©cambridge business publishing, 2010 consolidation subsequent to acquisition passage of time...

©Cambridge Business Publishing, 2010©Cambridge Business Publishing, 2010

Consolidation Subsequent to Acquisition

Passage of time affects revaluations of subsidiary assets and liabilities Triggers effects on

Income statement amounts The investment account on the parent’s

books due to use of the complete equity method

1


Complete Equity Method Used internally by parent company Differs from the equity method used for

external reporting

2

Impairment losses on indefinite life

intangibles including goodwill

Impairment losses on indefinite life

intangibles including goodwill

No equity in net income

adjustment for impairment

Unconfirmed profits on

downstream sales

Unconfirmed profits on

downstream sales

Internal ReportingInternal Reporting External ReportingExternal Reporting

Equity in net income reduced for impairment

losses

All unconfirmed downstream profits are deducted

Deducted to the extent of the

investor’s ownership interest


Goals of the Consolidation Elimination Process

Eliminates equity method income on the parent’s books and declared dividends on the subsidiary’s books

Eliminates stockholders’ equity accounts on the subsidiary’s books against the investment account on the parent’s books

Adjusts the subsidiary’s assets and liabilities for remaining acquisition date revaluations and eliminate the remainder of the investment balance

Adjusts reported expenses for current year revaluation write-offs

3


Eliminating Entries4

Current – Eliminate the current year equity method entries

Equity – Eliminate subsidiary’s beginning-of-year equity balances

Revalue – Recognize the beginning-of-current-year fair value revaluations

Write-Off – Recognize current year revaluation write-offs


Consolidation Process ExampleSuppose Time Warner pays $75 million for Midwest Cable on January 1, 2010. Midwest’s book value is $10 million. Book and fair values are the same except for equipment with fair value $15 million higher than book value. Midwest has unreported identifiable intangibles valued at $2 million.

5

Acquisition cost $75,000,000Book value of Midwest Cable 10,000,000Cost in excess of Midwest Cable's book value 65,000,000Differences between fair value and book value: Equipment $15,000,000 Identifiable intangibles 2,000,000 17,000,000

Goodwill $48,000,000

Acquisition analysis:


Consolidation Process Example continued

6

Midwest reports net income of $5 million and declares and pays cash dividends of $1 million to Time Warner in 2010. Revalued equipment has a remaining life of 20 years. Identifiable intangibles have 4 years of remaining life. Straight-line depreciation and amortization is used. Goodwill is not impaired.

Complete equity method:

Midwest Cable's reported income for 2010 $5,000,000.Adjustments for revaluation write-offs: Equipment ($15,000,000/20) (750,000)Identifiable intangibles ($2,000,000/4) (500,000)

Equity in income of Midwest Cable $3,750,000



Time Warner’s booksTo record equity in net income for 2010:

7

Investment in Midwest Cable 3,750,000 Equity in income of Midwest Cable 3,750,000

To record dividends received in 2010:Cash 1,000,000 Investment in Midwest Cable 1,000,000

Investment in Midwest Cable75,000,000

3,750,000 1,000,000

77,750,000



8

Eliminating entries at December 31, 2010:To eliminate equity in net income on the parent's books, dividends on the subsidiary's books, and restore the investment account to its beginning-of-year value:

(C) Equity in income of Midwest Cable 3,750,000 Dividends 1,000,000 Investment in Midwest Cable 2,750,000

To eliminate the subsidiary's beginning-of-year equity accounts against the investment account:

(E) Common stock, par 100,000 Additional paid-in capital 400,000 Retained earnings, January 1 9,500,000

Investment in Midwest Cable 10,000,000



9

Eliminating entries at December 31, 2010:To recognize the beginning-of-year revaluations and eliminate the remainder of the investment account balance:

(R) Plant and equipment, net 15,000,000 Identifiable intangibles 2,000,000 Goodwill 48,000,000

Investment in Midwest Cable 65,000,000

To write off equipment and identifiable intangibles revaluations for the current year, by recognizing additional depreciation and amortization expense:(O) Operating expenses 1,250,000

Plant and equipment, net 750,000 Identifiable intangibles 500,000


Consolidation Working Paper for Time Warner and Midwest Cable

10

Exhibit 4.1


Consolidated Financial Statements for Time Warner and Midwest Cable

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Consolidated Financial Statements for Time Warner and Midwest Cable

12


Complete Equity Method Also known as ‘one-line consolidation’

13

=

=

Equivalence of parent’s net income and consolidated net income Exhibit 4.2


One-Line Effects on Investor’s Books14

Investee’s assets and liabilities

Investor’s Balance SheetAssets: Investment in subsidiary…….$ xx

Investee’s revenues

and adjusted expenses

Investor’s Income StatementOther revenue: Equity in income………..…….$ xx


Revaluations in Subsequent Years

Requires recognition of write-offs of reported revaluations over time

Inventories Write off in year of reported sale

Plant and equipment Write off each year of useful life

Previously unreported intangibles Write off each year of useful life, or if impaired

Long-term debt Write off premium/discount over remaining life

Reported in eliminating entry ‘O’

15


Revaluations of InventoriesThe book value of a subsidiary’s inventory acquired on January 1, 2011 is $800,000, with its fair value at $1 million. FIFO is used.

