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Chapter 6

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  1. Chapter 6 Consolidated Financial Statements: On Date of Purchase-Type Business Combination

  2. Objectives of this Chapter • 1.To learn the accounting treatment and the preparation of consolidated financial statements for wholly owned subsidiariesa on date of purchase-type business combination; • a. As a result of using acquisition of common stock to carry out the business combination. The subsidiaries remain as separate legal entities. Consolidated FS-On Date of Purchase-Type

  3. Objectives of this Chapter • 2.To learn the accounting treatment and the preparation of consolidated financial statements for partially owned subsidiariesa on date of purchase-type business combination. • a. As a result of using acquisition of common stock to carry out the business combination. Consolidated FS-On Date of Purchase-Type

  4. Parent Company-Subsidiary Relationships • When a business combination is through acquisition of common stock and a controlling interest in the combinee’s voting common stock is acquired, the combinee (investee) becomes affiliated with the combinor (investor) parent company as a subsidiary. Consolidated FS-On Date of Purchase-Type

  5. Parent Company-Subsidiary Relationships (contd.) • The combinee is not dissolved and remains a separate legal entity. • A parent-subsidiary relationship is established. • Although a parent company and its subsidiary are two separate legal entities, they are a single economic entity due to the parent’s controlling interest on the investee company. Consolidated FS-On Date of Purchase-Type

  6. Parent Company-Subsidiary Relationships (contd.) • Thus, consolidated financial statements are issued to report the financial position and operating results of a parent company and its subsidiaries as though they are a single accounting entity. Consolidated FS-On Date of Purchase-Type

  7. Should All Subsidiaries Be Consolidated • SFAS No. 94, “Consolidation of All Majority-Owned Subsidiaries” issued in 1987 required the consolidation of nearly all subsidiaries (effective for financial statements for fiscal year ending after 12/15/1988). • SFAS No. 94 excluded those subsidiaries not actually controlled by the parent companies. Consolidated FS-On Date of Purchase-Type

  8. Controlling Interest • An investor’s direct or indirect ownership of more than 50% of an investor’s outstanding common stock is perceived as evidence to have the controlling interest in a parent-subsidiary relationship. Consolidated FS-On Date of Purchase-Type

  9. Controlling Interest (contd.) • However, some circumstances may negate the parent company’s actual control of the subsidiary and consolidated financial statements should NOT be prepared. Consolidated FS-On Date of Purchase-Type

  10. Controlling Interest (contd.) • Note: A parent company’s control of a subsidiary might be achieved indirectly. • Example: if A owns 80% of the outstanding common stock of B and 45% of C’s common stock. B also owns 45% of C ‘s common stock. A is effectively owns 90% of C’s common stock. Consolidated FS-On Date of Purchase-Type

  11. Arguments on the Traditional Concept of Control • The above definition of control (i.e., ownership of more than 50%) emphasizes on the legal form of control. • It is likely that an investor with a less than 50% ownership may have the control of the affiliate. Consolidated FS-On Date of Purchase-Type

  12. Arguments on the Traditional Concept of Control (contd.) • Financial Reporting Release (FRR) No. 25 of the SEC required companies subject to its jurisdiction to emphasize economic substance over legal form in adopting a consolidation policy. Similar view is also adopted by the FASB. • Note: for a wholly own subsidiary, there is no question about the controlling interest. Consolidated FS-On Date of Purchase-Type

  13. Consolidation of Wholly-Owned Subsidiary on Date of Purchase-Type Business Combination • Example 6.1: (textbook p235-243) • On December 31, 1999, Palm Corporation issued 10,000 shares of its $10 par common stock (current fair value $45 a share) to stockholders of Starr Company for all the outstanding $5 par common stock of Starr. Consolidated FS-On Date of Purchase-Type

  14. Consolidation of Wholly-Owned Subsidiary on Date of Purchase-Type Business Combination (contd.)Example 6.1: (contd.) • There was no contingent consideration. Out of the pocket cots of the business combination paid by Palm on December 31, 1999, consists of the following: (on p235) Consolidated FS-On Date of Purchase-Type

  15. Consolidation of Wholly-Owned Subsidiary on Date of Purchase-Type Business Combination (contd.)Example 6.1: (contd.) • The business combination qualified for purchase accounting. Starr company was to be a wholly owned subsidiary of Palm Corporation and continued as a separate legal entity. • Both constituent companies had a December 31 fiscal year and used the same accounting principles and procedures. Consolidated FS-On Date of Purchase-Type

  16. Consolidation of Wholly-Owned Subsidiary on Date of Purchase-Type Business Combination (contd.)Example 6.1: (contd.) • Thus, no adjusting entries are required for either company prior to the combination. • The income tax rate for each company was 40%. Consolidated FS-On Date of Purchase-Type

