Module 1 – Business Combination and Consolidation Stock Acquisition – Consolidated Financial Statements – AFTER 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. As discussed in ISMP #1 (Date of Acquisition) 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). We discussed a 3-Step Process (below) to be followed in the creation of consolidated financial statements. The same 3-Step Process is applied in Stock Acquisition – After Date of Acquisition but involves increased complexity due to the fact that time has passed (ongoing operations of the acquired company must be consolidated). Unlike the accounting for stock acquisitions as of the date of acquisition (which required the preparation of the consolidated balance sheet only) the accounting for stock acquisitions after the date of acquisition require consolidation for all financial statements (income statement, statement of retained earnings, balance sheet and statement of cash flows). The focus of this ISMP will be on the income statement, statement of retained earnings and the balance sheet. 3-Step Process: Step 1 – Assess the Business Scenario Step 2 – Prepare the CAD Step 3 – Determine Workpaper Entries Note: Refer to ISMP #1 for further detail. The first two steps of the three step process are the same for stock acquisitions on the date of acquisition as they are for stock acquisitions after the date of acquisition. The key changes take place in Step 3. Step 3 - Determine the Required Workpaper Entries • Complete Workpaper • Complete Financial Statement(s) To determine the required workpaper entries for stock acquisitions after the date of acquisition the method of accounting used by the parent company for the Investment in Subsidiary must be determined. The company has two accounting options for maintaining the investment in subsidiary account, the “Cost Method” or the “Equity Method.” The accounting method used dictates the workpaper entries required for consolidation. In either case, the resulting consolidated financial statements are identical. The key to accurate consolidated financial statements is the development and application of the appropriate workpaper entries. RECORDING AND MAINTAINING THE INVESTMENT IN SUBSIDIARY COST METHOD Recording the initial Investment in Subsidiary is the same whether the Cost Method or the Equity Method is applied. Account Debit Credit Investment in Subsidiary $1,000,000 *Cash $1,000,000 * - The method of payment in this example is cash, but other sources of funds could also be used to pay for the investment (i.e. issuance of stock). Maintaining the Investment in Subsidiary is where significant differences exist between the Cost Method and Equity Method, creating the need for different workpaper entries. Maintaining the “Investment in Subsidiary” account using the Cost Method could be described as NOT maintaining the “Investment in Subsidiary” account. Under the Cost Method there is no adjustment to the “Investment in Subsidiary” account balance (with the exception of instances where a liquidating dividend occurs). Thus, the only investment related entry, after the initial investment (purchase) entry, is the recording of dividend income. When a dividend is received the parent company makes the following investment related entry: Account Debit Credit Cash $40,000 Dividend Income $40,000 As you can see by the entry above the investment in subsidiary account is not affected. Therefore, the balance of the investment in subsidiary remains at the initial investment cost recorded on the date of acquisition. EQUITY METHOD Recording the initial Investment in Subsidiary is the same whether the Cost Method or the Equity Method is applied. Account Debit Credit Investment in Subsidiary $1,000,000 *Cash $1,000,000 * - The method of payment in this example is cash, but other sources of funds could also be used to pay for the investment (i.e. issuance of stock). Maintaining the “Investment in Subsidiary” account using the Equity Method of accounting could be described as a continuous effort to maintain an accurate valuation for reporting purposes. The