NON-PROFIT ACCOUNTING HW

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Chapter Three

Consolidations—Subsequent to

the Date of Acquisition

Learning Objective 3-1

Recognize the complexities in preparing consolidated financial reports that emerge from the passage of time.

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

Consolidation—The Effects Created by the Passage of Time

The passage of time creates complexities for internal record-keeping and the balance of the investment account varies due to the accounting method used.

A worksheet and consolidation entries are used to eliminate the investment account and record the subsidiary’s assets and liabilities to create a single set of financial statements for the combined business entity.

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Despite complexities created by the passage of time, the basic objective of all consolidations 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

A worksheet combines separately recorded revenues and expenses of parent and subsidiary.

Separate record-keeping systems result in subsidiary’s expenses based on original book values, not acquisition-date values that the parent must recognize.

Adjustments are made to reflect amortization of excess consideration transferred from parent over subsidiary’s book value.

Effects of any intra-entity transactions are removed.

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Subsequent to an acquisition, the parent company must report consolidated net income. Consolidated 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 parent’s consideration transferred over the subsidiary book value. Additionally, the effects of any intra-entity transactions are removed.

Investment Accounting—Parent

For internal record-keeping, parent uses an accounting method to monitor the two companies’ relationship.

Parent’s investment account balance and amount of income recognized vary over time depending upon the method chosen.

On the worksheet, parent’s investment account is eliminated so subsidiary’s actual assets and liabilities can be consolidated.

Income accrued by parent is removed and subsidiary’s revenues and expenses are included to create an income statement for the combined business entity.

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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 recognized. 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.

Learning Objective 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.

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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.

Investment Accounting by the Acquiring Company

Record-keeping if parent can exert control over subsidiary:

External financial reporting: Consolidation is required.

Internal record-keeping: Parent selects an investment accounting method to monitor activities of subsidiary.

Three prominent methods used to account for investments are:

Equity method

Initial value method

Partial equity method

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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, and the partial equity method.

At the acquisition date, each investment accounting method (equity, initial value, and partial 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.

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

Advantages of Each Investment Accounting Method

Equity method: Full accrual accounting—creates a total income figure reflective of the entire combined business entity.

Initial value (or “cost”) method: Cash basis accounting—easy to apply and gives a good measurement of cash flows generated by the investment.

Partial equity method: Accrual accounting without equity adjustments—usually gives balances approximating consolidation figures but easier to apply than equity method.

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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 combination 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. The equity method creates a parallel between the parent’s investment accounts and changes in the underlying equity of the acquired company.

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.

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 acquisition date.

The initial value method might be selected because the parent does not require an accrual-based income measure of subsidiary performance. Some firms may find the initial value method’s ease of application 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.

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.

Summary of Three Internal Accounting Techniques

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Method adopted:

Affects only separate financial records.

Has no impact on subsidiary’s balances.

Does not affect amounts reported on consolidated financial statements to external users.

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 internally 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.

Learning Objective 3-3a

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

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

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. Sun Company’s balances are shown below.

Subsequent Consolidation—Equity Method Example

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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 are given.

Equity Method Example—Allocation of Subsidiary Fair Value

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EXHIBIT 3.2 Excess Fair-Value Allocation

Equity Method Example—Amortization

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EXHIBIT 3.3 Annual Excess Amortization

Amortization includes amortization of definite-lived intangibles and depreciation of tangible assets. The acquisition-date fair value of Sun’s equipment is $30,000 less than its book value, a fair-value reduction and an expense reduction.

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 intangibles 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.

In this example, amortization will be $7,000 annually for five years until the Equipment fair-value reduction is fully removed.

Equity Method Example—Subsequent Consolidation

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Assume Sun Company earns income of $100,000 in 2017, declares a $40,0000 cash dividend August 1, and pays the dividend August 8.

For this example, assume that Sun earns income of $100,000 during the year 2017, 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.

Subsequent Consolidation—Worksheet Entries

Five entries consolidate the companies. Worksheet entries develop totals reported by the entity but are not physically recorded in the account balances of either company. The entries are:

S) Eliminates the subsidiary’s Stockholders’ equity account beginning balances and the book value component within the parent’s investment account.

A) Recognizes the unamortized Allocations as of the beginning of the current year associated with the adjustments to fair value.

I) Eliminates the subsidiary Income accrued by the parent.

D) Eliminates the subsidiary Dividends.

E) Recognizes excess amortization Expenses for the current period on the allocations from the original adjustments to fair value.

