Unit III - Consolidation Subsequent to Acquisition Date

Key Concepts:     Recording on the cost basis requires additional calculations of Ps net income and consolidated retained earnings Under the equity method, the Parent’s net income and retained earnings equals consolidated net income and consolidated retained earnings Preparation of consolidated statements – cost and equity methods - Exhibit 5.16, page 205 Impairment testing for intangible assets with definite useful lives: two step process (page 176): o step 1: is the asset impaired? o step 2: if so, calculate impairment loss as the difference between the recoverable amount f the asset and its carrying value Impairment testing for intangible assets with indefinite useful lives (example: goodwill): as singlestep process; i.e., if the recoverable amount is less than carrying value, asset is impaired by the difference – note that goodwill is no longer amortized but tested for impairment.

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Key Objectives:  Prepare consolidated financial statements for the first and subsequent year ends after acquisition for a parent and its wholly owned (or non-wholly owned) subsidiary when the parent uses the cost method or the equity method.

Resources     Text pages 170 - 206 Practice Exercises within the unit iStudy Website Unit Assignment

Before you begin your reading, review the key points, learning objectives and unit overview/notes. It is useful to keep the learning objectives in mind as you proceed through the required readings of each unit. The unit overview will provide additional detail. You may find it helpful to read the assigned chapters more than once, in order to fully grasp the concepts. Once you have finished reading each chapter and reviewing course notes, complete the indicated practice exercise and any applicable assignments prior to moving on to the next unit of study. In this unit, we begin our study of consolidation using the example companies P and S where P is the Parent company and S is the subsidiary company. The majority of the chapter discussion is on the cost method. The equity method only receives attention at the very end of the chapter beginning on page 202. Under the cost method, to prepare consolidated statements, we calculate P’s consolidated net income each year (see pages 184 – 185 for year 1 consolidated net income and page 187 for year 2 calculations of consolidated net income). Further, in the second and subsequent year, we must restate the opening balance of consolidated retained earnings to what it would be under the equity method. The rational is identified throughout the chapter but is also reinforced on page 189 – 190. When you get to this section, read it carefully! Again, we will use the direct approach to construct consolidated statements. This unit consists of three modules:

Module 1 – Consolidation under the cost method – 100% owned subsidiary Module 2 - Consolidation under the cost method – 80% owned subsidiary Module 3 – Consolidation after acquisition date under the equity method Unit 3 – Module 1 - Consolidation under the cost method – 100% owned subsidiary Unit 3 – Module 1 – Overview In this module you learn the key reasons that we need to make added calculations to consolidate financial statements under the cost method. Under the equity method the parent’s separate entity net income and retained earnings were equal to that of the consolidated entity. Under the cost method, this is not the case. Unit 3 – Module 1 – Specific Student Requirements Text, page 183 - 190 Unit 3 – Module 1 – Objectives By the end of this unit you will be able to:    Identify the differences between recoding an investment in a subsidiary company under the cost method and equity method Prepare a schedule to calculate consolidated net income each year Prepare a schedule to update the opening balance of consolidated retained earnings in a second and subsequent years under the cost method

Unit 3 – Module 1- Notes
WHAT IS DIFFERENT UNDER THE COST METHOD OF RECORDING AN INVESTMENT?

Under the cost method, there are some additional calculations that need to be done to prepare consolidated statements. The reason for this is that under the cost method, the investment account on the parent’s separate entity balance sheet is not changing as it did under the equity method. This is because dividends received by the parent from the subsidiary company are credited to the dividend income account and not the investment account as it is under the equity method (recall we discussed this in chapter 2). Further, there is no investment income account on the parent’s separate entity statements as we saw under the equity method (again, recall chapter 2). When the parent company records its investment using the cost method, it records dividends as income when declared. Company P's journal entry to record its portion of Company S's dividends is shown on page 184.
PREPARING CONSOLIDATED FINANCIAL STATEMENTS, UNDER THE COST METHOD - WHOLLY-OWNED SUBSIDIARIES, YEAR 1

Review the schedule on page 185: "Calculation of Consolidated Net Income — Year 1". Company P's net income must first be reduced by the recorded dividend income of $2,500 since this dividend from S is not included in consolidated net income. The second adjustment is to increase P’s net income by P's share in S's net income for the year and to include acquisition differential amortizations and goodwill impairment loss. As long as P uses the cost method, the adjustments and calculations on page 185 – 186

are not recorded in P's books. The schedules and calculations that allow for the preparation of consolidated financial statements are kept in separate working papers. Review the discussion on page 185 – 190 of the text- it fully describes why the cost method requires different calculations of consolidated net income and consolidated retained earnings in the second and subsequent years. Review the consolidated statements on page 186. Note the following points:  P's consolidated net income is not identical to its separate entity’s net income shown in Exhibit 5.5 because P uses the cost method for recording. This necessitates performing the calculation of consolidated net income The ending balance of $102,550 at December 31, Year 1 for P's consolidated retained earnings statement (Exhibit 5.5, page 186) is not the same as the balance of $99,800 at December 31, Year 1 reported under the cost method on P's separate entity statement (Exhibit 5.3, page 185). This is due to the difference in the way the dividend from S is recorded. However, the consolidated beginning retained earnings of $85,000 on page 186 is the same as P's opening retained earnings on page 185 because this is the retained earnings at date of acquisition and, at January 1 of Year 1, no time has elapsed for P to claim a share in S's net income.

