chapter 1 the equity method of accounting for

Chapter 02 - Consolidation of Financial Information

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CHAPTER 1 THE EQUITY METHOD OF ACCOUNTING FOR INVESTMENTS

Chapter Outline I. Three methods are principally used to account for an investment in equity securities along

with a fair value option.

A. Fair value method: applied by an investor when only a small percentage of a company’s voting stock is held.

1. Income is recognized when the investee declares a dividend.

2. Portfolios are reported at fair value. If fair values are unavailable, investment is reported at cost.

B. Consolidation: when one firm controls another (e.g., when a parent has a majority

interest in the voting stock of a subsidiary or control through variable interests, their financial statements are consolidated and reported for the combined entity.

C. Equity method: applied when the investor has the ability to exercise significant influence

over operating and financial policies of the investee.

1. Ability to significantly influence investee is indicated by several factors including representation on the board of directors, participation in policy-making, etc.

2. GAAP guidelines presume the equity method is applicable if 20 to 50 percent of the outstanding voting stock of the investee is held by the investor.

Current financial reporting standards allow firms to elect to use fair value for any new investment in equity shares including those where the equity method would otherwise apply. However, the option, once taken, is irrevocable. Investee dividends and changes in fair value over time are recognized as income.

On February 14, 2013, the FASB issued a Proposed Accounting Standards Update (ASU) entitled, Recognition and Measurement of Financial Assets and Financial Liabilities. The proposed ASU would eliminate the fair-value option for investments that qualify for equity method treatment. Fair-value accounting, however, would be extended to “equity method” investments that meet the criteria for classification as held for sale.

II. Accounting for an investment: the equity method

A. The investment account is adjusted by the investor to reflect all changes in the equity of the investee company.

B. Income is accrued by the investor as soon as it is earned by the investee.

C. Dividends declared by the investee create a reduction in the carrying amount of the Investment account. The text assumes all investee dividends are declared and paid in the same reporting period.



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III. Special accounting procedures used in the application of the equity method

A. Reporting a change to the equity method when the ability to significantly influence an investee is achieved through a series of acquisitions.

1. Initial purchase(s) will be accounted for by means of the fair value method (or at cost) until the ability to significantly influence is attained.

2. At the point in time that the equity method becomes applicable, a retrospective adjustment is made by the investor to convert all previously reported figures to the equity method based on percentage of shares owned in those periods.

3. This restatement establishes financial statement comparability across years.

B. Investee income from other than continuing operations

1. The investor recognizes its share of investee reported other comprehensive income (OCI) through the investment account and the investor’s own OCI.

2. Income items such as extraordinary gains and losses and discontinued operations that are reported separately by the investee should be shown in the same manner by the investor. The materiality of these other investee income elements (as it affects the investor) continues to be a criterion for separate disclosure.

C. Investee losses

1. Losses reported by the investee create corresponding losses for the investor.

2. A permanent decline in the fair value of an investee’s stock should be recognized immediately by the investor as an impairment loss.

3. Investee losses can possibly reduce the carrying value of the investment account to a zero balance. At that point, the equity method ceases to be applicable and the fair-value method is subsequently used.

D. Reporting the sale of an equity investment

1. The investor applies the equity method until the disposal date to establish a proper book value.

2. Following the sale, the equity method continues to be appropriate if enough shares are still held to maintain the investor’s ability to significantly influence the investee. If that ability has been lost, the fair-value method is subsequently used.

IV. Excess investment cost over book value acquired

A. The price an investor pays for equity securities often differs significantly from the investee’s underlying book value primarily because the historical cost based accounting model does not keep track of changes in a firm’s fair value.

B. Payments made in excess of underlying book value can sometimes be identified with specific investee accounts such as inventory or equipment.

C. An extra acquisition price can also be assigned to anticipated benefits that are expected to be derived from the investment. In accounting, these amounts are presumed to reflect an intangible asset referred to as goodwill. Goodwill is calculated as any excess payment that is not attributable to specific assets and liabilities of the investee. Because goodwill is an indefinite-lived asset, it is not amortized.

V. Deferral of unrealized gross profit in inventory

A. Profits derived from intra-entity transactions are not considered completely earned until the transferred goods are either consumed or resold to unrelated parties.



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B. Downstream sales of inventory

1. “Downstream” refers to transfers made by the investor to the investee.

2. Intra-entity gross profits from sales are initially deferred under the equity method and then recognized as income at the time of the inventory’s eventual disposal.

3. The amount of gross profit to be deferred is the investor’s ownership percentage multiplied by the markup on the merchandise remaining at the end of the year.

C. Upstream sales of inventory

1. “Upstream” refers to transfers made by the investee to the investor.

2. Under the equity method, the deferral process for unrealized profits is identical for upstream and downstream transfers. The procedures are separately identified in Chapter One because the handling does vary within the consolidation process.

Answers to Discussion Questions The textbook includes discussion questions to stimulate student thought and discussion. These questions are also designed to allow students to consider relevant issues that might otherwise be overlooked. Some of these questions may be addressed by the instructor in class to motivate student discussion. Students should be encouraged to begin by defining the issue(s) in each case. Next, authoritative accounting literature (FASB ASC) or other relevant literature can be consulted as a preliminary step in arriving at logical actions. Frequently, the FASB Accounting Standards Codification will provide the necessary support. Unfortunately, in accounting, definitive resolutions to financial reporting questions are not always available. Students often seem to believe that all accounting issues have been resolved in the past so that accounting education is only a matter of learning to apply historically prescribed procedures. However, in actual practice, the only real answer is often the one that provides the fairest representation of the a firm’s transactions. If an authoritative solution is not available, students should be directed to list all of the issues involved and the consequences of possible alternative actions. The various factors presented can be weighed to produce a viable solution. The discussion questions are designed to help students develop research and critical thinking skills in addressing issues that go beyond the purely mechanical elements of accounting.

Did the Cost Method Invite Manipulation? The cost method of accounting for investments often caused a lack of objectivity in reported income figures. With a large block of the investee’s voting shares, an investor could influence the amount and timing of the investee’s dividend declarations. Thus, when enjoying a good earnings year, an investor might influence the investee to withhold declaring a dividend until needed in a subsequent year. Alternatively, if the investor judged that its current year earnings “needed a boost,” it might influence the investee to declare a current year dividend. The equity method effectively removes managers’ ability to increase current income (or defer income to future periods) through their influence over the timing and amounts of investee dividend declarations.

At first glance it may seem that the fair value method allows managers to manipulate income because investee dividends are recorded as income by the investor. However, dividends paid typically are accompanied by a decrease in fair value (also recognized in income), thus leaving reported net income unaffected.



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Does the Equity Method Really Apply Here? The discussion in the case between the two accountants is limited to the reason for the investment acquisition and the current percentage of ownership. Instead, they should be examining the actual interaction that currently exists between the two companies. Although the ability to exercise significant influence over operating and financial policies appears to be a rather vague criterion, ASC 323 "Investments—Equity Method and Joint Ventures," clearly specifies actual events that indicate this level of authority (paragraph 323-10-15-6): Ability to exercise that influence may be indicated in several ways, such as representation on the board of directors, participation in policy-making processes, material intra-entity transactions, interchange of managerial personnel, or technological dependency. Another important consideration is the extent of ownership by an investor in relation to the concentration of other shareholdings, but substantial or majority ownership of the voting stock of an investee company by another investor does not necessarily preclude the ability to exercise significant influence by the investor. In this case, the accountants would be wise to determine whether Dennis Bostitch or any other member of the Highland Laboratories administration is participating in the management of Abraham, Inc. If any individual from Highland's organization is on Abraham’s board of directors or is participating in management decisions, the equity method would seem to be appropriate. Likewise, if significant transactions have occurred between the companies (such as loans by Highland to Abraham), the ability to apply significant influence becomes much more evident. However, if James Abraham continues to operate Abraham, Inc., with little or no regard for Highland, the equity method should not be applied. This possibility seems especially likely in this case since one stockholder, James Abraham, continues to hold a majority (2/3) of the voting stock. Thus, evidence of the ability to apply significant influence must be present before the equity method is viewed as applicable. The mere holding of 1/3 of the stock is not conclusive.



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Answers to Questions 1. The equity method should be applied if the ability to exercise significant influence over the

operating and financial policies of the investee has been achieved by the investor. However, if actual control has been established, consolidating the financial information of the two companies will normally be the appropriate method for reporting the investment.

2. According to FASB ASC paragraph 323-10-15-6 "Ability to exercise that influence may be

indicated in several ways, such as representation on the board of directors, participation in policy-making processes, material intra-entity transactions, interchange of managerial personnel, or technological dependency. Another important consideration is the extent of ownership by an investor in relation to the extent of ownership of other shareholdings." The most objective of the criteria established by the Board is that holding (either directly or indirectly) 20 percent or more of the outstanding voting stock is presumed to constitute the ability to hold significant influence over the decision-making process of the investee.

3. The dividends are reported as a deduction from the investment account, not revenue, to avoid reporting the income from the investee twice. The equity method is appropriate when an investor has the ability to exercise significant influence over the operating and financing decisions of an investee. Because dividends represent financing decisions, the investor may have the ability to influence dividend timing. If dividends were recorded as income, managers could affect reported income in a way that does not reflect actual performance. Therefore, in reflecting the close relationship between the investor and investee, the equity method employs accrual accounting to record income as it is earned by the investee. The investment account is increased for the investee”s earned income and then decreased as the income is distributed, through dividends. From the investor’s view, the decrease in the investment asset (from investee dividends) is offset by an immediate increase in dividends receivable and an eventual increase in cash.

4. If Jones cannot significantly influence the operating and financial policies of Sandridge, the

equity method should not be applied regardless of the ownership level. However, an owner of 25 percent of a company's outstanding voting stock is assumed to possess this ability. This presumption stands until overcome by predominant evidence to the contrary. Examples of indications that an investor may be unable to exercise significant influence over the operating and financial policies of an investee include (ASC 323-10-15-10): a. Opposition by the investee, such as litigation or complaints to governmental regulatory

authorities, challenges the investor's ability to exercise significant influence. b. The investor and investee sign an agreement under which the investor surrenders

significant rights as a shareholder. c. Majority ownership of the investee is concentrated among a small group of shareholders

who operate the investee without regard to the views of the investor. d. The investor needs or wants more financial information to apply the equity method than is

available to the investee's other shareholders (for example, the investor wants quarterly financial information from an investee that publicly reports only annually), tries to obtain that information, and fails.

e. The investor tries and fails to obtain representation on the investee's board of directors. 5. The following events necessitate changes in this investment account.

a. Net income earned by Watts would be reflected by an increase in the investment balance whereas a reported loss is shown as a reduction to that same account.



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b. Dividends declared by the investee decrease its book value, thus requiring a corresponding reduction to be recorded in the investment balance.

c. If, in the initial acquisition price, Smith paid extra amounts because specific investee assets and liabilities had values differing from their book values, amortization of this portion of the investment account is subsequently required. As an exception, if the specific asset is land or goodwill, amortization is not appropriate.

d. Intra-entity gross profits created by sales between the investor and the investee must be deferred until earned through usage or resale to outside parties. The initial deferral entry made by the investor reduces the investment balance while the eventual recognition of the gross profit increases this account.

6. The equity method has been criticized because it allows the investor to recognize income that

may not be received in any usable form during the foreseeable future. Income is being accrued based on the investee's reported earnings, not on the investor’s share of investee dividends. Frequently, equity income will exceed the investor’s share of investee cash dividends with no assurance that the difference will ever be forthcoming.

Many companies have contractual provisions (e.g., debt covenants, managerial compensation

contracts) based on ratios in the main body of the financial statements. Relative to consolidation, a firm employing the equity method will report smaller values for assets and liabilities. Consequently, higher rates of return for its assets and sales, as well as lower debt-to-equity ratios may result. Meeting such contractual provisions of may provide managers incentives to maintain technical eligibility for the equity method rather than full consolidation.

7. FASB ASC Topic 323 requires that a change to the equity method be reflected by a

retrospective adjustment. Although a different method may have been appropriate for the original investment, comparable balances will not be readily apparent if the equity method is now applied. For this reason, financial figures from all previous years presented are restated as if the equity method had been applied consistently since the date of initial acquisition.

8. In reporting equity earnings for the current year, Riggins must separate its accrual into two

components: (1) net income and (2) other comprehensive income or loss. This handling enables the reader of the investor's financial statements to assess the nature of the change to the investment account.

9. Under the equity method, losses are recognized by an investor at the time that they are

reported by the investee. However, because of the conservatism inherent in accounting, any permanent losses in value should also be recorded immediately. Because the investee's stock has suffered a permanent impairment in this question, the investor recognizes the loss applicable to its investment.

10. Following the guidelines established by the ASC, Wilson would recognize an equity loss of

$120,000 (40 percent) stemming from Andrews' reported loss. However, since the book value of this investment is only $100,000, Wilson's loss is limited to that amount with the remaining $20,000 being omitted. Subsequent income will be recorded by the investor based on investee dividends. If Andrews is ever able to generate sufficient future profits to offset the total unrecognized losses, the investor will revert to the equity method.

11. In accounting, goodwill is derived as a residual figure. It is the investor's cost in excess of its

share of the fair value of the investee assets and liabilities. Although a portion of the acquisition price may represent either goodwill or valuation adjustments to specific investee assets and



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liabilities, the investor records the entire cost in a single investment account. No separate identification of the cost components is made in the reporting process. Subsequently, the cost figures attributed to specific accounts (having a limited life), besides goodwill and other indefinite life assets, are amortized based on their anticipated lives. This amortization reduces the investment and the accrued income in future years.

12. On June 19, Princeton removes the portion of this investment account that has been sold and

recognizes the resulting gross profit or loss. For proper valuation purposes, the equity method is applied (based on the 40 percent ownership) from the beginning of Princeton's fiscal year until June 19. Princeton's method of accounting for any remaining shares after June 19 will depend upon the degree of influence that is retained. If Princeton still has the ability to significantly influence the operating and financial policies of Yale, the equity method continues to be appropriate based on the reduced percentage of ownership. Conversely, if Princeton no longer holds this ability, the fair-value method becomes applicable, based on the remaining equity value after the sale.

13. Downstream sales are made by the investor to the investee while upstream sales are from the

investee to the investor. These titles have been derived from the traditional positions given to the two parties when presented on an organization-type chart. Under the equity method, no accounting distinction is actually drawn between downstream and upstream sales. Separate presentation is made in this chapter only because the distinction does become significant in the consolidation process as will be demonstrated in Chapter Five.

14. The unrealized portion of an intra-entity gross profit is computed based on the markup on any

transferred inventory retained by the buyer at year's end. The markup percentage (based on sales price) multiplied by the intra-entity ending inventory gives the seller’s profit remaining in the buyer’s ending inventory. The product of the ownership percentage and this profit figure is the unrealized gross profit from the intra-entity transaction. This profit is deferred in the recognition of equity earnings until subsequently earned through use or resale to an unrelated party.

15. Intra-entity transfers do not affect the financial reporting of the investee except that the related

party transactions must be appropriately disclosed and labeled. 16. Under fair value accounting, firms report the investment’s fair value as an asset and changes

in fair value as earnings. Dividends from an investee are included in earnings under the fair value accounting. Dividends are not recognized in income but instead reduce the investment account under the equity method. Also, under the equity method, firms recognize their ownership share of investee profits adjusted for excess cost amortizations and intra-entity profits.



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Answers to Problems

1. D 2. B 3. C 4. B 5. D 6. A Acquisition price ............................................................................. $1,600,000

Equity income ($560,000 × 40%) .................................................... 224,000

Dividends (50,000 shares × $2.00).................................................. (100,000)

Investment in Harrison Corporation as of December 31 .............. $1,724,000

7. A Acquisition price ............................................................................. $700,000

Income accruals: 2014—$170,000 × 20% ....................................... 34,000

2015—$210,000 × 20% ...................................... 42,000

Amortization (see below): 2014 ...................................................... (10,000)

Amortization: 2015 .......................................................................... (10,000)

Dividends: 2014—$70,000 × 20% ................................................... (14,000)

2015—$70,000 × 20% .................................................... (14,000)

Investment in Martes, December 31, 2015 ..................................... $728,000

Acquisition price of Martes............................................................. $700,000

Acquired net assets (book value) ($3,000,000 × 20%) ................. (600,000)

Excess cost over book value to patent ......................................... $100,000

Annual amortization (10 year remaining life) ............................... $10,000

8. B Purchase price of Johnson stock .................. $500,000

Book value of Johnson ($900,000 × 40%) ...... (360,000)

Cost in excess of book value .................... $140,000

Remaining Annual

Payment identified with undervalued ............ life amortization Building ($140,000 × 40%) ......................... 56,000 7 yrs. $8,000

Trademark ($210,000 × 40%) ..................... 84,000 10 yrs. 8,400

Total ................................................................. $ -0- $16,400



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Investment purchase price ............................................ $500,000

Basic income accrual ($90,000 × 40%) .................... 36,000

Amortization (above) ................................................. (16,400)

Dividends declared ($30,000 × 40%) ....................... (12,000)

Investment in Johnson ................................................... $507,600

9. D The 2014 purchase is reported using the equity method.

Purchase price of Evan stock ......................................................... $600,000

Book value of Evan stock ($1,200,000 × 40%) ............................... (480,000)

Goodwill ........................................................................................... $120,000

Life of goodwill ................................................................................ indefinite

Annual amortization ........................................................................ (-0-)

Cost on January 1, 2014 ................................................................. $600,000

2014 Income accrued ($140,000 x 40%) ......................................... 56,000

2014 Dividend ($50,000 × 40%) ....................................................... (20,000)

2015 Income accrued ($140,000 × 40%) ......................................... 56,000

2015 Dividend ($50,000 × 40%) ....................................................... (20,000)

2016 Income accrued ($140,000 × 40%) ......................................... 56,000

2016 Dividend ($50,000 × 40%) ....................................................... (20,000)

Investment in Evan, 12/31/16 ..................................................... $708,000

10. D

11. A Gross profit rate (GPR): $36,000 ÷ $90,000 = 40%

Inventory remaining at year-end .................................................... $20,000

GPR ................................................................................................... × 40%

Unrealized gross profit .............................................................. $8,000

Ownership ........................................................................................ × 30%

Intra-entity gross profit—deferred ............................................ $ 2,400



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12. B Purchase price of Steinbart shares ............................................... $530,000

Book value of Steinbart shares ($1,200,000 × 40%)...................... (480,000)

Trade name ...................................................................................... $ 50,000

Remaining life of trade name .......................................................... 20 years

Annual amortization ........................................................................ $ 2,500

2014 Gross profit rate = $30,000 ÷ $100,000 = 30%

2015 Gross profit rate = $54,000 ÷ $150,000 = 36%

2015—Equity income in Steinbart:

Income accrual ($110,000 × 40%) ................................................... $44,000

Amortization (above) ....................................................................... (2,500)

Recognition of 2014 unrealized gross profit

($25,000 × 30% GPR × 40% ownership) .................................... 3,000

Deferral of 2015 unrealized gross profit

($45,000 × 36% GPR × 40% ownership ..................................... (6,480)

Equity income in Steinbart—2015 ............................................ $38,020

13. (6 minutes) (Investment account after one year)

Purchase price ..................................................................................... $1,160,000

Basic 2015 equity accrual ($260,000 × 40%) ..................................... 104,000

Amortization of copyright:

Excess payment ($1,160,000 – $820,000 = $340,000)

to copyright allocated over 10 year remaining life .................. (34,000)

Dividends (50,000 × 40%) .................................................................... (20,000)

Investment account balance at year end ........................................... $1,210,000

14. (7 minutes)

a. Purchase price ................................................................................. $ 2,290,000

Equity income accrual ($720,000 × 35%) ....................................... 252,000

Other comprehensive loss accrual ($100,000 × 35%) ................... (35,000)

Dividends (20,000 × 35%) ................................................................ (7,000)

Investment in Steel at December 31, 2015..................................... $2,500,000

b. Equity income of Steel = $252,000 (does not include OCI share which is

reported separately).



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15. (15 minutes) (Investment account after 2 years)

a. Acquisition price ................................................................................. $2,700,000

Book value acquired ($5,175,000 × 20%) ........................................... 1,035,000

Excess payment .................................................................................. $1,665,000

Excess fair value: Computing equipment ($700,000 × 20%) ........ 140,000

Excess fair value: Patented technology ($3,900,000 × 20%) ........ 780,000

Excess fair value: Trademark ($1,850,000 × 20%) ........................ 370,000

Goodwill ............................................................................................... $ 375,000

Amortization: Computing equipment ($140,000 ÷ 7) ....................................... $ 20,000

Patented technology ($780,000 ÷ 3) .......................................... 260,000

Trademark (indefinite) ............................................................... -0-

Goodwill (indefinite) ................................................................... -0-

Annual amortization ........................................................................ $280,000

b. Basic equity accrual 2014 ($1,800,000 × 20%) .................................. $360,000

Amortization—2014 (above) ............................................................... (280,000)

Equity in 2014 earnings of Sauk Trail ................................................ $ 80,000

Basic equity accrual 2015 ($1,985,000 × 20%) .................................. $397,000

Amortization—2015 (above) ............................................................... (280,000)

Equity in 2015 earnings of Sauk Trail ................................................ $117,000

c. Acquisition price ................................................................................. $2,700,000

Equity in 2014 earnings of Sauk Trail (above) .................................. 80,000

Dividends—2014 ($150,000 × 20%) .................................................... (30,000)

Investment in Sauk Trail, 12/31/14 ..................................................... $2,750,000


Equity in 2015 earnings of Sauk Trail (above) .................................. $117,000

Dividends—2015 ($160,000 × 20%) .................................................... (32,000)




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16. (10 minutes) (Investment account after 2 years with fair value accounting

included)

a. Acquisition price ................................................................................. $60,000

Book value—assets minus liabilities ($125,000 × 40%) ............... 50,000

Excess payment ......................................................................... $10,000

Value of patent in excess of book value ($15,000 × 40%) ............ 6,000

Goodwill ........................................................................................... $ 4,000

Amortization: Patent ($6,000 ÷ 6) ...................................................................... $1,000

Goodwill ...................................................................................... -0-

Annual amortization ............................................................. $1,000

Acquisition price ............................................................................. $60,000

Basic equity accrual 2014 ($30,000 × 40%) ................................... 12,000

Dividends—2014 ($10,000 × 40%) .................................................. (4,000)

Amortization—2014 (above) ........................................................... (1,000)

Investment in Holister, 12/31/14 ..................................................... $67,000

Basic equity accrual —2015 ($50,000 × 40%) ................................ 20,000

Dividends—2015 .............................................................................. (6,000)

Amortization—2015 (above) ........................................................... (1,000)

Investment in Holister, 12/31/15 ..................................................... $80,000

b. Dividend income ($15,000 × 40%) .................................................. $6,000

Increase in fair value ($75,000 – $68,000) ...................................... 7,000

Investment income under fair value accounting—2015 ............... $13,000

17. (10 minutes) (Equity entries for one year, includes intra-entity transfers but no unearned gross profit)

Purchase price of Burks stock ....................................................... $210,000

Book value of Burks stock ($360,000 × 40%) ................................ (144,000)

Unidentified asset (goodwill) .......................................................... $ 66,000

Life .................................................................................................... indefinite

Annual amortization ........................................................................ $ -0-

No unearned intra-entity profit exists at year’s end because all of the transferred merchandise was used during the period.



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17. (continued)

Investment in Burks, Inc. .......................................... 210,000

Cash (or a Liability) .............................................. 210,000

To record acquisition of a 40 percent interest in Burks.

Investment in Burks, Inc. .......................................... 32,000

Equity in Investee Income ................................... 32,000

To recognize 40 percent income earned during period by Burks, an equity method investment.

Dividend Receivable .................................................. 10,000

Investment in Burks, Inc. ..................................... 10,000

To record investee dividend declaration. Cash ............................................................................ 10,000

Dividend Receivable. ........................................... 10,000

To record collection of dividend from investee.

18. (20 Minutes) (Equity entries for one year, includes conversion to equity method)

The 2014 purchase must be restated to the equity method.

FIRST PURCHASE—JANUARY 1, 2014

Purchase price of McKenzie stock .................................................. $210,000

Book value of McKenzie stock ($1,700,000 × 10%) ........................ (170,000)

Cost in excess of book value .......................................................... $40,000

Excess cost assigned to undervalued land ($100,000 × 10%) ...... (10,000)

Trademark ......................................................................................... $30,000

Remaining life of trademark ........................................................... 10 years

Annual amortization ......................................................................... $ 3,000

BOOK VALUE—MCKENZIE—JANUARY 1, 2015 (before second purchase)

January 1, 2014 book value (given) ................................................ $1,700,000

2014 Net income ............................................................................... 240,000

2014 Dividends ................................................................................. (90,000)

January 1, 2015 book value ............................................................. $1,850,000



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18. (continued)

SECOND PURCHASE—JANUARY 1, 2015

Purchase price of McKenzie stock ............................................... $600,000

Book value of McKenzie stock (above) ($1,850,000 × 30%) ....... (555,000)

Cost in excess of book value ....................................................... $45,000

Excess cost assigned to undervalued land

($120,000 × 30%) ....................................................................... (36,000)

Trademark ...................................................................................... $ 9,000

Remaining life of Trademark ........................................................ 9 years

Annual Amortization ..................................................................... $ 1,000

Journal Entries:

To record second acquisition of McKenzie stock. Investment in McKenzie ............................................ 600,000 Cash ...................................................................... 600,000

Investment in McKenzie ............................................ 12,000 Retained Earnings—Prior Period Adjustment— 2014 Equity Income ....................................... 12,000

To restate reported figures for 2014 to the equity method. Reported income is $24,000 (10% of McKenzie’s income) less $3,000 (amortization on first purchase) = $21,000. Originally, Austin reported $9,000 (10% of the dividends). The adjustment increases the $9,000 to $21,000 for 2014.

Investment in McKenzie ............................................ 120,000 Equity Income—Investment in McKenzie ........... 120,000 To record income for the year: 40% of the $300,000 reported income.

Dividend Receivable .................................................. 44,000 Investment in McKenzie ....................................... 44,000

To record dividend declaration from McKenzie (40% of $110,000). Cash ............................................................................ 44,000 Dividend Receivable. ........................................... 44,000

To record collection of dividend from investee.

Equity Income—Investment in McKenzie ................ 4,000 Investment in McKenzie ....................................... 4,000

To record 2015 amortization: $3,000 for first purchase, $1,000 for second.



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19. (7 minutes) (Deferral of unrealized gross profit)

Ending inventory ($225,000 – $105,000) ............................................. $120,000

Gross profit percentage (GP $75,000 ÷ Sales $225,000) ................... × 33⅓%

Unrealized gross profit ......................................................................... $40,000

Ownership ............................................................................................. × 25%

Intra-entity unrealized gross profit—deferred .................................... $10,000

Entry to Defer Unrealized Gross Profit:

Equity Income from Schilling ....................................... 10,000 Investment in Schilling ............................................ 10,000

20. (10 minutes) (Reporting of equity income and transfers)

a. Equity in investee income:

Equity income accrual ($100,000 × 25%) .................................. $25,000

Less: deferral of intra-entity unrealized gross profit (below) (3,000)

Less: patent amortization (given) ............................................ (10,000)

Equity in investee income .................................................... $12,000

Deferral of intra-entity unrealized gross profit:

Remaining inventory—end of year ...................................... $32,000

Gross profit percentage (GP $30,000 ÷ Sales $80,000) ...... × 37½%

Profit within remaining inventory ........................................ $12,000

Ownership percentage ......................................................... × 25%

Intra-entity unrealized gross profit ............................................... $ 3,000

b. In 2015, the deferral of $3,000 will likely become realized by BuyCo’s

use or sale of this inventory. Thus, the equity accrual for 2015 will be increased by $3,000 in that year. Recognition of this amount is simply being delayed from 2014 until 2015, the year actually earned.

c. The direction (upstream versus downstream) of the intra-entity transfer does not affect the above answers. However as discussed in Chapter Five, a controlling interest calls for a 100% gross profit deferral for downstream intra-entity transfers. In the presence of only signification influence, however, equity method accounting is identical regardless of whether an intra-entity transfer is upstream or downstream.



Education.

21. (25 minutes) (Conversion from fair-value method to equity method with a

subsequent sale of a portion of the investment)

Equity method income accrual for 2015

30 percent of $644,000 for ½ year = ..................................... $ 96,600

24 percent of $644,000 for ½ year = ..................................... 77,280

Total income accrual (no amort. or unearned gross profit) .......... $173,880

Gain on sale (below) ....................................................................... 31,000

Total income statement effect – 2015 $204,880

Gain on sale of 9,000 shares of Marion:

Cost of initial acquisition—2013 .................................................... $435,000

10% income accrual (conversion made to equity method) .......... 35,900

10% of dividends ............................................................................. (10,700)

Cost of second acquisition—2014 ................................................. 1,000,000

30% income accrual—2014 ............................................................. 150,300

30% of dividends—2014 .................................................................. (39,750)

30% income accrual for ½ year—2015 ........................................... 96,600

30% of dividends for ½ year—2015 ................................................ (22,350)

Book value of 45,000 shares on July 1, 2015 .......................... $1,645,000

Cash proceeds from the sale: 9,000 shares × $40 ....................... $360,000

Less: book value of shares sold: $1,645,000 × (9,000 ÷ 45,000) .. 329,000

Gain on sale ................................................................................ $ 31,000

22. (25 minutes) (Verbal overview of equity method, includes conversion to equity method)

a. In 2014, the fair-value method (available-for-sale security) was appropriate. Thus, the only income recognized was the dividends declared. Collins should originally have reported dividend income equal to 10 percent of Merton’s dividends.

b. The assumption is that Collins’ level of ownership now provides the company with the ability to exercise significant influence over the operating and financial policies of Merton. Factors that indicate such a level of influence are described in the textbook and include representation on the investee’s board of directors, material intra-entity transactions, and interchange of managerial personnel.



Education.

22. (continued)

c. Despite holding 25 percent of Merton’s outstanding stock, application of the equity method is inappropriate absent the ability to apply significant influence. Factors that indicate a lack of such influence include: an agreement whereby the owner surrenders significant rights, a concentration of the remaining ownership, and failure to gain representation on the board of directors.

d. The equity method attempts to reflect the relationship between the investor and the investee in two ways. First, the investor recognizes investment income as soon as it is earned by the investee. Second, the Investment account reported by the investor is increased and decreased to indicate changes in the underlying book value of the investee.

e. Criticisms of the equity method include its emphasis on the 20-50% of voting stock in determining significant

influence vs. control allowing off-balance sheet financing potential biasing of performance ratios

Relative to consolidation, the equity method will report smaller amounts for assets, liabilities, revenues and expenses. However, income is typically the same as reported under consolidation. Therefore, companies that use the equity method, and avoid consolidation, often show enhanced debt-to equity ratios, as well as ratios for returns on assets and sales.

f. When an investor buys enough additional shares to gain the ability to exert significant influence, accounting for any shares previously owned must be adjusted to the equity method on a retrospective basis. Thus, in this case, the 10 percent interest held by Collins in 2014 must now be reported using the equity method. In this manner, the 2014 statements will be more comparable with those of 2015 and future years.

g. The price paid for each purchase is first compared to the equivalent book value on the date of acquisition. Any excess payment is then assigned to specific assets and liabilities based on differences between book value and fair value. If any residual amount of the purchase price remains unexplained, it is assigned to goodwill.



Education.

22. (continued)

h. Investee dividends reduce its book value. Because the investor’s Investment account tracks the investee’s book value, Collins records the dividend as a reduction in its Investment account. This method of recording also avoids double-counting of the revenue since the investor has already recorded the amount when earned by the investee. Under the equity method, revenues are recognized when earned by the investee but not through dividends as a distribution of the same earnings.

i. The Investment account will show the costs to obtain ownership of Merton. In addition, an equity accrual equal to 10 percent of the investee’s income for 2014 and 25 percent for 2015 is included. The investment balance will be reduced by 10 percent of any of Merton’s dividends during 2014 and 25 percent for 2015 dividends. Finally, the Investment account will be decreased by any amortization expense for both 2014 and 2015.

23. (20 minutes) (Verbal overview of intra-entity transfers and their impact on application of the equity method)

a. An upstream transfer goes from investee to investor whereas a downstream transfer is made by the investor to the investee.

b. The direction of an intra-entity transfer has no impact on reporting when the equity method is applied. The direction of the transfers was introduced in Chapter One because it does have an important impact on consolidation accounting as explained in Chapter Five.

c. To determine the intra-entity unrealized gross profit when applying the equity method, the transferred inventory that remains at year’s end is multiplied by the gross profit percentage. This computation derives the unrealized gross profit. The intra-entity portion of this gross profit is found by multiplying it by the percentage of the investee that is owned by the investor.

d. Parrot, as the investor, will accrue 42 percent of the income reported by Sunrise. However, this equity income will then be reduced by the amount of the unrealized intra-entity gross profit. These amounts can be combined and recorded as a single entry, increasing both the Investment account and an Equity Income account. As an alternative, separate entries can be made. The equity accrual is added to these two accounts while the deferral of the unrealized gross profit serves as a reduction.



Education.

23. (continued)

e. In the second year, Parrot again records an equity accrual for 42 percent of the income reported by Sunrise. The intra-entity portion of the unrealized gross profit created by the transfers for that year are delayed in the same manner as for 2014 in (d) above. However, for 2015, the gross profit deferred from 2014 must now be recognized. This transferred merchandise was sold during this second year so that the earnings process has now been culminated.

f. If none of the transferred merchandise remains at year-end, the intra-entity

transactions create no impact on the recording of the investment when applying the equity method. No gross profit remains unrealized.

g. The intra-entity transfers create no direct effects for Sunrise, the investee.

However, as related party transactions, the amounts, as well as the relationship, must be properly disclosed and labeled.

24. (15 minutes) (Verbal overview of the sale of a portion of an investment being reported on the equity method and the accounting for any shares that remain)

a. The equity method must be applied up to the date of the sale. Therefore, for

the current year until August 1, Einstein records an equity accrual recognizing 40 percent of Brooks’ reported income for that period. In addition, Einstein records any dividends declared by Brooks as a reduction in the carrying amount of the investment account. Finally, amortization of acquisition-date excess fair over book values are recorded through August 1. These entries establish an appropriate book value as of the date of sale. Then, an amount of that book value equal to the portion of the shares sold is removed to compute a gain or loss on sale.

b. Subsequent accounting for the remaining shares depends on the influence

retained post-sale. If Einstein maintains the ability to apply significant influence to the operating and financial decisions of Brooks, the equity method is still applicable based on the smaller new ownership percentage. However, if significant influence has been lost, Einstein should report the remaining shares by means of the fair-value method.

c. In this situation, three figures would be reported by Einstein. First, an

equity income balance is recorded that includes both the accrual and amortization prior to August 1. Second, a gain or loss should be shown for the sale of the shares. Third, any investee dividends declared after August 1 must be included in Einstein’s income statement as dividend revenue.



Education.

24. (continued)

d. No, the ability to apply significant influence to the investee was present prior to August 1 so that the equity method was appropriate. No change is made in those figures. However, after the sale, the remaining investment must be accounted for by means of the fair-value method.

25. (12 minutes) (Equity balances for one year includes intra-entity transfers)

a. Equity income accrual—2015 ($90,000 × 30%) ......................... $27,000

Amortization—2015 (given) ........................................................ (9,000)

Intra-entity profit recognized on 2014 transfer* ........................ 1,200

Intra-entity profit deferred on 2015 transfer** ........................... (2,640)

Equity income recognized by Matthew in 2015 ................... $16,560

*Gross profit rate (GPR) on 2014 transfer ($16,000/$40,000) ... 40%

Unrealized gross profit:

Remaining inventory (40,000 × 25%) .................................... $10,000

GPR (above) ........................................................................... × 40%

Ownership percentage .......................................................... × 30%

Intra-entity profit deferred from 2014 until 2015 ................. $ 1,200

**GPR on 2015 transfer ($22,000/$50,000) ................................. 44%

Unrealized gross profit:

Remaining inventory (50,000 × 40%) .................................... $20,000

GPR (above) ........................................................................... × 44%

Ownership percentage .......................................................... × 30%

Intra-entity profit deferred from 2015 until 2016 ................. $ 2,640

b. Investment in Lindman, 1/1/15 ................................................... $335,000

Equity income—2015 (see [a] above) ........................................ 16,560

Dividends—2015 ($30,000 × 30%) .............................................. (9,000)

Investment in Lindman, 12/31/15 ............................................... $342,560



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26. (20 Minutes) (Equity method balances after conversion to equity method. Must determine investee’s book value)

Part a

1. Allocation and annual amortization—first purchase 1/1/2014

Purchase price of 15 percent interest ....................................... $62,000

Net book value ($280,000 × 15%) ............................................... (42,000)

Franchise agreements ................................................................ $20,000

Remaining life of franchise agreements ................................... ÷ 10 years

Annual amortization .............................................................. $ 2,000

Allocation and annual amortization—second purchase 1/1/2015


Net book value $280,000 + $80,000 - $30,000 = $330,000.

($330,000 × 10%) .......................................................................... (33,000)

Franchise agreements ................................................................ $10,800

Remaining life of franchise agreements ................................... ÷ 9 years

Annual amortization .............................................................. $ 1,200

Investment in Bellevue account

January 1, 2014 purchase ........................................................... $62,000

2014 basic equity income accrual ($80,000 × 15%) .................. 12,000

2014 amortization on first purchase (above) ............................ (2,000)

2014 dividends ($30,000 × 15%) ................................................. (4,500)

Equity method balance 12/31/2014 $67,500

January 1, 2015 purchase ........................................................... 43,800

2015 basic equity income accrual ($100,000 × 25%) ................ 25,000


2015 amortization on second purchase (above) ...................... (1,200)

2015 dividends ($40,000 × 25%) ................................................. (10,000)

Investment in Bellevue—December 31, 2015 ...................... $123,100

2. Equity Income—2015

2015 basic equity income accrual ($100,000 × 25%) ................ $25,000



Equity income—2015 ............................................................. $21,800



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26. (continued)

3. The January 1, 2015 retrospective adjustments to convert the Investment in Bellevue to the equity method is as follows:

Unrealized Holding Gain—Shareholders’ Equity 3,700

Fair Value Adjustment (Available-for-Sale Securities) 3,700

To eliminate AFS fair value adjustment account balances for the investment in Bellevue (15% × $438,000 = $65,700 less $62,000 = $3,700)

Investment in Bellevue 5,500

Retained Earnings (January 1, 2015) 5,500

Retrospective adjustment to retained earnings to record 2014 equity method income for 15% investment (15% × $80,000 less $2,000 excess amortization less $4,500 dividend income recognized in 2014). [Alternative: Equity method balance of investment $67,500 less cost $62,000 = $5,500.]

Part b

1. Investment in Bellevue (25% × 468,000) $117,000

2. Dividend income (25% × 40,000) $10,000

Increase in fair value (25% × [$468,000 - $438,000]) 7,500

Reported income from Investment in Bellevue $17,500

27. (30 minutes) (Conversion to equity method, sale of investment, and unrealized gross profit)

Part a

Allocation and annual amortization—first purchase


Net book value ($800,000 × 10%) ............................................... (80,000)

Copyright ..................................................................................... $12,000

Remaining life of Copyright ............................................................. ÷ 16 yrs

Annual Amortization ........................................................................ $ 750



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27. Part a (continued)

Allocation and annual amortization—second purchase


Net book value ($800,000 is increased by $180,000

income but decreased by $80,000 in dividends)

($900,000 × 20%) ................................................................... (180,000)

Copyright ..................................................................................... $30,000

Remaining life of copyright ............................................................. 15 years

Annual amortization ......................................................................... $ 2,000

Equity income—2013 (after conversion to establish comparability)

2013 basic equity income accrual ($180,000 × 10%) ..................... $18,000

2013 amortization on first purchase (above) .................................. (750)

Equity income—2013 .................................................................. $17,250

Equity income 2014

2014 basic equity income accrual ($210,000 × 30%) ................ $63,000

2014 amortization on first purchase (above) ............................ (750)


Equity income 2014 .......................................................................... $60,250

Part b

Investment in Barringer

Purchase price—January 1, 2013 .................................................... $92,000

2013 equity income (above) ....................................................... 17,250

2013 dividends ($80,000 × 10%) ................................................. (8,000)

Purchase price January 1, 2014 ...................................................... 210,000

2014 equity income (above) ....................................................... 60,250

2014 dividends ($100,000 × 30%) ............................................... (30,000)

2015 basic equity income accrual ($230,000 × 30%) ................ 69,000



2015 dividends ($100,000 × 30%) ............................................... (30,000)

Investment in Barringer—12/31/15 .................................................. $377,750



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27. Part b (continued)

Gain on sale of investment in Barringer

Sales price (given) ...................................................................... $400,000

Book value 1/1/16 (above) .......................................................... (377,750)

Gain on sale of investment ................................................... $ 22,250

Part c

Deferral of 2014 unrealized gross profit into 2015

Ending inventory ......................................................................... $20,000

Gross profit percentage ($15,000 ÷ $50,000) ............................ × 30%

Unrealized gross profit .......................................................... $6,000

Anderson’s ownership ................................................................ × 30%

Unrealized intra-entity gross profit ...................................... $ 1,800

Deferral of 2015 unrealized gross profit into 2016

Ending inventory ......................................................................... $40,000

Gross profit percentage ($27,000 ÷ $60,000) ............................ × 45%

Unrealized gross profit .......................................................... $18,000

Anderson’s ownership ................................................................ × 30%

Unrealized intra-entity gross profit ...................................... $ 5,400

Equity Income—2015

2015 equity income accrual ($230,000 × 30%) .......................... $69,000



Realization of 2014 intra-entity profit (above) ........................... 1,800

Deferral of 2015 intra-entity profit (above) ................................ (5,400)

Equity Income—2015 ............................................................. $62,650



Education.

28. (40 Minutes) (Conversion to equity method and equity reporting after several years)

a. Annual Amortization

October 1, 2013 purchase

Purchase price ............................................................................ $7,475

Book value, 10/1/13:

As of 1/1/13 ......................................................... $100,000

Equity increase 1/1/13 to 10/1/13

($20,000 income less $8,000 dividends = $12,000)

× ¾ year ......................................................... 9,000

Book value of Barker, first purchase date $109,000

Acquired percentage.............................................. × 5% 5,450

Intangible assets .................................................... $2,025

Remaining life ......................................................... 15 years

Annual amortization—first purchase.................... $ 135

July 1, 2014 purchase

Purchase price ....................................................... $14,900

Book value, 7/1/14:

As of 1/1/14 ($100,000 + $20,000 - $8,000) ........ $112,000


($30,000 income less $16,000 dividends = $14,000)

× ½ year ........................................................ 7,000

Book value of Barker, second purchase date $119,000




Annual amortization—second purchase .............. $ 200

December 31, 2015 purchase

Purchase price ....................................................... $34,200

Book value, 12/31/15:

As of 1/1/15 ($112,000 + $30,000 - $16,000) ...... $126,000


($24,000 income less $9,000 dividends) ........... 15,000

Book value of Barker, third purchase $141,000


28. a (continued)



Education.



Annual amortization—third purchase .................. $ 400

Equity Income Reported by Smith

Reported for 2013 (3 months) after conversion

to equity method:

Accrual ($20,000 × ¼ year × 5%) ................ $250.00

Amortization on first purchase ($135 × ¼ year) (33.75)

Equity income 2013 ................................ $216.25

Reported for 2014 (5% for entire year and an additional 10%

for last 6 months) (after conversion to equity method):

Accrual—first purchase ($30,000 entire year × 5%) ...... 1,500

Accrual—second purchase ($30,000 × ½ year × 10%) .. 1,500

Amortization on first purchase, entire year ................... (135)

Amortization on second purchase ($200 × ½ year) ....... (100)

Equity income—2014 .................................................. $2,765

Reported for 2015 (15% for entire year; because final acquisition occurred at year end, neither income nor amortization is recognized):

Basic equity accrual ($24,000 × 15%) ............................. $3,600

Amortization on first purchase........................................ (135)

Amortization on second purchase .................................. (200)

Equity income—2015 .................................................. $3,265

b. Investment in Barker

Cost—first purchase ................................................................... $ 7,475.00

Cost—second purchase ............................................................. 14,900.00

Cost—third purchase .................................................................. 34,200.00

Equity Income (above)

2013 .......................................................................................... 216.25

2014 .......................................................................................... 2,765.00

2015 .......................................................................................... 3,265.00



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28. b (continued)

Less: investee dividends

2013 ($8,000 × ¼ × 5%)............................................................ (100.00)

2014 ($16,000 × 5% and $16,000 × 2/4 × 10%) ....................... (1,600.00)

2015 ($9,000 × 15%) ................................................................. (1,350.00)

Balance ........................................................................................ $59,771.25

29. (25 Minutes) (Preparation of journal entries for two years, includes losses and intra-entity transfers of inventory)

Journal Entries for Harper Co.

1/1/14 Investment in Kinman Co. ............ 210,000

Cash ......................................... 210,000

(To record initial investment)

During Dividends Receivable ................... 4,000

2014 Investment in Kinman Co. ...... 4,000

(To record dividend declaration: $10,000 x 40%)

Cash ............................................... 4,000

Dividends Receivable.............. 4,000

(To record receipt of dividend)

12/31/14 Equity in Kinman Income—Loss . 16,000

Other Comprehensive Loss of Kinman 8,000

Investment in Kinman Co. ...... 24,000

(To record accrual of income and OCI from

equity investee, 40% of reported balances)

12/31/14 Equity in Kinman Income—Loss . 3,300


(To record amortization relating to acquisition

of Kinman—see Schedule 1 below)



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29. (continued)

12/31/14 Equity in Kinman Income-Loss ... 2,000


(To defer unrealized gross profit on intra-entity

sale see Schedule 2 below)

During Dividends Receivable ................... 4,800

2015 Investment in Kinman Co. ...... 4,800

(To record dividend declaration: $12,000 x 40%)

Cash ............................................... 4,800

Dividends Receivable.............. 4,800

(To record receipt of dividend)


Equity in Kinman Income ........ 16,000

(To record 40% accrual of income as earned by

equity investee)

12/31/15 Equity in Kinman Income ............. 3,300


(To record amortization relating to acquisition

of Kinman)


Equity in Kinman Income ........ 2,000

(To recognize income deferred from 2014)

12/31/15 Equity in Kinman Income ............. 3,600


(To defer unrealized gross profit on intra-entity

sale—see Schedule 3 below)



Education.

