Advanced Financial Reporting – Module 2

Contents
Advanced Financial Reporting – Module 2 ........................................................................... 1
Lesson 2.1 Overview of Acquisition Model ...................................................................... 1
Lesson 2.2 Goodwill Equation ........................................................................................... 9
Lesson 2.3 Consolidated Financial Statements on the Business Date- Part 1 ................. 16
Lesson 2.3 Lesson 2.3 Consolidated Financial Statements on the Business Date- Part 2
.......................................................................................................................................... 30

Lesson 2.1 Overview of Acquisition Model

In Lesson 1 of Module 2, we will discuss the overview of the acquisition method. Let's start
with some basic terminology. Acquisition method is the method to account for a business
combination.
The acquisition date is the date on which the acquirer obtains control of the acquiree.

The acquirer is the parent company, is the entity that obtains control of the acquiree.
The acquiree, which will be called a subsidiary company, is the business that the acquirer
obtains control of in a business combination.

Fair value defined as the price that will be received to sell an asset or pay to transfer liability
in the orderly transaction between market participants and the measurement date.
A business combination is accounted for using the acquisition methods that requires to:
determine the acquisition date, to identify the accounting acquirer and the accounting
acquiree,

to recognize the identifiable assets acquired, the liabilities assumed, and any non-controlling
interest in the acquiree and measure all of them at their acquisition date fair value.
Also, acquisition method requires to recognize and measure goodwill, or gain from bargain
purchase using the goodwill equation.

The acquisition date is the date on which the acquirer obtains control of the acquiree.
Generally is the date on which they acquirer legally transfers: the consideration, acquires the
assets, and assumes the liabilities of the acquiree. Basically, this is the closing, the effective
date of the transaction.
Identifiable assets acquired and liabilities assumed are measured based on their acquisition
date fair value. However, some assets acquired and liabilities assumed should be measured
based on their specific GAAP and not based on their acquisition date fair value.

For example, income taxes, employee benefits, share-based payment awards, and assets held
for sale.
The consideration transferred in a business combination must be measured also at its
acquisition date fair value.

The consideration transferred may include: the assets transferred by the acquirer, the
liabilities incurred by the acquirer to the former owners of the acquiree, the equity interest
issued by the acquirer.
The consideration transferred may include: cash, assets other than cash, shares of common
stock of the acquirer, share options and share-based payment awards, and contingent
consideration. However, regardless what consideration was transferred onto business
combination, whether it was cash, other assets, shares of common stock, regardless, it must
be measured at its acquisition date fair value.

Let's see these real-life business combination. In 2012, Express Scripts Company acquired
Medco Company for approximately $30 billion. So for example, in this real-life business
combination, the consideration transferred to acquirer 100 percentage of Medco Company
consisted of: cash, approximately $11.3 billion, share issue to the Medco shareholders of
approximately $18 billion, and stock option, issued approximately $700 million. In this
course, we will discuss in depth, the accounting for all the components of the consideration
transferred in a business combination.
Lesson 2.2 Goodwill Equation

In Lesson 2, we will discuss the goodwill equation. Goodwill or gain from bargain purchase
must be recognized on the business combination date. They are measured using the goodwill
equation. Using the goodwill equation, the goodwill or gain from bargain purchase is
calculated following.

Fair value of the consideration transferred in a business combination, plus fair value of
the non-controlling interest, plus fair value of any previously held equity interests in the
acquiree, minus the fair value of identifiable net assets acquired. If the difference of this
equation is a positive difference, a goodwill, an intangible asset is recognized. If the
difference is a negative difference, a gain from bargain purchase is recognized directly in the
consolidated income statement.
So let's discuss the components of this equation. Non-controlling interest exists when less
than 100 percentage of voting interest were acquired. For example, if the parent company
acquired 80 percentage of the subsidiary company, the 20 percentages are held by the non
controlling interest. We will discuss the accounting for non-controlling interests later in the
course. Also, the previously held equity interest in the acquiree exists when the control of the
subsidiary was achieving stages. We will discuss the accounting for step-by-step acquisitions
later in this course.

