Under the partial equity method the parent recognizes income when

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chapter

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.