Class Notes For Advanced Accounting, 4th Edition
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Chapter 1
1
CHAPTER ONE – INTRODUCTION TO BUSINESS COMBINATIONS
I. BUSINESS COMBINATIONS
A business combination occurs when the operations of two or more companies
are brought under common control.
While merger activity (business combinations) experienced a slowdown in the
economic decline of 2002 through mid-2003, by July of 2003, evidence of
renewed interest was obvious. This trend continued, and global merger activity
passed the one trillion dollar mark for the first quarter of 2007, the greatest
activity on record according to CNN.
II. NATURE OF THE COMBINATION
A. Nature of the combination
1. In a friendly combination, the boards of directors of the potential
combining companies negotiate mutually agreeable terms of a
proposed combination. The proposal is then submitted to the
stockholders of the involved companies for approval.
2. An unfriendly (hostile) combination results when the board of
directors of a company targeted for acquisition resists the
combination. A formal tender offer enables the acquiring firm to
deal directly with individual shareholders.
B. Defense tactics
Resistance often involves various moves by the target company. Whether
or not such defenses are ultimately beneficial to shareholders remains a
controversial issue.
1. Poison pill: Issuing stock rights to existing shareholders
enabling them to purchase additional shares at a price below
market value, but exercisable only in the event of a potential
takeover.
Example: Cisco creates "poison pill" to block takeovers
by James Niccolai
http://www.computerworld.com/home/news.nsf/all/9806125poison
Cisco Systems, Inc. said yesterday that its board of directors has approved a
shareholder rights plan designed to protect the networking company's investors
in the event of a hostile takeover bid.
Known in the business world as a "poison pill," the plan is a strategic maneuver
to make the company's stock less attractive to potential bidders and to encourage
bidders to solicit offerings through the company's board of directors, the San
Jose, Calif., company said. A company spokeswoman said Cisco isn't currently
1
CHAPTER ONE – INTRODUCTION TO BUSINESS COMBINATIONS
I. BUSINESS COMBINATIONS
A business combination occurs when the operations of two or more companies
are brought under common control.
While merger activity (business combinations) experienced a slowdown in the
economic decline of 2002 through mid-2003, by July of 2003, evidence of
renewed interest was obvious. This trend continued, and global merger activity
passed the one trillion dollar mark for the first quarter of 2007, the greatest
activity on record according to CNN.
II. NATURE OF THE COMBINATION
A. Nature of the combination
1. In a friendly combination, the boards of directors of the potential
combining companies negotiate mutually agreeable terms of a
proposed combination. The proposal is then submitted to the
stockholders of the involved companies for approval.
2. An unfriendly (hostile) combination results when the board of
directors of a company targeted for acquisition resists the
combination. A formal tender offer enables the acquiring firm to
deal directly with individual shareholders.
B. Defense tactics
Resistance often involves various moves by the target company. Whether
or not such defenses are ultimately beneficial to shareholders remains a
controversial issue.
1. Poison pill: Issuing stock rights to existing shareholders
enabling them to purchase additional shares at a price below
market value, but exercisable only in the event of a potential
takeover.
Example: Cisco creates "poison pill" to block takeovers
by James Niccolai
http://www.computerworld.com/home/news.nsf/all/9806125poison
Cisco Systems, Inc. said yesterday that its board of directors has approved a
shareholder rights plan designed to protect the networking company's investors
in the event of a hostile takeover bid.
Known in the business world as a "poison pill," the plan is a strategic maneuver
to make the company's stock less attractive to potential bidders and to encourage
bidders to solicit offerings through the company's board of directors, the San
Jose, Calif., company said. A company spokeswoman said Cisco isn't currently
Chapter 1
1
CHAPTER ONE – INTRODUCTION TO BUSINESS COMBINATIONS
I. BUSINESS COMBINATIONS
A business combination occurs when the operations of two or more companies
are brought under common control.
While merger activity (business combinations) experienced a slowdown in the
economic decline of 2002 through mid-2003, by July of 2003, evidence of
renewed interest was obvious. This trend continued, and global merger activity
passed the one trillion dollar mark for the first quarter of 2007, the greatest
activity on record according to CNN.
II. NATURE OF THE COMBINATION
A. Nature of the combination
1. In a friendly combination, the boards of directors of the potential
combining companies negotiate mutually agreeable terms of a
proposed combination. The proposal is then submitted to the
stockholders of the involved companies for approval.
2. An unfriendly (hostile) combination results when the board of
directors of a company targeted for acquisition resists the
combination. A formal tender offer enables the acquiring firm to
deal directly with individual shareholders.
B. Defense tactics
Resistance often involves various moves by the target company. Whether
or not such defenses are ultimately beneficial to shareholders remains a
controversial issue.
1. Poison pill: Issuing stock rights to existing shareholders
enabling them to purchase additional shares at a price below
market value, but exercisable only in the event of a potential
takeover.
Example: Cisco creates "poison pill" to block takeovers
by James Niccolai
http://www.computerworld.com/home/news.nsf/all/9806125poison
Cisco Systems, Inc. said yesterday that its board of directors has approved a
shareholder rights plan designed to protect the networking company's investors
in the event of a hostile takeover bid.
Known in the business world as a "poison pill," the plan is a strategic maneuver
to make the company's stock less attractive to potential bidders and to encourage
bidders to solicit offerings through the company's board of directors, the San
Jose, Calif., company said. A company spokeswoman said Cisco isn't currently
1
CHAPTER ONE – INTRODUCTION TO BUSINESS COMBINATIONS
I. BUSINESS COMBINATIONS
A business combination occurs when the operations of two or more companies
are brought under common control.
While merger activity (business combinations) experienced a slowdown in the
economic decline of 2002 through mid-2003, by July of 2003, evidence of
renewed interest was obvious. This trend continued, and global merger activity
passed the one trillion dollar mark for the first quarter of 2007, the greatest
activity on record according to CNN.
II. NATURE OF THE COMBINATION
A. Nature of the combination
1. In a friendly combination, the boards of directors of the potential
combining companies negotiate mutually agreeable terms of a
proposed combination. The proposal is then submitted to the
stockholders of the involved companies for approval.
2. An unfriendly (hostile) combination results when the board of
directors of a company targeted for acquisition resists the
combination. A formal tender offer enables the acquiring firm to
deal directly with individual shareholders.
B. Defense tactics
Resistance often involves various moves by the target company. Whether
or not such defenses are ultimately beneficial to shareholders remains a
controversial issue.
1. Poison pill: Issuing stock rights to existing shareholders
enabling them to purchase additional shares at a price below
market value, but exercisable only in the event of a potential
takeover.
Example: Cisco creates "poison pill" to block takeovers
by James Niccolai
http://www.computerworld.com/home/news.nsf/all/9806125poison
Cisco Systems, Inc. said yesterday that its board of directors has approved a
shareholder rights plan designed to protect the networking company's investors
in the event of a hostile takeover bid.
Known in the business world as a "poison pill," the plan is a strategic maneuver
to make the company's stock less attractive to potential bidders and to encourage
bidders to solicit offerings through the company's board of directors, the San
Jose, Calif., company said. A company spokeswoman said Cisco isn't currently
Chapter 1
2
the target of a takeover bid, but added that such plans aren't uncommon at large
corporations.
Under the plan, Cisco shareholders would have the right to acquire for half price
one share in the company for each share held as of June 22. The plan would kick
in if a person or company acquires or announces an offer to acquire 15% or
more of the company's common stock, Cisco said.
2. Greenmail: The purchase of any shares held by the would-be
acquiring company at a price substantially in excess of their fair
value. The purchased shares are then held as treasury stock or
retired.
3. White knight or white squire: Encouraging a third firm more
acceptable to the target company management to acquire or merge
with the target company.
4. Pac-man defense: Attempting an unfriendly takeover of the would-
be acquiring company.
5. Selling the crown jewels: The sale of valuable assets to others to
make the firm less attractive to the would-be acquirer. The
negative aspect is that the firm, if it survives, is left without some
important assets.
6. Leveraged buyouts: The purchase of a controlling interest in the
target firm by its managers and third party investors, who usually
incur substantial debt in the process and subsequently take the firm
private. The bonds issued often take the form of high interest, high
risk “junk” bonds.
III. BUSINESS COMBINATIONS: WHY? WHY NOT?
A. A company may expand in several ways. Some firms concentrate on
internal expansion. For other firms external expansion is the goal; a
company may achieve significant cost savings as a result of external
expansion. In addition to rapid expansion, the business combination
method, or external expansion, has several other potential advantages over
internal expansion:
1. Operating synergies may take a variety of forms. In the case of
vertical mergers (a merger between a supplier and a customer),
synergies may result from the elimination of certain costs related to
negotiation, bargaining, and coordination between the parties. In
the case of a horizontal merger (a merger between competitors),
potential synergies include the combination of sales forces,
facilities, outlets, etc., and the elimination of unnecessary
duplication in costs.
2
the target of a takeover bid, but added that such plans aren't uncommon at large
corporations.
Under the plan, Cisco shareholders would have the right to acquire for half price
one share in the company for each share held as of June 22. The plan would kick
in if a person or company acquires or announces an offer to acquire 15% or
more of the company's common stock, Cisco said.
2. Greenmail: The purchase of any shares held by the would-be
acquiring company at a price substantially in excess of their fair
value. The purchased shares are then held as treasury stock or
retired.
3. White knight or white squire: Encouraging a third firm more
acceptable to the target company management to acquire or merge
with the target company.
4. Pac-man defense: Attempting an unfriendly takeover of the would-
be acquiring company.
5. Selling the crown jewels: The sale of valuable assets to others to
make the firm less attractive to the would-be acquirer. The
negative aspect is that the firm, if it survives, is left without some
important assets.
6. Leveraged buyouts: The purchase of a controlling interest in the
target firm by its managers and third party investors, who usually
incur substantial debt in the process and subsequently take the firm
private. The bonds issued often take the form of high interest, high
risk “junk” bonds.
III. BUSINESS COMBINATIONS: WHY? WHY NOT?
A. A company may expand in several ways. Some firms concentrate on
internal expansion. For other firms external expansion is the goal; a
company may achieve significant cost savings as a result of external
expansion. In addition to rapid expansion, the business combination
method, or external expansion, has several other potential advantages over
internal expansion:
1. Operating synergies may take a variety of forms. In the case of
vertical mergers (a merger between a supplier and a customer),
synergies may result from the elimination of certain costs related to
negotiation, bargaining, and coordination between the parties. In
the case of a horizontal merger (a merger between competitors),
potential synergies include the combination of sales forces,
facilities, outlets, etc., and the elimination of unnecessary
duplication in costs.
Chapter 1
2
the target of a takeover bid, but added that such plans aren't uncommon at large
corporations.
Under the plan, Cisco shareholders would have the right to acquire for half price
one share in the company for each share held as of June 22. The plan would kick
in if a person or company acquires or announces an offer to acquire 15% or
more of the company's common stock, Cisco said.
2. Greenmail: The purchase of any shares held by the would-be
acquiring company at a price substantially in excess of their fair
value. The purchased shares are then held as treasury stock or
retired.
3. White knight or white squire: Encouraging a third firm more
acceptable to the target company management to acquire or merge
with the target company.
4. Pac-man defense: Attempting an unfriendly takeover of the would-
be acquiring company.
5. Selling the crown jewels: The sale of valuable assets to others to
make the firm less attractive to the would-be acquirer. The
negative aspect is that the firm, if it survives, is left without some
important assets.
6. Leveraged buyouts: The purchase of a controlling interest in the
target firm by its managers and third party investors, who usually
incur substantial debt in the process and subsequently take the firm
private. The bonds issued often take the form of high interest, high
risk “junk” bonds.
III. BUSINESS COMBINATIONS: WHY? WHY NOT?
A. A company may expand in several ways. Some firms concentrate on
internal expansion. For other firms external expansion is the goal; a
company may achieve significant cost savings as a result of external
expansion. In addition to rapid expansion, the business combination
method, or external expansion, has several other potential advantages over
internal expansion:
1. Operating synergies may take a variety of forms. In the case of
vertical mergers (a merger between a supplier and a customer),
synergies may result from the elimination of certain costs related to
negotiation, bargaining, and coordination between the parties. In
the case of a horizontal merger (a merger between competitors),
potential synergies include the combination of sales forces,
facilities, outlets, etc., and the elimination of unnecessary
duplication in costs.
2
the target of a takeover bid, but added that such plans aren't uncommon at large
corporations.
Under the plan, Cisco shareholders would have the right to acquire for half price
one share in the company for each share held as of June 22. The plan would kick
in if a person or company acquires or announces an offer to acquire 15% or
more of the company's common stock, Cisco said.