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Five entries are needed to consolidate the companies. 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.

S) Eliminates the subsidiary’s Stockholders’ equity account beginning balances and the book value component within the parent’s investment account.

A) Recognizes the unamortized Allocations as of the beginning of the current year associated with the adjustments to fair value.

I) Eliminates the subsidiary Income accrued by the parent.

D) Eliminates the subsidiary Dividends.

E) Recognizes excess amortization Expenses for the current period on the allocations from the original adjustments to fair value.

Entry S removes:

Investment in Sun Company account and adds each asset and liability book values to the consolidated figures.

Sun’s stockholders’ equity accounts as of the beginning of the year.

The label “Entry S” always refers to the removal of a subsidiary’s beginning stockholders’ equity balances.

Subsequent Consolidation—Entry S

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Consolidation Entry S

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 adding the book values of each subsidiary asset and liability across to the consolidated figures.

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 subsidiary 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 balances: Both provide a measure of Sun’s book value as of January 1, 2017.

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. “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.

Subsequent Consolidation—Entry A

Entry A adjusts subsidiary balances from their book values to acquisition-date fair values and includes goodwill created by the acquisition. It represents the Allocations made in connection with the excess of the subsidiary’s fair values over its book values.

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Consolidation Entry A

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.

Subsequent Consolidation— Entries I and D

Entry I removes Sun’s income recognized by Parrot during the year so Sun’s revenue and expense accounts (and current amortization expense) can be brought into the consolidated totals.

Entry D removes the intra-entity transfer of cash for the dividends distributed to Parrot from Sun.

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Consolidation Entry I

Consolidation Entry D

“Entry I” (for Income) removes from the worksheet the subsidiary income recognized by Parrot 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 respective 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 subsidiary’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 recognized 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.

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.

Subsequent Consolidation—Entry E

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Entry E recognizes current year excess amortization expenses relating to the adjustments of Sun’s assets to acquisition-date fair values. It adjusts depreciation expense for the tangible asset equipment and adjusts amortization expense for the intangible asset patented technology.

Consolidation Entry E

This final worksheet entry recognizes the current year’s excess amortization expenses relating 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 mentioned earlier, we refer to the adjustments to all expenses resulting from excess acquisition-date fair-value allocations collectively as excess amortization expenses.

Consolidation Worksheet—Equity Method Applied

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Note that 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.

Consolidation Subsequent to Year of Acquisition—Equity Method

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Assume the January 1, 2020, Sun Company’s Retained Earnings balance has risen to $600,000. 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.

Assume that the January 1, 2020, Sun Company’s Retained Earnings 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.

Consolidation Subsequent to Year of Acquisition—Equity Method (continued)

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To analyze procedural changes due to passage of time, assume:

Parrot Company continues to hold its ownership of Sun Company as of December 31, 2020.

Sun now has a $40,000 liability payable to Parrot.

January 1, 2020, Sun’s Retained Earnings balance is $600,000.

Sun’s book value has increased by $220,000.

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 continual 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.

Consolidation Subsequent to Year of Acquisition—Equity Method (concluded)

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Parrot reports an Equity in Subsidiary Earnings balance of $153,000 (net income of $160,000–$7,000 in dividends).

The balance in the Investment in Sun Company account has been adjusted for:

The annual accrual of Sun’s income ($160,000).

The receipt of $40,000 in dividends from Sun.

The recognition of annual excess amortization expenses ($7,000).

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).

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

The annual accrual of Sun’s income.

The receipt of dividends from Sun.

The recognition of annual excess amortization expenses.

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

Consolidation Worksheet Subsequent to Year of Acquisition—Equity Method Applied

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Note that 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.

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.

Subsequent Consolidation—Entry P

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In addition to Entries S, A, I, D, and E, Entry P must be prepared.

Entry P eliminates an intra-entity Payable.

Intra-entity reciprocal accounts do not relate to outside parties.

Sun’s $40,000 payable and Parrot’s $40,000 receivable must be removed because the companies are being reported as a single entity.

All worksheet entries relate specifically to either previous years (S and A) or the current period (I, D, E, and P).

In addition to consolidation Entries S, A, I, D, and E, 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.

Thus, all worksheet entries relate specifically to either the previous years (S and A) or the current period (I, D, E, and P).

Learning Objective 3-3b

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

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

Subsequent Consolidations—Investment Recorded Using Initial Value or Partial Equity Method

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The parent company can use the initial value method or the partial equity method for internal record-keeping.

