Module 1 – Business Combination and Consolidation Stock Acquisition – Consolidated Financial Statements - Date of Acquisition Instructor Comment: The following lesson module was developed to assist students in their understanding of the corresponding subject matter in the course textbook. The following is not a replacement for the detailed presentation provided by the authors of the text, but instead is an attempt to provide students with a pragmatic direct review with heavy emphasis on process. My recommendation is to approach the course material in the following sequence. 1. Read/study the assigned corresponding sections of the text. 2. Read the “Chapter Review” (PowerPoint) posted in D2L. 3. Read/complete the corresponding instructor developed “Instructor Subject Matter Presentation” (THIS DOCUMENT) posted in D2L. 4. Complete the assigned text questions, exercises and problems (author recommended solutions for assigned odd exercises posted in D2L). 5. Review the corresponding instructor developed “Instructor Problem Solving Modules” posted in D2L. For stock acquisitions where significant influence and control exist, the acquirer (parent) is required by the SEC, for financial reporting purposes, to consolidate the acquired company (subsidiary). The development of consolidated financial statements is a complex process. In an effort to focus on the key aspects required for the accounting of consolidations we will apply a 3- Step Process. 3- Step Process: •Confirm business combination is a Stock Acquisition which requires consolidation •Determine where (timing) in the accounting process •% Ownership •Calcualate the Difference •Fair Value versus Book Value •Complete the Workpaper •Complete Financial Statement The application of the 3-Step Process will be demonstrated using a business case involving an acquisition. Business Case – Paper & Ink Corporation Paper & Ink Corporation is a manufacturer of computer paper and ink cartridges that supplies independent convenient stores, pharmacies, and hardware stores with a small inventory of personal computer (printer) supplies. These stores sell computer paper and ink cartridges to their customers, who are primarily individual consumers. Paper & Ink Corporation is able to keep their costs down by selling directly (not through a wholesaler) to the independent convenient stores, pharmacies, and hardware stores. Still, increasing direct competition from online wholesalers (independent convenient stores, pharmacies and hardware stores can order online as an alternative supplier) and the indirect competition from large computer supply stores (i.e. OfficeMax) has negatively impacted Paper & Ink Corporation’s sales (Paper & Ink Corporation is losing market share). After an extensive internal review the executive management team of Paper & Ink Corporation has determined that the company needs to diversify its product offerings to better differentiate themselves from their competition. Their idea is to add a new product line that will benefit both Paper & Ink Corporation and their customers. The key product that they have decided to add is ink refill capsules. The capsules come in two sizes: an individual (one ink cartridge refill) and a multiple (100 ink cartridge refill). The decision to add ink refill capsules was based on an internal review of the company’s strengths and weaknesses which is summarized in Exhibit A. Assume that on January 1, 2012 Paper & Ink Corporation (parent company) acquired 75% of the stock of Smooth Solutions (subsidiary company) for $31,000,000 (approximately 1.5X sales). Smooth Solutions stockholders have agreed to accept a combination of cash and Paper & Ink Corporation