In 1996, Berkshire Hathaway, Inc., acquired all of the outstanding stock of Geico, Inc., an insurance company. Although this transaction involved well-known companies, it was not unique; mergers and acquisitions have long been common in the business world.

Berkshire Hathaway’s current financial statements indicate that Geico

is still a component of this economic entity. However, Geico, Inc., con-

tinues as a separate legally incorporated concern long after its acquisi-

tion. As discussed in Chapter 2, a parent will often maintain separate legal

status for a subsidiary corporation to better utilize its inherent value as a

going concern.

For external reporting purposes, maintenance of incorporation cre-

ates an ongoing challenge for the accountant. In each subsequent period,

consolidation must be simulated anew through the use of a worksheet and

consolidation entries. Thus, for many years, the financial data for Berkshire

Hathaway and Geico (along with dozens of other subsidiaries) have been

brought together periodically to provide figures for the financial statements

that represent this business combination.

As also discussed in Chapter 2, the acquisition method governs the

way we initially record a business combination. In periods subsequent to

acquisition, the fair-value bases (established at the acquisition date) for sub-

sidiary assets acquired and liabilities assumed will be amortized (or tested

for possible impairment) for proper income recognition. Additionally, some

combinations require accounting for the eventual disposition of contingent

consideration, which, as presented later in this chapter, continues to follow a

fair-value model.

In the next several sections of this chapter, we present the procedures

to prepare consolidated financial statements in the years subsequent to

acquisition. We start by analyzing the relation between the parent’s inter-

nal accounting method for its subsidiary investment and the adjustments

required in consolidation. We also examine the specific procedures for

amortizing the acquisition-date fair-value adjustments to the subsidiary’s

assets and liabilities. We then cover testing for goodwill impairment and

post-acquisition accounting for contingent consideration. Finally, an appen-

dix presents the alternative goodwill model available as a reporting option

for private companies.

3 Consolidations— Subsequent to the Date of Acquisition

Learning Objectives After studying this chapter, you should be able to:

LO 3-1 Recognize the complexities in preparing consolidated financial reports that emerge from the passage of time.

LO 3-2 Identify and describe the various methods available to a parent company in order to maintain its investment in subsidiary account in its internal records.

LO 3-3 Prepare consolidated financial statements subsequent to acquisition when the parent has applied in its internal records:

a. The equity method. b. The initial value method. c. The partial equity method.

LO 3-4 Understand that a parent’s internal accounting method for its subsidiary investments has no effect on the resulting consolidated financial statements.

LO 3-5 Discuss the rationale for the goodwill impairment testing approach.

LO 3-6 Describe the procedures for conducting a goodwill impairment test.

LO 3-7 Describe the rationale and procedures for impairment testing for intangible assets other than goodwill.

LO 3-8 Understand the accounting and reporting for contingent consideration subsequent to a business acquisition.

LO 3-9 Appendix: Describe the alternative accounting treatments for goodwill and other intangible assets available for business combinations by private companies.

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Consolidation—The Effects Created by the Passage of Time In Chapter 2, consolidation accounting is analyzed at the date that a combination is created. The present chapter carries this process one step further by examining the consolidation pro- cedures that must be followed in subsequent periods whenever separate incorporation of the subsidiary is maintained.

Despite complexities created by the passage of time, the basic objective of all consolida- tions remains the same: to combine asset, liability, revenue, expense, and equity accounts of a parent and its subsidiaries. From a mechanical perspective, a worksheet and consolidation entries continue to provide structure for the production of a single set of financial statements for the combined business entity.

Consolidated Net Income Determination Subsequent to an acquisition, the parent company must report consolidated net income. Con- solidated income determination involves first combining the separately recorded revenues and expenses of the parent with those of the subsidiary on a consolidated worksheet. Because of separate record-keeping systems, however, the subsidiary’s expenses typically are based on their original book values and not the acquisition-date values the parent must recognize. Consequently, adjustments are made that reflect the amortization of the excess of the par- ent’s consideration transferred over the subsidiary book value. Additionally, the effects of any intra-entity transactions are removed.

The Parent’s Choice of Investment Accounting The time factor introduces other complications into the consolidation process as well. For internal record-keeping purposes, the parent must select and apply an accounting method to monitor the relationship between the two companies. The investment balance recorded by the parent varies over time as a result of the method chosen, as does the income subsequently rec- ognized. These differences affect the periodic consolidation process but not the figures to be reported by the combined entity. Regardless of the amount, the parent’s investment account is eliminated (brought to a zero balance) on the worksheet so that the subsidiary’s actual assets and liabilities can be consolidated. Likewise, the income figure accrued by the parent is removed each period so that the subsidiary’s revenues and expenses can be included when creating an income statement for the combined business entity.

Investment Accounting by the Acquiring Company For a parent company’s external financial reporting, consolidation of a subsidiary becomes necessary whenever control exists. For internal record-keeping, though, the parent has a choice for monitoring the activities of its subsidiaries. Although several variations occur in practice, three methods have emerged as the most prominent: the equity method, the initial value method,1 and the partial equity method.

At the acquisition date, each investment accounting method (equity, initial value, and par- tial equity) begins with an identical value recorded in an investment account. Typically the fair value of the consideration transferred by the parent will serve as the recorded valuation basis on the parent’s books.2

Subsequent to the acquisition date, the three methods produce different account balances for the parent’s investment in subsidiary, income recognized from the subsidiary’s activi- ties, and retained earnings accounts. Importantly, the selection of a particular method does not affect the totals ultimately reported for the combined companies. However, the parent’s

LO 3-2

Identify and describe the various methods available to a parent company in order to maintain its investment in subsidiary account in its internal records.

1 The initial value method is sometimes referred to as the cost method. 2 In the unusual case of a bargain purchase, the valuation basis for the investment account is the fair value of the net amount of the assets acquired and liabilities assumed.

LO 3-1

Recognize the complexities in preparing consolidated financial reports that emerge from the pas- sage of time.

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choice of an internal accounting method does lead to distinct procedures for consolidating the financial information from the separate organizations.

Internal Investment Accounting Alternatives—The Equity Method, Initial Value Method, and Partial Equity Method The internal reporting philosophy of the acquiring company often determines the accounting method choice for its subsidiary investment. Depending on the measures a company uses to assess the ongoing performances of its subsidiaries, parent companies may choose their own preferred internal reporting method. Regardless of this choice, however, the investment bal- ance will be eliminated in preparing consolidated financial statements for external reporting.

The Equity Method The equity method embraces full accrual accounting in maintaining the investment account and related income over time. Under the equity method, the acquiring company accrues income when the subsidiary earns it. To match the additional fair value recorded in the com- bination against income, amortization expense stemming from the original excess fair-value allocations is recognized through periodic adjusting entries. Unrealized gains on intra-entity transactions are deferred; subsidiary dividends serve to reduce the investment balance. As discussed in Chapter 1, the equity method creates a parallel between the parent’s investment accounts and changes in the underlying equity of the acquired company.3

When the parent has complete ownership, equity method earnings from the subsidiary, combined with the parent’s other income sources, create a total income figure reflective of the entire combined business entity. Consequently, the equity method often is referred to as a single-line consolidation. The equity method is especially popular in companies where management periodically (e.g., monthly or quarterly) measures each subsidiary’s profitability using accrual-based income figures.

The Initial Value Method Under the initial value method, the parent recognizes income from its share of any subsidiary dividends when declared. Because little time typically elapses between dividend declaration and cash distribution, the initial value method frequently reflects the cash basis for income recognition. No recognition is given to the income earned by the subsidiary. The investment balance remains on the parent’s financial records at the initial fair value assigned at the acqui- sition date.

The initial value method might be selected because the parent does not require an accrual- based income measure of subsidiary performance. For example, the parent may wish to assess subsidiary performance on its ability to generate cash flows, on revenues generated, or some other nonincome basis. Also, some firms may find the initial value method’s ease of applica- tion attractive. Because the investment account is eliminated in consolidation, and the actual subsidiary revenues and expenses are eventually combined, firms may avoid the complexity of the equity method unless they need the specific information provided by the equity income measure for internal decision making.

The Partial Equity Method A third method available to the acquiring company is a partial application of the equity method. Under this approach, the parent recognizes the reported income accruing from the subsidiary. Subsidiary dividends declared reduce the investment balance. However, no other equity adjustments (amortization or deferral of unrealized gains) are recorded. Thus, in many cases, earnings figures on the parent’s books approximate consolidated totals but without the effort associated with a full application of the equity method.

3 In Chapter 1, the equity method was introduced in connection with the external reporting of investments in which the owner held the ability to apply significant influence over the investee (usually by possessing 20 to 50 percent of the company’s voting stock). Here, the equity method is utilized for the internal report- ing of the parent for investments in which control is maintained. Although the accounting procedures are similar, the reason for using the equity method is different.

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Moreover, some parent companies rely on internally designed performance measures (rather than GAAP net income) to evaluate subsidiary management or make resource alloca- tion decisions. For such companies, a full equity method application may be unnecessary for internal purposes. In these cases, the partial equity method, although only approximating the GAAP income measure, may be sufficient for decision making.

Summary of Internal Investment Accounting Methods Exhibit 3.1 provides a summary of these three internal accounting techniques. Importantly, the method the acquiring company adopts affects only its separate financial records and has no impact on the subsidiary’s balances. Regardless of how the parent chooses to account inter- nally for its subsidiary, the selection of a particular method (i.e., initial value, equity, or partial equity) does not affect the amounts ultimately reported on consolidated financial statements to external users.

Because specific worksheet procedures differ based on the investment method utilized by the parent, the consolidation process subsequent to the date of combination will be intro- duced twice. First, we review consolidations in which the acquiring company uses the equity method. Then we redevelop all procedures when the investment is recorded by one of the alternative methods.

Subsequent Consolidation—Investment Recorded by the Equity Method Acquisition Made during the Current Year As a basis for this illustration, assume that Parrot Company obtains all of the outstanding common stock of Sun Company on January 1, 2017. Parrot acquires this stock for $800,000 in cash.

The book values as well as the appraised fair values of Sun’s accounts follow:

LO 3-3a

Prepare consolidated financial statements subsequent to acquisi- tion when the parent has applied the equity method in its internal records.

Method Investment Account Income Account Advantages

Equity Continually adjusted to reflect current owner’s equity of acquired company.

Income accrued as earned; amortization and other adjustments are recognized.

Acquiring company totals give a true representation of consolida- tion figures.

Initial value Remains at acquisition-date value assigned.

Dividends declared recorded as Dividend Income.

It is easy to apply; it often reflects cash flows from the subsidiary.

