How Does a Company Really Decide which Investment Method to Apply?
Students can come up with literally dozens of factors that should be considered by Pilgrim in making the decision as to the method of accounting for its subsidiary, Crestwood Corporation. The following is simply a partial list of possible points to consider.
� Use of the information. If Pilgrim does not monitor its own income levels closely, applying the equity method would seem to be a waste of time and energy. A company must plan to use the additional data before the task of accumulation becomes worthwhile.
� Size of the subsidiary. If the subsidiary is large in comparison to Pilgrim, the effort required of the equity method may be important. Income levels would probably be significant. However, if the subsidiary is actually quite small in relation to the parent, the impact might not be material enough to warrant the extra effort.
� Size of dividend payments. If Crestwood pays out most of its earnings each period as dividends, that figure will approximate equity income. Little additional information would be accrued by applying the equity method. In contrast, if dividends are small or not paid on a regular basis, a Dividend Income balance might vastly understate the profits to be recognized by the business combination.
� Amount of excess amortizations. If Pilgrim has paid a significant amount in excess of book value so that annual amortization charges are quite high, use of the equity method might be preferred to show the effect of this expense each month (or whenever internal reporting is made). In this case, waiting until the end of the year and recording all of the expense at one time through a worksheet entry might not be the best way to reflect the impact of the expense.
� Amount of intercompany transactions. As with amortization, the volume of transfers can be an important element in deciding which accounting method to use. If few intercompany sales are made, monitoring the subsidiary through the application of the equity method is less essential. Conversely, if the amount of these transactions IS significant, the added data can be helpful to company administrators evaluating operations.
� Sophistication of accounting systems. If Pilgrim and Crestwood both have advanced accounting systems, application of the equity method may be relatively simple. Unfortunately, if these systems are primitive, the cost and effort necessary to apply the equity method may outweigh any potential benefits.
� The timeliness and accuracy of income figures generated by Crestwood. If the subsidiary reports operating results on a regular basis (such as weekly or monthly) and these figures prove to be reliable, equity totals recorded by Pilgrim may serve as valuable information to the parent. However, if Crestwood's reports are slow and often require later adjustment, Pilgrim's use of the equity method will provide only questionable results.
1. a. CCES Corp., for its own recordkeeping, may apply the equity method to the investment in Schmaling. Under this approach, the parent's records parallel the activities of the subsidiary. Income will be accrued by the parent as it is earned by the subsidiary. Dividends paid by Schmaling cause a reduction in book value; therefore, the investment account is reduced by CCES in a corresponding manner. In addition, any excess amortization expense associated with the allocation of CCES's purchase price is recognized through a periodic adjustment. By applying the equity method, both the income and investment balances maintained by the parent accurately reflect consolidated totals. The equity method is especially helpful in monitoring the income of the business combination. This method can be, however, rather difficult to apply and a time-consuming process.
b. The initial value method. The initial value method can also be utilized by CCES Corporation. Any dividends received will be accounted for as income but no other investment entries are recorded. Thus, the initial value method is quite easy to apply. However, the balances found within the parent's financial records may not provide a reasonable representation of the totals that will result from consolidating the two companies.
c. The partial equity method combines the advantages of the previous two techniques. Income is accrued as earned by the subsidiary in the same manner as the equity method. Similarly, dividends are reported as a reduction in the investment account. However, no other entries are recorded; more specifically, amortization is not recognized by the parent. The method is, therefore, easier to apply than the equity method but the subsidiary's individual totals will still frequently approximate consolidated balances.
2. a. The consolidated total for equipment is made up of the sum of Maguire’s book value, Williams’ book value, and any unamortized excess acquisition-date fair value over book value attributable to Williams’ equipment.
b. Although an Investment in Williams account is appropriately maintained by the parent, from a consolidation perspective the balance is intercompany in nature. Thus, the entire amount will be eliminated in arriving at consolidated financial statements.
c. Only dividends paid to outside parties are included in consolidated statements. Because Maguire owns 100 percent of Williams, all of the subsidiary's dividends are intercompany. Consequently, only the dividends paid by the parent company will be reported in the financial statements for this business combination.
d. Any goodwill recognized within Maguire's original acquisition price must still be reported for consolidation purposes. Reductions to the goodwill balance are made if goodwill is determined to be impaired.
e. Unless intercompany revenues have been recorded, consolidation is achieved in subsequent periods by adding the two book values together.
f. Consolidated expenses can be determined by adding the parent's book value to that of the subsidiary and then including any amortization expense associated with the purchase price. As will be discussed in detail in Chapter Five, intercompany expenses can also be present which require elimination in arriving at consolidated figures.
g. Only the common stock outstanding for the parent company is included in consolidated totals.
h. The net income for a business combination is calculated as the difference between consolidated revenues and consolidated expenses.
3. When using the equity method, subsidiary earnings are accrued and amortization expense (associated with the acquisition price in a purchase) is recognized in the same manner as in the consolidation process. The equity method parallels consolidation. Thus, the net income and retained earnings reported by the parent company each year will equal the consolidated totals.
4. In the consolidation process, excess amortizations must be recorded annually for any portion of the purchase price that is allocated to specific accounts (other than land or to goodwill). Although this expense can be simulated in total on the parent's books by an equity method entry, the actual amortization of each allocated fair value adjustment is appropriate for consolidation. Hence, the effect of the parent's equity method amortization entry is removed as part of Entry I so that the amortization of specific accounts (e.g., depreciation) can be recorded (in consolidation Entry E).
5. When the initial value method is applied by the parent company, no accrual is recorded to reflect the subsidiary's change in book value during the years following acquisition. Furthermore, recognition of excess amortizations relating to the acquisition price is also omitted by the parent. The partial equity method, in contrast, records the subsidiary’s book value increases and decreases but not amortizations. Consequently, for both of these methods, a technique must be established within the consolidation process to record the omitted figures. Entry *C simply brings the parent's records (more specifically, the beginning retained earnings balance and the investment account) up-to-date as of the first day of the current year. If the initial value method has been applied by the acquiring company, any changes in the subsidiary's book value in previous years must be recorded on the worksheet along with the appropriate amount of amortization expense. For the partial equity method, only the amortization relating to these prior years needs to be recognized.
No similar entry is needed if the equity method has been applied; changes in the subsidiary's book value as well as excess amortization expense will be recorded each year by the parent. Thus, under the equity method, the parent's investment and beginning retained earnings balances are both correctly established without further adjustment.
6. Lambert's loan payable and the receivable held by Jenkins are intercompany accounts. As such, the reciprocal balances should be offset in the consolidation process. The $100,000 is not a debt to or a receivable from an unrelated (or outside) party and should, therefore, not be reported in consolidated financial statements. Additionally any interest income/expense recognized on this loan is also intercompany in nature and must likewise be eliminated.
7. Since the equity method has been applied by Benns, the $920,000 is composed of four balances:
a. The original consideration transferred by the parent;
b. The annual accruals made by Benns to recognize income as it is earned by the subsidiary;
c. The reductions that are created by the subsidiary's payment of dividends;
d. The periodic amortization recognized by Benns in connection with the allocations identified with its purchase price.
8. The $100,000 attributed to goodwill is reported at its original amount unless a portion of goodwill is impaired or a unit of the business where goodwill resides is sold.
9. A parent should consider recognizing an impairment loss for goodwill associated with a purchased subsidiary when, at the reporting unit level, the fair value is less than its carrying amount. Goodwill is reduced when its carrying value is less than its fair value. To compute fair value for goodwill, its implied value is calculated by subtracting the fair values of the reporting unit’s identifiable net assets from its total fair value. The impairment is recognized as a loss from continuing operations.
10. The additional consideration is merely an extra component of the price paid by Remo to purchase Albane. Thus, any goodwill recognized at the original date of acquisition will be increased in 2009 by $100,000. However, if a bargain purchase occurred on January 1, 2009, this new payment reduces the allocations to noncurrent assets previously recognized for consolidation purposes.
