In a 100 word initial post, please outline what you think the 3 most important considerations are for organizations to consider when implementing the equity method of accounting.

2) Chapter 2 Discussion

In a 100 word initial post, please identify what you think the most difficult part of the consolidation process is for most organizations

3) Chapter 3 Discussion

In a 200 word initial post, how would you recommend an organization to best handle events that occur subsequent to the acquisition of another entity?

4) Chapter 4 Discussion

In a 200 word initial post, please summarize what you believe the rights of outside shareholders (non-controlling interests) should be in terms of making decisions for the firm?

5) Chapter 5 Discussion

In a 200 word initial post, do you think that intra-entity asset entries have the potential to overstate the financial performance of the organization in the short-term?

6) Chapter 6 Discussion

In a 200 word initial post, please identify 3 ways that using VIEs as a part of the capital structure of the firm can lead to financial mis-reporting

7) Chapter 7 Discussion

In a 200 word post, identify how foreign currency transactions are different from transactions that are denominated the in same currency for all involved organization

Chapter Two

Consolidation of Financial Information

Current Accounting Standards for Business Combinations

The FASB Accounting Standards Codification (ASC) contains the current accounting standards for business combinations under the following topics:

“Business Combinations” (Topic 805)

“Consolidation” (Topic 810)

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The FASB Accounting Standards Codification (ASC) contains the current accounting standards for business combinations under the following topics:

“Business Combinations” (Topic 805)

“Consolidation” (Topic 810)

FASB ASC Topics 805 and 810

FASB Accounting Standards Codification (ASC) “Business Combinations” (Topic 805) and “Consolidation” (Topic 810) provide guidance using the acquisition method.

The acquisition method embraces the fair-value measurement for measuring and assessing business activity.

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The ASC “Business Combinations” topic provides guidance on the accounting and reporting for business combinations using the acquisition method. The acquisition method embraces a fair-value measurement attribute. Adoption of this attribute reflects the FASB’s increasing emphasis on fair value for measuring and assessing business activity.

The ASC “Consolidation” topic provides guidance on circumstances that require a firm to prepare consolidated financial reports and various other related reporting issues.

Learning Objective 2-1

2-4

Discuss the motives for business combinations.

LO 2-1: Discuss the motives for business combinations.

Reasons for Firms to Combine

No two business combinations are exactly alike, but they share one or more of the following characteristics that potentially enhance profitability:

Vertical integration.

Cost savings.

Quick entry for products into markets.

Economies of scale.

More attractive financing opportunities.

Diversification of business risk.

Business expansion.

Increasingly competitive environment.

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Although no two business combinations are exactly alike, many share one or more of the following characteristics that potentially enhance profitability:

Vertical integration of one firm’s output and another firm’s distribution or further processing.

Cost savings through elimination of duplicate facilities and staff.

Quick entry for new and existing products into domestic and foreign markets.

Economies of scale allowing greater efficiency and negotiating power.

The ability to access financing at more attractive rates. As firm size increases, negotiating power with financial institutions can increase also.

Diversification of business risk.

Business combinations also occur because many firms seek the continuous expansion of their organizations, often into diversified areas.

Recent Notable Business Combinations

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EXHIBIT 2.1 Recent Notable Business Combinations

A frequent economic phenomenon is the combining of two or more businesses into a single entity under common management and control. During recent decades, the United States and the rest of the world have experienced an enormous number of corporate mergers and takeovers, transactions in which one company gains control over another. According to Thomson Reuters, the number of mergers and acquisitions globally in 2015 exceeded 42,300, with a total value of more than $4.7 trillion. Of these deals, more than $2.3 trillion involved a U.S. firm.

Learning Objective 2-2

Recognize when consolidation of financial information into a single set of statements is necessary.

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LO 2-2: Recognize when consolidation of financial information into a single set of statements is necessary.

Consolidated Financial Reporting

Why consolidate financial information when two or more companies combine to create a single economic entity? According to FASB ASC (810-10-10-1):

Consolidated financial statements provide more meaningful information than separate statements.

Consolidated financial statements more fairly present the activities of the consolidated companies.