Goodwill is an intangible assets that represent the future economic benefits arising from other
assets acquired in the business combination, that are not individually identified and separately
recognized. Goodwill is an intangible asset that can be recognized only in a business
combination. It's reported in the consolidated balance sheet.

Goodwill is not amortized, since it has indefinite useful life. But it is tested for
impairment at least annually. We will discuss goodwill impairment test later in this course.
Now gain from bargain purchase, the negative difference of the goodwill equation is
recognized directly in the consolidated income statement.

Let's see the following example. On January 1 of 2008, company B issued 10,000 shares of
its one dollar per value common stock with the market price of five dollar per share and
transfer $70,000 in cash to acquire all the outstanding shares of common stock of company S.
On January 1 of 2018, company S's assets were reported at $200,000 and liabilities at
$110,000. These were also the fair values of the assets and liabilities. So let's look at this
example in detail.

Since Company P acquired 100 percentage of company S, there is no

non-controlling interests in this specific transaction. In addition, the control of company S
was achieved in one transaction. Thus, there are no previous held equity interests in company
S on the acquisition date. So in this specific case, the goodwill equations has only two
components; fair value of the consideration transferred minus the fair value of identifiable net
assets acquired. So let's calculate the fair value of the consideration transferred.
In this case, the fair value of consideration transfer has two components. First of all, the
shares of common stock it will transfer and the cash. Company P issued 10,000 shares of
common stock and the market price per share was five dollars. In addition, company P also
transferred $70,000 in cash. So all in all, the total fair value of the consideration transferred is
$120,000.
Now, let's calculate the fair value of identifiable net assets acquired. Fair value of identifiable
net assets acquired. So net assets will be the assets minus the liabilities of company S. In this
example, the fair values and the book values of assets and liabilities of company S are the
same. So the fair value of the assets was $200,000, the fair value of the liabilities was
$110,000.
So all in all, the fair value of identifiable net assets is $90,000. Finally, we have
all the components of the goodwill equation and we can calculate the goodwill or gain for
bargain purchase in this case. Goodwill equation. Fair value of consideration transferred was
$120,000 minus the fair value of identifiable net assets acquired of $90,000. So we got a
positive difference of 40,000. Since the difference is positive, a goodwill must be recognized
in the consolidated balance sheet.
In example 2, we will use the same data as in the previous example, except for the fact that
on January 1 of 2018, in the financial statements of company S, the land was reported a
$10,000 while its fair value was $60,000.

So guys, that amount of goodwill or gain from bargain purchase is recognized in this specific
case.
As in the previous example, the goodwill equation has only two components. Fair value of
consideration transfer of $120,000 and the fair value of identifiable net assets acquired. So
the fair value of identifiable net assets acquired consist of
the carrying amount of net assets acquired of $90,000 plus the excess of the fair value of the
land over the carrying amount of the land.
Excess of the fair value of the land over the carrying amount. So we know that the fair value
of the land is $60,000, while the carrying amount was only $10,000. So the fair value is
greater than the carrying amount by $50,000. So in this specific case, the fair value of
identifiable net assets is $140,000.
So now we all have all the components of the goodwill equation and we can calculate the
goodwill. Goodwill equation, fair value of consideration transferred, $12,000 minus the fair
value of identifiable net assets acquired of $140,000.
So in this specific case, we got a negative difference. Since the difference is negative, a gain
from bargain purchase is recognized in the consolidated income statement. Now, the
goodwill, a gain from bargain purchase. Gain from bargain purchase.
Lesson 2.3 Consolidated Financial Statements on the Business

Date- Part 1

In Lesson 3, we will discuss how to prepare the consolidated

financial statements on a business combination date. Consolidated financial statements are
the financial statements of a consolidated group of entities, that include the parents and all of
its subsidiaries, presented as those of a single economic entity. It means, even though, the
parent and the subsidies are separate legal entities, for financial accounting purposes, they are
treated as a single economic entity.
Separate financial statements are the financial statements of the parent company, in which it
accounts for the investment in the subsidiary using the cost method of accounting.

