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Chapter 4 Consolidation After Date of Acquisition Item Q4.

1 Topic Covered Explanation of why the various steps in the consolidation process must be repeated each reporting period. Exploration of effect of choice of working paper format. Explanation of advantage of using complete equity method. Why the equity method produces equivalence between P=s net income and retained earnings and the respective consolidated amounts. Explanation of how amortization of purchase premium is reflected on P=s income statement. Explanation of why a parent company might reasonably use the cost method to account for its investment in a subsidiary. Cash flow statement treatment of minority interest changes and equity method events. Explanation of how the passage of time affects the calculation of the equity method income accrual and 4-1 Level Low Time 5-10

Q4.2 Q4.3 Q4.4

Low Low Low

5-10 5-10 5-10

Q4.5

Low

5-10

Q4.6

Low

5-10

Q4.7

Mod

10-15

Q4.8

Mod

10-15

the consolidation process.

4-2

SUMMARY OF ASSIGNMENT MATERIAL (cont=d.) Item Q4.9 Topic Covered Difference between Minority Interest in Subsidiary and Minority Interest in Net Income. Explanation of how the Minority Interest in Subsidiary changes during the year and discussion of working paper entries needed. How consolidation procedures differ when pooling, rather than purchase, accounting is used. Effect of cost method on consolidation elimination. Preparation of acquisition entry and equity method entries.
Preparation of consolidation elimination entries at end of first year. Equity method entries and working paper eliminations; purchase premium allocation and amortization. Determination of investment b a l a n c e ,

Level Mod

Time 10-15

Q4.10

Mod

10-15

Q4.11

Mod

10-15

Q4.12 E4.1
E4.2

Low Mod
Mod

5-10 20-30
20-30

E4.3

Mod

30-40

E4.4

Mod

20-30

4-3

minority interest, and minority interest in net income. E4.5 Prepare consolidation elimination entries several years after acquisitionCpooling. Prepare consolidation elimination entries several years after acquisitionCpurchase. Mod 20-30

E4.6

Mod

20-30

SUMMARY OF ASSIGNMENT MATERIAL (cont=d.) Item E4.7 Topic Covered Determination of future consolidation elimination entries. Allocate purchase premium associated with an investment in a subsidiary, several years after acquisition. Interpreting elimination entries to answer questions regarding the method of recording a stock acquisition, the percentage of ownership interest, the date of acquisition, and purchase premium allocation. Preparation of consolidated income statement, incorporating purchase premium amortization and minority interest in net income. Level Mod Time 15-20

E4.8

Mod

20-30

E4.9

Mod

20-30

E4.10

Mod

20-30

4-4

E4.11

Preparation of the cash flow from operating activities section of a consolidated statement of cash flows.
Determination of the balance in the investment account under the equity and cost methods, and preparation of a journal entry to convert from the cost to the equity method. (Appendix) Preparation of journal entries after acquisition relative to the investment account for two consecutive years and elimination entries for those years assuming the cost method is used.

Mod

20-30

E4.12

Mod

20-30

E4.13

Mod

20-30

SUMMARY OF ASSIGNMENT MATERIAL (cont=d.) Item P4.1 Topic Covered Consolidated statements after d a t e o f acquisition; equity method accrual; purchase premium. P4.2 Equity method, investment balance, elimination entries, and minority interest, three years since acquisition. 4-5 Mod 30-40 Level Mod Time 35-45

P4.3

Parent company entries and working paper eliminations under the equity method; computation of consolidated net income, retained earnings and minority interest; purchase premium. Updating investment and stockholders' equity balances; preparation of consolidation elimination entries.
Calculate consolidated total assets, retained earnings and net income; profitability analysis using separate and consolidated statements; incomplete equity method. Computation of equity method income accrual and preparation of consolidated financial statement working paper; purchase premium. Computation of equity method income accrual and preparation of consolidated financial statement working paper; purchase discount.

Mod

30-40

P4.4

Mod

20-30

P4.5

High

40-50

P4.6

Mod

30-40

P4.7

Mod

40-50

4-6

SUMMARY OF ASSIGNMENT MATERIAL (cont=d.) Item P4.8 Topic Covered Comprehensive recording of prior period acquisition, investment account entries, and consolidation elimination entries. Inferring acquisition and consolidation information from actual financial statements. Preparation of computerized spreadsheet to solve consolidation problems. Compute return on assets under equity method and full consolidation; treatment of minority interest and net income. Consolidated statement of cash f l o w s for the current year. P4.13 Consolidated statement of cash f l o w s for the current year. Mod 35-45 Level High Time 50-60

P4.9

High

40-50

P4.10

High

60-80

P4.11

Mod

25-35

P4.12

Mod

35-45

P4.14

(Appendix) Parent company entries and working paper eliminations under cost and equity methods; computation of consolidated net income; purchase premium. (Appendix) Consolidated trial balance working paper two years after acquisition; cost method used by parent; explanation of differences which would arise if the business combinations had been a pooling instead of a purchase.

Mod

30-40

P4.15

Mod

30-40

CARRYBACK TABLE The carryback table identifies the assignment items which are new in this edition and those which are carried over from the seventh edition. For the latter, the problem number in the seventh edition is shown. New Problem Number New Problem Number New Proble m Numbe r
P4.1 P4.2 P4.3 P4.4 P4.5 P4.6 P4.7 P4.8

Source

Source

Source

Q4.1 Q4.2 Q4.3 Q4.4 Q4.5 Q4.6 Q4.7 Q4.8

Q4.1 Q4.2 Q4.3 Q4.4 Q4.5 Q4.6 new Q4.8

E4.1 E4.2 E4.3 E4.4 E4.5 E4.6 E4.7 E4.8

E4.11,2 E4.21,2 E4.31 E4.41 E4.5 E4.61 E4.7 E4.81

P4.11 P4.21 P4.31 P4.41 P4.51 P4.61 P4.7 P4.81,2

Q4.9 Q4.10 Q4.11 Q4.12

Q4.9 Q4.10 Q4.11 Q4.12

E4.9 E4.10 E4.11 E4.12 E4.13

E4.91 E4.10 EA.6 E4.111 E4.12

P4.9 P4.10 P4.11 P4.12 P4.13 P4.14 P4.15

P4.9 P4.101 P4.111 PA.41 PA.51 P4.121 P4.131

1 2

Revised for SFAS 141 and 142 requirements. Requirements revised.

Carryforward tables for all chapters, identifying the disposition of seventh edition assignment items, appear at the beginning of the solutions manual.

ANSWERS TO QUESTIONS Q4.1


Consolidation elimination entries must be repeated each time consolidated financial statements are prepared because the entries are not recorded on the books of either P or S. Since the entries are not recorded, the information is not automatically carried forward from period to period.

Q4.2
The consolidation process is the same, no matter which working paper format is used. The trial balance format simply lists accounts, while the financial statement format organizes the accounts according to their appearance on the financial statements.

Q4.3
The complete equity method parallels the consolidation process, reflecting the amortization of purchase premium or discount and the consolidation treatment of intercompany gains and losses. When the complete equity method is used, P's financial statements will reconcile to the consolidated financial statements--specifically P's net income will equal consolidated net income and P's retained earnings will equal consolidated retained earnings.

Q4.4
Following APBO 18, application of the equity method is viewed as a one-line consolidation. Thus, in computing the equity method accrual, all working paper adjustments that enter into the computation of consolidated net income must be considered. Items such as purchase premium or discount amortization and elimination of unconfirmed intercompany gains and losses are reflected in the equity method accrual. On the working paper, the equity method accrual is eliminated or reversed and all adjustments which caused it to differ from P's share of S's reported net income are made directly on the working paper. The result is that consolidated net income equals the parent's net income

including the equity method accrual. Consolidated retained earnings reflect consolidated net earnings and is reduced by dividends paid to the controlling shareholders. This will be

identical with P's retained earnings which include the equity method accrual and are reduced by dividends paid to P's shareholders (the controlling shareholders).

Q4.5 No. Rather than appear as an expense, the amortization of purchase premium will be reported as a reduction of P's "equity in the income of S" on P's income statement. Q4.6 A parent company might reasonably use the cost method to account for its investment in a majority-owned subsidiary because financial statements will be prepared on a consolidated basis. In the consolidation process, the investment account will be eliminated. The method used to maintain the investment account on the parent's books will therefore be irrelevant to the financial statements. While the details of the consolidation process will vary somewhat depending on the method used by the parent, the consolidated financial statements will be the same. If the parent company issues separate financial statements, however, use of the equity method is required. Q4.7 The minority interest in net income, a noncash deduction on the consolidated income statement, is added back to consolidated net income in the operating activities section. Dividends paid to minority shareholders are reported as financing cash outflows. Together these make up the current year=s change in minority interest. Equity method events related to unconsolidated equity investees are similar. The equity method income accrual is not a cash inflow and is subtracted from consolidated net income in the operating activities section. Dividends from equity investees represent realizations of those equity accruals and are added in the operating activities section. The net effect is a subtraction of undistributed equity method income, the amount not received in cash.

