Chapter 8

CONSOLIDATIONS: ON DATE OF PURCHASE-TYPE BUSINESS

COMBINATION
8.1 Parent Company- Subsidiary Relationships
If the investor acquires a controlling interest in the investee, a parent-
subsidiary relationship is established. The investee becomes a subsidiary
of the acquiring parent company but remains a separate legal entity.
Strict adherence to legal aspect requires issuance of separate financial
statements for the parent company and subsidiary but disregards the
substance of the relationship. A parent company and its subsidiary are a
single economic entity. In recognition of this fact, consolidated financial
statements are issued to report their financial and operating results as
though they comprised a single accounting entity.
Consolidated financial statements are similar to combined financial
statements of home office and its branches:
 Assets, liabilities, revenue, and expenses of the parent and its
subsidiaries are totaled
 Intracompany transactions and balances are eliminated
 And the final consolidated amounts are reported
The Financial Accounting Standards Board requires consolidation of
nearly all subsidiaries except those not actually controlled.
The Meaning of Controlling Interest
Traditionally, direct or indirect ownership of more than 50% of an
investee’s outstanding common stock is required to evidence controlling
interest. But some circumstances may negate actual control despite
existence of stock ownership:
 A subsidiary in liquidation or reorganization in court supervised
bankruptcy proceedings
 A foreign subsidiary in a country having severe production,
monetary, or income tax restrictions

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  Right of minority shareholders to effectively participate in the
financial and operating activities of the subsidiary
Control of a subsidiary might also be achieved indirectly. The traditional
definition of control is criticized for emphasizing the legal form over the
economic substance.
Consolidation of Wholly Owned Subsidiary on Date of Purchase-
Type Business Combination
There is no question of control of a wholly owned subsidiary. To
illustrate, assume that on December 31, 1999, Palm Corporation issued
10,000 shares of its $10 par common stock (current fair value $45 a
share) to stockholders of Star Company for all outstanding $5 par
common stock. There was no contingent consideration. Out of pocket
costs consist of:
Finder’s and legal fee relating to business combination 50,000
Costs associated with SEC registration 35,000
Total 85,000
Assume also that the business combination qualified for purchase
accounting because required conditions for pooling accounting were not
met. Star Company continues its corporate existence. Both constituent
companies had a December 31 fiscal year and used the same accounting
policies.
Financial statements of the constituent companies prior to
consummation of the business combination follow:

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 PALM CORPORATION AND STAR COMPANY
Separate Financial Statements (prior to purchase-type business combination)
For Year Ended December 31, 1999
Palm Star
Income Statement
Revenue
Net sales 990,000 600,000
Interest revenue 10,000
Total 1,000,000 600,000
Costs and expenses
Cost of goods sold 635,000 410,000
Operating expenses 158,333 73,333
Interest expense 50,000 30,000
Income taxes expense 62,667 34,667
Total 906,000 548,000
Net income 94,000 52,000
Statement of Retained Earnings
Retained earnings, beginning 65,000 100,000
Add: Net income 94,000 52,000
159,000 152,000
Less: Dividends 25,000 20,000
Retained earnings, ending 134,000 132,000

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 Balance Sheet
Assets
Cash 100,000 40,000
Inventories 150,000 110,000
Other current assets 110,000 70,000
Receivable from Star 25,000
Plant assets (net) 450,000 300,000
Patent (net) 20,000
Total assets 835,000 540,000
Liabilities and Stockholders’ Equity
Payable to Palm 25,000
Income taxes payable 26,000 10,000
Other liabilities 325,000 115,000
Common stock, $10 par 300,000
Common stock, $5 par 200,000
Additional paid in capital 50,000 58,000
Retained earnings 134,000 132,000
Total liab & stockholders’ equity 835,000 540,000

The December 31, 1999, current fair values of Star Company’s identifiable
assets were the same as their carrying amounts except the following:
Inventories 135,000
Plant assets (net) 365,000
Patent (net) 25,000
Palm Corporation recorded the combination as a purchase with the following
entries:
Investment in Star Co common stock 450,000
Common Stock (10,000*10) 100,000
Paid in Capital in Excess of Par 350,000

Investment in Star Co common stock 50,000

Paid in Capital in Excess of Par 35,000
Cash 85,000

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The foregoing journal entries do not include any debits or credits to
record individual assets and liabilities of Star Company in the accounts
of Palm Corporation because Star is not liquidated as in merger but
remains a separate legal entity.