2. Greenmail: The purchase of any shares held by the would-be
acquiring company at a price substantially in excess of their fair
value. The purchased shares are then held as treasury stock or
retired.
3. White knight or white squire: Encouraging a third firm more
acceptable to the target company management to acquire or merge
with the target company.
4. Pac-man defense: Attempting an unfriendly takeover of the would-
be acquiring company.
5. Selling the crown jewels: The sale of valuable assets to others to
make the firm less attractive to the would-be acquirer. The
negative aspect is that the firm, if it survives, is left without some
important assets.
6. Leveraged buyouts: The purchase of a controlling interest in the
target firm by its managers and third party investors, who usually
incur substantial debt in the process and subsequently take the firm
private. The bonds issued often take the form of high interest, high
risk “junk” bonds.
III. BUSINESS COMBINATIONS: WHY? WHY NOT?
A. A company may expand in several ways. Some firms concentrate on
internal expansion. For other firms external expansion is the goal; a
company may achieve significant cost savings as a result of external
expansion. In addition to rapid expansion, the business combination
method, or external expansion, has several other potential advantages over
internal expansion:
1. Operating synergies may take a variety of forms. In the case of
vertical mergers (a merger between a supplier and a customer),
synergies may result from the elimination of certain costs related to
negotiation, bargaining, and coordination between the parties. In
the case of a horizontal merger (a merger between competitors),
potential synergies include the combination of sales forces,
facilities, outlets, etc., and the elimination of unnecessary
duplication in costs.
Chapter 1
3
2. Combination may enable a company to compete more effectively
in the international marketplace.
3. Business combinations are sometimes entered into to take
advantage of income tax laws. The opportunity to file a
consolidated tax return may allow profitable corporations’ tax
liability to be reduced by the losses of unprofitable affiliates.
4. Diversification resulting from a merger offers a number of
advantages, including increased flexibility, an internal capital
market, an increase in the firm’s debt capacity, more protection
from competitors over proprietary information, and sometimes a
more effective utilization of the organization’s resources.
5. Divestitures accounted for over 30% of the merger and
acquisitions activity in each quarter from 1995 into mid-1998.
Shedding divisions that are not part of a company’s core business
became common during this period. In some cases the divestitures
may be viewed as “undoing” or “redoing” past acquisitions.
B. Notwithstanding its apparent advantages, business combination may not
always be the best means of expansion.
1. An overriding emphasis on rapid growth may result in the
pyramiding of one company on another without sufficient
management control over the resulting conglomerate.
Unsuccessful or incompatible combinations may lead to future
divestitures.
2. In order to avoid large dilutions of equity, some companies have
relied on the use of various debt and preferred stock instruments to
finance expansion, only to find themselves unable to provide the
required debt service during a period of decreasing economic
activity. The junk bond market used to finance many of the
mergers in the 1980s had essentially collapsed by the end of that
decade.
3. Business combinations may destroy, rather than create, value in
some instances.
IV. BUSINESS COMBINATIONS -- AN HISTORICAL PERSPECTIVE
A. In the United States there have been three fairly distinct periods
characterized by many business mergers, consolidations, and other forms
of combinations: 1880-1904; 1905-1930; and 1945-present.
3
2. Combination may enable a company to compete more effectively
in the international marketplace.
3. Business combinations are sometimes entered into to take
advantage of income tax laws. The opportunity to file a
consolidated tax return may allow profitable corporations’ tax
liability to be reduced by the losses of unprofitable affiliates.
4. Diversification resulting from a merger offers a number of
advantages, including increased flexibility, an internal capital
market, an increase in the firm’s debt capacity, more protection
from competitors over proprietary information, and sometimes a
more effective utilization of the organization’s resources.
5. Divestitures accounted for over 30% of the merger and
acquisitions activity in each quarter from 1995 into mid-1998.
Shedding divisions that are not part of a company’s core business
became common during this period. In some cases the divestitures
may be viewed as “undoing” or “redoing” past acquisitions.
B. Notwithstanding its apparent advantages, business combination may not
always be the best means of expansion.
1. An overriding emphasis on rapid growth may result in the
pyramiding of one company on another without sufficient
management control over the resulting conglomerate.
Unsuccessful or incompatible combinations may lead to future
divestitures.
2. In order to avoid large dilutions of equity, some companies have
relied on the use of various debt and preferred stock instruments to
finance expansion, only to find themselves unable to provide the
required debt service during a period of decreasing economic
activity. The junk bond market used to finance many of the
mergers in the 1980s had essentially collapsed by the end of that
decade.
3. Business combinations may destroy, rather than create, value in
some instances.
IV. BUSINESS COMBINATIONS -- AN HISTORICAL PERSPECTIVE
A. In the United States there have been three fairly distinct periods
characterized by many business mergers, consolidations, and other forms
of combinations: 1880-1904; 1905-1930; and 1945-present.
Chapter 1
4
1. 1880-1904, huge holding companies or trusts were created by
investment bankers seeking to establish monopoly control over
certain industries. This type of combination is generally called
horizontal integration because it involves the combination of
companies within the same industry.
2. 1905-1930, business combination activity of this period, fostered
by the federal government during World War I, was encouraged to
obtain greater standardization of materials and parts and to
discourage price competition. After the war, these combinations
were efforts to obtain better integration of operations, reduce costs,
and improve competitive positions rather than attempts to establish
monopoly control over an industry. This type of combination is
called vertical integration because it involves the combination of
a company with its suppliers or customers.
3. 1945-present, the third period has exhibited rapid growth in merger
activity since the mid-1960s, and even more rapid since the 1980s.
Some observers have called this activity "merger mania.''
Illustration 1-1 presents a rough graph of the level of merger
activity from 1972 to 2005 in number of deals, and from 1979 to
12005 in dollar volume. Illustration 1-2 presents summary
statistics on the level of activity for the year 2005 by industry
sector for acquisitions with purchase prices valued in excess of $10
million.
B. This most recent period can be further subdivided to focus on trends of
particular decades or subperiods.
1. From the 1950s to the 1970s most mergers were conglomerate
mergers. Here the primary motivation for combination was often to
diversify business risk
2. The 1980s were characterized by a relaxation in antitrust
enforcement during the Reagan administration and by the
emergence of high-yield junk bonds to finance acquisitions. The
dominant type of acquisition during this period and into the 1990s
has been strategic acquisitions claiming to benefit from
operating synergies. A temporary decline in activity near the end
of the 1980s may be traced to the collapse of the junk bond market
and to an economic recession.
3. By the mid-1990s the credit markets had recovered, and the
upsurge in mergers renewed to greater levels than ever before.
Deregulation undoubtedly played a role in the popularity of
4
1. 1880-1904, huge holding companies or trusts were created by
investment bankers seeking to establish monopoly control over
certain industries. This type of combination is generally called
horizontal integration because it involves the combination of
companies within the same industry.
2. 1905-1930, business combination activity of this period, fostered
by the federal government during World War I, was encouraged to
obtain greater standardization of materials and parts and to
discourage price competition. After the war, these combinations
were efforts to obtain better integration of operations, reduce costs,
and improve competitive positions rather than attempts to establish
monopoly control over an industry. This type of combination is
called vertical integration because it involves the combination of
a company with its suppliers or customers.
3. 1945-present, the third period has exhibited rapid growth in merger
activity since the mid-1960s, and even more rapid since the 1980s.
Some observers have called this activity "merger mania.''
Illustration 1-1 presents a rough graph of the level of merger
activity from 1972 to 2005 in number of deals, and from 1979 to
12005 in dollar volume. Illustration 1-2 presents summary
statistics on the level of activity for the year 2005 by industry
sector for acquisitions with purchase prices valued in excess of $10
million.
B. This most recent period can be further subdivided to focus on trends of
particular decades or subperiods.
1. From the 1950s to the 1970s most mergers were conglomerate
mergers. Here the primary motivation for combination was often to
diversify business risk
2. The 1980s were characterized by a relaxation in antitrust
enforcement during the Reagan administration and by the
emergence of high-yield junk bonds to finance acquisitions. The
dominant type of acquisition during this period and into the 1990s
has been strategic acquisitions claiming to benefit from
operating synergies. A temporary decline in activity near the end
of the 1980s may be traced to the collapse of the junk bond market
and to an economic recession.
3. By the mid-1990s the credit markets had recovered, and the
upsurge in mergers renewed to greater levels than ever before.
Deregulation undoubtedly played a role in the popularity of
Chapter 1
5
combinations in the 1990s. Although recent years have witnessed
few deals blocked due to antitrust enforcement. On May 13, 1998,
the United States government announced its intent to appoint a
panel of economic advisors to evaluate the impact of merger
activity on the economy.
V. TERMINOLOGY AND TYPES OF COMBINATIONS
A. From an accounting perspective, the distinction that is most important at
this stage is between an asset acquisition and a stock acquisition. An
asset acquisition involves the purchase of all of the acquired company’s
net assets, whereas a stock acquisition involves the attainment of control
via purchase of a controlling interest in the stock of the acquired company.
B. A statutory merger results when one company acquires all the net assets
of one or more other companies through an exchange of stock, payment of
cash or other property, or the issue of debt instruments (or a combination
of these methods). Thus, if A Company acquires B Company in a statutory
merger, the combination is often expressed as
Statutory Merger
+ =
C. A statutory consolidation results when a new corporation is formed to
acquire two or more other corporations through an exchange of voting
stock; the acquired corporations then cease to exist as separate legal
entities. Thus, if C Company is formed to consolidate A Company and B
Company, the combination is generally expressed as
Statutory Consolidation
+ =
D. A stock acquisition occurs when one corporation pays cash or issues
stock or debt for all or part of the voting stock of another company, and
the acquired company remains intact as a separate legal entity. Thus, if A
Company acquires 50% of the voting stock of B Company), a parent -
subsidiary relationship results. Consolidated financial statements
(explained in later chapters) are prepared and the business combination is
often expressed as
A Company B Company A Company
A Company B Company C Company
5
combinations in the 1990s. Although recent years have witnessed
few deals blocked due to antitrust enforcement. On May 13, 1998,
the United States government announced its intent to appoint a
panel of economic advisors to evaluate the impact of merger
activity on the economy.
V. TERMINOLOGY AND TYPES OF COMBINATIONS
A. From an accounting perspective, the distinction that is most important at
this stage is between an asset acquisition and a stock acquisition. An
asset acquisition involves the purchase of all of the acquired company’s
net assets, whereas a stock acquisition involves the attainment of control
via purchase of a controlling interest in the stock of the acquired company.
B. A statutory merger results when one company acquires all the net assets
of one or more other companies through an exchange of stock, payment of
cash or other property, or the issue of debt instruments (or a combination
of these methods). Thus, if A Company acquires B Company in a statutory
merger, the combination is often expressed as
Statutory Merger
+ =
C. A statutory consolidation results when a new corporation is formed to
acquire two or more other corporations through an exchange of voting
stock; the acquired corporations then cease to exist as separate legal
entities. Thus, if C Company is formed to consolidate A Company and B
Company, the combination is generally expressed as
Statutory Consolidation
+ =
D. A stock acquisition occurs when one corporation pays cash or issues
stock or debt for all or part of the voting stock of another company, and
the acquired company remains intact as a separate legal entity. Thus, if A
Company acquires 50% of the voting stock of B Company), a parent -
subsidiary relationship results. Consolidated financial statements
(explained in later chapters) are prepared and the business combination is
often expressed as
A Company B Company A Company
A Company B Company C Company
Loading page 6...
Chapter 1
6
Consolidated Financial Statements
+ =
VII. TAKEOVER PREMIUMS
A takeover premium is the term applied to the excess of the amount offered, or
agreed upon, in an acquisition over the prior stock price of the acquired firm.
VIII. AVOIDING THE PITFALLS BEFORE THE DEAL
To consider the potential impact on a firm’s earnings realistically, the acquiring
firm’s managers and advisors must exercise due diligence in considering the
information presented to them. Some of the factors to beware include:
A. Be cautious in interpreting any percentages presented by the selling
company.
B. Don’t neglect to include assumed liabilities in the assessment of the cost
of the merger. In addition to liabilities that are on the books of the
acquired firm, be aware of the possibility of less obvious liabilities.
C. Watch out for the impact on earnings of the allocation of expenses and the
effects of production increases, standard cost variances, LIFO liquidations,
and by-product sales.
D. Note any nonrecurring items which may have artificially or temporarily
boosted earnings. In addition to nonrecurring gains or revenues, look for
recent changes in estimates, accrual levels, and methods.
