Advanced Accounting, 12E Floyd A Beams Solution Manual

Advanced Accounting, 12E

Floyd A. Beams

Email: Richard@qwconsultancy.com

Chapter 1 BUSINESS COMBINATIONS Chapter Outline A BUSINESS COMBINATION IS THE UNION OF PREVIOUSLY SEPARATE BUSINESS ENTITIES. A

Horizontal integration is the combination of firms in the same business lines and markets.

B

Vertical integration is the combination of firms in the same business, but with operations in different, successive, stages of production and/or distribution.

C

Conglomeration is the combination of firms with unrelated and diverse products and/or service functions.

D

Reasons companies choose to expand through combination rather than by building new facilities include: 1 2 3 4 5 6

Cost advantage - may be less expensive to acquire rather than build facilities or develop R&D Lower risk - may be less risky to acquire product lines or markets rather than develop new products, particularly if the goal is diversification Fewer operating delays - the facilities are in place, thereby shortening the time to market Avoidance of takeovers Acquisition of intangible assets Other reasons - business tax advantages, such as tax loss carryforwards

ANTITRUST LAWS PROHIBIT BUSINESS COMBINATIONS THAT RESTRAIN TRADE OR IMPAIR COMPETITION. A

Proposed business combinations are reviewed by federal agencies such as the Justice Department, the Federal Trade Commission, the Federal Reserve Board, the Department of Transportation, the Federal Communications Commission, and the Securities and Exchange Commission.

B

State agencies review business combinations for possible violations of state statutes.

C

Combining companies can argue that cost savings or better products could offset decreased competition.

LEGAL FORM OF BUSINESS COMBINATIONS: .

1

A

Acquisition: 1 2

B

One corporation acquires the productive assets of another business entity and integrates those assets into its own operations (see B & C below), or One corporation obtains operating control over the productive facilities of another entity by acquiring a majority of its outstanding voting stock.

A + B = A + B (usually requires consolidated statements)

Merger: One corporation takes over all the operations of another business entity and that entity is dissolved (see Illustration 1-1).

A+B=A

C

Consolidation: A new corporation is formed to take over the assets and operations of two or more separate business entities and all the combining companies are dissolved (see Illustration 1-1).

A+B=C

D

Business combination: A corporation and one or more incorporated or unincorporated businesses are brought together under the control of a single management team. That control is established when:

E

1

One or more corporations becomes a subsidiary (i.e., when another corporation acquires a majority of its outstanding voting stock),

2

One company transfers its net assets to another, or

3

Each company transfers its net assets to a newly formed corporation.

Merger, consolidation, and acquisition are often used in a generic sense as synonyms for business combinations. The term "consolidation" also refers to the accounting process of combining a parent company’s financial statements with those of its subsidiaries.

GAAP .

2

A

The pooling of interest method of accounting was eliminated for all transactions initiated after June 30, 2001. All subsequent combinations must use the acquisition method.

2

Prior combinations accounted for by the pooling of interests method were allowed to continue as acceptable financial reporting practice for past business combinations.

3

Elimination of pooling makes U. S. GAAP more consistent with international accounting standards. Most major economies prohibit the use of pooling of interests accounting.

Acquisition method (all business combinations initiated after 12/15/08 follow the same GAAP used in recording the purchase of other assets and liabilities).

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1

1

Cost is measured by the cash disbursed, the fair value of property given up, or the fair value of securities issued.

2

Direct costs of acquisition: a

Direct costs of registering and issuing securities are charged against additional paid-in capital.

b

Other direct costs of combining (accounting and legal fees) are expensed.

c

Costs to close duplicate facilities, and other indirect costs are expensed.

Recording fair values in an acquisition – steps to record an acquisition: a

Determine the fair values of all identifiable tangible and intangible assets acquired and liabilities assumed.

b

GAAP provides specific guidelines for valuing assets and liabilities.

c

All identifiable assets and liabilities are valued regardless of whether they are recorded on the books of the acquired company (e.g., a patent where all R&D was expensed as incurred).

d

Assets and liabilities that arise from contingencies should be recognized at fair value if fair value can be reasonably estimated.

e

Exceptions to fair value include deferred tax assets and liabilities, pensions and other benefits, and leases. These items should be accounted for pursuant to specific accounting principles governing these items.

3

f

4

No value is assigned to goodwill recorded on the books of the acquired company.

The acquiring company records the assets received and liabilities assumed at their fair values. a

First, fair values are assigned to all identifiable tangible and intangible assets acquired and liabilities assumed.

(1) See text Exhibit 1-2 for a list of intangible assets that meet the criteria for recognition. Recognizable intangible assets must meet either a separability or a contractual-legal criterion.

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b

If cost is greater than fair value of the identifiable net assets acquired, the excess cost is assigned to goodwill.

c

If fair value is greater than cost, the excess fair value is recorded as an ordinary gain by the acquirer.

Contingent Consideration in a Purchase Business Combination a

Contingent consideration is an additional payment made to the previous stockholders of the acquired company contingent on future events or transactions. The contingent consideration may include the distribution of cash, other assets, or the issuance of debt or equity securities.

b

Contingent consideration must be measured and recorded at fair value as of the acquisition date as part of the consideration transferred in the acquisition.

c

If the contingent consideration is to be paid in additional shares to acquiree, it is in the form of equity, and the Investment and Paid in Capital accounts are increased by the value of the contingent consideration.

d

If the contingent consideration is to be paid in cash to the acquiree, the Investment and liability accounts are increased by the fair value of the contingent consideration.

e

If the contingency is based on security prices, the recorded cost of the acquired company should not change. When the contingency is resolved, the fair market value of the additional consideration is applied to proportionately reduce securities issued and recorded at the date of acquisition.

4

f

In the case of a liability, the acquirer measures the fair value of the contingency at each reporting date until the contingency is resolved, and changes in value are recorded as gains and losses, with corresponding adjustments to the liability.

THE GOODWILL CONTROVERSY A

Goodwill is defined as the excess of the investment cost over the fair value of assets received.

B

Goodwill is no longer amortized for financial reporting purposes. In certain cases, it can be amortized and deducted over 15 years.

C

Firms must periodically assess goodwill for impairment in its value. An impairment occurs when the recorded value of goodwill is greater than its fair value.

D

1

When an impairment occurs, firms must write down goodwill to a new estimated amount and record a loss in calculating net income of a period.

2

The treatment of goodwill has not retroactively changed, but firms will cease amortizing all previously recorded goodwill.

3

Goodwill and all other intangibles that have indefinite useful lives will be periodically reviewed (at least annually) and adjusted for value impairment but no longer amortized.

GAAP also redefines the reporting entity in accounting for intangible assets. Firms will treat goodwill and other intangible assets as assets of the business reporting unit.

1

These intangible assets will be reported based on their fair value at acquisition date.

E

Internally developed intangibles that are not specifically identifiable, have indeterminate lives, or are inherent in a continuing business related to the entity will not be recognized as an asset, but expensed (the same treatment will continue for acquired research and development costs).

F

Recognizing and measuring impairment losses related to goodwill, a two-step process 1 Step one compares carrying (book) values to fair values at the business reporting unit level. If fair value is less than book value, an impairment has occurred.

2

.

Step two measures the impairment. The carrying value of goodwill is compared to its implied fair value. The excess book value over implied fair value is the impairment loss. The loss cannot exceed the book value of the goodwill. Previously recognized impairment losses cannot be reversed.

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3

G

H

The impairment test is conducted at least annually, and more frequently if certain conditions warrant.

Amortization versus non-amortization 1

Amortization is required for intangible assets with a definite useful life.

2

The method of amortization should reflect the expected pattern of consumption of the economic benefits of the intangible asset.

3

If a pattern is not determinable, straight-line amortization is acceptable.

4

Firms will not amortize intangibles with an indefinite life that cannot be estimated.

Like goodwill, these assets should be periodically evaluated for possible impairments.

Financial Reporting: Financial statement disclosures for a business combination: a

The name and a brief description of the acquired company, acquisition date and portion of voting stock acquired, reason for the acquisition, and the manner in which acquirer obtained control.

b

Information about goodwill or gain from a bargain purchase.

c

Nature, terms, and fair value of consideration transferred.

d

Details about assets acquired, liabilities assumed, and any noncontrolling interests.

e

Reduction in acquirer’s pre-existing deferred tax asset valuation allowance due to the business combination.

f

Information about transactions with the acquire accounted for separately from the business combination.

g

Details about step acquisitions.

h

In the case of a public company acquirer, pro-forma information.

In addition, GAAP requires: 1

.

Material aggregate amounts of goodwill be reported as a separate balance sheet item 6

2

Goodwill impairment losses must be shown separately on the income statement as a component of income from operations

3

Increased disclosures for intangibles (See text Exhibit 1-3)

SARBANES-OXLEY ACT OF 2002 A

After the high-profile collapses of WorldCom, Enron, and other companies, Congress enacted legislation intended to prevent future financial reporting and auditing abuses, the result was the Sarbanes-Oxley Act of 2002 (SOX).

B

The new rules focus primarily on corporate governance, auditing, and internal control issues.

C

The law has far-reaching implications including:

D

1

Establishment of an independent board, Public Company Accounting Oversight Board, to regulate the accounting and auditing professions.

2

Requirements restricting certain services provided by auditors to their audit clients.

3

Requirements for greater independence of corporate board of directors.

4

Requirements that the CEO and CFO certify the financial statements and the entity’s internal control.

5

Requirements that independent auditors review and attest to management’s internal control assessments.

6

Increased disclosures relating to off-balance sheet financing, contractual obligations.

7

Increases the types of items requiring disclosure on Form 8-K and shortens the filing period.

Text Exhibit 1-5 provides an example of management’s responsibility for financial results and report on internal control.

Description of assignment material

Minutes

Questions (5) Exercises (5) El-1 4 MC general El-2 [Pat/Sag] AICPA 2 MC problem-type .

7

5 10

El-3 El-4 El-5

[Pal/Sip] Prepare stockholders’ equity section [Pan/Set] Journal entries to record an acquisition [Pan/Sis] Journal entries to record an acquisition with direct costs and fair value/book value differences

Problems (5) Pl-1 [Pin/San] Prepare balance sheet after acquisition Pl-2 [Pet/Sea] Prepare balance sheet after an acquisition Pl-3 [Par/Sin] Journal entries and balance sheet an acquisition Pl-4 [Pub/Sun] Allocation schedule and balance sheet Pl-5 [Pat/Saw] Journal entries and balance sheet for an acquisition

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20 20 18 25 35

Internet assignment Using annual reports from the websites of three major publicly traded companies, answer questions regarding merger activity. For one company, review Form 10-K and determine what additional information is disclosed that is not available in the annual report.

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8

Illustration 1-1

DIAGRAM OF BASIC TYPES OF BUSINESS COMBINATIONS MERGER

Company A (Surviving Entity)

Net assets of B

Company B (Dissolved Entity)

Company A may acquire the net assets of Company B by issuing debt or equity securities or assets directly to Company B for B's net assets or to B's stockholders for all of B's outstanding stock. In either case, Company B is dissolved and Company A takes over the net assets of Company B. A+B=A CONSOLIDATION Company B Net Assets of B

(Dissolved Entity)

Net Assets of C

Company C (Dissolved entity)

Company A (A new entity)

Company A may acquire the net assets of Company B and Company C by issuing stock directly to Companies B and C for their net assets or to the stockholders of Companies B and C for all of their stock. In either case, Companies B and C are dissolved and Company A takes over their assets.

A+B=C ACQUISITION OF NET ASSETS WITHOUT DISSOLUTION .

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Company A (Acquiring Entity)

All or a major portion of B's operating assets Company B

Same as for a merger or consolidation except that Company A issues debt or equity securities or assets directly to Company B and Company B continues to exist as a separate legal entity.

ACQUISITION OF OUTSTANDING STOCK

(Parent-Subsidiary operations and consolidated financial statements)

Over 50% of Stock of B

Company A (Parent)

Company B (Subsidiary)

Similar to a merger or consolidation except that Company A receives a majority of the outstanding voting stock of Company B by issuing debt or equity securities or assets to the stockholders of Company B. Company B continues to exist as a separate legal entity and to operate in a parentsubsidiary relationship with Company A. A+B=A+B

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10

Illustration 1-2 Business Combinations Mergers

Consolidations Acquisition of Net Assets

Acquisition of Controlling Interest

Purchase Accounting Needs Investment Acctg.

Cost vs. Equity Needs Consolidated Statements

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Chapter 2 STOCK INVESTMENTS - INVESTOR ACCOUNTING AND REPORTING Chapter Outline ACCOUNTING FOR STOCK INVESTMENTS – ALL STOCK INVESTMENTS MUST BE RECORDED AT THE INVESTOR’S COST (FAIR VALUE AT ACQUISITION).

A

TWO METHODS OF ACCOUNTING FOR STOCK INVESTMENTS GENERALLY APPLY (FAIR VALUE/COST AND EQUITY).

B

In the absence of evidence to the contrary, an investment of 20% or more is presumed to give the investor an ability to exercise significant influence. The equity method requires that the investment be recorded at cost and the investment account adjusted for earnings, losses, and dividends.

1

The equity method should not be used if the ability to exercise significant influence is temporary or if the investee is a foreign company operating under severe exchange restrictions or controls.

2

GAAP provides indicators of the inability to exercise significant influence: a

Opposition by the investee that challenges the investor’s influence

b

Surrender of significant stockholder rights by agreement between investor and investee

c

Concentration of majority ownership

d

Inadequate or untimely information to apply the equity method

e

Failure to obtain representation on the investee’s board of directors

ACCOUNTING FOR NONCURRENT COMMON STOCK INVESTMENTS UNDER THE FAIR VALUE/COST METHOD: A

The fair value/cost method is used for common stock investments of less than 20% unless it can be demonstrated that the investor company has the ability to exercise significant influence over the investee company.

B

GAAP classifies equity securities that have a readily determinable market value as either trading securities or available-for-sale securities.

1

.

Investment is initially recorded at cost.

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2

The investment is adjusted to fair value at the end of the fiscal period.

3

Unrealized gains or losses are reported either in income or as an equity adjustment to the balance sheet (other comprehensive income), depending on the company’s intention for holding the stock.

4

Unrealized gains and losses associated with ‘trading’ securities are recorded as part of income. a

5

Unrealized gains and losses associated with ‘available for sale’ securities are considered “other comprehensive income” and are reported in the income statement, on a separate statement of comprehensive income, or in a statement of changes in equity. a

C

Trading securities are very short-term holdings – continued relationships are not expected.

Only dividend income and realized gains and losses impact income and EPS for available for sale securities.

Under the fair value/cost method: 1

Investment is initially recorded at cost.

2

Dividends received are recorded as dividend income. a

An exception: Liquidating dividends are deducted from the investment account. Liquidating dividends are those dividends received in excess of the investor’s share of earnings after the stock is acquired and are considered a return of capital.

ACCOUNTING FOR NONCURRENT COMMON STOCK INVESTMENTS UNDER THE EQUITY METHOD: A

.

Application of the equity method 1

The investment is initially recorded at cost.

2

Subsequently, the investor records its share of the investee’s income as an increase to the investment account (losses will decrease the investment account).

3

Dividends received from the investee are recorded as a decrease to the investment account.

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a

4

The investment account moves in the same direction as the investee’s net assets (for example, income increases assets for both).

Additional adjustments are required. a

Intercompany profits and losses are eliminated until realized.

b

Cost-book value differentials are accounted for as if the investee were a consolidated subsidiary.

(1) The difference between the investment cost and the underlying equity is assigned to identifiable assets and liabilities based on their fair values with any remaining difference allocated to goodwill.

(2) The difference between investment cost and book value acquired will disappear over the remaining lives of identifiable assets and liabilities, except for amounts assigned to land, goodwill, and intangible assets having an indeterminate life, which are not amortized.

(3) If the book value acquired is greater than the investment cost, the difference should be allocated against non-current assets other than marketable securities with any remaining amount treated as an extraordinary gain (negative goodwill).

c

The investment is reported on one line of the investor’s balance sheet and income on one line of the investor’s income statement, a one-line consolidation.

(1) Except extraordinary and other below-the-line items

C

D

Accounting for an interim investment 1

Absent evidence to the contrary, income of the investee is assumed to be earned proportionately throughout the year.

2

The investee’s book value at an interim date is determined by adding income earned from the last statement date to beginning stockholders’ equity and deducting dividends declared to the date of purchase.

Investments acquired step-by-step 1

.

An investor may acquire significant influence through a series of purchases.

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2

Prior to obtaining significant influence, the fair value/cost method is used.

When an investment qualifies for the equity method, the investment account is adjusted to the equity method and the investor’s retained earnings are adjusted retroactively. a

E

This is a change in reporting entity and it requires retroactive restatement if material.

Sale of an equity interest 1

When an investor reduces its equity interest in an investee to below 20%, the retained investment is accounted for under the fair value/cost method. a

Gain or loss from the equity interest sold is the difference between the selling price and the book value of the equity interest immediately before the sale.

b

Immediately after the sale, the balance of the investment account becomes the new cost basis.

F

If the stock is purchased directly from the investee (rather than its shareholders), the investor’s interest is determined by dividing shares acquired by shares outstanding immediately after the issuance of the additional shares.

G

Investees with preferred stock

H

1

Special adjustments are necessary when investees have both common and preferred stock outstanding.

2

Investee’s stockholders’ equity must be allocated into its common and preferred stock components to determine the book value of the common stock investment.

3

Investee’s net income must also be allocated into common and preferred stock components.

4

Call or liquidating premiums and dividends in arrears must also be considered in determining the investor’s share of earnings.

EXTRAORDINARY ITEMS – one-line consolidation does not apply. Investment income must be separated into ordinary and extraordinary components.

DISCLOSURES FOR EQUITY INVESTMENTS

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A

B

Material investments accounted for by the equity method require disclosure of: 1

The investee’s name and percent of ownership in common stock, the investor’s accounting policies with respect to investments in common stock, the cost/book value differentials and accounting treatment

2

The aggregate value of each identified investment for which quoted market prices are available

3

Summarized information about the investee’s assets, liabilities, and results of operations

Related party transactions 1

Related party transactions arise when one of the transacting parties has the ability to significantly influence the operations of the other.

2

There is no presumption of arms-length bargaining between the related parties.

3

Required disclosures include the nature of the relationship, a description of the transaction, the dollar amount of the transaction (and any change in the method used to establish the terms of the transaction), and amounts due to or due from related parties at the balance sheet date for each balance sheet presented.

TESTING GOODWILL FOR IMPAIRMENT A

GAAP eliminates former requirements to amortize goodwill; rather, goodwill must be periodically tested for impairment.

1

B

Firms may find this valuable for two reasons. a

Firms may recognize significant impairment losses on initial adoption which are treated as a “cumulative effect of an accounting change” (appears after “income from operations”).

b

Firms will no longer report annual goodwill expense charges.

Recognizing and measuring impairment losses is a two-step process.

1

First, carrying values and fair values of net assets are compared at the business reporting unit level. a

.

If fair value is greater than carrying value, goodwill is deemed unimpaired and no further action is necessary.

16

b 2

Step 2, when necessary, requires a comparison of the carrying value of goodwill with its implied fair value.

3

The implied fair value of goodwill is determined in the same manner used to originally record the goodwill at the business combination date. a

4

E

Current market prices (in an active market) are considered the most reliable indicator of fair value.

Goodwill impairment testing must be conducted at least annually.

1

D

Allocate the fair value of the reporting unit to all identifiable assets and liabilities as if they had made the purchase on the measurement date.

Any excess is the implied fair value of goodwill.

The fair value of the reporting unit is the amount for which it could be purchased or sold in a current, arm’s-length transaction. a

C

If carrying value is greater than fair value, the firm proceeds to step 2.

More frequent testing may be required if certain events occur such as adverse changes in the legal or business climate, new and unanticipated competition, loss of key personnel, and other similar events.

Reporting and disclosure 1

Material aggregate amounts of goodwill must be reported as a separate line item on the balance sheet.

2

Goodwill impairment losses are shown separately in the income statement.

Equity method investments 1

Many of the rules regarding goodwill in purchase method business combinations (parent acquiring a controlling interest in a sub) also apply to goodwill arising from use of the equity method.

2

One notable exception is the rule regarding goodwill impairments – impairment tests are performed based on fair value versus book value of the investment taken as a whole.

Description of assignment material

Minutes

Questions (14)

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17

Exercises (16) E2-1 E2-2 E2-3 E2-4 E2-5 E2-6 E2-7 E2-8 E2-9 E2-10 E2-11

E2-12 E2-13 E2-14 E2-15 E2-16

5 MC general AICPA 8 MC general and problem-type [Tre/Bow] Calculate percentage ownership and goodwill from investment acquired directly from investee [Car/Med] Calculate income for midyear investment [Dok/Oak] Calculate income and investment balance allocation of excess to undervalued assets [Man/Nib] Journal entry to record income from investee with loss from discontinued operations 4 MC problem-type [Ray/Ton] Calculate investment balance four years after acquisition [Run/Nic] Calculate income and investment balance when investee capital structure includes preferred stock [Arb/Tee] Calculate income and investment balance for midyear investment [Pim/Fed] Adjust investment account and determine investment income when additional investment qualifies investee for the equity method of accounting [Tal/Riv] Journal entries (investment in previously unissued stock) [BIP/Cow] Prepare journal entries and income statement, and determine investment account balance [Val/Wat] Calculate income and investment account balance (investee has preferred stock) [Par/Sel] Goodwill impairment [Flash/Alpha/Beta] Goodwill impairment

10 35 12 15 15 10 20 15 20 15 25

15 20 20 10 10

Problems (12) P2-1 P2-2 P2-3 P2-4 P2-5 P2-6 P2-7 P2-8 P2-9 .

[Rit/Tel] Computations for a midyear purchase (investee has an extraordinary gain) [Put/Sel] Journal entries for midyear investment (cost and equity methods) [Vat/Zel] Computations for investee when excess allocated to inventories, building, and goodwill [Jack/Jill] Journal entries for midyear investment (excess allocated to land, equipment, and goodwill) [Quake/Tremor] Prepare an allocation schedule, compute income and the investment balance [Pal/Sap] Computations for a midyear acquisition [Dil/Lar] Partial income statement with an extraordinary item [Jen/Laura] Computations and journal entries with excess of of book value over fair value [Tricia/Lisa] Prepare allocation schedules under different stock 18

25 20 20 20 15 20 10 25 20

P2-10 P2-11 P2-12

price assumptions (bargain purchase) [Fred/Prima] Computations for a piecemeal acquisition [Pat/Sue] Computations and a correcting entry (errors) [John/Jojo] Allocation schedule and computations (excess cost over fair value)

Case study Coca Cola’s 2012 annual report is used to understand the equity method.

Internet assignment Ford’s 2012 annual report is used to study Ford’s intercompany investments.

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Chapter 3 AN INTRODUCTION TO CONSOLIDATED FINANCIAL STATEMENTS Chapter Outline A BUSINESS COMBINATION UNDER GAAP INCLUDES COMBINATIONS IN WHICH ONE OR MORE COMPANIES BECOME SUBSIDIARIES OF A PARENT CORPORATION. A

A corporation that holds a majority interest (over 50%) of the voting stock of another corporation is referred to as the parent company.

B

The interest not held by the parent company is referred to as the noncontrolling interest.

C

A corporation whose outstanding voting stock is over 50% owned by another corporation is a subsidiary of that corporation.

D

GAAP states that the acquisition of additional shares of a subsidiary is recorded by an increase in the investment account and a reduction of the noncontrolling interest, based on the carrying amount of the noncontrolling interest at the additional acquisition date.

APIC is adjusted for any difference between the price and the carrying amount.

E

The parent company and subsidiary exist as separate legal entities and maintain separate accounting records. However, each reporting period their separate accounting records are combined into one set of consolidated financial statements for reporting the financial position and results of operations of a consolidated reporting entity.

1

Consolidated financial statements are prepared for all the companies under the control of a single management team to reflect a single reporting entity with multiple divisions.

2

The purpose of consolidated financial statements is to present fairly, primarily for the benefit of the owners and creditors of the parent company, the results of operations and the financial position of a parent and all its subsidiaries as if the consolidated group were a single entity.

3

The subsidiary will continue to report the results of its separate operations to its noncontrolling stockholders.

4

The consolidated entity (the reporting entity) has no transactions and it does not maintain a ledger. The financial statements of the separate legal entities are combined only for external reporting purposes.

CONSOLIDATION POLICY .

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A

Under current GAAP, consolidation is required for all corporations that are over 50% owned except: 1 2 3 4 5

Where control does not rest with the majority ownership Formation of joint ventures The acquisition of an asset or group of assets that does not constitute a business A combination of entities under common control A combination between not-for-profit entities or the acquisition of a for-profit business by a not-for-profit entity

DISCLOSURE OF CONSOLIDATION POLICIES 1 2 3 4

the reporting period that includes a business combination a business combination that occurs after the reporting period but before the financial statements are issued provisional amounts related to business combinations adjustments related to business combinations

PARENT AND SUBSIDIARY WITH DIFFERENT FISCAL PERIODS A

Consolidated statements are prepared for and as of the end of the parent company’s fiscal period.

CONSOLIDATED FINANCIAL STATEMENTS A

A set of consolidated financial statements includes a consolidated balance sheet, a consolidated income statement and retained earnings statement, and a consolidated statement of cash flows.

B

The consolidated balance sheet, income statement, and retained earnings statement are prepared by combining the separate financial statements of the parent company and the subsidiary.

C

The consolidated cash flow statement, however, is prepared from the consolidated financial statements for two consecutive years.

THE CONSOLIDATED BALANCE SHEET

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21

A

The investment in subsidiary account on the parent company balance sheet and the stockholders’ equity accounts on the subsidiary’s balance sheet are reciprocal, both representing the net assets of the subsidiary.

1

The reciprocal investment in subsidiary on the parent’s balance sheet and subsidiary stockholders’ equity accounts are eliminated in consolidation (and are replaced by the individual assets and liabilities of the subsidiary). a

A one-line consolidation (the investment account) as discussed in Chapter 2 is replaced by details about individual assets and liabilities controlled by a single management group.

2

Non-reciprocal accounts are combined.

3

Reciprocal accounts are often eliminated.

B

The capital stock and retained earnings amounts that appear in the consolidated balance sheet are those of the parent company.

C

Unimpared cost-book value differentials are added to (or subtracted from) the asset and liability accounts that will appear in the consolidated balance sheet. Goodwill from the investment, which does not appear in the separate company statements, is added to the asset listing.

D

Intercompany balances are eliminated.

E

100% of the assets and liabilities of the parent company and subsidiary are shown in the consolidated balance sheet, and any noncontrolling interest in the subsidiary’s net assets is reported separately in the liability or the stockholders’ equity section.

1

Noncontrolling interest is computed as the noncontrolling interest ownership percentage times the subsidiary equity at the balance sheet date.

2

Classification of noncontrolling interest: a

GAAP requires that noncontrolling interest appear as a separate component of stockholders’ equity.

b

Income attributable to the noncontrolling interest is deducted from consolidated net income.

ASSIGNING EXCESS TO IDENTIFIABLE NET ASSETS AND GOODWILL

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22

A

Before the balance sheets of the parent and subsidiary can be combined, differences between the book values and fair values must be assigned to over-valued or undervalued identifiable assets.

B

Fair value-book value differentials are not recorded on the books of the parent company or its subsidiary, and therefore they must be entered in the working papers to adjust the subsidiary’s book values to the new cost basis for consolidated statement purposes.

1

The amounts assigned to identifiable assets and liabilities are for the fair value and book value difference because the price paid by the parent company/investor implies an investment price for 100% of the investment.

2

The noncontrolling interest's share of the subsidiary’s assets and liabilities are adjusted based on the price paid by the parent for the percentage owned by the parent.

3

The asset and liability amounts that appear in the consolidated balance sheet are determined by combining the separate parent company and subsidiary financial statement amounts (book value) with the debit and credit amounts entered in the adjustment and elimination columns.

4

If several asset and liability accounts are affected by cost-book value differentials, the use of an “unamortized excess” account simplifies the process of entering the cost-book value differentials in the working papers. The unamortized excess account does not affect the consolidated financial statements because it has equal debit and credit entries in the adjustment and elimination columns.

CONSOLIDATED INCOME STATEMENT A

Under GAAP consolidated net income is the net income of the consolidated group. The consolidated income statement must clearly separate income attributable to the controlling and noncontrolling interests.

B

Under the equity method, the parent company’s income statement shows revenues and expenses of the parent company and investment income from the subsidiary.

C

In contrast, the consolidated income statement shows the total revenues and expenses of the parent company and subsidiary (adjusted for amortization of the fair value-book value differentials) and an allocation as noted above.

D

The objective of a consolidated income statement is to show the income of a parent company and its subsidiaries as if there were a single entity.

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23

PUSH-DOWN ACCOUNTING A

Push-down accounting is the process of recording the effects of the purchase price assignment directly on the books of the subsidiary.

B

Push-down accounting affects the subsidiary’s separate books and financial statements, but it does not alter consolidated financial statement amounts.

1

Cost-book value differentials are recorded on the books of the subsidiary (i.e., pushed down to the subsidiary’s accounts). At the acquisition date:

2

C

a

The parent company records its investment as usual.

b

The subsidiary makes an entry on its own books to record the new asset bases, including goodwill, and reclassifies retained earnings to pushdown capital.

The balance sheets of the parent company and subsidiary are consolidated by eliminating the investment in subsidiary account against the subsidiary’s capital stock and push-down capital.

The SEC requires push-down accounting for SEC filings when a subsidiary is substantially wholly owned (90%) and has no public debt or preferred stock outstanding.

Description of assignment material Questions (18)

Minutes

Exercises (10) E3-1 6 MC general questions E3-2 7 MC general questions E3-3 AICPA 6 MC problem-type questions E3-4 [Pin/San] Correction of consolidated net income E3-5 [Pan/Sad] Disclosure of consolidated dividends E3-6 [Por/Sli] Prepare journal entries and balance sheet under pushdown accounting

12 15 30 15 10 20

E3-7

20

E3-8 E3-9 E3-10

.

[Pas/Sit] Prepare consolidated income statements with and without fairvalue-book value differentials [Pob/Sof] Calculate consolidated balance sheet amounts with goodwill and noncontrolling interest [Pas/Sal] Prepare stockholders’ equity section of consolidated balance sheet one year after acquisition [Pek/Slo] Prepare consolidated income statement three years after acquisition

24

15 18 20

Problems P3-1 P3-2 P3-3 P3-4 P3-5 P3-6 P3-7 P3-8

P3-9 P3-10 P3-11 P3-12

(12) [Pen/Sut] Prepare a consolidated balance sheet at acquisition and compute consolidated net income one year later [Par/Set] Allocation schedule for fair value/book value differential and consolidated balance sheet at acquisition [PJ/Sof] Prepare allocation schedule with book value greater than fair value.

[Pam/Sap] Given separate and consolidated balance sheets, reconstruct the schedule to allocate the cost-book value differential [Pal/Sor] Prepare a consolidated balance sheet one year after acquisition 20 [Per/Sim] Consolidated balance sheet working papers with goodwill and dividends [Portly/Slender] Calculate items that may appear in consolidated financial statements two years after acquisition Based on AICPA [Pod/Saw/Sun] Prepare journal entries to account for investments, and compute minority interest, consolidated retained earnings, and investment balances [Pan/Sun] Consolidated balance sheet workpapers (excess allocated to equipment and goodwill) [Pan/Sun] Calculate investment cost and account balances from a consolidated balance sheet four years after acquisition [Pop/Stu] Consolidated balance sheet working papers (fair value/book value differentials and noncontrolling interest) [Pen/Sam] Calculate separate company and consolidated statement items given investment account for three years

Internet assignment Using the 2009 Delta Airlines annual report, summarize the disclosures made concerning the merger with Northwest Airlines.

.

25

22 25 20 15

20 30 30

30 25 30 30

Chapter 4 CONSOLIDATION TECHNIQUES AND PROCEDURES Chapter Outline CONSOLIDATION WORKING PAPERS A

Consolidation working papers are a tool used to assemble and organize the information required to prepare consolidated financial statements.

B

All data presented in the consolidated financial statements can be determined independently from the working papers.

C

Working paper entries do not affect the general ledger accounts of either the parent company or its subsidiaries.

CONSOLIDATED FINANCIAL STATEMENTS A

Subsequent to acquisition, a consolidated income statement, balance sheet, retained earnings statement, and statement of cash flows must be prepared.

B

Steps in the process include: (more detail below) 1 Determine the method the parent is using to account for its investment (Cost or Equity method (see the electronic supplement to chapter 4)).

2 Set up the worksheet (Financial Statement, Trial Balance, or Other Approach) a 1st column is parent information b 2nd column is subsidiary information c middle columns include adjustment and elimination entries d final column is for the consolidated information 3

Prepare elimination/adjustment entries and post to worksheet: a intercompany profits and losses and subsidiary income and dividends b noncontrolling share of subsidiary income and dividends c elimination of reciprocal accounts d allocation and elimination of fair value differentials

4

Calculate noncontrolling interest in Net income and allocate/record.

5

Complete worksheet.

6 Prepare statements.

WORKING PAPER TECHNIQUES – additional notes

.

26

A

The financial statements of the parent company and subsidiary appear in the first two columns of the working papers, followed by debit and credit columns for the adjusting and eliminating entries. The final column shows the consolidated financial statements.

B

Some accounts are adjusted or eliminated and other accounts are added before the separate financial statement columns are combined into consolidated amounts.

C

Only account balances may be adjusted or eliminated.

D

Parent company and subsidiary net income (income statement) and ending retained earnings (retained earnings statement) balances are not accounts and are not subject to adjustment or elimination.

E

1

Consolidated net income consists of consolidated revenues less consolidated expenses.

2

Consolidated retained earnings consist of beginning consolidated retained earnings plus consolidated net income less parent company dividends.

All nominal accounts are assumed to be open and to permit adjustment.

CONSOLIDATION WORKING PAPER PROCEDURE – additional notes A

Determine the parent company’s method of accounting for its subsidiary.

B

Copy the separate company financial statements of the parent and subsidiary in the first two columns of the working papers.

C

Enter consolidation working paper entries in the adjustments and eliminations columns in the following sequence: 1

Adjust for errors or omissions in the separate company financial statements.

2

Eliminate intercompany profits and losses.

3

Eliminate income and dividends from the subsidiary and adjust the Investment in Subsidiary account to its beginning-of-the-period balance.

Record the adjustment to record the noncontrolling’s interest in subsidiary’s earnings (noncontrolling interest expense) and dividends.

4

.

27

5

Eliminate reciprocal investment in subsidiary and subsidiary equity balances, enter beginning of the period noncontrolling interest, and enter unamortized cost-book value differentials.

6

Amortize cost-book value differentials.

7

Eliminate other reciprocal balances (intercompany receivables and payables, for example).

D

Add the separate company accounts plus or minus any related amounts from the adjustments and eliminations column and enter the sum in the consolidated statement column.

E

Calculate consolidated net income as consolidated revenues less consolidated expenses and less noncontrolling interest expense and carry consolidated net income to the consolidated retained earnings statement.

F

Calculate consolidated retained earnings and carry that amount to the consolidated balance sheet.

G

Calculate the consolidated balance sheet total assets and total liabilities.

CONSOLIDATED STATEMENT OF CASH FLOWS A

A consolidated statement of cash flows is prepared from the consolidated balance sheets and the consolidated income statement using the same procedure used for separate company statements of cash flows.

1

B

C

.

The consolidated statement of cash flows is not prepared by combining the parent’s and subsidiaries’ separate statements of cash flows.

Both the direct and indirect methods for preparing the cash flows from operating activities section of the statement are permitted.

1

The cash flows from investing activities and the cash flows from financing activities sections are the same under the direct and indirect methods.

2

The direct method is the preferred method under GAAP, but most companies present the Statement of Cash Flows under the indirect method.

3

Items not involving cash are explained in notes or schedules to the cash flow statement.

The indirect method begins with consolidated net income (controlling share).

Items not providing or using cash are adjusted to arrive at net cash flows from operations.

28

D

1

Noncontrolling interest is added back since it was subtracted in arriving at consolidated net income, but does not represent a cash outflow.

2

Noncontrolling interest dividends decrease cash flow from financing activities.

Special attention is needed for investments accounted for using the equity method.

1

E

If the indirect method is used, the net amount of income less dividends received from equity investees (i.e., the change in the investment account) is deducted when computing the cash flow from operating activities section. (If dividends received are greater than income from equity investees, the net amount is an addition to net income.) a

Use of the equity method results in the parent recording this excess of income over dividends as income. However, there is no cash flow related to the entry.

b

Dividends received from equity investees increase cash without affecting income because the dividends are reflected in the investment account.