Preparation of Consolidated Balance Sheet without a Working Paper

The operating results of Palm and Star prior to the date of their business
combination those of two separate economic as well as legal entities. A
consolidated balance sheet is the only consolidated financial statement
issued by Palm and Star.
The preparation of a consolidated balance sheet may be accomplished
without the use of a supporting working paper. The parent company’s
investment account and the subsidiary’s stockholder’s equity accounts
do not appear in the consolidated balance sheet because they are
essentially reciprocal (intercompany) accounts.
Under purchase accounting theory:
 The parent company (combinor) assets and liabilities (other
than intercompany ones) are reflected at carrying amounts
 The subsidiary (combine) assets and liabilities (other than
intercompany ones) are reflected at current fair values in the
consolidated balance sheet
 Goodwill is recognized to the extent the cost of the parent’s
investment exceeds the current fair value of the subsidiary’s
identifiable net assets
Applying the foregoing principles to the Palm Corporation Star Company
relationship, the following consolidated balance sheet is produced:

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 PALM CORPORATION AND SUBSIDIARY
Consolidated Balance Sheet
December 31, 1999
Assets
Current assets:
Cash (15,000+40,000) 55,000
Inventories (150,000+135,000) 285,000
Other (110,000+70,000) 180,000
Total current assets 520,000
Plant assets (net) (450,000+365,000) 815,000
Intangible assets
Patent (net) (0+25,000) 25,000
Goodwill (net) 15,000 40,000
Total assets 1,375,000
Liabilities and Stockholders’ Equity
Liabilities:
Income taxes payable (26,000+10,000) 36,000
Other (325,000+115,000) 440,000
Total liabilities 476,000
Stockholders’ equity
Common stock, $10 par 400,000
Additional paid in capital 365,000
Retained earnings 134,000 809,000
Total stockholders’ equity 1,375,000

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Working paper for consolidated balance sheet
Working paper is usually required even for a parent company
and a wholly owned subsidiary.
Developing the elimination
The parent company’s investment account is similar to the
home office’s investment in branch account. However, the
subsidiary is a separate corporation not a branch and has
three conventional stockholders’ equity accounts rather than a
single home office reciprocal account used by a branch.
Accordingly, the elimination of the intercompany accounts
must decrease the investment account of the parent company
and the three stockholders’ equity accounts of the subsidiary
to zero.
The completed elimination for Palm Corporation and
subsidiary (in journal entry format) and the related working
paper for consolidated balance sheet are as follows:
a) Common Stock-Star 200,000
Additional Paid in Capital-Star 58,000
Retained Earnings- Star 132,000
Inventories- Star (135,000-110,000) 25,000
Plant Assets (net)-Star (365,000-300,000) 65,000
Patent (net)-Star (25,000-20,000) 5,000
Goodwill (net)-Star (500,000-485,000) 15,000
Investment in Star Co Common Stock 500,000

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 To eliminate intercompany investment and equity
accounts of subsidiary

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 Palm Corporation and Subsidiary
Working Paper for Consolidated Balance Sheet
December 31, 1999

Palm Star Elimination Consolidated

Assets
Cash 15,000 40,000 55,000
Inventories 150,000 110,000 a 25,000 285,000
Other current assets 110,000 70,000 180,000
Intercompany receivable/payable 25,000 (25,000)
Investment in Star Co 500,000 a (500,000)
Plant assets (net) 450,000 300,000 a 65,000 815,000
Patent (net) 20,000 a 5,000 25,000
Goodwill (net) a 15,000 15,000
Total assets 1,250,000 515,000 (390,000) 1,375,000
Liabilities & Stockholders’ Equity
Income taxes payable 26,000 10,000 36,000
Other liabilities 325,000 115,000 440,000
Common stock, $10 par 400,000 400,000
Common stock, $5 par 200,000 a (200,000)
Additional paid in capital 365,000 58,000 a (58,000) 365,000
Retained earnings 134,000 132,000 a (132,000) 134,000
Total 1,250,000 515,000 (390,000) 1,375,00

