SOLUTION'S MANUAL for Advanced Accounting 12e Joe Hoyle Thomas SchaeferTimothy Doupnik by welldoneassistant

SOLUTION'S MANUAL for Advanced Accounting 12e Joe Hoyle Thomas SchaeferTimothy Doupnik

Advanced Accounting 12e Joe Hoyle Thomas SchaeferTimothy Doupnik (Solutions Manual All Chapters, 100% Original Verified, A+ Grade) CHAPTER 1 THE EQUITY METHOD OF ACCOUNTING FOR INVESTMENTS Chapter Outline I.

Three methods are principally used to account for an investment in equity securities along with a fair value option. A. Fair value method: applied by an investor when only a small percentage of a company’s voting stock is held. 1. Income is recognized when the investee declares a dividend. 2. Portfolios are reported at fair value. If fair values are unavailable, investment is reported at cost. B. Consolidation: when one firm controls another (e.g., when a parent has a majority interest in the voting stock of a subsidiary or control through variable interests, their financial statements are consolidated and reported for the combined entity. C. Equity method: applied when the investor has the ability to exercise significant influence over operating and financial policies of the investee. 1. Ability to significantly influence investee is indicated by several factors including representation on the board of directors, participation in policy-making, etc. 2. GAAP guidelines presume the equity method is applicable if 20 to 50 percent of the outstanding voting stock of the investee is held by the investor. Current financial reporting standards allow firms to elect to use fair value for any new investment in equity shares including those where the equity method would otherwise apply. However, the option, once taken, is irrevocable. Investee dividends and changes in fair value over time are recognized as income. On February 14, 2013, the FASB issued a Proposed Accounting Standards Update (ASU) entitled, Recognition and Measurement of Financial Assets and Financial Liabilities. The proposed ASU would eliminate the fair-value option for investments that qualify for equity method treatment. Fair-value accounting, however, would be extended to “equity method” investments that meet the criteria for classification as held for sale.

II.

Accounting for an investment: the equity method A. The investment account is adjusted by the investor to reflect all changes in the equity of the investee company. B. Income is accrued by the investor as soon as it is earned by the investee. C. Dividends declared by the investee create a reduction in the carrying amount of the Investment account. The text assumes all investee dividends are declared and paid in the same reporting period.

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Chapter 01 - The Equity Method of Accounting for Investments

III.

Special accounting procedures used in the application of the equity method A. Reporting a change to the equity method when the ability to significantly influence an investee is achieved through a series of acquisitions. 1. Initial purchase(s) will be accounted for by means of the fair value method (or at cost) until the ability to significantly influence is attained. 2. At the point in time that the equity method becomes applicable, a retrospective adjustment is made by the investor to convert all previously reported figures to the equity method based on percentage of shares owned in those periods. 3. This restatement establishes financial statement comparability across years. B. Investee income from other than continuing operations 1. The investor recognizes its share of investee reported other comprehensive income (OCI) through the investment account and the investor’s own OCI. 2. Income items such as extraordinary gains and losses and discontinued operations that are reported separately by the investee should be shown in the same manner by the investor. The materiality of these other investee income elements (as it affects the investor) continues to be a criterion for separate disclosure. C. Investee losses 1. Losses reported by the investee create corresponding losses for the investor. 2. A permanent decline in the fair value of an investee’s stock should be recognized immediately by the investor as an impairment loss. 3. Investee losses can possibly reduce the carrying value of the investment account to a zero balance. At that point, the equity method ceases to be applicable and the fair-value method is subsequently used. D. Reporting the sale of an equity investment 1. The investor applies the equity method until the disposal date to establish a proper book value. 2. Following the sale, the equity method continues to be appropriate if enough shares are still held to maintain the investor’s ability to significantly influence the investee. If that ability has been lost, the fair-value method is subsequently used.

IV.

Excess investment cost over book value acquired A. The price an investor pays for equity securities often differs significantly from the investee’s underlying book value primarily because the historical cost based accounting model does not keep track of changes in a firm’s fair value. B. Payments made in excess of underlying book value can sometimes be identified with specific investee accounts such as inventory or equipment. C. An extra acquisition price can also be assigned to anticipated benefits that are expected to be derived from the investment. In accounting, these amounts are presumed to reflect an intangible asset referred to as goodwill. Goodwill is calculated as any excess payment that is not attributable to specific assets and liabilities of the investee. Because goodwill is an indefinite-lived asset, it is not amortized.

Deferral of unrealized gross profit in inventory A. Profits derived from intra-entity transactions are not considered completely earned until the transferred goods are either consumed or resold to unrelated parties.

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Chapter 01 - The Equity Method of Accounting for Investments

B. Downstream sales of inventory 1. “Downstream” refers to transfers made by the investor to the investee. 2. Intra-entity gross profits from sales are initially deferred under the equity method and then recognized as income at the time of the inventory’s eventual disposal. 3. The amount of gross profit to be deferred is the investor’s ownership percentage multiplied by the markup on the merchandise remaining at the end of the year. C. Upstream sales of inventory 1. “Upstream” refers to transfers made by the investee to the investor. 2. Under the equity method, the deferral process for unrealized profits is identical for upstream and downstream transfers. The procedures are separately identified in Chapter One because the handling does vary within the consolidation process.

Answers to Discussion Questions The textbook includes discussion questions to stimulate student thought and discussion. These questions are also designed to allow students to consider relevant issues that might otherwise be overlooked. Some of these questions may be addressed by the instructor in class to motivate student discussion. Students should be encouraged to begin by defining the issue(s) in each case. Next, authoritative accounting literature (FASB ASC) or other relevant literature can be consulted as a preliminary step in arriving at logical actions. Frequently, the FASB Accounting Standards Codification will provide the necessary support. Unfortunately, in accounting, definitive resolutions to financial reporting questions are not always available. Students often seem to believe that all accounting issues have been resolved in the past so that accounting education is only a matter of learning to apply historically prescribed procedures. However, in actual practice, the only real answer is often the one that provides the fairest representation of the a firm’s transactions. If an authoritative solution is not available, students should be directed to list all of the issues involved and the consequences of possible alternative actions. The various factors presented can be weighed to produce a viable solution. The discussion questions are designed to help students develop research and critical thinking skills in addressing issues that go beyond the purely mechanical elements of accounting. Did the Cost Method Invite Manipulation? The cost method of accounting for investments often caused a lack of objectivity in reported income figures. With a large block of the investee’s voting shares, an investor could influence the amount and timing of the investee’s dividend declarations. Thus, when enjoying a good earnings year, an investor might influence the investee to withhold declaring a dividend until needed in a subsequent year. Alternatively, if the investor judged that its current year earnings “needed a boost,” it might influence the investee to declare a current year dividend. The equity method effectively removes managers’ ability to increase current income (or defer income to future periods) through their influence over the timing and amounts of investee dividend declarations. At first glance it may seem that the fair value method allows managers to manipulate income because investee dividends are recorded as income by the investor. However, dividends paid typically are accompanied by a decrease in fair value (also recognized in income), thus leaving reported net income unaffected.

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Does the Equity Method Really Apply Here? The discussion in the case between the two accountants is limited to the reason for the investment acquisition and the current percentage of ownership. Instead, they should be examining the actual interaction that currently exists between the two companies. Although the ability to exercise significant influence over operating and financial policies appears to be a rather vague criterion, ASC 323 "Investments—Equity Method and Joint Ventures," clearly specifies actual events that indicate this level of authority (paragraph 323-10-15-6): Ability to exercise that influence may be indicated in several ways, such as representation on the board of directors, participation in policy-making processes, material intra-entity transactions, interchange of managerial personnel, or technological dependency. Another important consideration is the extent of ownership by an investor in relation to the concentration of other shareholdings, but substantial or majority ownership of the voting stock of an investee company by another investor does not necessarily preclude the ability to exercise significant influence by the investor. In this case, the accountants would be wise to determine whether Dennis Bostitch or any other member of the Highland Laboratories administration is participating in the management of Abraham, Inc. If any individual from Highland's organization is on Abraham’s board of directors or is participating in management decisions, the equity method would seem to be appropriate. Likewise, if significant transactions have occurred between the companies (such as loans by Highland to Abraham), the ability to apply significant influence becomes much more evident. However, if James Abraham continues to operate Abraham, Inc., with little or no regard for Highland, the equity method should not be applied. This possibility seems especially likely in this case since one stockholder, James Abraham, continues to hold a majority (2/3) of the voting stock. Thus, evidence of the ability to apply significant influence must be present before the equity method is viewed as applicable. The mere holding of 1/3 of the stock is not conclusive.

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Answers to Questions 1. The equity method should be applied if the ability to exercise significant influence over the operating and financial policies of the investee has been achieved by the investor. However, if actual control has been established, consolidating the financial information of the two companies will normally be the appropriate method for reporting the investment. 2. According to FASB ASC paragraph 323-10-15-6 "Ability to exercise that influence may be indicated in several ways, such as representation on the board of directors, participation in policy-making processes, material intra-entity transactions, interchange of managerial personnel, or technological dependency. Another important consideration is the extent of ownership by an investor in relation to the extent of ownership of other shareholdings." The most objective of the criteria established by the Board is that holding (either directly or indirectly) 20 percent or more of the outstanding voting stock is presumed to constitute the ability to hold significant influence over the decision-making process of the investee. 3. The dividends are reported as a deduction from the investment account, not revenue, to avoid reporting the income from the investee twice. The equity method is appropriate when an investor has the ability to exercise significant influence over the operating and financing decisions of an investee. Because dividends represent financing decisions, the investor may have the ability to influence dividend timing. If dividends were recorded as income, managers could affect reported income in a way that does not reflect actual performance. Therefore, in reflecting the close relationship between the investor and investee, the equity method employs accrual accounting to record income as it is earned by the investee. The investment account is increased for the investee”s earned income and then decreased as the income is distributed, through dividends. From the investor’s view, the decrease in the investment asset (from investee dividends) is offset by an immediate increase in dividends receivable and an eventual increase in cash. 4. If Jones cannot significantly influence the operating and financial policies of Sandridge, the equity method should not be applied regardless of the ownership level. However, an owner of 25 percent of a company's outstanding voting stock is assumed to possess this ability. This presumption stands until overcome by predominant evidence to the contrary. Examples of indications that an investor may be unable to exercise significant influence over the operating and financial policies of an investee include (ASC 323-10-15-10): a. Opposition by the investee, such as litigation or complaints to governmental regulatory authorities, challenges the investor's ability to exercise significant influence. b. The investor and investee sign an agreement under which the investor surrenders significant rights as a shareholder. c. Majority ownership of the investee is concentrated among a small group of shareholders who operate the investee without regard to the views of the investor. d. The investor needs or wants more financial information to apply the equity method than is available to the investee's other shareholders (for example, the investor wants quarterly financial information from an investee that publicly reports only annually), tries to obtain that information, and fails. e. The investor tries and fails to obtain representation on the investee's board of directors. 5. The following events necessitate changes in this investment account. a. Net income earned by Watts would be reflected by an increase in the investment balance whereas a reported loss is shown as a reduction to that same account. 1-5 .

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b. Dividends declared by the investee decrease its book value, thus requiring a corresponding reduction to be recorded in the investment balance. c. If, in the initial acquisition price, Smith paid extra amounts because specific investee assets and liabilities had values differing from their book values, amortization of this portion of the investment account is subsequently required. As an exception, if the specific asset is land or goodwill, amortization is not appropriate. d. Intra-entity gross profits created by sales between the investor and the investee must be deferred until earned through usage or resale to outside parties. The initial deferral entry made by the investor reduces the investment balance while the eventual recognition of the gross profit increases this account. 6. The equity method has been criticized because it allows the investor to recognize income that may not be received in any usable form during the foreseeable future. Income is being accrued based on the investee's reported earnings, not on the investor’s share of investee dividends. Frequently, equity income will exceed the investor’s share of investee cash dividends with no assurance that the difference will ever be forthcoming. Many companies have contractual provisions (e.g., debt covenants, managerial compensation contracts) based on ratios in the main body of the financial statements. Relative to consolidation, a firm employing the equity method will report smaller values for assets and liabilities. Consequently, higher rates of return for its assets and sales, as well as lower debtto-equity ratios may result. Meeting such contractual provisions of may provide managers incentives to maintain technical eligibility for the equity method rather than full consolidation. 7. FASB ASC Topic 323 requires that a change to the equity method be reflected by a retrospective adjustment. Although a different method may have been appropriate for the original investment, comparable balances will not be readily apparent if the equity method is now applied. For this reason, financial figures from all previous years presented are restated as if the equity method had been applied consistently since the date of initial acquisition. 8. In reporting equity earnings for the current year, Riggins must separate its accrual into two components: (1) net income and (2) other comprehensive income or loss. This handling enables the reader of the investor's financial statements to assess the nature of the change to the investment account. 9. Under the equity method, losses are recognized by an investor at the time that they are reported by the investee. However, because of the conservatism inherent in accounting, any permanent losses in value should also be recorded immediately. Because the investee's stock has suffered a permanent impairment in this question, the investor recognizes the loss applicable to its investment. 10. Following the guidelines established by the ASC, Wilson would recognize an equity loss of $120,000 (40 percent) stemming from Andrews' reported loss. However, since the book value of this investment is only $100,000, Wilson's loss is limited to that amount with the remaining $20,000 being omitted. Subsequent income will be recorded by the investor based on investee dividends. If Andrews is ever able to generate sufficient future profits to offset the total unrecognized losses, the investor will revert to the equity method. 11. In accounting, goodwill is derived as a residual figure. It is the investor's cost in excess of its share of the fair value of the investee assets and liabilities. Although a portion of the acquisition price may represent either goodwill or valuation adjustments to specific investee 1-6 .

Chapter 01 - The Equity Method of Accounting for Investments

assets and liabilities, the investor records the entire cost in a single investment account. No separate identification of the cost components is made in the reporting process. Subsequently, the cost figures attributed to specific accounts (having a limited life), besides goodwill and other indefinite life assets, are amortized based on their anticipated lives. This amortization reduces the investment and the accrued income in future years. 12. On June 19, Princeton removes the portion of this investment account that has been sold and recognizes the resulting gross profit or loss. For proper valuation purposes, the equity method is applied (based on the 40 percent ownership) from the beginning of Princeton's fiscal year until June 19. Princeton's method of accounting for any remaining shares after June 19 will depend upon the degree of influence that is retained. If Princeton still has the ability to significantly influence the operating and financial policies of Yale, the equity method continues to be appropriate based on the reduced percentage of ownership. Conversely, if Princeton no longer holds this ability, the fair-value method becomes applicable, based on the remaining equity value after the sale. 13. Downstream sales are made by the investor to the investee while upstream sales are from the investee to the investor. These titles have been derived from the traditional positions given to the two parties when presented on an organization-type chart. Under the equity method, no accounting distinction is actually drawn between downstream and upstream sales. Separate presentation is made in this chapter only because the distinction does become significant in the consolidation process as will be demonstrated in Chapter Five. 14. The unrealized portion of an intra-entity gross profit is computed based on the markup on any transferred inventory retained by the buyer at year's end. The markup percentage (based on sales price) multiplied by the intra-entity ending inventory gives the seller’s profit remaining in the buyer’s ending inventory. The product of the ownership percentage and this profit figure is the unrealized gross profit from the intra-entity transaction. This profit is deferred in the recognition of equity earnings until subsequently earned through use or resale to an unrelated party. 15. Intra-entity transfers do not affect the financial reporting of the investee except that the related party transactions must be appropriately disclosed and labeled. 16. Under fair value accounting, firms report the investment’s fair value as an asset and changes in fair value as earnings. Dividends from an investee are included in earnings under the fair value accounting. Dividends are not recognized in income but instead reduce the investment account under the equity method. Also, under the equity method, firms recognize their ownership share of investee profits adjusted for excess cost amortizations and intra-entity profits.

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Answers to Problems 1. D 2. B 3. C 4. B 5. D 6. A Acquisition price ............................................................................. $1,600,000 Equity income ($560,000 × 40%) .................................................... 224,000 Dividends (50,000 shares × $2.00).................................................. (100,000) Investment in Harrison Corporation as of December 31 .............. $1,724,000 7. A Acquisition price ............................................................................. Income accruals: 2014—$170,000 × 20%....................................... 2015—$210,000 × 20% ...................................... Amortization (see below): 2014 ...................................................... Amortization: 2015 .......................................................................... Dividends: 2014—$70,000 × 20% ................................................... 2015—$70,000 × 20% .................................................... Investment in Martes, December 31, 2015 .....................................

$700,000 34,000 42,000 (10,000) (10,000) (14,000) (14,000) $728,000

Acquisition price of Martes............................................................. Acquired net assets (book value) ($3,000,000 × 20%) ................. Excess cost over book value to patent ......................................... Annual amortization (10 year remaining life) ...............................

$700,000 (600,000) $100,000 $10,000

8. B Purchase price of Johnson stock .................. Book value of Johnson ($900,000 × 40%)...... Cost in excess of book value .................... Payment identified with undervalued ............ Building ($140,000 × 40%) ......................... Trademark ($210,000 × 40%) ..................... Total .................................................................

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$500,000 (360,000) $140,000 Remaining Annual life amortization

56,000 7 yrs. 84,000 10 yrs. $ -0-

$8,000 8,400 $16,400

Chapter 01 - The Equity Method of Accounting for Investments

Investment purchase price ............................................ Basic income accrual ($90,000 × 40%) .................... Amortization (above) ................................................. Dividends declared ($30,000 × 40%) ....................... Investment in Johnson ...................................................

$500,000 36,000 (16,400) (12,000) $507,600

9. D The 2014 purchase is reported using the equity method. Purchase price of Evan stock......................................................... $600,000 Book value of Evan stock ($1,200,000 × 40%) ............................... (480,000) Goodwill ........................................................................................... $120,000 Life of goodwill ................................................................................ indefinite Annual amortization ........................................................................ (-0-) Cost on January 1, 2014 ................................................................. 2014 Income accrued ($140,000 x 40%) ......................................... 2014 Dividend ($50,000 × 40%) ....................................................... 2015 Income accrued ($140,000 × 40%) ......................................... 2015 Dividend ($50,000 × 40%) ....................................................... 2016 Income accrued ($140,000 × 40%) ......................................... 2016 Dividend ($50,000 × 40%) ....................................................... Investment in Evan, 12/31/16.....................................................

$600,000 56,000 (20,000) 56,000 (20,000) 56,000 (20,000) $708,000

11. A Gross profit rate (GPR): $36,000 ÷ $90,000 = 40% Inventory remaining at year-end .................................................... GPR................................................................................................... Unrealized gross profit .............................................................. Ownership ........................................................................................ Intra-entity gross profit—deferred ............................................