The direct method begins with cash received from customers and investment income. Cash paid to suppliers, employees, and so on is offset against cash received to arrive at net cash flows from operating activities.

1

Consolidated income statement items involving cash flows are converted from the accrual to the cash basis.

2

Dividends received from equity investees are reported directly as cash flows from operating activities. (Since net income isn’t used to compute cash flows from operating activities, no adjustment is needed as described in “D” above.)

3

A schedule reconciling consolidated net income to operating cash flows is required (this is essentially the indirect method).

ELECTRONIC SUPPLEMENT A

.

Consolidation under an incomplete equity method – the absence of the equality of parent company net income and the controlling share of net income, and parent company retained earnings and consolidated retained earnings.

29

B

1

Results from an incorrect application of the equity method or use of the cost method of subsidiary accounting.

2

This is not considered a violation of GAAP as long as the consolidated financial statements prepared for stockholders are correct.

3

Approach to preparing consolidation working papers under an incomplete equity method – convert parent company’s accounts to the equity method as the first working paper entry.

Consolidation under the cost method (subsidiary income only recognized when dividends are declared).

1

Convert to the equity approach (see above).

2

Use traditional working paper entries to consolidate parent and subsidiary under the cost method. This method is easier to use for consolidations in the year of acquisition, but becomes more complicated in years after acquisition, especially if there are intercompany transactions.

ASSIGNMENT MATERIAL

Minutes

W4-1 Method of accounting for subsidiary investments 5 W4-2 Reciprocity between parent’s investment account and subsidiaries’ equity 5 accounts W4-3 Journal entries and computations (cost and equity methods) 30 W4-4 Equity and cost methods compared 15 W4-5 Consolidated financial statements (cost method) 30 W4-6 Working papers (incomplete equity method two years after acquisition) 40 W4-7 Working papers (cost method, one year after acquisition, several 40 adjustments) W4-8 Conversion to equity and working papers (cost method, four years after 40 acquisition)

APPENDIX – Trial Balance Workpaper Format Description of assignment material Questions (11) Exercises (7) E4-1 10 MC general questions .

10 30

E4-2 E4-3 E4-4 E4-5 E4-6 E4-7

[Pan/Sal] Consolidated statement items with equity method [Peg/San] General problems [Pen/Sin] Equity method 5 MC General questions on statement of cash flows [Par] Prepare cash flows from operating activities section [Pro] Prepare cash flows from operating activities section

Problems (19) P4-1 [Pea/Sen] Calculations five years after acquisition P4-2 [Pal/Sal] Workpapers and financial statements in year of acquisition P4-3 [Pan/Saf] Workpapers in year of acquisition, (goodwill and intercompany transactions) P4-4 [Pal/Sun] Consolidation working papers from separate financial statements P4-5 [Par/Sul] Workpapers in year of acquisition (excess allocated to inventory, building, equipment, patents, and goodwill) P4-6 [Pen/Syn] Workpapers (determine ownership interest, year after acquisition, excess assigned to land and patents) P4-7 [Par/Sol] Workpapers (year of acquisition, excess recorded for inventory, building equipment, and goodwill, intercompany balances) P4-8 [Pun/Son] Workpapers (excess assigned to undervalued land & goodwill) P4-9 [Pas/Sel] Workpapers (year of acquisition, excess recorded for inventory, equipment and patents, intercompany transactions) P4-10 [Pik/Sel] Workpapers (year of acquisition, fair/book value differentials, intercompany balances) P4-11 [Pil/Stu] Balance sheet (four years after acquisition, fair value/book value differentials) P4-12 [Pat/Sci] Workpapers (two years after acquisition, fair value/book differentials, adjustments) P4-13 [Ply/Ski] [Appendix] Workpapers for two successive years (equity method misapplied in second year) P4-14 [Pep/Sim] [Appendix] Investment account analysis and trial balance workpapers P4-15 [Peg/Sup/Ell] [Appendix] Trial balance workpapers and financial statements in year of acquisition P4-16 [Pil] Prepare cash flows from operating activities section (direct method) P4-17 [Pes] Prepare consolidated statement of cash flows using the direct method or indirect method P4-18 AICPA [Puh/Sto] Prepare consolidated statement of cash flows P4-19 [Pil] Prepare a consolidated statement of cash flows using either the direct or indirect method Internet assignment Using the 2009 Delta Airlines annual report, answer questions relating to goodwill, intangible assets, and noncontrolling interest.

.

31

20 15 20 15 15 15

35 50 50 40 50 50 45 40 40 50 35 50 50 50 80 20

30 50 40

Chapter 5 INTERCOMPANY PROFIT TRANSACTIONS - INVENTORIES Chapter Outline TRANSACTIONS BETWEEN AFFILIATED COMPANIES A

Transactions between affiliated companies (intercompany transactions) must be eliminated during the consolidation process.

B

Reciprocal account balances are eliminated.

1

C

For example, intercompany sales transactions create reciprocal sales and purchases accounts as well as reciprocal accounts receivable and accounts payable.

Gains and losses from intercompany transactions are eliminated until realized through use or through sale to an outside entity.

1

The total amount of the intercompany profit is eliminated, whether or not there is a noncontrolling interest.

2

The objective is to show the income and financial position of the consolidated entity as they would have appeared if the intercompany transaction had never taken place.

ELIMINATION OF INTERCOMPANY SALES AND COST OF GOODS SOLD A

Elimination of intercompany sales and cost of goods sold does not affect consolidated net income.

1

However, consolidated sales, cost of goods sold, and purchases will be reduced.

2

Since an equal amount of sales and cost of sales is eliminated, neither gross profit nor net income is affected.

B

Under a periodic inventory system, the working paper entry is a debit to sales and a credit to purchases.

C

Under a perpetual inventory system (discussed in the text), the working paper entry is a debit to sales and a credit to cost of goods sold.

SALES OF INVENTORY ITEMS (Illustration 5-1)

.

33

A

Downstream sales are those sales from a parent to its subsidiary.

1

The consolidation process eliminates the full amount of intercompany sales and cost of sales, regardless of whether the sales are downstream or upstream.

2

In a downstream sale, the parent company’s separate income includes the unrealized profit (in its sales and cost of sales accounts).

3

The subsidiary’s net income is not affected; therefore, the noncontrolling interest is computed as the subsidiary’s reported net income times the noncontrolling interest percentage.

4

The subsidiary’s ending inventory includes the unrealized profit until the merchandise is sold to outside entities.

5

B

a

The subsidiary’s ending inventory reflects the transfer price, rather than the cost to the consolidated entity.

b

In the consolidation working papers, the inventory is reduced to its cost basis by a debit to cost of goods sold and a credit to ending inventory.

Under the equity method, the full amount of unrealized profit from intercompany downstream sales is charged against income from subsidiary (i.e., not allocated to the noncontrolling interest).

Upstream sales are those sales from a subsidiary to its parent.

1

Again, the consolidation process eliminates the full amount of intercompany sales and cost of sales, regardless of whether the sales are downstream or upstream.

2

The subsidiary’s net income includes the full amount of the unrealized profits (included in its sales and cost of goods sold accounts). a

The unrealized profit in the subsidiary’s net income is allocated proportionately to the majority and noncontrolling interests in our text.

b

Consolidated net income and noncontrolling interest are computed on the basis of income that is realized from the viewpoint of the consolidated entity.

A subsidiary’s realized income is its reported net income, adjusted for intercompany profits from upstream sales.

c

.

34

3

The parent company’s separate income is not affected by unrealized profits from upstream sales, but its net income (which includes investment income) is affected.

4

The parent company’s ending inventory includes the unrealized inventory profit until the merchandise is sold to outside entities.

5

Under the equity method, only the parent’s proportionate share of unrealized profits from intercompany upstream sales is charged against income from the subsidiary.

ACCOUNTING FOR UNREALIZED PROFITS FROM DOWNSTREAM SALES A

In the consolidation working papers, the full amount of the intercompany sales is eliminated from sales and cost of goods sold.

B

The unrealized profit is deferred until it is realized when sold to an outside entity.

C

1

Deferral is accomplished in the consolidation working papers by a working paper entry that increases cost of goods sold for the unrealized profit and reduces the ending inventory to its cost basis (to the consolidated entity).

2

From the consolidated entity viewpoint, unrealized profits in the ending inventory understate cost of goods sold and overstate consolidated net income.

3

Under the equity method, the full amount of the unrealized profit in the subsidiary’s inventory is eliminated from investment income and from the investment in subsidiary account on the parent company books.

When the inventory items acquired by the subsidiary from the parent company are sold to outside entities, the intercompany profit is realized.

.

1

The unrealized profits in the ending inventory of one period are the unrealized profits in the beginning inventory in the next period.

2

The effect of unrealized profits in the beginning inventory is just opposite to that of unrealized profits in the ending inventory. a

Unrealized profits in the ending inventory (year of intercompany sale) have a direct relationship to consolidated net income.

b

Unrealized profits in the beginning inventory (year of sale to outside entities) have an inverse relationship to consolidated net income.

35

3

Under the equity method, the investment in subsidiary and income from subsidiary amounts are increased for the realization of the intercompany profits from the preceding period.

4

Realization of deferred profits in the subsidiary’s beginning inventory overstates cost of goods sold from the consolidated viewpoint.

5

The working paper entry to record the realization of deferred profits is a debit to the investment in subsidiary account and a credit to cost of goods sold.

6

a

The beginning inventory account cannot be adjusted directly because it has already been closed to the cost of goods sold account.

b

The debit to the investment account reestablishes reciprocity between the investment balance at the beginning of the period and the subsidiary’s equity accounts at the same date.

Unrealized inventory profits in consolidated financial statements are selfcorrecting over any two accounting periods.

ACCOUNTING FOR UNREALIZED PROFITS FROM UPSTREAM SALES A

As in the case of downstream sales, the full amount of the intercompany sales is eliminated from sales and cost of sales in the consolidation working papers.

B

Intercompany sales from the subsidiary to the parent company increase the subsidiary’s sales, cost of goods sold, gross profit, and net income.

C

The unrealized profit remains in the parent company’s inventory until the items are sold to outside entities.

.

1

If the selling subsidiary is 100% owned, the parent company defers 100% of any unrealized profits in the year of the intercompany sale.

2

If the selling subsidiary is partially owned, the parent company defers only its proportionate share of the unrealized profits in the year of the intercompany sale.

3

The noncontrolling interest is reduced for its proportionate share of any unrealized subsidiary profits. To compute noncontrolling interest, the unrealized profit is subtracted from the subsidiary’s reported net income, and the resulting subsidiary realized income is multiplied by the noncontrolling interest percentage.

36

D

Intercompany profit is recognized and realized when the inventory items are sold to outside entities.

1

2

Unrealized profits in the beginning inventory overstate cost of goods sold. a

In the consolidation working papers, a working paper entry reduces cost of goods sold to its cost basis (credit) and adjusts the investment account and beginning minority interest (debits) for the previously deferred unrealized profits in the beginning inventory.

b

Recall that the effect of unrealized profits in a beginning inventory on parent company and consolidated net income are opposite the effect of unrealized profits in an ending inventory.

Under the equity method, realization of previously deferred intercompany profits increases investment income and the investment in subsidiary account for the parent company’s proportionate share.

ELECTRONIC SUPPLEMENT A

The electronic supplement explains procedures when a parent is using either the incomplete equity method or cost method of accounting for its investment.

Continues the techniques used in applying an incomplete equity method when inventory is sold between the parent and subsidiary.

ASSIGNMENT MATERIAL

Minutes

Upstream sales – 3 MC questions Computations and correcting journal entries (downstream) Consolidated income statement (upstream sales) Journal entries and computation (upstream sales and incomplete equity method) W5-5 Computations (downstream sales, cost method, no noncontrolling interest) W5-6 Prepare parent company and consolidated income statements (downstream sales) W5-7 Consolidated balance sheet working papers W5-1 W5-2 W5-3 W5-4

APPENDIX A A

The SEC influence on accounting is discussed.

1) Securities Act of 1933 regulates initial issuances.

2) Securities Exchange Act of 1934 regulates subsequent trading.

3) Sarbanes-Oxley Act is a response to the “scandals.” .

37

15 10 15 30 30 30 45

4) Registration Statement for Security Issues 5) Integrated Disclosure System 6) SEC Developments B C

Regulations S-X prescribes rules foe SEC-filed financial statements.

Regulation S-K covers nonfinancial statement disclosures.

D

The SEC also regulates those international firms that list their shares on U.S. securities exchanges. IFRS-based financial statements may be permitted.

Description of assignment material

Minutes

Questions (14) Exercises (12) E5-1 E5-2 E5-3 E5-4 E5-5 E5-6 E5-7 E5-8 E5-9 E5-10 E5-11 E5-12

8 MC general questions AICPA 3 MC problem type 3 MC problem type (downstream sales) [Pid/Sed] 3 MC problem-type questions (upstream sales) [Par/Sel] 3 MC problem-type questions (upstream sales) 3 MC problem-type questions (upstream and downstream sales) [Pan/She] Determine consolidated net income with downstream intercompany sales [Pic/Sil] Consolidated income statement with downstream sales [Pug/Sev] Compute noncontrolling interest and consolidated cost of sales (upstream sales) [Pap/Sak] Consolidated income statement (upstream sales) [Pre/Sue] 3 MC problem-type questions (upstream sales) [Pul/Swa] Consolidated income statement (intercompany sales correction)

Problems (9) P5-1 [Por/Sam] Prepare consolidated income and retained earnings (upstream sales, noncontrolling interest) P5-2 [Put/Sam] Computations (upstream sales) P5-3 [Pot/San/Tay] Computations (parent buys from one subsidiary and sells to the other) P5-4 [Pli/Stu] Computations (upstream and downstream sales) P5-5 [Pan/Sal] Workpapers (100% owned, downstream sales, year after acquisition) P5-6 [Pay/Sue] Workpapers (noncontrolling interest, downstream sales, year after acquisition) P5-7 [Pol/San] Consolidation workpapers (upstream sales, .

38

16 15 15 15 15 15 12 15 12 15 15 20

20 20 50 45 45 60 60

noncontrolling interest) P5-8 [Pan/Sal] Consolidated working papers (downstream sales) P5-9 [Po/San] Consolidated workpapers (noncontrolling interest, upstream sales, intercompany receivables/payables) Internet assignment Using Ford Motor Company’s 2009 annual report from the website, discuss information presented concerning intercompany inventory transfers or intersegment sales.

.

39

50 50

Illustration 5-1 INTERCOMPANY INVENTORY PROFITS

P owns a 90% interest in S acquired at book value equal to fair value at the beginning of 20Xl. Separate incomes 20X1 P

S

Combined

Sales

$500,000

$300,000

$800,000

Cost of sales

(300,000)

(200,000)

(500,000)

Expenses

(100,000)

(50,000)

(150,000)

$100,000

$ 50,000

$150,000

Separate incomes Additional information: 1 2

Intercompany sales in 20Xl were $50,000.

Cost of inventory items sold intercompany was $40,000 and the intercompany profit was $10,000.

Unrealized profit at year-end 20Xl was $5,000.

3

Separate incomes 20X2 Sales

P $550,000

S $350,000

Combined $900,000

Cost of Sales

(300,000)

(200,000)

(500,000)

Expenses

(140,000)

( 90,000)

(230,000)

$110,000

$ 60,000

$170,000

Separate incomes

Additional information: 1 2

Intercompany sales in 20X2 were $80,000.

Cost of inventory items sold intercompany was $50,000 and the intercompany profit was $30,000.

Unrealized profit at year-end 20X2 was $10,000.

All intercompany profit deferred in 20Xl was realized in 20X2.

3 4

DOWNSTREAM SALES - 20XI .

($5,000 unrealized profit deferred] 40

One-line consolidation entry: Investment in S Income from S

$40,000 $40,000

To take up income from S computed as ($50,000 x 90%) – $5,000 unrealized profit deferred.

Consolidation working paper entries: a Sales

$50,000

Cost of sales To eliminate intercompany purchases and sales amounts. b

c

Cost of sales $ 5,000 Inventory To defer unrealized profit in ending inventory.

Income from S $40,000 Investment in S To eliminate income from S and return investment account to its beginning of the period balance.

DOWNSTREAM SALES - 20X2

.

$50,000

$ 5,000

$40,000

($5,000 realized profit; $10,000 profit deferred]

41

One-line consolidation entry: Investment in S $49,000 Income from S $49,000 To take up income from S computed as: ($60,000 x 90%) + realization of $5,000 in beginning inventory – deferral of $10,000 unrealized profit in ending inventory.

Consolidation working paper entries: a

Sales

$80,000

Cost of sales To eliminate intercompany purchases and sales. b

Investment in S $ 5,000 Cost of sales $ 5,000 To recognize previously deferred profit from beginning inventory.

c Cost of sales $10,000 Inventory To defer unrealized profit in ending inventory. d

Income from S $49,000 Investment in S To eliminate investment income and return investment account to its beginning of the period balance.

UPSTREAM SALES - 20XI

.

$80,000

($5,000 unrealized profit deferred]

42

$10,000

$49,000

One-line consolidation entry: Investment in S $40,500 Income from S $40,500 To take up income from S computed as ($50,000 - $5,000) x 90%.

Consolidation working paper entries: a Sales

$50,000 Cost of sales To eliminate intercompany purchases and sales amounts.

b

c

.

Cost of sales $ 5,000 Inventory To defer unrealized profit in ending inventory.

Income from S $40,500 Investment in S To eliminate income from S and return investment balance to its beginning of the period balance.

43

$50,000

$ 5,000

$40,500

UPSTREAM SALES - 20X2

[$5,000 realized profit; $10,000 profit deferred]

One-line consolidation entry: Investment in S $49,500 Income from S To take up income from S computed as: ($60,000 + $5,000 in beginning inventory - $10,000 unrealized profit in ending inventory) x 90%.

$49,500

Consolidation working paper entries: a

$80,000 Cost of sales To eliminate intercompany purchases and sales.

$80,000

b

Investment in S $ 4,500 Noncontrolling interest 500 Cost of sales $5,000 To recognize previously deferred profit from beginning inventory allocated to investment account and noncontrolling interest.

c

Cost of sales $10,000 Inventory To defer unrealized profit in ending inventory and return cost of sales to a cost basis.

d

.

Sales

Income from S $49,500 Investment from S To eliminate investment income and return investment account to its beginning of the period balance.

44

$10,000

$49,500

Chapter 6 INTERCOMPANY PROFIT TRANSACTIONS - PLANT ASSETS Chapter Outline SALE OF PLANT ASSETS TO AFFILIATED COMPANIES A

The sale of plant assets to affiliated companies at a price other than book value creates an unrealized gain or loss to the consolidated entity.

B

Gain or loss from the intercompany sale appears in the income statement of the selling affiliate in the year of sale.

C

The gain or loss is unrealized from the viewpoint of the consolidated entity until: • •

D

The plant asset is sold to an outside entity, or The asset is fully depreciated through use within the consolidated entity.

The effects of unrealized gains and losses are: • •

Eliminated from investment income in a one-line consolidation (use of equity method) Eliminated from consolidated financial statements through working paper entries.

DOWNSTREAM INTERCOMPANY SALE OF LAND (Illustration 6-1) A

In the year of an intercompany sale of land, an entry is made in the consolidation working papers to eliminate the full amount of the gain on the sale and reduce the land account to its cost to the consolidated entity.

1

This entry is the same for downstream and upstream intercompany land sales.

2

The parent company reduces its investment income and investment account for the unrealized intercompany profit.

B

While the land is held within the consolidated entity in years subsequent to the year of sale, a consolidation workpaper entry is required each year to reduce the land account to its cost basis (credit) and increase the investment account to establish reciprocity with the subsidiary’s equity accounts at the beginning of the period.

C

When the land is sold to an outside entity, the parent company recognizes the previously deferred gain from the intercompany sale.

.

45

1

A consolidation working paper entry converts the gain on sale of land to the gain to the consolidated entity and establishes reciprocity between beginning investment and subsidiary equity accounts.

2

The consolidated gain is the difference between the cost of the land and the final selling price to an outside entity.

UPSTREAM INTERCOMPANY SALE OF LAND (Illustration 6-1) A

In the year of the intercompany sale of land, the full amount of the gain on the sale is eliminated from the consolidated financial statements and the land is reported at its cost to the consolidated entity.

B

The parent company reduces its investment income for only its proportionate share of the unrealized gain because the noncontrolling interest is also charged with its share of the unrealized gain.

C

In the consolidation working papers, noncontrolling interest expense is computed as the subsidiary’s realized income times the noncontrolling interest percentage.

1

D

E

.

Realized income is the subsidiary’s reported income less unrealized gains and plus unrealized losses.

While the land is held within the consolidated entity in years subsequent to the year of sale, a consolidation working paper is required each year to: 1

Reduce the land account to its cost basis,

2

Increase the investment account for its share of the unrealized gain (this entry establishes reciprocity with the subsidiary’s equity accounts at the beginning of the period), and

3

Decrease the beginning noncontrolling interest to its balance at the end of the previous year (in other words, compute noncontrolling interest on the basis of realized income rather than on the basis of reported income).

When the parent company sells the land to an outside entity, the gain or loss to the parent is converted to a gain or loss to the consolidated entity for reporting in the consolidated financial statements.

1

The amount of the gain or loss is the difference between the cost of the land and final selling price to the outside entity.

2

A working paper entry enters the gain from the intercompany sale, increases the investment account to establish reciprocity with beginning 46

subsidiary equity accounts, and decreases the beginning noncontrolling interest to its balance at the end of the previous year.

3

Only the credit to the gain on land is different from the entries in the previous year in which the land was held within the consolidated entity.

4

On the parent company’s books, the parent’s share of the previously deferred gain from the intercompany sale is recognized and realized with an entry that increases investment income and the investment account.

DOWNSTREAM SALES OF DEPRECIABLE PLANT ASSETS (Illustration 6-2) A

In the year of sale, the unrealized gain from a downstream sale of plant assets is reflected in the parent company’s accounts.

1

The unrealized gain is eliminated in determining investment income under the equity method.

2

The unrealized gain does not appear in the consolidated income statement.

•

3

Next, depreciation expense and accumulated depreciation are reduced in the consolidation working papers.

• • •

4 B

Adjusts these items to the depreciated cost basis to the consolidated entity at the end of the year.

Adjusts depreciation expense to the amount it would have been had the intercompany sale not taken place.

By reducing depreciation expense, the gain is recognized on a piecemeal basis as the asset is used by the consolidated entity.

The noncontrolling interest computation is not affected.

In years subsequent to the year of intercompany sale, as the overstated plant asset is depreciated, the parent company adjusts it investment income for the piecemeal recognition of the previously unrecognized gain.

1 The full amount of the gain from the intercompany sale will be recognized through investment income by the end of the useful life of the plant asset.

2

.

The unrealized gain is removed from consolidated financial statements by a working paper entry that eliminates the gain and returns the plant asset to its depreciated cost to the consolidated entity at the time of sale.

Also at the end of the plant asset’s useful life, the investment account will reflect the parent’s proportionate share of the subsidiary’s underlying

47

equity, assuming there are no other unrealized profits or cost-book value differentials.

UPSTREAM SALES OF DEPRECIABLE PLANT ASSETS (Illustration 6-2) A

In the year of an upstream sale at other than book value, the gain or loss is reflected in the subsidiary accounts.

1

Investment income for the year of sale is adjusted for the parent’s share of the unrealized gain or loss and the parent’s share of any piecemeal recognition of the gain or loss through depreciation.

2

Noncontrolling interest share is computed as the noncontrolling interest ownership percentage times the subsidiary’s realized income.

•

Realized income is the subsidiary’s reported net income less the realized gain plus piecemeal recognition of the gain through depreciation.

3

The unrealized gain does not appear in the consolidated statements.

4

Consolidation working paper entries are required to eliminate the effects of the intercompany upstream sale.

• The unrealized gain is eliminated and the plant asset is returned to its depreciated cost to the consolidated entity at the time of sale.

• Excess depreciation for the current year (depreciation in excess of the amount that would have been recorded had the intercompany sale not taken place) is eliminated from the depreciation accounts. This is the piecemeal recognition of the gain.

B

.

In years subsequent to the year of the upstream intercompany sale, working paper entries: • Allocate the unrealized gain between the investment account and beginning noncontrolling interest, and • Return the plant asset and accumulated depreciation accounts to a cost basis to the consolidated entity.

1

The debit to noncontrolling interest adjusts the beginning noncontrolling interest balance of the current year to the ending balance of the previous year.

2

The debit to the investment account establishes reciprocity between the investment account balance and the subsidiary’s equity accounts at the beginning of the period.

48

3

When the full amount of the unrealized gain has been realized through depreciation, no further adjustments are necessary.

PLANT ASSETS SOLD AT OTHER THAN FAIR VALUE A

An intercompany sale of plant assets at a loss requires special evaluation to ensure the loss should not have been recognized by the selling affiliate prior to the intercompany sale.

B

Sale of assets above fair value also creates problems for the parties involved.

C

While the process for consolidation does not change, questions regarding inappropriate recognition of gains or losses could lead to charges of improper stewardship on the part of corporate directors.

INVENTORY ITEMS SOLD INTERCOMPANY FOR USE AS PLANT ASSETS A

The unrealized gain (gross profit) on the sale is recognized through depreciation by the purchasing affiliate.

B

Working paper entries in the year of intercompany sale:

C

1

Reduce sales for the intercompany sale, reduce cost of sales for the cost of the inventory item, and reduce the plant asset to its cost basis to the consolidated entity.

2

Eliminate depreciation expense (piecemeal recognition of the gross profit on sale occurs as the depreciation expense is eliminated).

Working paper entries in subsequent years will: • • •

Reduce the plant asset to its cost basis, Eliminate depreciation expense (piecemeal recognition of the gross profit on sale occurs as the depreciation expense is eliminated), and Establish reciprocity between beginning-of-the-period equity and investment amounts.

ELECTRONIC SUPPLEMENT The electronic supplement discusses situations where the parent company uses either the incomplete equity method or the cost method to account for its investment.

.

49

Continues the techniques used in applying an incomplete equity method when plant assets are sold between the parent and subsidiary.

ASSIGNMENT MATERIAL

Minutes

W6-1 Computations and corrections for downstream sale of building W6-2 Consolidated balance sheet after acquisition (incomplete equity method, downstream sale of inventory, upstream sale of land) W6-3 Consolidated income statements (cost method, noncontrolling interest, intercompany inventory sales, downstream sale of machinery) W6-4 [AICPA] Working papers (100% owned, cost method, midyear downstream sale of land and building, upstream inventory sales)

.

50

20 20 30 60

Description of assignment material

Minutes

Questions (10) Exercises (11) E6-1 4 MC general questions E6-2 [Par/Sam] Discuss effect of intercompany sale of land E6-3 [Pit/Sir] Computations for downstream and upstream sales of land E6-4 [Pig/Sal] Journal entries and consolidated income statement (downstream sale of building) E6-5 AICPA 4 MC general questions E6-6 6 MC problem type questions E6-7 [Pod/Sev] Consolidated income statement (sale of asset sold upstream 2 years earlier) E6-8 [Pep/Sat] Investment income from 40% investee (upstream and downstream sales) E6-9 [Pan/Sip] Upstream sale of equipment, noncontrolling interest E6-10 [Ped/Spa] Inventory items of parent capitalized by subsidiary E6-11 [Par/Sum] Consolidated net income (upstream and downstream sales) Problems (11) P6-1 [Pearl/Sear] Consolidated income statement (incomplete equity method downstream sales) P6-2 [Pal/Sim] Consolidated workpaper (downstream sales, intercompany receivable/payable) P6-3 [Pal/Sor] Consolidated workpaper (downstream sales, intercompany receivable/payable) P6-4 [Par/Sag] Workpaper in year of acquisition (downstream sales) P6-5 [Pal/Sto] Workpaper (downstream sales, two years) P6-6 [Pil/San] Workpaper (fair value/book value differential, downstream sales) P6-7 [Pot/Ski] Workpaper (downstream and upstream sales) P6-8 [Pic/Sic] Workpaper (incomplete equity method, upstream sale) P6-9 [Par/Sin]Workpaper (upstream sales current and previous years) P6-10 [Pal/Sun] Consolidation workpaper (upstream sales) P6-11 [Pape/Sach] 10 questions that analyze separate company and consolidated statements Internet assignment Using the AT&T annual report from its website, review and discuss information relating to intercompany asset transactions.

Illustration 6-1

.

51

12 15 20 15 12 30 25 15 20 20 35

25 50 50 50 50 50 70 90 60 45 30

INTERCOMPANY PROFITS ON LAND P owns a 90% interest in S, acquired at fair value at the beginning of 20Xl. During 20X1 land that cost $1,500 is sold intercompany for $2,500. The land is sold to an outside entity in 20X3 for $3,000.

Separate Incomes 20Xl:

Sales Expenses and cost of sales Gain on sale of land Separate incomes

P Sells Land to S Downstream P S $50,000 $30,000

S Sells Land to P Upstream P S $50,000 $30,000

(40,000)

(40,000)

(25,000)

$ 5,000

$10,000

1,000 $ 6,000

$35,000

$55,000

$35,000

(29,000) $ 6,000

(44,000) $11,000

(29,000) $ 6,000

$38,000

$60,000

$38,000

(30,000)

(50,000)

(30,000)

500 $ 8,500

500 $10,500

$ 8,000

1,000 $11,000

Separate Incomes 20X2: Sales $55,000 Expenses and cost of sales (44,000) Separate incomes $11,000

Separate Incomes 20X3: Sales $60,000 Expenses and cost of sales (50,000) Gain on sale of land Separate incomes $10,000

.

(25,000)

52

1

DOWNSTREAM SALE - 20XI:

$1,000 unrealized gain deferred

One-line consolidation entry: Investment in S $3,500 Income from S $3, 500 To record 90% of S's reported income and eliminate unrealized profit on land. [Computation: ($5,000 x 90%) - $1,000] Consolidation working paper entries:

.

a

Gain on sale of land $1,000 Land $1,000 To eliminate unrealized profit on sale of land to S and reduce land to its cost basis.

b

Income from S

$3,500 Investment in S $3,500 To eliminate investment income and return investment account to its beginning of the period balance.

53

2

DOWNSTREAM SALES - l9X2

One-line consolidation entry: Investment in S $5,400 Income from S To record 90% of S's reported income. Computation: $6,000 x 90%

$5,400

Consolidation working paper entries: a

b

Investment in S $1,000 Land To reduce land to its cost basis and adjust investment account to establish reciprocity with S's beginning of the period equity accounts.

Income from S

$5,400

Investment in S To eliminate investment income and return investment account to its beginning of the period balance.

.

$1,000

54

$5,400

3

DOWNSTREAM SALES - 20X3:

Land is sold to outside entity

One-line consolidation entry: Investment in S $8,650 Income from S To record 90% of S's reported income and recognize the previously deferred profit on the sale of land to S. Computation: $8,500 x 90% + $1,000

$8,650

Consolidation working paper entries: a

b

Investment in S $1,000 Gain on sale of land To adjust gain on sale of land to the $1,500 gain to the consolidated entity.

Income from S

$8,650

Investment in S To eliminate investment income and return investment account to its beginning of the period balance.

.

$1,000

55

$8,650

4

UPSTREAM SALES - 20XI:

$1,000 unrealized gain deferred

One-line consolidation entry: Investment in S $4,500 Income from S To record 90% of S's realized income. Computation: ($6,000 - $1,000 unrealized profit) x 90%

$4,500

Consolidation working paper entries: a

b

.

Gain on sale of land $1,000 Land To eliminate unrealized profit on sale of land to P and reduce land to its cost basis. $4,500 Investment in S To eliminate investment income and return investment account to its beginning of the period balance.

$1,000

Income from S

56

$4,500

5

UPSTREAM SALES - 20X2

One-line consolidation entry: Investment in S $5,400 Income from S To record 90% of S's reported income. Computation: $6,000 x 90%

$5,400

Consolidation working paper entries: a

b

Investment in S $ 900 Noncontrolling interest-beginning 100 Land To reduce land to its cost basis and adjust investment and beginning noncontrolling interest amounts to establish reciprocity with the beginning of the period equity accounts of S. Income from S

$5,400 Investment in S

$5,400

To eliminate investment income and return investment account to its beginning of the period balance.

.

$1,000

57

6

UPSTREAM SALE - 20X3: Sale to outside entity.

One-line consolidation entry: Investment in S $8,100 Income from S To record 90% of S's reported income and recognize the previously deferred profit on the sale of land to S. Computation: $8,000 x 90% + $900

$8,100

Consolidation working paper entries: a

b

.

Investment in S $ 900 Noncontrolling interest 100 Gain on sale of land To adjust gain on sale of land to the $1,500 gain to the consolidated entity. $8,100 Investment in S To eliminate investment income and return investment account to its beginning of the period balance.

$1,000

Income from S

58

$8,100

Illustration 6-2 INTERCOMPANY SALE OF MACHINERY P owns a 90% interest in S, acquired at book value equal to fair value at the beginning of 20XI. Part A

On January 1, 20Xl P sells machinery with a book value of $4,000 and a 10-year remaining useful life to S for $5,000.

20X1 20X2 Separate Incomes Separate Incomes P

S

P

S

$50,000

$30,000

$55,000

$35,000

Gain on sale of machinery 1,000 Depreciation expense (10,000) Other expenses (30,000) Separate incomes $11,000

( 5,500) (20,000) $ 4,500

(10,000) (34,000) $11,000

( 5,500) (24,000) $ 5,500

Sales

Part B

On January 1, 20X1 S sells machinery with a book value of $4,000 and a 10year remaining useful life to P for $5,000.

20X1 Separate Incomes P

Sales $50,000 Gain on sale of machinery Depreciation expense (10,500) Other expenses (30,000) Separate incomes $ 9,500

.

20X2 Separate Incomes S

P

S

$30,000

$55,000

$35,000

1,000 (5,000) (20,000) $ 6,000

(10,500) (34,000) $10,500

( 5,000) (24,000) $ 6,000

59

Part A: DOWNSTREAM SALE OF MACHINERY - 20XI ($1,000 gain - $100 unrealized gain deferred)

One-line consolidation entry: Investment in S $3,150 Income from S To record 90% share of S's net income less gain on sale of machinery plus piecemeal recognition of gain through depreciation. Computation: ($4,500 x 90%) - $1,000 + $100

$3,150

Consolidation working paper entries: a

b

c

Gain on machinery $1,000 Machinery To eliminate unrealized gain and reduce machinery to a cost basis.

Accumulated depreciation-machinery Depreciation expense To eliminate the current year's effect of the unrealized gain from depreciation accounts.

$

Income from S

$3,150

60

100 $ 100

Investment in S To eliminate investment income and adjust investment account to its beginning of the period balance.

.

$1,000

$3,150

Part A: DOWNSTREAM SALE OF MACHINERY - 20X2 ($100 of $900 deferred gain is recognized in 20X2)

One-line consolidation entry: Investment in S Income from S Computation: ($5,500 x 90%) + $100

$5,050 $5,050

Consolidation working paper entries: a

b

c

Accumulated depreciation-machinery $ 100 Depreciation expense To eliminate current year's effect of unrealized profit from depreciation accounts.

Investment in S $ 900 Accumulated depreciation 100 Machinery To eliminate unrealized profit from machinery and accumulated depreciation as of the beginning of the year and to adjust the investment account for the difference.

Income from S

100

$1,000

$5,050

Investment in S To eliminate investment income and adjust the investment account to the beginning of the period balance.

Part B: UPSTREAM SALE OF MACHINERY - 20XI ($1,000 - $100 unrealized gain deferred) .

$

61

$5,050

One-line consolidation entry: Investment in S $4,590 Income from S Computation: ($6,000 - $1,000 + $100) x 90%

$4,590

Consolidation working paper entries: a

b

c

.

Gain on sale of machinery $1,000 Machinery To eliminate unrealized gain and reduce machinery to a cost basis.

Accumulated depreciation-machinery $ 100 Depreciation expense To eliminate the current year's effect of unrealized gain from depreciation accounts. $4,590 Investment in S To eliminate investment income and adjust investment account to its beginning of the period balance.

$1,000

$ 100

Income from S

62

$4,590

PART B: UPSTREAM SALE OF MACHINERY - 20X2 ($100 of $900 deferred gain is recognized in 20X2)

One-line consolidation entry: Investment in S $5,490 Income from S To record 90% of S's realized income. Computation: ($6,000 + $100) x 90% Consolidation working paper entries: a Accumulated depreciation-machinery Depreciation expense To eliminate 20Xl unrealized gain from current depreciation accounts. b

c

$

100 $ 100

Investment in S $ 810 Noncontrolling interest-beginning 90 Accumulated depreciation 100 Machinery To eliminate unrealized profit from machinery and accumulated depreciation and to establish reciprocity between the majority and noncontrolling interests and subsidiary equity accounts as of the beginning of the period.