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The following features of the above working paper should be noted:
 The elimination is only a part of the working paper and not entered
into the books of the parent or subsidiary
 The elimination is used to reflect the difference between current
fair values and carrying amounts of the subsidiary’s identifiable
net assets as the subsidiary did not write up its assets to current
fair value
 The elimination column reflects increases and decreases rather
than debits and credits
 Intercompany receivables and payables are placed on the same line
of the working paper for consolidated balance sheet and combined
to produce a consolidated amount of zero
 The consolidated paid in capital amounts are those of the parent
company only. Subsidiaries’ paid in capital amounts are always
eliminated in the process of consolidation
 Consolidated retained earnings are those of the parent company
only in line with the theory that states purchase accounting
reflects a fresh start in an acquisition of net assets
 The consolidated amounts reflect the financial position of a single
economic entity comprising two legal entities with all intercompany
balances eliminated
The consolidated balance sheet is exactly the same as the one presented
on page 6.
8.3 Consolidation of Partially Owned Subsidiary on Date of Purchase
Type Business Combination
The consolidation of a parent company with its partially owned
subsidiary differs from a consolidation of wholly owned subsidiary in one
major respect- the recognition of minority interest.
Minority interest is a term applied to the claims of stockholders other
than the parent company to the net income or losses and net assets of

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the subsidiary. The minority interest in the subsidiary’s net income or
loss is displayed in the consolidated income statement, and the minority
interest in the subsidiary’s net assets is displayed in the consolidated
balance sheet.
To illustrate, assume that on December 31, 1999, Post Corporation
issued 57,000 of its $1 par common stock (current fair value $20 a
share)to stockholders of Sage Company in exchange for 38,000 of the
40,000 outstanding shares of $10 par common stock in a purchase type
business combination. Thus, Post acquired 95% (38,000/40,000)
interest in Sage, which became its subsidiary. There was no contingent
consideration. Out of pocket costs are:
Finder’s and legal fees 52,250
Costs associated with SEC registration 72,750
Total 125,000
Financial statements of Post and Sage just prior to combination were as
follows:

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 POST CORPORATION AND SAGE COMPANY
Separate Financial Statements (prior to purchase-type business combination)
For Year Ended December 31, 1999
Post Sage
Income Statement
Net sales 5,500,000 1,000,000
Costs and expenses
Cost of goods sold 3,850,000 650,000
Operating expenses 925,000 170,000
Interest expense 75,000 40,000
Income taxes expense 260,000 56,000
Total 5,110,000 916,000
Net income 390,000 84,000
Statement of Retained Earnings
Retained earnings, beginning 810,000 290,000
Add: Net income 390,000 84,000
1,200,000 374,000
Less: Dividends 150,000 40,000
Retained earnings, ending 1,050,000 334,000

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 Balance Sheet
Assets
Cash 200,000 100,000
Inventories 800,000 500,000
Other current assets 550,000 215,000
Plant assets (net) 3,500,000 1,100,000
Goodwill (net) 100,000
Total assets 5,150,000 1,915,000
Liabilities and Stockholders’ Equity
Income taxes payable 100,000 16,000
Other liabilities 2,450,000 930,000
Common stock, $1 par 1,000,000
Common stock, $10 par 400,000
Additional paid in capital 550,000 235,000
Retained earnings 1,050,000 334,000
Total liab & stockholders’ equity 5,150,000 1,915000

The December 31, 1999, current fair values of Sage Company’s

identifiable assets and liabilities were the same as their carrying
amounts except for the following:
Inventories 526,000
Plant assets (net) 1,290,000
Leasehold 30,000
Sage Company does not prepare journal entries related to the business
as it is continuing as a separate legal entity. But Post Corporation
prepares the following entries:

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 Investment in Sage Common Stock
(57,000*20) 1,140,000
Common Stock (57,000*1) 57,000
Paid in Capital in Excess of Par 1,083,000
To record issuance of 57,000 shares of common to acquire 38,000
of Sage Company’s outstanding 40,000 shares
Investment in Sage Common Stock 52,250
Paid in Capital in Excess of Par 72,750
Cash 125,000
To record payment of out of pocket expenses associated with
business combination
Working Paper for Consolidated Balance Sheet
It is advisable to use a working paper for preparation of a consolidated
balance sheet for a parent company and its partially owned subsidiary
due to complexities caused by the minority interest.
The differences between the carrying amounts of identifiable assets and
liabilities of the subsidiary with the current fair vales must be reflected
by means of elimination.