11. At present, the Securities and Exchange Commission requires the use of push-down accounting for the separate financial statements of a subsidiary where no substantial outside ownership exists. Thus, if Company A owns all of Company B, the push-down method of accounting would be appropriate for the separately issued statements of Company B. The SEC normally requires push-down accounting where 95 percent of a subsidiary is acquired and the company has no outstanding public debt or preferred stock.
Push-down accounting may be required if 80-95 percent of the outstanding voting stock is purchased. Push-down accounting is justified in that the consideration transferred by the present owners is reported. For example, if a piece of land costs Company B $10,000 but Company A pays $13,000 for the land when acquiring Company B, the land has a basis to the current owners of B of $13,000. If B's financial records had been united with A at the time of the acquisition, the land would have been reported at $13,000. Thus, leaving the $10,000 figure simply because separate incorporation is maintained is viewed, by proponents of push-down accounting, as unjustified.
12. When push-down accounting is applied, the subsidiary adjusts the book value of its assets and liabilities based on the allocations made at the date of the acquisition. Periodic amortization expense is recognized subsequently by the subsidiary on each of these allocations (except for land). Therefore, the income recorded by the subsidiary is a fair representation of that company's impact on consolidated earnings.
The parent uses no special procedures when push-down accounting is being applied. However, if the equity method is in use, amortization need not be recognized by the parent since that expense is included in the figure reported by the subsidiary.
13. Push-down accounting has become popular for the parent's internal reporting purposes for two reasons. First, this method simplifies the consolidation process each year. If purchase price allocations and subsequent amortization are recorded by the subsidiary, they do not need to be repeated each year on a consolidation worksheet. Second, recording of amortization by the subsidiary enables that company's information to provide a good representation of the impact that the acquisition has on the earnings of the business combination. For example, if the subsidiary earns $100,000 each year but annual amortization is $80,000, the acquisition is only adding $20,000 to the income of the combination each year rather than the $100,000 that is reported by the subsidiary unless push-down accounting is used.
3. A 4. D Willkom equipment book value—12/31/11 ......................... $210,000 Szabo book value—12/31/11 ................................................ 140,000 Original purchase price allocation to Szabo's equipment ($300,000 – $200,000) ........................................................... 100,000 Amortization of allocation ($100,000/10 years for 3 years) ...................................... (30,000) Consolidated equipment ...................................................... $420,000 5. A 6. B 7. D 8. B 9. A 10. C 11. C $60,000 allocation to equipment is "pushed-down" to subsidiary and
increases balance from $330,000 to $390,000. Consolidated balance is $420,000 plus $390,000.
12. (35 Minutes) (Determine consolidated retained earnings when parent uses various accounting methods. Determine Entry *C for each of these methods)
a. CONSOLIDATED RETAINED EARNINGS
� EQUITY METHOD Herbert (parent) balance—1/1/09 .................................. $400,000 Herbert income—2009 ................................................... 40,000 Herbert dividends—2009 (subsidiary dividends are intercompany and, thus, eliminated) ....................... (10,000) Rambis income—2009 (not included in parent's income) 20,000 Amortization—2009 ........................................................ (12,000) Herbert income—2010 ................................................... 50,000 Herbert dividends—2010 ................................................ (10,000) Rambis income—2010 ................................................... 30,000 Amortization—2010 ....................................................... (12,000) Consolidated Retained Earnings, 12/31/10 ................... $496,000
� PARTIAL EQUITY METHOD AND INITIAL VALUE METHOD Consolidated retained earnings are the same regardless of the method in use: the beginning balance plus the income of the parent less the dividends of the parent plus the income of the subsidiary less amortization expense. Thus, consolidated retained earnings on December 31, 2010 are $496,000 as computed above.
b. Investment in Rambis—Equity Method Rambis fair value 1/1/09 ............................................................ $574,000 Rambis income 2009 .................................................................. 20,000 Rambis dividends 2009 ............................................................. (5,000) Herbert’s 2009 excess fair over book value amortization ..... (12,000) Investment account balance 1/1/10 .......................................... $577,000 Investment in Rambis—Partial Equity Method Rambis fair value 1/1/09 ............................................................ $574,000 Rambis income 2009 .................................................................. 20,000 Rambis dividends 2009 ............................................................. (5,000) Investment account balance 1/1/10 .......................................... $589,000 Investment in Rambis—Initial value method Rambis fair value 1/1/09 ............................................................ $574,000 Investment account balance 1/1/10 .......................................... $574,000
� EQUITY METHOD No entry is needed to convert the past figures to the equity method since that method has already been applied.
� PARTIAL EQUITY METHOD Amortization for the prior years (only 2009 in this case) has not been recorded and must be brought into the consolidation through worksheet entry *C: ENTRY *C Retained Earnings, 1/1/10 (Parent) .................... 12,000 Investment in Rambis .................................... 12,000 (To record 2009 amortization in consolidated figures. Expense was omitted because of application of partial equity method.)
� INITIAL VALUE METHOD Amortization for the prior years (only 2009 in this case) has not been recorded and must be brought into the consolidation through worksheet entry *C. In addition, only dividend income has been recorded by the parent ($5,000 in 2009). In this prior year, Rambis reported net income of $20,000. Thus, the parent has not recorded the $15,000 income in excess of dividends. That amount must also be included in the consolidation through entry *C: ENTRY *C Investment in Rambis ......................................... 3,000 Retained Earnings, 1/1/10 (Parent) ............... 3,000 (To record 2009 unrecognized subsidiary earnings as part of the parent’s retained earnings. $15,000 income of subsidiary was not recorded by parent (income in excess of dividends). Amortization expense of $12,000 was not recorded under the initial value method. Note that *C adjustments bring the parent’s January 1, 2010 Retained Earnings balance equal to that of the equity method.
13. (30 Minutes) (A variety of questions on equity method, initial value method, and partial equity method.)
a. An allocation of the acquisition price (based on the fair value of the
shares Issued) must be made first. Acquisition fair value (consideration paid by Haynes) $135,000 Book value equivalency ................................................. (100,000) Excess of Turner fair value over book value ............... $35,000
Excess fair value assigned to specific Annual Excess accounts based on fair value Life Amortizations Equipment ......................... $5,000 5 yrs. $1,000 Customer List ...................... 30,000 10 yrs. 3,000 $4,000
Acquisition fair value ...................................................... $135,000 2009 Income accrual ...................................................... 110,000 2009 Dividends paid by Turner ..................................... (50,000) 2009 Amortizations (above) ........................................... (4,000) 2010 Income accrual ...................................................... 130,000 2010 Dividends paid by Turner ..................................... (40,000) 2010 Amortizations ........................................................ (4,000) Investment in Turner account balance ......................... $277,000
b. Net income of Haynes .................................................... $240,000 Net Income of Turner ..................................................... 130,000 Depreciation expense ..................................................... (1,000) Amortization expense ..................................................... (3,000) Consolidated net income 2010 ................................ $366,000 c. Equipment balance Haynes ........................................... $500,000 Equipment balance Turner ............................................ 300,000 Allocation based on fair value (above) ......................... 5,000 Depreciation for 2009-2010 ........................................... (2,000) Consolidated equipment—December 31, 2010 ............ $803,000 Parent's choice of an investment method has no impact on consolidated
d. If the initial value method was applied during 2009, the parent would have recorded dividend income of $50,000 rather than $110,000 (as equity income). Income is, therefore, understated by $60,000. In addition, amortization expense of $4,000 was not recorded. Thus, the January 1, 2010, retained earnings is understated by $56,000 ($60,000 – $4,000). An Entry *C is necessary on the worksheet to correct this equity figure:
If the partial equity method was applied during 2009, the parent would have failed to record amortization expense of $4,000. Retained earnings are overstated by $4,000 and are corrected through Entry *C:
If the equity method was applied during 2009, the parent's retained earnings are the same as the consolidated figure so that no adjustment is necessary.