Partial equity

Adjusted only for accrued income and dividends declared by the acquired company.

Income accrued as earned; no other adjustments recognized.

It usually gives balances approxi- mating consolidation figures, but it is easier to apply than equity method.

EXHIBIT 3.1 Internal Reporting of Investment Accounts by Acquiring Company

Book Values 1/1/17

Fair Values 1/1/17 Difference

Current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 320,000 $ 320,000 $ –0– Trademarks (indefinite life) . . . . . . . . . . . . . . . . . 200,000 220,000 + 20,000 Patented technology (10-year remaining life) . . . . . . . . . . . . . . . . . . . .

320,000 450,000 +130,000

Equipment (5-year remaining life) . . . . . . . . . . . 180,000 150,000 (30,000) Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (420,000) (420,000) –0–

Net book value . . . . . . . . . . . . . . . . . . . . . . . . . $ 600,000 $ 720,000 $ 120,000

Common stock—$40 par value . . . . . . . . . . . . . $ (200,000) Additional paid-in capital . . . . . . . . . . . . . . . . . . . (20,000) Retained earnings, 1/1/17. . . . . . . . . . . . . . . . . . (380,000)

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Parrot considers the economic life of Sun’s trademarks as extending beyond the foresee- able future and thus having an indefinite life. Such assets are not amortized but are subject to periodic impairment testing.4 For the definite lived assets acquired in the combination (pat- ented technology and equipment), we assume that straight-line amortization and depreciation with no salvage value is appropriate.5

Parrot paid $800,000 cash to acquire Sun Company, clear evidence of the fair value of the consideration transferred. As shown in Exhibit 3.2, individual allocations are used to adjust Sun’s accounts from their book values to their acquisition-date fair values. Because the total value of these assets and liabilities was only $720,000, goodwill of $80,000 must be recog- nized for consolidation purposes.

Each of these allocated amounts (other than the $20,000 attributed to trademarks and the $80,000 for goodwill) represents a valuation associated with a definite life. As discussed in Chapter 1, Parrot must amortize each allocation over its expected life. The expense recogni- tion necessitated by this fair-value allocation is calculated in Exhibit 3.3.

Two aspects of this amortization schedule warrant further explanation. First, we use the term amortization in a generic sense to include both the amortization of definite-lived intan- gibles and depreciation of tangible assets. Second, the acquisition-date fair value of Sun’s equipment is $30,000 less than its book value. Therefore, instead of attributing an additional amount to this asset, the $30,000 allocation actually reflects a fair-value reduction. As such, the amortization shown in Exhibit 3.3 relating to Equipment is not an additional expense but instead is an expense reduction.

4 In other cases, trademarks can have a definite life and thus would be subject to regular amortization. 5 Unless otherwise stated, all amortization and depreciation expense computations in this textbook are based on the straight-line method with no salvage value.

PARROT COMPANY 100 Percent Acquisition of Sun Company

Allocation of Acquisition-Date Subsidiary Fair Value January 1, 2017

Sun Company fair value (consideration transferred by Parrot Company) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $800,000 Book value of Sun Company: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $200,000 Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Retained earnings, 1/1/17 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380,000 (600,000)

Excess of fair value over book value. . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000 Allocation to specific accounts based on fair values:. . . . . . . . . . . . . . Trademarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,000 Patented technology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130,000 Equipment (overvalued). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (30,000) 120,000

Excess fair value not identified with specific accounts—goodwill . . . $ 80,000

EXHIBIT 3.2 Excess Fair-Value Allocation

PARROT COMPANY 100 Percent Acquisition of Sun Company

Excess Amortization Schedule—Allocation of Acquisition-Date Fair Values

Account Allocation Remaining Useful Life

Annual Excess Amortizations

Trademarks $ 20,000 Indefinite $ –0– Patented technology 130,000 10 years 13,000 Equipment (30,000) 5 years (6,000) Goodwill 80,000 Indefinite –0–

$ 7,000*

*Total excess amortizations will be $7,000 annually for five years until the equipment allocation is fully removed. At the end of each asset’s life, future amortizations will change.

EXHIBIT 3.3 Annual Excess Amortization

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Having determined the allocation of the acquisition-date fair value in the previous example as well as the associated amortization, the parent’s separate record-keeping for its first year of Sun Company ownership can be constructed. Assume that Sun earns income of $100,000 dur- ing the year, declares a $40,000 cash dividend on August 1, and pays the dividend on August 8.

In this first illustration, Parrot has adopted the equity method. Apparently, this company believes that the information derived from using the equity method is useful in its evaluation of Sun.

Application of the Equity Method

Parrot’s Financial Records 1/1/17 Investment in Sun Company . . . . . . . . . . . . . . . . . . . . . . . . . . . 800,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800,000 To record the acquisition of Sun Company.

8/1/17 Dividend Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 Investment in Sun Company. . . . . . . . . . . . . . . . . . . . . . . 40,000 To record cash dividend declaration from subsidiary.

8/8/17 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 Dividend Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 To record receipt of the subsidiary cash dividend.

12/31/17 Investment in Sun Company . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 Equity in Subsidiary Earnings . . . . . . . . . . . . . . . . . . . . . . 100,000 To accrue income earned by 100 percent owned subsidiary.

12/31/17 Equity in Subsidiary Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000 Investment in Sun Company. . . . . . . . . . . . . . . . . . . . . . . 7,000 To recognize amortizations on allocations made in acqui- sition of subsidiary (see Exhibit 3.3).

Parrot’s application of the equity method, as shown in this series of entries, causes the Investment in Sun Company account balance to rise from $800,000 to $853,000 ($800,000 − $40,000 + $100,000 − $7,000). During the same period the parent recognizes a $93,000 equity income figure (the $100,000 earnings accrual less the $7,000 excess amortization expenses).

The consolidation procedures for Parrot and Sun one year after the date of acquisition are illustrated next. For this purpose, Exhibit 3.4 presents the separate 2017 financial statements for these two companies. Parrot recorded both investment-related accounts (the $853,000 asset balance and the $93,000 income accrual) based on applying the equity method.

Determination of Consolidated Totals Before becoming immersed in the mechanical aspects of a consolidation, the objective of this process should be understood. As indicated in Chapter 2, in the preparation of consolidated financial reports, the subsidiary’s revenue, expense, asset, and liability accounts are added to the parent company balances. Within this procedure, several important guidelines must be followed:

∙ Sun’s assets and liabilities are adjusted to reflect the allocations originating from their acquisition-date fair values.

∙ Because of the passage of time, the income effects (e.g., amortizations) of these allocations must also be recognized within the consolidation process.

∙ Any reciprocal or intra-entity6 accounts must be offset. If, for example, one of the compa- nies owes money to the other, the receivable and the payable balances have no connection with an outside party. Thus, when the companies are viewed as a single consolidated entity, the receivable and the payable represent intra-entity balances that should be elimi- nated for external reporting purposes.

6 The FASB Accounting Standards Codification (ASC) uses the term intra-entity to describe transfers of assets across business entities affiliated though common stock ownership or other control mechanisms. The phrase indicates that although such transfers occur across separate legal entities, they are nonetheless made within a commonly controlled entity. Prior to the use of the term intra-entity, such amounts were rou- tinely referred to as intercompany balances.

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The consolidation of the two sets of financial information in Exhibit 3.4 is a relatively uncom- plicated task and can even be carried out without the use of a worksheet. Understanding the origin of each reported figure is the first step in gaining a knowledge of this process.

∙ Revenues = $1,900,000. The revenues of the parent and the subsidiary are added together. ∙ Cost of goods sold = $932,000. The cost of goods sold of the parent and subsidiary are

added together. ∙ Amortization expense = $165,000. The balances of the parent and of the subsidiary are

combined along with the $13,000 additional amortization from the recognition of the excess fair value over book value attributed to the subsidiary’s patented technology, as shown in Exhibit 3.3.

∙ Depreciation expense = $110,000. The depreciation expenses of the parent and subsidiary are added together along with the $6,000 reduction in equipment depreciation, as indicated in Exhibit 3.3.

∙ Equity in subsidiary earnings = –0–. The investment income recorded by the parent is eliminated and replaced by adding across the subsidiary’s revenues and expenses to the consolidated totals.

∙ Net income = $693,000. Consolidated revenues less consolidated expenses. ∙ Retained earnings, 1/1/17 = $840,000. The parent figure only. This acquisition-date

parent’s balance has yet to be affected by any equity method adjustments.

PARROT COMPANY AND SUN COMPANY Financial Statements

For Year Ending December 31, 2017

Parrot Company

Sun Company

Income Statement Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (1,500,000) $ (400,000) Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700,000 232,000 Amortization expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000 32,000 Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 36,000 Equity in subsidiary earnings . . . . . . . . . . . . . . . . . . . . . . (93,000) –0–

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (693,000) $ (100,000)

Statement of Retained Earnings Retained earnings, 1/1/17 . . . . . . . . . . . . . . . . . . . . . . . . $ (840,000) $ (380,000) Net income (above) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (693,000) (100,000) Dividends declared* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000 40,000

Retained earnings, 12/31/17 . . . . . . . . . . . . . . . . . . . $ (1,413,000) $ (440,000)

Balance Sheet Current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,040,000 $ 400,000 Investment in Sun Company (at equity) . . . . . . . . . . . . . 853,000 –0– Trademarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000 200,000 Patented technology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 370,000 288,000 Equipment (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000 220,000

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,113,000 $ 1,108,000

Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (980,000) $ (448,000) Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (600,000) (200,000) Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . (120,000) (20,000) Retained earnings, 12/31/17 (above) . . . . . . . . . . . . . . (1,413,000) (440,000)

Total liabilities and equity . . . . . . . . . . . . . . . . . . . . . . . $ (3,113,000) $ (1,108,000)

Note: Parentheses indicate a credit balance. *Dividends declared, whether currently paid or not, provide the appropriate amount to include in a statement of retained earnings. To help keep the number of worksheet rows (i.e., dividends payable and receivable) at a minimum, throughout this text we assume that dividends are declared and paid in the same period.

EXHIBIT 3.4 Separate Records—Equity Method Applied

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∙ Dividends declared = $120,000. The parent company balance only because the subsid- iary’s dividends are attributable intra-entity to the parent, not to an outside party.

∙ Retained earnings, 12/31/17 = $1,413,000. Consolidated retained earnings as of the begin- ning of the year plus consolidated net income less consolidated dividends declared.

∙ Current assets = $1,440,000. The parent’s book value plus the subsidiary’s book value. ∙ Investment in Sun Company = –0–. The asset recorded by the parent is eliminated and

replaced by adding the subsidiary’s assets and liabilities across to the consolidated totals. ∙ Trademarks = $820,000. The parent’s book value plus the subsidiary’s book value plus

the $20,000 acquisition-date fair-value allocation. Note that the trademark has an indefi- nite life and therefore is not amortized.

