Business Combinations & ConsolidationsMAROOF H. SABRI

CPA

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Contents1. When to Consolidate and When not to?

2. Acquisition Method

3. Intercompany Entries

4. Consolidation Working Paper

5. Combined Financial Statements and how do they differ from Consolidated Financial Statements

6. Adjustments in Detail

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Consolidated Financial Statements Consolidated Financial Statements:• Mean one set of financial statements is presented for both Parent and Subsidiaries

• Are more meaningful that Separate Financial Statements

• Necessary for Fair representation of an Entity as a whole

• Emphasize “substance over form”• Economic substance is preferred over legal relationships

• Can not be represented by using of Equity Method instead of Consolidated Financial Statements

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Consolidated Financial Statements -Limitations•Some stakeholders remain uniformed of subsidiaries financial statements:• Non Controlling interest Shareholders

• Creditors of Subsidiaries

•Distortion of Results• Offsetting of financial performance of one subsidiary against another one

•Unreliable Analysis • Due to aggregation and non availability of separate financial statements

(Segment reporting does provide some information but not equivalent to separate Financial statements)

•Retained Earnings• Only Parents retained earnings are presented, no separation of individual subsidiaries’ retained

earnings

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When to Consolidate?Ownership Significant Influence Method Consolidate?

Less than 20% No Cost Method Do not Consolidate

Less than 50% Yes Equity Method Do not Consolidate

More than 50% Yes Consolidation Consolidate

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Cost Method•Investor owns < 20% of Investee, with NO Significant Influence

•If Significant Influence – Use Equity Method

•Liquidated Dividends – Reduce Investment

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Cost Method – Balance Sheet Presentation

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•Presented as Investment:

•Trading Securities (or) Cost + Unrealized Gains- Unrealized Losses –Liquidating Dividends

•Available for Sales SecuritiesCost + Unrealized Gains- Unrealized Losses –Liquidating Dividends

Balance Sheet

Cost Method – Income Statement Treatment

•Unrealized Gains - Income

•Cash Dividends - IncomeTrading

Securities

•Unrealized Gains – Other Comprehensive Income

•Cash Dividends - Income

Available for Sales Securities

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Equity Method•Typically 20 to 50% Ownership

•If ownership less than 20% BUT significant influence exists

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Equity Method – Balance Sheet Presentation•Presented in Investment Account

Cost of Investment

+ % of Net Income of Investee- % of Cash Dividends distributed by Investee

- FV Adjustment – Depreciation

= Investment to be Reported in Balance Sheet

Fair Value (FV) Adjustement is the difference between Fair Value and Book Value of Investee

FV Adjustments of PPE are subject to Depreciation, excluding Land

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Equity Method – Income Statement Treatment•Results of Operations f Investees are recorded as Income of Investee times % Holding

•Dividends distributed DO NOT affect Income statement since they affect Investment account on balance sheet

•Fair Value Adjustments and Depreciation are recorded in income statement

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ConsolidationBUSINESS COMBINATIONS AND CONSOLIDATIONS

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When to Consolidate?•When a Parent-Subsidiary Relationship is formed, Consolidated Financial Statements are used, treating both subsidiary and parent company as one entity

•If Ownership is more than 50% - Investor is Parent of Investee Company

•More than 50% Ownership means – Control of Subsidiary – Consolidated FS are needed

•Presenting Consolidated Financial Statements is more meaningful and required by GAAP

•Do not Consolidate if Parent doesn’t have control of subsidiary even though holding more than 50% of ownership• Bankruptcy

• Legal Reorganization

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Accounting Standards IFRS 3 (2008) resulted from a joint project with the US Financial Accounting Standards Board (FASB) and replaced IFRS 3 (2004). FASB issued a similar standard in December 2007 (SFAS 141(R)). The revisions result in a high degree of convergence between IFRSs and US GAAP in the accounting for business combinations, although some potentially significant differences remain.

For More details on IFRS 3, please visit below link:

https://www.iasplus.com/en-us/standards/international/ifrs-en-us/ifrs3

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Acquisition Method •Acquisition Method is used for Business Combination by both US GAAP and IFRS

•Two Main Principles applied while using Acquisition Method:1. Recognition Principle – All Subsidiary’s assets and liabilities are recognized

2. Measurement Principle – Measure all recognized assets and liabilities at Acquisition Date Fair value.

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Acquisition Method •Investment is Valued at Fair Value of Consideration given or received whichever is more clearly evident

•Investment by Acquirer can be through any of below:• Cash

• Issuance of Shares

• Issuance of Debt Securities

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Acquisition Method – Treatment of Costs•Accounting treatment of different Costs involved in Acquisition method are:• Direct and Indirect Costs – expensed out

• If Acquisition is done by issuing new shares - Stock Issuance costs reduce the Paid-in-Capital

• If Acquisition is done by issuing debt securities (Bonds) – Debt Issuance Costs are Capitalized and Amortized

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Acquisition Method – Recording of Investment• Accounting for Acquisition begins at date of acquisition

• Acquirer adjusts its financial statements with below entriesDebit – Investment in Subsidiary

Credit – Cash (If cash is paid) OR

Credit – Common Stock (at Par)

Credit – Additional Paid in Capital (Fair Value of common stock less Par Value of Common Stock)

• Above entries are done in Acquirer’s Financial Statements at date of Acquisition

