anthonyIM_12

CHAPTER 12ACQUISITIONS AND CONSOLIDATED STATEMENTS

Changes from Eleventh Edition

Updated from Eleventh Edition.

ApproachThe results under the purchase method are of considerable importance, and also of considerable interest to the student. The results are mystifying at first, but something worth learning about. It is probably desirable to go through the illustrative situation in some detail.

The material on consolidated statements is brief, but we believe adequate for the objective of this book. Students should be able to grasp the general idea of what is going on without much difficulty and therefore should understand the meaning of consolidated statements when they read them. They should not, of course, be left with the impression that they know all about how to prepare such statements, and reference to the number of pages devoted to this topic in an intermediate or advanced text may be desirable: in some texts, 200 pages. If instructors wish to go further, they can develop worksheets for the asset valuation or minority interest situations.

Cases

Hardin Tool Company gives a simple set of numbers to illustrate the effect of purchase method accounting, both at the time of acquisition and subsequently. It provides an excellent overview.

Carter Corporation is a straightforward problem on the preparation of consolidated statements.

Keane’s Acquisition of Metro Information Services is an actual merger that can be used to illustrate the purchase method.

Productos Finas a consolidation exercise. This case is new with the Twelfth Edition.

Problems

Problem 12-1Company P should use the equity method. It owns more that 20 percent of Company S.

Investment on January 1dr. Investment..........................................................................................................................................................................................600,000

cr. Cash.................................................................................................................................................................................................600,000

Income and Dividendsdr. Investment.......................................................................................................................................................................................... 120,000*

cr. Equity Income.................................................................................................................................................................................120,000

* ($300,000 x .4)

dr. Cash.................................................................................................................................................................................................... 40,000*cr. Investment.......................................................................................................................................................................................40,000

* ($100,000 x .4)

On December 31, the investment in Company P would be reported as $680,000 ($600,000 + $120,000 - $40,000).

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Accounting: Text and Cases 12e – Instructor’s Manual Anthony/Hawkins/Merchant

Problem 12-2

Company P should use the cost method to account for its investment in Company S. Company P own less than 20 percent of Company S.

Original Investmentdr. Investment..........................................................................................................................................................................................1,000,000

cr. Cash.................................................................................................................................................................................................1,000,000

Dividend Payment receiveddr. Cash....................................................................................................................................................................................................25,000

cr. Dividend Income.............................................................................................................................................................................25,000

Problem 12-3Year 1(1) dr. Investment..........................................................................................................................................................................................700,000

cr. Cash................................................................................................................................................................................................700,000

(2) dr. Investment.......................................................................................................................................................................................... 24,500*cr. Equity Income................................................................................................................................................................................ 24,500

* ($70,000 x .35)

(3) dr. Cash.................................................................................................................................................................................................... 21,000*cr. Investment...................................................................................................................................................................................... 21,000

*($60,000 x .35)

Year 2(1) dr. Investment..........................................................................................................................................................................................75,000

cr. Cash................................................................................................................................................................................................75,000

(2) No entry.

(3) dr. Investment.......................................................................................................................................................................................... 60,000cr. Equity Income.............................................................................................................................................................................. 60,000

(150,000 x .4)

(4) dr. Cash....................................................................................................................................................................................................40,000cr. Investment......................................................................................................................................................................................40,000

Problem 12-4Goodwill Calculation

Ba BeCurrent assets..........................................................................................................................................................................................$150,000 (Appraised value)Net fixed assets........................................................................................................................................................................................555,600 (Appraised value)Other assets.............................................................................................................................................................................................. 134,400 (Appraised value)

Total Assets.......................................................................................................................................................................................840,000Liabilities................................................................................................................................................................................................. 192,000

Net Assets.........................................................................................................................................................................................648,000Purchase price.......................................................................................................................................................................................... 870,000Goodwill..................................................................................................................................................................................................$222,000

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©2007 McGraw-Hill/Irwin Chapter 12

Consolidated Balance Sheet

Elder BaBe ConsolidatedCurrent assets..........................................................................................................................................................................................$ 1,104,000 $150,000 $ 1,254,000Net fixed assets........................................................................................................................................................................................32,814,000 555,600 33,369,600Other assets..............................................................................................................................................................................................14,412,000 134,400 14,546,400Goodwill.................................................................................................................................................................................................. --- --- 222,000