Equity Method attempts to account for all income and dividends (based on the ownership %) recorded by the subsidiary. Essentially, the change in the investment in subsidiary balance reflects the true value of the investment assuming income less dividends is a true reflection of value change. Therefore, the investment related entries, after the initial investment (purchase) entry, is the recording of income and dividends. The recording of income is accounted for using the following entry (assume the subsidiary is 80% owned and had income of $250,000): Account Debit Credit Investment in Subsidiary $200,000 Equity in Subsidiary Income $200,000 Clearly, the above entry impacts the investment in subsidiary account balance (increasing the account balance by $200,000). The accounting for dividend declared and paid follows the same logic. If the parent company is receiving dividends, the parent is essentially taking value out of the investment. The recording of dividend received is accounted for using the following entry (assume the subsidiary is 80% owned and declared a dividend of $50,000): Account Debit Credit Cash $40,000 Investment in Subsidiary $40,000 Clearly, the above entry impacts the investment in subsidiary account balance (decreasing the account balance by $40,000). Q1. – Calculation – What it the “Investment in Subsidiary” account balance at the end of the year (in the example above) using the Cost Method and Equity Method? WORKPAPER ENTRIES – ELIMINATION OF THE INVESTMENT IN SUBSIDIARY The investment related entries (discussed above) must be taken into account when developing workpaper entries. The workpaper entries essentially eliminate the investment in subsidiary (key offset is the equity accounts of the subsidiary) which upon elimination allows for the consolidation of the parent and subsidiary, which combines the related income statement, statement of retained earnings, and balance sheet accounts of the parent and subsidiary. COST METHOD Workpaper entries required for the Cost Method must account for all of the investment entries made (or not made) to the investment in subsidiary account. In addition, for the Cost Method, the timing of the consolidation impacts the application of the workpaper entries. The two time periods are the Year of Acquisition and After Year of Acquisition. Cost Method -Year of Acquisition – Is the first year of ownership of the subsidiary. Thus, if the subsidiary was purchased on January 1, 2010 and we are reporting for the year ending December 31, 2010, we would be reporting Year of Acquisition. Assume the following base information: COST METHOD USED BY PARENT REAL Entry De bit Credit Jan. 1, 2010 Investment in Subsidiary $ 500,000 Cash $ 500,000 Purchased 80% of subsidiary. Subsidiary Equity Position as of 1/ 1/ 2010: Common Stock $ 10,000 APIC $ 300,000 Retained Earnings $ 240,000 $ 550,000 CAD 80% Ownership 80% 20% 100% Parent NCI Total Implied Fair Value Given Up $ 500,000 $ 125,000 $ 625,000 Book Value Received $ 440,000 $ 110,000 $ 550,000 Difference $ 60,000 $ 15,000 $ 75,000 Land $ 60,000 $ 15,000 $ 75,000 Balance $ - $ - $ - 100% 80% During 2010, Subsidiary declared dividends in the amount of $ 50,000 $ 40,000 During 2010, Subsidiary had net income in the amount of $ 250,000 $ 200,000 Subsidiary Retained Earnings as of 12/31/2009 was $ 240,000 For the Year of Acquisition –COST METHOD - the following three workpaper entries are required: 1 Eliminate (parents share) of current year subsidiary dividend income. REAL Entry De bit Credit Cash $ 40,000 Dividend Income $ 40,000 Workpaper Entry (1) De bit Dividend Income $ 40,000 Dividend Declared - Subsidiary $ Cre dit 40,000 2 Eliminate the Investment in Subsidiary account against (offset by) the subsidiary equity accounts. Workpaper Entry (2) De bit Cre dit A Common Stock - Subsidiary $ 10,000 A APIC - Subsidiary $ 300,000 B Retained Earnings - Subsidiary $ 240,000 C Difference $ 75,000 D Investment in Subsidiary $ 500,000 E NCI $ 125,000 Notes: Remember, 100% of the sub's equity account balances need to be eliminated. A No change from the date