$20,000 × 40% $8,000 × 30% $ 2,400

10. D

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12. B Purchase price of Steinbart shares ............................................... Book value of Steinbart shares ($1,200,000 × 40%)...................... Trade name ...................................................................................... Remaining life of trade name.......................................................... Annual amortization ........................................................................ 2014 Gross profit rate = $30,000 ÷ $100,000 = 30% 2015 Gross profit rate = $54,000 ÷ $150,000 = 36% 2015—Equity income in Steinbart: Income accrual ($110,000 × 40%) ................................................... Amortization (above) ....................................................................... Recognition of 2014 unrealized gross profit ($25,000 × 30% GPR × 40% ownership) .................................... Deferral of 2015 unrealized gross profit ($45,000 × 36% GPR × 40% ownership ..................................... Equity income in Steinbart—2015 ............................................

$530,000 (480,000) $ 50,000 20 years $ 2,500

$44,000 (2,500) 3,000 (6,480) $38,020

13. (6 minutes) (Investment account after one year) Purchase price ..................................................................................... $1,160,000 Basic 2015 equity accrual ($260,000 × 40%) ..................................... 104,000 Amortization of copyright: Excess payment ($1,160,000 – $820,000 = $340,000) to copyright allocated over 10 year remaining life .................. (34,000) Dividends (50,000 × 40%) .................................................................... (20,000) Investment account balance at year end ........................................... $1,210,000 14. (7 minutes) a. Purchase price ................................................................................. $ 2,290,000 Equity income accrual ($720,000 × 35%) ....................................... 252,000 Other comprehensive loss accrual ($100,000 × 35%)................... (35,000) Dividends (20,000 × 35%) ................................................................ (7,000) Investment in Steel at December 31, 2015 .................................... $2,500,000 b. Equity income of Steel = $252,000 (does not include OCI share which is reported separately).

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15. (15 minutes) (Investment account after 2 years) a. Acquisition price ................................................................................. $2,700,000 Book value acquired ($5,175,000 × 20%) ........................................... 1,035,000 Excess payment .................................................................................. $1,665,000 Excess fair value: Computing equipment ($700,000 × 20%) ........ 140,000 Excess fair value: Patented technology ($3,900,000 × 20%) ........ 780,000 Excess fair value: Trademark ($1,850,000 × 20%) ........................ 370,000 Goodwill ............................................................................................... $ 375,000 Amortization: Computing equipment ($140,000 ÷ 7) ....................................... $ 20,000 Patented technology ($780,000 ÷ 3) .......................................... 260,000 Trademark (indefinite)................................................................ -0Goodwill (indefinite) ................................................................... -0Annual amortization ........................................................................ $280,000 b. Basic equity accrual 2014 ($1,800,000 × 20%) .................................. Amortization—2014 (above) ............................................................... Equity in 2014 earnings of Sauk Trail ................................................

$360,000 (280,000) $ 80,000

Basic equity accrual 2015 ($1,985,000 × 20%) .................................. Amortization—2015 (above) ............................................................... Equity in 2015 earnings of Sauk Trail ................................................

$397,000 (280,000) $117,000

Acquisition price ................................................................................. $2,700,000 Equity in 2014 earnings of Sauk Trail (above) .................................. 80,000 Dividends—2014 ($150,000 × 20%) .................................................... (30,000) Investment in Sauk Trail, 12/31/14 ..................................................... $2,750,000 Investment in Sauk Trail, 12/31/14 ..................................................... $2,750,000 Equity in 2015 earnings of Sauk Trail (above) .................................. $117,000 Dividends—2015 ($160,000 × 20%) .................................................... (32,000) Investment in Sauk Trail, 12/31/15 ..................................................... $2,835,000

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16. (10 minutes) (Investment account after 2 years with fair value accounting included) a. Acquisition price ................................................................................. $60,000 Book value—assets minus liabilities ($125,000 × 40%) ............... 50,000 Excess payment ......................................................................... $10,000 Value of patent in excess of book value ($15,000 × 40%) ............ 6,000 Goodwill ........................................................................................... $ 4,000

Amortization: Patent ($6,000 ÷ 6) ...................................................................... Goodwill ...................................................................................... Annual amortization .............................................................

$1,000 -0$1,000

Acquisition price ............................................................................. Basic equity accrual 2014 ($30,000 × 40%) ................................... Dividends—2014 ($10,000 × 40%) .................................................. Amortization—2014 (above) ........................................................... Investment in Holister, 12/31/14 ..................................................... Basic equity accrual —2015 ($50,000 × 40%) ................................ Dividends—2015 .............................................................................. Amortization—2015 (above) ........................................................... Investment in Holister, 12/31/15 .....................................................

$60,000 12,000 (4,000) (1,000) $67,000 20,000 (6,000) (1,000) $80,000

Dividend income ($15,000 × 40%) .................................................. Increase in fair value ($75,000 – $68,000) ...................................... Investment income under fair value accounting—2015 ...............

$6,000 7,000 $13,000

17. (10 minutes) (Equity entries for one year, includes intra-entity transfers but no unearned gross profit) Purchase price of Burks stock ....................................................... $210,000 Book value of Burks stock ($360,000 × 40%) ................................ (144,000) Unidentified asset (goodwill) .......................................................... $ 66,000 Life .................................................................................................... indefinite Annual amortization ........................................................................ $ -0No unearned intra-entity profit exists at year’s end because all of the transferred merchandise was used during the period.

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17. (continued) Investment in Burks, Inc. .......................................... 210,000 Cash (or a Liability) .............................................. To record acquisition of a 40 percent interest in Burks.

210,000

Investment in Burks, Inc. .......................................... 32,000 Equity in Investee Income ................................... 32,000 To recognize 40 percent income earned during period by Burks, an equity method investment. Dividend Receivable .................................................. Investment in Burks, Inc. ..................................... To record investee dividend declaration.

10,000

Cash ............................................................................ Dividend Receivable. ........................................... To record collection of dividend from investee.

10,000

18. (20 Minutes) (Equity entries for one year, includes conversion to equity method) The 2014 purchase must be restated to the equity method. FIRST PURCHASE—JANUARY 1, 2014 Purchase price of McKenzie stock.................................................. Book value of McKenzie stock ($1,700,000 × 10%) ........................ Cost in excess of book value .......................................................... Excess cost assigned to undervalued land ($100,000 × 10%) ...... Trademark ......................................................................................... Remaining life of trademark ........................................................... Annual amortization .........................................................................

$210,000 (170,000) $40,000 (10,000) $30,000 10 years $ 3,000

BOOK VALUE—MCKENZIE—JANUARY 1, 2015 (before second purchase) January 1, 2014 book value (given) ................................................ $1,700,000 2014 Net income ............................................................................... 240,000 2014 Dividends ................................................................................. (90,000) January 1, 2015 book value ............................................................. $1,850,000

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18.

(continued) SECOND PURCHASE—JANUARY 1, 2015 Purchase price of McKenzie stock ............................................... Book value of McKenzie stock (above) ($1,850,000 × 30%) ....... Cost in excess of book value ....................................................... Excess cost assigned to undervalued land ($120,000 × 30%)....................................................................... Trademark ...................................................................................... Remaining life of Trademark ........................................................ Annual Amortization ..................................................................... Journal Entries: To record second acquisition of McKenzie stock. Investment in McKenzie ............................................ Cash ...................................................................... Investment in McKenzie ............................................ Retained Earnings—Prior Period Adjustment— 2014 Equity Income .......................................

$600,000 (555,000) $45,000 (36,000) $ 9,000 9 years $ 1,000

600,000 600,000 12,000 12,000

To restate reported figures for 2014 to the equity method. Reported income is $24,000 (10% of McKenzie’s income) less $3,000 (amortization on first purchase) = $21,000. Originally, Austin reported $9,000 (10% of the dividends). The adjustment increases the $9,000 to $21,000 for 2014. Investment in McKenzie ............................................ 120,000 Equity Income—Investment in McKenzie........... 120,000 To record income for the year: 40% of the $300,000 reported income. Dividend Receivable .................................................. 44,000 Investment in McKenzie....................................... To record dividend declaration from McKenzie (40% of $110,000).

44,000

Cash ............................................................................ Dividend Receivable. ........................................... To record collection of dividend from investee.

44,000

Equity Income—Investment in McKenzie ................ 4,000 Investment in McKenzie....................................... 4,000 To record 2015 amortization: $3,000 for first purchase, $1,000 for second.

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19. (7 minutes) (Deferral of unrealized gross profit) Ending inventory ($225,000 – $105,000) ............................................. Gross profit percentage (GP $75,000 ÷ Sales $225,000) ................... Unrealized gross profit ......................................................................... Ownership ............................................................................................. Intra-entity unrealized gross profit—deferred ....................................

$120,000 × 33⅓% $40,000 × 25% $10,000

Entry to Defer Unrealized Gross Profit: Equity Income from Schilling ....................................... Investment in Schilling ............................................

10,000 10,000

20. (10 minutes) (Reporting of equity income and transfers) a. Equity in investee income: Equity income accrual ($100,000 × 25%).................................. Less: deferral of intra-entity unrealized gross profit (below) Less: patent amortization (given) ............................................ Equity in investee income ....................................................

$25,000 (3,000) (10,000) $12,000

Deferral of intra-entity unrealized gross profit: Remaining inventory—end of year ...................................... Gross profit percentage (GP $30,000 ÷ Sales $80,000)...... Profit within remaining inventory ........................................ Ownership percentage ......................................................... Intra-entity unrealized gross profit ...............................................

$32,000 × 37½% $12,000 × 25% $ 3,000

b. In 2015, the deferral of $3,000 will likely become realized by BuyCo’s use or sale of this inventory. Thus, the equity accrual for 2015 will be increased by $3,000 in that year. Recognition of this amount is simply being delayed from 2014 until 2015, the year actually earned. c. The direction (upstream versus downstream) of the intra-entity transfer does not affect the above answers. However as discussed in Chapter Five, a controlling interest calls for a 100% gross profit deferral for downstream intra-entity transfers. In the presence of only signification influence, however, equity method accounting is identical regardless of whether an intra-entity transfer is upstream or downstream.

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Chapter 01 - The Equity Method of Accounting for Investments

21. (25 minutes) (Conversion from fair-value method to equity method with a subsequent sale of a portion of the investment) Equity method income accrual for 2015 30 percent of $644,000 for ½ year = ..................................... 24 percent of $644,000 for ½ year = ..................................... Total income accrual (no amort. or unearned gross profit) .......... Gain on sale (below) ....................................................................... Total income statement effect – 2015

$ 96,600 77,280 $173,880 31,000 $204,880

Gain on sale of 9,000 shares of Marion: Cost of initial acquisition—2013 .................................................... $435,000 10% income accrual (conversion made to equity method) .......... 35,900 10% of dividends ............................................................................. (10,700) Cost of second acquisition—2014 ................................................. 1,000,000 30% income accrual—2014 ............................................................. 150,300 30% of dividends—2014 .................................................................. (39,750) 30% income accrual for ½ year—2015 ........................................... 96,600 30% of dividends for ½ year—2015................................................ (22,350) Book value of 45,000 shares on July 1, 2015 .......................... $1,645,000 Cash proceeds from the sale: 9,000 shares × $40 ....................... Less: book value of shares sold: $1,645,000 × (9,000 ÷ 45,000) .. Gain on sale ................................................................................

$360,000 329,000 $ 31,000

22. (25 minutes) (Verbal overview of equity method, includes conversion to equity method) a. In 2014, the fair-value method (available-for-sale security) was appropriate. Thus, the only income recognized was the dividends declared. Collins should originally have reported dividend income equal to 10 percent of Merton’s dividends. b. The assumption is that Collins’ level of ownership now provides the company with the ability to exercise significant influence over the operating and financial policies of Merton. Factors that indicate such a level of influence are described in the textbook and include representation on the investee’s board of directors, material intra-entity transactions, and interchange of managerial personnel.

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Chapter 01 - The Equity Method of Accounting for Investments

22.

(continued) c. Despite holding 25 percent of Merton’s outstanding stock, application of the equity method is inappropriate absent the ability to apply significant influence. Factors that indicate a lack of such influence include: an agreement whereby the owner surrenders significant rights, a concentration of the remaining ownership, and failure to gain representation on the board of directors. d. The equity method attempts to reflect the relationship between the investor and the investee in two ways. First, the investor recognizes investment income as soon as it is earned by the investee. Second, the Investment account reported by the investor is increased and decreased to indicate changes in the underlying book value of the investee. e. Criticisms of the equity method include ▪ its emphasis on the 20-50% of voting stock in determining significant influence vs. control ▪ allowing off-balance sheet financing ▪ potential biasing of performance ratios Relative to consolidation, the equity method will report smaller amounts for assets, liabilities, revenues and expenses. However, income is typically the same as reported under consolidation. Therefore, companies that use the equity method, and avoid consolidation, often show enhanced debt-to equity ratios, as well as ratios for returns on assets and sales. f. When an investor buys enough additional shares to gain the ability to exert significant influence, accounting for any shares previously owned must be adjusted to the equity method on a retrospective basis. Thus, in this case, the 10 percent interest held by Collins in 2014 must now be reported using the equity method. In this manner, the 2014 statements will be more comparable with those of 2015 and future years. g. The price paid for each purchase is first compared to the equivalent book value on the date of acquisition. Any excess payment is then assigned to specific assets and liabilities based on differences between book value and fair value. If any residual amount of the purchase price remains unexplained, it is assigned to goodwill.

1-17 .

Chapter 01 - The Equity Method of Accounting for Investments

22.

(continued) h. Investee dividends reduce its book value. Because the investor’s Investment account tracks the investee’s book value, Collins records the dividend as a reduction in its Investment account. This method of recording also avoids double-counting of the revenue since the investor has already recorded the amount when earned by the investee. Under the equity method, revenues are recognized when earned by the investee but not through dividends as a distribution of the same earnings. i. The Investment account will show the costs to obtain ownership of Merton. In addition, an equity accrual equal to 10 percent of the investee’s income for 2014 and 25 percent for 2015 is included. The investment balance will be reduced by 10 percent of any of Merton’s dividends during 2014 and 25 percent for 2015 dividends. Finally, the Investment account will be decreased by any amortization expense for both 2014 and 2015.

23. (20 minutes) (Verbal overview of intra-entity transfers and their impact on application of the equity method) a. An upstream transfer goes from investee to investor whereas a downstream transfer is made by the investor to the investee. b. The direction of an intra-entity transfer has no impact on reporting when the equity method is applied. The direction of the transfers was introduced in Chapter One because it does have an important impact on consolidation accounting as explained in Chapter Five. c. To determine the intra-entity unrealized gross profit when applying the equity method, the transferred inventory that remains at year’s end is multiplied by the gross profit percentage. This computation derives the unrealized gross profit. The intra-entity portion of this gross profit is found by multiplying it by the percentage of the investee that is owned by the investor. d. Parrot, as the investor, will accrue 42 percent of the income reported by Sunrise. However, this equity income will then be reduced by the amount of the unrealized intra-entity gross profit. These amounts can be combined and recorded as a single entry, increasing both the Investment account and an Equity Income account. As an alternative, separate entries can be made. The equity accrual is added to these two accounts while the deferral of the unrealized gross profit serves as a reduction.

1-18 .

Chapter 01 - The Equity Method of Accounting for Investments

23. (continued) e. In the second year, Parrot again records an equity accrual for 42 percent of the income reported by Sunrise. The intra-entity portion of the unrealized gross profit created by the transfers for that year are delayed in the same manner as for 2014 in (d) above. However, for 2015, the gross profit deferred from 2014 must now be recognized. This transferred merchandise was sold during this second year so that the earnings process has now been culminated. f.

If none of the transferred merchandise remains at year-end, the intra-entity transactions create no impact on the recording of the investment when applying the equity method. No gross profit remains unrealized.

g. The intra-entity transfers create no direct effects for Sunrise, the investee. However, as related party transactions, the amounts, as well as the relationship, must be properly disclosed and labeled. 24. (15 minutes) (Verbal overview of the sale of a portion of an investment being reported on the equity method and the accounting for any shares that remain) a. The equity method must be applied up to the date of the sale. Therefore, for the current year until August 1, Einstein records an equity accrual recognizing 40 percent of Brooks’ reported income for that period. In addition, Einstein records any dividends declared by Brooks as a reduction in the carrying amount of the investment account. Finally, amortization of acquisition-date excess fair over book values are recorded through August 1. These entries establish an appropriate book value as of the date of sale. Then, an amount of that book value equal to the portion of the shares sold is removed to compute a gain or loss on sale. b. Subsequent accounting for the remaining shares depends on the influence retained post-sale. If Einstein maintains the ability to apply significant influence to the operating and financial decisions of Brooks, the equity method is still applicable based on the smaller new ownership percentage. However, if significant influence has been lost, Einstein should report the remaining shares by means of the fair-value method. c. In this situation, three figures would be reported by Einstein. First, an equity income balance is recorded that includes both the accrual and amortization prior to August 1. Second, a gain or loss should be shown for the sale of the shares. Third, any investee dividends declared after August 1 must be included in Einstein’s income statement as dividend revenue.

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Chapter 01 - The Equity Method of Accounting for Investments

24. (continued) d. No, the ability to apply significant influence to the investee was present prior to August 1 so that the equity method was appropriate. No change is made in those figures. However, after the sale, the remaining investment must be accounted for by means of the fair-value method. 25. (12 minutes) (Equity balances for one year includes intra-entity transfers) a. Equity income accrual—2015 ($90,000 × 30%) ......................... Amortization—2015 (given) ........................................................ Intra-entity profit recognized on 2014 transfer*........................ Intra-entity profit deferred on 2015 transfer** ........................... Equity income recognized by Matthew in 2015 ...................

$27,000 (9,000) 1,200 (2,640) $16,560

*Gross profit rate (GPR) on 2014 transfer ($16,000/$40,000) ... Unrealized gross profit: Remaining inventory (40,000 × 25%) .................................... GPR (above) ........................................................................... Ownership percentage .......................................................... Intra-entity profit deferred from 2014 until 2015 .................

40%

**GPR on 2015 transfer ($22,000/$50,000) ................................. Unrealized gross profit: Remaining inventory (50,000 × 40%) .................................... GPR (above) ........................................................................... Ownership percentage .......................................................... Intra-entity profit deferred from 2015 until 2016 .................

$20,000 × 44% × 30% $ 2,640

b. Investment in Lindman, 1/1/15 ................................................... Equity income—2015 (see [a] above) ........................................ Dividends—2015 ($30,000 × 30%) .............................................. Investment in Lindman, 12/31/15 ...............................................

$335,000 16,560 (9,000) $342,560

1-20 .

$10,000 × 40% × 30% $ 1,200

44%

Chapter 01 - The Equity Method of Accounting for Investments

26. (20 Minutes) (Equity method balances after conversion to equity method. Must determine investee’s book value) Part a 1. Allocation and annual amortization—first purchase 1/1/2014 Purchase price of 15 percent interest ....................................... $62,000 Net book value ($280,000 × 15%) ............................................... (42,000) Franchise agreements ................................................................ $20,000 Remaining life of franchise agreements ................................... ÷ 10 years Annual amortization .............................................................. $ 2,000 Allocation and annual amortization—second purchase 1/1/2015 Purchase price of 10 percent interest ....................................... Net book value $280,000 + $80,000 - $30,000 = $330,000. ($330,000 × 10%).......................................................................... Franchise agreements ................................................................ Remaining life of franchise agreements ................................... Annual amortization ..............................................................