14. (20 minutes) (Record a merger combination with subsequent testing for goodwill impairment).
a. In accounting for the combination, the total fair value of Beltran (consideration
transferred) is allocated to each identifiable asset acquired and liability assumed with any remaining excess as goodwill.
Cash paid $450,000 Fair value of shares issued 1,248,000 Fair value transferred $1,698,000 Fair value transferred (above) $1,698,000 Fair value of net assets acquired and liabilities assumed 1,298,000 Goodwill recognized in the combination $400,000
Entry by Francisco to record assets acquired and liabilities assumed in the combination with Beltran:
Cash $ 75,000 Receivables 193,000 Inventory 281,000 Patents 525,000 Customer relationships 500,000 Equipment 295,000 Goodwill 400,000 Accounts Payable $ 121,000 Long-Term Liabilities 450,000 Cash 450,000 Common Stock (Francisco Co., par value) 104,000 Additional Paid-in Capital 1,144,000 b. Step one in goodwill impairment test: Fair value of reporting unit as a whole 1,425,000 Book value of reporting unit's net assets 1,585,000
Because the total fair value of the reporting unit is less than its carrying value, a potential goodwill impairment loss exists, step two is performed:
Fair value of reporting unit as a whole $1,425,000 Fair values of reporting unit's net assets (excluding goodwill) 1,325,000 Implied fair value of goodwill 100,000 Book value of goodwill 400,000 Goodwill impairment loss $300,000
Step 1 Fair value of reporting unit = $650 Carrying value of reporting unit = 780 Because fair value < carrying value, there is a potential goodwill impairment
loss. Step 2 Fair value of reporting unit $650 Fair value of net assets excluding goodwill Tangible assets $110 Recognized intangibles 230 Unrecognized intangibles 200 540 Implied value of goodwill 110 Carrying value of goodwill 500 Goodwill impairment loss $390 b. Tangible assets, net $80 Goodwill 110 Customer list -0- Patent -0-
16. (30 minutes) (Goodwill impairment and intangible assets.) Part a
Goodwill Impairment Test—Step 1 Total fair Carrying Potential goodwill value value impairment? Sand Dollar $510,000 < $530,000 yes Salty Dog 580,000 < 610,000 yes Baytowne 560,000 > 280,000 no Part b
Goodwill Impairment Test—Step 2 (Sand Dollar and Salty Dog only)
Sand Dollar—total fair value $510,000 Fair values of identifiable net assets Tangible assets $190,000 Trademark 150,000 Customer list 100,000 Liabilities (30,000) 410,000 Implied value of goodwill 100,000 Carrying value of goodwill 120,000 Impairment loss $20,000
Salty Dog—total fair value $580,000 Fair values of identifiable net assets Tangible assets $200,000 Unpatented technology 125,000 Licenses 100,000 425,000 Implied value of goodwill 155,000 Carrying value of goodwill 150,000 No impairment—implied value > carry value -0-
Part c No changes in tangible assets or identifiable intangibles are reported based on goodwill impairment testing. The sole purpose of the valuation exercise is to estimate an implied value for goodwill. Destin will report a goodwill impairment loss of $20,000, which will reduce the amount of goodwill allocated to Sand Dollar. However, because the fair value of Sand Dollar’s trademarks is less than its carrying amount, the account should be subjected to a separate impairment testing procedure to see if the carrying value is “recoverable” in future estimated cash flows.
17. (30 Minutes) (Consolidation entries for two years. Parent uses equity method.)
Fair Value Allocation and Annual Amortization: Acquisition fair value (consideration paid) ............ $490,000 Book value (assets minus liabilities or total stockholders' equity) .................................................................. (400,000) Excess fair value over book value .......................... $90,000 Excess fair value assigned to specific accounts based on individual fair values Annual Excess Life Amortizations Land .................................... $10,000 -- -- Buildings ............................. 40,000 4 yrs. $10,000 Equipment ........................... (20,000) 5 yrs. (4,000) Total assigned to specific accounts ........................ 30,000 Goodwill .............................. 60,000 Indefinite -0- Total .................................... $90,000 $6,000 Consolidation Entries as of December 31, 2009 Entry S Common Stock—Abernethy ................................ 250,000 Additional Paid-in Capital ................................... 50,000 Retained Earnings—1/1/09 ................................. 100,000 Investment in Abernethy ............................... 400,000 (To eliminate stockholders' equity accounts of subsidiary) Entry A Land ..................................................................... 10,000 Buildings .............................................................. 40,000 Goodwill ............................................................... 60,000 Equipment ...................................................... 20,000 Investment in Abernethy ............................... 90,000
(To recognize allocations attributed to fair value of specific accounts at acquisition date with residual fair value recognized as goodwill).
17. (continued) Entry I Equity in Subsidiary Earnings ........................... 74,000 Investment in Abernethy ............................... 74,000 (To eliminate $80,000 income accrual for 2009 less $6,000 amortization recorded by parent using equity method) Entry D Investment in Abernethy ..................................... 10,000 Dividends Paid ............................................... 10,000 (To eliminate intercompany dividend transfers) Entry E Depreciation expense .......................................... 6,000 Equipment ............................................................. 4,000 Buildings ......................................................... 10,000 (To record 2009 amortization expense) Consolidation Entries as of December 31, 2010
Entry S Common Stock—Abernethy ............................... 250,000 Additional Paid-in Capital ................................... 50,000 Retained Earnings—1/1/10 .................................. 170,000 Investment in Abernethy ............................... 470,000
(To eliminate beginning stockholders' equity of subsidiary—the Retained Earnings account has been adjusted for 2009 income and dividends. Entry *C is not needed because equity method was applied.)
Entry A Land ..................................................................... 10,000 Buildings .............................................................. 30,000 Goodwill ............................................................... 60,000 Equipment ...................................................... 16,000 Investment in Abernethy ............................... 84,000
(To recognize allocations relating to investment—balances shown here are as of beginning of current year [original allocation less excess amortizations for the prior period])
17. (continued) Entry I Equity in Subsidiary Earnings ........................... 104,000 Investment in Abernethy ............................... 104,000
(To eliminate $110,000 income accrual less $6,000 amortization recorded by parent during 2010 using equity method)
Entry D Investment in Abernethy ..................................... 30,000 Dividends Paid ............................................... 30,000
(To eliminate intercompany dividend transfers) Entry E Same as Entry E for 2009 18. (35 Minutes) (Consolidation entries for two years. Parent uses initial value
method.)