of acquisition. B We need to eliminate RE balance as of the beginnng of the current year. C Never changes. D Investment in Subsidiary (Investment Account Value at the Beg. Of the Current Year) E NCI (NCI Account Value at the Beg. Of the Current Year) Q2. – Short Answer - The adjustment to the “Investment in Subsidiary” account is as of the beginning of the year. What is the logic or reason the adjustment is as of the beginning of the year? 3 Distribute the difference between implied and book value of the equity acquired. Workpaper Entry (3) De bit Cre dit Land $ 75,000 Difference $ 75,000 Cost Method - After Year of Acquisition – Is the second year of ownership and beyond. Thus, if the subsidiary was purchased on January 1, 2010 (continuing with the same example) and we are reporting for the year ending December 31, 2013, we would be reporting After Year of Acquisition. Additional Data: 100% 80% During 2013, Subsidiary declared dividends in the amount of $ 100,000 $ 80,000 During 2013, Subsidiary had net income in the amount of $ 350,000 $ 280,000 Subsidiary Retained Earnings as of 12/31/2009 was $ 240,000 Subsidiary Retained Earnings as of 12/31/2012 was $ 450,000 Cost Method - After Year of Acquisition - the following workpaper entries are made: 1 Establish Reciprocity (catch up impact of parent's share of the subsidiary's income less dividends). Subsidiary's Retained Earnings at the beginning of the current year (January 1, 2013) $ 450,000 Subsidiary's Retained Earnings at acquisition (January 1, 2010) $ 240,000 Difference - Represents the net earnings change (net income less dividends) $ 210,000 NET Earnings Change Parent's Share 80% $ 168,000 Investment in Sub Workpaper Entry De bit Credit $ 42,000 NCI's % is 20% Investment in Subsidiary $ 168,000 Retained Earnings 1/1 Current Year - Parent $ 168,000 2 Eliminate (parents share) of current year subsidiary dividend income. REAL Entry De bit $ Credit 80,000 2013 Cash $ 80,000 Dividend Income $ De bit 80,000 Workpaper Entry Credit Dividend Income Dividend Declared - Subsidiary $ 80,000 3 Eliminate the Investment in Subsidiary account against (offset by) the subsidiary's equity accounts. At Acquisition Beg. Current Year CAD 80% Ownership 80% 20% 100% Common Stock $ Parent NCI Total Implied APIC $ 10,000 300,000 $ 10,000 $ 300,000 Fair Value Given Up Book Value Received Difference Land (1) Balance $ 500,000 $ $ 450,000 $ $ 50,000 $ $ 50,000 $ $ - $ 125,000 50,000 75,000 75,000 - $ 625,000 $ 550,000 $ 75,000 $ 75,000 $ - Retained Earn. $ $ 240,000 550,000 $ 450, 000 Workpaper Entry De bit Credit $ 125,000 NCI (At acquisition) $ 42,000 NCI's % of Net Earnings Change A Common Stock - Subsidiary A APIC - Subsidiary B Retained Earnings - Subsidiary C Difference D Investment in Subsidiary E NCI $ 10,000 $ 300,000 $ 450,000 $ 75,000 $ 835,000 $ 668,000 $ 167,000 $ 835,000 $ 167,000 $ 500,000 Invest. in Sub (At acquisition) $ 168,000 Reciprocity Entry $ 668,000 Notes: Remember, 100% of the sub's equity account balances need A No change from the date of acquisition. to be eliminated. B We need to eliminate RE balance as of the beginnng of the current year. C Never changes. D Investment in Subsidiary (Investment Account Value at the Beg. Of the Current Year + Reciprocity) E NCI (NCI Value at acquisition + NCI % of Subsidiary Net Earnings since acquisition) 4 Distribute the difference between implied and book value of the equity acquired. Land $ 75,000 Difference $ 75,000 Equity Method -Year of Acquisition – Is the first year of ownership of the subsidiary. Thus, if the subsidiary was purchased on January 1, 2010 and we are reporting for the year ending December 31, 2010, we would be reporting Year of Acquisition. Review the following base data: EQUITY METHOD USED BY PARENT REAL Entry De bit Credit Jan. 1, 2010 Investment in Subsidiary $ 500,000 Cash $ 500,000 Purchased 80% of subsidiary Subsidiary Equity Position as of 1/ 1/ 2010: Common Stock $ 10,000 APIC $ 300,000 Retained Earnings $ 240,000 $ 550,000 CAD 80% Ownership 80% 20% 100% Parent NCI Total Implied Fair Value Given Up $ 500,000 $ 125,000 $ 625,000 Book Value Received $ 440,000 $ 110,000 $ 550,000 Difference $ 60,000 $ 15,000 $ 75,000 Land $ 60,000 $ 15,000 $ 75,000 Balance $ - $ - $ - 100% 80% During 2010, Subsidiary declared dividends in the amount of $ 50,000 $ 40,000 During 2010, Subsidiary had net income in the amount of $ 250,000 $ 200,000 100% 80% During 2011, Subsidiary declared dividends in the amount of $ 125,000 $ 100,000 During 2011, Subsidiary had net income in the amount of $ 125,000 $ 100,000 100% 80% During 2012, Subsidiary declared dividends in the amount of $ 125,000 $ 100,000 During 2012, Subsidiary had net income in the amount of $ 135,000 $ 108,000 100% 80% During 2013, Subsidiary declared dividends in the amount of $ 100,000 $ 80,000 During 2013, Subsidiary had net income in the amount of $ 350,000 $ 280,000 Investment in Subsidiary RETAINED EARNINGS 80% Bal ance Subsidiary Retained Earnings as of 12/31/2009 was $ 240,000 $ 500, 000 as of 1/1/2010 Sub Income 2010 $ 250,000 $ 200,000 $ 200,000 Sub Dividend 2010 $ (50,000) $ (40,000) $ (40,000) Subsidiary Retained Earnings as of 12/31/2010 was $ 440,000 $ 660,000 as of 12/31/2010 Sub Income 2011 $ 125,000 $ 100,000 $ 100,000 Sub Dividend 2011 $ (125,000) $ (100,000) $ (100,000) Subsidiary Retained Earnings as of 12/31/2011 was $ 440,000 $ 660,000 as of 12/31/2011 Sub Income 2012 $ 135,000 $ 108,000 $ 108,000 Sub Dividend 2012 $ (125,000) $ (100,000) $ (100,000) Subsidiary Retained Earnings as of 12/31/2012 was $ 450,000 $ 668,000 as of 12/31/2012 Required: PREPARE THE WORKPAPER (and related workpaper entries)THAT WOULD BE MADE IN THE PREPARATION OF THE CONSOLIDATED FINANCIAL STATEMENTS ON DECEMBER 31, 2010 Equity Method - Year of Acquisition - the following workpaper entries are made: Using the above information, the workpaper entries for the Equity Method – Year of Acquisition are as follows: Equity Method - Year of Acquisition - the following workpaper entries are made: 1 Eliminate (parents share) of current year subsidiary income (Equity in Subsidiary Income). REAL Entry De bit Credit 2010 Investment in Subsidiary $ 200,000 Equity in Sub Income $ 200,000 Workpaper Entry (1) De bit Cre dit Equity in Sub Income $ 200,000 Investment in Subsidiary $ 200,000 2 Eliminate (parents share) of current year subsidiary dividends. REAL Entry De bit Credit 2010 Cash $ 40,000 Investment in Subsidiary $ 40,000 Workpaper Entry (2) De bit Cre dit Investment in Subsidiary $ 40,000 Dividend Declared - Subsidiary $ 40,000 Q3. – True/False – The entry to eliminate subsidiary dividends (above) will reduce the subsidiary dividends to zero? Explain your answer. 3 Eliminate the Invest. in Subsidiary account against (offset by) the subsidiary equity accounts. 80% Ownership 80% 20% 100% Parent NCI Total Implied Fair Value Given Up $ 500,000 $ 125,000 $ 625,000 Book Value Received $ 440,000 $ 110,000 $ 550,000 Difference $ 60,000 $ 15,000 $ 75,000 Land $ 60,000 $ 15,000 $ 75,000 Balance $ - $ - $ - Workpaper Entry (3) De bit Cre dit A Common Stock - Subsidiary $ 10,000 A APIC - Subsidiary $ 300,000 B Retained Earnings - Subsidiary $ 240,000 C Difference $ 75,000 D Investment in Subsidiary $ 500,000 E NCI $ 125,000 At Acquisition Beg. Current Year RE Change Common Stock $ 10,000 $ 10,000 APIC $300,000 $ 300,000 Retained Earn. $240,000 $ 240, 000 $ - $550,000 $ 550,000 Notes: Remember, 100% of the sub's equity account balances need to be eliminated. A No change from the date of acquisition. B We need to eliminate RE balance as of the beginnng of the current year. C Never changes. D Investment in Subsidiary (Investment Account Value at the Beg. Of the Current Year) E NCI (NCI Account Value at the Beg. Of the Current Year ) Q4. – Short Answer - Explain why the entry to eliminate the investment in subsidiary account is identical to the same entry for the Cost Method – Year of Acquisition? 