(33,000) $10,800 ÷ 9 years $ 1,200

Investment in Bellevue account January 1, 2014 purchase........................................................... 2014 basic equity income accrual ($80,000 × 15%) .................. 2014 amortization on first purchase (above) ............................ 2014 dividends ($30,000 × 15%) ................................................. Equity method balance 12/31/2014 January 1, 2015 purchase........................................................... 2015 basic equity income accrual ($100,000 × 25%) ................ 2015 amortization on first purchase (above) ............................ 2015 amortization on second purchase (above) ...................... 2015 dividends ($40,000 × 25%) ................................................. Investment in Bellevue—December 31, 2015 ......................

$62,000 12,000 (2,000) (4,500) $67,500 43,800 25,000 (2,000) (1,200) (10,000) $123,100

2. Equity Income—2015 2015 basic equity income accrual ($100,000 × 25%) ................ 2015 amortization on first purchase (above) ............................ 2015 amortization on second purchase (above) ...................... Equity income—2015 .............................................................

$25,000 (2,000) (1,200) $21,800

1-21 .

$43,800

Chapter 01 - The Equity Method of Accounting for Investments

26. (continued) 3. The January 1, 2015 retrospective adjustments to convert the Investment in Bellevue to the equity method is as follows: Unrealized Holding Gain—Shareholders’ Equity 3,700 Fair Value Adjustment (Available-for-Sale Securities)

3,700

To eliminate AFS fair value adjustment account balances for the investment in Bellevue (15% × $438,000 = $65,700 less $62,000 = $3,700) Investment in Bellevue Retained Earnings (January 1, 2015)

5,500 5,500

Retrospective adjustment to retained earnings to record 2014 equity method income for 15% investment (15% × $80,000 less $2,000 excess amortization less $4,500 dividend income recognized in 2014). [Alternative: Equity method balance of investment $67,500 less cost $62,000 = $5,500.] Part b 1.

Investment in Bellevue (25% × 468,000)

$117,000

Dividend income (25% × 40,000) $10,000 Increase in fair value (25% × [$468,000 - $438,000]) 7,500 Reported income from Investment in Bellevue $17,500

27. (30 minutes) (Conversion to equity method, sale of investment, and unrealized gross profit) Part a Allocation and annual amortization—first purchase Purchase price of 10 percent interest ....................................... Net book value ($800,000 × 10%) ............................................... Copyright ..................................................................................... Remaining life of Copyright ............................................................. Annual Amortization ........................................................................

1-22 .

$92,000 (80,000) $12,000 ÷ 16 yrs $ 750

Chapter 01 - The Equity Method of Accounting for Investments

27. Part a (continued) Allocation and annual amortization—second purchase Purchase price of 20 percent interest ....................................... $210,000 Net book value ($800,000 is increased by $180,000 income but decreased by $80,000 in dividends) ($900,000 × 20%) ................................................................... (180,000) Copyright ..................................................................................... $30,000 Remaining life of copyright .............................................................  15 years Annual amortization ......................................................................... $ 2,000 Equity income—2013 (after conversion to establish comparability) 2013 basic equity income accrual ($180,000 × 10%) ..................... $18,000 2013 amortization on first purchase (above).................................. (750) Equity income—2013 .................................................................. $17,250 Equity income 2014 2014 basic equity income accrual ($210,000 × 30%) ................ 2014 amortization on first purchase (above) ............................ 2014 amortization on second purchase (above) ...................... Equity income 2014 ..........................................................................

$63,000 (750) (2,000) $60,250

Part b Investment in Barringer Purchase price—January 1, 2013.................................................... 2013 equity income (above) ....................................................... 2013 dividends ($80,000 × 10%) ................................................. Purchase price January 1, 2014 ...................................................... 2014 equity income (above) ....................................................... 2014 dividends ($100,000 × 30%) ............................................... 2015 basic equity income accrual ($230,000 × 30%) ................ 2015 amortization on first purchase (above) ............................ 2015 amortization on second purchase (above) ...................... 2015 dividends ($100,000 × 30%) ............................................... Investment in Barringer—12/31/15 ..................................................

$92,000 17,250 (8,000) 210,000 60,250 (30,000) 69,000 (750) (2,000) (30,000) $377,750

1-23 .

Chapter 01 - The Equity Method of Accounting for Investments

27. Part b (continued) Gain on sale of investment in Barringer Sales price (given) ...................................................................... Book value 1/1/16 (above) .......................................................... Gain on sale of investment ...................................................

$400,000 (377,750) $ 22,250

Part c Deferral of 2014 unrealized gross profit into 2015 Ending inventory ......................................................................... Gross profit percentage ($15,000 ÷ $50,000) ............................ Unrealized gross profit .......................................................... Anderson’s ownership................................................................ Unrealized intra-entity gross profit ......................................

$20,000 × 30% $6,000 × 30% $ 1,800

Deferral of 2015 unrealized gross profit into 2016 Ending inventory ......................................................................... Gross profit percentage ($27,000 ÷ $60,000) ............................ Unrealized gross profit .......................................................... Anderson’s ownership................................................................ Unrealized intra-entity gross profit ......................................

$40,000 × 45% $18,000 × 30% $ 5,400

Equity Income—2015 2015 equity income accrual ($230,000 × 30%) .......................... 2015 amortization on first purchase (above) ............................ 2015 amortization on second purchase (above) ...................... Realization of 2014 intra-entity profit (above)........................... Deferral of 2015 intra-entity profit (above) ................................ Equity Income—2015 .............................................................

$69,000 (750) (2,000) 1,800 (5,400) $62,650

1-24 .

Chapter 01 - The Equity Method of Accounting for Investments

28. (40 Minutes) (Conversion to equity method and equity reporting after several years) a. Annual Amortization October 1, 2013 purchase Purchase price ............................................................................ Book value, 10/1/13: As of 1/1/13 ......................................................... $100,000 Equity increase 1/1/13 to 10/1/13 ($20,000 income less $8,000 dividends = $12,000) × ¾ year ......................................................... 9,000 Book value of Barker, first purchase date $109,000 Acquired percentage ............................................. × 5% Intangible assets .................................................... Remaining life......................................................... Annual amortization—first purchase.................... July 1, 2014 purchase Purchase price ....................................................... Book value, 7/1/14: As of 1/1/14 ($100,000 + $20,000 - $8,000) ........ $112,000 Equity increase 1/1/14 to 7/1/14 ($30,000 income less $16,000 dividends = $14,000) × ½ year ........................................................ 7,000 Book value of Barker, second purchase date $119,000 Acquired percentage ............................................. × 10% Intangible assets .................................................... Remaining life......................................................... Annual amortization—second purchase .............. December 31, 2015 purchase Purchase price ....................................................... Book value, 12/31/15: As of 1/1/15 ($112,000 + $30,000 - $16,000) ...... Equity increase 1/1/15 to 12/31/15 ($24,000 income less $9,000 dividends)........... Book value of Barker, third purchase Acquired percentage ............................................. 1-25 .

$7,475

5,450 $2,025 15 years $ 135

$14,900

11,900 $3,000 15 years $ 200

$34,200 $126,000 15,000 $141,000 × 20%

28,200

Chapter 01 - The Equity Method of Accounting for Investments

28. a (continued) Intangible assets .................................................... Remaining life......................................................... Annual amortization—third purchase ..................

$6,000 15 years $ 400

Equity Income Reported by Smith Reported for 2013 (3 months) after conversion to equity method: Accrual ($20,000 × ¼ year × 5%) ................ Amortization on first purchase ($135 × ¼ year) Equity income 2013................................

$250.00 (33.75) $216.25

Reported for 2014 (5% for entire year and an additional 10% for last 6 months) (after conversion to equity method): Accrual—first purchase ($30,000 entire year × 5%) ...... Accrual—second purchase ($30,000 × ½ year × 10%) .. Amortization on first purchase, entire year ................... Amortization on second purchase ($200 × ½ year) ....... Equity income—2014 ..................................................

1,500 1,500 (135) (100) $2,765

Reported for 2015 (15% for entire year; because final acquisition occurred at year end, neither income nor amortization is recognized): Basic equity accrual ($24,000 × 15%) ............................. Amortization on first purchase ....................................... Amortization on second purchase .................................. Equity income—2015 ..................................................

$3,600 (135) (200) $3,265

b. Investment in Barker Cost—first purchase ................................................................... $ 7,475.00 Cost—second purchase ............................................................. 14,900.00 Cost—third purchase .................................................................. 34,200.00 Equity Income (above) 2013 .......................................................................................... 216.25 2014 .......................................................................................... 2,765.00 2015 .......................................................................................... 3,265.00

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Chapter 01 - The Equity Method of Accounting for Investments

28. b (continued) Less: investee dividends 2013 ($8,000 × ¼ × 5%)............................................................ 2014 ($16,000 × 5% and $16,000 × 2/4 × 10%) ....................... 2015 ($9,000 × 15%)................................................................. Balance ........................................................................................

(100.00) (1,600.00) (1,350.00) $59,771.25

29. (25 Minutes) (Preparation of journal entries for two years, includes losses and intra-entity transfers of inventory) Journal Entries for Harper Co. 1/1/14

During 2014

12/31/14

Investment in Kinman Co. ............ Cash ......................................... (To record initial investment)

210,000

Dividends Receivable ................... 4,000 Investment in Kinman Co. ...... (To record dividend declaration: $10,000 x 40%)

4,000

Cash ............................................... Dividends Receivable ............. (To record receipt of dividend)

4,000

Equity in Kinman Income—Loss . 16,000 Other Comprehensive Loss of Kinman 8,000 Investment in Kinman Co. ...... (To record accrual of income and OCI from equity investee, 40% of reported balances) Equity in Kinman Income—Loss . 3,300 Investment in Kinman Co. ...... (To record amortization relating to acquisition of Kinman—see Schedule 1 below)

1-27 .

210,000

24,000

3,300

Chapter 01 - The Equity Method of Accounting for Investments

29. (continued) 12/31/14

During 2015

12/31/15

Equity in Kinman Income-Loss ... 2,000 Investment in Kinman Co. ...... (To defer unrealized gross profit on intra-entity sale see Schedule 2 below) Dividends Receivable ................... 4,800 Investment in Kinman Co. ...... (To record dividend declaration: $12,000 x 40%)

4,800

Cash ............................................... Dividends Receivable.............. (To record receipt of dividend)

4,800

Investment in Kinman Co. ............ 16,000 Equity in Kinman Income........ (To record 40% accrual of income as earned by equity investee) Equity in Kinman Income ............. 3,300 Investment in Kinman Co. ...... (To record amortization relating to acquisition of Kinman) Investment in Kinman Co. ............ 2,000 Equity in Kinman Income........ (To recognize income deferred from 2014) Equity in Kinman Income ............. 3,600 Investment in Kinman Co. ...... (To defer unrealized gross profit on intra-entity sale—see Schedule 3 below)

1-28 .

2,000

16,000

3,300

2,000

3,600

Chapter 01 - The Equity Method of Accounting for Investments

29. (continued) Schedule 1—Allocation of Purchase Price and Related Amortization Purchase price ........................................................ Percentage of book value acquired ($400,000 × 40%)..................................................... Payment in excess of book value ..............................

$210,000 (160,000) $50,000 Remaining Annual Life Amortization

Excess payment identified with specific assets: Building ($40,000 × 40%) $16,000 10 yrs. Royalty agreement ($85,000 × 40%) 34,000 20 yrs. Total annual amortization

$1,600 1,700 $3,300

Schedule 2—Deferral of Unrealized Gross Profit—2014 Inventory remaining at end of year ................................................. Gross profit percentage ($30,000 ÷ $90,000) .................................. Gross profit remaining in inventory .......................................... Ownership percentage ..................................................................... Unrealized gross profit to be deferred until 2015 .....................

$15,000 × 33⅓% $5,000 × 40% $ 2,000

Schedule 3—Deferral of Unrealized Gross Profit—2015 Inventory remaining at end of year (30%) ...................................... Gross profit percentage ($30,000 ÷ $80,000) .................................. Gross profit remaining in inventory .......................................... Ownership percentage ..................................................................... Unrealized gross profit to be deferred until 2016 .....................

1-29 .

$24,000 × 37½% $9,000 × 40% $ 3,600

Chapter 01 - The Equity Method of Accounting for Investments

30. (35 Minutes) (Investment sale with equity method applied both before and after. Includes other comprehensive loss and intra-entity inventory transfer) Income effects for year ending December 31, 2015 Equity income in Seacrest, Inc. (Schedule 1) ...........................

$116,000

Other comprehensive loss—Seacrest, Inc. 1/1/15 to 8/1/15 ($120,000 × 40% × 7/12 year) ............. . (28,000) 8/1/15 to 12/31/15 ($120,000 × 32% × 5/12 year) ......... (16,000)

$(44,000)

Gain on sale of 8,000 shares of Seacrest (Schedule 2) .................

$ 25,000

Schedule 1—Equity Income in Seacrest, Inc. Investee income accrual—operations $342,000 × 40% × 7/12 year.................................... $342,000 × 32% × 5/12 year.................................... Amortization $12,000 × 7/12 year ................................................. After 20 percent of stock is sold (8,000 ÷ 40,000 shares): $12,000 × 80% × 5/12 year ................. Recognition of unrealized gross profit Remaining inventory—12/31/14 ............................ Gross profit percentage on original sale ($20,000 ÷ $50,000)............................................ Gross profit remaining in inventory ..................... Ownership percentage .......................................... Intra-entity gross profit recognized in 2015 ......... Equity income in Seacrest, Inc. .......................

1-30 .

$79,800 45,600

$125,400

$7,000 4,000

(11,000)

$10,000 × 40% $4,000 × 40% 1,600 $116,000

Chapter 01 - The Equity Method of Accounting for Investments

30. (continued) Schedule 2—Gain on Sale of Investment in Seacrest, Inc. Book value—investment in Seacrest, Inc.—1/1/15 (given) ........ Investee income accrual—1/1/15 – 8/1/15 (Schedule 1) ............. Investee other comprehensive loss 1/1/15 – 8/1/15 .................... Amortization—1/1/15 – 8/1/15 (Schedule 1) ................................. Recognition of deferred profit (Schedule 1) ................................ Investment in Seacrest book value 8/1/15........................................ Percentage of investment sold (8,000 ÷ 40,000 shares) ............. Book value of shares being sold.................................................. Proceeds from sale of shares....................................................... Gain on sale of 8,000 shares of Seacrest. ..............................

$293,600 79,800 (28,000) (7,000) 1,600 $340,000 × 20% $ 68,000 93,000 $ 25,000

31. (30 Minutes) (Compute equity balances for three years. Includes intra-entity inventory transfer) Part a. Equity Income 2013 Basic equity accrual ($598,000 × ½ year × 25%) ....................... Amortization (½ year—see Schedule 1) .................................... Equity Income—2013 .............................................................

$74,750 (30,800) $43,950

Equity Income 2014 Basic equity accrual ($639,600 × 25%) ..................................... Amortization (see Schedule 1) .................................................. Deferral of unrealized profit (see Schedule 2) ......................... Equity Income—2014 ............................................................

$159,900 (61,600) (6,000) $92,300

Equity Income 2015 Basic equity accrual ($692,400 × 25%) ..................................... Amortization (see Schedule 1) .................................................. Recognition of deferred profit (see Schedule 2) ..................... Equity Income—2015 ............................................................

$173,100 (61,600) 6,000 $117,500

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Chapter 01 - The Equity Method of Accounting for Investments

31. (continued) Schedule 1—Acquisition Price Allocation and Amortization Acquisition price (88,000 shares × $13) $1,144,000 Book value acquired ($2,925,600 × 25%) 731,400 Payment in excess of book value $412,600 Excess payment identified with specific assets: Equipment ($364,000 × 25%) Copyright ($972,000 × 25%) Goodwill Total annual amortization (full year)

Remaining Annual Life Amortization

$91,000 7 yrs. 243,000 5 yrs. 78,600 indefinite

$13,000 48,600 -0$61,600

Schedule 2—Deferral of Unrealized Intra-entity Gross Profit Intra-entity Gross Profit Percentage: Sales $152,000 Cost of goods sold 91,200 Gross profit $ 60,800 Gross profit percentage: $60,800 ÷ $152,000 = 40% Inventory remaining at December 31, 2014 ................................. Gross profit percentage ............................................................... Total profit on intra-entity sale still held by affiliate ................... Investor ownership percentage.................................................... Unrealized intra-entity gross profit deferred from 2014 until 2015..........................................................................

$60,000 × 40% $24,000 × 25% $ 6,000

Part b. Investment in Shaun—December 31, 2015 balance Acquisition price ........................................................................... $1,144,000 2013 Equity income (above) ......................................................... 43,950 2013 Dividends declared during half year (88,000 shares × $1.00) (88,000) 2014 Equity income (above) ......................................................... 92,300 2014 Dividends declared (88,000 shares × $1.00 × 2) ................. (176,000) 2015 Equity income (above) ......................................................... 117,500 2015 Dividends declared (88,000 shares × $1.00 × 2) ................. (176,000) Investment in Shaun—12/31/15........................................... $957,750

1-32 .

Chapter 01 - The Equity Method of Accounting for Investments

32. (65 Minutes) (Journal entries for several years. Includes conversion to equity method and a sale of a portion of the investment) 1/1/13

Investment in Sumter ..................... 192,000 Cash ........................................... (To record cost of 16,000 shares of Sumter Company.)

9/15/13

Cash ................................................. 8,000 Dividend Income ........................ 8,000 (Annual dividends declared and received from Sumter Company. Because declaration and payment are on same day, a dividend receivable account is unnecessary.)

9/15/14

Cash ................................................. 8,000 Dividend Income ........................ 8,000 (Annual dividends declared and received from Sumter Company.)

1/1/15

Investment in Sumter ..................... 965,750 Cash ........................................... (To record cost of 64,000 additional shares of Sumter Company.)

1/1/15

Investment in Sumter ..................... 36,800 Retained Earnings—Prior Period Adjustment—Equity in Investee Income (Retrospective adjustment necessitated by change to equity method. Change in figures previously reported for 2013 and 2014 are calculated as follows.)

1-33 .

192,000

965,750

36,800

Chapter 01 - The Equity Method of Accounting for Investments

32. (continued) 2013 as reported

2013—equity method (as restated)

Income (dividends)..........$8,000

Income (8% of $300,000 reported income) .............................. $24,000 Change in investment balance (equity income less dividends) .................... $16,000

Change in investment Balance .................................. -02014 as reported Income (dividends)..........$8,000 Change in investment Balance .................................. -0-

2014—equity method (as restated) Income (8% of $360,000 reported income) .............................. $28,800 Change in investment balance (equity income less dividends) .................... $20,800

2013 increase in reported income ($24,000 – $8,000)................. 2014 increase in reported income ($28,800 – $8,000)................. Retrospective adjustment—income (above) ...............................