Purchase Price Allocation and Annual Excess Amortizations: Acquisition date value (consideration paid) ..... $500,000 Book value ........................................................... (400,000) Excess price paid over book value .................... $100,000
Excess price paid assigned to specific Annual Excess accounts based on fair values Life Amortizations Equipment $20,000 5 yrs. $4,000 Long-term liabilities 30,000 4 yrs. 7,500 Goodwill $50,000 Indefinite -0- Total $100,000 $11,500 Consolidation Entries as of December 31, 2009 Entry S Common Stock—Abernethy .............................. 250,000 Additional Paid-in Capital .................................. 50,000 Retained Earnings—1/1/09 ................................ 100,000 Investment in Abernethy ............................... 400,000 (To eliminate stockholders' equity accounts of subsidiary) Entry A Equipment ........................................................... 20,000 Long-term Liabilities .......................................... 30,000 Goodwill .............................................................. 50,000 Investment in Abernethy .............................. 100,000
(To recognize allocations determined above in connection with acquisition-date fair values)
18. (continued) Entry I Dividend Income ................................................ 10,000 Dividends Paid .............................................. 10,000
(To eliminate intercompany dividend payments recorded by parent as income)
Entry E Depreciation expense ........................................ 4,000 Interest expense .................................................. 7,500 Equipment ...................................................... 4,000 Long-term liabilities ....................................... 7,500 (To record 2009 amortization expense) Consolidation Entries as of December 31, 2010 Entry *C Investment in Abernethy .................................... 58,500 Retained Earnings—1/1/10 (Chapman) ....... 58,500
(To convert parent company figures to equity method by recognizing subsidiary's increase in book value for prior year [$80,000 net income less $10,000 dividend payment] and excess amortizations for that period [$11,500])
Entry S Common Stock—Abernethy .............................. 250,000 Additional Paid-in Capital .................................. 50,000 Retained Earnings—1/1/10 ................................ 170,000 Investment in Abernethy .............................. 470,000
(To eliminate beginning of year stockholders' equity accounts of subsidiary. The retained earnings balance has been adjusted for 2009 income and dividends)
Entry A Equipment ........................................................... 16,000 Long-term Liabilities .......................................... 22,500 Goodwill .............................................................. 50,000 Investment in Abernethy .............................. 88,500
(To recognize allocations relating to investment—balances shown here are as of the beginning of the current year [original allocation less excess amortizations for the prior period])
Entry I Dividend Income ................................................ 30,000 Dividends Paid ......................................... 30,000
(To eliminate intercompany dividend payments recorded by parent as income)
19. (20 Minutes) (Consolidation entries for two years. Parent uses partial equity
method.) Fair Value Allocation and Annual Excess Amortizations: Abernethy fair value (consideration paid) .............. $520,000 Book value ................................................................ (400,000) Excess fair value over book value (all goodwill) ... $120,000 Life assigned to goodwill ......................................... Indefinite Annual excess amortizations .................................. -0-
Consolidation Entries as of December 31, 2009 Entry S Common Stock—Abernethy ............................... 250,000 Additional Paid-in Capital ................................... 50,000 Retained Earnings—Abernethy—1/1/09 ............ 100,000 Investment in Abernethy ............................... 400,000 (To eliminate stockholders' equity accounts of subsidiary) Entry A Goodwill ............................................................... 120,000 Investment in Abernethy ............................... 120,000 (To recognize goodwill portion of the original acquisition fair value) Entry I Equity in Earnings of Subsidiary ........................ 80,000 Investment in Abernethy ............................... 80,000
(To eliminate intercompany income accrual for the current year based on the parent's usage of the partial equity method)
Entry D Investment in Abernethy ..................................... 10,000 Dividends Paid ............................................... 10,000 (To eliminate intercompany dividend transfers) Entry E—Not needed. Goodwill is not amortized. Consolidation Entries as of December 31, 2010 Entry *C—Not needed. Goodwill is not amortized. Entry S Common Stock—Abernethy ................................ 250,000 Additional Paid-in Capital—Abernethy .............. 50,000 Retained Earnings—Abernethy—1/1/10 ............ 170,000 Investment in Abernethy ............................... 470,000
(To eliminate beginning of year stockholders' equity accounts of subsidiary—the retained earnings balance has been adjusted for 2009 Income and dividends.)
Entry A Goodwill ............................................................... 120,000 Investment in Abernethy ............................... 120,000
(To recognize original goodwill balance.) Entry I Equity in Earnings of Subsidiary ........................ 110,000 Investment in Abernethy ............................... 110,000
(To eliminate Intercompany Income accrual for the current year.) Entry D Investment in Abernethy ..................................... 30,000 Dividends Paid ............................................... 30,000 (To eliminate Intercompany dividend transfers.) Equity E—not needed 20. (45 Minutes) (Variety of questions about the three methods of recording an
Investment in a subsidiary for internal reporting purposes.)
a. Purchase Price Allocation and Annual Amortization:
Hamilton’s acquisition-date fair value ..... $510,000 Book value (assets minus liabilities or stockholders' equity) ...................... 450,000 Fair value in excess of book value .......... 60,000 Annual Excess Allocation to equipment based on Life Amortizations difference between fair value and book value ................................................. 50,000 5 yrs. $10,000 Goodwill ..................................................... $10,000 indefinite -0- Total .......................................................... $10,000
EQUITY METHOD Investment Income—2010: Equity accrual (based on Hamilton's income) $60,000 Amortization (above) ..................................................... (10,000) Total ................................................................................. $50,000
20. (continued) INITIAL VALUE METHOD Investment Income—2010: Dividend Income (none indicated) ............................... -0- Investment in Hamilton—December 31, 2010: Consideration transferred for Hamilton ....................... $510,000
b. The consolidated account balances are not affected by the method of recording used by the parent. Thus, consolidated Expenses ($480,000 or $290,000 + $180,000 + amortizations of $10,000) are the same regardless of whether the equity method, the partial equity method, or the initial value method is applied by Jefferson.
c. The consolidated account balances are not affected by the method of
recording used by the parent. Thus, consolidated Equipment ($970,000 or $520,000 + $420,000 + allocation of $50,000 – two years of excess depreciation of $20,000) is the same regardless of whether the equity method, the partial equity method, or the initial value method is applied by Jefferson.
d. Jefferson Retained Earnings—Equity Method Jefferson Retained Earnings—1/1/09 ................................. $860,000 Jefferson income 2009 (400,000 – 290,000) ....................... 110,000 2009 equity accrual for Hamilton income .......................... 55,000 2009 excess amortization .................................................... (10,000) Jefferson Retained Earnings—1/1/10 ................................. $1,015,000 Jefferson Retained Earnings—Partial Equity Method
Jefferson Retained Earnings—1/1/09 ................................. $860,000 Jefferson income 2009 (400,000 – 290,000) ....................... 110,000 2009 equity accrual for Hamilton income .......................... 55,000 Jefferson Retained Earnings—1/1/10 ................................. $1,025,000 Jefferson Retained Earnings—Initial value method
Jefferson Retained Earnings—1/1/09 ................................. $860,000 Jefferson income 2009 (400,000 – 290,000) ....................... 110,000 2009 dividend income from Hamilton ................................. 5,000 Jefferson Retained Earnings—1/1/10 ................................. $975,000
e. EQUITY METHOD—Entry *C is not utilized since parent's retained earnings balance is correct.
PARTIAL EQUITY METHOD—Entry *C is needed to record amortization
for prior year.
Retained earnings, 1/1/10 (parent) ..................... 10,000 Investment in Hamilton ................................. 10,000
INITIAL VALUE METHOD—Entry *C is needed to record increase in
subsidiary's book value ($50,000) and amortization ($10,000) for prior year.
Investment in Hamilton ....................................... 40,000 Retained earnings, 1/1/10 (parent) ............... 40,000
f. Entry S is not affected by the method used by the parent to record the
Investment in Hamilton. Under each of these three methods, the following Entry S would be appropriate for 2010:
Common stock (Hamilton) ............................ 150,000 Retained earnings, 1/1/10 (Hamilton) ............ 350,000 Investment in Hamilton ............................ 500,000
g. Consolidated revenues (add the two book values) $640,000 Consolidated expenses (add the two book values and excess amortizations) ............................ (480,000) Consolidated net income ................................... $160,000
21. (15 Minutes) (Consolidated accounts one year after acquisition)
Stanza acquisition fair value ($10,000 in stock issue costs reduce additional paid-in capital) .................... $680,000 Book value of subsidiary (1/1/10 stockholders' equity balances) ..... (480,000) Fair value in excess of book value .......... $200,000
Excess fair value allocated to copyrights Life Amortizations based on fair value .............................. 120,000 6 yrs. $20,000 Goodwill ..................................................... $80,000 indefinite -0- Total ...................................................... $20,000
21. (continued) b. Consolidated net income, 2010 Revenues (add book values) ........................ $1,100,000 Expenses: Add book values ....................................... $700,000 Excess amortizations ............................... 20,000 720,000 Consolidated net income ............................... $380,000
c. Consolidated retained earnings, 12/31/10 Retained earnings 1/1/10 (Penske) ............... $600,000 Net income 2010 (above) ............................... 380,000 Dividends paid 2010 (Penske) ...................... (80,000) Total ........................................................... $900,000
Stanza's retained earnings balance as of January 1, 2010, is not included
because these operations occurred prior to the purchase. Stanza's dividends were paid to Penske and therefore are excluded because they are intercompany in nature.
