accounted for by the purchase method.

A gain on bargain purchase is recognized at the acquisition date.

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Purchase-Date Cost Allocations (Including Bargain Purchases) (continued)

Note that current assets and liabilities did not share in the proportionate reduction to cost. Long-term assets were subject to the reduction because their fair-value estimates were considered less reliable than current items and liabilities. Finally, in rare situations, firms recognized an extraordinary gain on a purchase but only in the very unusual case that the long-term assets were reduced to a zero valuation.

In contrast, the acquisition method embraces the fair-value concept and discards the consideration transferred as a valuation basis for the business acquired in a bargain purchase. Instead, the acquirer measures and recognizes the fair values of each of the assets acquired and liabilities assumed at the date of combination, regardless of the consideration transferred in the transaction. As a result, (1) no assets are recorded at amounts below their assessed fair values, as is the case with bargain purchases accounted for by the purchase method, and (2) a gain on bargain purchase is recognized at the acquisition date.

Direct Combination Costs and Contingent Consideration

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Under the purchase method, the investment cost basis included direct combination costs for professional services to assist in various phases of the transaction.

Contingent consideration obligations arising from agreements to provide additional payments to former owners if they meet specified future performance measures are accounted for as postcombination adjustments to the purchase cost (or stockholders’ equity if the parent’s equity share value is involved) upon resolution of the contingency.

Almost all business combinations employ professional services to assist in various phases of the transaction. Examples include target identification, due diligence regarding the value of an acquisition, financing, tax planning, and preparation of formal legal documents. Prior to 2009, under the purchase method, the investment cost basis included direct combination costs.

Often business combination negotiations result in agreements to provide additional payments to former owners if they meet specified future performance measures. The purchase method accounted for such contingent consideration obligations as postcombination adjustments to the purchase cost (or stockholders’ equity if the contingency involved the parent’s equity share value) upon resolution of the contingency.

In-Process Research and Development

Under the purchase method, financial reporting standards required immediate expensing of acquired IPR&D if the project had not yet reached technological feasibility and the assets had no future alternative uses.

Expensing acquired IPR&D was consistent with the accounting treatment for a firm’s ongoing research and development costs.

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Prior to 2009, financial reporting standards required the immediate expensing of acquired IPR&D if the project had not yet reached technological feasibility and the assets had no future alternative uses. Expensing acquired IPR&D was consistent with the accounting treatment for a firm’s ongoing research and development costs.

The Pooling of Interests Method: Continuity of Previous Ownership

Under the pooling of interests method, owners of separate firms agreed to combine for mutual benefit and continue as owners of a combined firm.

Assets and liabilities were never bought or sold. Owners exchanged ownership shares to become joint owners of the combined firm.

One ownership group did not replace another. The method assured continuity of ownership interests before and after the business combination.

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Historically, former owners of separate firms would agree to combine for their mutual benefit and continue as owners of a combined firm. It was asserted that the assets and liabilities of the former firms were never really bought or sold; former owners merely exchanged ownership shares to become joint owners of the combined firm. Combinations characterized by exchange of voting shares and continuation of previous ownership became known as pooling of interests. Rather than an exchange transaction with one ownership group replacing another, a pooling of interests was characterized by a continuity of ownership interests before and after the business combination. Prior to its elimination, this method was applied to a significant number of business combinations.

The Pooling of Interests Method Process

Two important steps characterized the pooling of interests method:

The book values of the assets and liabilities of both companies became the book values reported by the combined entity.

The revenue and expense accounts were combined retrospectively as well as prospectively. The idea of continuity of ownership gave support for the recognition of income accruing to the owners both before and after the combination.

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To reflect the continuity of ownership, two important steps characterized the pooling of interests method:

The book values of the assets and liabilities of both companies became the book values reported by the combined entity.

Pooling of Interests Review

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Reported income was typically higher than under the purchase accounting method.

There was less depreciation and amortization expense due to the smaller asset bases.

Prior to 2002, both the purchase and pooling of interest methods were allowed.

New standards set strict criteria for use of the pooling method.

If business combinations failed to meet the criteria, they had to be accounted for by the purchase method.

Therefore, in a pooling, reported income was typically higher than under the contemporaneous purchase accounting. Under pooling, not only did the firms retrospectively combine incomes but also the smaller asset bases resulted in smaller depreciation and amortization expenses. Because net income reported in financial statements often is used in a variety of contracts, including managerial compensation, managers considered the pooling method an attractive alternative to purchase accounting.

