Chapter 2
Consolidation of Financial Information
Answers to Questions
1. A business combination is the process of forming a single economic entity by the uniting of two or more organizations under common ownership. The term also refers to the entity that results from this process.
2. (1) A statutory merger is created whenever two or more companies come together to form a business combination and only one remains in existence as an identifiable entity. This arrangement is often instituted by the acquisition of substantially all of an enterprise’s assets. (2) a statutory merger can also be produced by the acquisition of a company’s capital stock. This transaction is labeled a statutory merger if the acquired company transfers its assets and liabilities to the buyer and then legally dissolves as a corporation. (3) A statutory consolidation results when two or more companies transfer all of their assets or capital stock to a newly formed corporation. The original companies are being “consolidated” into the new entity. (4) A business combination is also formed whenever one company gains control over another through the acquisition of outstanding voting stock. Both companies retain their separate legal identities although the common ownership indicated that only a single economic entity exists.
3. Consolidated financial statements represent accounting information gathered form two or more separate companies. This data, although accumulated individually by the organizations, is brought together (or consolidated) to describe the single economic entity created by the business combination.
4. Companies that form a business combination will often retain their separate legal identities as well as their individual accounting systems. In such cases, internal financial data continues to be accumulated by each organization. Separate financial reports may be required for outside shareholders (a noncontrolling interest), the government, debt holders, etc. This information may also be utilized in corporate evaluations and other decision making. However, the business combination must periodically produce consolidated financial statements encompassing all of the companies within the single economic entity. A worksheet is used to organize and structure this process. The worksheet allows for a simulated consolidation to be carried out on a regular, periodic basis without affecting the financial records of the various component companies.
5. Three characteristics are normally indicative of a purchase:
(1) One of the companies can clearly be identified as the acquiring party;
(2) A bargained exchange transaction has taken place to form the business combination;
(3) A purchase price can be determined as the cost incurred by the acquiring company to gain control over the acquired company.
Conversely, a pooling of interests is viewed as the uniting of ownership interests through the exchange of equity securities. In such transactions, (1) the distinction between acquirer and acquiring company is not always clear and (2) the price of the transaction may not be easy to determine. More precise characteristics of a pooling of interests can be seen in the 12 criteria established by the Accounting Principles Board. These requirements hold, in part, that substantially all of one company must be obtained (at least 90 percent) in a transaction that is carried to conclusion within one year. In addition, assets cannot be sold off unless duplication results from the combination.
6. APB Opinion Number 16 specifies several situations in which the fair market value of the 50,000 shares being issued might be difficult to ascertain. These examples include:
§ The shares may be newly issued (if Jones has just been created) so that no accurate value has as of yet been established;
§ Jones may be a closely held corporation so that no market value is available for its shares;
§ The number of newly issued shares (especially if the amount is large in comparison to the quantity of previously outstanding shares) may cause the price of the stock to fluctuate widely so that no accurate market value can be determined during a reasonable period of time;
§ Jones’ stock may have historically experienced drastic swings in price. Thus, a quoted figure at any specific point in time may not be an adequate or representative value for long-term accounting purposes.
7. In every business combination, the assets and liabilities of the acquiring company retain their book values. The problem facing the accountant is the recorded basis to be used for the assets and liabilities of the acquired company. For a purchase, these accounts are traditionally consolidated at fair market value with any excess payment being attributed to goodwill. If the acquiring company pays an amount less than fair market value, the difference is accounted for by decreasing the values assigned to the noncurrent assets (other than long-term marketable securities). A deferred credit will also have to be recognized if the reduction is of sufficient size. In a pooling of interests, the book values of the two companies provide the basis for consolidating assets and liabilities.
8. In a purchase the revenues and expenses (both current and past) of the parent are included within reported figures. However, the revenues and expenses of the subsidiary are only consolidated from the date of the acquisition forward. The operations of the subsidiary are only applicable to the business combination if earned subsequent to its creation.