$16,000 20,800 $36,800

2013 increase in investment in Sumter balance—equity method 2014 increase in investment in Sumter balance—equity method Retrospective adjustment—Investment in Sumter (above) ..

$16,000 20,800 $36,800

9/15/15

12/31/15

Cash............................................................ 40,000 Investment in Sumter........................... (Annual dividend declared and received from Sumter [40% × $100,000]) Investment in Sumter ................................ Equity in Investee Income ................... (To accrue 2015 income based on 40% ownership of Sumter)

160,000

Equity in Investee Income ........................ Investment in Sumter........................... (Amortization of $50,550 patent [indicated in problem] over 15 years)

3,370

1-34 .

40,000

160,000

3,370

Chapter 01 - The Equity Method of Accounting for Investments

32. (continued) 7/1/16

7/1/16

Investment in Sumter ................................ Equity in Investee Income ................... (To accrue ½ year income of 40% ownership = $380,000 × ½ × 40%)

76,000

Equity in Investee Income ........................ Investment in Sumter........................... (To record ½ year amortization of patent to establish correct book value for investment as of 7/1/16)

1,685

Cash ........................................................... Investment in Sumter (rounded) ......... Gain on Sale of Investment ................. (20,000 shares of Sumter Company sold; investment basis computed below.)

425,000

76,000

1,685

Investment in Sumter and cost of shares sold: 1/1/13 Acquisition .................................................................... 1/1/15 Acquisition ..................................................................... 1/1/15 Retrospective adjustment ............................................ 9/15/15 Dividends ..................................................................... 12/31/15 Basic equity accrual.................................................. 12/31/15 Amortization .............................................................. 7/1/16 Basic equity accrual...................................................... 7/1/16 Amortization .................................................................. Investment in Sumter—7/1/16 balance.............................. Percentage of shares sold (20,000 ÷ 80,000) .................... Cost of shares sold (rounded) ...........................................

346,374 78,626

192,000 965,750 36,800 (40,000) 160,000 (3,370) 76,000 (1,685) $1,385,495 × 25% $ 346,374

Because 20,000 of 80,000, or ¼, of shares are sold, the percentage retained is ¾ of 40% = 30%. 9/15/16

Cash........................................................... 30,000 Investment in Sumter.......................... (To record annual dividend declared and received)

1-35 .

30,000

Chapter 01 - The Equity Method of Accounting for Investments

32. (continued) 12/31/16

12/31/16

Equity in Sumter ........................................ 57,000 Equity in Investee Income ................... (To record ½ year income based on remaining 30% ownership: $380,000 × 1/2 × 30%)

57,000

Equity in Investee Income ........................ 1,264 (rounded) Investment in Sumter........................... 1,264 (To record ½ year of patent amortization— computation presented below)

Annual patent amortization—original computation ................... Percentage of shares retained (60,000 ÷ 80,000) ........................ Annual patent amortization—current ......................................... Patent amortization for half year ..................................................

$3,370 × 75% $2,528.50 $1,263.75

33. (25 Minutes) (Equity income balances for two years, includes intra-entity transfers) Equity Income 2014 Basic equity accrual ($250,000 × 30%) ................................... Amortization (see Schedule 1) ................................................ Deferral of unrealized gross profit (see Schedule 2) ............ Equity Income—2014 ..........................................................

$75,000 (18,000) (9,000) $48,000

Equity Income (Loss—2015) Basic equity accrual ($100,000 [loss] × 30%) ........................ Amortization (see Schedule 1) ................................................ Realization of deferred gross profit (see Schedule 2) .......... Deferral of unrealized gross profit (see Schedule 3) ............ Equity Loss—2015 ..............................................................

$(30,000) (18,000) 9,000 (4,500) $(43,500)

1-36 .

Chapter 01 - The Equity Method of Accounting for Investments

33. (continued) Schedule 1 Purchase price ................................................... $770,000 Book value acquired ($1,200,000 × 30%) ......... 360,000 Payment in excess of book value .................... $410,000 Remaining Annual

Excess payment identified with specific assets: Life Amortization Customer list ($300,000 × 30%) 90,000 5 yrs. $18,000 Excess not identified with specific accounts Goodwill $320,000 indefinite -0Total annual amortization $18,000 Schedule 2 Inventory remaining at December 31, 2014 ................................. Gross profit percentage ($60,000 ÷ $160,000) ............................. Total unrealized gross profit ........................................................ Investor ownership percentage.................................................... Unrealized intra-entity gross profit —12/31/14 (To be deferred until realized in 2015) .................................... Schedule 3 Inventory remaining at December 31, 2015 ................................. Gross profit percentage ($35,000 ÷ $175,000) ............................. Total unrealized gross profit ........................................................ Investor ownership percentage.................................................... Unrealized intra-entity gross profit —12/31/15 (To be deferred until realized in 2016) ....................................

1-37 .

$80,000 × 37½% $30,000 × 30% $ 9,000

$75,000 × 20% $15,000 × 30% $ 4,500

Chapter 01 - The Equity Method of Accounting for Investments

Solutions to Develop Your Skills Excel Assignment No. 1 (less difficult)—see textbook Website for the Excel file solution Parts 1, 2 and 3 Growth rate in income Dividends Cost Annual amortization 1st year PHC income Percentage owned

10% $30,000 $700,000 (given in problem) $15,000 $185,000 40%

PHC reported income Amortization Equity earnings

2015 $74,000 15,000 $59,000

2016 $81,400 15,000 $66,400

2017 $89,540 15,000 $74,540

2018 $98,494 15,000 $83,494

Beginning Balance Equity earnings Dividends Ending Balance

$700,000 59,000 (12,000) $747,000

$747,000 66,400 (12,000) $801,400

$801,400 74,540 (12,000) $863,940

$863,940 $935,434 83,494 93,343 (12,000) (12,000) $935,434 $1,016,777

8.43% 9.25%

8.89%

9.30%

ROI Average

9.66%

2019 $108,343 15,000 $93,343

9.98%

Part 3 Growth rate in income Dividends Cost

10% $30,000 $639,794

Annual amortization 1st year PHC income Percentage owned

$15,000 $185,000 40%

(Determined through Solver under Tools command)

PHC reported income Amortization Equity earnings

$74,000 15,000 $59,000

$81,400 15,000 $66,400

$89,540 15,000 $74,540

$98,494 15,000 $83,494

$108,343 15,000 $93,343

Beginning Balance Equity earnings Dividends Ending Balance

$639,794 59,000 (12,000) $686,794

$686,794 66,400 (12,000) $741,194

$741,194 74,540 (12,000) $803,734

$803,734 83,494 (12,000) $875,228

$875,228 93,343 (12,000) $956,571

9.22% 10.00%

9.67%

10.06%

10.39%

10.67%

ROI Average

1-38 .

Chapter 01 - The Equity Method of Accounting for Investments

Excel Assignment No. 2 (more difficult)—see textbook Website for the Excel file solution Intergen’s ownership percentage of Ryan

40% Intra-entity Transfer Price = $1,025,000 Cell F4

Ryan's Income Statement Sales Beginning inventory Purchases from Intergen Inventory remaining Ending inventory Cost of goods sold Net income

$900,000 $ -0$1,025,000 25% $ 256,250 $768,750 $131,250

Income to Intergen—40% Income to two equity partners—60%

Intergen's Income Statement Sales Cost of goods sold Gross profit Equity in Ryan's earnings Net income *(52,500 – (40% × 256,250 × 175,000/1,025,000))

$ 52,500 $ 78,750

Rate of Return Analysis Investment Base $1,000,000 $300,000

Intergen Two outside equity partners Difference

$1,025,000 $ 850,000 $ 175,000 $ 35,000* $ 210,000

Rate of Return 21.00% 26.25% -5.25%

Use Goal Seek or Solver under the Tools command to set Cell D20 to zero by changing Cell F4

Intergen’s ownership percentage of Ryan = 40% Intra-entity Transfer Price = 1,050,000 Ryan's Income Statement Sales Beginning inventory Purchases from Intergen Inventory Ending inventory Cost of goods sold Net income

$900,000 $ -0$1,050,000 25% $ 262,500

Income to Intergen—40% Income to two equity partners—60%

$787,500 $112,500

Intergen's Income Statement Sales Cost of goods sold Gross profit Equity in Ryan's earnings Net income

*[45,000 – (40% ×262,500 × 200,000 ÷ 1,050,000)]

$ 45,000 $ 67,500

Rate of Return Analysis Intergen Two outside equity partners Difference

Investment Base $1,000,000 $300,000

1-39 .

$1,050,000 $ 850,000 $ 200,000 $ 25,000* $ 225,000

Rate of Return 22.50% 22.50% 0.00%

Chapter 01 - The Equity Method of Accounting for Investments

Solution to Coca-Cola Company Analysis Case 1. In its 2012 10-K, Coca-Cola lists the following companies as significant equity method investees: • • •

Coca-Cola Hellenic Bottling Company S.A. ("Coca-Cola Hellenic"). Coca-Cola FEMSA, S.A.B. de C.V. ("Coca-Cola FEMSA"). Coca-Cola Amatil Limited ("Coca-Cola Amatil").

As part of strategic business alliances, each of these companies bottle, market, and distribute Coca-Cola’s products in various designated geographic areas throughout the world, thus generating substantial revenues for the Coca-Cola Company. According to Coca-Cola’s 2012 annual report (page 10), We make equity investments in selected bottling operations with the intention of maximizing the strength and efficiency of the Coca-Cola system's production, distribution and marketing capabilities around the world. These investments are intended to result in increases in unit case volume, net revenues and profits at the bottler level, which in turn generate increased concentrate sales for our Company's concentrate and syrup business. When this occurs, both we and our bottling partners benefit from long-term growth in volume, improved cash flows and increased shareowner value.

2. From the Coca-Cola Company’s 2012 10-K report (page 85), We use the equity method to account for investments in companies, if our investment provides us with the ability to exercise significant influence over operating and financial policies of the investee. Our consolidated net income includes our Company’s proportionate share of the net income or loss of these companies.

3. 2012 equity income = $819 million. 4. In general, the equity method provides cost-based values while fair values provide exit-based values. The relevance of the equity method valuation derives from the investment’s nature as a productive asset for the investor. Because of their business relationship the investee represents an extension of the investor and frequently a key part of the investor’s business model. Coca-Cola, for example, has a high level of operational influence over its investees who, in turn receive exclusive rights to bottle and distribute Coca-Cola products in specific geographic areas. Because of its significance influence, investors may wish to judge the results of operations of CocaCola’s investees as it related to Coca-Cola’s ownership. Additionally, the equity method provides results consistent with accrual accounting recognizing the net effect of investee revenues and expenses as they are earned by the investor. When possible, fair values are measured using market prices for the investor’s shares of the investee. Although exit prices represent a “hypothetical” sale transaction, they indicate the market’s assessment of the investor’s position in the investee and thus may be relevant. However, if the investor has no plans to sell the shares, exit prices may be of limited relevance for investors’ decision making. 1-40 .

Chapter 01 - The Equity Method of Accounting for Investments

RESEARCH AND ANALYSIS CASE—IMPAIRMENT 1. Paragraph 323-10-35-32 of the FASB ASC states that A loss in value of an investment which is other than a temporary decline shall be recognized. Evidence of a loss in value might include, but would not necessarily be limited to, absence of an ability to recover the carrying amount of the investment or inability of the investee to sustain an earnings capacity which would justify the carrying amount of the investment. A current fair value of an investment that is less than its carrying amount may indicate a loss in value of the investment. However, a decline in the quoted market price below the carrying amount or the existence of operating losses is not necessarily indicative of a loss in value that is other than temporary. All are factors to be evaluated. 2. Given the facts in the case, a very good case can be made that the decline in value appears permanent. The change in competitive environment, decline in revenues, drop in share value, and the lack of a responsive business plan all point to a loss that is other than temporary. 3. No, according to FASB ASC para. 350-20-35-59, the equity method investment as a whole is reviewed for impairment, not the underlying assets. The FASB concluded that because equity method goodwill is not separable from the related investment, that goodwill should not be separately tested for impairment.

1-41 .

Chapter 01 - The Equity Method of Accounting for Investments

Research Case Solution -- Noncontrolling Shareholder Rights 1. Protective Rights (ASC Topic 810, Consolidation 810-10-25-10) Noncontrolling rights (whether granted by contract or by law) that would allow the noncontrolling shareholder to block corporate actions would be considered protective rights and would not overcome the presumption of consolidation by the investor with a majority voting interest in its investee. The following list is illustrative of the protective rights that often are provided to the noncontrolling shareholder but is not all-inclusive: a. Amendments to articles of incorporation of the investee b. Pricing on transactions between the owner of a majority voting interest and the investee and related self-dealing transactions c. Liquidation of the investee or a decision to cause the investee to enter bankruptcy or other receivership d. Acquisitions and dispositions of assets that are not expected to be undertaken in the ordinary course of business (noncontrolling rights relating to acquisitions and dispositions of assets that are expected to be made in the ordinary course of business are participating rights; determining whether such rights are substantive requires judgment in light of the relevant facts and circumstances [see paragraphs 810-10-25-13 and 810-10-55-1]) e. Issuance or repurchase of equity interests. 2. Substantive Participating Rights (ASC Topic 810, Consolidation 810-10-25-11) Noncontrolling rights (whether granted by contract or by law) that would allow the noncontrolling shareholder to participate in determining certain financial and operating decisions in the ordinary course of business shall be considered substantive participating rights and would overcome the presumption that the investor with a majority voting interest shall consolidate its investee. Example: In its 2012 10-K annual report, Sprint cited substantive participating rights of the noncontrolling interest as a reason for not consoldating its investment in Clearwire. 3. (FASB ASC Topic 810, Consolidation 810-10-25-11) Substantive participating rights would overcome the presumption that the investor with a majority voting interest shall consolidate its investee. The following list is illustrative of substantive participating rights, but is not necessarily all-inclusive: a. Selecting, terminating, and setting the compensation of management responsible for implementing the investee's policies and procedures

1-42 .

Chapter 01 - The Equity Method of Accounting for Investments

b. Establishing operating and capital decisions of the investee, including budgets, in the ordinary course of business. 4. Assessing Individual Noncontrolling Rights (FASB ASC Topic 810, Consolidation 810-10-55-1 b and c) b. Existing facts and circumstances should be considered in assessing whether the rights of the noncontrolling shareholder relating to an investee's incurring additional indebtedness are protective or participating rights. For example, if it is reasonably possible or probable that the investee will need to incur the level of borrowings that requires noncontrolling shareholder approval in its ordinary course of business, the rights of the noncontrolling shareholder would be viewed as substantive participating rights. c. The rights of the noncontrolling shareholder relating to dividends or other distributions may be protective or participating and should be assessed in light of the available facts and circumstances. For example, rights to block customary or expected dividends or other distributions may be substantive participating rights, while rights to block extraordinary distributions would be protective rights.

1-43 .

Chapter 02 - Consolidation of Financial Information

CHAPTER 2 CONSOLIDATION OF FINANCIAL INFORMATION Accounting standards for business combination are found in FASB ASC Topic 805, “Business Combinations” and Topic 810, “Consolidation.” These standards require the acquisition method which emphasizes acquisition-date fair values for recording all combinations. In this chapter, we first provide coverage of expansion through corporate takeovers and an overview of the consolidation process. Then we present the acquisition method of accounting for business combinations followed by limited coverage of the purchase method and pooling of interests provided in the Appendix to this chapter.

Chapter Outline I.

Business combinations and the consolidation process A. A business combination is the formation of a single economic entity, an event that occurs whenever one company gains control over another B. Business combinations can be created in several different ways 1. Statutory merger—only one of the original companies remains in business as a legally incorporated enterprise. a. Assets and liabilities can be acquired with the seller then dissolving itself as a corporation. b. All of the capital stock of a company can be acquired with the assets and liabilities then transferred to the buyer followed by the seller’s dissolution. 2. Statutory consolidation—assets or capital stock of two or more companies are transferred to a newly formed corporation 3. Acquisition by one company of a controlling interest in the voting stock of a second. Dissolution does not take place; both parties retain their separate legal incorporation. C. Financial information from the members of a business combination must be consolidated into a single set of financial statements representing the entire economic entity. 1. If the acquired company is legally dissolved, a permanent consolidation is produced on the date of acquisition by entering all account balances into the financial records of the surviving company. 2. If separate incorporation is maintained, consolidation is periodically simulated whenever financial statements are to be prepared. This process is carried out through the use of worksheets and consolidation entries. Consolidation worksheet entries are used to adjust and eliminate subsidiary company accounts. Entry “S” eliminates the equity accounts of the subsidiary. Entry “A” allocates exess payment amounts to identifiable assets and liabilities based on the fair value of the subsidiary accounts. (Consolidation journal entries are never recorded in the books of either company, they are worksheet entries only.)

2-1 ..

Chapter 02 - Consolidation of Financial Information

II.

III.

The Acquisition Method A. The acquisition method replaced the purchase method. For combinations resulting in complete ownership, it is distinguished by four characteristics. 1. All assets acquired and liabilities assumed in the combination are recognized and measured at their individual fair values (with few exceptions). 2. The fair value of the consideration transferred provides a starting point for valuing and recording a business combination. a. The consideration transferred includes cash, securities, and contingent performance obligations. b. Direct combination costs are expensed as incurred. c. Stock issuance costs are recorded as a reduction in paid-in capital. d. The fair value of any noncontrolling interest also adds to the valuation of the acquired firm and is covered beginning in Chapter 4 of the text. 3. Any excess of the fair value of the consideration transferred over the net amount assigned to the individual assets acquired and liabilities assumed is recognized by the acquirer as goodwill. 4. Any excess of the net amount assigned to the individual assets acquired and liabilities assumed over the fair value of the consideration transferred is recognized by the acquirer as a “gain on bargain purchase.” B. In-process research and development acquired in a business combination is recognized as an asset at its acquisition-date fair value. Convergence between U.S. GAAP and IAS A. IFRS 3 – nearly identical to U.S. GAAP because of joint efforts B. IFRS 10 – Consolidated Finanical Statements and IFRS 12 – Disclosure of Interests in Other Entities both become effective in 2013. Some differences between these and GAAP

APPENDIX: The Purchase Method A. The purchase method was applicable for business combinations occurring for fiscal years beginning prior to December 15, 2008. It was distinguished by three characteristics. 1. One company was clearly in a dominant role as the purchasing party 2. A bargained exchange transaction took place to obtain control over the second company. 3. A historical cost figure was determined based on the acquisition price paid. a. The cost of the acquisition included any direct combination costs. b. Stock issuance costs were recorded as a reduction in paid-in capital and are not considered to be a component of the acquisition price. B. Purchase method procedures 1. The assets and liabilities acquired were measured by the buyer at fair value as of the date of acquisition. 2. Any portion of the payment made in excess of the fair value of these assets and liabilities was attributed to an intangible asset commonly referred to as goodwill.

2-2 ..