16

Subsidiary’s accounting records:

Cost of goods sold 800,000 Inventory 800,000

Cost of goods sold on consolidated income statement $1,000,000Cost basis of beginning inventory 800,000Eliminating adjustment on working paper $ 200,000

Consolidation working paper: Eliminating entry to revalue cost of sales to acquisition cost:

To record sale of beginning inventory during 2011:

Calculate the adjustment to be made:

(O) Cost of goods sold 200,000 Inventory 200,000


Revaluations of Depreciable Assets17

The book value of a subsidiary’s equipment on January 1, 2011 is $50 million, with its fair value at $70 million, with a remaining useful life of 10 years and no residual value. Straight-line depreciation is used.

Annual depreciation recorded by subsidiary ($50 M ÷ 10 yrs) $5,000,000Depreciation at fair value ($70 M ÷ 10 yrs) 7,000,000Additional depreciation on working paper $2,000,000

Consolidation working paper: Eliminating entry to revalue depreciation to reflect fair value at date of acquisition:

(O) Depreciation Expense 2,000,000 Plant and equipment, net * 2,000,000

*or accumulated depreciation


Revaluations of Long-Term Debt

The subsidiary reports $100 million of 5% bonds payable at January 1, 2011, issued in 2010 at par, and due on December 31, 2020. The fair value of the bonds is $90 million on January 1, 2011.

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Bond discount amortization: $10,000,000 ÷ 10 years = $1,000,000

Consolidation working paper: Eliminating entry to amortize bond discount for 2011:

(O) Interest expense 1,000,000 Bonds payable (or bond discount) 1,000,000


Previously Reported Intangibles With Limited Lives

Amortized over estimated useful life Amortized amount equal to recorded

amount of the asset less estimated residual value (usually zero)

Amortization method reflects the pattern in which the economic benefits are consumed Generally straight-line method

19

Examples: Favorable lease agreements and customer lists


Previously Reported Intangible Assets with Indefinite Lives

If no factors appear to limit the intangible asset’s life, the life is deemed to be indefinite

Examples Brand names Franchises Goodwill Acquired in-process research and

development

20


Impairment Testing for Intangibles Other Than Goodwill

If carrying amount of the asset exceeds its fair value Recognize an impairment loss

Once impairment loss is recorded, no reversal is allowed for increases in value

Guided by SFAS 144

21


Impairment Testing for Intangibles Other Than Goodwill

Two step process

22

Step 1: Undiscounted cash flows expected from the future use of the asset and its subsequent

dispositionLess Than

Asset’s carrying value?

Impairment has incurred

Yes

No impairment

No Step 2: Amount of loss = Book value of intangible asset

less Present value of the future

cash flows


Goodwill

An indefinite life intangible Per SFAS 142, must be regularly tested for

impairment Impairment losses reported in the operating

section of the income statement If material, reported as a separate line item

Goodwill has meaning only in the context of a business unit Represents a variety of intangible benefits

connected with that business, beyond its tangible and identifiable intangible net assets

23


Goodwill Impairment

Testing required at least annually unless circumstances indicate the likelihood of impairment is remote

More frequent testing needed for A significant downturn in the business climate Adverse legal or regulatory outcomes Unanticipated new competition Loss of key personnel Expectation that a reporting unit will be sold

24


Impairment Testing for GoodwillTwo step process

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Step 1: Is fair value of the reporting unit

Less ThanCarrying value?

Impairment may be incurred

Yes

No impairment

No Step 2: Estimate implied fair value of the reporting unit’s goodwill.

Is the implied fair value Less Than

its carrying amount?