4 Distribute the difference between implied and book value of the equity acquired. Workpaper Entry (4) De bit Cre dit Land $ 75,000 Difference $ 75,000 The following 3- Section workpaper has been developed to exhibit how the workpaper entries are utilized in the workpaper to arrive at correctly stated consolidated balances. Calc. and Input NCI Portion of Sub Income $ 215,000 20% NCI % $ 43,000 $ The Net Income calculated above is carried down to the Statement of Retained Earnings (blue line below). (3) 00 Equity Method - After Year of Acquisition – Is the second year of ownership and beyond. Thus, if the subsidiary was purchased on January 1, 2010 (continuing with the same example) and we are reporting for the year ending December 31, 2013, we would be reporting After Year of Acquisition. The same journal entries are used for the Equity Method – Year of Acquisition and Equity Method – After Year of Acquisition. Required: PREPARE THE WORKPAPER (and related workpaper entries)THAT WOULD BE MADE IN THE PREPARATION OF THE CONSOLIDATED FINANCIAL STATEMENTS ON DECEMBER 31, 2013 Equity Method - AFTER Year of Acquisition - the following workpaper entries are made: 1 Eliminate (parents share) of current year subsidiary income (Equity in Subsidiary Income). REAL Entry De bit Credit 2013 Investment in Subsidiary $ 280,000 Equity in Sub Income $ 280,000 Workpaper Entry (1) De bit Cre dit Equity in Sub Income $ 280,000 Investment in Subsidiary $ 280,000 2 Eliminate (parents share) of current year subsidiary dividends. REAL Entry De bit Credit 2013 Cash $ 80,000 Investment in Subsidiary $ 80,000 Workpaper Entry (2) De bit Cre dit Investment in Subsidiary $ 80,000 Dividend Declared - Subsidiary $ 80,000 3 Eliminate the Investment in Subsidiary account against (offset by) the subsidiary equity account s. CAD 80% Ownership 80% 20% 100% Parent NCI Total Implied Fair Value Given Up $ 500,000 $ 125,000 $ 625,000 Book Value Received $ 1 $ 110,000 $ 550,000 Difference $ 499,999 $ 15,000 $ 75,000 Land $ 499,999 $ 15,000 $ 75,000 Balance $ - $ - $ - At Acquisition Beg. Current Year RE Change Common Stock $ 10,000 $ 10,000 APIC $300,000 $ 300,000 Retained Earn. $240,000 $ 450, 000 $ 210,000 $550,000 $ 760,000 Workpaper Entry (3) De bit Cre dit A Common Stock - Subsidiary $ 10,000 A APIC - Subsidiary $ 300,000 B Retained Earnings - Subsidiary $ 450,000 C Difference $ 75,000 D Investment in Subsidiary $ 668,000 E NCI $ 167,000 $ 835,000 $ 835,000 $ 125,000 NCI (At acquisition) $ 42,000 NCI's % of Net Earnings Change $ 167,000 $ 500,000 Investment in Sub (At acquisition) $ 168,000 RE Change @ 80% $ 668,000 Investment in Sub (At 12/31/12) Notes: Remember, 100% of the sub's equity account balances need to be eliminated. A No change from the date of acquisition. B We need to eliminate RE balance as of the beginnng of the current year. C Never changes. D Investment in Subsidiary (Investment Account Value at the Beg. Of the Current Year) E NCI @ Acquisition + NCI % Ownership of Change in RE Q5. – Short Answer – Why is the credit to the Investment in Subsidiary for $668,000 the same as the entry (to eliminate the investment in subsidiary account) used in the Cost Method – After Year of Acquisition (both were for a $668,000 credit)? 4 Distribute the difference between implied and book value of the equity acquired. Workpaper Entry (4) De bit Cre dit Land $ 75,000 Difference $ 75,000 DIFFERENCES – ACCOUNTING FOR DEPRECIABLE ASSETS Assume that in the above example that the “Difference” between Fair Value Given Up and Book Value Received was due to the FMV of Equipment being greater than the related book value by $75,000 (instead of Land per above). Assumption: At purchase on January 1, 2010 the remaining useful life of the equipment (discussed in the preceding paragraph) of 10 years. The allocation of difference entry would be as follows: Note: The following entries would be necessary for the Cost Method and the Partial Equity Method. 2010 Entry Account Equipment Difference Debit $75,000 Credit $75,000 Depreciation Expense $ 7,500 Equipment $ 7,500 2011 Entry Account Equipment Difference Debit $75,000 Credit $75,000 Beg. Retained Earnings – Parent $ 6,000 Note 1 NCI $ 1,500 Depreciation Expense Equipment $ 7,500 $15,000 Note 1 – Impact of previous year depreciation expense on Parent RE and NCI (must be accounted for).