∙ Patented technology = $775,000. The parent’s book value plus the subsidiary’s book value plus the $130,000 acquisition-date fair-value allocation less current year amortization of $13,000.

∙ Equipment = $446,000. The parent’s book value plus the subsidiary’s book value less the $30,000 fair-value reduction allocation plus the current year expense reduction of $6,000.

∙ Goodwill = $80,000. The residual allocation shown in Exhibit 3.2. Note that goodwill is considered to have an indefinite life and thus is not amortized.

∙ Total assets = $3,561,000. A vertical summation of consolidated assets. ∙ Liabilities = $1,428,000. The parent’s book value plus the subsidiary’s book value. ∙ Common stock = $600,000. The parent’s book value. Subsidiary shares owned by the par-

ent are treated as if they are no longer outstanding. ∙ Additional paid-in capital = $120,000. The parent’s book value. Subsidiary shares owned

by the parent are treated as if they are no longer outstanding. ∙ Retained earnings, 12/31/17 = $1,413,000. Computed previously. ∙ Total liabilities and equities = $3,561,000. A vertical summation of consolidated liabili-

ties and equities.

Consolidation Worksheet Although the consolidated figures to be reported can be computed as just shown, accountants normally prefer to use a worksheet. A worksheet provides an organized structure for this process, a benefit that becomes especially important in consolidating complex combinations.

For Parrot and Sun, only five consolidation entries are needed to arrive at the same fig- ures previously derived for this business combination. As discussed in Chapter 2, worksheet entries are the catalyst for developing totals to be reported by the entity but are not physically recorded in the individual account balances of either company.

Consolidation Entry S

Common Stock (Sun Company) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000 Additional Paid-In Capital (Sun Company) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Retained Earnings, 1/1/17 (Sun Company) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380,000 Investment in Sun Company. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000

As shown in Exhibit 3.2, Parrot’s $800,000 Investment account balance at January 1, 2017, reflects two components: (1) a $600,000 amount equal to Sun’s book value and (2) a $200,000 figure attributed to the acquisition-date difference between the book value and fair value of Sun’s assets and liabilities (with a residual allocation made to goodwill). Entry S removes the $600,000 component of the Investment in Sun Company account which is then replaced by add- ing the book values of each subsidiary asset and liability across to the consolidated figures. A second worksheet entry (Entry A) eliminates the remaining $200,000 portion of the January 1, 2017 Investment in Sun account and replaces it with the specific acquisition-date excess fair over book value allocations along with any goodwill. Importantly, worksheet entries S and A are part of the sequence of worksheet adjustments that bring the investment account to zero.

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Entry S also removes Sun’s stockholders’ equity accounts as of the beginning of the year. Because consolidated statements are prepared for the parent company owners, the subsid- iary equity accounts are not relevant to the business combination and should be eliminated for consolidation purposes. The elimination is made through this entry because the equity accounts and the $600,000 component of the investment account represent reciprocal bal- ances: Both provide a measure of Sun’s book value as of January 1, 2017.

Before moving to the next consolidation entry, a clarification point should be made. In actual practice, worksheet entries are usually identified numerically. However, as in the pre- vious chapter, the label “Entry S” used in this example refers to the elimination of Sun’s beginning Stockholders’ Equity. As a reminder of the purpose being served, all worksheet entries are identified in a similar fashion. Thus, throughout this textbook, “Entry S” always refers to the removal of the subsidiary’s beginning stockholders’ equity balances for the year against the book value portion of the investment account.

Consolidation Entry A

Trademarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 Patented Technology. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130,000 Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 Investment in Sun Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000

Equity in Subsidiary Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93,000 Investment in Sun Company. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93,000

Investment in Sun Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 Dividends Declared . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000

Consolidation Entry A adjusts the subsidiary balances from their book values to acquisition-date fair values (see Exhibit 3.2) and includes goodwill created by the acquisition. This entry is labeled “Entry A” to indicate that it represents the Allocations made in connection with the excess of the subsidiary’s fair values over its book values. Sun’s accounts are adjusted collectively by the $200,000 excess of Sun’s $800,000 acquisition-date fair value over its $600,000 book value.

Consolidation Entry I

“Entry I” (for Income) removes from the worksheet the subsidiary income recognized by Par- rot during the year. For reporting purposes, we must add the subsidiary’s individual revenue and expense accounts (and the current excess amortization expenses) to the parent’s respec- tive amounts to arrive at consolidated totals. Worksheet entry I thus effectively removes the one-line Equity in Subsidiary Earnings which is then replaced with the addition of the sub- sidiary’s separate revenues and expenses (already listed on the worksheet in the subsidiary’s balances). The $93,000 figure eliminated here represents the $100,000 income accrual rec- ognized by Parrot, reduced by the $7,000 in excess amortizations. Observe that the entry originally recorded by the parent is simply reversed on the worksheet to remove its impact.

Consolidation Entry D

The dividends declared by the subsidiary during the year also must be eliminated from the consolidated totals. The entire $40,000 dividend goes to the parent, which from the viewpoint of the consolidated entity is simply an intra-entity transfer. The dividend declaration did not affect any outside party. Therefore, “Entry D” (for Dividends) is designed to offset the impact of this transaction by removing the subsidiary’s Dividends Declared account. Because the equity method has been applied, Parrot originally recorded these dividends as a decrease in the Investment in Sun Company account. To eliminate the impact of this reduction, the investment account is increased.

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Consolidation Entry E

Amortization Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,000 Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 Patented Technology. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,000 Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

This final worksheet entry recognizes the current year’s excess amortization expenses relat- ing to the adjustments of Sun’s assets to acquisition-date fair values. Because the equity method amortization was eliminated within Entry I, “Entry E” (for Expense) now enters on the worksheet the current year expense attributed to each of the specific account allocations (see Exhibit 3.3). Note that we adjust depreciation expense for the tangible asset equipment and we adjust amortization expense for the intangible asset patented technology. As men- tioned earlier, we refer to the adjustments to all expenses resulting from excess acquisition- date fair-value allocations collectively as excess amortization expenses.

Thus, the worksheet entries necessary for consolidation when the parent has applied the equity method are as follows:

Entry S—Eliminates the subsidiary’s stockholders’ equity accounts as of the beginning of the current year along with the equivalent book value component within the parent’s investment account. Entry A—Recognizes the unamortized allocations as of the beginning of the current year associated with the original adjustments to fair value. Entry I—Eliminates the impact of intra-entity subsidiary income accrued by the parent. Entry D—Eliminates the impact of intra-entity subsidiary dividends. Entry E—Recognizes excess amortization expenses for the current period on the alloca- tions from the original adjustments to fair value.

Exhibit 3.5 provides a complete presentation of the December 31, 2017, consolidation worksheet for Parrot Company and Sun Company. The series of entries just described brings together the separate financial statements of these two organizations. Note that the consoli- dated totals are the same as those computed previously for this combination.

Observe that Parrot separately reports net income of $693,000 as well as ending retained earnings of $1,413,000, figures that are identical to the totals generated for the consolidated entity. However, subsidiary income earned after the date of acquisition is to be added to that of the parent. Thus, a question arises in this example as to why the parent company figures alone equal the consolidated balances of both operations.

In reality, Sun’s income for this period is contained in both Parrot’s reported balances and the consolidated totals. Through the application of the equity method, the current year earn- ings of the subsidiary have already been accrued by Parrot along with the appropriate amorti- zation expense. The parent’s Equity in Subsidiary Earnings account is, therefore, an accurate representation of Sun’s effect on consolidated net income. If the equity method is employed properly, the worksheet process simply replaces this single $93,000 balance with the specific revenue and expense accounts that it represents. Consequently, when the parent employs the equity method, its net income and retained earnings mirror consolidated totals.

Consolidation Subsequent to Year of Acquisition—Equity Method In many ways, every consolidation of Parrot and Sun prepared after the date of acquisition incorporates the same basic procedures outlined in the previous section. However, the con- tinual financial evolution undergone by the companies prohibits an exact repetition of the consolidation entries demonstrated in Exhibit 3.5.

As a basis for analyzing the procedural changes necessitated by the passage of time, assume that Parrot Company continues to hold its ownership of Sun Company as of December 31, 2020. This date was selected at random; any date subsequent to 2017 would serve equally well to illustrate this process. As an additional factor, assume that Sun now has a $40,000 liability that is payable to Parrot.

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For this consolidation, assume that the January 1, 2020, Sun Company’s Retained Earn- ings balance has risen to $600,000. Because that account had a reported total of only $380,000 on January 1, 2017, Sun’s book value apparently has increased by $220,000 during the 2017–2019 period. Although knowledge of individual operating figures in the past is not required, Sun’s reported totals help to clarify the consolidation procedures.

Year Sun Company

Net Income Dividends Declared

Increase in Book Value

Ending Retained Earnings

2017 $100,000 $ 40,000 $ 60,000 $ 440,000 2018 140,000 50,000 90,000 530,000 2019 90,000 20,000 70,000 600,000

$330,000 $110,000 $220,000

Investment: Equity Method

PARROT COMPANY AND SUN COMPANY Consolidation Worksheet

For Year Ending December 31, 2017

Accounts Parrot

Company Sun

Company

Consolidation Entries Consolidated

TotalsDebit Credit

Income Statement Revenues (1,500,000) (400,000) (1,900,000) Cost of goods sold 700,000 232,000 932,000 Amortization expense 120,000 32,000 (E) 13,000 165,000 Depreciation expense 80,000 36,000 (E) 6,000 110,000 Equity in subsidiary earnings (93,000) –0– (I) 93,000 –0–

Net income (693,000) (100,000) (693,000)

Statement of Retained Earnings Retained earnings, 1/1/17 (840,000) (380,000) (S) 380,000 (840,000) Net income (above) (693,000) (100,000) (693,000) Dividends declared 120,000 40,000 (D) 40,000 120,000

Retained earnings, 12/31/17 (1,413,000) (440,000) (1,413,000)

Balance Sheet Current assets 1,040,000 400,000 1,440,000 Investment in Sun Company 853,000 –0– (D) 40,000 (S) 600,000 –0–

(A) 200,000 (I) 93,000

Trademarks 600,000 200,000 (A) 20,000 820,000 Patented technology 370,000 288,000 (A) 130,000 (E) 13,000 775,000 Equipment (net) 250,000 220,000 (E) 6,000 (A) 30,000 446,000 Goodwill –0– –0– (A) 80,000 80,000

Total assets 3,113,000 1,108,000 3,561,000

Liabilities (980,000) (448,000) (1,428,000) Common stock (600,000) (200,000) (S) 200,000 (600,000) Additional paid-in capital (120,000) (20,000) (S) 20,000 (120,000) Retained earnings, 12/31/17 (above) (1,413,000) (440,000) (1,413,000)

Total liabilities and equities (3,113,000) (1,108,000) 982,000 982,000 (3,561,000)

EXHIBIT 3.5 Consolidation Worksheet—Equity Method Applied

Note: Parentheses indicate a credit balance. Consolidation entries: (S) Elimination of Sun’s stockholders’ equity January 1 balances and the book value portion of the investment account. (A) Allocation of Sun’s acquisition-date excess fair values over book values. (I) Elimination of parent’s equity in subsidiary earnings accrual. (D) Elimination of intra-entity dividends. (E) Recognition of current year excess fair-value amortization and depreciation expenses.