Income from S

$1,000

$5,490

Investment in S To eliminate investment income and adjust the investment account to the beginning of the period balance.

.

$5,490

63

$5,490

Chapter 8 CONSOLIDATIONS - CHANGES IN OWNERSHIP INTERESTS Chapter Outline ACQUISITION OF A SUBSIDIARY DURING AN ACCOUNTING PERIOD A

When a subsidiary is acquired during an accounting period, the subsidiary’s sales and expenses are included in the consolidated income statement for the full year.

B

The income of a subsidiary earned prior to acquisition is included in the acquisition’s purchase price negotiated by the parent.

1

This purchased income (or preacquisition earnings) must be eliminated from consolidated income.

2

In theory the elimination could be made by either eliminating the preacquisition sales and cost of goods sold or by eliminating the preacquisition income.

3

Earlier GAAP recommended the latter method. That is, including the detailed sales and cost of goods sold information, but deducting preacquisition income to arrive at consolidated net income.

4

GAAP changed in 2007 and now states that consolidated net income should only reflect subsidiary earnings subsequent to acquisition date. Preacquisition earnings should not appear. Essentially the books of the subsidiary are closed at acquisition date.

Dividends paid on the purchased company’s stock before the stock is acquired by the parent company during an accounting period are referred to as preacquisition dividends.

C

1

D

Preacquisition dividends are eliminated because they are not part of the equity acquired.

Changes in consolidation working paper procedures for acquisitions during an accounting period are as follows: 1

.

In the working paper entry that eliminates the reciprocal Investment in Subsidiary and subsidiary equity accounts: a

Preacquisition income is eliminated in the consolidation working papers as a debit, and

b

Preacquisition dividends are eliminated.

76

2

The reason for including the above items in the working paper entry is that subsidiary equity balances are eliminated as of the beginning of the period and the investment balance is eliminated as of the date of acquisition within the period (and thus reflects the purchased income and preacquisition dividends).

3

Preacquisition income, like noncontrolling interest income, is deducted from total consolidated income as a separate item in the consolidated income statement.

When the parent company’s interest increases during the year, noncontrolling interest is computed on the basis of the noncontrolling shares outstanding at year- end.

E

CONTROLLING INTEREST ACQUIRED THROUGH A SERIES OF STOCK PURCHASES A

When a corporation acquires a controlling interest through a series of stock purchases over a period of time, a cost/book value differential is determined for each investment.

B

If the piecemeal acquisitions are made within an accounting period, preacquisition income and dividends are determined for each investment.

C

Income, dividends, and amortization of cost-book value differentials are determined for each investment.

D

The noncontrolling interest income is based on the noncontrolling interest ownership at year end as long as the parent company’s ownership interest did not decrease.

WHEN A PARENT COMPANY SELLS AN OWNERSHIP INTEREST, THE GAIN OR LOSS ON THE SALE IS THE DIFFERENCE BETWEEN THE PROCEEDS FROM THE SALE AND THE BOOK (CARRYING) VALUE OF THE INVESTMENT INTEREST SOLD. A

When a parent company sells an ownership interest, the gain or loss on the sale is the difference between: • •

B

The sales proceeds, and The book value of the investment sold

Under GAAP, when a consolidated group of firms is involved, we only record gain/loss when the interest sold leads to deconsolidation of a former subsidiary. Otherwise it is treated as an equity transaction.

.

77

C

If the investment was acquired through piecemeal acquisitions, the shares sold must be identified with particular acquisitions.

D

At the beginning of the period, the sale of an interest at a price in excess of book value reduces the investment account and creates a gain on the sale that is both a gain for the parent company and the consolidated entity.

E

1

In the consolidation working papers, the gain is carried to the consolidated income statement column.

2

Noncontrolling interest is computed on the basis of the ending noncontrolling interest percentage when an investment interest is sold at the beginning of the period.

The sale of an interest during an accounting period may be recorded as of the actual sale date or, as an expedient, as of the beginning of the period.

•

1

Beginning of the period sale assumption: a b c d e

2

The gain on the sale is the difference between the proceeds and the book value of the interest sold at the beginning of the period.

Noncontrolling interest is computed as if the ending noncontrolling interest had been outstanding throughout the year.

Any dividends received on the interest sold prior to the sale must be included in the calculation of the gain or loss on sale.

Parent company and consolidated net income are not affected by the beginning of the period assumption.

Any difference in the gain or loss on sale is exactly offset by differences in computing the income from subsidiary, amortization of cost-book value differentials, and noncontrolling interest amounts.

Actual sale date: a

b

.

Use of the beginning of the period assumption is more efficient and practical because current retained earnings information is usually not available during the period.

The parent company makes an entry to bring the investment account to its book value on the date of sale (i.e., the parent records income from subsidiary, including amortization of cost book value differentials, from the beginning of the period to the sale date).

The proceeds from the sale of the investment are recorded, the investment account is credited for the book value of the interest sold, and a gain or loss is recognized for the difference.

78

c

d

e

f

At the end of the period, the parent company records investment income on the investment interest retained from the date of sale to the end of the period.

Investment income for the year is the total of the investment income on the interest held at the beginning of the period to the date of sale plus investment income on the percentage interest retained from the sale date to the end of the period.

Noncontrolling interest income is calculated as the noncontrolling interest’s beginning of the period percentage times the subsidiary’s income to the date of sale plus the noncontrolling interest’s ending percentage times the subsidiary’s income from the date of sale to the end of the period.

Comparison of the actual sale date and the beginning of the year sale date assumption: (1)

The year-end investment account balance and ending noncontrolling interest are the same under the two assumptions.

(2)

Cash flow from the proceeds of the sale and dividends received are the same under the two assumptions.

(3)

The difference in the gain on the sale of an interest under the two assumptions is offset by differences in (a) noncontrolling interest income, (b) the parent company’s share of subsidiary income, and (c) amortization of cost book value differentials.

SALE OR REPURCHASE OF SUBSIDIARY CAPITAL STOCK A

Subsidiary operations may be expanded through the issuance of additional shares of stock, or operations may be contracted through repurchase of the shares.

•

The parent company, through its controlling interest, makes the decisions for the subsidiary.

B

The noncontrolling interest shareholders may exercise their preemptive right to subscribe to additional stock issuances in proportion to their holdings.

C

The parent company’s investment in subsidiary may be impacted by subsidiary sales and purchases of its own shares.

•

.

This depends on the purchase or sales price of the shares. GAAP requires that capital transactions of an investee that affect the investor’s share of stockholders’ equity of the investee should be accounted for as if the investee were a consolidated subsidiary.

79

D

The parent company’s percentage ownership in the subsidiary is determined by dividing the number of shares held by the parent by the total number of subsidiary shares outstanding after the sale or purchase.

E

Sales of stock by a subsidiary to its parent company result in cost/book value differentials equal to the parent company’s share of the difference in the subsidiary’s stockholders’ equity immediately before and immediately after the sale of stock.

1

The book value of the investment interest acquired from the subsidiary is computed as: a

2

If the parent company acquires the additional shares at book value, the parent’s investment account increases by the amount of the purchase, but there is no costbook value differential on the new investment.

3

If the parent company acquires the additional shares at a price above book value, the parent’s investment account increases by the amount of the purchase and a cost-book value differential is computed on the new investment. a b

4

The excess cost over book value acquired is assigned to identifiable assets or goodwill and amortized over the life of the assets.

The amortization of the cost-book value differentials remaining from the original investment does not change.

If the parent company acquires the additional shares at a price less than book value, the parent’s investment account increases by the amount of the purchase price. a

F

The underlying book value of the parent company’s interest after the purchase of the additional shares less the underlying book value of the parent company’s interest before the purchase.

As an expedient, the excess book value over cost is charged to any goodwill from the parent’s earlier investments in the subsidiary.

Sales of stock by a subsidiary to outside entities are considered capital transactions.

1

The effect on the parent company’s investment in subsidiary account depends on the selling price of the subsidiary’s shares.

2

The increase or decrease in the parent company’s underlying book value in the subsidiary is computed as the parent company’s equity in the subsidiary after the stock issuance less the parent company’s equity in the subsidiary before the stock issuance. a

.

If the subsidiary shares are sold at book value, the parent company’s equity in the subsidiary is not affected.

80

b c 3

If the subsidiary shares are sold above book value, the parent company’s equity in the subsidiary increases.

If the subsidiary shares are sold below book value, the parent company’s equity in the subsidiary decreases.

There are two methods of accounting for the decreased ownership interest on the parent company books: a

The parent’s additional paid-in capital account and investment account are adjusted for the change in underlying equity.

(1) (2)

Unamortized cost-book value differentials are not adjusted for the decreased ownership interest.

This method is supported by GAAP which excludes adjustments from transactions in a company’s own stock from net income.

G

If the parent company and noncontrolling interests (outside investors) purchase the shares relative to their existing stock ownership, there will be no adjustment to additional paid-in capital, regardless of the price paid for the stock. Similarly, the parent company will have no excess cost over book value acquired.

H

Treasury stock transactions by a subsidiary: 1

Insignificant treasury stock transactions do not require adjustments because they tend to be offsetting.

2

Acquisition of treasury shares by a subsidiary decreases subsidiary stockholders’ equity and subsidiary shares outstanding. a

If the subsidiary buys the shares from the noncontrolling shareholders at book value, the parent company’s percentage ownership increases, but its share of the subsidiary equity is unchanged. No adjustment is required.

b

If the subsidiary buys the shares from noncontrolling shareholders at a price above book value, the parent company’s percentage ownership increases, but its share of the subsidiary’s book value decreases.

(1) (2)

.

The parent company records the decrease by a debit to additional paid-in capital and a credit to the investment account.

The amount of the decrease is the parent’s share of the subsidiary’s book value before the treasury stock transaction less the parent’s share of the subsidiary’s book value after the treasury stock transaction.

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c

If the subsidiary buys the shares from noncontrolling shareholders at a price below book value, the parent company’s percentage ownership increases and its share of the subsidiary’s book value increases.

(1)

The investment account is increased and additional paid-in capital is increased.

(2)

The increase is the parent’s share of subsidiary’s book value immediately after the treasury stock transaction less the book value immediately before the treasury stock transaction.

STOCK DIVIDENDS AND STOCK SPLITS A

Subsidiary stock splits increase the number of outstanding shares, but do not affect subsidiary net assets or the parent company and noncontrolling interest ownership percentages.

B

Stock dividends lead to some changes in the subsidiary’s equity accounts.

1

An amount of retained earnings equal to the par or stated value or the market price of the additional shares issued is transferred to paid-in capital. Thus, the subsidiary equity accounts in the consolidation working papers are affected.

2

Stock dividends do not affect parent company accounting.

Description of Assignment Material

Minutes

Questions (11) Exercises (13) E8-1 [Pie/Set] Allocate income and dividends to controlling, noncontrolling, and preacquisition interests E8-2 [Pin/Sip] Piecemeal acquisition of controlling interest with preacquisition income and dividends E8-3 [Pet/Sap] Journal entries (sale of an interest - beginning of year assumption) E8-4 [Pal/Sag] Sale of equity interest - beginning of year or actual sale date assumption) E8-5 [Pig/Set] Computations and workpaper entries (midyear acquisition) E8-6 [Pal/Sow] Additional stock issued by subsidiary directly to parent) E8-7 [Pod/Sod] Additional stock issued by subsidiary under different assumptions E8-8 [Pam/Sat] Subsidiary issues additional stock .

82

10 15 15 20 25 15 20 20

E8-9 E8-10 E8-11 E8-12 E8-13

under different assumptions [Pin/Sum] Midyear piecemeal acquisitions with goodwill [Pit/Sad] Computations for sale of an interest [Pan/Soy] Changes in subsidiary’s outstanding shares [Put/Son] Journal entries when subsidiary issues additional shares directly to parent [Pat/Sir] Computations and entries (subsidiary issues additional shares to outside entities)

Problems (12) P8-1 [Par/Sin] Midyear acquisition and purchase of additional shares P8-2 [Pin/Sit] Computations and entries (subsidiary issues additional shares to public) P8-3 [Pat/Saw] Journal entries for sale of an interest P8-4 [Pam/Son] Reduction of interest owned under three options P8-5 [Pal/Sal] Subsidiary issues additional shares P8-6 [Pot/Sod] Midyear purchase of additional interest, preacquisition income P8-7 [Pod/Saw] Consolidated income statement (midyear purchase of additional interest) P8-8 [Pop/Sat] Workpaper (acquisition of 80% interest, downstream inventory sales) P8-9 [Pal/Sid] Workpaper (noncontrolling interest, preacquisition income, downstream sale of equipment, upstream sale of land, subsidiary holds parent’s bonds) P8-10 [Pam/Sam] Workpaper (midyear purchase of 10% interest, downstream sales) P8-11 [Pan/Sly] Workpaper (midyear acquisition, preacquisition income and dividends, upstream sale of inventory, downstream sale of inventory item used by subsidiary as plant asset) P8-12 [Pop/Sat] Consolidated statement of cash flows - indirect method (sale of an interest) Internet assignment Review the Google, Incorporated 2012 annual report from their website and prepare a brief summary of Google’s acquisition activities during 2011 and 2012. a. How many were interim acquisitions? b. How many combinations were recorded using the acquisition method of accounting? c. Were acquisitions completed by exchanging shares or through cash payments?

.

83

30 25 20 20 15

20 15 15 35 25 30 30 40 40

50

50

Chapter 9 INDIRECT AND MUTUAL HOLDINGS Chapter Outline AFFILIATION STRUCTURES FOR INDIRECT HOLDINGS A

Indirect holdings are investments that enable the investor to control or significantly influence the decisions of an investee not directly owned through its investment in an investee that is directly owned.

1

Father-son-grandson affiliation structure a

P 70% A 80% B P directly owns 70% of A P indirectly owns 56% of B (70% x 80%) Noncontrolling interest in A is 30% Noncontrolling interest in B is 44% [(30% x 80%) + 20%] Consolidate P, A, and B

b

P 70% A 60% B P directly owns 70% of A P indirectly owns 42% of B (70% x 60%) Noncontrolling interest in A is 30% Noncontrolling interest in B is 58% [(30% x 60%) + 40%] Consolidate P, A, and B. Over 50% of B’s stock is held within the consolidated entity.

.

85

c

P 70% A 40% B P directly owns 70% of A P indirectly owns 28% of B (70% x 40%) Noncontrolling interest in A is 30% Noncontrolling interest in B is 72% [(30% x 40%) + 60%] Consolidate P and A. Include B as equity investee.

2

Connecting affiliates: a

P 60%

40%

A

B 30%

P directly owns 60% of A. P directly owns 40% of B. P indirectly owns 18% of B (60% x 30%).

P’s total ownership in B is 58% (40% + 18%) Noncontrolling interest in A is 40%.

Noncontrolling interest in B is 42% [30% + (40% x 30%)] Consolidate P, A, and B. b

P 70%

20%

A

B 25%

P directly owns 70% of A. P directly owns 20% of B. P indirectly owns 17.5% of B (70% x 25%).

P’s total ownership in B is 37.5% (20% + 17.5%) Noncontrolling interest in A is 30%.

Noncontrolling interest in B is 62.5% [55% + (30% x 25%)] Consolidate P and A. Include B as an equity investee.

.

86

B

The computation of parent company and consolidated net income for indirect holding situations can be easily determined by reference to ownership interests in each affiliate or by a schedule approach. Assume that P, A, and B companies from the illustrative affiliation structures have separate earnings as follows: P A B 1

Parent company net income and consolidated net income can be determined on the basis of the parent’s percentage ownership in the separate realized earnings of the subsidiaries. a

Refer to the first affiliation structure diagram in which P owns 70% of A and A owns 80% of B. (1)

(2)

b

(2)

P’s net income consists of P’s $50,000 separate income + 60% of A’s separate income + 58% of B’s separate income. Thus, P’s net income (and consolidated net income) is $91,400 ($50,000 + $24,000 + $17,400).

Noncontrolling interest income consists of 40% of A’s $40,000 separate income + 42% of B’s $30,000 separate income for a total noncontrolling interest income of $28,600.

Parent company net income and noncontrolling interest income can also be computed using a schedule approach. Schedules are especially useful when the affiliates have cost/book value differentials and unrealized profits. a

.

P’s net income consists of P’s $50,000 separate income + 70% of A’s $40,000 separate income + 56% of B’s $30,000 separate income. P’s net income (and consolidated net income) is $94,800 ($50,000 + $28,000 + $16,800).

Noncontrolling interest income consists of 30% of A’s $40,000 separate income + 44% of B’s $30,000 separate income for a total noncontrolling interest income of $25,200.

Now refer to the first connecting affiliation structure diagram in which P owns 60% of A and 40% of B. A owns 30% of B. (1)

2

$50,000 $40,000 $30,000

The computation of net income is accomplished from the bottom of the affiliation structure to the top. In other words, realized income of the lowest affiliate is computed and allocated first, and so on.

87

b

Refer to the second father-son-grandson affiliation diagram in which P owns 70% of A and A owns 60% of B. A’s separate income of $40,000 includes a $3,000 unrealized profit on land sold to B. A schedule approach to the computation of consolidated net income and noncontrolling interest income is as follows:

Separate earnings Less: Unrealized profit on sale of land Separate realized earnings Allocate B’s income to A Allocate A’s income to P Consolidated net income Noncontrolling interest

P $50,000

50,000 38,500

A $40,000

B $30,000

(3,000) 37,000 18,000 (38,500)

30,000 (18,000)

$88,500 $16,500

_______ $12,000

AFFILIATION STRUCTURES FOR MUTUAL HOLDINGS A

Mutual holdings are a special type of indirect holdings in which an affiliated company indirectly owns itself.

B

Parent company is mutually owned: P 70%

10% S

P owns 70% of S S owns 10% of P Outside entities hold 30% of S’s stock and 90% of P’s stock.

.

1

Parent company stock that is mutually held may be accounted for by either the treasury stock approach or the conventional approach.

2

Under the treasury stock approach, the parent company stock held by the subsidiary is considered treasury stock of the consolidated entity. a

The investment in parent company stock is maintained on a cost basis.

b

The cost of the investment is deducted from stockholders’ equity in the consolidated balance sheet.

88

3

Under the conventional approach parent company stock held by a subsidiary is considered constructively retired. a

Capital stock and retained earnings applicable to the mutually held stock do not appear in the consolidated statements.

b

Parent company capital stock and retained earnings will not equal consolidated capital stock and retained earnings unless the parent company makes an entry on its separate books to record the constructive retirement of stock as an actual retirement.

c

The incomes of the parent and subsidiary are mutually related and should be determined simultaneously. The use of simultaneous equations is one approach. It involves two steps: (1) (2)

(3)

Income of the parent and subsidiary are computed on a consolidated basis that includes the mutual income.

The parent’s income on a consolidated basis is then multiplied by the ownership percentage held outside the affiliated group to determine the parent’s net income (and consolidated net income). Likewise, the subsidiary’s income on a consolidated basis is multiplied by the noncontrolling interest percentage to determine the noncontrolling interest income on an equity basis.

Refer to the diagram for mutually held parent company stock in which the parent company owns 70% of the stock of the subsidiary and the subsidiary owns 10% of the stock of the parent. Separate earnings for P and A are $76,600 and $50,000, respectively, and there are no cost/book value differentials or unrealized profits. Computations are as follows:

P = P’s income on a consolidated basis A = A’s income on a consolidated basis P = P’s separate earnings of $76,600 + 70% of A A = A’s separate earnings of $50,000 + 10% of P P = $76,600 + .7($50,000 + .lP) P = $76,600 + $35,000 + .07P .93P = $111,600 P = $120,000 (income on a consolidated basis) P’s net income = $120,000 x 90% = $108,000 A = $50,000 + ($120,000 x 10%) A = $62,000 (income on a consolidated basis) Noncontrolling interest income = $62,000 x 30% = $18,600 C

Subsidiary stock mutually owned: P .

89

70% A 60%

20%

B When the mutual holdings involve subsidiaries holding the stock of each other, the treasury stock approach is not applicable and the separate incomes of the affiliates should be allocated using the conventional approach.

Description of assignment material

Minutes

Questions (15) Exercises (13) E9-1 [Pen/Sal] Calculate consolidated net income E9-2 [Pub] Allocate investment income and loss E9-3 [Place] Prepare an income allocation schedule (includes unrealized profit on land) E9-4 [Pin] 3 MC problems (determine equation to compute income from subsidiary, noncontrolling interest share, and controlling interest share of consolidated net income) E9-5 [Pal, etc] Prepare income allocation schedule (5 affiliates and unrealized inventory profit) E9-6 [Pet] Calculate controlling interest share and noncontrolling interest share of consolidated income E9-7 [Pan] 5 MC problem-type questions (no intercompany profits) E9-8 [Pat] 4 MC problem-type questions correcting net income (for unrealized profits) E9-9 [Pan] Calculate consolidated net income (conventional method (no complications)) E9-10 [Pad] Prepare computations (subsidiary stock mutually held, no unrealized profits) E9-11 [Pin] AICPA 4 MC problem-type questions (mutually held parent company stock) E9-12 [Pet] 2 MC problem-type questions (mutually held parent company stock) E9-13 [Pug] Computations (treasury stock and conventional) Problems (7) P9-1 [Pad] Schedule for allocating income (unrealized profits and goodwill) P9-2 [Pot] Prepare journal entries, computations, and a financial position summary (unrealized profits) P9-3 [Pen] Financial statement workpaper (goodwill and unrealized profits) P9-4 [Par] Computations for mutually held subsidiaries P9-5 [Pin] Financial statement working papers (treasury stock approach) P9-6 [Par] Consolidation workpaper second year (conventional approach) .

90

20 20 20 15

25 20 25 20 15 20 25 20 30

35 50 80 40 50 80

P9-7

[Pan] Computations and entries (parent stock mutually held)

60

Internet assignment Visit PepsiCo’s website and list well-known companies now owned by PepsiCo in grandfatherfather-son-type indirect holdings.

.

91

Chapter 10 SUBSIDIARY PREFERRED STOCK, CONSOLIDATED EARNINGS PER SHARE, AND CONSOLIDATED INCOME TAXATION Chapter Outline SUBSIDIARIES WITH PREFERRED STOCK OUTSTANDING (Illustration 10-1) The stockholders’ equity of a subsidiary with preferred stock outstanding is allocated to the preferred stockholders, based on the preferred contract, and the remainder is common stockholders’ equity.

A

B

1

The preferred stockholders’ equity is based on the call or redemption price.

2

If the preferred stock has no redemption provision, the preferred equity is based on par value plus any liquidation premium.

3

If the preferred stock is cumulative, the preferred stockholders’ equity includes any dividends in arrears.

Net income of an investee or subsidiary with preferred stock outstanding is allocated to the preferred stockholders, based on the preferred contract, and the remainder is allocated to common stockholders.

C

1

If the preferred stock is nonparticipating, income is assigned to preferred stockholders based on the preference rate or amount.

2

If the preferred stock is cumulative and nonparticipating, the current year dividend requirement is assigned to preferred stock, regardless of whether the directors declare any dividend.

3

If the preferred stock is noncumulative and nonparticipating, only dividends declared and in the amount declared are assigned to preferred stockholders.

A parent company buys common stock of a subsidiary that has cumulative, nonparticipating preferred stock in its capital structure:

.

1

Preferred equity is deducted from total stockholders’ equity to determine common stockholders’ equity.

2

The price paid for the investment in common equity is compared to the fair value the common equity interest acquired to determine goodwill.

3

The parent’s share of subsidiary reported income is its ownership interest times the subsidiary’s income allocated to the common stock.

92

D

4

Noncontrolling interest that appears in the consolidated balance sheet consists of the preferred stockholders’ equity plus the noncontrolling interest in the subsidiary’s common stockholders’ equity.

5

Noncontrolling interest income in the consolidated income statement consists of the income to preferred stockholders plus the noncontrolling interest’s share of the subsidiary’s income to common stock.

6

In the consolidation working papers, an entry is necessary to reclassify the preferred stock as noncontrolling interest.

A parent company acquires the preferred stock of a subsidiary: 1

From the viewpoint of the consolidated entity, the preferred stock is retired and no longer a noncontrolling interest. a

2

In the consolidation working papers, the equity related to the preferred stock held by the parent and the investment in preferred stock are eliminated. a

3

.

The retirement of the preferred stock is really a constructive retirement because the stock will be reported as outstanding in the separate financial statements of the subsidiary.

Any difference is charged or credited to additional paid-in capital. If additional paid-in capital is insufficient to absorb the excess of purchase price over book value, the parent’s retained earnings is charged.

In the parent company’s separate books, the investment in subsidiary preferred stock is adjusted to its book value at acquisition and the parent’s additional paid-in capital is charged or credited for the difference between the cost of the investment and its underlying book value. a

The investment in preferred stock is accounted for on the basis of its book value, and not on the basis of the cost or equity methods.

b

Without this adjustment on the parent company books, parent company net income and stockholders’ equity would not equal consolidated net income and stockholders’ equity.

c

If the constructive retirement is not recorded on the parent’s books, the investment is maintained on a cost basis. In this case, a working paper adjustment to additional paid-in capital is required for each year the statements are consolidated. The consolidated financial statements are not affected by the parent company’s accounting for its investment.

93

PARENT COMPANY AND CONSOLIDATED EARNINGS PER SHARE (Illustration 10-2) A

Parent company and consolidated earnings per share are identical. Basic earnings per share are always identical when the parent company uses the complete equity method.

B

1

When a subsidiary has no potentially dilutive securities, the procedures for computing consolidated EPS are the same as for separate entities.

2

When a subsidiary has potentially dilutive securities, the potential dilution must be considered in computing the parent’s diluted EPS. a

If the subsidiary’s potentially dilutive securities are convertible into subsidiary common stock, the potential dilution is reflected in subsidiary EPS computations, which are then used in determining parent company EPS.

b

If the subsidiary’s potentially dilutive securities are convertible into parent company common stock, they are treated as parent company dilutive securities and are included directly in computing the parent company's EPS. In this case subsidiary EPS computations are not used in parent company EPS computations.

Dilutive securities of the subsidiary convertible into subsidiary shares: 1

The diluted earnings of the parent company are adjusted to replace the parent’s equity in subsidiary realized income with the parent’s share of the diluted earnings of the subsidiary. a

The “parent’s equity in subsidiary realized income” is the parent’s percentage interest in the reported income of the subsidiary adjusted for the effects of intercompany profits from upstream sales and constructive gains or losses of the subsidiary.

(1)

b

.

The amortization of cost/book value differentials, unrealized profits for downstream sales, and constructive gains and losses assigned to the parent company that are excluded from the computation of income from subsidiary are not considered in the computation of the parent’s equity in subsidiary realized income.

This is because these items do not affect the subsidiary’s equity.

This computation of the subsidiary’s EPS is made only for the purpose of calculating the parent’s EPS and it may not be the same as one prepared by the subsidiary for its own external reporting.

94

(1)

c

C

Subsidiary EPS computations are based on subsidiary realized income. For this purpose, unrealized profits of the subsidiary are eliminated and constructive gains and losses of the subsidiary are included.

The “parent’s equity in the subsidiary’s diluted earnings” is computed by multiplying the subsidiary shares owned by the parent by the subsidiary’s diluted EPS.

Diluted securities of a subsidiary convertible into parent company shares: 1

The parent company common shares are adjusted when potentially dilutive securities of the subsidiary are convertible into parent company stock.

2

Income attributable to the potentially dilutive securities of the subsidiary under the “if converted” method is added to the parent’s earnings in calculating the parent’s diluted earnings.

ACCOUNTING FOR INCOME TAXES OF CONSOLIDATED ENTITIES A

A consolidated entity may elect to file a consolidated tax return if it is classified as an affiliated group under §§ 1501 through 1504 of the IRC.

B

1

An affiliated group exists when a common parent corporation owns at least 80% of the voting power of all classes of stock and 80% or more of the total value of all outstanding stock of each of the includable corporations. The common parent must meet the 80% requirements directly for at least one includable corporation.

2

All consolidated entities that are not an affiliated group must file separate returns for each affiliated company.

Consolidated tax returns of consolidated entities: 1

2

.

Intercompany dividends are excluded from taxable income. This 100% exclusion of dividends from members of the affiliated group applies even if the companies file separate tax returns.

Losses of one affiliate can be offset against income of other affiliates. Loss carryforwards existing at the time an affiliate is acquired can be offset only against taxable income of that affiliate.

3

Intercompany profits and losses are deferred until realized.

4

Each subsidiary included in the consolidated tax return must use the parent’s tax year.

95

C

Separate tax returns of consolidated entities: 1

Dividends from members of the same affiliated group are 100% excludable from income even when separate returns are filed.

2

80% of the dividends received from domestic corporations that are 20% to 80% owned are excludable and 70% of the dividends received from domestic corporations that are less than 20% owned are excludable from taxable income.

3

Income taxes are payable on unrealized intercompany profits, but taxes otherwise payable are reduced for unrealized intercompany losses.

INCOME TAX ALLOCATION (Illustration 10-3) A

Under GAAP, the objectives of accounting for income taxes are:

B

1

To recognize the amount of taxes payable or refundable for the current year, and

2

To recognize deferred tax liabilities and assets for the future tax consequences of events that have been recognized in the financial statements or tax returns.

Events that have future tax consequences are temporary differences.

1

Some accounting/income tax differences are temporary differences when separate tax returns are filed, but not when consolidated tax returns are filed. a

b

C

Unrealized and constructive gains and losses from intercompany transactions are temporary differences when separate tax returns are filed. This is because the gains and losses are not included in accounting income until realized; but the individual companies are taxed on the income included in their separate statements.

Unrealized and constructive gains and losses from intercompany transactions are not temporary differences when consolidated returns are filed. This is because the gains and losses are deferred until realized in both the consolidation working papers and the consolidated tax return.

Temporary differences 1

.

Temporary differences from undistributed earnings of a subsidiary (or equity investee):

96

2

D

a

Investors pay income taxes on dividends currently received (distributed income) from equity investees and subsidiaries that are not members of the affiliated group.

b

The investor provides for deferred income taxes on its share of the investee’s undistributed income (i.e., the investee’s net income less dividends).

Temporary differences from unrealized gains and losses from intercompany transactions in separate tax returns: a

The selling entity includes the gain or loss from the intercompany sale in its separate tax return and pays the tax or receives the tax benefit currently.

b

The tax effect of the temporary difference from the unrealized gain or loss is included in measuring the income tax expense of the selling affiliate. Under this approach: (1)

Intercompany profits are eliminated on a gross basis.

(2)

Consolidated income tax expense is equal to the combined income tax expense of the consolidated entities.

When consolidated tax returns are filed, the tax liability is allocated among the affiliated companies. The four methods currently used to allocate income taxes among affiliates are: 1

Separate return method - each subsidiary computes its income taxes as if it were filing a separate return

2

Agreement method - the tax expense is allocated by agreement between the parent and subsidiaries

3

With-or-without method - the income tax provision is computed for the group with and without the pretax income of the subsidiary and the subsidiary’s income tax expense is the difference

4

Percentage allocation method - the consolidated income tax expense is allocated to a subsidiary on the basis of its pretax income as a percentage of consolidated pretax income. This method is used in the textbook.

BUSINESS COMBINATIONS (Illustration 10-4) A

Business combinations may be taxable or tax free under the IRC. Any of the following combinations is possible. .

97

1

In a taxable purchase business combination, the assets and liabilities of the acquired corporation are revalued to reflect the acquisition values for both accounting and tax purposes.

2

In a tax-free purchase business combination, the assets and liabilities are carried forward at their book values for tax purposes, but are revalued for accounting purposes.

B

When assets and liabilities are revalued for tax purposes, the seller recognizes gain or loss equal to the fair value of the consideration received minus the tax bases of the assets or stock sold.

C

Accounting for a taxable purchase business combination:

D

1

Assets and liabilities acquired are recorded at their gross amount.

2

Since the tax basis and the book basis are the same, no deferred tax assets or liabilities are recorded.

3

Goodwill is tax deductible for purchases after August 1993 based on the Revenue Reconciliation Act of 1993 (section 197). The amortization period for tax purposes is 15 years. Goodwill is no longer amortized for financial reporting purposes.

Accounting for a tax-free purchase business combination: 1

Assets and liabilities are recorded at their gross amount.

2

The difference between the tax basis (book values) and the assigned values of assets and liabilities acquired times the tax rate is recorded as a deferred tax liability or deferred tax asset. Goodwill is excluded—no deferred tax liability is set up for goodwill.

3

Goodwill is not tax deductible.

FINANCIAL STATEMENT DISCLOSURES FOR INCOME TAXES A

Deferred tax assets or liabilities are disclosed on the balance sheet in two categories, a current and a non-current amount based on the related asset or liability.

1

.

If the deferred item is not related to a specific item, its classification depends on the reversal date of the temporary difference.

98

B

Significant components of income tax expense or benefit should be disclosed on the income statement, or in the notes to the financial statements.

1

Amounts allocated to continuing operations, discontinued operations, extraordinary items, and prior-period adjustments should be separately disclosed.

Description of Assignment Material Minutes Questions

(17)

Exercises E10-1

(19) AICPA [Pin/Sob] 4 MC problem type questions 20 (preferred stock and income tax) [Pod/Sir] [Preferred Stock] Subsidiary preferred stock with 20 dividends in arrears [Par/Sol] [Preferred Stock] Goodwill and investment income 25 subsidiary preferred stock [Pen/San] [Preferred Stock] Investment cost and net income 20 subsidiary preferred stock [Pam/Sun] [Preferred Stock] Journal entries - parent owns 25 both common and preferred stock of subsidiary [Pay/Set] [Preferred stock] Fair value/book value differentials for preferred 20 and common stock [EPS] 3 MC general questions 10 [Pal/Sod] [EPS] 4 MC problem-type questions (consolidated EPS with 20 goodwill, noncontrolling interest, and warrants) [Put/San] [EPS] Consolidated basic and diluted EPS 20 (noncontrolling interest, warrants convertible into subsidiary shares) [Pin/Sal] [EPS] Consolidated EPS with unrealized profit from 25 upstream sale [Pow/Soy] [EPS] Subsidiary EPS and consolidated EPS with 25 goodwill and warrants [Tax] 4 MC general questions 15 [Tax] 5 MC problem-type questions (asset allocation in business 25 combination, tax effect from equity investees) [Pit/Sol] [Tax] Compare separate and consolidated tax filings 15 [Pan/Sum] [Tax] Consolidated income statement 30 (downstream sale of equipment) [Ped/Sun] [Tax] Journal entries for unrealized profit with 20 separate and consolidated tax returns [Pin/Son] [Tax] Journal entries for unrealized profit from 20 upstream sale and separate tax returns [Pax/Sonny] [Tax] Valuation allowance 20 [Pony/Slew] [Tax] Valuation allowance 20

E10-2 E10-3 E10- 4 E10-5 E10-6 E10-7 E10-8 E10-9 E10-10 E10-11 E10-12 E10-13 E10-14 E10-15 E10-16 E10-17 E10-18 E10-19 .

99

Problems (16) P10-1 Par/Sun] [Preferred stock] Investment in common stock (subsidiary preferred stock) P10-2 [Pun/Set] [Preferred stock] Consolidation entries investments in preferred and common stock - midyear purchases P10-3 [Pat/Sal] [Preferred stock] Consolidation workpaper (subsidiary preferred stock, equity method, midyear purchase) P10-4 [Pari/Sak] [Preferred stock] Consolidation workpaper (subsidiary preferred stock, downstream inventory sales, upstream sale of land, subsidiary bonds) P10-5 [Pal/Sir] [EPS] Computing EPS with convertible debenture P10-6 [Pen/She] [EPS] Compute basic and diluted EPS (options; preferred stock) P10-7 [Pro/Sit] [EPS] Convertible preferred stock and amortization of excess) P10-8 [Pin/Sum] [EPS] Compute consolidated EPS (subsidiary diluted) P10-9 [Pit/Sim] [EPS] Computations (subsidiary with preferred stock and warrants) P10-10 [Par/Sam] [Tax] Comparative income statements (consolidated and separate tax returns) P10-11 [Pan/Sir] [Tax] Computations and income statement (upstream sales) P10-12 [Pub/Sew] Consolidated income statement (downstream sales) P10-13 [Pen/Soo] [Tax] Reconstruct workpaper (separate and consolidated income statements) P10-14 [Par/Sad] [Tax] Allocate fair value/book value differentials in a taxable purchase business combination P10-15 [Pop/Son] [Tax] Consolidated income statement (separate income tax returns and intercompany equipment) P10-16 [Pix/Sal] Computations (separate tax returns with goodwill, downstream inventory sales, and upstream land sale)

20 40 60 70

35 30 40 20 40 25 30 40 20 20 40 40

Internet assignment Using the Dow Chemical Company 2009 annual report from the company’s website, prepare a summary of major topics discussed in the chapter.