d. Consolidated goodwill, 12/31/10 Allocation (above) .......................................... $80,000
22. (30 Minutes) (Consolidated balances three years after the date of
acquisition. Includes questions about parent's method of recording investment for internal reporting purposes.)
a. Acquisition-Date Fair Value Allocation and Amortization: Consideration transferred 1/1/09 ............. $600,000 Book value (given) .................................... (470,000) Annual Fair value in excess of book value ..... 130,000 Excess Allocation to equipment based on Life Amortizations difference in fair value and book value ............................................ 90,000 10 yrs. $9,000 Goodwill ..................................................... $40,000 indefinite -0- Total ...................................................... $9,000
b. The parent's choice of an investment method has no impact on the consolidated totals. The choice of an investment method only affects the internal reporting of the parent.
c. The initial value method is used. The parent's Investment in Subsidiary
account still retains the original consideration transferred of $600,000. In addition, the Investment Income account equals the amount of dividends paid by the subsidiary.
d. If the partial equity method had been utilized, the investment income
account would have shown an equity accrual of $100,000. If the equity method had been applied, the Investment Income account would have included both the equity accrual of $100,000 and excess amortizations of $9,000 for a balance of $91,000.
e. Initial Value Method—Foxx’s Retained Earnings—1/1/11 Foxx’s 1/1/11 balance (initial value method was employed) $1,100,000 Partial Equity Method—Foxx’s Retained Earnings—1/1/11 Foxx’s 1/1/11 balance (initial value method) ..................... $1,100,000 2009 net equity accrual for Greenburg (90,000 – 20,000) . 70,000 2010 net equity accrual for Greenburg (100,000 – 20,000) 80,000 Foxx’s 1/1/11 Retained Earnings ........................................ $1,250,000
Equity Method—Foxx’s Retained Earnings—1/1/11 Foxx’s 1/1/11 balance (initial value method) ..................... $1,100,000 2009 net equity accrual for Greenburg (90,000 – 20,000) . 70,000 2009 excess fair over book value amortization ................. (9,000) 2010 net equity accrual for Greenburg (100,000 – 20,000) 80,000 2010 excess fair over book value amortization ................. (9,000) Foxx’s 1/1/11 Retained Earnings ........................................ $1,232,000
23. (50 Minutes) (Consolidated totals for a purchase. Worksheet is produced as a separate requirement.)
a. O’Brien acquisition-date fair value .................... $550,000 O’Brien book value ............................................. (350,000) Fair value in excess of book value .................... $200,000
23. (continued) Excess assigned to specific Annual accounts based on fair value Life Excess Amortizations Trademarks .............................. 100,000 indefinite -0- Customer relationships ........... 75,000 5 yrs. $15,000 Equipment ................................ (30,000) 10 yrs. (3,000) Goodwill ................................... 55,000 indefinite -0- Total .......................................... $200,000 $12,000
If the partial equity method were in use, the Income of O’Brien account would have had a balance of $222,000 (100% of O’Brien's reported income for the period). If the initial value method were in use, the Income of O’Brien account would have had a balance of $80,000 (100% of the dividends paid by O’Brien). Thus, the equity method must be in use. The Income of O’Brien balance is an equity accrual of $222,000 (100% of O’Brien’s reported income) less excess amortizations of $12,000 (as computed above).
b. Students can develop consolidated figures conceptually, without relying on a
worksheet or consolidation entries. Thus, part b. asks students to determine independently each balance to be reported by the business combination. � Revenues = $1,645,000 (the accounts of both companies combined)
� Cost of Goods Sold = 528,000 (the accounts of both companies combined)
� Amortization Expense = $40,000 (the accounts of both companies and the acquisition-related adjustment of $15,000)
� Depreciation Expense = $142,000 (the accounts for both companies and the acquisition-related depreciation adjustment of $3,000)
� Income of O’Brien = $0 (the balance reported by the parent is removed and replaced with the subsidiary’s individual revenue and expense accounts)
� Net Income = 935,000 (consolidated revenues less expenses)
� Retained Earnings, 1/1 = $700,000 (only the parent's retained earnings figure is included)
� Dividends Paid = $142,000 (the subsidiary's dividends were paid to the parent and, thus, as an intercompany transfer are eliminated)
� Retained Earnings, 12/31 = $1,493,000 (the beginning balance for the parent plus consolidated net income less consolidated [parent] dividends)
� Cash = $290,000 (the accounts of both companies are added together)
� Receivables = $281,000 (the accounts of both companies are combined)
� Inventory = $310,000 (the accounts of both companies are combined)
24. (60 Minutes) (Consolidation worksheet five years after acquisition with parent using initial value method. Effects of using equity method also included)
Acquisition-Date Fair Value Allocation and Annual Amortization:
a. Aaron fair value (stock exchanged at fair value) ....................................... $470,000 Book value of subsidiary ....................... (360,000) Excess fair value over book value ........ $110,000
Excess assigned to specific accounts based on fair values Annual Excess
Life Amortizations Royalty agreements $60,000 6 yrs. $10,000 Trademark 50,000 10 yrs. 5,000 Total $110,000 $15,000
The parent company is apparently applying the initial value method: only dividend income is recognized during the current year and the investment account retains its original $470,000 balance. Therefore, both the subsidiary's change in retained earnings during 2009–2012 as well as the amortization for that period must be brought into the consolidation. Aaron' retained earnings January 1, 2013 ........................ $490,000 Retained earnings at date of purchase ............................. (230,000) Increase since date of purchase ........................................ $260,000 Excess amortization expenses ($15,000 x 4 years) ......... (60,000) Conversion to equity method for years prior to 2013 (Entry *C) ................................................................... $200,000 Explanation of Consolidation Entries Found on Worksheet
Entry*C: Converts 1/1/13 figures from initial value method to equity method as per computation above.
Entry S: Eliminates stockholders' equity accounts of subsidiary as of the beginning of current year.
Entry A: Recognizes allocations to royalty agreements and trademark. This entry establishes unamortized balances as of the beginning of the current year.
Entry I: Eliminates intercompany dividends.
Entry E: Records excess amortization expenses for the current year. See next page for worksheet.
b. If the equity method had been applied by Michael, three figures on that company's financial records would be different: Equity in Earnings of Aaron, Retained Earnings—1/1/13, and Investment in Aaron Co.
Equity in Earnings of Aaron: $135,000 (the parent would accrue 100% of Aaron's $150,000 income but must also recognize $15,000 in amortization expense.)
Retained Earnings, 1/1/13: $1,080,000 (increases by $200,000—the parent would have recognized the $260,000 increment in the subsidiary's book value during previous years as well as $60,000 in excess amortization expenses for these same four years [see Part a.])
Investment in Aaron: $800,000 (increases by $330,000—the parent would have recognized the $260,000 increment in the subsidiary's book value during previous years as well as $60,000 in excess amortization expenses for these same four years [see Part a.]. In the current year, income of $135,000 would have been recognized [see above] along with a reduction of $5,000 for dividends received).
c. No Entry *C is needed on the worksheet if the equity method is applied. Both the investment account as well as beginning retained earnings would be stated appropriately.
Entry I would have been used to eliminate the $135,000 Equity in Earnings of Aaron from the parent's income statement and from the Investment in Aaron Co. account.
Entry D would eliminate the $5,000 current year dividend from Dividends Paid and the Investment in Aaron account balances.
d. Consolidated figures are not affected by the investment method used by the parent. The parent company balances would differ and changes would be required in the worksheet entries. However, the figures to be reported do not depend on the parent's selection of a method.