Consolidation is the process of presenting together all the assets and liabilities and income
statement items of the parent and the subsidiary, as if they are a single economic entity.
Consolidated financial statements must be reported by the parent company on each reporting
period date. For example, at the end of the fiscal year.

However, consolidation is a very complicated and time-consuming process. Thus, for internal
bookkeeping purposes during the year, in this separate financial status of the parent, the
parent accounts for its investment in the subsidiary using the cost method of accounting.
Let's assume on January 1 of 2018, Company P acquired 100 percentages of Company S, 100
percentages control. At the end of the reporting period, at the end of the year, Company P
must report consolidated financial statements, in which it's consolidates Company S,
consolidated financial statements. But the consolidation process, it's a very long and time-
consuming process. It cannot be done during every single day of the year.
So during the year, for internal bookkeeping purposes, Company P accounts for its
investment in Company S using the cost method of accounting. During the year for
internal bookkeeping purposes, Company P accounts for its investment in Company S using
the cost method of accounting.
Only at the end of the reporting period, there is a consolidation process to convert the
separate financial statements of the parent, in which the parent accounts for the investment in
the subsidiary using the cost method of accounting to the real consolidated financial
statement that must be reported. In this course, we will discuss the consolidation process, all
the consolidation adjustments, and all the elimination that must be made.
Under the cost method of accounting, the investment is always reported at its historical cost,
on the acquisition date, five years after the acquisition date, 700 years after the acquisition
date. But dividends received from the investee are recognized as dividend income.

Let us see the following example. On January 1 of 2018, Company P paid $5,000 for all the
outstanding shares of common stock of Company S.

Assume that on the acquisition date, the book values of all the assets and liabilities of
Company S equal their fair values.
The following are the financial statements of Company P and Company S on January 1 of
2018, just prior to the acquisition.

In the separate financial statements for internal bookkeeping purposes, Company P records
this transaction using the cost method. So the pre-consolidation journal entry recorded my
Company P was credit cash for $5,000 that we pay to acquire all the shares of common stock
of Company S, and debit investment in company S for $5,000. After journal entry was
recorded, Company P, the parent company, will convert it separate financial statements, in
which it accounts for the investment in Company S using the cost method of accounting to
the consolidated financial statements, in which Company P will consolidate all the assets and
liabilities of Company S. So what is the consolidation process?
First of all, we will create the consolidation spreadsheet that includes the following five
columns.

The first one will be, separate financial statements of the parent. The second column,
financial statements of the subsidiary.
The third and fourth columns will be debit and credit adjustments, and the last column will be
consolidated financial statements.

Please note, after the pre-consolidation journal entry was recorded, the cash balance in the
separate financial standards of the parent decreased by $,5000 and the investment in S
account of $5,000 is reported. So this is the consolidation spreadsheet that includes the five
columns.
The fourth step of the consolidation process is P plus S step. We will combine the financial
statements of the subsidiary with the separate financial statements of the parent company.
Basically, we will just add the entire balance sheet of a Company S to the balance sheet of
Company P. The journal entry is to record the balance sheet of Company S in a debit and
credit format.

So this is the journal entry P plus S. Basically, the entire balance sheet of Company S was
recorded in the debit and credit format, all the assets, liabilities, and equity accounts. Now,
after the fourth step of the consolidation process P plus S, we combine all the financial
statements of the parent with the financial statements of the subsidiary.
After we combine the parent's and subsidiary's financial statements, we need to make the
necessary consolidation adjustments, the journal entries, to prepare the consolidated balance
sheet.

So what are the consolidation adjustments? The adjustment number 1, we need to calculate
and record goodwill or gain from bargain purchase recognized on the acquisition date.
So guys, what amount of goodwill or gain from bargain purchase is recognized on the
acquisition of Company S?