Q4.8 As time passes, most elements of the purchase premium or purchase discount are amortized. Once fully amortized, the steps of establishing, allocating, and amortizing the purchase premium or purchase discount drop out of the equity method income accrual and the consolidation process. Items not subject to periodic depreciation/amortization, such as land and goodwill, remain as part of the premium until impaired or disposed of. Q4.9 Students often become confused over the meaning of the "minority interest" on the balance sheet and the "minority interest" on the income statement. Note that stockholders' equity at a point in time - balance sheet date - is a stock while net income over a period of time is a flow. Minority Interest in Subsidiary on the balance sheet represents the portion of the subsidiary's total stockholders' equity at the balance sheet date that is owned by outside or minority shareholders. Alternatively, it is the book value of the subsidiary's shares not owned by P. Each year, the Minority Interest in Subsidiary (balance sheet) is increased by the minority's share of S's net income and decreased by the minority's share of S's dividends. S's net income is a flow; the controlling interest's share becomes part of consolidated net income. In computing consolidated net income, the minority's share of S's net income is deducted from the combined net income of the affiliates on the consolidated income statement. Thus Minority Interest in Net Income relates only to the flow of S's current period income and not to the cumulative stock of S's contributed capital and retained earnings at a point in time. Each year's Minority Interest in Net Income (income statement) is reflected in the Minority Interest in Subsidiary (balance sheet).

Q4.10 The change in the minority interest during the year is the difference between the book value of the minority's shares at the end of the year and the book value of those shares at the beginning of the year. Although the minority interest will change if S issues or retires shares or P purchases or sells shares of S, these matters will not be considered in the book until Chapter 11. At this point in the text, the Minority Interest in Subsidiary changes only because (1) the subsidiary reported net income or loss during the year and (2) the subsidiary declared dividends during the year. The minority's share of S's reported income (loss) will increase (decrease) the Minority Interest in Subsidiary. Therefore, Minority Interest in S = (1-)(Net Income (Loss) - Dividends of S). Working paper entries are made specifically to enter the minority's share of S's reported net income and dividends in the Minority Interest in Subsidiary on the balance sheet. The entries are: Minority Interest in Net Income XXX

Minority Interest in XXX Subsidiary To increase the book value of the minority's shares by the minority's portion of S's reported net income. Minority Interest in Subsidiary XXX

Dividends - S XXX To decrease the book value of the minority's shares by the minority's portion of S's dividends. These entries could also be combined with the net increase (decrease) in the minority interest being credited (debited) to Minority Interest in Subsidiary.

Q4.11 In a pooling, the investment account is always carried at the book value of P's share of S's stockholders' equity; no purchase premium or discount exists. (In Chapters 5 and 6 we'll see that unconfirmed intercompany gains and losses can create a difference between the investment account and the related portion of the subsidiary's stockholders' equity; however, book values and not fair values continued to provide the basis for the investment account). Therefore, no purchase premium or discount exists to be reclassified and amortized on the working paper or to be amortized in computing the equity method accrual. It is important to recognize, however, that aside from the absence of purchase premium or discount, consolidation procedures for a pooling are the same as for a purchase. The subsidiary's retained earnings are also eliminated on the working paper in a pooling because they were recorded by P as part of recording the stock acquisition. Q4.12 Under the cost method, P will record as income its share of any dividends declared by S. This item must be eliminated in consolidation. SOLUTIONS TO EXERCISES E4.1 ACQUISITION AND EQUITY METHOD ACCOUNTING Requirement 1: 1/1/X3 Investment in Williams Various stockholder equity accounts To record investment in Williams.

450,000 450,000

12/31/X3 Cash Investment in Williams To record dividends received from Williams. 12/31/X3 Investment in Williams

24,000 24,00 0

78,00 0

Equity in Income of 78,00 Williams 0 To record equity method income accrual - James= share of the net income of Williams (100% x $80,000) less $2,000 depreciation of purchase premium (plant assets, $50,000/25). Requirement 2:
1/1/X3 Investment in Williams 450,000 Various stockholder equity accounts To record investment in Williams. 12/31/X3 Cash 19,200 19,200 450,00 0

Investment in Williams To record dividends received from Williams (80% x $24,000).

12/31/X3 Investment in Williams

62,400

Equity in Income of 62,40 Williams 0 To record equity method income accrual - James' share of the net income of Williams ($64,000 = 80% x $80,000) less $1,600 amortization of purchase premium (plant assets are $40,000 = (.8 x $50,000), depreciated over 25 years).

E4.2 CONSOLIDATION AT END OF FIRST YEAR Equity in Income of M Dividends - S Investment in S Note: $30,000 = (.9 x $100,000) - $50,000 (COGS) $10,000 (Depr = $150,000/15). Common Stock Retained Earnings Purchase Premium Investment in S Minority Interest in S Current Assets Property, Plant & Equipment Goodwill Purchase Premium Cost of Goods Sold Depreciation Expense Current Assets Plant, Property & Equipment Minority Interest in Net Income Dividends - S Minority Interest in S 50,000 10,000 50,00 0 10,00 0 10,00 0 1,00 0 9,00 0 50,000 150,00 0 300,00 0 500,000 400,000 600,000 500,000 1,400,000 100,000 30,000 9,000 21,00 0

E4.3 ELIMINATION ENTRIES AFTER FIRST AND SECOND YEARS Requirement 1: Cash (or Dividends Receivable) 420,00 0

Investment in 420,000 S To record P's share of S's dividends; $420,000 = .7 x $600,000. Investment in S 890,00 0 890,000

Income from S To record the equity method income accrual for 20X2, per the following schedule. P's share of S's net income (.7 x $1,600,000) Less amortization of purchase premium: Sale of revalued inventory (.4 x $200,000) Additional depreciation ($500,000/5) Impairment of goodwill Total amortization Net equity method income accrual for 20X2

$1,120,000

$ 80,000 100,000 50,00 0 (230,000) $ 890,000

4-19

E4.3 (cont=d.) Consolidated Financial Statement Working Paper


Income from S Investment in S Dividend - S 890,000 470,00 0 420,00 0

To eliminate the equity method entries made by P in 20X2 thereby adjusting the investment account to its balance on 1/2/X2.
Purchase Premium Stockholders' Equity: S (($5,200,000 $1,000,000)/.7) Investment in S Minority Interest in S (.3 x $6,000,000) 1,000,00 0 6,000,00 0 5,200,00 0 1,800,00 0

To reclassify the purchase premium, eliminate the Investment in S against 70 percent of the stockholders' equity of S and reclassify the remaining stockholders' equity as minority interest, all as of 1/2/X2.
Inventory Equipment Goodwill Purchase Premium 200,000 500,000 300,000 1,000,00 0

To allocate the purchase premium to the assets of S Company and goodwill as of 1/2/X2.
Cost of Goods Sold (or Inventory, 1/1, I/S) Depreciation Expense Impairment Loss Inventory 80,000 100,000 50,000 80,000

4-20

Equipment Goodwill To recognize current year amortization of the purchase premium in the consolidated income statement for 20X2.

100,00 0 50,000

4-21

E4.3 (cont=d.) Minority Interest in Net Income (.3 x $1,600,000) 480,000

Dividends - S (.3 x $600,000) 180,000 Minority Interest in 300,000 S To record the change in the minority interest during 20X2 consisting of the minority's interest in net income decreased by S Company's dividends paid to minority shareholders. Requirement 2: Consolidated Financial Statement Working Paper Purchase Premium 770,000 Investment in S 770,000 To reclassify the unamortized purchase premium at 1/1/X3; $770,000 = $1,000,000 - $230,000. Inventory Equipment Goodwill 120,000 400,000 250,000 770,000

Purchase Premium To allocate the unamortized purchase premium at 1/1/X3 among the assets of S Company and goodwill. Cost of Goods Sold (or Inventory, 1/1 I/S) Depreciation Expense 120,000 100,000

Inventory Equipment To recognize current year amortization of the purchase premium in the consolidated income statement for 20X3.

120,000 100,000

4-22

E4.4 EQUITY METHOD AND MINORITY INTEREST Requirement 1:


Investment - January 1, 20X8 Equity method income accrual for 20X8: Brussels' net income ($400,000 x 80%) Amortization of purchase premium: Equipment (($300,000)/10) Buildings ($400,000/20) Long-term debt ($250,000/10) Less 80% of Brussels= dividends Investment - December 31, 20X8 $2,600,000 320,000 30,000 (20,000) (25,000) (72,000) $2,833,000

Requirement 2:
Brussels' stockholders equity - January 1, 20X8 Net income for 20X8 Dividends Brussels' stockholders' equity - December 31, 20X8 $2,400,000 400,000 (90,000) $2,710,000

Minority interest: $2,710,000 x 20% = $542,000 Requirement 3: Minority interest in net income: $400,000 x 20% = $80,000 E4.5 CONSOLIDATION AFTER SEVERAL YEARSBPOOLING
Equity in Income of S Dividends - S Investment in S Stockholders' Equity - S Investment in S Minority Interest in S Minority Interest in Net Income 10,000 5,900,00 0 5,605,00 0 295,000 190,00 0 38,000 152,00 0

4-23

Dividends - S Minority Interest

2,000 8,000

4-24

E4.6 CONSOLIDATION AFTER SEVERAL YEARS


Equity in Income of S Dividends - S Investment in S Stockholders' Equity - S Purchase Premium Investment in S 3,500,00 0 550,000 3,350,00 0 430,000 80,000 350,00 0

Minority Interest 700,000 in S NOTE: $550,000 = $1,000,000 - $200,000 - (5 x $50,000)


Land Equipment Purchase Premium Depreciation Expense Accumulated Depreciation Minority Interest in Net Income Dividends - S Minority Interest in S 120,00 0 20,00 0 100,00 0 50,000 50,000 300,00 0 250,00 0 550,00 0