For a pooling of interests, where neither company is considered to be truly in a parent or subsidiary position, the revenues and expenses are consolidated as if the two companies had always been joined.
9. Morgan’s additional purchase price may be attributed to many factors: favorable earnings projections, competitive bidding to acquire Jennings, etc. However, in accounting for a purchase combination, any amount paid by the parent company in excess of the subsidiary’s fair market value is reported as goodwill.
10. This business combination must be accounted for as a purchase because the acquisition was consummated by a cash transaction. Normally, in a purchase, all of the subsidiary’s asset and liability accounts are recorded at fair market value (see Answer 7 above). However, since Lambert paid less than the total fair market value for Catron’s net assets, a full allocation in this manner is not possible. When a bargain purchase has occurred APB Opinion 16 requires that a proportional reduction be recorded in the values reported for noncurrent assets (other than long-term investments in marketable securities). If the decrease is of such a magnitude that these accounts will be consolidated at zero values, any further reduction is recognized as a deferred credit.
11. When shares are issued in a purchase, they are recorded at their fair market value as if the stock had actually been sold with the money obtained being used to acquire the subsidiary. The Common Stock account is recorded at the par value of these shares with any excess amount attributed to additional paid-in capital.
12. In a purchase, all consolidation costs are included in the purchase price being paid to obtain the subsidiary. Consequently, the $98,000 is an added component of this price. An exception is made, though, for any stock issuance costs. Such costs are recorded as a reduction in additional paid-in capital (or retained earnings, if an Additional Paid-in Capital account does not exist). The $56,000 will be recorded in that manner.
13. When two companies are brought together in a pooling of interests, all income balances from previous operations are reported through combined totals. Thus, in reporting current and past time periods, all figures are shown as if the two companies had always been a single entity.
In a purchase, the acquired company’s earnings that were generated during periods preceding the combination are totally omitted. For reporting purposes, only the acquiring company’s revenues and expenses are included for the periods prior to the purchase while the income figures of both companies are combined thereafter.
Answers to Purchase Method Problems
1. B
2. D
3. C
4. D
5. D
6. B
7. D
8. C Atkins records new shares at market value because combination is a purchase.
Value of shares issued (51,000 x $3) $153,000
Par value of shares issued (51,000 x $1) 51,000
Additional paid-in capital $102,000
In a purchase, the parent makes no change in retained earnings.
9. C Because the parent paid $2 million which is larger than fair market value of the subsidiary’s net assets ($1,650,000), all accounts are recorded at fair market value with the excess being attributed to goodwill
10. C Because the purchase price was $1.5 million, less was paid than the fair market of the subsidiary’s net assets ($1,650,000). This bargain purchase of $150,000 is assigned to land and buildings based on their relative fair market values: land 40% and buildings—60%. A $60,000 reduction is assigned to the Land account and a $90,000 reduction is assigned to the Buildings account. These balances are consolidated after these reductions to their fair market values.
11. B Acquisition price (fair market value) $400,000
Book value of subsidiary (assets minus liabilities) (300,000)
Payment in excess of book value 100,000
Allocation of excess payment
Identified with specific accounts:
—Inventory 30,000
—Land 20,000
—Buildings 25,000
—Long-term liabilities 10,000
Goodwill 15,000
12. A In a purchase, the subsidiary’s income is only included if generated after the acquisition.
13. A All of Tucker’s accounts should be consolidated at fair market value in a purchase. In this instance, however, Allen has paid $50,000 below fair market value of $385,000. This $50,000 reduction is assigned to the three noncurrent assets based on fair market value.
Fair Market
Value Ratio Reduction
Land $200,000 200,000 x 50,000 $20,000
500,000
Buildings 225,000 225,000 x 50,000 22,500
500,000
Equipment 75,000 75,000 x 50,000 7,500
500,000
Total $500,000 $50,000
Consolidated Totals:
Inventory—$365,000 (combine Tucker’s fair market value).
