Chapter 7

1. Chapter 7 Consolidated Financial Statements: Subsequent to Date of Purchase-Type Business Combination

2. Objectives of this Chapter • Prepare the consolidated financial statements for the parent company and its subsidiaries for the years following business combination for purchase-type business combination • For wholly owned purchased subsidiaries • For partially owned purchased subsidiaries Consolidated FS-Subsequent to date of purchase type

3. Accounting for Operating Results of Wholly Owned Purchased Subsidiaries • A parent company may choose the equity method or the cost method in accounting for the operating results of purchased subsidiaries. Consolidated FS-Subsequent to date of purchase type

4. Equity Method • The parent company recognizes its share of the subsidiary’s net income or loss and adjusted for the depreciation and amortization of the step up on purchased subsidiary’s net assets. • The parent company also recognizes its share of dividends declared by the subsidiary. Consolidated FS-Subsequent to date of purchase type

5. Equity Method (contd.) • Thus, the equity method is consistent with the accrual basis accounting. • Equity method emphasizes the economic substance of the parent-subsidiary. • Dividends declared by subsidiaries are not revenue to the parent company, rather, they are a liquidation of a portion of the parent company’s investment in the subsidiary. Consolidated FS-Subsequent to date of purchase type

6. Cost Method • Under this method, the parent company accounts for the operations of a subsidiary only to the extend that dividends are declared by the subsidiary. • This method emphasizes the legal form of the parent-subsidiary relationship. Consolidated FS-Subsequent to date of purchase type

7. Choosing Between Equity Method and Cost Method • Consolidated financial statement amounts are the same regardless of the method used to account for a subsidiary’s operations. • The differences are in the working paper elimination. Consolidated FS-Subsequent to date of purchase type

8. Choosing Between Equity Method and Cost Method (contd.) • Equity method is appropriate for both pooled subsidiaries and purchased subsidiaries. • The cost method is only appropriate for purchased subsidiaries. Consolidated FS-Subsequent to date of purchase type

9. Example 7.1: Equity Method for holly Owned Purchased Subsidiary for First Year after Business Combination (textbook p286-296) • Assumed that Palm Corporation had used purchase accounting for the December 31, 1999, business combination with its wholly owned subsidiary- Starr Company. Starr had a net income of $60,000 (income statement is on p293 of the textbook) for the year ended December 31, 2000. Consolidated FS-Subsequent to date of purchase type

10. Example 7.1: (contd.) • On December 20, 2000, Starr’s board of directors declared a cash dividend of $0.60 a share on the 40,000 outstanding shares of common stock owned by Palm. The divided was payable January8, 2001, to stockholders recorded December 29, 2000. Consolidated FS-Subsequent to date of purchase type

11. Example 7.1: (contd.) • Starr’s December 20, 2000, journal entry to record the dividend declaration is as follows: • 12/20 • Dividends Declared 24,000 • Intercompany Dividend payable 24,000 • The intercompany dividend payable account must be eliminated in the preparation of consolidated financial statements for the year 2000. Consolidated FS-Subsequent to date of purchase type

12. Example 7.1: (contd.) • Under the equity method, Palm Corp. prepares the following journal entries to record the dividend and net income of Starr for the year ended 12/31/2000: • 12/20/00 • Intercompany • Dividend Receivable 24,000 • Investment in Starr Company Stock 24,000 • To record the dividends declared by Starr. Consolidated FS-Subsequent to date of purchase type

13. Example 7.1: (contd.) • 12/31/00 • Investment in • Starr Company Stock 60,000 • Intercompany Investment Income 60,000 • To record the Palm’s share (100%) of net income on • Starr under equity method Consolidated FS-Subsequent to date of purchase type

14. Adjustment of Purchased Subsidiary’s Net Income • Since Palm’s acquisition of Starr is accounted for using the purchase method, adjustments are needed to adjust Starr’s net income for depreciation and amortization attributable to the step up on Starr’s net assets on 12/31/99. Consolidated FS-Subsequent to date of purchase type

15. Adjustment of Purchased Subsidiary’s Net Income (contd.) • Assumed that on 12/31/99, differences between the current fair values and carrying amounts of Starr’s net assets were as follows (also see p236 and p241 of chapter 6 of the textbook): Consolidated FS-Subsequent to date of purchase type

16. Adjustment of Purchased Subsidiary’s Net Income (contd.) Consolidated FS-Subsequent to date of purchase type

17. Adjustment of Purchased Subsidiary’s Net Income (contd.) • Palm prepares the following journal entry to account for the depreciation and amortization of the step up on Starr’s net assets: • 12/31/2000 • Intercompany • Investment Income 30,500 • Investment in • Starr Company Stock 30,500 Consolidated FS-Subsequent to date of purchase type