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For 2020, the current year, we assume that Sun reports net income of $160,000 and declares and pays cash dividends of $70,000. Because it applies the equity method, Parrot recognizes earnings of $160,000. Furthermore, as shown in Exhibit 3.3, amortization expense of $7,000 applies to 2020 and must also be recorded by the parent. Consequently, Parrot reports an Equity in Subsidiary Earnings balance for the year of $153,000 ($160,000 − $7,000).

Although this income figure can be reconstructed with little difficulty, the current balance in the Investment in Sun Company account is more complicated. Over the years, the initial $800,000 acquisition price has been subjected to adjustments for

1. The annual accrual of Sun’s income. 2. The receipt of dividends from Sun. 3. The recognition of annual excess amortization expenses.

Exhibit 3.6 analyzes these changes and shows the components of the Investment in Sun Com- pany account balance as of December 31, 2020.

Following the construction of the Investment in Sun Company account, the consolida- tion worksheet developed in Exhibit 3.7 should be easier to understand. Current figures for both companies appear in the first two columns. The parent’s investment balance and equity income accrual as well as Sun’s income and stockholders’ equity accounts correspond to the information given previously. Worksheet entries (lettered to agree with the previous illustra- tion) are then utilized to consolidate all balances.

Several steps are necessary to arrive at these reported totals. The subsidiary’s assets, lia- bilities, revenues, and expenses are added to those same accounts of the parent. The unam- ortized portion of the original acquisition-date fair-value allocations are included along with current excess amortization expenses. The investment and equity income balances are both eliminated as are the subsidiary’s stockholders’ equity accounts. Intra-entity dividends are removed as are the existing receivable and payable balances between the two companies.

Consolidation Entry S Once again, this first consolidation entry offsets reciprocal amounts representing the subsid- iary’s book value as of the beginning of the current year. Sun’s January 1, 2020, stockholders’

PARROT COMPANY Investment in Sun Company Account

As of December 31, 2020 Equity Method Applied

Fair value of consideration transferred at date of acquisition $ 800,000 Entries recorded in prior years: Accrual of Sun Company’s income 2017 $100,000 2018 140,000 2019 90,000 330,000 Sun Company—Dividends declared 2017 $ (40,000) 2018 (50,000) 2019 (20,000) (110,000) Excess amortization expenses 2017 $ (7,000) 2018 (7,000) 2019 (7,000) (21,000) Entries recorded in current year—2020 Accrual of Sun Company’s income $160,000 Sun Company—Dividends declared (70,000) Excess amortization expenses (7,000) 83,000

Investment in Sun Company, 12/31/20 $1,082,000

EXHIBIT 3.6 Investment Account under Equity Method

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equity accounts are eliminated against the book value portion of the parent’s investment account. Here, though, the amount eliminated is $820,000 rather than the $600,000 shown in Exhibit 3.5 for 2017. Both balances have changed during the 2017–2019 period. Sun’s operations caused a $220,000 increase in retained earnings. Parrot’s application of the equity method created a parallel effect on its Investment in Sun Company account (the income accrual of $330,000 less dividends collected of $110,000).

Although Sun’s Retained Earnings balance is removed in this entry, the income this com- pany earned since the acquisition date is still included in the consolidated figures. Parrot accrues these profits annually through application of the equity method. Thus, elimination of the subsidiary’s entire Retained Earnings is necessary; a portion was earned prior to the acquisition and the remainder has already been recorded by the parent.

Investment: Equity Method

PARROT COMPANY AND SUN COMPANY Consolidation Worksheet

For Year Ending December 31, 2020

Accounts Parrot

Company Sun

Company

Consolidation Entries Consolidation TotalsDebit Credit

Income Statement Revenues (2,100,000) (600,000) (2,700,000) Cost of goods sold 1,000,000 380,000 1,380,000 Amortization expense 200,000 20,000 (E) 13,000 233,000 Depreciation expense 100,000 40,000 (E) 6,000 134,000 Equity in subsidiary earnings (153,000) –0– (I) 153,000 –0–

Net income (953,000) (160,000) (953,000)

Statement of Retained Earnings Retained earnings, 1/1/20 (2,044,000) (600,000) (S) 600,000 (2,044,000) Net income (above) (953,000) (160,000) (953,000) Dividends declared 420,000 70,000 (D) 70,000 420,000

Retained earnings, 12/31/20 (2,577,000) (690,000) (2,577,000)

Balance Sheet Current assets 1,705,000 500,000 (P) 40,000 2,165,000 Investment in Sun Company 1,082,000 –0– (D) 70,000 (S) 820,000 –0–

(A) 179,000 (I) 153,000

Trademarks 600,000 240,000 (A) 20,000 860,000 Patented technology 540,000 420,000 (A) 91,000 (E) 13,000 1,038,000 Equipment (net) 420,000 210,000 (E) 6,000 (A) 12,000 624,000 Goodwill –0– –0– (A) 80,000 80,000

Total assets 4,347,000 1,370,000 4,767,000

Liabilities (1,050,000) (460,000) (P) 40,000 (1,470,000) Common stock (600,000) (200,000) (S) 200,000 (600,000) Additional paid-in capital (120,000) (20,000) (S) 20,000 (120,000) Retained earnings, 12/31/20 (above) (2,577,000) (690,000) (2,577,000)

Total liabilities and equities (4,347,000) (1,370,000) 1,293,000 1,293,000 (4,767,000)

Note: Parentheses indicate a credit balance. Consolidation entries: (S) Elimination of Sun’s stockholders’ equity January 1 balances and the book value portion of the investment account. (A) Allocation of Sun’s acquisition-date excess fair values over book values, unamortized balance as of beginning of year. (I) Elimination of parent’s equity in subsidiary earnings accrual. (D) Elimination of intra-entity dividends. (E) Recognition of current year excess fair-value amortization and depreciation expenses. (P) Elimination of intra-entity receivable/payable.

EXHIBIT 3.7 Consolidation Worksheet Subsequent to Year of Acquisition—Equity Method Applied

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Entry S removes these balances as of the first day of 2020 rather than at the end of the year. The consolidation process is made a bit simpler by segregating the effect of preceding opera- tions from the transactions of the current year. Thus, all worksheet entries relate specifically to either the previous years (S and A) or the current period (I, D, E, and P).

Consolidation Entry A In the initial consolidation (2017), fair-value allocations amounting to $200,000 were entered, but these balances have now undergone three years of amortization. As computed in Exhibit 3.8, expenses for these prior years totaled $21,000, leaving a balance of $179,000. Allocation of this amount to the individual accounts is also determined in Exhibit 3.8 and reflected in worksheet Entry A. As with Entry S, these balances are calculated as of January 1, 2020, and replaced by current year expenses as shown in Entry E.

Consolidation Entry I As before, this entry eliminates the equity income recorded currently by Parrot ($153,000) in connection with its ownership of Sun. The subsidiary’s revenue and expense accounts are left intact so they can be included in the consolidated figures.

Consolidation Entry D This worksheet entry offsets the $70,000 intra-entity dividends (from Sun to Parrot) during the current period.

Consolidation Entry E Excess amortization expenses relating to acquisition-date fair-value adjustments are individu- ally recorded for the current period.

Before progressing to the final worksheet entry, note the close similarity of these entries with the five entries incorporated in the 2017 consolidation (Exhibit 3.5). Except for the numerical changes created by the passage of time, the entries are identical.

Consolidation Entry P This last entry (labeled “Entry P” because it eliminates an intra-entity Payable) introduces a new element to the consolidation process. As noted earlier, intra-entity reciprocal accounts do not relate to outside parties. Therefore, Sun’s $40,000 payable and Parrot’s $40,000 receivable must be removed on the worksheet because the companies are being reported as a single entity.

In reviewing Exhibit 3.7, note several aspects of the consolidation process:

∙ The stockholders’ equity accounts of the subsidiary are removed. ∙ The Investment in Sun Company and the Equity in Subsidiary Earnings are both removed. ∙ The parent’s Retained Earnings balance is not adjusted. Because the parent applies the

equity method this account should be correct. ∙ The acquisition-date fair-value adjustments to the subsidiary’s assets are recognized but

only after adjustment for prior periods’ annual excess amortization expenses. ∙ Intra-entity balances such as dividends and receivables/payables are offset.

Annual Excess Amortizations

Accounts Original Allocation 2017 2018 2019 Balance 1/1/20

Trademarks $ 20,000 $ –0– $ –0– $ –0– $ 20,000 Patented technology 130,000 13,000 13,000 13,000 91,000 Equipment (30,000) (6,000) (6,000) (6,000) (12,000) Goodwill 80,000 –0– –0– –0– 80,000

$200,000 $ 7,000 $ 7,000 $ 7,000 $179,000

$21,000

EXHIBIT 3.8 Excess Amortizations Relating to Individual Accounts as of January 1, 2020

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Subsequent Consolidations—Investment Recorded Using Initial Value or Partial Equity Method Acquisition Made during the Current Year As discussed at the beginning of this chapter, the parent company may opt to use the initial value method or the partial equity method for internal record-keeping rather than the equity method. Application of either alternative changes the balances recorded by the parent over time and, thus, the procedures followed in creating consolidations. However, choosing one of these other approaches does not affect any of the final consolidated figures to be reported.

When a company utilizes the equity method, it eliminates all reciprocal accounts, assigns unamortized fair-value allocations to specific accounts, and records amortization expense for the current year. Application of either the initial value method or the partial equity method has no effect on this basic process. For this reason, a number of the consolidation entries remain the same regardless of the parent’s investment accounting method.

In reality, just three of the parent’s accounts actually vary because of the method applied:

∙ The investment account. ∙ The income recognized from the subsidiary. ∙ The parent’s retained earnings (in periods after the initial year of the combination).