29. (continued)

Schedule 1—Allocation of Purchase Price and Related Amortization

Purchase price ........................................................ $210,000 Percentage of book value acquired ($400,000 × 40%) ..................................................... (160,000) Payment in excess of book value .............................. $50,000

Remaining Annual Excess payment identified with specific assets: Life Amortization Building ($40,000 × 40%) $16,000 10 yrs. $1,600

Royalty agreement ($85,000 × 40%) 34,000 20 yrs. 1,700

Total annual amortization $3,300

Schedule 2—Deferral of Unrealized Gross Profit—2014

Inventory remaining at end of year ................................................. $15,000

Gross profit percentage ($30,000 ÷ $90,000) .................................. × 33⅓%

Gross profit remaining in inventory .......................................... $5,000

Ownership percentage ..................................................................... × 40%

Unrealized gross profit to be deferred until 2015 ..................... $ 2,000

Schedule 3—Deferral of Unrealized Gross Profit—2015

Inventory remaining at end of year (30%) ....................................... $24,000

Gross profit percentage ($30,000 ÷ $80,000) .................................. × 37½%

Gross profit remaining in inventory .......................................... $9,000

Ownership percentage ..................................................................... × 40%

Unrealized gross profit to be deferred until 2016 ..................... $ 3,600



Education.

30. (35 Minutes) (Investment sale with equity method applied both before and after. Includes other comprehensive loss and intra-entity inventory transfer)

Income effects for year ending December 31, 2015

Equity income in Seacrest, Inc. (Schedule 1) ........................... $116,000

Other comprehensive loss—Seacrest, Inc.

1/1/15 to 8/1/15 ($120,000 × 40% × 7/12 year) ............. . (28,000)

8/1/15 to 12/31/15 ($120,000 × 32% × 5/12 year) ......... (16,000) $(44,000)

Gain on sale of 8,000 shares of Seacrest (Schedule 2) ................. $ 25,000

Schedule 1—Equity Income in Seacrest, Inc.

Investee income accrual—operations

$342,000 × 40% × 7/12 year .................................... $79,800

$342,000 × 32% × 5/12 year .................................... 45,600 $125,400

Amortization

$12,000 × 7/12 year ................................................. $7,000

After 20 percent of stock is sold (8,000 ÷ 40,000

shares): $12,000 × 80% × 5/12 year ................. 4,000 (11,000)

Recognition of unrealized gross profit

Remaining inventory—12/31/14 ............................ $10,000

Gross profit percentage on original sale

($20,000 ÷ $50,000) ............................................ × 40%

Gross profit remaining in inventory ..................... $4,000

Ownership percentage ........................................... × 40%

Intra-entity gross profit recognized in 2015 ......... 1,600

Equity income in Seacrest, Inc. ....................... $116,000



Education.

30. (continued)

Schedule 2—Gain on Sale of Investment in Seacrest, Inc.

Book value—investment in Seacrest, Inc.—1/1/15 (given) ......... $293,600

Investee income accrual—1/1/15 – 8/1/15 (Schedule 1) ............. 79,800

Investee other comprehensive loss 1/1/15 – 8/1/15 .................... (28,000)

Amortization—1/1/15 – 8/1/15 (Schedule 1) ................................. (7,000)

Recognition of deferred profit (Schedule 1) ................................ 1,600

Investment in Seacrest book value 8/1/15 ........................................ $340,000

Percentage of investment sold (8,000 ÷ 40,000 shares) ............. × 20%

Book value of shares being sold .................................................. $ 68,000

Proceeds from sale of shares ....................................................... 93,000

Gain on sale of 8,000 shares of Seacrest. .............................. $ 25,000

31. (30 Minutes) (Compute equity balances for three years. Includes

intra-entity inventory transfer)

Part a.

Equity Income 2013

Basic equity accrual ($598,000 × ½ year × 25%) ....................... $74,750

Amortization (½ year—see Schedule 1) .................................... (30,800)

Equity Income—2013 ............................................................. $43,950

Equity Income 2014

Basic equity accrual ($639,600 × 25%) ..................................... $159,900

Amortization (see Schedule 1) .................................................. (61,600)

Deferral of unrealized profit (see Schedule 2) ......................... (6,000)

Equity Income—2014 ............................................................ $92,300

Equity Income 2015

Basic equity accrual ($692,400 × 25%) ..................................... $173,100

Amortization (see Schedule 1) .................................................. (61,600)

Recognition of deferred profit (see Schedule 2) ..................... 6,000

Equity Income—2015 ............................................................ $117,500



Education.

31. (continued) Schedule 1—Acquisition Price Allocation and Amortization

Acquisition price (88,000 shares × $13) $1,144,000

Book value acquired ($2,925,600 × 25%) 731,400

Payment in excess of book value $412,600

Remaining Annual Excess payment identified with specific assets: Life Amortization

Equipment ($364,000 × 25%) $91,000 7 yrs. $13,000

Copyright ($972,000 × 25%) 243,000 5 yrs. 48,600

Goodwill 78,600 indefinite -0-

Total annual amortization (full year) $61,600 Schedule 2—Deferral of Unrealized Intra-entity Gross Profit

Intra-entity Gross Profit Percentage:

Sales $152,000

Cost of goods sold 91,200

Gross profit $ 60,800

Gross profit percentage: $60,800 ÷ $152,000 = 40% Inventory remaining at December 31, 2014 ................................. $60,000

Gross profit percentage ............................................................... × 40%

Total profit on intra-entity sale still held by affiliate ................... $24,000

Investor ownership percentage .................................................... × 25%

Unrealized intra-entity gross profit deferred from

2014 until 2015 .......................................................................... $ 6,000 Part b.

Investment in Shaun—December 31, 2015 balance

Acquisition price ........................................................................... $1,144,000

2013 Equity income (above) ......................................................... 43,950

2013 Dividends declared during half year (88,000 shares × $1.00) (88,000)


2014 Dividends declared (88,000 shares × $1.00 × 2) ................. (176,000)


2015 Dividends declared (88,000 shares × $1.00 × 2) ................. (176,000)

Investment in Shaun—12/31/15 ........................................... $957,750



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32. (65 Minutes) (Journal entries for several years. Includes conversion to

equity method and a sale of a portion of the investment)

1/1/13 Investment in Sumter ..................... 192,000

Cash ........................................... 192,000

(To record cost of 16,000 shares of Sumter Company.)

9/15/13 Cash ................................................. 8,000

Dividend Income ........................ 8,000

(Annual dividends declared and received from Sumter Company. Because declaration and payment are on same day, a dividend receivable account is unnecessary.)

9/15/14 Cash ................................................. 8,000

Dividend Income ........................ 8,000

(Annual dividends declared and received from Sumter Company.)


Cash ........................................... 965,750

(To record cost of 64,000 additional shares of

Sumter Company.)


Retained Earnings—Prior Period

Adjustment—Equity in Investee Income 36,800

(Retrospective adjustment necessitated by change to equity method. Change in figures previously reported for 2013 and 2014 are calculated as follows.)



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32. (continued)

2013 as reported

Income (dividends) ......... $8,000

Change in investment

Balance ................................... -0-

2013—equity method (as restated)

Income (8% of $300,000

reported income) .............................. $24,000

Change in investment balance (equity income less dividends) .................... $16,000

2014 as reported

Income (dividends) ......... $8,000

Change in investment

Balance ................................... -0-

2014—equity method (as restated)

Income (8% of $360,000

reported income) .............................. $28,800

Change in investment balance (equity income less dividends) .................... $20,800

2013 increase in reported income ($24,000 – $8,000) ................. $16,000

2014 increase in reported income ($28,800 – $8,000) ................. 20,800

Retrospective adjustment—income (above) ............................... $36,800

2013 increase in investment in Sumter balance—equity method $16,000

2014 increase in investment in Sumter balance—equity method 20,800

Retrospective adjustment—Investment in Sumter (above) .. $36,800

9/15/15 Cash ............................................................ 40,000

Investment in Sumter ........................... 40,000

(Annual dividend declared and received from Sumter

[40% × $100,000])

12/31/15 Investment in Sumter ................................ 160,000

Equity in Investee Income ................... 160,000

(To accrue 2015 income based on 40%

ownership of Sumter)

12/31/15 Equity in Investee Income ........................ 3,370


(Amortization of $50,550 patent

[indicated in problem] over 15 years)



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32. (continued)

7/1/16 Investment in Sumter ................................ 76,000


(To accrue ½ year income of 40% owner-

ship = $380,000 × ½ × 40%)

7/1/16 Equity in Investee Income ........................ 1,685


(To record ½ year amortization of patent

to establish correct book value for invest-

ment as of 7/1/16)

7/1/16 Cash ........................................................... 425,000

Investment in Sumter (rounded) ......... 346,374

Gain on Sale of Investment ................. 78,626

(20,000 shares of Sumter Company sold;

investment basis computed below.)

Investment in Sumter and cost of shares sold:

1/1/13 Acquisition .................................................................... $ 192,000

1/1/15 Acquisition ..................................................................... 965,750

1/1/15 Retrospective adjustment ............................................ 36,800

9/15/15 Dividends ..................................................................... (40,000)

12/31/15 Basic equity accrual .................................................. 160,000

12/31/15 Amortization .............................................................. (3,370)

7/1/16 Basic equity accrual ...................................................... 76,000

7/1/16 Amortization .................................................................. (1,685)

Investment in Sumter—7/1/16 balance .............................. $1,385,495

Percentage of shares sold (20,000 ÷ 80,000) .................... × 25%

Cost of shares sold (rounded) ........................................... $ 346,374

Because 20,000 of 80,000, or ¼, of shares are sold, the percentage retained is ¾ of 40% = 30%.

9/15/16 Cash ........................................................... 30,000

Investment in Sumter .......................... 30,000

(To record annual dividend declared and received)



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32. (continued)

12/31/16 Equity in Sumter ........................................ 57,000


(To record ½ year income based on

remaining 30% ownership: $380,000 × 1/2 × 30%)

12/31/16 Equity in Investee Income ........................ 1,264 (rounded)


(To record ½ year of patent amortization—

computation presented below)

Annual patent amortization—original computation ................... $3,370

Percentage of shares retained (60,000 ÷ 80,000) ........................ × 75%

Annual patent amortization—current ......................................... $2,528.50

Patent amortization for half year .................................................. $1,263.75

33. (25 Minutes) (Equity income balances for two years, includes intra-entity transfers)

Equity Income 2014

Basic equity accrual ($250,000 × 30%) ................................... $75,000

Amortization (see Schedule 1) ................................................ (18,000)

Deferral of unrealized gross profit (see Schedule 2) ............ (9,000)

Equity Income—2014 .......................................................... $48,000

Equity Income (Loss—2015)

Basic equity accrual ($100,000 [loss] × 30%)......................... $(30,000)

Amortization (see Schedule 1) ................................................ (18,000)

Realization of deferred gross profit (see Schedule 2)........... 9,000

Deferral of unrealized gross profit (see Schedule 3) ............ (4,500)

Equity Loss—2015 .............................................................. $(43,500)



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33. (continued)

Schedule 1

Purchase price ................................................... $770,000

Book value acquired ($1,200,000 × 30%) ......... 360,000

Payment in excess of book value .................... $410,000

Remaining Annual Excess payment identified with specific assets: Life Amortization Customer list ($300,000 × 30%) 90,000 5 yrs. $18,000

Excess not identified with specific accounts

Goodwill $320,000 indefinite -0-

Total annual amortization $18,000

Schedule 2

Inventory remaining at December 31, 2014 ................................. $80,000

Gross profit percentage ($60,000 ÷ $160,000) ............................. × 37½%

Total unrealized gross profit ........................................................ $30,000


Unrealized intra-entity gross profit —12/31/14

(To be deferred until realized in 2015) .................................... $ 9,000

Schedule 3

Inventory remaining at December 31, 2015 ................................. $75,000

Gross profit percentage ($35,000 ÷ $175,000) ............................. × 20%

Total unrealized gross profit ........................................................ $15,000


Unrealized intra-entity gross profit —12/31/15

(To be deferred until realized in 2016) .................................... $ 4,500



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Solutions to Develop Your Skills

Excel Assignment No. 1 (less difficult)—see textbook Website for the Excel file solution

Parts 1, 2 and 3

Growth rate in income 10% Dividends $30,000 Cost $700,000 (given in problem) Annual amortization $15,000 1st year PHC income $185,000 Percentage owned 40% 2015 2016 2017 2018 2019 PHC reported income $74,000 $81,400 $89,540 $98,494 $108,343 Amortization 15,000 15,000 15,000 15,000 15,000 Equity earnings $59,000 $66,400 $74,540 $83,494 $93,343 Beginning Balance $700,000 $747,000 $801,400 $863,940 $935,434 Equity earnings 59,000 66,400 74,540 83,494 93,343 Dividends (12,000) (12,000) (12,000) (12,000) (12,000) Ending Balance $747,000 $801,400 $863,940 $935,434 $1,016,777 ROI 8.43% 8.89% 9.30% 9.66% 9.98% Average 9.25% Part 3 Growth rate in income 10% Dividends $30,000 Cost $639,794 (Determined through Solver under Tools command) Annual amortization $15,000 1st year PHC income $185,000 Percentage owned 40% PHC reported income $74,000 $81,400 $89,540 $98,494 $108,343 Amortization 15,000 15,000 15,000 15,000 15,000 Equity earnings $59,000 $66,400 $74,540 $83,494 $93,343 Beginning Balance $639,794 $686,794 $741,194 $803,734 $875,228 Equity earnings 59,000 66,400 74,540 83,494 93,343 Dividends (12,000) (12,000) (12,000) (12,000) (12,000) Ending Balance $686,794 $741,194 $803,734 $875,228 $956,571 ROI 9.22% 9.67% 10.06% 10.39% 10.67% Average 10.00%



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Excel Assignment No. 2 (more difficult)—see textbook Website for the Excel file solution

Intergen’s ownership percentage of Ryan 40% Intra-entity Transfer Price = $1,025,000 Cell F4 Ryan's Income Statement Intergen's Income Statement Sales $900,000 Sales $1,025,000 Beginning inventory $ -0- Cost of goods sold $ 850,000 Purchases from Intergen $1,025,000 Gross profit $ 175,000 Inventory remaining 25% Equity in Ryan's earnings $ 35,000* Ending inventory $ 256,250 Net income $ 210,000 Cost of goods sold $768,750 Net income $131,250 *(52,500 – (40% × 256,250 × 175,000/1,025,000)) Income to Intergen—40% $ 52,500 Income to two equity partners—60% $ 78,750

Rate of Return Analysis Investment Base Rate of Return Intergen $1,000,000 21.00% Two outside equity partners $300,000 26.25% Difference -5.25%

Intergen’s ownership percentage of Ryan = 40% Intra-entity Transfer Price = 1,050,000 Ryan's Income Statement Intergen's Income Statement Sales $900,000 Sales $1,050,000 Beginning inventory $ -0- Cost of goods sold $ 850,000 Purchases from Intergen $1,050,000 Gross profit $ 200,000 Inventory 25% Equity in Ryan's earnings $ 25,000* Ending inventory $ 262,500 Net income $ 225,000 Cost of goods sold $787,500 Net income $112,500 *[45,000 – (40% ×262,500 × 200,000 ÷ 1,050,000)] Income to Intergen—40% $ 45,000 Income to two equity partners—60% $ 67,500

Rate of Return Analysis Investment Base Rate of Return Intergen $1,000,000 22.50% Two outside equity partners $300,000 22.50% Difference 0.00%

Use Goal Seek or Solver under the Tools command to set Cell D20 to zero by changing Cell F4



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Solution to Coca-Cola Company Analysis Case

1. In its 2012 10-K, Coca-Cola lists the following companies as significant equity method investees:

Coca-Cola Hellenic Bottling Company S.A. ("Coca-Cola Hellenic").

Coca-Cola FEMSA, S.A.B. de C.V. ("Coca-Cola FEMSA").

Coca-Cola Amatil Limited ("Coca-Cola Amatil").

As part of strategic business alliances, each of these companies bottle, market, and distribute Coca-Cola’s products in various designated geographic areas throughout the world, thus generating substantial revenues for the Coca-Cola Company. According to Coca-Cola’s 2012 annual report (page 10),

We make equity investments in selected bottling operations with the intention of maximizing the strength and efficiency of the Coca-Cola system's production, distribution and marketing capabilities around the world. These investments are intended to result in increases in unit case volume, net revenues and profits at the bottler level, which in turn generate increased concentrate sales for our Company's concentrate and syrup business. When this occurs, both we and our bottling partners benefit from long-term growth in volume, improved cash flows and increased shareowner value.

2. From the Coca-Cola Company’s 2012 10-K report (page 85),

We use the equity method to account for investments in companies, if our investment provides us with the ability to exercise significant influence over operating and financial policies of the investee. Our consolidated net income includes our Company’s proportionate share of the net income or loss of these companies.

3. 2012 equity income = $819 million.

4. In general, the equity method provides cost-based values while fair values provide exit-based values. The relevance of the equity method valuation derives from the investment’s nature as a productive asset for the investor. Because of their business relationship the investee represents an extension of the investor and frequently a key part of the investor’s business model. Coca-Cola, for example, has a high level of operational influence over its investees who, in turn receive exclusive rights to bottle and distribute Coca-Cola products in specific geographic areas. Because of its significance influence, investors may wish to judge the results of operations of Coca-Cola’s investees as it related to Coca-Cola’s ownership. Additionally, the equity method provides results consistent with accrual accounting recognizing the net effect of investee revenues and expenses as they are earned by the investor.

When possible, fair values are measured using market prices for the investor’s shares of the investee. Although exit prices represent a “hypothetical” sale transaction, they indicate the market’s assessment of the investor’s position in the investee and thus may be relevant. However, if the investor has no plans to sell the shares, exit prices may be of limited relevance for investors’ decision making.



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RESEARCH AND ANALYSIS CASE—IMPAIRMENT

1. Paragraph 323-10-35-32 of the FASB ASC states that

A loss in value of an investment which is other than a temporary decline shall be recognized. Evidence of a loss in value might include, but would not necessarily be limited to, absence of an ability to recover the carrying amount of the investment or inability of the investee to sustain an earnings capacity which would justify the carrying amount of the investment. A current fair value of an investment that is less than its carrying amount may indicate a loss in value of the investment. However, a decline in the quoted market price below the carrying amount or the existence of operating losses is not necessarily indicative of a loss in value that is other than temporary. All are factors to be evaluated.

2. Given the facts in the case, a very good case can be made that the decline in value

appears permanent. The change in competitive environment, decline in revenues, drop in share value, and the lack of a responsive business plan all point to a loss that is other than temporary.

3. No, according to FASB ASC para. 350-20-35-59, the equity method investment as a

whole is reviewed for impairment, not the underlying assets. The FASB concluded that because equity method goodwill is not separable from the related investment, that goodwill should not be separately tested for impairment.



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Research Case Solution -- Noncontrolling Shareholder Rights

1. Protective Rights (ASC Topic 810, Consolidation 810-10-25-10) Noncontrolling rights (whether granted by contract or by law) that would allow the noncontrolling shareholder to block corporate actions would be considered protective rights and would not overcome the presumption of consolidation by the investor with a majority voting interest in its investee. The following list is illustrative of the protective rights that often are provided to the noncontrolling shareholder but is not all-inclusive: a. Amendments to articles of incorporation of the investee

b. Pricing on transactions between the owner of a majority voting interest and the investee and related self-dealing transactions

c. Liquidation of the investee or a decision to cause the investee to enter bankruptcy or other receivership

d. Acquisitions and dispositions of assets that are not expected to be undertaken in the ordinary course of business (noncontrolling rights relating to acquisitions and dispositions of assets that are expected to be made in the ordinary course of business are participating rights; determining whether such rights are substantive requires judgment in light of the relevant facts and circumstances [see paragraphs 810-10-25-13 and 810-10-55-1])

e. Issuance or repurchase of equity interests.

2. Substantive Participating Rights (ASC Topic 810, Consolidation 810-10-25-11)

Noncontrolling rights (whether granted by contract or by law) that would allow the noncontrolling shareholder to participate in determining certain financial and operating decisions in the ordinary course of business shall be considered substantive participating rights and would overcome the presumption that the investor with a majority voting interest shall consolidate its investee. Example: In its 2012 10-K annual report, Sprint cited substantive participating rights of the noncontrolling interest as a reason for not consoldating its investment in Clearwire.

3. (FASB ASC Topic 810, Consolidation 810-10-25-11) Substantive participating rights would overcome the presumption that the investor with a majority voting interest shall consolidate its investee. The following list is illustrative of substantive participating rights, but is not necessarily all-inclusive: a. Selecting, terminating, and setting the compensation of management

responsible for implementing the investee's policies and procedures

http://asc.fasb.org/link&sourceid=SL2277806-111677&objid=6924405

http://asc.fasb.org/link&sourceid=SL2277807-111677&objid=6924405



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b. Establishing operating and capital decisions of the investee, including budgets, in the ordinary course of business.

4. Assessing Individual Noncontrolling Rights (FASB ASC Topic 810, Consolidation

810-10-55-1 b and c)

b. Existing facts and circumstances should be considered in assessing whether

the rights of the noncontrolling shareholder relating to an investee's incurring additional indebtedness are protective or participating rights. For example, if it is reasonably possible or probable that the investee will need to incur the level of borrowings that requires noncontrolling shareholder approval in its ordinary course of business, the rights of the noncontrolling shareholder would be viewed as substantive participating rights.

c. The rights of the noncontrolling shareholder relating to dividends or other

distributions may be protective or participating and should be assessed in light of the available facts and circumstances. For example, rights to block customary or expected dividends or other distributions may be substantive participating rights, while rights to block extraordinary distributions would be protective rights.



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CHAPTER 2 CONSOLIDATION OF FINANCIAL INFORMATION

Accounting standards for business combination are found in FASB ASC Topic 805, “Business Combinations” and Topic 810, “Consolidation.” These standards require the acquisition method which emphasizes acquisition-date fair values for recording all combinations.

In this chapter, we first provide coverage of expansion through corporate takeovers and an overview of the consolidation process. Then we present the acquisition method of accounting for business combinations followed by limited coverage of the purchase method and pooling of interests provided in the Appendix to this chapter.

Chapter Outline

I. Business combinations and the consolidation process

A. A business combination is the formation of a single economic entity, an event that occurs whenever one company gains control over another

B. Business combinations can be created in several different ways

1. Statutory merger—only one of the original companies remains in business as a legally incorporated enterprise.

a. Assets and liabilities can be acquired with the seller then dissolving itself as a corporation.

b. All of the capital stock of a company can be acquired with the assets and liabilities then transferred to the buyer followed by the seller’s dissolution.

2. Statutory consolidation—assets or capital stock of two or more companies are transferred to a newly formed corporation

3. Acquisition by one company of a controlling interest in the voting stock of a second. Dissolution does not take place; both parties retain their separate legal incorporation.

C. Financial information from the members of a business combination must be consolidated into a single set of financial statements representing the entire economic entity.

1. If the acquired company is legally dissolved, a permanent consolidation is produced on the date of acquisition by entering all account balances into the financial records of the surviving company.

2. If separate incorporation is maintained, consolidation is periodically simulated whenever financial statements are to be prepared. This process is carried out through the use of worksheets and consolidation entries. Consolidation worksheet entries are used to adjust and eliminate subsidiary company accounts. Entry “S” eliminates the equity accounts of the subsidiary. Entry “A” allocates exess payment amounts to identifiable assets and liabilities based on the fair value of the subsidiary accounts. (Consolidation journal entries are never recorded in the books of either company, they are worksheet entries only.)



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II. The Acquisition Method

A. The acquisition method replaced the purchase method. For combinations resulting in complete ownership, it is distinguished by four characteristics.

1. All assets acquired and liabilities assumed in the combination are recognized and measured at their individual fair values (with few exceptions).

2. The fair value of the consideration transferred provides a starting point for valuing and recording a business combination.

a. The consideration transferred includes cash, securities, and contingent performance obligations.

b. Direct combination costs are expensed as incurred.

c. Stock issuance costs are recorded as a reduction in paid-in capital.

d. The fair value of any noncontrolling interest also adds to the valuation of the acquired firm and is covered beginning in Chapter 4 of the text.

3. Any excess of the fair value of the consideration transferred over the net amount assigned to the individual assets acquired and liabilities assumed is recognized by the acquirer as goodwill.

4. Any excess of the net amount assigned to the individual assets acquired and liabilities assumed over the fair value of the consideration transferred is recognized by the acquirer as a “gain on bargain purchase.”

B. In-process research and development acquired in a business combination is recognized as an asset at its acquisition-date fair value.

III. Convergence between U.S. GAAP and IAS

A. IFRS 3 – nearly identical to U.S. GAAP because of joint efforts

B. IFRS 10 – Consolidated Finanical Statements and IFRS 12 – Disclosure of Interests in Other Entities both become effective in 2013. Some differences between these and GAAP

APPENDIX:

The Purchase Method

A. The purchase method was applicable for business combinations occurring for fiscal years beginning prior to December 15, 2008. It was distinguished by three characteristics.

1. One company was clearly in a dominant role as the purchasing party

2. A bargained exchange transaction took place to obtain control over the second company.

3. A historical cost figure was determined based on the acquisition price paid.

a. The cost of the acquisition included any direct combination costs.

b. Stock issuance costs were recorded as a reduction in paid-in capital and are not considered to be a component of the acquisition price.

B. Purchase method procedures

1. The assets and liabilities acquired were measured by the buyer at fair value as of the date of acquisition.

2. Any portion of the payment made in excess of the fair value of these assets and liabilities was attributed to an intangible asset commonly referred to as goodwill.



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3. If the price paid was below the fair value of the assets and liabilities, the accounts of the acquired company were still measured at fair value except that the values of certain noncurrent assets were reduced in total by the excess cost. If these values were not great enough to absorb the entire reduction, an extraordinary gain was recognized.

The Pooling of Interest Method (prohibited for combinations after June 2002)

A. A pooling of interests was formed by the uniting of the ownership interests of two companies through the exchange of equity securities. The characteristics of a pooling are fundamentally different from either the purchase or acquisition methods.

1. Neither party was truly viewed as an acquiring company.

2. Precise cost figures stemming from the exchange of securities were difficult to ascertain.

3. The transaction affected the stockholders rather than the companies.

B. Pooling of interests accounting

1. Because of the nature of a pooling, determination of an acquisition price was not relevant.

a. Since no acquisition price was computed, all direct costs of creating the combination were expensed immediately.

b. In addition, new goodwill arising from the combination was never recognized in a pooling of interests. Similarly, no valuation adjustments were recorded for any of the assets or liabilities combined.

2. The book values of the two companies were simply brought together to produce a set of consolidated financial records. A pooling was viewed as affecting the owners rather than the two companies.

3. The results of operations reported by both parties were combined on a retroactive basis as if the companies had always been together.

4. Controversy historically surrounded the pooling of interests method.

a. Any cost figures indicated by the exchange transaction that created the combination were ignored.

b. Income balances previously reported were altered since operations were combined on a retroactive basis.

c. Reported net income was usually higher in subsequent years than in a purchase since no goodwill or valuation adjustments were recognized which require amortization.



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Answers to Questions

1. A business combination is the process of forming a single economic entity by the uniting of two or more organizations under common ownership. The term also refers to the entity that results from this process.

2. (1) A statutory merger is created whenever two or more companies come together to form a business combination and only one remains in existence as an identifiable entity. This arrangement is often instituted by the acquisition of substantially all of an enterprise’s assets. (2) A statutory merger can also be produced by the acquisition of a company’s capital stock. This transaction is labeled a statutory merger if the acquired company transfers its assets and liabilities to the buyer and then legally dissolves as a corporation. (3) A statutory consolidation results when two or more companies transfer all of their assets or capital stock to a newly formed corporation. The original companies are being “consolidated” into the new entity. (4) A business combination is also formed whenever one company gains control over another through the acquisition of outstanding voting stock. Both companies retain their separate legal identities although the common ownership indicates that only a single economic entity exists.

3. Consolidated financial statements represent accounting information gathered from two or more separate companies. This data, although accumulated individually by the organizations, is brought together (or consolidated) to describe the single economic entity created by the business combination.

4. Companies that form a business combination will often retain their separate legal identities as well as their individual accounting systems. In such cases, internal financial data continues to be accumulated by each organization. Separate financial reports may be required for outside shareholders (a noncontrolling interest), the government, debt holders, etc. This information may also be utilized in corporate evaluations and other decision making. However, the business combination must periodically produce consolidated financial statements encompassing all of the companies within the single economic entity. The purpose of a worksheet is to organize and structure this process. The worksheet allows for a simulated consolidation to be carried out on a regular, periodic basis without affecting the financial records of the various component companies.

5. Several situations can occur in which the fair value of the 50,000 shares being issued might be difficult to ascertain. These examples include:

The shares may be newly issued (if Jones has just been created) so that no accurate value has yet been established;

Jones may be a closely held corporation so that no fair value is available for its shares;

The number of newly issued shares (especially if the amount is large in comparison to the quantity of previously outstanding shares) may cause the price of the stock to fluctuate widely so that no accurate fair value can be determined during a reasonable period of time;

Jones’ stock may have historically experienced drastic swings in price. Thus, a quoted figure at any specific point in time may not be an adequate or representative value for long-term accounting purposes.

6. For combinations resulting in complete ownership, the acquisition method allocates the fair value of the consideration transferred to the separately recognized assets acquired and liabilities assumed based on their individual fair values.

7. The revenues and expenses (both current and past) of the parent are included within reported figures. However, the revenues and expenses of the subsidiary are consolidated from the date of the acquisition forward within the worksheet consolidation process. The



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operations of the subsidiary are only applicable to the business combination if earned subsequent to its creation.

8. Morgan’s additional acquisition value may be attributed to many factors: expected synergies between Morgan’s and Jennings’ assets, favorable earnings projections, competitive bidding to acquire Jennings, etc. In general however, any amount paid by the parent company in excess of the fair values of the subsidiary’s net assets acquired is reported as goodwill.

9. In the vast majority of cases the assets acquired and liabilities assumed in a business combination are recorded at their fair values. If the fair value of the consideration transferred (including any contingent consideration) is less than the total net fair value assigned to the assets acquired and liabilities assumed, then an ordinary gain on bargain purchase is recognized for the difference.

10. Shares issued are recorded at fair value as if the stock had been sold and the money obtained used to acquire the subsidiary. The Common Stock account is recorded at the par value of these shares with any excess amount attributed to additional paid-in capital.

11. The direct combination costs of $98,000 are allocated to expense in the period in which they occur. Stock issue costs of $56,000 are treated as a reduction of APIC.



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Answers to Problems

1. D

2. B

3. D

4. A

5. B

6. A

7. A

8. B

9. C

10. C 11. B Consideration transferred (fair value) $800,000 Cash $150,000 Accounts receivable 140,000 Software 320,000 Research and development asset 200,000 Liabilities (130,000) Fair value of net identifiable assets acquired 680,000 Goodwill $120,000 12. C Legal and accounting fees accounts payable $15,000 Contingent liabilility 20,000 Donovan’s liabilities assumed 60,000 Liabilities assumed or incurred $95,000 13. D Consideration transferred (fair value) $420,000 Current assets $90,000 Building and equipment 250,000 Unpatented technology 25,000 Research and development asset 45,000 Liabilities (60,000) Fair value of net identifiable assets acquired 350,000 Goodwill $ 70,000 Current assets $ 90,000 Building and equipment 250,000 Unpatented technology 25,000 Research and development asset 45,000 Goodwill 70,000 Total assets $480,000



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14. C Value of shares issued (51,000 × $3) ...................................... $153,000 Par value of shares issued (51,000 × $1) ................................ 51,000 Additional paid-in capital (new shares) ................................. $102,000 Additional paid-in capital (existing shares) .......................... 90,000 Consolidated additional paid-in capital (fair value) ............... $192,000

At the acquisition date, the parent makes no change to retained earnings. 15. B Consideration transferred (fair value) .......................... $400,000 Book value of subsidiary (assets minus liabilities) .... (300,000) Fair value in excess of book value ........................... 100,000 Allocation of excess fair over book value identified with specific accounts: Inventory ..................................................................... 30,000 Patented technology .................................................. 20,000 Land ............................................................................ 25,000 Long-term liabilities ................................................... 10,000 Goodwill ...................................................................... $15,000 16. D TruData patented technology ........................................ $230,000 Webstat patented technology (fair value) .................... 200,000 Acquisition-date consolidated balance sheet amount $430,000 17. C TruData common stock before acquisition .................. $300,000 Common stock issued (par value) ................................ 50,000 Acquisition-date consolidated balance sheet amount $350,000

18. B TruData’s 1/1 retained earnings .................................... $130,000 TruData’s income (1/1 to 7/1) ........................................ 80,000 Acquisition-date consolidated balance sheet amount $210,000

19. a. An intangible asset acquired in a business combination is recognized as an asset apart from goodwill if it arises from contractual or other legal rights (regardless of whether those rights are transferable or separable from the acquired enterprise or from other rights and obligations). If an intangible asset does not arise from contractual or other legal rights, it shall be recognized as an asset apart from goodwill only if it is separable, that is, it is capable of being separated or divided from the acquired enterprise and sold, transferred, licensed, rented, or exchanged (regardless of whether there is an intent to do so). An intangible asset that cannot be sold, transferred, licensed, rented, or exchanged individually is considered separable if it can be sold, transferred, licensed, rented, or exchanged with a related contract, asset, or liability.

b. Trademarks—usually meet both the separability and legal/contractual criteria.



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Customer list—usually meets the separability criterion. Copyrights on artistic materials—usually meet both the separability and

legal/contractual criteria. Agreements to receive royalties on leased intellectual property—usually

meet the legal/contractual criterion. Unpatented technology—may meet the separability criterion if capable

of being sold even if in conjunction with a related contract, asset, or liability.

20. (12 minutes) (Journal entries to record a merger—acquired company dissolved) Inventory 600,000 Land 990,000 Buildings 2,000,000 Customer Relationships 800,000 Goodwill 690,000 Accounts Payable 80,000 Common Stock 40,000 Additional Paid-In Capital 960,000 Cash 4,000,000 Professional Services Expense 42,000 Cash 42,000 Additional Paid-In Capital 25,000 Cash 25,000 21. (12 minutes) (Journal entries to record a bargain purchase—acquired company dissolved) Inventory 600,000 Land 990,000 Buildings 2,000,000 Customer Relationships 800,000 Accounts Payable 80,000 Cash 4,200,000 Gain on Bargain Purchase 110,000 Professional Services Expense 42,000 Cash 42,000



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22. (15 Minutes) (Consolidated balances)

In acquisitions, the fair values of the subsidiary's assets and liabilities are consolidated (there are a limited number of exceptions). Goodwill is reported at $80,000, the amount that the $760,000 consideration transferred exceeds the $680,000 fair value of Sol’s net assets acquired.

Inventory = $670,000 (Padre's book value plus Sol's fair value)

Land = $710,000 (Padre's book value plus Sol's fair value)

Buildings and equipment = $930,000 (Padre's book value plus Sol's fair value)

Franchise agreements = $440,000 (Padre's book value plus Sol's fair value)

Goodwill = $80,000 (calculated above)

Revenues = $960,000 (only parent company operational figures are reported at date of acquisition)

Additional paid-in capital = $265,000 (Padre's book value adjusted for stock issue less stock issuance costs)

Expenses = $940,000 (only parent company operational figures plus acquisition-related costs are reported at date of acquisition)

Retained earnings, 1/1 = $390,000 (Padre's book value only)

Retained earnings, 12/31 = $410,000 (beginning retained earnings plus revenues minus expenses, of Padre only)



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23. (20 minutes) Journal entries for a merger using alternative values. a. Acquisition date fair values: Cash paid $700,000 Contingent performance liability 35,000 Consideration transferred $735,000 Fair values of net assets acquired 750,000 Gain on bargain purchase $ 15,000 Receivables 90,000 Inventory 75,000 Copyrights 480,000 Patented Technology 700,000 Research and Development Asset 200,000 Current liabilities 160,000 Long-Term Liabilities 635,000 Cash 700,000 Contingent Performance Liability 35,000 Gain on Bargain Purchase 15,000 Professional Services Expense 100,000 Cash 100,000 b. Acquisition date fair values: Cash paid $800,000 Contingent performance liability 35,000 Consieration transferred $835,000 Fair values of net assets acquired 750,000 Goodwill $ 85,000 Receivables 90,000 Inventory 75,000 Copyrights 480,000 Patented Technology 700,000 Research and Development Asset 200,000 Goodwill 85,000 Current Liabilities 160,000 Long-Term Liabilities 635,000 Cash 800,000 Contingent Performance Liability 35,000 Professional Services Expense 100,000 Cash 100,000



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24. (20 Minutes) (Determine selected consolidated balances) Under the acquisition method, the shares issued by Wisconsin are recorded at

fair value using the following journal entry: Investment in Badger (value of debt and shares issued) . 900,000 Common Stock (par value) ............................................ 150,000 Additional Paid-In Capital (excess over par value) ..... 450,000 Liabilities ......................................................................... 300,000 The payment to the broker is accounted for as an expense. The stock issue

cost is a reduction in additional paid-in capital. Professional Services Expense .......................................... 30,000 Additional Paid-In Capital ................................................... 40,000 Cash .............................................................................. 70,000 Allocation of Acquisition-Date Excess Fair Value: Consideration transferred (fair value) for Badger Stock $900,000 Book Value of Badger, 6/30 ................................................ 770,000 Fair Value in Excess of Book Value .............................. $130,000 Excess fair value (undervalued equipment) ...................... 100,000 Excess fair value (overvalued patented technology) ....... (20,000) Goodwill .......................................................................... $ 50,000

CONSOLIDATED BALANCES:

Net income (adjusted for professional services expense. The figures earned by the subsidiary prior to the takeover are not included) ...................................................................... $ 210,000

Retained earnings, 1/1 (the figures earned by the subsidiary prior to the takeover are not included) ................................... 800,000

Patented technology (the parent's book value plus the fair value of the subsidiary) ........................................................... 1,180,000

Goodwill (computed above) .................................................... 50,000

Liabilities (the parent's book value plus the fair value of the subsidiary's debt plus the debt issued by the parent in acquiring the subsidiary) .................................................... 1,210,000

Common stock (the parent's book value after recording the newly-issued shares) ......................................................... 510,000

Additional Paid-in Capital (the parent's book value after recording the two entries above) ................................... 680,000



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25. (20 minutes) (Preparation of a consolidated balance sheet)*

CASEY COMPANY AND CONSOLIDATED SUBSIDIARY KENNEDY

Worksheet for a Consolidated Balance Sheet January 1, 2015

Casey Kennedy Adjust. & Elim. Consolidated Cash 457,000 172,500 629,500 Accounts receivable 1,655,000 347,000 2,002,000 Inventory 1,310,000 263,500 1,573,500 Investment in Kennedy 3,300,000 -0- (S) 2,600,000 (A) 700,000 -0- Buildings (net) 6,315,000 2,090,000 (A) 382,000 8,787,000 Licensing agreements -0- 3,070,000 (A) 108,000 2,962,000 Goodwill 347,000 -0- (A) 426,000 773,000 Total assets 13,384,000 5,943,000 16,727,000 Accounts payable (394,000) (393,000) (787,000) Long-term debt (3,990,000) (2,950,000) (6,940,000) Common stock (3,000,000) (1,000,000) (S) 1,000,000 (3,000,000) Additional paid-in cap. -0- (500,000) (S) 500,000 -0- Retained earnings (6,000,000) (1,100,000) (S) 1,100,000 (6,000,000) Total liab. & equities (13,384,000) (5,943,000) 3,408,000 3,408,000 (16,727,000)

*Although this solution uses a worksheet to compute the consolidated amounts, the problem does not require it.

26. (50 Minutes) (Determine consolidated balances for a bargain purchase.)

a. Marshall’s acquisition of Tucker represents a bargain purchase because the fair value of the net assets acquired exceeds the fair value of the consideration transferred as follows:

Fair value of net assets acquired $515,000 Fair value of consideration transferred 400,000 Gain on bargain purchase $115,000

In a bargain purchase, the acquisition is recorded at the fair value of the net assets acquired instead of the fair value of the consideration transferred (an exception to the general rule).

Prior to preparing a consolidation worksheet, Marshall records the three transactions that occurred to create the business combination.

Investment in Tucker ............................................... 515,000 Long-term Liabilities ............................................................... 200,000 Common Stock (par value) ..................................................... 20,000 Additional Paid-In Capital ....................................................... 180,000 Gain on Bargain Purchase ..................................................... 115,000

(To record liabilities and stock issued for Tucker acquisition fair value)



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26. (continued)

Professional Services Expense .......................... 30,000 Cash .............................................................. 30,000 (to record payment of professional fees) Additional Paid-In Capital ................................... 12,000 Cash .............................................................. 12,000 (To record payment of stock issuance costs)

Marshall's trial balance is adjusted for these transactions (as shown in the worksheet that follows).

Next, the $400,000 fair value of the investment is allocated: Consideration transferred at fair value ................................... $400,000 Book value (assets minus liabilities or total stockholders' equity) .................................................. 460,000 Book value in excess of consideration transferred ........ (60,000) Allocation to specific accounts based on fair value: Inventory ................................................................... 5,000 Land ........................................................................ 20,000 Buildings ................................................................... 30,000 55,000 Gain on bargain purchase (excess net asset fair value over consideration transferred) ......................................... $(115,000)

CONSOLIDATED TOTALS Cash = $38,000. Add the two book values less acquisition and stock issue

costs

Receivables = $360,000. Add the two book values.

Inventory = $505,000. Add the two book values plus the fair value adjustment

Land = $400,000. Add the two book values plus the fair value adjustment.

Buildings = $670,000. Add the two book values plus the fair value adjustment.

Equipment = $210,000. Add the two book values.

Total assets = $2,183,000. Summation of the above individual figures.

Accounts payable = $190,000. Add the two book values.

Long-term liabilities = $830,000. Add the two book values plus the debt

incurred by the parent in acquiring the subsidiary.

Common stock = $130,000.The parent's book value after stock issue to acquire the subsidiary.

Additional paid-in capital = $528,000.The parent's book value after the stock issue to acquire the subsidiary less the stock issue costs.

Retained earnings = $505,000. Parent company balance less $30,000 in professional services expense plus $115,000 gain on bargain purchase.

Total liabilities and equity = $2,183,000. Summation of the above figures.


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26. (continued)

b. MARSHALL COMPANY AND CONSOLIDATED SUBSIDIARY

Worksheet

January 1, 2015

Marshall Tucker Consolidation Entries Consolidated

Accounts Company* Company Debit Credit Totals

Cash ............................................ 18,000 20,000 38,000

Receivables ............................... 270,000 90,000 360,000

Inventory ................................... 360,000 140,000 (A) 5,000 505,000

Land ........................................... 200,000 180,000 (A) 20,000 400,000

Buildings (net) .......................... 420,000 220,000 (A) 30,000 670,000

Equipment (net) ........................ 160,000 50,000 210,000

Investment in Tucker ................ 515,000 (S) 460,000

(A) 55,000 -0-

Total assets ............................... 1,943,000 700,000 2,183,000

Accounts payable ...................... (150,000) (40,000) (190,000)

Long-term liabilities ................. (630,000) (200,000) (830,000)

Common stock .......................... (130,000) (120,000) (S) 120,000 (130,000)

Additional paid-in capital ......... (528,000) -0- (528,000)

Retained earnings, 1/1/15 ......... ( 505,000) (340,000) (S) 340,000 (505,000)

Total liab. and owners’ equity .. (1,943,000) (700,000) 515,000 515,000 (2,183,000)

Marshall's accounts have been adjusted for acquisition entries (see part a.).



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27. (Prepare a consolidated balance sheet)

Consideration transferred at fair value .............. $495,000 Book value ........................................................... 265,000 Excess fair over book value ............................... 230,000 Allocation of excess fair value to specific assets and liabilities: to computer software ..................................... $50,000 to equipment ................................................... (10,000) to client contracts .......................................... 100,000 to in-process research and development ... 40,000 to notes payable ............................................. (5,000) 175,000 Goodwill ............................................................... $ 55,000

Pratt Spider Debit Credit Consolidated

Cash 36,000 18,000 54,000 Receivables 116,000 52,000 168,000 Inventory 140,000 90,000 230,000 Investment in Spider 495,000 -0- (S) 265,000 (A) 230,000 -0- Computer software 210,000 20,000 (A) 50,000 280,000 Buildings (net) 595,000 130,000 725,000 Equipment (net) 308,000 40,000 (A) 10,000 338,000 Client contracts -0- -0- (A) 100,000 100,000 Research and devlopment asset -0- -0- (A) 40,000 40,000 Goodwill -0- -0- (A) 55,000 55,000 Total assets 1,900,000 350,000 1,990,000

Accounts payable (88,000) (25,000) (113,000) Notes payable (510,000) (60,000) (A) 5,000 (575,000) Common stock (380,000) (100,000) (S)100,000 (380,000) Additional paid-in capital (170,000) (25,000) (S) 25,000 (170,000) Retained earnings (752,000) (140,000) (S)140,000 (752,000) Total liabilities and equities (1,900,000) (350,000) 510,000 510,000 (1,990,000)



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27. (continued) Pratt Company and Subsidiary Consolidated Balance Sheet December 31, 2015

Assets Liabilities and Owners’ Equity Cash $ 54,000 Accounts payable $ 113,000 Receivables 168,000 Notes payable 575,000 Inventory 230,000 Computer software 280,000 Buildings (net) 725,000 Equipment (net) 338,000 Client contracts 100,000 Research and Common stock 380,000 development asset 40,000 Additional paid in capital 170,000 Goodwill 55,000 Retained earnings 752,000 Total assets $1,990,000 Total liabilities and equities $1,990,000

28. (15 minutes) (Acquisition method entries for a merger) Case 1: Fair value of consideration transferred $145,000 Fair value of net identifiable assets 120,000 Excess to goodwill $25,000

Case 1 journal entry on Allerton’s books:

Current Assets 60,000 Building 50,000 Land 20,000 Trademark 30,000 Goodwill 25,000 Liabilities 40,000 Cash 145,000 Case 2: Bargain Purchase under acquisition method Fair value of consideration transferred $110,000 Fair value of net identifiable assets 120,000 Gain on bargain purchase $ 10,000

Case 2 journal entry on Allerton’s books:

Current Assets 60,000 Building 50,000 Land 20,000 Trademark 30,000 Gain on Bargain Purchase 10,000 Liabilities 40,000 Cash 110,000



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Problem 28. (continued)

In a bargain purchase, the acquisition method employs the fair value of the net identifiable assets acquired as the basis for recording the acquisition. Because this basis exceeds the amount paid, Allerton recognizes a gain on bargain purchase. This is an exception to the general rule of using the fair value of the consideration transferred as the basis for recording the combination.