Application of either alternative changes the balances recorded by the parent over time and the consolidation process.

Neither of these approaches affect any of the final consolidated balances reported.

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.

Subsequent Consolidations—Accounts That Vary

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Just three parent’s accounts vary because of the method applied:

Investment account.

Income recognized from the subsidiary.

Parent’s retained earnings (periods after year of combination).

Only differences found in these balances affect the consolidation process when another method is applied. Accounting for these three balances any time after the acquisition date is of special importance.

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 balances is of special importance.

Consolidation Entries—Initial Value Method

Two entries for the initial value method are different from those for the equity method.

Entry S is the same as the equity method.

Entry A is the same as the equity method.

Entry I is different using the initial value method:

It eliminates the parent’s Dividend Income account and the sub’s Dividends Declared account.

Entry D is not needed.

Entry E is the same as the equity method.

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

Consolidation Entry A, the subsidiary’s excess acquisition-date fair value over book value, is allocated to the subsidiary’s assets and liabilities based on their fair values at the date of acquisition. Any residual is attributed to goodwill. This procedure is identical to the corresponding entry in Exhibit 3.5 in which the equity method was applied.

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

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.

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.

Applying the Initial Value Method

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When the initial value method is used by parent, the income and investment accounts on the parent company’s separate statements vary.

Significant difference between the initial value method and the equity method:

Parent’s separate statements do not reflect consolidated income totals when the initial value method is used.

Because equity adjustments are not recorded, neither parent’s reported net income nor its retained earnings provides an accurate portrayal of consolidated figures.

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 the parent’s reported net income nor its retained earnings provides an accurate portrayal of consolidated figures.

Learning Objective 3-3c

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

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

Consolidation Entries—Partial Equity Method

The same two entries are different for the partial equity method.

Entry S is the same as the equity method.

Entry A is the same as the equity method.

Entry I is different using the partial equity method:

It eliminates the parent’s equity in the sub’s income and reduces the Investment account.

Entry D eliminates the Dividends Declared account.

Entry E is the same as the equity method.

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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 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 intra-entity dividend must also be removed (Entry D). The Dividends Declared account is simply deleted.

Consolidation Entries—Comparison of Methods

Remember:

Entries S, A, and E are the same for all three methods.

The parent’s record-keeping is limited to two periodic journal entries:

Annual accrual of subsidiary income.

Receipt of dividends.

The Investment and Income account balances differ for the other methods and so will the worksheet Entries I and D.

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Remember that just three of the parent’s accounts actually vary because of the method applied: (1) the investment account, (2) the income recognized from the subsidiary, and (3) 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. The parent’s record-keeping is limited to two periodic journal entries (Entry I and D). All other consolidation entries (Entries S, A, and E) are the same for all three methods.

Consolidated financial worksheets have now been completed when the parent uses the equity, initial value, and partial equity methods. Note the identical final consolidated column balances across the three internal methods of investment accounting. Thus, the parent’s internal investment method choice has no effect on the resulting consolidated financial statements.

Learning Objective 3-4

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

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

Consolidation Subsequent to Year of Acquisition—Initial Value and Partial Equity Methods

Consolidated financial statements require a full accrual-based measurement of both income and retained earnings.

Neither the initial value nor the partial equity method provides a full accrual-based measure.

The initial value method uses the cash basis for income recognition of dividends.

The partial equity method only partially accrues subsidiary income.

New worksheet adjustments are needed to convert the parent’s beginning of the year retained earnings balance to a full-accrual basis.

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When consolidation procedures for the initial value method and the partial equity method are used, in both cases, establishment of an appropriate beginning retained earnings figure becomes a significant goal of the consolidation.

Consolidated financial statements require a full accrual-based measurement of both income and retained earnings. The initial value method, however, recognizes income when the subsidiary 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.

Consolidation Subsequent to Year of Acquisition—Entry *C

Beginning Retained Earnings account must be increased or decreased to create the same effect as the equity method.

Entry *C. The C refers to the Conversion being made to equity method (full-accrual) totals. The asterisk indicates that this entry relates solely to transactions of prior periods.

Entry *C, the adjustment of the parent’s beginning Retained Earnings, should be recorded before other worksheet entries to align the beginning balances for the year.

After the initial year of acquisition, an Entry *C is required if the parent has not applied the equity method.

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If the equity method is applied, the process 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 recognized income for these past three years under each method is first determined. For consolidation purposes, the beginning retained earnings account must then be increased or decreased to create the same effect as the 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. Entry *C should be recorded before the other worksheet entries to align the beginning balances for the year.