25. (65 Minutes) (Consolidated totals and worksheet five years after acquisition. Parent uses equity method. Includes goodwill impairment.)
a. Acquisition-date fair value allocations (given) Life Excess
Amortizations Land $90,000 -- -- Equipment 50,000 10 yrs. $5,000 Goodwill 60,000 indefinite 0 Total $200,000 $5,000
The problem states that the equity method is in use. Thus, the $135,000 "Equity in Income of Small" would be comprised of a $140,000 equity accrual (100% of the subsidiary's reported earnings) less $5,000 in amortization expense computed above.
b. � Revenues = $1,535,000 (both balances are added together)
� Cost of Goods Sold = $640,000 (both balances are added)
� Depreciation Expense = $307,000 (both balances are added along with excess equipment depreciation)
� Equity in Income of Small = $0 (the parent's income balance is removed and replaced with Small's individual revenue and expense accounts)
� Net Income = $588,000 (consolidated expenses are subtracted from consolidated revenues)
� Retained Earnings, 1/1/13 = $1,417,000 (the parent’s balance)
� Dividends Paid = $310,000 (the parent number alone because the subsidiary's dividends are intercompany, paid to Giant)
� Retained Earnings, 12/31/13 = $1,695,000 (the parent’s balance at beginning of the year plus consolidated net income less consolidated dividends paid)
� Current Assets = $706,000 (both book balances are added together while the $10,000 intercompany receivable is eliminated)
� Investment in Small = $0 (the parent's asset is removed so that Small's individual asset and liability accounts can be brought into the consolidation)
� Land = $695,000 (both book balances are added together along with the purchase price allocation of $90,000)
� Buildings = $723,000 (both book balances are added together)
� Equipment = $959,000 (both book balances are added plus the unamortized portion of the purchase price allocation [$50,000 less $25,000 after 5 years of excess depreciation])
� Goodwill = $60,000 (represents the original price allocation)
� Total Assets = $3,143,000 (summation of all consolidated assets)
� Liabilities = $1,198,000 (both balances are added together while the $10,000 intercompany payable is eliminated)
� Common Stock = $250,000 (parent balance only)
� Retained Earnings, 12/31/13 = $1,695,000 (see above)
� Total Liabilities and Equity = $3,143,000 (summation of all consolidated liabilities and equity)
a. Worksheet is presented on following page. b. If all goodwill from the Small investment was determined to be impaired,
Giant would make the following journal entry on its books:
Goodwill impairment loss 60,000 Investment in Small 60,000 After this entry, the worksheet process would no longer require an adjustment in Entry (A) to recognize goodwill. The impairment loss would simply carry over to the consolidated income column. The impairment loss would be reported as a separate line item in the operating section of the consolidated income statement.
26. (30 Minutes) (Determine consolidated accounts and consolidation entries five years after purchase. Parent applies equity method.) a. Fair Value Allocation and Annual Amortization
Annual Excess Allocation Life Amortizations
Land ..................................... $20,000 Buildings .............................. (30,000) 10 yrs. $(3,000) Equipment ............................ 60,000 5 yrs. 12,000 Customer List ...................... 100,000 20 yrs. 5,000 Total ..................................... $14,000
CONSOLIDATED TOTALS
� Revenues = $850,000 (add the two book values)
� Cost of Goods Sold = $380,000 (the accounts of both companies are added together)
� Depreciation Expense = $179,000 (the accounts are added and include the excess depreciation adjustment of $9,000)
� Amortization Expense = $5,000 (current amortization for customer list recognized in acquisition)
� Buildings (net) = $625,000 (add the two book values less the purchase price allocation [a $30,000 reduction] after removing 5 years of amortization totaling $15,000)
� Equipment (net) = $450,000 (add the two book values. The purchase price allocation is completely amortized at end of current year)
� Customer List = $75,000 ($100,000 original allocation less $25,000 [5 years of amortization])
� Common stock = $300,000 (parent company balance only)
� Additional paid-in capital = $50,000 (parent company balance only) b. The method used by the parent is only important in determining the
parent's separate account balances (which are given here or are not needed) or consolidation worksheet entries (which are not required in a.)
c. Consolidation Entry S Common Stock (Hill) ............................ 40,000 Additional paid-in capital (Hill) ........... 160,000 Retained Earnings 1/1 ......................... 600,000 Investment in Hill ............................ 800,000 (To eliminate beginning stockholders' equity of subsidiary) Consolidation Entry A Land ...................................................... 20,000 Equipment (net) ................................... 12,000 Customer List (net) .............................. 80,000 Buildings (net) ................................ 18,000 Investment in Hill ............................ 94,000
(To record unamortized allocation balances as of beginning of current year)
Consolidation Entry I Investment Income .............................. 86,000 Investment in Hill ............................ 86,000
(To remove equity income recognized during year—equity method accrual of $100,000 [based on subsidiary's income] less amortization of $14,000 for the year)
Consolidation Entry D Investment in Hill ................................. 40,000 Dividends Paid ................................ 40,000 (To remove Intercompany dividend payments) Consolidation Entry E Amortization expense ........................... 5,000 Depreciation expense ........................... 9,000 Buildings .............................................. 3,000 Equipment ........................................ 12,000 Customer List .................................. 5,000 (To recognize excess acquisition-date fair-value amortizations for the period)
27. (30 Minutes) (Determine parent company and consolidated account balances for a bargain purchase combination. Parent applies equity method)
a. Acquisition-Date Fair Value Allocation and Annual Excess Amortization
Consideration transferred ............ $1,090,000 Santiago book value (given) .......... $950,000 Technology undervaluation (6 yr. life) 240,000 Acquisition fair value of net assets 1,190,000 Gain on bargain purchase .............. $(100,000)
Santiago income .............................. $(200,000) Technology amortization ................ 40,000 Equity earnings in Santiago ........... $(160,000) Fair value of net assets at acquisition-date $1,190,000 Equity earnings from Santiago ....... 160,000 Dividends received .......................... (50,000) Investment in Santiago 12/31/09 .... $1,300,000
Because a bargain purchase occurred, Santiago’s net asset fair value replaces the fair value of the consideration transferred as the initial value assigned to the subsidiary on Peterson’s books.
28. (35 minutes) (Acquisition method: Contingent performance obligation and worksheet adjustments for equity and initial value methods.) a. Investment in Wolfpack, Inc. 500,000 Contingent performance obligation 35,000 Cash 465,000 b. 12/31/09 Loss from increase in contingent performance obligation 5,000 Contingent performance obligation 5,000 12/31/10 Loss from increase in contingent performance obligation 10,000 Contingent performance obligation 10,000 12/31/10 Contingent performance obligation 50,000 Cash 50,000 c. Equity Method
Common stock- Wolfpack 200,000 Retained earnings-Wolfpack 180,000 Investment in Wolfpack 380,000 Royalty agreements 90,000 Goodwill 60,000 Investment in Wolfpack 150,000 Equity earnings of Wolfpack 65,000 Investment in Wolfpack 65,000 Investment in Wolfpack 35,000 Dividends paid 35,000 Amortization expense 10,000 Royalty agreements 10,000 d. Initial Value Method Investment in Wolfpack 30,000 Retained earnings-Branson 30,000 Common stock 200,000 Retained earnings-Wolfpack 180,000 Investment in Wolfpack 380,000
29. (45 Minutes) (Prepare consolidation worksheet five years after purchase.
Parent applies equity method. Includes question on push-down accounting.) a. Allocation of Acquisition-Date Fair Value and Determination of
Amortization: Storm’s acquisition-date fair value .................... $140,000 Book value of Storm (acquisition date) ............. (105,000) Fair value in excess of book value .................... $35,000
Excess assigned to specific accounts: Annual Excess Life Amortizations
Land ........................................... $10,000 – – Equipment ................................. 5,000 5 yrs. $1,000 Formula ...................................... 20,000 20 yrs. 1,000 Total ................................................ $35,000 $2,000
The equity in subsidiary earnings account reflects the equity method. The initial value method would have recorded $40,000 (100% of dividend payments) as income while the partial equity method would have shown $68,000 (100% of the subsidiary's income). Under the equity method, an income accrual of $66,000 is recognized (100% of reported income less the $2,000 in excess amortization expenses computed above).
b. Explanation of Consolidation Entries Found on Worksheet
Entry S—Eliminates stockholders' equity accounts of the subsidiary as of the beginning of the current year.