29. (25 minutes) (Combination entries—acquired entity dissolved)

Cash consideration transferred $310,800 Contingent performance obligation 17,900 Consideration transferred (fair value) 328,700 Fair value of net identifiable assets 294,700 Goodwill $ 34,000

Journal entries:

Receivables 83,900 Inventory 70,250 Buildings 122,000 Equipment 24,100 Customer List 25,200 Research and Development Asset 36,400 Goodwill 34,000 Current Liabilities 12,900 Long-Term Liabilities 54,250 Contingent Performance Liability 17,900 Cash 310,800

Professional Services Expense 15,100 Cash 15,100



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30. (30 Minutes) (Overview of the steps in applying the acquisition method when shares have been issued to create a combination. Part h. includes a bargain purchase.)

a. The fair value of the consideration includes Fair value of stock issued $1,500,000 Contingent performance obligation 30,000 Fair value of consideration transferred $1,530,000

b. Stock issue costs reduce additional paid-in capital.

c. In a business combination, direct acquisition costs (such as fees paid to investment banks for arranging the transaction) are recognized as expenses.

d. The par value of the 20,000 shares issued is recorded as an increase of $20,000 in the Common Stock account. The $74 fair value in excess of par value ($75 – $1) is an increase to additional paid-in capital of $1,480,000 ($74 × 20,000 shares).

e. Fair value of consideration transferred (above) $1,530,000 Receivables $ 80,000 Patented technology 700,000 Customer relationships 500,000 In-process research and development 300,000 Liabilities (400,000) 1,180,000 Goodwill $ 350,000 f. Revenues and expenses of the subsidiary from the period prior to the

combination are omitted from the consolidated totals. Only the operational figures for the subsidiary after the purchase are applicable to the business combination. The previous owners earned any previous profits.

g. The subsidiary’s Common Stock and Additional Paid-in Capital accounts have no impact on the consolidated totals.

h. The fair value of the consideration transferred is now $1,030,000. This amount indicates a bargain purchase calculated as follows:

Fair value of consideration transferred $1,030,000 Receivables $ 80,000 Patented technology 700,000 Customer relationships 500,000 Research and development asset 300,000 Liabilities (400,000) 1,180,000 Gain on bargain purchase $ 150,000

The values of SafeData’s assets and liabilities would be recorded at fair value, but there would be no goodwill recognized and a gain on bargain purchase would be reported.



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31. (50 Minutes) (Prepare balance sheet for a statutory merger using the acquisition method. Also, use worksheet to derive consolidated totals.) a. In accounting for the combination of NewTune and On-the-Go, the fair value of

the acquisition is allocated to each identifiable asset and liability acquired with any remaining excess attributed to goodwill.

Fair value of consideration transferred (shares issued) $750,000 Fair value of net assets acquired: Cash $ 29,000 Receivables 63,000 Trademarks 225,000 Record music catalog 180,000 In-process research and development 200,000 Equipment 105,000 Accounts payable (34,000) Notes payable (45,000) 723,000 Goodwill $ 27,000

Journal entries by NewTune to record combination with On-the-Go:

Cash 29,000 Receivables 63,000 Trademarks 225,000 Record Music Catalog 180,000 Research and Development Asset 200,000 Equipment 105,000 Goodwill 27,000 Accounts Payable 34,000 Notes Payable 45,000 Common Stock (NewTune par value) 60,000 Additional Paid-In Capital 690,000 (To record merger with On-the-Go at fair value) Additional Paid-In Capital 25,000 Cash 25,000 (Stock issue costs incurred)



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Problem 31 (continued): Post-Combination Balance Sheet: Assets Liabilities and Owners’ Equity Cash $ 64,000 Accounts payable $ 144,000 Receivables 213,000 Notes payable 415,000 Trademarks 625,000 Record music catalog 1,020,000 Research and development asset 200,000 Common stock 460,000 Equipment 425,000 Additional paid-in capital 695,000 Goodwill 27,000 Retained earnings 860,000 Total $2,574,000 Total $2,574,000

b. Because On-the-Go continues as a separate legal entity, NewTune first records the acquisition as an investment in the shares of On-the-Go. Journal entries:

Investment in On-the-Go 750,000 Common Stock (NewTune, Inc., par value) 60,000 Additional Paid-In Capital 690,000 (To record acquisition of On-the-Go's shares) Additional Paid-In Capital 25,000 Cash 25,000 (Stock issue costs incurred)

Next, NewTune’s accounts are adjusted for the two immediately preceding entries to facilitate the worksheet preparation of the consolidated financial statements.



31. (continued) NEWTUNE, INC., AND ON-THE-GO CO. b. Consolidation Worksheet January 1, 2015

Consolidation Entries Consolidated Accounts NewTune, Inc. On-the-Go Co. Debit Credit Totals

Cash 35,000 29,000 64,000 Receivables 150,000 65,000 (A) 2,000 213,000 Investment in On-the-Go 750,000 -0- (S) 270,000 (A) 480,000 -0- Trademarks 400,000 95,000 (A) 130,000 625,000 Record music catalog 840,000 60,000 (A) 120,000 1,020,000 Research and development asset -0- -0- (A) 200,000 200,000 Equipment 320,000 105,000 425,000 Goodwill -0- -0- (A) 27,000 27,000 Totals 2,495,000 354,000 2,574,000 Accounts payable 110,000 34,000 144,000 Notes payable 370,000 50,000 (A) 5,000 415,000 Common stock 460,000 50,000 (S) 50,000 460,000 Additional paid-in capital 695,000 30,000 (S) 30,000 695,000 Retained earnings 860,000 190,000 (S) 190,000 860,000 Totals 2,495,000 354,000 752,000 752,000 2,574,000

Note: The accounts of NewTune have already been adjusted for the first three journal entries indicated in the answer to Part b. to record the acquisition fair value and the stock issuance costs.

The consolidation entries are designed to:

Eliminate the stockholders’ equity accounts of the subsidiary (S)

Record all subsidiary assets and liabilities at fair value (A)

Recognize the goodwill indicated by the acquisition fair value (A)

Eliminate the Investment in On-the-Go account (S, A) c. The consolidated balance sheets in parts a. and b. above are identical. The financial reporting consequences for a 100% stock acquisition vs. a merger are the same. The economic substances of the two forms of the transaction are identical and, therefore, so are the resulting financial statements. The difference is in the journal entry to record the acquisition in the parent company books.

Chapter 03 - Consolidations—Subsequent to the Date of Acquisition


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32. (40 minutes) (Prepare a consolidated balance sheet using the acquisition method).

a. Journal entries to record the acquisition on Pacifica’s records.

Investment in Seguros 1,062,500 Common Stock (50,000 × $5) 250,000 Additional Paid-In Capital (50,000 × $15) 750,000 Contingent Performance Obligation 62,500

The contingent consideration is computed as: $130,000 payment × 50% probability × 0.961538 present value factor

Professional Services Expense 15,000 Cash 15,000 Additional Paid-In Capital 9,000 Cash 9,000 b. and c.

Pacifica Seguros Consolidation Entries

Consolidated Balance

Sheet

Revenues (1,200,000) (1,200,000)

Expenses 890,000 890,000

Net income (310,000) (310,000)

Retained earnings, 1/1 (950,000) (950,000)

Net income (310,000) (310,000)

Dividends declared 90,000 90,000

Retained earnings, 12/31 (1,170,000) (1,170,000)

Cash 86,000 85,000 171,000

Receivables and inventory 750,000 190,000 (A) 10,000 930,000

Property, plant and equipment 1,400,000 450,000 (A)150,000 2,000,000

Investment in Seguros 1,062,500 (S) 705,000 0

(A) 357,500

Research and development asset (A)100,000 100,000

Goodwill (A) 77,500 77,500

Trademarks 300,000 160,000 (A) 40,000 500,000

Total assets 3,598,500 885,000 3,778,500

Liabilities (500,000) (180,000) (680,000)

Contingent performance obligation (62,500) (62,500)

Common stock (650,000) (200,000) (S) 200,000 (650,000)

Additional paid-in capital (1,216,000) (70,000) (S) 70,000 (1,216,000)

Retained earnings (1,170,000) (435,000) (S) 435,000 (1,170,000)

Total liabilities and equities (3,598,500) (885,000) 1,072,500 1,072,500 (3,778,500)



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Answers to Appendix Problems

33. (25 minutes) Journal entries for a merger using legacy purchase method. Also compare to acquisition method. a. Purchase Method 1. Purchase price (including acquisition costs) $635,000 Fair values of net assets acquired 525,000 Goodwill $110,000 Journal entry:

Current Assets 80,000 Equipment 180,000 Trademark 320,000 Goodwill 110,000 Liabilities 55,000 Cash 635,000 2. Acquisition date fair values: Purchase price (including acquisition costs) $450,000 Fair values of net assets acquired 525,000 Bargain purchase ($ 75,000) Allocation of bargain purchase to long-term assets acquired: Total Asset Fair value Prop. reduction reduction

Equipment $180,000 36% x $75,000 = $27,000 Trademark 320,000 64% x 75,000 = 48,000 $500,000 $75,000 Journal entry:

Current Assets 80,000 Equipment ($180,000 – $27,000) 153,000 Trademark ($320,000 – $48,000) 272,000 Liabilities 55,000 Cash 450,000



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33. continued b. Acquisition Method 1. Consideration transferred $ 610,000 Fair values of net assets acquired 525,000 Goodwill $ 85,000 Journal entry:

Current Assets 80,000 Equipment 180,000 Trademark 320,000 Goodwill 85,000 Liabilities 55,000 Cash 610,000

Professional Services Expense 25,000 Cash 25,000 2. Consideration transferred $425,000 Fair values of net assets acquired 525,000 Gain on bargain purchase ($100,000) Journal entry:

Current Assets 80,000 Equipment 180,000 Trademark 320,000 Liabilities 55,000 Gain on Bargain Purchase 100,000 Cash 425,000

Professional Services Expense 25,000 Cash 25,000



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34. (25 minutes) (Pooling vs. purchase involving an unrecorded intangible)

a. Purchase Pooling

Inventory $ 650,000 $ 600,000 Land 750,000 450,000 Buildings 1,000,000 900,000 Unpatented technology 1,500,000 -0- Goodwill 600,000 -0- Total $4,500,000 $1,950,000

b. Pre-acquisition revenues and expenses were excluded from consolidated results under the purchase method, but were included under the pooling method.

c. Poolings, in most cases, produce higher rates of return on assets than

purchase accounting because the denominator typically is much lower. In the case of the Swimwear acquisition pooling produced an increment to total assets of $1,950,000 compared to $4,500,000 under purchase accounting. Future EPS under poolings were also higher because of lower future depreciation and amortization of the smaller asset base.

Managers whose compensation contracts involved accounting performance measures clearly had incentives to use pooling of interest accounting whenever possible.



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Chapter 2 Develop Your Skills CONSIDERATION OR COMPENSATION CASE (estimated time 40 minutes) According to FASB ASC (805-10-55-25): If it is not clear whether an arrangement for payments to employees or selling shareholders is part of the exchange for the acquiree or is a transaction separate from the business combination, the acquirer should consider the following indicators:

a. Continuing employment. The terms of continuing employment by the selling shareholders who become key employees may be an indicator of the substance of a contingent consideration arrangement. The relevant terms of continuing employment may be included in an employment agreement, acquisition agreement, or some other document. A contingent consideration arrangement in which the payments are automatically forfeited if employment terminates is compensation for postcombination services. Arrangements in which the contingent payments are not affected by employment termination may indicate that the contingent payments are additional consideration rather than compensation.

b. Duration of continuing employment. If the period of required employment coincides with or is longer than the contingent payment period, that fact may indicate that the contingent payments are, in substance, compensation.

c. Level of compensation. Situations in which employee compensation other than the contingent payments is at a reasonable level in comparison to that of other key employees in the combined entity may indicate that the contingent payments are additional consideration rather than compensation.

d. Incremental payments to employees. If selling shareholders who do not become employees receive lower contingent payments on a per-share basis than the selling shareholders who become employees of the combined entity, that fact may indicate that the incremental amount of contingent payments to the selling shareholders who become employees is compensation.

e. Number of shares owned. The relative number of shares owned by the selling shareholders who remain as key employees may be an indicator of the substance of the contingent consideration arrangement. For example, if the selling shareholders who owned substantially all of the shares in the acquiree continue as key employees, that fact may indicate that the arrangement is, in substance, a profit-sharing arrangement intended to provide compensation for postcombination services. Alternatively, if selling shareholders who continue as key employees owned only a small number of shares of the acquiree and all selling shareholders receive the same amount of contingent consideration on a per-share basis, that fact may indicate that the contingent payments are additional consideration. The preacquisition ownership interests held by parties related to selling shareholders who continue as key employees, such as family members, also should be considered.

f. Linkage to the valuation. If the initial consideration transferred at the acquisition date is based on the low end of a range established in the valuation of the acquiree and the contingent formula relates to that valuation approach, that fact may suggest that the contingent payments are additional consideration. Alternatively, if the contingent payment formula is consistent with prior profit-sharing arrangements, that fact may suggest that the substance of the arrangement is to provide compensation.



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g. Formula for determining consideration. The formula used to determine the contingent payment may be helpful in assessing the substance of the arrangement. For example, if a contingent payment is determined on the basis of a multiple of earnings, that might suggest that the obligation is contingent consideration in the business combination and that the formula is intended to establish or verify the fair value of the acquiree. In contrast, a contingent payment that is a specified percentage of earnings might suggest that the obligation to employees is a profit-sharing arrangement to compensate employees for services rendered.

Suggested answer: Note: This case was designed to have conflicting indicators across the various criteria identified in the FASB ASC for determining the issue of compensation vs. consideration. Thus, the solution is subject to alternative explanations and student can be encouraged to use their own judgment and interpretations in supporting their answers. In the author’s judgment, the $8 million contingent payment (fair value = $4 million) is contingent consideration to be included in the overall fair value NaviNow records for its acquisition of TrafficEye. This contingency is not dependent on continuing employment (criteria a.), and uses a formula based on a component of earnings (criteria g.). Even though the four former owners of TrafficEye owned 100% of the shares (criteria e.), which suggests the $8 million is compensation, the overall fact pattern indicates consideration because no services are required for the payment. The profit-sharing component of the employment contract appears to be compensation. Criteria g. specifically identifies profit-sharing arrangements as indicative of compensation for services rendered. Criteria a. also applies given that the employees would be unable to participate in profit-sharing if they terminate employment. Although the employees receive non-profit sharing compensation similar to other employees (criteria c.), the overall pattern of evidence suggests that any payments made under the profit-sharing arrangement should be recognized as compensation expense when incurred and not contingent consideration for the acquisition.



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ASC RESEARCH CASE—DEFENSIVE INTANGIBLE ASSET (35 MINUTES)

a. The ASC Glossary defines a defensive intangible asset as “An acquired intangible asset in a situation in which an entity does not intend to actively use the asset but intends to hold (lock up) the asset to prevent others from obtaining access to the asset.” ASC 820-10-35-10D also observes that To protect its competitive position, or for other reasons, a reporting entity may intend not to use an acquired nonfinancial asset actively, or it may intend not to use the asset according to its highest and best use. For example, that might be the case for an acquired intangible asset that the reporting entity plans to use defensively by preventing others from using it. Nevertheless, the reporting entity shall measure the fair value of a nonfinancial asset assuming its highest and best use by market participants.

According to ASC 350-30-25-5 a defensive intangible asset should be accounted for as a separate unit of accounting (i.e., an asset separate from other assets of the acquirer). It should not be included as part of the cost of an entity's existing intangible asset(s) presumably because the defensive intangible asset is separately identifiable. b. The identifiable assets acquired in a business combination should be measured at their acquisition-date fair values (ASC 805-20-30-1).

c. A fair value measurement assumes the highest and best use of an asset by market participants. Highest and best use is determined based on the use of the asset by market participants, even if the intended use of the asset by the reporting entity is different (ASC 820-10-35-10). Importantly, highest and best use provides maximum value to market participants. The highest and best use of the asset establishes the valuation premise used to measure the fair value of the asset—in this case an in-exchange premise maximizes the value of the asset at $2 million. d. A defensive intangible asset shall be assigned a useful life that reflects the entity's consumption of the expected benefits related to that asset. The benefit a reporting entity receives from holding a defensive intangible asset is the direct and indirect cash flows resulting from the entity preventing others from realizing any value from the intangible asset (defensively or otherwise). An entity shall determine a defensive intangible asset's useful life, that is, the period over which an entity consumes the expected benefits of the asset, by estimating the period over which the defensive intangible asset will diminish in fair value. The period over which a defensive intangible asset diminishes in fair value is a proxy for the period over which the reporting entity expects a defensive intangible asset to contribute directly or indirectly to the future cash flows of the entity. (ASC 350-30-35A)

It would be rare for a defensive intangible asset to have an indefinite life because the fair value of the defensive intangible asset will generally diminish over time as a result of a lack of market exposure or as a result of competitive or other factors. Additionally, if an acquired intangible asset meets the definition of a defensive intangible asset, it shall not be considered immediately abandoned. (ASC 350-30-35B)

http://asc.fasb.org/glossarysection&trid=2155951&id=SL2217318-110257



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RESEARCH CASE—CELGENE’S ACQUISITION OF AVILA THERAPEUTICS

(25 Minutes) 1. From Celgene’s 2012 10-K report (Note 2), “We acquired Avila to enhance our portfolio of potential therapies for patients with life-threatening illnesses worldwide.” 2. Celgene accounted for its March 7, 2012 acquisition of Avila Therapeutics using the acquisition method. Accordingly, Celgene recorded the acquisition at $535 million. 3. From Celgene’s 12/31/12 10-K report (dollars in thousands) Cash consideration: Cash $363,405 Contingent consideration 171,654 Total fair value of consideration transferred $535,059 Working capital (cash, A/R, A/P, etc.) $ 11,987 Property, plant, and equipment 2,559 Platform technology intangible asset 330,800 In-process research and development product rights 198,400 Net deferred tax liability (164,993) Total fair value of net identifiable assets 378,753 Goodwill $156,306 Celgene determined these allocations by estimating fair values for each of the assets acquired and the liabilities assumed. 4. As shown in the part 3. Schedule above, Celgene included $171.654 million of fair value contingent consideration in its consideration transferred. If all milestones are achieved, contingent consideration could reach a maximum of $595 million. 5. Acquired in-process research and development product rights are accounted for as an intangible asset with an indefinite life.



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CHAPTER 3 CONSOLIDATIONS—SUBSEQUENT TO

THE DATE OF ACQUISITION

I. Several factors serve to complicate the consolidation process when it occurs subsequent to the date of acquisition. In all combinations within its own internal records the acquiring company will utilize a specific method to account for the investment in the acquired company.

1. Three alternatives are available

a. Initial value method (also known as the cost method)

b. Equity method

c. Partial equity method

2. Depending upon the method applied, the acquiring company will record earnings from its ownership of the acquired company. This total must be eliminated on the consolidation worksheet and be replaced by the subsidiary’s revenues and expenses.

3. Under each of these three methods, the balance in the Investment account will also vary. It too must be removed in producing consolidated statements and be replaced by the subsidiary’s assets and liabilities.

II. For combinations subsequent to the acquisition date, certain procedures are required. If

the parent applies the equity method, the following process is appropriate.

A. Assuming that the acquisition was made during the current fiscal period

1. The parent adjusts its own Investment account to reflect the subsidiary’s income and dividend declarations as well as any amortization expense relating to excess acquisition-date fair value over book value allocations and goodwill.

2. Worksheet entries are then used to establish consolidated figures for reporting purposes.

a. Entry S offsets the subsidiary’s stockholders’ equity accounts against the book value component of the Investment account (as of the acquisition date).

b. Entry A recognizes the excess fair over book value allocations made to specific subsidiary accounts and/or to goodwill.

c. Entry I eliminates the investment income balance accrued by the parent.

d. Entry D removes intra-entity dividend declarations

e. Entry E recognizes the current excess amortization expenses on the excess fair over book value allocations.

f. Entry P eliminates any intra-entity payable/receivable balances.

B. Assuming that the acquisition was made during a previous fiscal period

1. Most of the consolidation entries described above remain applicable regardless of the time that has elapsed since the combination was formed.

2. The amount of the subsidiary’s stockholders’ equity to be removed in Entry S will differ each period to reflect the balance as of the beginning of the current year



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3. The allocations established by entry A will also change in each subsequent consolidation. Only the unamortized balances remaining as of the beginning of the current period are recognized in this entry.

III. For a combination where the parent has applied an accounting method other than the

equity method, the consolidation procedures described above must be modified.

A. If the initial value method is applied by the parent company, the intra-entity dividends eliminated in Entry I will only consist of the dividends transferred from the subsidiary. No separate Entry D is needed.

B. If the partial equity method is in use, the intra-entity income to be removed in Entry I is the equity accrual only; no amortization expense is included. Intra-entity dividends are eliminated through Entry D.

C. In any time period after the year of acquisition.

1. The initial value method recognizes neither income in excess of dividend declarations nor excess amortization expense. Thus, for all years prior to the current period, both of these figures must be entered directly into the consolidation. Entry*C is used for this purpose; it converts all prior amounts to equity method balances.

2. The partial equity method does not recognize excess amortization expenses. Therefore, Entry*C converts the appropriate account balances to the equity method by recognizing the expense that relates to all of the past years.

IV. Bargain purchases

A. As discussed in Chapter Two, bargain purchases occur when the parent company transfers consideration less than net fair values of the subsidiary’s assets acquired and liabilities assumed.

B. The parent recognizes an excess of net asset fair value over the consideration transferred as a “gain on bargain purchase.”

V. Goodwill Impairment

A. When is goodwill impaired?

1. Goodwill is considered impaired when the fair value of its related reporting unit falls below its carrying value. Goodwill should not be amortized, but should be tested for impairment at the reporting unit level (operating segment or lower identifiable level).

2. Goodwill should be tested for impairment at least annually.

3. Interim impairment testing is necessary in the presence of negative indicators such as an adverse change in the business climate or market, legal factors, regulatory action, an introduction of competition, or a loss of key personnel.

B. How is goodwill tested for impairment?

1. All acquired goodwill should be assigned to reporting units. It would not be unusual for the total amount of acquired goodwill to be divided among a number of reporting units. Goodwill may be assigned to reporting units of the acquiring entity that are expected to benefit from the synergies of the combination even though other assets or liabilities of the acquired entity may not be assigned to that reporting unit.



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2. Goodwill is tested for impairment through an optional assessment process followed by a two-step approach (if necessary).

a. Entities are allowed the option of conducting a qualitative assessment of goodwill to assess whether the two-step testing procedure is required. Under the qualitative assessment, management evaluates relevant events or circumstances to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If it is more likely than not that the fair value of a reporting unit is less than its carrying amount, then the entity performs the two-step testing procedure. Otherwise, no further tests are required.

b. The first step simply compares the fair value amount of a reporting unit to its carrying amount. If the fair value of the reporting unit exceeds its carrying amount, goodwill is not considered impaired and no further analysis is necessary.

c. The second step is a comparison of goodwill to its carrying amount. If the implied value of a reporting unit’s goodwill is less than its carrying value, goodwill is considered impaired and a loss is recognized. The loss is equal to the amount by which goodwill exceeds its implied value.

3. The implied value of goodwill should be calculated in the same manner that goodwill is calculated in a business combination. That is, an entity should allocate the fair value of the reporting unit to all of the assets and liabilities of that unit (including any unrecognized intangible assets) as if the reporting unit had been acquired in a business combination and the fair value of the reporting unit was the value assigned at a subsidiary’s acquisition date. The excess “acquisition-date” fair value over the amounts assigned to assets and liabilities is the implied value of goodwill. This allocation is performed only for purposes of testing goodwill for impairment and does not require entities to record the “step-up” in net assets or any unrecognized intangible assets.

C. How is the impairment recognized in financial statements?

1. The aggregate amount of goodwill impairment losses should be presented as a separate line item in the operating section of the income statement unless a goodwill impairment loss is associated with a discontinued operation.

2. A goodwill impairment loss associated with a discontinued operation should be included (on a net-of-tax basis) within the results of discontinued operations.

VI. Contingent consideration

A. The fair value of any contingent consideration is included as part of the consideration transferred.

B. If the contingency results in a liability (typically a cash payment), changes in the fair value of the contingency are recognized in income as they occur.

C. If the contingency calls for an additional equity issue at a later date, the acquisition-date fair value of the contingency is not adjusted over time. Any subsequent shares issued as a consequence of the contingency are simply recorded at the original acquisition-date fair value. This treatment is similar to other equity issues (e.g., common stock, preferred stock, etc.) in the parent’s owners’ equity section.

VII. Push-down accounting



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A. A subsidiary may record any acquisition-date fair value allocations directly onto its own financial records rather than through the use of a worksheet. Subsequent amortization expense on these allocations could also be recorded by the subsidiary.

B. Push-down accounting reports the assets and liabilities of the subsidiary at the amount the new owner paid. It also assists the new owner in evaluating the profitability that the subsidiary is adding to the business combination.

C. Push-down accounting can also make the consolidation process easier since allocations and amortization need not be included as worksheet entries.

Answers to Discussion Questions

How Does a Company Really Decide which Investment Method to Apply?

Students can come up with dozens of factors that Pilgrim should consider in choosing its internal method of accounting for its subsidiary, Crestwood Corporation. The following is only a partial list of possible points to consider.

Use of the information. If Pilgrim does not monitor its subsidiary’s income levels closely, applying the equity method may be not be fruitful. A company must plan to use the data before the task of accumulation becomes worthwhile. For example, Crestwood may use the information for evaluating the performance of the subsidiary’s managers.

Size of the subsidiary. If the subsidiary is large in comparison to Pilgrim, the effort required of the equity method may be important. Income levels would probably be significant. However, if the subsidiary is actually quite small in relation to the parent, the impact might not be material enough to warrant the extra effort.

Size of dividend declarations. If Crestwood distributes most of its income as dividends, that figure will approximate equity income. Little additional information would be accrued by applying the equity method. In contrast, if dividends are small or not declared on a regular basis, a Dividend Income balance might vastly understate the profits to be recognized by the business combination.

Amount of excess amortizations. If Pilgrim has paid a significant amount in excess of book value, its annual amortization charges are high, and use of the equity method might be preferred to show the amortization effect each reporting period. In this case, waiting until year end and recognizing all of the expense at one time through a worksheet entry might not be the best way to reflect the impact of the expense.

Amount of intra-entity transactions. As with amortization, the volume of transfers can be an important element in deciding which accounting method to use. If few intra-entity sales are made, monitoring the subsidiary through the application of the equity method is less essential. Conversely, if the amount of these transactions IS significant, the added data can be helpful to company administrators evaluating operations.

Sophistication of accounting systems. If Pilgrim and Crestwood both have advanced accounting systems, application of the equity method may be relatively easy. Unfortunately, if these systems are primitive, the cost and effort necessary to apply the equity method may outweigh any potential benefits.

The timeliness and accuracy of income figures generated by Crestwood. If the subsidiary reports operating results on a regular basis (such as weekly or monthly) and these figures prove to be reliable, equity totals recorded by Pilgrim may serve as valuable information to the parent. However, if Crestwood's reports are slow and often require later adjustment, Pilgrim's use of the equity method will provide only questionable results.



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1. a. CCES Corp., for its own recordkeeping, may apply the equity method to its Investment in Schmaling. Under this approach, the parent's records parallel the activities of the subsidiary. The parent accrues income as it is earned by the subsidiary. Dividends declared by Schmaling reduce its book value; therefore, CCES reduces the investment account. In addition, any excess amortization expense associated with CCES's acquisition-date fair value allocations is recognized through a periodic adjustment. By applying the equity method, both the parent’s income and investment balances accurately reflect consolidated totals. The equity method is especially helpful in monitoring the income of the business combination. This method can be, however, rather difficult to apply and a time consuming process.

b. The initial value method. The initial value method can also be utilized by CCES Corporation. Any dividends declared are recognized as income but no other investment entries are made. Thus, the initial value method is easy to apply. However, the resulting account balances of the parent may not provide a reasonable representation of the totals that result from consolidating the two companies.

c. The partial equity method combines the advantages of the previous two techniques. Income is accrued as earned by the subsidiary as under the equity method. Similarly, dividends reduce the investment account. However, no other entries are recorded; more specifically, amortization is not recognized by the parent. The method is, therefore, easier to apply than the equity method but the subsidiary's individual totals will still frequently approximate consolidated balances.

2. a. The consolidated total for equipment is made up of the sum of Maguire’s book value, Williams’ book value, and any unamortized excess acquisition-date fair value over book value attributable to Williams’ equipment.

b. Although an Investment in Williams account is appropriately maintained by the parent, from a consolidation perspective the balance is intra-entity in nature. Thus, the entire amount is eliminated in arriving at consolidated financial statements.

c. Only dividends declared to outside parties are included in consolidated statements. Because Maguire owns 100 percent of Williams, all of the subsidiary's dividends are intra-entity. Consequently, only the dividends declared by the parent company will be reported in the financial statements for this business combination.

d. Any acquisition-date goodwill must still be reported for consolidation purposes. Reductions to goodwill are made if goodwill is determined to be impaired.

e. Unless intra-entity revenues have been recorded, consolidation is achieved in subsequent periods by adding the two book values together.

f. Consolidated expenses are determined by combining the parent's and subsidiary amounts including any amortization expense associated with the acquisition-date fair value allocations. As discussed in Chapter Five, intra-entity expenses can also require elimination in arriving at consolidated figures.

g. Only the parent’s common stock outstanding is included in consolidated totals.

h. The net income for a business combination is calculated as the difference between consolidated revenues and consolidated expenses.



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3. Under the equity method, the parent accrues subsidiary earnings and amortization expense (associated with acquisition-date fair value allocations) in the same manner as in the consolidation process. The equity method parallels consolidation. Thus, the parent’s net income and retained earnings each year will equal the consolidated totals.

4. In the consolidation process, excess amortizations must be recognized annually for any portion of the acquisition-date fair value allocations to specific assets or liabilities (other than indefinite-lived assets). Although this expense can be simulated in total on the parent's books by an equity method entry, the actual amortization of each allocated fair value adjustment is appropriate for consolidation. Hence, the effect of the parent's equity method amortization entry is removed as part of Entry I so that the amortization of specific accounts (e.g., depreciation) can be recognized (in consolidation Entry E).

5. When a parent applies the initial value method, no accrual is recorded to reflect the subsidiary's change in book value subsequent to acquisition. Recognition of excess amortizations relating to the acquisition is also omitted by the parent. The partial equity method, in contrast, records the subsidiary’s book value increases and decreases but not amortizations. Consequently, for both of these methods, a technique must be employed in the consolidation process to recognize the omitted figures. Entry *C simply brings the parent's figures (more specifically, the beginning retained earnings balance and the investment account) up-to-date as of the first day of the current year. If the acquirer applies the initial value method, changes in the subsidiary's book value in previous years are recognized on the worksheet along with the appropriate amount of amortization expense. For the partial equity method, only the amortization relating to these prior years needs to be recognized.

No similar entry to *C is needed when the parent applies the equity method. The parent will record changes in the subsidiary's book value as well as excess amortization each year. Thus, under the equity method, the parent's investment and beginning retained earnings balances are both correctly established and need no further adjustment.

6. Lambert's loan payable and the receivable held by Jenkins are intra-entity accounts. The consolidation process offsets these reciprocal balances. The $100,000 is neither a debt to nor a receivable from an unrelated (or outside) party and is, therefore, not reported in consolidated financial statements. Any interest income/expense recognized on this loan is also intra-entity in nature and must likewise be eliminated.

7. Because Benns applies the equity method, the $920,000 is composed of four balances:

a. The original consideration transferred by the parent;

b. Benns’ annual accruals to recognize subsidiary net income as it is earned

c. The reductions that are created by the subsidiary's declaration of dividends

d. The periodic amortization recognized by Benns in connection with the allocations identified with its acquisition-date fair value allocations.

8. The $100,000 attributed to goodwill is reported at its original amount unless a portion of goodwill is impaired or a unit of the business where goodwill resides is sold.

9. A parent should consider recognizing an impairment loss for goodwill associated with an acquired subsidiary when, at the reporting unit level, the fair value is less than its carrying amount. Goodwill is reduced when its carrying value is less than its fair value. To compute fair value for goodwill, its implied value is calculated by subtracting the fair values of the reporting unit’s identifiable net assets from its total fair value. The impairment is recognized as a loss from continuing operations.



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10. The acquisition-date fair value of the contingent payment is part of the consideration transferred by Reimers to acquire Rollins and thus is part of the overall fair value assigned to the acquisition. If the contingency is a liability (to be settled in cash or other assets) then the liability is adjusted to fair value through time. If the contingency is a component of equity (e.g., to be settled by the parent issuing equity shares), then the equity instrument is not adjusted to fair value over time.

11. At present, the Securities and Exchange Commission requires the use of push-down accounting for the separate financial statements of a subsidiary where no substantial outside ownership exists. Thus, if Company A owns all of Company B, the push-down method of accounting is appropriate for the separately issued statements of Company B. The SEC normally requires push-down accounting where 95 percent of a subsidiary is acquired and the company has no outstanding public debt or preferred stock.

Push-down accounting may be required if 80-95 percent of the outstanding voting stock is acquired. Push-down accounting uses the consideration transferred as the valuation basis for the subsidiary in consolidated reports. For example, if a piece of land costs Company B $10,000 but Company A allocates a $13,000 fair value to the land in acquiring Company B, the land has a basis to the current owners of B of $13,000. If B's financial records had been united with A at the time of the acquisition, the land would have been reported at $13,000. Thus, keeping the $10,000 figure simply because separate incorporation is maintained is viewed, by proponents of push-down accounting, as unjustified.

12. When push-down accounting is applied, the subsidiary adjusts the book value of its assets and liabilities based on the acquisition-date fair value allocations. The subsidiary then recognizes periodic amortization expense on those allocations with definite lives. Therefore, the subsidiary’s recorded income equals its impact on consolidated earnings.

The parent uses no special procedures when push-down accounting is being applied. However, if the equity method is in use, amortization need not be recognized by the parent since that expense is included in the figure reported by the subsidiary.



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Answers to Problems

1. A

2. B

3. A

4. A Paar’s equipment book value—12/31/14 ............................ $294,000 Kimmel’s equipment book value—12/31/14 ....................... 190,400 Original acquisition-date allocation to Kimmel's equipment ($400,000 – $272,000) ........................................................... 128,000 Amortization of allocation

($128,000 ÷ 10 years for 3 years) ................................... (38,400) Consolidated equipment ...................................................... $574,000

5. A 6. B 7. D 8. B 9. B Phoenix revenues $498,000 Phoenix expenses 350,000 Net income before Sedona effect 148,000 Equity income from Sedona 55,000 Consolidated net income $203,000 -or- Consolidated revenues $783,000 Consolidated expenses (includes $35K amortization) 580,000 Consolidated net income $203,000 10. A (same as Phoenix because of equity method use). 11. C Consideration transferred at fair value $600,000 Book value acquired 420,000 Excess fair over book value 180,000 to equipment 80,000 to customer list (4-year remaining life) $100,000 Three years since acquisition, ¼ of acquisition-date value remains. 12. B 13. C



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14. D The $105,000 excess acquisition-date fair value allocation to equipment is "pushed-down" to the subsidiary and increases its balance to $441,500. The consolidated balance is $871,500 ($430,000 book value for Crawford plus fair value for Nashville $441,500).

15. (35 Minutes) (Determine consolidated retained earnings when parent uses

various accounting methods. Determine Entry *C for each of these methods) a. CONSOLIDATED RETAINED EARNINGS--EQUITY METHOD Herbert (parent) balance—1/1/14 .................................. $400,000 Herbert income—2014 ................................................... 40,000

Herbert dividends—2014 (subsidiary dividends are

intra-entity and, thus, eliminated) ............................ (10,000) Rambis income—2014 (not included in parent's income) 20,000 Amortization—2014 ........................................................ (12,000)

Herbert income—2015 ...................................................... 50,000

Herbert dividends—2015 ................................................ (10,000) Rambis income—2015 ................................................... 30,000 Amortization—2015 ....................................................... (12,000) Consolidated retained earnings, 12/31/15 ..................... $496,000

PARTIAL EQUITY METHOD AND INITIAL VALUE METHOD Consolidated RE are the same regardless of the method in use: the beginning balance plus the income less the dividends of the parent plus the income of the subsidiary less amortization expense. Thus, December 31, 2015 consolidated RE are $496,000 as computed above.

b. Investment in Rambis—equity method Rambis fair value 1/1/14 ............................................................. $574,000 Rambis income 2014 .................................................................. 20,000 Rambis dividends 2014 ............................................................. (5,000) Herbert’s 2014 excess fair over book value amortization ...... (12,000)

Investment account balance 1/1/15 $577,000

Investment in Rambis—partial equity method Rambis fair value 1/1/14 ............................................................. $574,000 Rambis income 2014 .................................................................. 20,000 Rambis dividends 2014 ............................................................. (5,000) Investment account balance 1/1/14 .......................................... $589,000 Investment in Rambis—Initial value method



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Rambis fair value 1/1/14 ............................................................. $574,000

Investment account balance 1/1/15 $574,000



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15. (continued)

c. ENTRY *C

EQUITY METHOD No entry is needed to convert the past figures to the equity method since that method has already been applied.

PARTIAL EQUITY METHOD Amortization for the prior years (only 2014 in this case) has not been recorded and must be brought into the consolidation through worksheet entry *C:

ENTRY *C

Retained earnings, 1/1/15 (Parent) ..................... 12,000

Investment in Rambis ........................................................... 12,000

(To recognize 2014 amortization in consolidated figures. Expense was omitted because of application of partial equity method.)

INITIAL VALUE METHOD Amortization for the prior years (only 2014 in this case) has not been recorded and must be brought into the consolidation through worksheet entry *C. In addition, only dividend income has been recorded by the parent ($5,000 in 2014). In this prior year, Rambis reported net income of $20,000. Thus, the parent has not recorded the $15,000 income in excess of dividends. That amount must also be included in the consolidation through entry *C:

ENTRY *C

Investment in Rambis ...................................................................................... 3,000

Retained earnings, 1/1/15 (Parent) ...................................... 3,000

(To recognize 2014 unrecognized subsidiary earnings as part of the parent’s retained earnings. $15,000 net income of subsidiary was not recorded by parent (income in excess of dividends). Amortization expense of $12,000 was not recorded under the initial value method. Note that *C adjustments bring the parent’s January 1, 2015 Retained Earnings balance equal to that of the equity method.



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16. (30 Minutes) (A variety of questions on equity method, initial value method, and partial equity method.)

a. An allocation of the acquisition price (based on the fair value of the shares issued) must be made first.

Acquisition fair value (consideration paid by Haynes) ................................................... $135,000

Book value equivalency ................................................. (100,000) Excess of Turner fair value over book value ............... $ 35,000

Excess fair value assigned to specific Remaining Annual excess accounts based on fair value life amortizations Equipment ......................... $5,000 5 yrs. $1,000 Customer List ...................... 30,000 10 yrs. 3,000 $4,000

Acquisition-date fair value ..................................................... $135,000

2014 Income accrual .............................................................. 110,000

2014 Dividends declared by Turner .............................. (50,000) 2014 Amortizations (above) ........................................... (4,000) 2015 Income accrual ...................................................... 130,000 2015 Dividends declared by Turner .............................. (40,000) 2015 Amortizations ........................................................ (4,000) Investment in Turner account balance ......................... $277,000

b. Net income of Haynes .................................................... $240,000 Net Income of Turner ..................................................... 130,000 Depreciation expense ..................................................... (1,000) Amortization expense ..................................................... (3,000) Consolidated net income 2015 ................................ $366,000 c. Equipment balance Haynes ........................................... $500,000 Equipment balance Turner ............................................ 300,000 Allocation based on fair value (above) ......................... 5,000 Depreciation for 2014-2015 ............................................ (2,000) Consolidated equipment—December 31, 2015 ............. $803,000

Parent's choice of an investment method has no impact on consolidated totals.



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16. (continued)

d. If the initial value method was applied during 2014, the parent would have recorded dividend income of $50,000 rather than $110,000 (as equity income). Income is, therefore, understated by $60,000. In addition, amortization expense of $4,000 was not recorded. Thus, the January 1, 2015, retained earnings is understated by $56,000 ($60,000 – $4,000). Worksheet Entry *C thus serves to adjust the parent’s beginning retained earning to a full accrual basis:

Investment in Turner ................................................... ....... 56,000

Retained earnings, 1/1/15 (Haynes) .............. 56,000

If the partial equity method was applied during 2014, the parent would have failed to record amortization expense of $4,000. Retained earnings are overstated by $4,000 and are corrected through Entry *C:

Retained earnings, 1/1/15 (Haynes) ........................... ......... 4,000

Investment in Turner ..................................... 4,000

If the equity method was applied during 2014, consolidated retained earnings would equal the parent's retained earnings. Thus, no adjustment would be necessary.



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17. (20 minutes) (Record a merger combination with subsequent testing for goodwill impairment).

a. In accounting for the combination, the total fair value of Beltran (consideration

transferred) is allocated to each identifiable asset acquired and liability assumed with any remaining excess as goodwill.

Cash paid $ 450,000 Fair value of shares issued 1,248,000 Consideration transferred $1,698,000 Consideration transferred (above) $1,698,000 Fair value of net assets acquired and liabilities assumed 1,298,000 Goodwill recognized in the combination $ 400,000

Entry by Francisco to record assets acquired and liabilities assumed in the combination with Beltran:

Cash 75,000 Receivables 193,000 Inventory 281,000 Patents 525,000 Customer relationships 500,000 Equipment 295,000 Goodwill 400,000 Accounts payable 121,000 Long-term liabilities 450,000 Cash 450,000 Common stock (Francisco Co., par value) 104,000 Additional paid-in capital 1,144,000 b. Step one in goodwill impairment test: Fair value of reporting unit as a whole 1,425,000 Book value of reporting unit's net assets 1,585,000

Because the total fair value of the reporting unit is less than its carrying value, a potential goodwill impairment loss exists, step two is performed:

Fair value of reporting unit as a whole $1,425,000 Fair values of reporting unit's net assets (excluding goodwill) 1,325,000 Implied fair value of goodwill 100,000 Book value of goodwill 400,000 Goodwill impairment loss $ 300,000



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18. (20 minutes) (Goodwill impairment testing.)

a. Goodwill Impairment

Step 1 Fair value of reporting unit = $1,028 Carrying value of reporting unit = 1,094 Because fair value < carrying value, there is a potential goodwill impairment

loss. Step 2 Fair value of reporting unit $1,028 Fair value of net assets excluding goodwill Tangible assets $137 Recognized intangibles 326 Unrecognized intangibles 255 718 Implied value of goodwill 310 Carrying value of goodwill 755 Goodwill impairment loss $445 b. Tangible assets, net $84 Goodwill 310 Patent -0- Customer list -0-



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19. (30 minutes) (Goodwill impairment and intangible assets.) Part a: Goodwill Impairment Test—Step 1 Total fair Carrying Potential goodwill value value impairment? Sand Dollar $510,000 < $530,000 yes Salty Dog 580,000 < 610,000 yes Baytowne 560,000 > 280,000 no Part b: Goodwill Impairment Test—Step 2 (Sand Dollar and Salty Dog only)

Sand Dollar—total fair value $510,000 Fair values of identifiable net assets Tangible assets $190,000 Trademark 150,000 Customer list 100,000 Liabilities (30,000) 410,000 Implied value of goodwill 100,000 Carrying value of goodwill 120,000 Impairment loss $20,000

Salty Dog—total fair value $580,000 Fair values of identifiable net assets Tangible assets $200,000 Unpatented technology 125,000 Licenses 100,000 425,000 Implied value of goodwill 155,000 Carrying value of goodwill 150,000 No impairment—implied value > carry value -0-

Part c: No changes in tangible assets or identifiable intangibles are reported based on goodwill impairment testing. The sole purpose of the valuation exercise is to estimate an implied value for goodwill. Destin will report a goodwill impairment loss of $20,000, which will reduce the amount of goodwill allocated to Sand Dollar. However, because the fair value of Sand Dollar’s trademark is less than its carrying amount, the account should be subjected to a separate impairment testing procedure to see if the carrying value is “recoverable” in future estimated cash flows.



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20. (30 Minutes) (Consolidation entries for two years. Parent uses equity method.) Fair Value Allocation and Annual Amortization:

Acquisition fair value (consideration transferred) ... ... $490,000

Book value (assets minus liabilities or total stockholders' equity) .................................................................. (400,000) Excess fair value over book value .......................... $ 90,000 Excess fair value assigned to specific accounts based on individual fair values Remaining Annual excess

life amortizations Land .................................... $10,000 -- -- Buildings ............................. 40,000 4 yrs. $10,000 Equipment ........................... (20,000) 5 yrs. (4,000)

Total assigned to specific

accounts ........................ 30,000 Goodwill .............................. 60,000 indefinite -0-

Total ....................................... $90,000 . $6,000 Consolidation Entries as of December 31, 2014 Entry S

Common stock—Abernethy ................................... 250,000

Additional paid-in capital .................................... 50,000 Retained earnings—1/1/14 .................................. 100,000 Investment in Abernethy ............................... 400,000 (To eliminate stockholders' equity accounts of subsidiary) Entry A Land ..................................................................... 10,000

Buildings ................................................................ 40,000

Goodwill ............................................................... 60,000 Equipment ...................................................... 20,000 Investment in Abernethy ............................... 90,000

(To recognize allocations attributed to fair value of specific accounts at acquisition date with residual fair value recognized as goodwill).

Entry I

Equity in subsidiary earnings ............................ 74,000 Investment in Abernethy ............................... 74,000 (To eliminate $80,000 income accrual for 2014 less $6,000 amortization recorded by parent using equity method)



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20. (continued) Entry D Investment in Abernethy .................................... 10,000 Dividends declared ........................................ 10,000 (To eliminate intra-entity dividend transfers) Entry E Depreciation expense .......................................... 6,000 Equipment ............................................................. 4,000 Buildings ......................................................... 10,000 (To recognize current year amortization expense) Consolidation Entries as of December 31, 2015

Entry S Common stock—Abernethy ............................... 250,000 Additional paid-in capital .................................... 50,000 Retained earnings—1/1/15 ................................... 170,000 Investment in Abernethy ............................... 470,000

(To eliminate beginning stockholders' equity of subsidiary—the Retained Earnings account has been adjusted for 2014 income and dividends. Entry *C is not needed because equity method was applied.)