Consolidated companies may retain their legal identities as separate corporations.

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The consolidation of financial information into a single set of statements becomes necessary when the business combination of two or more companies creates a single economic entity. As stated in FASB ASC (810-10-10-1): “There is a presumption that consolidated financial statements are more meaningful than separate financial statements and that they are usually necessary for a fair presentation when one of the entities in the consolidated group directly or indirectly has a controlling financial interest in the other entities.”

Consolidated Financial Reporting (continued)

To explain the process of preparing consolidated financial statements for a business combination, we address three questions:

How is a business combination formed?

What constitutes a controlling financial interest?

How is the consolidation process carried out?

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To explain the process of preparing consolidated financial statements for a business combination, we address three questions:

How is a business combination formed?

What constitutes a controlling financial interest?

How is the consolidation process carried out?

Learning Objective 2-3

Define the term business combination and differentiate across various forms of business combinations.

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LO 2-3: Define the term business combination and differentiate across various forms of business combinations.

Business Combinations

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A business combination:

Refers to a transaction or other event in which an acquirer obtains control over one or more businesses.

Is formed by a wide variety of transactions or events with various formats.

Can differ widely in legal form.

Unites two or more enterprises into a single economic entity that requires consolidated financial statements.

A business combination refers to a transaction or other event in which an acquirer obtains control over one or more businesses.

Business combinations are formed by a wide variety of transactions or events with various formats. For example, each of the transactions on the following slides is identified as a business combination although it differs widely in legal form. In every case, two or more enterprises are being united into a single economic entity so that consolidated financial statements are required.

Types of Business Combinations – Statutory Mergers

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Statutory merger: Any business combination in which only one of the original companies continues to exist. The two types of statutory mergers are:

A business combination in which one company obtains all of the assets, and often the liabilities, of another company.

A business combination in which one company obtains all of the capital stock of another company. The acquiring company must gain 100 percent control of all shares of stock before legally dissolving the company.

Any business combination in which only one of the original companies continues to exist is referred to in legal terms as a statutory merger. One company company obtains the assets, and often the liabilities, of another company in exchange for cash, other assets, liabilities, stock, or a combination of these. The second organization normally dissolves itself as a legal corporation. Thus, only the acquiring company remains in existence, having absorbed the acquired net assets directly into its own operations.

Another type of statutory merger is when one company obtains all of the capital stock of another in exchange for cash, other assets, liabilities, stock, or a combination of these. After gaining control, the acquiring company can decide to transfer all assets and liabilities to its own financial records with the second company being dissolved as a separate corporation. The business combination is, once again, a statutory merger because only one of the companies maintains legal existence. This statutory merger, however, is achieved by obtaining equity securities rather than by buying the target company’s assets. Because stock is obtained, the acquiring company must gain 100 percent control of all shares before legally dissolving the subsidiary.

Types of Business Combinations—Other Models

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Statutory consolidation: A specific type of business combination that unites two or more companies under the ownership of a newly created company. Two or more companies transfer either their assets or their capital stock to a newly formed corporation.

Control without dissolution: When one company achieves legal control over another by acquiring a majority of voting stock, although control is present, no dissolution takes place. Each company remains in existence as an incorporated operation.

A statutory consolidation occurs when two or more companies transfer either their assets or their capital stock to a newly formed corporation. Both original companies are dissolved, leaving only the new organization in existence. A business combination effected in this manner is a statutory consolidation. The use here of the term consolidation should not be confused with the accounting meaning of that same word. In accounting, consolidation refers to the mechanical process of bringing together the financial records of two or more organizations to form a single set of statements. A statutory consolidation denotes a specific type of business combination that has united two or more existing companies under the ownership of a newly created company.

Another type of business combination is when one company achieves legal control over another by acquiring a majority of voting stock. Although control is present, no dissolution takes place; each company remains in existence as an incorporated operation. NBC Universal, as an example, continues to retain its legal status as a corporation after being acquired by Comcast Corporation. Separate incorporation is frequently preferred to take full advantage of any intangible benefits accruing to the acquired company as a going concern. Better utilization of such factors as licenses, trade names, employee loyalty, and the company’s reputation can be possible when the subsidiary maintains its own legal identity. Moreover, maintaining an independent information system for a subsidiary often enhances its market value for an eventual sale or initial public offering as a stand-alone entity.