4-25

E4.7 PROJECTING CONSOLIDATION ENTRIES Requirement 1: Land Equipment Purchase Premium Depreciation Expense Equipment Requirement 2: Land Purchase Premium Requirement 3: No entry required. E4.8 ALLOCATION OF PURCHASE PREMIUM AFTER SEVERAL YEARS The allocation of purchase premium as of January 1, 20X7 would be: Original 1/1/X7 Component Amount Prior Amortization Amount Accounts $(3,000) Fully amortized $ 0 Receivable Inventory 12,000 Fully amortized 0 Equipment 75,000 6 years at $7,500 30,000 Patents 30,000 Fully amortized 0 Goodwill 100,000 $15,000 85,000 impairment loss 4-26 80,00 0 80,000 6,000 6,000 80,00 0 18,00 0 98,000

$214,000

$115,000

4-27

E4.9 INTERPRETING ELIMINATION ENTRIES Requirement 1: The acquisition was recorded as a purchase, because a purchase premium is shown in the consolidation elimination entries. Requirement 2: The parent owns 85 percent of the stock of S. Minority interest is $135,000/($600,000 + $300,000) = 15%. Requirement 3: Observe that 4 years' depreciation had been recorded prior to 20X6; thus the acquisition occurred at the beginning of 20X2. Requirement 4: Patents balance 1/1/X6 Prior amortization: $3,750 x 4 Original balance Requirement 5: The patents are being amortized over 20 years ($75,000/20 = $3,750). $60,000 15,000 $75,000

E4.10

CONSOLIDATED INCOME STATEMENT Parson Company and Subsidiary Consolidated Income Statement For the Year Ended June 30, 20X7

Sales Cost of Goods Sold ($3,000,000+ $800,000+.8($160,000)) Depreciation Expense ($500,000+ $140,000-.8($200,000)/10) Interest Expense ($100,000+ $60,000+.8($l00,000)/5) Other Expenses Operating Expenses Minority Interest in Net Income (.2 x $300,000) Total Expenses Consolidated Net Income E4.11

$7,000,000 $3,928,000 624,000 176,000 1,300,000 $6,028,000 60,000 $6,088,000 $ 912,000

CONSOLIDATED STATEMENT OF CASH FLOWS $1,000,000 180,000 25,000 30,000 40,000 (18,000) $1,257,000

Computation of Cash Provided by Operations Consolidated net income Addition (subtraction) of items affecting cash: Depreciation expense Amortization expense Impairment loss (goodwill) Minority interest in net income Undistributed equity method income Cash provided by operations

E4.12

COST AND EQUITY METHODS (APPENDIX)

Requirement 1: The balance in the Investment in Sue account at January 1, 20X4 under the cost method used by Peggy is $500,000, the original purchase price. Requirement 2: Conversion to equity method: Peggy's equity in undistributed earnings of Sue since acquisition: 80% x ($135,000 Total net income minus $46,000 dividends) Amortization of purchase premium: Equipment ($60,000/10) x 4 years Increase in Investment in Sue account Balance per books Corrected balance Requirement 3: Investment in Sue Retained Earnings 47,20 0

$ 71,200 (24,00 0) $ 47,200 500,00 0 $547,20 0

47,20 0 To adjust Peggy's accounts from cost method to complete equity method. Adjustment needed: Equity in undistributed earnings of Sue of 20X0 20X4: [.8 X ($135,000 - $46,000)] Less four years purchase premium amortization (4 X $6,000)

$71,200 (24,000)

$47,200

E4.13

ELIMINATION ENTRIES: COST AND EQUITY METHODS (APPENDIX)

Requirement 1: (Equity Method) Books of P Company 20X4 Cash Dr. 135,00 0 Cr. 135,00 0 20X5 Dr. Cr. 162,00 0 162,00 0

Investment in S To record dividends received from S. Investment in S 215,00 0

260,00 0 260,00 0

Income from 215,00 S 0 To record P's equity accrual (90 percent of S's reported net income less $10,000 (= $100,000/10) of amortization of identifiable intangibles.

Consolidated Financial Statement Working Paper 20X4 20X5 Dr. Cr. Dr. Cr. Income from 215,00 260,00 S 0 0 Dividends 135,00 162,00 S 0 0 Investment 80,000 98,000 in S To reverse the current year's equity method entries. Intangible Assets 100,000 90,000 Investment 100,00 90,000 in S 0 To reclassify the unamortized purchase

premium as of the beginning of the year.

E4.13 (cont=d.) 20X4 Dr. Stockholders' Equity S Investm ent in S 2,000,00 0 1,800,000 Cr. Dr. 20X5 Cr.

2,100,000 1,890,00 0 210,000

Min. Int. in S 200,000 To eliminate the investment account against the stockholders' equity of S and establish the minority interest, all as of the beginning of the year [($2,000,000 = ($1,900,000 - $100,000)/.9] Min. Int. in NI 25,000 30,000 DivsBS 15,000 Min. Int. in S 10,000 To record the change in the minority interest during the year. Requirement 2: (Cost method) Books of P Company 20X4 Dr. Cr. Cash 135,00 0 Dividend 135,00 Income 0 To record dividends received from S.

18,000 12,000

20X5 Dr. 162,00 0

Cr. 162,00 0

E4.13 (cont=d.) Consolidated Financial Statement Working Paper 20X4 20X5 Dr. Cr. Dr. Cr. Dividend 135,00 162,00 Income 0 0 Dividends 135,00 162,00 S 0 0 To eliminate intercompany dividends. Investment in S No entry 80,00 0 80,00 0

Retained Earnings P To adjust the investment account to the equity basis as of January 1, 20X5 [$80,000 = .9($250,000 - $150,000) - $100,000/10].

NOTE: The remaining entries, beginning with the reclassification of the identifiable intangibles, are the same under both the cost and equity methods.

SOLUTIONS TO PROBLEMS P4.1CONDENSED CONSOLIDATED FINANCIAL STATEMENTS ONE YEAR AFTER ACQUISITION Requirement 1: Schedule to Compute the Equity Method Income Ponon=s share of Santo=s net income (.8 X $5,000,000) Purchase premium amortization: Sale of revalued inventory (.75 X $2,000,000) Depreciation of revalued plant assets ($8,500,000/8.5) Amortization of premium on revalued longterm debt ($1,000,000/10) Amortization of patents ($500,000/4) Equity method income accrual Requirement 2:
Consolidated Financial Statement Working Paper Equity in Income of 1,475,000 Santo Investment in 1,475,000 Santo To reverse equity method entry and adjust the investment account to beginning-of-year balance. Purchase Premium Investment in Santo To reclassify unamortized purchase premium. Inventory Plant Assets, Net Patents Goodwill Long-Term Debt 2,000,000 8,500,00 0 500,000 2,000,000 1,000,000 12,000,00 0 12,000,00 0

Accrual $4,000,000 -1,500,000 -1,000,000 + 100,000 - 125,000 $1,475,000

Purchase Premium

12,000,00 0

To allocate purchase premium.

P4.1 (cont=d.) Capital Stock Santo Retained Earnings - Santo 6,000,00 0 4,000,00 0 8,000,000

Investment in Santo ($21,475,000 $1,475,000 $12,000,000) Minority Interest in Santo [.2 X ($6,000,000 + $4,000,000)] To eliminate the investment account against the stockholders= equity of Santo and establish the minority interest as of January 2, 20X3. Cost of Goods Sold Depreciation Expense Amortization Expense Long-Term Debt 1,500,000 1,000,000 125,000 100,000

2,000,000

Interest and Other Expenses Inventory Plant Assets, Net (or Accumulated Depreciation) Patents To recognize purchase premium amortization. Minority Interest in Net Income (.2 X5,000,000) 1,000,000

100,000 1,500,000 1,000,000 125,000

Minority Interest in 1,000,000 Santo To recognize the minority interest in net income and update the minority interest in Santo to its December 31, 20X3 balance. P4.1 (cont=d.) Requirement 3: Ponon Corporation and Santo Corporation Consolidated Income Statement for the Year Ended December 31, 20X3
Sales Cost of Goods Sold ($18,000,000 + $4,000,000 + $1,500,000) Depreciation Expense ($2,000,000 + $3,200,000 + $1,000,000) Amortization Expense Interest and Other Expenses ($5,400,000 + $1,000,000 - $100,000) Minority Interest in Net Income Total Expenses Net Income $43,200,00 0 $23,500,00 0 6,200,000 125,000 6,300,000 1,000,000 $37,125,00 0 $ 6,075,000

Ponon Corporation and Santo Corporation Consolidated Balance Sheet December 31, 20X3
ASSETS Cash and Receivables Inventory [$5,000,000 + $5,200,000 +($2,000,000 $1,500,000)] Plant Assets, Net [$8,000,000 + $12,000,000 + ($8,500,000 - $1,000,000)] Patents ($500,000 - $125,000) Goodwill Total Assets LIABILITIES AND STOCKHOLDERS = EQUITY $ 7,600,000 10,700,000 27,500,000 375,000 2,000,000 $48,175,00 0

Current Liabilities Long-Term Debt [$15,000,000 +$3,300,000 + ($1,000,000 - $100,000)] Capital Stock Retained Earnings Minority Interest in Santo [.2 X ($6,000,000 + $9,000,000)] Total Liabilities and Stockholders= Equity