  17. Consolidation of Wholly-Owned Subsidiary on Date of Purchase-Type Business Combination (contd.)Example 6.1: (contd.) • Financial statements of Palm Corporation and Starr Company for the year ended December 31, 1999, prior to consummation of the business combination are as follows: (textbook p236) Consolidated FS-On Date of Purchase-Type

  18. Consolidation of Wholly-Owned Subsidiary on Date of Purchase-Type Business Combination (contd.)Example 6.1: (contd.) • PALM CORPORATION AND STARR COMPANY • Separate Financial Statements (prior to purchase-type business combination) • For Year Ended December 31,1999 (Continued) Consolidated FS-On Date of Purchase-Type

  19. Consolidation of Wholly-Owned Subsidiary on Date of Purchase-Type Business Combination (contd.)Example 6.1: (contd.) • Contd. (Continued) Consolidated FS-On Date of Purchase-Type

  20. Consolidation of Wholly-Owned Subsidiary on Date of Purchase-Type Business Combination (contd.)Example 6.1: (contd.) • Contd. (Continued) Consolidated FS-On Date of Purchase-Type

  21. Consolidation of Wholly-Owned Subsidiary on Date of Purchase-Type Business Combination (contd.)Example 6.1: (contd.) • Contd. (Continued) Consolidated FS-On Date of Purchase-Type

  22. Consolidation of Wholly-Owned Subsidiary on Date of Purchase-Type Business Combination (contd.)Example 6.1: (contd.) • Contd. Consolidated FS-On Date of Purchase-Type

  23. Consolidation of Wholly-Owned Subsidiary on Date of Purchase-Type Business Combination (contd.)Example 6.1: (contd.) • On December 31, 1999, current fair values of Starr Company’s identifiable assets and liabilities were the same as their carrying amounts, except for the three assets listed below: (on p236) Consolidated FS-On Date of Purchase-Type

  24. Consolidation of Wholly-Owned Subsidiary on Date of Purchase-Type Business Combination (contd.)Example 6.1: (contd.) • Nojournal entries were needed for Starr because it continued to be a separate legal entity. Palm Corp. recorded the combination as a purchase on December 31, 1999 as follows: (textbook p237) Consolidated FS-On Date of Purchase-Type

  25. Consolidation of Wholly-Owned Subsidiary on Date of Purchase-Type Business Combination (contd.)Example 6.1: (contd.) • Journal Entries for Palm Corp., 12/31/1999 Consolidated FS-On Date of Purchase-Type

  26. Consolidation of Wholly-Owned Subsidiary on Date of Purchase-Type Business Combination (contd.)Example 6.1: (contd.) • Note: Starr remains as a separate legal entity and therefore was not liquidated as in a merger (i.e., statutory merger or consolidation merger). • The journal entries of Palm in this business combination do not include any debits or credits to record individual assets and liabilities of Starr Company as in the case of mergers. Consolidated FS-On Date of Purchase-Type

  27. Consolidation of Wholly-Owned Subsidiary on Date of Purchase-Type Business Combination (contd.)Example 6.1: (contd.) • The following are the account balances of affected accounts after posting the journal entries of the purchase-type business combination: Consolidated FS-On Date of Purchase-Type

  28. Consolidation of Wholly-Owned Subsidiary on Date of Purchase-Type Business Combination (contd.)Example 6.1: (contd.) Consolidated FS-On Date of Purchase-Type

  29. Preparation of Consolidated Balance Sheet without a Working Paper • key principles in preparing the consolidated balance sheet statement for a parent company and its subsidiary: • 1. The parent company’s investment account and the subsidiary’s stockholder’s equity accounts should not appear in the consolidated balance sheet.a • a. This is because they are reciprocal accounts. Consolidated FS-On Date of Purchase-Type

  30. Preparation of Consolidated Balance Sheet without a Working Paper (contd.) • key principles (contd.) • 2. The subsidiary’s assets and liabilities (other than intercompany ones) are reported at current fair values in the consolidated balance sheet. • The parent’s are reported at carrying amounts.a • a. Due to this is a purchase-type business combination. Consolidated FS-On Date of Purchase-Type

  31. Preparation of Consolidated Balance Sheet without a Working Paper (contd.) • key principles (contd.) • 3. Goodwill is recognized as an intangible asset. • Goodwill is calculated as the difference between the cost of the parent’s investment and the current fair value of the subsidiary’s identifiable net assets. Consolidated FS-On Date of Purchase-Type

  32. Preparation of Consolidated Balance Sheet without a Working Paper (contd.) • Applying these principles to Palm Corp. and Starr company parent-subsidiary relationship, the following consolidated balance sheet is prepared: (p238-p239) Consolidated FS-On Date of Purchase-Type

  33. Preparation of Consolidated Balance Sheet without a Working Paper (contd.) • PALM CORPORATION AND SUBSIDIARY • Consolidated Balance Sheet • December 31, 1999 (Continued) Consolidated FS-On Date of Purchase-Type

  34. Preparation of Consolidated Balance Sheet without a Working Paper (contd.) • Consolidated Balance Sheet (contd.) • 12/31/1999 Consolidated FS-On Date of Purchase-Type