Entry A

Land ..................................................................... 10,000 Buildings .............................................................. 30,000 Goodwill ............................................................... 60,000 Equipment ...................................................... 16,000 Investment in Abernethy ............................... 84,000

(To recognize allocations relating to investment—balances shown here are as of beginning of current year [original allocation less excess amortizations for the prior period])

Entry I Equity in subsidiary earnings ............................ 104,000 Investment in Abernethy ............................... 104,000

(To eliminate $110,000 income accrual less $6,000 amortization recorded by parent during 2015 using equity method)

Entry D Investment in Abernethy .................................... 30,000 Dividends declared ........................................ 30,000

(To eliminate intra-entity dividend transfers) Entry E Same as Entry E for 2014



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21. (35 Minutes) (Consolidation entries for two years. Parent uses initial value method.)

Acquisition-date allocation and annual excess fair value amortizations: Acquisition date value (consideration paid) ................ $500,000

Book value ........................................................... (400,000) Excess price paid over book value .................... $100,000

Excess price paid assigned to specific Remaining Annual excess accounts based on fair values life amortizations Equipment $ 20,000 5 yrs. $4,000 Long-term liabilities 30,000 4 yrs. 7,500 Goodwill 50,000 indefinite -0- Total $100,000 $11,500 Consolidation entries as of December 31, 2014 Entry S Common stock—Abernethy .............................. 250,000 Additional paid-in capital ................................... 50,000

Retained earnings—1/1/14 ................................... 100,000

Investment in Abernethy ............................... 400,000 (To eliminate stockholders' equity accounts of subsidiary) Entry A Equipment ........................................................... 20,000 Long-term liabilities ........................................... 30,000 Goodwill .............................................................. 50,000 Investment in Abernethy .............................. 100,000

(To recognize allocations determined above in connection with acquisition-date fair values)

Entry I

Dividend income ................................................... 10,000

Dividends declared ....................................... 10,000 (To eliminate intra-entity dividend declarations recorded by parent as income)

Entry E Depreciation expense ........................................ 4,000 Interest expense .................................................. 7,500 Equipment ...................................................... 4,000 Long-term liabilities ....................................... 7,500 (To recognize 2014 amortization expense)



Education.

21. (continued) Consolidation Entries as of December 31, 2015 Entry *C Investment in Abernethy ................................... 58,500 Retained earnings—1/1/15 (Chapman) ........ 58,500

(To convert parent company figures to equity method by recognizing subsidiary's increase in book value for prior year [$80,000 net income less $10,000 dividend declaration] and excess amortizations for that period [$11,500])

Entry S

Common stock—Abernethy .............................. 250,000 Additional paid-in capital ................................... 50,000 Retained earnings—1/1/15 ................................. 170,000

Investment in Abernethy ................................. 470,000

(To eliminate beginning of year stockholders' equity accounts of subsidiary. The retained earnings balance has been adjusted for 2014 net income and dividends)

Entry A Equipment ........................................................... 16,000 Long-term liabilities ........................................... 22,500 Goodwill .............................................................. 50,000 Investment in Abernethy .............................. 88,500

(To recognize allocations relating to investment—balances shown here are as of the beginning of the current year [original allocation less excess amortizations for the prior period])

Entry I

Dividend income ................................................ 30,000 Dividends declared .................................. 30,000

(To eliminate intra-entity dividend declarations recorded by parent as income)

Entry E

Same as Entry E for 2014



Education.

22. (20 Minutes) (Consolidation entries for two years. Parent uses partial equity method.) Fair value allocation and annual excess amortizations: Abernethy fair value (consideration paid) .................... $520,000 Book value ...................................................................... (400,000) Excess fair value over book value (all goodwill) ......... $120,000 Excess amortization (indefinite life for goodwill) ........ -0-

Consolidation Entries as of December 31, 2014 Entry S Common stock—Abernethy ............................... 250,000 Additional paid-in capital .................................... 50,000

Retained earnings—Abernethy—1/1/14 ............... 100,000

Investment in Abernethy ............................... 400,000 (To eliminate stockholders' equity accounts of subsidiary) Entry A Goodwill ............................................................... 120,000 Investment in Abernethy ............................... 120,000 (To recognize goodwill portion of the original acquisition fair value) Entry I Equity in earnings of subsidiary ......................... 80,000 Investment in Abernethy ............................... 80,000

(To eliminate intra-entity income accrual for the current year based on the parent's usage of the partial equity method)

Entry D Investment in Abernethy .................................... 10,000 Dividends declared ........................................ 10,000 (To eliminate intra-entity dividend transfers) Entry E—Not needed. Goodwill is not amortized. Consolidation Entries as of December 31, 2015 Entry *C—Not needed. Goodwill is not amortized. Entry S

Common stock—Abernethy ................................... 250,000

Additional paid-in capital—Abernethy .............. 50,000 Retained earnings—Abernethy—1/1/15 ............ 170,000 Investment in Abernethy ............................... 470,000



Education.

22. (continued)

(To eliminate beginning of year stockholders' equity accounts of subsidiary—the retained earnings balance has been adjusted for 2014 income and dividends.)

Entry A Goodwill ............................................................... 120,000

Investment in Abernethy .................................. 120,000

(To recognize original goodwill balance.) Entry I Equity in earnings of subsidiary ......................... 110,000 Investment in Abernethy ............................... 110,000

(To eliminate Intra-entity Income accrual for the current year.) Entry D Investment in Abernethy .................................... 30,000 Dividends declared ........................................ 30,000 (To eliminate Intra-entity dividend transfers.) Equity E—not needed 23. (45 Minutes) (Variety of questions about the three methods of recording an Investment in a subsidiary for internal reporting purposes.)

a. Acquisition-Date Fair-Value Allocation and Annual Amortization:

Clay’s acquisition-date fair value ...... $510,000

Book value (assets minus liabilities

or stockholders' equity) ................ 450,000 Fair value in excess of book value .... 60,000 Remaining Annual excess Allocation to equipment based on ...... life amortizations fair and book value difference ............ 50,000 5 yrs. $10,000 Goodwill ............................................... $10,000 indefinite -0- Total .................................................... $10,000

EQUITY METHOD Investment Income—2015: Equity accrual (based on Clay's net income) .............. $60,000 Amortization (above) ..................................................... (10,000) Investment income for 2015 ................................................ $50,000



Education.

23. (continued) Investment in Clay—December 31, 2015:

Consideration transferred for Clay ................................. $510,000

2014: Equity accrual (based on Clay's net Income) ......... 55,000 Excess amortizations (above) ................................. (10,000) Dividends ................................................................... (5,000)

2015:

Equity accrual (based on Clay's net Income) .......... 60,000 Excess amortizations ............................................... (10,000) Dividends ................................................................... (8,000)

Total ................................................................................ $592,000 INITIAL VALUE METHOD Investment Income—2015:

Dividend income ................................................................... $8,000

Investment in Clay—December 31, 2015: Consideration transferred for Clay ............................... $510,000

b. The reported consolidated balances are not affected by the parent’s investment accounting method. Thus, consolidated expenses ($480,000 or $290,000 + $180,000 + amortizations of $10,000) are the same regardless of whether the equity method, the partial equity method, or the initial value method is applied by Adams.

c. The reported consolidated balances are not affected by the parent’s

investment accounting method. Thus, consolidated equipment ($970,000 or $520,000 + $420,000 + allocation of $50,000 – two years of excess depreciation totaling $20,000) is the same regardless of whether the equity method or the initial value method is applied by Adams.

d. Adams retained earnings—Equity method

Adams retained earnings—1/1/14 ................................................................... $860,000

Adams income 2014 ............................................................. 125,000 2014 equity accrual for Clay income .................................. 55,000 2014 excess amortization .................................................... (10,000) Adams retained earnings—1/1/15 ....................................... $1,030,000 Adams retained earnings—Initial value method

Adams retained earnings—1/1/14 ................................................................... $860,000

Adams income 2014 ............................................................. 125,000 2014 dividend income from Clay ........................................ 5,000 Adams retained earnings—1/1/15 ....................................... $990,000



Education.

23. (continued)

e. EQUITY METHOD—Entry *C is not utilized since parent's retained

earnings balance is correct.

INITIAL VALUE METHOD—Entry *C is needed to recognize increase in subsidiary's book value ($55,000 income less 5,000 dividends) and amortization ($10,000) for prior year.

Investment in Clay .............................................. 40,000 Retained earnings, 1/1/15 (parent) ................ 40,000

f. Consolidated worksheet entry S for 2015:

Common stock (Clay) .................................... 150,000

................................................. Retained earnings, 1/1/15 (Clay) 350,000

Investment in Clay .................................... 500,000

g. Consolidated revenues (combined) .................. $640,000 Consolidated expenses (combined plus excess amortization) ..................................... (480,000) Consolidated net income .................................... $160,000

24. (15 Minutes) (Consolidated accounts one year after acquisition)

Stanza acquisition fair value ($10,000 in stock issue costs reduce additional paid-in capital) .................... $680,000

Book value of subsidiary

(1/1/15 stockholders' equity balances) ..... (480,000) Fair value in excess of book value .......... $200,000

Remaining Excess fair value allocated to copyrights life Amortization based on fair value .............................. 120,000 6 yrs. $20,000 Goodwill ..................................................... $ 80,000 indefinite -0- Total ...................................................... $20,000

a. Consolidated copyrights Penske (book value) ...................................... $900,000 Stanza (book value) ....................................... 400,000 Allocation (above) .......................................... 120,000 Excess amortization, 2015 ............................ (20,000) Total ........................................................... $1,400,000



Education.

24. (continued) b. Consolidated net income, 2015 Revenues (add book values) ........................ $1,100,000 Expenses: Add book values ....................................... $700,000 Excess amortizations ............................... 20,000 720,000 Consolidated net income ............................... $380,000

c. Consolidated retained earnings, 12/31/15 Retained earnings 1/1/15 (Penske) ............... $600,000 Net income 2015 (above) ............................... 380,000 Dividends declared 2015 (Penske) ............... (80,000) Total ........................................................... $900,000

Stanza's retained earnings balance as of January 1, 2015, is not

included because these operations occurred prior to the acquisition. Stanza's dividends were attributable to Penske and therefore are excluded because they are intra-entity in nature.

d. Consolidated goodwill, 12/31/15

Allocation (above) ................................................... $80,000

25. (30 Minutes) (Consolidated balances three years after the date of acquisition. Includes questions about parent's method of recording investment for internal reporting purposes.)

a. Acquisition-Date Fair Value Allocation and Amortization: Consideration transferred 1/1/13 ............. $600,000 Book value (given) .................................... (470,000) Fair value in excess of book value ..... 130,000 Annual Remaining excess Allocation to equipment based on Life amortizations fair and book value difference 90,000 10 yrs. $9,000

Goodwill ......................................................................... $40,000 indefinite -0-

Total ...................................................... $9,000

CONSOLIDATED BALANCES

Depreciation expense = $659,000 (book values plus $9,000 excess depreciation)

Dividends declared = $120,000 (parent balance only. Subsidiary's dividends are eliminated as intra-entity transfer)

Revenues = $1,400,000 (add book values)

Equipment = $1,563,000 (add book values plus $90,000 allocation less three years of excess depreciation [$27,000])



Education.

25. (continued)

Buildings = $1,200,000 (add book values)

Goodwill = $40,000 (original residual allocation)

Common Stock = $900,000 (parent balance only)

b. The parent's choice of an investment method has no impact on the consolidated totals. The choice of an investment method only affects the internal reporting of the parent.

c. The initial value method is used. The parent's Investment in Subsidiary

account still retains the original consideration transferred of $600,000. In addition, the Investment Income account equals the amount of dividends declared by the subsidiary.

d. If the partial equity method had been utilized, the investment income

account would have shown an equity accrual of $100,000. If the equity method had been applied, the Investment Income account would have included both the equity accrual of $100,000 and excess amortizations of $9,000 for a balance of $91,000.

e. Initial value method—Foxx’s retained earnings—1/1/15

Foxx’s 1/1/15 balance (initial value method was employed) ......... $1,100,000

Partial equity method—Foxx’s retained earnings—1/1/15

Foxx’s 1/1/15 balance (initial value method) ................................................... $1,100,000

2013 net equity accrual for Greenburg ($90,000 – $20,000) .......................... 70,000

2014 net equity accrual for Greenburg ($100,000 – $20,000) ..... 80,000

Foxx’s 1/1/15 retained earnings .......................................... $1,250,000

Equity method—Foxx’s retained earnings—1/1/15

Foxx’s 1/1/15 balance (initial value method) ................................................... $1,100,000

2013 net equity accrual for Greenburg ($90,000 – $20,000) .......................... 70,000

2013 excess fair over book value amortization ................................................ (9,000)

2014 net equity accrual for Greenburg ($100,000 – $20,000) ....... 80,000

2014 excess fair over book value amortization ................................................ (9,000)

Foxx’s 1/1/15 retained earnings ....................................................................... $1,232,000



Education.

26. (50 Minutes) (Consolidated totals for an acquisition where parent employs the equity method. Worksheet is produced as a separate requirement.) a. Sea Cliff acquisition-date fair value ................... $6,000,000 Sea Cliff book value ............................................ (2,500,000)

.................................................................... Fair value in excess of book value ....................................................................................................... $3,500,000

Excess assigned to specific Annual

accounts based on fair value Remaining excess

life amortization

Computer software ................ $1,200,000 12 yrs. $100,000 Patented technology ............ 2,100,000 7 yrs. 300,000 Goodwill ................................ 200,000 indefinite -0- Total ....................................... $3,500,000 $400,000

b. Equity earnings in Sea Cliff:

Because Persoff uses the equity method, the $575,000 "Equity earnings in Sea Cliff" reflects a $975,000 equity accrual (100% of Sea Cliff’s reported earnings) less $400,000 in excess amortization expense computed above.

c. Investment in Sea Cliff:

Fair value at 1/1/13 ................................................................. $6,000,000 Persoff's equity in Sea Cliff earnings (net of amortization): 2013 .................................................................. $500,000 2014 .................................................................. 540,000 2015 .................................................................. 575,000 Post-acquisition earnings net of amortization .................... 1,615,000 Sea Cliff dividends since acquisition ................................... (450,000) Investment balance at 12/31/15 ............................................. $7,165,000



26. continued (part d.) PERSOFF COMPANY AND CONSOLIDATED SUBSIDIARY

Consolidation Worksheet For Year Ending December 31, 2015

Income Statement Persoff Sea Cliff Adjustments & Eliminations Consolidated Revenues (2,720,000) (2,250,000) (4,970,000) Cost of goods sold 1,350,000 870,000 2,220,000 Depreciation 275,000 380,000 655,000 Amortization 370,000 25,000 E 400,000 795,000 Equity earnings in Sea Cliff (575,000) I 575,000 0

Net income (1,300,000) (975,000) (1,300,000)

Statement of Retained Earnings Retained earnings 1/1 (7,470,000) (3,240,000) S 3,240,000 (7,470,000) Net income (above) (1,300,000) (975,000) (1,300,000) Dividends declared 600,000 150,000 150,000 D 600,000

Retained earnings 12/31 (8,170,000) (4,065,000) (8,170,000)

Balance Sheet Current assets 490,000 375,000 865,000 Investment in Sea Cliff 7,165,000 D 150,000 575,000 I 4,040,000 S -0- 2,700,000 A

Computer software 300,000 45,000 A 1,000,000 100,000 E 1,245,000 Patented technology 800,000 80,000 A 1,500,000 300,000 E 2,080,000 Goodwill 100,000 0 A 200,000 300,000 Equipment 1,835,000 4,500,000 6,335,000

Total assets 10,690,000 5,000,000 10,825,000

Liabilities (520,000) (135,000) (655,000) Common stock (2,000,000) (800,000) S 800,000 (2,000,000) Retained earnings 12/31 (8,170,000) (4,065,000) (8,170,000)

Total liabilities and equity (10,690,000) (5,000,000) 7,865,000 7,865,000 (10,825,000)



Education.

27. (50 Minutes) (Consolidated totals for an acquisition where parent employs the equity method. Worksheet is produced as a separate requirement.) a. Osprey acquisition-date fair value ..................... $2,017,000 Osprey book value ............................................... (1,550,000)

..................................................................... Fair value in excess of book value $467,000

Excess assigned to specific Annual accounts based on fair value Remaining excess life amortization Equipment............................... $120,000 8 yrs. $15,000 Customer list ......................... 160,000 4 yrs. 40,000 Trademark ............................... 50,000 indefinite -0- Goodwill ................................. 137,000 indefinite -0- Total ....................................... $467,000 $55,000

b. Investment in Osprey:

Fair value at 1/1/14 ................................................................. $2,017,000 Peregrine's equity in Osprey earnings: 2014: ($175,000 – $55,000) ............................. $120,000 2015: ($378,000 – $55,000) ............................. 323,000 Post-acquisition earnings less excess amortization .......... 443,000 Osprey dividends since acquisition ..................................... (70,000) Investment balance at 12/31/15 ............................................ $2,390,000



P 27 (continued) part d. PEREGRINE COMPANY AND CONSOLIDATED SUBSIDIARY Consolidation Worksheet

For Year Ending December 31, 2015

Income Statement Peregrine Osprey Adjustments & Eliminations Consolidated

Sales (4,200,000) (2,200,000) (6,400,000)

Cost of goods sold 2,300,000 1,550,000 3,850,000

Depreciation expense 493,000 272,000 E 15,000 780,000

Amortization expense 105,000 -0- E 40,000 145,000

Equity earnings in Osprey (323,000) -0- I 323,000 -0-

Net income (1,625,000) (378,000) (1,625,000)

Statement of Retained Earnings

Retained earnings 1/1 (2,900,000) (900,000) S 900,000 (2,900,000)

Net income (1,625,000) (378,000) (1,625,000)

Dividends declared 150,000 45,000 45,000 D 150,000


Balance Sheet

Cash 430,000 88,000 518,000

Accounts receivable 690,000 75,000 765,000

Inventory 890,000 420,000 1,310,000

Investment in Osprey 2,390,000 -0- D 45,000 1,700,000 S -0-

412,000 A

323,000 I

Equipment (net) 6,000,000 1,400,000 A 105,000 15,000 E 7,490,000

Customer lists 115,000 -0- A 120,000 40,000 E 195,000

Trademarks 2,500,000 850,000 A 50,000 3,400,000

Goodwill 185,000 -0- A 137,000 322,000

Total assets 13,200,000 2,833,000 14,000,000

Accounts payable (500,000) (75,000) (575,000)

Long-term debt (1,325,000) (725,000) (2,050,000)

Common stock - Peregrine (7,000,000) (7,000,000)

Common stock - Osprey (800,000) S 800,000


Total liabilities and SE (13,200,000) (2,833,000) 2,535,000 2,535,000 (14,000,000)



Education.

28. (50 Minutes) (Consolidated totals for an acquisition. Worksheet is produced as a separate requirement.)

a. O’Brien acquisition-date fair value .................... $550,000 O’Brien book value ............................................. (350,000)

.................................................................... Fair value in excess of book value .......................................................................................................... $200,000

Excess assigned to specific Annual

accounts based on fair value Remaining excess

life amortizations

Trademarks .............................. $100,000 indefinite -0- Customer relationships ........... 75,000 5 yrs. $15,000 Equipment ................................ (30,000) 10 yrs. (3,000) Goodwill ................................... 55,000 indefinite -0- Total .......................................... $200,000 $12,000

If the partial equity method were in use, the Income of O’Brien account would have had a balance of $222,000 (100% of O’Brien's reported income for the period). If the initial value method were in use, the Income of O’Brien account would have had a balance of $80,000 (100% of the dividends declared by O’Brien). The Income of O’Brien balance is an equity accrual of $222,000 (100% of O’Brien’s reported income) less excess amortizations of $12,000 (as computed above). Thus, the equity method must be in use.

b. Students can develop consolidated figures conceptually, without relying on a worksheet or consolidation entries. Thus, part b. asks students to determine independently each balance to be reported by the business combination.

Revenues = $1,645,000 (the accounts of both companies combined)

Cost of goods sold = 528,000 (the accounts of both companies combined)

Amortization expense = $40,000 (the accounts of both companies and the acquisition-related adjustment of $15,000)

Depreciation expense = $142,000 (the accounts for both companies and the acquisition-related depreciation adjustment of $3,000)

Income from O’Brien = $0 (the balance reported by the parent is removed and replaced with the subsidiary’s individual revenue and expense accounts)

Net Income = 935,000 (consolidated revenues less expenses)

Retained earnings, 1/1 = $700,000 (only the parent's retained earnings figure is included)

Dividends declared = $142,000 (the subsidiary's dividends were attributable to the parent and, thus, as an intra-entity transfer are eliminated)



Education.

Retained earnings, 12/31 = $1,493,000 (the beginning balance for the parent plus consolidated net income less consolidated [parent] dividends)



Education.

28. (continued)

Cash = $290,000 (the accounts of both companies are added together)

Receivables = $281,000 (the accounts of both companies are combined)

Inventory = $310,000 (the accounts of both companies are combined)

Investment in O’Brien = $0 (the parent’s balance is removed and replaced with the subsidiary’s individual asset and liability accounts)

Trademarks = $634,000 (the accounts of both companies are added together plus the 100,000 fair value adjustment)

Customer relationships = $60,000 (the initial $75,000 fair value adjustment less $15,000 amortization expense)

Equipment = $1,170,000 (both company’s balances less the $30,000 fair value adjustment net of $3,000 in depreciation expense reduction)

Goodwill = $55,000 (the original allocation)

Total assets = $2,800,000 (summation of consolidated balances)

Liabilities = $907,000 (the accounts of both companies are combined)

Common stock = $400,000 (parent balance only)

Retained earnings, 12/31 = $1,493,000 (computed above)

Total liabilities and equities = 2,800,000 (summation of consolidated balances)



28. (Continued) c. PATRICK COMPANY AND CONSOLIDATED SUBSIDIARY

Consolidation Worksheet For Year Ending December 31

Consolidation Entries Consolidated Accounts Patrick O’Brien Debit Credit Totals Revenues (1,125,000) (520,000) (1,645,000)

Cost of goods sold 300,000 228,000 528,000 Depreciation expense 75,000 70,000 (E) 3,000 142,000 Amortization expense 25,000 -0- (E) 15,000 40,000

Income from O’Brien (210,000) -0- (I) 210,000 -0- Net income (935,000) (222,000) (935,000)

Retained earnings, 1/1 (700,000) (250,000) (S)250,000 (700,000) Net income (above) (935,000) (222,000) (935,000) Dividends declared 142,000 80,000 (D) 80,000 142,000 Retained earnings, 12/31 (1,493,000) (392,000) (1,493,000)

Cash 185,000 105,000 290,000 Receivables 225,000 56,000 281,000 Inventory 175,000 135,000 310,000 Investment in O’Brien 680,000 (D) 80,000 (S) 350,000 (A) 200,000 -0- (I) 210,000 Trademarks 474,000 60,000 (A) 100,000 634,000 Customer relationships -0- -0- (A) 75,000 (E) 15,000 60,000

Equipment (net) 925,000 272,000(E) 3,000(A) 30,0001,170,000

Goodwill -0- -0- (A) 55,000 55,000 Total assets 2,664,000 628,000 2,800,000

Liabilities (771,000) (136,000) (907,000) Common stock (400,000) (100,000) (S)100,000 (400,000) Retained earnings (above) (1,493,000) (392,000) (1,493,000) Total liabilities and equity (2,664,000) (628,000) 888,000 888,000 (2,800,000)



Education.

29. (60 Minutes) (Consolidation worksheet five years after acquisition with parent using initial value method. Effects of using equity method also included)

Acquisition-date fair value allocation and annual amortization:

a. Aaron fair value (stock exchanged at fair value) ....................................... $470,000 Book value of subsidiary ....................... (360,000) Excess fair value over book value ........ $110,000

Excess assigned to specific accounts based on fair values Remaining Annual excess

life amortizations Royalty agreements $ 60,000 6 yrs. $10,000 Trademark 50,000 10 yrs. 5,000 Total $110,000 $15,000

The parent company is apparently applying the initial value method: only dividend income is recognized during the current year and the investment account retains its original $470,000 balance. Therefore, both the subsidiary's change in retained earnings during 2011–2014 as well as the amortization for that period must be brought into the consolidation. Aaron's retained earnings January 1, 2015 ....................... $490,000 Retained earnings at acquisition-date ............................... (230,000) Increase since acquisition-date ......................................... $260,000 Excess amortization expenses ($15,000 x 4 years) .......... (60,000) Conversion to equity method for years prior to 2015 (Entry *C) ................................................................... $200,000 Explanations of consolidation worksheet entries

Entry*C: Converts 1/1/15 figures from initial value method to equity method as per computation above.

Entry S: Eliminates stockholders' equity accounts of subsidiary as of the beginning of current year.

Entry A: Recognizes allocations to royalty agreements and trademark. This entry establishes unamortized balances as of the beginning of the current year.

Entry I: Eliminates intra-entity dividends.

Entry E: Recognizes excess amortization expenses for the current year. See next page for worksheet.



29. a. (continued) MICHAEL COMPANY AND CONSOLIDATED SUBSIDIARY


Consolidation Entries Consolidated Accounts Michael Aaron Debit Credit Totals Revenues (610,000) (370,000) (980,000)

Cost of goods sold 270,000 140,000 410,000 Amortization expense 115,000 80,000 (E) 15,000 210,000 Dividend income (5,000) -0- (I) 5,000 -0-

Net income (230,000) (150,000) (360,000) Retained earnings 1/1 (880,000) (*C) 200,000 (1,080,000) (490,000) (S) 490,000 -0- Net income (above) (230,000) (150,000) (360,000) Dividends declared 90,000 5,000 (I) 5,000 90,000 Retained earnings 12/31 (1,020,000) (635,000) (1,350,000) Cash $110,000 $15,000 $125,000 Receivables 380,000 220,000 600,000 Inventory 560,000 280,000 840,000 Investment in Aaron Co. 470,000 -0- (*C) 200,000 (S) 620,000 -0- (A) 50,000 Copyrights 460,000 340,000 800,000 Royalty agreements 920,000 380,000 (A) 20,000 (E) 10,000 1,310,000 Trademark -0- -0- (A) 30,000 (E) 5,000 25,000 Total assets 2,900,000 1,235,000 3,700,000 Liabilities (780,000) (470,000) (1,250,000) Preferred stock (300,000) -0- (300,000) Common stock (500,000) (100,000) (S) 100,000 (500,000) Additional paid-in capital (300,000) (30,000) (S) 30,000 (300,000) Retained earnings 12/31 (1,020,000) (635,000) (1,350,000) Total liabilities and equity (2,900,000) (1,235,000) 890,000 890,000 (3,700,000) Parentheses indicate a credit balance.



Education.

29. (continued)

b. If the equity method had been applied by Michael, three figures on that company's financial records would be different: Equity in Earnings of Aaron, Retained Earnings—1/1/15, and Investment in Aaron Co.

Equity in earnings of Aaron: $135,000 (the parent would accrue 100% of Aaron's $150,000 income but must also recognize $15,000 in amortization expense.)

Retained earnings, 1/1/15: $1,080,000 (increases by $200,000—the parent would have recognized the $260,000 increment in the subsidiary's book value during previous years as well as $60,000 in excess amortization expenses for these same four years [see Part a.])

Investment in Aaron: $800,000 (increases by $330,000—the parent would have recognized the $260,000 increment in the subsidiary's book value during previous years as well as $60,000 in excess amortization expenses for these same four years [see Part a.]. In the current year, net income of $135,000 would have been recognized [see above] along with a reduction of $5,000 for subsidiary dividends declared).

c. No Entry *C is needed on the worksheet if the equity method is applied. Both the investment account as well as beginning retained earnings would be stated appropriately.

Entry I would have been used to eliminate the $135,000 Equity in Earnings of Aaron from the parent's income statement and from the Investment in Aaron Co. account.

Entry D would eliminate the $5,000 current year dividend from Dividends Declared and the Investment in Aaron account balances.

d. Consolidated figures are not affected by the investment method used by the parent. The parent company balances would differ and changes would be required in the worksheet entries. However, the figures to be reported do not depend on the parent's selection of a method.



Education.

30. (65 Minutes) (Consolidated totals and worksheet five years after acquisition. Parent uses equity method. Includes goodwill impairment.)

a. Acquisition-date fair value allocations (given) Remaining Annual excess

life amortizations Land $90,000 -- -- Equipment 50,000 10 yrs. $5,000 Goodwill 60,000 indefinite -0- Total $200,000 $5,000

Because Giant uses the equity method, the $135,000 "Equity in Income of Small" reflects a $140,000 equity accrual (100% of Small’s reported earnings) less $5,000 in amortization expense computed above.

b. Revenues = $1,535,000 (both balances are added together)

Cost of goods sold = $640,000 (both balances are added)

Depreciation expense = $307,000 (both balances are added along with excess equipment depreciation)

Equity in income of Small = $0 (the parent's Equity in Income of Small balance is removed and replaced with Small's individual revenue and expense accounts)

Net income = $588,000 (consolidated expenses are subtracted from consolidated revenues)

Retained earnings, 1/1/15 = $1,417,000 (the parent’s balance)

Dividends declared = $310,000 (the parent number alone because the subsidiary's dividends are intra-entity)

Retained earnings, 12/31/15 = $1,695,000 (the parent’s balance at beginning of the year plus consolidated net income less consolidated dividends declared)

Current assets = $706,000 (both book balances are added together while the $10,000 intra-entity receivable is eliminated)

Investment in Small = $0 (the parent's asset is removed so that Small's individual asset and liability accounts can be brought into the consolidation)

Land = $695,000 (both book balances are added together along with the acquisition-date fair value allocation of $90,000)

Buildings = $723,000 (both book balances are added together)

Equipment = $959,000 (both book balances are added plus the unamortized portion of the acquisition-date fair value allocation [$50,000 less $25,000 after 5 years of excess depreciation])



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30. b. (continued)

Goodwill = $60,000 (represents the original acquisition-date allocation)

Total assets = $3,143,000 (summation of all consolidated assets)

Liabilities = $1,198,000 (both balances are added together while the $10,000 intra-entity payable is eliminated)

Common stock = $250,000 (parent balance only)

Retained earnings, 12/31/15 = $1,695,000 (see above)

Total liabilities and equity = $3,143,000 (summation of all consolidated liabilities and equity)

d. Worksheet is presented on following page. e. If all goodwill from the Small investment was determined to be impaired,

Giant would make the following journal entry on its books:

Goodwill impairment loss 60,000 Investment in Small 60,000 After this entry, the worksheet process would no longer require an adjustment in Entry (A) to recognize goodwill. The impairment loss would simply carry over to the consolidated income column. The impairment loss would be reported as a separate line item in the operating section of the consolidated income statement.



30. c. (continued) GIANT COMPANY AND SMALL COMPANY


Consolidation Entries Consolidated Accounts Giant Small Debit Credit Totals Revenues ............................................................. (1,175,000) (360,000) (1,535,000)

Cost of goods sold ........................................... 550,000 ......90,000 640,000

Depreciation expense ......................................... 172,000 130,000 (E) 5,000 307,000 Equity income of Small ...................................... (135,000) -0- (I) 135,000 -0- Net income ..................................................... (588,000) (140,000) (588,000) Retained earnings 1/1 ......................................... (1,417,000) (620,000) (S) 620,000 (1,417,000) Net income (above) ............................................. (588,000) (140,000) (588,000) Dividends declared ............................................. 310,000 110,000 (D) 110,000 310,000 Retained earnings 12/31 ............................... (1,695,000) (650,000) (1,695,000) Current assets ..................................................... 398,000 318,000 (P) 10,000 706,000 Investment in Small ............................................ 995,000 -0- (D) 110,000 (S) 790,000 -0- (A) 180,000 (I) 135,000 Land .................................................................. 440,000 165,000 (A) 90,000 695,000 Buildings (net) ..................................................... 304,000 419,000 723,000 Equipment (net) ................................................... 648,000 286,000 (A) 30,000 (E) 5,000 959,000 Goodwill ............................................................... -0- -0- (A) 60,000 60,000 Total assets ................................................... 2,785,000 1,188,000 3,143,000 Liabilities ............................................................. (840,000) (368,000) (P) 10,000 (1,198,000) Common stock .................................................... (250,000) (170,000) (S)170,000 (250,000) Retained earnings (above) ................................. (1,695,000) (650,000) (1,695,000) Total liabilities and equity ............................ (2,785,000) (1,188,000) 1,230,000 1,230,000 (3,143,000) Parentheses indicate a credit balance.



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31. (45 Minutes) (Consolidated totals and worksheet two years after acquisition. Parent uses initial value method. Includes question comparing initial value and equity methods).

a. 12/31/2015 Pinnacle Strata Adjustments and Eliminations Consolidated

Sales (7,000,000) (3,000,000) (10,000,000)

Cost of goods sold 4,650,000 1,700,000 6,350,000

Interest expense 255,000 160,000 415,000


Amortization expense 600,000 E 20,000 580,000

Dividend income (50,000) D 50,000 0

Net Income (1,560,000) (190,000) (1,690,000)

Retained earnings 1/1/15 (5,000,000) (1,350,000) S 1,350,000 *C 240,000 (5,240,000)

Net income (1,560,000) (190,000) (1,690,000)

Dividends declared 560,000 50,000 D 50,000 560,000

Retained earnings 12/31/15 (6,000,000) (1,490,000) (6,370,000)

Cash 433,000 165,000 598,000

Accounts receivable 1,210,000 200,000 P 85,000 1,325,000

Inventory 1,235,000 1,500,000 2,735,000

Investment in Strata 3,200,000 *C 240,000 S 2,850,000 0

A 590,000

Buildings (net) 5,572,000 2,040,000 A 270,000 E 30,000 7,852,000

Licensing agreements 1,800,000 E 20,000 A 80,000 1,740,000

Goodwill 350,000 A 400,000 750,000

Total Assets 12,000,000 5,705,000 15,000,000

Accounts payable (300,000) (715,000) P 85,000 (930,000)

Long-term debt (2,700,000) (2,000,000) (4,700,000)

Common stock - Pinnacle (3,000,000) (3,000,000)

Common stock - Strata (1,500,000) S 1,500,000 0

Retained earnings 12/31/15 (6,000,000) (1,490,000) (6,370,000)

Total Liabilities and OE (12,000,000) (5,705,000) 3,945,000 3,945,000 (15,000,000)

b. Subsidiary income (190,000 – 10,000) ...................................................... $180,000

1/1/15 retained earnings (5,000,000 + 240,000) ............................ $5,240,000

Investment in Strata:

Initial value basis .................................................................... $3,200,000

Conversion to equity as of 1/1/15 .................. 240,000

Net income for 2015 ........................................ 180,000

Dividends for 2015 ........................................... (50,000) .......... 370,000

Equity method balance 12/31/15 ............................................. $3,570,000

c. The internal method choice for investment accounting has no effect on consolidated financial statements.



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32. (30 Minutes) (Determine consolidated accounts and consolidation entries five years after acquisition. Parent applies equity method.)

a. Fair value allocation and annual amortization Remaining Annual excess Allocation life amortizations

Land .......................................... $20,000 Buildings ........................................ (30,000) 10 yrs. $(3,000) Equipment ...................................... 60,000 5 yrs. 12,000 Customer List ................................. 100,000 20 yrs. 5,000 Total .......................................... $14,000

CONSOLIDATED TOTALS

Revenues = $850,000 (add the two book values)

Cost of goods sold = $380,000 (the accounts of both companies are added together)

Depreciation expense = $179,000 (the accounts are added and include the excess depreciation net adjustment of $9,000)

Amortization expense = $5,000 (current amortization for customer list recognized in acquisition)

Buildings (net) = $625,000 (add the two book values less the acquisition-date fair value allocation [a $30,000 reduction] after removing 5 years of amortization totaling $15,000)

Equipment (net) = $450,000 (add the two book values. The acquisition-date fair value allocation is completely amortized at end of current year)

Customer list = $75,000 ($100,000 original allocation less $25,000 [5 years of amortization])

Common stock = $300,000 (parent company balance only)

Additional paid-in capital = $50,000 (parent company balance only) b. The method used by the parent is only important in determining the parent's

separate account balances (which are given here or are not needed) or consolidation worksheet entries (which are not required in a.)



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32. (continued)

c. Consolidation entry S Common stock (Hill) ............................ 40,000 Additional paid-in capital (Hill) ........... 160,000 Retained earnings 1/1 .......................... 600,000

........................................................................................ Investment in Hill 800,000

(To eliminate beginning stockholders' equity of subsidiary) Consolidation entry A Land ...................................................... 20,000 Equipment (net) ................................... 12,000 Customer list (net) ............................... 80,000 Buildings (net) ................................ 18,000 Investment in Hill ............................ 94,000

(To recognize unamortized allocation balances as of beginning of current year)

Consolidation entry I Investment income .............................. 86,000

................................................................... Investment in Hill 86,000

(To remove equity income recognized during year—equity method accrual of $100,000 [based on subsidiary's income] less amortization of $14,000 for the year)

Consolidation entry D Investment in Hill ................................. 40,000

................................................................... Dividends declared 40,000

(To remove Intra-entity dividend declarations) Consolidation entry E Amortization expense ........................... 5,000 Depreciation expense ........................... 9,000 Buildings .............................................. 3,000 Equipment ........................................ 12,000 Customer list ................................... 5,000 (To recognize excess acquisition-date fair-value amortizations for the period)



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33. (30 Minutes) (Determine parent company and consolidated account balances for a bargain purchase combination. Parent applies equity method)

a. Acquisition-date fair value allocation and annual excess amortization

Consideration transferred ............... $1,183,000

Chandler book value (given) .......... $1,105,000 Technology undervaluation (6 yr. life) 204,000

Acquisition-date fair value of net assets 1,309,000

Gain on bargain purchase ................. $(126,000)

Chandler net income .......................... $(233,000)

Technology amortization ................... 34,000

Equity earnings in Chandler .............. $(199,000)

Fair value of net assets at acquisition-date $1,309,000

Equity earnings from Chandler ......... 199,000

Dividends declared ............................ (40,000)

Investment in Chandler 12/31/15 ....... $1,468,000

Because a bargain purchase occurred, Chandler’s net asset fair value replaces the fair value of the consideration transferred as the initial value assigned to the subsidiary on the books of the parent, Brooks.



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33 continued (part b.)

Income Statement Brooks Chandler Adj. & Elim. Consolidated

Revenues (640,000) (587,000) (1,227,000)

Cost of goods sold 255,000 203,000 458,000

Gain on bargain purchase (126,000) -0- (126,000) Depreciation and amortization 150,000 151,000 (E) 34,000 335,000 Equity earnings in Chandler (199,000) -0- (I) 199,000 -0-

Net income (560,000) (233,000) (560,000)

Statement of Retained Earnings

Retained earnings, 1/1 (1,835,000) (805,000) (S) 805,000 (1,835,000)

Net income (above) (560,000) (233,000) (560,000)

Dividends declared 100,000 40,000 (D) 40,000 100,000

Retained earnings, 12/31 (2,295,000) (998,000) (2,295,000)

Balance Sheet

Current assets 343,000 432,000 775,000

Investment in Chandler 1,468,000 -0- (D) 40,000 (I) 199,000

(S)1,105,000 -0-

(A) 204,000

Trademarks 134,000 221,000 355,000

Patented technology 395,000 410,000 (A) 204,000 (E) 34,000 975,000

Equipment 693,000 341,000 1,034,000

Total assets 3,033,000 1,404,000 3,139,000

Liabilities (203,000) (106,000) (309,000)

Common stock (535,000) (300,000) (S) 300,000 (535,000)





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34. (35 minutes) (Contingent performance obligation and worksheet adjustments for equity and initial value methods.) a. Investment in Wolfpack, Inc. 500,000 Contingent performance obligation 35,000 Cash 465,000 b. 12/31/14 Loss from increase in contingent performance obligation 5,000 Contingent performance obligation 5,000 12/31/15 Loss from increase in contingent performance obligation 10,000 Contingent performance obligation 10,000 12/31/15 Contingent performance obligation 50,000 Cash 50,000 c. Equity Method

Common stock- Wolfpack 200,000 Retained earnings-Wolfpack 180,000 Investment in Wolfpack 380,000 Royalty agreements 90,000 Goodwill 60,000 Investment in Wolfpack 150,000 Equity earnings of Wolfpack 65,000 Investment in Wolfpack 65,000 Investment in Wolfpack 35,000 Dividends declared 35,000 Amortization expense 10,000 Royalty agreements 10,000 d. Initial Value Method Investment in Wolfpack 30,000 Retained earnings-Branson 30,000 Common stock 200,000 Retained earnings-Wolfpack 180,000 Investment in Wolfpack 380,000



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34. (continued) Royalty agreements 90,000 Goodwill 60,000 Investment in Wolfpack 150,000 Dividend income 35,000 Dividends declared 35,000 Amortization expense 10,000 Royalty agreements 10,000

35. (45 Minutes) (Prepare consolidation worksheet five years after acquisition.

Parent applies equity method. Includes question on push-down accounting.) a. Allocation of Acquisition-Date Fair Value and Determination of

Amortization:

Storm’s acquisition-date fair value ...................... ... $140,000

Book value of Storm (acquisition date) ............. (105,000) Fair value in excess of book value ....................... ... $ 35,000

Excess assigned to specific accounts: Remaining Annual excess life amortizations

Land ........................................... $10,000 – – Equipment ................................. 5,000 5 yrs. $1,000 Formula ...................................... 20,000 20 yrs. 1,000 Total ................................................ $35,000 $2,000

The equity in subsidiary earnings reflects the equity method. The initial value method would have recorded $40,000 (100% of dividend declared) as income while the partial equity method would have shown $68,000 (100% of the subsidiary's income). Under the equity method, a $66,000 income accrual is recognized (100% of reported income less the $2,000 in excess amortization expenses computed above).

b. Explanation of Consolidation Entries Found on Worksheet

Entry S—Eliminates stockholders' equity accounts of the subsidiary as of the beginning of the current year.

Entry A—Recognizes remaining unamortized allocation from

acquisition-date fair value adjustments. As of the beginning of the current year, equipment and formula have undergone four years of amortization.

Entry I—Eliminates intra-entity income accrual for the current year.

Entry D—Eliminates intra-entity dividend transfers.



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Entry E—Recognizes excess amortization expenses for current year.



35. (continued) Palm and Subsidiary Consolidated Worksheet for year ended December 31, 2015

Consolidation Entries Consolidated Accounts Palm Co. Storm Co. Debit Credit Totals Income Statement Revenues ........................................................... (485,000) (190,000) (675,000) Cost of goods sold ........................................... 160,000 70,000 230,000 Depreciation expense ....................................... 130,000 52,000 (E) 1,000 183,000 Amortization expense ....................................... -0- -0- (E) 1,000 1,000 Equity in subsidiary earnings .......................... (66,000) -0- (I) 66,000 -0- Net income ................................................... (261,000) (68,000) (261,000) Statement of Retained Earnings Retained earnings 1/1 ....................................... (659,000) (98,000) (S) 98,000 (659,000) Net income (above) ........................................... (261,000) (68,000) (261,000) Dividends declared ........................................... 175,500 40,000 (D) 40,000 175,500 Retained earnings 12/31 ............................. (744,500) (126,000) (744,500) Balance Sheet Current assets ................................................... 268,000 75,000 343,000 Investment in Storm Co. ................................... 216,000 -0- (D) 40,000 (S) 163,000 -0- (A) 27,000 (I) 66,000 Land ................................................................ 427,500 58,000 (A) 10,000 495,500 Buildings and equipment (net) ........................ 713,000 161,000 (A) 1,000 (E) 1,000 874,000 Formula .............................................................. -0- -0- (A) 16,000 (E) 1,000 15,000 Total assets ................................................. 1,624,500 294,000 1,727,500 Current liabilities ............................................... (110,000) (19,000) (129,000) Long-term liabilities .......................................... (80,000) (84,000) (164,000) Common stock .................................................. (600,000) (60,000) (S) 60,000 (600,000) Additional paid-in capital ................................. (90,000) (5,000) (S) 5,000 (90,000) Retained earnings 12/31 ................................... (744,500) (126,000) (744,500) Total liabilities and equity .......................... (1,624,500) (294,000) 298,000 298,000 (1,727,500)



Parentheses indicate a credit balance.



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35. (continued)

c. If push-down accounting had been applied, the acquisition-date fair value allocations to land ($10,000), equipment ($5,000), and formula ($20,000) would have been entered into the subsidiary's balances with an offsetting $35,000 increase in additional paid-in capital. The equipment and the formula would then have been amortized by the subsidiary as annual expenses of $1,000 each. For 2015, the subsidiary's expenses would have been $2,000 higher leaving reported net income at $66,000. At the end of 2015, land would still have been $10,000 higher because no amortization is recorded on that asset. Equipment would be no higher at this time since the $5,000 allocation is fully depreciated at the end of this fifth year. However, the secret formula would be recorded by the subsidiary as $15,000, the $20,000 allocation less five years of amortization at $1,000 per year.