$ 7,100,000 19,200,000 8,000,000 10,875,000 3,000,000 $48,175,00 0

P4.2EQUITY METHOD AND ELIMINATING ENTRIES THREE YEARS AFTER ACQUISITION Requirement 1: Schedule to Compute the Equity method Income Accrual for the year Ended December 31, 20X8. P=s share of S=s net income (.9 X $130,000) $117,000 Purchase premium amortization: (1) Reduced depreciation on plant assets (.9 X + 9,000 $100,000)/10 Amortization of intangibles ($330,000)/20) (2) - 16,500 Net equity income accrual $109,500 (1) Because S=s inventory is carried at LIFO, and the inventory increased since acquisition, none of the undervalued LIFO inventory would have been sold; hence, no amortization of this amount. (2) Intangibles = $330,000 [= $600,000 - (.9 X $400,000) + (.9 X 100,000)]. Requirement 2: Schedule to Compute the Balance in the Investment in S at December 31, 20X8 Investment cost, December 31, 20X5 $2,000,00 0 Plus P=s share of S=s cumulative net income since acquisition (.9 X $400,000) 360,000 Less P=s share of S=s cumulative dividends since acquisition (.9 X .6 X $400,000) 216,000 Plus reduced depreciation on overvalued plant assets [3 X (.9 X 100,000)/10] 27,000 Less amortization of intangibles [3 X 49,500 ($330,000/20)] Balance in Investment in S, December 31, 20X8 $2,121,50 0

P4.2 (cont=d.) Requirement 3: Equity in Income of S (from Requirement 1) Dividends-S (.9 X .6 X $130,000 ) Investment in S To reverse 20X8 equity method entries. Purchase Premium ($600,000 + [2 X (.9 X $100,000)/10]- [(2 X $330,000)/20] 109,500 70,200

39,300

585,000

Investment in 585,00 S 0 To establish unamortized purchase premium as of January 1, 20X8. Inventory Identifiable Intangibles Plant Assets, N e t Purchase 585,000 Premium To allocate unamortized purchase premium as of January 1, 20X8. Stockholders= Equity - S {[($2,000,000 360,000 297,000 72,000

$600,000)/.9]+ [(1 - . 6) X ($400,000 $130,000)]

1,663,55 6

Investment in S ($2,121,500 $39,300 1,497,20 $585,000) 0 Minority Interest in 166,356 S To eliminate the stockholders= equity of S against the Investment in S and establish the Minority Interest in S as of January 1, 20X8.

P4.2 (cont=d.) NOTE: At this point the Investment in S is fully eliminated ($2,121,500 - $39,300 - $585,000 - $1,497,200 = 0). Plant Assets, Net (or Accumulated Depreciation) Amortization Expense 9,00 0 16,5 00 16,50 0 9,000

Identifiable Intangibles Depreciation Expense To recognize 20X8 purchase premium amortization. Minority Interest in Net Income 13,0 00

Dividends - S 7,800 Minority Interest in 5,200 S to recognize the Minority Interest in Net Income in 20X8 and update the Minority Interest in S at December 31, 20X8. Requirement 4: The Minority Interest in S at December 31, 20X8 of $171,556 is 10% of S=s stockholders= equity on that date, $1,715,556, explained next. Ninety percent of S=s stockholders= equity at the December 31, 20X5 acquisition date is $1,400,000 (= $2,000,000 purchase price - $600,000 purchase premium). Therefore, 100% is $1,555,556 (= $1,400,000/.9). In the three years since acquisition, S=s stockholders= equity grew by $160,000 [= total income of $400,000 - $240,000 (60%) paid out in dividends]. Thus at December 31, 20X8, S=s stockholders= equity is $1,715,556 (= $1,555,556 + $160,000). The Minority Interest in S is 10% of that amount, or $171, 556. This is also the sum of the amounts in the

fourth and sixth eliminating entries; $171,556 = $166,356 + $5,200.

P4.3EQUITY METHOD ENTRIES, ELIMINATIONS, AND CONSOLIDATION COMPUTATIONS Requirement 1: Total purchase premium at 12/31/X0 $30,000 P's share of amount attributable to equipment (.6 x $30,000 $50,000) Computation of Equity Method Income Accrual P' s share of S's net income (.6 x $20,000) $12,000 Less amortization of purchase premium: Additional depreciation ($30,000/10) 3,000 Net equity method income accrual for 20X3 $ 9,000 Books of P Company Investment in S 9,000 Income from S 9,000 To record P's share of S's net income for 20X3, reduced by purchase premium amortization. Cash 4,800 4,800 Investment in S To record P's share of dividends paid by S Company; 6 x $8,000. Requirement 2: Consolidated Financial Statement Working Paper Income from S 9,000 Dividends - S 4,800 Investment in S 4,200 To eliminate the equity method entries recorded by P, thereby adjusting the investment account to its balance on 1/1/X3.

P4.3 (cont=d.) Capital Stock - S Retained Earnings S, 1/1/X3 Purchase Premium Investment in S 100,00 0 130,00 0 24,000 162,00 0 92,000

Minority Interest in S To eliminate the Investment in S against the stockholders' equity of S Company and establish the unamortized purchase premium and minority interest in S, all as of 1/1/X3. Notes: (1)

P paid $150,000 for a 60% interest having a book value of $120,000. therefore, 100% of S's net assets had a book value of $200,000 (=$120,000/.6). Since the capital stock of S is $100,000, S's retained earnings must also have been $100,000 at 12/31/X0. At 1/1/X3, however, S Company's retained earnings had grown to $130,000 (=$100,000+$70,000-$40,000). The original purchase premium of $30,000 has, at 1/1/X3, been reduced by two years' amortization amounting to $6,000 (=2x$3,000). Its unamortized balance at 1/1/X3 is $24,000 (=$30,000-$6,000). The investment account balance at 1/1/X3 consists of original cost of $150,000 plus 60% of the growth in S Company's retained earnings in 20X1 and 20X2, $18,000 (=.6($70,000- $40,000) less two years of purchase premium amortization, $6,000; $162,000 = $150,000 + $18,000 - $6,000.

(2)

(3)

(4)

Minority interest in S at 1/1/X3 is 40% of $230,000 (=$100,000+$130,000).

P4.3 (cont=d.) Equipment Accumulated Depreciation Purchase Premium 30,0 00 6,000

24,00 0 To allocate the unamortized purchase premium at 1/1/X3 to the assets of S Company. The accumulated depreciation is the amount allocated since acquisition on 12/31/X0. Depreciation Expense 3,00 0

Accumulated 3,000 Depreciation To recognize current year amortization of the purchase premium in the consolidated income statement. Minority Interest in Net Income 8,00 0

Dividends - S 3,200 Minority Interest in 4,800 S To record the change in the minority interest during 20X3. Requirement 3: Consolidated Retained Earnings at 12/31/X3 P Company's retained earnings from its own $220,00 operations 0 Plus 60% of S Company's net income in 20X1,20X2 and 20X3; .6($70,000 + $20,000) 54,000 Less three years of purchase premium (9,000) amortization Consolidated retained earnings at 12/31/X3 $265,00 0

Minority Interest in S at 12/31/X3 Minority interest in S at 1/1/X3; .4 x $230,000 Change in minority interest during 20X3 Minority interest in S at 12/31/X3

$ 92,000 4,800 $96,800

P4.3 (cont=d.) Requirement 4: Consolidated Net Income for 20X3 P's net income from its own operations Plus P's equity method income accrual Consolidated net income for 20X3 P4.4ANALYSIS OF INVESTMENT ACCOUNT AND ELIMINATION ENTRIES Requirement 1: Initial cost, January 1, 20X1 $5,000,00 0 Share of Sunny's income, 20X1-X5 $800,000 x .9 720,000 Amortization of purchase premium: Inventory (100,000) Equipment ($200,000 x (5/10)) (100,000) Goodwill impairment (25,000 ) Balance, December 31, 20X5 $5,495,00 0 NOTE: Original purchase premium was $500,000 ( = $5,000,000 .9 x $5,000,000), allocated $100,000 to inventory, $200,000 to equipment, and $200,000 to goodwill. Requirement 2: Balance, January 1, 20X1 Net income, 20X1-X5 $5,000,000 800,000 $36,000 9,000 $45,000

Balance, December 31, 20X5 Requirement 3: Equity in Income of S Investment in S

$5,800,000

61,000 61,00 0

P4.4 (cont=d.) Stockholders' Equity - S Purchase Premium Investment in S Minority Interest in S Equipment Goodwill Purchase Premium Depreciation Expense Equipment Minority Interest in Net Income Minority Interest in S P4.5CONSOLIDATION CALCULATIONS AND RATIO ANALYSISBINCOMPLETE EQUITY METHOD Requirement 1: Because the incomplete equity method is used, purchase premium amortization is not reflected in the investment account. Thus we can compute the original purchase premium as follows: Purchase premium: Original allocation: $208,00 = $664,000 - .8 X ($100,000 + 0 $470,000) $160,00 (= .8 X $200,000) to long-term 0 liabilities (debit balance) 9,00 0 9,000 20,00 0 20,000 100,000 175,000 275,000 5,800,000 275,000 5,495,00 0 580,000

48,000 (= $208,000 - $160,000) to identifiable intangibles $208,00 0

P4.5 (cont=d.) Of this amount, total amortization in the three years since acquisition is: Interest expense (amortization of discount on long-term liabilities) = $48,000 [= 3 X ($160,000/10)] Amortization expense (identifiable intangibles) = $6,000 [= 3 X ($48,000/24)] Consolidated total assets at December 31, 20X6 is $7,022,000: $7,022,000 = $5,414,000 + $2,230,000 - $664,000 + ($48,000 - $6,000) identifiable intangibles NOTE: Amortization of discount on long-term liabilities does not affect total assets.
NOTE: Consolidated total liabilities and stockholders= equity also is $7,022,000 [= $5,414,000 + $2,230,000 - ($100,000 + $470,000) ($160,000 - $48,000 amortization) - $6,000 intangibles amortization expense - $48,000 interest expense + $114,000 minority interest]. Consolidated net income for the year ended December 31, 20X6 is $782,000: $782,000 = $800,000 - ($16,000 + $2,000) purchase premium amortization = $600,000 + (.8 X $250,000) - ($16,000 + $2,000) Consolidated retained earnings at December 31, 20X6 is $2,160,000: $2,160,000 = $2,214,000 - 3 X ($16,000 + $2,000) total purchase premium amortization

Requirement 2: (000 eliminated)


a. b. ROA 1,000*/5,414 = .185 1,046**/7,000 = .150 ROS 1,000*/6,000 = . 167 1,046**/(6,000 + TATO 6,000/5,414 = 1.11 (6,000 +

c.