E. Be careful of CEO egos.
IX. DETERMINING PRICE AND METHOD OF PAYMENT IN BUSINESS
COMBINATIONS
Whether an acquisition is structured as an asset acquisition or a stock acquisition,
the acquiring firm must choose to finance the combination with cash, stock, or
debt (or some combination).
Financial
Statements of
A Company
Financial
Statements of
B Company
Consolidated
Financial
Statements of
A Company and
B Company
6
Consolidated Financial Statements
+ =
VII. TAKEOVER PREMIUMS
A takeover premium is the term applied to the excess of the amount offered, or
agreed upon, in an acquisition over the prior stock price of the acquired firm.
VIII. AVOIDING THE PITFALLS BEFORE THE DEAL
To consider the potential impact on a firm’s earnings realistically, the acquiring
firm’s managers and advisors must exercise due diligence in considering the
information presented to them. Some of the factors to beware include:
A. Be cautious in interpreting any percentages presented by the selling
company.
B. Don’t neglect to include assumed liabilities in the assessment of the cost
of the merger. In addition to liabilities that are on the books of the
acquired firm, be aware of the possibility of less obvious liabilities.
C. Watch out for the impact on earnings of the allocation of expenses and the
effects of production increases, standard cost variances, LIFO liquidations,
and by-product sales.
D. Note any nonrecurring items which may have artificially or temporarily
boosted earnings. In addition to nonrecurring gains or revenues, look for
recent changes in estimates, accrual levels, and methods.
E. Be careful of CEO egos.
IX. DETERMINING PRICE AND METHOD OF PAYMENT IN BUSINESS
COMBINATIONS
Whether an acquisition is structured as an asset acquisition or a stock acquisition,
the acquiring firm must choose to finance the combination with cash, stock, or
debt (or some combination).
Financial
Statements of
A Company
Financial
Statements of
B Company
Consolidated
Financial
Statements of
A Company and
B Company
Loading page 7...
Chapter 1
7
A. When a business combination is effected through an open-market
acquisition of stock, no particular problems arise in connection with
determining price or method of payment. Price is determined by the
normal functioning of the stock market, and payment is generally in cash,
although some or all of the cash may have to be raised by the acquiring
company through debt or equity issues.
B. When a business combination is effected by a stock swap, or exchange of
securities, both price and method of payment problems arise. In this case,
the price is expressed in terms of a stock exchange ratio, which is
generally defined as the number of shares of the acquiring company to be
exchanged for each share of the acquired company, and constitutes a
negotiated price. It is important to understand that each constituent of the
combination makes two kinds of contributions to the new entity -- net
assets and future earnings. The accountant often becomes deeply involved
in the determination of the values of these contributions.
X. NET ASSET AND FUTURE EARNINGS CONTRIBUTIONS
A. Determination of an equitable price for each constituent company, and of
the resulting exchange ratio, requires the valuation of each company's net
assets, as well as their expected contribution to the future earnings of the
new entity. To estimate current replacement costs of real estate and other
items of plant and equipment, the services of appraisal firms may be
needed.
B. Estimation of the value of goodwill to be included in an offering price is
subjective. A number of alternative methods are available, usually
involving the discounting of expected future cash flows (or free cash
flows), earnings, or excess earnings over some period of years. Generally,
the use of free cash flows or earnings yields an estimate of the entire firm
value (including goodwill), whereas the use of excess earnings yields an
estimate of the goodwill component of total firm value.
C. Steps in the excess earnings approach:
Excess Earnings Approach to Estimating Goodwill
1. Identify a normal rate of return on assets for firms similar to the
company being targeted.
2. Apply the rate of return identified in step 1 to the level of
identifiable assets (or net assets) of the target to approximate what
the “normal” firm in this industry might generate with the same
level of resources. We will refer to the product as “normal
earnings.”
3. Estimate the expected future earnings of the target.
4. Subtract the normal earnings calculated in step 2 from the expected
target earnings from step 3. The difference is “excess earnings.”
7
A. When a business combination is effected through an open-market
acquisition of stock, no particular problems arise in connection with
determining price or method of payment. Price is determined by the
normal functioning of the stock market, and payment is generally in cash,
although some or all of the cash may have to be raised by the acquiring
company through debt or equity issues.
B. When a business combination is effected by a stock swap, or exchange of
securities, both price and method of payment problems arise. In this case,
the price is expressed in terms of a stock exchange ratio, which is
generally defined as the number of shares of the acquiring company to be
exchanged for each share of the acquired company, and constitutes a
negotiated price. It is important to understand that each constituent of the
combination makes two kinds of contributions to the new entity -- net
assets and future earnings. The accountant often becomes deeply involved
in the determination of the values of these contributions.
X. NET ASSET AND FUTURE EARNINGS CONTRIBUTIONS
A. Determination of an equitable price for each constituent company, and of
the resulting exchange ratio, requires the valuation of each company's net
assets, as well as their expected contribution to the future earnings of the
new entity. To estimate current replacement costs of real estate and other
items of plant and equipment, the services of appraisal firms may be
needed.
B. Estimation of the value of goodwill to be included in an offering price is
subjective. A number of alternative methods are available, usually
involving the discounting of expected future cash flows (or free cash
flows), earnings, or excess earnings over some period of years. Generally,
the use of free cash flows or earnings yields an estimate of the entire firm
value (including goodwill), whereas the use of excess earnings yields an
estimate of the goodwill component of total firm value.
C. Steps in the excess earnings approach:
Excess Earnings Approach to Estimating Goodwill
1. Identify a normal rate of return on assets for firms similar to the
company being targeted.
2. Apply the rate of return identified in step 1 to the level of
identifiable assets (or net assets) of the target to approximate what
the “normal” firm in this industry might generate with the same
level of resources. We will refer to the product as “normal
earnings.”
3. Estimate the expected future earnings of the target.
4. Subtract the normal earnings calculated in step 2 from the expected
target earnings from step 3. The difference is “excess earnings.”
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Chapter 1
8
If the normal earnings are greater than the target’s expected
earnings, then no goodwill is implied under this approach.
5. To compute estimated goodwill from “excess earnings,” we must
assume an appropriate time period and a discount rate. The shorter
the time period and the higher the discount rate, the more
conservative the estimate. Because of the assumptions needed in
step 5, a range of goodwill estimates may be obtained simply by
varying the assumed discount rate and/or the assumed discount
period.
6. Add the estimated goodwill from step 5 to the fair value of the
firm’s net identifiable assets to arrive at a possible offering price.
XI. ALTERNATIVE CONCEPTS OF CONSOLIDATED FINANCIAL
STATEMENTS
A. Parent Company Concept:
The parent company concept emphasizes the interests of the parent's
shareholders. As a result, the consolidated financial statements reflected
those stockholder interests in the parent itself, plus their undivided
interests in the net assets of the parent's subsidiaries.
B. Economic Unit Concept:
The economic unit concept emphasizes control of the whole by a single
management. As a result, under this concept, consolidated financial
statements are intended to provide information about a group of legal
entities - a parent company and its subsidiaries - operating as a single unit.
In its most recent pronouncements, FASB has opted to adopt this
concept, and the 4th edition chapters (2 through 9) are based on the
economic unit concept.
C. Noncontrolling Interest
1. Under the economic unit concept, a noncontrolling interest is a
part of the ownership equity in the entire economic unit.
2. Under the parent company concept, the nature and classification
of a noncontrolling interest are unclear.
D. Consolidated Net Income
1. Under the parent company concept, consolidated net income
consists of the realized combined income of the parent company
and its subsidiaries after deducting noncontrolling interest in
income; that is, the noncontrolling interest in income is deducted
as an expense item in determining consolidated net income.
8
If the normal earnings are greater than the target’s expected
earnings, then no goodwill is implied under this approach.
5. To compute estimated goodwill from “excess earnings,” we must
assume an appropriate time period and a discount rate. The shorter
the time period and the higher the discount rate, the more
conservative the estimate. Because of the assumptions needed in
step 5, a range of goodwill estimates may be obtained simply by
varying the assumed discount rate and/or the assumed discount
period.
6. Add the estimated goodwill from step 5 to the fair value of the
firm’s net identifiable assets to arrive at a possible offering price.
XI. ALTERNATIVE CONCEPTS OF CONSOLIDATED FINANCIAL
STATEMENTS
A. Parent Company Concept:
The parent company concept emphasizes the interests of the parent's
shareholders. As a result, the consolidated financial statements reflected
those stockholder interests in the parent itself, plus their undivided
interests in the net assets of the parent's subsidiaries.
B. Economic Unit Concept:
The economic unit concept emphasizes control of the whole by a single
management. As a result, under this concept, consolidated financial
statements are intended to provide information about a group of legal
entities - a parent company and its subsidiaries - operating as a single unit.
In its most recent pronouncements, FASB has opted to adopt this
concept, and the 4th edition chapters (2 through 9) are based on the
economic unit concept.
C. Noncontrolling Interest
1. Under the economic unit concept, a noncontrolling interest is a
part of the ownership equity in the entire economic unit.
2. Under the parent company concept, the nature and classification
of a noncontrolling interest are unclear.
D. Consolidated Net Income
1. Under the parent company concept, consolidated net income
consists of the realized combined income of the parent company
and its subsidiaries after deducting noncontrolling interest in
income; that is, the noncontrolling interest in income is deducted
as an expense item in determining consolidated net income.
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9
2. Under the economic unit concept, consolidated net income
consists of the total realized combined income of the parent
company and its subsidiaries. The total combined income is then
allocated proportionately to the noncontrolling interest and the
controlling interest. Noncontrolling interest in income is
considered an allocated portion of consolidated net income, rather
than an element in the determination of consolidated net income.
E. Consolidated Balance Sheet Values
1. Under the parent company concept, the value assigned to the net
assets should not exceed cost to the parent company.
2. Under the economic unit concept, on the date of acquisition, the
net assets of the subsidiary are included in the consolidated
financial statements at their book value plus the entire difference
between their fair value and their book value.
F. Elimination of Unrealized Intercompany Profit
The elimination methods associated with these two points of view are
generally referred to as total (100%) elimination and partial elimination.
Note: this issue is unlikely to mean much to students at this point in their
study, and may be returned to after chapter 6. It is included here,
nonetheless, for the sake of thoroughness and because the discussion is
fairly intuitive.
1. Partial elimination is consistent with the parent company concept.
2. Total elimination is consistent with the economic unit concept.
3. Current and Past Practice
a. Current (and past) practice follows neither the parent
company nor the economic unit concept entirely. The
differences in practice relate primarily to the classification
of noncontrolling interest and the total elimination of
unrealized intercompany profits in assets acquired from an
affiliate. However, as previously stated, the expectation is
that the economic entity concept will be followed in the
future.
b. Current accounting standards require the total elimination
of unrealized intercompany profit in assets acquired from
affiliated companies, regardless of the percentage of
ownership.
9
2. Under the economic unit concept, consolidated net income
consists of the total realized combined income of the parent
company and its subsidiaries. The total combined income is then
allocated proportionately to the noncontrolling interest and the
controlling interest. Noncontrolling interest in income is
considered an allocated portion of consolidated net income, rather
than an element in the determination of consolidated net income.
E. Consolidated Balance Sheet Values
1. Under the parent company concept, the value assigned to the net
assets should not exceed cost to the parent company.
2. Under the economic unit concept, on the date of acquisition, the
net assets of the subsidiary are included in the consolidated
financial statements at their book value plus the entire difference
between their fair value and their book value.
F. Elimination of Unrealized Intercompany Profit
The elimination methods associated with these two points of view are
generally referred to as total (100%) elimination and partial elimination.
Note: this issue is unlikely to mean much to students at this point in their
study, and may be returned to after chapter 6. It is included here,
nonetheless, for the sake of thoroughness and because the discussion is
fairly intuitive.
1. Partial elimination is consistent with the parent company concept.
2. Total elimination is consistent with the economic unit concept.
3. Current and Past Practice
a. Current (and past) practice follows neither the parent
company nor the economic unit concept entirely. The
differences in practice relate primarily to the classification
of noncontrolling interest and the total elimination of
unrealized intercompany profits in assets acquired from an
affiliate. However, as previously stated, the expectation is
that the economic entity concept will be followed in the
future.
b. Current accounting standards require the total elimination
of unrealized intercompany profit in assets acquired from
affiliated companies, regardless of the percentage of
ownership.
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10
10
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Chapter 2
1
CHAPTER TWO – ACCOUNTING FOR BUSINESS COMBINATIONS
I. METHOD OF ACCOUNTING FOR NET ASSET ACQUISITIONS:
PURCHASE OR ACQUISITION ACCOUNTING
A. Accounting standards now mandate the use of the acquisition (purchase)
method for accounting for mergers & acquisitions. Until 2001, companies
had a choice, albeit strictly regulated, between these two methods:
1. Pooling of interests – previous standards clearly defined the
criteria necessary to qualify for this accounting treatment, and the
SEC was involved in its enforcement.
