Chapter 7

Consolidated Financial
Statements:
Subsequent to Date of
Business Combination

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc. 2006

 Scope of Chapter
 Accounting for operating results of both wholly
owned and partially owned subsidiaries is
described and illustrated.
 Accounting for inter-company transactions not
involving a profit (gain) or a loss, as well as
those involving a profit or a loss, are dealt with.

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 Accounting For Operating Results
Of Wholly Owned Subsidiaries

 Accounting for operating results of

consolidated subsidiaries, a parent
company may choose either of the two
methods:
– Equity Method of Accounting
– Cost Method of Accounting

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 Equity Method
 Parent company recognizes its share of the
subsidiary’s net income or net loss
 Adjusted for depreciation and amortization of
differences between current fair values and
carrying amounts of a subsidiary’s identifiable net
assets on the date of business combination
 Share of dividends declared by the subsidiary.

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 Equity Method
 Equity method of accounting is quite similar
to home office accounting for a branch’s
operations.
 Proponents claim that equity method
stresses the economic substance of the
parent-subsidiary relationship.
 Dividends declared by a subsidiary do not
constitute revenue to the parent company.

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 Equity Method
 Proponents of the method maintain that the
method is consistent with the accrual basis
of accounting
 It recognizes increases or decreases in the
carrying amount of the parent company’s
investment in the subsidiary
 When they are realized by the subsidiary as
net income or net loss, not when they are
paid by the subsidiary as dividends.
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 Cost Method
 Parent company accounts for the operations of
a subsidiary only to the extent that dividends
are declared by the subsidiary.
 Net income or net loss of the subsidiary is not
recognized by the parent company.
 Supporters of the method contend that the
method appropriately recognizes the legal form
of parent – subsidiary relationship.

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 Cost Method
 Dividends declared by subsidiary are
recognized as revenue by the parent
company.
 Dividends declared by subsidiary in excess
of post-combination net income constitute a
reduction of the carrying amount of the
parent company’s investment in the
subsidiary.

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 Cost Method
 According to the proponents of the cost
method, a parent company realizes revenue
from an investment in a subsidiary when the
subsidiary declares dividend
 Not when the subsidiary reports net income.

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 Choosing Between Equity Method
And Cost Method

 Consolidated financial statement amounts are

the same, regardless of which method is used
to account for subsidiary’s operations.
 Working paper eliminations used in the two
methods are different.

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 Working Paper Eliminations for
Equity Method

 Three components of the subsidiary’s stock

holders’ equity are reciprocal to the parent
company’s Investment Ledger Account.
 Subsidiary’s beginning-of-year retained
earnings amount is eliminated.
 Subsidiary’s dividends are an offset to the
subsidiary’s retained earnings.

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 Working Paper Eliminations for
Equity Method

 Balance of the parent company’s

Investment Ledger Account is net of the
dividends received from the subsidiary.
 Elimination of the subsidiary’s beginning-of-
year retained earnings makes beginning-of-
year consolidated retained earnings
identical to the end-of-previous-year
consolidated retained earnings.

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 Working Paper Eliminations for
Equity Method

 Debits to the subsidiary’s plant assets,

patent, and goodwill bring into the
consolidated balance sheet the un-
amortized differences between current
fair values and carrying amounts of the
subsidiary’s assets on the date of the
business combination.

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 Working Paper Eliminations for
Equity Method

 Amount of the parent company’s inter-

company investment income is an
element of the balance of the parent’s
Investment Ledger Account.

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 Working Paper Eliminations for
Equity Method

 In effect, the elimination of the inter-

company investment income comprises a
reclassification of the inter-company
investment income to the adjusted
components of the subsidiary’s net
income in the consolidated income
statement.

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 Working Paper Eliminations for
Equity Method

 Increases in the subsidiary’s cost of

goods sold and operating expenses, in
effect, reclassify the comparable
decrease in the parent company’s
Investment ledger account under the
equity method of accounting.

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 Emphasized Aspects of
Working Paper

 Inter-company receivable and payable,

placed in adjacent columns on the same
line, are offset without a formal elimination.
 Elimination cancels all inter-company
transactions and balances not dealt with by
the offset described above.

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 Emphasized Aspects of
Working Paper

 Elimination cancels the subsidiary’s retained

earnings balance at the beginning-of-year
 FIFO is used by subsidiary to account for
inventories;
 Difference attributable to subsidiary’s beginning inventories
is allocated to cost of goods sold for the year ended

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 Emphasized Aspects of
Working Paper

 Income tax effects of the elimination’s

increase in subsidiary’s expenses are not
included in the elimination.
 One of the effects of the elimination is to
reduce the differences between the current
fair values and the carrying amounts of the
subsidiary’s net assets
 excepting land and goodwill, on the business
combination date.

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 Emphasized Aspects of
Working Paper

 Parent company’s use of the equity method of

accounting results in the equalities described
below:
– Parent Company Net Income = Consolidated Net Income.
– Parent Company Retained Earnings = Consolidated Retained Earnings.

 Despite the equalities, consolidated financial

statements are superior to parent company
financial statements for the presentation of
financial position and operating results of parent
and subsidiary companies.

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 Closing Entries
 After consolidated financial statements have been
completed, both the parent and its subsidiary
companies prepare and post closing entries, to
complete the accounting cycle for the year.
 Subsidiary’s closing entries are prepared in the usual
fashion.
 Parent company’s use of equity method of accounting
necessitates specialized closing entries.

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 Closing Entries
 Equity method of accounting disregards legal
form in favor of economic substance
 State corporation laws generally require
separate accounting for retained earnings
available for dividends to stockholders.

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 Accounting for Operating Results
of Partially Owned Subsidiaries

 Accounting for the operating results of a

partially owned subsidiary requires the
computation of the minority interest in net
income or net losses of the subsidiary.

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 Accounting for Operating Results
of Partially Owned Subsidiaries

 Under the economic unit concept, the

consolidated income statement of a
parent company and its partially owned
subsidiaries includes an allocation of total
consolidated income to the parent
company and the minority interest.

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 Concluding Comments
 In today’s financial accounting
environment, the equity method of
accounting for a subsidiary’s operations
is preferable to the cost method for the
following reasons:
 The equity method is consistent with the accrual basis of
accounting
 Emphasizes economic substance of the parent company
– subsidiary relationship, while the cost method
emphasizes legal form.

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 Concluding Comments
- Equity method permits the use of parent company
journal entries to reflect many items that must be
included in working paper eliminations in the cost
method
– Formal journal entries in the accounting records
provide a better record than do working paper
eliminations.
– Equity method facilitates issuance of separate
financial statements, if required by SEC
regulations or other considerations.
– Equity method provides a useful self checking
technique.
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