• What is Acquisition Price?• Acquisition price is the consideration given or received and always equal to Investment in Subsidiary

• After making above Entries, Consolidation Entries are done

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Acquisition Method – Adjustments• After recording Investment in Subsidiaries, below adjustments are made during consolidation:

1. Eliminate Equity of Subsidiary

2. Eliminate Investment in Subsidiary

3. Create Non Controlling Interest if subsidiary is not acquired 100%

4. Adjust the Balance Sheet of Subsidiary to Fair Value

5. Record Identifiable Intangible Assets of Subsidiary at Fair Value

6. Calculate and create good will or record gain otherwise

A comprehensive example is provided in end of this presentation

In next slides, a brief overview of Acquisition Method presented

All these adjustments are explained in detail in last section of this presentation

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Acquisition Method – Adjustments1. Eliminate Equity of Subsidiary

◦ Adjustments are made on the Consolidating working papers

◦ All the equity accounts of subsidiary are debited (or credited if they have debit balances) at date of acquisition with pre-acquisition account balances

◦ Consolidated Equity is Parent’s equity plus any Non Controlling Interest

◦ Non Controlling Interest will be discussed later…

2. Eliminate Investment in Subsidiary ◦ On consolidated working paper, Investment in Subsidiary account of Parent is eliminated

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Acquisition Method – Adjustments3. Create Non Controlling Interest

• Since whole of subsidiary’s Pre-Acquisition equity is eliminated, a Non Controlling Interest (NCI) is created.

• NCI is not created for fully owned subsidiaries

• NCI is created during Consolidation through Elimination Entry

• On Financial Statements• NCI is presented separate from parent’s equity in Consolidated Equity section.

• NCI Is calculated by multiplying Fair Value of Subsidiary x Non Controlling percentage

• NCI must be recognized as a line item and deducted, calculated by multiplying Subsidiary’s Income with NCI percentage

• Comprehensive income attributable to NCI is shown separately on Consolidated statement of comprehensive income

• A reconciliation for NCI at beginning and end of period is also shown on Consolidated Statement of Changes in Equity

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Acquisition Method – Adjustments4. Adjust the Balance Sheet of Subsidiary to Fair Value

◦ All balance sheet accounts are adjusted to Fair value

◦ This adjustment is a must and has nothing to do with Acquisition price

◦ This adjustment is needed for full fair value of assets and liabilities of subsidiary even if it’s a partial ownership

◦ Accomplished through elimination journal entry on consolidation workpaper

5. Record Identifiable Intangible Assets of Subsidiary at Fair Value◦ Parent records all Identifiable Intangible Assets of subsidiary even if they are acquired initially at

zero cost.

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Acquisition Method – Adjustments6. Calculate and create good will or record gain otherwise

◦ Good will = Excess of Acquisition cost plus non controlling interest over the Fair Value of Net Assets of Subsidiary

◦ Good will is debited on Consolidated Financial Statements

◦ In case if the resultant figure is negative, recognize a gain

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Acquisition Method – Adjustments•Elimination Entry is summarized as below:

Debit – All Equity Accounts of Subsidiary (Common stock, Additional paid up capital, retained earnings etc)

Credit – Investment in Subsidiary

Credit –Non Controlling InterestDebit – Fair Value adjustments to Balance Sheet accounts(or Credit if its lower than Book Value)

Debit – Identifiable intangible Assets at Fair Value

Debit – Good will (Or Credit Gain)

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Acquisition Method – Adjustments

Fair Value of Subsidiary = Acquisition Price + FV Non Controlling Interest

Good Will = Fair Value of subsidiary – Fair Value of Subsidiary’s Net Assets

Fair Value Adjustments = Fair Value of Subsidiary’s Net Assets – Fair Value of Subsidiary’s Book value

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Elimination of Intercompany Transactions•During preparation of Consolidated Financial Statements all Intercompany transactions are eliminated.

1. Intercompany payables and receivables are eliminated 100%

2. Intercompany Sales and Purchases are eliminated 100%

3. Intercompany Fixed Assets transactions, Eliminate Gain on Sale/Depreciation Expenses

4. Gain and Loss on Intercompany sales of Land is unrecognized and recognized in case of subsequent sales to third party outside of parent – subsidiary group.

5. Interest Income and Interest Expenses are removed if the borrowings are from one another.

6. Intercompany inventory adjustment – Remove the element of profit recognized in one company if there is an inventory held by other company on balance sheet date

7. If debt of one company is acquired by another company, Gain/loss is recognized in the consolidated financial statements through elimination entry

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Consolidation – Comprehensive Example

Please refer to the case study handed over to you

Use the spreadsheet and prepare consolidated financial statements

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Combined Financial Statements•What are combined Financial Statements

•Why they are needed

•How do they Differ from Consolidated FS

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Combined Financial Statements1. Combined Financial Statements are prepared when there is no parent subsidiary

relationship but the companies are related to each other through1. Common Control

2. Companies under same management

3. An individual owns many companies

4. Many unconsolidated subsidiaries are combined for example foreign subsidiaries

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Combined Financial Statements1. When different companies are combined:

1. Since there is no parent-subisidiary relationship, capital stock and retained earnings are added up instead of elimination

2. Income statement is added across all subsidiaries

3. Intercompany balances and transactions are eliminated

4. Non Controlling interest is calculated and presented in the same way as in Consolidated Financial Statements

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