2. Acquisition (Purchase) - all other combinations (i.e, those not
qualifying for pooling treatment) were always accounted for by the
purchase method, as all combinations are currently.
II. PRO FORMA STATEMENTS AND DISCLOSURE REQUIREMENT
A. Pro forma statements have historically served two functions in relation to
business combinations:
1. To provide information in the planning stages of the combination,
and
2. To disclose relevant information subsequent to the combination.
Note: This aspect was particularly important prior to the
elimination of the pooling method, as a means of enabling users to
compare mergers despite the dissimilarity on the face of the
principal statements between those accounted for under purchase
and pooling.
B. The term “pro forma” is also frequently used, aside from mergers, to
indicate any calculations which are computed “as if” alternative rules or
standards had been applied. For example, a firm may disclose in its press
releases that earnings excluding certain one-time charges reflect a more
positive trend than the GAAP-reported EPS. However, the SEC has
recently cracked down on the extent to which these types of pro forma
calculations may be presented, and the details that should be included in
such announcements.
C. The notes to the statements contain useful information to facilitate
comparison between periods.
III. EXPLANATION AND ILLUSTRATION OF ACQUISITION
ACCOUNTING
1
CHAPTER TWO – ACCOUNTING FOR BUSINESS COMBINATIONS
I. METHOD OF ACCOUNTING FOR NET ASSET ACQUISITIONS:
PURCHASE OR ACQUISITION ACCOUNTING
A. Accounting standards now mandate the use of the acquisition (purchase)
method for accounting for mergers & acquisitions. Until 2001, companies
had a choice, albeit strictly regulated, between these two methods:
1. Pooling of interests – previous standards clearly defined the
criteria necessary to qualify for this accounting treatment, and the
SEC was involved in its enforcement.
2. Acquisition (Purchase) - all other combinations (i.e, those not
qualifying for pooling treatment) were always accounted for by the
purchase method, as all combinations are currently.
II. PRO FORMA STATEMENTS AND DISCLOSURE REQUIREMENT
A. Pro forma statements have historically served two functions in relation to
business combinations:
1. To provide information in the planning stages of the combination,
and
2. To disclose relevant information subsequent to the combination.
Note: This aspect was particularly important prior to the
elimination of the pooling method, as a means of enabling users to
compare mergers despite the dissimilarity on the face of the
principal statements between those accounted for under purchase
and pooling.
B. The term “pro forma” is also frequently used, aside from mergers, to
indicate any calculations which are computed “as if” alternative rules or
standards had been applied. For example, a firm may disclose in its press
releases that earnings excluding certain one-time charges reflect a more
positive trend than the GAAP-reported EPS. However, the SEC has
recently cracked down on the extent to which these types of pro forma
calculations may be presented, and the details that should be included in
such announcements.
C. The notes to the statements contain useful information to facilitate
comparison between periods.
III. EXPLANATION AND ILLUSTRATION OF ACQUISITION
ACCOUNTING
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2
A. If cash is used, payment equals cost; if debt securities are used, present
value of future payments represents cost.
B. Assets acquired via issued shares are recorded at fair values of the stock
given or the assets received whichever is more clearly evident.
C. If stock is actively traded, market price is a better estimate of fair value
than appraisal values.
D. Goodwill (GW) is recorded as any excess of total cost over the sum of
amounts assigned to identifiable assets and liabilities and, under SFAS No.
142 [ASC 350] is no longer amortized.
E. Goodwill must be tested for impairment at a level referred to as a
reporting unit – generally a level lower than that of the entire entity. If the
implied fair value of the reporting unit’s goodwill is less than its carrying
amount, goodwill is considered impaired.
F. Goodwill impairment losses should be aggregated and presented as a
separate line item in the operating section of the income statement.
G. Bargain acquisition—when the net amount of fair values of identifiable
assets less liabilities exceeds the total cost of the acquired company—a
gain is recognized in the period of the acquisition under current GAAP.
H. When S Company acquires P Company with stock, common stock is
credited for the par value of the shares issued, with the remainder credited
to other contributed capital. Individual assets acquired and liabilities
assumed are recorded at their fair values. Plant assets and other long-lived
assets are recorded at their fair values unless a bargain has occurred, in
which case their values are reduced below fair value to the extent of the
bargain. When the cost exceeds the fair value of identifiable net assets,
any excess of cost over the fair value is recorded as goodwill.
I. Income Tax Consequences of Acquisition Method Business
Combinations: deferred tax assets and/or liabilities must be recognized for
differences between the assigned values and tax bases of the assets and
liabilities acquired. Such differences are likely when the combination is
tax-free to the sellers.
2
A. If cash is used, payment equals cost; if debt securities are used, present
value of future payments represents cost.
B. Assets acquired via issued shares are recorded at fair values of the stock
given or the assets received whichever is more clearly evident.
C. If stock is actively traded, market price is a better estimate of fair value
than appraisal values.
D. Goodwill (GW) is recorded as any excess of total cost over the sum of
amounts assigned to identifiable assets and liabilities and, under SFAS No.
142 [ASC 350] is no longer amortized.
E. Goodwill must be tested for impairment at a level referred to as a
reporting unit – generally a level lower than that of the entire entity. If the
implied fair value of the reporting unit’s goodwill is less than its carrying
amount, goodwill is considered impaired.
F. Goodwill impairment losses should be aggregated and presented as a
separate line item in the operating section of the income statement.
G. Bargain acquisition—when the net amount of fair values of identifiable
assets less liabilities exceeds the total cost of the acquired company—a
gain is recognized in the period of the acquisition under current GAAP.
H. When S Company acquires P Company with stock, common stock is
credited for the par value of the shares issued, with the remainder credited
to other contributed capital. Individual assets acquired and liabilities
assumed are recorded at their fair values. Plant assets and other long-lived
assets are recorded at their fair values unless a bargain has occurred, in
which case their values are reduced below fair value to the extent of the
bargain. When the cost exceeds the fair value of identifiable net assets,
any excess of cost over the fair value is recorded as goodwill.
I. Income Tax Consequences of Acquisition Method Business
Combinations: deferred tax assets and/or liabilities must be recognized for
differences between the assigned values and tax bases of the assets and
liabilities acquired. Such differences are likely when the combination is
tax-free to the sellers.
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Chapter 2
3
IV. CONTINGENT CONSIDERATION IN A PURCHASE
A. Contingency—transfer of assets subsequent to acquisition from parent to
subsidiary, generally dependent of some measure of performance.
B. Contingency based on earnings is probably the most common, but it may
create conflicts upon implementation because of measures which are out
of the control of certain managers after the merger, as well as creating
possible incentives for manipulation of earnings numbers (and may lead to
decisions which are short-term rather than long-term focused).
C. Contingency based on security prices serves to correct some of the
shortcomings of contingency calculations based on earnings (manipulation
of numbers, for example), but leads to its own set of problems; for
example, market prices fluctuate in response to many economy-wide
factors that are almost completely outside the managers’ control.
V. LEVERAGED BUYOUTS
A. Group of employees/management creates a new company to acquire all
the outstanding shares of employer/original company.
B. Consensus position is that only portion of the net assets acquired with
borrowed funds have actually been purchased and therefore recorded at
cost.
APPENDIX A: Deferred Taxes in Business Combinations
A. Motivation for selling firm: structure the deal so that any gain resulting is
tax-free at the time of the combination.
B. Deferred tax liability (or asset) needs to be recognized by purchaser when
the book value of the assets is used (inherited) for tax purposes, but the
fair value is recognized in the accounting books under purchase
accounting rules.
3
IV. CONTINGENT CONSIDERATION IN A PURCHASE
A. Contingency—transfer of assets subsequent to acquisition from parent to
subsidiary, generally dependent of some measure of performance.
B. Contingency based on earnings is probably the most common, but it may
create conflicts upon implementation because of measures which are out
of the control of certain managers after the merger, as well as creating
possible incentives for manipulation of earnings numbers (and may lead to
decisions which are short-term rather than long-term focused).
C. Contingency based on security prices serves to correct some of the
shortcomings of contingency calculations based on earnings (manipulation
of numbers, for example), but leads to its own set of problems; for
example, market prices fluctuate in response to many economy-wide
factors that are almost completely outside the managers’ control.
V. LEVERAGED BUYOUTS
A. Group of employees/management creates a new company to acquire all
the outstanding shares of employer/original company.
B. Consensus position is that only portion of the net assets acquired with
borrowed funds have actually been purchased and therefore recorded at
cost.
APPENDIX A: Deferred Taxes in Business Combinations
A. Motivation for selling firm: structure the deal so that any gain resulting is
tax-free at the time of the combination.
B. Deferred tax liability (or asset) needs to be recognized by purchaser when
the book value of the assets is used (inherited) for tax purposes, but the
fair value is recognized in the accounting books under purchase
accounting rules.
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4
APPENDIX B: Did Firms Prefer Pooling; And, If So, Why?
I. A. Some facts about pooling
1. Majority of US mergers did not meet pooling criteria. Therefore
the purchase method was more widely used, but firms (especially
in large mergers) sometimes went to great lengths to qualify for
pooling treatment. Furthermore, when the elimination of the
pooling method was proposed, it meant with vehement protests
from a number of fronts.
2. Why did firms care? The two methods resulted in a substantial
difference in the way the combined financial statements appeared.
3. Pooling—neither of the two firms was considered dominant. The
acquiring firm was termed the “issuer” and the other firm was the
“non-issuer.” Assets, liabilities, and retained earnings were taken
forward at their previous carrying amounts. Operating results of
the two companies were combined for the entire period being
presented, regardless of the date of acquisition. Previously issued
statements (when presented) were restated as if the companies had
always been combined.
4. Pooling--income statements subsequent to the transaction did not
include goodwill amortization, excess depreciation, or other
charges due to asset revaluing.
5. Purchase accounting yields a generally lower net income divided
by a larger base of assets, and therefore a substantially decreased
return on assets (ROA) in most cases relative to pooling.
However, this effect has been lessened by another FASB change
which essentially eliminates the amortization of goodwill.
6. Pooling required review of prior year statements which facilitated
trend analysis.
7. See Illustration 2-1 for comparison of the two methods
8. Balance sheet differences—Purchase accounting reflects more
current values for the combining firm’s assets and liabilites.
Pooling combined retained earnings of the two firms (in most
cases), leading to generally greater retained earnings balances for
the combined entity relative to purhase. Purchase, on the other
hand, does not reflect any retained earnings from the acquired
entity.
4
APPENDIX B: Did Firms Prefer Pooling; And, If So, Why?
I. A. Some facts about pooling
1. Majority of US mergers did not meet pooling criteria. Therefore
the purchase method was more widely used, but firms (especially
in large mergers) sometimes went to great lengths to qualify for
pooling treatment. Furthermore, when the elimination of the
pooling method was proposed, it meant with vehement protests
from a number of fronts.
2. Why did firms care? The two methods resulted in a substantial
difference in the way the combined financial statements appeared.
3. Pooling—neither of the two firms was considered dominant. The
acquiring firm was termed the “issuer” and the other firm was the
“non-issuer.” Assets, liabilities, and retained earnings were taken
forward at their previous carrying amounts. Operating results of
the two companies were combined for the entire period being
presented, regardless of the date of acquisition. Previously issued
statements (when presented) were restated as if the companies had
always been combined.
4. Pooling--income statements subsequent to the transaction did not
include goodwill amortization, excess depreciation, or other
charges due to asset revaluing.
5. Purchase accounting yields a generally lower net income divided
by a larger base of assets, and therefore a substantially decreased
return on assets (ROA) in most cases relative to pooling.
However, this effect has been lessened by another FASB change
which essentially eliminates the amortization of goodwill.
6. Pooling required review of prior year statements which facilitated
trend analysis.
7. See Illustration 2-1 for comparison of the two methods
8. Balance sheet differences—Purchase accounting reflects more
current values for the combining firm’s assets and liabilites.
Pooling combined retained earnings of the two firms (in most
cases), leading to generally greater retained earnings balances for
the combined entity relative to purhase. Purchase, on the other
hand, does not reflect any retained earnings from the acquired
entity.
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Chapter 2
5
B. Treatment of Acquisition Expenses Contrasted
1. Pooling—all types of expenses (direct, indirect, and security issue
costs) were expensed in the period incurred.
2. Purchase—each category of expenses is treated differently, as
shown below.