Because the asset and liability account balances are not physically combined as in statutory mergers and consolidations, each company continues to maintain an independent accounting system. To reflect the combination, the acquiring company enters the takeover transaction into its own records by establishing a single investment asset account. However, the newly acquired subsidiary omits any recording of this event; its stock is simply transferred to the parent from the subsidiary’s shareholders. Thus, the subsidiary’s financial records are not directly affected by a takeover.

Types of Business Combinations—Variable Interest Entity (VIE)

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Variable interest entity (VIE): Vehicle for control exercised through contractual arrangements with a sponsoring firm that may not own the VIE but becomes its “primary beneficiary” with rights to its residual profits.

Contract forms include leases, participation rights, guarantees, or other interests. Criticized in the past for providing sponsoring firms with off-balance-sheet financing and sometimes questionable profits.

Current GAAP expands the notion of control and thus requires consolidation of VIEs by their primary beneficiary.

A final vehicle for control of another business entity does not involve a majority voting stock interest or direct ownership of assets. Control of a variable interest entity (VIE) by design often does not rest with its equity holders. Instead, control is exercised through contractual arrangements with a sponsoring firm that, although it technically may not own the VIE, becomes its “primary beneficiary” with rights to its residual profits. These contracts can take the form of leases, participation rights, guarantees, or other interests. Past use of VIEs was criticized because these structures provided sponsoring firms with off-balance-sheet financing and sometimes questionable profits on sales to their VIEs. Prior to 2004, many sponsoring entities of VIEs did not technically meet the definition of a controlling financial interest (i.e., majority voting stock ownership) and thus did not consolidate their VIEs. Current GAAP, however, expands the notion of control and thus requires consolidation of VIEs by their primary beneficiary.

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Formats of Business Combinations

EXHIBIT 2.2 Business Combinations

Business combinations are created in many distinct forms. The specific format is a critical factor in the subsequent consolidation of financial information. Exhibit 2.2 provides an overview of the various combinations.

FASB Control Model

The FASB ASC (810-10-15-8) provides guidance and describes control as follows:

The usual condition for a controlling financial interest is ownership of a majority voting interest, and, therefore, as a general rule ownership by one reporting entity, directly or indirectly, of more than 50 percent of the outstanding voting shares of another entity is a

condition pointing toward consolidation.

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The definition of control is central to determining when two or more entities become one economic entity and therefore one reporting entity. Control of one firm by another is most often achieved through the acquisition of voting shares. The ASC (810-10-15-8) describes control as follows:

By exercising majority voting power, one firm can literally dictate the financing and operating activities of another firm. Accordingly, U.S. GAAP traditionally has pointed to a majority voting share ownership as a controlling financial interest that requires consolidation.

Notably, the power to control may also exist with less than 50 percent of the outstanding shares of another entity. The ASC (810-10-15-8) goes on to observe that:

The power to control may also exist with a lesser percentage of ownership, for example, by contract, lease, agreement with other stockholders, or by court decree.

When one company gains control over another, a business combination is created, and a single set of consolidate financial statements must be prepared. How?

Parent’s and subsidiary’s financial data are brought together.

Financial position, results of operations, and cash flows are reported for the combined entity.

Reciprocal accounts and intra-entity transactions are adjusted or eliminated to ensure reported balances represent the single entity.

Consolidation of Financial Information

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When one company gains control over another, a business combination is established. Financial data gathered from the individual companies are then brought together to form a single set of consolidated statements. Although this process can be complicated, the objectives of a consolidation are straightforward—to report the financial position, results of operations, and cash flows for the combined entity. As a part of this process, reciprocal accounts and intra-entity transactions must be adjusted or eliminated to ensure that all reported balances truly represent the single entity. Applicable consolidation procedures vary significantly depending on the legal format employed in creating a business combination.

What Is to Be Consolidated and When?

If dissolution occurs: All appropriate account balances are physically consolidated in the financial records of the survivor. Permanent consolidation occurs at the combination date.