18. Adjustment of Purchased Subsidiary’s Net Income (contd.) • The annual depreciation and amortization of the step up are as follows: Consolidated FS-Subsequent to date of purchase type

19. Adjustment of Purchased Subsidiary’s Net Income (contd.) • After the three foregoing journal entries, Palm Corp.’s Investment in Starr Company’s Common Stock and intercompany Investment Income accounts are as follows: Consolidated FS-Subsequent to date of purchase type

20. Adjustment of Purchased Subsidiary’s Net Income (contd.) • a. Issuance of common stock (by Palm) in the acquisition of Starr. • b. Direct out-of-pocket costs of business combination. • c. Recognition of dividend declared by the subsidiary-Starr. • d. Recognition of wholly owned subsidiary’s (Starr) net income. • e. Recognition of depre. and amor. on the step-up of Starr’s net assets. Consolidated FS-Subsequent to date of purchase type

21. Adjustment of Purchased Subsidiary’s Net Income (contd.) Consolidated FS-Subsequent to date of purchase type

22. Development of the Elimination • Analysis of Investment in Starr Stock account(for the year ended 12/31/2000) Consolidated FS-Subsequent to date of purchase type

23. Development of the Elimination (contd.) • Note: • 1. The ending balance on the carrying amount (book value),$426,000, equals the balance the total stockholder’s equity of Starr on 12/31/2000 as follows (see the balance sheet section of Starr on p293 of textbook): Consolidated FS-Subsequent to date of purchase type

24. Development of the Elimination (contd.) Consolidated FS-Subsequent to date of purchase type

25. Development of the Elimination (contd.) • The $79,500 balance on the Step-up column represents the unamortized excess amount (the difference between the current fair value of net assets and the carrying amount). The details are in the following table: Consolidated FS-Subsequent to date of purchase type

26. Development of the Elimination (contd.) Consolidated FS-Subsequent to date of purchase type

27. Palm Corp. and Subsidiary Working Paper Elimination (on 12/31/2000) • All three basic financial statements (the income statement, the statement of retained earnings and the balance sheet) must be consolidated for accounting period following the date of a purchase-type business combination.The items that must be included in the elimination are: Consolidated FS-Subsequent to date of purchase type

28. Palm Corp. and Subsidiary Working Paper Elimination (on 12/31/2000) (contd.) • 1)The subsidiary’s beginning balance of stockholder’s equity accounts and its dividends and parent’s investment account; • 2)the parent’s intercompany investment income ; • 3)unamortized current fair value excess of the subsidiary; • 4)certain operating expense of the subsidiary. Consolidated FS-Subsequent to date of purchase type

29. Palm Corp. and Subsidiary Working Paper Elimination (on 12/31/2000) (contd.) • Assuming that Starr allocates machinery depreciation and patent amortization entirely to cost of goods sold, goodwill amortization entirely to operating expense and building depreciation 50% each to cost of goods sold and operating expenses, the working paper elimination (in journal entry format) for Palm and subsidiary on 12/31/2000 is as follows: Consolidated FS-Subsequent to date of purchase type

30. Palm Corp. and Subsidiary Working Paper Elimination (on 12/31/2000) (contd.) Consolidated FS-Subsequent to date of purchase type

31. Palm Corp. and Subsidiary Working Paper Elimination (on 12/31/2000) (contd.) • Note: • 1. Income tax effects are disregarded • 2. the computation of cost of goods sold and operating expense are as follows: Consolidated FS-Subsequent to date of purchase type

32. Palm Corp. and Subsidiary Working Paper Elimination (on 12/31/2000) (contd.) Consolidated FS-Subsequent to date of purchase type

33. Equity Method: Wholly Owned Subsidiary Subsequent to Date of Purchase-type Business Combination (on p293 of textbook) • PALM CORPORATION AND SUBSIDIARY • Working paper for Consolidated Financial Statements • For Year Ended December 31,2000 Consolidated FS-Subsequent to date of purchase type

34. Equity Method: Wholly Owned Subsidiary Subsequent to Date of Purchase-type Business Combination (contd.) • PALM CORPORATION AND SUBSIDIARY • Working paper for Consolidated Financial Statements • For Year Ended December 31,2000 (Continued) Consolidated FS-Subsequent to date of purchase type