Total assets........................................................................................................................................................................................$49,392,000

Current liabilities.....................................................................................................................................................................................$ 3,600,000 $ 42,000 $ 3,642,000Long-term debt........................................................................................................................................................................................15,582,000 150,000 15,732,000Common stock.........................................................................................................................................................................................24,000,000 --- 24,000,000Paid-in capital..........................................................................................................................................................................................5,418,000 --- 5,418,000Retained earnings.................................................................................................................................................................................... 600,000 --- 600,000

Total liabilities and equity................................................................................................................................................................$49,392,000

Problem 12-5

(1) dr. Sales (Subsidiary)..............................................................................................................................................................................337,000cr. Cost of Goods Sold........................................................................................................................................................................337,000

(2) dr. Accounts Payable (Parent).................................................................................................................................................................73,000cr. Accounts Receivable (Subsidiary).................................................................................................................................................73,000

(3) dr. Loan Payable (Subsidiary).................................................................................................................................................................396,000cr. Loan Receivable (Parent)...............................................................................................................................................................396,000

(4) An entry to eliminate Pebble’s investment in Sandvel is necessary, although the problem does not provide the equity amounts for Sandvel. The entry would be structured as follows:

Capital Stock (Subsidiary)…………….. X Retained Earnings (Subsidiary)..............................................................................................................................................................3.1 million - X

Investment in Sandvel (Parent)...........................................................................................................................................................3.1 million

Problem 12-6a. Pooling of Interests

CompanyA

CompanyB

Pooling of Interests

Current assets..........................................................................................................................................................................................$ 500,000 $150,000 $ 650,000Fixed assets.............................................................................................................................................................................................. 700,000 250,000 950,000

Totals..................................................................................................................................................................................................$1,200,000 $400,000 $1,600,000

Current liabilities.....................................................................................................................................................................................$ 250,000 $ 75,000 $ 325,000Long-term liabilities................................................................................................................................................................................ 175,000 50,000 225,000Capital stock, $20 per.............................................................................................................................................................................. 400,000 --- 660,000*Capital stock, $10, per............................................................................................................................................................................. --- 170,000 ---Additional paid-in capital........................................................................................................................................................................ 175,000 60,000 145,000+Retained earnings.................................................................................................................................................................................... 200,000 45,000 245,000

Totals..................................................................................................................................................................................................$1,200,000 $400,000 $1,600,000

* $400,000 + ($650,000 / $50) x $20)+ Plug figure (= $175,000 + $60,000 + $170,000 - $260,000)

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Purchase Accounting

Company A

Company B (Market Value) Purchase

Current assets..........................................................................................................................................................................................$ 500,000 $175,000 $ 575,000*Fixed assets.............................................................................................................................................................................................. 700,000 325,000 1,025,000Goodwill.................................................................................................................................................................................................. --- --- 275,000+

Totals..................................................................................................................................................................................................$1,200,000 $500,000 $1,875,000

Current liabilities.....................................................................................................................................................................................$ 250,000 $ 75,000 $ 325,000Long-term liabilities................................................................................................................................................................................ 175,000 50,000 775,000^Capital stock, $20 per.............................................................................................................................................................................. 400,000 --- 400,000Capital stock, $10 per.............................................................................................................................................................................. --- --- ---Additional paid-in capital........................................................................................................................................................................ 175,000 --- 175,000Retained earnings.................................................................................................................................................................................... 200,000 --- 200,000

Totals..................................................................................................................................................................................................$1,200,000 $125,000 $1,875,000

* ($500,000 - $100,000) + $175,000+ Plug ($650,000 – ($500,000 - $125,000)^ ($175,000 + $550,000) + $50,000

Cases

Case 12-1: Hardin Tool Company *

Note: This case is unchanged from the Eleventh Edition.

Approach

This is a straightforward exercise to give the student practice in applying the pooling of interests and purchase methods of accounting for a business combination. The case purposely avoids the complications of intercompany transactions, which are dealt with in Case 12-2.