The only new element is the adjustment of the parent’s beginning 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.

Other Consolidation Entries

In addition to the Entries S, A, I, D, E, and *C, intercompany debt (payables and/or receivables) must be eliminated in entry P.

If a subsidiary’s long-term debt exceeds its fair value:

A consolidation entry is required to decrease the long-term debt reported in the consolidated balance sheet.

In periods subsequent to acquisition, worksheet entries are needed to increase the interest expense to be recognized in the consolidated balance sheet.

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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 initial fair value are recorded (Entry A) at their unamortized balances as of January 1, 2020. 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 are offset (Entry P).

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 amortized 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). Consequently, 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.

The sole acquisition-date excess fair value adjustment made 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 consolidated 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 balance sheet.

Consolidated Totals Subsequent to Acquisition

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EXHIBIT 3.14 Consolidated Totals Subsequent to Acquisition

Consolidated Worksheet Entries

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Learning Objective 3-5

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Discuss the rationale for the goodwill impairment testing approach.

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

Goodwill and Other Intangible Assets (ASC Topic 350)

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FASB ASC Topic 350, “Intangibles—Goodwill and Other,” provides accounting standards for reporting income statement effects of impairment of intangibles acquired in a business combination.

When accounting for goodwill subsequent to the acquisition date, GAAP requires an impairment approach rather than amortization.

FASB reasoned that goodwill can decrease over time.

It does not do so in a “rational and systematic” manner.

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.

Goodwill and Other Intangible Assets (ASC Topic 350)—Impairment

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Goodwill impairment losses are reported as operating items in the consolidated income statement.

FASB provides firms the option to conduct a qualitative analysis to assess whether further testing procedures are appropriate.

If circumstances indicate a potential decline in the fair value of a reporting unit below its carrying amount, further tests are required to see if goodwill is the source of the decline.

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.

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 appropriate. 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.

Learning Objective 3-6

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Describe the procedures for conducting a goodwill impairment test.

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

When to Test Goodwill for Impairment?

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FASB ASC (paragraph 350-20-35-28) requires an entity to assess its goodwill for impairment annually for each reporting unit where goodwill resides.

More frequent impairment assessment is required if events or circumstances change that make it more likely than not that reporting unit’s fair value has fallen below its carrying amount.

If after performing the qualitative assessment, it appears that it is more likely than not the fair value is less than its carrying amount, Step 1 of the two-step impairment test is required.

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.

In contrast to the qualitative assessment, Steps 1 and 2 rely on quantitative fair-value measures for reporting units as a whole and for their underlying individual assets and liabilities. If, after performing the qualitative assessment, 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.

Step 1: Is the Carrying Amount of a Reporting Unit More Than Its Fair Value?

Calculate fair values for each reporting unit with allocated goodwill.

Fair value (with allocated goodwill) is compared to the carrying value (including goodwill) of the consolidated entity’s reporting unit.

Does fair value of the reporting unit exceed carrying value?

If yes, Goodwill is NOT impaired. No further testing is required.

If no, a second step must be taken to test for impairment.

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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 goodwill has been impaired and to measure the amount of impairment.

Step 2: Is Goodwill’s Implied Value Less Than Its Carrying Amount?

Step 2 compares the implied fair value of goodwill to its carrying amount.

Implied value of goodwill can be determined using quoted market prices, similar businesses, or present value of future cash flows.

Is implied fair value of goodwill less than recorded goodwill?

If no, Goodwill is NOT impaired. No further testing is required.

If yes, an impairment loss is recorded for the excess carrying value over implied fair value.

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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 combination.

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. 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 goodwill over its implied fair value.

Goodwill Impairment Test Example

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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 reporting 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.

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 reporting 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.

Goodwill Impairment Test Example—Unit Goodwill Fair Values

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Newcall tests for goodwill impairment. DSM Wireless’s fair value has fallen to $600 million, well below its current carrying amount. The company attributes the decline in value to a failure to realize expected cost-saving synergies with VisionTalk.

Each reporting unit’s acquisition-date fair values are as follows:

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.

Goodwill Impairment Test Example—Allocation of Fair Value

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Newcall derived implied fair value of goodwill through the following allocation of the December 31, 2017 fair value of DSM Wireless:

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 allocation of the December 31, 2017, fair value of DSM Wireless as shown.

Goodwill Impairment Test Example—Results

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Goodwill is now valued at $4,000,000.

