Majority, Active Investments
When one investor firm owns more than 50% of the voting stock of another company, the investor firm generally has control. This control may occur at both a broad policymaking level and a day-to-day operational level. The majority investor in this case is the parent, and the majority-owned company is the subsidiary. Financial reporting requires combining, or consolidating, the financial statements of majority-owned companies with those of the parent (unless for legal or other reasons the parent cannot exercise control).\
Purpose of Consolidated Statements
A consolidation of the financial statements of the parent and each of its subsidiaries presents the results of operations, financial position, and changes in cash flows of an affiliated group of companies under the control of a parent, essentially as if the group of companies were a single entity. The parent and each subsidiary are legally separate entities, but they operate as one centrally controlled economic entity. Consolidated financial statements generally provide more useful information to the shareholders of the parent corporation than do separate financial statements of the parent and each subsidiary.
In general, consolidated financial statements also provide more useful information than does the equity method used to account for minority, active investments. The parent, because of its voting interest, can effectively control the use of the subsidiary’s assets, financial leverage, dividend policy, and strategies. Consolidation of the individual assets, liabilities, revenues, and expenses of both the parent and the subsidiary provides a more complete and realistic picture of the operations and financial position of the whole economic entity. It is common practice in the United States to present only the consolidated statements in published annual reports. In some cases, firms do report separate financial statements for consolidated subsidiaries. For example, large conglomerates such as General Electric and Ford report separate financial statements for their finance subsidiaries.
Corporate Acquisitions and Consolidated Financial Statements Illustrated
Corporate acquisitions occur when one corporation acquires a majority ownership interest in another corporation. Current standards are the result of a joint project between the FASB and IASB on business combinations.27 This section deals with two types of business combinations: (1) statutory mergers that result when one entity acquires all of the assets and liabilities of another entity and places the acquired assets and liabilities on its books and (2) acquisitions of between 51% and 100% of the common stock of an acquired entity, where the acquired entity continues to operate as a separate legal entity with separate financial records.28 Both types of business combinations use the acquisition method and have the same financial statement effects. However, acquisitions of over 50% are active, majority investments as described in the preceding section and thus require the preparation of consolidation worksheets to support consolidated financial statements
To illustrate merger and acquisition accounting, assume that, on December 31, 2013, Parent Company issues 100,000 shares of its common stock to acquire 100% of the common stock of Sub Company. In addition, Parent agrees to pay former Sub Company shareholders an additional $500,000 in cash if certain earnings projections are achieved over the next two years. Based on probabilities of achieving the earnings projections, Parent estimates the fair value of this promise to be $300,000. Parent pays $20,000 in legal fees and $25,000 in stock issue costs to effect the acquisition. Parent also incurs $10,000 in internal costs related to management’s time to complete the transaction. Parent’s shares have a fair value of $30 per share at the date of acquisition. Exhibit 8.9 provides the book values of Parent Company and the book and fair values of Sub Company at the date of acquisition.\
Statutory Merger. To record the acquisition assuming that Sub Company is dissolved (a statutory merger), the acquisition method is applied to this business combination using the following three steps
1. Measure the fair value of the consideration transferred to acquire Sub. A key concept underlying the acquisition method is measurement of the transaction at the fair value transferred by Parent. Parent chose to issue common stock with a fair value of $3,000,000 (10,000 shares 3 $30 fair value per share) and to incur a liability (the contingent consideration obligation) with a fair value of $300,000. Parent also incurred $55,000 in related legal costs, internal costs, and stock issue costs. Because accounting standards define fair value as the price received to sell an asset or the price paid to transfer a liability in an orderly transaction between market participants at the measurement date, standard setters concluded that the fair value of the transaction is the net proceeds from the stock issue, $2,975,000 ($3,000,000 $25,000 costs to issue), plus the fair value of the stock issue costs, $25,000, plus the fair value of the liability assumed, $300,000, which sum to $3,300,000. (Alternatively, just add the fair value of the stock issued to the fair value of the liability assumed because stock issue costs appear as an addition to and subtraction from fair value.) The legal costs of $20,000 and the internal costs of $10,000 are expenses of the period and are not considered part of the acquisition price.