Common stock-Sage 400,000

Additional Paid in Capital-Sage 235,000
Retained earnings-Sage 334,000
Inventories-Sage (526,000-500,000) 26,000
Plant Assets (net) (1,290,000-1,100,000) 190,000
Leasehold 30,000
Investment in Sage Common Stock-Post 1,192,250
The debit side of the above entry represents the current fair values of
Sage Company’s identifiable tangible and intangible assets (1,215,000)

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while the credit side represents Post’s total investment 1,192,250. Two
items should be recorded to complete the elimination: minority interest
and goodwill.
Computation of Minority Interest
Current fair value of Sage’s identifiable net assets 1,215,000
Minority interest (100-95) 0.05
Minority interest (1,215,000*.05) 60,750
This is recorded as credit as it represents claim on the net assets.
Computation of goodwill
Cost of Post Corporation’s 95% interest 1,192,250
Less: Current fair vale of identifiable net assets acquired
(1,215,000*.95) 1,154,250
Goodwill 38,000
The completed elimination in journal entry format would be:
Common stock-Sage 400,000
Additional Paid in Capital-Sage 235,000
Retained earnings-Sage 334,000
Inventories-Sage (526,000-500,000) 26,000
Plant Assets (net) (1,290,000-1,100,000) 190,000
Leasehold 30,000
Goodwill 38,000
Investment in Sage Common Stock-Post 1,192,250
Minority Interest 60,750

Working Paper for Consolidated Balance Sheet

The following is the working paper for consolidated balance sheet for Post
Corporation and subsidiary
Assignments
Review questions
Exercises

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6-1, 6-3, 6-5, 6-7, 6-10
Problems
6-2, 6-5

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 Post Corporation and Subsidiary
Working Paper for Consolidated Balance Sheet
December 31, 1999

Post Sage Elimination Consolidated

Assets
Cash 75,000 100,000 175,000
Inventories 800,000 500,000 a 26,000 1,326,000
Other current assets 550,000 215,000 765,000
Investment in Sage Co 1,192,250 a (1,192,250)
Plant assets (net) 3,500,000 1,100,000 a 190,000 4,790,000
Leasehold a 30,000 30,000
Goodwill (net) a 38,000 138,000
Total assets 6,217,250 1,915,000 (908,250) 7,224,000
Liabilities & Stockholders’ Equity
Income taxes payable 100,000 16,000 116,000
Other liabilities 2,450,000 930,000 3,380,000
Minority interest a 60,750 60,750
Common stock, $1 par 1,057,000 1,057,000
Common stock, $5 par 400,000 a (400,000)
Additional paid in capital 1,560,250 235,000 a (235,000) 1,560,250
Retained earnings 1,050,000 334,000 a (334,000) 1,050,000
Total 6,217,250 1,915,000 (908,250) 7,224,000

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Nature of Minority Interest
Two concepts for consolidated financial statements have been developed
to account for minority interest: the parent company concept and the
economic unit concept.
The parent company concept apparently treats the minority interest in
net assets of a subsidiary as a liability. This liability is increased by an
expense representing the minority’s share of the subsidiaries net income
(or decreased by the minority’s share of net loss). Dividends declared to
minority shareholders decrease the liability to them.
The economic unit concept displays the minority interest in the
subsidiary’s net assets stockholders’ equity section of the consolidated
balance sheet. The consolidated income statement displays the minority
interest in the subsidiary’s net income as a subdivision of total
consolidated net income.
Note that there is no ledger account for minority interest in net assets of
subsidiary, in either parent company’s or the subsidiary’s accounting
records.
Advantages and Shortcomings of Consolidated Financial Statements
Advantages
 Enable stockholders and prospective investors to view
comprehensive financial information for the economic unit without
regard for legal separateness of the individual companies.
Shortcomings
 Less useful to creditors of each company and minority
stockholders as they do not give information about operating
results and financial position of the individual companies.
 Consolidated financial statements of diversified companies
(conglomerates) are impossible to classify into a single industry
and thus cannot be used for comparative purposes by financial
analysts. (For assignments go to page 14)

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