Only the differences found in these balances affect the consolidation process when another method is applied. Thus, any time after the acquisition date, accounting for these three bal- ances is of special importance.

To illustrate the modifications required by the adoption of an alternative accounting method, the consolidation of Parrot and Sun as of December 31, 2017, is reconstructed. Only one differing factor is introduced: the method by which Parrot accounts for its invest- ment. Exhibit 3.9 presents the 2017 consolidation based on Parrot’s use of the initial value method. Exhibit 3.10 demonstrates this same process assuming that the parent applied the partial equity method. Each entry on these worksheets is labeled to correspond with the 2017 consolidation in which the parent used the equity method (Exhibit 3.5). Furthermore, differ- ences with the equity method (both on the parent company records and with the consolidation entries) are highlighted on each of the worksheets.

Initial Value Method Applied—2017 Consolidation Although the initial value method theoretically stands in marked contrast to the equity method, few reporting differences actually exist. In the year of acquisition, Parrot’s income and investment accounts relating to the subsidiary are the only accounts affected.

Under the initial value method, income recognition in 2017 is limited to the $40,000 divi- dend received by the parent; no equity income accrual is made. At the same time, the invest- ment account retains its $800,000 initial value. Unlike the equity method, no adjustments are recorded in the parent’s investment account in connection with the current year operations, subsidiary dividends, or amortization of any fair-value allocations.

After the composition of the dividend income and investment accounts has been estab- lished, worksheet entries can be used to produce the consolidated figures found in Exhibit 3.9 as of December 31, 2017.

Consolidation Entry S As with the previous Entry S in Exhibit 3.5, the $600,000 component of the investment account is eliminated against the beginning stockholders’ equity account of the subsidiary. Both are equivalent to Sun’s net assets at January 1, 2017, and are, therefore, reciprocal bal- ances that must be offset. This entry is not affected by the accounting method in use.

Consolidation Entry A Sun’s $200,000 excess acquisition-date fair value over book value is allocated to Sun’s assets and liabilities based on their fair values at the date of acquisition. The $80,000 residual is

LO 3-3b

Prepare consolidated financial statements subsequent to acquisi- tion when the parent has applied the initial value method in its internal records.

LO 3-3c

Prepare consolidated financial statements subsequent to acquisi- tion when the parent has applied the partial equity method in its internal records.

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attributed to goodwill. This procedure is identical to the corresponding entry in Exhibit 3.5 in which the equity method was applied.

Consolidation Entry I Under the initial value method, the parent records dividends declared by the subsidiary as income. Entry I removes this Dividend Income account along with Sun’s Dividends Declared. From a consolidated perspective, these two $40,000 balances represent an intra-entity transfer that had no financial impact outside of the entity. In contrast to the equity method, Parrot has not accrued subsidiary income, nor has amortization been recorded; thus, no further income elimination is needed.

Investment: Initial Value Method

PARROT COMPANY AND SUN COMPANY Consolidation Worksheet

For Year Ending December 31, 2017

Accounts Parrot

Company Sun

Company

Consolidation Entries Consolidation TotalsDebit Credit

Income Statement Revenues (1,500,000) (400,000) (1,900,000) Cost of goods sold 700,000 232,000 932,000 Amortization expense 120,000 32,000 (E) 13,000 165,000 Depreciation expense 80,000 36,000 (E) 6,000 110,000 Dividend income (40,000) * –0– (I) 40,000 * –0–

Net income (640,000) (100,000) (693,000)

Statement of Retained Earnings Retained earnings, 1/1/17 (840,000) (380,000) (S) 380,000 (840,000) Net income (above) (640,000) (100,000) (693,000) Dividends declared 120,000 40,000 (I) 40,000 * 120,000

Retained earnings, 12/31/17 (1,360,000) (440,000) (1,413,000)

Balance Sheet Current assets 1,040,000 400,000 1,440,000 Investment in Sun Company 800,000 * –0– (S) 600,000 –0–

(A) 200,000 Trademarks 600,000 200,000 (A) 20,000 820,000 Patented technology 370,000 288,000 (A) 130,000 (E) 13,000 775,000 Equipment (net) 250,000 220,000 (E) 6,000 (A) 30,000 446,000 Goodwill –0– –0– (A) 80,000 80,000

Total assets 3,060,000 1,108,000 3,561,000

Total liabilities and equities (3,060,000) (1,108,000) 889,000 889,000 (3,561,000)

Note: Parentheses indicate a credit balance. *Boxed items highlight differences with consolidation in Exhibit 3.5. Consolidation entries: (S) Elimination of Sun’s stockholders’ equity January 1 balances and the book value portion of the investment account. (A) Allocation of Sun’s acquisition-date excess fair values over book values. (I) Elimination of intra-entity dividend income and dividends declared by Sun. (E) Recognition of current year excess fair-value amortization and depreciation expenses. Note: Consolidation entry (D) is not needed when the parent applies the initial value method because entry (I) eliminates the intra-entity dividend effects.

EXHIBIT 3.9 Consolidation Worksheet—Initial Value Method Applied

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Dividend Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 Dividends Declared . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 To eliminate intra-entity income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Consolidation Entry D When the initial value method is applied, the parent records intra-entity dividends as income. Because these dividends were already removed from the consolidated totals by Entry I, no separate Entry D is required.

Investment: Partial Equity Method

PARROT COMPANY AND SUN COMPANY Consolidation Worksheet

For Year Ending December 31, 2017

Accounts Parrot

Company Sun

Company

Consolidation Entries Consolidation TotalsDebit Credit

Net income (700,000) (100,000) (693,000)

Statement of Retained Earnings Retained earnings, 1/1/17 (840,000) (380,000) (S) 380,000 (840,000) Net income (above) (700,000) (100,000) (693,000) Dividends declared 120,000 40,000 (D) 40,000 120,000

Retained earnings, 12/31/17 (1,420,000) (440,000) (1,413,000)

Balance Sheet Current assets 1,040,000 400,000 1,440,000 Investment in Sun Company 860,000 * –0– (D) 40,000 (S) 600,000 –0–

(A) 200,000 (I) 100,000 *

Total assets 3,120,000 1,108,000 3,561,000

Total liabilities and equities (3,120,000) (1,108,000) 989,000 989,000 (3,561,000)

Note: Parentheses indicate a credit balance. *Boxed items highlight differences with consolidation in Exhibit 3.5. Consolidation entries: (S) Elimination of Sun’s stockholders’ equity January 1 balances and the book value portion of the investment account. (A) Allocation of Sun’s acquisition-date excess fair values over book values. (I) Elimination of parent’s equity in subsidiary earnings accrual. (D) Elimination of intra-entity dividends. (E) Recognition of current year excess fair-value amortization and depreciation expenses.

EXHIBIT 3.10 Consolidation Worksheet—Partial Equity Method Applied

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Consolidation Entry E Regardless of the parent’s method of accounting, the reporting entity must recognize excess amortizations for the current year in connection with the original fair-value allocations. Thus, Entry E serves to bring the current year expenses into the consolidated financial statements.

Consequently, using the initial value method rather than the equity method changes only Entries I and D in the year of acquisition. Despite the change in methods, reported figures are still derived by (1) eliminating all reciprocals, (2) allocating the excess portion of the acquisition-date fair values, and (3) recording amortizations on these allocations. As indicated previously, the consolidated totals appearing in Exhibit 3.9 are identical to the figures produced previously in Exhibit 3.5. Although the income and the investment accounts on the parent company’s separate statements vary, the consolidated balances are not affected.

One significant difference between the initial value method and equity method does exist: The parent’s separate statements do not reflect consolidated income totals when the initial value method is used. Because equity adjustments (such as excess amortizations) are not recorded, neither Parrot’s reported net income of $640,000 nor its retained earnings of $1,360,000 provides an accurate portrayal of consolidated figures.

Partial Equity Method Applied—2017 Consolidation Exhibit 3.10 presents a worksheet to consolidate these two companies for 2017 (the year of acquisition) based on the assumption that Parrot applied the partial equity method. Again, the only changes from previous examples are found in (1) the parent’s separate records for this investment and its related income and (2) worksheet Entries I and D.

As discussed earlier, under the partial equity approach, the parent’s record-keeping is lim- ited to two periodic journal entries: the annual accrual of subsidiary income and the recogni- tion of dividends. Hence, within the parent’s records, only a few differences exist when the partial equity method is applied rather than the initial value method. The entries recorded by Parrot in connection with Sun’s 2017 operations illustrate both of these approaches.

Therefore, by applying the partial equity method, the investment account on the parent’s balance sheet rises to $860,000 by the end of 2017. This total is composed of the original $800,000 acquisition-date fair value for Sun adjusted for the $100,000 income recognition and the $40,000 cash dividend. The same $100,000 equity income figure appears within the parent’s income statement. These two balances are appropriately found in Parrot’s records in Exhibit 3.10.

Because of differences in income recognition and the effects of subsidiary dividends, Entries I and D again differ on the worksheet. For the partial equity method, the $100,000 equity income is eliminated (Entry I) by reversing the parent’s entry. Removing this accrual allows the individual revenue and expense accounts of the subsidiary to be reported without double-counting. The $40,000 intra-entity dividend must also be removed (Entry D). The Dividends Declared account is simply deleted. However, elimination of the dividend from the

Parrot Company Initial Value Method 2017

Parrot Company Partial Equity Method 2017

Dividend Receivable . . . . . . 40,000 Dividend Receivable . . . . . . 40,000 Dividend Income. . . . . . 40,000 Investment in Sun

Company . . . . . . . . . . . 40,000 Subsidiary dividends declared. Subsidiary dividends declared. Cash . . . . . . . . . . . . . . . . . . . . 40,000 Cash . . . . . . . . . . . . . . . . . . . . 40,000 Dividend Receivable . . 40,000 Dividend Receivable . . 40,000 To record the receipt of the cash dividend.

To record the receipt of the cash dividend.

Investment in Sun Company 100,000 Equity in Subsidiary

Earnings . . . . . . . . . . . . 100,000 Accrual of subsidiary income.

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Investment in Sun Company actually causes an increase because the dividend was recorded by Parrot as a reduction in that account. All other consolidation entries (Entries S, A, and E) are the same for all three methods.

Comparisons across Internal Investment Methods Consolidated financial worksheets have now been completed when the parent uses the equity, initial value, and partial equity methods. At this point it is instructive to compare the final con- solidated balances in Exhibits 3.5, 3.9, and 3.10. Note the identical final consolidated column balances across the three internal methods of investment accounting. Thus, the parent’s inter- nal investment method choice has no effect on the resulting consolidated financial statements.