Entry A—Records remaining unamortized allocation from acquisition-
date fair value adjustments. As of the beginning of the current year, equipment and formula have undergone four years of amortization.
Entry I—Eliminates intercompany income accrual for the current year.
c. If push-down accounting had been applied, the purchase price allocations to land ($10,000), equipment ($5,000), and formula ($20,000) would have been entered into the subsidiary's balances with an offsetting $35,000 increase in additional paid-in capital. The equipment and the formula would then have been amortized by the subsidiary as annual expenses of $1,000 each. For 2013, the subsidiary's expenses would have been $2,000 higher leaving reported net income at $66,000. At the end of 2013, land would still have been $10,000 higher because no amortization is recorded on that asset. Equipment would be no higher at this time since the $5,000 allocation is fully depreciated at the end of this fifth year. However, the secret formula would be recorded by the subsidiary as $15,000, the $20,000 allocation less five years of amortization at $1,000 per year.
30. (20 Minutes) (Consolidated balances three years after purchase. Parent has applied the equity method.)
a. Schedule 1—Acquisition-Date Fair Value Allocation and Amortization Jasmine’s acquisition-date fair value $206,000 Book value of Jasmine .................. (140,000) Fair value in excess of book value 66,000 Excess fair value assigned to specific accounts based on individual fair values Annual Excess Life Amortization Equipment ................................. 54,400 8 yrs. $6,800 Buildings (overvalued) ............. (10,000) 20 yrs. (500) Goodwill .................................... $21,600 indefinite -0- Total ........................................... $6,300 Investment in Jasmine Company—12/31/11 Jasmine’s acquisition-date fair value ............................ $206,000 2009 Increase in book value of subsidiary .................. 40,000 2009 Excess amortizations (Schedule 1) ..................... (6,300) 2010 Increase in book value of subsidiary .................. 20,000 2010 Excess amortizations (Schedule 1) ..................... (6,300) 2011 Increase in book value of subsidiary .................. 10,000 2011 Excess amortizations (Schedule 1) ..................... (6,300) Investment in Jasmine Company ............................ $257,100
30. (continued) b. Equity in Subsidiary Earnings Income accrual ................................................................ $30,000 Excess amortizations (Schedule 1) .............................. (6,300) Equity in subsidiary earnings .................................. $23,700 c. Consolidated Net Income Consolidated revenues (add book values) .................. $414,000 Consolidated expenses (add book values) .................. (272,000) Excess amortization expenses (Schedule 1) ............... (6,300) Consolidated net income .............................................. $135,700 d. Consolidated Equipment Book values added together ......................................... $370,000 Allocation of purchase price ......................................... 54,400 Excess depreciation ($6,800 × 3) .................................. (20,400) Consolidated equipment .......................................... $404,000
e. Consolidated Buildings .................................................. Book values added together ......................................... $288,000 Allocation of purchase price ......................................... (10,000) Excess depreciation ($500 × 3) ..................................... 1,500 Consolidated buildings ............................................. $279,500
f. Consolidated goodwill Allocation of excess fair value to goodwill ................... $21,600
g. Consolidated Common Stock ........................................ $290,000
As a purchase, the parent's balance of $290,000 is used (the acquired company's common stock will be eliminated each year on the consolidation worksheet).
h. Consolidated Retained Earnings ................................... $410,000
Tyler's balance of $410,000 is equal to the consolidated total because
the equity method has been applied. 31. (35 minutes) (Consolidation with IPR&D, equity method) a. Consideration transferred 1/1/09 $1,765,000 Increase in Salsa’s RE to1/1/10 150,000 In-process R&D write-off in 2009 (44,000) Amortizations 2009 (7,000) Income 2010 210,000 Dividends paid 2010 (25,000) Amortization 2010 (7,000) Investment balance 12/31/10 $2,042,000
32. (55 minutes) (Goodwill impairment test, consolidated balances, and worksheet)
a. Prine should compare Lydia’s total fair value to its carrying value, as
follows: 12/31 Carrying value (equity method balance) $120,070,000 12/31 Fair value 110,000,000 Excess carrying value over fair value $10,070,000 Because fair value is less than carrying value, Prine is required to
further test whether goodwill is impaired. b. 12/31 Fair value for Lydia $110,000,000 Fair values of assets and liabilities Cash $109,000 Receivables (net) 897,000 Movie library 60,000,000 Broadcast licenses 20,000,000 Equipment 19,000,000 Current liabilities (650,000) Long-term debt (6,250,000) Total net fair value 93,106,000 Implied fair value for goodwill 16,894,000 Carrying value for goodwill 50,000,000 Impairment loss $33,106,000 Journal Entry by Prine: Goodwill impairment loss 33,106,000 Investment in Lydia Co. 33,106,000 c. Combined revenues $30,000,000 Combined expenses (including excess amortization) 22,200,000 Income before impairment loss 7,800,000 Goodwill impairment loss—Lydia (33,106,000) Net loss $(25,306,000) d. Consolidated goodwill = $50,000,000 – $33,106,000 = $16,894,000
32. (continued) e. Consolidated broadcast licenses = $350,000 + $14,014,000 = $14,364,000 The consolidated balance equals the sum of parent’s book value plus
the fair value of the subsidiary broadcast licenses at acquisition date adjusted for any changes since acquisition. Because the subsidiary’s book value equaled fair value at acquisition date, no worksheet adjustment is needed. Because the broadcast licenses are considered to have indefinite lives, they are not amortized. Note that the 12/31 fair value, assessed for purposes of computing implied value for goodwill, is not used for financial reporting purposes.
Jonas recognized several identifiable intangibles from its acquisition of Innovation+. Jonas expresses the desire to expense these intangible assets in the acquisition period.
1. Advise Jonas on the acceptability of its suggested immediate write-off.
According to paragraph 12 of SFAS 142 an intangible asset shall not be written down or off in the period of acquisition unless it becomes impaired during that period.
2. Indicate the relevant factors to consider in allocating the values assigned to identifiable intangibles acquired in a business combination.
The accounting for a recognized intangible asset is based on its useful life to the reporting entity. An intangible asset with a finite useful life is amortized; an intangible asset with an indefinite useful life is not amortized. The useful life of an intangible asset to an entity is the period over which the asset is expected to contribute directly or indirectly to the future cash flows of that entity. Other factors to be considered are legal, regulatory, or contractual provisions, effects of obsolescence, demand, competition, and other economic factors, and the level of maintenance expenditures required to obtain the expected future cash flows from the asset. (paragraph 11 SFAS 142)
The price paid by Jonas for Innovation+ indicates a large amount was paid for goodwill. However, Jonas worries that any future goodwill impairment may send the wrong signal to its investors about the wisdom of the Innovation+ acquisition. Jonas thus wishes to allocate all the goodwill to one account called “enterprise goodwill.” In this way, Jonas hopes to minimize the possibility of goodwill impairment because a decline in goodwill in one business unit may be offset by an increase in the value of goodwill in another business unit.
3. Jonas’ suggested treatment of goodwill is inappropriate. To ensure that goodwill increases in one reporting unit do not offset decreases in others, SFAS 142 requires an allocation of goodwill acquired in a business combination across business units that benefit from the goodwill.