If separate incorporation is maintained: Only the financial statement information (on work papers, not the actual records) is consolidated. The consolidation process is carried out at regular intervals whenever financial statements are to be prepared.

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What is to be consolidated?

If dissolution takes place, appropriate account balances are physically consolidated in the surviving company’s financial records.

If separate incorporation is maintained, only the financial statement information (not the actual records) is consolidated

When does the consolidation take place?

If dissolution occurs, a permanent consolidation occurs at the combination date.

If separate incorporation is maintained, the consolidation process is carried out at regular intervals whenever financial statements are to be prepared.

How Does Consolidation Affect the Accounting Records?

If dissolution occurs:

Dissolved company’s records are closed out. Surviving company’s accounts are adjusted to include appropriate balances of the dissolved company.

If separate incorporation is maintained:

Each company continues to retain its own records. Worksheets facilitate the periodic consolidation process without disturbing individual accounting systems.

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How does consolidation affect the accounting records?

If dissolution takes place, the surviving company’s accounts are adjusted to include appropriate balances of the dissolved company. The dissolved company’s records are closed out.

If separate incorporation is maintained, each company continues to retain its own records. Using worksheets facilitates the periodic consolidation process without disturbing individual accounting systems.

Learning Objective 2-4

Describe the valuation principles of the acquisition method.

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LO 2-4: Describe the valuation principles of the acquisition method.

The Acquisition Method

The acquisition method is required to account for a business combination. It embraces the fair value in measuring the acquirer’s interest in the acquired business.

Applying the acquisition method involves using fair value to recognize and measure:

The consideration transferred for the acquired business and any noncontrolling interest.

Separately identified assets acquired and liabilities assumed.

Goodwill, or a gain from a bargain purchase.

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Regardless of whether the acquired firm maintains its separate incorporation or dissolution takes place, current standards require the acquisition method to account for business combinations. Applying the acquisition method involves recognizing and measuring

The consideration transferred for the acquired business and any noncontrolling interest.

The separately identified assets acquired and liabilities assumed.

Goodwill, or a gain from a bargain purchase.

Fair value is the measurement attribute used to recognize these and other aspects of a business combination.

Fair Value

GAAP requires that fair value of assets acquired and liabilities assumed in a business combination be determined at the acquisition date.

Fair value: The price that would be received from selling an asset or paid for transferring a liability in an orderly transaction between market participants at the measurement date.

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LO 5

Fair value, as defined by GAAP, is the price that would be received from selling an asset or paid for transferring a liability in an orderly transaction between market participants at the measurement date. However, determining the acquisition-date fair values of the individual assets acquired and liabilities assumed can prove challenging.

Valuation Techniques

ASC (820-10-35-28) identifies three valuation techniques:

The market approach estimates fair values using other market transactions involving similar assets or liabilities.

The income approach relies on multi-period estimates of future cash flows projected to be generated by an asset.

The cost approach estimates fair values by reference to the current cost of replacing an asset with another of comparable economic utility.

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LO 5

The ASC (820-10-35-28) points to three sets of valuation techniques typically employed: the market approach, the income approach, and the cost approach.

The market approach estimates fair values using other market transactions involving similar assets or liabilities. In a business combination, assets acquired such as marketable securities and some tangible assets may have established markets that can provide comparable market values for estimating fair values. Similarly, the fair values of many liabilities assumed can be determined by reference to market trades for similar debt instruments.

The income approach relies on multi-period estimates of future cash flows projected to be generated by an asset. These projected cash flows are then discounted at a required rate of return that reflects the time value of money and the risk associated with realizing the future estimated cash flows. The multi-period income approach is often useful for obtaining fair value estimates of intangible assets and acquired in-process research and development.

The cost approach estimates fair values by reference to the current cost of replacing an asset with another of comparable economic utility. Used assets can present a particular valuation challenge if active markets only exist for newer versions of the asset. Thus, the cost to replace a particular asset reflects both its estimated replacement cost and the effects of obsolescence. In this sense, obsolescence is meant to capture economic declines in value including both technological obsolescence and physical deterioration. The cost approach is widely used to estimate fair values for many tangible assets acquired in business combinations such as property, plant, and equipment.