35. Equity Method: Wholly Owned Subsidiary Subsequent to Date of Purchase-type Business Combination (contd.) • PALM CORPORATION AND SUBSIDIARY • Working paper for Consolidated Financial Statements • For Year Ended December 31,2000 Consolidated FS-Subsequent to date of purchase type

36. Equity Method: Wholly Owned Subsidiary Subsequent to Date of Purchase-type Business Combination (contd.) • PALM CORPORATION AND SUBSIDIARY • Working paper for Consolidated Financial Statements • For Year Ended December 31,2000 Consolidated FS-Subsequent to date of purchase type

37. Equity Method: Wholly Owned Subsidiary Subsequent to Date of Purchase-type Business Combination (contd.) • Notes: • 1.The intercompany receivable and payable, placed in adjacent columns on the same line, are offset without a formal elimination. • 2. The FIFO methods used by Starr; thus, the $25,000 difference attributable to the beginning inventories of Starr is allocated to the cost of goods sold for year 2000. Consolidated FS-Subsequent to date of purchase type

38. Equity Method: Wholly Owned Subsidiary Subsequent to Date of Purchase-type Business Combination (contd.) • 3. The step up (current fair value excess on Starr’s net assets) is only included in the consolidated balance sheet for the unamortized balance. • 4. Step- up on land is not subject to amortization. Consolidated FS-Subsequent to date of purchase type

39. Equity Method: Wholly Owned Subsidiary Subsequent to Date of Purchase-type Business Combination (contd.) • 5. The use of equity method results in: • Parent company net income = consolidated net income • Parent company retained earnings = consolidated retained earnings • These equalities exist when the equity method is used and no intercompany profits accounted for in the determination of consolidated net assets. Consolidated FS-Subsequent to date of purchase type

40. Equity Method: Wholly Owned Subsidiary Subsequent to Date of Purchase-type Business Combination (contd.) • 6. Consolidated financial statements provide more information than those of the parent company despite the equalities in the net income and retained earnings. • 7. The retained earnings of Palm on 12/31/2000 includes only $29,500 share of the subsidiary’s adjusted net income for the year ended 12/31/2000. Consolidated FS-Subsequent to date of purchase type

41. Consolidated Financial Statements (for example 7.1) • The consolidated income statement, statement of retained earnings and balance sheet of Palm corp. and subsidiary for the year ended December 31, 2000 are as follows: (on p294 and 295 of textbook) Consolidated FS-Subsequent to date of purchase type

42. Consolidated Financial Statements (contd.) • PALM CORPORATION AND SUBSIDIARY • Consolidated Income Statement • For Year Ended December 31,2000 Consolidated FS-Subsequent to date of purchase type

43. Consolidated Financial Statements (contd.) • PALM CORPORATION AND SUBSIDIARY • Consolidated Statement of Retained Earnings • For Year Ended December 31,2000 Consolidated FS-Subsequent to date of purchase type

44. Consolidated Financial Statements (contd.) • PALM CORPORATION AND SUBSIDIARY • Consolidated Balance Sheet • For Year Ended December 31,2000 • Assets Consolidated FS-Subsequent to date of purchase type

45. Consolidated Financial Statements (contd.) • PALM CORPORATION AND SUBSIDIARY • Consolidated Balance Sheet • For Year Ended December 31,2000 • Liabilities $ Stockholders’ Equity Consolidated FS-Subsequent to date of purchase type

46. Closing Entries for Example 7.1 • Closing entries should be prepared for both the parent company and the subsidiary at the end of the fiscal year after the financial statements[1] being prepared. • The closing entries for the subsidiary are prepared in the usual fashion. • The closing entries for the parent company are prepared in the usual fashion except for the closing of the income summary to the retained earnings. Consolidated FS-Subsequent to date of purchase type

47. Closing Entries (contd.) • Palm Corporation prepares the closing entries on 12/31/2000, after the consolidated financial statements have been prepared, as follows: • Note: Palm closes its income statement accounts, not the consolidated I/S accounts. Consolidated FS-Subsequent to date of purchase type

48. Closing Entries (contd.) • [1] Consolidated financial statements for the parent company and the regular F/S for the subsidiary. • The parent and subsidiary are two separate legal entities. When consolidated F/S are prepared using the equity method, the economic substance of the parent-subsidiary relationship is being emphasized rather than their legal form. Consolidated FS-Subsequent to date of purchase type

49. Closing Entries (contd.) Consolidated FS-Subsequent to date of purchase type

50. Closing Entries (contd.) Consolidated FS-Subsequent to date of purchase type