ELECTRONIC SUPPLEMENT ACCOUNTING FOR BRANCH OPERATIONS BRANCHES ARE SEPARATE ACCOUNTING ENTITIES, BUT NOT SEPARATE LEGAL ENTITIES

.

100

A

Branch financial statements are used only for internal reporting purposes.

B

Financial statements of the business entity are prepared by combining branch statements with the home office statements.

C

Sales agencies are not separate accounting or business entities.

HOME OFFICE AND BRANCH ACCOUNTS A

Home office books - The home office accounts for its investment in the branch through an asset account entitled “investment in branch,” or simply “branch.”

B

Branch books - The branch has a reciprocal equity account entitled “home office” which replaces the usual equity accounts. A decrease in the branch account on the home office books should be accompanied by a decrease in the home office account on the branch books.

HOME OFFICE AND BRANCH ACCOUNTS ARE COMBINED IN PREPARING FINANCIAL STATEMENTS AS FOLLOWS: A

Establish reciprocity between home office and branch accounts

B

Eliminate unrealized profits from transfers between home office and branch

C

Eliminate reciprocal accounts

D

Combine nonreciprocal accounts

MERCHANDISE TRANSFERS FROM THE HOME OFFICE TO THE BRANCH A

Home office books - Merchandise transferred to the branch represents an additional investment in the branch and the branch account is debited. The related credit is to the “shipments to branch” account. Shipments to branch is a contra purchases account on the home office books.

B

Branch books - The branch debits “shipments from home office,” an inventory account, and credits the related home office account.

FREIGHT COSTS A

The cost of transporting merchandise to its final sale location is an inventoriable cost that is included in the branch inventory and cost of goods sold computations.

.

101

B

1

If the home office pays the freight, it debits the branch account and credits a payable or cash. The branch debits freight in and credits the home office account.

2

If the branch pays the freight, it records the payment in the usual way and increases (credits) the home office account. The home office makes no entry relating to the freight.

Excessive freight charges - Costs incurred to transport merchandise back and forth between the home office and branch or between branches because of shortages in some locations or because defective merchandise is returned is not an inventoriable cost for the branch. Excessive freight charges should be charged to “loss on excessive freight charges” on the home office books.

EXPENSE ALLOCATION A

If the home office pays for services that will benefit the branch, the home office should allocate the expense between home office and branch.

B

If the branch pays for services that will benefit both the branch and the home office, the expense should be allocated proportionately between the two.

Description of assignment material

Minutes

Questions (8) Problems (7) W-9 [Arnimal] Home office and branch journal entries (transfers at cost) W-10 [Yak] Adjusting entries on home office books to eliminate unrealized profits W-11 [Medina] Determine cost of goods sold with outside purchases W-12 [Liberty] Prepare a reconciliation of home office and branch accounts W-13 [Manning] Prepare a cost of sales schedule and comparative home office, branch, and combined income statements W-14 [Tanker] Closing entries, combined balance sheet, and income statement W-15 [Anselmo] Prepare a schedule of cost of sales and combining working papers

.

102

25 12 15 12 40 25 50

Illustration 10-1 Preferred Stock SUBSIDIARY WITH PREFERRED STOCK OUTSTANDING Assumptions 1

P owns 90% of S’s outstanding common stock.

2

S has $100,000 par of cumulative 10% preferred stock outstanding.

3

P’s separate income for 20Xl is $100,000.

4

S’s separate income for 20Xl is $40,000.

Outside Stockholders Hold All of S’s Preferred Stock

P Holds 30% of S’s Preferred Stock

$100,000

$100,000

27,000

27,000

$127,000

3,000 $130,000

$140,000

$140,000

3,000 7,000 3,000 $l27,000

3,000 7,000

P’s net income for 20XI P's separate income P's income from S Income from S -- common 90% x ($40,000 - $10,000) Income from S -- preferred 30% x $10,000 P's net income

Consolidated net income for 20XI Combined separate incomes of P and S Less: Noncontrolling interest Common 10% x ($40,000 - $10,000) Preferred 70% x $10,000 30% x $10,000 Consolidated net income Note:

.

$130,000

Since the preferred stock of S is cumulative, P's net income and consolidated net income are the same regardless of whether S declares dividends during the year.

103

Illustration 10-2 Earnings per Share BASIC COMPUTATIONS FOR CONSOLIDATED EARNINGS PER SHARE 1

Subsidiary has no potentially dilutive securities (PDS) outstanding: Parent’s income to common + parent’s adjustment for PDS ____________________ Parent’s common shares outstanding + shares represented by parent’s PDS

EPS =

2

Subsidiary has potentially dilutive securities (PDS) outstanding convertible into subsidiary common stock:

EPS =

3

Parent’s income to common + parent’s adjustment for PDS + replacement calculation for subsidiary’s PDS Parent’s common shares outstanding + shares represented by parent’s PDS

Subsidiary has potentially dilutive securities (PDS) outstanding and convertible into parent common stock:

EPS =

.

Parent’s income to common + parent’s adjustment for its PDS + adjustment for subsidiary’s PDS convertible into parent common stock__________ Parent’s common shares outstanding + shares represented by parent’s PDS and subsidiary’s PDS

104

Illustration 10-3 Accounting for Income Taxes

ACCOUNTING FOR DISTRIBUTED AND UNDISTRIBUTED INCOME Assumptions 1

P owns 60% of S, a domestic corporation.

2

S reports net income of $250,000 and pays $150,000 dividends.

3

A flat 34% tax rate is applicable.

P's share of S's distributed income: 60% x $150,000 dividends

$90,000

P's tax liability on the $90,000 dividends received: $90,000 dividends x 20% taxable x 34% tax rate

$ 6,120

P's share of S's undistributed income: ($250,000 - $150,000) x 60%

$60,000

P provides for income taxes on undistributed earnings: $60,000 x 20% taxable x 34% tax rate

$ 4,080

Income taxes currently payable Deferred income taxes Income tax expense

.

$6,120 4,080 $10,200

105

Illustration 10-4 SEPARATE TAX RETURNS AND INTERCOMPANY GAIN Assumptions 1 2 3 4 5

P owns a 60% interest in S. P sells land that cost $12,000 to S for $18,000.

A 34% tax rate is applicable.

S pays $10,000 dividends during the year.

Income statements for P and S are as follows:

Sales Gain on sale of land Income from S Cost of sales Operating expenses Income tax expense Net Income

P

S

$200,000 6,000 5,880 (120,000) (60,000) (7,608) $ 24,272

$150,000

(90,000) (30,000) (10,200) $ 19,800

P's income from S: $19,800 x 60% owned - $6,000 unrealized gain from sale of land P's share of S's undistributed income: ($19,800 income - $10,000 dividends) x 60% x 20% taxable = $1,176 P's income tax expense is computed as follows: Tax on operating income ($200,000 sales - $120,000 cost of sales - $60,000 operating expense) x 34% Tax on gain from sale of land ($6,000 x 34%) Tax on dividends received ($10,000 x 60% x 20% taxable x 34%) Taxes currently payable Less: Change in deferred income taxes: (Unrealized gain on land $6,000 less the $1,176 taxable share of S's undistributed earnings) x 34% Income tax expense

$6,800 2,040 408 9,248

(1,640) $7,608

P will increase a deferred tax asset or decrease a deferred tax liability by $1,640.

ELECTRONIC SUPPLEMENT .

106

A

Describes accounting for sales agencies and branches: 1.

Sales agencies display merchandise and take orders, but do not stock merchandise to fill customer orders.

2.

Branch operations stock merchandise, make sales to customers, pass on customer credit, collect receivables, incur expenses, and perform functions associated with the operations of a separate business enterprise.

B

Sales agencies usually only require cash receipt and disbursement records, which are maintained in the central accounting system of the controlling enterprise.

C

Branch accounting involves segmenting the accounting system of an enterprise into separate accounting systems for home office and branch operations. Home office and branch financial statements are combined in a manner similar to consolidating parent and subsidiary financial statements.

D

The home office and branch accounts should be reconciled at year-end to ensure that errors have not been made and that there are reciprocal balances between the two.

E

Financial statements for the enterprise as a whole are developed by combining the separate statements of the home office and its branches.

ASSIGNMENT MATERIAL W10-1 W10-2 W10-3 W10-4 W10-5 W10-6 W10-7 W10-8 W10-9 W10-10 W10-11 W10-12 W10-13 W10-14 W10-15

.

Minutes

Branch accounting question Sales agency question Sales agency question Branch account function question Home office/branch question Reciprocal balance question Transfer price question Allocation of home office expense question Home office and branch journal entries Adjusting entries on home office books to eliminate unrealized profits Determine cost of goods sold with outside purchases Prepare a reconciliation of home office and branch accounts Cost of sales schedule and comparative home office, branch, and combined income statements Closing entries, combined balance sheet, and income statement Prepare a schedule of cost of sales and combining working papers

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5 5 5 5 5 5 5 5 30 10 15 20 30 45 45

Chapter 11 CONSOLIDATION THEORIES, PUSH-DOWN ACCOUNTING, AND CORPORATE JOINT VENTURES Chapter Outline CONSOLIDATION UNDER PARENT COMPANY AND ENTITY THEORIES (Illustration 11-1) A

Contemporary theory evolved from practice and is essentially an entity approach to the preparation of consolidated financial statements.

B

Traditional theory reflected parts of both the parent-company theory and the entity theory.

C

Underlying assumptions of the parent company theory are summarized as follows: 1

The viewpoint is that consolidated financial statements are an extension of parent company statements and are prepared from the viewpoint of parent company stockholders.

2

Consolidated net income is a measure of income to the parent company stockholders.

3

Noncontrolling interest is a liability from the viewpoint of parent company shareholders.

4

Similarly, noncontrolling interest share is considered an expense from the viewpoint of the majority stockholders.

5

Subsidiary assets are initially consolidated at their book values plus the parent’s share of any excess of fair value over book value. a

.

Subsidiary net assets are revalued only to the extent acquired by the parent company.

6

The noncontrolling interest in subsidiary assets and liabilities is consolidated at book value.

7

All unrealized gains and losses from downstream intercompany sales are eliminated until realized.

8

Unrealized gains and losses from upstream intercompany sales are eliminated to the extent of the parent company ownership interest.

109

a

D

The amount not eliminated is considered realized for noncontrolling shareholders.

Underlying assumptions of the entity theory are summarized as follows: 1

The viewpoint is that of the consolidated entity as a whole. a

E

The consolidated statements should provide information for all interest holders.

2

Total consolidated net income is a measurement of income to all equity stockholders, and it is allocated in the financial statements to majority and noncontrolling interests.

3

Noncontrolling interest is an equity interest shown in the stockholders’ equity section of the consolidated balance sheet.

4

Subsidiary assets and liabilities are consolidated at their fair values.

5

A total subsidiary value is imputed from the price paid by the parent company for its majority interest.

6

All unrealized gains and losses from downstream intercompany sales are eliminated until realized.

7

Unrealized gains and losses on upstream intercompany sales are eliminated by allocating them proportionately to majority and noncontrolling interests.

See Exhibit 11-1 in the text for a comparison of consolidation theories.

F

Consolidated Stockholders’ Equity: Current GAAP (contemporary theory differs slightly from entity theory in reporting consolidated stockholders’ equity). Under entity theory, both controlling and noncontrolling interests are components of consolidated equity. Further, entity theory would show the components of each interest, i.e., breaking the controlling and noncontrolling interests into their respective shares of contributed capital and retained earnings. Under GAAP, the noncontrolling interest is shown as a single, combined amount under consolidated stockholders’ equity.

PARENT COMPANY ACCOUNTING UNDER THE EQUITY METHOD A

Parent company and entity theories do not affect parent company accounting under the equity method.

.

110

1

This is because the extra values under entity theory were reflected in the noncontrolling interest, not the majority interest.

B

The separate company statements will be the same for the parent and subsidiary under both theories.

C

Consolidated statements are affected, however, and different amounts are likely for consolidated assets, liabilities, and noncontrolling interests.

PUSH-DOWN ACCOUNTING (Illustration 11-2) Under push-down accounting, the fair values of an acquired subsidiary’s assets and liabilities are recorded in the separate financial statements of the purchased subsidiary (values “pushed down” to subsidiary’s statements).

A

B

1

The SEC requires push-down accounting in its filings when a subsidiary is substantially wholly owned (usually 90%) with no substantial publicly held debt or preferred stock outstanding.

2

Push-down accounting affects only the subsidiary’s separate financial statements. a

Without push-down accounting, the allocation of the purchase price to identifiable assets and goodwill is done in the consolidation workpaper.

b

Under push-down accounting, the allocation is done on the books of the subsidiary.

c

Consolidated financial statements are exactly the same under either procedure.

Supporters of push-down accounting are not in agreement regarding:

C

1

The percentage ownership necessary for push-down accounting, and

2

Whether the allocation should reflect 100% of the fair values of the subsidiary’s assets and liabilities if less than a 100% change in ownership has occurred.

Push-down accounting can be applied under either parent company theory or entity theory.

1

Push-down accounting under parent company theory: a

.

Cost/book value differentials are allocated in the usual manner.

111

b

The values from the allocation schedule are pushed down to the subsidiary records. The subsidiary makes a journal entry to revalue assets and liabilities, eliminate retained earnings, and enter push-down capital.

(1)

2

For example, if a 90% interest is purchased, 90% of the difference between cost and fair value is pushed down to the subsidiary’s books.

Push-down accounting under entity theory: a

A total value of the subsidiary is imputed from the price paid by the parent for the interest acquired.

(1)

(2)

b

The excess implied value over the book value of the subsidiary’s net assets is assigned to the individual assets and liabilities on the basis of 100% of the fair value/book value differentials and the remainder to goodwill.

For example, if a 90% interest is purchased, 100% of the implied value (difference between cost and fair value) is pushed down to the subsidiary’s books.

The subsidiary makes a journal entry to revalue assets and liabilities, eliminate retained earnings, and record push-down capital.

JOINT VENTURES A

Joint ventures are business entities that are owned, operated, and jointly controlled by a small group of investors (venturers) for the conduct of specific business undertakings that provide mutual benefit for each of the venturers.

1

B

No single venturer controls the operations.

Joint ventures may be organized as corporations, partnerships, or undivided interests. The AICPA’s SOP 78-9 defines the following forms of joint ventures: 1

A corporate joint venture is a corporation owned and operated by a small group of venturers to accomplish a mutually beneficial venture or project. a

b

.

Venturers that can participate in the management of the corporate joint venture and hold no more than 50% interest in the venture account for their interest by the equity method.

A corporation that is a subsidiary of another corporation is not a corporate joint venture.

112

(1)

2

The subsidiary is consolidated in the financial statements of the majority owner. The other investors account for their investments under the equity method.

Unincorporated joint ventures include the following: a

A general partnership is an association in which each partner has unlimited liability. A limited liability partnership is an association in which one or more general partners have unlimited liability and one or more partners have limited liability.

(1)

(2) (3)

b

GAAP explains that many of the provisions of the equity method should be applied to investments in unincorporated joint ventures.

Partnership profits and losses accrued by the venturers are generally reflected in the partners’ financial statements.

The elimination of intercompany profits and losses is generally appropriate.

An undivided interest is an ownership arrangement in which two or more parties jointly own property and title is held individually to the extent of each party’s interest. Each venturer is proportionately liable for the venturer’s share of each liability.

(1) (2)

Some undivided interests are accounted for in the same manner as partnership joint ventures.

Others follow specialized industry practices in which each venturer accounts for its pro rata share of the assets, liabilities, revenues, and expenses of the joint venture in its own financial statements. This is called pro rata or proportionate consolidation.

VARIABLE INTEREST ENTITIES A

The FASB coined the term variable interest entity.

1

B

A variable interest entity (VIE) is a special purpose entity, which will require consolidation due to contractual or financial arrangements other than voting interests.

A variable interest entity can take the form of a corporation, partnership, limited liability company or trust-type arrangement.

1 A potential VIE must be a separate entity, not a subset, branch, or division of another entity.

.

113

2

Pensions and certain other entities are specifically excluded.

C

GAAP’s definition of VIEs requiring consolidation encompasses situations where a company may only own a minimal voting equity interest, but be contractually required to provide additional financial support in the event of future operating losses.

D

Primary beneficiaries are required to consolidate VIEs.

E

1

An enterprise shall consolidate a VIE if it has a variable interest that will absorb a majority of the VIE’s expected losses, receive a majority of the VIE’s expected returns, or both.

2

If one entity will receive the majority of a VIE’s losses, and another the majority of residual returns, the one absorbing the losses consolidates the VIE.

All enterprises holding a significant interest in a VIE must provide certain disclosures.

1

F

The primary beneficiaries of a VIE must provide more extensive disclosures than the other enterprises not deemed the primary beneficiary.

The primary beneficiary consolidates based on fair value on the date they become primary beneficiary.

1

If the primary beneficiary has transferred assets to the VIE, they are transferred at book value and no gain or loss is recorded on the transfer.

2

Goodwill may be recorded only if the VIE is a business (as defined in FIN 46(R)). Otherwise, any excess of consideration paid over fair value of assets is treated as an extraordinary loss.

3

Estimating fair value may be challenging if the VIE invests in unique assets; firms may need to use expected future cash flows as a means of estimating fair value.

Description of assignment material

Minutes

Questions (12) Exercises (13) E11-1 7 MC general questions (parent company and entity theories) E11-2 5 MC general questions (joint ventures) E11-3 5 MC problem-type questions (parent company and entity theories) E11-4 [Pod/Sad] Computations (parent company and entity theories) E11-5 [Par/Sal] Computations under parent company and entity theories .

114

15 10 20 20 20

E11-6 E11-7 E11-8 E11-9 E11-10 E11-11 E11-12 E11-13 Problems P11-1 P11-2 P11-3 P11-4 P11-5 P11-6 P11-7 P11-8 P11-9 P11-10 P11-11

(fair value/book value differentials) [Pub/Sal] Computations under parent company, entity and traditional theories (mid-year acquisition) [Pal/Sal] Computations under parent company, entity, and traditional theories (upstream sales) [Pad/Sol] Compute consolidated net income under the three theories (upstream and downstream sales) [Pin/Set] Journal entries for push-down accounting [Sun] Determine investment income for corporate joint venturers [Pat] Accounting for a VIE beyond the initial measurement date [Pal/Pot] VIE reporting and disclosure requirements [Jenn/Laura] Determining the primary beneficiary in a VIE (11) [Pin/Son] Consolidated balance sheets (parent company and entity theories) [Par/Sip] Consolidated balance sheet and income statement under entity theory [Pal/Sin] Computations (parent company and entity theories) [Pit/Sam] Comparative consolidated financial statements under alternative theories [Pad/Sit] Comparative balance sheets under traditional and entity theories AICPA [P/S] Separate and consolidate financial statements – entity theory [Pay/Sap] Journal entry to record push down, subsidiary balance sheet, and investment income [Par/Son] Journal entries and calculations for push-down accounting [Paw/Sun] Journal entries and comparative balance sheets at acquisition for push-down [Paw/Sun] Consolidation working papers one year after acquisition under push-down accounting (both 90% and 100% ownership assumptions) [Pep/Jay] Working papers for proportionate consolidation (joint venture)

Internet assignment Using the Dow Chemical Company 2009 annual report from the website, prepare a summary of joint venture activities.

.

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20 15 15 20 12 15 15 10

30 30 30 50 40 70 30 30 25 70 50

Illustration 11-1 COMPARISON OF PARENT COMPANY THEORY AND ENTITY THEORY ASSET VALUATION Pet Company acquires a 90% interest in Sam Company for $63,000 on January 1, 20X2.

Book values and fair values of Sam’s assets and equities are summarized as follows:

Other current assets Inventories Plant assets-net Total assets

Book Value $40,000 15,000 30,000 $85,000

Fair Value $40,000 20,000 38,000 $98,000

Liabilities Capital stock $10 par Retained earnings Total equities

$38,000 25,000 22,000 $85,000

$38,000

Difference $5,000 8,000

Allocation of Purchase Price under Parent Company Theory: The parent’s share of subsidiary assets and liabilities are revalued.

Cost Book value acquired ($47,000 x 90%) Excess cost over book value acquired Excess allocated to: Inventories ($5,000 x 90%) Plant assets-net ($8,000 x 90%) Remainder to goodwill Excess cost over book value acquired

$63,000 42,300 $20,700 $ 4,500 7,200 9,000 $20,700

Allocation of Purchase Price under Entity Theory: A total implied value for the subsidiary's assets and liabilities is computed based on the price paid for the parent’s 90% share.

Implied value of Sam ($63,000/90%) Book value of Sam’s net assets Excess implied value over book value Excess allocated to: Inventory (100% of difference) Plant assets-net (100% of difference) Remainder to goodwill Excess implied value over book value

.

$70,000 47,000 $23,000 $ 5,000 8,000 10,000 $23,000

116

Consolidated Balance Sheets at Acquisition Parent Company Theory Pet 90% Adjustments and Sam Eliminations Other current assets $ 55,000 $40,000 Inventory 25,000 15,000 a 4,500 Plant assets—net 70,000 30,000 a 7,200 Investment in Sam 63,000 a 63,000 Goodwill a 9,000 Total assets $213,000 $85,000 Liabilities $120,000 $38,000 Capital stock 60,000 25,000 a 25,000 Retained earnings 33,000 22,000 a 22,000 Noncontrolling a 4,700 interest Total equities $213,000 $85,000 *Noncontrolling interest equals 10% of the book value of Sam's net assets.

Consolidated Balance Sheet $ 95,000 44,500 107,200 9,000 $255,700 $158,000 60,000 33,000 4,700 $255,700

Entity Theory Pet Other current assets Inventory Plant assets—net Investment in Sam Goodwill Total assets

$ 55,000 25,000 70,000 63,000 $213,000

90% Adjustments and Sam Eliminations $40,000 15,000 a 5,000 30,000 a 8,000 a 63,000 a 10,000 $85,000

Consolidated Balance Sheet $ 95,000 45,000 108,000 10,000 $258,000

Liabilities $120,000 $38,000 $158,000 Capital stock 60,000 25,000 a 25,000 60,000 Retained earnings 33,000 22,000 a 22,000 33,000 Noncontrolling a 7,000 7,000 interest Total equities $213,000 $85,000 $258,000 *Noncontrolling interest equals 10% of the value implied by Pet's purchase price for its 90% interest ($63,000 / 90%) x 10% = $7,000.

.

117

Important points from the illustration: 1

Goodwill. Goodwill can be determined independently. Under entity theory, goodwill is the difference between the total implied value of Sam’s net assets ($70,000) and the fair value of Sam’s net assets ($60,000). Under parent company theory, goodwill is the difference between the investment cost ($63,000) and the fair value acquired ($60,000 x 90%).

2

Asset and liability valuations. Consolidated net assets are $2,300 greater under entity theory ($100,000) than under parent company theory ($97,700). *

Consolidated net assets under parent company theory consist of the combined book values of Pet and Sam’s net assets plus 90% of the excess of fair value of Sam’s net assets over the book value of those assets.

*

Consolidated net assets under entity theory consist of the book value of Pet’s net assets plus the fair value of Sam’s net assets.

3

Stockholders’ equity. On the consolidated balance sheet, capital stock and retained earnings (the majority interest in consolidated net assets) are the same under parent company and entity theories.

4

Noncontrolling interest. The $2,300 difference in the value of consolidated net assets under parent company and entity theories lies in the measurement of noncontrolling interest ($7,000 under entity theory and $4,700 under parent company theory). If there is no noncontrolling interest, there are no differences in the value of consolidated net assets among the three theories.

5

Under parent company theory, the purchase price is allocated to the fair values of the identifiable assets and goodwill acquired. Under entity theory, the total fair value of the entity implied by the purchase price is allocated to the fair values of the identifiable net assets and to goodwill.

.

118

Illustration 11-2 PUSH-DOWN ACCOUNTING UNDER PARENT COMPANY AND ENTITY THEORIES

Assumptions 1

Pip Company acquires a 90% interest in Ski Company for $585,000 on January 1, 20X2.

2

Book values and fair values of Ski’s assets and liabilities are summarized as follows: Book Value

Fair Value

Difference

Current assets Land Buildings-net Equipment-net Total assets

$240,000 100,000 250,000 300,000 $890,000

$240,000 120,000 300,000 270,000 $930,000

$20,000 50,000 (30,000)

Liabilities Capital stock $10 par Retained earnings Total equities

$380,000 300,000 210,000 $890,000

$380,000

Goodwill can be computed independently as follows: Parent company theory Cost of 90% interest Fair value of interest acquired ($550,000 x 90%) Goodwill

$585,000 495,000 $ 90,000

Entity theory Implied value of Ski ($585,000 / 90%) Fair value of Ski Goodwill

$650,000 550,000 $100,000

.

119

Parent company theory allocation schedule: Cost Book value acquired ($510,000 x 90%) Excess cost over book value acquired Excess allocated to: Land ($20,000 x 90%) Buildings-net ($50,000 x 90%) Equipment-net (-$30,000 x 90%) Goodwill Excess cost over book value acquired

$585,000 459,000 $126,000 $ 18,000 45,000 (27,000) 90,000 $126,000

Push-down entry under parent company theory is recorded on Ski’s books: Land Buildings-net Goodwill Retained earnings Equipment Push-down capital

$

18,000 45,000 90,000 210,000 $ 27,000 336,000

Entity theory allocation schedule: Implied value of Ski ($585,000 / 90%) Book value of Ski’s net assets Excess implied value over book value acquired Excess allocated to: Land Buildings-net Equipment-net Goodwill Excess implied value over book value acquired

$650,000 510,000 $140,000 $ 20,000 50,000 (30,000) 100,000 $140,000

Push-down entry under entity theory is recorded on Ski’s books: Land Buildings-net Goodwill Retained earnings Equipment-net Push-down capital

.

$ 20,000 50,000 100,000 210,000 $ 30,000 350,000

120

Chapter 12 DERIVATIVES AND FOREIGN CURRENCY: CONCEPTS AND COMMON TRANSACTIONS Chapter Outline A

A derivative is the name given to a broad range of financial securities whose common characteristic is that the derivative contract’s value to the investor is related to fluctuations in price, rate, or some other variable that underlies it.

B

A HEDGE is a combined transaction of an existing position and a derivative contract that is designed to manage risk to the firm. Hedge transactions are accomplished using a type of derivative.

C

A forward contract is an agreement between two parties to exchange different currencies or a commodity at a specified future date and at a pre-agreed price and quantity. The agreement may require actual delivery or may allow a net settlement.

1

A net settlement allows the payment of money so that the parties are in the same economic position as they would have been if delivery had occurred.

D

A futures contract shares essentially the same characteristics as a forward contract, but is standardized, allowing it to be easily traded in markets.

E

Options are a common hedging instrument in which only one of the contracting parties is required to perform while the other party has the ability, but not the obligation, to perform. Option types are either call (right to buy) or put (right to sell).

F

Swaps are contracts to exchange an ongoing stream of cash flows and are commonly negotiated on an individual basis.

FOREIGN EXCHANGE CONCEPTS AND DEFINITIONS A

A transaction is measured in a particular currency when it is recorded in the financial records in that currency.

1

Assets and liabilities are denominated in a currency if their amounts are fixed in terms of that currency and will be settled in that currency. a

For example, U.S. Company buys merchandise from a Mexican firm for 500,000 pesos, payable in 10 days. The transaction is denominated in pesos; however, U.S. Company must measure the purchase in U.S. dollars before it can be recorded. This is done through the use of exchange rates.

.

121

B

An exchange rate is the ratio between a unit of one currency and the amount of another currency for which that unit can be exchanged. From the viewpoint of a U.S. company: 1

A direct quotation is expressed in U.S. dollars. It is the U.S. dollar equivalent of 1 unit of a foreign currency. a

2

A direct quotation for Mexican pesos might be $.08. The purchase denominated at 500,000 pesos is measured at $40,000 U.S. (500,000 pesos x $.08).

An indirect quotation is expressed in the foreign currency. It is the foreign currency equivalent to one U.S. dollar. a

An indirect quotation for Mexican pesos is expressed as 12.5 pesos. The 500,000 pesos purchase is measured at $40,000 (500,000 pesos / 12.5 pesos).

3

A spot rate is the exchange rate for immediate delivery of currencies exchanged.

4

The current rate is the rate at which one unit of currency can be exchanged for another currency at the balance sheet date or the transaction date.

5

The historical rate is the rate in effect at the date a specific transaction or event occurred.

FOREIGN EXCHANGE TRANSACTIONS OTHER THAN FORWARD CONTRACTS A

B

Foreign exchange transactions are transactions whose terms are denominated in a currency other than an entity’s functional currency.

1

A foreign transaction is a transaction between entities in different countries. The transaction is a foreign currency transaction only if it is denominated in a foreign currency from a U.S. firm’s viewpoint.

2

International transactions denominated in U.S. dollars are not foreign currency transactions from a U.S. firm’s viewpoint.

GAAP requirements for foreign currency transactions other than derivatives: 1

The transaction is translated into U.S. dollars at the spot rate in effect at the transaction date. a

An exchange gain or loss results when the exchange rate changes between the transaction date and the settlement date.

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122

b

2

An exchange gain or loss occurs only when the transaction is denominated in a foreign currency.

At the balance sheet date, recorded balances that are denominated in a foreign currency are adjusted to the current exchange rate. a

The difference between the recorded balance and the adjusted balance at the balance sheet date is the exchange gain or loss to be included in current income.

Description of assignment material

Minutes

Questions (13) Exercises (11) E12-1 4 multiple choice questions E12-2 4 multiple choice questions E12-3 3 multiple choice questions E12-4 [Zimmer] Accounting for foreign-currency denominated purchases E12-5 [Aviator] Accounting for foreign currency-denominated purchases settled in subsequent year E12-6 [Wick] Accounting for foreign currency-denominated sales settled in subsequent year E12-7 [Door] Accounting for foreign currency-denominated sales E12-8 AICPA 4 short problem-type questions E12-9 [Monroe] Various foreign currency-denominated transactions settled in subsequent year E12-10 [American TV] Various foreign currency-denominated transactions settled in subsequent year E2-11 [Martin] Accounting for speculative hedges Problems (5) P12-1 [TCO] The Economics of derivatives P12-2 [Sue] The Economics of derivatives P12-3 [Sue] The Economics of derivatives P12-4 [Lincoln International] Accounting for foreign currencydenominated receivables and payables – multiple years P12-5 [Shelton] Foreign currency-denominated receivables and payables – multiple years Internet assignment Go to the CNBC.com website and answer questions about commodities.

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20 20 15 15 15 10 10 20 15 15 15

15 30 30 30 30

Chapter 13 ACCOUNTING FOR DERIVATIVES AND HEDGING ACTIVITIES Chapter Outline HEDGE ACCOUNTING A

A hedge contract is a form of derivative. ASC Topic 815 establishes three defining characteristics for a derivative: 1

One or more underlyings and one or more notional amounts or payment provisions or both,

2

No initial net investment or one that is smaller than required for other similar contracts,

3

Net settlement required or permitted, can readily be settled net outside the contract, or asset delivery provision.

For hedged items and the associated derivatives, formal documentation must be prepared at the hedge inception.

B

For hedged items and the derivative instruments designated to hedge them to qualify for hedge accounting, formal documentation must be prepared at the inception of the hedge.

C

1

Among other things, this documentation describes the relationship between the hedged item and the derivative, and the risk management objective and strategy the company is achieving through the hedging relationship.

2

Once a type of risk is identified that qualifies for hedge accounting, the effectiveness of the hedge is assessed both at the inception of the hedge and during the hedge’s existence.

One of three types of hedge accounting must be used to account for the derivative and the related hedge item.

.

1

Fair value hedge accounting is used when the item being hedged is an existing asset or liability position and firm purchase or sale commitment. Both the item being hedged and the derivative are marked to fair value and the gain or loss is immediately recognized in earnings.

2

Cash flow hedge accounting hedges the exposure to variability in expected future cash flows associated with that risk. The effective portion of the related

124

gain or loss recognition is deferred until the forecasted transaction affects income. a

The gain or loss is included as a component of Accumulated Other Comprehensive Income (AOCI).

3

Hedge of a net investment in a foreign subsidiary, which is covered in chapter 14.

4

See the Gre Company example in the text.

EXAMPLES OF HEDGES A

Fair value hedges 1

B

Appropriate for highly effective hedges of either existing asset or liability positions or firm sales/purchase commitments a

The owner of an asset enters into a forward contract to sell the asset at an agreed-upon price at a later date. The accounting for this situation requires writing the derivative to market at each financial statement date and increase or decrease the value of the asset by the change in fair value from the date the contract is signed to the financial statement date.

b

The asset is not marked to fair value unless the fair value equals original cost on the date the contract is signed. If the values are different, the asset will only be changed by the difference between its fair value and the fair value at the derivative signing date. This is known as the mixedattribute model.

Cash flow hedges 1

Option contracts - designed to limit a company’s exposure to price changes in forecasted purchases of assets. a

2

Futures contracts – cash flow hedge of forecasted transactions. a

.

The option must be recorded at fair value on the financial statement date (computed as the present value of the option payment). The gain or loss is deferred by including it in other comprehensive income.

The futures contract has an observable market and must be market-tomarket at year end. Gains and losses are included in other comprehensive income.

125

Interest rate swaps and cash flow hedge accounting – reduce the risk of variable interest rate loans.

C

1

Treated as cash flow hedges as they reduce the variability in cash flows related to the debt.

D

Interest rate swaps and fair value hedge accounting – reduces the risk of the fair value of fixed rate loan fluctuation due to changes in market interest rates.

E

Foreign currency derivatives and hedging activities – GAAP requires marking to fair value (the current spot rate) foreign-currency denominated receivables and payables at year end. The resulting gain or loss is recognized immediately in income. The forward premium or discount is the difference between the contracted forward rate and the spot rate on the date the contract is entered into.

1

For a forward contract to qualify for cash flow hedge accounting, it must have the following characteristics: a

Cash flow hedges can be used in recognized foreign currencydenominated asset and liability situations if the variability of the cash flows is completely eliminated by the hedge.

b

The transaction gain or loss arising from the remeasurement of the foreign currency-denominated asset or liability is offset by a related amount reclassified from other comprehensive income to earnings each period.

c

The premium or discount related to the hedge is amortized into income using the effective interest rate.

Fair value hedge accounting of an identifiable foreign currency commitment – a foreign currency commitment is a contract or agreement denominated in foreign currency that will result in a foreign currency transaction at a future date. It differs from an exposed asset or liability position because it does not meet the accounting tests for recording the related asset or liability on the books.

F

.

1

If the forward contract is designated as a hedge of an identifiable foreign currency commitment, the purchase is recorded as a contract receivable and contract payable.

2

Both must be adjusted on the balance sheet date using the forward rate of the currency.

3

The recorded gain or loss on the hedge needs to be offset by a corresponding gain or loss on the underlying firm commitment.

126

G

Cash flow hedge of an anticipated foreign currency transaction 1

Anticipated commitments don’t create hedged items on the balance sheet that must be marked to market.

2

The forward contract, however, must be recorded at estimated fair value at year end.

3

Resulting gains or losses on cash flow hedges are recorded in other comprehensive income.

Speculation – A derivative instrument that speculates in foreign currency price movements is valued at forward rates throughout the life of the contract. All gains and losses on the contract are included in current income.

H

Description of assignment material

Minutes

Questions (10) Exercises (7) E13-1 [Jol] Hedge of an anticipated purchase E13-2 [Jol] Hedge of a firm purchase commitment E13-3 [Brk] Firm sales commitment E13-4 [Wil] Hedging of an existing asset E13-5 [AICPA] Various foreign currency hedge situations E13-6 [Win] Firm purchase commitment, foreign currency hedge E13-7 [Baz] Firm purchase commitment, foreign currency hedge to hedge net liability position

Problems P13-1 P13-2 P13-3 P13-4 P13-5 P13-6 P13-7 P13-8

(8) [NGW] Cash flow hedge, futures contract [Ins] Fair value hedge, option [Cam] Cash flow hedges, interest rate swap [Cam] Fair value hedge, interest rate swap [Bay] Foreign currency hedge, existing receivable [Fix] Foreign currency hedge, firm purchase commitment [Bat] Foreign currency hedge, anticipated sale [Mar] Foreign currency hedge, existing payable

15 15 15 15 12 12 12

25 30 30 30 20 30 20 22

Internet assignment Using Xerox Corporation’s 2010 annual report from their website, answer questions relating to derivative and foreign currency transactions.

.