stock as payment. The stock price of Paper & Ink Corporation (market price per NASDAQ) at the market close on December 31, 2011 was $25/share. Purchase Price: $ 31,000,000 Payment: Cash $ 3,100,000 Stock $ 27,900,000 Mkt Price $ 25 # of Shares 1,116,000 The following are the financial statements (balance sheet) for the two companies immediately before the acquisition. BALANCE SHEET $ US Paper & Ink Corp. Smooth Solutions 12/31/2011 12/31/ 2011 Cash $ 5,550,000 $ 200,000 Short-Term Investments $ 2,400,000 $ - Accounts Receivable $ 5,500,000 $ 5,250,000 Inventory $ 10,000,000 $ 11,300,000 Equipment $ 19,325,000 $ 7,450,000 Trucks $ 4,200,000 $ 1,900,000 Trailers $ 2,400,000 $ 750,000 Other Assets $ 1,750,000 $ 1,150,000 Building $ 875,000 $ 750,000 Land $ 500,000 $ 425,000 Long-Term Investments $ 4,500,000 $ - Other Long Term Assets $ 1,200,000 $ 1,350,000 Goodwill $ - $ - Difference $ - $ - Total Assets $ 58,200,000 $ 30,525,000 Accounts Payable $ 7,250,000 $ 4,250,000 Other Current Liabilities $ 3,250,000 $ 2,150,000 Notes Payable $ 4,000,000 $ - Credit Line $ 5,000,000 $ 7,000,000 Long Term Debt $ 5,400,000 $ 3,350,000 Other Long Term Liabilities $ - $ - Total Liabilities $ 24,900,000 $ 16,750,000 Common Stock (Par $.10) $ 250,000 $ 125,000 APIC $ 22,000,000 $ 11,500,000 RE $ 11,050,000 $ 900,000 Total Equity $ 33,300,000 $ 13,775,000 Total Liabilities and Equity $ 58,200,000 $ 30,525,000 •Confirm business combination is a Stock Acquisition which requires consolidation •Determine where (timing) in the accounting process Step 1 - Assess the Business Scenario Assessing the business scenario can have many meanings. For now, we will focus on the accounting aspects of the transaction. In terms of the accounting, Paper & Ink Corporation is buying 75% of the stock of Smooth Solutions. Instructor Insight: It may not always be readily clear what type of transaction is taking place (asset acquisition or stock acquisition). Particularly, in instances where 100% of the acquisition target is purchased. In reality we would need more detailed information to know how each transaction would need to be accounted. For example, assuming Paper & Ink Corporation did purchase 100% of the stock of Smooth Solutions, will Paper & Ink Corporation retire the stock of Smooth Solutions which would likely result in the dissolution of Smooth Solutions as a legal entity. If this were the case, the transaction would be accounted for as an asset acquisition. If Paper & Ink Corporation held the stock (NOT retire the stock) Smooth Solutions would continue to exist as a separate legal entity. Thus, we know we would need to account for this transaction (business combination) as a stock acquisition. Based on the information provided, we have determined that we are dealing with a stock acquisition. We also need to determine what point in time we are in the transaction. In this scenario it appears we are just before the actual transaction “Date of Acquisition.” We know this is likely the case by both the description of events, “The following are the financial statements (balance sheet) for the two companies immediately before the acquisition.” In addition, when reviewing Paper & Ink Corporations balance sheet there is no investment in subsidiary account. Having determined that the actual transaction has yet to be recorded, we know that Paper & Ink Corporation will need to make the accounting entry at the time of the transaction. Thus, we will assume that the $31 million dollar payment to the shareholders of Smooth Solutions takes place. Therefore, Paper & Ink Corporation will need to make the following entry: Account De bit Credit Investment in Subsidiary (Smooth Solutions) $ 