36. (20 Minutes) (Consolidated balances three years after acquisition. Parent

has applied the equity method.) a. Schedule 1—Acquisition-Date Fair Value Allocation and Amortization Jasmine’s acquisition-date fair value $206,000 Book value of Jasmine .................. (140,000) Fair value in excess of book value 66,000 Excess fair value assigned to specific accounts based on individual fair values Remaining Annual excess

life amortization

Equipment .............................. $54,400 8 yrs. $6,800 Buildings (overvalued) .......... (10,000) 20 yrs. (500) Goodwill .................................. $21,600 indefinite -0- Total ........................................... $6,300 Investment in Jasmine Company—12/31/15: Jasmine’s acquisition-date fair value ............................ $206,000

2013 Increase in book value of subsidiary 40,000

2013 Excess amortizations (Schedule 1) ..................... (6,300) 2014 Increase in book value of subsidiary ................... 20,000 2014 Excess amortizations (Schedule 1) ..................... (6,300) 2015 Increase in book value of subsidiary ................... 10,000 2015 Excess amortizations (Schedule 1) ..................... (6,300) Investment in Jasmine Company 12/31/15 .............. $257,100



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36. (continued) b. Equity in subsidiary earnings:

Income accrual ................................................................ $30,000 Excess amortizations (Schedule 1) .............................. (6,300) Equity in subsidiary earnings .................................. $23,700 c. Consolidated net income:

Consolidated revenues (add book values) .................. $414,000 Consolidated expenses (add book values) .................. (272,000) Excess amortization expenses (Schedule 1) ............... (6,300) Consolidated net income ............................................... $135,700 d. Consolidated equipment:

Book values added together ......................................... $370,000 Acquisition-date fair value allocation ........................... 54,400 Excess depreciation ($6,800 × 3) .................................. (20,400) Consolidated equipment .......................................... $404,000

e. Consolidated buildings:

Book values added together ......................................... $288,000 Acquisition-date fair value allocation ............................ (10,000) Excess depreciation ($500 × 3) ..................................... 1,500 Consolidated buildings ............................................. $279,500

f. Allocation of excess fair value to goodwill ................... $21,600

g. Consolidated common stock ......................................... $290,000

The parent's $290,000 balance appropriately shows the parent company stockholders’ contributed capital (the acquired company's common stock will be eliminated each year on the consolidation worksheet).

h. Consolidated retained earnings ..................................... $410,000

Tyler's balance of $410,000 is equal to the consolidated total because

the equity method has been applied. 37. (35 minutes) (Consolidation with IPR&D, equity method) a. Consideration transferred 1/1/14 $1,765,000 Increase in Salsa’s retained earnings to 1/1/15 150,000 In-process R&D write-off in 2014 (44,000) Amortizations 2014 (7,000) Income 2015 210,000 Dividends declared 2015 (25,000) Amortization 2015 (7,000) Investment balance 12/31/15 $2,042,000



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37. (continued)

b. The IPR&D was abandoned in 2014 and the original asset was written off to expense to reflect the absence of future economic benefits. Because the parent applies the equity method, the investment account was reduced by $44,000.

c. Picante and Subsidiary Salsa Consolidated Worksheet

for the year ended December 31, 2015 12/31/15 12/31/15

Accounts Picante Salsa Adjustments Consolidated

Sales (3,500,000) (1,000,000) (4,500,000)

Cost of goods sold 1,600,000 630,000 2,230,000

Depreciation expense 540,000 160,000 (E) 7,000 707,000

Subsidiary income (203,000) (I) 203,000 -0-

Net Income (1,563,000) (210,000) (1,563,000)

Retained earnings 1/1/15 (3,000,000) (800,000) (S) 800,000 (3,000,000)

Net Income (1,563,000) (210,000) (1,563,000)


Retained earnings 12/31/15 (4,363,000) (985,000) (4,363,000)

Cash 228,000 50,000 278,000


Inventory 900,000 580,000 1,480,000

Investment in Salsa 2,042,000 (D) 25,000 (S)1,800,000 -0-

(A) 64,000

(I) 203,000

Land 3,500,000 700,000 4,200,000

Equipment (net) 5,000,000 1,700,000 (A) 49,000 (E) 7,000 6,742,000

Goodwill 290,000 -0- (A) 15,000 305,000

Total assets 12,800,000 3,185,000 14,000,000


Long-term debt (3,094,000) (800,000) (3,894,000)

Common stock—Picante (5,150,000) (5,150,000)

Common stock—Salsa (1,000,000) (S)1,000,000

Retained earnings 12/31/15 (4,363,000) (985,000) (4,363,000)

(12,800,000) (3,185,000) 2,099,000 2,099,000 (14,000,000)



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38. (55 minutes) (Goodwill impairment, consolidated balances, and worksheet) a. Prine compares Lydia’s total fair value to its carrying value, as follows: 12/31 Carrying value (equity method balance) $120,070,000 12/31 Fair value 110,000,000 Excess carrying value over fair value $10,070,000 Because fair value is less than carrying value, Prine is required to

further test whether goodwill is impaired. b. 12/31 Fair value for Lydia $110,000,000 Fair values of assets and liabilities Cash $109,000 Receivables (net) 897,000 Movie library 60,000,000 Broadcast licenses 20,000,000 Equipment 19,000,000 Current liabilities (650,000) Long-term debt (6,250,000) Total net fair value 93,106,000 Implied fair value for goodwill 16,894,000 Carrying value for goodwill 50,000,000 Impairment loss $33,106,000 Journal Entry by Prine: Goodwill impairment loss 33,106,000 Investment in Lydia Co. 33,106,000 c. Combined revenues $30,000,000 Combined expenses (including excess amortization) 22,200,000 Income before impairment loss 7,800,000 Goodwill impairment loss—Lydia (33,106,000) Consolidated net loss $(25,306,000) d. Consolidated goodwill = $50,000,000 – $33,106,000 = $16,894,000 e. Consolidated broadcast licenses = $350,000 + $14,014,000 = $14,364,000 The consolidated balance is the parent’s book value plus the fair value

of the subsidiary acquisition-date value adjusted for changes since acquisition. Because the subsidiary’s book value equaled fair value at acquisition date, there is no fair value adjustment. Because the broadcast licenses have indefinite lives, they are not amortized. Note that the 12/31 fair value, assessed for purposes of computing implied value for goodwill, is not used for financial reporting purposes.



38. f. (continued) Prine and Lydia Consolidated Worksheet

December 31 Adjusting Entries Consolidated Accounts Prine, Inc. Lydia Co. Debit Credit Totals Revenues (18,000,000) (12,000,000) (30,000,000) Expenses 10,350,000 11,800,000 (E) 50,000 22,200,000 Equity in Lydia earnings (150,000) -0- (I) 150,000 -0- Impairment loss 33,106,000 -0- 33,106,000 Net loss (income) 25,306,000 (200,000) 25,306,000 Retained earnings 1/1 (52,000,000) (2,000,000) (S) 2,000,000 (52,000,000) Dividends declared 300,000 80,000 (D) 80,000 300,000 Net loss (income) 25,306,000 (200,000) 25,306,000 Retained earnings 12/31 (26,394,000) (2,120,000) (26,394,000) Cash 260,000 109,000 369,000 Receivables (net) 210,000 897,000 1,107,000 Investment in Lydia, Co. 86,964,000 -0- (D) 80,000 (S)69,500,000 -0- (A)17,394,000 (I) 150,000 Broadcast licenses 350,000 14,014,000 14,364,000 Movie library 365,000 45,000,000 45,365,000 Equipment (net) 136,000,000 17,500,000 (A) 500,000 (E) 50,000 153,950,000 Goodwill -0- -0- (A)16,894,000 16,894,000 Total assets 224,149,000 77,520,000 232,049,000 Current liabilities (755,000) (650,000) (1,405,000) Long-term debt (22,000,000) (7,250,000) (29,250,000) Common stock (175,000,000) (67,500,000) (S)67,500,000 (175,000,000) Retained earnings 12/31 (26,394,000) (2,120,000) (26,394,000)




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RESEARCH CASE SOLUTION

Jonas recognized several identifiable intangibles from its acquisition of Innovation Plus. Jonas expresses the desire to expense these intangible assets in the acquisition period.

1. Advise Jonas on the acceptability of its suggested immediate write-off.

An intangible asset should not be written down or off in the period of acquisition unless it becomes impaired during that period.

2. Indicate the relevant factors to consider in allocating the values assigned to identifiable intangibles acquired in a business combination.

The accounting for a recognized intangible asset is based on its useful life to the reporting entity. An intangible asset with a finite useful life is amortized; an intangible asset with an indefinite useful life is not amortized. The useful life of an intangible asset to an entity is the period over which the asset is expected to contribute directly or indirectly to the future cash flows of that entity. Other factors to be considered are legal, regulatory, or contractual provisions, effects of obsolescence, demand, competition, and other economic factors, and the level of maintenance expenditures required to obtain the expected future cash flows from the asset (ASC 350-30-35-3).

The price paid by Jonas for Innovation Plus indicates a large amount was paid for goodwill. However, Jonas worries that any goodwill impairment may send the wrong signal to its investors about the wisdom of the acquisition. Jonas thus wishes to allocate all the goodwill to one account called “enterprise goodwill.” In this way, Jonas hopes to minimize the possibility of goodwill impairment because a decline in goodwill in one business unit may be offset by an increase in the value of goodwill in another business unit.

3. Jonas’ suggested treatment of goodwill is inappropriate. To ensure that goodwill increases in one reporting unit do not offset decreases in others, goodwill acquired in a business combination is allocated across business units that benefit from the goodwill.

4. Per the FASB ASC (350-20-35-41):

For the purpose of testing goodwill for impairment, all goodwill acquired in a business combination shall be assigned to one or more reporting units as of the acquisition date. Goodwill shall be assigned to reporting units of the acquiring entity that are expected to benefit from the synergies of the combination even though other assets or liabilities of the acquired entity may not be assigned to that reporting unit. The total amount of acquired goodwill may be divided among a number of reporting units. The methodology used to determine the amount of goodwill to assign to a reporting unit shall be reasonable and supportable and shall be applied in a consistent manner.



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Therefore, Jonas’ desire to minimize the possibility of goodwill impairment should not be a factor in allocating goodwill to reporting units.

MICROSOFT IMPAIRMENT ANALYSIS CASE SOLUTION The following all can be found in Microsoft Corporation’s 2012 10-K annual report.

1. Microsoft’s OnOnline Services Division incurred a $6.193 billion goodwill impairment loss assess on May 1, 2012 Online Services Division (“OSD”) develops and markets information and content designed to help people simplify tasks and make more informed decisions online, and help advertisers connect with audiences. OSD offerings include Bing, MSN, adCenter, and advertiser tools. Bing and MSN generate revenue through the sale of search and display advertising, accounting for nearly all of OSD’s annual revenue. (page 6)

2. Goodwill impairment appeared on the 2012 income statement and cash flow statement as follows:

Goodwill impairment $6,193 million operating expense in the Income Statement.

Goodwill impairment $6,193 addition to net income to arrive at net cash from operations in the Cash Flows Statement.

3. The impairment was the result of the OSD unit experiencing slower than projected growth in search queries and search advertising revenue per query, slower growth in display revenue, and changes in the timing and implementation of certain initiatives designed to drive search and display revenue growth in the future. Although revenues increased compared to the prior year, the industry is highly competitive and certain operational challenges have affected our expectations such that future growth and profitability are lower than previous estimates. In addition, in the current year, we added a business-specific risk factor to the weighted average cost of capital used to calculate the discounted cash flows of OSD in estimating the fair value of the business. This business-specific risk factor reflects the increased uncertainty in forecasting the future performance of OSD. (page 64)

4. Microsoft’s Note 10 - Goodwill (page 64) states the following:

We tested goodwill for impairment as of May 1, 2012 at the reporting unit level using a discounted cash flow methodology with a peer-based, risk-adjusted



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weighted average cost of capital. We believe use of a discounted cash flow approach is the most reliable indicator of the fair values of the businesses. Upon completion of the annual test, OSD goodwill was determined to be impaired. The impairment was the result of the OSD unit experiencing slower than projected growth in search queries and search advertising revenue per query, slower growth in display revenue, and changes in the timing and implementation of certain initiatives designed to drive search and display revenue growth in the future. Although revenues increased compared to the prior year, the industry is highly competitive and certain operational challenges have affected our expectations such that future growth and profitability are lower than previous estimates. In addition, in the current year, we added a business-specific risk factor to the weighted average cost of capital used to calculate the discounted cash flows of OSD in estimating the fair value of the business. This business-specific risk factor reflects the increased uncertainty in forecasting the future performance of OSD. Because our annual test indicated that OSD’s carrying value exceeded its estimated fair value, a second phase of the goodwill impairment test (“Step 2”) was performed specific to OSD. Under Step 2, the fair value of all OSD assets and liabilities were estimated, including tangible assets, existing technology, trade names, and partner relationships for the purpose of deriving an estimate of the implied fair value of goodwill. The implied fair value of the goodwill was then compared to the recorded goodwill to determine the amount of the impairment. Assumptions used in measuring the value of these assets and liabilities included the discount rates, royalty rates, and obsolescence rates used in valuing the intangible assets, and pricing of comparable transactions in the market in valuing the tangible assets. (page 64)



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FASB ASC AND IASB RESEARCH CASE

1. GAAP prohibits reversal of impairment losses for goodwill. IFRS also prohibits reversal of impairment losses for goodwill

2. Requirements for goodwill impairment differ under IFRS. Under IFRS, goodwill impairment testing uses a one-step approach: The recoverable amount of the CGU (cash-generating unit) or group of CGUs (i.e., the higher of its fair value minus costs to sell and its value in use) is compared with its carrying amount. An impairment loss is recognized in operating results as the excess of carrying over the recoverable amount. The impairment loss is allocated first to goodwill and then pro rata to the other assets of the CGU or group of CGUs to the extent that the impairment exceeds goodwill’s book value.

IAS 36 Impairment of Assets: 88. When, as described in paragraph 81, goodwill relates to a cash-generating unit but has not been allocated to that unit, the unit shall be tested for impairment, whenever there is an indication that the unit may be impaired, by comparing the unit’s carrying amount, excluding any goodwill, with its recoverable amount. Any impairment loss shall be recognised in accordance with paragraph 104.

90. A cash-generating unit to which goodwill has been allocated shall be tested for impairment annually, and whenever there is an indication that the unit may be impaired, by comparing the carrying amount of the unit, including the goodwill, with the recoverable amount of the unit. If the recoverable amount of the unit exceeds the carrying amount of the unit, the unit and the goodwill allocated to that unit shall be regarded as not impaired. If the carrying amount of the unit exceeds the recoverable amount of the unit, the entity shall recognise the impairment loss in accordance with paragraph 104.

104. An impairment loss shall be recognised for a cash-generating unit (the smallest group of cash-generating units to which goodwill or a corporate asset has been allocated) if, and only if, the recoverable amount of the unit (group of units) is less than the carrying amount of the unit (group of units). The impairment loss shall be allocated to reduce the carrying amount of the assets of the unit (group of units) in the following order:

(a) first, to reduce the carrying amount of any goodwill allocated to the cash-generating unit (group of units); and

(b) then, to the other assets of the unit (group of units) pro rata on the basis of the carrying amount of each asset in the unit (group of units).

These reductions in carrying amounts shall be treated as impairment losses on individual assets and recognised in accordance with paragraph 60.



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Excel Case 1 Solution a. Innovus employs initial value method to account for ChipTech.

Innovus ChipTech Adjustments Consolidated Revenues (990,000) (210,000) (1,200,000) Cost of good sold 500,000 90,000 590,000 Depreciation expense 100,000 5,000 105,000 Amortization expense 55,000 18,000 (E) 20,000 93,000 Dividend income (40,000) -0- (I) 40,000 -0- Net Income (375,000) (97,000) (412,000) Retained earnings 1/1 (1,555,000) (450,000) (S)450,000 (*C) 60,000 (1,615,000) Net income (375,000) (97,000) (412,000) Dividends declared 250,000 40,000 (I) 40,000 250,000 Retained earnings 12/31 (1,680,000) (507,000) (1,777,000) Current assets 960,000 355,000 1,315,000 Investment in Chiptech 670,000 (*C) 60,000 (S) 580,000 (A) 150,000 -0- Equipment (net) 765,000 225,000 990,000 Trademark 235,000 100,000 (A) 36,000 (E) 4,000 367,000 Existing technology 0 45,000 (A) 64,000 (E) 16,000 93,000 Goodwill 450,000 -0- (A) 50,000 500,000 Total assets 3,080,000 725,000 3,265,000 Liabilities (780,000) (88,000) (868,000) Common stock (500,000) (100,000) (S)100,000 (500,000) Additional paid-in capital (120,000) (30,000) (S) 30,000 (120,000) Retained earnings 12/31 (1,680,000) (507,000) (1,777,000)

Total liabilities and equity (3,080,000) (725,000) 850,000 850,000 (3,265,000)



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Excel Case 1 Solution (continued) b. Innovus employs initial value method to account for ChipTech and goodwill is impaired.

Innovus ChipTech Consolidated Revenues (990,000) (210,000) (1,200,000) Cost of good sold 500,000 90,000 590,000 Depreciation expense 100,000 5,000 105,000 Amortization expense 55,000 18,000 (E) 20,000 93,000 Impairment loss 50,000 50,000 Dividend income (40,000) -0- (I) 40,000 -0- Net Income (325,000) (97,000) (362,000) Retained earnings 1/1 (1,555,000) (450,000) (S)450,000 (*C) 60,000 (1,615,000) Net income (325,000) (97,000) (362,000) Dividends declared 250,000 40,000 (I) 40,000 250,000 Retained earnings 12/31 (1,630,000) (507,000) (1,727,000) Current assets 960,000 355,000 1,315,000 Investment in Chiptech 620,000 (*C) 60,000 (S)580,000 (A)100,000 -0- Equipment (net) 765,000 225,000 990,000 Trademark 235,000 100,000 (A) 36,000 (E) 4,000 367,000 Existing technology -0- 45,000 (A )64,000 (E) 16,000 93,000 Goodwill 450,000 -0- 450,000 Total assets 3,030,000 725,000 3,215,000 Liabilities (780,000) (88,000) (868,000) Common stock (500,000) (100,000) (S)100,000 (500,000) Additional paid-in capital (120,000) (30,000) (S) 30,000 (120,000) Retained earnings 12/31 (1,630,000) (507,000) (1,727,000)


Alternatively, the goodwill impairment loss could have been recognized as an adjustment on the worksheet.



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Excel Case 2 Solution Part a: Investment in Wi-Free account balance 12/31/15 Wi-Free’s acquisition-date fair value $730,000 Change in Wi-Free’s retained earnings for 2014 80,000 2014 amortization (4,500) 2014 in-process R&D write-off (75,000) 2015 reported Wi-Free income 180,000 2015 Wi-Free dividend (50,000) 2015 amortization (4,500) Balance 12/31/15 $856,000

Part b: Consolidation Entries Consolidated

Hi-Speed Wi-Free Debit Credit Totals Revenues (1,100,000) (325,000) (1,425,000) Cost of goods sold 625,000 122,000 747,000 Depreciation expense 140,000 12,000 152,000 Amortization expense 50,000 11,000 (E) 12,000 (E) 7,500 65,500 Equity in subsidiary earnings (175,500) -0- (I)175,500 -0- Net Income (460,500) (180,000) (460,500) Retained earnings 1/1 (1,552,500) (450,000) (S)450,000 (1,552,500) Net income (460,500) (180,000) (460,500) Dividends declared 250,000 50,000 (D) 50,000 250,000 Retained earnings 12/31 (1,763,000) (580,000) (1,763,000) Current assets 1,034,000 345,000 (P) 30,000 1,349,000 Investment in Wi-Free 856,000 (D) 50,000 (I) 175,500 (S)580,000 (A)150,500 0 Equipment (net) 713,000 305,000 1,018,000 Computer software 650,000 130,000 (E) 7,500 (A) 22,500 765,000 Internet domain name 0 100,000 (A)108,000 (E) 12,000 196,000 Goodwill -0- -0- (A) 65,000 65,000 Total assets 3,253,000 880,000 3,393,000 Liabilities (870,000) (170,000) (P) 30,000 (1,010,000) Common stock (500,000) (110,000) (S)110,000 (500,000) Additional paid-in capital (120,000) (20,000) (S) 20,000 (120,000) Retained earnings 12/31 (1,763,000) (580,000) (1,763,000)

Total liab. and equity (3,253,000) (880,000) 1,028,000 1,028,000 (3,393,000)



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Chapter 3 - Computer Project

PECOS COMPANY AND SUARO COMPANY

Consolidated Information Worksheet

Pecos Suaro

Revenues (1,052,000) (427,000)

Operating expenses 821,000 262,000

Amortization of intangibles 0

Goodwill impairment loss 0

Income of Suaro 0

Net income (165,000)

Retained earnings—Pecos, 1/1

Retained earnings—Suaro, 1/1 0 (201,000)

Net income (above) 0 (165,000)

Dividends declared 200,000 35,000

Retained earnings, 12/31 (331,000)

Cash 195,000 95,000

Receivables 247,000 143,000

Inventory 415,000 197,000

Investment in Suaro 0

Land 341,000 85,000

Equipment (net) 240,100 100,000

Software 0 312,000

Other intangibles 145,000 0

Goodwill 0 0

Total assets 932,000

Liabilities (1,537,100) (251,000)

Common stock (500,000) (350,000)

Retained earnings (above) (331,000)

Total liabilities and equity (932,000)



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Consolidated Information Worksheet (continued)

Fair Value Allocation Schedule

Acquisition-date fair value 1,450,000

Book value 476,000

Excess fair value over book value 974,000

Amortizations and Write-off

2014 2015

Land (10,000) 0 0

Brand Name 60,000 0 0

Software 100,000 50,000 50,000

IPR&D 300,000 300,000 0

Goodwill 524,000 0 0

Total 974,000 350,000 50,000

Suaro's Retained Earnings Changes

2014 2015

Income 75,000 165,000

Dividends 0 35,000



Chapter 3 - Computer Project Solution


Consolidated Worksheet

For the Year Ended December 31, 2015

EQUITY METHOD

Consolidation Entries Consolidated

Pecos Suaro Debit Credit Totals

Revenues (1,052,000) (427,000) (1,479,000)

Operating expenses 821,000 262,000 1,083,000

Amortization of intangibles 0 0 (E) 50,000 50,000

Goodwill impairment loss 0 0 0

Income of Suaro (115,000) 0 (I) 115,000 0

Net income (346,000) (165,000) (346,000)

Retained earnings—Pecos, 1/1 (655,000) 0 (655,000)

Retained earnings—Suaro, 1/1 0 (201,000) (S) 201,000 0

Net income (above) (346,000) (165,000) (346,000)


Retained earnings, 12/31 (801,000) (331,000) (801,000)

Cash 195,000 95,000 290,000

Receivables 247,000 143,000 390,000

Inventory 415,000 197,000 612,000

Investment in Suaro 1,255,000 0 (D) 35,000 (S) 551,000 0

(A) 624,000



(I) 115,000 Consolidated Worksheet (continued)

Land 341,000 85,000 (A) 10,000 416,000

Equipment (net) 240,100 100,000 340,100

Software 0 312,000 (A) 50,000 (E) 50,000 312,000

Other intangibles 145,000 0 145,000

Brand name 0 0 (A) 60,000 60,000

Goodwill 0 0 (A) 524,000 524,000

Total assets 2,838,100 932,000 3,089,100

Liabilities (1,537,100) (251,000) (1,788,100)

Common stock (500,000) (350,000) (S) 350,000 (500,000)

Retained earnings (above) (801,000) (331,000) (801,000)

Total liabilities and equity (2,838,100) (932,000) 1,385,000 1,385,000 (3,089,100)

Shaded items were provided on the Consolidated Information Worksheet



Chapter 3 – Computer Project Solution




PARTIAL EQUITY METHOD



Revenues (1,052,000) (427,000) (1,479,000)




Income of Suaro (165,000) 0 (I) 165,000 0

Net income (396,000) (165,000) (346,000)

Retained earnings—Pecos, 1/1 (1,005,000) 0 (*C) 350,000 (655,000)


Net income (above) (396,000) (165,000) (346,000)


Retained earnings, 12/31 (1,201,000) (331,000) (801,000)

Cash 195,000 95,000 290,000

Receivables 247,000 143,000 390,000

Inventory 415,000 197,000 612,000

Investment in Suaro 1,655,000 0 (D) 35,000 (S) 551,000 0

(A) 624,000

(I) 165,000

(*C) 350,000



Consolidated Worksheet (continued)

Land 341,000 85,000 (A) 10,000 416,000

Equipment (net) 240,100 100,000 340,100

Software 0 312,000 (A) 50,000 (E) 50,000 312,000


Brand name 0 0 (A) 60,000 60,000

Goodwill 0 0 (A) 524,000 524,000

Total assets 3,238,100 932,000 3,089,100

Liabilities (1,537,100) (251,000) (1,788,100)

Common stock (500,000) (350,000) (S) 350,000 (500,000)

Retained earnings (above) (1,201,000) (331,000) (801,000)









INITIAL VALUE METHOD



Revenues (1,052,000) (427,000) (1,479,000)




Income of Suaro (35,000) 0 (I) 35,000 0

Net income (266,000) (165,000) (346,000)

Retained earnings—Pecos, 1/1 (930,000) 0 (*C) 275,000 (655,000)


Net income (above) (266,000) (165,000) (346,000)

Dividends declared 200,000 35,000 (I) 35,000 200,000


Cash 195,000 95,000 290,000

Receivables 247,000 143,000 390,000

Inventory 415,000 197,000 612,000

Investment in Suaro 1,450,000 0 (S) 551,000 0

(A) 624,000

(*C) 275,000




Land 341,000 85,000 (A) 10,000 416,000

Equipment (net) 240,100 100,000 340,100

Software 0 312,000 (A) 50,000 (E) 50,000 312,000


Brand name 0 0 (A) 60,000 60,000

Goodwill 0 0 (A) 524,000 524,000

Total assets 3,033,100 932,000 3,089,100

Liabilities (1,537,100) (251,000) (1,788,100)

Common stock (500,000) (350,000) (S) 350,000 (500,000)






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Chapter 3 – Computer Project


Goodwill Impairment Loss Effects

Without With

Impairment Impairment

Common shares outstanding 500,000 500,000

Consolidated net income/(loss) 346,000 (178,000)

Consolidated assets, 1/1/15 2,943,100 2,943,100

Consolidated assets, 12/31/15 3,089,100 2,565,100

Consolidated equity, 1/1/15 1,155,000 1,155,000

Consolidated equity, 12/31/15 1,301,000 777,000

Consolidated liabilities 1,788,100 1,788,100

Earnings-per-share 0.69 -0.36

Return on assets 11.47% -6.46%

Return on equity 28.18% -18.43%

Debt-to-equity 1.37 2.30





EQUITY METHOD – GOODWILL IMPAIRMENT LOSS



Revenues (1,052,000) (427,000) (1,479,000)



Goodwill impairment loss 524,000 0 524,000

Income of Suaro (115,000) 0 (I) 115,000 0

Net income 178,000 (165,000) 178,000

Chapter 04 - Consolidated Financial Statements and Outside Ownership


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Retained earnings—Pecos, 1/1 (655,000) 0 (655,000)


Net income (above) 178,000 (165,000) 178,000



Cash 195,000 95,000 290,000

Receivables 247,000 143,000 390,000

Inventory 415,000 197,000 612,000

Investment in Suaro 731,000 0 (D) 35,000 (S) 551,000 0

(A) 100,000

(I) 115,000


Land 341,000 85,000 (A) 10,000 416,000

Equipment (net) 240,100 100,000 340,100

Software 0 312,000 (A) 50,000 (E) 50,000 312,000


Brand name 0 0 (A) 60,000 60,000

Goodwill 0 0 0

Total assets 2,314,100 932,000 2,565,100

Liabilities (1,537,100) (251,000) (1,788,100)

Common stock (500,000) (350,000) (S) 350,000 (500,000)






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CHAPTER 4 CONSOLIDATED FINANCIAL STATEMENTS

AND OUTSIDE OWNERSHIP Chapter Outline

I. Outside ownership may be present within any business combination.

A. Complete ownership of a subsidiary is not a prerequisite for consolidation—only enough voting shares need be owned so that the acquiring company has the ability to control the decision-making process of the acquired company.

B. Any ownership interest in a subsidiary company by a party unrelated to the acquiring company is termed a noncontrolling interest.

II. Valuation of subsidiary assets and liabilities poses a challenge when a noncontrolling interest is present.

A. The accounting emphasis is placed on the entire entity that results from the business combination when control has been obtained. The parent company that controls its subsidiary must consolidate 100% of subsidiary assets, liabilities, revenues, and expense are consolidated even when its ownership is less than 100%.

B. The consolidated valuation basis for a newly acquired subsidiary is the acquisition-date fair value of the company (most frequently determined by the consideration transferred and the fair value of the noncontrolling interest); specific subsidiary assets and liabilities are measured at their acquisition-date fair values.

C. The noncontrolling interest balance is reported in the parent’s consolidated financial statements as a component of stockholders' equity.

III. Consolidations involving a noncontrolling interest—subsequent to the date of acquisition

A. Four noncontrolling interest figures are determined for reporting purposes

1. Beginning of year balance sheet amount

2. Net income attributable to noncontrolling interest

3. Dividends declared by subsidiary during the period attributable to the noncontrolling interest

4. End of year balance sheet amount

B. Noncontrolling interest balances are accumulated in a separate column in the consolidation worksheet

1. The beginning of year figure is entered on the worksheet as a component of Entries S and A

2. The net income attributable to the noncontrolling interest is established by a columnar entry that simultaneously reports the balance in both the consolidated income statement and the noncontrolling interest column

3. Dividends declared to these outside owners are reflected by extending the subsidiary's Dividends declared balance (after eliminating intra-entity transfers) into the noncontrolling interest column as a reduction

4. The end of year noncontrolling interest total is the summation of the three items above and is reported in stockholders' equity.



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IV. Step acquisitions

A. An acquiring company may make several different purchases of a subsidiary's stock in order to gain control

B. Upon attaining control, all of the parent’s previous investments in the subsidiary are adjusted to fair value and a gain or loss recognized as appropriate

C. Upon attaining control, the valuation basis for the subsidiary is established at its total fair value (the sum of the fair values of the controlling and noncontrolling interests)

D. Post-control subsidiary stock acquisitions by the parent are considered transactions with current owners of the consolidated entity. Thus such post-control stock acquisitions neither result in gains or losses nor provide a basis for subsidiary asset remeasurement to fair value. The difference between the sale proceeds and the carrying value of the shares sold (equity method) is recorded as an adjustment to the parent’s additional paid in capital.

V. Sales of subsidiary stock

A. The proper book value must be established within the parent's Investment account so that the sales transaction can be correctly recorded

B. The investment balance is adjusted as if the equity method had been applied during the entire period of ownership

C. If only a portion of the shares are being sold, the book value of the investment account is reduced using either a FIFO or a weighted-average cost flow assumption

D. If the parent maintains control, any difference between the proceeds of the sale and the equity-adjusted book value of the share sold is recognized as an adjustment to additional paid-in capital.

E. If the parent loses control with the sale of the subsidiary shares, the difference between the proceeds of the sale and the equity-adjusted book value of the share sold is recognized as a gain or loss.

F. Any interest retained by the parent company should be accounted for by either consolidation, the equity method, or the fair value method depending on the influence remaining after the sale.

Answer to Discussion Question:

Do you think the FASB made the correct decision in requiring consolidated financial statements to recognize all subsidiary’s assets and liabilities at fair value regardless of the percentage ownership acquired by the parent? As the quotes from the five accounting professionals illustrate, the decision to require the revaluation of 100% of a newly controlled subsidiary’s assets and liabilities—regardless of percentage ownership—was not without some controversy. Students can use the quotes to discuss cost-benefit issues, relevance of capturing the underlying economics, use of hypothetical transactions in financial reporting, potential for abuse, etc. The requirement to value all acquisition date subsidiary assets at 100% fair value thus provides a useful vehicle for the class to discuss the many issues surrounding standard setters’ decisions.



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Answer to Discussion Question:

DOES GAAP UNDERVALUE POST-CONTROL STOCK ACQUISITIONS?

From the Berkshire Hathaway 2012 annual 10-K report: We have owned a controlling interest in Marmon Holdings, Inc. (“Marmon”) since 2008. In the fourth quarter of 2012, pursuant to the terms of the 2008 Marmon acquisition agreement, we acquired an additional 10% of the outstanding shares of Marmon held by noncontrolling interests for aggregate consideration of approximately $1.4 billion. Approximately $800 million of the consideration was paid in the fourth quarter of 2012, and the remainder is payable in March 2013. In the fourth quarter of 2010, we acquired 16.6% of Marmon’s outstanding common stock for approximately $1.5 billion. As a result of these acquisitions, our ownership interest in Marmon has increased to approximately 90%. These purchases were accounted for as acquisitions of noncontrolling interests. The differences between the consideration paid or payable and the carrying amounts of the noncontrolling interests acquired were recorded as reductions in Berkshire’s shareholders equity of approximately $700 million in 2012 and $614 million in 2010. We are contractually required to acquire substantially all of the remaining noncontrolling interests of Marmon no later than March 31, 2014, for an amount that will be based on Marmon’s future operating results.

On the date control is established, the new subsidiary’s valuation basis is established. Subsequent acquisitions of any remaining portions of the noncontrolling interests do not establish a new valuation basis for the subsidiary. In the Berkshire case, the new valuation basis for Marmon was established in 2008 when its 64% control was acquired. Berkshire then increases Marmon’s consolidated carrying amount as Marmon earns income, not by subsequent purchases of Marmon’s noncontrolling shares. Berkshire’s payments for its post-control equity acquisitions (16% and 10%) were in excess of Marmon’s proportionate carrying amounts. Because these transactions were with owners (not outside parties), no gain or loss is recorded. Berkshire reduces its paid-in capital the for excess of the purchase price over the carrying amount. The accounting is similar to retirement of stock for a payment in excess of the company’s proportionate carrying amount. Mr.Buffett may be correct that the current market value of Marmon is $4.6 bilion more that its carrying amount. However, GAAP does not, in general, record unrealized increases in a firm’s market value as increases in reported asset amounts.



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1. "Noncontrolling interest" refers to an equity interest that is held in a member of a business combination by an unrelated (outside) party.

2. Acquisition method = $220,000 (fair value) 3. A control premium is the portion of an acquisition price (above currently traded market

values) paid by a parent company to induce shareholders to sell a sufficient number of shares to obtain control. The extra payment typically becomes part of the goodwill acquired in the acquisition attributable to the parent company.

4. Current accounting standards require the noncontrolling interest to appear in the stockholders' equity section. The noncontrolling interest's share of the subsidiary’s net income is shown as an allocated component of consolidated net income.

5. The ending noncontrolling interest is determined on a consolidation worksheet by adding the four components found in the noncontrolling interest column: (1) the beginning balance of the subsidiary’s book value, (2) the noncontrolling interest share of the adusted acquisition-date excess fair over book value allocation, (3) its share of current year net income, (4) less dividends declared to these outside owners.

6. Allsports should remove the pre-acquisition revenues and expenses from the consolidated totals. These amounts were earned (incurred) prior to ownership by Allsports and therefore should are not earnings for the current parent company owners.

7. Following the second acquisition, consolidation is appropriate. Once Tree gains control, the 10% previous ownership is included at fair value as part of the total consideration transferred by Tree in the acquisition.

8. When a company sells a portion of an investment, it must remove the carrying value of that portion from its investment account. The carrying value is based upon application of the equity method. Thus, if either the initial value method or the partial equity method has been used, Duke must first restate the account to the equity method before recording the sales transaction. The same method is applied to the operations of the current period occurring prior to the time of sale.

9. Unless control is surrendered, the acquisition method views the sale of subsidiary's stock as a transaction with its owners. Thus, no gain or loss is recognized. The difference between the sale proceeds and the carrying value of the shares sold (equity method) is accounted for as an adjustment to the parent’s additional paid in capital.

10. The accounting method choice for the remaining shares depends upon the current relationship between the two firms. If Duke retains control, consolidation is still required. However, if the parent now can only significantly influence the decision-making process, the equity method is applied. A third possibility is Duke may have lost the power to exercise even significant influence. The fair value method then is appropriate.



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Answers to Problems

1. C 2. A At the date control is obtained, the parent consolidates subsidiary assets at fair value ($549,000 in this case) regardless of the parent’s percentage ownership. 3. D In consolidating the subsidiary's figures, all intra-entity balances must be eliminated in their entirety for external reporting purposes. Even though the subsidiary is less than fully owned, the parent nonetheless controls it. 4. C An asset acquired in a business combination is initially valued at 100%

acquisition-date fair value and subsequently amortized its useful life.

Patent fair value at January 1, 2014 ............................................... $45,000 Amortization for 2 years (10 year remaining life) .......................... (9,000) Patent reported amount December 31, 2015 ................................. $36,000 5. C 6. B Combined revenues ........................................................................ $1,100,000 Combined expenses ........................................................................ (700,000) Excess acquisition-date fair value amortization ........................... (15,000) Consolidated net income ................................................................ $385,000 Less: noncontrolling interest share ($85,000 × 40%) ................... (34,000) Consolidated net income to Chamberlain Corporation ............... $351,000 7. C Consideration transferred by Pride ............................................... $540,000 Noncontrolling interest fair value .................................................. 60,000 Star acquisition-date fair value ...................................................... $600,000 Star book value ................................................................................ 420,000 Excess fair over book value ........................................................... $180,000 Amort. to equipment (8 year remaining life) ........................... $ 80,000 $10,000 to customer list (4 year remaining life) ....................... 100,000 25,000 $35,000 Combined revenues ........................................................................ $783,000 Combined expenses ..................................................... $545,000 Excess fair value amortization .................................... 35,000 580,000 Consolidated net income ................................................................ $203,000 8. A Under the equity method, consolidated RE = parent’s RE. 9. B



Education.

10. A Amie, Inc. fair value at July 1, 2015:

30% previously owned fair value (30,000 shares × $5) ................ $150,000 60% new shares acquired (60,000 shares × $6) ............................ 360,000 10% NCI fair value (10,000 shares × $5) ......................................... 50,000 Acquisition-date fair value .............................................................. $560,000 Net assets' fair value ....................................................................... 500,000 Goodwill .......................................................................................... $60,000 11. C 12. B Fair value of 30% noncontrolling interest on April 1 .................... $165,000 30% of net income for remainder of year ($240,000 × 30%) ......... 72,000 Noncontrolling interest December 31 ............................................ $237,000 13. C Proceeds of $80,000 less $64,000 (⅓ × $192,000) book value = $16,000 Control is maintained so excess proceeds go to APIC. 14. B Combined revenues ........................................................................ $1,300,000 Combined expenses ........................................................................ (800,000) Trademark amortization .................................................................. (6,000) Patented technology amortization ................................................. (8,000) Consolidated net income ............................................................... $486,000 15. C Subsidiary net income ($100,000 – $14,000 excess amortizations) ................... $86,000 Noncontrolling interest percentage ............................................... 40% Net income attributable to noncontrolling interest ...................... $34,400

Fair value of noncontrolling interest at acquisition date ............. $200,000 40% change in previous year Solar book value ............................ ($530,000 – $400,000) × 40% ..................................................... 52,000 40% of excess fair value amortization—year one ......................... (5,600) Net income attributable to noncontrolling interest (above) ......... 34,400 Noncontrolling interest at end of year ........................................... $280,800 16. A West trademark balance ................................................................. $260,000 Solar trademark balance ................................................................. 200,000 Acquisition-date fair value allocation ............................................ 60,000 Excess fair value amortization for two years ................................ (12,000) Consolidated trademarks ............................................................... $508,000



Education.

17. A Acquisition-date fair value ($60,000 ÷ 80%) .................................. $75,000 Strand's book value ........................................................................ (50,000) Fair value in excess of book value ................................................ $25,000

Excess assigned to inventory (60%) ................................ $15,000 Excess assigned to goodwill (40%) .............................. $10,000 Park current assets ......................................................... ........ $70,000

Strand current assets ..................................................... .......... 20,000

Excess inventory fair value ............................................ ..... 15,000

Consolidated current assets .......................................... ...... $105,000

18. D Park noncurrent assets ............................................. ........ $90,000

Strand noncurrent assets .............................................. .......... 40,000

Excess fair value to goodwill ......................................... ..... 10,000

Consolidated noncurrent assets ................................... ...... $140,000

19. B Add the two book values and include 10% (the $6,000 current portion) of the

loan taken out by Park to acquire Strand. 20. B Add the two book values and include 90% (the $54,000 noncurrent portion) of

the loan taken out by Park to acquire Strand. 21. C Park stockholders' equity ......................................... ........ $80,000

Noncontrolling interest at fair value (20% × $75,000) .. ..................... 15,000

Total stockholders' equity .............................................. ........ $95,000



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22. (15 minutes) (Compute consolidated net income and noncontrolling

interest)

.................................................................... 2014 2015

a. Harrison net income ............................................ $220,000 $260,000

Starr net income .............................................................. 70,000 90,000

Acquisition-date excess fair value amortization .......... ... (8,000) (8,000)

Consolidated net income ............................................... $282,000 $342,000

b. Starr fair value .................................................................... $1,200,000 ..

Fair value of consideration transferred ........................ ..... 1,125,000

Noncontrolling interest fair value .................................. ........ $75,000

Noncontrolling interest fair value January 1, 2014 (above) ................ $75,000

2014 income to NCI ([$70,000 – $8,000] × 10%) ................ ............ 6,200

2014 dividends to NCI .................................................... ....... (3,000)

Noncontrolling interest reported value December 31, 2014 .......... 78,200

2015 net income attributable to NCI ([$90,000 – $8,000] × 10%) ........... 8,200

2015 dividends to NCI .................................................... ..................... (3,000)

Noncontrolling interest reported value December 31, 2015 $83,400



Education.

23. (30 minutes) (Consolidated balances, allocation of consolidated net income to controlling and noncontrolling interest, calculation of noncontrolling interest).

a. Stayer’s technology processes: Acquisition-date fair value (20 year remaining life) $1,000,000 2015 amortization (50,000) Technology processes 12/31/15 $ 950,000 b. Stayer’s building:

Acquisition-date fair value (10 year remaining life) $345,000 2015 depreciation (34,500) Building 12/31/15 $310,500 -or- $175,500 + $150,000 – $15,000 = $310,500

c. Controlling interest in consolidated net income: Net income–Johnsonville $650,000 Net income–Stayer adjusted for excess fair value amortization (see part d below) 285,000 Consolidated net income 935,000 Less: net income attributable to noncontrolling interest (see part d below) (57,000) Net income attributable to Johnsonville Co. $878,000 -OR-

Johnsonville’s separate net income $650,000 Stayer’s reported net income 350,000 Excess fair value amortization: Technology processes (50,000) Building ($345,000 – $195,000) ÷ 10 years (15,000)

Stayer’s adjusted net income 285,000 Johnsonville’s ownership percentage 80% 228,000 Net income attributable to Johnsonville Co. $878,000 d. Net income attributable to noncontrolling interest: Stayer’s reported net income 350,000 Excess fair value amortization: Technology processes (50,000) Building ($345,000 – $195,000) ÷ 10 years (15,000) Stayer’s adjusted net income 285,000 Noncontrolling interest percentage 20% Net income attributable to noncontrolling interest $57,000



Education.

23. (continued) e. Noncontrolling interest: Acquisition-date balance 1/1/15 Total Stayer fair value ($3,000,000 ÷ 80%) $3,750,000 Noncontrolling interest percentage 20% Noncontrolling interest acquisition-date fair value $750,000 Net income attributable to noncontrolling interest 57,000 Noncontrolling interest share of Stayer dividends (20% × $50,000) (10,000) Noncontrolling interest 12/31/15 $ 797,000 24. (40 minutes) (Several valuation and income determination questions for a business combination involving a noncontrolling interest.) a. Business combinations are recorded generally at the fair value of the consideration

transferred by the acquiring firm plus the acquisition-date fair value of the noncontrolling interest.

Patterson’s consideration transferred ($31.25 × 80,000 shares) .......... $2,500,000

Noncontrolling interest fair value ($30.00 × 20,000 shares) ................. 600,000

Soriano’s total fair value January 1 ............................... ... $3,100,000

b. Each identifiable asset acquired and liability assumed in a business combination is initially reported at its acquisition-date fair value.

c. In periods subsequent to acquisition, the subsidiary’s assets and liabilities are reported at their book values adjusted for acquisition-date fair value allocations and for subsequent amortization and depreciation on those allocations. Except for certain financial items, the subsidiary’s assets and liabilities are not continually adjusted for changing fair values.

d. Soriano’s total fair value January 1 ............................... ... $3,100,000

Soriano’s net assets book value ................................... .. 1,290,000

Excess acquisition-date fair value over book value .... ... $1,810,000

Adjustments from book to fair values ...........................

Buildings and equipment ...................................................... (250,000)

Trademarks ...................................................... 200,000

Patented technology .............................................................. 1,060,000

Unpatented technology ......................................................... 600,000 1,610,000

Goodwill .................................................................... ..................... $ 200,000

e. Combined revenues .............................................................................. $4,400,000 Combined expenses ............................................................................. (2,350,000) Building and equipment excess depreciation .................................... 50,000 Trademark excess amortization .......................................................... (20,000) Patented technology amortization ...................................................... (265,000) Unpatented technology amortization .................................................. (200,000)



Education.

Consolidated net income ..................................................................... $1,615,000 24. (continued) To noncontrolling interest: Soriano’s revenues ......................................................................... $1,400,000 Soriano’s expenses ......................................................................... (600,000) Total excess amortization expenses (above) ................................ (435,000) Soriano’s adjusted net income ....................................................... $ 365,000 Noncontrolling interest percentage ownership ............................ 20% Net income attributable to noncontrolling interest ...................... $ 73,000 To controlling interest: Consolidated net income ................................................................ $1,615,000 Net income attributable to noncontrolling interest ...................... (73,000) Net income attributable to Patterson ............................................. $1,542,000 -OR- Patterson’s revenues ...................................................................... $3,000,000 Patterson’s expenses ...................................................................... 1,750,000 Patterson’s separate net income ................................................... $1,250,000 Patterson’s share of Soriano’s adjusted net income (80% × $365,000) ................................................................... 292,000 Consolidated net income attributable to Patterson ...................... $1,542,000 f. Fair value of noncontrolling interest January 1 ................................. $ 600,000 Net income attributable to noncontrolling interest ............................ 73,000 Dividends (20% × $30,000) ................................................................... (6,000) Noncontrolling interest December 31 ................................................. $ 667,000

g. If Soriano’s acquisition-date total fair value was $2,250,000, then a bargain purchase has occurred.

Collective fair values of Soriano’s net assets .............. ... $2,900,000

Soriano’s total fair value January 1 ............................... ... $2,250,000

Bargain purchase ............................................................ ... $ 650,000

The acquisition method requires that the subsidiary assets acquired and

liabilities assumed be recognized at their acquisition date fair values regardless of the assessed fair value. Therefore, none of Soriano’s identifiable assets and liabilities would change as a result of the assessed fair value. When a bargain purchase occurs, however, no goodwill is recognized.



Education.

25. (30 minutes) Step acquisition. a. Investment in Sellinger 445,000 Cash 415,000 Additional paid-in capital 30,000 Acquisition-date fair value ($1,141,000 ÷ .7) $1,630,000 Sellinger net income 2014 340,000 Excess fair value amortization 2014 (40,000) Sellinger dividends 2014 (150,000) Acquisition-date adjusted subsidiary value 12/31/14 1,780,000 Percent acquired 1/1/15 0.25 Acquisition-date based value of newly acquired shares $ 445,000 Acquisition price for 25% interest 415,000 Credit to Palka’s APIC $ 30,000 b. Initial value for 70% acquisition $1,141,000 70% of adjusted 2014 subsidiary net income ($340,000 – $40,000) 210,000 70% of subsidiary dividends 2014 (105,000) Adjusted fair value of newly acquired shares 445,000 95% of adjusted subsidiary 2015 net income ($440,000 – $40,000) 380,000 95% of subsidiary dividends 2015 (171,000) Investment in Sellinger 12/31/15 $1,900,000



Education.