Consolidation Subsequent to Year of Acquisition—Initial Value and Partial Equity Methods By again incorporating the December 31, 2020, financial data for Parrot and Sun (presented in Exhibit 3.7), consolidation procedures for the initial value method and the partial equity method are examined for years subsequent to the date of acquisition. In both cases, establishment of an appropriate beginning retained earnings figure becomes a significant goal of the consolidation.

Conversion of the Parent’s Retained Earnings to a Full-Accrual (Equity) Basis Consolidated financial statements require a full accrual-based measurement of both income and retained earnings. The initial value method, however, recognizes income when the sub- sidiary declares a dividend thus ignoring when the underlying income was earned. The partial equity method only partially accrues subsidiary income. Thus, neither provides a full accrual- based measure of the subsidiary activities on the parent’s income. As a result, over time the parent’s retained earnings account fails to show a full accrual-based amount. Therefore, new worksheet adjustments are required to convert the parent’s beginning of the year retained earnings balance to a full-accrual basis. These adjustments are made to beginning of the year retained earnings because current year earnings are readily converted to full-accrual basis by simply combining current year revenue and expenses. The resulting current year combined income figure is then added to the adjusted beginning of the year retained earnings to arrive at a full-accrual ending retained earnings balance.

This concern was not faced previously when the equity method was adopted. Under that approach, the parent’s Retained Earnings account balance already reflects a full-accrual basis so that no adjustment is necessary. In the earlier illustration, the $330,000 income accrual for the 2017–2019 period as well as the $21,000 amortization expense was recognized by the parent in applying the equity method (see Exhibit 3.6). Having been recorded in this man- ner, these two balances form a permanent part of Parrot’s retained earnings and are included automatically in the consolidated total. Consequently, if the equity method is applied, the pro- cess is simplified; no worksheet entries are needed to adjust the parent’s Retained Earnings account to record subsidiary operations or amortization for past years.

Conversely, if a method other than the equity method is used, a worksheet change must be made to the parent’s beginning Retained Earnings account (in every subsequent year) to equate this balance with a full-accrual amount. To quantify this adjustment, the parent’s recog- nized income for these past three years under each method is first determined (Exhibit 3.11). For consolidation purposes, the beginning retained earnings account must then be increased or decreased to create the same effect as the equity method.

LO 3-4

Understand that a parent’s inter- nal accounting method for its subsidiary investments has no effect on the resulting consoli- dated financial statements.

PARROT COMPANY AND SUN COMPANY Previous Years—2017–2019

Equity Method

Initial Value Method

Partial Equity Method

Equity accrual $330,000 $ –0– $330,000 Dividend income –0– 110,000 –0– Excess amortization expenses (21,000) –0– –0–

Increase in parent’s retained earnings $309,000 $110,000 $330,000

EXHIBIT 3.11 Retained Earnings Differences

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Initial Value Method Applied—Subsequent Consolidation As shown in Exhibit 3.11, if Parrot applied the initial value method during the 2017–2019 period, it recognizes $199,000 less income than under the equity method ($309,000 − $110,000). Two items cause this difference. First, Parrot has not accrued the $220,000 increase in the subsidiary’s book value across the periods prior to the current year. Although the $110,000 in dividends was recorded as income, the parent never recognized the remainder of the $330,000 earned by the subsidiary.7 Second, no accounting has been made of the $21,000 excess amortization expenses. Thus, the parent’s beginning Retained Earnings account is $199,000 ($220,000 − $21,000) below the appropriate consolidated total and must be adjusted.8

To simulate the equity method so that the parent’s beginning Retained Earnings account reflects a full-accrual basis, this $199,000 increase is recorded through a worksheet entry. The initial value method figures reported by the parent effectively are converted into equity method balances.

7 Two different calculations are available for determining the $220,000 in nonrecorded income for prior years: (1) subsidiary income less dividends declared and (2) the change in the subsidiary’s book value as of the first day of the current year. The second method works only if the subsidiary has had no other equity transactions such as the issuance of new stock or the purchase of treasury shares. Unless otherwise stated, the assumption is made that no such transactions have occurred. 8 Because neither the income in excess of dividends nor excess amortization is recorded by the parent under the initial value method, its beginning Retained Earnings account is $199,000 less than the $2,044,000 reported under the equity method ( Exhibit 3.7 ). Thus, a $1,845,000 balance is shown in Exhibit 3.12 ($2,044,000 less $199,000). Conversely, if the partial equity method had been applied, Parrot’s absence of amortization would cause the Retained Earnings account to be $21,000 higher than the figure derived by the equity method. For this reason, Exhibit 3.13 shows the parent with a beginning Retained Earnings account of $2,065,000 rather than $2,044,000.

Investment in Sun Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199,000 Retained Earnings, 1/1/20 (Parrot Company) . . . . . . . . . . . . . . . . . . . . . . 199,000 To convert parent’s beginning retained earnings from the initial value method to equity method.

This adjustment is labeled Entry *C. The C refers to the conversion being made to equity method (full-accrual) totals. The asterisk indicates that this equity simulation relates solely to transactions of prior periods. Thus, Entry *C should be recorded before the other worksheet entries to align the beginning balances for the year.

Exhibit 3.12 provides a complete presentation of the consolidation of Parrot and Sun as of December 31, 2020, based on the parent’s application of the initial value method. After Entry *C has been recorded on the worksheet, the remainder of this consolidation follows the same pattern as previous examples. Sun’s stockholders’ equity accounts are eliminated (Entry S) while the allocations stemming from the $800,000 initial fair value are recorded (Entry A) at their unamortized balances as of January 1, 2020 (see Exhibit 3.8). Intra-entity dividend income is removed (Entry I) and current year excess amortization expenses are recognized (Entry E). To complete this process, the intra-entity receivable and payable of $40,000 are offset (Entry P).

In retrospect, the only new element introduced here is the adjustment of the parent’s begin- ning Retained Earnings. For a consolidation produced after the initial year of acquisition, an Entry *C is required if the parent has not applied the equity method.

Partial Equity Method Applied—Subsequent Consolidation Exhibit 3.13 demonstrates the worksheet consolidation of Parrot and Sun as of December 31, 2020, when the investment accounts have been recorded by the parent using the partial equity method. This approach accrues subsidiary income each year but records no other equity adjustments. Therefore, as of December 31, 2020, Parrot’s Investment in Sun Company account has a balance of $1,110,000:

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Fair value of consideration transferred for Sun Company 1/1/17 $ 800,000 Sun Company’s 2017–2019 increase in book value: Accrual of Sun Company’s income $ 330,000 Sun Company’s dividends (110,000) 220,000

Sun Company’s 2020 operations: Accrual of Sun Company’s income $ 160,000 Sun Company’s dividends (70,000) 90,000

Investment in Sun Company, 12/31/20 (Partial equity method) $1,110,000

Investment: Initial Value Method

PARROT COMPANY AND SUN COMPANY Consolidation Worksheet

For Year Ending December 31, 2020

Accounts Parrot

Company Sun

Company

Consolidation Entries Consolidation TotalsDebit Credit

Income Statement Revenues (2,100,000) (600,000) (2,700,000) Cost of goods sold 1,000,000 380,000 1,380,000 Amortization expense 200,000 20,000 (E) 13,000 233,000 Depreciation expense 100,000 40,000 (E) 6,000 134,000 Dividend income (70,000) * –0– (I) 70,000 * –0–

Net income (870,000) (160,000) (953,000)

Statement of Retained Earnings Retained earnings, 1/1/20 Parrot Company (1,845,000)† * (*C) 199,000 * (2,044,000) Sun Company (600,000) (S) 600,000 –0– Net income (above) (870,000) (160,000) (953,000) Dividends declared 420,000 70,000 (I) 70,000 * 420,000

Retained earnings, 12/31/20 (2,295,000) (690,000) (2,577,000)

Balance Sheet Current assets 1,705,000 500,000 (P) 40,000 2,165,000 Investment in Sun Company 800,000* –0– (*C) 199,000 (S) 820,000 –0–

(A) 179,000 Trademarks 600,000 240,000 (A) 20,000 860,000 Patented technology 540,000 420,000 (A) 91,000 (E) 13,000 1,038,000 Equipment (net) 420,000 210,000 (E) 6,000 (A) 12,000 624,000 Goodwill –0– –0– (A) 80,000 80,000

Total assets 4,065,000 1,370,000 4,767,000

Total liabilities and equities (4,065,000) (1,370,000) 1,339,000 1,339,000 (4,767,000)

Note: Parentheses indicate a credit balance. *Boxed items highlight differences with consolidation in Exhibit 3.7. †See footnote 8. Consolidation entries: (*C) To convert parent’s beginning retained earnings to full accrual basis. (S) Elimination of Sun’s stockholders’ equity January 1 balances and the book value portion of investment account. (A) Allocation of Sun’s excess acquisition-date fair value over book value, unamortized balance as of beginning of year. (I) Elimination of intra-entity dividend income and dividends declared by Sun. (E) Recognition of current year excess fair-value amortization and depreciation expenses. (P) Elimination of intra-entity receivable/payable. Note: Consolidation entry (D) is not needed when the parent applies the initial value method because entry (I) eliminates the intra-entity dividend effects.

EXHIBIT 3.12 Consolidation Worksheet Subsequent to Year of Acquisition—Initial Value Method Applied

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As indicated here and in Exhibit 3.11, Parrot has recognized the yearly equity income accrual but not amortization. When the parent employs the partial equity method, the parent’s beginning Retained Earnings account must be adjusted to include this expense. Therefore, Entry *C provides the three-year $21,000 amortization total to simulate the equity method and, hence, consolidated totals.

Investment: Partial Equity Method

PARROT COMPANY AND SUN COMPANY Consolidation Worksheet

For Year Ending December 31, 2020

Accounts Parrot

Company Sun

Company

Consolidation Entries Consolidation

TotalsDebit Credit

Net income (960,000) (160,000) (953,000)

Statement of Retained Earnings Retained earnings, 1/1/20 Parrot Company (2,065,000)† * (*C) 21,000 * (2,044,000) Sun Company (600,000) (S) 600,000 –0– Net income (above) (960,000) (160,000) (953,000) Dividends declared 420,000 70,000 (D) 70,000* 420,000

Retained earnings, 12/31/20 (2,605,000) (690,000) (2,577,000)

Balance Sheet Current assets 1,705,000 500,000 (P) 40,000 2,165,000 Investment in Sun Company 1,110,000 * –0– (D) 70,000 (*C) 21,000 * –0–

(S) 820,000 (A) 179,000 (I) 160,000 *

Total assets 4,375,000 1,370,000 4,767,000

Total liabilities and equities (4,375,000) (1,370,000) 1,321,000 1,321,000 (4,767,000)

Note: Parentheses indicate a credit balance. *Boxed items highlight differences with consolidation in Exhibit 3.7. †See footnote 8. Consolidation entries: (*C) To convert parent’s beginning retained earnings to full accrual basis. (S) Elimination of Sun’s stockholders’ equity January 1 balances and the book value portion of investment account. (A) Allocation of Sun’s excess acquisition-date fair over book value, unamortized balance as of beginning of year. (I) Elimination of parent’s equity in subsidiary earnings accrual. (D) Elimination of intra-entity dividends. (E) Recognition of current year excess fair-value amortization and depreciation expenses. (P) Elimination of intra-entity receivable/payable.