Chapter 02 - Consolidation of Financial Information

3. If the price paid was below the fair value of the assets and liabilities, the accounts of the acquired company were still measured at fair value except that the values of certain noncurrent assets were reduced in total by the excess cost. If these values were not great enough to absorb the entire reduction, an extraordinary gain was recognized. The Pooling of Interest Method (prohibited for combinations after June 2002) A. A pooling of interests was formed by the uniting of the ownership interests of two companies through the exchange of equity securities. The characteristics of a pooling are fundamentally different from either the purchase or acquisition methods. 1. Neither party was truly viewed as an acquiring company. 2. Precise cost figures stemming from the exchange of securities were difficult to ascertain. 3. The transaction affected the stockholders rather than the companies. B. Pooling of interests accounting 1. Because of the nature of a pooling, determination of an acquisition price was not relevant. a. Since no acquisition price was computed, all direct costs of creating the combination were expensed immediately. b. In addition, new goodwill arising from the combination was never recognized in a pooling of interests. Similarly, no valuation adjustments were recorded for any of the assets or liabilities combined. 2. The book values of the two companies were simply brought together to produce a set of consolidated financial records. A pooling was viewed as affecting the owners rather than the two companies. 3. The results of operations reported by both parties were combined on a retroactive basis as if the companies had always been together. 4. Controversy historically surrounded the pooling of interests method. a. Any cost figures indicated by the exchange transaction that created the combination were ignored. b. Income balances previously reported were altered since operations were combined on a retroactive basis. c. Reported net income was usually higher in subsequent years than in a purchase since no goodwill or valuation adjustments were recognized which require amortization.

2-3 ..

Chapter 02 - 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. (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 indicates that only a single economic entity exists. Consolidated financial statements represent accounting information gathered from 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. 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. The purpose of a worksheet is 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. Several situations can occur in which the fair 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 yet been established; ▪ Jones may be a closely held corporation so that no fair 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 fair 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. For combinations resulting in complete ownership, the acquisition method allocates the fair value of the consideration transferred to the separately recognized assets acquired and liabilities assumed based on their individual fair values.

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Chapter 02 - Consolidation of Financial Information

10.

11.

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 consolidated from the date of the acquisition forward within the worksheet consolidation process. The operations of the subsidiary are only applicable to the business combination if earned subsequent to its creation. Morgan’s additional acquisition value may be attributed to many factors: expected synergies between Morgan’s and Jennings’ assets, favorable earnings projections, competitive bidding to acquire Jennings, etc. In general however, any amount paid by the parent company in excess of the fair values of the subsidiary’s net assets acquired is reported as goodwill. In the vast majority of cases the assets acquired and liabilities assumed in a business combination are recorded at their fair values. If the fair value of the consideration transferred (including any contingent consideration) is less than the total net fair value assigned to the assets acquired and liabilities assumed, then an ordinary gain on bargain purchase is recognized for the difference. Shares issued are recorded at fair value as if the stock had been sold and the money obtained 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. The direct combination costs of $98,000 are allocated to expense in the period in which they occur. Stock issue costs of $56,000 are treated as a reduction of APIC.

2-5 ..

Chapter 02 - Consolidation of Financial Information

Answers to Problems 1.

10. C 11. B Consideration transferred (fair value) Cash Accounts receivable Software Research and development asset Liabilities Fair value of net identifiable assets acquired Goodwill 12. C Legal and accounting fees accounts payable Contingent liabilility Donovan’s liabilities assumed Liabilities assumed or incurred 13. D Consideration transferred (fair value) Current assets Building and equipment Unpatented technology Research and development asset Liabilities Fair value of net identifiable assets acquired Goodwill Current assets Building and equipment Unpatented technology Research and development asset Goodwill Total assets

$150,000 140,000 320,000 200,000 (130,000) 680,000 $120,000 $15,000 20,000 60,000 $95,000 $420,000 $90,000 250,000 25,000 45,000 (60,000) 350,000 $ 70,000 $ 90,000 250,000 25,000 45,000 70,000 $480,000

2-6 ..

$800,000

Chapter 02 - Consolidation of Financial Information

14. C Value of shares issued (51,000 × $3) ...................................... $153,000 Par value of shares issued (51,000 × $1) ................................ 51,000 Additional paid-in capital (new shares) ................................. $102,000 Additional paid-in capital (existing shares) .......................... 90,000 Consolidated additional paid-in capital (fair value)............... $192,000 At the acquisition date, the parent makes no change to retained earnings. 15. B Consideration transferred (fair value) .......................... Book value of subsidiary (assets minus liabilities) .... Fair value in excess of book value ........................... Allocation of excess fair over book value identified with specific accounts: Inventory ..................................................................... Patented technology .................................................. Land ............................................................................ Long-term liabilities ................................................... Goodwill ......................................................................

$400,000 (300,000) 100,000

16. D TruData patented technology........................................ Webstat patented technology (fair value) .................... Acquisition-date consolidated balance sheet amount

$230,000 200,000 $430,000

17. C TruData common stock before acquisition.................. Common stock issued (par value) ................................ Acquisition-date consolidated balance sheet amount

$300,000 50,000 $350,000

18. B TruData’s 1/1 retained earnings .................................... TruData’s income (1/1 to 7/1) ........................................ Acquisition-date consolidated balance sheet amount

$130,000 80,000 $210,000

19.a.

30,000 20,000 25,000 10,000 $15,000

An intangible asset acquired in a business combination is recognized as an asset apart from goodwill if it arises from contractual or other legal rights (regardless of whether those rights are transferable or separable from the acquired enterprise or from other rights and obligations). If an intangible asset does not arise from contractual or other legal rights, it shall be recognized as an asset apart from goodwill only if it is separable, that is, it is capable of being separated or divided from the acquired enterprise and sold, transferred, licensed, rented, or exchanged (regardless of whether there is an intent to do so). An intangible asset that cannot be sold, transferred, licensed, rented, or exchanged individually is considered separable if it can be sold, transferred, licensed, rented, or exchanged with a related contract, asset, or liability.

b. ◼ Trademarks—usually meet both the separability and legal/contractual criteria. 2-7 ..

Chapter 02 - Consolidation of Financial Information ◼ ◼ ◼ ◼

Customer list—usually meets the separability criterion. Copyrights on artistic materials—usually meet both the separability and legal/contractual criteria. Agreements to receive royalties on leased intellectual property—usually meet the legal/contractual criterion. Unpatented technology—may meet the separability criterion if capable of being sold even if in conjunction with a related contract, asset, or liability.

20. (12 minutes) (Journal entries to record a merger—acquired company dissolved) Inventory Land Buildings Customer Relationships Goodwill Accounts Payable Common Stock Additional Paid-In Capital Cash

600,000 990,000 2,000,000 800,000 690,000

Professional Services Expense Cash

42,000

Additional Paid-In Capital Cash

25,000

80,000 40,000 960,000 4,000,000

42,000

25,000

21. (12 minutes) (Journal entries to record a bargain purchase—acquired company dissolved) Inventory Land Buildings Customer Relationships Accounts Payable Cash Gain on Bargain Purchase

600,000 990,000 2,000,000 800,000

Professional Services Expense Cash

42,000

80,000 4,200,000 110,000

42,000

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Chapter 02 - Consolidation of Financial Information

22. (15 Minutes) (Consolidated balances) In acquisitions, the fair values of the subsidiary's assets and liabilities are consolidated (there are a limited number of exceptions). Goodwill is reported at $80,000, the amount that the $760,000 consideration transferred exceeds the $680,000 fair value of Sol’s net assets acquired. ▪ Inventory = $670,000 (Padre's book value plus Sol's fair value) ▪ Land = $710,000 (Padre's book value plus Sol's fair value) ▪ Buildings and equipment = $930,000 (Padre's book value plus Sol's fair value) ▪ Franchise agreements = $440,000 (Padre's book value plus Sol's fair value) ▪ Goodwill = $80,000 (calculated above) ▪ Revenues = $960,000 (only parent company operational figures are reported at date of acquisition) ▪ Additional paid-in capital = $265,000 (Padre's book value adjusted for stock issue less stock issuance costs) ▪ Expenses = $940,000 (only parent company operational figures plus acquisition-related costs are reported at date of acquisition) ▪ Retained earnings, 1/1 = $390,000 (Padre's book value only) ▪ Retained earnings, 12/31 = $410,000 (beginning retained earnings plus revenues minus expenses, of Padre only)

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Chapter 02 - Consolidation of Financial Information

23. (20 minutes) Journal entries for a merger using alternative values. a. Acquisition date fair values: Cash paid Contingent performance liability Consideration transferred Fair values of net assets acquired Gain on bargain purchase

$700,000 35,000 $735,000 750,000 $ 15,000

Receivables 90,000 Inventory 75,000 Copyrights 480,000 Patented Technology 700,000 Research and Development Asset 200,000 Current liabilities 160,000 Long-Term Liabilities 635,000 Cash 700,000 Contingent Performance Liability 35,000 Gain on Bargain Purchase 15,000 Professional Services Expense Cash

100,000 100,000

b. Acquisition date fair values: Cash paid Contingent performance liability Consieration transferred Fair values of net assets acquired Goodwill

$800,000 35,000 $835,000 750,000 $ 85,000

Receivables 90,000 Inventory 75,000 Copyrights 480,000 Patented Technology 700,000 Research and Development Asset 200,000 Goodwill 85,000 Current Liabilities 160,000 Long-Term Liabilities 635,000 Cash 800,000 Contingent Performance Liability 35,000 Professional Services Expense Cash

100,000 100,000

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Chapter 02 - Consolidation of Financial Information

24. (20 Minutes) (Determine selected consolidated balances) Under the acquisition method, the shares issued by Wisconsin are recorded at fair value using the following journal entry: Investment in Badger (value of debt and shares issued) 900,000 Common Stock (par value) ............................................ 150,000 Additional Paid-In Capital (excess over par value) ..... 450,000 Liabilities......................................................................... 300,000 The payment to the broker is accounted for as an expense. The stock issue cost is a reduction in additional paid-in capital. Professional Services Expense.......................................... Additional Paid-In Capital ................................................... Cash ..............................................................................

30,000 40,000 70,000

Allocation of Acquisition-Date Excess Fair Value: Consideration transferred (fair value) for Badger Stock Book Value of Badger, 6/30 ................................................ Fair Value in Excess of Book Value .............................. Excess fair value (undervalued equipment) ...................... Excess fair value (overvalued patented technology) ....... Goodwill ..........................................................................

$900,000 770,000 $130,000 100,000 (20,000) $ 50,000

CONSOLIDATED BALANCES: ▪ Net income (adjusted for professional services expense. The figures earned by the subsidiary prior to the takeover are not included) ...................................................................... $ 210,000 ▪ Retained earnings, 1/1 (the figures earned by the subsidiary prior to the takeover are not included) ................................... 800,000 ▪ Patented technology (the parent's book value plus the fair value of the subsidiary) ........................................................... 1,180,000 ▪ Goodwill (computed above) .................................................... 50,000 ▪ Liabilities (the parent's book value plus the fair value of the subsidiary's debt plus the debt issued by the parent in acquiring the subsidiary) .................................................... 1,210,000 ▪ Common stock (the parent's book value after recording the newly-issued shares)......................................................... 510,000 ▪ Additional Paid-in Capital (the parent's book value after recording the two entries above) ................................... 680,000

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Chapter 02 - Consolidation of Financial Information

25. (20 minutes) (Preparation of a consolidated balance sheet)* CASEY COMPANY AND CONSOLIDATED SUBSIDIARY KENNEDY Worksheet for a Consolidated Balance Sheet January 1, 2015 Cash Accounts receivable Inventory Investment in Kennedy

Casey 457,000 1,655,000 1,310,000 3,300,000

Kennedy 172,500 347,000 263,500 -0-

Buildings (net) Licensing agreements Goodwill Total assets

6,315,000 -0347,000 13,384,000

2,090,000 3,070,000 -05,943,000

Accounts payable Long-term debt Common stock Additional paid-in cap. Retained earnings Total liab. & equities

(394,000) (3,990,000) (3,000,000) -0(6,000,000) (13,384,000)

(393,000) (2,950,000) (1,000,000) (500,000) (1,100,000) (5,943,000)

Adjust. & Elim.

(A) 382,000 (A) 426,000

(S) 1,000,000 (S) 500,000 (S) 1,100,000 3,408,000

Consolidated 629,500 2,002,000 1,573,500 (S) 2,600,000 (A) 700,000 -08,787,000 (A) 108,000 2,962,000 773,000 16,727,000 (787,000) (6,940,000) (3,000,000) -0(6,000,000) 3,408,000 (16,727,000)

*Although this solution uses a worksheet to compute the consolidated amounts, the problem does not require it.

26. (50 Minutes) (Determine consolidated balances for a bargain purchase.) a. Marshall’s acquisition of Tucker represents a bargain purchase because the fair value of the net assets acquired exceeds the fair value of the consideration transferred as follows: Fair value of net assets acquired $515,000 Fair value of consideration transferred 400,000 Gain on bargain purchase $115,000 In a bargain purchase, the acquisition is recorded at the fair value of the net assets acquired instead of the fair value of the consideration transferred (an exception to the general rule). Prior to preparing a consolidation worksheet, Marshall records the three transactions that occurred to create the business combination. Investment in Tucker ............................................... 515,000 Long-term Liabilities ............................................................... 200,000 Common Stock (par value) ..................................................... 20,000 Additional Paid-In Capital ....................................................... 180,000 Gain on Bargain Purchase ..................................................... 115,000 (To record liabilities and stock issued for Tucker acquisition fair value)

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Chapter 02 - Consolidation of Financial Information

26. (continued) Professional Services Expense.......................... Cash .............................................................. (to record payment of professional fees)

30,000

Additional Paid-In Capital ................................... Cash .............................................................. (To record payment of stock issuance costs)

12,000

30,000

12,000

Marshall's trial balance is adjusted for these transactions (as shown in the worksheet that follows). Next, the $400,000 fair value of the investment is allocated: Consideration transferred at fair value ................................... $400,000 Book value (assets minus liabilities or total stockholders' equity) .................................................. 460,000 Book value in excess of consideration transferred ........ (60,000) Allocation to specific accounts based on fair value: Inventory ................................................................... 5,000 Land ........................................................................ 20,000 Buildings ................................................................... 30,000 55,000 Gain on bargain purchase (excess net asset fair value over consideration transferred) ......................................... $(115,000) CONSOLIDATED TOTALS ▪ Cash = $38,000. Add the two book values less acquisition and stock issue costs ▪ Receivables = $360,000. Add the two book values. ▪ Inventory = $505,000. Add the two book values plus the fair value adjustment ▪ Land = $400,000. Add the two book values plus the fair value adjustment. ▪ Buildings = $670,000. Add the two book values plus the fair value adjustment. ▪ Equipment = $210,000. Add the two book values. ▪ Total assets = $2,183,000. Summation of the above individual figures. ▪ Accounts payable = $190,000. Add the two book values. ▪ Long-term liabilities = $830,000. Add the two book values plus the debt incurred by the parent in acquiring the subsidiary. ▪ Common stock = $130,000.The parent's book value after stock issue to acquire the subsidiary. ▪ Additional paid-in capital = $528,000.The parent's book value after the stock issue to acquire the subsidiary less the stock issue costs. ▪ Retained earnings = $505,000. Parent company balance less $30,000 in professional services expense plus $115,000 gain on bargain purchase. ▪ Total liabilities and equity = $2,183,000. Summation of the above figures.

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Chapter 02 - Consolidation of Financial Information

26. (continued) b.

MARSHALL COMPANY AND CONSOLIDATED SUBSIDIARY Worksheet January 1, 2015

Accounts Cash ............................................ Receivables ............................... Inventory ................................... Land ........................................... Buildings (net) .......................... Equipment (net) ........................ Investment in Tucker ................

Marshall Company* 18,000 270,000 360,000 200,000 420,000 160,000 515,000

Tucker Company 20,000 90,000 140,000 180,000 220,000 50,000

Total assets ...............................

1,943,000

700,000

Accounts payable ...................... Long-term liabilities ................. Common stock .......................... Additional paid-in capital ......... Retained earnings, 1/1/15 ......... Total liab. and owners’ equity ..

(150,000) (630,000) (130,000) (528,000) ( 505,000) (1,943,000)

(40,000) (200,000) (120,000) -0(340,000) (700,000)

Consolidation Entries Consolidated Debit Credit Totals 38,000 360,000 (A) 5,000 505,000 (A) 20,000 400,000 (A) 30,000 670,000 210,000 (S) 460,000 (A) 55,000 -02,183,000

(S) 120,000 (S) 340,000 515,000

Marshall's accounts have been adjusted for acquisition entries (see part a.).

2-14 ..

(190,000) (830,000) (130,000) (528,000) (505,000) 515,000 (2,183,000)

Chapter 02 - Consolidation of Financial Information

27. (Prepare a consolidated balance sheet) Consideration transferred at fair value .............. Book value ........................................................... Excess fair over book value ............................... Allocation of excess fair value to specific assets and liabilities: to computer software ..................................... to equipment................................................... to client contracts .......................................... to in-process research and development ... to notes payable ............................................. Goodwill ...............................................................