26. (20 Minutes) (Determine consolidated income balances, includes a mid-year acquisition)

a. Acquisition-date total fair value .......................... $594,000 Book value of net assets ...................................... (400,000) Fair value in excess of book value ..................... $194,000

Excess fair value assigned to specific Remaining Annual excess accounts based on fair value life amortizations

Patent .......................................................... 140,000 5 years $28,000 Land .......................................................... 10,000 Buildings ......................................................... 30,000 10 years 3,000 Goodwill .......................................................... 14,000 Total .......................................................... -0- $31,000

Consolidated figures following January 1 acquisition date: Combined revenues ....................................................... ... $1,500,000

Combined expenses ....................................................... ... (1,031,000)

Consolidated net income ............................................... ........ 469,000

Net income to noncontrolling interest ([200,000 – 31,000] × 30%) ....... (50,700)

Net income attributable to Parker, Inc. ......................... ..... $ 418,300

b. Consolidated figures following April 1 acquisition date:

Combined revenues (1) ................................................... ... $1,350,000

Combined expenses (2) .................................................. .. (923,250)

Consolidated net income .............................................. ..... $ 426,750

Net income attributable to noncontrolling interest (3) . . (38,025)

Net income attributable to Parker, Inc .......................... ..... $ 388,725

(1) $900,000 Parker revenues plus $450,000 of post-acquisition Sawyer revenues

(2) $600,000 Parker expenses plus $300,000 of post-acquisition Sawyer expenses plus $23,250 amortization expenses for 9 months

(3) ($200,000 – 31,000) adjusted subsidiary net income × 30% × ¾ year



Education.

27. (15 minutes) Consolidated figures with noncontrolling interest

Fair value of company (given) $60,000 Book value (10,000) Fair value in excess of book value 50,000 to machine ($50,000 – $10,000) 40,000 ÷ 10 = $4,000 per year to process trade secret $10,000 ÷ 4 = 2,500 per year $6,500 per year

Consolidated figures:

Net income attributable to noncontrolling interest

= 40% ($50,000 revenues less $26,500 expenses) = $9,400

End-of-year noncontrolling interest:

Beginning balance (40% $60,000) $24,000

Net income allocation (from above) 9,400

Dividend reduction (40% $5,000) (2,000) End-of-year noncontrolling interest $31,400

Machine (net) = $45,000 ($9,000 book value plus $40,000 excess allocation less $4,000 excess depreciation for one year).

Process trade secret (net) = $10,000 – $2,500 = $7,500



Education.

28. (45 minutes) Noncontrolling interest in the presence of a control premium. a. Goodwill allocation: Parflex NCI Acquisition-date fair value $344,000 $36,000 Share of identifiable net assets ($324,000 + $18,000) 307,800 34,200 Goodwill allocation $36,200 $1,800 b. Investment in Eagle Initial value $344,000 Change in Eagle’s RE × 90% ($341,000 – $174,000) × 90% 150,300 Excess amortization (3 years) × 90% (5,400) Investment in Eagle 12/31/15 $488,900 -OR- Investment in Eagle Initial value $344,000 2013-2014 change in Eagle’s RE × 90% ($278,000 – $174,000) × 90% 93,600 Excess fair value amortization (3,600) Equity income 2015 (below) 79,200 Eagle 2015 dividends × 90% (24,300) Investment in Eagle 12/31/15 $488,900 Equity in Eagle’s earnings: Eagles reported 2015 net income $90,000 Excess equipment amortization (2,000) Adjusted net income $88,000 Parflex ownership share 90% Equity in Eagle’s earnings $79,200



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28. continued

c. December 31, 2015 Parflex Eagle Adjustments NCI Consolidated

Sales (862,000) (366,000) (1,228,000)

Cost of goods sold 515,000 209,000 724,000


Equity in Eagle's earnings (79,200) 0 I 79,200 0

Separate company net income (235,000) (90,000)

Consolidated net income (243,800)

to noncontrolling interest (8,800) 8,800

to Parflex Corporation (235,000)

Retained earnings, 1/1 (500,000) (278,000) S 278,000 (500,000)

Net income (above) (235,000) (90,000) (235,000)

Dividends declared 130,000 27,000 24,300 D 2,700 130,000


Cash and receivables 135,000 82,000 217,000

Inventory 255,000 136,000 391,000

Investment in Eagle 488,900 0 D 24,300 385,200 S -0-

12,600 A1

36,200 A2

79,200 I

Property & equipment (net) 964,000 328,000 A1 14,000 2,000 E 1,304,000

Goodwill A2 38,000 38,000

Total assets 1,842,900 546,000 1,950,000

Liabilities (722,900) (55,000) (777,900)

Common stock (515,000) (150,000) S 150,000 (515,000)

NCI 1/1 42,800 S

1,400 A1

1,800 A2 (46,000)

NCI 12/31 (52,100) (52,100)


Total liabilities and equities (1,842,900) (546,000) 585,500 585,500 (1,950,000)



Education.

29. (25 Minutes) (Determine consolidated balances for a step acquisition).

a. Amsterdam fair value implied by price paid by Morey $560,000 ÷ 70% = $800,000

b. Revaluation gain: 1/1 equity investment in Amsterdam (book value) $178,000 25% net income for 1st 6 months 8,750 Investment book value at 6/30 186,750 Fair value of investment at 6/30 (25% × $800,000) 200,000 Gain on revaluation to fair value $ 13,250

c. Goodwill at 12/31: Fair value of Amsterdam at 6/30 $800,000 Book value at 6/30 (700,000 + [70,000 ÷ 2]) 735,000 Excess fair value $ 65,000 Allocation to goodwill (no impairment) $ 65,000

d. Noncontrolling interest: 5% fair value balance at 6/30 $40,000 5% subsidiary net income from 6/30 to 12/31 1,750 5% subsidiary dividends (1,000) Noncontrolling interest 12/31 $40,750



Education.

30. (30 Minutes) (Reporting the sale of a portion of an investment in a subsidiary.) a. Posada records an accrual of $7,950 (see computation below) as "Equity Income from Sold Shares of Sabathia" for the January 1, 2015 to October 1, 2015 period which will appear in the 2015 consolidated income statement. The consolidation will continue to include all of Sabathia's accounts but now recognizing a 40% noncontrolling interest.

Sabathia fair value 1/1/13 ......................................... $1,200,000

Sabathia book value ................................................. (1,130,000) Patent .................................................................... $70,000

Remaining life of patent ............................................ 5 years Annual amortization .................................................. $14,000 Posada’s share of Sabathia’s net income accruing to shares sold: Sabathia's net income ............................................... $120,000

Excess patent fair value amortization ........................... (14,000)

Sabathia's adjusted net income..................................... 106,000

Fraction of year held ................................................. 9/12

Sabathia’s adjusted net income for 9 months .............. 79,500

Percentage owned by Posada .................................. ..... 70%

Posada’s share of Sabathia’s 9 month net income ..... 55,650

Shares sold—1,000 out of 7,000 .............................. 1/7

Posada’s income for shares sold ............................ $7,950

b. As long as control is maintained, the acquisition method considers transactions in the stock of a subsidiary, whether purchases or sales, as transactions in the equity of the consolidated entity.

Posada’s investment book value 10/1/15 1/1/15 balance (given—equity method) ................... $1,085,000 Recognition of 1/1/15–10/1/15 period: Income accrual ($120,000 × 70% × ¾) ................ 63,000 Dividends ($40,000 × 70% × ¾) ........................... (21,000) Amortization ($14,000 × 70% × ¾) ...................... (7,350) Pre-sale investment book value—10/1/15 ................ $1,119,650 Computation of income effect—sale transaction 10/1/15 book value (above) ....................................... $1,119,650 Portion of investment sold (1,000/7,000 shares) .... 1/7 Book value of investment sold ................................ $ 159,950

Proceeds .................................................................... 191,000 Credit to Posada’s additional paid-in capital .......... $ 31,050 c. Because Posada continues to hold 6,000 shares of Sabathia, control is still

maintained and consolidated financial statements would be appropriate with a noncontrolling interest of 40 percent.



Education.

31. (35 Minutes) (Consolidation entries and the effect of different investment methods)

a. From the original fair value allocation, $30,000 is assigned based on the fair value of the patent. With a 5-year remaining life, excess amortization will be $6,000 per year.

Because the equity method is in use, no Entry *C is required. Entry S Common stock (Bandmor) ............................ 300,000 Retained earnings, 1/1/15 (Bandmor) ........... 268,000 Investment in Bandmor (70%) ................. 397,600 Noncontrolling interest in Bandmor, 1/1/15 170,400 (To eliminate stockholders' equity accounts of subsidiary and

recognize outside ownership. Retained earnings figure includes 2013 and 2014 net income and dividends.)

Entry A Patent .............................................................. 18,000 Goodwill .......................................................... 190,000 Investment in Bandmor ............................ 145,600 Noncontrolling interest in Bandmor (30%) 62,400 (To recognize unamortized portions of acquisition-date fair value

allocations. No control premium, so goodwill is allocated proportionately. Patent has undergone two years amortization)

Entry I Equity in Bandmor earnings ......................... 72,800 Investment in Bandmor ............................ 72,800 (To eliminate intra-entity income balance. Equity accrual of $72,800

[70% × ($110,000 – 6,000 amortization)] has been recorded) Entry D Investment in Bandmor ................................. 42,000 Dividends declared ................................... 42,000 (To eliminate current intra-entity dividend transfers—70% of $60,000) Entry E Amortization expense ..................................... 6,000 Patent ......................................................... 6,000 (To recognize amortization for current year)

Entry P Accounts payable .......................................... 22,000 Accounts receivable ................................. 22,000 (To eliminate intra-entity payable/receivable balance)



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31. (continued) b. If the initial value method had been applied, the parent would have recorded only the subsidiary dividends declared as income rather than an equity accrual. Therefore, Entry *C is needed to adjust the parent's beginning retained earnings for 2015 to the equity method. During 2013 and 2014, the subsidiary earned a total net income of $171,000 but declared dividends of only $83,000. The parent's share of the difference is $61,600 (70% of $88,000 [$171,000 - $83,000]). In addition, the parent’s 70% share of excess amortization expense for two years must also be included ($8,400 = 2 years × $6,000 per year × 70%). The net amount to be recognized is $53,200 ($61,600 - $8,400). ENTRY *C Investment in Bandmor ................................. 53,200 Retained earnings, 1/1/15 ........................ 53,200 c. If the partial equity method had been applied, only the excess amortization

expenses for the previous two years would have been omitted from the parent's retained earnings. As shown above, that figure is $8,400 (2 years × $6,000 per year × 70%).

ENTRY *C Retained earnings, 1/1/15 .............................. 8,400 Investment in Bandmor ............................ 8,400 d. Net income attributable to noncontrolling interest—2015 [($110,000 – 6,000) × 30%] ............................. $31,200 Noncontrolling interest (NCI) fair value January 1, 2013 $210,000 Adjustments to original basis: 2013 NI to noncontrolling interest .................... $20,700 Dividends to NCI ........................................ (11,700) 9,000 2014 NI to noncontrolling interest .................... $27,000 Dividends to NCI ........................................ (13,200) 13,800 2015 Net income to noncontrolling interest ..... $31,200 Dividends to NCI ........................................ (18,000) 13,200 Noncontrolling interest in Bandmor 12/31/15 .... $246,000 –OR– Worksheet adjustment S ........................................................ $170,400 Worksheet adjustment A ........................................................ 62,400 2015 net income attributable to noncontrolling interest ...... 31,200 2015 dividends to noncontrolling interest ........................... (18,000) Noncontrolling interest in Bandmor 12/31/15 ....................... $246,000



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32. (45 Minutes) (Asks about several consolidated balances and consolidation process. Includes the different accounting methods to record investment.)

a. Schedule 1—Fair Value Allocation and Excess Amortizations Consideration transferred by Miller ......... $664,000 Noncontrolling interest fair value ............. 166,000 Taylor’s fair value ....................................... $830,000 Taylor’s book value .................................... (600,000) Fair value in excess of book value .......... 230,000

Excess fair value assigned to specific Remaining Annual excess accounts based on fair value life amortizations

Excess fair value assigned to buildings 80,000 20 years $4,000

Goodwill ........................................... $150,000 ......... indefinite -0-

Total ....................................................... $4,000 b. $150,000 (see schedule 1 above) c. Entry (S)

Common stock (Taylor) ...................................... 300,000 Additional paid-in capital (Taylor) ..................... 90,000 Retained earnings (Taylor) ................................. 210,000 Investment in Taylor Company (80%) .......... 480,000 Noncontrolling interest in Taylor (20%) ....... 120,000 Entry (A)—no control premium

Buildings .............................................................. 80,000 Goodwill ............................................................... 150,000 Investment in Taylor Company (80%) .......... 184,000 Noncontrolling interest in Taylor (20%) ....... 46,000 d. (1) Equity method

Income accrual (80%) ........................................... $56,000 Excess amortization expense .............................. (3,200) Investment income .......................................... $52,800 (2) Partial equity method

Income accrual (80%) ........................................... $56,000 (3) Initial value method

Dividends received (80%) ..................................... $8,000



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32. (continued)

e. (1) Equity method

.................................................................... Initial fair value paid $664,000

Income accrual 2013–2015 ($260,000 × 80%) ..... 208,000 Dividends 2013–2015 ($45,000 × 80%) ................ (36,000) Excess amortizations 2013–2015 ($3,200 × 3) .... (9,600) Investment in Taylor—12/31/15 ...................... $826,400

(2) Partial Equity Method

Investment in Taylor—12/31/15 = $836,000 (initial value paid plus income accrual of $208,000 less dividends of $36,000 [no excess amortizations])

(3) Initial Value Method

Investment in Taylor—12/31/15 = $664,000 (original value paid)

f. Using the acquisition method, the allocation will be the total difference ($80,000) between the buildings' book value and fair value. Based on a 20 year remaining life, annual excess amortization is $4,000.

Miller book value—buildings ......................................... $800,000 Taylor book value—buildings ....................................... 300,000 Allocation ........................................................................ 80,000 Excess amortizations for 2013–2014 ($4,000 × 2) ........ (8,000) Consolidated buildings account ............................. $1,172,000

g. Acquisition-date fair value allocated to goodwill (see schedule 1 above) ............................................ $150,000

h. If the parent has been applying the equity method, the stockholders'

equity accounts on its books will already represent consolidated totals. The common stock and additional paid-in capital figures to be reported are the parent balances only. As to retained earnings, the equity method will properly record all subsidiary net income and amortization so that the parent balance is also a reflection of the consolidated total.



Education.

33. (20 Minutes) (A variety of consolidated balances-midyear acquisition) Consideration transferred by Karson (cash and contingent consideration) ......... $1,360,000 Noncontrolling interest fair value ................. 340,000 Reilly’ fair value (given) .................................. $1,700,000 Book value of Reilly ........................................ (1,450,000)* Fair value in excess of book value ................. $250,000

Excess fair value assigned to specific Remaining Annual excess

accounts based on fair value life amortizations Trademarks .................................................. 150,000 5 years $30,000 Goodwill ....................................................... $100,000 indefinite -0- Total .......................................................... $30,000 *Reilly book value, January 1 (Common stock + APIC + RE) ...................... $1,400,000 Increase in book value: Net income (revenues less cost of goods sold and expenses) ................... $120,000 Dividends .................................................. (20,000) Change during year ................................. $100,000 Change during first 6 months of year ..... 50,000 Reilly book value, July 1 (acquisition date) ........... ..... $1,450,000 CONSOLIDATION TOTALS:

Sales (1) $1,050,000

Cost of goods sold (2) 540,000

Operating expenses (3) 265,000

Consolidated net income $245,000

Net income attributable to noncontrolling interest (4) $9,000

(1) $800,000 Karson revenues plus $250,000 (post-acquisition subsidiary revenue)

(2) $400,000 Karson COGS plus $140,000 (post-acquisition subsidiary COGS)

(3) $200,000 Karson operating expenses plus $50,000 (post-acquisition subsidiary operating expenses) plus ½ year excess amortization of $15,000

(4) 20% of post-acquisition subsidiary net income less excess fair value amortization [20% × ½ year × (120,000 – 30,000)] = $9,000

Retained earnings, 1/1 = $1,400,000 (the parent’s balance because the

subsidiary was acquired during the current year)

Trademarks = $935,000 (add the two book values and the excess fair value allocation after taking one-half year excess amortization)

Goodwill = $100,000 (the original allocation)



Education.

34. (25 Minutes) (A variety of consolidated questions and balances)

a. Nascent applies the initial value method because the original price of $414,000 is still in the Investment in Sea-Breeze account. In addition, the Investment Income account is equal to 60 percent of the dividends declared by the subsidiary during the year.

b. Consideration transferred in acquisition . $414,000 Noncontrolling interest fair value ............. 276,000 Sea-Breeze fair value 1/1/12 ...................... $690,000 Sea-Breeze book value 1/1/12 550,000 Excess fair value over book value $140,000


accounts based on fair value life amortizations Buildings ............................................... 60,000 6 years $10,000 Equipment ............................................. (20,000) 4 years (5,000) Patent ..................................................... 100,000 10 years 10,000 Total ..................................................... -0- $15,000

c. If the equity method had been applied, the Investment Income account

would show the basic equity accrual less amortization: 60% of (the subsidiary's net income of $90,000 less $15,000 excess fair value amortization) = $45,000.

d. The initial value method recognizes neither the increase in the

subsidiary's book value nor the excess amortization expenses for prior years. At the acquisition date, the subsidiary’s book value was $550,000 as indicated by the assets less liabilities. At the beginning of the current year, the book value of the subsidiary is $780,000 as indicated by beginning stockholders' equity balances.

Increase in book value during prior years

($780,000 – $550,000)........................................................... $230,000 Less excess amortization ......................................................... (45,000) Net increase in book value ........................................................ $185,000 Ownership .................................................................................. 60%

Increase required in parent's retained earnings, 1/1/15 ........................................ $111,000

Parent's retained earnings, 1/1/15 as reported ....................... 700,000 Parent’s share of consolidated retained earnings, 1/1/15 ...... $811,000

e. Consolidated net income and allocation

Revenues (add book values) $900,000 Expenses (add book values and excess amortization) (635,000) Consolidated net Income $265,000 Net income attributable to noncontrolling interest ($90,000 – 15,000) × 40% 30,000 Net income attributable to Nascent, Inc. $235,000



Education.

34. (continued)

f. Consolidated buildings, 1/1/12 (subsidiary): Book value ............................................................................. $300,000 Acquisition-date fair-value allocation ................................ 60,000 Consolidation figure ............................................................ $360,000

g. Consolidated buildings, 12/31/15: Parent's book value ............................................................. $700,000 Subsidiary's book value ...................................................... 200,000 Original allocation ................................................................ 60,000 Amortization ($10,000 × 4 years) ........................................ (40,000) Consolidated balance .......................................................... $920,000



Education.

35. (Acquisition Method Consolidated Balances)

Adjustments

December 31, 2015 Paloma San Marco & Eliminations NCI Consolidated

Revenues (1,843,000) (675,000) (2,518,000)

Cost of goods sold 1,100,000 322,000 1,422,000

Depreciation expense 125,000 120,000 245,000

Amortization expense 275,000 11,000 (E) 80,000 366,000


Equity in San Marco Income (121,500) (I)121,500 -0-



To noncontrolling interest (13,500) (13,500)

To Paloma Company (437,000)

Retained Earnings 1/1 (2,625,000) (395,000) (S)395,000 (2,625,000)

Net Income (437,000) (215,000) (437,000)

Dividends declared 350,000 25,000 (D) 22,500 2,500 350,000

Retained Earnings 12/31 (2,712,000) (585,000) (2,712,000)

Current Assets 1,204,000 430,000 1,634,000

Investment in San Marco 1,854,000 (D) 22,500 (S)769,500

(A)985,500 -0-

(I) 121,500

Customer base -0- -0- (A)720,000 (E) 80,000 640,000

Buildings and Equipment 931,000 863,000 1,794,000

Copyrights 950,000 107,000 1,057,000

Goodwill (A)375,000 375,000

Total Assets 4,939,000 1,400,000 5,500,000

Accounts Payable (485,000) (200,000) (685,000)

Notes Payable (542,000) (155,000) (697,000)

NCI in San Marco (S) 85,500

(A)109,500 (195,000)

(206,000) (206,000)

Common Stock (900,000) (400,000) (S)400,000 (900,000)

Additional Paid-In Capital (300,000) (60,000) (S) 60,000 (300,000)

Retained Earnings 12/31 (2,712,000) (585,000) (2,712,000)

Total Liab. and SE (4,939,000) (1,400,000) 2,174,000 2,174,000 (5,500,000)



Education.

35. (Continued) Controlling Noncontrolling Interest Interest Fair value at acquisition date $1,710,000 $190,000 Relative fair values of identifiable net assets

90% and 10% of $1,525,000 (acquisition date recorded fair value plus customer base) 1,372,500 152,500

Goodwill $337,500 $37,500 b. If the acquisition-date fair value of the noncontrolling interest was $167,500, both

goodwill (NCI portion) and the noncontrolling interest balance would be reduced equally by $22,500 as follows:

Fair value of San Marco Company (1,710,000 + 167,500) $1,877,500 Carrying amount acquired 725,000 Excess fair value 1,152,500 to customer base 800,000 to goodwill $352,500 Noncontrolling interest balance beginning of year* $(172,500) Net income attributable to noncontrolling interest (13,500) Dividends declared to noncontrolling interest 2,500 Noncontrolling interest end of year $(183,500)

* NCI at beginning of year Common stock-subsidiary $400,000 APIC-subsidiary 60,000 Retained earnings-subsidiary 1/1 395,000

Total $855,000 Noncontrolling interest percentage 10% Noncontrolling share of subsidiary book value 85,500 Noncontrolling share of 1/1 customer base excess 72,000 Noncontrolling share of goodwill (below) 15,000

Noncontrolling interest 1/1 $172,500

Controlling Noncontrolling Interest Interest Fair value at acquisition date $1,710,000 $167,500 Relative fair values of identifiable net assets

90% and 10% of $1,525,000 (acquisition date recorded fair value plus customer base) 1,372,500 152,500

Goodwill $ 337,500 $15,000



Education.

36. (60 Minutes) (Consolidation worksheet and income statement with parent using initial value method. Also consolidated balances with a control premium paid by parent.)

a. Fair Value Allocation and Amortization Consideration transferred by Holtz ................ $576,000 Noncontrolling interest fair value .................. 144,000 Devine total fair value 1/1/14 ........................... $720,000 Devine book value 1/1/14 ................................ (326,500) Fair value in excess of book value ................ $393,500


accounts based on fair value: life amortizations Building ....................................................... 85,500 5 years $17,100 Trademark ................................................. 64,000 10 years 6,400 Goodwill ...................................................... $244,000 indefinite -0- $23,500

Explanation of Consolidation Entries Found on Worksheet

Entry *C: Convert the parent’s 1/1/15 retained earnings balance from the initial value method to the accrual basis. Change in subsidiary RE from 1/1/14 to 1/1/15 ........ $70,000 Excess amortization for 2014 .................................... 23,500 Adjusted subsidiary RE increase .............................. $46,500 Percentage ownership by parent .............................. 80% *C conversion entry ................................................... $37,200

Entry S: Eliminates stockholders' equity accounts of subsidiary while

recognizing noncontrolling interest balance (20%) as of the beginning of the current year.

Entry A: Recognizes acquisition-date fair value allocations less one year of

amortization for building and trademark and increases beginning balance of the noncontrolling interest for its share.

Entry I: Eliminates Intra-entity dividends declared by subsidiary and recorded

as income by parent.

Entry E: Recognizes amortization expense for current year.

Columnar entry—Recognizes net income attributable to noncontrolling interest [($97,000 – $23,500) × 20%].



36. a. (continued) HOLTZ CORPORATION AND DEVINE, INC. Consolidation Worksheet

For Year Ending December 31, 2015 Holtz Devine Consolidation Entries Noncontrolling Consolidated Accounts Corporation Inc. Debit Credit Interest Totals

Sales (641,000) (399,000) (1,040,000) Cost of goods sold 198,000 176,000 374,000 Operating expenses 273,000 126,000 (E) 23,500 422,500 Dividend income (16,000) ___ _-0- (I) 16,000 -0- Separate company net income (186,000) (97,000) Consolidated net income (243,500) NI attributable to noncontrolling interest (14,700) 14,700 NI attributable to Holtz Corp. (228,800) Retained earnings, 1/1 (762,000) (296,500) (S) 296,500 (*C) 37,200 (799,200) Net income (above) (186,000) (97,000) (228,800) Dividends declared 70,000 20,000 (I) 16,000 4,000 70,000 Retained earnings, 12/31 (878,000) (373,500) (958,000) Current assets 121,000 120,500 241,500 Investment in Devine 576,000 -0- (*C) 37,200 (S)317,200 -0- (A)296,000 Buildings and equipment (net) 887,000 335,000 (A) 68,400 (E) 17,100 1,273,300 Trademarks 149,000 236,000 (A) 57,600 (E) 6,400 436,200 Goodwill -0- -0- (A)244,000 244,000 Total assets 1,733,000 691,500 2,195,000 Liabilities (535,000) (218,000) (753,000) Common stock (320,000) (100,000) (S)100,000 (320,000) Retained earnings, 12/31 (above) (878,000) (373,500) (958,000) NCI in Devine, 1/1 (S) 79,300 (A) 74,000 (153,300) NCI in Devine, 12/31 (164,000) (164,000) Total liabilities and equities (1,733,000) (691,500) 843,200 843,200 (2,195,000)



Education.

36. (continued) b. HOLTZ CORPORATION AND DEVINE, INC.

Consolidated Income Statement For Year Ending December 31, 2015

Sales $1,040,000 Cost of goods sold $374,000 Operating expenses 422,500 Total expenses 796,500 Consolidated net income $243,500

To 20% noncontrolling interest $14,700 To Holtz Corporation $228,800 c. Consideration transferred by Holtz for 80% of Devine $576,000 Noncontrolling interest fair value ($4.76 × 20,000 shares) 95,200 Devine fair value $671,200 Fair value of Devine’s underlying net assets 476,000 Goodwill $195,200 If the noncontrolling interest fair value was $4.76 per share at the acquisition date, then goodwill declines to $195,200. The noncontrolling interest total would also decline from $164,000 to $115,200. Worksheet entries (S), (A1) and (A2) assuming a $4.76 noncontrolling interest acquisition-date fair value: (S) Common stock-Devine 100,000 Retained earnings- Devine 1/1 296,500 Investment in Devine 317,200 Noncontrolling interest 79,300 (A1) Buildings and equipment (net) 68,400 Trademarks 57,600 Investment in Devine 100,800 Noncontrolling interest 25,200

(A2) Goodwill 195,200 Investment in Devine 195,200 Controlling Noncontrolling Interest Interest Fair value at acquisition date $576,000 $95,200 Relative fair values of identifiable net assets

80% and 20% of $476,000 (acquisition date fair value of net identifiable assets) 380,800 95,200

Goodwill $195,200 -0-



Education.

37. (40 Minutes) (Determine consolidated balances.) Acquisition-date subsidiary fair value (given) ... $1,003,400 Book value of subsidiary (given) ....................... (690,000) Fair value in excess of book value ..................... $313,400 Allocations to specific accounts based on difference between fair value and book value Land ................................................................ $225,000 Buildings and equipment .............................. (24,000) Copyright ........................................................ 94,000 Notes payable ................................................. 18,400 313,400 Total ....................................................... -0- Annual excess amortizations: Buildings and equipment [$(24,000) ÷ 10 years] $(2,400) Copyright ($94,000 ÷ 20 years) 4,700 Notes payable ($18,400 ÷ 8 years) 2,300 Total $4,600 Consolidated Totals:

Revenues = $2,079,880 (add the two book values)

Cost of goods sold = $1,206,000 (add the two book values)

Depreciation expense = $283,200 (add the two book values less $2,400 excess adjustment)

Amortization expense = $10,800 (add the two book values plus $4,700 excess adjustment)

Interest expense = $63,600 (add the two book values plus $2,300 excess adjustment)

Equity in income of Sierra = -0- (eliminated so that the individual revenues and expenses of the subsidiary can be included in the consolidated figures)

Consolidated net income = $516,280 (revenues less expenses)

Net income attributable to noncontrolling interest = $44,280 ($226,000 reported subsidiary net income less $4,600 net excess amortization expense multiplied by 20 percent outside ownership)

Net income to Padre Company = $472,000 ($516,280 consolidated net income less noncontrolling interest share of $44,280)

Retained earnings, 1/1 = $1,275,000 (parent company balance only)

Dividends declared = $260,000 (parent company balance; subsidiary's declarations to parent are intra-entity, declarations to outside owners decrease noncontrolling interest balance)



Education.

37. (continued)

Retained earnings, 12/31 = $1,487,000 (consolidated balance on 1/1 plus net income to Padre Co. less Padre’s dividends declared) or simply the parent’s RE because parent employs the equity method.

Current assets = $1,620,860 (add the two book values)

Investment in Sierra = -0- (eliminated so that the individual assets and liabilities of the subsidiary can be included in the consolidated figures)

Land = $650,000 (add the book values plus the $225,000 excess allocation)

Buildings and equipment (net) = $1,162,800 (add the book values less the $24,000 allocation [asset was overvalued] plus the excess amortization)

Copyright = $205,200 (book value plus $94,000 excess allocation less amortization for the year)

Total assets = $3,638,860

Accounts payable = $469,000 (add book values)

Notes payable = $700,900 (add the book values less $18,400 excess allocation plus amortization)

Noncontrolling interest in subsidiary = $231,960 (20% of fair value as of 1/1 [$200,680] plus net income attributable to noncontrolling interest [$44,280] less dividends declared to outside owners [$13,000])

Common stock = $300,000 (parent company balance)

Additional paid-in capital = 450,000 (parent company balance)

Retained earnings, 12/31 = $1,487,000 (computed above)

Total liabilities and equities = $3,638,860



37. (continued) Acquisition Method Consolidation Entries Noncontrolling Consolidated Accounts Padre Sierra Debit Credit Interest Totals

Revenues ............................................. (1,394,980) (684,900) (2,079,880) Cost of goods sold .............................. 774,000 432,000 1,206,000 Depreciation expense ......................... 274,000 11,600 (E) 2,400 283,200 Amortization expense ......................... -0- 6,100 (E) 4,700 10,800 Interest expense .................................. 52,100 9,200 (E) 2,300 63,600

Equity in income of Sierra ................. (177,120) -0- (I) 177,120 -0- Separate company net income .......... (472,000) (226,000)

Consolidated net income ................... (516,280) NI to noncontrolling interest ............ (44,280) 44,280 NI to Padre Company ....................... (472,000)

Retained earnings 1/1 ........................ (1,275,000) (530,000) (S) 530,000 (1,275,000) Net income (above) ............................ (472,000) (226,000) (472,000) Dividends declared ............................ 260,000 65,000 (D) 52,000 13,000 260,000 Retained earnings 12/31 .............. (1,487,000) (691,000) (1,487,000)

Current assets .................................... 856,160 764,700 1,620,860 Investment in Sierra ........................... 927,840 (D) 52,000 (S) 552,000 ........................................................ (I) 177,120 ........................................................ (A) 250,720 -0- Land ..................................................... 360,000 65,000 (A) 225,000 650,000 Buildings and equipment (net) .......... 909,000 275,400 (E) 2,400 (A) 24,000 1,162,800 Copyright ............................................ -0- 115,900 (A) 94,000 (E) 4,700 205,200 Total assets ................................... 3,053,000 1,221,000 3,638,860

Accounts payable .............................. (275,000) (194,000) (469,000) Notes payable ..................................... (541,000) (176,000) (A) 18,400 (E) 2,300 (700,900) NCI in Sierra 1/1 ................................... (S) 138,000 NCI in Sierra 12/31 ............................... (A) 62,680 (200,680) ........................................................ (231,960) (231,960) Common stock ................................... (300,000) (100,000) (S) 100,000 (300,000) Additional paid-in capital ................... (450,000) (60,000) (S) 60,000 (450,000) Retained earnings 12/31 .... (above) … (1,487,000) (691,000) (1,487,000) Total liab. and stockholders' equity (3,053,000) (1,221,000) 1,265,920 1,265,920 (3,638,860)



Education.

38. (55 Minutes) (Consolidated worksheet) a. Consideration transferred by Adams $603,000 Noncontrolling interest fair value 67,000 Acquisition-date total fair value $670,000 Book value of Barstow (CS + RE 12/31/13) (460,000) Excess fair value over book value 210,000 Excess fair value assigned to specific Remaining Annual excess

accounts based on fair value life amortizations Land $30,000 — — Buildings (20,000) 10 years ($2,000) Equipment 40,000 5 years 8,000 Patents 50,000 10 years 5,000 Notes payable 20,000 5 years 4,000 120,000 Goodwill $90,000 indefinite -0- Total $15,000

b. Because investment income is exactly 90 percent of Barstow's reported earnings, Adams apparently is applying the partial equity method.

c. d. Explanation of Consolidation Entries Found on Worksheet

Entry *C—Converts Adams's financial records from the partial equity method to the equity method by recognizing amortization for 2014. Total expense was $15,000 but only 90 percent (or $13,500) applied to the parent.

Entry S—Eliminates subsidiary's stockholders' equity while recording noncontrolling interest balance as of January 1, 2015.

Entry A—Records unamortized allocation balances as of January 1, 2015. The acquisition method attributes 10 percent of these amounts to the non-controlling interest.

Entry I—Eliminates intra-entity income accrual for 2015.

Entry D—Eliminates intra-entity dividend transfers.

Entry E—Records amortization expense for current year.

Columnar Entry—Recognizes noncontrolling interest's share of consolidated net income as follows:

Net income attributable to noncontrolling interest (Columnar Entry) Barstow reported net income ....................................... ...... $120,000

Excess amortization expenses 2015 .............................................. (15,000) Adjusted net income of Barstow ............................................. $105,000 Noncontrolling interest ownership ............................................... 10% Net income attributable to noncontrolling interest ................. $ 10,500



38. c. and d. (continued) ADAMS CORPORATION AND BARSTOW, INC. Consolidation Worksheet-Acquisition Method For Year Ending December 31, 2015 Noncontrolling Consolidated

Adams Corp. Barstow Inc. Debit Credit Interest Totals

Revenues (940,000) (280,000) (1,220,000) Cost of goods sold 480,000 90,000 570,000 Depreciation expense 100,000 55,000 (E) 6,000 161,000 Amortization expense (E) 5,000 5,000 Interest expense 40,000 15,000 (E) 4,000 59,000 Investment income (108,000) -0- (I) 108,000 -0- Separate company net income (428,000) (120,000) Consolidated net income (425,000) NI to noncontrolling interest (10,500) 10,500 NI to Adams Corporation (414,500)

Retained earnings, 1/1 (1,367,000) (340,000) (C*) 13,500 (1,353,500) (S) 340,000 Net income (428,000) (120,000) (414,500) Dividends declared 110,000 70,000 (D) 63,000 7,000 110,000 Retained earnings, 12/31 (1,685,000) (390,000) (1,658,000)

Current assets 610,000 250,000 860,000 Investment in Barstow 702,000 (D) 63,000 (*C) 13,500 -0- (S) 468,000 (A) 175,500 (I) 108,000 Land 380,000 150,000 (A) 30,000 560,000 Buildings 490,000 250,000 (E) 2,000 (A) 18,000 724,000 Equipment 873,000 150,000 (A) 32,000 (E) 8,000 1,047,000 Patents -0- -0- (A) 45,000 (E) 5,000 40,000 Goodwill -0- -0- (A) 90,000 90,000 Total assets 3,055,000 800,000 3,321,000

Notes payable (860,000) (230,000) (A) 16,000 (E) 4,000 (1,078,000) Common stock (510,000) (180,000) (S) 180,000 (510,000) Retained earnings, 12/31 (1,685,000) (390,000) (1,658,000) (S) 52,000 Noncontrolling interest (A) 19,500 (71,500) (75,000) (75,000) Total liabilities and stockholders' equity (3,055,000) (800,000) 934,500 934,500 (3,321,000)



Education.

39. (25 minutes) (Consolidated balances after a mid-year acquisition) a. Investment account balance indicates the initial value method. Consideration transferred by Gibson ....... $528,000 Noncontrolling interest fair value ............ 352,000 Davis acquisition-date fair value ............. 880,000 Book value of Davis (see below) ............... (765,000) Fair value in excess of book value ................ ......... $115,000


accounts based on fair value: life amortizations Equipment (overvalued) .................. (30,000) 5 years $(6,000) Goodwill .......................................... $145,000 indefinite -0- Total ...................................................... $(6,000) Amortization for 9 months .................. $(4,500)

Acquisition-date subsidiary book value: Book value of Davis, 1/1/15 (CS + 1/1 RE) ............... $740,000 Increase in book value-net income (dividends were declared after acquisition) ......................... $100,000 Time prior to purchase (3 months) .......................... × ¼ year 25,000 Book value of Davis, 4/1/15 (acquisition date) ........ $765,000

Consolidated income statement:

Revenues (1) $825,000 Cost of goods sold (2) $405,000 Operating expenses (3) 214,500 619,500 Consolidated net income 205,500 Net income attributable to noncontrolling interest (4) 28,200 Net income to Gibson Company $177,300

(1) $900,000 combined revenues less $75,000 (preacquisition subsidiary revenue)

(2) $440,000 combined COGS less $35,000 (preacquisition subsidiary COGS) (3) $234,000 combined operating expenses less $15,000 (preacquisition

subsidiary operating expenses) less nine month excess overvalued equipment depreciation reduction of $4,500

(4) 40% of post-acquisition subsidiary net income less excess amortization

b. Goodwill = $145,000 (original allocation) ................................................................ Equipment = $774,500 (add the two book values less $30,000 reduction to fair value plus $4,500 nine months excess ................................................................ amortization)

Common stock = $630,000 (parent company balance only) Buildings = $1,124,000 (add the two book values) Dividends declared = $80,000 (parent company balance only)



Education.

40. (40 minutes) Determine consolidated balance for a mid-year acquisition. a. Consideration transferred by Truman .......... $720,000 Noncontrolling interest fair value ................. 290,000 Atlanta’s acquisition-date total fair value ...... $1,010,000 Book value of Atlanta ...................................... (840,000) Fair value in excess of book value ................. $ 170,000


accounts based on fair value life amortizations Patent ......................................................... 100,000 5 years $20,000 Goodwill ....................................................... $ 70,000 indefinite -0- Total .......................................................... $20,000 b. Goodwill allocation with control premium Controlling Noncontrolling Interest Interest Fair values at acquisition date $720,000 $290,000 Relative fair values of identifiable net assets

70% and 30% of $940,000 (acquisition date book value plus patent = net asset fair value) 658,000 282,000

Goodwill $ 62,000 $ 8,000 c. Initial value at acquisition date $720,000 Truman’s share of Atlanta’s net income for half year ([$120,000 – 20,000 amortization × ½ year] × 70%) 35,000 Dividends 2015 ($80,000 × ½ year × 70%) (28,000) Investment account balance 12/31/15 $727,000



Education.

40. (continued) d. Consolidated Worksheet

TRUMAN COMPANY AND SUBSIDIARY ATLANTA COMPANY Consolidation Worksheet


Truman Atlanta Adjustments & Eliminations NCI Cons.

Revenues (670,000) (400,000) (S)200,000 (870,000)

Operating Expenses 402,000 280,000 (E) 10,000 (S)140,000 552,000

Net income of subsidiary (35,000) (I) 35,000 -0-



Net income attributable to NCI (15,000) 15,000

Net income attributable to Truman (303,000)

Retained earnings, 1/1 (823,000) (500,000) (S) 500,000 (823,000)

Net income (above) (303,000) (120,000) (303,000)

Dividends declared 145,000 80,000 (S) 40,000 12,000

(D) 28,000 145,000

Retained earnings 12/31 (981,000) (540,000) (981,000)

Current assets 481,000 390,000 871,000

Investment in Atlanta 727,000 (D) 28,000 (S)588,000 -0-

(I) 35,000

(A1) 70,000

(A2) 62,000

Land 388,000 200,000 588,000

Buildings 701,000 630,000 1,331,000

Patent (A1)100,000 (E) 10,000 90,000

Goodwill (A2) 70,000 70,000

Total assets 2,297,000 1,220,000 2,950,000

Liabilities (816,000) (360,000) (1,176,000)

Common stock (95,000) (300,000) (S) 300,000 (95,000)

Additional paid-in capital (405,000) (20,000) (S) 20,000 (405,000)

Retained earnings 12/31 (981,000) (540,000) (981,000)

Noncontrolling interest 7/1 (A1) 30,000

(A2) 8,000 (S) 252,000 (290,000)

Noncontrolling interest 12/31 (293,000) (293,000)

Total liab. and equity (2,297,000) (1,220,000) 1,263,000 1,263,000 (2,950,000)



Education.

41. (60 minutes) (Consolidated statements for a step acquisition) a. Fair value of Sysinger 1/1/15 (given) $1,750,000 Book value of Sysinger 1/1/15 (CS + APIC + RE) 1,300,000 Excess fair value over book value 450,000 To customer contract (4 year remaining life) 400,000 To goodwill $50,000

b. Equity in earnings of Sysinger 2015 net income (150,000 × 95%) $142,500 Amortization (100,000 × 95%) (95,000) Equity in earnings of Sysinger $47,500 Revaluation of 15% block to fair value

Consideration transferred $184,500 2014 net income (100,000 × 15%) 15,000 2014 dividends (30,000 × 15%) (4,500) Book value at 1/1/15 195,000 Fair value at 1/1/15 262,500 Gain on revaluation $67,500

Investment account balance

Fair value at 1/1/15 (15% block) $262,500 Consideration transferred 1/1/15 (80% block) 1,400,000 Equity earnings 2015 Net income (95% × 150,000) 142,500 Customer contract amortization (95,000) 47,500 Dividends (40,000 × 95%) (38,000) Investment in Sysinger 12/31/15 $1,672,000



41. (Continued) c. Allan and Sysinger Consolidation Worksheet

For Year Ending December 31, 2015 Allan Sysinger Consolidation Entries Noncontrolling Consolidated Accounts Company Company Debit Credit Interest Totals Revenues (931,000) (380,000) (1,311,000) Operating expenses 615,000 230,000 (E)100,000 945,000 Equity earnings of Sysinger (47,500) -0- (I) 47,500 -0- Gain on revaluation (67,500) -0- (67,500) Separate company net income (431,000) (150,000) Consolidated net income (433,500) NI attributable to noncontrolling interest (2,500) 2,500 NI attributable to Allan Company (431,000)

Retained earnings, 1/1 (965,000) (600,000) (S) 600,000 (965,000) Net income (431,000) (150,000) (431,000) Dividends declared 140,000 40,000 (D) 38,000 2,000 140,000 Retained earnings 12/31 (1,256,000) (710,000) (1,256,000)

Current assets 288,000 540,000 828,000 Investment in Sysinger 1,672,000 -0- (D) 38,000 (S)1,235,000 -0- (I) 47,500 (A) 427,500 Property, plant, and equipment 826,000 590,000 1,416,000 Patented technology 850,000 370,000 1,220,000 Customer contract -0- -0- (A) 400,000 (E) 100,000 300,000 Goodwill -0- (A) 50,000 50,000 Total assets 3,636,000 1,500,000 3,814,000

Liabilities (1,300,000) (90,000) (1,390,000) Common stock (900,000) (500,000) (S) 500,000 (900,000) Additional paid-in capital (180,000) (200,000) (S) 200,000 (180,000) Retained earnings 12/31 (1,256,000) (710,000) (1,256,000) NCI in Sysinger, 1/1 -0- -0- (S) 65,000 (A) 22,500 (87,500) NCI in Sysinger, 12/31 -0- -0- (88,000) (88,000) Total liab. and stockholders' equity (3,636,000) (1,500,000) 1,935,500 1,935,500 (3,814,000)



Education.

42. (60 minutes) (Step acquisition—control previously acquired.)

a. According to the acquisition method, the valuation basis for a subsidiary is established on the date control is obtained, in this case January 1, 2014. Subsequent acquisitions are valued consistent with this initial value after adjusting the investment for subsidiary net income and other changes. Because subsequent acquisitions are considered as transactions in the parent’s own equity, no gains or losses are recorded. Differences in cash paid and the underlying value are recorded as adjustments to APIC. Fair value of Keane Company 1/1/14 ($573,000 ÷ 60%) $955,000 Keane net income 2014 150,000 Excess fair value amortization for copyright (20,000)* Keane dividends 2014 (80,000) Initial fair value adjusted to 1/1/15 $1,005,000 Percent acquired in step acquisition 30% Value assigned to 30% acquisition 301,500 Cash paid for the 30% acquisition 300,000 Credit to APIC from 30% step acquisition $ 1,500 *Fair value of Keane Company 1/1/14 ($573,000 ÷ 60%) $955,000 Book value of Keane Company 1/1/14 (given) 810,000 Excess fair value over book value 145,000 To copyright (6 year remaining life) 120,000 To goodwill $25,000 Entry to record 30% additional investment in Keane: 1/1/15 Investment in Keane 301,500 Cash 300,000 APIC from step acquisition 1,500 b. Investment in Keane Company 1/1/14 $573,000 2014 Equity earnings [60% × (150,000 – 20,000)] 78,000 2014 Dividends from Keane (60% × $80,000) (48,000) Additional acquisition of 30% interest 301,500 2015 Equity earnings [90% × (180,000 – 20,000)] 144,000 2015 Dividends from Keane (90% × $60,000) (54,000) Investment in Keane Company 12/31/15 $994,500



42. (continued) part c. BRETZ, INC. AND KEANE COMPANY Consolidation Worksheet

Year Ending December 31, 2015

Consolidation Entries Noncontrolling Consolidated Accounts Bretz, Inc. Keane Co. Debit Credit Interest Totals Revenues (402,000) (300,000) (702,000) Operating expenses 200,000 120,000 (E) 20,000 340,000 Equity in Keane’s income (144,000) (I) 144,000 Separate company net income (346,000) (180,000) Consolidated net income (362,000) NI attributable to noncontrolling interest (16,000) 16,000 NI attributable to Bretz, Inc. (346,000)

Retained earnings, 1/1 (797,000) (500,000) (S) 500,000 (797,000) Net income (above) (346,000) (180,000) (346,000) Dividends declared 143,000 60,000 (D) 54,000 6,000 143,000 Retained earnings, 12/31 (1,000,000) (620,000) (1,000,000)

Current assets 224,000 190,000 414,000 Investment in Keane Company 994,500 (S) 792,000 0 (D)54,000 (A) 112,500 (I) 144,000 Trademarks 106,000 600,000 706,000 Copyrights 210,000 300,000 (A)100,000 (E) 20,000 590,000 Equipment (net) 380,000 110,000 490,000 Goodwill (A) 25,000 25,000 Total assets 1,914,500 1,200,000 2,225,000

Liabilities (453,000) (200,000) (653,000) Common stock (400,000) (300,000) (S)300,000 (400,000) Additional paid-in capital (60,000) (80,000) (S) 80,000 (60,000) APIC-step acquisition (1,500) (1,500) Retained earnings,12/31 (1,000,000) (620,000) (1,000,000) Non-controlling interest 1/1 (A) 12,500 (S) 88,000 (100,500) Non-controlling interest 12/31 (110,500) (110,500) Total liabilities and equities (1,914,500) (1,200,000) 1,223,000 1,223,000 (2,225,000)

Chapter 05 - Consolidated Financial Statements—Intra-Entity Asset Transactions


ACCOUNTING THEORY RESEARCH CASE: NONCONTROLLING INTEREST In deliberations prior to the issuance of SFAS 160, “Noncontrolling Interests in Consolidated Financial Statements,” the FASB considered three alternatives for displaying the noncontrolling interest in the consolidated balance sheet What were these three alternatives?