Pooling Purchase
Direct Expenses Expense (IS) Capitalize (GW or PPE)
Indirect Expense Expense (IS) Expense
Security Issue Costs Expense (IS) Adjust additional PIC
C. PURCHASE VERSUS POOLING -- AUTHORITATIVE POSITION (AND
HISTORICAL PERSPECTIVE)
1. The Financial Accounting Standards Board (FASB) has recently
eliminated the pooling method. As a result, all acquisitions are now
accounted for by the purchase method.
2. Prior to the issuance of APB Opinion No. 16, “Business Combinations,”
the pooling method was widely used and abused. This opinion delineated
the specific conditions under which pooling was required; all other
combinations had to be accounted for as purchases.
a. Paragraphs 45--48 of Opinion No. 16 spelled out the specific conditions
under which pooling was required.
b. Twelve conditions in Opinion No. 16 were specified to meet requirements
for pooling.
c. Opinion No. 16 attempted to define criteria clearly, remove any choice of
method (other than that provided by judicious planning of a combination's
terms), and prohibit partial pooling.
3. Advantages and disadvantages, both theoretical and practical, were noted
for both methods.
4. Opinion No. 16, issued in 1970, significantly reduced the proportion of
business combinations accounted for as poolings of interests and improved
business combination accounting and reporting to a large extent. However,
pooling remained a popular and controversial method for very large
mergers until FASB eliminated it in 2001.
5
B. Treatment of Acquisition Expenses Contrasted
1. Pooling—all types of expenses (direct, indirect, and security issue
costs) were expensed in the period incurred.
2. Purchase—each category of expenses is treated differently, as
shown below.
Pooling Purchase
Direct Expenses Expense (IS) Capitalize (GW or PPE)
Indirect Expense Expense (IS) Expense
Security Issue Costs Expense (IS) Adjust additional PIC
C. PURCHASE VERSUS POOLING -- AUTHORITATIVE POSITION (AND
HISTORICAL PERSPECTIVE)
1. The Financial Accounting Standards Board (FASB) has recently
eliminated the pooling method. As a result, all acquisitions are now
accounted for by the purchase method.
2. Prior to the issuance of APB Opinion No. 16, “Business Combinations,”
the pooling method was widely used and abused. This opinion delineated
the specific conditions under which pooling was required; all other
combinations had to be accounted for as purchases.
a. Paragraphs 45--48 of Opinion No. 16 spelled out the specific conditions
under which pooling was required.
b. Twelve conditions in Opinion No. 16 were specified to meet requirements
for pooling.
c. Opinion No. 16 attempted to define criteria clearly, remove any choice of
method (other than that provided by judicious planning of a combination's
terms), and prohibit partial pooling.
3. Advantages and disadvantages, both theoretical and practical, were noted
for both methods.
4. Opinion No. 16, issued in 1970, significantly reduced the proportion of
business combinations accounted for as poolings of interests and improved
business combination accounting and reporting to a large extent. However,
pooling remained a popular and controversial method for very large
mergers until FASB eliminated it in 2001.
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6
II. A LOOK BACK: EXPLANATION AND ILLUSTRATION OF POOLING OF
INTERESTS
A. Business combination process in which two or more groups of
stockholders united their ownership interests by an exchange of common
stock.
B. Owners retained proprietary rights
C. Fair value of assets and liabilities were ignored except in the
determination of an equitable exchange ratio of common stock. Assets
and liabilities were carried forward at book value.
D. Equity allocation to common stock, to other contributed capital and to
retained earnings:
1. If par value of shares issued equals par value of existing shares on
books of the combining firm—show addition of all other
contributed capital and retained earnings.
2. If par value of shares issued exceeds par value of existing shares—
equity transfer rule—when the par (or stated) value of the shares
issued by the issuing firm exceeds the total par or stated value of
the combining company'’ stock, the excess should be deducted first
from the combined other contributed capital and then from
combined retained earnings (RE).
3. If par value of shares issued is less than par value of existing
shares on books of the combining firm—show addition of other
contributed capital and retained earnings plus additional “other
contributed capital” for the difference between par values.
4. Results of operations for that period were the sum of the results of:
(1) Operations of the separate companies as if they had been
combined from the beginning of the fiscal period to the
date the combination is consummated.
(2) The combined operations from that date to the end of the
period.
III. FINANCIAL STATEMENT DIFFERENCES BETWEEN ACCOUNTING
METHODS
A. Purchase and pooling of interest methods were not intended to be
considered as alternatives in accounting for a specific business
combination. Nonetheless business managers often regarded them as such
in the planning stages of an acquisition. Furthermore, those acquisitions
that were initially recorded under the pooling rules remain on the books
under those rules; i.e. the elimination was not retroactive. Thus, it is
6
II. A LOOK BACK: EXPLANATION AND ILLUSTRATION OF POOLING OF
INTERESTS
A. Business combination process in which two or more groups of
stockholders united their ownership interests by an exchange of common
stock.
B. Owners retained proprietary rights
C. Fair value of assets and liabilities were ignored except in the
determination of an equitable exchange ratio of common stock. Assets
and liabilities were carried forward at book value.
D. Equity allocation to common stock, to other contributed capital and to
retained earnings:
1. If par value of shares issued equals par value of existing shares on
books of the combining firm—show addition of all other
contributed capital and retained earnings.
2. If par value of shares issued exceeds par value of existing shares—
equity transfer rule—when the par (or stated) value of the shares
issued by the issuing firm exceeds the total par or stated value of
the combining company'’ stock, the excess should be deducted first
from the combined other contributed capital and then from
combined retained earnings (RE).
3. If par value of shares issued is less than par value of existing
shares on books of the combining firm—show addition of other
contributed capital and retained earnings plus additional “other
contributed capital” for the difference between par values.
4. Results of operations for that period were the sum of the results of:
(1) Operations of the separate companies as if they had been
combined from the beginning of the fiscal period to the
date the combination is consummated.
(2) The combined operations from that date to the end of the
period.
III. FINANCIAL STATEMENT DIFFERENCES BETWEEN ACCOUNTING
METHODS
A. Purchase and pooling of interest methods were not intended to be
considered as alternatives in accounting for a specific business
combination. Nonetheless business managers often regarded them as such
in the planning stages of an acquisition. Furthermore, those acquisitions
that were initially recorded under the pooling rules remain on the books
under those rules; i.e. the elimination was not retroactive. Thus, it is
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7
important to realize that so long as those companies do not unwind or spin
off such prior acquisitions, the “old” pooling rules will continue to affect
the appearance of financial statements for years to come.
B. Purchase accounting tends to report higher asset values but lower earnings
(due to excess depreciation and amortization) versus pooling of interest.
C. Bargain purchases—purchase price below fair value of identifiable net
assets—will yield ordinary gain under acquisition (purchase) rules. (In the
past, extraordinary gains were sometimes recorded.)
7
important to realize that so long as those companies do not unwind or spin
off such prior acquisitions, the “old” pooling rules will continue to affect
the appearance of financial statements for years to come.
B. Purchase accounting tends to report higher asset values but lower earnings
(due to excess depreciation and amortization) versus pooling of interest.
C. Bargain purchases—purchase price below fair value of identifiable net
assets—will yield ordinary gain under acquisition (purchase) rules. (In the
past, extraordinary gains were sometimes recorded.)
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1
CHAPTER THREE – CONSOLIDATED FINANCIAL STATEMENTS
I. DEFINITIONS OF SUBSIDIARY AND CONTROL
A. Subsidiary: Situation wherein a parent company (and/or parent’s other
subsidiaries) owns a controlling interest in the voting shares of another company, usually
more than 50% of the voting shares.
B. Control: The ability of an entity to direct the policies and management that guide the
ongoing activities of another entity so as to increase its benefits and limit its losses from
that other entity’s activities. For purposes of consolidated financial statements, control
involves decision-making ability that is not shared with others. It stresses the need to
prepare consolidated financial statements whenever control exists, even in the absence of a
majority ownership.
C. Parent: When a stock acquisition occurs, the acquiring company is generally referred to
as the parent.
D. Noncontrolling (minority) interest: Shareholders holding the remaining stock in a
subsidiary outside of that held by the parent company.
E. Affiliated companies: The related companies having a joint relationship. Each of the
affiliated companies continues its separate legal existence.
II. REQUIREMENTS FOR THE INCLUSION OF SUBSIDIARIES
IN THE CONSOLIDATED FINANCIAL STATEMENTS
A. Given the purpose that consolidated statements is to present for a single accounting entity
the net resources and operating results of a group of companies under common control,
also considering the problems related to off-balance-sheet financing, the FASB has taken
the position that essentially all controlled corporations should be consolidated.
B. Under some circumstances, majority-owned subsidiaries should be excluded from the
consolidated statements. Those circumstances include:
1. Control does not rest with the majority owner – e.g. as when the firm is in
bankruptcy.
2. A foreign company is domiciled in a country with foreign exchange restrictions,
controls, or governmentally imposed uncertainties that cast significant doubt on the
parent’s ability to control the subsidiary.
3. Majority owned investments that are not consolidated for one of the above reasons
are normally reported as investments using the cost method (with fair value
adjustments, if needed) because the subsidiaries are not controlled nor significantly
influenced by the parent company.
III. REASONS FOR SUBSIDIARY COMPANIES
1
CHAPTER THREE – CONSOLIDATED FINANCIAL STATEMENTS
I. DEFINITIONS OF SUBSIDIARY AND CONTROL
A. Subsidiary: Situation wherein a parent company (and/or parent’s other
subsidiaries) owns a controlling interest in the voting shares of another company, usually
more than 50% of the voting shares.
B. Control: The ability of an entity to direct the policies and management that guide the
ongoing activities of another entity so as to increase its benefits and limit its losses from
that other entity’s activities. For purposes of consolidated financial statements, control
involves decision-making ability that is not shared with others. It stresses the need to
prepare consolidated financial statements whenever control exists, even in the absence of a
majority ownership.
C. Parent: When a stock acquisition occurs, the acquiring company is generally referred to
as the parent.
D. Noncontrolling (minority) interest: Shareholders holding the remaining stock in a
subsidiary outside of that held by the parent company.
E. Affiliated companies: The related companies having a joint relationship. Each of the
affiliated companies continues its separate legal existence.
II. REQUIREMENTS FOR THE INCLUSION OF SUBSIDIARIES
IN THE CONSOLIDATED FINANCIAL STATEMENTS
A. Given the purpose that consolidated statements is to present for a single accounting entity
the net resources and operating results of a group of companies under common control,
also considering the problems related to off-balance-sheet financing, the FASB has taken
the position that essentially all controlled corporations should be consolidated.
B. Under some circumstances, majority-owned subsidiaries should be excluded from the
consolidated statements. Those circumstances include:
1. Control does not rest with the majority owner – e.g. as when the firm is in
bankruptcy.
2. A foreign company is domiciled in a country with foreign exchange restrictions,
controls, or governmentally imposed uncertainties that cast significant doubt on the
parent’s ability to control the subsidiary.
3. Majority owned investments that are not consolidated for one of the above reasons
are normally reported as investments using the cost method (with fair value
adjustments, if needed) because the subsidiaries are not controlled nor significantly
influenced by the parent company.
III. REASONS FOR SUBSIDIARY COMPANIES
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2
A. Stock acquisition is relatively simple in some cases. Mechanisms such as open market
purchases and cash tender offers help avoid the often long & difficult negotiations of stock
for stock exchange in complete takeovers.
B. Control of subsidiary’s operations can be accomplished with smaller investment – not all
of the subsidiary’s stock must be acquired, but only a sufficient portion to achieve control.
C. Limited liability - separate legal existence of individual affiliates provides an element of
protection of the parent’s assets from creditors of the subsidiary.
D. In some cases, one of the entities may be subject to regulation while others are not.
In a stock acquisition, the other entities may maintain their unregulated status.
IV. CONSOLIDATED FINANCIAL STATEMENTS
A. Statements prepared for a parent company and its subsidiaries. They represent the sum of
assets, liabilities, revenues, and expenses of the affiliates after eliminating the effect of any
transactions among the affiliated companies.
B. When a parent acquires controlling interest in a subsidiary, the parent makes an entry to
debit Investment in Subsidiary and credit either cash, debt, or stock (or combination)
depending on medium of exchange. Assume the acquisition has a cash purchase price of
$5 million. Entry in parent’s books is:
C.