31,000,000 Cash $ 3,100,000 Common Stock (1,116,000 @ $.10) $ 111,600 APIC $ 27,788,400 To record the 75% stock acquisition of Smooth Solutions on January 1, 2012. APIC $ 416,826 Cash $ 416,826 To record stock registration fees for issuance of 1,116,000 common shares. Note – These are actual journal entries (REAL entries) that are made in Paper & Ink Corporation’s ledger at the time of acquisition. Q1. Short Answer - Immediately after the above transaction what change(s) will be made on the respective books (ledger) of each company? Please explain why or why not changes are made to each company’s respective financial statement(s). Paper & Ink Corporation: Smooth Solutions: Q2. Calculations - Show the calculations confirming the following balance sheet accounts have correctly stated balances (per the balance sheet below): Cash $ 2,033,174 Common Stock $ 361,600 APIC $49,371,574 Q3. Short Answer – Explain why the subsidiary company’s cash account was not impacted by the purchase transaction? BALANCE SHEET $ US Paper & Ink Corp Smooth Solutions 1/ 01/2012 1/01/2012 Cash $ 2,033,174 $ 200,000 Short-Term Investments $ 2,400,000 $ - Accounts Receivable $ 5,500,000 $ 5,250,000 Inventory $ 10,000,000 $ 11,300,000 Invesment in Subsidiary $ 31,000,000 $ - Equipment $ 19,325,000 $ 7,450,000 Trucks $ 4,200,000 $ 1,900,000 Trailers $ 2,400,000 $ 750,000 Other Assets $ 1,750,000 $ 1,150,000 Building $ 875,000 $ 750,000 Land $ 500,000 $ 425,000 Long-Term Investments $ 4,500,000 $ - Other Long Term Assets $ 1,200,000 $ 1,350,000 Total Assets $ 85,683,174 $ 30,525,000 Accounts Payable $ 7,250,000 $ 4,250,000 Other Current Liabilities $ 3,250,000 $ 2,150,000 Notes Payable $ 4,000,000 $ - Credit Line $ 5,000,000 $ 7,000,000 Long Term Debt $ 5,400,000 $ 3,350,000 Total Liabilities $ 24,900,000 $ 16,750,000 Common Stock (Par $.10) $ 361,600 $ 125,000 APIC $ 49,371,574 $ 11,500,000 RE $ 11,050,000 $ 2,150,000 Total Equity $ 60,783,174 $ 13,775,000 Total Liabilities and Equity $ 85,683,174 $ 30,525,000 Q4. True/False – The existing liability accounts on the subsidiary’s balance sheet will always equal fair value? Explain your answer. Q5. Short Answer – Explain how to account for assets and liabilities identified at the time of the acquisition but are not listed on the subsidiary company’s balance sheet? Q6. Multiple Choice – To calculate the total implied value of the acquired company the following data points are needed: a. % ownership acquired, fair value given up, and fair value received b. % ownership acquired, fair value received, book value received c. The implied value is based on an outside valuation of the acquired company. d. % ownership acquired and fair value given up •% Ownership • Calcualate the Difference • Fair Value versus Book Value Computation and Allocation of Difference (CAD) Schedule. % of ownership = 75% 25% 100% Non Contrilling Parent Interest (NCI) Total Implied Value Fair Value Given Up ? Book Value Received ? Difference Accounts Receivable Inventory Equipment Trucks Trailers Other Assets Building Land Other Long Term Assets Patent Rights - Note 1 Customer List - Note 2 Brand Names - Note 3 $ 31,000,000 $ 10,331,250 $ 20,668,750 $ 10,333,333 $ $ 3,443,750 $ $ 6,889,583 $ $ $ $ $ $ $ $ $ $ $ $ $ 41,333,333 13,775,000 27,558,333 (500,000) (300,000) 2,550,000 (800,000) (200,000) (650,000) $ 250,000 1,575,000 (600,000) 1,000,000 500,000 2,000,000 4,825,000 Net Increase in Assets Contaminated Land - Clean Up Estimate - Note 4 Employee Lawsuit - Note 5 Customer Lawsuit - Note 6 Balance Goodwill Balance $ 800,000 $ 100,000 $ $ 250,000 $ $ 23,883,333 $ 23,883,333 $ - 1,150,000 3,675,000 Net Increase in Liabilities Net Increase Note: Fair value differences are calculated on the schedule below. Fair Value vs. BALANCE SHEET Fair Value Report Book Value $ US Smooth Solutions Smooth Solutions Smooth Solutions 1/ 01/2012 1/ 01/2012 1/ 01/ 2012 Cash $ 200,000 $ 200,000 $ - Short-Term Investments $ - $ - $ - Accounts Receivable $ 5,250,000 $ 4,750,000 $ (500,000) Inventory $ 11,300,000 $ 11,000,000 $ (300,000) Equipment $ 7,450,000 $ 10,000,000 $ 2,550,000 Trucks $ 1,900,000 $ 1,100,000 $ (800,000) Trailers $ 750,000 $ 550,000 $ (200,000) Other Assets $ 1,150,000 $ 500,000 $ (650,000) Building $ 750,000 $ 1,000,000 $ 250,000 Land $ 425,000 $ 2,000,000 $ 1,575,000 Long-Term Investments $ - $ - $ - Other Long Term Assets $ 1,350,000 $ 750,000 $ (600,000) Patent Rights - Note 1 $ - $ 1,000,000 $ 1,000,000 Customer List - Note 2 $ - $ 500,000 $ 500,000 Brand Names - Note 3 $ - $ 2,000,000 $ 2,000,000 Total Assets $ 30,525,000 $ 35,350,000 $ 4,825,000 Accounts Payable $ 4,250,000 $ 4,250,000 $ - Other Current Liabilities $ 2,150,000 $ 2,150,000 $ - Notes Payable $ - $ - $ - Credit Line $ 7,000,000 $ 7,000,000 $ - Long Term Debt $ 3,350,000 $ 3,350,000 $ - Other Long Term Liabilities $ - $ - $ - Contaminated Land - Clean Up Estimate - Note 4 $ 800,000 $ 800,000 Employee Lawsuit - Note 5 $ 100,000 $ 100,000 Customer Lawsuit - Note 6 $ - $ 250,000 $ 250,000 Total Liabilities $ 16,750,000 $ 17,900,000 $ 1,150,000 Common Stock (Par $.10) $ 125,000 APIC $ 11,500,000 RE $ 900,000 Total Equity $ 13,775,000 Total Liabilities and Equity $ 30,525,000 • Complete the Workpaper • Complete Financial Statement Q7. True/False - Workpaper entries are journal entries that are ultimately recorded in the parent company’s ledger. Explain your answer. As discussed in your reading, when significant influence and control exists, the equity investment must be consolidated into the company’s financial statements. Prior to creating consolidated financial statements the investors and creditors of Paper & Ink Corporation have a limited view of the company’s investment in Smooth Solutions. Simply, a $31 million dollar asset called Investment in Subsidiary. Not only is the investment difficult to assess, it represents more than 50% of Paper & Ink Corporation’s net assets. Clearly, the required accounting to consolidate the investment will better reflect the company’s financial (and economic) position. The consolidation process is simply an accounting method that results in a better presentation of a company’s financial statements. To determine the correct balance of the combined company’s accounts the accountant employs the use of a tool called a workpaper. The workpaper does the following: Parent Company Accounts + Subsidiary Company Accounts + Workpaper Entries = Parent & Subsidiary Company Consolidated Account Balances In addition, a separate account (NCI) must be created for those investors of the acquired company (subsidiary company) that did not sell their ownership (shares). This account is called the Noncontrolling Interest or NCI. A separate line item is required for the net value of the subsidiary held by the NCI shareholders in the Consolidated Financial Statements. This account is included the equity section of the consolidated balance sheet. The workpaper entries are basically the adjustments needed to arrive at a correctly stated consolidated account balance. Reminder: Workpaper entries are not real entries and therefore do not impact the respective company’s ledger. They are adjustment entries used in the workaper process to arrive at the correct consolidated balance(s). The inputs into the workpaper entry are driven from the CAD. Computation and Allocation of Difference (CAD) Schedule. % of