As usual, we will use the goodwill equation to calculate goodwill on the acquisition date. The
fair value of identifiable assets acquired is $5,000, $9000 for assets minus 4,000 for
liabilities. Note, the fair values and the book values of assets and liabilities of Company S are
exactly the same. Fair value of consolidation transfer of $5,000, minus the fair value of
identifiable net assets of $5,000 will give me no goodwill, zero. So in this specific case, no
goodwill or gain for bargain purchase is recognized. Thus basically, no adjustment is needed.
Adjustment number 2 will be to remove the investment in company S account. No investment
in the subsidiary account is reported in the consolidated financial statements. Instead of
reporting the investment in the subsidiary account, the consolidated financial statements
report all the assets and liabilities of the parent, together with the assets and liabilities of the
subsidiary, as if they are a single economic entity. Thus, the investment account in Company
S must be removed, credited by $5,000.

The adjustment number 3 is to adjust all the assets and liabilities of the subsidiary, so they
will be reported based on the acquisition date fair values. As was previously discussed, the
identifiable assets acquired and liabilities assumed must be measured at the requisition date
fair values. But in this specific example, no adjustment is needed, since the book values of
assets and liabilities of Company S equal their fair values.
The adjustment number 4 will be to remove the shareholder's equity accounts of the
subsidiary. The shareholders of the parent company are the owner of the consolidated group.
Thus, on the business combination date, only the shareholders equity accounts of the parent
company are reported in the consolidated balance sheet. So the equity accounts of Company
S must be removed. We will debit the equity accounts of Company S.

After all the adjustments were made, we will record and insert the consolidation journal entry
to the consolidation spreadsheet, and we will calculate the correct balances that should be
reported in the consolidated financial statements.
So what is the consolidation journal entry? First of all, we will remove credit investment in
Company S account because we know no investment in the subsidiary account should be
reported in the consolidated financial statements. Then, we will remove all the equity
accounts of the subsidiary. So the retained earnings is debited for $2,000, the common stock
is debited for $500, and the additional paid-in capital is debited for $2,500.

After this consolidation journal entry was recorded, we can insert it into the consolidated
spreadsheet, and find the correct consolidated balances. So in respect to cash, no adjustments
were done. Company P plus Company S, together will be $2,500. The same idea for accounts
receivable. No adjustments were made, $1,000 Company P, $3000 Company S, in the
consolidated financial statements $4,000.
Also, no adjustments for inventory. So the inventory is reported at $5,000. No adjustments
for the property and equipment. In respect to investment in Company S, we credit investment
for $5,000. So nothing is reported in the consolidated financial statements.
So the total assets will be $19,000. No adjustments were done for accounts payable. No
adjustments were done for bonds payable, but all the equity accounts of the subsidiary must
be removed. So we debited the retained earnings of the subsidiary, and in the consolidated
financial statement, the retained earnings of $3,000 is reported.
The same idea for common stock. We remove the common stock of the subsidiary. So only
the common stock of the parent company is reported in the consolidated financial statements,
and the same idea for the additional paid-in capital. As you can see, assets equals
liabilities plus equity, and my balance sheet is bonds.

Lesson 2.3 Lesson 2.3 Consolidated Financial Statements on

the Business Date- Part 2

Using the data from the previous example, now assumes that the following acquisition date
fair values for company S.
The inventory, the fair value of $3000, and the fair value of bonds payable was $4,500. So
the same pre-consolidation journal entry is recorded by Company P. Again, we will credit
cash for $5,000, and we will recognize the investment in the company S, the debit $5,000.

The same consolidation spreadsheet is prepared in the same journal entry P plus S is
recorded. We will combine the balance sheet of a company S, P is the balance sheet of
company P.
So this is the consolidation spreadsheet.