Investment in Subsidiary $5,000,000
Cash $5,000,00
C. The investment account represents the parent’s investment in the different asset and
liability accounts of the subsidiary. The subsidiary continues to maintain detailed books
based on historical book values, which are not as current as the market values assessed by
the parent at the date of acquisition but are detailed as to classification. Consolidation
process summarization:
Investment Account on
the Parent’s Books
Asset and Liability
Accounts on the
Subsidiary’s Books
Valuation in the
financial statements MARKET VALUE HISTORICAL VALUE
Classification in the
financial statements
ONE ACCOUNT MULTIPLE
ACCOUNTS
D. Process of preparing consolidated financial statements aims to achieve market value and
multiple accounts characteristics (items in the diagonal in part C above). Consolidated
statements ignore the legal aspects of the separate entities and focus on the economic
entity under the control of management, and thus focus on substance rather than form.
Consolidated statements are not to be used as substitutes for the statements prepared by
the separate subsidiaries.
2
A. Stock acquisition is relatively simple in some cases. Mechanisms such as open market
purchases and cash tender offers help avoid the often long & difficult negotiations of stock
for stock exchange in complete takeovers.
B. Control of subsidiary’s operations can be accomplished with smaller investment – not all
of the subsidiary’s stock must be acquired, but only a sufficient portion to achieve control.
C. Limited liability - separate legal existence of individual affiliates provides an element of
protection of the parent’s assets from creditors of the subsidiary.
D. In some cases, one of the entities may be subject to regulation while others are not.
In a stock acquisition, the other entities may maintain their unregulated status.
IV. CONSOLIDATED FINANCIAL STATEMENTS
A. Statements prepared for a parent company and its subsidiaries. They represent the sum of
assets, liabilities, revenues, and expenses of the affiliates after eliminating the effect of any
transactions among the affiliated companies.
B. When a parent acquires controlling interest in a subsidiary, the parent makes an entry to
debit Investment in Subsidiary and credit either cash, debt, or stock (or combination)
depending on medium of exchange. Assume the acquisition has a cash purchase price of
$5 million. Entry in parent’s books is:
C.
Investment in Subsidiary $5,000,000
Cash $5,000,00
C. The investment account represents the parent’s investment in the different asset and
liability accounts of the subsidiary. The subsidiary continues to maintain detailed books
based on historical book values, which are not as current as the market values assessed by
the parent at the date of acquisition but are detailed as to classification. Consolidation
process summarization:
Investment Account on
the Parent’s Books
Asset and Liability
Accounts on the
Subsidiary’s Books
Valuation in the
financial statements MARKET VALUE HISTORICAL VALUE
Classification in the
financial statements
ONE ACCOUNT MULTIPLE
ACCOUNTS
D. Process of preparing consolidated financial statements aims to achieve market value and
multiple accounts characteristics (items in the diagonal in part C above). Consolidated
statements ignore the legal aspects of the separate entities and focus on the economic
entity under the control of management, and thus focus on substance rather than form.
Consolidated statements are not to be used as substitutes for the statements prepared by
the separate subsidiaries.
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3
V. INVESTMENTS AT THE DATE OF ACQUISITION
A. Recording Investments at Cost (Parent’s Books)
1. Purchase method – stock investment is recorded at its cost as measured by the fair
value of the consideration given or received, whichever is more clearly evident.
2. Both direct and indirect costs (costs of maintaining an M&A dept, for example)
should be expensed as incurred.
B. If cash is used for the acquisition, the investment is recorded at its cash cost, including
broker's fees and other direct costs of the investment.
C. If the company acquires only part of shares and pays an acquisition fee, the investment is
recorded at its cost of purchasing shares and other direct costs of investment.
D. If the company issues stock in the acquisition, the investment is recorded at the fair value
of the stock issued, giving effect to any costs of registering the stock issue.
E. If the company pays additional fees, such as a finder’s fee, the cost of that fee should be
expensed under Exposure Draft No. 1204-001.
VI. CONSOLIDATED BALANCE SHEETS: THE USE OF WORKPAPERS
A. The use of workpapers
1. Consolidated balance sheet reports the sum of the assets and liabilities of a parent
and its subsidiaries as if they constituted a single company.
2. Assets and liabilities are summed in their entirety (whether 100% ownership or
not).
3. Noncontrolling interests are reflected as a component of owner’s equity.
4. Eliminations must be made to cancel effects of transactions among the parent and
its subsidiaries, as shown in the table below.
5. A workpaper is used to summarize the effects of the various additions,
eliminations, etc.
Intercompany Accounts to be Eliminated
Parent’s Accounts Subsidiary’s Accounts
Investment in Subsidiary Against Equity Accounts
Intercompany receivable
(payable)
Against Intercompany payable
(receivable)
Advances to subsidiary (from
subsidiary)
Against Advances to parent (to parent)
Interest revenue (interest
expense)
Against Interest expense (interest
revenue)
Dividend revenue (dividends
declared) Against
Dividends declared (dividend
revenue)
Management fee received from Against Management fee paid to
3
V. INVESTMENTS AT THE DATE OF ACQUISITION
A. Recording Investments at Cost (Parent’s Books)
1. Purchase method – stock investment is recorded at its cost as measured by the fair
value of the consideration given or received, whichever is more clearly evident.
2. Both direct and indirect costs (costs of maintaining an M&A dept, for example)
should be expensed as incurred.
B. If cash is used for the acquisition, the investment is recorded at its cash cost, including
broker's fees and other direct costs of the investment.
C. If the company acquires only part of shares and pays an acquisition fee, the investment is
recorded at its cost of purchasing shares and other direct costs of investment.
D. If the company issues stock in the acquisition, the investment is recorded at the fair value
of the stock issued, giving effect to any costs of registering the stock issue.
E. If the company pays additional fees, such as a finder’s fee, the cost of that fee should be
expensed under Exposure Draft No. 1204-001.
VI. CONSOLIDATED BALANCE SHEETS: THE USE OF WORKPAPERS
A. The use of workpapers
1. Consolidated balance sheet reports the sum of the assets and liabilities of a parent
and its subsidiaries as if they constituted a single company.
2. Assets and liabilities are summed in their entirety (whether 100% ownership or
not).
3. Noncontrolling interests are reflected as a component of owner’s equity.
4. Eliminations must be made to cancel effects of transactions among the parent and
its subsidiaries, as shown in the table below.
5. A workpaper is used to summarize the effects of the various additions,
eliminations, etc.
Intercompany Accounts to be Eliminated
Parent’s Accounts Subsidiary’s Accounts
Investment in Subsidiary Against Equity Accounts
Intercompany receivable
(payable)
Against Intercompany payable
(receivable)
Advances to subsidiary (from
subsidiary)
Against Advances to parent (to parent)
Interest revenue (interest
expense)
Against Interest expense (interest
revenue)
Dividend revenue (dividends
declared) Against
Dividends declared (dividend
revenue)
Management fee received from Against Management fee paid to
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4
subsidiary subsidiary
Sales to subsidiary (purchases of
inventory from subsidiary)
Against Purchases of inventory from
parent (sales to parent)
B. Investment elimination
1. An important basic elimination in the preparation of consolidated statements is the
elimination of the investment account and the related subsidiary's stockholders'
equity.
2. To start the process of combining the individual assets and liabilities of a parent
company and its subsidiary at the date of acquisition, the first step is to prepare a
“Computation and Allocation of Difference between Implied and Book Value”
schedule (CAD). Preparation of this schedule requires us to address two basic
issues.
a. Determine the percentage of stock acquired in the subsidiary (Is it a 100%
acquisition, or a smaller percentage?) and calculate Implied Value (IV) by
dividing the purchase price by the percentage acquired.
b. Compare the IV to the book value of the equity of the target. If a difference
between implied and book value exists, we must then allocate that difference to
adjust the underlying assets and/or liabilities of the acquired company.
c. Book value of the equity = Assets of S Company minus Liabilities of S
Company, or recorded values of all S Company equity accounts summed.
d. Note that the comparison is implied value (IV) to book value, rather than
market value of the acquired entity.
e. The steps above lead to the following possible cases:
CASE 1. The value of the subsidiary (IV), as implied by the purchase price, is
equal to the book value of the subsidiary company's equity, and
(a) The parent company acquires 100% of the subsidiary
company's stock; or
(b) The parent company acquires less than 100% of the
subsidiary company's stock.
CASE 2. The IV exceeds the book value of the subsidiary company's equity, and
(a) The parent company acquires 100% of the subsidiary
company's stock; or
(b) The parent company acquires less than 100% of the
subsidiary company's stock.
CASE 3. The IV is less than the book value of the subsidiary company's equity,
and
(a) The parent company acquires 100% of the subsidiary
company's stock; or
(b) The parent company acquires less than 100% of the
subsidiary company's stock.
D. Illustration of the alternatives
1. Case 1(a): IV (implied value) Is Equal to Book Value of Subsidiary Stock– Total
Ownership (100% of Subsidiary Stock Acquired)
4
subsidiary subsidiary
Sales to subsidiary (purchases of
inventory from subsidiary)
Against Purchases of inventory from
parent (sales to parent)
B. Investment elimination
1. An important basic elimination in the preparation of consolidated statements is the
elimination of the investment account and the related subsidiary's stockholders'
equity.
2. To start the process of combining the individual assets and liabilities of a parent
company and its subsidiary at the date of acquisition, the first step is to prepare a
“Computation and Allocation of Difference between Implied and Book Value”
schedule (CAD). Preparation of this schedule requires us to address two basic
issues.
a. Determine the percentage of stock acquired in the subsidiary (Is it a 100%
acquisition, or a smaller percentage?) and calculate Implied Value (IV) by
dividing the purchase price by the percentage acquired.
b. Compare the IV to the book value of the equity of the target. If a difference
between implied and book value exists, we must then allocate that difference to
adjust the underlying assets and/or liabilities of the acquired company.
c. Book value of the equity = Assets of S Company minus Liabilities of S
Company, or recorded values of all S Company equity accounts summed.
d. Note that the comparison is implied value (IV) to book value, rather than
market value of the acquired entity.
e. The steps above lead to the following possible cases:
CASE 1. The value of the subsidiary (IV), as implied by the purchase price, is
equal to the book value of the subsidiary company's equity, and
(a) The parent company acquires 100% of the subsidiary
company's stock; or
(b) The parent company acquires less than 100% of the
subsidiary company's stock.
CASE 2. The IV exceeds the book value of the subsidiary company's equity, and
(a) The parent company acquires 100% of the subsidiary
company's stock; or
(b) The parent company acquires less than 100% of the
subsidiary company's stock.
CASE 3. The IV is less than the book value of the subsidiary company's equity,
and
(a) The parent company acquires 100% of the subsidiary
company's stock; or
(b) The parent company acquires less than 100% of the
subsidiary company's stock.
D. Illustration of the alternatives
1. Case 1(a): IV (implied value) Is Equal to Book Value of Subsidiary Stock– Total
Ownership (100% of Subsidiary Stock Acquired)
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5
P acquires all outstanding stock (5,000 shares) of S Company for a cash payment
of $80,000
Journal entry:
Investment in S Company $80,000
Cash $80,000
P company's cash balance drops to $20,000 and an investment of $80,000 is
recognized
Computation and allocation of difference between implied and book value:
Cost of investment (purchase price) = IV $80,000
Book value of equity $80,000
Difference between implied and book value 0
Note: Eliminating entries are made to cancel the effects of intercompany
transactions and are made on workpapers only
Eliminating entry in this example:
Common Stock - S Company $50,000
Other Contributed Capital - S Company $10,000
Retained Earnings - S Company $20,000
Investment in S Company $80,000
A workpaper for the preparation of a consolidated balance sheet for P and S
Companies on January 1, 2007, the date of acquisition, is presented in Illustration
3-2.
2. CASE 1(b): IV Is Equal to Book Value of Subsidiary Company's Stock– Partial
Ownership (Less than 100% of Subsidiary Stock Acquired)
P acquires 90% of outstanding stock (4,500 shares) of S Company for a cash
payment of $72,000
In this case, consideration must be given to a noncontrolling interest because P
owns less than 100% of S Company.
Journal entry:
Investment in S Company $72,000
Cash $72,000
P Company's cash balance drops to $28,000 and an investment of $72,000 is
recognized
5
P acquires all outstanding stock (5,000 shares) of S Company for a cash payment
of $80,000
Journal entry:
Investment in S Company $80,000
Cash $80,000
P company's cash balance drops to $20,000 and an investment of $80,000 is
recognized
Computation and allocation of difference between implied and book value:
Cost of investment (purchase price) = IV $80,000
Book value of equity $80,000
Difference between implied and book value 0
Note: Eliminating entries are made to cancel the effects of intercompany
transactions and are made on workpapers only
Eliminating entry in this example:
Common Stock - S Company $50,000
Other Contributed Capital - S Company $10,000
Retained Earnings - S Company $20,000
Investment in S Company $80,000
A workpaper for the preparation of a consolidated balance sheet for P and S
Companies on January 1, 2007, the date of acquisition, is presented in Illustration
3-2.