Impairment is incurred

Yes

No

Write-off is required


Amortization of Specific IntangiblesExample

On January 1, 2012, Primus Telecommunication Group acquires all of the voting stock of Matrix Internet. Previously unrecorded intangibles at acquisition are:

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Intangible asset (in millions) Fair Value Useful LifeCustomer Lists $150 5 yearsBrand names 240 4 years

Customer lists $150 ÷ 5 = $30Brand names $240 ÷ 4 = $60Total amortization expense $90

2012 amortization (in millions):

Must be assessed for impairment at least annually


Impairment of Specific Intangibles Example continued

The following information is provided by Primus at December 31, 2012:

27

Intangible asset (in millions)

Total expected future cash inflows,

undiscounted

Total expected future cash inflows, discounted

Customer lists $100 $80Brand names 200 125

Impairment loss (in millions):

Impairment loss of $40 million must be reported.

Identifiable intangible

(in millions) Book value

Step 1 Step 2 Book value greater than undiscounted

cash flow?

Impairment loss = Book value less

discounted cash flowCustomer lists $150 - $30 = $120 Yes ($120 > $100) $120 - $80 = $40Brand names $240 - $60 - $180 No ($180 < $200)


Impairment of Goodwill ExamplePrimus Telecommunication Group acquires all of the voting stock of Matrix Internet with goodwill as follows:

28

Impairment testing at the end of the year:Step 1 - Compare the fair value to the book value of each reporting unit.

Intangible asset Fair Value Useful Life

Goodwill $3,200 million Indefinite

Goodwill assigned to Broadband unit $1,920 millionGoodwill assigned to Wholesale Carrier unit 1,280 millionTotal goodwill $3,200 million

Broadband Wholesale CarrierFair value of unit $17,600 million. $8,640 million.Book value of unit (15,040) million (8,960) millionDifference $ 2,560 million. $ (320) million

Goodwill may be impaired


Impairment of Goodwill Example continued

Step 2 - Compare fair value of the unit to the fair value of the identifiable net assets of the unit:

29

Fair value of Wholesale unit $8,640 millionFair value of identifiable net assets of Wholesale 7,520 millionCurrent fair value of goodwill 1,120 millionCarrying amount of goodwill 1,280 millionDifference $ 160 million

Goodwill assigned to Wholesale Carrier is impaired by $160 million.

To record amortization expense and impairment losses on previously unreported intangibles and goodwill for 2012:(O) Amortization expense 90,000,000 Impairment loss on identifiable intangibles 40,000,000 Goodwill impairment loss 160,000,000

Customer lists 70,000,000 Brand names 60,000,000 Goodwill 160,000,000


Consolidation in Subsequent Years Illustration

IBM buys all of the voting stock of DataFile, Inc. on July 1, 2010 for $25 million cash. DataFile’s book value was $5.3 million.

30

Goodwill calculation:Acquisition cost $25,000,000Book value of DataFile 5,300,000Cost in excess of DataFile's book value 19,700,000Differences between fair value and books value:

Current assets $ (300,000) Plant and equipment;, net 10,000,000

Patents and copyrights 4,000,000 Brand names 1,000,000

Lease agreements 600,000

Customer relationships 3,000,000

Long-term debt (2,000,000) 16,300,000Goodwill $ 3,400,000


Consolidation in Subsequent Years Illustration continued

Exhibit 4.3

31

Revaluation Write-Off information for DataFile Acquisition:


Consolidation after One Year Illustration continued

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DataFile reports income of $3 million and paid dividends of $400,000 to IBM during its fiscal year ending June 30, 2011.

Equity in income calculation:DataFile's reported income for fiscal 2011 $ 3,000,000 Adjustments for revaluation write-offs of:

Current assets (cost of goods sold) 300,000 Plant and equipment (depreciation expense) (400,000)Patents and copyrights (amortization expense) (800,000)Brand names (impairment loss) (100,000)Lease agreements (amortization expense) (300,000)Customer relationships (amortization expense) (1,000,000)Long-term debt (Interest expense) 500,000

Equity in income of DataFile $ 1,200,000



33

DataFile reports income of $3 million and paid dividends of $400,000 to IBM during its fiscal year ending June 30, 2011.

Equity method entries on IBM’s books during fiscal 2011:

To record equity in net income for fiscal 2011:

To record dividends received in fiscal 2011:

Investment in DataFile 1,200,000 Equity in income of DataFile 1,200,000

Cash 400,000 Investment in DataFile 400,000

Investment in DataFile25,000,000

1,200,000 400,000

25,800,000

Balance in investment account


Consolidation Working Paper after One Year Illustration continued

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Exhibit 4.4



35

Eliminating entries:

To eliminate equity in net income on the parent's books, dividends on the subsidiary's books, and restore the investment account to its beginning-of-the year value:

(C) Equity in income of DataFile 1,200,000 Dividends 400,000 Investment in DataFile 800,000

To eliminate the subsidiary's beginning-of-year equity accounts against the investment account balance:

