Preparing Consolidated Statements at the Date of Acquisition
Exhibit 8.13 presents the worksheet necessary to consolidate Parent and Sub at the date of acquisition. The primary objective of the worksheet is to replace the Investment in Sub account with the aforementioned three components in the account.
Exhibit 8.13 presents the worksheet necessary to consolidate Parent and Sub at the date of acquisition. The primary objective of the worksheet is to replace the Investment in Sub account with the aforementioned three components in the account.
1. In the Eliminations column, ‘‘Investment in Sub’’ is removed so that, after the row is summed, the account does not appear in the Consolidated column. From a consolidated viewpoint, the combined Parent and Sub entity does not have an investment in Sub separate from the entity’s ownership of all of Sub’s assets. Because Parent will add the individual assets and liabilities of Sub into the consolidated totals, maintaining the Investment in Sub account would be double-counting
2. All of the individual assets and liabilities from Sub Company’s own financial statements are added to Parent’s individual assets and liabilities by summing each row to obtain the consolidated total. Sub’s shareholders’ equity accounts are eliminated because no outside ownership of Sub’s shares exists. These steps accomplish the objective of having the first component of the acquisition price, book value of Sub, appear in the consolidated totals.
2. All of the individual assets and liabilities from Sub Company’s own financial statements are added to Parent’s individual assets and liabilities by summing each row to obtain the consolidated total. Sub’s shareholders’ equity accounts are eliminated because no outside ownership of Sub’s shares exists. These steps accomplish the objective of having the first component of the acquisition price, book value of Sub, appear in the consolidated totals.
3. The remainder of the eliminations add the second (differences between fair and book values of Sub’s identifiable net assets) and third (goodwill) components of the acquisition price into the consolidated totals. The consolidated assets and liabilities appearing in Parent’s consolidated financial statements are equal to the sum of Parent’s book values and Sub’s fair values as remeasured at the acquisition date. Sub’s income statement amounts are not part of the consolidation process because the consolidated entity has not yet engaged in operations. The elimination entries are worksheet entries only. They are not entered in the financial records of Parent or Sub. Therefore, the consolidation worksheet must be prepared each reporting period.
A Note on Acquisition Reserves
Use of the acquisition method often entails establishing specific ‘‘acquisition reserves’’ at the time one company acquires another company because the acquiring company may not know the potential losses inherent in the acquired assets or the potential liabilities of the acquired company. Acquisition reserve accounts increase a liability or reduce an asset. The acquiring company will allocate a portion of the purchase price to various types of acquisition reserves (for example, estimated losses on long-term contracts and estimated liabilities for unsettled lawsuits). An acquiring company has up to one year after the date of acquisition to revalue these acquisition reserves as new information becomes available. After that, the acquisition reserve amounts remain in the accounts and absorb losses as they occur. That is, the acquiring firm charges actual losses against the specific acquisition reserves established, instead of against income, to measure the expected loss.
A Note on Acquisition Reserves
Use of the acquisition method often entails establishing specific ‘‘acquisition reserves’’ at the time one company acquires another company because the acquiring company may not know the potential losses inherent in the acquired assets or the potential liabilities of the acquired company. Acquisition reserve accounts increase a liability or reduce an asset. The acquiring company will allocate a portion of the purchase price to various types of acquisition reserves (for example, estimated losses on long-term contracts and estimated liabilities for unsettled lawsuits). An acquiring company has up to one year after the date of acquisition to revalue these acquisition reserves as new information becomes available. After that, the acquisition reserve amounts remain in the accounts and absorb losses as they occur. That is, the acquiring firm charges actual losses against the specific acquisition reserves established, instead of against income, to measure the expected loss.
To illustrate, assume that an acquired company has an unsettled lawsuit for which the acquiring company anticipates a $10 million pretax loss will ultimately result. It allocates $10 million to an acquisition reserve (estimated liability from lawsuit). Theacquiring firm would presumably pay less for this company because of the potential liability. Assume that settlement of the lawsuit occurs three years after the date of the acquisition for $8 million (pretax). The accountant offsets the $8 million loss against the $10 million reserve instead of against net income for the year. Furthermore, the accountant reverses the $2 million remaining in the acquisition reserve, increasing net income in the year of the settlement.
Acquisition reserves can affect assessments of the quality of accounting information, and regulators carefully monitor their use (and abuse). When used properly, an acquisition reserve is an accounting mechanism that helps ensure that the assets and liabilities of an acquired company reflect market values. However, given the estimates required in establishing such reserves, management has some latitude in managing earnings.
Acquisition reserves can affect assessments of the quality of accounting information, and regulators carefully monitor their use (and abuse). When used properly, an acquisition reserve is an accounting mechanism that helps ensure that the assets and liabilities of an acquired company reflect market values. However, given the estimates required in establishing such reserves, management has some latitude in managing earnings.
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