1,096***/7,000 = . 157

2,000) = .131 1,096***/(6,000 + 2,000) = .137

2,000)/7,000 = 1.14 (6,000 + 2,000)/7,000 = 1.14

P4.5 (cont=d.) *1,000 = 800 + 200 interest ** 1,046 = 780 + (200 + 50 + 16) interest *** 1,096 = 1,046 + 50 minority interest in net income
Both b. and c. report lower profitability than a. because the equity method ratios do not include the total assets or sales of Satellite and do not add back Satellite=s interest expense, increased by the applicable purchase premium amortization. The total assets turnover ratios are similar in this problem whether consolidated or not. When the equity method is used in a., the asset base in the ROA includes the investment account balance (80% of Satellite=s net assets + some purchase premium), not the total assets of Satellite deployed to generate the reported income. In general, the consolidated totals in b. and c. provide a more complete and credible assessment of profitability than do equity method amounts in a. Comparing b. and c., we note that in consolidation, 100% of the assets and sales of Satellite are included in the consolidated totals whereas consolidated net income includes 80% of Satellite=s net income. To correct this mismatch, and place income and assets or sales on the same basis, we should add back the minority interest in net income (or not subtract it in the first place), as in c. This gives us group income (total for P and S) in the numerator and group assets and sales in the denominator (total for P and S), a better comparison.

P4.6CONSOLIDATED FINANCIAL STATEMENT WORKING PAPER--PURCHASE PREMIUM


Requirement 1: Slim's reported net income Less purchase premium amortization: Sale of undervalued inventory Additional depreciation on plant assets ($200,000/10) Amortization of discount on long-term debt ($100,000/5) Total purchase premium amortization Net equity method income accrual $610,000 $100,000 20,000 20,000 $140,000 $470,000

P4.6 (cont=d.) Requirement 2: Paltry Company and Subsidiary Slim Company Consolidated Financial Statement Working Paper For the Year Ended December 31, 20X7
Income Statement Sales Income from Slim Inventory, 12/31/X7 Total Credits Inventory, 1/2/X7 Purchases Operating Expenses Interest Expense Total Debits Net Income-to Ret. Earn. Stmt. P Company 12,780,000 470,000 3,200,000 16,450,000 3,000,000 8,000,000 2,100,000 160,000 13,260,000 3,190,000 S Company (100%) 5,400,000 -1,350,000 6,750,000 1,400,000 3,000,000 1,700,000 40,000 6,140,000 610,000 (1) (4) (4) (4) Adjustments & Eliminations Dr. Cr. 470,000 470,000 100,000 20,000 20,000 140,000 610,000 -4,550,000 22,730,000 4,500,000 11,000,000 3,820,000 220,000 19,540,000 3,190,000 Consolidated 18,180,000

Retained Earnings Statement Ret. Earnings, 1/2/X7-P 4,200,000 Ret. Earnings, 1/2/X7-S Net Income-from Inc Stmt Dividends - P Dividends - S Ret. Earn, 12/31/X7to Bal Sht -3,190,000 (300,000) -7,090,000

-4,200,000 1,000,000 610,000 -(80,000) 1,530,000 (2)1,000,000 610,000 (1) 80,000 1,610,000 80,000 -3,190,000 (300,000) -7,090,000

P4.6 (cont'd.) Paltry Company and Subsidiary Slim Company Consolidated Financial Statement Working Paper For the Year Ended December 31, 20X7
Balance Sheet Cash and Receivables Inventory Investment in Slim Plant Assets Accumulated Depreciation Purchase Premium Goodwill Total Current Liabilities Long-Term Debt Capital Stock - P Capital Stock - S Ret Earn-from Earn Stmt Minority Interest in S Total P Company 2,800,000 3,200,000 2,390,000 5,000,000 (1,200,000) 12,190,000 2,600,000 1,700,000 800,000 -7,090,000 12,190,000 S Company (100%) 880,000 1,350,000 -2,300,000 -(2) (3) 4,530,000 2,300,000 500,000 -200,000 1,530,000 4,530,000 800,000 400,000 1,500,000 Adjustments & Eliminations Dr. Cr. Consolidated 3,680,000 4,550,000 -7,500,000 (4) (3) 20,000 800,000 3,310,000 (1,220,000) -400,000 14,910,000 4,900,000 2,120,000 800,000 -7,090,000 14,910,000

(3) (3)

100,000 200,000

(4) 100,000 (1) 390,000 (2)2,000,000

(3) (2)

100,000 200,000 1,610,000 1,910,000 3,410,000

(4)

20,000

80,000 100,000 3,410,000

P4.6 (cont'd.) (1) (2) (3) To eliminate the equity method entries made by Paltry during 20X7. To eliminate the investment account against the stockholders' equity of Slim and reclassify the purchase premium, all as of 1/2/X7. To allocate the purchase premium among the assets and liabilities of Slim and to Goodwill. Goodwill of $400,000 = $2,000,000 - $200,000 - $1,000,000 - $100,000 $200,000 - $100,000 (decrease in long term debt). To record current year amortization of the purchase premium; alternatively, this amount could be credited directly to Plant Assets as S's accumulated depreciation recorded during 20X7 is not separately disclosed. Formal Adjusting and Eliminating Entries (Not Required) (1) Income from Slim Dividends - Slim Investment in Slim To eliminate the equity method entries made by Paltry during 20X7. (2) Capital Stock - Slim Retained Earnings Slim Purchase Premium 200,000 1,000,0 00 800,000 2,000,0 00 470,000 80,000 390,00 0

(4)

Investment in Slim To eliminate the investment account and establish the purchase premium, as of 1/2/X7.

P4.6 (cont'd.) (3) Inventory Plant Assets Goodwill Long-Term Debt Purchase Premium To allocate the purchase premium among the assets and liabilities of Slim and to goodwill. (4) Inventory, 1/2, Income Statement Operating Expenses Interest Expense 100,000 200,000 400,000 100,000 800,00 0

100,000 20,000 20,000

Inventory 100,000 Accumulated 20,000 Depreciation Long-Term Debt 20,000 To record current year purchase premium amortization.

P4.7CONSOLIDATED FINANCIAL STATEMENT WORKING PAPER--PURCHASE DISCOUNT Requirement 1: P's share of S's reported net income Less purchase discount amortization: Amortization of premium on note receivable ((.8x$20,000)/5) Reduction in depreciation on buildings and equipment ((.8x$100,000)/20) Amortization of premium on long-term debt((.8x$80,000)/10) Total purchase discount amortization Net equity method income accrual (1) $320,000 = .8($3,200,000-($440,000+ $2,440,000-$500,000)+ $8,000-$410,000-$18,000). Note that S Company uses the LIFO cost flow assumption to account for its inventories. Since the beginning inventory is undervalued, application of LIFO implies that the beginning inventory is still on hand and the portion of the purchase discount allocated to it has not been amortized. $320,000 (1) $ 3,200 (4,000) (6,400) $(7,200) (2) $327,200

(2)

Note: The purchase discount at 1/2/X1 amounted to ($80,000) (=$1,470,000 +$50,000-.8($100,000+ $1,900,000)). The initial allocation is $48,000 (=.8($500,000-$440,000)) to Inventory, ($80,000) (=.8($400,000-$500,000) to Buildings and Equipment, $16,000(=.8($130,000-$110,000)) to Notes Receivable, Noncurrent, and ($64,000)(=.8($300,000)-($220,000)) to Long-Term Debt.