127

Chapter 14 FOREIGN CURRENCY FINANCIAL STATEMENTS Chapter Outline THE FUNCTIONAL CURRENCY CONCEPT A

U.S. corporations convert the foreign currency financial statements of their foreign subsidiaries into U.S. dollars underGAAP.

B

Foreign currency financial statements are statements prepared in a currency other than the reporting currency (the U.S. dollar) of the U.S. parent-investor.

1

C

Statements of operations located outside the U.S. that are prepared in U.S. dollarsare not foreign currency statements.

The method for converting the foreign currency statements into U.S. dollars and the classification of the resulting gain or loss depends on the foreign entity’s functional currency (currency of the primary economic environment in which the entity operates).

APPLICATION OF THE FUNCTIONAL CURRENCY CONCEPT A

Foreign currency statements must be in conformitywith generally accepted accounting principlesbefore they can be translated.

B

Account balances on the foreign currency statements that are denominated in a foreign currency from the viewpoint of the foreign entity must be adjusted to reflect current exchange rates.

1

For example, a German subsidiary must adjust a yen-dominated accounts receivable balance to reflect the yen to euro current exchange rate.

An objectiveof the functional currency concept is to measure a foreign entity’s assets, liabilities, and operations in its functional currency.

C

1

Subsequently, the foreign entity’s financial statements are consolidated with the U.S. parent in the reporting enterprise’s currency (the U.S. dollar).

Converting the foreign entity’s financial statements into the currency of the parent may require translation, remeasurement, or both.

D

1

.

The method selected dependson whether the foreign subsidiary’s books are maintained in its functional currency, or a currency different from its functional currency.

128

2

Functional currency is the currency of the primary economic environment in which the subsidiary operates, normally the currency in which it collects its receivables and pays its liabilities.

3

Other factors, including management’s judgment, impact the selection of a subsidiary’s functional currency.

4

If a subsidiary’s functional currency is the U.S. dollar, the foreign financial statements are remeasured into U.S. dollars using the temporal method.

5

If a subsidiary’s functional currency is the local currency of the foreign entity, its financial statements are translated into U.S. dollars using the current rate method.

When the foreign entity’s books are maintained in its functional currency (that is, functional = local), the statements are translated into the currency of the reporting entity using the current rate method.

E

1

Translation involves expressing functional currency measurements in the reporting currency.

2

All elements of financial statements (except stockholders’ equity) are translated using a current exchange rate (the current rate method.)

3

As an expedient, revenues and expenses are usually translated at a weighted average exchange rate for the period.

4

The effects of the exchange rate changes are reported as stockholders’ equity adjustments, in Other Comprehensive Income, because they are not expected to impact the cash flows of the parent-investor.

5

The equity adjustments from translation are accumulated until the investment is sold or liquidated, at which time they are treated as adjustments to the gain or loss on sale.

When the foreign entity’s books are not maintained in its functional currency (that is, functional NOT= local), the statements are remeasured in the functional currency using the temporal method.

F

.

1

If the functional currency is the reporting currency (functional = U.S. dollar) the conversion is complete.

2

If the functional currency is not the U.S. dollar, the remeasured statements must then be translated into U.S. dollars using the current rate method.

129

G

3

Under the temporal method,monetary assets and liabilities are remeasured at current exchange rates and other assets and equities are remeasured at historical rates.

4

Gains or losses from remeasuring the foreign currency statements are included in income because they are expected to impact cash flows of the parent-investor.

Intercompany transactions between a U.S. parent and its foreign subsidiary may be a foreign currency transaction to one affiliate, neither affiliate or to both affiliates.

1

The transaction is a foreign currency transaction of a particular affiliate if it results in a receivable or payable balancedenominated in a currencyother than that entity’s functional currency.

2

Intercompany account balances denominated in a foreign currency are adjusted at the balance sheet date to the current exchange rate. a

If the intercompany balances are not of a long-term investment nature, the exchange gain or loss is included in income for the period.

b

An exchange gain or loss on settlement is also included in income for the period.

c

If the intercompany balances are of a long-term investment nature (settlement is not expected in the foreseeable future), the exchange gain or loss is reported in stockholders’ equity (in Other Comprehensive Income) as an equity adjustment from translation.

FOREIGN ENTITIES OPERATING IN HIGHLY INFLATIONARY ECONOMIES A

According to GAAP,a highly inflationary economy is one with a cumulative three-year inflation rate of approximately 100 percent or more.

B

Foreign currency financial statements of entities operating in highly inflationary economies are remeasured using the U.S. dollar reporting currency as the functional currency.

C

Exchange gains and losses are recognized in the income for the period.

BUSINESS COMBINATIONS A

Theassets and liabilities are translated into U.S. dollars using thecurrent exchange rate in effect at the date of the business combination.

.

130

B

The identifiable assets and liabilities are adjusted to their fair values in local currency and translated at the exchange rate on the date of the business combination. Any difference between the investment fair value and translated net assets acquired is goodwill or a bargain purchase.

1

When the foreign entity’s functional currency is its local currency, the excess cost over book value acquired is assigned to assets, liabilities, and goodwill in local currency units and subsequently translated at current exchange rates.

2

When the foreign entity’s functional currency is the U.S. dollar, remeasurement is required. The excess allocated to identifiable net assets is amortized at the historical exchange rate in effect at the time of the business combination.

C

The noncontrolling interest in a foreign subsidiary is computed after the foreign currency financial statements have been translated or remeasured into U.S. dollars.

D

Similarly, the equity method is applied after the foreign entity’s financial statements have been translated or remeasured into U.S. dollars.

TRANSLATION OF A FOREIGN SUBSIDIARY (Illustration 13-1) A

Any intercompany accountbalances denominated in a foreign currency are adjusted at the balance sheet date to the current exchange rate.

1

If the intercompany transaction is of a long-term investment nature, the gain or loss is included in other comprehensive income.

2

Otherwise, the gain or loss is included in income of the period.

When the foreign subsidiary’s adjusted trial balance is translated using the current rate method:

B

1

Assets and liabilities are translated at the current rate at the balance sheet date.

2

Revenues and expenses are usually translated at an average rate.

3

Dividends are translated at the rate in effect when the dividends are paid.

4

Retained earnings (RE) is not translated after the acquisition date. a

.

In years subsequent to the year of acquisition, RE equals RE at acquisition, plus net income, less dividends after acquisition, all in translated dollar amounts.

131

5

Capital stock and other paid-in capital accounts are translated at the exchange rate in effect when the subsidiary (or investee) was acquired.

6

The difference between the translated debits and the translated credits is an equity adjustment from translation and is reported in Other Comprehensive Income. a

An inequality results from translating some accounts using the current rate (assets) and other accounts using the historical rate (capital stock).

C

The translated financial statements are used in applying the equity method.

D

Noncontrolling interest is computed as a percentage of the subsidiary’stranslated stockholders’ equity; in other words, the equity adjustment from translation is included in the computation.

E

The elimination of intercompany profits should be based on the exchange rates in effect when the intercompany transaction took place; however, reasonable approximations or averages are permitted by GAAP.

REMEASUREMENT OF A FOREIGN SUBSIDIARY A

When the functional currencyis the U.S. dollar, the foreign entity’s accounts are remeasured into U.S. dollars.

B

The objective of remeasurement is to produce the same results as if the books of the subsidiary had been maintained in U.S. dollars.

C

When the adjusted trial balance of a foreign subsidiary is remeasured: 1

Monetary assets are remeasured at the current rate (the same as they are in translated statements).

2

Dividends paid are translated at reciprocal amounts in dollars recorded by the parent company on its own books.

3

Inventories are remeasured at historical rates.

4

Purchases are remeasured at average rates.

5

Expenses are remeasured at average rates during the period if they relate to monetary items and at historical exchange rates if they relate to nonmonetary items, such as plant assets or intangibles. a

.

If a single expense account relates to both monetary and nonmonetary items, the remeasurement involves more computations than the application of a single average rate.

132

6

Capital stock and other paid-in capital are remeasured at historical exchange rates (the same as in translated amounts).

7

The retained earnings (RE) balance is computed, but not remeasured. a

8

Ending RE = Beginning RE + remeasured net income – remeasured dividends.

Total debits in the remeasured trial balance are subtracted from total credits and the resulting exchange gain or loss is included in income for the period. a

Again, an inequality results from translating some accounts using different rates from other accounts.

D

The equity method is applied to the remeasured financial statements. Since all remeasurement gains and losses are recognized in current income, the equity method is the same as for domestic subsidiaries.

E

Because inventory and cost of sales accounts are remeasured at historical exchange rates, intercompany profits in consolidation working papers are eliminated in the same manner as for domestic subsidiaries.

HEDGING A NET INVESTMENT IN A FOREIGN ENTITY A

AU.S. firm may enter into a forward contract to hedge anet investment in a foreign entity whose functional currency is other than the U.S. dollar.

1

Procedures to hedgean investment in a foreign subsidiary are not applicable to investees with a U.S. dollar functional currency (accounted for as speculation). a

.

This is because conversion of the investee’s financial statements into U.S. dollars results in a gain or loss that is included in net income. The gain or loss from the related hedge is also included in net income.

2

Translation of the financial statements of a foreign entity whose functional currency is not the U.S. dollar produces a gain or loss that is excluded from net income and is reported in Other Comprehensive Income.

3

A gain and loss on a hedge of a net investment in a foreign investee is also excluded from net income, and is reported in Other Comprehensive Income.

4

The investee’s assets and liabilities hedge each other, so only the net assets are exposed to exchange rate gains and losses.

133

5

To hedge the foreign currency exposure, the translation adjustment from the hedge must move in the opposite direction of the translation adjustment from the net assets of the investee.

Description of Assignment Material

Minutes

Questions (12) Exercises (8) E14-1 E14-2 E14-3 E14-4 E14-5 E14-6 E14-7 E14-8

9 MC general questions – translation/remeasurement differences AICPA 5 MC general questions [Pai/Sta] Acquisition date effects (100% ownership, excess allocated to land, equipment, and goodwill) [Port/Stadt] Inventory remeasurement effect [Pana/Sim] Acquisition – excel allocation and amortization effect [Pal/Sta] Acquisition - excess allocation and amortization effect [Pac/Swi] Acquisition - excess allocation AICPA 7 MC problem-type questions

20 15 20 10 15 20 15 30

Problems (9) P14-1 P14-2 P14-3 P14-4 P14-5 P14-6

[Pak/Sco] Parent accounting under the equity method [Pla/Sorr] Parent accounting under the equity method [Pyl/Soo] Translation worksheet, parent accounting [Pet/Sul] Translation worksheet, parent accounting [Par/Sar] Remeasurement worksheet [Phi/Stu] Remeasurement worksheet

P14-7 P14-8 P14-9

[Pel/Sar] Translation worksheet, parent accounting [PWA/SAA] Parent accounting and consolidation under translation [Par/San] Translation worksheet, parent accounting, consolidation

25 25 25 25 20 30 35 60

Internet assignment Using Ford Motor Company’s 2009 annual report from its website, answer questions regarding functional currencies, reporting of remeasurement and translation gains and losses and cash flow hedges.

.

134

70

Illustration 14-1 TRANSLATION AND CONSOLIDATION OF A FOREIGN SUBSIDIARY Sub Corporation is a foreign firm whose local currency is designated LCU (local currency units.)

The exchange rate on December 31, 20Xl is 2 LCU for $1 U.S., and the December 31, 20Xl balance sheet of Sub in LCU and U.S. dollars is as follows:

LCU

Exchange Rate

U.S. Dollars

Cash Plant assets-net Total assets

5,000 20,000 25,000

$.50 .50

$ 2,500 10,000 $12,500

Capital stock Retained earnings Total equities

20,000 5,000 25,000

.50

$10,000 2,500 $12,500

On January 1, 20X2 Par Corporation, a U.S. firm, acquires all the capital stock of Sub for $15,000. Par's management determines that the functional currency of its subsidiary, Sub Corporation, is the LCU. Any excess of cost over book value is attributable to a patent and is to be amortized over 5 years.

Cost of investment in Sub at January 1, 20X2

$15,000

Book value of interest acquired

12,500

Patent (in $)

$ 2,500

Patent in LCU $2,500/$.50 = 5,000 LCU January 1, 20X2 purchase of Sub Corporation Par records its investment in Sub as follows: Investment in Sub $15,000 Cash To record acquisition of Sub equal to book value plus $2,500 patent (5,000 LCU patent) with a 5-year amortization period.

.

135

$15,000

ACTIVITIES – 20X2: The exchange rates for LCU for 20X2 are $.475 average for the year, $.47 when the dividends are paid, and $.45 at December 31, 20X2.

A translation worksheet to convert Sub's accounts in LCU into U.S. dollars under the current rate method is as follows: Translation Worksheet December 31, 20X2

Cash Plant assets-net Expenses Dividends Equity adjustment, 20X2 change

LCU 17,000 18,000 8,000 2,000

45,000 Capital stock Retained earnings Revenue

20,000 5,000 20,000 45,000

Exchange Rate $.45 C .45 C .475 A .47 H

U.S. Dollars $ 7,650 8,100 3,800 940

1,510 $22,000 .50 H measured .475 A

$10,000 2,500 9,500 $22,000

One-line Consolidation - 20X2 Par records its income and dividends from Sub for 20X2 as follows: Cash

$ 940 Investment in Sub $ To record dividends received (2,000 LCU x $.47 exchange rate).

Investment in Sub $4,190 Equity adjustment from translation 1,510 Income from Sub To record equity in Sub's income ($9,500 - $3,800).

Income from Sub $ 475 Equity adjustment from translation 225 Investment in Sub To record amortization of patent computed as follows: 5,000 LCU / 5 years x $.475 exchange rate = $475 4,000 LCU ending balance x $.45 current rate = $1,800 Patent change: $2,500 - $1,800 = $700

.

136

940

$5,700

$ 700

Consolidation - 20X2: Working papers to consolidate the financial statements of Par and Sub for the year ended December 31, 20X2 are illustrated as follows: Par Corporation and Subsidiary Consolidation Working Papers for the year ended December 31, 20X2 Par Sub Adjustment and Eliminations Income Statement Revenue Income from Sub Expenses Net income Retained Earnings Statement Retained earnings-Par Retained earnings-Sub Net income Dividends Retained earnings 12/31/20X2 Balance Sheet Cash Plant assets-net Investment in Sub

$30,000 5,225 (25,000) $10,225

$ 2,940 12,000 17,550

Patent Capital stock Retained earnings Equity adjustment-Par Equity adjustment-Sub

$32,490 $20,000 14,225 (1,735) $32,490

.

$9,500

$39,500

a. 5,225 (3,800) c. 475 $5,700

(29,275) $10,225

$10,000 10,225 (6,000) $14,225

Consolidate d Statements

$10,000 $2,500 b. 2,500 5,700 (940) $7,260

a.

940

$ 7,650 8,100

$10,590 20,100 a.

4,285

b. 2,275 $15,750 $10,000 b. 10,000 7,260 (1,510) b. 1,510 $15,750

137

10,225 (6,000) $14,255

b. 13,265 c.

475

1,800 $32,490 $20,000 14,225 (1,735) $32,490

ACTIVITIES - 20X3: The exchange rates for LCU for 20X3 are $.425 average for the year, $.42 when the dividends are paid, and $.40 at December 31, 20X3.

A translation worksheet to convert Sub's accounts in LCU into U.S. dollars under the current rate method is as follows: Translation Worksheet December 31, 20X3

Cash Plant assets-net Expenses Dividends Equity adjustment, 20X3 change

Exchange Rate $.40 C .40 C .425 A .42 H

LCU 10,000 36,000 12,000 2,000

2,035 $26,375

60,000 Capital stock Retained earnings, Jan. 1 Equity adjustment balance on January 1 Revenue

U.S. Dollars $ 4,000 14,400 5,100 840

20,000 15,000

25,000 60,000

.50 H measured

$10,000 7,260

measured .425 A

(1,510) 10,265 $26,375

One-line Consolidation - 20X3 Par records its income and dividends from Sub for 20X3 as follows: Cash

$ 840 Investment in Sub To record dividends received (2,000 LCU x $.42 exchange rate).

Investment in Sub $3,490 Equity adjustment from translation 2,035 Income from Sub To record equity in Sub's income ($10,625 - $5,100).

Income from Sub $ 425 Equity adjustment from translation 175 Investment in Sub To record amortization of patent computed as follows: 5,000 LCU / 5 years x $.425 exchange rate = $425 3,000 LCU ending balance x $.40 current rate = $1,200 Patent change: $1,800 - $1,200 = $600 .

138

$ 840

$5,525

$

600

Consolidation – 20X3: Working papers to consolidate the financial statements of Par and Sub for the year ended December 31, 20X3 are illustrated as follows: Par Corporation and Subsidiary Consolidation Working Papers for the year ended December 31, 20X3 Par Sub Adjustment and Eliminations Income Statement Revenue Income from Sub Expenses Net income Retained Earnings Statement Retained earnings-Par Retained earnings-Sub Net income Dividends Retained earnings 12/31/20X2 Balance Sheet Cash Plant assets-net Investment in Sub

$31,000 5,100 (26,000) $10,100

$10,625

$41,625

a. 5,100 (5,100) c. 425 $5,525

(31,525) $10,100

$14,225 10,100 (6,000) $18,325

$14,225 $7,260 b. 7,260 5,525 (840) $11,945

$ 2,780 12,000 19,600

$ 4,000 14,400

$34,380 $20,000 18,325 (3,945)

$18,400 $10,000 b. 10,000 11,945

$34,380

.

(3,545) b. 3,545 $18,400

139

a.

840

10,100 (6,000) $18,355 $6,780 26,400

a. 4,260 b. 15,340 b. 1,625

Patent Capital stock Retained earnings Equity adjustment-Par Equity adjustment-Sub

Consolidate d Statements

c.

425

1,200 $34,380 $20,000 18,325 (3,945) $34,380

Reconciliation of Par’s Investment Account and Sub’s Equity at December 31, 20X3

Equity in sub

Patent Amortization and Adjustments

Investment in Sub

$12,500

$2,500

$15,000

Income 20X2

5,700

(475)

5,225

Equity adjustment20X2 change

(1,510)

(225)

(1,735)

Balance January 1, 20X2

Dividends

(940)

(940)

Balance Dec. 31, 20X2

15,750

17,550

Income 20X3

5,525

(425)

5,100

Equity adjustment, 20X3 change

(2,035)

(175)

(2,210)

Dividends Balance Dec. 31, 20X3

.

(840) $18,400

140

(840) $1,200

$19,600

Chapter 15 SEGMENT AND INTERIM FINANCIAL REPORTING Chapter Outline DISAGGREGATION A company’s financial information can be disaggregated to provide information useful to financial statement users in assessing management’s effectiveness.

A

1

Segment reporting discloses information in the same way management organizes the enterprise into units for internal decision making.

2

Interim reporting provides timely information to financial statement users on a quarterly basis.

SEGMENT REPORTING A

Segments reporting under GAAP applies to all public business entities that have issued debt or equity securities and are required to file financial statements with the SEC. 1

Segments based on a management approach are called operating segments. a

B

Pension and other postretirement benefit plans, and corporate headquarters or other functional departments are not operating segments.

2

Segments may be either geographical or industry related, based on internal company segmentation.

3

Amounts reported in the financial statements are the amounts reported to the chief operating decision maker. Internal allocations made to the operating segment are included in the segment reports.

4

Segment reporting is required for interim reports as well as annual reports.

Disclosures may appear within the body of the financial statements, in statement notes, or in separate schedules that are an integral part of the financial statements.

.

141

IDENTIFYING REPORTABLE SEGMENTS A

An operating segment engages in business activity, has operating results regularly reviewed by the enterprise’s chief operating decision maker and has discrete financial information available.

B

Similar segments can be combined if they have similar economic characteristics and are similar in each of the following areas.

• • • • •

C

The nature of their products and services The nature of the production process The type or class of customer The distribution method for the products or services The regulatory environment

Operating segments are reportable if they meet certain materiality thresholds.

D

1

10% revenue test: The segment’s revenue is 10% or more of the combined revenue (including intersegment sales and transfers) of all operating segments.

2

10% asset test: The segment’s identifiable assets (those assets that are reviewed by the chief operating decision maker) are 10% or more of the combined identifiable assets of all operating segments.

3

10% operating profit test: The segment’s operating profit or operating loss (in absolute amounts) is 10% or more of the greater (in absolute amounts) of (a) the combined operating profits of all industry segments that did not incur an operating loss, or (b) the combined operating loss of all industry segments that did incur an operating loss.

Reportable operating segments determined under the above tests must represent a substantial portion of the enterprise’s operations.

1

Reported segments must include 75% of all external revenue, Excluding intersegment revenue.

2

If not, additional segments must be identified as reportable. a

.

This can be done by aggregating smaller segments that meet most of the aggregation criteria shown above.

142

E

Required disclosures for each reportable operating segment include: • • • • • • • • • • • • •

A measure of profit or loss Total assets Amount of revenue from external customers Amount of revenue from other operating segments of the same entity Interest revenue Interest expense (If a segment’s revenues are primarily interest and the chief operating decision maker relies on net interest revenue to evaluate performance, the segment may report interest revenue net of interest expense.)

Depreciation, depletion and amortization expense Unusual items Equity in the net income of investees accounted for by the equity method Income tax expense or benefit Extraordinary items Significant noncash items other than depreciation, depletion, and amortization expense If reviewed by the chief operating decision maker, other items are required that may include: amount of investment in equity investments, the total expenditures for additions to long-lived assets other than financial instruments and certain other items, and deferred tax assets.

RECONCILIATION OF SEGMENT INFORMATION A

A reconciliation between the segment data and consolidated information must be provided for: • •

• •

The total of reportable segments’ revenues and reported consolidated revenues The total reportable segments’ profit or loss and consolidated income before taxes (However, if items like taxes and extraordinary items are included in segment profit or loss, segment profit or loss can be reconciled to consolidated income after these items are included.)

Total reportable segments’ assets are reconciled to consolidated assets The total reportable segments’ amounts for every other significant item of information disclosed with their corresponding consolidated amount

ENTERPRISE WIDE DISCLOSURES A

Enterprises also report limited information(if not otherwise reported as part of segment information).

1

.

Products and Services: If practical, revenue from each product or service (or group of similar products or services) should be disclosed.

143

2

Geographic Information: If practical, geographical information should include revenues from external customers in the enterprise’s home country and outside the home country. If the revenue from any one country is material (over 10%), this information should also be disclosed separately. Similar treatment is accorded long-lived assets.

3

Major Customers: Disclosure of the existence of major customers (a single customer who accounts for 10% or more of the revenue) must be disclosed, including the amount of the revenue but not necessarily the identity of the customer. Groups under common control count as a single customer. However, different levels of government count as different entities.

INTERIM FINANCIAL REPORTING A

Interim Financial Reports provide information about firm operations for less than a full year.

1

Guidelines apply to any publicly traded company that issues interim financial information to its security holders.

2

Interim reports are usually unaudited, but the quarterly information in the annual report is “reviewed” by the CPA. a

3

Interim reports do not constitute fair presentations of financial information in conformity with GAAP.

Each interim period is considered an integral part of each annual period (integral theory), rather than a basic accounting period unto itself (discrete theory).

B

Revenue is recognized when earned following the same principles as used for the annual period.

C

Product costs

.

1

The gross profit method can be used for pricing interim inventories when a company does not use the perpetual inventory method and is too costly to perform an inventory count. The method must yield a reasonable estimate of inventory and cost of goods sold.

2

Inventory market declines are not deferred unless considered temporary.

3

If LIFO inventories are liquidated at an interim date but are expected to be replaced by year end, cost of sales should include the cost of replacing the LIFO base. The amount of current cost in excess of historical cost may be shown as a current liability on an interim balance sheet.

144

4

D

Planned variances under a standard cost system that are expected to be absorbed by year-end are usually deferred at the interim date.

Expenses other than product costs 1

Annual expenses are usually allocated to the interim periods that are expected to be benefited. However, expenses of an interim period that would not be deferred at year end, are not deferred.

2

Advertising costs are expensed in the interim period unless they clearly benefit subsequent interim periods.

3

Income taxes for interim reporting are divided into:

4

E

a

Taxes applicable to income from continuing operations before income taxes, excluding unusual or infrequently occurring items and

b

Taxes applicable to significant unusual or infrequently occurring items, discontinued items, and extraordinary items.

Computation for income taxes in interim period: a

The estimated effective annual tax rate is applied to taxable income from continuing operations excluding unusual and infrequently occurring items.

b

The year-to-date tax expense less the tax expense recognized in earlier interim periods is the tax expense for the current interim period.

c

Tax effects of unusual and infrequently occurring items are calculated separately and added to the tax expense of the interim period in which the items are reported.

d

Gains and losses on discontinued operations and extraordinary items are reported on a net-of-tax basis.

The minimum financial information to be disclosed in interim reports of publicly traded companies includes: • • • • • • • .

Sales or gross revenues Provisions for income taxes Extraordinary items net of income taxes Net income and comprehensive income Basic and diluted earnings per share Seasonal revenue, costs, or expenses Significant changes in estimates of income tax expense 145

• • • • • •

Disposal of a component of an entity, extraordinary items and unusual or infrequently occurring items Contingent items Changes in accounting principles or estimates Significant changes in financial position When interim data are reported on a regular basis, information should be reported for the current year to date, or the last twelve months to date with comparable information for the preceding year.

For each reportable operating segment: o Revenue from external customers o Intersegment revenue o A measure of segment profit or loss o Total assets if there has been a material change since the last annual report o A description of a change in segmentation since the last annual report o A reconciliation of total of reportable segments’ measure of profit or loss to the entity’s income before taxes, extraordinary items, and discontinued operations.

•

Information about defined benefit pension plans and other defined benefit post retirement benefits: o Amount of net periodic benefit cost recognized for each period for which a statement of income is presented o Total amount of contributions paid, and expected to be paid during the fiscal year if significantly different from amounts previously disclosed

• •

Information about the use of fair value to measure assets and liabilities Information about derivative instruments, fair value of financial instruments, certain investments in debt and equity securities, and other-than-temporary impairments

F

When an enterprise regularly reports interim data, it must also report for the current year-to-date or the last 12 months to date, with comparable information for the preceding year.

G

SEC requires quarterly reports on Form 10-Q to be filed within 45 days after the end of the quarter. Additional information required by the SEC includes:

.

1

Comparative consolidated balance sheets as of the end of the current quarter and at the prior year-end.

2

Comparative consolidated income statements for the current quarter and the same quarter of the prior year, and the current year to date and the prior year-todate.

146

3

Comparative consolidated statements of cash flows for the current year to date and the prior year-to-date.

Description of assignment material

Minutes

Questions (15) Exercises (10) E15-1 6 MC general questions (segment disclosure) E15-2 [Vic]Apply threshold tests – disclosure E15-3 [Sur] Apply threshold tests E15-4 [Wow] Segment and enterprise disclosures E15-5 [Coy] 8 MC problem-type questions (threshold tests ) E15-6 [Nog] 3 MC problem-type questions (threshold tests) E15-7 4 MC general and problem-type questions E15-8 [Ent] Interim tax E15-9 5 MC problem-type questions E15-10 [Tap] Interim accounting under LIFO

16 25 25 15 35 20 15 15 25 10

Problems P15-1 P15-2 P15-3 P15-4 P15-5 P15-6 P15-7 P15-8

15 25 30 45 50 40 40 35

(8) [Wod] Apply threshold tests [Hay] Apply threshold tests [DaP] Apply threshold tests – disclosure [Mer] Apply threshold tests – Segment and enterprise-wide disclosure [Rad] Apply threshold tests - disclosure [Tut] Apply threshold tests – disclosure [Cob]Apply threshold tests – disclosure [Tor] Interim reporting – tax

Internet assignment Using the H.J. Heinz website, obtain the most recent annual report and answer questions regarding the company’s segment disclosures.

.

147

Illustration 15-1 TESTS FOR REPORTABLE INDUSTRY SEGMENTS REVENUE TEST Timber

Mining

Defense

Sales to unaffiliated customers

$ 8,000

$51,000

$50,000

Sales to affiliates

2,000

Test values: Timber Mining Defense Finance Total

$10,000

$51,000

$55,000

$ 5,000

$ 3,000

$ 5,000

$ 3,000

$ 10,000 51,000 55,000 5,000 $121,000 x 10% = $12,100 test value

Reportable industry segments: Mining and Defense

.

Corporate

5,000

Interest from nonaffiliates Total revenues

Finance

148

IDENTIFIABLE ASSETS TEST Timber

Mining

Defense

Finance

Corporate

$ 9,000

$34,000

$32,000

$15,000

$30,000

Goodwill

6,000

9,000

Intersegment loans

10,000

Tangible assets excluding intersegment loans

Total assets Test values: Timber Mining Defense Finance Total

$ 9,000

25,000

$ 50,000

$ 41,000

$ 9,000 50,000 41,000 40,000 $140,000 x 10% = $14,000 test value

Reportable segments: Mining, Defense, Finance

.

$40,000

149

$30,000

OPERATING PROFITS TEST Timber

Mining

Defense

Finance

Corporate

Revenue (see revenue test)

$10,000

$ 51,000

$ 55,000

$ 5,000

$3,000

Cost of sales: To unaffiliated customers

(5,000)

(25,000)

(29,000)

To affiliated customers

(2,000)

Allocated Expenses

(1,000)

(5,000)

(7,000)

Other expenses

(4,500)

(10,000)

(9,000)

Interest expense to outsiders

(1,000)

(1,000)

Income from equity investee

1,000

Extraordinary Gain

6,000

Income (loss)

$(2,500)

(1,000)

$10,000

$17,000

(1,000) 20,000

$3,000

$22,000

Test values: Timber (only one with negative income) – absolute value is $2,500, and the test value would be $250. Use the higher test value generated by segments with profits.

Mining Defense ($17,000 - $6,000 extraordinary gain) Finance Totals Test Value is

$10,000 11,000 3,000 $24,000 x .10 $2,400

Reportable industry segments: All segments

.

150

Illustration 15-2 ACCOUNTING FOR INCOME TAXES FROM CONTINUING OPERATIONS IN INTERIM STATEMENTS

1

Estimate an annual effective tax rate at the end of each quarter.

2

Apply the annual effective tax rate to the income earned for the year to date.

3

Deduct the income tax reported in the previous interim reports from the income tax on the year-to-date income to determine the current quarter’s income tax.

A company estimates a 30% effective income tax rate at the end of the first and second quarters.

Actual income Estimated income Income taxes reported on interim statement

First Quarter $119,000

Second Quarter $129,000

Third Quarter $155,000

Fourth Quarter $160,000

(35,700) $ 83,300

(38,700) $ 90,300

At the end of the third quarter, the company revises its effective income tax rate to 31.5%. Tax in the third interim report will be computed: Tax on year-to-date income ($403,000 x .315 effective tax rate) Less: Income taxes from first 2 quarters ($35,700 + $38,700)

(74,400)

Income taxes reported in third quarter

$ 52,545

.

$126,945

151

Chapter 16 PARTNERSHIPS -- FORMATION, OPERATIONS, AND CHANGES IN OWNERSHIP INTERESTS Chapter Outline NATURE OF PARTNERSHIP ORGANIZATION A

Partnership is defined as an association of two or more persons to carry on as coowners of a business for profit.

B

Characteristics

C

1

Limited life - the legal life of a partnership terminates with the admission of a new partner, withdrawal or death of an old partner, voluntary dissolution by the partners, or involuntary dissolution.

2

Mutual agency - each partner is assumed to be an agent for the partnership with the power to bind all the other partners by his/her actions on behalf of the partnership.

3

Unlimited liability - each partner is liable for all partnership debts.

Articles of partnership (the partnership agreement) should be written (but oral agreements may be legal and binding).

1

The agreement should specify: • • • • • •

2

The types of products and services to be provided and other details of the business, Rights and responsibilities of partners, Initial investments and provisions for additional investments, Asset drawing provisions, Profit and loss sharing formulas, and Procedures for dissolving the partnership

Profits and losses are divided equally if there is no specific partnership agreement.

D

Partnerships do not pay federal income taxes, but the IRS requires filing of a financial information return.

E

Partners own their share of the partnership but do not have ownership shares in the individual assets of the entity.

.

152

INVESTMENTS AND DISINVESTMENTS (Illustration 16-1) A

Initial investments 1

All property brought into the partnership or acquired by the partnership is partnership property.

2

Initial investment is recorded in the partners’ capital accounts at its fair value at the time of transfer to the partnership.

3

Unidentifiable assets in initial investment arise when partners agree on relative capital interests not aligned with investments of identifiable assets. a

Under the bonus approach, the unidentifiable asset is not recorded on the partnership books and the capital accounts are adjusted to meet the conditions of the partnership agreement.

•

b

That is, the other partners give a “bonus” to the incoming partner whose share of capital exceeds his investment.

Under the goodwill approach , the unidentifiable asset is measured and recorded by reference to the total partnership capital implied by the other partners’ investment divided by the other partners’ interest.

•

The goodwill the incoming partner brings to the partnership allowed him to receive capital in excess of his investment.

B

The same valuation rules apply for additional investments as apply for initial investments.

C

Withdrawals are large and irregular disinvestments charged directly to partners’ capital accounts.

D

Drawings, drawing allowances, and salary allowances are:

E

1

Regular amounts that are withdrawn in anticipation of profits and charged to individual partner drawings accounts.

2

Closed to the capital accounts at the end of each accounting period, before preparation of the partnership balance sheet.

Loans and advances 1

.

Loans made to the partnership by a partner earn interest and are considered liabilities of the partnership.

153

2

Loans made to a partner by the partnership are partnership assets.

PARTNERSHIP OPERATIONS A

Financial statements of a partnership include a balance sheet, an income statement, a statement of partnership capital, and a statement of cash flows.

B

Profit and loss sharing agreements provide for the division of profits.

1

Salaries and bonuses to partners and interest on capital accounts are not expenses and do not affect the measurement of partnership income.

2

The order of the partnership agreement is followed regardless of the income or loss experienced by the partnership.

3

Absent a specific agreement, losses are divided the same as profits.

4

Capital to be considered in profit and loss sharing agreements may be beginning, ending, or average capital balances. Average capital means weighted average unless otherwise specified in the partnership agreement.

CHANGES IN PARTNERSHIP INTERESTS A

B

.

Assignment of an interest: 1

The partnership is not dissolved.

2

An assignee does not become a partner.

3

The assignee is entitled to partner’s share of profits and losses and a share of partnership assets in the event of liquidation.

4

The only accounting necessary is to record the capital transfer from the assignor to the assignee.

Admission of a new partner, either by purchasing an interest from old partners or investing in an existing partnership 1

Admission of a new partner requires consent of all existing partners

2

The old partnership is dissolved.

3

A new partnership agreement is developed.

154

4

C

Absent a new agreement, profits and losses are divided equally among the partners.

Purchase of an interest from existing partners 1

The partnership receives no new capital.

2

Revaluation/goodwill procedure

3

a

The revaluation should be completed before the admission of the new partner.

b

Since the partnership receives no money, the amount paid to the old partners provides little evidence for revaluation and appraisals must be relied on for an equitable distribution of total partners’ capital.

c

Identifiable assets and liabilities are revalued before goodwill is recorded (and existing partner capital accounts are increased at the same time).

d

An entry is made to transfer capital from the selling partner(s) to the new partner.

Nonrevaluation/bonus procedure a

The bonus procedure requires an entry be made to transfer capital of old partners to the new partner’s capital account.

b

Without revaluation, the new partner’s capital account may not equal his or her payments to the old partners.

INVESTING IN AN EXISTING PARTNERSHIP A

The old partnership is legally dissolved.

B

Noncash investments are valued using the same valuation techniques as used for initial investments.

C

Investment of the new partner is recorded under the provisions of the new partnership agreement.

D

Basis for revaluation of the partnership 1

.

If the new partner’s capital interest in the total of the old capital plus new investment is less than the new partner’s investment, there is an implication that the old partnership had unrecorded asset value. (Illustration 15-2) 155

a

Revaluation is determined by dividing the new partner’s capital investment by his or her interest in the new partnership.

b

The unrecorded asset value may be recognized by the goodwill or bonus approach.

(1)

(2)

2

.

Goodwill approach (a)

The difference between the implied value and the total of the old capital plus the new investment is goodwill.

(b)

The goodwill is divided among the old partners in their old profit and loss sharing ratios before the admittance of the new partners.

Under the bonus approach, the assets are not revalued, but the difference between the new partner’s investment and his/her capital credit is divided among the old partners in their old profit sharing ratios.

If the new partner’s capital interest in the total of the old capital plus new investment is greater than the new partner’s investment, there is an implication that the new partner is bringing unidentifiable assets into the partnership.

(Illustration 16-3) a

The total capital of the new partnership is determined by dividing the old partners’ capital by the old partners’ interest retained in the new partnership.

b

The unidentifiable asset value from the incoming partner can be recognized by either the goodwill or the bonus approach.