Goodwill and Gains on Bargain Purchases

What if the consideration transferred does NOT equal the fair value of the assets acquired?

If the consideration transferred exceeds the net amount of the assets acquired and liabilities assumed, the difference is attributed to the asset goodwill by the acquiring company.

If the fair value of the assets acquired and liabilities assumed exceeds the consideration transferred, a “gain on bargain purchase” is recognized by the acquiring business.

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When the consideration transferred exceeds the acquisition-date net amount of the identified assets acquired and the liabilities assumed, the acquirer recognizes the asset goodwill for the excess. Goodwill is defined as an asset representing the future economic benefits arising in a business combination that are not individually identified and separately recognized. Goodwill often embodies the expected synergies that the acquirer expects to achieve through control of the acquired firm’s assets. Goodwill may also capture non-recognized intangibles of the acquired firm such as employee expertise.

Conversely, if the collective fair value of the net identified assets acquired and liabilities assumed exceeds the consideration transferred, the acquirer recognizes a “gain on bargain purchase.” In such cases, the fair value of the net assets acquired replaces the consideration transferred as the valuation basis for the acquired firm. Bargain purchases can result from business divestitures forced by regulatory agencies or other types of distress sales. Before recognizing a gain on bargain purchase, however, the acquirer must reassess whether it has correctly identified and measured all of the acquired assets and liabilities.

Learning Objective 2-5

Determine the total fair value of the consideration transferred for an acquisition and allocate that fair value to specific subsidiary assets acquired

(including goodwill) and liabilities assumed or to a gain on bargain purchase.

2-25

LO 2-5: Determine the total fair value of the consideration transferred for an acquisition and allocate that fair value to specific subsidiary assets acquired (including goodwill) and liabilities assumed or to a gain on bargain purchase.

Consideration Transferred = Fair Value of Net Assets Acquired Example

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Assume that BigNet agrees to pay cash of $550,000 and to issue 20,000 previously unissued shares of its $10 par value common stock (currently selling for $100 per share) for all of Smallport’s assets and liabilities.

Following the acquisition, Smallport then dissolves itself as a legal entity. The consideration transferred from BigNet to Smallport exactly equals the collective fair values of Smallport’s assets less liabilities.

Assume that after negotiations with the owners of Smallport, BigNet Company agrees to pay cash of $550,000 and to issue 20,000 previously unissued shares of its $10 par value common stock (currently selling for $100 per share) for all of Smallport’s assets and liabilities. Following the acquisition, Smallport then dissolves itself as a legal entity. The consideration transferred from BigNet to Smallport exactly equals the collective fair values of Smallport’s assets less liabilities.

Procedures for Consolidating Financial Information

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The $2,550,000 fair value of the consideration transferred by BigNet equals the collective fair values of Smallport’s assets less liabilities and serves as the basis for recording the combination.

The $2,550,000 fair value of the consideration transferred by BigNet represents the fair value of the acquired Smallport business and serves as the basis for recording the combination in total.

Procedures for Consolidating Financial Information (continued)

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Legal and accounting distinctions divide business combinations into separate categories. Various procedures are utilized in this process according to the following sequence:

Acquisition method when dissolution takes place.

Acquisition method when separate incorporation is maintained.

When an acquired firm’s legal status is dissolved in a business combination, the continuing firm owns the former firm’s net assets.

Legal as well as accounting distinctions divide business combinations into several separate categories. To facilitate the introduction of consolidation accounting, we present the various procedures utilized in this process according to the following sequence:

Acquisition method when dissolution takes place.

Acquisition method when separate incorporation is maintained.

When an acquired firm’s legal status is dissolved in a business combination, the continuing firm owns the former firm’s net assets.

Acquisition Method When Dissolution Takes Place

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The continuing firm prepares a journal entry to record

Fair value of the consideration transferred to acquire the dissolved firm.

Identified assets acquired and liabilities assumed at their individual fair values.

The entry to record the fair value of the combination depends on whether the consideration transferred is equal to, exceeds, or is less than the fair value of the net assets of the firm dissolved.

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