(E) Common stock, par 500,000 Additional paid-in capital 2,000,000 Retained earnings, July 1 2,800,000

Investment in DataFile 5,300,000



36


To recognize the beginning-of-year revaluations and eliminate the remainder of the investment account balance:

(R) Plant and equipment, net 10,000,000 Patents and copyrights 4,000,000 Brand names 1,000,000 Lease agreements 600,000 Customer relationships 3,000,000 Goodwill 3,400,000

Current assets 300,000 Long-term debt 2,000,000 Investment in DataFile 19,700,000



37

Eliminating entries: To adjust current year cost of goods sold to reflect inventory revaluation:

(O-1) Current assets 300,000 Cost of goods sold 300,000

To adjust current year depreciation expense to reflect plant and equipment revaluation:

(O-2) Operating expense (depreciation) 400,000 Plant and equipment, net 400,000

(O-3) Operating expense (amortization) 2,100,000 Patents and copyrights 800,000 Lease agreements 300,000 Customer relationships 1,000,000

To adjust current year amortization expense to reflect revaluations of limited life intangibles:



38

Eliminating entries: To adjust current year interest expense to reflect long-term debt revaluation:

(O-4) Long-term debt 500,000 Operating expense (interest) 500,000

To record brand names impairment for the current year:

(O-5) Operating expense (impairment loss) 100,000 Brand names 100,000



39

Consolidated financial statements:



40



Consolidation after Two Years Illustration

41

DataFile reports income of $3.5 million and pays dividends of $200,000 for its fiscal year ending June 30, 2012. Year-end impairment testing reveals no impairment loss for brand names, and $700,000 impairment to goodwill.

Calculation of equity in income of DataFile for 2012:

DataFile's reported income for fiscal 2012 $ 3,500,000 Adjustments for revaluation write-offs of:

Plant and equipment (depreciation expense) (400,000)Patents and copyrights (amortization expense) (800,000)Lease agreements (amortization expense) (300,000)Customer relationships (amortization expense) (1,000,000)Long-term debt (Interest expense) 500,000 Goodwill (Impairment loss) (700,000)

Equity in income of DataFile $ 800,000


Consolidation after Two Years Illustration

42

DataFile reports income of $3.5 million and paid dividends of $200,000 to IBM during its fiscal year ending June 30, 2012.

Equity method entries on IBM’s books during fiscal 2012:

To record equity in net income for fiscal 2012:

To record dividends received in fiscal 2012:

Investment in DataFile 800,000 Equity in income of DataFile 800,000

Cash 200,000 Investment in DataFile 200,000

Investment in DataFile25,800,000

800,000 200,000

26,400,000

Balance in investment account


Consolidation after Two Years Illustration continued

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Exhibit 4.5



44


To eliminate equity in net income on the parent's books, dividends on the subsidiary's books, and restore the investment account to its beginning-of-the year value:

(C) Equity in income of DataFile 800,000 Dividends 200,000 Investment in DataFile 600,000

To eliminate the subsidiary's beginning-of-year equity accounts against the investment account:

(E) Common stock, par 500,000 Additional paid-in capital 2,000,000 Retained earnings, July 1 5,400,000

Investment in DataFile 7,900,000



45


To recognize the beginning-of-year revaluations and eliminate the remainder of the investment account balance:

(R) Plant and equipment, net 9,600,000 Patents and copyrights 3,200,000 Brand names 900,000 Lease agreements 300,000 Customer relationships 2,000,000 Goodwill 3,400,000

Long-term debt 1,500,000 Investment in DataFile 17,900,000



46


To adjust current year depreciation expense to reflect plant and equipment revaluation:

(O-1) Operating expense (depreciation) 400,000 Plant and equipment, net 400,000

(O-2) Operating expense (amortization) 2,100,000 Patents and copyrights 800,000 Lease agreements 300,000 Customer relationships 1,000,000

To adjust current year amortization expense to reflect revaluations of limited life intangibles:



47

Eliminating entries: To adjust current year interest expense to reflect long-term debt revaluation:

(O-3) Long-term debt 500,000 Operating expense (interest) 500,000

To record goodwill impairment for the current year:

(O-4) Operating expense (impairment loss) 700,000 Goodwill 700,000



48




49



IFRS for Acquired Specific Intangibles

IAS 38 criteria to be reportable Intangible must be either separable or

contractual Similar to U.S. GAAP

Generally carried at cost less accumulated amortization and impairments IFRS allows fair value reporting in limited

circumstances

50


Intangibles Reported Using the Cost Model Under IFRS

Intangibles with limited lives Amortized over the period the intangible is

expected to produce cash flows Amortization methods same as for plant and

equipment Estimates used in reporting periodic

amortization must be reviewed regularly Estimated changes reflected in future periods only