2. CASE 1(b): IV Is Equal to Book Value of Subsidiary Company's Stock– Partial
Ownership (Less than 100% of Subsidiary Stock Acquired)
P acquires 90% of outstanding stock (4,500 shares) of S Company for a cash
payment of $72,000
In this case, consideration must be given to a noncontrolling interest because P
owns less than 100% of S Company.
Journal entry:
Investment in S Company $72,000
Cash $72,000
P Company's cash balance drops to $28,000 and an investment of $72,000 is
recognized
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6
Computation and Allocation of Difference Schedule
Parent Non- Total
Share Controlling Value
Share
Purchase price and implied value $72,000 8,000 80,000
Less: Book value of equity acquired:
Common stock 45,000 5,000 50,000
Other contributed capital 9,000 1,000 10,000
Retained earnings 18,000 2,000 20,000
Total book value 72,000 8,000 80,000
Difference between implied and book value 0 0 0
Eliminating entry in this example:
Common Stock - S Company $50,000
Other Contributed Capital - S Company $10,000
Retained Earnings - S Company $20,000
Investment in S Company $72,000
Noncontrolling Interest in Equity (NCI) 8,000
Illustration 3 shows the balance sheets of S and P Company before the
consolidation, the eliminating entries, as well as the consolidated balance sheet.
Note that the investment by P in S reflects only its percentage of S Company’s
equity. Thus, when eliminating the equity accounts of S, we must recognize the
emergence of a noncontrolling interest (NCI). Nonetheless, all the assets and
liabilities of S Company and P Company are used to make up the consolidated
balance sheet because the purpose of the latter is to show the resources that are
under control of a single management, not owned! The noncontrolling interest
represents the ownership of other shareholders in the net assets of S Company.
And last, note that the assets are $8,000 greater than in the example before because
P Company has $8,000 more left in cash (on the equity side of the balance sheet
this difference is made up by the noncontrolling interest).
3. CASE 2(b): Implied Value (IV) Exceeds Book Value of Subsidiary Company's
Stock Acquired – Partial Ownership (Less than 100% of the Subsidiary Company's
Stock Acquired) [Note that Case 2(a) is omitted here, as it is relatively easy to
understand once Case 2(b) is grasped.]
P acquires 80% of outstanding stock (4,000 shares) of S Company for a cash
payment of $74,000
Again, consideration must be given to a noncontrolling interest because P owns
less than 100% of S Company. At the same time, the amount by which IV exceeds
the book value of S Company equity must be allocated to an asset or assets in the
workpaper entries.
6
Computation and Allocation of Difference Schedule
Parent Non- Total
Share Controlling Value
Share
Purchase price and implied value $72,000 8,000 80,000
Less: Book value of equity acquired:
Common stock 45,000 5,000 50,000
Other contributed capital 9,000 1,000 10,000
Retained earnings 18,000 2,000 20,000
Total book value 72,000 8,000 80,000
Difference between implied and book value 0 0 0
Eliminating entry in this example:
Common Stock - S Company $50,000
Other Contributed Capital - S Company $10,000
Retained Earnings - S Company $20,000
Investment in S Company $72,000
Noncontrolling Interest in Equity (NCI) 8,000
Illustration 3 shows the balance sheets of S and P Company before the
consolidation, the eliminating entries, as well as the consolidated balance sheet.
Note that the investment by P in S reflects only its percentage of S Company’s
equity. Thus, when eliminating the equity accounts of S, we must recognize the
emergence of a noncontrolling interest (NCI). Nonetheless, all the assets and
liabilities of S Company and P Company are used to make up the consolidated
balance sheet because the purpose of the latter is to show the resources that are
under control of a single management, not owned! The noncontrolling interest
represents the ownership of other shareholders in the net assets of S Company.
And last, note that the assets are $8,000 greater than in the example before because
P Company has $8,000 more left in cash (on the equity side of the balance sheet
this difference is made up by the noncontrolling interest).
3. CASE 2(b): Implied Value (IV) Exceeds Book Value of Subsidiary Company's
Stock Acquired – Partial Ownership (Less than 100% of the Subsidiary Company's
Stock Acquired) [Note that Case 2(a) is omitted here, as it is relatively easy to
understand once Case 2(b) is grasped.]
P acquires 80% of outstanding stock (4,000 shares) of S Company for a cash
payment of $74,000
Again, consideration must be given to a noncontrolling interest because P owns
less than 100% of S Company. At the same time, the amount by which IV exceeds
the book value of S Company equity must be allocated to an asset or assets in the
workpaper entries.
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7
Journal entry:
Investment in S Company $74,000
Cash $74,000
P Company's cash balance is to $26,000 and an investment of $74,000 is
recognized. We assume in this case that the difference between the book value of
the equity and the implied value is attributable to undervalued land.
Computation and Allocation of Difference Schedule
Parent Non- Total
Share Controlling Value
Share
Purchase price and implied value $74,000 18,500 92,500
Less: Book value of equity acquired:
Common stock 40,000 10,000 50,000
Other contributed capital 8,000 2,000 10,000
Retained earnings 16,000 4,000 20,000
Total book value 64,000 16,000 80,000
Difference between implied and book value 10,000 2,500 12,500
Adjust land upward (mark to market) (10,000) (2,500) (12,500)
Balance - 0 - - 0 - - 0 -
Eliminating entry in this example:
Common Stock - S Company $50,000
Other Contributed Capital - S Company $10,000
Retained Earnings - S Company $20,000
Difference between implied and book value $12,500
Investment in S Company $74,000
Noncontrolling Interest (NCI) 18,500
Land $12,500
Difference between implied and book value $12,500
As one can see, the account “Difference between implied and book value” is only a
temporary account; the debit to land could also have been made in the early journal
entry when the equity accounts of S Company were eliminated.
Illustration 3-4 shows the balance sheets of S and P Company before the
consolidation, the eliminating entries, as well as the consolidated balance sheet.
Note the adjustment of land.
7
Journal entry:
Investment in S Company $74,000
Cash $74,000
P Company's cash balance is to $26,000 and an investment of $74,000 is
recognized. We assume in this case that the difference between the book value of
the equity and the implied value is attributable to undervalued land.
Computation and Allocation of Difference Schedule
Parent Non- Total
Share Controlling Value
Share
Purchase price and implied value $74,000 18,500 92,500
Less: Book value of equity acquired:
Common stock 40,000 10,000 50,000
Other contributed capital 8,000 2,000 10,000
Retained earnings 16,000 4,000 20,000
Total book value 64,000 16,000 80,000
Difference between implied and book value 10,000 2,500 12,500
Adjust land upward (mark to market) (10,000) (2,500) (12,500)
Balance - 0 - - 0 - - 0 -
Eliminating entry in this example:
Common Stock - S Company $50,000
Other Contributed Capital - S Company $10,000
Retained Earnings - S Company $20,000
Difference between implied and book value $12,500
Investment in S Company $74,000
Noncontrolling Interest (NCI) 18,500
Land $12,500
Difference between implied and book value $12,500
As one can see, the account “Difference between implied and book value” is only a
temporary account; the debit to land could also have been made in the early journal
entry when the equity accounts of S Company were eliminated.
Illustration 3-4 shows the balance sheets of S and P Company before the
consolidation, the eliminating entries, as well as the consolidated balance sheet.
Note the adjustment of land.
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Chapter 3
8
d. Bidding war over company to be acquired drives the price up
4. CASE 3(b): Implied Value (IV) Is Less than Book Value of Subsidiary Stock–
Partial Ownership (Less than 100% of Subsidiary Stock Acquired) [Note that Case
3(a) is omitted here, as it is relatively easy to understand once Case 3(b) is
grasped.]
P acquires 80% of outstanding stock (4,000 shares) of S Company for a cash
payment of $60,000
Again, consideration must be given to a noncontrolling interest because P owns
less than 100% of S Company. At the same time, the amount that exceeds the
book value of S Company equity must be allocated to an asset (or a gain may be
recognized, if no market value adjustments are warranted); however this time, the
value of the asset is written down rather than up.
Journal entry:
Investment in S Company $60,000
Cash $60,000
P Company's cash balance is to $40,000 and an investment of $60,000 is
recognized. We assume in this case that the difference between the book value of
the equity and the implied value is attributable to overvalued land.
Computation and Allocation of Difference Schedule
Parent Non- Total
Share Controlling Value
Share
Purchase price and implied value $60,000 15,000 $75,000
Less: Book value of equity acquired:
Common stock 40,000 10,000 50,000
Other contributed capital 8,000 2,000 10,000
Retained earnings 16,000 4,000 20,000
Total book value 64,000 16,000 $80,000
Difference between implied and book value (4,000) (1,000) (5,000)
Land, adjust downward 4,000 1,000 5,000
Balance - 0 - - 0 - - 0 -
Eliminating entry in this example:
Common Stock - S Company $50,000
Other Contributed Capital - S Company $10,000
Retained Earnings - S Company $20,000
Difference between implied
8
d. Bidding war over company to be acquired drives the price up
4. CASE 3(b): Implied Value (IV) Is Less than Book Value of Subsidiary Stock–
Partial Ownership (Less than 100% of Subsidiary Stock Acquired) [Note that Case
3(a) is omitted here, as it is relatively easy to understand once Case 3(b) is
grasped.]
P acquires 80% of outstanding stock (4,000 shares) of S Company for a cash
payment of $60,000
Again, consideration must be given to a noncontrolling interest because P owns
less than 100% of S Company. At the same time, the amount that exceeds the
book value of S Company equity must be allocated to an asset (or a gain may be
recognized, if no market value adjustments are warranted); however this time, the
value of the asset is written down rather than up.
Journal entry:
Investment in S Company $60,000
Cash $60,000
P Company's cash balance is to $40,000 and an investment of $60,000 is
recognized. We assume in this case that the difference between the book value of
the equity and the implied value is attributable to overvalued land.
Computation and Allocation of Difference Schedule
Parent Non- Total
Share Controlling Value
Share
Purchase price and implied value $60,000 15,000 $75,000
Less: Book value of equity acquired:
Common stock 40,000 10,000 50,000
Other contributed capital 8,000 2,000 10,000
Retained earnings 16,000 4,000 20,000
Total book value 64,000 16,000 $80,000
Difference between implied and book value (4,000) (1,000) (5,000)
Land, adjust downward 4,000 1,000 5,000
Balance - 0 - - 0 - - 0 -
Eliminating entry in this example:
Common Stock - S Company $50,000
Other Contributed Capital - S Company $10,000
Retained Earnings - S Company $20,000
Difference between implied
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Chapter 3
9
Difference between implied and book value $5,000
Land $5,000
Illustration 3-5 shows the balance sheets of S and P Company before the
consolidation, the eliminating entries, as well as the consolidated balance sheet.
Note the (downward) adjustment of land.
E. Subsidiary Treasury Stock Holdings
Treasury stock is excluded from the computation of the percentage of interest acquired
because the latter is based on stock outstanding
Example: P Company acquires 18,000 of S Company’s shares for $320,000
S Company’s equity section appears as follows:
Common stock, $10 par, 25,000 shares issued $250,000
Other contributed capital $50,000
Retained Earnings $125,000
$425,000
Less: Treasury stock at cost, 1,000 shares $25,000
$400,000
P Company’s interest in S Company is 18,000/24,000 = 75%. Implied Value (IV) =
$320,000/75%, or $426,667. The NCI is 25% x $426,667, or $106,667.
Since Treasury Stock is a contra account, P Company’s share must be reduced
accordingly.
Eliminating entry:
Common Stock - S Company $250,000
Other Contributed Capital - S Company $ 50,000
Retained Earnings - S Company $ 125,000
Difference between IV and Book Value $ 26,667
Treasury stock $ 25,000
Investment in S Company $320,000
Noncontrollling Interest in Equity (NCI) $106,667
E. Other Intercompany Balance Sheet Eliminations
All receivables or payables as well as cash advances must be eliminated against the
reciprocal accounts of the other company.
A $5,000 cash advance by P Company to S Company:
Advance from P Company $25,000
Advance to S Company $25,000
F. Adjusting Entries Prior to Eliminating Entries
In case certain transactions are not completed, adjusting entries must be made.
VII. A COMPREHENSIVE ILLUSTRATION - MORE THAN ONE SUBSIDIARY COMPANY
(Illustration 3-6, 3-7)
9
Difference between implied and book value $5,000
Land $5,000
Illustration 3-5 shows the balance sheets of S and P Company before the
consolidation, the eliminating entries, as well as the consolidated balance sheet.