ownership = 75% 25% 100% Non Controlling Parent Interest (NCI) Total Implied Value Fair Value Given Up ? $ 31,000,000 $ 10,333,333 $ 41,333,333 Book Value Received ? $ 10,331,250 $ 3,443,750 $ 13,775,000 Difference $ 20,668,750 $ 6,889,583 $ 27,558,333 Credit Investment in Subsidiary – Smooth Solutions $31,000,000 NCI $10,333,333 The CAD first compares the fair value given up to the book value received. The next question is to investigate whether there are any assets and liabilities that have a fair value that is different from book value. This information is used to both determine if there is goodwill (or gain) and to complete the 2nd part of the workpaper entry. The second workpaper entry is to properly allocate the difference account. Q8. – Prepare Entry - Complete the workpaper entry to allocate the difference account. Account (2) Debit Credit Q9. - True or False - The balance sheet of Paper & Inc. Corp. has a line item “Investment in Subsidiary” with a balance of $31,000,000. This balance is the total implied value of the subsidiary. Explain your answer. Q10. Multiple Choice ??This investment in subsidiary account would be found in which section of the parent company balance sheet? a. Equity b. Liabilities c. Assets d. Not included in the balance sheet Once the workpaper entries are completed we can then complete the actual workpaper. The workpaper entry populates the workpaper and provides the necessary information to compute the consolidated balances. Consolidation Workpaper BALANCE SHEET $ US Paper & Ink Corp. Smooth Solutions Workpaper Entries and Noncontrolling Consolidated Parent Subsidiary Eliminations Interest Balances 1/01/2012 1/01/2012 De bit Credit Cash $ 2,033,174 $ 200,000 $ 2,233,174 Short-Term Investments $ 2,400,000 $ - $ 2,400,000 Accounts Receivable $ 5,500,000 $ 5,250,000 $ 500,000 (2) $ 10,250,000 Inventory $ 10,000,000 $ 11,300,000 $ 300,000 (2) $ 21,000,000 Invesment in Subsidiary $ 31,000,000 $ - $ 31,000,000 (1) $ - Equipment $ 19,325,000 $ 7,450,000 $ 2,550,000 (2) $ 29,325,000 Trucks $ 4,200,000 $ 1,900,000 $ 800,000 (2) $ 5,300,000 Trailers $ 2,400,000 $ 750,000 $ 200,000 (2) $ 2,950,000 Other Assets $ 1,750,000 $ 1,150,000 $ 650,000 (2) $ 2,250,000 Building $ 875,000 $ 750,000 $ 250,000 (2) $ 1,875,000 Land $ 500,000 $ 425,000 $ 1,575,000 (2) $ 2,500,000 Long-Term Investments $ 4,500,000 $ - $ 600,000 (2) $ 3,900,000 Other Long Term Assets $ 1,200,000 $ 1,350,000 $ 2,550,000 Patent Rights - Note 1 $ - $ 1,000,000 (2) $ 1,000,000 Customer List - Note 2 $ - $ 500,000 (2) $ 500,000 Brand Names - Note 3 $ - $ 2,000,000 (2) $ 2,000,000 Goodwill $ - $ - $ 23,883,333 (2) $ 23,883,333 Difference $ - $ - $ 27,558,333 (1) $ 27,558,333 $ - Total Assets $ 85,683,174 $ 30,525,000 $ 113,916,507 Accounts Payable $ 7,250,000 $ 4,250,000 $ 11,500,000 Other Current Liabilities $ 3,250,000 $ 2,150,000 $ 5,400,000 Notes Payable $ 4,000,000 $ - $ 4,000,000 Credit Line $ 5,000,000 $ 7,000,000 $ 12,000,000 Long Term Debt $ 5,400,000 $ 3,350,000 $ 8,750,000 Other Long Term Liabilities $ - $ - $ - Contaminated Land - Clean Up Estimate - Note 4 $ 800,000 (2) $ 800,000 Employee Lawsuit - Note 5 $ 100,000 (2) $ 100,000 Customer Lawsuit - Note 6 $ - $ - $ 250,000 (2) $ 250,000 Total Liabilities $ 24,900,000 $ 16,750,000 $ 42,800,000 NCI $ 10,333,333 (1 $ 10,333,333 Common Stock (Par $.10) $ 361,600 $ 125,000 $ 125,000 (1) $ 361,600 Shares Issued and Outstanding $ 0.10 3,616,000 1,250,000 APIC $ 49,371,574 $ 11,500,000 $ 11,500,000 (1) $ 49,371,574 RE $ 11,050,000 $ 2,150,000 $ 2,150,000 (1) $ 11,050,000 Total Equity $ 60,783,174 $ 13,775,000 $ 71,116,507 Total Liabilities and Equity $ 85,683,174 $ 30,525,000 $ 113,916,507