Question 1 HARDIN TOOL COMPANY

Consolidated Balance SheetsAs of the Proposed Acquisition Date

(thousands of dollars)

Assets Pooling PurchaseCurrent assets..........................................................................................................................................................................................$ 678 $ 678Plant and equipment................................................................................................................................................................................ 1,002 1,1611

Goodwill.................................................................................................................................................................................................. --- 2002

Total assets.........................................................................................................................................................................................$1,680 $2,039Liabilities and Equity

Current liabilities.....................................................................................................................................................................................$ 370 $ 370Long-term debt........................................................................................................................................................................................ 205 205Common stock ($1 par)........................................................................................................................................................................... 200 200Additional paid-in capital........................................................................................................................................................................ 2523 9183

*This teaching note was prepared by James S. Reece. Copyright © James S. Reece.

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Retained earnings.................................................................................................................................................................................... 653 346Total liabilities and equity..................................................................................................................................................................$1,680 $2,039

1 Difference between Hardin’s appraisal value ($600,000) and book value ($441,000) is attributable to fixed assets; hence Pratt’s fixed assets are shown at $312,000 + $159,000 = $471,000 with purchase accounting, giving consolidated fixed assets of $690,000 (Hardin) + $471,000 (Pratt) = $1,161,000.

2 Excess of purchase price (100,000 * $8 = $800,000) over fair value of net assets of Hardin ($600,000).3 “Plug” figure. Students should note that with pooling treatment, owners’ equity equals $1,105,000, which is the sum of the preacquisition owners’ equities of the two firms ($100,000 + $218,000 + $346,000 for Hardin + $40,000 + $94,000 + $307,000 for Pratt = $1,105,000). With purchase treatment consolidated owners’ equity reflects both the $159,000 write-up of Pratt’s fixed assets and the $200,000 goodwill (excess of purchase pace over fair value of acquired net assets). With purchase accounting, the substance of the transaction is that Hardin issued 100,000 shares for cash (cr. Cash, $800,000; cr. Stock at par, $100,000; cr. Additional paid-in capital, $700,000); then the $800,000 cash was used to acquire $917,000 of assets ($558,000 book value + $159,000 write-up + $200,000 goodwill) and Hardin assumed $117,000 of liabilities. The $918,000 consolidated additional paid-in capital is thus this “new” $700,000 plus the $218,000 already on Hardin’s balance sheet.

In addition, the instructor may wish to discuss determination of Pratt’s purchase price and the appraisal value of its net (particularly fixed) assets. Is the investment banker the best judge of the worth of 100,000 new shares of Hardin’s stock? Why not use a market price? If a market price is used, should it be the price as of the date of the “handshake” agreement, the signing of a formal agreement, or the effective date of the agreement; or should it be some sort of average market price? How can an appraiser judge “fair value” of Pratt’s fixed assets? If an appraiser is not the best judge, then who is? Should several independent appraisals be made? (Anyone who has had a house appraised knows the appraisals will differ.) Of course, there are no clear answers to these questions, and the student should recognize these “gray matters” that underlie the straightforward application of accounting techniques.

Question 2 HARDIN TOOL COMPANY

Condensed Consolidated Income StatementFor the First Year after Combination

(In thousands, except per share amounts)

Pooling TreatmentSales.....................................................................................................................................................................................................$3,600Expenses............................................................................................................................................................................................... 2,740Income.................................................................................................................................................................................................. 860Income tax expense.............................................................................................................................................................................. 301Net income...........................................................................................................................................................................................$ 559

Earnings per share................................................................................................................................................................................ $2.80Purchase Treatment

Unadjusted income (as above).............................................................................................................................................................$ 860Additional depreciation........................................................................................................................................................................ 161

Taxable income.................................................................................................................................................................................... 844Income tax expense.............................................................................................................................................................................. 295Net income...........................................................................................................................................................................................$ 549

Earnings per share................................................................................................................................................................................ $2.75

1$159,000 + 10 years = $16.000

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Question 3

This question turns the case into an introductory finance case, with the opportunity to discuss financial leverage. Both of these new alternatives would have to be accounted for as a purchase. Assuming the common stock is still valued at $8 per share, the income statements would be as follows:

Preferred Stock Debentures

Unadjusted income..................................................................................................................................................................................$860 $860Additional depreciation........................................................................................................................................................................... 16 16Additional interest................................................................................................................................................................................... --- 40Taxable income....................................................................................................................................................................................... 844 804Income tax expense................................................................................................................................................................................. 295 281Net income.............................................................................................................................................................................................. 549 523Preferred dividend................................................................................................................................................................................... 40 ---Income available to common..................................................................................................................................................................$509 $523

Earnings per share (150,000 shares)........................................................................................................................................................$3.39 $3.49

The debenture alternative provides more leverage than the preferred stock alternative. In this simplified problem, this occurs solely because the interest cost on debt is tax deductible, making the net interest cost $26 versus the nondeductible preferred dividend of $40. If the company has the debt capacity to issue debentures rather than preferred stock, then they should do so. However, calculation of long-term debt/equity ratios for the four alternatives suggests that the debt capacity probably does exist. (Return on common equity figures are shown to quantify the effect of leverage; these can be omitted if the instructor wishes since they arc not formally covered until the next chapter.)

Debt/Equity ROE (common)Pooling, stock exchange:.........................................................................................................................................................................$205/$1,105 = 18.6% $559/$1,105 = 50.6%Purchase, stock exchange:.......................................................................................................................................................................$205/$1,464 = 14.0% $549/$1,464 = 37.5%Purchase, with preferred..........................................................................................................................................................................$205/$1,464 = 14.0% $509/$1,064 = 47.8%Purchase, with debentures:......................................................................................................................................................................$605/$1,064 = 56.9% $523/$1,064 = 49.2%

Case 12-2: Carter Corporation *

Note: This case is unchanged from the Eleventh Edition.

Approach

This case gives practice in construction of consolidated statements and is constructed in such a way that it progresses by stages from straightforward adjustments to the more difficult and intricate adjustments.

Answers to Questions

Exhibit A is a consolidation worksheet for the problem as originally presented. The resulting financial statements are shown in the first column of Exhibit B. It may be useful to reconcile with the beginning retained earnings before consolidation, as follows:

*This teaching note was prepared by Robert N. Anthony. Copyright © Robert N. Anthony.

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Carter’s ending retained earnings were...................................................................................................................................................$396,100Carter added to retained earnings during 20xl........................................................................................................................................ -27,200Therefore, Carter retained earnings on January 1, 20xl were.................................................................................................................368,900Consolidated addition to retained earnings in 20xl................................................................................................................................. 44,200Consolidated retained earnings, December 31,20x1...............................................................................................................................$413,100

Corrections (Question 2)

1. Diroff shareholders’ equity at acquisition was $142,800 ($159,800 - $17,000). Carter paid $142,800 for 75 percent of this equity, which had a book value of 75 percent of $142,800, or $107,100. Therefore, the initial consolidated balance sheet must show Goodwill of $35,700 (unless the assets are restated, and we have no evidence of this). The offset, at the time of acquisition, is to Minority interest. Amortization of goodwill disallowed by FAS 1 and 2. Minority interest would have increased by 25 percent of the increase in Diroff’s retained earnings since acquisition with a corresponding reduction in consolidated retained earnings. In summary, minority interest would be:

At time of acquisition..............................................................................................................................................................................$35,70025 percent of $17,000 increase to retained earnings............................................................................................................................... 4,250

$39,950

2. The entire $37,400 listed as other income constitutes income to the consolidated entity, so the $30,600 erroneously subtracted from it should be added back. This increases net income and retained earnings by $30,600. However, the assumed dividend was also subtracted erroneously from retained earnings, so this adjustment must be reversed, leaving no net effect on consolidated retained earnings.

Since Diroff has not paid the dividend, it must appear as one of its current liabilities. The $22,950(75 percent) owed to Carter must be eliminated as an intercompany transaction, by decreasing current liabilities and increasing retained earnings.