EXHIBIT 3.13 Consolidation Worksheet Subsequent to Year of Acquisition—Partial Equity Method Applied

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Consolidation Entry *C

Retained Earnings, 1/1/20 (Parrot Company). . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000 Investment in Sun Company. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000 To convert parent’s beginning Retained Earnings from partial equity method to equity method by including excess amortizations.

By recording Entry *C on the worksheet, all of the subsidiary’s operational results for the 2017–2019 period are included in the consolidation. As shown in Exhibit 3.13, the remainder of the worksheet entries follow the same basic pattern as that illustrated previously for the year of acquisition (Exhibit 3.10).

Summary of Worksheet Procedures Having three investment methods available to the parent means that three sets of entries must be understood to arrive at reported figures appropriate for a business combination. The pro- cess can initially seem to be a confusing overlap of procedures. However, at this point in the coverage, only three worksheet entries actually are affected by the choice of either the equity method, partial equity method, or initial value method: Entries *C, I, and D. Furthermore, accountants should never get so involved with a worksheet and its entries that they lose sight of the balances that this process is designed to calculate. Exhibit 3.14 provides a summary of the final consolidated totals and how they are calculated. These figures are never affected by the parent’s choice of an accounting method.

After the appropriate balance for each account is understood, worksheet entries assist the accountant in deriving these figures. To help clarify the consolidation process required under each of the three accounting methods, Exhibit 3.14 describes the purpose of each worksheet entry: first during the year of acquisition and second for any period following the year of acquisition.

Discussion Question

In consolidation worksheet entry *C, we adjust the parent’s beginning of the year retained earnings to a full accrual basis. Why don’t we adjust to the parent’s end of the year retained earnings balance on the consolidated worksheet?

Clearly, in a consolidated balance sheet, we wish to report the parent’s end-of-period consolidated retained earnings at its full accrual GAAP basis. To accomplish this goal, we utilize the following sep- arate individual components of end-of-period retained earnings available on the worksheet.

Beginning of the year balance (after *C adjustment if parent does not employ equity method) + Net income (parent’s share of consolidated net income adjusted to full accrual by combining revenues and expenses—including excess acquisition-date fair value amortizations) − Dividends (parent’s dividends) = End of the year balance The worksheet provides for the computation of current year full accrual consolidated net

income via the income statement section. Dividends are already provided in the retained earn- ings section of the consolidated worksheet. The only component of the ending balance of retained earnings that requires a special adjustment (*C) is the beginning balance.

How does the consolidation worksheet entry *C differ when the parent uses the initial value method versus the partial equity method? Why is no *C adjustment needed when consolidated statements are prepared for the first fiscal year-end after the business combination?

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Current revenues Parent revenues are included. Subsidiary revenues are included but only for the period since the acquisition.

Current expenses Parent expenses are included. Subsidiary expenses are included but only for the period since the acquisition. Amortization expenses of the excess fair-value allocations are included by recognition on the worksheet.

Investment (or dividend) income

Income recognized by parent is eliminated and effectively replaced by the subsidiary’s revenues and expenses.

Retained earnings, beginning balance

Parent balance is included. The change in the subsidiary balance since acquisition is included either as a regular accrual by the parent or through a worksheet entry to increase parent balance. Past amortization expenses of the excess fair-value allocations are included either as a part of parent balance or through a work- sheet entry.

Assets and liabilities Parent balances are included. Subsidiary balances are included after adjusting for acquisition- date fair values less amortization to beginning of current period. Intra-entity receivable/payable balances are eliminated.

Goodwill Investment in subsidiary

Original fair-value allocation is included unless reduced by impairment. Asset account recorded by parent is eliminated on the worksheet so that the balance is not included in consolidated figures.

Capital stock and addi- tional paid-in capital

Parent balances only are included although they will have been adjusted at acquisition date if stock was issued.

*The next few chapters discuss the necessity of altering some of these balances for consolidation purposes. Thus, this table is not definitive but is included only to provide a basic overview of the consolidation process as it has been described to this point.

EXHIBIT 3.14 Consolidated Totals Subsequent to Acquisition*

Discussion Question

HOW DOES A COMPANY REALLY DECIDE WHICH INVESTMENT METHOD TO APPLY?

Pilgrim Products, Inc., buys a controlling interest in the common stock of Crestwood Corpora- tion. Shortly after the acquisition, a meeting of Pilgrim’s accounting department is convened to discuss the internal reporting procedures required by the ownership of this subsidiary. Each member of the staff has a definite opinion as to whether the equity method, initial value method, or partial equity method should be adopted. To resolve this issue, Pilgrim’s chief financial officer outlines several of her concerns about the decision.

I already understand how each method works. I know the general advantages and disad- vantages of all three. I realize, for example, that the equity method provides more detailed information whereas the initial value method is much easier to apply. What I need to know are the factors specific to our situation that should be considered in deciding which method to adopt. I must make a recommendation to the president on this matter, and he will want firm reasons for my favoring a particular approach. I don’t want us to select a method and then find out in six months that the information is not adequate for our needs or that the cost of adapting our system to monitor Crestwood outweighs the benefits derived from the data.

What are the factors that Pilgrim’s officials should evaluate when making this decision?

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Equity Method Applied Initial Value Method Applied Partial Equity Method Applied

Any Time during Year of Acquisition

Entry S Beginning stockholders’ equity of sub- sidiary is eliminated against book value portion of investment account. Same as equity method. Same as equity method.

Entry A Excess fair value is allocated to assets and liabilities based on difference in book values and fair values; residual is assigned to goodwill. Same as equity method. Same as equity method.

Entry I Equity income accrual (including amorti- zation expense) is eliminated. Dividend income is eliminated.

Equity income accrual is eliminated.

Entry D Intra-entity dividends declared by subsid- iary are eliminated.

No entry—intra-entity dividends are eliminated in Entry I. Same as equity method.

Entry E Current year excess amortization expenses of fair-value allocations are recorded. Same as equity method. Same as equity method.

Entry P Intra-entity payable/receivable balances are offset. Same as equity method. Same as equity method.

Any Time Following Year of Acquisition

Entry *C

No entry—equity income for prior years has already been recognized along with amortization expenses.

Increase in subsidiary’s book value during prior years and excess amortization expenses are recognized (conversion is made to equity method).

Excess amortization expenses for prior years are recognized (conversion is made to equity method).

Entry S Same as initial year. Same as initial year. Same as initial year.

Entry A Unamortized excess fair value at begin- ning of year is allocated to specific accounts and to goodwill. Same as equity method. Same as equity method.

Entry I Same as initial year. Same as initial year. Same as initial year.

Entry D Same as initial year. Same as initial year. Same as initial year.

Entry E Same as initial year. Same as initial year. Same as initial year.

Entry P Same as initial year. Same as initial year. Same as initial year.

EXHIBIT 3.15 Consolidation Worksheet Entries

Excess Fair Value Attributable to Subsidiary Long- Term Debt: Post-Acquisition Procedures In the previous consolidation examples for Parrot and Sun Company, the acquisition-date excess fair values were attributed solely to long-term assets. Similarly, however, the acquisition-date fair value of subsidiary long-term debt may also differ from its carrying amount. Although the long-term debt adjustment to fair value is relatively straightforward, the adjustments to interest expense in periods subsequent to acquisition require additional analysis.

In subsequent periods, the acquisition-date fair value adjustment to long-term debt is amor- tized to interest expense over the remaining life of the debt. When the acquisition-date fair value of subsidiary long-term debt exceeds its carrying amount on the subsidiary’s books, the parent increases the value of the debt reported on its consolidated balance sheet (and vice-versa). Conse- quently, when the parent reflects the increased value of the subsidiary’s long-term debt valuation, it must reduce interest expense recognized on the consolidated income statement over the debt’s remaining life. When the long-term debt valuation is decreased, interest expense increases.

Exhibit 3.16 summarizes the worksheet effects when acquisition-date long-term debt’s carrying amount differs from its fair value.

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At first glance, it may seem counterintuitive that when long-term debt is increased, inter- est expense is decreased. Certainly for plant assets like equipment, when we increase their carrying amounts to acquisition-date fair values on the worksheet, we increase the related depreciation expense. Why do we seem to do the opposite for long-term liabilities?

The answer can be seen in the fact that even though the acquisition-date value of the subsid- iary’s long-term debt exceeds its carrying amount, the acquisition does not affect the subsidiary’s contractual obligation for repaying the debt. The ultimate amount of debt to be repaid at maturity remains the same. For example, assume Pax Company acquires Sax Company on January 1, 2017. Exhibit 3.17 provides information about Sax Company’s long-term debt:

December 31, 2017, Consolidation Worksheet Consolidation Entry A Investment in Sax Company 5,000 Long-term debt 5,000 To adjust the subsidiary’s long-term debt to acquisition-date fair value.

Consolidation Entry E Long-term debt 1,000 Interest expense 1,000 To recognize the reduction in current year interest expense

December 31, 2018, Consolidation Worksheet Consolidation Entry A Investment in Sax Company 4,000 Long-term debt 4,000 To adjust the subsidiary’s long-term debt to unamortized balance as of the beginning of the year ($5,000 – $1,000 from year 2017). Consolidation Entry E Long-term debt 1,000 Interest expense 1,000 To recognize the reduction in current year interest expense

EXHIBIT 3.18 Worksheet Adjustments for Excess Acquisition-Date Fair Value Attributable to Subsidiary Long-Term Debt

Long-Term Debt January 1, 2017

Long-Term Debt Maturity Value

January 1, 2022

Fair value $105,000 $100,000 Carrying amount 100,000 100,000

EXHIBIT 3.17 Acquisition-Date Long- Term Debt Valuation

Long-Term Debt Valuation at Acquisition Date

Worksheet Adjustment to Long-Term Debt

Worksheet Adjustment to Interest Expense

Fair value > Carrying amount Increase long-term debt to adjust to fair value (less previous periods interest amortization)

Debit Long-Term Debt and credit Interest Expense

Fair value < Carrying amount Decrease long-term debt to adjust to fair value (less previous periods interest amortization)

Debit Interest Expense and credit Long-Term Debt

EXHIBIT 3.16 Long-Term Debt: Consolidation Worksheet Adjustments

By acquiring Sax, Pax has taken on $105,000 of fair value debt, but will only have to pay back $100,000 at the debt’s maturity date. As shown in Exhibit 3.18, the additional $5,000 excess fair over book value (that will not be repaid) is recognized as a reduction in overall inter- est expense, similar to amortizing a bond premium. Therefore, when consolidated statements are prepared, interest expense is reduced over the life of the long-term debt.