4. SFAS 142 indicates the relevant factors to consider in allocating goodwill across an enterprise’s business units.
Per SFAS 142 paragraph 34:
For the purpose of testing goodwill for impairment, all goodwill acquired in a business combination shall be assigned to one or more reporting units as of the acquisition date. Goodwill shall be assigned to reporting units of the acquiring entity that are expected to benefit from the synergies of the combination even though other assets or liabilities of the acquired entity may not be assigned to that reporting unit. The total amount of acquired goodwill may be divided among a number of reporting units. The methodology used to
determine the amount of goodwill to assign to a reporting unit shall be reasonable and supportable and shall be applied in a consistent manner.
Therefore, Jonas’ desire to minimize the possibility of goodwill impairment should not be a factor in allocating goodwill to reporting units.
Wendy’s International Analysis Case Solution—Goodwill Impairment
1. How much did Wendy’s pay for Baja Fresh in 2002? How did Wendy’s allocate the purchase price to the net assets of Baja Fresh?
The following is from Wendy’s January 2, 2004 annual report:
Baja Fresh Acquisition As of (In thousands) June 19, 2002 Current assets $5,111 Property and equipment 34,970 Goodwill 226,781 Intangible assets 34,000 Other assets 2,736 Total assets acquired $303,598 Current liabilities $(1,800) Long-term debt (14,393) Total liabilities (16,193) Net assets acquired $287,405
2. Why did Wendy’s recognize a goodwill impairment loss for its Baja Fresh
reporting unit in 2004? From the 2004 annual report:
The Company tests goodwill for impairment annually (or in interim periods if events or changes in circumstances indicate that its carrying amount may not be recoverable) by comparing the fair value of each reporting unit, as measured by discounted cash flows and market multiples based on earnings, to the carrying value, to determine if there is an indication that a potential impairment may exist. One of the most significant assumptions is the projection of future sales. The Company reviews its assumptions each time goodwill is tested for impairment and makes appropriate adjustments, if any, based on facts and circumstances available at that time. In the fourth quarter of 2004, the Company tested goodwill for impairment and recorded an impairment charge of $190.0 million related to Baja Fresh, which is included in the Developing Brands segment. The Company, with the assistance of an independent third-party, determined the amount of the charge, which was primarily based on comparative market data.
3. How were the performance bonuses of Wendy’s top executives affected by
the 2004 goodwill impairment charge? What ratios determined these performance bonuses? How will the 2004 goodwill impairment charge affect the executives’ ability to earn future bonuses?
From the 2004 annual report: The aggregate effect of the goodwill impairment, restaurant closings and market impairments was to reduce the Company’s reported earnings per share and return on assets for 2004 below the threshold performance objectives established by the Committee under the Senior Executive Plan. As a result, Mr. Schuessler and Mrs. Anderson received no bonus for 2004, and Mr. Mueller received only that portion of his award opportunity that reflected the extent to which the Wendy’s North America income goal was exceeded for the year.
Because of the large write-off in 2004, $190 million of the original $226.8 million of the goodwill from the Baja Fresh acquisition is no longer part of total assets. Thus, future return-on-asset ratios will benefit from a denominator effect and future EPS will not be subject to the $190 million portion for impairment.
4. Referring to Wendy’s 2006 financial reports, what other impairment charges did Wendy’s incur with respect to Baja Fresh? How was the loss on sale of Baja Fresh reported?
From the 2006 annual report: During the second quarter of 2006, as a result of continuing poor sales performance at Baja Fresh and the Company’s consideration of alternatives for the Baja Fresh business, the Company tested goodwill of Baja Fresh for impairment in accordance with SFAS No. 142 and tested other intangibles and fixed assets in accordance with SFAS No. 144 using the held and used model, and recorded a Baja Fresh goodwill pretax impairment charge of $46.9 million ($46.1 million after-tax), a Baja Fresh impairment charge of $25.8 million ($16.0 million after-tax) related to the Baja Fresh trade name and $49.8 million ($30.9 million after-tax) in Baja Fresh fixed asset impairment charges. Also from the 2006 annual report: During the third quarter of 2006, the Company’s Board of Directors approved the sale of Baja Fresh and on November 28, 2006, the Company completed the sale and, accordingly, the results of operations of Baja Fresh are reflected as discontinued operations for all periods presented and the assets and liabilities of Baja Fresh are reflected as discontinued operations at January 1, 2006.
AOL Time Warner Analysis Case Solution—Goodwill Impairment
1. How did AOL determine the initial amount of goodwill to recognize in its
merger with Time Warner?
The merger of America Online and Time Warner has been accounted for by AOL Time Warner as an acquisition of Time Warner under the purchase method of accounting for business combinations.
Under the purchase method of accounting, the cost, including transaction costs, to acquire Time Warner was allocated to the underlying net assets, based on their respective estimated fair values.
The excess of the purchase price over the estimated fair values of the net assets acquired was recorded as goodwill.
2. How did AOL Time Warner determine the $99 billion impairment charge to its
goodwill? What procedures will Time Warner follow in the future to assess the value of its goodwill?
AOL Time Warner determined the goodwill write-down by employing the two-step impairment test. In step one, the carrying value of each reporting unit was compared to its fair value. If the book value of the reporting unit exceeded the fair value, AOL employed step two by comparing goodwill’s book value to its implied fair value.
From the 2002 annual report:
The $54.199 billion goodwill impairment is associated entirely with goodwill resulting from the Merger. The amount of the impairment primarily reflects the decline in the Company's stock price since the Merger was announced and valued for accounting purposes in January of 2000. Prior to performing the review for impairment, FAS 142 required that all goodwill deemed to be related to the entity as a whole be assigned to all of the Company's reporting units, including the reporting units of the acquirer. This differs from the previous accounting rules where goodwill was assigned only to the businesses of the company acquired. As a result, a portion of the goodwill generated in the Merger has been reallocated to the AOL segment. During the fourth quarter of 2002, the Company performed its annual impairment review for goodwill and other intangible assets and recorded an additional charge of $45.538 billion, which is recorded as a component of operating income in the accompanying consolidated statement of operations. The $45.538 billion is reflective of the overall decline in market values and includes charges to reduce the carrying value of goodwill at the AOL segment ($33.489 billion), Cable segment ($10.550 billion) and Music
segment ($646 million), as well as a charge to reduce the carrying value of brands and trademarks at the Music segment ($853 million).
3. What business areas has AOL designated as its reporting units? Why is it
important to define the reporting unit?
A reporting unit is an operating segment or a component. AOL’s reporting units are consistent with its operating segments, which are classified based on different business interest areas as follows:
1ST
quarter 2002 Reporting Units impairment loss AOL -0- Cable $22,980 Filmed Entertainment 4,091 Networks 13,077 Music 4,796 Publishing 9,259 Total 1
st quarter 2005 impairment losses $54,203
Since the goodwill impairment test is dependent upon the fair value of a reporting unit, companies may prefer to aggregate operating segment components when identifying reporting units so that they can reduce the probability of a goodwill impairment charge.
4. What effects does SFAS 142 have on AOL Time Warner’s earnings performance both in the short term and in the long run?
In the short term, the $54 billion directly reduced AOL Time Warner’s net income and retained earnings, resulting in a net loss of $54.240 billion in the first quarter.
Because this charge was recorded as “cumulative effect of accounting change,” it didn’t affect AOL’s operating income. As a non-cash charge, it didn’t affect cash flow either. However, the 4
th quarter charge of $45.5 billion,
was recorded as a component of operating income in the accompanying consolidated statement of operations. Only in the 1
st quarter of 2002 were
firm’s allowed to avoid reporting goodwill impairment losses in operating income.
In the long run, SFAS 142 eliminates the amortization of goodwill, but companies face the risk of further goodwill impairment. So, the rule may make Time Warner and other public companies more accountable for acquisition choices.
5. The rationale is to improve the financial reporting. The accounting treatment
for goodwill should better reflect the underlying economics of goodwill.
Instead of regarding goodwill as a steadily “wasting” asset, the impairment method regards the goodwill as one that sporadically declines or even conceivably maintains its value in perpetuity, which is consistent with the concept of representational faithfulness.