P4.7 (cont'd.) Requirement 2: P Company and Subsidiary S Company Consolidated Financial Statement Working Paper For the Year Ended December 31, 20X1
Income Statement Sales Income from S Interest Income Inventory, 12/31/X1 Total Credits Inventory, 1/2/X1 Purchases Operating Expenses Interest Expense Total Debits Minority Int. in Net Income Net Income-to Ret Earn Stmt P Company 7,000,000 327,200 -1,800,000 9,127,200 1,700,000 4,800,000 750,000 60,000 7,310,000 -1,817,200 S Company (80%) 3,200,000 8,000 500,000 3,708,000 440,000 2,440,000 410,000 18,000 3,308,000 -400,000 Adjustments & Eliminations Dr. Cr. (1) (4) 327,200 3,200 (4) (4) 330,400 48,000 (4) (4) 48,000 (5) 80,000 458,400 58,400 48,000 48,000 4,000 6,400 10,400 Consolidated 10,200,000 4,800 2,348,000 12,552,800 2,188,000 7,240,000 1,156,000 71,600 10,655,600 80,000 1,817,200

P4.7 (cont'd.)
Retained Earnings Statement Ret Earnings, 1/2/X1-P Ret Earnings, 1/2/X1-S P Company 2,810,000 -S Company (80%) -1,900,000 (2) 1,900,000 Adjustments & Eliminations Dr. Cr. Consolidated 2,810,000 --

Net Income-from Inc Stmt Dividends - P Dividends - S Ret Earn, 12/31/X1to Bal Sht Balance Sheet Cash and Receivables Inventory Investment in S Notes Receivable, Noncurrent Land Buildings and Equipment Accumulated Depreciation Purchase Discount Total

1,817,200 (120,000) -4,507,200

400,000 -(50,000) 2,250,000

458,400 (1) (5) 2,358,400

58,400 40,000 10,000 108,400

1,817,200 (120,000) -4,507,200

1,000,000 1,800,000 1,807,200 -600,000 2,200,000 (700,000) 6,707,200

1,580,000 500,000 -108,000 330,000 600,000 (50,000) 3,068,000

(3)

48,000 (1) 287,200 (2)1,520,000

2,580,000 2,348,000 -120,800 930,000 2,720,000 (746,000) -7,952,800

(3)

16,000

(4) (3)

3,200 80,000 80,000 1,970,400

(4) (3)

4,000 80,000 148,000

(2)

P4.7 (cont'd.)
Balance Sheet Current Liabilities Long-term Debt Capital Stock - P Capital Stock - S Ret Earn-from Ret Earn Stmt Minority Interest in S Total P Company 1,400,000 600,000 200,000 -4,507,200 -6,707,200 S Company (80%) 500,000 218,000 -100,000 2,250,000 -3,068,000 2,464,800 2,612,800 Adjustments & Eliminations Dr. Cr. Consolidated 1,900,000 875,600 200,000 -4,507,200 470,000 7,952,800

(4) (2)

6,400 100,000 2,358,400

(3)

64,000

108,400 (2) (5) 400,000 70,000 642,400 2,612,800

P4.7 (cont'd.) (1) (2) To eliminate the equity method entries made by P during 20X1. To eliminate the investment account against 80 percent of the stockholders' equity of S, reclassify the remaining stockholders' equity as minority interest and establish the purchase discount. To allocate the purchase discount as of 1/2/X1 among the assets and liabilities of S Company to the extent of P's 80 percent interest. To record current year amortization of the purchase discount. To record the change in the minority interest during 20X1. Formal Adjusting and Eliminating Entries (Not Required) (1) Income from S Dividends - S Investment in S (2) Retained Earnings-S,1/1 Capital Stock - S Purchase Discount Investment in S Minority Interest in S (3) Inventory 4-66 48,000 1,900,00 0 100,000 80,000 1,520,00 0 400,000 327,20 0 40,000 287,200

(3) (4) (5)

Notes Receivable, Noncurrent Purchase Discount Buildings and Equipment Long-Term Debt

16,000 80,000 80,000 64,000

4-67

P4.7 (cont'd.) (4) Interest Income Accumulated Depreciation Long-Term Debt Operating Expenses Interest Expense Notes Receivable, Noncurrent (5) Minority Interest in Net Income Dividends - S Minority Interest in S 80,000 10,00 0 70,00 0 3,200 4,000 6,400 4,000 6,400 3,200

4-68

P4.8ACCOUNTING FOR ACQUISITION, INVESTMENT, AND CONSOLIDATION Requirement 1: A stock acquisition has occurred. Plumbing Professionals, Inc., acquired 80% of the outstanding shares of common stock of Sewer Specialists, Inc., for cash. Both companies remain separate legal entities. Requirement 2: Net income of Sewer Specialists for 20X6: Sales Cost of goods sold Gross profit Selling, general and administrative expenses Net income Plumbing Professionals' interest Plumbing Professionals= share $400,000 180,000 220,000 70,000 $150,000 x 80% $120,000[E]

Equity in income of Sewer Specialists = $96,000 ( = .8 x $120,000) Since $120,000 does not equal $96,000, Plumbing Professionals is using the complete equity method. Plumbing Professionals has recorded more than merely its share of Sewer Specialists 20X6 net income.

4-69

P4.8 (cont=d.) Requirement 3: Investment in Sewer Specialists 01/01/X4 20X4 and 20X5 Original investment Excess depreciation on $820,000 [A] equipment $48,000 [C] 20X4 and 20X5 20X4 Share of net income and Excess inventory sold cash dividends 30,000 [D] 80,000 [B] 12/31/X5 Balance $822,000 20X6 Share of net income 120,000 [E] 12/31/X6 Balance $878,000 Computations: Original investment: 80,000 20X6 Share of cash dividends 40,000 [F] Excess depreciation on equipment 24,000 [G]

shares of common stock

x $10 per share $800,000 common stock purchase price + 20,000 legal fees $820,000 [A] cost of investment

4-70

P4.8 (cont'd.) Share of net income and cash dividends for 20X4 and 20X5: $200,000 retained earnings--Sewer, 01/01/X6 -100,000 retained earnings--Sewer, 01/01/X4 $100,000 earnings less cash dividends since acquisition x 80% Plumbing Professionals' interest $ 80,000 [B] Plumbing Professionals' share Share of cash dividends for 20X6: $50,000 cash dividends declared--Sewer x 80% Plumbing Professionals' interest $40,000 [F] Plumbing Professionals' share Adjustments under complete equity method: Equipment: $120,000/5 years = $24,000/yr $24,000 x 2 = $48,000 [C] $24,000 [G] Land: for 20X4 - 20X8 extra depreciation expense for 20X4 and 20X5 for 20X6

No adjustment to net income since not sold.

Inventory:$30,000 [D] extra cost of goods sold in 20X4 since sold under FIFO method in 20X4

4-71

P4.8 (cont'd.) Goodwill: Book value of net assets of Sewer Specialists on 01/01/X4: common stock $100,000 additional paid-in-capital 400,000 retained earnings 100,000 net assets $600,000 Plumbing Professionals' x 80% interest Plumbing Professionals' $480,000 share Positive goodwill computation: original investment Plumbing Professionals' share of Sewer Specialists' net assets purchase premium allocated to equipment allocated to land allocated to inventory goodwill Requirement 5: Entries to consolidate on 12/31/X6: a) Equity in Income of Sewer Specialists Investment in Sewer 4-72 $820,000 -480,000 $340,000 [J] -120,000 - 50,000 - 30,000 $140,000

120,000 [E] 120,0

Specialists To reverse share of 20X6 net income. P4.8 (cont'd.) b) Investment in Sewer Specialists

00

24,000

Equity in Income of Sewer 24,000 Specialists To reverse excess depreciation expense on equipment for 20X6 (24,000 [G]). c) Investment in Sewer Specialists Dividends-Sewer Specialists To reverse shares of 20X6 cash dividends. d) Adjusted to complete equity--already there 400,000

40,000 [F] 40,000

e) Common Stock-Sewer Specialists Additional Paid-In Capital--Sewer Specialists Retained Earnings--Sewer Specialists Purchase Premium Investment in 4-73

100,000 200,000 262,000 [H]

Sewer Specialists 822,000 Minority Interest in Sewer 140,000[I] Specialists To eliminate investment account balance as of 12/31/X5.

4-74

P4.8 (cont'd.) purchase premium, 01/01/X4 extra depreciation expense 20X4 and 20X5 extra cost of goods sold 20X4 purchase premium, 12/31/X5 common stock--Sewer, 12/31/X6 additional paid-in-capital--Sewer, 12/31/X6 retained earnings--Sewer, 12/31/X6 net assets--Sewer, 12/31/X6 minority interest percentage minority interest in Sewer Specialists, 12/31/X6 f) Goodwill Equipment (120,000 48,000) Land $340,000 [J] - 48,000 [C] - 30,000 [D] $262,000 [H] $100,000 400,000 200,000 $700,000 x 20% $140,000 [I]

140,00 0 72,000 50,000 262,000

Purchase Premium [H] To allocate purchase premium for 20X4 and 20X5. g)
Depreciation Expense Accumulated Depreciation--Equipment To depreciate excess equipment for 20X6. 24,000 [G]

24,000

h)
Minority interest in net income (150,000 x 20%) Dividends--Sewer Specialists (50,000 x 20%) Minority interest in 30,000 10,000

4-75

Sewer Specialists To update the minority interest for 20X6.