In step number 2, we need to make all the necessary consolidation adjustments, the journal
entries to prepare the consolidated balance sheet.
Adjustment number 1 will be to calculate and record goodwill or gain from bargain purchase
recognized on the acquisition date.

So what do you think? That amount of goodwill or gain from bargain purchase is recognized
in this specific case.
The fair value of the identifiable assets acquired is $10,000, $1,500 was cash, $3,000
accounts receivable, and also $3,000 for inventory, and 2,500 for property plant equivalents.
Please note, the fair value of inventory is $3,000, the fair value of the rest of the assets are the
same as the book values.

The fair value of liabilities assumed is $5,500, $1,000 for accounts payable, but the fair value
of bonds payable was $4,500.
Thus, the fair value of identifiable net assets acquired is $4,500, $10,000, fair value of
identifiable assets acquired minus $5,500 fair value of liabilities assumed.

As usual, we will use the goodwill equation to calculate goodwill in this specific case. The
fair value of the concentration transfer was $5,000, the fair value of identifiable net assets
acquired was 4,500. So the difference is a positive difference of $500, so goodwill is
recognized. So goodwill of $500 is recognized, basically is debited in my consolidation
journal entry.
In the adjustment number 2, we need to remove the investment in S account. So the
investment in company S account of $5,000 must be credited, removed.

In adjustment number 3, we need to adjust all the assets and liabilities of the subsidiary, so
they will be reported based on their acquisition date fair values.
The only adjustments are for inventory in bonds payable, since the fair values differ from
their book values. In respect to the inventory, we must increase debit inventory by $1,000,
and why? Because the fair value of a $3,000, while the book value was only $2,000. Also, we
must increase credit bonds payable by $1,500. The fair value of bonds payable was 4,500,
while the book value was only $3,000.

In adjustment number 4, we need to remove all the shareholders equity accounts of the
subsidiary. So all the equity accounts of company S must be removed, debited in my
consolidation journal entry.
After the consolidation adjustments were made, we need to record and insert the
consolidation journal entry into the consolidation spreadsheet, and calculate the correct
balances that should be reported in the consolidated financial statements.

So this is the consolidation journal entry. We recognize debited goodwill for $500, so
goodwill was debited for 500. We must remove the investment in company S account, so
investment in company S account is credited for $5,000. Then the inventory must be debited
for $1,000, and why? Because we must adjust the inventory to its fair value, so we must
increase it by $1,000. The same idea for bonds payable, the fair value was greater than the
book value by 1,500, so we must credit increase bonds payable for $1,500. Then as usual we
must remove all the equity accounts of the subsidiary, so retained earnings is debited for
$2,000, common stock is debited for 500, and additional paid-in capital of the subsidiary is
debited for $2,500.
After this consolidation journal entry was recorded, we need to insert it into the consolidation
spreadsheet and find the correct consolidated balances. So let's do it. Again, no adjustments
to cash. The cash is P plus S, $2,500, no adjustment to accounts receivable, P plus S will be
$4,000. Inventory is debited for $1,000 must be increased to adjusted for its fair value, so the
inventory is reported $6,000.
Property plan equipment no adjustments, P plus S, $7,500, and we credit an investment in
company S for $5,000. So no investment in company S is reported in the consolidated
financial statement. Goodwill must be reported only in the consolidated balance sheet. So
goodwill was debited for $500, and is reported at $500 in the consolidated balance sheet, the
total assets will be 20,500. No adjustments were done to accounts payable, so accounts
payable would be reported at $3,000 in the consolidated financial statements.
Bonds payable was credited for $1,500, so in the consolidated financial statements the bonds
payable will be reported $8,500. All the equity accounts on the subsidiary must be debited.
So we debited retained earnings for $2,000, we also debited the common stock for $500, and
we also debited the additional paid-in capital for $2,500. Please note, all the equity accounts
in the consolidated financial statements, only business combination date are the equity
accounts of the parent company. So all the liabilities and equity together is 20,500 and my
balance sheet is balanced.