(1)

Under the goodwill approach, assets are revalued to their fair values and goodwill to the new partner is recorded.

(2)

Using the bonus approach (a)

Assets are not revalued

(b)

Capital balances of the old partners are reduced for the bonus to the new partner and the new partner’s capital account is recorded according to the partnership agreement.

156

DISSOLUTION OF A CONTINUING PARTNERSHIP THROUGH DEATH OR RETIREMENT A

The old partnership is dissolved and the retiring partner (or estate of a deceased partner) receives a settlement. Partner can dissociate at any time.

B

If the partnership agreement does not specify a settlement.

C

1

Buyout price = amount that would have been distributable to the dissociating partner if assets were sold equal to the greater of liquidation value or value based on sale of entire business.

2

The retiring partner, or estate of the deceased partner, receives that amount plus interest as an ordinary creditor. a

If there is a time lapse between the dissolution and settlement dates, the capital balance is reclassified as a liability.

b

Any interest on the liability up to the settlement date is an expense of the partnership.

Recording the settlement with a retiring or deceased partner: 1

If the retiring partner receives an amount equal to his or her final capital balance, the only entry is a debit to the capital account and a credit to cash.

2

If the retiring partner receives more than the balance in his or her capital account, an undervaluation of the partnership on the partnership books is implied. The excess payment can be recorded in one of three ways. a

If a bonus is paid to the retiring partner, the excess payment to the retiring partner is charged to the remaining partners in their relative profit sharing ratios.

b

If goodwill is to be recorded, and only goodwill equal to the excess payment to the retiring partner is to be recorded, then only the retiring partner’s share of partnership assets is revalued.

c

If total implied goodwill is to be recorded, a revaluation of total partnership capital that is based on the excess payment to the retiring partner (1)

.

A total undervaluation of the partnership is determined by dividing the excess payment to the retiring partner by the retiring partner’s profit-sharing ratio.

157

(2)

3

The goodwill is recorded and credited to all partners’ capital accounts before settlement with the retiring partner.

If the retiring partner receives less than the balance of his or her account, the partners may agree that the partnership is worth less than its book value. a

Overvalued assets should be written down to fair values in the partners’ profit-sharing ratios before settlement with the retiring partner.

b

If a bonus to continuing partners is to be recorded, a bonus equal to the excess of the retiring partner’s capital account over the cash paid by the partnership in settlement of the retiring partner’s interest is credited to the continuing partners’ capital account balances in their relative profit-sharing ratios.

LIMITED PARTNERSHIPS A

B

.

The unlimited liability characteristic is circumvented in this instance.

1

The limited partnership consists of at least one general partner, who has unlimited liability, and one or more limited partners whose risk is limited to their equity interest in the venture.

2

The limited partner is excluded from the management of the entity.

The partnership agreement must be written, signed by the partners, and filed with the appropriate state agency.

158

Description of assignment material

Minutes

Questions (15) Exercises E16-1 E16-2 E16-3 E16-4 E16-5 E16-6 E16-7 E16-8 E16-9 E16-10 E16-11 E16-12 E16-13 E16-14 E16-15 E16-16 E16-17 E16-18 E16-19 E16-20 E16-21 Problems P16-1 P16-2

P16-3 P16-4 P16-5 .

(21) [Car/Lam] Computing initial partner investments [Arnold/Beverly/Carolyn] Partnership income allocation – bonus [Mel/Dav] Partnership income allocation – salary allowance [Cari/Helen/Brandie] Partnership income allocation - salary allowance and interest [Bird/Cage/Dean] Partnership income allocation – Partnership capital statement [BIG] Partnership income allocation – assignment of interest to a third party [Fax/Bel/Rob] Recording new partner investment [Bow/Mon/Joh] Recording new partner investment – Revaluation case [Sprint/Jog/Run/Walk] Recording new partner investment – Revaluation and non revaluation cases [Manda/Eme/Fot/Box] Recording new partners investment - Nonrevaluation case [Nix/Man/Per] Partner retirement entries [Beck/Dee/Lynn] Partner retirement entries – fair value adjustment [Kathy/Eddie] Partnership income allocation - salary allowance, bonus, and additional contributions [Byd/Box/Dan/Fus] Partnership retirement – Revaluation and bonus approaches 5 MC problem-type questions 5 MC problem-type questions AICPA 5 MC problem-type questions AICPA 7 MC problem-type questions [Kray/Lam/Mann] Partnership income allocation – salary allowance and interest [Gro/Ham/Iot] Recording new partner investment [Cas/Don/Ear] Partnership retirement - various situations (14) [Ellen/Fargo/Gary] Partnership income allocation - statement of partnership capital [Mortin/Oscar/Trent] Recording new partner investment – Revaluation and nonrevaluation cases [Ashe/Barbour] Partnership income allocation (interest, salary, bonus) [Alex/Carl/Erika] Partnership income allocation – complex, net loss partners’ capital, and correcting journal entries [Katie/Lynda/Molly] Partnership income allocation – profit sharing 159

10 15 10 15 20 10 15 16 20 20 15 15 10 20 25 25 25 35 25 15 20

25 20 15 40 35

P16-6 P16-7 P16-8 P16-9 P16-10 P16-11 P16-12 P16-13 P16-14

Based on beginning, ending, and average capital balances [Jones/Keller/Glade] Partnership income allocation – correction of an error [Addie/Bal/Cathy] Recording new partner investment and subsequent balance sheet [Ann/Bob/Carrie/Darling] Recording new partner investment various situations [Pat/Mik/Hay/Con] Recording new partner investment various situations [Aida/Thais/Carmen] Recording new partner investment various situations [Harry/Iona/Jerry] Partnership income allocation – multiple years [Parker/Boone] Partnership income allocation [Peter/Quarry/Sherel] Recording new partner investment complex revaluation and nonrevaluation case [Timmy/Lassie] Partnership income allocations

60 20 30 35 25 40 50 45 20

Internet assignment Answer a series of questions regarding the publicly-traded limited partnership of Cedar Fair, L.P.

.

160

Illustration 16-1 SUMMARY OF PARTNERSHIP ORGANIZATION AND OPERATIONS Partnership formation * Noncash assets invested in a partnership are recorded at their fair values (i.e., present values for receivables and current cost for inventories and other assets. *

Partner liabilities assumed in a partnership formation should be recorded at their present values as indicators of their fair market values.

*

Failure to record assets invested and liabilities assumed at the fair values results in individual partner inequities.

Partnership income (loss) * Income or loss should be distributed in accordance with the partnership agreement. In the absence of an agreement, income or loss is shared equally. *

Partnership profit and loss sharing agreements frequently specify allocations for partner salaries, interest on capital account balances, and bonuses. Such items do not constitute expenses of the partnership.

*

Residual income or loss of a partnership should be allocated according to the residual profit and loss sharing ratios.

Partnership dissolution * A partnership entity is dissolved in a legal sense whenever there is an ownership change in the partnership. *

Dissolution of a partnership entity in a legal sense does not necessarily mean liquidation of the partnership business.

*

The admission or withdrawal of a partner is recorded under the bonus or the goodwill procedure.

*

An individual may become a partner by purchasing an interest from an existing partner, or by investing cash or other resources in the partnership.

.

a

All existing partners must agree to the admission of a new partner.

b

Partnership assets may or may not be revalued upon the admission or withdrawal of a partner.

161

Illustration 16-2 INVESTMENT IN AN EXISTING PARTNERSHIP Pat and Mike are partners with capital balances of $50,000 and $40,000, respectively, and they share profits and losses equally. They admit Sid for a 30% interest for a cash investment of $60,000.

1

Bonus procedure (Assets not revalued) Journal entry to record Sid's admission: Cash

$60,000

Pat capital $ 7,500 Mike capital 7,500 Sid capital 45,000 Old capital of $90,000 + $60,000 investment = $150,000 new capital.

New balances: Pat $57,500; Mike $47,500; Sid $45,000 = $150,000.

2

Goodwill procedure Journal entry to record revaluation Goodwill $50,000 Pat capital $25,000 Mike capital 25,000 Investment of $60,000/30% interest = $200,000 implied total capital.

Total capital $200,000 - ($90,000 old capital + $60,000 new investment) = $50,000 goodwill.

Journal entry to record admission of Sid: Cash

$60,000 Sid capital $60,000 New balances: Pat $75,000; Mike $65,000; Sid $60,000 = $200,000.

.

162

Illustration 16-3 INVESTMENT IN AN EXISTING PARTNERSHIP Pat and Mike are partners with capital balances of $50,000 and $40,000, respectively. They share profits and losses equally. They admit Sid to a 30% interest for a cash investment of $30,000.

1

Bonus procedure (Assets not revalued) Journal entry to record Sid's admission: Cash Pat capital Mike capital

$30,000 3,000 3,000

Sid capital $36,000 Old capital of $90,000 + $30,000 investment = $120,000 new capital.

Sid capital = $120,000 new capital x 30% interest = $36,000.

Sid’s capital credit $36,000 - $30,000 cash payment = $6,000 bonus to new partner.

New balances: Pat $47,000; Mike $37,000; Sid $36,000 = $120,000 total capital.

2

Goodwill procedure (Assets revalued) Journal entry to record admission of Sid and revaluation: Cash Goodwill

$30,000 8,571

Sid capital $38,571 Old capital $90,000/70% interest retained by old partners = $128,571 (rounded) new capital.

New capital $128,571 - ($90,000 old capital + $30,000 investment) = $8,571.

New balances: Pat $50,000; Mike $40,000; Sid $38,571 = $128,571.

.

163

Chapter 17 PARTNERSHIP LIQUIDATION Chapter Outline PARTNERSHIP LIQUIDATION A

A partnership liquidation is the termination of a partnership as a business entity.

B

Overview of liquidation process for a solvent partnership (partnership assets are greater than partnership liabilities):

C

1

Noncash assets are converted into cash.

2

Gains and losses and expenses incurred during the liquidation period are recognized.

3

Liabilities are settled.

4

Cash is distributed to the partners according to the final balances in their capital accounts.

Order of distribution of assets in a liquidation of a partnership 1

Amounts owed to creditors other than partners and amounts owed to partners other than for capital and profits.

2

Amounts due to partners liquidating their capital balances upon conclusion of the liquidation of partnership assets and liabilities a

All profits, losses, and drawing balances are closed to capital accounts before any distributions are made.

D

Partnership liquidation statement is a summary of transactions and balances during the liquidation stage.

E

Debit capital balances in a solvent partnership may result from recognizing losses during the liquidation process.

.

1

The partners with debit balances are normally obligated to use their personal assets to settle their partnership obligations.

2

If the partners with debit capital balances have inadequate personal assets, the partners with credit balances normally assume losses equal to the debit capital balances and share the losses in their relative profit and loss sharing ratios.

164

3

If the partnership has a loan balance from an insolvent partner a

No cash should be distributed for the loan without agreement from all partners.

b

A partner’s personal creditors have a prior claim on personal assets.

SCHEDULE OF SAFE PAYMENTS (Illustration 17-1) A

Safe payments are distributions to partners that can be made with the assurance that any resources distributed will not have to be returned to the partnership (assumes a worst-case scenario)

B

In calculating safe payments, the following assumptions are made:

C

.

1

All partners are considered personally insolvent.

2

All noncash assets are considered possible losses.

3

Some cash may be withheld to cover liquidation expenses, unrecorded liabilities, and general contingencies. The cash withheld is considered a loss in determining safe payments.

The safe payments schedule for determining advance distributions to partners is prepared after non-partner liabilities have been paid.

1

The schedule begins with each partner’s equity (each partner’s capital account plus loans to the partnership and less loans from the partnership).

2

Possible losses (from noncash assets and cash withheld balances) are allocated to the partners in the profit and loss sharing ratios and deducted from the equity balances.

3

Any negative partner equity is allocated to partners with equity in their relative profit and loss sharing ratios.

4

Step 3 is repeated until no remaining partner shows negative equity.

5

The amount shown for partners with equity will equal the cash available for distribution.

6

Advance distributions require approval from all partners.

165

INSTALLMENT LIQUIDATIONS A

Installment liquidations involve the distribution of cash to partners as it becomes available during the liquidation period and before all liquidation gains and losses have been realized.

1

Payments to partners can be determined by a safe payment schedule for each installment distribution.

2

When the partners’ capital accounts are aligned in the profit and loss sharing ratios, safe payment schedules will not be necessary.

3

Once all the partners are included in an installment distribution, future installment payments to the partners will be in the profit sharing ratios. Thus, additional safe payment schedules are not necessary.

PARNTER VULNERABILITY RANKING A

Cash distribution plans involve ranking partners in terms of their vulnerability to possible losses, preparing a schedule of assumed loss absorption, and preparing a cash distribution plan.

B

How vulnerable a partner is to possible losses (vulnerability ranking) is determined by dividing each partner’s equity by his or her profit sharing ratio.

1

C

D

A schedule of assumed loss absorption is prepared using the vulnerability rankings.

1

The schedule begins with pre-liquidation equities and charges each partner’s equity with its share of the partnership loss that would exactly eliminate the equity of the most vulnerable partner.

2

Each remaining partner’s equity is charged with its share of the loss that would exactly eliminate the equity of the next most vulnerable partner.

3

This process is repeated until the equities of all but the least vulnerable partner have been reduced to zero.

A cash distribution plan is prepared from the schedule of assumed loss absorption.

1

.

This amount is the maximum loss that the partner could absorb without reducing his or her equity below zero.

Under the plan, the first cash available for distribution goes to pay nonpartner liabilities.

166

E

2

Next, the least vulnerable partner will receive an amount of cash that will align that partner’s equity in the relative profit and loss sharing ratio with the next least vulnerable partner.

3

This process is continued until all partners’ capital balances are aligned.

4

Remaining distributions are in the profit and loss sharing ratio.

A cash distribution schedule can be prepared from the cash distribution plan. The schedule shows how cash is distributed as it becomes available.

INSOLVENT PARTNERS AND PARTNERSHIPS A

The UPA specifies priorities for the distribution of partnership assets in liquidation and for the distribution of the personal assets.

B

Partnership creditors must first seek recovery of their claims from partnership property.

1

C

.

Creditors of individual partners must first seek recovery of their claims from individual property.

Often with a solvent partnership, but insolvent partner: 1

Partnership creditors recover their claims from partnership property.

2

An insolvent partner’s personal creditors have a claim against partnership assets to the extent of the insolvent partner’s equity in such assets.

3

Creditors of an insolvent partner with a credit capital balance may have a claim against the personal assets of a solvent partner with a debit capital balance to the extent of the debit capital balance.

4

Partners with debit capital balances are obligated to the partnership for the amount of the debit balance; however, if the partner with the debit balance is insolvent, that partner’s personal assets will go to his personal creditors.

167

Description of assignment material

Minutes

Questions (12) Exercises E17-1 E17-2 E17-3 E17-4 E17-5 E17-6 E17-7 E17-8 E17-9 E17-10 E17-11 E17-12 Problems P17-1 P17-2 P17-3 P17-4 P17-5 P17-6 P17-7 P17-8 P17-9 P17-10 P17-11 P17-12

(12) [Folly/Frill] Simple liquidation - Schedule of cash available [Mike/Nan/Okey] Liquidation - Journal entries [Fred/Ethel/Lucy] Liquidation – Cash distribution computation, safe payments schedule [Jan/Kim/Lee] Liquidation – Cash distribution computation, safe payments schedule [Ali/Bart/Carri] Liquidation - capital balance computation correcting an error [Evers/Freda/Grace] Safe payments schedule [Alice/Betty/Carle] Statement of partnership liquidation [Daniel/Eric/Fred] Statement of partnership liquidation partner insolvency case [Ace/Ben/Cid/Don] Statement of partnership liquidation partner insolvency case [Denver/Elsie/Fannie/George] Safe payments schedule [Quen/Reed/Stacy] 3 MC problem-type questions (installment liquidation 6 MC general and problem-type questions (12) [Barney/Betty/Rubble] Cash distribution plan and entries - installment [Chan/Dickerson/Grunther] Cash distribution plan [Fred/Flint/Wilma] Cash distribution plan [Gary/Henry/Ian/Joseph] Installment liquidation [Eli/Joe/Ned] Statement of partnership liquidation [Jones/Smith/Tandy] Installment liquidation [Lin/Mary//Nell] Installment liquidation [Jason/Kelly/Becky] Installment liquidation - safe payments schedule [Roger/Susan/Tom] Installment liquidation – safe payments schedule [Rob/Tom/Val] Installment liquidation [Jee/Moore/Olsen] Installment liquidation [Beams/Plank/Timbers] Installment liquidation

12 12 12 15 5 5 15 20 20 25 20 15 25 20 20 20 35 30 40 50 45 50 55 50 70

Internet assignment Perform an Internet search and find an investment club organized as a partnership. Review the by-laws and provisions made for the death/retirement of a partner and the ultimate liquidation of the partnership.

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Illustration 17-1 PARTNERSHIP DISSOLUTION AND LIQUIDATION Jas, Kal, and Lou decide to dissolve their partnership on May 1, 20X7 and to liquidate their partnership as soon as possible after May 1. A condensed balance sheet with profit sharing percentages is as follows: Condensed Balance Sheet as of May 1, 20X7 Assets Cash Inventory (per books) Other assets (per books) Goodwill

$ 50,000 100,000 130,000 20,000 $300,000

Equities Accounts payable Jas capital 20% Kal capital 40% Lou capital 40%

$120,000 40,000 80,000 60,000 $300,000

Additional information *

The inventory was sold for $70,000 during May.

*

Other assets with a book value of $90,000 were sold for $50,000.

*

On June 1 the partners agree to distribute available cash immediately except for a $10,000 contingency fund.

Appropriate distributions are based on a Statement of Partnership Liquidation and a Safe Payments Schedule.

.

169

Balances: May 1 Goodwill write-off Sale of inventory Sale of other assets Predistribution balances Cash distribution: Priority claims Partners Balances

Partner equities Loss on noncash assets Contingency fund Safe payments to partners

Jas, Kal, and Lou Partnership Statement of Partnership Liquidation from May 1 to June 1, 20X7 Cash Noncash Priority Jas Capital Kal Capital Assets Claims 20% 40% $50,000 $250,000 $120,000 $40,000 $80,000 (20,000) (4,000) (8,000) 70,000 (100,000) (6,000) (12,000) 50,000 (90,000) (8,000) (16,000) 170,000 (120,000) (40,000) $10,000

40,000

120,000

22,000

44,000

24,000

(12,000) $10,000

(24,000) $20,000

(4,000) $20,000

(120,000) $40,000

0

Jas, Kal, and Lou Partnership Safe Payments Schedule from May 1 to June 1, 20X7 Jas Capital-20% Kal Capital-40% Lou Capital-40% $22,000 $44,000 $24,000 (8,000) (16,000) (16,000) (2,000) (4,000) (4,000) $12,000 $24,000 $4,000

Note the safe payment schedule's assumption that all remaining noncash assets are losses.

.

Lou Capital 40% $60,000 (8,000) (12,000) (16,000)

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Total $90,000 (40,000) (10,000) $40,000

Chapter 18 CORPORATE LIQUIDATIONS AND REORGANIZATIONS Chapter Outline BANKRUPTCY LAW A

Bankruptcy law is contained in Title 11 of the United States Code (USC), referred to as the Bankruptcy Act.

B

The Bankruptcy Reform Act was passed in 1978 and has been amended several times.

C

The Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) of 2005

D

1

Made it more difficult for debtors to abuse the spirit behind bankruptcy provisions.

2

Debtor company is given 120 days initially to submit a plan of reorganization.

Exclusivity period is limited to a maximum of 18 months.

3

Retail debtors now have only 120 days to assume or reject non-residential real property unexpired leases with a maximum 90-day extension.

Provisions of the Act and its amendments 1

2

.

The Bankruptcy Act created bankruptcy courts. a

The jurisdiction of the bankruptcy court covers all cases under Title 11 of U.S.C.

b

Congress attempted to speed up bankruptcy cases with amendments to the Act in 1994. The court was given the authority to set dates by which certain parties to the bankruptcy case must complete their duties.

The Bankruptcy Act created the Office of U.S. Trustee. a

U.S. trustees are appointed by the attorney general.

b

U.S. trustees are responsible for the administration of bankruptcy cases.

c

U.S. trustees maintain and supervise a panel of private trustees to serve in liquidation cases.

d

A U.S. trustee serves as trustee or interim trustee in some cases where a private trustee is not available.

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e

3

The U.S. trustee monitors appointed creditor committees and presides over creditor meetings.

The Bankruptcy Act also provides for bankruptcy judges. a

Bankruptcy judges are appointed by Federal Appeals Court Judges for a 14-year period.

b

The role of the bankruptcy judge is judicial, and duties of the bankruptcy judge include: • • •

E

Settling disputes in the case.

Approving all payments of debts incurred before the bankruptcy filing.

Approving all other payments that are considered extraordinary.

Corporate bankruptcy cases 1

A case begins when a petition is filed under which the debtor is initially brought into bankruptcy court.

2

The petition may be filed by the debtor (a voluntary bankruptcy proceeding) or by creditors (an involuntary bankruptcy proceeding).

3

The petition may be filed under Chapter 7 or Chapter 11 of the Bankruptcy Act.

4

a

Chapter 11 petitions anticipate the reorganization of the debtor.

b

Chapter 7 cases anticipate the debtor’s liquidation.

The Bankruptcy Court has the power to: • Enter the order for relief (accept the petition), • Dismiss the case, • Convert a Chapter 7 case to a Chapter 11 case, or • Convert a Chapter 11 case to a Chapter 7 case

CHAPTER 7 LIQUIDATION CASES A

Commencing a Chapter 7 case 1

.

A Chapter 7 case is commenced voluntarily when the debtor corporation files a petition with the bankruptcy court.

172

2

A Chapter 7 case is commenced involuntarily when:

3

a

A filing is made by 3 or more creditors holding unsecured claims aggregating at least $12,300, or

b

A single creditor with an unsecured claim of at least $12,300 files, and there are fewer than 12 unsecured creditors.

c

The Court will accept the petition under Chapter 7 if the creditors prove their claims or if the debtor does not contest the petition on a timely basis

d

The debtor may respond by filing for protection under Chapter 11.

The filing of a case creates an estate.

B

The U.S. trustee (or the bankruptcy judge in non U.S. trustee districts) appoints an interim trustee to take possession of the debtor corporation’s estate until a trustee is elected.

C

Unsecured creditors with undisputed claims vote for a trustee.

1

Electing a trustee requires that creditors holding at least 20% in amount of claims vote and that one candidate gets the votes of creditors holding a majority of the amount of claims voting.

2

If a trustee is not elected, the interim trustee serves as trustee.

D

Unsecured creditors that can vote also elect a creditors’ committee of 3 to 11 members.

E

The trustee takes possession of the estate, converts the estate assets into cash, and distributes the proceeds according to priority of claims, as directed by the bankruptcy court. The trustee also:

F .

1

Investigates the financial affairs of the debtor.

2

Provides information about the debtor’s estate and its administration to parties in interest.

3

Examines creditor claims and objects to claims that appear improper. The trustee may be able to void certain voidable preferences.

4

Operates the debtor’s business if authorized to do so.

5

Files reports on trusteeship as required by the court.

Claims in a Chapter 7 case are paid according to Exhibit 18-2 in the text.

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1

Claims secured by valid liens are paid to the extent of the proceeds from the sale of the property pledged as security. a

2

3

4 G

H

Unsecured priority claims are divided into 6 classes. a

The first class, administrative expenses of the liquidation case, is paid in full before the next class (claims incurred between the date of filing an involuntary petition and the date an interim trustee was appointed) receives any distribution.

b

The second class is paid in full before the third class, and so on.

c

If cash is insufficient to pay all claims in a given class, distributions are made on a pro rata basis.

Unsecured nonpriority claims are divided into 4 classes. a

Again, the first class is paid in full before cash is distributed to the second class and so on.

b

If there is insufficient cash for a class, distributions within the class are made on a pro rata basis.

Stockholders receive remaining assets after all claims are paid.

The statement of affairs is a financial statement that emphasizes liquidation values.

1

The statement shows balance sheet information with assets measured at expected net realizable values and classified on the basis of availability for fully secured, partially secured, priority, and unsecured creditors.

2

Liabilities are classified as priority, fully secured, partially secured, and unsecured.

3

The statement is prepared as of a specific date.

The statement of realization and liquidation is an activity statement that shows progress toward the liquidation of a debtor’s estate.

1

.

Any amount of remaining debt left unpaid becomes an unsecured nonpriority claim.

It informs the bankruptcy court and interested creditors of the trustee’s accomplishments.

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I

2

The Bankruptcy Act does not require this statement but allows the judge to prescribe the form in which the information is presented in court.

3

Basic financial statements with supporting schedules can also meet this information need.

The bankruptcy case is closed when the estate is fully administered and the trustee is dismissed.

CHAPTER 11 REORGANIZATION CASES A

Commencing a Chapter 11 case 1

A case is initiated voluntarily when a debtor corporation files a petition with the bankruptcy court.

2

A case is initiated involuntarily when creditors file a petition (in accordance with the same $10,000 claim limitations applicable to Chapter 7 filings).

3

If the court grants the petition for protection from creditors, it enters an order for relief under Chapter 11. Alternatively, the court may dismiss the petition or convert the case to a Chapter 7 case.

B

When the order for relief is granted, the bankruptcy judge appoints a U.S. trustee to administer the case.

C

A private trustee may be appointed for cause, but otherwise the debtor corporation is continued in possession of the estate and is referred to as a debtor in possession. If the court appoints a private trustee for cause, a party in interest may request that a trustee be elected.

1

.

The duties of the trustee or debtor in possession include: a

Being accountable for the debtor’s property, including operations of the debtor’s business

b

Filing a list of creditors, schedules of assets and liabilities, and a statement of financial affairs

c

Furnishing information and reports requested by the court about the estate and its administration

d

Examining creditor claims and objecting to claims that appear improper

e

Filing a reorganization plan or reporting why one will not be filed 175

D

E

F

f

Filing final reports as required by the court.

g

Negotiating with creditors and stockholders through creditors’ committees and equity holders’ committees

Creditors’ committees are responsible for protecting the interests of the creditors they represent.

1

A creditors’ committee is appointed by the U.S. trustee as soon as practicable after the order for relief is granted.

2

All negotiations between the debtor and the pre-petition creditors are carried out through creditors’ committees.

3

Generally, governmental units cannot serve on creditors’ committees; however, in some cases, the PBGC can be a voting member.

While operating under Chapter 11, the debtor corporation may be able to: 1

Reduce labor costs through layoffs, wage reductions, or termination of pension plans

2

Reject executory contracts and unexpired leases

3

Reduce interest expense because interest accrued on unsecured debt stops at the time the petition is filed

4

Prevent foreclosure on the debtor’s assets (except as permitted by the bankruptcy court)

5

Force a debt restructuring

The reorganization plan must be fair and equitable to all interests concerned.

1

During the first 120 days after the order of relief is filed, only the debtor corporation can file a reorganization plan. a

2

Chapter 11 of the Bankruptcy Act requires that the reorganization plan must: a b c d

.

Once the exclusivity period has expired, any party of interest may file a plan.

Identify classes of claims (there are some exceptions) Specify any class of claims that is not impaired Specify any class of claims that is impaired Treat all claims within a particular class alike 176

e f g

3

4

Provide adequate means for the plan’s execution Prohibit the issuance of nonvoting equity securities Contain provisions for the selection of officers and directors that are consistent with the interests of creditors, equity holders, and public policy

For the bankruptcy court to confirm a plan, each class of claims must have accepted the plan or not be impaired under it. a

Within each class, each holder of a claim must either have accepted the plan or receive not less than that holder would receive if the debtor corporation were liquidated.

b

Classes of claims that are unimpaired are assumed to have accepted the plan.

c

Classes that receive nothing are assumed to have rejected it without the necessity of a vote.

d

Acceptance of a plan by a class of claims requires approval of at least two-thirds in amount and over half in number of claims.

After the plan has been approved, the court holds a confirmation hearing. a

Confirmation by the court constitutes discharge of the debtor except for claims provided for in the reorganization plan.

FINANCIAL REPORTING DURING REORGANIZATION A

B

The balance sheet should present pre-petition liabilities subject to compromise separately from those not subject to compromise.

1

Prepetition liabilities subject to compromise are the unsecured and undersecured liabilities incurred before the Chapter 11 filing.

2

Liabilities not subject to compromise include fully secured liabilities incurred before the Chapter 11 filing and all post-petition liabilities.

Effects of reorganization on income and cash flow statements: 1

.

Expenses directly related to the Chapter 11 proceedings are expensed as incurred.

177

2

Revenues, expenses, gains, and losses related to the reorganization are reported separately in the income statement as reorganization items except those required to be reported as discontinued operations.

3

The amount of interest that will be paid during the bankruptcy proceedings, or the probable amount to be allowed, should be reported as interest expense. a

4

Earnings per share are reported as usual. a

5

C

The difference between this amount and contractual interest should be disclosed in a financial statement note.

Probable issuances of common stock under a reorganization plan should be disclosed.

Cash flow items relating to the reorganization should be disclosed separately from other cash flows.

Consolidated financial statements do not provide enough information about bankruptcy proceedings. a

GAAP requires condensed combined financial statements for all entities in reorganization proceedings be presented as supplementary information.

b

Consolidation may be inappropriate for some subsidiaries in bankruptcy (control may not be present if a trustee is appointed to operate the company).

FINANCIAL REPORTING FOR THE EMERGING COMPANY A

The reorganization value of a company approximates the fair value of the entity without considering liabilities, and determines how much creditors will recover on their claims.

B

Financial reporting depends on if the company emerging from bankruptcy is essentially a new company. An emerging company qualifies for fresh start reporting if both of the following conditions are met: 1

.

The reorganization value immediately before the date of confirmation of the reorganization plan is less than the total of all postpetition liabilities and allowed claims, and

178

2

C

D

.

Holders of existing voting shares immediately before confirmation of the reorganization plan receive less than 50% of the emerging entity. The loss of control must be substantive and not temporary.

Fresh start reporting results in a new reporting entity with no retained earnings or deficit balance.

1

The reorganization value of the company is allocated to tangible and intangible assets according to the acquisition method of accounting.

2

Any excess of reorganization value over tangible and identifiable intangible assets is an unidentifiable intangible asset, “reorganization value in excess of the amount allocable to identifiable assets.”

3

Liabilities, other than deferred income taxes, should be reported at their current value at the confirmation date.

4

The final statements of the old entity should disclose the effects of the adjustments on the asset and liability accounts resulting from fresh start reporting and the effects of debt forgiveness. The ending balance sheet of the old entity should be the same as the beginning balance sheet of the new entity, including a zero retained earnings balance.

5

Disclosures in the new balance sheet include those listed above for inclusion in the old balance sheet, plus significant factors relating to the determination of reorganization value.

Companies that do not qualify for fresh start reporting should report liabilities compromised at their present values under the provisions of GAAP. 1

Debt forgiveness should be reported as an extraordinary item.

2

Quasi-reorganization accounting should not be used.

179

Description of assignment material

Minutes

Questions (17) Exercises E18-1 E18-2 E18-3 E18-4 E18-5

Problems P18-1 P18-2 P18-3 P18-4 P18-5 P18-6 P18-7

(5) 4 MC general questions [Hal] 4 MC general questions (Financial reporting during bankruptcy) [Ram/Pat] Financial reporting during bankruptcy - distributions to creditors [Bax] Chapter 11 Fresh start reporting requirements [Hol] Financial reporting during bankruptcy - distributions to creditors (7) [Sco] Financial reporting during bankruptcy [Justin] Financial reporting during bankruptcy [Fabulous Fakes] Claims rankings and cash distribution upon liquidation [Hanna] Financial Reporting during bankruptcy - prepare a statement of affairs [Dawn] Financial reporting during bankruptcy - prepare a statement of affairs [Everlast Window] Financial reporting during bankruptcy [Lowstep] Installment liquidation

Internet assignment Answer questions about Delta Airlines.

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180

25 10 10 15 16

45 30 30 60 80 60 40

Chapter 19 AN INTRODUCTION TO ACCOUNTING FOR STATE AND LOCAL GOVERNMENTAL UNITS Chapter Outline HISTORICAL DEVELOPMENT OF ACCOUNTING PRINCIPLES FOR STATE AND LOCAL GOVERNMENTAL UNITS A

A governmental unit is generally created for the administration of public affairs and has one or more of the following characteristics: 1

Popular election of officers or appointment (or approval) of a controlling majority of the members of the governing body by officials of one or more state or local governments.

2

The potential for unilateral dissolution by a government with the net assets reverting to a government.

3

The power to enact or enforce a tax.

4

The ability to issue debt exempt from federal taxation.

B

Prior to 1984 the National Committee on Governmental Accounting (NCGA), a committee of the Government Finance Officers Association, provided much of the guidance for state and local governmental accounting.

C

The Government Accounting Standards Board (GASB) was formed in 1984. Its first pronouncement, GASB Statement No. 1, Authoritative Status of NCGA Pronouncements and AICPA Industry Audit Guide, designated all NCGA Statements and Interpretations as “generally accepted accounting principles” until changed or superseded by the GASB.

D

In 1985, the GASB integrated all effective accounting and reporting standards into one publication called Codification of Governmental Accounting and Financial Reporting Standards.

E

.

1

This Codification is revised annually with all official GASB pronouncements.

2

Constitutes GAAP for governmental units.

The GAAP hierarchy for state and local governmental units, including special entities, is set forth in GASB Statement No.55, The Hierarchy for State and Local Governments, and identifies the following sources of accounting principles:

181

1

GASB Statements and Interpretations

2

GASB Technical Bulletins (including AICPA Industry Audit and Accounting Guides and Statements of Position if specifically made applicable to state and local governments by the AICPA and cleared by the GASB).

3

Consensus positions of the GASB Emerging Issues Task Force and AICPA Practice Bulletins if specifically made applicable to state and local governments by the AICPA and cleared by the GASB (No GASB Emerging Issues Task Force exists currently).

4

Implementation Guides published by the GASB staff and industry practices that are widely recognized and prevalent in state and local government.

OVERVIEW OF BASIC GOVERNMENTAL ACCOUNTING MODELS AND PRINCIPLES A

The focus of governmental accounting and financial reporting is on accountability to the public and governmental authorities.

B

State and local governmental units engage in both business-type and general governmental activities.

1

Business-type activities provide services to users for a fee that are intended to recover all, or a substantial portion, of the costs of providing the services.

2

General governmental activities provide goods and services to citizens without regard to their ability to pay. a

C

Fund accounting is the use of multiple accounting entities to account for resources segregated according to purpose.

1

A fund is an accounting entity.

2

Each fund is used to account for only a portion of a government's activities, assets, liabilities, and equities.

3

Each fund has a self -balancing set of accounts.

4

There are three broad categories of funds: a

.

Usually financed by taxes or intergovernmental grants and subsidies

Proprietary funds, which are similar to business accounting entities, are used to account for business-type activities.

182

D

b

Governmental funds, which are essentially working capital entities, are used to account for governmental-type activities.

c

Fiduciary or trust and agency funds.

The proprietary fund accounting model is very similar to the business accounting model.

1

Proprietary funds are used to account for activities of government that are financed primarily from user charges – similar to a business activity.

2

Proprietary fund accounting and reporting are very similar to business accounting and reporting.

3

The proprietary fund accounting equation is the same as that for a business except that the term “net assets” is used to represent fund equity.

Current Assets + Non-Current Assets – Current Liabilities – Non-Current Liabilities = Net Assets

E

4

Most proprietary fund transactions are accounted for in the same way that they would be for a similar business operation.

5

Proprietary funds are accounted for using the accrual basis of accounting for revenues and expenses.

The general government accounting model is used to account for most general government functions such as public safety, education, and the judicial system.

1

Governmental funds, in their simplest form, are simply working capital accounting entities.

2

The basic governmental fund accounting equation is: Current assets - Current liabilities = Fund balance

3

Fixed assets and unmatured long-term debt are not accounted for in these funds. a

4

F

The modified accrual basis of accounting is used in governmental funds.

Revenues and expenditures are reported.

The following types of funds are identified for use by state and local governments: 1

.

Records are maintained for both of these types of accounts and reflected in the government-wide financial statements.

Governmental funds include 5 types of funds.

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2

3

G

The general fund to account for all financial resources except those required to be accounted for in another fund.

b

Special revenue funds to account for the proceeds of specific revenue sources (other than permanent funds or for major capital projects or debt service) that are legally restricted to expenditures for specified purposes.

c

Capital projects funds to account for financial resources to be used for the acquisition or construction of major capital facilities (other than those financed by proprietary funds and trust funds).

d

Debt service funds to account for the accumulation of resources for, and payment of, general long-term debt principal and interest.

e

Permanent funds to account for resources that are permanently restricted, but whose earnings are expendable for the benefit of the government or its citizenry.