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 required describing:

The facts and circumstances leading to the impairment.

The method used to determine fair value of the associated reporting unit.

The reported values for all of DSM Wireless’s remaining assets and liabilities do not change.

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

The ASC requires special application of testing procedures if a reporting unit has a zero or negative carrying amount.

In that case, the ASC permits an entity to forego Step 2 of the impairment test unless it is more likely than not that goodwill is impaired.

The entity must consider the same factors as in the qualitative assessment for individual reporting units.

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Zero or Negative Carrying Amounts

One final issue regarding goodwill impairment testing deserves mentioning. When a reporting 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. Therefore, 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 likelihood of goodwill impairment, an entity must consider the same factors as in the qualitative assessment for individual reporting units.

Comparisons with International Accounting Standards

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IFRS and U.S. GAAP require an assessment for goodwill impairment at least annually and more frequently if impairment is indicated. Both state that goodwill impairments, once recognized, are not recoverable.

U.S. GAAP: Goodwill acquired in a business combination is allocated to reporting units (operating segments or a business component one level below) expected to benefit from the goodwill.

IFRS: International Accounting Standard (IAS) 36 requires goodwill acquired in a business combination to be allocated to cash-generating units at which goodwill is monitored.

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.

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 business 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-generating 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.”

Comparisons with International Accounting Standard—Fair Values

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U.S. GAAP: A reporting unit’s implied goodwill fair value is the excess of the reporting unit’s fair value over the fair value of its identifiable net assets. If the goodwill carrying amount is greater than its implied fair value, an impairment loss is recognized.

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, other assets of the cash-generating unit are reduced pro-rata based on carrying amounts of the assets.

FASB and IASB will include impairment recognition and reporting in a future convergence project.

U.S. GAAP. In Step 2, 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. 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.

Learning Objective 3-7

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Describe the rationale and procedures for impairment testing for intangible assets other than goodwill.

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

Other Intangibles—Finite Lives

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All identified intangible assets with finite lives should be amortized over their economic useful life that reflects the pattern of decline in the economic usefulness of the asset.

Factors to 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.

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.

Other Intangibles—Indefinite Lives

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Intangible assets with indefinite lives are tested for impairment on an annual basis. An entity has the option to first perform qualitative assessments to determine whether “it is more likely than not” that the asset is impaired.

If so, a quantitative test must be performed. The asset’s carrying value is compared to its fair value. If fair value is less than carrying value, the intangible asset is considered impaired and an impairment loss is recognized. The asset’s carrying value is reduced accordingly.

Any recognized intangible assets considered to possess indefinite lives are not amortized but instead are assessed for impairment on an annual basis. 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 factors 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.

If the qualitative assessment indicates that impairment is likely, the entity then must perform a quantitative test to determine if a loss has occurred. To test an indefinite-lived intangible 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 impairment loss is recognized. The asset’s carrying amount is reduced accordingly for the excess of its carrying amount over its fair value.

Learning Objective 3-8

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Understand the accounting and reporting for contingent consideration subsequent to a business acquisition.

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

Contingent Consideration in Business Combinations—Future Performance

Contingency agreements, consideration based on future performance, often accompany business combinations.

The acquiring firm estimates the fair value of the contingency and records a liability equal to the present value of the future payment if appropriate.

The liability continues to be measured at fair value with corresponding recognition of gains or losses from the revaluation.

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Contingency agreements frequently accompany business combinations. In many cases, the target firm asks for consideration based on projections of its future performance.

The acquisition-date fair value assigned to a subsidiary can be based, at least in part, on the fair value of any contingent consideration. Determine the fair values of the contingency and record a liability if appropriate. 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.

Contingent Consideration in Business Combinations—Equity Obligations

Contingent obligations classified as equity are reported as a component of stockholders’ equity.

Equity contingencies are not remeasured at fair value.

Whether contingent obligations are a liability or equity, the initial value recognized in the combination does not change regardless of whether the contingency is eventually paid or not.

A loss from revaluation of a contingent performance obligation is reported in the consolidated income statement as a component of ordinary income.

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Obligations classified as equity are not subsequently remeasured at fair value, consistent with other equity issues (e.g., common stock).

For contingent obligations classified as equity, no remeasurement to fair value takes place. Whether contingent obligations are a liability or equity, the initial value recognized in the combination does not change regardless of whether the contingency is eventually paid or not.

A loss from revaluation of the contingent performance obligation is reported in the consolidated income statement as a component of ordinary income.