20,000

4-76

P4.9INTERPRETING CONSOLIDATED FINANCIAL STATEMENTS Requirement 1: The total value of the Wallace stock issued in the acquisition was $14,000,000, as determined from the information in the consolidated statement of stockholders' equity: Common stock--par value $ 608,000 Additional capital 13,392,000 $14,000,000 On a per-share basis, Wallace stock was worth approximately $23($14,000,000/608,034). Requirement 2: Investment in Colorforms Cash Common stock Additional (paid-in) capital Requirement 3: Since the acquisition price was $27,000,000 and resulting goodwill was $15,564,000, the fair value of net assets acquired was $11,436,000 ($27,000,000 - $15,564,000). Colorforms' total liabilities were $17,500,000, making the fair value of total identifiable assets $28,936,000. Thus, consolidated total assets would be:
Wallace's total assets at 7/31/91 Fair value of Colorforms' total identifiable assets at acquisition $399,093,00 0 28,936,000

27,000,00 0 13,000,00 0 608,034 13,391,96 6

4-77

Goodwill Less: cash paid in acquisition Consolidated total assets 8/1/91

15,564,000 (13,000,000) $430,593,000

4-78

P4.9 (cont=d.) Requirement 4: Goodwill amortization for the year was $389,000, determined as follows: Balance 7/31/91 $ 1,382,000 Amount added from Colorforms acquisition 15,564,00 0 $16,946,0 00 Balance 7/31/92 16,557,00 0 Amount amortized $ 389,000 It appears that a 40-year life is being used ($15,564,000/40 approximately equals $389,000). Requirement 5: The price per share paid for the 23,000 shares repurchased during the year was $24 (=(23,000 + 529,000)/23,000). The Wallace shares were valued at $23 in the acquisition and then bought back at $24. Had the buyback cash been included in the original transaction, in lieu of the 23,000 shares, goodwill would have been affected only slightly, increasing by $23,000 (=($24 - $23) x 23,000 shares) from $15,564,000 to $15,587,000, a change of about one-tenth of one percent.

P4.10

DEVELOPING AN AUTOMATED SPREADSHEET FOR CONSOLIDATION

Note to instructor: This assignment asks the student to develop a computerized spreadsheet that will automate the standard consolidation entries, such as those shown in Exhibit 4.3 in the chapter. To be correct, the spreadsheet needs to work under various conditions, including cases where one or more components of the purchase premium is fully amortized. To grade this assignment, enter a set of test data in the student's program, and see if the proper results are achieved. If not, I return the program (with the test data results) to the student for revision. Typical students may need two or three iterations to get their program working. This has proven to be a very good assignment to get students to generalize the consolidation elimination process. Following are two sets of test data for use in evaluating students' programs. P4.10 (cont=d.) Data set A:
1. Current trial balances for P and S:

Cash and receivables Inventory Equipment Accumulated depreciation Investment in S Liabilities Common stock APIC

Parent Sub 80,000 30,000 275,000 140,000 800,000 710,000 (355,000) (210,000) 504,600 (230,000) (130,000) (400,000) (200,000) (100,000) (50,000)

Retained earnings Dividends Revenue Cost of goods sold Depreciation Other expenses Income from S 2. 3. 4. Percentage of P owned by S: 80%

(390,000) (250,000) 70,000 20,000 (920,000) (300,000) 485,000 210,000 110,000 20,000 110,600 10,000 (40,200)

Original cost of acquisition: $400,000 Retained earnings of S at acquisition: $100,000

5. Allocation and amortization of original purchase premium: Inventory 20% 1 year Equipment 50% 10 years Identifiable 30% 20 years intangibles 6. Year: 3

P4.10 (cont=d.) The consolidated trial balance that results from these data is as follows: Cash and receivables 110,000 Inventory 415,000 Equipment 1,570,000 Accumulated depreciation (583,000) Identifiable intangibles 30,600 Liabilities (360,000) Common stock (400,000) APIC (100,000)

Retained earnings

(390,000)

Minority interest Dividends Revenue Cost of goods sold Depreciation Amortization expense Other expenses Minority interest in net income The consolidation elimination entries are: (1) Income from S Dividends - S Investment in S

(108,000) 70,000 (1,220,000) 695,000 136,000 1,800 120,600 12,000

40,200 16,00 0 24,20 0

(2)
Common Stock APIC Retained Earnings Purchase Premium Investment in S Minority Interest 200,000 50,000 250,000 80,400 480,40 0 100,00 0

P4.10 (cont=d.) (3) Equipment Identifiable Intangibles Accumulated Depreciation Purchase Premium (4) Depreciation Expense Amortization Expense Accumulated Depreciation Identifiable Intangibles (5) Minority Interest in Net Income Dividends - S

60,000 32,400 12,00 0 80,40 0 6,000 1,800 6,000 1,800 12,00 0 Minority Interest 4,00 0 8,00 0

Data set B: 1. Current trial balances for P and S:


Cash and receivables Inventory Equipment Accumulated depreciation Investment in S Liabilities Common stock APIC Parent 100,850 210,000 700,000 (410,000) 549,150 (100,000) (350,000) (60,000) Sub 40,000 160,000 600,000 (200,000) (70,000) (100,000) (70,000)

Retained earnings Dividends Revenue Cost of goods sold Depreciation Other expenses Income from S

(480,000) 40,000 (800,000) 450,000 120,000 105,450 (75,450)

(280,000) 10,000 (700,000) 460,000 70,000 80,000

P4.10 (cont=d.) 2. 3. 4. Percentage of P owned by S: 90% Original cost of acquisition: $500,000 Retained earnings of S at acquisition: $180,000

5. Allocation and amortization of original purchase premium: Inventory 10% 1 year Equipment 30% 5 years Identifiable 60% 20 years intangibles 6. Year: 7

The consolidated trial balance that results from these data is as follows: Cash and receivables 140,850 Inventory 370,000 Equipment 1,355,500 Accumulated depreciation (665,000) Identifiable intangibles 72,150 Liabilities (170,000) Common stock (350,000) APIC (60,000)

Retained earnings

(480,000)

Minority interest Dividends Revenue Cost of goods sold Depreciation Amortization expense Other expenses Minority interest in net income

(53,000) 40,000 (1,500,000) 910,000 190,000 5,500 185,450 9,000

P4.10 (cont=d.) The consolidation elimination entries are: (1) Income from S Dividends - S Investment in S (2) Common Stock APIC Retained Earnings Purchase Premium Investment in S Minority Interest (3) Identifiable Intangibles Purchase Premium (4) Amortization Expense Identifiable Intangibles (5) Minority Interest in Net Income Dividends - S 9,000 1,00 77,700 77,70 0 5,550 5,550 75,450 9,000 66,45 0 100,00 0 70,000 280,00 0 77,700 482,70 0 45,000

Minority Interest

0 8,00 0

P4.11 Requirement 1:

RATIO ANALYSIS C EQUITY METHOD AND CONSOLIDATION

Purchase premium = plant assets = $2,500,000 - .8 X $2,500,000 = $500,000 Annual extra depreciation = $500,000/10 = $50,000 Equity method income accrual = .8 X $400,000 - $50,000 = $270,000 P=s share of S=s dividends = .8 X $200,000 = $160,000 Investment account balance at 12/31/X4 = $2,500,000 + $270,000 - $160,000 = $2,610,000 ROA = ($1,000,000 + $270,000)/($10,000,000 + $2,610,000) = .101 Requirement 2: Premium balance at December 31, 20X4 = $500,000 - $50,000 = $450,000 Consolidated net income = $1,000,000 + .8 X $400,000 - $50,000 = $1,270,000 Minority interest in net income = .2 X $400,000 = $80,000 ROA = ($1,270,000 + $80,000)/($10,000,000 + $6,000,000 + $450,000) =.082 Because the denominator includes 100% of S=s assets, not 80%, the numerator should include 100% of S=s income so that the profitability of all the assets can be assessed. Thus the Minority Interest In Net Income should be added to the numerator. NOTE: Consolidated total assets does not include the portion of the Investment in S balance representing P=s share of the book value of S=s net assets but does include the unamortized purchase premium (plant assets in this problem). The elimination process removes the Investment in S and replaces it in consolidation with the underlying assets (and liabilities, not considered here) of S plus any unamortized purchase premium.

P4.11 (cont=d.) Requirement 3: Because the consolidated balance sheet includes all assets controlled by P, the ROA that measures the profitability of all of those assets gives the best measure of the profitability of that asset portfolio. The ROA under full consolidation should therefore be used with the numerator reflecting the total income generated by those assets (= consolidated net income + minority interest in net income). The equity method treats P=s interest in S as an investment and the denominator of the ROA includes P=s share of the net assets of S (plus a purchase premium in this problem). Thus under the equity method, the ROA reflects the profitability of P=s total assets, excluding the investment account, plus the return on P=s share of S=s net assets. The result is to add together two inconsistent measures--return on P=s total assets + return on P=s share of S=s net assets--and overstate the profitability of the entire asset portfolio controlled by P.