Proprietary funds include: a

Enterprise funds to account for providing goods and services to the public to be financed by user charges.

b

Internal service funds to account for a department that provides goods and services to other departments of a government on a costreimbursement basis.

Fiduciary funds include: a

Pension trust funds to account for governmental pension plans if the trustee is the government.

b

Investment trust funds to account for the external portion of investment trust pools reported by the sponsoring government.

c

Private-purpose trust funds to report all other trust arrangements.

d

Agency funds account for resources a government is holding as an agent on behalf of third parties outside the government.

Different bases of accounting are used for the general governmental fund model and the proprietary fund model.

1

.

a

The basis of accounting used for proprietary funds, the accrual basis, is essentially the same as for business entities.

184

2

H

I

The basis of accounting for governmental funds is the modified accrual basis, and is unique to governments.

Under the modified accrual basis of accounting 1

Revenues are recognized when they become available and measurable to meet current obligations.

2

Expenditures are recognized in the accounting period in which the liability is incurred (except for unmatured interest on general long-term debt which is recognized when due).

Revenue recognition is determined by the nature of the underlying transaction.

1

Exchange transactions are those in which each party receives and gives up essentially equal values.

2

Non-exchange transactions are those in which a government gives or receives value without directly receiving or giving equal value in exchange. a

Non-exchange transactions include derived tax revenues like sales and income taxes assessed on the value a taxpayer spends or earns,

b

Imposed non-exchange revenues such as property taxes assessed on the property value,

c

Government mandated non-exchange transactions, and voluntary nonexchange transactions like grants and donations.

3

In general, the transaction should be substantially complete prior to revenue recognition.

4

The available criterion means that the revenue must be legally available for expenditure in the period and collected within a specified period (of not more than 60 days) after the end of the fiscal year.

5

The net revenue approach is used.

6

Many investments are accounted for at fair value under GASB Statement No. 31. Therefore, investment income includes changes in the fair value of these investments without regard to the 60-day rule.

J

Expenses of a government unit are similar to those of a business enterprise while expenditures in a government fund reflect the use of working capital.

.

185

1

Expenses are recognized in proprietary funds statements and recognized in the period incurred.

2

Expenditures are recognized in governmental funds statements to reflect the cost of goods acquired during a period, whether or not consumed, and with limited exception, government funds recognize expenditures in the period that the fund liability is incurred under the modified accrual basis.

3

In government-wide statements all funds report expenses under the accrual basis.

4

In governmental funds, the purchase of a fixed asset results in a capital outlay expenditure in the year of acquisition and no additional expenditures in the future. a

5

Proceeds from general long-term debt issuances increase current assets and fund balance but the liability is not recorded in the governmental funds statements. a

K

L

.

The same purchase within a proprietary fund results in a capitalized asset with annual depreciation expense.

The liability will appear within the government-wide statement of net assets for the same item.

Transactions between two funds must be classified into various categories of interfund transactions.

1

Each of these transaction types is accounted for and reported differently.

2

The categories are interfund loans, interfund transfers, interfund services provided and used, and interfund reimbursements.

An annual budget must be adopted by every governmental unit. Only the general fund and special revenue funds are required to use formal budgetary accounting practices.

1

A budget is a plan of financial operations consisting of an estimate of proposed expenditures for a given period and the proposed means of financing them.

2

Appropriations are approved or authorized expenditures. If an appropriation is allocated to a specific time period, it is termed an allotment.

3

A comparison of actual and budgetary amounts is required to be included in the annual operating statement of each governmental fund for which an annual budget has been legally adopted.

186

THE FINANCIAL REPORTING ENTITY A

GASB Statement No. 14, “The Financial Reporting Entity,” explains that the financial reporting unit is made up of the primary government and its component units.

1

The primary government has a separately elected governing body, is legally separate, and is fiscally independent of other state and local government units.

2

Component units are legally separate organizations for which the government is financially accountable or maintains a significant relationship.

3

Component units may be blended with the primary government only if a voting majority of the primary government governing body serves on the component unit governing board and constitutes a voting majority of that board.

4

GASB Statement No. 39, “Determining Whether Certain Organizations are Component Units,” provides criteria for deciding whether organizations should be reported as component units of the primary government.

COMPREHENSIVE ANNUAL FINANCIAL REPORT (CAFR) A

A comprehensive annual financial report (CAFR) should be prepared and published by every governmental entity. The reporting requirements for the CAFR include the preparation government-wide financial statements on the accrual basis of accounting.

B

The CAFR is the entity’s official annual report and has three sections: an introductory section, a financial section, and a statistical section.

.

1

The introductory section of a CAFR includes a table of contents, a letter of transmittal, a list of principal officers, and an organization chart.

2

The financial section includes the MD&A, the auditor’s report, the governmentwide financial statements, and the fund financial statements. a

The auditor’s report of a CAFR indicates the statements are the responsibility of management and expresses an opinion on whether they are presented in conformity with generally accepted accounting principles.

b

The MD&A is a descriptive presentation of the government’s financial activities based on currently known facts, decisions, and conditions. This is similar to a corporate MD&A.

c

Government-wide financial statements provide consolidated information for the government as a whole. Operational Accountability measures 187

the extent of a government’s success at meeting operating objectives efficiently and effectively.

d

1

These statements report governmental activities, business-type activities, and discretely presented components units.

2

All data is reported on the accrual basis.

3

Financial statements include the statement of net assets and the statement of activities.

Individual fund financial statements are presented to focus on fiscal responsibility. Fund financial statements must include a separate column for each major governmental fund.

1

The general fund is always a major fund.

e

Budgetary comparisons for the general fund and special revenue funds must be presented for each fund with a legally adopted budget. These may be presented as a comparison statement within the financial statements or, as a schedule with the CAFR required supplementary information.

f

Governments are required to supply supplementary information on pension plans, budgetary comparisons, and infrastructure assets if applicable.

g

The financial statements include notes and required disclosures essential to the fair presentation of the statements.

h

Under GASB 34, capital assets including infrastructure are capitalized and depreciated on the government-wide financial statements.

i

Combining financial statements that combine individual funds into an aggregate set of totals by classification or activity are a required part of the CAFR.

C

The statistical section of the CAFR contains statistical tables with comparative data from several time periods. Fifteen specific tables should be included unless inapplicable.

D

GASB suggests governments supplement the CAFR with additional information about its service efforts and accomplishments (SEA) deemed important to its citizens.

1

.

SEA is a type of performance measurement, enabling citizens and managers to evaluate the manner and effectiveness of the government’s operations.

188

Description of assignment material Questions Exercises E19-1 E19-2 E19-3 E19-4 E19-5 E19-6 E19-7 E19-8 E19-9 E19-10 E19-11 E19-12 E19-13

Minutes

(23) (13) 5 MC general questions AICPA 5 MC general questions 5 MC general questions 5 MC general questions 5 MC general questions Identification of fund type Transaction analysis - governmental Transaction analysis – proprietary funds Identification of fund type Identification of fund type Identification of fund type [Sioux Falls] Identification of fund type and transaction analysis [Perez] Identification of fund type and transaction analysis

10 10 10 10 10 10 30 20 10 10 10 20 20

Internet assignment 1.

Visit the GASB website and answer questions regarding GASB standards.

2.

Locate the website for the municipality in which your college or university is located and review the CAFR if available.

.

189

Chapter 20 ACCOUNTING FOR STATE AND LOCAL GOVERNMENTAL UNITS – GOVERNMENTAL FUNDS Chapter Outline RECENT CHANGES TO GOVERNMENTAL FUND ACCOUNTING A

GASB statement No. 54 (2009) established five classifications of governmental fund balance listed in decreasing order in spending constraints: 1 2 3 4 5

Nonspendable fund balance Restricted fund balance Committed fund balance Assigned fund balance Unassigned fund balance

THE GENERAL FUND A

The general fund (GF) is the entity that a government uses to account for all unrestricted resources except those to be accounted for in a specific fund. There is only one general fund.

B

Formal budgetary accounting is required.

1

The GASB Codification requires governments classify revenues by source (taxes, licenses) and expenditures by character class (current services, capital outlays) and purpose (general government, public safety).

2

The approved budget is recorded in the accounts of the general ledger as follows: Estimated revenues xxx Appropriations Estimated other financing uses Unreserved fund balance

.

xxx xxx xxx

3

Details of planned revenues are recorded in a subsidiary revenue ledger and appropriation details are recorded in a subsidiary expenditure ledger.

4

Compliance with the approved budget is required. A statement of revenues, expenditures, and changes in fund balance – budget and actual is required to demonstrate compliance with the budget.

190

5

C

Some governments require revenues exceed appropriations, resulting in a balanced budget.

Revenue transactions follow the modified accrual basis of accounting and are recognized in the period they become measurable and available.

1

The 60-day rule helps establish availability.

2

Uncollectible taxes are recorded as revenue adjustments, not expenditures.

3

Derived tax revenues, such as sales and income taxes, are recognized when the underlying transaction (e.g., the sale) takes place.

4

Revenues from other sources such as, licenses, permits, and fines are typically recorded when cash is received.

D

Expenditures are recorded when the related liability is incurred.

E

The law limits expenditures to those for which appropriations have been made.

Encumbrance accounting recognizes commitments made for goods on order and for unperformed contracts to help prevent overspending.

F

Fixed assets do not appear as assets in the governmental fund statements. Instead they are capitalized and included in the government-wide financial statement.

1

Thus, fixed assets are one of the reconciling items between the two statements.

G

Supply acquisitions may be treated as expenditures either when purchased or when used as long as significant amounts of inventory are reported on the balance sheet.

H

Lease agreements fall under the provisions of FASB Statement No. 13. A capital lease is recorded as an expenditure and other financing source as if long-term debt had been issued.

I

Intrafund transfers are classified as reciprocal if the fund expects repayment or nonreciprocal if the flow of assets does not require repayment.

SPECIAL REVENUE FUNDS A

A special revenue fund (SRF) is the fund entity that a government uses to account for specific revenue sources (other than resources from permanent funds, major capital projects, or debt service on general long-term debt) that are restricted by law or administrative action to expenditures for a specific purpose.

1

.

This demonstrates compliance with legal or administrative requirements.

191

2 B

The accounting in an SRF is similar to the accounting in a GF.

Grant funds restricted to a specific purpose are often accounted for in an SRF. 1

Grant revenues can be recognized as such when all eligibility requirements set forth in the grant have been met, if the funds are available to meet current liabilities.

2

If grant funds are disbursed to the government prior to the eligibility requirements having been met, they must be accounted for as deferred revenues.

PERMANENT FUNDS A

Permanent funds (PF) is a new governmental fund category created by GASB 34 that is used to account for nonexpendable resources set aside for support of a government’s programs or citizenry.

1

Governments use a PF to account for contributions for which the grantor specifies that a principal amount must be maintained but for which the interest accumulation or asset appreciation or both may be used for a specific purpose.

2

Revenues will come from interest and asset appreciation.

3

Expenditures will be recorded as incurred.

CAPITAL PROJECTS FUNDS A

.

Capital projects funds (CPF) are governmental funds used to account for resources for the acquisition or construction of major capital facilities other than those financed by trust and proprietary funds.

1

A CPF is created when it is legally authorized and it exists for the life of the project.

2

A CPF uses modified accrual accounting and revenue and expenditure accounts.

Formal budgetary accounting need not be used unless several projects are financed through the same fund, or the governmental unit is the primary contractor for the facilities.

3

A CPF is not required for the acquisition of minor general fixed assets. These acquisitions are accounted for in the general fund or a special revenue fund.

192

4

B

Typical financing sources of a CPF include bond issue proceeds, grants, shared revenues, transfers from other funds, and contributions from property owners (for special assessment projects).

Accounting for a CPF 1

When the fund is created, a memorandum entry is made in the fund for its authorization.

2

Interfund transfers are not revenues and expenditures of the funds involved.

They are nonreciprocal, nonexchange transactions and are classified in the financial statements as “other financing sources or uses.”

3

Bond issue proceeds are recognized in a CPF when the bonds are sold. Bond proceeds are classified in the financial statements as “other financing sources.”

The proceeds from special assessment debt are described as contributions from property owners rather than bond proceeds. a

When bonds are issued at a premium, the full amount of the proceeds is recorded in the CPF and the premium is transferred to the debt service fund. The premium cannot be used as an addition to the project authorization.

b

When bonds are issued at a discount, the proceeds are recorded in the CPF and the discount, in effect, reduces the project authorization unless additional resources are provided for the project from other sources.

c

Authorized but unissued bonds at an interim statement date should not be accrued. The unissued bonds are disclosed in notes to the financial statements.

4

When a contract is awarded, the full amount for the contract is encumbered.

Construction contracts often require that a retained percentage be withheld from progress payments until completion of the project and final inspection.

5

Under modified accrual accounting, intergovernmental revenue may be accrued in some circumstances if the commitment is firm. Restricted grants are recognized as revenues when all grant stipulations, including incurring expenditures for the qualified purpose, are met.

SPECIAL ASSESSMENT ACTIVITIES A

.

Special assessments are tax levies on a limited group of property owners to finance public improvements that are expected to benefit those property owners.

193

1

A special assessments project usually originates when property owners petition the governmental unit for an improvement such as construction of a sidewalk or paving a street.

2

If the project is authorized, the government obtains financing, makes the improvement, and levies the special assessments against the property owners. If the project will also benefit the general citizenry, the government may pay a portion of the cost.

3

Often special assessment bonds are issued to pay the construction costs and the special assessments are collected in installments over the term of the special assessment bond issue. The interest charged on the unpaid special assessment balance is used to cover the interest on the bonds.

4

Capital improvements related to special assessment projects are accounted for in a CPF.

B

Debt service on special assessment debt for which the governmental unit is obligated in some manner is reported in the governmental activities of the government-wide statement of net position.

C

Debt service on special assessment debt for which the governmental unit is not obligated in any way is accounted for in an agency fund. The obligation is disclosed only in notes to the financial statements.

DEBT SERVICE FUNDS A

.

Debt service funds (DSF) are governmental funds that are used to account for the receipt of resources to be used for debt service, and the use of those resources to make principal and interest payments on general long-term debt obligations.

1

A separate DSF is usually created to account for each major general longterm debt issue. However, a DSF is not required by GAAP unless it is legally or contractually mandated or a government is accumulating resources to be used to pay future years' debt service payments.

2

Debt service funds generally use modified accrual accounting to account for revenues and expenditures. a

The GASB Codification identifies a major expenditure recognition exception related to debt service expenditures for general long-term debt.

b

Principal and interest expenditures on general long-term debt are to be recognized in the period that they are legally due and payable, i.e., the period in which they mature.

194

•

However, if the payment is due early (within a few weeks) in the next fiscal year, and resources are available in the fund before the end of the current year, a government is permitted, but not required, to accrue the next principal and interest payment.

B

Debt service funds for term bond issues involve sinking fund operations, as resources are accumulated to retire all of the debt at maturity, as well as accounting for the regular interest payments on the debt.

C

Debt service funds for serial bond issues involve receiving resources as needed and distributing those resources for the principal and interest payments. No significant balances would be carried over from one period to the next.

GOVERNMENTAL FUND FINANCIAL STATEMENTS A

Required governmental fund financial statements include a statement of net position or balance sheet, and a statement of revenues, expenditures, and changes in fund balance.

1

Budgetary comparison information must be presented for the GF and each SRF that has a legally adopted budget. This is required supplementary information.

2

The budgetary basis comparison must be presented on the budgetary basis of accounting, even if it differs from GAAP. A reconciliation of the budget to GAAP statements must appear either on the face of the statements or in the notes to the statements.

PREPARING THE GOVERNMENT-WIDE FINANCIAL STATEMENTS A

B

A government must include governmental fund activities in the government-wide financial statements.

1

These are prepared on the accrual basis rather than the modified accrual basis.

2

There must be a conversion of governmental fund information for the government-wide financial statements. A conversion worksheet is an optional internal document that may be helpful to meet this requirement.

The government-wide financial statements include a statement of net position and a statement of activities.

1

.

GASB 34 requires a reconciliation between the total fund balance for governmental funds (reported on the fund financial statements) and the net position for governmental funds (reported on the government-wide financial statements.

195

2

GASB 34 requires a reconciliation between the change in fund balance (reported on the fund statement of revenues, expenditures, and change in fund balance) and the change in net position (reported on the statement of activities).

3

Both reconciliations may appear either on the face of the fund financial statements or in an accompanying schedule.

Description of assignment material

Minutes

Questions

(21)

Exercises E20-1 E20-2 E20-3 E20-4 E20-5 E20-6 E20-7 E20-8 E20-9 E20-10

(15) 5 MC general questions 5 MC general questions 5 MC general questions 5 MC general questions AICPA 5 MC general questions AICPA 5 MC general and problem-type questions [Jedville] General fund journal entries (property taxes) [Any City] Governmental fund closing entries [Millar] Preparation of fund balance sheet [Madelyn] Preparation of fund statement of revenues, expenditures, and changes in fund balance General fund journal entries [Rochester] General fund journal entries Governmental fund journal entries [Alantown] Governmental fund reconciliation to total net position [Boulder] Governmental fund reconciliation to total net position

E20-11 E20-12 E20-13 E20-14 E20-15 Problems P20-1 P20-2 P20-3 P20-4 P20-5 P20-6 P20-7 P20-8 P20-9 P20-10 P20-11 P20-12

.

(12) [Orchard Park] Preparation of general fund balance sheet [Batavia] Preparation of general fund statements [Tyler] Government fund journal entries, budgetary comparison, and reconciling items [Fort Collins] Governmental fund conversion worksheet AICPA [Oslo] Reconstruct general fund journal entries AICPA [Lahti] Journal entries from the trial balance [Volendam] Preparation of fund statement of revenues, expenditures, and changes in fund balance [Lilehammar] Debt service fund journal entries [Stockholm] Capital projects fund journal entries [Malmo] Journal entries associated with a capital project AICPA [Cerone] Capital projects fund journal entries and balance sheet [Catalina] Capital projects fund journal entries and financial statements

196

10 10 12 10 10 20 15 20 20 20 25 25 15 20 20

25 30 45 30 30 30 25 20 20 25 40 50

Internet assignment 1.

Choose a CAFR from a city, state, or local government. Answer questions relating to the government unit you selected.

2.

Using the website from the municipality where your college or university is located, answer questions.

3.

Using the website from the county where your college or university is located, answer questions.

.

197

Chapter 21 ACCOUNTING FOR STATE AND LOCAL GOVERNMENTAL UNITS – PROPRIETARY AND FIDUCIARY FUNDS Chapter Outline PROPRIETARY FUNDS A

Proprietary funds are used to account for business-type activities providing goods and services to users and financing those services primarily from user charges.

1

Proprietary funds are accounted for using the accrual basis of accounting for revenues and expenses. a

Revenues are recognized when earned and measurable.

b

Expenses are recognized in the period incurred, if measurable.

2

Fixed assets of the proprietary fund are fund fixed assets. Long-term obligations expected to be serviced by proprietary fund revenues are fund longterm debt.

3

Lease agreements of proprietary funds are accounted for within the fund under the provisions of FASB Statement No. 13. a

B

Accounting and reporting standards applicable to proprietary activities are provided in GASB Statement No. 20 as follows: 1

2

.

Except operating leases with scheduled rent increases, which recognize rental revenue as it accrues over the lease term.

Governmental proprietary activities must apply: a

All applicable GASB statements and

b

All FASB and predecessor standards issued before November 30, 1989 that do not conflict with GASB standards

Governmental proprietary activities may either apply: a

All FASB standards issued after November 30, 1989 as long as they do not conflict with GASB standards, or

b

No FASB standards issued after November 30, 1989 even if they modify or rescind earlier issued FASB statements.

198

C

Proprietary funds include enterprise funds and internal service funds.

INTERNAL SERVICE FUNDS A

Internal service funds (ISF) provide goods and services to other departments or agencies of the governmental unit on a cost reimbursement basis.

1

B

In some cases, the initial financing for the fund comes from the governmental unit. a

A contribution (nonreciprocal transfer) is classified as a part of fund equity.

b

The government may provide a loan to the ISF to be recorded as a long-term liability that will be repaid from future operating flows of the fund.

c

Short-term interfund loans are recorded as “due to GF” and “due from ISF,” etc.

d

Receivables from the sale of goods and services are recorded as revenues to the ISF with a corresponding “due from GF” or “due from SRF,” etc.

ISF are reported in a unique manner under GASB 34 because they provide goods and services to government units.

1

In fund financial statements they are reported with the proprietary funds. a

2

.

All ISF are aggregated into a single column within the proprietary fund financial statements.

Within the government-wide financial statements, ISF are reported with the government activities. a

ISF balance sheet accounts are included in the statement of net assets.

b

The statement of activities only includes ISF revenues and expenses resulting from transactions involving entities outside the primary reporting entity.

c

Thus, interfund transactions are eliminated much like they are in consolidated financial statements.

199

ENTERPRISE FUNDS A

An enterprise fund (EF) provides goods and services financed through user charges to the general public on a continuing basis.

1

Enterprise funds may be used for any service for which there is a significant potential for financing through user charges.

2

Enterprise funds must be used for any business activities:

3

B

a

Financed with debt secured solely by net revenue from fees and charges to external users,

b

Operating under laws or regulations requiring the cost of providing the service, including capital cost, be recovered through user charges,

c

Establishing prices to cover the costs, including capital, to cover the cost of providing the service.

The accounting is essentially the same as for the ISF, and the same financial statements are required.

Utilities frequently require customer deposits before service starts and refund those deposits when service is terminated.

1

Deposits from developers are segregated and reported as restricted assets in the EF balance sheet.

2

Customer deposits remain in current liabilities until they are applied against unpaid bills or refunded to customers.

PROPRIETARY FUND FINANCIAL STATEMENTS A

Required fund financial statements include: 1

A statement of net assets or balance sheet a

.

In place of the stockholder’s equity section, a government’s net assets include capital assets, net of related debt; restricted net assets, and unrestricted net assets

2

A statement of revenues, expenses, and changes in net assets

3

A statement of cash flows 200

a

The direct method is required.

b

GASB’s cash flows statement has 4 separate sections: • • • •

Cash flows from operating activities, Cash flows from noncapital financing activities, Cash flows from capital and related financing activities, and Cash flows from investing activities.

FIDUCIARY FUNDS A

Fiduciary funds are used to account for assets held by the government as trustee or agent for another entity and include agency funds, private-purpose trust funds, investment trust funds, and pension trust funds.

1

B

The accrual basis of accounting is used.

Agency funds (AF) do not have revenues or expenses since their operations are of a custodial nature.

1

2

Agency funds are used when agency responsibilities involve numerous transactions, include several different governmental units, and/or do not arise from normal and recurring operations of another fund. a

A separate agency fund is not required when regular liability accounting is adequate to show how the local government’s fiduciary responsibilities have been met (collection of state sales taxes, for example).

b

Agency funds are used for the debt service transactions of a special assessment bond issue when the government is not obligated in any manner.

Operations of agency funds are custodial: a

Agency funds have asset and liability accounts, but they do not have revenues and expenses.

b

The accounting equation for an agency fund: Assets = Liabilities

3

.

AFs are included in the statement of fiduciary net assets. They are not included in the government-wide financial statements.

201

C

Trust funds (TF) 1

Investment trust funds are fiduciary funds used to account for multigovernment external investment pools sponsored by the governmental entity. a

2

Private purpose trust funds are used to account for resources (other than investment pool and employee benefits) that are held for the benefit of parties outside the governmental entity. a

3

GASB Statement No. 31 describes the accounting for investment trust funds. Accounting for investment trust funds is not covered in depth in this chapter.

Financial statements for a private purpose trust fund include a statement of fiduciary net assets, and a statement of changes in fiduciary net assets.

Pension trust funds (PTFs) are reported following specialized guidance for defined benefit pension plans. a

Two financial statements are required – a statement of plan net assets and a statement of changes in plan net assets.

b

A schedule of funding progress and a schedule of employer contributions, reporting actuarial information must be presented as required supplementary information.

c

Governments account for public retirement systems (PERS) through pension trust funds. There are 2 types: defined benefit and defined contribution. Pension plans can be single-employer or multipleemployer.

d

Accounting and reporting for pension trust funds is governed by GASB Statements No. 25 & 27. Reporting differs for governmental funds and proprietary funds.

e

GASB Statements No. 43 and No. 45 establish standards for reporting, measuring, recognizing and displaying other post employment benefits (OPEB) to qualified employees.

PREPARING THE GOVERNMENT-WIDE FINANCIAL STATEMENTS A

The government-wide financial statements include a column for business-type activities that includes enterprise fund amounts only.

.

202

1

Since the accrual basis is used for the proprietary funds, the amounts can simply be transferred from the fund statements to the government-wide statements with the following exception: a

2

Internal balances must be eliminated or shown as interfund balances in the statement of net assets.

Internal service funds are reported with governmental activities with internal balances eliminated.

REQUIRED PROPRIETARY FUND NOTE DISCLOSURES A

EF debt backed by revenue-generating activity must present certain detailed segment information in the notes to the financial statement.

Description of assignment material

Minutes

Questions

(16)

Exercises E21-1 E21-2 E21-3 E21-4 E21-5 E21-6 E21-7 E21-8 E21-9 E21-10

(10) 5 MC general questions AICPA 5 MC general questions 5 MC general questions 5 MC general questions AICPA 6 MC questions (problems) [Laramee] Agency fund statement of net assets Enterprise Fund journal entries and reporting Identification of fund type Journal entries – various funds Net asset classification

10 10 10 10 20 20 15 15 20 10

Problems P21-1 P21-2 P21-3 P21-4 P21-5 P21-6 P21-7

(7) [Thomasville] Internal service fund entries [Fiedler] Enterprise fund journal entries and trial balance [Douwe] Preparation of internal service fund statements [Monee] Preparation of trust fund statements [Duchy] Preparation of trust fund statements AICPA [Meringen] Internal service fund journal entries [Caleb] Enterprise fund statement of cash flows

25 30 28 30 30 35 35

Internet assignment 1.

Select a CAFR from a city, county, or local government and answer questions relating to proprietary and fiduciary funds.

2.

Using the website for the municipality of your college or university, answer questions .

203

3.

.

relating to utilities.

Locate the website for your hometown, and answer questions pertaining to transit services.

204

Chapter 22 ACCOUNTING FOR NOT-FOR-PROFIT ORGANIZATIONS Chapter Outline THE NATURE OF NOT-FOR-PROFIT (NFP) ORGANIZATIONS A

B

An NFP organization possesses the following characteristics: 1

Receives significant contributions from resource providers who do not expect a commensurate return.

2

Operates for purposes other than to provide goods and services at a profit.

3

Does not possess ownership interests like those of a business.

NFP organizations fall into one of the following four categories: 1

Voluntary health and welfare organizations,

2

Other not-for-profit organizations,

3

Health care entities, and

4

Colleges and universities.

C

An NFP organization must be designated as governmental or non-governmental to determine if they will follow GASB or FASB standards.

D

A governmental NFP organization meets the earlier criteria described and also possesses one of the following:

E

.

1

Officers are elected by popular vote or appointed by a government.

2

A government can unilaterally dissolve the entity with net assets reverting back to the government.

3

The entity has the power to enact and enforce a tax levy.

Governmental NFP organizations are considered special purpose governments and are generally required to follow GASB standards, but their reporting requirements may be reduced.

205

F

Nongovernmental not-for-profit organizations, colleges and universities, and hospitals are required to follow FASB pronouncements.

NOT-FOR-PROFIT ACCOUNTING PRINCIPLES A

B

Unique financial accounting and reporting principles applicable to nongovernmental not-for-profit entities are set forth primarily in FASB Statement Nos. 116 (accounting for contributions), 117 (financial statement display), 124 (accounting for investments), 136 (transfers of assets), and 157 & 159 (fair value).

1

The AICPA audit guide, Audits of Not-for-Profit Organizations provides guidance for accounting and reporting for voluntary health and welfare organizations, private colleges and universities, and other NFP organizations.

2

The FASB has issued an exposure draft to develop guidance on reporting for combinations of NFP, expected to be issued as a standard in 2005.

Financial Statements provided by an NFP organization include a statement of financial position, statement of activities, statement of cash flows, and accompanying notes.

1

Voluntary health and welfare organizations must also provide a statement of functional expenses.

2

Reporting requirements are based on a division of net assets into three classifications depending on the existence or absence of donor-imposed restrictions.

3

.

a

Permanently restricted net assets are the portion of net assets whose use is limited by donor-imposed stipulations that do not expire and cannot be removed by action of the not-for-profit entity.

b

Temporarily restricted net assets are the portion of net assets whose use is limited by donor-imposed stipulations that either expire (time restrictions) or can be removed by the organization fulfilling the stipulations (purpose restrictions).

c

Unrestricted net assets are the portion of net assets that carry no donor-imposed stipulations. Net assets restricted by the governing board of the not-for-profit entity are classified as unrestricted.

NFP entities use the accrual basis of accounting.

206

4

The statement of financial position reports total assets, total liabilities, the three classes of net assets, and total net assets. a

5

.

Assets do not need to be disaggregated on the basis of donor restrictions but assets with donor-imposed restrictions that limit their use to long-term purposes should be separated from assets available for current use.

The statement of activities provides information about the change in amount and nature of net assets. a

Depreciation expense is recognized on all long-lived assets including donated assets. Works of art and historical treasures that meet certain criteria may be treated as collections and need not be capitalized and depreciated.

b

Revenues, expenses, gains, and losses and other changes should be presented by net asset class.

1

Revenues increase unrestricted net assets unless the use of the assets received is limited by donor-imposed restrictions.

2

Expenses decrease unrestricted net assets.

3

Generally, revenues and expenses are reported gross and gains and losses are reported net. Investment income is reported net of related expenses.

4

Expenses must be classified by function as either program services or support services. a

Program services are activities that fulfill the purpose of the organization, such as distributing goods and services to recipients.

b

Supporting services include management and general, fundraising, and membership development activities.

5

A statement of functional expenses is required for voluntary health and welfare organizations. The statement reports expenses by function and by natural classifications in a matrix format.

6

A statement of cash flows for the NFP uses the same classifications as business entities, except that the definition of financing activities is expanded to include resources that are 207

donor restricted for long-term purposes. Cash restricted for longterm purposes is excluded from cash.

C

Contributions are defined as an unconditional transfer of assets or settlement of a liability in a voluntary, nonreciprocal transfer by another entity acting other than as an owner.

1

Examples of contributions are cash, long-lived assets, gifts in kind, securities, use of facilities, services, and promises to give. a

Promises to give are verifiable written or oral agreements to contribute cash or other assets. They may be conditional or unconditional.

1

Unconditional promises to give are recognized as revenues in the period in which the promise to give is received.

2

Conditional promises to give are recognized as revenues in the period in which the conditions are substantially met. A conditional gift of cash or other assets may have to be returned to the donor if the condition is not met, and it should be accounted for as refundable advance.

b

Other contributions are generally recorded at their fair values and recognized as revenues or gains in the period received.

c

Contributions may have conditions, be restricted, or be unrestricted by the donor.

d

1

A donor-imposed condition provides that the donor’s money be returned if the condition is not met.

2

A donor-imposed restriction limits the use of the contributed assets.

Expiration of a donor-imposed restriction is recognized in the period the time restriction expires or the purpose restriction is met by a qualifying expenditure. If a contribution has more than one restriction, the effect of the expiration is recognized when the last restriction expires.

1

e

.

Resources in temporarily restricted net assets are reclassified as unrestricted net assets, and net assets released from restrictions are reported in the statement of activity.

Gifts of long-lived assets may be either restricted or unrestricted.

208

D

E

.

1

The assets are reported as restricted support in temporarily restricted net assets if donor restricted or if the organization has a policy of implying a time restriction over the life of the asset. Depreciation is recorded as an expense in unrestricted net assets, and an equal (typically) amount is reclassified from temporarily restricted net assets to unrestricted net assets.

2

If the organization has no policy of implying a time restriction on gifts of long-lived assets and the gift is not donor restricted, the asset is reported as unrestricted support that increases unrestricted net assets.

Contributions do not include exchange transactions, agency transactions, and certain gifts in kind.

1

Exchange transactions are reciprocal transfers such as the sale of goods and services. Resources received in exchange transactions are unrestricted revenues and net assets, even if the resource provider limits their use.

2

Agency transactions are transfers of assets to the not-for-profit entity for which it has no discretion on the use or disposition of the resources, and the assets are passed on to a third party. The receipt of assets increases the assets and liabilities of the not-for-profit entity and disbursement of the resources decreases the assets and liabilities.

3

Gifts in kind are contributions if the not-for-profit entity has discretion over the disposition of the resources and a fair value can be reasonably determined.

4

FASB Statement No. 116 limits the recognition of contributed services to those which (a) create or enhance nonfinancial assets of the organization or (b) require specialized skills, are provided by people with those skills, and would need to be purchased if not received through donation.

NFP organizations measure contributions at fair value.

1

FASB Statement No. 116 identifies quoted market prices as the best estimate of fair market value. If a reasonable estimate of fair market value cannot be made, the contribution should not be recognized.

2

If the fair value of a contributed asset changes significantly between the pledge date and the date received, no additional revenue is recognized for increases in the value. If the value decreases, the difference is reported as a change in the net asset class in which the revenue was originally reported.

209

F

FASB Statement No. 116 encourages capitalization of collections of arts and treasures but does not require it as long as the assets are held for public exhibition rather than financial gain.

G

Many NFP organizations use fund accounting as a convenient method for segregating their accounting records by specific purposes but fund accounting is not required.

VOLUNTARY HEALTH AND WELFARE ORGANIZATIONS A

Voluntary health and welfare organizations (VHWO) are supported by and provide services to the public.

1

VHWO follow FASB standards, and the AICPA Audit and Accounting Guide, Audits of Not-for-Profit Organizations.

NON-GOVERNMENTAL NOT-FOR-PROFIT HOSPITALS AND OTHER HEALTH CARE ORGANIZATIONS (HCO) A

B

Hospitals and other health care providers may be organized as governmental not-forprofit entities, nongovernmental not-for-profit entities, or business enterprises owned by investors and operated for profit.

1

Accounting for a hospital or other health care provider depends on its organization.

2

The AICPA Audit and Accounting Guide, Health Care Organizations, provides guidance for accounting and reporting for both governmental and nongovernmental HCO. Both the GASB and the FASB have approved the AICPA guide.

Hospital operating revenue consists of patient service revenues, premium fees, and other operating revenues.

1

Patient service revenue includes nursing services and other professional services. Patient service revenue is reported net of contractual adjustments, charity services, and courtesy discounts. a

.

Patient revenues are recorded at full established fees when service has been rendered. For uncollectible amounts, bad debt expense is recorded and an allowance account is used to reduce net receivables for estimated bad debt.

210

b

Charity care is provided free to qualifying patients. Charity care is excluded from gross patient service revenues and from expenses.

2

Premium fees, subscriber fees, or capitation fees are revenues from agreements to provide services without regard to actual services provided.

These are recorded separately from patient service revenue.

3

The classification “other operating revenue” includes revenue from services to patients other than for health care, and revenues from sales and services provided to nonpatients.

C

Hospitals record operating expenses on an accrual basis and usually include functional categories for nursing services, other professional services, general services, fiscal services, administrative services, interest, and depreciation provisions.

D

Nongovernmental health care entities' financial statements include a balance sheet or statement of financial position, a statement of operations, a statement of changes in net assets, and a statement of cash flows and follow essentially the same guidance as other nongovernment, not-for-profit entities.

PRIVATE NOT-FOR-PROFIT COLLEGES AND UNIVERSITIES A

Primary authority over accounting principles comes from the FASB. The AICPA Audit and Accounting Guide: Not-For- Profit Organizations incorporates FASB standards.

B

Colleges and universities use accrual accounting. Revenues are recognized when earned and expenses are recognized when the related materials or services are received.

1

Unrestricted expenses are broadly classified as educational and general expenditures or as auxiliary expenditures. Functional classifications include the following: a b c d e f g h

.

Instruction Research Public service (activities to provide noninstructional services to external groups) Academic support (support for instruction, research and publications) Student services (amounts spent for admissions, registrar, and student well-being) Institutional support (administration and long-range planning) Operation and maintenance of plant (does not include auxiliary enterprises and university hospitals) Scholarships and fellowships

211

C

As with other NFP organizations, private colleges and universities classify net assets, and revenues, expenses, gains, and losses based on the existence or absence of donor-imposed restrictions (unrestricted, temporarily restricted, or permanently restricted), in accordance with FASB pronouncements.