1. As a liability 2. As equity 3. In the “mezzanine” area between liabilities and owners’ equity

What criteria did the FASB use to evaluate the desirability of each alternative? The FASB evaluated whether the classifications conformed to current definitions of financial statement elements (assets, liabilities, or equity) as articulated in FASB Concept Statement No. 6. In what specific ways did FASB Concept Statement 6 affect the FASB’s evaluation of these alternatives? From SFAS 160 paragraphs 32-34

If it required that the noncontrolling interest be reported in the mezzanine, the Board would have had to create a new element—noncontrolling interest in subsidiaries—specifically for consolidated financial statements. The Board concluded that no compelling reason exists to create a new element specifically for consolidated financial statements to report the interests in a subsidiary held by owners other than the parent. The Board believes that using the existing elements of financial statements along with appropriate labeling and disclosure provides financial information in the consolidated financial statements that is representationally faithful, understandable, and relevant to the entity’s owners, creditors, and other resource providers. The Board concluded that a noncontrolling interest in a subsidiary does not meet the definition of a liability in the Board’s conceptual framework. Paragraph 35 of Concepts Statement 6 defines liabilities as “probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events” The Board concluded that a noncontrolling interest represents the residual interest in the net assets of a subsidiary within the consolidated group held by owners other than the parent. The noncontrolling interest, therefore, meets the definition of equity in Concepts Statement 6. Paragraph 49 of Concepts Statement 6 defines equity (or net assets) as “the residual interest in the assets of an entity that remains after deducting its liabilities.”



RESEARCH CASE: COCA-COLA’S ACQUISITION OF COCA-COLA ENTERPRISES

1. How did Coca-Cola allocate the acquisition-date fair value of CCE among the assets acquired and liabilities assumed?

Note 2 (Acquisitions and Divestitures) of Coca-Cola’s 2010 10-K shows the following allocation for the CCE acquisition:

Cash and cash equivalents $ 49 Marketable securities 7 Trade accounts receivable 1,194 Inventories 696 Other current assets 744 Property, plant and equipment 5,385 Bottlers' franchise rights with indefinite lives 5,100 Other intangible assets 1,032 Other noncurrent assets 261 Total identifiable assets acquired 14,468

Accounts payable and accrued expenses 1,826 Loans and notes payable 266 Long-term debt 9,345 Pension and other postretirement liabilities 1,313 Other noncurrent liabilities 2,603 Total liabilities assumed 15,353

Net liabilities assumed (885) Goodwill 7,746 Less: Noncontrolling interests 13

Net assets acquired $ 6,848

2. What are employee replacement awards? How did Coca-Cola account for the replacement

award value provided to the former employees of CCE?

Employee replacement award represent various share-based payments to employees that the acquiring firm replaces with new awards based on its shares. The ASC requires that if replacement awards are based on past service, their fair value is included in consideration transferred. If the replacement award are for future service, their value is expensed as incurred. Coca-Cola followed the ASC for its replacement awards (10-K Note 2).

3. How did Coca-Cola account for its 33 percent interest in CCE prior to the acquisition of the 67 percent not already owned by Coca-Cola?

Coca-Cola used the equity method to account for its previous 33 percent investment in CCE (10-K page 53).

4. Upon acquisition of the additional 67 percent interest, how did Coca-Cola account for the change in fair value of its original 33 percent ownership interest?

“We remeasured our equity interest in CCE to fair value upon the close of the transaction. As a result, we recognized a gain of approximately $4,978 million, which was classified in the line item other income (loss) — net in our consolidated statement of income.” (10-K Note 2).



INSTAPOWER: FASB ASC AND IFRS RESEARCH CASE

1. What is the total consideration transferred by Q-Car to acquire its 90 percent controlling interest in InstaPower?

Cash $60,000,000 Shares of Q-Car stock 27,000,000 Contingency 10,000,000 Total consideration transferred $97,000,000

The shares of Q-Car stock and the contingency are both measured at their acquisition-date fair values (ASC 805-30-30-7, ASC 805-30-25-5).

2. What values should Q-Car assign to identifiable assets and liabilities as part of the

acquisition accounting?

Cash $ 270,000 Accounts receivable 800,000 Land 2,930,000 Building 19,000,000 Machinery 46,000,000 Trademark 8,000,000 Research and development asset 14,000,000 Accounts payable (1,000,000) Total identifiable net asset fair value $90,000,000 (ASC 805-20-30-1)

3. What is the acquisition-date value assigned to the 10 percent noncontrolling interest? What

are the noncontrolling interest valuation alternatives available under IFRS?

Under U.S. GAAP, the acquisition-date noncontrolling interest is measured at its fair value. In this case, there are no readily available market values for the noncontrolling shares so Q-Car has relied on other valuation techniques to arrive at an estimated fair value of $11,000,000.

IFRS allows two alternative measures for the noncontrolling interest. The first is identical to the U.S. measure. The second alternative uses the noncontrolling interest percentage of the fair value of the subsidiary’s identifiable net assets. In this case, the second alternative provides a value of $9,000,000 ($90,000,000 x 10%).

4. Under U.S. GAAP, what amount should Q-Car recognize as goodwill from the acquisition? What alternative valuations are available for goodwill under IFRS?

Goodwill under U.S. GAAP (ASC 805-30-30-1) and IFRS alternative 1 (IFRS 3 IN 8):

Consideration transferred (above) $ 97,000,000 Acquisition-date noncontrolling interest fair value 11,000,000 Acquisition-date value assigned to subsidiary $108,000,000 Net assets acquired fair value (above) 90,000,000 Goodwill $ 18,000,000

Goodwill under IFRS alternative 2:

Consideration transferred (above) $ 97,000,000 Acquisition-date NCI value assigned (above) 9,000,000 Acquisition-date value assigned to subsidiary $106,000,000 Net assets acquired fair value (above) 90,000,000 Goodwill $ 16,000,000



CHAPTER 5 CONSOLIDATED FINANCIAL STATEMENTS—

INTRA-ENTITY ASSET TRANSACTIONS

Chapter Outline

I. The transfer of assets between the companies forming a business combination is a common practice. The opportunity for such direct acquisition (especially of inventory) is often the underlying motive for the creation of the combination.

II. Intra-entity inventory transfers

A. The individual accounting systems of the two companies will record the transfer as a sale by one party and as a purchase by the other

B. Because the transaction was not made with an outside, unrelated party, the sales and purchases balances created by the transfer are eliminated in consolidation (Entry Tl)

C. Any transferred inventory retained at the end of the year is recorded at its transfer price which in (many cases) will include an unrealized gross profit

1. For consolidation purposes, this intra-entity gross profit must be deferred by eliminating the amount from the inventory account on the balance sheet and from the ending inventory figure within cost of goods sold (Entry G).

2. Because transfer effects carry over to the subsequent fiscal period, the unrealized gross profit must also be removed a second time: from the beginning inventory component of cost of goods sold and from the beginning retained earnings balance (Entry *G).

a. The retained earnings figure being adjusted is that of the original seller.

b. If the equity method has been applied and the transfer was made downstream (by the parent), the beginning retained earnings account will be correct; therefore, in this one case, the adjustment is to the Investment in Subsidiary account.

3. The consolidation process is designed to shift the profit from the period of transfer into the time period in which the goods are actually sold to unrelated parties or consumed

D. Effect of deferral process on the valuation of a noncontrolling interest

1. Official accounting pronouncements permit but do not require deferral of unrealized profits on the valuation of noncontrolling interest balances

2. This textbook adjusts the noncontrolling interest balances but only if the sale was made upstream from subsidiary to parent. Downstream sales are made by the parent and, thus, are viewed as having no effect on the outside interest.

III. Intra-entity land transfers

A. Any gain created by intra-entity land transfers is unrealized and will remain so until the land is sold to an outside party

B. For each subsequent consolidation, the recorded value of the land account is reduced to original cost. The unrealized gain recorded by the seller must also be removed and deferred until the land is sold to an outsider.

1. In the year of transfer, an actual gain account exists within the accounting records of the seller and must be removed.

2. In all later time periods, since the unrealized gain has become an element of the seller's beginning retained earnings balance, the reduction is made to this equity account.

3. If the land is ever sold to an outside party, the intra-entity gain is realized and has to be recognized within that time period.



IV. Intra-entity transfer of depreciable assets

A. As with other intra-entity transfers, any unrealized gross profit must be deferred for consolidation purposes to establish appropriate historical cost balances.

B. However, the difference between the transfer-based accounting value and the historical cost of the asset will change each year because of the effects of depreciation. The amount of unrealized gain within retained earnings will also be reduced annually since excess depreciation expense is recognized (and closed into retained earnings) based on the inflated transfer price.

C. Consequently, elimination of the unrealized gain (within retained earnings) and the reduction of the asset value to historical cost will differ from year to year.

D. Also within the consolidation process, the recorded depreciation expense must be decreased every period to an amount appropriately based on the asset's original acquisition price.


Earnings Management: By selling goods to special purpose entities that it controlled but did not consolidate, did Enron overstate its earnings? According to the Power’s Report (Report of Investigation by the Special Investigative Committee of the Board of Directors of Enron Corp.—February 1, 2004)

These partnerships—Chewco, LJM1, and LJM2—were used by Enron Management to enter into transactions that it could not, or would not, do with unrelated commercial entities. Many of the most significant transactions apparently were designed to accomplish favorable financial statement results, not to achieve bona fide economic objectives or to transfer risk. (page 4)

Assuming Enron controlled LJM2, the transactions that produced the $67 million gain and the $20.3 million agency fee were not arm’s length and thus did not provide a proper basis for recognizing income. What effect does consolidation have on the financial reporting for transactions with controlled entities?

In consolidation, all intra-entity profit would have been deferred until the goods were sold to an outside party. Also the intra-entity note receivable and payable would have been eliminated in consolidation.

As noted by Bala Dahran in his February 6, Congressional Testimony

Despite their potential for economic and business benefits, the use of SPEs has always raised the question of whether the sponsoring company has some other accounting motivations, such as hiding of debt, hiding of poor-performing assets, or earnings management. Additionally, explosive growth in the use of SPEs led to debates among managers, auditors and accounting standard setters as to whether and when SPEs should be consolidated. This is because the intended accounting effects of SPEs can only be achieved if the SPEs are reported as unconsolidated entities separate from the sponsoring entity.

FASB Activity on Variable Interest Entities (VIEs) Fortunately the FASB’s ASC Topic 810 explains how to identify an SPE (a type of entity that is often a VIE) that is not subject to control through voting ownership interests, but is nonetheless controlled by another enterprise and therefore subject to consolidation. The entity that controls the SPE is then required to include the assets, liabilities, and results of the activities of the SPE in its consolidated financial statements.



What Price Should We Charge Ourselves?

Transfer pricing is actually a topic for a managerial accounting discussion. Students, though, need to be aware that managerial and financial accounting do overlap at times. In this illustration, the price set by company officials for this component will affect the specific consolidation procedures needed in the preparation of financial statements for external reporting purposes.

Since Slagle owns 100 percent of Harrison's common stock, consolidated net income will not be altered by the transfer pricing decision. All intra-entity transactions as well as unrealized profits will be removed entirely. However, because the sales are upstream, if a noncontrolling interest had been present, the portion of the subsidiary's net income attributed to these outside owners would be influenced by the markup. Both the noncontrolling interest figure on the balance sheet and on the income statement are impacted by the amount of profits that remain unrealized when transactions are from subsidiary to parent.

To the accountant, the easiest approach is to set the transfer price at the seller's cost ($70.00 in this case). No intra-entity profits are created and the consolidation process is less complicated. However, as indicated in the narrative, that price may penalize the seller since no profits are recognized by that profit center. In addition, the buyer will then show artificially inflated income. Thus, some amount of profit is usually built into transfer pricing decisions. Those students who have already completed cost/managerial accounting can be asked to describe the various factors that should influence the establishment of this price. Interaction between accounting courses is beneficial to the students.




1. One reason for the significant volume and frequency of intra-entity transfers is that many business combinations are specifically organized so that the companies can provide products for each other. This design is intended to benefit the business combination as a whole because of the economies provided by vertical integration. In effect, more profit can often be generated by the combination if one member is able to buy from another rather than from an outside party.

2. The sales between Barker and Walden totaled $100,000. Regardless of the ownership percentage or the gross profit rate, the $100,000 was simply an intra-entity asset transfer. Thus, within the consolidation process, the entire $100,000 should be eliminated from both the Sales and the Purchases (Inventory) accounts.

3. Sales price per unit ($900,000 ÷ 3,000 units) $ 300 Number of units in Safeco’s ending inventory × 500 Intra-entity inventory at transfer price $150,000 Gross profit rate (0.6 ÷ 1.6) .375 Intra-entity profit in ending inventory $ 56,250

4. In intra-entity transactions, a transfer price is often established that exceeds the cost of the inventory. Hence, the seller is recording a gross profit on its books that, from the perspective of the business combination as a whole, remains unrealized until the asset is consumed or sold to an outside party. Any unrealized gross profit on merchandise still held by the buyer must be deferred whenever consolidated financial statements are prepared. For the year of transfer, this consolidation procedure is carried out by removing the unrealized gross profit from the inventory account on the balance sheet and from the ending inventory balance within cost of goods sold. In the year following the transfer (if the goods are resold or consumed), the realized gross profit must be recognized within the consolidation process. Reductions are made on the worksheet to the beginning inventory component of cost of goods sold and to the beginning retained earnings balance of the original seller. The gross profit is thus taken out of last year’s earnings (retained earnings) and recognized in the current year through the reduction of cost of goods sold. If the transfer was downstream in direction and the parent company has applied the equity method, the adjustment in the subsequent year is made to the Investment in Subsidiary account rather than to retained earnings.

5. On the individual financial records of James, Inc., a gross profit is recorded in the year of transfer. From the viewpoint of the business combination, this gross profit is actually earned in the period in which the products are sold or consumed by Matthews Co. An initial consolidation entry must be made in the year of transfer to defer any gross profit that remains unrealized. A second entry must be made in the following time period to allow the gross profit to be recognized in the year of its ultimate realization.

6. Currently accounting pronouncement allow discretion regarding the effect of unrealized intra-entity profits and noncontrolling interest values. This textbook reasons that unrealized profits relate to the seller and to the computation of the seller's income. Therefore, any unrealized profits created by upstream transfers (from subsidiary to parent) are attributed to the subsidiary. The effects resulting from the deferral and eventual recognition of these intra-entity profits are considered in the calculation of noncontrolling interest balances. In contrast, unrealized profits from downstream transfers are viewed as relating solely to the parent (as the seller) and, thus, have no effect on the noncontrolling interest.

7. Consolidated financial statements are largely unchanged across downstream versus upstream transfers. Sales and purchases (Inventory) balances created by the transactions are eliminated in total. Any unrealized gross profits remaining at the end of a fiscal period get deferred until ultimately earned through sale or consumption of the assets.



The direction of intra-entity transfers (upstream versus downstream) does have one effect on consolidated financial statements. In computing noncontrolling interest balances (if present), the deferral of unrealized gross profits on upstream sales is taken into account. Downstream sales, however, are attributed to the parent and are viewed as having no impact on the outside interest.

8. The computation of this noncontrolling interest balance depends on the direction of the intra-entity transfers which is not indicated in the question. If the unrealized gross profits were created by downstream sales from King to Pawn, they relate only to King. The net income attributable to

the noncontrolling interest is not affected and would be $11,000 ($110,000 × 10%). In contrast, if

the transfers were upstream from Pawn to King, the deferral and recognition of the profits are attributed to Pawn. Pawn's "realized" net income would be $80,000 and the noncontrolling interest's share of consolidated net income is reported as $8,000: Pawn's reported net income .......................................... $110,000 Recognition of prior year unrealized gross profit ........... 30,000 Deferral of current year unrealized gross profit ............. (60,000) Pawn's realized net income ........................................... $ 80,000 Outside ownership percentage ...................................... 10% Net income attributable to noncontrolling interest ........... $ 8,000

9. The deferral and subsequent recognition of intra-entity profits are allocated to the noncontrolling interest in the same periods as the parent. When one affiliate sells to another affiliate, ownership does not change and therefore the underlying profit is deferred. When the purchasing affiliate subsequently sells the inventory to an entity outside the affiliated group, ownership changes, and the profit may be recognized. Intra-entity profits are not really eliminated, but simply deferred until a sale to an outsider takes place.

10. Several differences can be cited that exist between the consolidated process applicable to inventory transfers and that which is appropriate for land transfers. The total intra-entity Sales balance is offset against Purchases (Inventory) when inventory is transferred but no corresponding entry is needed when land is involved. Furthermore, in the year of the sale, ending unrealized inventory gross profits are deferred through an adjustment to cost of goods sold, but a specific gross profit account exists (and must be removed) when land has been sold. Finally, unrealized inventory gross profits are usually expected to be realized in the year following the transfer. This effect is mirrored in that period by reduction of the beginning inventory figure (within cost of goods sold). For land transfers, however, the unrealized gain must be repeatedly deferred in each fiscal period for as long as the land continues to be held within the business combination.

11. As long as the land is held by the parent, its recorded value must be reduced to historical cost within each consolidated set of financial statements. In the year of the original transfer, the asset reduction is offset against the subsidiary's recorded gain. For all subsequent years in which the property is held, the credit to the Land account is made against the beginning retained earnings balance of the subsidiary (since the unrealized gain will have been closed into that account).

According to this question, the land is eventually sold to an outside party. The intra-entity gain (which has been deferred in each of the previous years) is realized by the sale and should be recognized in the consolidated statements of this later period.

Because the transfer was upstream from subsidiary to parent, the above consolidated entries will also affect any noncontrolling interest balances being reported. Because of the deferral of the intra-entity gross profit, the realized net income balances applicable to the subsidiary will be less than the reported values. In the year of resale, however, the realized net income for consolidation purposes is higher than reported. All noncontrolling interest totals are computed on the realized balances rather than the reported figures.



12. Depreciable assets are often transferred between the members of a business combination at amounts in excess of book value. The buyer will then compute depreciation expense based on this inflated transfer price rather than on an historical cost basis. From the perspective of the business combination, depreciation should be calculated solely on historical cost figures. Thus, within the consolidation process for each period, adjustment of the depreciation (that is recorded by the buyer) is necessary to reduce the expense to a cost-based figure.

13. From the viewpoint of the business combination, an unrealized gain has been created by the intra-entity transfer and must be deferred in the preparation of consolidated financial statements. This unrealized gain is closed by the seller into retained earnings necessitating subsequent reductions to that account. In the individual financial records, however, another income effect is created which gradually reduces the overstatement of retained earnings each period. The asset will be depreciated by the buyer based on the inflated transfer price. The resulting expense will be higher than the amount appropriate to the historical cost of the item. Because this excess depreciation is closed into retained earnings annually, the overstatement of the equity account is gradually reduced to a zero balance over the remaining life of the asset.



Answers to Problems 1. D 2. B Merchandise remaining in James’s inventory $250,000 × 40% = $100,000. Unrealized gross profit (based on subsidiary's gross profit rate as the seller)

$100,000 × 30% = $30,000. James’s ownership percentage of Carl has no impact on this computation.

3. A 4. D UNREALIZED GROSS PROFIT, 12/31/14 Intra-entity gross profit ($200,000 – $160,000) ........ ....... $40,000

Inventory remaining at year's end ................................................ 18% Unrealized intra-entity gross profit, 12/31/14 ............................... $ 7,200 UNREALIZED GROSS PROFIT, 12/31/15 Intra-entity gross profit ($350,000 – $297,500) ............................. $52,500 Inventory remaining at year's end ................................................ 30% Unrealized intra-entity gross profit, 12/31/15 ............................... $15,750 CONSOLIDATED COST OF GOODS SOLD

Parent balance .......................................................................... $607,500 Subsidiary balance ................................................................... 450,000 Remove intra-entity transfer .................................................... (350,000)

..................................................................................................... Recognize 2014 deferred gross profit ................................................................. (7,200)

Defer 2015 unrealized gross profit .......................................... 15,750 Cost of goods sold ......................................................................... $716,050 5. A Intra-entity sales and purchases of $100,000 must be eliminated. Additionally, an

unrealized gross profit of $10,000 must be removed from ending inventory based on a gross profit rate of 25 percent ($200,000 gross profit ÷ $800,000 sales) which is multiplied by the $40,000 ending balance. This deferral increases cost of goods sold because ending inventory is a negative component of that computation. Thus, cost of goods sold for consolidation purposes is $690,000 ($600,000 + $180,000 – $100,000 + $10,000).

6. C The only change here from Problem 5 is the gross profit rate which would now be

40 percent ($120,000 gross profit $300,000 sales). Thus, the unrealized gross profit to be deferred is $16,000 ($40,000 × 40%). Consequently, consolidated cost of goods sold is $696,000 ($600,000 + $180,000 – $100,000 + $16,000).



7. B UNREALIZED GROSS PROFIT, 12/31/14 ................................................................................ Ending inventory $40,000

................................................................................ Gross profit rate ($33,000 ÷ $110,000) ............................................................... ....... 30%

Unrealized intra-entity gross profit, 12/31/14 ......................... $12,000 UNREALIZED GROSS PROFIT, 12/31/15

................................................................................ Ending inventory $50,000

................................................................................ Gross profit rate ($48,000 ÷ $120,000) ............................................................... ....... 40%

................................................................................ Unrealized intra-entity gross profit, 12/31/15 ...................................................... ....... $20,000

NET INCOME ATTRIBUTABLE TO NONCONTROLLING INTEREST

................................................................................ Reported net income for 2015 ................................................................................ $90,000

................................................................................ Realized gross profit deferred in 2014 ....................................................................... ......... 12,000

................................................................................ Deferral of 2015 unrealized gross profit ........................................................... ....... (20,000)

................................................................................ Realized net income of subsidiary ............................................................. ....... $82,000

................................................................................ Outside ownership 10%

................................................................................ Noncontrolling interest $ 8,200

8. A Individual records after transfer:

12/31/14 Machinery = $40,000 Gain = $10,000 Depreciation expense $8,000 ($40,000 ÷ 5 years) Net effect on income = $2,000 ($10,000 – $8,000) 12/31/15 Depreciation expense = $8,000 Consolidated figures—historical cost:

12/31/14 Machinery = $30,000 Depreciation expense = $6,000 ($30,000 ÷ 5 years) 12/31/15 Depreciation expense = $6,000 Adjustments for consolidation purposes:



2014: $2,000 income is reduced to a $6,000 expense (net income is reduced by $8,000) 2015: $8,000 expense is reduced to a $6,000 expense (net income is increased by $2,000)



9. D UNREALIZED GAIN Transfer price ............................................................................ $430,400 Book value (original cost less two years depreciation) ........ 368,000 Unrealized gain .......................................................................... $ 62,400

EXCESS DEPRECIATION

Annual depreciation based on cost ($460,000 ÷ 10 years) ..... $46,000 Annual depreciation based on transfer price ($430,400 ÷ 8 years) ............................................................. 53,800 Excess depreciation ................................................................. $ 7,800

ADJUSTMENTS TO CONSOLIDATED NET INCOME

Defer unrealized gain ................................................................ $(62,400) Remove excess depreciation ................................................... 7,800 Net reduction in consolidated net income .............................. $(54,600)

10. D Add the two book values and remove $100,000 intra-entity transfers. 11. C Intra-entity gross profit ($100,000 - $80,000) ............................... $20,000 Inventory remaining at year's end ................................................ 60% Unrealized intra-entity gross profit ............................................... $12,000 CONSOLIDATED COST OF GOODS SOLD

Parent balance .......................................................................... $140,000 Subsidiary balance ................................................................... 80,000 Remove intra-entity transfer .................................................... (100,000) Defer unrealized gross profit (above) ..................................... 12,000

Cost of goods sold ......................................................................... $132,000 12. C Consideration transferred ............................ $260,000 Noncontrolling interest fair value .................. 65,000 Suarez total fair value ..................................... $325,000 Book value of net assets ................................ (250,000) Excess fair over book value $ 75,000 Remaining Annual Excess Excess fair value to undervalued assets: Life Amortizations Equipment .................................................. $25,000 5 years $5,000 Secret Formulas ........................................ 50,000 20 years 2,500 Total ............................................................... -0- $7,500

Consolidated expenses = $37,500 (add the two book values and include current year amortization expense)



13. A 20% of the beginning book value $50,000 Excess fair value allocation (20%× $75,000) 15,000 20% share of Suarez net income adjusted for amortization (20% × [110,000 – 7,500]) 20,500 Ending noncontrolling interest balance $85,500 14. C Add the two book values plus the $25,000 original allocation less one year of

excess amortization expense ($5,000). 15. B Add the two book values less the ending unrealized gross profit of $12,000.

Combined pre-consolidation inventory balances ........................ $260,000 Intra-entity gross profit ($100,000 – $80,000) ................... $20,000 Inventory remaining at year's end ........................... 60%

Unrealized intra-entity gross profit, 12/31 .................................... 12,000 Consolidated total for inventory .................................................... $248,000 16. (15 Minutes) (Determine selected consolidated balances; includes inventory transfers and an outside ownership.) Customer list amortization = $78,000 ÷ 4 years = $19,500 per year Intra-entity gross profit ($180,000 – $130,000) ............................. $50,000 Inventory remaining at year end .................................................... 10% Unrealized intra-entity gross profit, 12/31 ............... ....... $ 5,000

CONSOLIDATED TOTALS

Inventory = $795,000 (add the two book values and subtract the ending unrealized gross profit of $5,000)

Sales = $1,620,000 (add the two book values and subtract the $180,000 intra-entity transfer)

Cost of goods sold = $725,000 (add the two book values and subtract the intra-entity transfer and add [to defer] ending unrealized gross profit)

Operating expenses = $549,500 (add the two book values and the amortization expense for the period)

Barone’s net income ........................................................... $100,000 Intra-entity gross profit deferral ........................................ (5,000) Excess fair value amortization........................................... (19,500) Adjusted subsidiary net income ........................................ $75,500 Noncontrolling interest percentage .................................. 10% Net income attributable to noncontrolling interest ....... $ 7,550

Gross profit deferral is allocated to the noncontrolling interest because the transfer was upstream from Barone to Allister.



17. (60 minutes) (Downstream intra-entity profit adjustments when parent uses equity method and a noncontrolling interest is present)

Consideration transferred by Corgan $980,000 Noncontrolling interest fair value 245,000 Smashing’s acquisition-date fair value 1,225,000 Book value of subsidiary 950,000 Excess fair over book value 275,000

Excess assigned to covenants 275,000

Remaining useful life in years ÷ 20 Annual amortization $13,750 2014 Ending Inventory Profit Deferral

Cost = $100,000 ÷ 1.6 = $62,500 Intra-entity gross profit = $100,000 – $62,500 = $37,500 Ending inventory gross profit = $37,500 × 40% = $15,000

2015 Ending Inventory Profit Deferral

Cost = $120,000 ÷ 1.6 = $75,000 Intra-entity gross profit = $120,000 – $75,000 = $45,000

Ending inventory gross profit = $45,000 40% = $18,000

a. Investment account:

Consideration transferred, January 1, 2014 $980,000

Smashing’s 2014 net income × 80% $120,000 Covenant amortization (13,750 × 80%) (11,000) Ending inventory profit deferral (100%) (15,000) Equity in Smashing’s earnings 94,000

2014 dividends (28,000) Investment balance 12/31/14 $1,046,000

Smashing’s 2015 net income × 80% $104,000 Covenants amortization (13,750 × 80%) (11,000) Beginning inventory profit recognition 15,000 Ending inventory profit deferral (100%) (18,000) Equity in Smashing’s earnings 90,000 2015 dividends (36,000) Investment balance 12/31/15 $1,100,000



17. (continued) b. 12/31/15 Worksheet Adjustments

*G Investment in Smashing 15,000 Cost of goods sold 15,000 S Common stock—Smashing 700,000

Retained earnings—Smashing 365,000

Investment in Smashing 852,000 Noncontrolling interest 213,000 A Covenants 261,250

Investment in Smashing 209,000

Noncontrolling interest 52,250

I Equity in earnings of Smashing 90,000 Investment in Smashing 90,000 D Investment in Smashing 36,000 Dividends declared 36,000 E Amortization expense 13,750 Covenants 13,750 TI Sales 120,000 Cost of goods sold 120,000 G Cost of goods sold 18,000 Inventory 18,000



18. (40 Minutes) (Series of independent questions concerning various aspects of the consolidation process when intra-entity transfers have occurred)

a. Placid Lake's 2015 net income before effect from Scenic ...... $300,000 Scenic's reported net income 2015 ......................................... 110,000 Amortization expense (given) ................................................. (5,000) Realization of 2014 intra-entity gross profit (see below) ...... 7,200 Deferral of 2015 intra-entity gross profit (see below) ............ (16,200) Consolidated net income .......................................................... $396,000

2014 Unrealized gross profit to be recognized in 2015:

Intra-entity gross profit on transfers ($90,000 – $54,000) ...... $36,000 ................................................................................ Inventory retained at end of 2014 ................................................................................ .. 20%

Unrealized gross profit—12/31/14 ...................................... $ 7,200

2015 Unrealized gross profit deferred:

Intra-entity gross profit on transfers ($120,000 – $66,000) .... $54,000 ................................................................................ Inventory retained at end of 2015 ................................................................................ ... 30%

Unrealized gross profit—12/31/15 ....................................... $16,200 b. Noncontrolling interest's share of consolidated net income (upstream sales): Scenic's reported net income 2015 .......................................... $110,000

Amortization of excess fair value to intangibles ..................... (5,000) 2014 gross profit realized in 2015 (upstream sales) .............. 7,200 2015 gross profit deferred (upstream sales) .......................... (16,200) Scenic's realized net income ................................................... $96,000

................................................................................ Noncontrolling interest ownership ............................................................. 20%

Noncontrolling interest share of consolidated net income .... $19,200 Placid Lake’s net income from own operations ...................... $300,000 Placid Lake’s share of Scenic’s adjusted NI (80%× $96,000) ... 76,800 Placid Lake’s share of consolidated net income ................... $376,800

c. Noncontrolling interest's share of consolidated net income (downstream sales): Downstream transfers do not affect the noncontrolling interest.

Scenic's reported net income 2015 after amortization ........... $105,000 ................................................................................ Noncontrolling interest ownership ............................................................. 20%

Noncontrolling interest share of consolidated net income ... $21,000 Placid Lake’s net income from own operations ...................... $300,000 Placid Lake’s share of Scenic’s adjusted NI (80% × $105,000) 84,000



Realization of 2014 intra-entity gross profit (see part a.) ..... 7,200 Deferral of 2015 intra-entity gross profit (see part a.) ............ (16,200) Placid Lake’s share of consolidated net income ................... $375,000



18. (continued) d. Inventory—Placid Lake book value ......................................... $140,000 Inventory—Scenic book value ................................................. 90,000 Unrealized gross profit, 12/31/15 (see part a) ......................... (16,200) Consolidated inventory ............................................................ $213,800 (Direction of transfer has no impact here)

e. Land—Placid Lake’s book value ............................................. $600,000 Land—Scenic's book value ...................................................... 200,000 Elimination of unrealized intra-entity gain on land ................ (20,000) Consolidated land balance ...................................................... $780,000

f. The intra-entity transfer was upstream from Scenic to Placid Lake. Because the

transfer occurred in 2014, beginning retained earnings of the seller for 2015 contains the remaining portion of the unrealized gain.

Transfer pricing figures:

2014 Equipment = $80,000 Gain = $20,000 ($80,000 – $60,000) Depreciation expense = $16,000 ($80,000 ÷ 5) Income effect = $4,000 ($20,000 – $16,000) Accumulated depreciation = $16,000

2015 Depreciation expense = $16,000 Accumulated depreciation = $32,000

Historical cost figures:

2014 Equipment = $100,000 Depreciation expense = $12,000 ($60,000 ÷ 5 years) Accumulated depreciation = $52,000 ($40,000 + $12,000)

2015 Depreciation expense = $12,000 Accumulated depreciation = $64,000

CONSOLIDATION ENTRIES FOR TRANSFERRED EQUIPMENT ENTRY *TA Retained earnings, 1/1/15 (Scenic) .......................... 16,000 Equipment ($100,000 – $80,000) .............................. 20,000 Accumulated depreciation ($52,000 – $16,000) .. 36,000

To change beginning of year figures to historical cost by removing impact of 2014 transactions. Retained earnings reduction removes $4,000 income effect (above) and replaces it with $12,000 depreciation expense for 2014.



18. (continued) ENTRY ED Accumulated depreciation ....................................... 4,000 Depreciation expense .......................................... 4,000 To reduce depreciation from transfer price ($16,000) to historical cost of $12,000.

This intra-entity transfer was upstream from Scenic to Placid Lake. Thus, income effects are assumed to relate to the original seller (Scenic). Because the sale occurred in 2014, the only effect in 2015 relates to depreciation expense. The expense based on the transfer price is $4,000 higher than the amount based on the historical cost. As an upstream transfer, this adjustment affects Scenic and the noncontrolling interest computations.

Transfer price depreciation: $80,000 ÷ 5 yrs. = $16,000 Historical cost depreciation (based on book value): $60,000 ÷ 5 yrs. = $12,000

Net income attributable to noncontrolling interest Scenic's reported net income less excess amortization ........ $105,000 Reduction of depreciation expense to historical cost figure .. 4,000 Scenic's realized net income ..................................................... $109,000 Outside ownership percentage ................................................. 20% Net income attributable to noncontrolling interest ............ $ 21,800



19. (20 Minutes) (Consolidation entries and noncontrolling interest balances affected by inventory transfers.)

a. Conversion from Markup on Cost to Gross Profit Rate

Markup (given as a percentage of cost) .................................. 25%

Convert to gross profit rate [.25 (1.00 + 0.25)] ...................... 20% Noncontrolling Interest's Share of Consolidated Net Income

Reported net income of subsidiary—2015 ................................................................................. $160,000

2014 intra-entity gross profit realized in 2015

($250,000 × 30% × 20%) ........................................................ 15,000 2015 intra-entity gross profit deferred ($300,000 × 30% × 20%) ........................................................ (18,000) Realized net income of subsidiary—2015 ......................... $157,000 Outside ownership .................................................................... 40%

Noncontrolling interest's share of consolidated net income ............................... $ 62,800

b. Entry *G Retained earnings, Jan. 1 (subsidiary) ......... 15,000 .................................... Cost of goods sold 15,000

To remove intra-entity gross profit from previous year so that it can be recognized in current year.

Entry Tl Sales ................................................................. 300,000 .................................... Cost of goods sold 300,000

To eliminate intra-entity inventory sale and purchase. Entry G Cost of goods sold ......................................... 18,000

...................................................................................... Inventory 18,000

To remove effects of current year unrealized gross profit.



20. (30 Minutes) (Compute selected balances based on three different intra-entity asset transfer scenarios)

a. Consolidated Cost of Goods Sold Protrade’s cost of goods sold ................................................. $410,000 Seacraft’s cost of goods sold .................................................. 317,000 Elimination of 2015 intra-entity transfers ............................... (134,000) Realized gross profit deferred in 2014 (2015 beginning inventory) $52,000 transfer price ÷ 1.6 = $32,500 cost $52,000 – $32,500 = $19,500 unrealized gross profit ...... (19,500) Deferral of 2015 unrealized gross profit in ending inventory: $66,000 transfer price ÷ 1.6 = $41,250 cost $66,000 – $41,250 = $24,750 unrealized gross profit ...... 24,750 Consolidated cost of goods sold ............................................ $598,250 Consolidated Inventory Protrade book value ............................................................ $370,000 Seacraft book value ............................................................. 144,000 Defer ending unrealized gross profit (see above) ............ (24,750) Consolidated Inventory ....................................................... $489,250 Net income attributable to noncontrolling interest:

Because all intra-entity sales were downstream, the deferrals do not affect Seacraft. Thus, the noncontrolling interest share is 20% of the $154,000 reported net income (revenues minus cost of goods sold and expenses) or $30,800.

b. Consolidated Cost of Goods Sold

Protrade book value ................................................................. $410,000 Seacraft book value .................................................................. 317,000 Elimination of 2015 intra-entity transfers ............................... (104,000) Realized gross profit deferred in 2014 (2015 beginning inventory) $45,000 transfer price ÷ 1.6 = $28,125 cost $45,000 – $28,125 = $16,875 unrealized gross profit ........ (16,875) Deferral of 2015 unrealized gross profit in ending inventory: $59,000 transfer price ÷ 1.6 = $36,875 cost $59,000 – $36,875 = $22,125 unrealized gross profit ........ 22,125 Consolidated cost of goods sold ............................................ $628,250



20. b. (continued)

Consolidated inventory

Protrade book value ............................................ ..... $370,000

Seacraft book value .................................................................. 144,000 Defer ending unrealized gross profit (see above) .................. (22,125) Consolidated inventory ............................................................ $491,875

Net income attributable to noncontrolling interest

Since all intra-entity sales are upstream, the effect on Seacraft's net income must be reflected in the noncontrolling interest computation:

Seacraft reported net income .................................................. $154,000 2014 unrealized gross profit realized in 2015 (above) ........... 16,875 2015 unrealized gross profit deferred until 2016 (above) ...... (22,125) Seacraft realized net income ................................................... $148,750 Outside ownership percentage ................................................ 20% Net income attributable to noncontrolling interest ................. $ 29,750

c. Consolidated buildings (net):

Protrade’s buildings ..................................................................................... $382,000

Seacraft's buildings ............................................... 181,000 Remove write-up created by transfer ($128,000 – $74,000) ......................................... $(54,000) Remove excess depreciation created by transfer ($54,000 unrealized gain ÷ 5-year remaining life × 2 years) .................................. 21,600 (32,400) Consolidated buildings (net) ................................ $530,600

Consolidated expenses:

Protrade’s book value ........................................... $174,000 Seacraft's book value ............................................ 129,000 Remove excess depreciation on transferred building ($54,000 unrealized gain ÷ 5 year remaining life) (10,800) Consolidated expenses ......................................... $292,200

Net income attributable to noncontrolling interest:

Because the transfer was made downstream, it has no effect on the noncontrolling interest. Thus, Seacraft's reported net income ($154,000 computed as revenues minus cost of goods sold and expenses) is used for this computation. The 20 percent outside ownership will be allotted consolidated net income of $30,800 (20% × $154,000).



21. (15 Minutes) (Prepare consolidated income statement with a wholly-owned subsidiary, includes transfers)

a. In this business combination, the direction of the intra-entity transfers (either

upstream or downstream) is not important to the consolidated totals. Because Akron controls all of Toledo's outstanding stock, no noncontrolling interest figures are computed. If present, noncontrolling interest balances are affected by upstream sales but not by downstream.

For purposes of a 2015 consolidation, the following worksheet entries would

affect income statement balances:

Entry *G Retained earnings, 1/1/15 (seller) ....... 17,500 Cost of goods sold ......................... 17,500

To remove 2014 unrealized gross profit from beginning account balances. Gross profit is the 25% gross profit rate ($80,000 ÷ $320,000) multiplied by remaining inventory ($70,000).

Entry E Amortization expense .......................... 15,000 Patented technology ...................... 15,000 To recognize excess amortization expense for the current period.

Entry Tl Sales ...................................................... 320,000 Cost of goods sold ......................... 320,000 To eliminate intra-entity transfers of inventory during 2015.

Entry G Cost of goods sold .............................. 12,500 Inventory ......................................... 12,500

To remove 2015 unrealized gross profit from ending account balances. Gross profit is the 25% gross profit rate ($80,000 ÷ $320,000) multiplied by remaining inventory ($50,000).

b. By including the impact of each of these four consolidation entries, the

following income statement can be created from the individual account balances:

AKRON, INC. AND CONSOLIDATED SUBSIDIARY

Income Statement Year Ending December 31, 2015

Sales ..................................................................................... $1,380,000 Cost of goods sold .............................................................. 575,000 Gross profit ..................................................................... 805,000 Operating expenses ............................................................ 635,000 Consolidated net income ............................................... $170,000



22. (60 minutes) (Downstream intra-entity asset transfer when parent uses equity method and when a noncontrolling interest is present)

a. Investment account: Consideration paid (fair value) 1/1/14 $810,000 Netspeed’s reported net income for 2014 $80,000 Database amortization (12,000) Netspeed’s adjusted net income $68,000 Quickport's ownership percentage 90% Quickport's share of Netspeed’s net income $61,200 Gain on equipment transfer deferral (3,000) Depreciation adjustment (6 months) 500 Equity in earnings of Netspeed Company, $58,700 Quickport’s share of Netspeed’s dividends (90%) (7,200) Balance 12/31/14 $861,500 Netspeed’s reported net income for 2015 $115,000

Database amortization (12,000) Netspeed’s adjusted 2015 net income $103,000 Quickport's ownership percentage 90% Quickport's share of Netspeed net income $ 92,700 Depreciation adjustment 1,000

Equity in earnings of Netspeed Company, 2015 $93,700 Quickport’s share of Netspeed’s dividends, 2015 (90%) (7,200) Balance 12/31/15 $948,000

b. 12/31/15 Worksheet Adjustments

*TA Equipment 6,000 Investment in Netspeed .......... 2,500

Accumulated depreciation .......... 8,500

To transfer the unrealized intra-entity equipment reduction (as of Jan. 1, 2015) from the Investment account to the equipment and A.D. accounts.

S Common stock—Netspeed 800,000 Retained earnings—Netspeed 112,000 Investment in Netspeed 820,800 Noncontrolling interest 91,200

A Database 48,000 Investment in Netspeed 43,200 Noncontrolling interest 4,800

I Equity in earnings of Netspeed 93,700 Investment in Netspeed 93,700

D Investment in Netspeed 7,200 Dividends declared 7,200



22. (continued)

E Amortization expense 12,000 Database 12,000

ED Accumulated depreciation 1,000 Depreciation expense 1,000

23. (20 Minutes) (Consolidation entries for intra-entity equipment transfer.)

INDIVIDUAL RECORDS BASED ON TRANSFER PRICE

12/31/13 Equipment = $95,000 Gain on transfer = $45,000 ($95,000 – $50,000) Depreciation expense = $19,000 ($95,000 ÷ 5 years) Accumulated depreciation = $19,000

12/31/14 Depreciation expense $19,000 Accumulated depreciation = $38,000 (2 years)

12/31/15 Effect on retained earnings, 1/1/15 = $7,000 credit balance (gain less two years depreciation)

Depreciation expense = $19,000 Accumulated depreciation = $57,000 (3 years)

CONSOLIDATED REPORTING BASED ON HISTORICAL COST

12/31/13 Equipment = $130,000 Depreciation expense = $10,000 ($50,000 ÷ 5 years) Accumulated depreciation = $90,000 ($80,000 + $10,000)

12/31/14 Depreciation expense = $10,000 Accumulated depreciation = $100,000 ($90,000 + $10,000)

12/31/15 Effect on retained earnings, 1/1/15 = ($20,000) (two years depreciation) Depreciation expense = $10,000 Accumulated depreciation = $110,000 ($100,000 + $10,000)

Entry *TA ............................................................................. Retained earnings, 1/1/15 (Padre) ................................................................................ 27,000

Equipment ($130,000 – $95,000) .................................... 35,000 Accumulated depreciation ($100,000 – $38,000) 62,000

To adjust to beginning-of-year balances for consolidated entity. Retained earnings adjustment reduces $7,000 credit balance to $20,000 debit balance as computed above.



Entry ED .............................................................................. Accumulated depreciation 9,000

................................................................ Depreciation expense 9,000

To remove excess depreciation for current year to reflect an allocation of the historical cost ($10,000) rather than the transfer price ($19,000).

24. (20 Minutes) (Determine consolidated net income when an intra-entity transfer of

equipment occurs. Includes an outside ownership)

a. Net income—Ackerman ............................................................ $300,000 Net income—Brannigan ............................................................ 98,000 Excess amortization for unpatented technology .................... (4,000) Remove unrealized gain on equipment .................................. (90,000) ($200,000 – $110,000) Remove excess depreciation created by

inflated transfer price ($90,000 ÷ 5) .................................... 18,000 Consolidated net income ......................................................... $322,000 b. Net income calculated in (part a.) ............................................ $322,000 Net income attributable to noncontrolling interest: Net income—Brannigan ......................................... $98,000 Excess amortization .............................................. (4,000) Adjusted net income .............................................. $94,000 NI attributable to the noncontrolling interest ...................... 10% (9,400) Consolidated net income to parent company ......................... $312,600 c. Net income calculated in (part a.) ............................................ $322,000 NI attributable to noncontrolling interest (see Schedule 1) ... (2,200) Consolidated net income to parent company ......................... $319,800 Schedule 1: Net income attributable to noncontrolling interest (includes

upstream transfer) Reported subsidiary net income .............................................. $98,000 Excess amortization .................................................................. (4,000) Defer unrealized gain on equipment transfer ......................... (90,000) Eliminate excess depreciation ($90,000 ÷ 5) ........................... 18,000 Brannigan's realized net income ............................................. $22,000

Outside ownership ............................................................................................................... 10%

Net income attributable to noncontrolling interest ............................................... $ 2,200

d. Net income 2016—Ackerman ................................................... 320,000 Net income 2016—Brannigan .................................................. 108,000 Excess amortization .................................................................. (4,000) Eliminate excess depreciation stemming from transfer



($90,000 ÷ 5) (year after transfer) ....................................... 18,000 Consolidated net income ................................................ $442,000



25. (35 minutes) (Compute consolidated totals with transfers of both inventory and a building.)