Intangibles with indefinite lives Not amortized Assumptions must be reassessed each period

51

Same as U.S. GAAP

Same as U.S. GAAP


Intangibles Reported Using the Cost Model Under IFRS

All identifiable intangibles reported at cost are subject to impairment testing

Impairment testing differs from U.S. GAAP IAS 36 impairment testing

52

Book value

Asset’s ‘Value-in-use’ (Generally present value of future expected cash flows)

Net market value (fair value less selling costs)

Compared toor

Greater of

One-Step Test


Intangibles Reported Using the Cost Model Under IFRS Example

53

The following information is provided by Primus at December 31, 2012:

There is no active market for the intangibles.

Impairment loss:

U.S. GAAP impairment loss = $40 million

IFRS impairment loss = $95 million

Customer lists$120,000,000 – $80,000,000 = $40,000,000

Brand names$180,000,000 – $125,000,000 = 55,000,000

Total impairment loss $95,000,000

Intangible asset (in millions)

Book valueTotal expected

future cash inflows, undiscounted

Total expected future cash inflows,

discountedCustomer lists $120 $100 $80 Brand names 180 200 125


Intangibles Reported Using Revaluation Model Under IFRS

54

IAS 38 defines fair value as market value Mark-to-market allowed under IFRS

Limited to intangibles traded in an active market Examples: Liquor licenses in some states,

franchise rights Increases in value reported directly in equity

Except for reversals of previously reported impairment losses

Decreases in value reported directly in equity Except for reductions exceeding previous

increases which are reported in income


Intangibles Reported Using Revaluation Model Under IFRS Example

55

Generic computer software valued at $10 million with an active trading market is acquired in a business combination on January 1, 2011. The software has a 5-year estimated life, and no residual value. Straight-line amortization is used. Fair value at December 31, 2011 is $12,000,000.

To record amortization on the computer software for 2011:Annual amortization = $10,000,000 ÷ 5 years = $2,000,000

Amortization expense 2,000,000 Computer software 2,000,000

Computer software 4,000,000 Revaluation surplus (OCI) 4,000,000

To revalue the computer software to fair value as of December 31, 2011:$12,000,000 – [$10,000,000 – $2,000,000] = $4,000,000


Intangibles Reported Using Revaluation Model Under IFRS Example continued

56

Fair value at December 31, 2012 is $8,000,000. The adjusted basis is $12,000,000 fair value at end of 2011.

To record amortization on the computer software for 2012:

Amortization expense 3,000,000 Computer software 3,000,000

Revaluation surplus (OCI) 1,000,000 Computer software 1,000,000

To revalue the computer software to fair value as of December 31, 2012:

$8,000,000 – [$12,000,000 – $3,000,000] = ($1,000,000)

Annual amortization = $12,000,000 ÷ 4 years = $3,000,000


Goodwill Impairment Under IFRS57

Differs from U.S. GAAP in two ways

1.Goodwill is allocated to ‘cash generating units’ (CGUs), not operating units

2.One step computation of impairment loss Book value less fair value of the CGU Loss limited to carrying value of goodwill

IFRS impairment loss likely to be higher than under U.S. GAAP.


Goodwill Impairment Under IFRS

58

Primus Telecommunication Group acquires all of the voting stock of Matrix Internet on January 1, 2012. Information on December 31, 2012 values is as follows:

Amounts in millionsBook value of goodwill

Fair value of CGU

Book value of CGU

Fair value of identifiable net

assetsBroadband internet $ 320 $ 8,000 $ 4,800 $ 7,040 Broadband data 1,600 9,600 10,240 8,640 Wholesale VoIP 960 4,800 5,440 4,480 Wholesale data services 320 3,840 3,520 3,040 Totals $3,200 $26,240 $24,000 $23,200


Goodwill Impairment Under IFRS continued

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Comparing each unit’s book value with its fair value:

Book value exceeds fair value so impairment loss of $1,280,000,000 must be recognized

(in millions)Broadband

InternetBroadband

DataWholesale

VoIP

Wholesale Data

ServicesFair value of CGU $8,000 $9,600 $4,800 $3,840Book value of CGU 4,800 10,240 5,440 3,520Impairment? No Yes Yes NoImpairment loss - $640 $640 -

U.S. GAAP impairment loss = $160,000,000IFRS impairment loss = $1,280,000,000

©cambridge business publishing, 2010 consolidation subsequent to acquisition passage of time...

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