EXHIBIT AConsolidation Worksheet

Separate StatementsCarter Diroff Adjustments

Balance Sheets Dr. Cr. ConsolidatedAssetsCash.........................................................................................................................................................................................................57,800 20,400 78,200Accounts receivable................................................................................................................................................................................110,500 35,700 5,100 141,100Inventory.................................................................................................................................................................................................120,700 54,400 175,100Investment in subsidiary..........................................................................................................................................................................142,800 --- 142,800 ---Plant (net)................................................................................................................................................................................................477,700 134,300 612,000Loans receivable...................................................................................................................................................................................... --- 32,300 32,300 ---

Total....................................................................................................................................................................................................909,500 277,100 1,006,400Liabilities and EquityCurrent liabilities.....................................................................................................................................................................................88,400 62,900 5,100 146,200Noncurrent liabilities...............................................................................................................................................................................170,000 54,400 32,300 192,100Capital stock............................................................................................................................................................................................255,000 102,000 102,000 255,000Retained earnings....................................................................................................................................................................................396,100 57,800 40,800 ______ 413,100

Total....................................................................................................................................................................................................909,500 277,100 180,200 180,800 1,006,400

Income Statement Data

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Sales.........................................................................................................................................................................................................1,040,400 408,000 34,000 1,414,400Cost of sales.............................................................................................................................................................................................816,000 299,200 34,000 1,081,200Expenses..................................................................................................................................................................................................234,600 61,200 295,800Other income...........................................................................................................................................................................................37,400 --- 30,600 6,800Dividends.................................................................................................................................................................................................--- 30,600 30,600 0

The net effect on consolidated retained earnings is:As stated in Exhibit A..........................................................................................................................................................................$413,100Deduct minority interest in earnings.................................................................................................................................................... (4,250)Add elimination of dividend to Carter................................................................................................................................................. 22,950

Revised retained earnings.................................................................................................................................................................$431,800

The financial statements after these revisions are shown in the second column of Exhibit B.

Unsold Merchandise

The financial statements report $13,600 of Carter inventory that contains a 25 percent (8,500 / 34,000) unrealized profit, $3,400. This profit must be eliminated from the consolidated inventory, minority interest, and consolidated retained earnings. Minority interest is reduced by one-fourth of the unrealized profit, or $850, and consolidated retained earnings is reduced by $2,550.

Dividend

The big change between the original and revised consolidated statements came from the mishandling of dividend revenue. Correction of this change increased net income by 67 percent, net profit margin percentage from 3.1 percent to 5.2 percent, and owners’ equity by 8.1 percent. The current redo was also affected by this correction, increasing from 2.70 to 3.17. (Return on investment ratios also changed, but these are not covered until the next chapter.) Correction for the omission of minority interest had no impact in terms of ratio analysis, unless an analyst were to eliminate minority interest from owners’ equity in doing an analysis (as is the case with some analysts). Correction for unrealized profit on intracompany sales has a relatively minor impact on the current ratio and on inventory turnover (from 6.17 to 6.30).

Exhibit BCARTER CORPORATION

Consolidated Financial StatementsBalance Sheet

As of December 31, 20x1

AssetsAs Originally

Prepared As RevisedCurrent Assets:

Cash......................................................................................................................................................................................................$ 78,200 $ 78,200Accounts receivable............................................................................................................................................................................. 141,100 141,100Inventory.............................................................................................................................................................................................. 175,100 175,100

Total current assets 394,400 394,400Plant (net)................................................................................................................................................................................................ 612,000 612,000Goodwill.................................................................................................................................................................................................._________ 35,700

Total assets........................................................................................................................................................................................$1,006,400 $1,042,100

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Liabilities and EquityCurrent liabilities.....................................................................................................................................................................................$ 146,200 $ 123,250Noncurrent liabilities............................................................................................................................................................................... 192,100 192,100Minority interest...................................................................................................................................................................................... 39,9501

Capital stock............................................................................................................................................................................................ 255,000 255,000Retained earnings.................................................................................................................................................................................... 413,100 431,8001

Total liabilities and equity................................................................................................................................................................$1,006,400 $1,042,100

Income StatementFor the year ended December 31, 20x1

Sales.........................................................................................................................................................................................................$1,414,400 $1,414,400Cost of sales............................................................................................................................................................................................. 1,081,200 1,081,200

Gross margin..................................................................................................................................................................................... 333,200 333,200Expenses.................................................................................................................................................................................................. (295,800) (295,800)Other income........................................................................................................................................................................................... 6,800 37,400

Net income........................................................................................................................................................................................$ 44,200 $ 74,800

1Per question 3, each of these amounts needs to be reduced.

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