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PREPARING CONSOLIDATED FINANCIAL STATEMENTS, UNDER THE COST METHOD - WHOLLY-OWNED SUBSIDIARIES, YEAR 2

The calculation of consolidated net income is at the bottom of page 187. We need to calculate consolidated retained earnings as of the beginning of the period when consolidating more than one year after acquisition. This is because the retained earnings figure in P's separate entity statements represents only P's separate entity past years' net income less dividends paid and/or declared by P. These retained earnings include dividends from S recorded as dividend income under the cost method. To determine the consolidated opening retained earnings figure for the current year, P's separate entity retained earnings must be adjusted for   P’s share in the change in S’s retained earnings since the acquisition date, all acquisition differential amortizations and goodwill impairment losses from the date of acquisition up to but not including the current year (this year’s adjustments go directly into the calculation of consolidated net income for this year).

Review pages 188 – 190 now before moving on to module 2.

Unit 3 – Module 2 - Consolidation under the cost method – 80% owned subsidiary Unit 3 – Module 2 – Overview The process for preparing consolidated statements for a non-wholly owned subsidiary is similar to that for wholly owned subsidiaries. You will apply the same concepts as you did in the previous module in this unit. This unit will reacquaint you with the concept of non-controlling interest (NCI) and its impact on consolidated financial statements. Unit 3 – Module 2 – Specific Student Requirements Text, page 191 – 201 Unit 3 – Module 2 – Objectives By the end of this unit you will be able to:  Prepare consolidated financial statements for the first and subsequent year ends after acquisition for a parent and its non-wholly owned subsidiary when the parent uses the cost method

Unit 3 – Module 2 – Notes Review exhibit 6.8 on page 231. The calculation of goodwill is identical to that in the previous pages of the chapter; however, we added the calculation on NCI at acquisition date. Referring to the examples provided in the text on pages 232 - 238, note the following important points when the parent uses the cost method and the direct approach is used to consolidate financial statements: ● Consolidated net income must be calculated in Years 1 and 2 (and in all subsequent years) to adjust P’s Year 2 net income obtained with the cost method to what it would have been if the equity method been used. ● In the second and subsequent years, the beginning balance of retained earnings must be calculated in order to adjust these retained earnings to the equity method balance. ● Dividend income does not appear in the consolidated statements (this is an inter-corporate dividend as is nothing more than an exchange of cash between two related parties; therefore, from a consolidated perspective, the net impact is zero.
A Note on Intercompany Payables and Receivables

Consolidated statements are supposed to reflect financial transactions with unrelated parties to the reporting entity. This means that intercompany transactions between the parent and subsidiary company are eliminated to reflect only those transactions with outside entities. If intercompany payables and receivables were not eliminated, they would overstate payables and receivables on the consolidated statements from a single-entity point of view. A sample of how the intercompany eliminating entries would appear on the worksheet to eliminate the intercompany balances are on page 201.

Unit 3 – Module 3: Equity Method of Recording an Investment (pages 202 – 204) This module introduces you to the equity method of recording the investment in a subsidiary and then consolidating the financial statements. The equity method differs from the cost method in that the investment account balance on the balance sheet will change from its historical cost based due to three main items: a) The investor’s percentage share of the investee’s separate entity income b) Amortization of the acquisition differential based on the investor’s ownership share of the investee’s outstanding common shares c) Cash dividends received (or receivable) from the investee Under the equity method, characteristics of the Investment in the investee account and the Investment income account are as follows:  End-of-period Investment in the investee account balance equals o o o beginning of period investment account balance plus proportionate share of the investee's net income (or net loss) for the period minus proportionate share of the investee's dividends paid during the period, plus or minus adjustments for acquisition differential amortization and goodwill impairment for the period, plus or minus intercompany eliminations

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Investment income from the investee for the period equals o proportionate share of the investee's income or loss for the period o plus or minus adjustments for acquisition differential amortization and goodwill impairment for the period o plus or minus inter-company eliminations

See the journal entries on page 202 and 203 that are made in the investor’s books to update the value of the Investment account on the balance sheet and the value of investment income on the income statement. Once posted, page 203 shows you final balances that will show in the individual investment income and investment account on the balance sheet. Under the equity method, consolidated retained earnings and consolidated net income are the same as the parent company’s separate entity retained earnings and separate entity net income The equity method captures the investor’s share of the subsidiary company’s net income earned, along with the net effect of any items that would be made on consolidated financial statements. Specifically, all post-acquisition retained earnings of the subsidiary company update the consolidated statements. This means that in all case, the equity method will produce the same consolidated net income as the Parent’s separate entity income. Unit 3 – All Modules – Practice Exercise: Let’s practice! Try the following problems to test your knowledge of this complex area of consolidations. Remember, the solutions for all ―Let’s Practice‖ problems are posted to AVENUE TO LEARN under Let’s Practice! Solutions. Chapter 5, Cost Method: Problem 9 and Problem 12 Equity Method: Problem 2

Unit III – Consolidation Subsequent to Acquisition - CREDIT ASSIGNMENT 3
Following is the third of your five credit assignments on which you will be evaluated. Each problem/case states what is required. Provide all calculations that support your work.

Credit Assignment: Due Date:

Chapter 5: Problem 1, Problem 7, Problem 10, Problem 13 Refer to Assignment Schedule.

When submitting an assignment, be sure to prepare and submit the assignment electronically in Word Format. When composing paragraphs, double space and use proper grammar and language at all times. Submit your completed assignment via the AVENUE TO LEARN drop box by the specified due date.

Final Examination – 60%

A final examination will be administered following Unit V. Refer to your assignment schedule to identify the specific deadline date by which the final examination must be written. When you have submitted your third assignment, submit a separate request to write the final exam via the drop box in Avenue to Learn or send an email to conted@mcmaster.ca with the Subject line: ‖Request to write final exam 570-434‖ You will be contacted by the Program Associate and advised of your examination date and location details. Completion of the final examination is a mandatory component of this course. .