Cash Receivables Inventory Investment in Spider

Pratt

Spider

36,000 116,000 140,000 495,000

18,000 52,000 90,000 -0-

$495,000 265,000 230,000

$50,000 (10,000) 100,000 40,000 (5,000)

Debit

Credit

175,000 $ 55,000 Consolidated 54,000 168,000 230,000

(S) 265,000 (A) 230,000

-0280,000 725,000 338,000 100,000

Computer software 210,000 Buildings (net) 595,000 Equipment (net) 308,000 Client contracts -0Research and devlopment asset -0Goodwill -0Total assets 1,900,000

20,000 (A) 50,000 130,000 40,000 (A) 10,000 -0- (A) 100,000 -0- (A) 40,000 -0- (A) 55,000 350,000

40,000 55,000 1,990,000

Accounts payable Notes payable Common stock Additional paid-in capital Retained earnings Total liabilities and equities

(88,000) (510,000) (380,000)

(25,000) (60,000) (A) 5,000 (100,000) (S)100,000

(113,000) (575,000) (380,000)

(170,000) (752,000)

(25,000) (S) 25,000 (140,000) (S)140,000

(170,000) (752,000)

(1,900,000)

(350,000)

510,000

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510,000 (1,990,000)

Chapter 02 - Consolidation of Financial Information

27. (continued)

Pratt Company and Subsidiary Consolidated Balance Sheet December 31, 2015 Assets Liabilities and Owners’ Equity Cash $ 54,000 Accounts payable $ 113,000 Receivables 168,000 Notes payable 575,000 Inventory 230,000 Computer software 280,000 Buildings (net) 725,000 Equipment (net) 338,000 Client contracts 100,000 Research and Common stock 380,000 development asset 40,000 Additional paid in capital 170,000 Goodwill 55,000 Retained earnings 752,000 Total assets $1,990,000 Total liabilities and equities $1,990,000

28. (15 minutes) (Acquisition method entries for a merger) Case 1: Fair value of consideration transferred Fair value of net identifiable assets Excess to goodwill

$145,000 120,000 $25,000

Case 1 journal entry on Allerton’s books: Current Assets Building Land Trademark Goodwill Liabilities Cash

60,000 50,000 20,000 30,000 25,000 40,000 145,000

Case 2: Bargain Purchase under acquisition method Fair value of consideration transferred Fair value of net identifiable assets Gain on bargain purchase

$110,000 120,000 $ 10,000

Case 2 journal entry on Allerton’s books: Current Assets Building Land Trademark Gain on Bargain Purchase Liabilities Cash

60,000 50,000 20,000 30,000 10,000 40,000 110,000

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Chapter 02 - Consolidation of Financial Information

Problem 28. (continued) In a bargain purchase, the acquisition method employs the fair value of the net identifiable assets acquired as the basis for recording the acquisition. Because this basis exceeds the amount paid, Allerton recognizes a gain on bargain purchase. This is an exception to the general rule of using the fair value of the consideration transferred as the basis for recording the combination. 29. (25 minutes) (Combination entries—acquired entity dissolved) Cash consideration transferred Contingent performance obligation Consideration transferred (fair value) Fair value of net identifiable assets Goodwill

$310,800 17,900 328,700 294,700 $ 34,000

Journal entries: Receivables 83,900 Inventory 70,250 Buildings 122,000 Equipment 24,100 Customer List 25,200 Research and Development Asset 36,400 Goodwill 34,000 Current Liabilities Long-Term Liabilities Contingent Performance Liability Cash

12,900 54,250 17,900 310,800

Professional Services Expense Cash

15,100

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Chapter 02 - Consolidation of Financial Information

30. (30 Minutes) (Overview of the steps in applying the acquisition method when shares have been issued to create a combination. Part h. includes a bargain purchase.) a. The fair value of the consideration includes Fair value of stock issued Contingent performance obligation Fair value of consideration transferred

$1,500,000 30,000 $1,530,000

b. Stock issue costs reduce additional paid-in capital. c. In a business combination, direct acquisition costs (such as fees paid to investment banks for arranging the transaction) are recognized as expenses. d. The par value of the 20,000 shares issued is recorded as an increase of $20,000 in the Common Stock account. The $74 fair value in excess of par value ($75 – $1) is an increase to additional paid-in capital of $1,480,000 ($74 × 20,000 shares). e. Fair value of consideration transferred (above) Receivables $ 80,000 Patented technology 700,000 Customer relationships 500,000 In-process research and development 300,000 Liabilities (400,000) Goodwill

$1,530,000

1,180,000 $ 350,000

f. Revenues and expenses of the subsidiary from the period prior to the combination 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. g. The subsidiary’s Common Stock and Additional Paid-in Capital accounts have no impact on the consolidated totals. h. The fair value of the consideration transferred is now $1,030,000. This amount indicates a bargain purchase calculated as follows: Fair value of consideration transferred Receivables Patented technology Customer relationships Research and development asset Liabilities Gain on bargain purchase

$1,030,000 $ 80,000 700,000 500,000 300,000 (400,000)

1,180,000 $ 150,000

The values of SafeData’s assets and liabilities would be recorded at fair value, but there would be no goodwill recognized and a gain on bargain purchase would be reported. 2-18 ..

Chapter 02 - Consolidation of Financial Information

31. (50 Minutes) (Prepare balance sheet for a statutory merger using the acquisition method. Also, use worksheet to derive consolidated totals.) a. In accounting for the combination of NewTune and On-the-Go, the fair value of the acquisition is allocated to each identifiable asset and liability acquired with any remaining excess attributed to goodwill. Fair value of consideration transferred (shares issued) $750,000 Fair value of net assets acquired: Cash $ 29,000 Receivables 63,000 Trademarks 225,000 Record music catalog 180,000 In-process research and development 200,000 Equipment 105,000 Accounts payable (34,000) Notes payable (45,000) 723,000 Goodwill $ 27,000 Journal entries by NewTune to record combination with On-the-Go: Cash 29,000 Receivables 63,000 Trademarks 225,000 Record Music Catalog 180,000 Research and Development Asset 200,000 Equipment 105,000 Goodwill 27,000 Accounts Payable Notes Payable Common Stock (NewTune par value) Additional Paid-In Capital (To record merger with On-the-Go at fair value) Additional Paid-In Capital Cash (Stock issue costs incurred)

25,000 25,000

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34,000 45,000 60,000 690,000

Chapter 02 - Consolidation of Financial Information

Problem 31 (continued): Post-Combination Balance Sheet: Assets Cash Receivables Trademarks Record music catalog Research and development asset Equipment Goodwill Total

64,000 213,000 625,000 1,020,000

200,000 425,000 27,000 $2,574,000

Liabilities and Owners’ Equity Accounts payable $ 144,000 Notes payable 415,000

Common stock Additional paid-in capital Retained earnings Total

460,000 695,000 860,000 $2,574,000

b. Because On-the-Go continues as a separate legal entity, NewTune first records the acquisition as an investment in the shares of On-the-Go. Journal entries: Investment in On-the-Go Common Stock (NewTune, Inc., par value) Additional Paid-In Capital (To record acquisition of On-the-Go's shares)

750,000

Additional Paid-In Capital Cash (Stock issue costs incurred)

25,000

60,000 690,000

25,000

Next, NewTune’s accounts are adjusted for the two immediately preceding entries to facilitate the worksheet preparation of the consolidated financial statements.

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Chapter 02 - Consolidation of Financial Information

31. (continued) b.

NEWTUNE, INC., AND ON-THE-GO CO. Consolidation Worksheet January 1, 2015 Consolidation Entries Accounts NewTune, Inc. On-the-Go Co. Debit Credit Cash 35,000 29,000 Receivables 150,000 65,000 (A) 2,000 Investment in On-the-Go 750,000 -0(S) 270,000 (A) 480,000 Trademarks 400,000 95,000 (A) 130,000 Record music catalog 840,000 60,000 (A) 120,000 Research and development asset -0-0(A) 200,000 Equipment 320,000 105,000 Goodwill -0-0(A) 27,000 Totals 2,495,000 354,000 Accounts payable 110,000 34,000 Notes payable 370,000 50,000 (A) 5,000 Common stock 460,000 50,000 (S) 50,000 Additional paid-in capital 695,000 30,000 (S) 30,000 Retained earnings 860,000 190,000 (S) 190,000 Totals 2,495,000 354,000 752,000 752,000

Consolidated Totals 64,000 213,000 -0625,000 1,020,000 200,000 425,000 27,000 2,574,000 144,000 415,000 460,000 695,000 860,000 2,574,000

Note: The accounts of NewTune have already been adjusted for the first three journal entries indicated in the answer to Part b. to record the acquisition fair value and the stock issuance costs. The consolidation entries are designed to: ▪ Eliminate the stockholders’ equity accounts of the subsidiary (S) ▪ Record all subsidiary assets and liabilities at fair value (A) ▪ Recognize the goodwill indicated by the acquisition fair value (A) ▪ Eliminate the Investment in On-the-Go account (S, A) c. The consolidated balance sheets in parts a. and b. above are identical. The financial reporting consequences for a 100% stock acquisition vs. a merger are the same. The economic substances of the two forms of the transaction are identical and, therefore, so are the resulting financial statements. The difference is in the journal entry to record the acquisition in the parent company books.

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Chapter 02 - Consolidation of Financial Information

32. (40 minutes) (Prepare a consolidated balance sheet using the acquisition method). a. Journal entries to record the acquisition on Pacifica’s records. Investment in Seguros 1,062,500 Common Stock (50,000 × $5) 250,000 Additional Paid-In Capital (50,000 × $15) 750,000 Contingent Performance Obligation 62,500 The contingent consideration is computed as: $130,000 payment × 50% probability × 0.961538 present value factor Professional Services Expense Cash Additional Paid-In Capital Cash

15,000 15,000 9,000 9,000

b. and c.

Revenues Expenses Net income

(1,200,000) 890,000 (310,000)

Consolidated Balance Sheet (1,200,000) 890,000 (310,000)

Retained earnings, 1/1 Net income Dividends declared Retained earnings, 12/31

(950,000) (310,000) 90,000 (1,170,000)

Cash Receivables and inventory Property, plant and equipment Investment in Seguros

86,000 750,000 1,400,000 1,062,500

Pacifica

Seguros

85,000 190,000 450,000

(A) 10,000 (A)150,000 (S) 705,000 (A) 357,500

Research and development asset Goodwill Trademarks Total assets

300,000 3,598,500

160,000 885,000

Liabilities Contingent performance obligation Common stock Additional paid-in capital Retained earnings Total liabilities and equities

(500,000) (62,500) (650,000) (1,216,000) (1,170,000) (3,598,500)

(180,000) (200,000) (70,000) (435,000) (885,000)

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Consolidation Entries

(A)100,000 (A) 77,500 (A) 40,000

(S) 200,000 (S) 70,000 (S) 435,000 1,072,500

171,000 930,000 2,000,000 0 100,000 77,500 500,000 3,778,500

1,072,500

(680,000) (62,500) (650,000) (1,216,000) (1,170,000) (3,778,500)

Chapter 02 - Consolidation of Financial Information

Answers to Appendix Problems 33. (25 minutes) Journal entries for a merger using legacy purchase method. Also compare to acquisition method. a. Purchase Method 1. Purchase price (including acquisition costs) Fair values of net assets acquired Goodwill

$635,000 525,000 $110,000

Journal entry: Current Assets Equipment Trademark Goodwill Liabilities Cash

80,000 180,000 320,000 110,000 55,000 635,000

2. Acquisition date fair values: Purchase price (including acquisition costs) $450,000 Fair values of net assets acquired 525,000 Bargain purchase ($ 75,000) Allocation of bargain purchase to long-term assets acquired:

Equipment Trademark

Fair value

Prop.

Total reduction

Asset reduction

$180,000 320,000 $500,000

36% x $75,000 = 64% x 75,000 =

$27,000 48,000 $75,000

Journal entry: Current Assets Equipment ($180,000 – $27,000) Trademark ($320,000 – $48,000) Liabilities Cash

80,000 153,000 272,000 55,000 450,000

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Chapter 02 - Consolidation of Financial Information

33. continued b. Acquisition Method 1. Consideration transferred Fair values of net assets acquired Goodwill

$ 610,000 525,000 $ 85,000

Journal entry: Current Assets Equipment Trademark Goodwill Liabilities Cash

80,000 180,000 320,000 85,000

Professional Services Expense Cash

25,000

55,000 610,000 25,000

2. Consideration transferred Fair values of net assets acquired Gain on bargain purchase

$425,000 525,000 ($100,000)

Journal entry: Current Assets Equipment Trademark Liabilities Gain on Bargain Purchase Cash

80,000 180,000 320,000

Professional Services Expense Cash

25,000

55,000 100,000 425,000 25,000

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Chapter 02 - Consolidation of Financial Information

34. (25 minutes) (Pooling vs. purchase involving an unrecorded intangible) a.

Purchase Inventory Land Buildings Unpatented technology Goodwill Total

Pooling

$ 650,000 $ 600,000 750,000 450,000 1,000,000 900,000 1,500,000 -0600,000 -0$4,500,000 $1,950,000

b. Pre-acquisition revenues and expenses were excluded from consolidated results under the purchase method, but were included under the pooling method. c. Poolings, in most cases, produce higher rates of return on assets than purchase accounting because the denominator typically is much lower. In the case of the Swimwear acquisition pooling produced an increment to total assets of $1,950,000 compared to $4,500,000 under purchase accounting. Future EPS under poolings were also higher because of lower future depreciation and amortization of the smaller asset base. Managers whose compensation contracts involved accounting performance measures clearly had incentives to use pooling of interest accounting whenever possible.

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Chapter 02 - Consolidation of Financial Information

Chapter 2 Develop Your Skills CONSIDERATION OR COMPENSATION CASE (estimated time 40 minutes) According to FASB ASC (805-10-55-25): If it is not clear whether an arrangement for payments to employees or selling shareholders is part of the exchange for the acquiree or is a transaction separate from the business combination, the acquirer should consider the following indicators: a. Continuing employment. The terms of continuing employment by the selling shareholders who become key employees may be an indicator of the substance of a contingent consideration arrangement. The relevant terms of continuing employment may be included in an employment agreement, acquisition agreement, or some other document. A contingent consideration arrangement in which the payments are automatically forfeited if employment terminates is compensation for postcombination services. Arrangements in which the contingent payments are not affected by employment termination may indicate that the contingent payments are additional consideration rather than compensation. b. Duration of continuing employment. If the period of required employment coincides with or is longer than the contingent payment period, that fact may indicate that the contingent payments are, in substance, compensation. c. Level of compensation. Situations in which employee compensation other than the contingent payments is at a reasonable level in comparison to that of other key employees in the combined entity may indicate that the contingent payments are additional consideration rather than compensation. d. Incremental payments to employees. If selling shareholders who do not become employees receive lower contingent payments on a per-share basis than the selling shareholders who become employees of the combined entity, that fact may indicate that the incremental amount of contingent payments to the selling shareholders who become employees is compensation. e. Number of shares owned. The relative number of shares owned by the selling shareholders who remain as key employees may be an indicator of the substance of the contingent consideration arrangement. For example, if the selling shareholders who owned substantially all of the shares in the acquiree continue as key employees, that fact may indicate that the arrangement is, in substance, a profit-sharing arrangement intended to provide compensation for postcombination services. Alternatively, if selling shareholders who continue as key employees owned only a small number of shares of the acquiree and all selling shareholders receive the same amount of contingent consideration on a per-share basis, that fact may indicate that the contingent payments are additional consideration. The preacquisition ownership interests held by parties related to selling shareholders who continue as key employees, such as family members, also should be considered. f. Linkage to the valuation. If the initial consideration transferred at the acquisition date is based on the low end of a range established in the valuation of the acquiree and the contingent formula relates to that valuation approach, that fact may suggest that the contingent payments are additional consideration. Alternatively, if the contingent payment formula is consistent with prior profitsharing arrangements, that fact may suggest that the substance of the arrangement is to provide compensation. 2-26 ..

Chapter 02 - Consolidation of Financial Information

g. Formula for determining consideration. The formula used to determine the contingent payment may be helpful in assessing the substance of the arrangement. For example, if a contingent payment is determined on the basis of a multiple of earnings, that might suggest that the obligation is contingent consideration in the business combination and that the formula is intended to establish or verify the fair value of the acquiree. In contrast, a contingent payment that is a specified percentage of earnings might suggest that the obligation to employees is a profit-sharing arrangement to compensate employees for services rendered. Suggested answer: Note: This case was designed to have conflicting indicators across the various criteria identified in the FASB ASC for determining the issue of compensation vs. consideration. Thus, the solution is subject to alternative explanations and student can be encouraged to use their own judgment and interpretations in supporting their answers. In the author’s judgment, the $8 million contingent payment (fair value = $4 million) is contingent consideration to be included in the overall fair value NaviNow records for its acquisition of TrafficEye. This contingency is not dependent on continuing employment (criteria a.), and uses a formula based on a component of earnings (criteria g.). Even though the four former owners of TrafficEye owned 100% of the shares (criteria e.), which suggests the $8 million is compensation, the overall fact pattern indicates consideration because no services are required for the payment. The profit-sharing component of the employment contract appears to be compensation. Criteria g. specifically identifies profit-sharing arrangements as indicative of compensation for services rendered. Criteria a. also applies given that the employees would be unable to participate in profit-sharing if they terminate employment. Although the employees receive non-profit sharing compensation similar to other employees (criteria c.), the overall pattern of evidence suggests that any payments made under the profit-sharing arrangement should be recognized as compensation expense when incurred and not contingent consideration for the acquisition.

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Chapter 02 - Consolidation of Financial Information

ASC RESEARCH CASE—DEFENSIVE INTANGIBLE ASSET (35 MINUTES) a. The ASC Glossary defines a defensive intangible asset as “An acquired intangible asset in a situation in which an entity does not intend to actively use the asset but intends to hold (lock up) the asset to prevent others from obtaining access to the asset.” ASC 820-10-35-10D also observes that To protect its competitive position, or for other reasons, a reporting entity may intend not to use an acquired nonfinancial asset actively, or it may intend not to use the asset according to its highest and best use. For example, that might be the case for an acquired intangible asset that the reporting entity plans to use defensively by preventing others from using it. Nevertheless, the reporting entity shall measure the fair value of a nonfinancial asset assuming its highest and best use by market participants. According to ASC 350-30-25-5 a defensive intangible asset should be accounted for as a separate unit of accounting (i.e., an asset separate from other assets of the acquirer). It should not be included as part of the cost of an entity's existing intangible asset(s) presumably because the defensive intangible asset is separately identifiable. b. The identifiable assets acquired in a business combination should be measured at their acquisition-date fair values (ASC 805-20-30-1). c. A fair value measurement assumes the highest and best use of an asset by market participants. Highest and best use is determined based on the use of the asset by market participants, even if the intended use of the asset by the reporting entity is different (ASC 820-10-35-10). Importantly, highest and best use provides maximum value to market participants. The highest and best use of the asset establishes the valuation premise used to measure the fair value of the asset—in this case an in-exchange premise maximizes the value of the asset at $2 million. d. A defensive intangible asset shall be assigned a useful life that reflects the entity's consumption of the expected benefits related to that asset. The benefit a reporting entity receives from holding a defensive intangible asset is the direct and indirect cash flows resulting from the entity preventing others from realizing any value from the intangible asset (defensively or otherwise). An entity shall determine a defensive intangible asset's useful life, that is, the period over which an entity consumes the expected benefits of the asset, by estimating the period over which the defensive intangible asset will diminish in fair value. The period over which a defensive intangible asset diminishes in fair value is a proxy for the period over which the reporting entity expects a defensive intangible asset to contribute directly or indirectly to the future cash flows of the entity. (ASC 350-30-35A) It would be rare for a defensive intangible asset to have an indefinite life because the fair value of the defensive intangible asset will generally diminish over time as a result of a lack of market exposure or as a result of competitive or other factors. Additionally, if an acquired intangible asset meets the definition of a defensive intangible asset, it shall not be considered immediately abandoned. (ASC 350-30-35B)

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Chapter 02 - Consolidation of Financial Information

RESEARCH CASE—CELGENE’S ACQUISITION OF AVILA THERAPEUTICS (25 Minutes) 1. From Celgene’s 2012 10-K report (Note 2), “We acquired Avila to enhance our portfolio of potential therapies for patients with life-threatening illnesses worldwide.” 2. Celgene accounted for its March 7, 2012 acquisition of Avila Therapeutics using the acquisition method. Accordingly, Celgene recorded the acquisition at $535 million. 3. From Celgene’s 12/31/12 10-K report (dollars in thousands) Cash consideration: Cash Contingent consideration Total fair value of consideration transferred Working capital (cash, A/R, A/P, etc.) Property, plant, and equipment Platform technology intangible asset In-process research and development product rights Net deferred tax liability Total fair value of net identifiable assets Goodwill

$363,405 171,654 $535,059 $ 11,987 2,559 330,800 198,400 (164,993) 378,753 $156,306

Celgene determined these allocations by estimating fair values for each of the assets acquired and the liabilities assumed. 4. As shown in the part 3. Schedule above, Celgene included $171.654 million of fair value contingent consideration in its consideration transferred. If all milestones are achieved, contingent consideration could reach a maximum of $595 million. 5. Acquired in-process research and development product rights are accounted for as an intangible asset with an indefinite life.