  35. Preparation of Consolidated Balance Sheet without a Working Paper (contd.) • Notes for the above consolidated balance sheet: • 1. The parent company’s assets and liabilities are reported at the carrying amount while the subsidiaries are reported at the fair market value. • 2. Intercompany accounts (parent’s investment, subsidiary’s stockholders’ equity and intercompany receivable/payable) are excluded from the statement. Consolidated FS-On Date of Purchase-Type

  36. Preparation of Consolidated Balance Sheet without a Working Paper (contd.) • 3. Goodwill is computed as the cost of parent’s investment ($500,000) minus the fair value of the subsidiary’s identifiable net assets ($485,000).a • a. Net assets = $485,000 => • 200,000+58,000+132,000 (the net assets at carrying amount of Starr)+25,000 (step up for inventories)+65,000(step up for plant assets)+5,000 (step up for patent) Consolidated FS-On Date of Purchase-Type

  37. Working Paper for consolidated Balance Sheet • The consolidated balance sheet on the date of purchase-type business combination can also be prepared using a working paper approach. Accounts need to be eliminated in the working paper are: • 1. Investment account of the parent company. • 2. Stockholder equity’s accounts of the subsidiary, and • 3. Intercompany accounts (i.e.,receivable/ payable). Consolidated FS-On Date of Purchase-Type

  38. Working Paper for consolidated Balance Sheet (contd.) • In addition, subsidiary’s assets need to be increased to the fair market value. • If the investment of the parent company is greater than the fair value of the net assets of the subsidiary, the excess amount is recorded as goodwill. Consolidated FS-On Date of Purchase-Type

  39. Working Paper for consolidated Balance Sheet (contd.) • If the fair value of the net assets is in excess of the investment, the excess is to reduce proportionately the amounts of noncurrent assets other than long-term investments in marketable securities. • Any remaining excess is credit to the negative goodwill account and is amortized over a maximum period of 40 years. Consolidated FS-On Date of Purchase-Type

  40. Working Paper for consolidated Balance Sheet (contd.) • Based on these principles, the following entries are prepared before preparing the working paper: Consolidated FS-On Date of Purchase-Type

  41. Working Paper for consolidated Balance Sheet (contd.) • PALM CORPORATION AND SUBSIDIARY • Working Paper Elimination • December 31,1999 Consolidated FS-On Date of Purchase-Type

  42. Working Paper for consolidated Balance Sheet (contd.) • The above entries are only entered into the elimination column of the working paper for consolidated balance sheet. These entries are NOT entered in either the parent company’s or the subsidiary’s accounting records. Consolidated FS-On Date of Purchase-Type

  43. Working Paper for consolidated Balance Sheet (contd.) • The following working paper for the consolidated balance sheet statement on the date of purchase-type business combination is prepared incorporating the above entries: (on p242) Consolidated FS-On Date of Purchase-Type

  44. Working Paper for consolidated Balance Sheet (contd.) • PALM CORPORATION AND SUBSIDIARY • Working Paper for Consolidated Balance Sheet • December 31, 1999 (Continued) Consolidated FS-On Date of Purchase-Type

  45. Working Paper for consolidated Balance Sheet (contd.) • Contd. Consolidated FS-On Date of Purchase-Type

  46. Notes to Working Paper for Consolidated Balance Sheets • Note to the above working paper: Intercompany receivables and payables are placed on the same line to produce a consolidated amount of zero. • The following is the consolidated balance sheet statement based on the consolidated column of the working paper. This statement is the same as the one presented earlier without the working paper: Consolidated FS-On Date of Purchase-Type

  47. Consolidated Balance Sheet Based on Working Paper • PALM CORPORATION AND SUBSIDIARY • Consolidated Balance Sheet • December 31, 1999 (Continued) Consolidated FS-On Date of Purchase-Type

  48. Consolidated Balance Sheet Based on Working Paper (contd.) • Consolidated Balance Sheet (contd.) • 12/31/1999 Consolidated FS-On Date of Purchase-Type

  49. Consolidated Balance Sheet Based on Working Paper (contd.) • In addition to the consolidated balance sheet on 12/31/99, Palm Corp.’s published financial statements for the year ended 12/31/1999 also include the unconsolidatedaincome statement, statement of retained earnings (illustrated on pages 18-20) and an unconsolidated statement of cash flows. • a. This is because at the date of purchase for purchase-type business combination, no consolidated I/S is needed. Consolidated FS-On Date of Purchase-Type

  50. Consolidation of Partially Owned Subsidiary on date of Purchase-Type Business Combination • Minority interests: A term applied to the claims of stockholders other than the parent company (the controlling interest) to the net income or losses and net assets of the subsidiary. • The consolidation of a parent company and its partially owned subsidiary differs from the consolidation of a wholly owned subsidiary in the recognition of minority interest. Consolidated FS-On Date of Purchase-Type