Prior to 2002, accounting and reporting standards allowed both the purchase and pooling of interest methods for business combinations. However, standard setters established strict criteria for use of the pooling method. The criteria were designed to prevent managers from engaging in purchase transactions and then reporting them as poolings of interests. Business combinations that failed to meet the pooling criteria had to be accounted for by the purchase method.

Pooling of Interests Criteria

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Objectives of the criteria:

To ensure complete fusion of the two organizations, one company had to obtain substantially all (90 percent or more) of the voting stock of the other.

To prevent purchase combinations from being disguised as poolings.

Past experience had shown that combination transactions were frequently manipulated so that they would qualify for pooling of interests treatment (usually to increase reported earnings). A number of qualifying criteria for pooling of interests treatment were designed to stop this practice.

These criteria had two overriding objectives. First, to ensure the complete fusion of the two organizations, one company had to obtain substantially all (90 percent or more) of the voting stock of the other. The second general objective of these criteria was to prevent purchase combinations from being disguised as poolings. Past experience had shown that combination transactions were frequently manipulated so that they would qualify for pooling of interests treatment (usually to increase reported earnings). However, subsequent events, often involving cash being paid or received by the parties, revealed the true nature of the combination: One company was purchasing the other in a bargained exchange. A number of qualifying criteria for pooling of interests treatment were designed to stop this practice.

Characteristics of the Purchase Method

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Characteristics of the purchase method:

Valuation basis is cost and includes direct combination costs but excludes the contingent consideration.

Cost is allocated to the assets acquired and liabilities assumed based on their individual fair values (unless a bargain purchase occurs and then the long-term items may be recorded as amounts less than their fair values).

Goodwill is the excess of cost over the fair values of the net assets purchased.

Acquired in-process research and development is expensed immediately at the purchase date.

Note the following characteristics of the purchase method:

The valuation basis is cost and includes direct combination costs but excludes the contingent consideration.

The cost is allocated to the assets acquired and liabilities assumed based on their individual fair values (unless a bargain purchase occurs and then the long-term items may be recorded as amounts less than their fair values).

Goodwill is the excess of cost over the fair values of the net assets purchased.

Acquired in-process research and development is expensed immediately at the purchase date.

Characteristics of the Pooling of Interests Method

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Characteristics of the pooling of interests method:

Accounting incorporated a continuation of previous book values and ignored fair values exchanged in a business combination.

Previously unrecognized (typically internally developed) intangibles continue to be reported at a zero value postcombination.

Values an acquired firm at its previously recorded book value, so no new amount for goodwill was ever recorded in a pooling.

Note the following characteristics of the pooling of interests method:

Because a pooling of interests was predicated on a continuity of ownership, the accounting incorporated a continuation of previous book values and ignored fair values exchanged in a business combination.

Previously unrecognized (typically internally developed) intangibles continue to be reported at a zero value postcombination.

Because the pooling of interests method values an acquired firm at its previously recorded book value, no new amount for goodwill was ever recorded in a pooling.

Characteristics of the Acquisition Method

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Characteristics of the acquisition method:

Valuation basis is fair value of consideration transferred and includes the contingent consideration but excludes direct combination costs.

Assets acquired and liabilities assumed are recorded at their individual fair values.

Goodwill is the excess of the consideration transferred over the fair values of the net assets acquired.

Acquired in-process research and development is recognized as an asset.

Professional service fees to help accomplish the acquisition are expensed.

Note the following characteristics of the acquisition method:

The valuation basis is fair value of consideration transferred and includes the contingent consideration but excludes direct combination costs.

The assets acquired and liabilities assumed are recorded at their individual fair values.

Goodwill is the excess of the consideration transferred over the fair values of the net assets acquired.

Acquired in-process research and development is recognized as an asset.

Professional service fees to help accomplish the acquisition are expensed.

Learning Objective 2-10

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Appendix 2B: Explain the rationale and procedures underlying a subsidiary’s election to adopt pushdown accounting.

LO 2-10: Appendix 2B: Explain the rationale and procedures underlying a subsidiary’s election to adopt pushdown accounting.

Appendix 2B: Pushdown Accounting—External Reporting

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To address valuation issues for a subsidiary’s separately issued financial statements, the FASB issued Accounting Standards Update (ASU) No. 2014-17, Business Combinations: Pushdown Accounting, in November 2014. The ASU:

Does not require pushdown accounting when the acquired firm maintains separate incorporation.