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Chapter 03 - Consolidations—Subsequent to the Date of Acquisition

CHAPTER 3 CONSOLIDATIONS—SUBSEQUENT TO THE DATE OF ACQUISITION I.

Several factors serve to complicate the consolidation process when it occurs subsequent to the date of acquisition. In all combinations within its own internal records the acquiring company will utilize a specific method to account for the investment in the acquired company. 1. Three alternatives are available a. Initial value method (also known as the cost method) b. Equity method c. Partial equity method 2. Depending upon the method applied, the acquiring company will record earnings from its ownership of the acquired company. This total must be eliminated on the consolidation worksheet and be replaced by the subsidiary’s revenues and expenses. 3. Under each of these three methods, the balance in the Investment account will also vary. It too must be removed in producing consolidated statements and be replaced by the subsidiary’s assets and liabilities.

II.

For combinations subsequent to the acquisition date, certain procedures are required. If the parent applies the equity method, the following process is appropriate. A. Assuming that the acquisition was made during the current fiscal period 1. The parent adjusts its own Investment account to reflect the subsidiary’s income and dividend declarations as well as any amortization expense relating to excess acquisition-date fair value over book value allocations and goodwill. 2. Worksheet entries are then used to establish consolidated figures for reporting purposes. a. Entry S offsets the subsidiary’s stockholders’ equity accounts against the book value component of the Investment account (as of the acquisition date). b. Entry A recognizes the excess fair over book value allocations made to specific subsidiary accounts and/or to goodwill. c. Entry I eliminates the investment income balance accrued by the parent. d. Entry D removes intra-entity dividend declarations e. Entry E recognizes the current excess amortization expenses on the excess fair over book value allocations. f. Entry P eliminates any intra-entity payable/receivable balances. B. Assuming that the acquisition was made during a previous fiscal period 1. Most of the consolidation entries described above remain applicable regardless of the time that has elapsed since the combination was formed. 2. The amount of the subsidiary’s stockholders’ equity to be removed in Entry S will differ each period to reflect the balance as of the beginning of the current year

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Chapter 03 - Consolidations—Subsequent to the Date of Acquisition

3. The allocations established by entry A will also change in each subsequent consolidation. Only the unamortized balances remaining as of the beginning of the current period are recognized in this entry. III.

For a combination where the parent has applied an accounting method other than the equity method, the consolidation procedures described above must be modified. A. If the initial value method is applied by the parent company, the intra-entity dividends eliminated in Entry I will only consist of the dividends transferred from the subsidiary. No separate Entry D is needed. B. If the partial equity method is in use, the intra-entity income to be removed in Entry I is the equity accrual only; no amortization expense is included. Intra-entity dividends are eliminated through Entry D. C. In any time period after the year of acquisition. 1. The initial value method recognizes neither income in excess of dividend declarations nor excess amortization expense. Thus, for all years prior to the current period, both of these figures must be entered directly into the consolidation. Entry*C is used for this purpose; it converts all prior amounts to equity method balances. 2. The partial equity method does not recognize excess amortization expenses. Therefore, Entry*C converts the appropriate account balances to the equity method by recognizing the expense that relates to all of the past years.

IV.

Bargain purchases A. As discussed in Chapter Two, bargain purchases occur when the parent company transfers consideration less than net fair values of the subsidiary’s assets acquired and liabilities assumed. B. The parent recognizes an excess of net asset fair value over the consideration transferred as a “gain on bargain purchase.”

Goodwill Impairment A. When is goodwill impaired? 1. Goodwill is considered impaired when the fair value of its related reporting unit falls below its carrying value. Goodwill should not be amortized, but should be tested for impairment at the reporting unit level (operating segment or lower identifiable level). 2. Goodwill should be tested for impairment at least annually. 3. Interim impairment testing is necessary in the presence of negative indicators such as an adverse change in the business climate or market, legal factors, regulatory action, an introduction of competition, or a loss of key personnel. B. How is goodwill tested for impairment? 1. All acquired goodwill should be assigned to reporting units. It would not be unusual for the total amount of acquired goodwill to be divided among a number of reporting units. Goodwill may be assigned to reporting units of the acquiring entity that are expected to benefit from the synergies of the combination even though other assets or liabilities of the acquired entity may not be assigned to that reporting unit.

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Chapter 03 - Consolidations—Subsequent to the Date of Acquisition

2. Goodwill is tested for impairment through an optional assessment process followed by a two-step approach (if necessary). a. Entities are allowed the option of conducting a qualitative assessment of goodwill to assess whether the two-step testing procedure is required. Under the qualitative assessment, management evaluates relevant events or circumstances to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If it is more likely than not that the fair value of a reporting unit is less than its carrying amount, then the entity performs the two-step testing procedure. Otherwise, no further tests are required. b. The first step simply compares the fair value amount of a reporting unit to its carrying amount. If the fair value of the reporting unit exceeds its carrying amount, goodwill is not considered impaired and no further analysis is necessary. c. The second step is a comparison of goodwill to its carrying amount. If the implied value of a reporting unit’s goodwill is less than its carrying value, goodwill is considered impaired and a loss is recognized. The loss is equal to the amount by which goodwill exceeds its implied value. 3. The implied value of goodwill should be calculated in the same manner that goodwill is calculated in a business combination. That is, an entity should allocate the fair value of the reporting unit to all of the assets and liabilities of that unit (including any unrecognized intangible assets) as if the reporting unit had been acquired in a business combination and the fair value of the reporting unit was the value assigned at a subsidiary’s acquisition date. The excess “acquisition-date” fair value over the amounts assigned to assets and liabilities is the implied value of goodwill. This allocation is performed only for purposes of testing goodwill for impairment and does not require entities to record the “stepup” in net assets or any unrecognized intangible assets. C. How is the impairment recognized in financial statements?

1. The aggregate amount of goodwill impairment losses should be presented as a separate line item in the operating section of the income statement unless a goodwill impairment loss is associated with a discontinued operation.

2. A goodwill impairment loss associated with a discontinued operation should

VI.

be included (on a net-of-tax basis) within the results of discontinued operations. Contingent consideration A. The fair value of any contingent consideration is included as part of the consideration transferred. B. If the contingency results in a liability (typically a cash payment), changes in the fair value of the contingency are recognized in income as they occur. C. If the contingency calls for an additional equity issue at a later date, the acquisitiondate fair value of the contingency is not adjusted over time. Any subsequent shares issued as a consequence of the contingency are simply recorded at the original acquisition-date fair value. This treatment is similar to other equity issues (e.g., common stock, preferred stock, etc.) in the parent’s owners’ equity section.

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Chapter 03 - Consolidations—Subsequent to the Date of Acquisition

VII.

Push-down accounting A. A subsidiary may record any acquisition-date fair value allocations directly onto its own financial records rather than through the use of a worksheet. Subsequent amortization expense on these allocations could also be recorded by the subsidiary. B. Push-down accounting reports the assets and liabilities of the subsidiary at the amount the new owner paid. It also assists the new owner in evaluating the profitability that the subsidiary is adding to the business combination. C. Push-down accounting can also make the consolidation process easier since allocations and amortization need not be included as worksheet entries.

Answers to Discussion Questions How Does a Company Really Decide which Investment Method to Apply? Students can come up with dozens of factors that Pilgrim should consider in choosing its internal method of accounting for its subsidiary, Crestwood Corporation. The following is only a partial list of possible points to consider. ▪

Use of the information. If Pilgrim does not monitor its subsidiary’s income levels closely, applying the equity method may be not be fruitful. A company must plan to use the data before the task of accumulation becomes worthwhile. For example, Crestwood may use the information for evaluating the performance of the subsidiary’s managers.

▪

Size of the subsidiary. If the subsidiary is large in comparison to Pilgrim, the effort required of the equity method may be important. Income levels would probably be significant. However, if the subsidiary is actually quite small in relation to the parent, the impact might not be material enough to warrant the extra effort.

▪

Size of dividend declarations. If Crestwood distributes most of its income as dividends, that figure will approximate equity income. Little additional information would be accrued by applying the equity method. In contrast, if dividends are small or not declared on a regular basis, a Dividend Income balance might vastly understate the profits to be recognized by the business combination.

▪

Amount of excess amortizations. If Pilgrim has paid a significant amount in excess of book value, its annual amortization charges are high, and use of the equity method might be preferred to show the amortization effect each reporting period. In this case, waiting until year end and recognizing all of the expense at one time through a worksheet entry might not be the best way to reflect the impact of the expense.

▪

Amount of intra-entity transactions. As with amortization, the volume of transfers can be an important element in deciding which accounting method to use. If few intra-entity sales are made, monitoring the subsidiary through the application of the equity method is less essential. Conversely, if the amount of these transactions IS significant, the added data can be helpful to company administrators evaluating operations.

▪

Sophistication of accounting systems. If Pilgrim and Crestwood both have advanced accounting systems, application of the equity method may be relatively easy. Unfortunately, if these systems are primitive, the cost and effort necessary to apply the equity method may outweigh any potential benefits.

▪

The timeliness and accuracy of income figures generated by Crestwood. If the subsidiary reports operating results on a regular basis (such as weekly or monthly) and these figures prove to be reliable, equity totals recorded by Pilgrim may serve as valuable information to 3-4

Chapter 03 - Consolidations—Subsequent to the Date of Acquisition

the parent. However, if Crestwood's reports are slow and often require later adjustment, Pilgrim's use of the equity method will provide only questionable results.

Answers to Questions 1.

a. CCES Corp., for its own recordkeeping, may apply the equity method to its Investment in Schmaling. Under this approach, the parent's records parallel the activities of the subsidiary. The parent accrues income as it is earned by the subsidiary. Dividends declared by Schmaling reduce its book value; therefore, CCES reduces the investment account. In addition, any excess amortization expense associated with CCES's acquisition-date fair value allocations is recognized through a periodic adjustment. By applying the equity method, both the parent’s income and investment balances accurately reflect consolidated totals. The equity method is especially helpful in monitoring the income of the business combination. This method can be, however, rather difficult to apply and a time consuming process. b. The initial value method. The initial value method can also be utilized by CCES Corporation. Any dividends declared are recognized as income but no other investment entries are made. Thus, the initial value method is easy to apply. However, the resulting account balances of the parent may not provide a reasonable representation of the totals that result from consolidating the two companies. c. The partial equity method combines the advantages of the previous two techniques. Income is accrued as earned by the subsidiary as under the equity method. Similarly, dividends reduce the investment account. However, no other entries are recorded; more specifically, amortization is not recognized by the parent. The method is, therefore, easier to apply than the equity method but the subsidiary's individual totals will still frequently approximate consolidated balances.

a. The consolidated total for equipment is made up of the sum of Maguire’s book value, Williams’ book value, and any unamortized excess acquisition-date fair value over book value attributable to Williams’ equipment. b. Although an Investment in Williams account is appropriately maintained by the parent, from a consolidation perspective the balance is intra-entity in nature. Thus, the entire amount is eliminated in arriving at consolidated financial statements. c. Only dividends declared to outside parties are included in consolidated statements. Because Maguire owns 100 percent of Williams, all of the subsidiary's dividends are intra-entity. Consequently, only the dividends declared by the parent company will be reported in the financial statements for this business combination. d. Any acquisition-date goodwill must still be reported for consolidation purposes. Reductions to goodwill are made if goodwill is determined to be impaired. e. Unless intra-entity revenues have been recorded, consolidation is achieved in subsequent periods by adding the two book values together. f.

Consolidated expenses are determined by combining the parent's and subsidiary amounts including any amortization expense associated with the acquisition-date fair value allocations. As discussed in Chapter Five, intra-entity expenses can also require elimination in arriving at consolidated figures.

g. Only the parent’s common stock outstanding is included in consolidated totals.

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Chapter 03 - Consolidations—Subsequent to the Date of Acquisition

h. The net income for a business combination is calculated as the difference between consolidated revenues and consolidated expenses. 3.

Under the equity method, the parent accrues subsidiary earnings and amortization expense (associated with acquisition-date fair value allocations) in the same manner as in the consolidation process. The equity method parallels consolidation. Thus, the parent’s net income and retained earnings each year will equal the consolidated totals.

In the consolidation process, excess amortizations must be recognized annually for any portion of the acquisition-date fair value allocations to specific assets or liabilities (other than indefinite-lived assets). Although this expense can be simulated in total on the parent's books by an equity method entry, the actual amortization of each allocated fair value adjustment is appropriate for consolidation. Hence, the effect of the parent's equity method amortization entry is removed as part of Entry I so that the amortization of specific accounts (e.g., depreciation) can be recognized (in consolidation Entry E).

When a parent applies the initial value method, no accrual is recorded to reflect the subsidiary's change in book value subsequent to acquisition. Recognition of excess amortizations relating to the acquisition is also omitted by the parent. The partial equity method, in contrast, records the subsidiary’s book value increases and decreases but not amortizations. Consequently, for both of these methods, a technique must be employed in the consolidation process to recognize the omitted figures. Entry *C simply brings the parent's figures (more specifically, the beginning retained earnings balance and the investment account) up-to-date as of the first day of the current year. If the acquirer applies the initial value method, changes in the subsidiary's book value in previous years are recognized on the worksheet along with the appropriate amount of amortization expense. For the partial equity method, only the amortization relating to these prior years needs to be recognized. No similar entry to *C is needed when the parent applies the equity method. The parent will record changes in the subsidiary's book value as well as excess amortization each year. Thus, under the equity method, the parent's investment and beginning retained earnings balances are both correctly established and need no further adjustment.

Lambert's loan payable and the receivable held by Jenkins are intra-entity accounts. The consolidation process offsets these reciprocal balances. The $100,000 is neither a debt to nor a receivable from an unrelated (or outside) party and is, therefore, not reported in consolidated financial statements. Any interest income/expense recognized on this loan is also intra-entity in nature and must likewise be eliminated.

Because Benns applies the equity method, the $920,000 is composed of four balances: a. b. c. d.

The original consideration transferred by the parent; Benns’ annual accruals to recognize subsidiary net income as it is earned The reductions that are created by the subsidiary's declaration of dividends The periodic amortization recognized by Benns in connection with the allocations identified with its acquisition-date fair value allocations.

The $100,000 attributed to goodwill is reported at its original amount unless a portion of goodwill is impaired or a unit of the business where goodwill resides is sold.

A parent should consider recognizing an impairment loss for goodwill associated with an acquired subsidiary when, at the reporting unit level, the fair value is less than its carrying amount. Goodwill is reduced when its carrying value is less than its fair value. To compute fair value for goodwill, its implied value is calculated by subtracting the fair 3-6

Chapter 03 - Consolidations—Subsequent to the Date of Acquisition

10.

11.

values of the reporting unit’s identifiable net assets from its total fair value. The impairment is recognized as a loss from continuing operations. The acquisition-date fair value of the contingent payment is part of the consideration transferred by Reimers to acquire Rollins and thus is part of the overall fair value assigned to the acquisition. If the contingency is a liability (to be settled in cash or other assets) then the liability is adjusted to fair value through time. If the contingency is a component of equity (e.g., to be settled by the parent issuing equity shares), then the equity instrument is not adjusted to fair value over time. At present, the Securities and Exchange Commission requires the use of push-down accounting for the separate financial statements of a subsidiary where no substantial outside ownership exists. Thus, if Company A owns all of Company B, the push-down method of accounting is appropriate for the separately issued statements of Company B. The SEC normally requires push-down accounting where 95 percent of a subsidiary is acquired and the company has no outstanding public debt or preferred stock. Push-down accounting may be required if 80-95 percent of the outstanding voting stock is acquired. Push-down accounting uses the consideration transferred as the valuation basis for the subsidiary in consolidated reports. For example, if a piece of land costs Company B $10,000 but Company A allocates a $13,000 fair value to the land in acquiring Company B, the land has a basis to the current owners of B of $13,000. If B's financial records had been united with A at the time of the acquisition, the land would have been reported at $13,000. Thus, keeping the $10,000 figure simply because separate incorporation is maintained is viewed, by proponents of push-down accounting, as unjustified.

12.

When push-down accounting is applied, the subsidiary adjusts the book value of its assets and liabilities based on the acquisition-date fair value allocations. The subsidiary then recognizes periodic amortization expense on those allocations with definite lives. Therefore, the subsidiary’s recorded income equals its impact on consolidated earnings. The parent uses no special procedures when push-down accounting is being applied. However, if the equity method is in use, amortization need not be recognized by the parent since that expense is included in the figure reported by the subsidiary.

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Chapter 03 - Consolidations—Subsequent to the Date of Acquisition

Answers to Problems 1. A 2. B 3. A 4. A Paar’s equipment book value—12/31/14 ............................ $294,000 Kimmel’s equipment book value—12/31/14 ....................... 190,400 Original acquisition-date allocation to Kimmel's equipment ($400,000 – $272,000) ........................................................... 128,000 Amortization of allocation ($128,000 ÷ 10 years for 3 years) ................................... (38,400) Consolidated equipment ...................................................... $574,000 5. A 6. B 7. D 8. B 9. B Phoenix revenues Phoenix expenses Net income before Sedona effect Equity income from Sedona Consolidated net income -orConsolidated revenues Consolidated expenses (includes $35K amortization) Consolidated net income

$498,000 350,000 148,000 55,000 $203,000 $783,000 580,000 $203,000

10. A (same as Phoenix because of equity method use). 11. C Consideration transferred at fair value Book value acquired Excess fair over book value to equipment to customer list (4-year remaining life)

$600,000 420,000 180,000 80,000 $100,000

Three years since acquisition, ¼ of acquisition-date value remains. 12. B 13. C

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Chapter 03 - Consolidations—Subsequent to the Date of Acquisition

14. D The $105,000 excess acquisition-date fair value allocation to equipment is "pushed-down" to the subsidiary and increases its balance to $441,500. The consolidated balance is $871,500 ($430,000 book value for Crawford plus fair value for Nashville $441,500). 15. (35 Minutes) (Determine consolidated retained earnings when parent uses various accounting methods. Determine Entry *C for each of these methods) a. CONSOLIDATED RETAINED EARNINGS--EQUITY METHOD Herbert (parent) balance—1/1/14 .................................. $400,000 Herbert income—2014 ................................................... 40,000 Herbert dividends—2014 (subsidiary dividends are intra-entity and, thus, eliminated) ............................ (10,000) Rambis income—2014 (not included in parent's income) 20,000 Amortization—2014 ........................................................ (12,000) Herbert income—2015 ................................................... 50,000 Herbert dividends—2015 ................................................ (10,000) Rambis income—2015 ................................................... 30,000 Amortization—2015 ....................................................... (12,000) Consolidated retained earnings, 12/31/15 ..................... $496,000 ▪

PARTIAL EQUITY METHOD AND INITIAL VALUE METHOD Consolidated RE are the same regardless of the method in use: the beginning balance plus the income less the dividends of the parent plus the income of the subsidiary less amortization expense. Thus, December 31, 2015 consolidated RE are $496,000 as computed above.

b. Investment in Rambis—equity method Rambis fair value 1/1/14............................................................. $574,000 Rambis income 2014 .................................................................. 20,000 Rambis dividends 2014.............................................................. (5,000) Herbert’s 2014 excess fair over book value amortization ...... (12,000) Investment account balance 1/1/15 .......................................... $577,000 Investment in Rambis—partial equity method Rambis fair value 1/1/14............................................................. $574,000 Rambis income 2014 .................................................................. 20,000 Rambis dividends 2014.............................................................. (5,000) Investment account balance 1/1/14 .......................................... $589,000 Investment in Rambis—Initial value method Rambis fair value 1/1/14............................................................. $574,000 Investment account balance 1/1/15 .......................................... $574,000

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Chapter 03 - Consolidations—Subsequent to the Date of Acquisition

15. (continued) c.