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Microsoft $5.1 billion Yahoo! 4.5 billion Devon Energy 1.9 billion Rent-a-Center 1.2 billion Time, Inc. 952 million J. Crew 676 million Staples 410 million The Hershey Company 31 million Pep Boys 23.9 million

EXHIBIT 3.19 Recent Goodwill Impairments

To complete this example, we assume the sole acquistion-date excess fair value adjust- ment made by Pax Company is to long-term debt, and straight-line amortization is used for the interest adjustments.

Finally, the carrying amount of a subsidiary’s long-term debt may exceed its fair value. In that case, a consolidation entry is required to decrease the long-term debt reported in the con- solidated balance sheet. Then, in periods subsequent to acquisition, worksheet entries are also needed to increase the amount of interest expense to be recognized in the consolidated income statement.

Goodwill Impairment FASB ASC Topic 350, “Intangibles—Goodwill and Other,” provides accounting standards for determining, measuring, and reporting goodwill impairment losses. Because goodwill is considered to have an indefinite life, an impairment approach is used rather than amortization. The FASB reasoned that although goodwill can decrease over time, it does not do so in the “rational and systematic” manner that periodic amortization suggests. Only upon recognition of an impairment loss (or partial sale of a subsidiary) will goodwill decline from one period to the next. Goodwill impairment losses are reported as operating items in the consolidated income statement.

The notion of an indefinite life allows many firms to report the original amount of good- will recognized in a business combination. However, goodwill can become impaired, requir- ing loss recognition and a reduction in the amount reported in the consolidated balance sheet. Evidence shows that goodwill impairment losses can be substantial. Exhibit 3.19 provides examples of some recent goodwill impairment losses. Unlike amortization, which periodi- cally reduces asset values, impairment must first be revealed before a write-down is justified. Accounting standards therefore require periodic tests for goodwill impairment.

Goodwill impairment tests are performed at the reporting unit level within a combined entity. As discussed next, all assets acquired (including goodwill) and liabilities assumed in a business combination must be assigned to reporting units within a consolidated enterprise. The goodwill residing in each reporting unit is then separately subjected to periodic impair- ment reviews. Current financial reporting standards require, at a minimum, an annual assess- ment for potential goodwill impairment.

Because impairment testing procedures can be costly, the FASB provides firms the option to first conduct a qualitative analysis to assess whether further testing procedures are appro- priate. If circumstances indicate a potential decline in the fair value of a reporting unit below its carrying amount, then further tests are required to see if goodwill is the source of the decline. Our coverage of goodwill impairment addresses the following:

∙ The assignment of acquired goodwill to reporting units. ∙ The option to conduct an annual qualitative test for potential goodwill impairment. ∙ Goodwill impairment testing procedures. ∙ A FASB proposal to simplify goodwill impairment testing. ∙ Comparison with international accounting standards.

LO 3-5

Discuss the rationale for the goodwill impairment testing approach.

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Assigning Goodwill to Reporting Units Combined companies typically organize themselves into separate units along distinct operat- ing lines. Each individual operating unit has responsibility for managing its assets and liabili- ties to earn profits for the combined entity. These operating units report information about their earnings activities to top management to support decision making. Such operating units are known as reporting units.

Following a business combination, the identifiable assets and liabilities acquired are assigned to the firm’s reporting units based on where they will be employed. Any amount assigned to goodwill also is assigned to reporting units expected to benefit from the synergies of the combination. Thus, any individual reporting unit where goodwill resides is the appro- priate level for goodwill impairment testing.

In practice, firms often assign goodwill to reporting units either at the level of a reporting segment—as described in ASC Topic 280, “Segment Reporting”—or at a lower level within a segment of a combined enterprise. Reporting units may thus include the following:

∙ A component of an operating segment at a level below that operating segment. Segment management should review and assess performance at this level. Also, the component should be a business in which discrete financial information is available and should differ economically from other components of the operating segment.

∙ The segments of an enterprise. ∙ The entire enterprise.

For example, Qorvo, Inc. is a wireless technology firm serving the mobile device, net- works infrastructure, and defense and aerospace markets. In its recent annual report Qorvo identified its two business segments, MP and IDP (Mobile Products and Infrastructure and Defense Products), as its reporting units:

For fiscal 2015, we have determined that our reporting units are MP and IDP for purposes of allo- cating and testing goodwill. . .Goodwill is allocated to our reporting units based on the expected benefit from the synergies of the business combinations generating the underlying goodwill.

Thus, all goodwill impairment testing is performed at the reporting unit level, rather than collectively at the combined entity level. Separate testing of goodwill within individual reporting units also prevents the masking of goodwill impairment in one reporting unit with contemporaneous increases in the value of goodwill in other reporting units.

Qualitative Assessment Option Because goodwill impairment tests require firms to calculate fair values for their reporting units each year, such a comprehensive measurement exercise can be costly. To help reduce costs, FASB ASC Topic 305 allows an entity the option to first assess qualitative factors to determine whether more rigorous testing for goodwill impairment is needed. The qualitative approach assesses the likelihood that a reporting unit’s fair value is less than its carrying amount. The more-likely-than-not threshold is defined as having a likelihood of more than 50 percent.

In assessing whether a reporting unit’s fair value exceeds its carrying amount, a firm must examine all relevant facts and circumstances, including

∙ Macroeconomic conditions such as a deterioration in general economic conditions, limita- tions on accessing capital, fluctuations in foreign exchange rates, or other developments in equity and credit markets.

∙ Industry and market considerations such as a deterioration in the environment in which an entity operates, an increased competitive environment, a decline (both absolute and rela- tive to its peers) in market-dependent multiples or metrics, a change in the market for an entity’s products or services, or a regulatory or political development.

∙ Cost factors such as increases in raw materials, labor, or other costs that have a negative effect on earnings.

∙ Overall financial performance such as negative or declining cash flows or a decline in actual or planned revenue or earnings.

LO 3-6

Describe the procedures for conducting a goodwill impair- ment test.

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∙ Other relevant entity-specific events such as changes in management, key personnel, strat- egy, or customers; contemplation of bankruptcy; or litigation.

∙ Events affecting a reporting unit such as a change in the carrying amount of its net assets, a more-likely-than-not expectation of selling or disposing all, or a portion of, a reporting unit, the testing for recoverability of a significant asset group within a reporting unit, or recognition of a goodwill impairment loss in the financial statements of a subsidiary that is a component of a reporting unit.

∙ If applicable, a sustained decrease (both absolute and relative to its peers) in share price. (FASB ASC para. 350-20-35-3C)

The underlying rationale for comparing a reporting unit’s fair value and carrying amount is as follows. If a reporting unit’s fair value is deemed greater than its carrying amount, then its col- lective net assets are maintaining their value. It then can be argued that a decline in any particular asset (i.e., goodwill) within the reporting unit is also unlikely and no further impairment tests are necessary. On the other hand, if the relevant facts and circumstances listed above suggest that a reporting unit’s fair value is likely less than its carrying amount, then more rigorous testing for goodwill impairment is appropriate. Nonetheless, a qualitative assessment of a sufficient fair value for a reporting unit circumvents further goodwill impairment testing.

The FASB ASC (paragraph 350-20-35-28) requires an entity to assess its goodwill for impairment annually for each of its reporting units where goodwill resides. Moreover, more frequent impairment assessment is required if events or circumstances change that make it more likely than not that a reporting unit’s fair value has fallen below its carrying amount.

Testing Goodwill for Impairment Goodwill impairment testing and measurement involves a two-step process.9 In contrast to the qualitative assessment, Steps 1 and 2 rely on quantitative fair-value measures for report- ing units as a whole and for their underlying individual assets and liabilities. If, after perform- ing the qualitative assessment described above, an entity concludes that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, then the entity is required to proceed to the first step of the two-step impairment test.10

Step 1: Is the Carrying Amount of a Reporting Unit More Than Its Fair Value? In the first step of impairment testing, the consolidated entity calculates fair values for each of its reporting units with allocated goodwill. Each reporting unit’s fair value is then compared with its carrying amount (including goodwill). If an individual reporting unit’s fair value exceeds its carrying amount, its goodwill is not considered impaired, and the second step in testing is not performed—goodwill remains at its current carrying amount. However, if the fair value of a reporting unit has fallen below its carrying amount, a potential for goodwill impairment exists. In this case, a second step must be performed to determine whether good- will has been impaired and to measure the amount of impairment.

Step 2: Is Goodwill’s Implied Value Less Than Its Carrying Amount? If Step 1 indicates potential goodwill impairment, Step 2 then compares the fair value of goodwill to its carrying amount. Because, by definition, goodwill is not separable from other assets, it is not possible to directly observe its fair value. Therefore, an implied fair value for goodwill is calculated in a similar manner to the determination of goodwill in a business com- bination. As stated in the FASB ASC (para. 350-20-35-14):

The implied fair value of goodwill shall be determined in the same manner as the amount of goodwill recognized in a business combination . . . That is, an entity shall assign the fair value of a 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 . . .

9 As discussed later in this chapter, FASB has proposed the elimination of step 2 of the goodwill impairment measurement procedure. 10 An entity, on the basis of its discretion, may bypass the qualitative assessment for any reporting unit in any period and proceed directly to performing the first step of the impairment test. An entity may resume per- forming the qualitative assessment in any subsequent period (FASB ASC para. 350-20-35-3B).

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Newcall’s Reporting Units Goodwill

Acquisition-Date Fair Values January 1, 2017

DSM Wired $22,000,000 $950,000,000 DSM Wireless 155,000,000 748,000,000 VisionTalk 38,000,000 502,000,000

DSM Wireless December 31, 2017, fair value $600,000,000 Fair values of DSM Wireless net assets at December 31, 2017: Current assets $ 50,000,000 Property 125,000,000 Equipment 265,000,000 Subscriber list 140,000,000 Patented technology 185,000,000 Current liabilities (44,000,000) Long-term debt (125,000,000)

Value assigned to identifiable net assets $596,000,000

Implied fair value of goodwill $ 4,000,000 Goodwill carrying amount before impairment 155,000,000

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