Land—410,000 (combine Tucker’s fair market value less $20,000 reduction for bargain purchase).
Retained earnings—$130,000 (Allen’s balance only is included as combination is a purchase).
14. D Total acquisition price of $400,000 is $15,000 in excess of Tucker’s fair market value. Hence, that excess is recorded as Goodwill. Consolidated retained earnings is Allen’s beginning balance because the combination is a purchase.
15. (30 Minutes) (Overview of the steps in applying the purchase method when shares have been issued to create a combination. Includes a bargain purchase.)
a. Purchases are recorded at the fair market value sacrificed. In this case, 20,000 shares were issued valued at $55 per share. Thus, the purchase price is $1.1 million.
b. The book value is found by subtracting the assets from the liabilities. For Bakel, the assets are $1,380,000 and the liabilities are $400,000 for a book value of the company’s net assets of $980,000. The same total can be derived from the stockholders’ equity accounts after closing out revenues and expenses.
c. In a purchase, stock issue costs are recorded as a reduction in additional paid-in capital. Other direct costs of a combination are added to the purchase price
d. The par value of the 20,000 shares issued is recorded as an increase of $100,000 in the Common Stock account. The $50 market value in excess of par value ($55 - $5) is an increase in additional paid-in capital of $1 million ($50 x 20,000 shares).
e. Purchase price (above) $1,100,000
Book value (above) 980,000
Price in excess of book value $ 120,000
Allocations to specific accounts based on
difference between fair market value and
book value:
Inventory $ 80,000
Land (200,000)
Building 100,000
Liabilities 70,000 50,000
Goodwill $ 70,000
f. In-process research and development would be recorded at $60,000 and goodwill would be reduced to $10,000. Acquired in-process research and development is typically reported as an expense in the year of the acquisition assuming (1) no alternative use for the assets involved in the research and development, and (2) no resulting products hvae reached technological feasibility.
g. In a purchase, any revenues and expenses of the subsidiary from the period before the combination was created are omitted from the consolidated totals. Only the operational figures for the subsidiary after the purchase are applicable to the business combination. The previous owners earned any previous profits.
h. The subsidiary’s Common Stock and Additional Paid-in Capital accounts have no impact on the consolidated totals.
i. The subsidiary’s asset and liability accounts will be consolidated at their fair market values with any excess payment being attributed to goodwill. The equity, revenue, and expense figures of the subsidiary do not affect the business combination at the date of acquisition. The parent must record the issuance of the 20,000 new shares and the payment of the stock issue costs.
j. If the stock was worth only $40 per share, the purchase price is now $800,000. This amount indicates a bargain purchase:
Purchase price (above) $ 800,000
Book value (above) 980,000
Book value in excess of purchase price $ (180,000)
Allocations to specific accounts based on
difference between fair market value
and book value:
Inventory $ 80,000
Land (200,000)
Building 100,000
Liabilities 70,000 50,000
Excess fair market value over cost ($230,000)
The bargain purchase figure must be allocated between the land and building based on their fair market values of $400,000 (40%) and $600,000 (60%). Therefore, all of the assets and liabilities will be consolidated at fair market value except that the land will be reported at $92,000 below market value ($230,000 x 40%) and the building will be reported at $138,000 below market value ($230,000 x 60%).
16. (10 Minutes) (Consolidated balances for a purchase.)
a. This combination must be a purchase because cash was paid.
Purchase price (fair market value):
—Cash $1,400,000
—Stock issued 800,000 $2,200,000
Book value of assets (no liabilities are indicated) 2,000,000
Cost in excess of book value $ 200,000
Excess cost assigned to Buildings account
based on fair market value $ 100,000
Goodwill $ 100,000
b. None of Winston’s expenses will be included in consolidated figures as of the date of acquisition. In a purchase, only subsidiary expenses incurred after that date are applicable to the business combination. As a purchase, the $30,000 stock issue costs reduce additional paid-in capital.