ENTRY *C

▪

EQUITY METHOD No entry is needed to convert the past figures to the equity method since that method has already been applied.

▪

PARTIAL EQUITY METHOD Amortization for the prior years (only 2014 in this case) has not been recorded and must be brought into the consolidation through worksheet entry *C: ENTRY *C Retained earnings, 1/1/15 (Parent) ..................... 12,000 Investment in Rambis .................................... 12,000 (To recognize 2014 amortization in consolidated figures. Expense was omitted because of application of partial equity method.)

▪

INITIAL VALUE METHOD Amortization for the prior years (only 2014 in this case) has not been recorded and must be brought into the consolidation through worksheet entry *C. In addition, only dividend income has been recorded by the parent ($5,000 in 2014). In this prior year, Rambis reported net income of $20,000. Thus, the parent has not recorded the $15,000 income in excess of dividends. That amount must also be included in the consolidation through entry *C: ENTRY *C Investment in Rambis ......................................... 3,000 Retained earnings, 1/1/15 (Parent) ............... 3,000 (To recognize 2014 unrecognized subsidiary earnings as part of the parent’s retained earnings. $15,000 net income of subsidiary was not recorded by parent (income in excess of dividends). Amortization expense of $12,000 was not recorded under the initial value method. Note that *C adjustments bring the parent’s January 1, 2015 Retained Earnings balance equal to that of the equity method.

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Chapter 03 - Consolidations—Subsequent to the Date of Acquisition

16. (30 Minutes) (A variety of questions on equity method, initial value method, and partial equity method.) a. An allocation of the acquisition price (based on the fair value of the shares issued) must be made first. Acquisition fair value (consideration paid by Haynes) Book value equivalency ................................................. Excess of Turner fair value over book value ............... Excess fair value assigned to specific accounts based on fair value Equipment ......................... $5,000 Customer List ...................... 30,000

$135,000 (100,000) $ 35,000

Remaining life

Annual excess amortizations

5 yrs. 10 yrs.

$1,000 3,000 $4,000

Acquisition-date fair value ............................................. 2014 Income accrual ...................................................... 2014 Dividends declared by Turner .............................. 2014 Amortizations (above) ........................................... 2015 Income accrual ...................................................... 2015 Dividends declared by Turner .............................. 2015 Amortizations ........................................................ Investment in Turner account balance .........................

$135,000 110,000 (50,000) (4,000) 130,000 (40,000) (4,000) $277,000

b. Net income of Haynes .................................................... Net Income of Turner ..................................................... Depreciation expense ..................................................... Amortization expense ..................................................... Consolidated net income 2015 ................................

$240,000 130,000 (1,000) (3,000) $366,000

c. Equipment balance Haynes ........................................... Equipment balance Turner ............................................ Allocation based on fair value (above) ......................... Depreciation for 2014-2015 ............................................ Consolidated equipment—December 31, 2015.............

$500,000 300,000 5,000 (2,000) $803,000

Parent's choice of an investment method has no impact on consolidated totals.

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Chapter 03 - Consolidations—Subsequent to the Date of Acquisition

16. (continued) d. If the initial value method was applied during 2014, the parent would have recorded dividend income of $50,000 rather than $110,000 (as equity income). Income is, therefore, understated by $60,000. In addition, amortization expense of $4,000 was not recorded. Thus, the January 1, 2015, retained earnings is understated by $56,000 ($60,000 – $4,000). Worksheet Entry *C thus serves to adjust the parent’s beginning retained earning to a full accrual basis: Investment in Turner ........................................... Retained earnings, 1/1/15 (Haynes) ..............

56,000 56,000

If the partial equity method was applied during 2014, the parent would have failed to record amortization expense of $4,000. Retained earnings are overstated by $4,000 and are corrected through Entry *C: Retained earnings, 1/1/15 (Haynes) ................... Investment in Turner .....................................

4,000 4,000

If the equity method was applied during 2014, consolidated retained earnings would equal the parent's retained earnings. Thus, no adjustment would be necessary.

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Chapter 03 - Consolidations—Subsequent to the Date of Acquisition

17. (20 minutes) (Record a merger combination with subsequent testing for goodwill impairment). a. In accounting for the combination, the total fair value of Beltran (consideration transferred) is allocated to each identifiable asset acquired and liability assumed with any remaining excess as goodwill. Cash paid Fair value of shares issued Consideration transferred

$ 450,000 1,248,000 $1,698,000

Consideration transferred (above) Fair value of net assets acquired and liabilities assumed Goodwill recognized in the combination

$1,698,000 1,298,000 $ 400,000

Entry by Francisco to record assets acquired and liabilities assumed in the combination with Beltran: Cash 75,000 Receivables 193,000 Inventory 281,000 Patents 525,000 Customer relationships 500,000 Equipment 295,000 Goodwill 400,000 Accounts payable Long-term liabilities Cash Common stock (Francisco Co., par value) Additional paid-in capital b. Step one in goodwill impairment test: Fair value of reporting unit as a whole Book value of reporting unit's net assets

121,000 450,000 450,000 104,000 1,144,000

1,425,000 1,585,000

Because the total fair value of the reporting unit is less than its carrying value, a potential goodwill impairment loss exists, step two is performed: Fair value of reporting unit as a whole $1,425,000 Fair values of reporting unit's net assets (excluding goodwill) 1,325,000 Implied fair value of goodwill 100,000 Book value of goodwill 400,000 Goodwill impairment loss $ 300,000

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Chapter 03 - Consolidations—Subsequent to the Date of Acquisition

18. (20 minutes) (Goodwill impairment testing.) a. Goodwill Impairment Step 1 Fair value of reporting unit = Carrying value of reporting unit =

$1,028 1,094

Because fair value < carrying value, there is a potential goodwill impairment loss. Step 2 Fair value of reporting unit $1,028 Fair value of net assets excluding goodwill Tangible assets $137 Recognized intangibles 326 Unrecognized intangibles 255 718 Implied value of goodwill 310 Carrying value of goodwill 755 Goodwill impairment loss $445 b. Tangible assets, net Goodwill Patent Customer list

$84 310 -0-0-

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Chapter 03 - Consolidations—Subsequent to the Date of Acquisition

19. (30 minutes) (Goodwill impairment and intangible assets.) Part a: Goodwill Impairment Test—Step 1

Sand Dollar Salty Dog Baytowne

Total fair value $510,000 580,000 560,000

< < >

Carrying Potential goodwill value impairment? $530,000 yes 610,000 yes 280,000 no

Part b: Goodwill Impairment Test—Step 2 (Sand Dollar and Salty Dog only) Sand Dollar—total fair value Fair values of identifiable net assets Tangible assets Trademark Customer list Liabilities Implied value of goodwill Carrying value of goodwill Impairment loss

$510,000 $190,000 150,000 100,000 (30,000)

Salty Dog—total fair value Fair values of identifiable net assets Tangible assets $200,000 Unpatented technology 125,000 Licenses 100,000 Implied value of goodwill Carrying value of goodwill No impairment—implied value > carry value

410,000 100,000 120,000 $20,000 $580,000

425,000 155,000 150,000 -0-

Part c: No changes in tangible assets or identifiable intangibles are reported based on goodwill impairment testing. The sole purpose of the valuation exercise is to estimate an implied value for goodwill. Destin will report a goodwill impairment loss of $20,000, which will reduce the amount of goodwill allocated to Sand Dollar. However, because the fair value of Sand Dollar’s trademark is less than its carrying amount, the account should be subjected to a separate impairment testing procedure to see if the carrying value is “recoverable” in future estimated cash flows.

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Chapter 03 - Consolidations—Subsequent to the Date of Acquisition

20.

(30 Minutes) (Consolidation entries for two years. Parent uses equity method.) Fair Value Allocation and Annual Amortization: Acquisition fair value (consideration transferred) . $490,000 Book value (assets minus liabilities or total stockholders' equity) .................................................................. (400,000) Excess fair value over book value .......................... $ 90,000 Excess fair value assigned to specific accounts based on individual fair values Remaining Annual excess life

amortizations

Land .................................... Buildings ............................. Equipment ...........................

$10,000 40,000 (20,000)

-4 yrs. 5 yrs.

-$10,000 (4,000)

Total assigned to specific accounts ........................ Goodwill .............................. Total ....................................

30,000 60,000 $90,000

indefinite

-0$6,000

Consolidation Entries as of December 31, 2014 Entry S Common stock—Abernethy ................................ 250,000 Additional paid-in capital .................................... 50,000 Retained earnings—1/1/14 .................................. 100,000 Investment in Abernethy ............................... (To eliminate stockholders' equity accounts of subsidiary)

400,000

Entry A Land ..................................................................... 10,000 Buildings .............................................................. 40,000 Goodwill ............................................................... 60,000 Equipment ...................................................... 20,000 Investment in Abernethy ............................... 90,000 (To recognize allocations attributed to fair value of specific accounts at acquisition date with residual fair value recognized as goodwill). Entry I Equity in subsidiary earnings ............................ 74,000 Investment in Abernethy ............................... 74,000 (To eliminate $80,000 income accrual for 2014 less $6,000 amortization recorded by parent using equity method)

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Chapter 03 - Consolidations—Subsequent to the Date of Acquisition

20. (continued) Entry D Investment in Abernethy .................................... Dividends declared ........................................ (To eliminate intra-entity dividend transfers)

10,000 10,000

Entry E Depreciation expense .......................................... 6,000 Equipment............................................................. 4,000 Buildings ......................................................... (To recognize current year amortization expense)

10,000

Consolidation Entries as of December 31, 2015 Entry S Common stock—Abernethy ............................... 250,000 Additional paid-in capital .................................... 50,000 Retained earnings—1/1/15................................... 170,000 Investment in Abernethy ............................... 470,000 (To eliminate beginning stockholders' equity of subsidiary—the Retained Earnings account has been adjusted for 2014 income and dividends. Entry *C is not needed because equity method was applied.) Entry A Land ..................................................................... 10,000 Buildings .............................................................. 30,000 Goodwill ............................................................... 60,000 Equipment ...................................................... 16,000 Investment in Abernethy ............................... 84,000 (To recognize allocations relating to investment—balances shown here are as of beginning of current year [original allocation less excess amortizations for the prior period]) Entry I Equity in subsidiary earnings ............................ 104,000 Investment in Abernethy ............................... 104,000 (To eliminate $110,000 income accrual less $6,000 amortization recorded by parent during 2015 using equity method) Entry D Investment in Abernethy .................................... Dividends declared ........................................ (To eliminate intra-entity dividend transfers) Entry E Same as Entry E for 2014

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30,000 30,000

Chapter 03 - Consolidations—Subsequent to the Date of Acquisition

21.

(35 Minutes) (Consolidation entries for two years. Parent uses initial value method.) Acquisition-date allocation and annual excess fair value amortizations: Acquisition date value (consideration paid) ..... $500,000 Book value ........................................................... (400,000) Excess price paid over book value .................... $100,000 Excess price paid assigned to specific accounts based on fair values Equipment Long-term liabilities Goodwill Total

$ 20,000 30,000 50,000 $100,000

Remaining life

Annual excess amortizations

5 yrs. 4 yrs. indefinite

$4,000 7,500 -0$11,500

Consolidation entries as of December 31, 2014 Entry S Common stock—Abernethy .............................. 250,000 Additional paid-in capital ................................... 50,000 Retained earnings—1/1/14 ................................. 100,000 Investment in Abernethy ............................... (To eliminate stockholders' equity accounts of subsidiary)

400,000

Entry A Equipment ........................................................... 20,000 Long-term liabilities ........................................... 30,000 Goodwill .............................................................. 50,000 Investment in Abernethy .............................. 100,000 (To recognize allocations determined above in connection with acquisition-date fair values) Entry I Dividend income ................................................ 10,000 Dividends declared ....................................... 10,000 (To eliminate intra-entity dividend declarations recorded by parent as income) Entry E Depreciation expense ........................................ Interest expense .................................................. Equipment ...................................................... Long-term liabilities ....................................... (To recognize 2014 amortization expense)

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4,000 7,500 4,000 7,500

Chapter 03 - Consolidations—Subsequent to the Date of Acquisition

21. (continued) Consolidation Entries as of December 31, 2015 Entry *C Investment in Abernethy ................................... 58,500 Retained earnings—1/1/15 (Chapman) ........ 58,500 (To convert parent company figures to equity method by recognizing subsidiary's increase in book value for prior year [$80,000 net income less $10,000 dividend declaration] and excess amortizations for that period [$11,500]) Entry S Common stock—Abernethy .............................. 250,000 Additional paid-in capital ................................... 50,000 Retained earnings—1/1/15 ................................. 170,000 Investment in Abernethy .............................. 470,000 (To eliminate beginning of year stockholders' equity accounts of subsidiary. The retained earnings balance has been adjusted for 2014 net income and dividends) Entry A Equipment ........................................................... 16,000 Long-term liabilities ........................................... 22,500 Goodwill .............................................................. 50,000 Investment in Abernethy .............................. 88,500 (To recognize allocations relating to investment—balances shown here are as of the beginning of the current year [original allocation less excess amortizations for the prior period]) Entry I Dividend income ................................................ 30,000 Dividends declared .................................. 30,000 (To eliminate intra-entity dividend declarations recorded by parent as income) Entry E Same as Entry E for 2014

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Chapter 03 - Consolidations—Subsequent to the Date of Acquisition

22.

(20 Minutes) (Consolidation entries for two years. Parent uses partial equity method.) Fair value allocation and annual excess amortizations: Abernethy fair value (consideration paid) .................... Book value ...................................................................... Excess fair value over book value (all goodwill) .........

$520,000 (400,000) $120,000

Excess amortization (indefinite life for goodwill) ........

-0-

Consolidation Entries as of December 31, 2014 Entry S Common stock—Abernethy ............................... 250,000 Additional paid-in capital .................................... 50,000 Retained earnings—Abernethy—1/1/14 ............ 100,000 Investment in Abernethy ............................... (To eliminate stockholders' equity accounts of subsidiary)

400,000

Entry A Goodwill ............................................................... 120,000 Investment in Abernethy ............................... 120,000 (To recognize goodwill portion of the original acquisition fair value) Entry I Equity in earnings of subsidiary ......................... 80,000 Investment in Abernethy ............................... 80,000 (To eliminate intra-entity income accrual for the current year based on the parent's usage of the partial equity method) Entry D Investment in Abernethy .................................... Dividends declared ........................................ (To eliminate intra-entity dividend transfers)

10,000 10,000

Entry E—Not needed. Goodwill is not amortized. Consolidation Entries as of December 31, 2015 Entry *C—Not needed. Goodwill is not amortized. Entry S Common stock—Abernethy ................................ Additional paid-in capital—Abernethy .............. Retained earnings—Abernethy—1/1/15 ............ Investment in Abernethy ...............................

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250,000 50,000 170,000 470,000

Chapter 03 - Consolidations—Subsequent to the Date of Acquisition

22. (continued) (To eliminate beginning of year stockholders' equity accounts of subsidiary—the retained earnings balance has been adjusted for 2014 income and dividends.) Entry A Goodwill ............................................................... Investment in Abernethy ............................... (To recognize original goodwill balance.)

120,000 120,000

Entry I Equity in earnings of subsidiary ......................... 110,000 Investment in Abernethy ............................... 110,000 (To eliminate Intra-entity Income accrual for the current year.) Entry D Investment in Abernethy .................................... Dividends declared ........................................ (To eliminate Intra-entity dividend transfers.)

30,000 30,000

Equity E—not needed

23.

(45 Minutes) (Variety of questions about the three methods of recording an Investment in a subsidiary for internal reporting purposes.) a. Acquisition-Date Fair-Value Allocation and Annual Amortization: Clay’s acquisition-date fair value ...... $510,000 Book value (assets minus liabilities or stockholders' equity) ................ 450,000 Fair value in excess of book value .... 60,000 Allocation to equipment based on ...... fair and book value difference ............ Goodwill ............................................... Total ....................................................

Remaining Annual excess life amortizations

50,000 5 yrs. $10,000 indefinite

EQUITY METHOD Investment Income—2015: Equity accrual (based on Clay's net income) .............. Amortization (above) ..................................................... Investment income for 2015 ................................................

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$10,000 -0$10,000

$60,000 (10,000) $50,000

Chapter 03 - Consolidations—Subsequent to the Date of Acquisition

23. (continued) Investment in Clay—December 31, 2015: Consideration transferred for Clay ............................... 2014: Equity accrual (based on Clay's net Income) ......... Excess amortizations (above) ................................. Dividends ...................................................................

$510,000 55,000 (10,000) (5,000)

2015: Equity accrual (based on Clay's net Income).......... Excess amortizations ............................................... Dividends ................................................................... Total ................................................................................

60,000 (10,000) (8,000) $592,000

INITIAL VALUE METHOD Investment Income—2015: Dividend income ...........................................................

$8,000

Investment in Clay—December 31, 2015: Consideration transferred for Clay ...............................

$510,000

b. The reported consolidated balances are not affected by the parent’s investment accounting method. Thus, consolidated expenses ($480,000 or $290,000 + $180,000 + amortizations of $10,000) are the same regardless of whether the equity method, the partial equity method, or the initial value method is applied by Adams. c. The reported consolidated balances are not affected by the parent’s investment accounting method. Thus, consolidated equipment ($970,000 or $520,000 + $420,000 + allocation of $50,000 – two years of excess depreciation totaling $20,000) is the same regardless of whether the equity method or the initial value method is applied by Adams. d. Adams retained earnings—Equity method Adams retained earnings—1/1/14 ....................................... Adams income 2014 ............................................................. 2014 equity accrual for Clay income .................................. 2014 excess amortization .................................................... Adams retained earnings—1/1/15 .......................................

$860,000 125,000 55,000 (10,000) $1,030,000

Adams retained earnings—Initial value method Adams retained earnings—1/1/14 ....................................... Adams income 2014 ............................................................. 2014 dividend income from Clay ........................................ Adams retained earnings—1/1/15 .......................................

$860,000 125,000 5,000 $990,000

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