Note the (downward) adjustment of land.
E. Subsidiary Treasury Stock Holdings
Treasury stock is excluded from the computation of the percentage of interest acquired
because the latter is based on stock outstanding
Example: P Company acquires 18,000 of S Company’s shares for $320,000
S Company’s equity section appears as follows:
Common stock, $10 par, 25,000 shares issued $250,000
Other contributed capital $50,000
Retained Earnings $125,000
$425,000
Less: Treasury stock at cost, 1,000 shares $25,000
$400,000
P Company’s interest in S Company is 18,000/24,000 = 75%. Implied Value (IV) =
$320,000/75%, or $426,667. The NCI is 25% x $426,667, or $106,667.
Since Treasury Stock is a contra account, P Company’s share must be reduced
accordingly.
Eliminating entry:
Common Stock - S Company $250,000
Other Contributed Capital - S Company $ 50,000
Retained Earnings - S Company $ 125,000
Difference between IV and Book Value $ 26,667
Treasury stock $ 25,000
Investment in S Company $320,000
Noncontrollling Interest in Equity (NCI) $106,667
E. Other Intercompany Balance Sheet Eliminations
All receivables or payables as well as cash advances must be eliminated against the
reciprocal accounts of the other company.
A $5,000 cash advance by P Company to S Company:
Advance from P Company $25,000
Advance to S Company $25,000
F. Adjusting Entries Prior to Eliminating Entries
In case certain transactions are not completed, adjusting entries must be made.
VII. A COMPREHENSIVE ILLUSTRATION - MORE THAN ONE SUBSIDIARY COMPANY
(Illustration 3-6, 3-7)
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Chapter 3
10
Parent company owns a direct controlling interest in more than one subsidiary
A. Balance sheet of each affiliate is entered on the workpaper.
B. Any adjustments are prepared.
C. All related intercompany accounts, including those between subsidiary companies, are
eliminated.
D. Remaining balances are combined, constituting a consolidated balance sheet.
E. Formal consolidated balance sheet is prepared from the detail in the consolidated balance
sheet columns of the workpaper.
F. Balance sheet data are classified according to normal balance sheet arrangements.
G. Noncontrolling interest in consolidated net assets is reported as a component of
stockholders’ equity.
VIII. LIMITATIONS OF CONSOLIDATED STATEMENTS:
A. Noncontrolling stockholders and regulatory agencies – consolidated statements contain
insufficient detail about individual subsidiaries.
B. Creditors – have claims only against the resources of particular subsidiary, unless the
parent guarantees the claims.
C. Financial analysts – difficult to analyze or compare diversified companies operating across
several industries.
10
Parent company owns a direct controlling interest in more than one subsidiary
A. Balance sheet of each affiliate is entered on the workpaper.
B. Any adjustments are prepared.
C. All related intercompany accounts, including those between subsidiary companies, are
eliminated.
D. Remaining balances are combined, constituting a consolidated balance sheet.
E. Formal consolidated balance sheet is prepared from the detail in the consolidated balance
sheet columns of the workpaper.
F. Balance sheet data are classified according to normal balance sheet arrangements.
G. Noncontrolling interest in consolidated net assets is reported as a component of
stockholders’ equity.
VIII. LIMITATIONS OF CONSOLIDATED STATEMENTS:
A. Noncontrolling stockholders and regulatory agencies – consolidated statements contain
insufficient detail about individual subsidiaries.
B. Creditors – have claims only against the resources of particular subsidiary, unless the
parent guarantees the claims.
C. Financial analysts – difficult to analyze or compare diversified companies operating across
several industries.
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Chapter 3
11
Appendix A: Deferred Taxes on the Date of Acquisition
A. If a purchase acquisition is tax-free to the seller, the tax bases of the acquired assets and
liabilities are carried forward at book value.
B. The assets and liabilities of the acquired company are recorded on the consolidated books
at adjusted fair value.
C. The difference between the tax bases and the recorded values gives rise to deferred taxes.
Appendix B: Consolidation of Variable Interest Entities (VIEs)
A. An entity is considered a VIE and is subject to consolidation under FASB Interpretation No.
46 if:
1. Its total equity at risk is not adequate to allow the entity to finance its own activities
without additional subordinated financial support,
2. If the voting rights of the equity investors do not reflect their economic interests, or
3. If the equity investors lack one or more of the following three characteristics:
a. Direct or indirect ability to make decisions that control the entity,
b. The obligation to absorb the expected losses of the entity, or
c. The right to receive the expected residual returns of the entity.
B. The primary beneficiary of a VIE must disclose:
1. The nature, purpose, size, and activities of the VIE,
2. The carrying amount and classification of consolidated assets that are collateral for the
obligations of the VIE,
3. Any lack of recourse by creditors of a consolidated VIE to the general credit of the
primary beneficiary.
11
Appendix A: Deferred Taxes on the Date of Acquisition
A. If a purchase acquisition is tax-free to the seller, the tax bases of the acquired assets and
liabilities are carried forward at book value.
B. The assets and liabilities of the acquired company are recorded on the consolidated books
at adjusted fair value.
C. The difference between the tax bases and the recorded values gives rise to deferred taxes.
Appendix B: Consolidation of Variable Interest Entities (VIEs)
A. An entity is considered a VIE and is subject to consolidation under FASB Interpretation No.
46 if:
1. Its total equity at risk is not adequate to allow the entity to finance its own activities
without additional subordinated financial support,
2. If the voting rights of the equity investors do not reflect their economic interests, or
3. If the equity investors lack one or more of the following three characteristics:
a. Direct or indirect ability to make decisions that control the entity,
b. The obligation to absorb the expected losses of the entity, or
c. The right to receive the expected residual returns of the entity.
B. The primary beneficiary of a VIE must disclose:
1. The nature, purpose, size, and activities of the VIE,
2. The carrying amount and classification of consolidated assets that are collateral for the
obligations of the VIE,
3. Any lack of recourse by creditors of a consolidated VIE to the general credit of the
primary beneficiary.
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Chapter 4
1
CHAPTER FOUR – CONSOLIDATED FINANCIAL STATEMENTS AFTER ACQUISITION
I. THREE METHODS OF REPORTING ON PARENT’S BOOKS
A. Investments in voting stock of other companies may be consolidated, or they may be
separately reported in the financial statements at cost, at fair value, or at equity. The
method of reporting adopted depends on a number of factors including the size of the
investment, the extent to which the investor exercises control over the activities of the
investee, and the marketability of the securities.
B. Generally speaking, there are three levels of influence or control by an investor over an
investee, which determine the appropriate accounting treatment. There are no absolute
percentages to distinguish among these levels, but there are guidelines. The three levels
and the corresponding accounting treatment are summarized as follows:
Level
Guideline
Percentages Usual Accounting Treatment
No significant
influence
Less than 20% Investment carried at fair value at current year-
end (trading or available for sale securities) –
method traditionally referred to as “Cost”
method with an adjustment for market changes.
Significant
influence (no
control)
20 to 50% Investment measured under the equity method
Effective
control
Greater than
50%
Consolidated statements required
(investment eliminated, combined financial
statements): investment recorded under cost,
partial equity, or complete equity method.
C. Differences among the three methods in accounting for the investment on the books of the
parent are also summarized in Figure 4-1.
D. Cost Method on Books of Investor
P Company acquired 90% of the outstanding voting stock of S Company at the beginning
of Year 1 for $800,000. Income (loss) of S Company and dividends declared by S
Company during the next three years were: During the third year, the firm pays a
liquidating dividend (i.e. the cumulative dividends declared exceeds the cumulative
income earned).
Year
Income
(Loss)
Dividends
Declared
Cumulative Income Over
(Under) Dividends
1 $90,000 $30,000 $60,000
2 (20,000) 30,000 10,000
3 10,000 30,000 (10,000)
P’s books
Year 1 – P’s Books
Investment in S Company 800,000
Cash 800,000
1
CHAPTER FOUR – CONSOLIDATED FINANCIAL STATEMENTS AFTER ACQUISITION
I. THREE METHODS OF REPORTING ON PARENT’S BOOKS
A. Investments in voting stock of other companies may be consolidated, or they may be
separately reported in the financial statements at cost, at fair value, or at equity. The
method of reporting adopted depends on a number of factors including the size of the
investment, the extent to which the investor exercises control over the activities of the
investee, and the marketability of the securities.
B. Generally speaking, there are three levels of influence or control by an investor over an
investee, which determine the appropriate accounting treatment. There are no absolute
percentages to distinguish among these levels, but there are guidelines. The three levels
and the corresponding accounting treatment are summarized as follows:
Level
Guideline
Percentages Usual Accounting Treatment
No significant
influence
Less than 20% Investment carried at fair value at current year-
end (trading or available for sale securities) –
method traditionally referred to as “Cost”
method with an adjustment for market changes.
Significant
influence (no
control)
20 to 50% Investment measured under the equity method
Effective
control
Greater than
50%
Consolidated statements required
(investment eliminated, combined financial
statements): investment recorded under cost,
partial equity, or complete equity method.
C. Differences among the three methods in accounting for the investment on the books of the
parent are also summarized in Figure 4-1.
D. Cost Method on Books of Investor
P Company acquired 90% of the outstanding voting stock of S Company at the beginning
of Year 1 for $800,000. Income (loss) of S Company and dividends declared by S
Company during the next three years were: During the third year, the firm pays a
liquidating dividend (i.e. the cumulative dividends declared exceeds the cumulative
income earned).
Year
Income
(Loss)
Dividends
Declared
Cumulative Income Over
(Under) Dividends
1 $90,000 $30,000 $60,000
2 (20,000) 30,000 10,000
3 10,000 30,000 (10,000)
P’s books
Year 1 – P’s Books
Investment in S Company 800,000
Cash 800,000
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Chapter 4
2
To record the initial investment
Cash 7,000
Dividend Income 27,000
To record dividends received .9($30,000).
Year 2 – P’s Books
Cash 7,000
Dividend Income 27,000
To record dividends received .9($30,000).
Year 3 – P’s Books
Cash 7,000
Dividend Income 18,000
Investment in S Company 9,000
To record dividends received, $9,000 of which represents a return of investment.
After these entries are posted, the investment account will appear as follows:
Investment in S company (Cost Method)
Year 1 Cost 800,000
Year 3 Liquidating dividend 9,000
Year 3 Balance 791,000
Year 1 entries record the initial investment and the receipt of dividends from S Company.
In Year 2, although S Company incurred a $20,000 loss, there was a $60,000 excess of
earnings over dividends in Year 1. Consequently, the dividends received are recognized as
income by P Company. In Year 3, however, a liquidating dividend occurs. From the point
of view of a parent company, a purchased subsidiary is deemed to have distributed a
liquidating dividend when the cumulative amount of its dividends declared exceeds its
cumulative reported earnings after its acquisition. Such excess dividends are treated as a
return of capital, and are recorded as a reduction of the investment account rather than as
dividend income. The liquidating dividend is 90% of the excess of dividends paid over
cumulative earnings since acquisition (90% of $10,000).
E. Partial Equity Method on Books of Investor
P Company has elected to use the partial equity method to record the investment in S
Company above. The entries for the first three years would appear as follows:
Year 1
2
To record the initial investment
Cash 7,000
Dividend Income 27,000
To record dividends received .9($30,000).
Year 2 – P’s Books
Cash 7,000
Dividend Income 27,000
To record dividends received .9($30,000).
Year 3 – P’s Books
Cash 7,000
Dividend Income 18,000
Investment in S Company 9,000
To record dividends received, $9,000 of which represents a return of investment.
After these entries are posted, the investment account will appear as follows:
Investment in S company (Cost Method)
Year 1 Cost 800,000
Year 3 Liquidating dividend 9,000
Year 3 Balance 791,000
Year 1 entries record the initial investment and the receipt of dividends from S Company.
In Year 2, although S Company incurred a $20,000 loss, there was a $60,000 excess of
earnings over dividends in Year 1. Consequently, the dividends received are recognized as
income by P Company. In Year 3, however, a liquidating dividend occurs. From the point
of view of a parent company, a purchased subsidiary is deemed to have distributed a
liquidating dividend when the cumulative amount of its dividends declared exceeds its
cumulative reported earnings after its acquisition. Such excess dividends are treated as a
return of capital, and are recorded as a reduction of the investment account rather than as
dividend income. The liquidating dividend is 90% of the excess of dividends paid over
cumulative earnings since acquisition (90% of $10,000).
E. Partial Equity Method on Books of Investor
P Company has elected to use the partial equity method to record the investment in S
Company above. The entries for the first three years would appear as follows:
Year 1
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