P4.12

CONSOLIDATED STATEMENT OF CASH FLOWS

Prep Corporation and Subsidiary Consolidated Statement of Cash Flows Cash Flows from Operating Activities: Net Income Add (Subtract) Items Not Affecting Cash: Depreciation Expense $350,00 0 Goodwill Impairment Loss 30,000 Minority Interest in Net Income 24,000 Loss on Retirement of Plant Assets 50,000 Changes in Current Assets and Liabilities: Increase in Other Current Assets (400,000 ) Decrease in Current Liabilities (268,000 ) Net Cash Flows from Operating Activities Cash Flows from Investing Activities: Acquisition of Plant Assets ($4,000,000 - ($4,200,000 - $500,000)) Cash Flows from Financing Activities: Increase in Noncurrent Liabilities $100,00 0 Dividends Paid to Majority (70,000) Stockholders Dividends Paid to Minority (16,000 Stockholders ) Net Decrease in Cash

$400,000

454,000

(668,000) $186,000

(300,000)

14,000 $(100,000 )

P4.13

CONSOLIDATED STATEMENT OF CASH FLOWS

P Company and S Company Consolidated Statement of Cash Flows For the Year ended December 31, 20X7 Cash Flows from Operating Activities: Net Income $ 600,000 Add (Subtract) Items Not Affecting Cash: Depreciation Expense $250,00 0 Goodwill Impairment Loss 25,000 Minority Interest in Net Income 12,000 287,000 Changes in Current Assets and Liabilities: Increase in Other Current Assets $(100,00 0) Increase in Current Liabilities 250,000 150,000 Net Cash Flows from Operating $1,037,00 Activities 0 Cash Flows from Investing Activities: Sale of Plant Assets $ 25,000 Acquisition of Plant Assets (675,000 (650,000) ) Cash Flows from Financing Activities: Increase in Other Liabilities $ 150,000 Issuance of Capital Stock 200,000 Dividends Paid to Majority (435,000 Stockholders ) Dividends Paid to Minority (2,000) (87,000) Stockholders Net Increase in Cash $ 300,000

P4.14

INVESTOR ACCOUNTING--COST AND EQUITY METHODS, PURCHASE PREMIUM (APPENDIX)

Requirement 1: Books of Paint Corporation Investment in Soil 77,500 Income from Soil To record Paint's share of Soil's net income, reduced by purchase premium amortization during 20X4; $77,500 = .9($200,000)-$75,000-$27,500. Cash 81,000 81,000 Investment in Soil To record the receipt of $81,000 (=.9x$90,000) of dividends from Soil Company. Requirement 2: Cash 81,000 Dividend 81,000 Revenue To record dividend revenue of $81,000 (=.9 x $90,000) from Soil under the cost method. Requirement 3: Consolidated Financial Statement Working Paper Investment in Soil 3,500 Income from Soil 77,500 Dividends - Soil 81,000 To eliminate the equity method entries, thereby adjusting the investment account to its beginning of year balance.

77,500

P4.14 (cont=d.) Stockholders' Equity Soil Purchase Premium 3,000,00 0 500,000 3,200,00 0 300,000

Investment in Soil Minority Interest in Soil To eliminate the investment in Soil against 90 % of Soil's stockholders' equity and establish the purchase premium and minority interest, all as of 1/1/X4.

Note: the book value of the 90 percent interest acquired by Paint was $2,700,000 (=$3,200,000-$500,000). Accordingly, the book value of all of Soil's stockholders' equity at 1/1/X4 was $3,000,000 (=$2,700,000/.9). Inventory (Balance Sheet) Depreciable Assets Goodwill 75,000 275,000 150,000

Purchase 500,00 Premium 0 To allocate the purchase premium among Soil Company's assets and goodwill. Depreciation Expense Inventory 1/1/X4 (Income Statement) 27,50 0 75,00 0

Accumulated 27,50 Depreciation 0 Inventory (Balance 75,00 Sheet) 0 To record amortization of the purchase premium for 20X4.

Minority Interest in Net Income Dividends - Soil Minority Interest in Soil

20,00 0 9,000 11,00 0

To record the change in the minority interest during 20X4.

P4.14 (cont=d.) Requirement 4: Dividend Revenue 81,000 81,000 Dividends - Soil To eliminate intercompany dividends received from Soil Company.

Note: The investment account under the cost method is stated at its balance on 1/1/X4. Reversal of the equity method entries achieves the same result in this, the first year after acquisition. Therefore, the additional eliminating entries are the same as those required by the equity method (given in part 3). In subsequent years, however, use of the cost method creates the need for another working paper entry to adjust the investment account to the equity basis at the beginning of the year. Requirement 5: Consolidated net income is $577,500, Paint's net income from its own operations, $500,000, plus the equity method income accrual of $77,500.

P4.15

Requirement 1:

CONSOLIDATED TRIAL BALANCE WORKING PAPER--COST METHOD (APPENDIX)


Consolidated Trial Balance Working Paper December 31, 20X6
Consolidated Adjustments & Eliminations Trial Dr. Cr. Balance 4,110,000 3,360,000 (4) (1) (3) (4) 90,000 250,000 270,000 180,000 (3) 270,000 (5)1,170,000 (4) 270,000 (6) 10,000 3,410,000 440,000 4,620,000 170,000 (3,800,000) (2,500,000) (5) (7) (5) (5) 400,000 900,000 (1) (2) (7) 250,000 180,000 20,000 130,000 98,000 (228,000) (550,000) (2,150,000) 500,000 (2,150,000) 500,000 170,000 (3,800,000) (2,500,000) (228,000) (550,000) 3,360,000 3,410,000 440,000 4,620,000 Consolidated Income Statement Consolidated Retained Statement Consolidated Balance Sheet 4,110,000

Account Cash and Receivables Inventory, Jan. 1, 20X6 Inventory, Dec. 31, 20X6 Land Other Plant Assets (Net) Investment in NEO Purchase Premium Identifiable Intangibles Current Liabilities Noncurrent Liabilities Minority Interest in NEO Capital Stock Retained Earnings, Jan. 1 Dividends Sales Dividend Income Purchases

EON Dr.(Cr.) 2,610,000 1,960,000 2,030,000 200,000 3,170,000 1,190,000 (2,300,000) (1,800,000) (550,000) (1,900,000) 500,000 (11,000,000) (180,000) 6,200,000

NEO Dr.(Cr.) 1,500,000 1,400,000 1,380,000 150,000 1,450,000 (1,500,000) (700,000) (400,000) (900,000) 200,000 (6,500,000) 4,000,000

(2)

180,000

(17,500,000) (17,500,000) 10,200,000 10,200,000

P4.15 (cont'd.)
Consolidated Adjustments & Eliminations Trial Dr. Cr. Balance (6) 10,000 3,210,000 ConsoliConsoliConsolidated dated dated Income Retained Balance Statement Statement Sheet 3,210,000

Account Operating Expenses Inventory, Dec. 31,20X6 Minority Interest in Net Income

EON Dr.(Cr.) 1,900,000 (2,030,000) -0

NEO Dr.(Cr.) 1,300,000 (1,380,000) -0

(3,410,000) (3,410,000) (7) 118,000 2,398,000 2,398,000 118,000 118,000 0 (4,022,000) (4,022,000) (5,672,000) (5,672,000) 0

Consolidated net income Consolidated Retained Earnings, Dec. 31, 20X6

P4.15 (cont'd.) (1) (2) (3) (4) (5) (6) (7) To adjust the investment account to the equity basis as of January 1, 20X6. To eliminate the intercompany dividends. To reclassify the unamortized purchase premium as of January 1, 20X6. To allocate the unamortized purchase premium to Land and Identifiable Intangibles. To eliminate the investment account against NEO's stockholders' equity and establish the minority interest as of January 1, 20X6. To recognize amortization of identifiable intangibles for 20X6. To record the change in the minority interest during 20X6.

NOTE: Original purchase premium (on 1/2/X4), was $290,000 [=$1,190,000 - .9($400,000 + $600,000)] and was allocated to Land, $90,000 (=.9 x $100,000) and Identifiable Intangibles (20-year life), $200,000 (=.9 x $222,222). Formal Eliminating Entries (Not Required) Consolidated Trial Balance Working Paper (1)
Investment in NEO Retained Earnings - EON 250,000 250,000

To adjust the investment account to the equity basis at the beginning of the year; $250,000 = EON's share of the growth in NEO's retained earnings during 20X4 and 20X5, $270,000 =.9($900,000 - $600,000) less amortization of identifiable intangibles for 20X4 and 20X5, $20,000 (= 2($200,000/20)). (2)
Dividend Income 180,000

Dividends - NEO

180,000

To eliminate the intercompany dividends ($180,000 = .9 x $200,000). P4.15 (cont=d.) (3) Purchase Premium 270,000 270,00 0

Investment in NEO To reclassify the unamortized purchase premium as of January 1, 20X6; $270,000 = $1,190,000 .9($400,000 + $600,000) - $20,000 (identifiable intangibles amortization for 20X4 and 20X5). (4) Land Identifiable Intangibles 90,000 180,000

Purchase Premium To allocate the unamortized purchase premium to Land ($90,000 = .9 x $100,000) and to Identifiable Intangibles ($180,000 = $200,000 - $20,000). (5) Capital Stock - NEO Retained Earnings NEO 400,000 900,000

270,00 0

Investment in 1,170,0 NEO 00 Minority Interest in NEO 130,000 To eliminate the investment account against the stockholders' equity of NEO and establish the minority interest, all as of 1/1/X6. (6)

Operating Expenses

10,000

Identifiable 10,000 Intangibles To recognize identifiable intangibles amortization for 20X6.

P4.15 (cont=d.) (7) Minority Interest in Net Income

118,000

Dividends - NEO 20,000 Minority Interest in NEO 98,000 To recognize the change in the minority interest during 20X6; $118,000 = .1[$6,500,000 - ($1,400,000 + $4,000,000 - $1,380,000) - $1,300,000]. Requirement 2: If this combination was accounted for as a pooling, the investment account would be recorded at $900,000, the book value of 90 percent of NEO's stockholders' equity. There would be no purchase premium to be concerned about. Therefore, the following differences would arise: ! Entry (1), which adjusts the investment account to the equity basis as of January 1, 20X6, would be for $270,000 [= .9($900,000 - $600,000)]; no prior period amortization would be reflected. Entries (3), (4), and (6) would not be needed. Consolidated net income would be $4,032,000 (= $4,022,000 + $10,000, the current year's amortization of identifiable intangibles). Consolidated retained earnings would be $5,702,000 (= $5,672,000 + $30,000, the identifiable intangibles amortization for the three years since acquisition). Land would be carried at $350,000 (= $440,000 $90,000) on the consolidated balance sheet and identifiable intangibles would not be present.

! !