D

The required financial statements of a college or university include a statement of financial position, a statement of activities, and a statement of cash flows (direct or indirect method). There are acceptable alternatives to the statement of activities.

E

Internal Accounting and Control – the AICPA model – The AICPA fund structure is typically used by colleges and universities in their accounting structure for internal control purposes. Private colleges and universities are now required to report their resources based on restrictions rather than fund. The fund accounting structure is based on the following 6 funds and as many subgroups as needed.

1

The current operating funds grouping includes the resources that are expendable for operating purposes. Only current funds have revenues and expenditures. Revenues are classified by source and expenditures are classified by function. The current operating funds grouping contains two subgroups: restricted current funds and unrestricted current funds.

2

The loan funds group accounts for resources held to provide loans to students.

3

The endowment funds group consists of gifts with specified maintenance and distribution. A separate fund is used for each endowment.

4

Annuity and income funds account for special types of endowments.

5

The plant funds group account for the financial resources of the physical plant, additions, improvements, replacements, and related indebtedness.

6

Agency funds are used to account for assets held in trust for students, faculty members, or their organizations.

Description of assignment material

Minutes

Questions

(21)

Exercises E22-1 E22-2 E22-3 E22-4 E22-5 E22-6

(9) 5 MC general questions (nongovernmental not-for-profit entities) 5 MC general questions (nongovernmental not-for-profit entities) 5 MC general questions (voluntary health and welfare organizations) 5 MC general questions (colleges and universities) 5 MC general questions (colleges and universities) 5 MC general questions (hospitals)

.

212

10 10 10 10 10 10

E22-7 E22-8 E22-9 Problems P22-1 P22-2 P22-3 P22-4 P22-5 P22-6 P22-7 P22-8

5 MC general questions (hospitals) Not-for-profit expense classifications (voluntary health and welfare organization) Journal entries - various NFP organizations (8) Journal entries - various NFP organizations [Share Shop] Journal entries - Voluntary health and welfare organization [Hometown Hospital] Statement of operations - Nongovernmental not-for-profit health care organization Journal entries and statement of activities – Nongovernmental not-for-profit college [Community Society] Statement of activities - Nongovernmental not-for-profit entity Journal entries - Nongovernmental not-for-profit university [Good Grubb] Journal entries – Voluntary health and welfare organization [Fort Collins] Non-governmental not-for-profit health care organization

Internet assignment 1.

Find financial statements for the United Way on the web and answer questions.

2.

Visit the AICPA website and summarize an article from Journal of Accountancy.

3.

Visit NACUBO’s website and prepare a summary of an advisory report.

4.

Visit guidestar.com, obtain Form 990, and answer questions.

.

213

10 15 30

30 25 25 25 25 25 20 35

Chapter 23 ESTATES AND TRUSTS Chapter Outline FIDUCIARY ACCOUNTING A

Estate and trust managers operate in a good-faith custodial relationship with the beneficiaries.

B

A fiduciary (individual or entity authorized to take possession of the property of others) could be an executor, a trustee, an administrator, and a guardian.

ESTATES AND TRUSTS A

Both are subject to various laws: 1 2

Estates are subject to probate laws (vary among states).

Estates and Trusts may be subject to taxation: a Inheritance taxes – federal and state b Income taxes – federal and state

ESTATES A

Come into existence upon the death of an individual.

B

Testate refers to dying with a will. Intestate refers to dying without a will.

C

Consist of property owned at date of death.

D

Estates Testate Will Executor

E

Steps in Estate Administration: 1 2 3 4 5

.

Intestate No Will Administrator

Petition filed with probate court to probate a will – testacy proceeding to determine will validity.

Confirmation Representative is appointed Distribution of estate property Estate administration 214

a b c

d e f g

Personal representative distributes via will to devisees (heirs) or laws of intestate succession.

Devisees can be specific or general.

The Uniform Probate Code (UPC) says an intestate estate goes to spouse if no descendants or all surviving descendants if also descendants of surviving spouse. If descendants from prior marriage, spouse gets first $100,000 and one-half of the rest. The other one-half goes to descendants (see state law).

Inventory of estate property is prepared within 3 months including FMV at date of death and any liens.

Homestead allowance allows the surviving spouse to exempt certain property from claims against the estate.

Reasonable family allowance during administration is permitted.

Claims: 1) 2)

3) 6

Notice is published to present claims within 4 months or be barred.

If insufficient funds, the UPC says pay as follows: a) Costs and expenses of administration b) Reasonable funeral and necessary pre-death medical expenses c) Debts and taxes with preferences under federal or state law d) All other claims Secured claims may be paid.

Estate Accounting a Inventory is recorded including assets assumed and liabilities paid. b Fiduciary must distinguish between principal and income (applies to estates and trusts). This process follows the Revised Uniform Principal and Income Act. Principal - Expenses to settle estate - Asset at death including receivables/bonds included at FMV - Gains and losses on disposal of principal assets c

Journal entries distinguishing principal from income are made.

Examples Assets – prin XXX Est. Prin XXX To open estate

.

Income - Income earned after death (revenue – expenses)

215

Assets – inc XXX Est. Inc

XXX

Est. Prin XXX Assets XXX To close estate .

d

Est. Inc XXX Assets

XXX

Charge and Discharge Statement is prepared Estate Principal I charge myself for …

I credit myself for …

Assets remaining Estate Income I charge myself for …

I credit myself for …

Assets remaining

e

Estate Taxation 1)

2)

7

Economic growth and Tax Relief Reconciliation Act of 2001 (see Exhibit 23-3 in text for tax rate schedule). Tax repealed in 2010 but returned in 2011.

Federal and possibly state income taxes might apply.

Federal Form 1041, U.S. Fiduciary Income Tax Return, must be filed. Schedule K-1 is used to report beneficiary’s share of revenue.

Trust Accounting a Testamentary trust is created pursuant to a will and is administered by a trustee. b Accounting generally parallels estate accounting after the trust is created.

Description of assignment material

Minutes

Questions (12) Exercises (12) E 23-1 [Rock] Journal entries for estate E 23-2 [Rainey] Journal entries for estate E 23-3 [Troy] Journal entries for estate E 23-4 [Tim/Triciao] Accounting for an estate E 23-5 [Carpenter] Journal entries and accounting for an estate E 23-6 [Sooner XXV] Prepare journal entries for a trust .

216

15 15 15 15 25 20

E 23-7 [Sooner XXV] Prepare charge and discharge statement E 23-8 [Lisa Ann] Prepare journal entries for a trust E 23-9 [Josephine Frederick] Prepare journal entries for a trust E 23-10 [Dogbert] Estate tax calculation E 23-11 [Rainy] Estate tax calculation E 23-12 [Jerome] Estate tax calculation

15 15 15 10 10 10

Problems (8) P 23-1 [Olson] Estate accounting P 23-2 [Olson] Creation of a trust P 23-3 [Wilson] Estate accounting P 23-4 [Wilson] Charge and discharge statement for an estate P 23-5 [Wilson] Creation of a trust P 23-6 [Josephson] Estate accounting P 23-7 [Josephson] Charge and discharge statement for an estate P 23-8 [Josephson] Creation of a trust

30 20 20 15 15 20 15 15

Internet assignment Answer questions about your state’s inheritance/estate tax, your state’s version of the Revised Uniform Principal and Income Act, and, intestate distribution for your state.

.

217

Chapter 1 ELECTRONIC SUPPLEMENT SOLUTIONS Solution W1-1 The acquisition method follows traditional accounting. The net assets acquired in the business combination are recorded based on their fair market value at the combination date. Under pooling, the net assets are recorded based on their existing book values on the records of the combining companies.

Solution W1-2 If total paid-in capital of the combining companies exceeded the par or stated value of the outstanding shares of the surviving company, the amount of excess becomes the additional paid-in capital of the surviving company, and the total retained earnings of the combining companies becomes the retained earnings of the surviving company. If the par or stated value of outstanding shares of the surviving exceeded the total paid-in capital of the combining companies, the combined retained earnings is reduced by the excess and the surviving company has no additional paid-in capital.

Solution W1-3 Under both pooling and the acquisition method, all costs of the combination are recorded as expenses of the combined companies in the year of combination. Costs of registering and issuing securities are an exception. These are charged against additional paid-in of the parent/acquirer.

Solution W1-4 1.

d

2.

d

d

2.

b

b

2.

c

Solution W1-5 1.

Solution W1-6 1.

3.

a

Solution W1-7 Net assets (+A) Common stock (+SE) APIC (+SE) Retained earnings (+SE) Expenses (E,-SE) Cash (-A)

2,200 1,200 800 200 60 60

Solution W1-8 Net assets (+A) 2,070 Common stock (+SE) Retained earnings (+SE) Investment in Service Corporation (-A)

1,470 570 30

Solution W1-9 Pooled Balance Sheets Tansy

Vatters

800,000 shares

1,000,000 shares

Current assets

15,000

4,000

19,000

19,000

Plant assets - net

40,000

6,000

46,000

46,000

Total assets

55,000

10,000

65,000

65,000

Liabilities

10,000

3,000

13,000

13,000

Common stock

30,000

4,000

38,000

40,000

APIC

3,000

2,000

2,000

0

Retained earnings

12,000

1,000

12,000

12,000

Total equities

55,000

10,000

65,000

65,000

Solution W1-10 1.

2.

Net assets (+A) Common stock (+SE) APIC +-SE) Retained earnings (+SE)

800

Net assets (+A) Common stock (+SE) Retained earnings (+SE)

800

350 150 300

770 30

Solution W1-11 Net assets (+A) Treasury stock (-SE) Common stock (+SE) APIC (+SE) Retained earnings (+SE)

11,500 500 10,000 1,000 1,000

Solution W1-12 Part 1. a.

Investment in EPA (+A) Common stock (+SE) APIC (+SE) Retained earnings (+SE) b.

18,300 13,000 4,000 1,300

Investment in Century (+A) 18,700 Common stock (+SE) 12,000 Retained earnings (+SE) 6,700 Note: Century=s Inventory and Retained Earnings would each have increased by $1,000 to reflect the change to FIFO. The adjustment would have been made prior to recording the combination.

c.

Other expenses (E,-SE) Cash (-A)

200 200

Part 2.

Patio Assets Cash Receivables - net Inventories Investment in EPA Investment in Century Land Building - net Equipment - net Total assets Liabilities & Equity Accounts payable Bonds payable Capital stock APIC Retained earnings Total equities

EPA

2,000 3,000 5,500 21,000

4,000 5,000 14,000 18,300 18,700 3,000 10,500 8,500 82,000

Eliminations DR CR POOLE D 4,000 5,000 14,000 18,300 0 18,700 0 3,000 10,500 8,500 45,000

2,300 0 6,000 2,700 10,000 21,000

5,000 3,000 41,000 8,300 24,700 82,000

5,000 3,000 25,000 1,300 10,700 45,000

Century Combined

3,000 3,500 6,000

1,000 1,500 8,000

37,000

1,000 7,500 3,000 24,000

25,000 1,300 10,700 37,000

2,700 3,000 10,000 4,300 4,000 24,000

18,300 18,700

16,000 7,000 14,000 37,000 37,000

Solution W1-13 Pooling Ainsley

Biker

Elimin.

CR

DR

Assets Cash 3,000 Receivables - net 5,500 Inventories 6,000 Other current assets 1,500 Investment in Biker 7,000 Plant assets - net 16,000 Total assets 39,000

5,000 12,000

Consolidate d 4,000 7,500 9,500 2,000 7,000 0 21,000 44,000

Liabilities & Equity Accounts payable 5,000 Other liabilities 3,800 Capital stock 20,000 APIC 3,000 Retained earnings 7,200 Total equities 39,000

1,800 3,200 3,000 1,200 2,800 12,000

3,000 1,200 2,800 7,000

6,800 7,000 20,000 3,000 7,200 44,000

Biker

DR

1,000 2,000 3,500 500

Acquisition Method Ainsley Assets Cash 3,000 Receivables - net 5,500 Inventories 6,000 Other current assets 1,500 Investment in Biker 12,500 Goodwill Plant assets - net 16,000 Total assets 44,500

5,000 12,000

Liabilities & Equity Accounts payable 5,000 Other liabilities 3,800 Capital stock 20,000 APIC 10,500 Retained earnings 5,200 Total equities 44,500

1,800 3,200 3,000 1,200 2,800 12,000

1,000 2,000 3,500 500

7,000

Elimin.

CR

500 100 2,300 2,400

200 3,000 1,200 2,800 12,500

Consolidate d 4,000 7,500 10,000 2,100 12,500 0 2,300 23,400 49,300

12,500

6,800 6,800 20,000 10,500 5,200 49,300

Chapter 3 ELECTRONIC SUPPLEMENT SOLUTIONS Solution W3-1 If the combining companies continue to exist as separate legal entities, then pooling procedures are based on parentsubsidiary accounting procedures.

Solution W3-2 The parent company accounts for its investment on its records using the equity method of accounting (cost method or partial equity method accounting are also acceptable). In preparing financial statements, the parent company must consolidate the pooled subsidiary. Pooling differs from acquisition method accounting in that it is based on recorded book values of the subsidiary=s net assets, not fair values at the combination date.

Solution W3-3 A parent company may pool all of the retained earnings of a 100% owned subsidiary, as long as the par value of shares issued in the combination is less than or equal to the par value of the outstanding stock of the subsidiary.

Solution W3-4 The Investment account represents the parent company=s share of the net assets of the subsidiary company. The capital stock account records parent company shares issued in the combination at par value. Retained earnings are subsidiary company retained earnings being recognized by the combined company (again based on the percentage of shares acquired). The APIC represents a plug figure to balance the entry. It also can be viewed as APIC of the subsidiary being recognized by the combined company.

Solution W3-5 Yes, the parent was able to recognize the full amount of retained earnings. This is evidenced by the credit to retained earnings. The APIC will be less than the parent company APIC prior to the pooling. The entry records a decrease in APIC. Solution W3-6 GAAP requires that subsequent acquisition of noncontrolling interest shares be accounted for using the acquisition method. Therefore, the 4% interest would have been recorded using fair value at the acquisition date. All subsequent share purchases are treated as treasury stock transactions.

Solution W3-7 1.

Investment in Sun (+A) Capital stock (+SE) APIC (+SE) Retained earnings (+SE)

1,260 500 580 180

Solution W3-7 (continued) 2.

Eliminations Pal *

Sun

Debits

Credits

Current assets

4,000

Investment in Sun

1,260

Plant assets - net

6,000

1,400

7,400

Total assets

11,260

2,200

12,200

Liabilities

4,000

800

4,800

Noncontrolling interest (10%)

800

Consolidated 4,800

1,260

-

140

-

140

Capital stock

3,500

800

800

3,500

Additional paid-in capital

2,580

400

400

2,580

Retained earnings

1,180

200

200

1,180

Total equities

11,260

2,200

12,200

* Reflects investment entry.

Solution W3-8 1.

Investment in Sir (+A) 500,000 Common stock (+SE) APIC (+SE) Retained earnings (+SE)

250,000 100,000 150,000 Eliminations

Pam * Capital stock

Sir

Debits

Credits

Consolidated

1,000

300

300

1,000

Additional paid-in capital

600

50

50

600

Retained earnings

350

150

150

350

* Reflects investment

Solution W3-8 (continued) 2.

Investment in Sir (+A) 450,000 Common stock (+SE) Retained earnings (+SE)

350,000 100,000 Eliminations

Pam * Noncontrolling interest (10%)

Sir

Debits

Credits

-

50

Consolidated 50

Capital stock

850

300

300

850

Additional paid-in capital

500

50

50

500

Retained earnings

300

150

150

300

* Reflects investment Solution W3-9 1.

Investment in Sal (+A) Common stock (+SE) APIC (+SE) Retained earnings (+SE)

5,000,000 3,000,000 1,500,000 500,000 Eliminations

Pen *

Sal

Debits

Credits

Consolidated

Capital stock

13,000

3,000

3,000

13,000

Additional paid-in capital

2,500

1,500

1,500

2,500

Retained earnings

5,500

500

500

5,500

* Reflects investment 2.

Investment in Sal (+A) Common stock (+SE)

5,000,000 5,000,000 Eliminations Pen *

Sal

Debits

Credits

Consolidated

Capital stock

15,000

3,000

3,000

15,000

Additional paid-in capital

1,000

1,500

1,500

1,000

Retained earnings

5,000

500

500

5,000

Solution W3-9 (continued) 3.

Investment in Sal (+A) Common stock (+SE) APIC (+SE) Retained earnings (+SE)

4,500,000 3,000,000 1,050,000 450,000 Eliminations

Pen * Noncontrolling interest (10%)

Sal

Debits

Credits

-

500

Consolidated 500

Capital stock

13,000

3,000

3,000

13,000

Additional paid-in capital

2,050

1,500

1,500

2,050

Retained earnings

5,450

500

500

5,450

4.

Investment in Sal (+A) APIC (-SE) Common stock (+SE)

4,500,000 500,000 5,000,000 Eliminations Pen *

Noncontrolling interest (10%) Capital stock Additional paid-in capital Retained earnings

Sal

Debits

-

Credits 500

Consolidated 500

15,000

3,000

3,000

15,000

500

1,500

1,500

500

5,000

500

500

5,000

Chapter 4 ELECTRONIC SUPPLEMENT SOLUTIONS Solution W4-1 The method used by a parent company in accounting for its subsidiary can be determined by examining the separate financial statements of the parent company and the subsidiary. If the cost method is used, the parent company will report dividend income from the subsidiary and the investment account will be stated at original cost (fair value). If the equity method is used, the parent company will report investment income from the subsidiary, and the investment account will reflect subsidiary income since acquisition. When the equity method is used but the difference between investment fair value and book value has not been amortized on the parent company’s books, the difference between the investment balance and underlying book value at any statement date will reflect the difference between the investment fair value and underlying book value at the time of acquisition.

Solution W4-2 When the cost method is used, reciprocity between the investment account balance and the underlying subsidiary equity is established by adjusting the parent company’s investment and retained earnings accounts for the parent’s share of the change in subsidiary retained earnings between the dates the subsidiary was acquired and the beginning of the current year.

Solution W4-3 1

2

3

Cost method Cash 30,000 Dividend income To record receipt of dividends ($40,000  75%).

Cost method Investment cost January 1, 2013 Less: Dividends in excess of earnings ($30,000 - $10,000)  75% Investment account balance — cost method Equity method Investment in Sin 45,000 Income from Sin To record share of Sin’s net income ($60,000  75%).

Cash

4

5

30,000 Investment in Sin To record receipt of dividends ($40,000  75%).

30,000

$300,000 (15,000) $285,000

45,000

30,000

Investment balance under equity method Investment cost Add: Share of income for 2013 and 2014 ($70,000  75%) Less: Share of dividends for 2013 and 2014 ($70,000  75%) Investment in Sin balance December 31, 2014

$300,000 52,500 (52,500) $300,000

Consolidated net income Pin’s separate income Add: Investment income Controlling share of consolidated net income

$ 90,000 45,000 $135,000

109

110

Consolidation Techniques and Procedures

Solution W4-4 Cost method 1a

Investment balance December 31, 2011 (original cost) Price implies book value equals fair value

1b

Consolidated net income under cost method Net income of Pot Less: Dividend income from Sil ($25,000  80%) Separate income of Pot Add: Pot’s share of Sil’s income ($60,000  80%) Controlling share of consolidated net income

$160,000

$120,000 (20,000) 100,000 48,000 $148,000

Equity method 2a

2b 2c

Investment in Sil December 31, 2011 Cost January 1, 2011 Add: Income from Sil Less: Dividends from Sil Investment in Sil under equity method

$160,000 48,000 (20,000) $188,000

Controlling share of consolidated net income (equal to Pot’s income)

$120,000

Noncontrolling interest December 31, 2011 Sil’s equity January 1 Add: Net income Deduct: Dividends Sil’s equity at December 31 Noncontrolling interest percentage Noncontrolling interest December 31

$200,000 60,000 (25,000) $235,000 20% $ 47,000

Chapter 4

111

Solution W4-5 1

Pan Company Balance Sheet at December 31, 2011 Assets Cash Accounts receivable Other assets Investment in Sim Total assets

2

$

2,500 15,000 120,000 88,000

$225,500

Liabilities and Stockholders’ Equity Liabilities $ 80,000 Stockholders’ equity: Capital stock $100,000 Paid-in excess 10,000 Retained earnings 35,500 145,500 Total equities $225,500

Pan Company and Subsidiary Consolidated Income Statement for the year ended December 31, 2011 Sales Cost of goods sold Gross profit Operating expenses Total consolidated net income Less: Noncontrolling interest shareb Controlling share of consolidated net income b

$190,000 80,000 110,000 65,000 45,000 4,000 $ 41,000

Noncontrolling interest share is 20% of Sim’s $20,000 income.

3

Pan Company and Subsidiary Consolidated Balance Sheet at December 31, 2011 Assets Cash Accounts receivable Other assets Goodwilla

$ 17,500 40,000 220,000 10,000

Total assets

$287,500

a b c

Liabilities and Stockholders’ Equity Liabilities $110,000 Stockholders’ equity: Capital stock $100,000 Paid-in excess 10,000 Retained earningsb 43,500 Noncontrolling interestc 24,000 177,500 Total equities $287,500

(Cost $88,000 – implies total fair value = $110,000. Book value equals $100,000.

Therefore, goodwill equals $10,000.)

Retained earnings — Pan January 1 of $22,500 plus controlling share of consolidated net income of $41,000 less dividends of Pan of $20,000.

Noncontrolling interest January 1 of $22,000 (at fair value) plus noncontrolling interest share of income of $4,000 less noncontrolling interest dividends of $2,000.

112

Consolidation Techniques and Procedures

Solution W4-6 Preliminary computations Investment cost

$ 98,000

Implied total fair value ($98,000 / 70%) Book value of Sim Excess fair value over book value

$140,000 100,000 $ 40,000

Excess allocated to: Inventories (sold in 2011) Patents (amortized over 10 years at $3,000 per year) Excess fair value over book value

$ 10,000 30,000 $ 40,000

Conversion to equity method Retained Earnings — Pil

Investment in Sim

Income from Sim

Prior-year effect Excess allocated to inventory Patent amortization 2011

$(10,000) (3,000)

$(10,000) (3,000)

Current-year effect Patent amortization Total Adjustment

$(13,000)

(3,000) $(16,000)

$(3,000) $(3,000)

Phil’s 70% share

$ (9,100)

$(11,200)

$(2,100)

Working paper entries in journal form A

Income from Sim 2,100 9,100 Retained earnings — Pil Investment in Sim 11,200 To correct investment income, the investment in Sim account and retained earnings for amortization of fair value — book value differentials.

b

Income from Sim 18,900 Dividends 14,000 Investment in Sim 4,900 To eliminate income and dividends from Sim and return the investment account to its beginning-of-the-period balance.

c

40,000 Retained earnings — Sim 80,000 Capital stock — Sim Patents 27,000 Investment in Sim 102,900 Noncontrolling interest December 31, 2011 44,100 To eliminate reciprocal equity and investment balances, establish beginning noncontrolling interest, and enter unamortized patents.

d

Other expenses Patents To enter current patent amortization.

3,000

Noncontrolling interest share Dividends — Sim

8,100

e

3,000

6,000

Chapter 4

113

Noncontrolling Interest 2,100 Enter noncontrolling interest share of sub. income and dividends

114

Consolidation Techniques and Procedures

Solution W4-6 (continued) Conversion to equity as first working paper entry: Pil Corporation and Subsidiary Consolidation Working Papers for the year ended December 31, 2012

Income Statement Sales Income from Sim

Pil

Sim 80%

$ 500,000 21,000

$ 100,000

240,000* 174,000*

40,000* 30,000*

Cost of sales Other expenses Consolidated NI Noncontrolling share Controlling share of NI

$ 107,000

Retained Earnings Retained earnings — Pil

$ 110,000

Retained earnings December 31 Balance Sheet Cash Accounts receivable Inventories

$

107,000✓ 70,000*

Dividends

3,000

e

8,100

a

9,100

280,000* 207,000* $ 113,000 8,100* $ 104,900

40,000

$ 100,900

c 40,000 104,900

30,000✓ 20,000*

b e

14,000 6,000

70,000*

$

50,000

$ 135,800

$

$

30,000 20,000 15,000 105,000

$

58,000 40,000 60,000 220,000 119,000

a 11,200 b 4,900 c 102,900 c 27,000 d 3,000

$ 497,000

$ 170,000

$

$

50,000 300,000 147,000✓

$ 497,000 Noncontrolling interest January 1 Noncontrolling interest December 31 Deduct

d

30,000

Patents

*

$ 600,000

$ 147,000

Plant assets — net Investment in Sim

Accounts payable Capital stock Retained earnings

Consolidated Statements

a 2,100 b 18,900

$

Retained earnings — Sim Controlling share of NI

Adjustments and Eliminations

40,000 80,000

24,000 $ 572,000 $

c 80,000

50,000✓

88,000 60,000 75,000 325,000

90,000 300,000 135,800

$ 170,000 c e

44,100 2,100

46,200 $ 572,000

Chapter 4

115

Solution W4-7 (continued) Alternative solution — no initial conversion to equity Working paper entries in journal form a

Income from Sim 21,000 Dividends 14,000 Investment in Sim 7,000 To establish reciprocity as of the beginning of the period. [This entry eliminates the investment increase for 2012 as it was reported in Pil’s books against the dividends received from Sim, and credits the investment account for the difference. The investment account balance is now the beginning-of-the-period balance.]

b

7,000 Retained earnings — Pil 80,000 Capital stock — Sim 40,000 Retained earnings — Sim Patents 30,000 Investment in Sim 112,000 Noncontrolling interest January 1 45,000 To eliminate reciprocal investment and equity amounts, establish beginning noncontrolling interest, enter the original patents, and charge Pil’s retained earnings for 70% of the excess allocated to inventories.

c

2,100 Retained earnings — Pil Noncontrolling interest 900 Other expenses 3,000 Patents 6,000 To enter the current year’s patent amortization and charge both Pil’s retained earnings and the noncontrolling interest for patent amortization for 2011.

d

Noncontrolling Interest share 8,100 6,000 Dividends — Sim Noncontrolling Interest 2,100 To enter noncontrolling interest share of sub.income and dividends

116

Consolidation Techniques and Procedures

Solution W4-7 (continued) Alternative solution — no initial conversion to equity Pil Corporation and Subsidiary Consolidation Working Papers for the year ended December 31, 2012

Income Statement Sales Income from Sim Cost of sales Other expenses Consolidated NI Noncontrolling expense Controlling share of NI Retained Earnings Retained earnings — Pil

Pil

Sim 80%

$ 500,000 21,000 240,000* 174,000*

$ 100,000

$ 107,000

$

$ 107,000✓ 70,000*

Dividends Retained earnings December 31 Balance Sheet Cash Accounts receivable Inventories

3,000

d

8,100

280,000* 207,000* $ 113,000 8,100*

40,000

$ 104,900

b 7,000 c 2,100 b 40,000

$ 100,900 104,900

30,000✓ 20,000*

a d

14,000 6,000

70,000*

$

50,000

$ 135,800

$

$

30,000 20,000 15,000 105,000

$

58,000 40,000 60,000 220,000 119,000

b 30,000 $ 497,000 $

$ 497,000

a 7,000 b 112,000 c 6,000

$ 170,000

50,000 $ 300,000 147,000✓

Noncontrolling interest January 1 Noncontrolling interest December 31 Deduct

c

30,000

Patents

*

$ 600,000

$ 147,000

Plant assets — net Investment in Sim

Accounts payable Capital stock Retained earnings

Consolidated Statements

a 21,000 40,000* 30,000*

$ 110,000

Retained earnings — Sim Controlling share of NI

Adjustments and Eliminations

88,000 60,000 75,000 325,000

24,000 $ 572,000

40,000 80,000 b 80,000 50,000✓

$

90,000 300,000 131,000

$ 170,000 C

900

b d

45,000 2,100

46,200 $ 572,000

Chapter 4

117

Solution W4-7 Supporting computations Investment cost January 1, 2011 Implied total fair value ($180,000 / 60%) Book value Excess fair value over book value – allocated to machinery 2011 Amortization of excess

Machinery $50,000/4 years

$180,000 $300,000 250,000 $ 50,000 $12,500

Consolidated net income: Put’s separate income ($116,000 - $6,000 dividends from Set) Add: Income from Set (($60,000 - $12,500 amortization)  60%) Controlling share of consolidated net income

$110,000 28,500 $138,500

Investment in Set (equity basis): Investment cost January 1, 2011 Share of Set’s income for 2011 Less: Dividends for 2011 ($20,000  60%) Investment in Set December 31, 2011 (under the equity method)

$180,000 28,500 (12,000) $196,500

Working paper entries in general journal form: a

Dividends receivable 6,000 Dividends from Set 6,000 Error correction—dividends declared but not recorded by Put.

b

Dividends from Set 12,000 Dividends Error correction from using the cost method.

12,000

c

50,000 Retained earnings — Set 200,000 Capital stock — Set 50,000 Plant and equipment — net Investment in Set 180,000 Noncontrolling interest 120,000 To eliminate reciprocal equity and investment balances and enter excess allocated to plant and equipment, and beginning noncontrolling interest.

d

Operating expenses 12,500 12,500 Plant and equipment — net To record depreciation on excess allocated to plant and equipment.

e

Dividends payable Dividends receivable To eliminate reciprocal balances.

6,000

Accounts payable Accounts receivable To eliminate reciprocal balances.

5,000

Noncontrolling Interest Share Dividends — Set

19,000

f

g

6,000

5,000

8,000

118

Consolidation Techniques and Procedures

Noncontrolling Interest 11,000 To enter noncontrolling interest share of sub.income and dividends

Chapter 4

119

Solution W4-7 (continued) Put Corporation and Subsidiary Consolidation Working Papers for the year ended December 31, 2011 Put Income Statement Net sales Dividends from Set Cost of goods sold Operating expenses Consolidated net income Noncontrolling share Controlling share of NI Retained Earnings Retained earnings — Put Retained earnings — Set Controlling share of NI Dividends Retained earnings December 31 Balance Sheet Cash Accounts receivable Inventories Other current assets Land Plant and equipment — net Investment in Set Dividends receivable

Accounts payable Dividends payable Other liabilities Capital stock Retained earnings

$900,000 6,000 600,000* 190,000*

150,000* 90,000*

$ 1,200,000 b

12,000

d

12,500

g $116,000

a

6,000

$

750,000* 292,500* 157,500 19,000* 138,500

$

112,000

19,000

$ 60,000

$112,000 $ 50,000 116,000✓ 100,000*

$ 90,000

26,000 26,000 82,000 80,000 160,000 340,000 200,000

15,000 20,000 60,000 5,000 30,000 230,000

$914,000

$360,000

$ 24,000

$ 15,000 10,000 45,000 200,000

62,000 700,000 128,000✓

c

50,000 138,500

60,000✓ 20,000*

$128,000

Noncontrolling interest January 1 Noncontrolling interest December 31 Deduct

$300,000

Consolidated Statements

$

$914,000

*

Adjustments and Eliminations

Set 80%

b g

f

c

50,000

a

6,000

12,000 8,000

100,000* $

150,500

$

41,000 41,000 142,000 85,000 190,000 607,500

5,000

d 12,500 c 200,000 e 6,000

$ 1,106,500 f e

5,000 6,000

$

c 200,000

90,000✓

34,000 4,000 107,000 700,000 150,500

$360,000 c 100,000 g 11,000

111,000 $ 1,106,500

120

Consolidation Techniques and Procedures

Solution W4-8 Preliminary computations Note: Dividend income ($57) / Total Dividend ($60) = 95%.

Fair value — book value differential: Investment cost July 1, 2011

$104,500

Implied fair value ($104,500 / 95%) Book value Excess fair value over book value

$110,000 71,000 $ 39,000

Allocation and amortization schedule: Plant and equipment (5-year life) Patents (amortized over 10 years)

Allocation $15,000 24,000 $39,000

Amortization 2012 — 2014 $ 9,000 7,200 $16,200

Unamortized June 30, 2014 $ 6,000 16,800 $22,800

Sue’s reported net income Less: Current year amortization of excess fair values Sue’s adjusted net income

$ 62,000 (5,400) $ 56,600

Noncontrolling interest share (5%) Pap’s Income from Sue (95%)

$ 2,830 $ 53,770

Consolidated net income Pap’s separate income ($115,000 - $57,000 dividend income) Add: Income from Sue Controlling share of consolidated net income

$ 58,000 53,770 $111,770

1

Cost-to-Equity Conversion Schedule Retained Investment Income Earnings in Sue from Sue Prior years’ effect 95% of Sue’s change in retained earnings ($81,000 - $21,000  95%)

$57,000

$57,000

Amortization of excess (95%): Plant and equipment Patents

(8,550) (6,840)

(8,550) (6,840)

Current year’s effect Reclassify dividend income as a decrease in the investment account

(57,000)

Equity in Sue’s adjusted Income

53,770

$53,770

$38,380

$53,770

$41,610

Dividend Income

$(57,000)

$(57,000)

Chapter 4

121

Solution W4-8 (continued) A

Dividend income 57,000 Investment in Sue 38,380 41,610 Retained earnings — Pap Income from Sue 53,770 To convert Pap’s investment from cost to equity as explained in the conversion to equity schedule.

b

Income from Sue 53,770 Investment in Sue 3,230 Dividends 57,000 To eliminate income and dividends and return the investment account to its beginning-of-the-period balance.

c

81,000 Retained earnings — Sue Unamortized excess 22,800 50,000 Capital stock — Sue Investment in Sue 146,110 Noncontrolling interest 7,690 To eliminate reciprocal equity and investment balances, and enter the unamortized excess and beginning noncontrolling interest.

d

Plant and equipment 15,000 Patents 16,800 Accumulated depreciation 9,000 Unamortized excess 22,800 To allocate the unamortized excess as of June 30, 2014.

e

Other expenses 5,400 Accumulated depreciation Patents To enter current year amortization of excess.

3,000 2,400

f

100,000 Note payable — 8% Note receivable 100,000 To eliminate reciprocal note receivable and payable amounts.

g

Interest payable 4,000 Interest receivable 4,000 To eliminate reciprocal interest receivable and payable amounts.

h

Interest income 8,000 Interest expense 8,000 To eliminate reciprocal interest income and expense amounts.

i

Dividends payable 14,250 Dividends receivable 14,250 To eliminate reciprocal dividends receivable and payable amounts.

j

Noncontrolling Interest share 2,830 3,000 Dividends — Sue Noncontrolling Interest 170 To enter noncontrolling interest share of sub.income and dividends

122

Consolidation Techniques and Procedures

Solution W4-8 (continued) Pap and Subsidiary Consolidation Working Papers for the year ended June 30, 2015 Pap Income Statement Sales Dividend income Income from Sue Interest income Cost of sales Interest expense Other expenses Consolidated NI Noncontrolling share Controlling share of NI Retained Earnings Retained earnings — Pap

$ 500,000 57,000

h

8,000

420,000* e

5,400

j

2,830

215,400* $ 114,600 2,830* $ 111,770

c

a

41,610

b j

57,000 3,000

$ 189,610

81,000 111,770

62,000✓ 60,000*

50,000*

83,000

$ 251,380

$

$

22,000 30,000

$

67,250 60,000 4,000 14,250 100,000 300,000 72,000*

100,000

g i 75,000 200,000 50,000*

$ 678,000

$ 277,000

$

$

40,000 25,000

400,000 213,000✓ $ 678,000

Noncontrolling interest June 30, 2014 Noncontrolling interest June 30, 2015 Deduct

81,000

53,770

$

Note receivable Patents Unamortized excess

*

$

a

$ 213,000

104,500

Note payable — 8% Capital stock Retained earnings

62,000

115,000✓ 50,000*

Investment in Sue

Accounts payable Dividends payable Interest payable

$

57,000 53,770 8,000

$ 148,000

Dividends

Balance Sheet Cash Accounts receivable Interest receivable Dividends receivable Other assets Plant and equipment Accumulated Depreciation

120,000* 8,000* 60,000*

Consolidated Statements $ 750,000

a b h

150,000*

Retained earnings — Sue Controlling share of NI

Retained earnings - June 30

$ 250,000

8,000 300,000*

$ 115,000

Adjustments and Eliminations

Sue

d

4,000 14,250 175,000 515,000

15,000

a b

38,380 3,230

d c

16,800 22,800

89,250 90,000

d 9,000 e 3,000 c 146,110

134,000*

f 100,000 e 2,400 d 22,800

14,400 $ 749,650

25,000 15,000 4,000 100,000

i 14,250 g 4,000 f 100,000

$

50,000

c

50,000

j

170

65,000 25,750

400,000 251,380

83,000✓ $ 277,000 c

7,690 7,520 $ 749,650

Chapter 4

123