Provides an option to apply pushdown accounting following a business combination in which the acquirer obtains control of an acquired entity and the acquired entity maintains separate incorporation.

If pushdown accounting is used, the parent’s acquisition date valuations are “pushed down” to the subsidiary’s financial statements.

An additional reporting issue arises concerning the separate postacquisition financial statements of subsidiary companies that maintain separate incorporation.

To address the valuation issues for a subsidiary’s separately issued financial statements, the FASB issued Accounting Standards Update (ASU) No. 2014-17, Business Combinations: Pushdown Accounting, in November 2014. The ASU does not require pushdown accounting but instead provides an option to apply pushdown accounting following a business combination in which the acquirer obtains control of an acquired entity and the acquired entity maintains separate incorporation. A newly acquired entity (e.g., subsidiary firm) may elect the option to apply pushdown accounting in the reporting period immediately following the acquisition. Alternatively, a newly acquired company may simply choose to continue using its previous accounting valuations in separately issued financial statements.

When an acquired entity elects to apply pushdown accounting, it reflects in its financial statements the valuations for the individual assets and liabilities used by the parent in allocating the consideration transferred in the acquisition. Thus, the parent’s acquisition-date valuations for its newly acquired subsidiary are “pushed down” to the subsidiary’s financial statements.

Pushdown Accounting—Other Issues

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Goodwill: Goodwill recognized in the combination is reported in the acquired entity’s separate financial statements.

Bargain purchase gains: The acquired entity does not recognize the gain in its income statement but as an adjustment to its additional paid-in capital.

Acquisition-related liabilities: Only the debt for which the acquired firm is jointly or severally liable must be recognized.

Acquisition-date subsidiary retained earnings: Company is recognized as a new reporting entity. Acquired firm reports zero acquisition-date retained earnings.

When an entity elects pushdown accounting, any goodwill recognized in the combination is reported in the acquired entity’s separate financial statements.

An exception to pushdown accounting’s general rule of using the parent’s valuations for the subsidiary’s separate financial statement occurs for bargain purchases. Recall that when the fair values assigned to the subsidiary’s collective net assets exceeds the parent’s consideration transferred, the parent recognizes a bargain purchase gain on its income statement. In this case, however, pushdown accounting requires that the acquired entity not recognize the gain in its income statement but instead as an adjustment to its additional paid-in capital. The reflection of the bargain purchase gain in additional paid-in capital prevents income recognition by both the acquirer and the acquiree for the same event.

When acquisition-related liabilities arise, pushdown accounting recognizes only the debt that the acquired firm must recognize under other generally accepted accounting principles. Thus, if an acquired firm is either jointly or severally liable for repayment of the debt, such debt is pushed down to its separate financial statements, possibly including debt incurred by the acquirer.

After recognizing the new basis for its assets and liabilities, the acquired firm must then report the effects of the acquisition in its owners’ equity section. Because pushdown accounting treats the acquired firm as a new reporting entity, the acquired firm reports zero acquisition-date retained earnings. The elimination of acquisition-date subsidiary retained earnings is consistent with consolidated financial reporting.

Pushdown Accounting—Internal Reporting

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Pushdown accounting has several advantages for internal reporting.

It simplifies the consolidation process.

Amortizations of the excess fair value allocation would be incorporated in subsequent periods as well.

Pushdown accounting does not address the many issues in preparing consolidated financial statements.

Pushdown accounting has several advantages for internal reporting. For example, it simplifies the consolidation process. If the subsidiary enters the acquisition-date fair value allocations into its records, worksheet Entry A (to recognize the allocations originating from the fair-value adjustments) is not needed. Amortizations of the excess fair value allocation (see Chapter 3) would be incorporated in subsequent periods as well.

Despite some simplifications to the consolidation process, pushdown accounting does not address the many issues in preparing consolidated financial statements that appear in subsequent chapters of this text. Therefore, it remains to be seen how many acquired companies will choose to elect pushdown accounting. For newly acquired subsidiaries that expect to issue new debt or eventually undergo an initial public offering, fair values may provide investors with a better understanding of the company.

In summary, pushdown accounting provides a newly acquired subsidiary the option to revalue its assets and liabilities to acquisition-date fair values in its separately reported financial statements. This valuation option may be useful when the parent expects to offer the subsidiary shares to the public following a period of planned improvements. Other benefits from pushdown accounting may arise when the subsidiary plans to issue debt and needs its separate financial statements to incorporate acquisition-date fair values and previously unrecognized intangibles in their standalone financial reports.