2. Measure the fair values of the identifiable assets acquired, liabilities assumed, and noncontrolling interests (if any). In arriving at the $3,300,000 acquisition price, Parent estimated the value of the net assets of Sub Company whether or not they were recorded on Sub’s books. The information provided in Exhibit 8.9 indicates that cash, accounts payable, and notes payable had acquisition date fair values equal to their book values. The equality of book and fair values for short-term monetary assets and liabilities (that is, assets and liabilities with fixed cash flows set by contract) is common. Also, with the advent of the fair value option, the likelihood that book values and fair values will be identical increases. Parent estimates the fair value of receivables to be $450,000, which is $50,000 less than book value, an indication that Parent believes that Sub has under-reserved for potential uncollectible accounts. Parent estimates that Sub’s nonmonetary assets, inventory, and property, plant, and equipment have fair values that are greater than their book values. The acquirer must recognize separately from goodwill any intangible
When one investor firm owns more than 50% of the voting stock of another company, the investor firm generally has control. This control may occur at both a broad policymaking level and a day-to-day operational level. The majority investor in this case is the parent, and the majority-owned company is the subsidiary. Financial reporting requires combining, or consolidating, the financial statements of majority-owned companies with those of the parent (unless for legal or other reasons the parent cannot exercise control).\
Purpose of Consolidated Statements
A consolidation of the financial statements of the parent and each of its subsidiaries presents the results of operations, financial position, and changes in cash flows of an affiliated group of companies under the control of a parent, essentially as if the group of companies were a single entity. The parent and each subsidiary are legally separate entities, but they operate as one centrally controlled economic entity. Consolidated financial statements generally provide more useful information to the shareholders of the parent corporation than do separate financial statements of the parent and each subsidiary.
In general, consolidated financial statements also provide more useful information than does the equity method used to account for minority, active investments. The parent, because of its voting interest, can effectively control the use of the subsidiary’s assets, financial leverage, dividend policy, and strategies. Consolidation of the individual assets, liabilities, revenues, and expenses of both the parent and the subsidiary provides a more complete and realistic picture of the operations and financial position of the whole economic entity. It is common practice in the United States to present only the consolidated statements in published annual reports. In some cases, firms do report separate financial statements for consolidated subsidiaries. For example, large conglomerates such as General Electric and Ford report separate financial statements for their finance subsidiaries.
Corporate Acquisitions and Consolidated Financial Statements Illustrated
Corporate acquisitions occur when one corporation acquires a majority ownership interest in another corporation. Current standards are the result of a joint project between the FASB and IASB on business combinations.27 This section deals with two types of business combinations: (1) statutory mergers that result when one entity acquires all of the assets and liabilities of another entity and places the acquired assets and liabilities on its books and (2) acquisitions of between 51% and 100% of the common stock of an acquired entity, where the acquired entity continues to operate as a separate legal entity with separate financial records.28 Both types of business combinations use the acquisition method and have the same financial statement effects. However, acquisitions of over 50% are active, majority investments as described in the preceding section and thus require the preparation of consolidation worksheets to support consolidated financial statements
To illustrate merger and acquisition accounting, assume that, on December 31, 2013, Parent Company issues 100,000 shares of its common stock to acquire 100% of the common stock of Sub Company. In addition, Parent agrees to pay former Sub Company shareholders an additional $500,000 in cash if certain earnings projections are achieved over the next two years. Based on probabilities of achieving the earnings projections, Parent estimates the fair value of this promise to be $300,000. Parent pays $20,000 in legal fees and $25,000 in stock issue costs to effect the acquisition. Parent also incurs $10,000 in internal costs related to management’s time to complete the transaction. Parent’s shares have a fair value of $30 per share at the date of acquisition. Exhibit 8.9 provides the book values of Parent Company and the book and fair values of Sub Company at the date of acquisition.\
Statutory Merger. To record the acquisition assuming that Sub Company is dissolved (a statutory merger), the acquisition method is applied to this business combination using the following three steps
1. Measure the fair value of the consideration transferred to acquire Sub. A key concept underlying the acquisition method is measurement of the transaction at the fair value transferred by Parent. Parent chose to issue common stock with a fair value of $3,000,000 (10,000 shares 3 $30 fair value per share) and to incur a liability (the contingent consideration obligation) with a fair value of $300,000. Parent also incurred $55,000 in related legal costs, internal costs, and stock issue costs. Because accounting standards define fair value as the price received to sell an asset or the price paid to transfer a liability in an orderly transaction between market participants at the measurement date, standard setters concluded that the fair value of the transaction is the net proceeds from the stock issue, $2,975,000 ($3,000,000 $25,000 costs to issue), plus the fair value of the stock issue costs, $25,000, plus the fair value of the liability assumed, $300,000, which sum to $3,300,000. (Alternatively, just add the fair value of the stock issued to the fair value of the liability assumed because stock issue costs appear as an addition to and subtraction from fair value.) The legal costs of $20,000 and the internal costs of $10,000 are expenses of the period and are not considered part of the acquisition price.
2. Measure the fair values of the identifiable assets acquired, liabilities assumed, and noncontrolling interests (if any). In arriving at the $3,300,000 acquisition price, Parent estimated the value of the net assets of Sub Company whether or not they were recorded on Sub’s books. The information provided in Exhibit 8.9 indicates that cash, accounts payable, and notes payable had acquisition date fair values equal to their book values. The equality of book and fair values for short-term monetary assets and liabilities (that is, assets and liabilities with fixed cash flows set by contract) is common. Also, with the advent of the fair value option, the likelihood that book values and fair values will be identical increases. Parent estimates the fair value of receivables to be $450,000, which is $50,000 less than book value, an indication that Parent believes that Sub has under-reserved for potential uncollectible accounts. Parent estimates that Sub’s nonmonetary assets, inventory, and property, plant, and equipment have fair values that are greater than their book values. The acquirer must recognize separately from goodwill any intangible
assets that arise from legal or contractual rights or that can be sold or otherwise separated from the acquired enterprise. The FASB has identified a nonexhaustive list of possible identifiable intangible assets other than goodwill that meet the criteria for recognition as assets. (See Exhibit 8.10.) Parent identifies three such intangible assets that are not recorded on Sub’s books. Sub has customer lists with fair values of $100,000, unpatented technology that has a fair value of $200,000, and in-process R&D that has a fair value of $300,000. These assets have no book value because Sub engaged in internal marketing, advertising, and R&D activities to create them, and, by rule, expensed them previously.
3. Assign any excess consideration to goodwill or record a gain from a bargain purchase. The difference between the fair value given by the acquirer and the fair values of the individual identifiable assets is goodwill. In this example, Parent gave $3,300,000 to acquire net assets of Sub that had a fair value of $2,350,000 ($4,850,000 fair value assets $2,500,000 fair value liabilities). Therefore, goodwill is the difference, $950,000 ($3,300,000 $2,350,000). The parties, in their.
3. Assign any excess consideration to goodwill or record a gain from a bargain purchase. The difference between the fair value given by the acquirer and the fair values of the individual identifiable assets is goodwill. In this example, Parent gave $3,300,000 to acquire net assets of Sub that had a fair value of $2,350,000 ($4,850,000 fair value assets $2,500,000 fair value liabilities). Therefore, goodwill is the difference, $950,000 ($3,300,000 $2,350,000). The parties, in their.
negotiation, assign an enterprise value to Sub that exceeds the sum of the fair values of identifiable assets. Goodwill represents the superior expected profitability of Sub’s operations that exceeds what one would expect from Sub’s assets
If Parent acquired Sub at a bargain, the fair value given would have been less than the fair values of the individual identifiable assets. Bargain purchases rarely occur given the rational behavior of owners. However, they do exist, often because of some unusual circumstance that requires a quick liquidation of a company, such as the death of an owner or forced liquidation due to bankruptcy or other financial distress. If a bargain purchase occurs, the acquirer has an economic gain equal to the fair value received less the fair value given. The gain is reported on the acquirer’s income statement. During the recent financial crisis, a number of healthy banks recognized gains on bargain purchases of distressed banks (and often the acquisitions were assisted by the FDIC). In 2008, for example, J. P. Morgan Chase & Co. acquired Washington Mutual, recognizing a $1.9 billion gain from the bargain purchase
Exhibit 8.11 shows the effects of the acquisition and the journal entry to record the acquisition on Parent’s books at December 31, 2013. Parent records the fair value of assets
If Parent acquired Sub at a bargain, the fair value given would have been less than the fair values of the individual identifiable assets. Bargain purchases rarely occur given the rational behavior of owners. However, they do exist, often because of some unusual circumstance that requires a quick liquidation of a company, such as the death of an owner or forced liquidation due to bankruptcy or other financial distress. If a bargain purchase occurs, the acquirer has an economic gain equal to the fair value received less the fair value given. The gain is reported on the acquirer’s income statement. During the recent financial crisis, a number of healthy banks recognized gains on bargain purchases of distressed banks (and often the acquisitions were assisted by the FDIC). In 2008, for example, J. P. Morgan Chase & Co. acquired Washington Mutual, recognizing a $1.9 billion gain from the bargain purchase
Exhibit 8.11 shows the effects of the acquisition and the journal entry to record the acquisition on Parent’s books at December 31, 2013. Parent records the fair value of assets
and liabilities received from Sub and the fair values of consideration given to Sub’s shareholders (the contingent performance obligation and the common stock issued). Note that identifiable intangible assets, in-process R&D, and goodwill are recorded at their fair values, even though their original book values on Sub’s books were zero. Given that many firms expensed in-process R&D in the past, the change in U.S. GAAP and IFRS to the current acquisition accounting standards is a significant change for firms acquiring technology- intensive firms. Legal costs and management time related to the combination are expensed as part of operating expenses. Stock issue costs reduce the proceeds of the issue and thus are treated as a reduction of additional paid-in capital. Because Sub’s assets and liabilities now appear on Parent’s books and Sub no longer exists as a separate legal entity, Parent does not have to prepare consolidated financial statements.
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