Excess Amortization Expenses Equipment $60,000 ÷ 10 years = $ 6,000 per year Franchises $80,000 ÷ 20 years = 4,000 per year Annual excess amortizations $10,000 Unrealized Gross Profit—Inventory, 1/1/15: Gross profit ($70,000 – $49,000) .............................................. $21,000 Gross profit rate ($21,000 ÷ $70,000) ....................................... 30%

Remaining inventory ............................................................................................................ $30,000

Gross profit rate ................................................................................................................... 30%

Unrealized gross profit, 1/1/15 .................................................. $ 9,000 Unrealized Gross Profit—Inventory, 12/31/15: Gross profit ($100,000 – $50,000) ............................................ $50,000

Gross profit rate ($50,000 ÷ $100,000) ............................................................................... 50%

Remaining inventory ................................................................ $40,000

Gross profit rate .................................................................................................................... 50%

Unrealized gross profit, 12/31/15 ............................................. $20,000 Impact of Intra-Entity Building Transfer:

12/31/14—Transfer price figures Transfer price ....................................................................... $50,000 Gain on transfer ($50,000 – $30,000) .................................. 20,000 Depreciation expense ($50,000 ÷ 5 years) ......................... 10,000 Accumulated depreciation .................................................. 10,000 12/31/15—Transfer price figures Depreciation expense ......................................................... 10,000 Accumulated depreciation .................................................. 20,000 12/31/14—Historical cost figures Historical cost ...................................................................... $70,000 Depreciation expense ($30,000 book value ÷ 5 years) ..... 6,000 Accumulated depreciation ($40,000 + $6,000) .................. 46,000 12/31/15—Historical cost figures Depreciation expense ......................................................... 6,000 Accumulated depreciation .................................................. 52,000



25. (continued) CONSOLIDATED BALANCES

Sales = $1,000,000 (add the two book values and subtract $100,000 in intra-entity transfers)

Cost of Goods Sold = $571,000 (add the two book values and subtract $100,000 in intra-entity purchases. Subtract $9,000 because of the previous year unrealized gross profit and add $20,000 to defer the current year unrealized gross profit.)

Operating Expenses = $206,000 (add the two book values and include the $10,000 excess amortization expenses but remove the $4,000 in excess depreciation expense [$10,000 – $6,000] created by building transfer)

Investment Income = $0 (the intra-entity balance is removed so that the individual revenue and expense accounts of the subsidiary can be shown)

Inventory = $280,000 (add the two book values and subtract the $20,000 ending unrealized gross profit)

Equipment (net) = $292,000 (add the two book values and include the $60,000 allocation from the acquisition-date fair value less three years of excess amortizations)

Buildings (net) = $528,000 (add the two book values and subtract the $20,000 unrealized gain on the transfer after two years of excess depreciation [$4,000 per year])



26. (35 Minutes) (Prepare consolidation entries for a business combination with intra-entity inventory and equipment transfers; includes an outside ownership.)

a. Entry *G Retained earnings, 1/1/15 (Sledge) ............... 2,000 .................................... Cost of goods sold 2,000

To remove unrealized gross profit from beginning account balances. This is the 40% gross profit rate ($6,000 ÷ $15,000) multiplied by remaining inventory ($5,000).

Entry *TA Equipment ........................................................ 4,000 Investment in Sledge ...................................... 2,400 ........................ Accumulated depreciation 6,400

To adjust the equipment balance to original cost ($16,000) and to adjust accumulated depreciation to the correct consolidated January 1, 2015 balance ($7,000 less $600 extra depreciation in 2014). The net reduction to the reported equipment balance (cost less A.D. = $2,400) equals the amount of unrealized gain at January 1, 2015. The $2,400 debit to the Investment account appropriately transfers the reduction in the net book value of the transferred equipment to the subsidiary’s accounts. The Investment account was reduced by $3,000 in 2014 for the original intra-entity gain and increased by $600 in 2014 for the extra depreciation ($3,000 gain ÷ 5 years) through application of the equity method. Entry ED (below) completes the adjustment of A.D. and depreciation expense to their correct December 31, 2015 balances.

Entry S ................................................................................ Common stock (Sledge) 120,000

Retained earnings, 1/1/15 (adjusted) (Sledge) ........ 258,000 ..................................................................... Investment in Sledge (80%) 302,400

..................................................................... Noncontrolling interest in Sledge, 1/1/15 (20%) .............................................................. 75,600

To eliminate subsidiary's stockholders' equity accounts (after adjustment for Entry *G) and recognize noncontrolling interest balance as of January 1, 2015.

Entry A Contracts ($60,000 – $3,000 for 2 years) ................ 54,000 Buildings ($20,000 – $2,000 for 2 years) ................. 16,000



..................................................................... Investment in Sledge (80%) 56,000

..................................................................... Noncontrolling interest in Sledge, 1/1/15 (20%) .............................................................. 14,000

To recognize acquisition-date fair value allocations adjusted for 2 years of amortization (2013 and 2014).



26. (continued) Entry I Equity in income of Sledge ...................................... 10,600 ..................................................................... Investment in Sledge 10,600

To remove parent’s recognized intra-entity income using equity method.

Subsidiary reported net income .................................................................... $20,000 Realized upstream intra-entity gross profit in beginning inventory ...... 2,000 Deferred upstream intra-entity gross profit in ending inventory ............ (4,500) Excess amortization .................................................................................... (5,000) 2015 realized subsidiary net income ............................................................. $12,500 Parent’s ownership percentage ..................................................................... 80% Parent’s share of subsidiary realized net income ....................................... $10,000 Depreciation adjustment from 2014 downstream fixed asset sale ......... 600 Parent’s recorded 2015 equity income from subsidiary ............................. $10,600

Entry E ................................................................................ Depreciation expense 2,000

Amortization expense ............................................... 3,000 ..................................................................... Contracts ($60,000 ÷ 20 years) 3,000

Buildings ($20,000 ÷ 10 years) ........................... 2,000 To recognize 2015 excess amortizations. Entry TI Sales ........................................................................... 20,000 ..................................................................... Cost of goods sold 20,000

To eliminate intra-entity inventory transfers during 2015. Entry G Cost of goods sold ................................................... 4,500 ..................................................................... Inventory 4,500

To remove unrealized gross profit from ending account balances. The gross profit is the 45% gross profit rate ($9,000 ÷ $20,000) multiplied by remaining inventory ($10,000).

Entry ED ................................................................................ Accumulated depreciation 600

..................................................................... Depreciation expense 600

To eliminate excess depreciation on equipment recorded at transfer price. Expense is being reduced from the recorded amount ($2,400 or $12,000 ÷ 5) to historical cost figure ($1,800 or $9,000 ÷ 5).



26. (continued) b. Net income attributable to noncontrolling interest (2015)

Revenues .................................................................................... $130,000 Cost of goods sold ................................................................... (70,000) Other expenses ......................................................................... (40,000) Excess acquisition-date fair value amortization ..................... (5,000) Net income adjusted for amortization ............................... $15,000 Gross profit on 2014 upstream inventory transfer realized in 2015 (Entry *G) ................................................. 2,000 Gross profit on 2015 upstream inventory transfer deferred until 2016 (Entry G) .............................................. (4,500) Realized net income of subsidiary—2015 ................................ $12,500 Outside ownership .................................................................... 20% Net income attributable to noncontrolling interest .......... $ 2,500

27. (65 Minutes) (Determine consolidation totals after answering a series of questions

about combination and intra-entity inventory transfers)

a. Consideration transferred ....................... $342,000 Noncontrolling interest fair value ............. 38,000 Subsidiary fair value at acquisition-date 380,000 Book value .................................................. (326,000) Fair value in excess of book value .......... $54,000 Remaining Annual Excess Excess fair value assignments Life Amortizations To building ........................................... 18,000 9 yrs. $2,000 To patented technology ...................... 36,000 6 yrs. 6,000 Totals ..................................................... -0- $8,000 b. Because Brey sold inventory to Pitino, the transfers are upstream.

c. Gross profit on 2014 transfers ($135,000 – $81,000) .............. $54,000 Gross profit percentage ($54,000 ÷ $135,000) ........................ 40% Inventory remaining, 12/31/14 ................................................. $37,500 Gross profit percentage ........................................................... 40% Unrealized gross profit, January 1, 2015 ............................... $15,000 d. Gross profit on 2015 transfers ($160,000 – $92,800) ............. $67,200 Gross profit percentage ($67,200 ÷ $160,000) ........................ 42% Inventory remaining, 12/31/15 ................................................. $50,000 Gross profit percentage ........................................................... 42% Unrealized gross profit, December 31, 2015 ........................... $21,000



27. (continued) e. Pitino is applying the equity method because the $68,400 equals neither 90% of

Brey's reported net income nor 90% of the dividends declared by Brey. Brey’s reported net income ..................................................... $90,000 Excess fair value amortization.................................................. (8,000) Realized gross profit ............................................................... 15,000 Deferred gross profit ................................................................. (21,000) Adjusted subsidiary net income ............................................... $76,000 Ownership ................................................................................. 90% Equity in earnings of Brey ....................................................... $68,400 f. Brey’s adjusted net income (see e.) ........................................ $76,000 Outside ownership .................................................................... 10% Net income attributable to noncontrolling interest ................ $ 7,600

g. Investment in Brey (consideration transferred) ..................... $342,000 Net income of Brey Reported 2013 ....................................... $64,000 2014 ................................................. 80,000 2015 ................................................ 90,000 Total ................................................ 234,000 Unrealized gross profit, 12/31/15(see d.) (21,000) Realized net income 2013-2015 ......... 213,000 Pitino’s ownership ............................... 90% 191,700 Excess amortizations ($8,000 × 3 years × 90%) (21,600) Dividends declared by Brey 2013 ................................................. $19,000 2014 ................................................. 23,000 2015 ................................................ 27,000 Total ................................................ 69,000 Pitino's ownership ............................... 90% (62,100) Investment in Brey, 12/31/15 ................... $450,000 h. Entry S Common stock (Brey) ............................... 150,000 Retained earnings, 1/1/15 (Brey) (reduced by 1/1/15 unrealized gross profit) ................. 263,000 Investment in Brey (90%) .................... 371,700 Noncontrolling interest in Brey (10%) 41,300



27. (continued) part i.

Sales Revenues = $1,068,000 (total less $160,000 intra-entity sales)

Cost of Goods Sold = $570,000 (add book values less $160,000 in intra-entity purchases. Also, adjust for 2014 unrealized gross profit [subtract $15,000] and 2015 unrealized gross profit [add $21,000])

Expenses = $260,400 (add book values with $8,000 amortization for excess fair value allocations)

Equity in Earnings of Brey = $0 (intra-entity balance is eliminated to include individual revenue and expense accounts of the subsidiary)

Consolidated Net Income = $237,600 (consolidated revenues less COGS and expenses)

Net Income Attributable to Noncontrolling Interest = $7,600 (see f.)

Net Income to Pitino (parent) = $230,000 (consolidated revenues less consolidated cost of goods sold, expenses, and the noncontrolling interest's share of the subsidiary's net income)

Retained Earnings, 1/1 = $488,000 (parent equity method balance)

Dividends Declared = $136,000 (parent balance only)

Retained Earnings, 12/31 = $582,000 (consolidated beginning balance plus net income less dividends declared)

Cash and Receivables = $228,000 (total less $16,000 intra-entity balance)

Inventory = $370,000 (total less ending unrealized gross profit)

Investment in Brey = $0 (intra-entity balance is eliminated so that the individual assets and liabilities of the subsidiary can be reported)

Land, Buildings, and Equipment = $1,304,000 (add book values and include a $12,000 net allocation after 3 years of amortization)

Patented Technology = $18,000 (original allocation after 3 years of amortization [$6,000 per year])

Total Assets = $1,920,000 (add consolidated figures)

Liabilities = $773,000 (add book values less $16,000 intra-entity balance)

Noncontrolling Interest in Brey, 12/31 = $50,000 ([10% of subsidiary's book value at beginning of period plus unamortized excess less beginning unrealized gross profit] plus 10% of the subsidiary's realized net income less 10% of subsidiary dividends).


Retained Earnings, 12/31 = $582,000 (see above)

Total Liabilities and Stockholders' Equity = $1,920,000 (summation)



28. (20 Minutes) (Computation of selected consolidation balances as affected by downstream inventory transfers)

UNREALIZED GROSS PROFIT, 12/31/14: (downstream transfer) Intra-entity gross profit ($120,000 – $72,000) ......................... $48,000 Inventory remaining at year's end ...................... .... 30%

Unrealized intra-entity gross profit, 12/31/14 ............................... $14,400 UNREALIZED GROSS PROFIT, 12/31/15: (downstream transfer) Intra-entity gross profit ($250,000 – $200,000) ....................... $50,000 Inventory remaining at year's end ...................... .... 20%

Unrealized intra-entity gross profit, 12/31/15 ............................... $10,000 CONSOLIDATED TOTALS

Sales = $1,150,000 (combine amounts and eliminate intra-entity sales of $250,000)

Cost of goods sold: Brannigan's book value ............................................................ $535,000 Zeigler's book value .................................................................. 400,000 Eliminate intra-entity transfers ................................................ (250,000) Realized gross profit deferred in 2014 .................................... (14,400) Deferral of 2015 unrealized gross profit ................................. 10,000 Cost of goods sold .............................................................. $680,600

Operating expenses = $210,000 (add the two book values and include intangible amortization for current year)

Dividend income = -0- (intra-entity transfer eliminated in consolidation)

Net income attributable to noncontrolling interest: (impact of transfers is not included because they were downstream)

Zeigler reported net income for 2015 .................................................................... $(100,000)

Intangible amortization .......................................................................................... 10,000

Zeigler adjusted net income .................................................................................... (90,000)

Outside ownership ................................................................................................. 30%

................................................ Net income attributable to noncontrolling interest $(27,000)

Inventory = $980,000 (combine amounts less the $10,000 ending unrealized gross profit)

Noncontrolling interest in subsidiary 30% beginning $950,000 book value ...................................... $(285,000) Excess January 1 intangible allocation (30% × $395,000) ... (118,500)

Net income attributable to noncontrolling interest .................................................... (27,000)

Dividends (30% × $50,000) .......................................................................................... 15,000

Total noncontrolling interest at 12/31/15 ............................... $(415,500)



29. (25 Minutes) (Computation of selected consolidation balances as affected by upstream inventory transfers)

UNREALIZED GROSS PROFIT, 12/31/14: (upstream transfer) Intra-entity gross profit ($120,000 – $72,000) ......................... $48,000 Inventory remaining at year's end ........................................... 30% Unrealized intra-entity gross profit, 12/31/14 ............................... $14,400 UNREALIZED GROSS PROFIT, 12/31/15: (upstream transfer) Intra-entity gross profit ($250,000 – $200,000) ....................... $50,000 Inventory remaining at year's end ........................................... 20% Unrealized intra-entity gross profit, 12/31/15 ............................... $10,000 CONSOLIDATED TOTALS

Sales = $1,150,000 (combine amounts and eliminate intra-entity transfer) Cost of goods sold:

Brannigan's COGS book value ................................................ $535,000 Zeigler's COGS book value ...................................................... 400,000 Eliminate intra-entity transfers ................................................ (250,000) Realized gross profit deferred in 2014 .................................... (14,400) Deferral of 2015 unrealized gross profit ................................. 10,000 Consolidated cost of goods sold ....................................... $680,600

Operating expenses = $210,000 (combine amounts and include intangible amortization for current year)

Dividend income = -0- (intra-entity transfer eliminated in consolidation) Net income attributable to noncontrolling interest: (impact of transfers is

included because they were upstream)

Zeigler reported net income for 2015 .................................................................................. $100,000

Intangible amortization .......................................................................................... (10,000)

2014 gross profit recognized in 2015 ................................. 14,400 2015 gross profit deferred .................................................. (10,000) Zeigler realized net income for 2015 ................................... $94,400

Outside ownership ........................................................................................................ 30%

Net income attributable to noncontrolling interest ................ $28,320 Inventory = $980,000 (combine amounts and defer the $10,000 ending

unrealized gross profit) Noncontrolling interest in subsidiary, 12/31/15

30% beginning book value less $14,400 unrealized gross profit (30% × $935,600) ........................ $(280,680) Excess intangible allocation (30% × $395,000) .................. (118,500)

Net income attributable to noncontrolling interest ........... (28,320)

Dividends (30% × $50,000) ...................................................................................... 15,000

Total noncontrolling interest at 12/31/15 ............................ $(412,500)



30. (75 Minutes) (Determine consolidated balances after impact of upstream Inventory transfers and downstream transfer of building. Parent uses initial value method.)

PRELIMINARY COMPUTATIONS a. Consideration transferred ....................... $657,000 Noncontrolling interest fair value ............. 73,000 Subsidiary fair value at acquisition-date 730,000 Book value .................................................. (620,000) Fair value in excess of book value .......... $110,000 Remaining Annual Excess Excess fair value assignments Life Amortizations to equipment ......................................... 20,000 4 yrs. $5,000 to liabilities ........................................... 40,000 5 yrs. 8,000 to brand names .................................... 50,000 10 yrs. 5,000 Totals ..................................................... -0- $18,000

Determination of subsidiary book value on 1/1/14

Book value, 1/1/15 (based on stockholders' equity accounts) $700,000 Eliminate net income – 2014 .................................................... (80,000) Eliminate dividends – 2014 ...................................................... -0- Book value, 1/1/14 ............................................................... $620,000 Beginning inventory unrealized gross profit, 12/31/14 (Upstream) Ending Inventory ($145,000 × 30%) ......................................... $43,500 Gross profit rate (given) ...................................... ....... 20%

Unrealized intra-entity gross profit, 12/31/14 ......................... $ 8,700 Ending inventory unrealized gross profit, 12/31/15 (Upstream) Ending Inventory ($160,000 × 40%) ......................................... $64,000 Gross profit rate (given) ...................................... ....... 20%

Unrealized intra-entity gross profit, 12/31/15 ......................... $12,800 Building unrealized gross profit, 1/2/14 (Downstream) Transfer price ............................................................................ $25,000 Book value ................................................................................. 10,000 Unrealized gross profit ............................................................. $15,000 Annual excess depreciation Annual depreciation based on book value ($10,000 ÷ 5 years) $2,000 Annual depreciation based on transfer price ($25,000 ÷ 5 years) ............................................................... 5,000 Excess annual depreciation ..................................................... $3,000



30. (continued)

Adjustment to buildings to return to historical cost at 1/1/15 Consolidation Transfer Price Historical Cost Adjustment

Buildings $25,000 $100,000 $75,000

Accumulated depreciation (1/1/15 balance after 1 more year of depreciation) 5,000 92,000 87,000 Consolidated Totals

Sales and other Income = $1,240,000 (add the two book values and eliminate the intra-entity transfers)

Cost of goods sold: Moore's book value ................................................................... $500,000 Kirby's book value .................................................................... 400,000 Eliminate intra-entity transfers ................................................ (160,000) Realized gross profit deferred in 2014 ..................................... (8,700) Deferral of 2015 unrealized gross profit ................................. 12,800 Cost of goods sold ................................................................... $744,100

Operating and interest expenses = $275,000 (add the two book values and include $18,000 amortization for current year but eliminate $3,000 excess depreciation from asset transfer)

Net income attributable to noncontrolling interest = $1,790 (impact of inventory transfers is included because they were upstream but building transfer is omitted because it was downstream)

Reported net income for 2015 ....................................................... $40,000 Realized gross profit deferred in 2014 .................................... 8,700 Deferral of 2015 unrealized gross profit ................................. (12,800) Realized net income of subsidiary .......................................... $35,900 Excess fair value amortization.................................................. (18,000) Adjusted subsidiary net income ............................................... 17,900 Outside ownership ......................................................................... 10% Net income attributable to noncontrolling interest ................. $ 1,790

Consolidated net income = $220,900 (consolidated sales less consolidated cost of goods sold, expenses, and noncontrolling interest)

To noncontrolling interest = $1,790 (above) To controlling interest = $219,110



30. (continued)

Retained earnings, 1/1/15 = $1,025,970 (because the parent uses the initial value method, worksheet entries adjust its retained earnings for changes in subsidiary's book value, excess amortizations, and the impact of unrealized gross profits in previous years)

Moore's reported balance, 1/1/15 ................................. $990,000 Impact of building transfer (parent's income was overstated by the $15,000 gain but has been reduced by one prior year of excess depreciation) .................... (12,000) Adjustments to convert initial value to equity method: Increase in subsidiary's book value during prior years .................................................................... $80,000 Excess fair value amortization ................................. (18,000) Deferral of 12/31/14 unrealized gross profit (subsidiary's prior income was overstated) ...... (8,700) Realized increase in book value ......................... 53,300 Ownership ................................................................... 90%

Equity accrual ............................................................ 47,970 Retained Earnings, 1/1/15 ................................... $1,025,970

Dividends declared = $130,000 (parent balance only)

Retained Earnings, 12/31/15 = $1,115,080 (the beginning balance plus controlling interest share of consolidated net income less dividends declared)

Cash and Receivables = $397,000 (add the two book values)

Inventory = $371,200 (add the two book values and defer the $12,800 ending unrealized gross profit)

Investment in Kirby = -0- (eliminated for consolidation purposes)

Equipment (Net) = $1,030,000 (add the two book values adjusted for excess allocation and amortization)

Buildings = $1,725,000 (add the two book values and add the $75,000 impact to return to historical cost as computed above for transfer)

Accumulated Depreciation = $384,000 (add the two book values plus adjustment to historical cost ($87,000 at beginning of year less $3,000 excess depreciation for current year)

Other Assets = $300,000 (add the two book values)

Brand Names = $40,000 (the original $50,000 allocation less two years of amortization at $5,000 per year)

Total Assets = $3,479,200 (summation of the consolidated totals)

Liabilities = $1,684,000 (add the two book values and subtract the original allocation [$40,000] after two years of amortization [$8,000 per year])



30. (continued)

Noncontrolling interest 12/31/15 = $80,120 (10 percent of $691,300 adjusted beginning book value [$700,000 less $8,700 deferral of unrealized gross profit] plus $9,200 share of beginning unamortized excess fair value allocations plus $1,790 net income share)


Retained Earnings, 12/31/15 = $1,115,080 (computed above)

Total Liabilities and Equities = $3,479,200 (summation of consolidated balances). The same consolidation balances can be derived using a worksheet and the following

adjusting and eliminating entries:

CONSOLIDATION ENTRIES Entry *G Retained earnings, 1/1/15 (Kirby) ....................... 8,700 Cost of goods sold ......................................... 8,700 (To recognize 2014 deferred gross profit as income in 2015) Entry *TA Building ................................................................. 75,000 Retained earnings, 1/1/15 (Moore) ...................... 12,000 Accumulated depreciation ............................. 87,000 (To adjust 1/1/15 balance to historical cost figures) Entry *C Investment in Kirby .............................................. 47,970 Retained earnings, 1/1/15 (Moore) ................ 47,970 (To convert from initial value to equity method as follows:) Increase in subsidiary's book value during prior years (income of $80,000) ........................................................... $80,000 Excess amortization for 2014 ................................................. (18,000) Deferral of 12/31/14 unrealized gross profit .......................... (8,700) Realized increase in subsidiary's book value ....................... $53,300 Ownership ............................................................................... 90% Conversion to equity method (full accrual) adjustment ...... $47,970

S Common stock (Kirby) ........................................ 150,000 Retained earnings, 1/1/15 as adjusted (Kirby) .... 541,300 Investment in Kirby (90%) .............................. 622,170 Noncontrolling interest in Kirby (10%) ......... 69,130 (To eliminate subsidiary's beginning stockholders' equity accounts and

recognize beginning noncontrolling interest balance)



30. (continued)

A Liabilities .............................................................. 32,000

Equipment ............................................................ 15,000

Brand names ........................................................ 45,000 Investment in Kirby ........................................ 82,800

Noncontrolling interest in Kirby (10%) ......... 9,200 (To recognize unamortized balance of excess allocations as of 1/1/15. Figures have been reduced by one year of amortization) Entry I (the subsidiary declared no dividends so no adjustment needed) E Operating and interest expense .......................... 18,000 Liabilities ......................................................... 8,000 Equipment ........................................................ 5,000 Brand names ................................................... 5,000 (To recognize excess amortization expenses for current year) Tl Sales ..................................................................... 160,000 Cost of goods sold ......................................... 160,000 (To eliminate intra-entity transfers for 2015) G Cost of goods sold .............................................. 12,800 Inventory ......................................................... 12,800 (To defer ending unrealized inventory gross profit)

ED Accumulated depreciation .................................. 3,000 Depreciation expense .................................... 3,000 (To adjust depreciation for current year created by transfer of building)



30. continued: Worksheet (not part of requirements)

Moore Company and Subsidiary Consolidated Worksheet

December 31, 2015

Moore Kirby NCI Consolidated

Sales and other income (800,000) (600,000) (TI) 160,000 (1,240,000)

Cost of goods sold 500,000 400,000 (G) 12,800 (G*) 8,700 744,100

(TI)160,000

Op. and interest expenses 100,000 160,000 (E) 18,000 (ED) 3,000 275,000

Separate company income (200,000) (40,000)


to noncontrolling interest (1,790) 1,790

to Moore Company (219,110)

Retained earnings, 1/1 (990,000) (TA*) 12,000 (*C) 47,970 (1,025,970)

(550,000) (S) 541,300

(G*) 8,700

Net income (200,000) (40,000) (219,110)

Dividends declared 130,000 0 130,000


Cash and receivables 217,000 180,000 397,000

Inventory 224,000 160,000 (G) 12,800 371,200

Investment in Kirby 657,000 0 (*C) 47,970 (S) 622,170 0

(A) 82,800

Equipment (net) 600,000 420,000 (A) 15,000 (E) 5,000 1,030,000

Buildings 1,000,000 650,000 (TA*) 75,000 1,725,000

Acc. depreciation—buildings (100,000) (200,000) (ED) 3,000 (TA*) 87,000 (384,000)

Brand names 0 0 (A) 45,000 (E) 5,000 40,000

Other assets 200,000 100,000 300,000

Total assets 2,798,000 1,310,000 3,479,200

Liabilities (1,138,000) (570,000) (A) 32,000 (E) 8,000 (1,684,000)

Common stock (600,000) (150,000) (S)150,000 (600,000)

Noncontrolling interest , 1/1 (S) 69,130

(A) 9,200 (78,330)

Noncontrolling interest,12/31 (80,120) (80,120)





31. (55 Minutes) (Investment account balance and consolidated worksheet with downstream inventory transfers when parent uses equity method) Acquisition-date fair value allocation and excess amortizations

a. Consideration transferred .......................... $372,000 Noncontrolling interest fair value ................ 248,000 Subsidiary fair value at acquisition-date ... $620,000 Acquisition-date book value ........................ (320,000) Fair value in excess of book value ............. $300,000 Remaining Annual Excess Excess fair value assignments ............... Life Amortizations to patents ................................................. 70,000 10 yrs. $7,000 to customer list ....................................... 45,000 15 yrs. 3,000 to goodwill ............................................... $185,000 indefinite -0- $10,000

Determination of Investment in Stinson account balance

Consideration transferred ................................................... $372,000 Increase in Stinson’s retained earnings 1/1/14 to 1/1/15 [(280,000 – 220,000) × 60%] .......................................... $36,000 Excess fair value amortization × 60% ............................ (6,000) 2014 ending inventory profit deferral (100%) ................ (10,000) 20,000

McIlroy’s equity in earnings of Stinson for 2015* ........ 28,000 Stinson 2015 dividends declared to McIlroy ................. (9,000) Investment account balance 12/31/15 ................................. $411,000

* Stinson’s 2015 net income ............................................. $60,000 Excess fair value amortization ....................................... (10,000) Adjusted net income ....................................................... $50,000 McIlroy’s percentage ownership .................................... 60% McIlroy’s share of Stinson’s adjusted net income ....... $30,000 2014 intra-entity inventory profit recognized ................ 10,000 2015 intra-entity inventory profit deferred .................... (12,000) McIlroy’s equity in earnings of Stinson ......................... $28,000 Intra-entity profits (downstream) 2014 2015 Intra-entity transfers remaining in inventory $50,000 $40,000 Gross profit rate** 20% 30% $10,000 $12,000

**(150,000 – 120,000) ÷ 150,000 = 20%

(160,000 – 112,000) ÷ 160,000 = 30%



31. (continued) b. McIlroy Stinson Adj. & Elim. NCI Consolidated

Sales (700,000) (335,000) (TI)160,000 (875,000) Cost of goods sold 460,000 205,000 (G) 12,000 (*G) 10,000 507,000 (TI) 160,000

Operating expenses 188,000 70,000 (E) 10,000 268,000 Equity in earnings of Stinson (28,000) (I) 28,000 -0- Separate company net income (80,000) (60,000) Consolidated net income (100,000) to noncontrolling interest (20,000) 20,000 to McIlroy, Inc. (80,000)

Retained earnings, 1/1 (695,000) (280,000) (S) 280,000 (695,000) Net income (above) (80,000) (60,000) (80,000) Dividends declared 45,000 15,000 (D) 9,000 6,000 45,000 Retained earnings, 12/31 (730,000) (325,000) (730,000)

Cash and receivables 248,000 148,000 396,000 Inventory 233,000 129,000 (G) 12,000 350,000 Investment in Stinson 411,000 -0- (D) 9,000 (S) 228,000 -0- (*G) 10,000 (A)174,000 (I) 28,000

Buildings (net) 308,000 202,000 510,000 Equipment (net) 220,000 86,000 306,000 Patents (net) -0- 20,000 (A) 63,000 (E) 7,000 76,000 Customer list (A) 42,000 (E) 3,000 39,000 Goodwill (A)185,000 185,000 Total assets 1,420,000 585,000 1,862,000 Liabilities (390,000) (160,000) (550,000) Common stock (300,000) (100,000) (S) 100,000 (300,000) Noncontrolling interest 1/1 (S) 152,000 (A)116,000 (268,000)

Noncontrolling interest 12/31 (282,000) (282,000) Retained earnings, 12/31 (730,000) (325,000) (730,000) Total liabilities and equities (1,420,000) (585,000) 899,000 899,000 (1,862,000)



32. Investment balance and worksheet preparation—upstream sales, equity method a. 2015 net income reported by Sander $230,000 Excess patent fair value amortization ($350,000 ÷ 5 years) (70,000) Deferred gross profit for 12/31/15 intra-entity inventory (160,000 × 25%) (40,000) Recognized gross profit for 1/1/15 intra-entity inventory (125,000 × 28%) 35,000 Sander’s net income adjusted $155,000 To controlling interest (80%) $124,000 To noncontrolling interest (20%) $31,000

Adjustments

b. Plymouth Sander & Eliminations NCI Consolidated

Revenues (1,740,000) (950,000) (TI) 300,000 (2,390,000)

Cost of goods sold 820,000 500,000 (G) 40,000 (TI)300,000 1,025,000

(*G) 35,000

Depreciation expense 104,000 85,000 189,000

Amortization expense 220,000 120,000 (E) 70,000 410,000


Equity in earnings of Sander (124,000) (I) 124,000 0


Consolidated net income (731,000) to noncontrolling interest (31,000) 31,000

to Plymouth Corp. (700,000)

Retained earnings 1/1 (2,800,000) (345,000) (S) 310,000 (2,800,000)

(*G) 35,000

Net income (700,000) (230,000) (700,000)

Dividends declared 200,000 25,000 (D) 20,000 5,000 200,000

Retained earnings 12/31 (3,300,000) (550,000) (3,300,000)

Cash 535,000 115,000 650,000


Inventory 990,000 800,000 (G) 40,000 1,750,000

Investment in Sander 1,420,000 (D) 20,000 (S)968,000

(A)348,000 0

(I) 124,000

Buildings and equipment 1,025,000 863,000 1,888,000

Patents 950,000 107,000 (A) 210,000 (E) 70,000 1,197,000

Goodwill (A) 225,000 225,000

Total Assets 5,495,000 2,100,000 6,500,000


Notes payable (545,000) (450,000) (995,000)

Noncontrolling interest 1/1 (S)242,000

(A) 87,000 (329,000)

Noncontrolling interest 12/31 (355,000) (355,000)

Common stock (900,000) (800,000) (S) 800,000 (900,000)

APIC (300,000) (100,000) (S) 100,000 (300,000)

Retained earnings 12/31 (3,300,000) (550,000) (3,300,000)

Total liab. and SE (5,495,000) (2,100,000) 2,234,000 2,234,000 (6,500,000)



33. (50 Minutes) (Prepare consolidation entries for a combination where upstream inventory transfers have occurred as well as downstream equipment transfers. Parent has applied initial value method) Consideration transferred ............................... $665,000 Noncontrolling interest fair value ..................... 285,000 Subsidiary fair value at acquisition-date ......... $950,000 Book value .......................................................... (800,000) Fair value in excess of book value .................. $150,000 Remaining Annual Excess Excess fair value assignments .................... Life Amortizations to building ..................................................... 50,000 5 yrs. $10,000 to franchise agreements ............................. 100,000 10 yrs. 10,000

-0- $20,000 Inventory Transfers (Upstream) 2014 gross profit deferred until 2015 ($12,000 × 30%) . ......... $3,600 2015 gross profit deferred until 2016 ($18,000 × 30%) ................. $5,400 Equipment Transfer (Downstream) Unrealized gain as of January 1, 2015: Unrealized gain on transfer (1/1/14) ........................................ $36,000 2014 excess depreciation ($36,000 ÷ 6 yrs.) ........................... (6,000) Unrealized gain January 1, 2015 .................................................... $30,000 Excess depreciation—2015 ($36,000 ÷ 6 yrs.) .............. ......... $6,000

Entry *G Retained earnings, 1/1/15 (Young) ..................... 3,600 Cost of goods sold ......................................... 3,600

To recognize upstream intra-entity inventory gross profit deferred from previous year.

Entry *TA Retained earnings, 1/1/15 (Monica) ................... 30,000 Equipment ($50,000 – $36,000) ........................... 14,000 Accumulated depreciation ($50,000 – $6,000) 44,000

To return equipment accounts to beginning book value based on historical cost and to remove unrealized gain from beginning retained earnings.



33. (continued) Entry *C Investment in Young ...................................... 123,480 Retained earnings, 1/1/15 (Monica) ......... 123,480

Because the parent uses the initial value method, its retained earnings must be adjusted for the subsidiary's increase in book value less excess amortizations and upstream profits during 2013–2014 as follows.

Retained earnings of Young, December 31, 2015 (given) $740,000 Eliminate income and dividends of Young ($160,000 – $50,000) ............................................ (110,000) Retained earnings of Young, December 31, 2014 .. 630,000 Removal of unrealized gross profit (Entry *G) ....... (3,600) Realized retained earnings of Young, December 31, 2014 ............................................... 626,400 Retained earnings at date of acquisition ................ (410,000) Increase in retained earnings during 2013–2014 .... 216,400 Ownership percentage ............................................. 70% Income accrual to be recognized ............................ 151,480 Excess amortization for 2013–2014 ($20,000 × 70%× 2 yrs.) (28,000) ENTRY *C ADJUSTMENT (above) ........................... $123,480

Entry S Common stock (Young) ...................................... 300,000 Additional paid-in capital (Young) ...................... 90,000 Retained earnings, 1/1/15 (Young) (adjusted for *G) ............................... 626,400 Investment in Young (70%) ...................... 711,480 Noncontrolling interest in Young (30%) .. 304,920 To eliminate stockholders' equity accounts of subsidiary and recognize

noncontrolling interest; amount of retained earnings was previously reduced to realized balance by Entry *G. The $626,400 figure is computed above.

Entry A Franchise agreement ............................................ 80,000 Buildings .............................................................. 30,000 Investment in Young ...................................... 77,000 Noncontrolling interest in Young (30%) ....... 33,000 To recognize amount paid within acquisition price for buildings and the

franchise agreement. Balances have been reduced by two years of excess amortizations.



33. (continued)

Entry I Dividend income .................................................. 35,000 Dividends declared ......................................... 35,000 To eliminate Intra-entity dividend declarations recorded by parent as income

under the initial value method.

Entry E Depreciation expense ........................................... 10,000 Amortization expense .......................................... 10,000 Franchise agreement ..................................... 10,000 Buildings .......................................................... 10,000 To recognize current year excess amortization expense.

Entry Tl Sales ..................................................................... 90,000 Cost of goods sold ......................................... 90,000 To remove intra-entity inventory transfers made during the current year.

Entry G Cost of goods sold .............................................. 5,400 Inventory .......................................................... 5,400 To defer unrealized gross profit on 2015 intra-entity inventory transfers

(computed above).

Entry ED Accumulated depreciation .................................. 6,000 Depreciation expense .................................... 6,000 To remove current year depreciation on transferred item since its historical

cost has been fully depreciated.

Noncontrolling Interest's Share of Consolidated Net Income Reported net income of Young (given) ............................. $160,000 Excess fair value amortization ........................................... (20,000) Recognition of 2014 unrealized gross profit (Entry *G) ... 3,600 Deferral of 2015 unrealized gross profit (Entry G) (upstream) (5,400) Realized net income of Young ........................................... $138,200 Outside ownership percentage .......................................... 30% Net income attributable to noncontrolling interest .......... $ 41,460



34. (35 Minutes) (Consolidation entries with upstream Inventory transfers and downstream equipment transfers. Parent uses equity method)

Entry *G (Same as Entry *G in Problem 33.)

Entry *TA Investment in Young ............................................ 30,000 Equipment ............................................................ 14,000 Accumulated depreciation ............................. 44,000 To return equipment account to its book value based on historical cost.

Because the parent uses the equity method and the transfer is downstream, the unrealized gain has already been removed from the parent's retained earnings. Thus, the remaining gain is eliminated here from the Investment account rather than from retained earnings.

Entry *C (No Entry *C is needed because equity method has been applied.)

Entry S (Same as Entry S in Problem 33.)

Entry A (Same as Entry A in Problem 33.)

Entry I Investment income .............................................. 102,740 Investment in Young ...................................... 102,740 To eliminate intra-entity income accrual.

Reported net income of Young (given) ...................................... $160,000

Excess fair value amortization .................................................... (20,000) Recognition of 2014 unrealized gross profit (Entry *G) ............ 3,600 Deferral of 2015 unrealized gross profit (Entry G) (upstream) . (5,400) Realized net income of Young .................................................... $138,200 Outside ownership percentage ................................................... 70% Monica’s share of Young’s realized net income ........................ $ 96,740 Depreciation adjustment for asset transfer gain ........................ 6,000 Equity accrual for 2015 ........................................................... $102,740

Entry D Investment in Young ............................................ 35,000 Dividends declared ......................................... 35,000 To eliminate intra-entity dividend transfers.

Entry E (Same as Entry E in Problem 33.)

Entry TI (Same as Entry Tl in Problem 33.)

Entry G (Same as Entry G in Problem 33.)

Entry ED (Same as Entry ED in Problem 33.)

Net income attributable to noncontrolling interest (Same as in Problem 33.)



35. (60 Minutes) (Consolidation worksheet for combination with upstream inventory transfers and downstream transfer of land. Also asks about transfer of a building. Parent uses partial equity method.)

Consideration transferred ............................... $570,000 Noncontrolling interest fair value ..................... 380,000 Subsidiary fair value at acquisition-date ......... $950,000 Book value .......................................................... (850,000) Fair value in excess of book value .................. $100,000 Remaining Annual Excess Excess fair value assignment ..................... Life Amortization to customer list ............................................. 100,000 20 yrs. $5,000

-0- a. CONSOLIDATION ENTRIES Entry *TL ..................... Retained earnings, 1/1/15 (Gibson) 40,000

............................................................ Land 40,000

To remove unrealized gain on Intra-entity downstream transfer of land made in 2014.

Entry *G Retained earnings, 1/1/15 (Keller) ................. 10,000 Cost of goods sold .................................... 10,000 To defer unrealized upstream Inventory gross profit from 2014 until 2015

computed as the 2014 ending inventory balance of $30,000 (20% × $150,000) multiplied by 33-1/3% gross profit rate ($50,000 ÷ $150,000).

Entry *C Retained earnings, 1/1/15 (Gibson) ............... 9,000 Investment in Keller .................................. 9,000

Parent is applying the partial equity method as can be seen by the amount in the Equity in earnings of Keller Company account (60 percent of the reported balance). Thus, the parent’s share of amortization of $3,000 ($100,000 divided by 20 years × 60%) must be recognized for the previous year 2014. In addition, the equity accrual recorded by the parent has been based on Keller's reported net income. As shown in Entry *G, $10,000 of that reported net income has not actually been realized as of January 1, 2015. Thus, the previous accrual must be reduced by $6,000 to mirror the parent's 60% ownership. The total of the two adjustments being made here is $9,000.



35. (continued)

Entry S Common stock (Keller) .................................. 320,000 Additional paid-in capital ............................... 90,000 Retained earnings, 1/1/15 (Keller) (adjusted for Entry *G) ............................................... 610,000 Investment in Keller (60%) .................. 612,000 Noncontrolling interest in Keller, 1/1/15 (40%) 408,000 To remove stockholders' equity accounts of Keller and recognize beginning

noncontrolling interest. Retained earnings balance has been adjusted in Entry *G.

Entry A Customer list .................................................... 95,000 Investment in Keller .................................. 57,000 Noncontrolling interest in Keller, 1/1/15 (40%) 38,000 To recognize amount paid within acquisition price for the customer list.

Original balance is adjusted for previous year’s amortization.

Entry I Equity in earnings of Keller ........................... 84,000 Investment in Keller .................................. 84,000 To eliminate intra-entity income accrual.

Entry D Investment in Keller ....................................... 36,000 Dividends declared ................................... 36,000 To eliminate intra-entity (60%) dividend transfers.

Entry E Amortization expense ..................................... 5,000 Customer list ............................................. 5,000 To recognize current period excess amortization expense.

Entry P Liabilities .......................................................... 40,000 Accounts receivable ................................. 40,000 To eliminate intra-entity debt.

Entry Tl Sales ................................................................. 200,000 Cost of goods sold .................................... 200,000 To eliminate current year intra-entity inventory transfer.



35. (continued) Entry G Cost of goods sold ......................................... 12,000 Inventory ..................................................... 12,000 To defer 2015 unrealized inventory gross profit. Unrealized gain is the

ending inventory of $40,000 (20% of $200,000) multiplied by 30% gross profit rate ($60,000 ÷ $200,000).

Net income attributable to noncontrolling interest Keller reported net income ....................................................... $140,000

Excess fair value amortization .................................................. (5,000) 2014 Intra-entity gross profit realized in 2015 (inventory) ....... 10,000 2015 Intra-entity gross profit deferred (inventory) .................. (12,000) Keller realized net income 2015 ................................................. $133,000 Outside ownership percentage ................................................. 40% Net income attributable to noncontrolling interest ........... $ 53,200



35. a. (continued) GIBSON AND KELLER Consolidation Worksheet


Consolidation Entries Noncontrolling Consolidated Accounts Gibson Keller Debit Credit Interest Totals Sales (800,000) (500,000) (TI) 200,000 (1,100,000) Cost of goods sold 500,000 300,000 (G) 12,000 (*G) 10,000 602,000 (TI) 200,000 Operating expenses 100,000 60,000 (E) 5,000 165,000 Equity in earnings of Keller (84,000) -0- (I) 84,000 -0- Separate company net net income (284,000) (140,000) Consolidated net income (333,000) To noncontrolling interest (53,200) 53,200

To Gibson Company (279,800) RE, 1/1—Gibson (1,116,000) (*TL) 40,000 (1,067,000) (*C) 9,000 RE, 1/1—Keller (620,000) (*G) 10,000 (S) 610,000 Net income (above) (284,000) (140,000) (279,800) Dividends declared 115,000 60,000 (D) 36,000 24,000 115,000 Retained earnings, 12/31 (1,285,000) (700,000) (1,231,800) Cash 177,000 90,000 267,000 Accounts receivable 356,000 410,000 (P) 40,000 726,000 Inventory 440,000 320,000 (G) 12,000 748,000 Investment in Keller 726,000 (D) 36,000 (*C) 9,000 -0- (S) 612,000 (I) 84,000 (A) 57,000 Land 180,000 390,000 (*TL) 40,000 530,000 Buildings and equipment (net) 496,000 300,000 796,000 Customer list -0- -0- (A) 95,000 (E) 5,000 90,000 Total assets 2,375,000 1,510,000 3,157,000 Liabilities (480,000) (400,000) (P) 40,000 (840,000) Common stock (610,000) (320,000) (S) 320,000 (610,000) Additional paid-in capital (90,000) (S) 90,000 Retained earnings, 12/31 (1,285,000) (700,000) (1,231,800) NCI in Keller, 1/1 (S) 408,000 (408,000) (A) 38,000 (38,000) NCI In Keller, 12/31 (475,200) (475,200) Total liabilities and equity (2,375,000) (1,510,000) 1,551,000 1,551,000 (3,157,000)



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35. (continued)

b. If the intra-entity transfer had been a building rather than land, two adjustments to the consolidation entries would be needed. Entry *TL would be changed and relabeled as Entry *TA and an Entry ED would be added to eliminate the overstatement of depreciation expense for 2015. All other consolidation entries would be the same as shown in Part a. As a downstream transfer, entries *C and S are not affected.

Entry *TA Retained earnings, 1/1/15 (Gibson) .............. 36,000 Buildings ........................................................ 40,000 Accumulated depreciation ....................... 76,000 To defer unrealized gain ($40,000 original amount less one year of

excess depreciation at $4,000 per year) as of beginning of year. Entry also returns Buildings account to historical cost (from $100,000 to $140,000) and Accumulated Depreciation account to historical cost (original $80,000 less one year of excess depreciation at $4,000). Because the Buildings account is shown at net value in the information given in this problem, the above entry would probably be made as follows:

Entry *TA (Alternative) Retained earnings, 1/1/15 (Gibson) .............. 36,000 Buildings (net) .......................................... 36,000 Entry ED Accumulated depreciation ............................ 4,000 Operating (or depreciation) expense ...... 4,000 To remove excess depreciation for current year created by transfer

price. Excess depreciation for each year would be $4,000 based on allocating the $60,000 historical cost book value over 10 years ($6,000 per year) rather than the $100,000 transfer price ($10,000 per year).



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36. (40 Minutes) (Prepare consolidation worksheet with intra-entity transfer of inventory and land. No outside ownership exists)

a. Skyline reported net income ..................................................... $(88,000) Patented technology amortization ............................................ 15,000 Beginning inventory gross profit recognized .......................... (14,400) Ending inventory gross profit deferred .................................... 14,000 Deferral of land gain on sale ..................................................... 18,000 Equity in Skyline’s earnings ...................................................... $(55,400) b. Acquisition-Date Fair Value Allocation Consideration transferred (fair value of shares issued) ........ $450,000 Book value of subsidiary .......................................................... 300,000 Fair value in excess of book value .......................................... $150,000 Excess fair over book value assigned to: Trademarks (indefinite life) ................................................... 30,000

Patented technology ......................................................................................................... $120,000

Remaining life of patented technology ............................................................................. 8 years

Annual amortization .................................................................. $ 15,000

Unrealized Upstream Inventory Gross Profit, 1/1 Inventory being held ($50,000 × 72%) ...................................... $36,000 Gross profit rate ($20,000 ÷ $50,000) ....................................... 40% Unrealized gross profit, 1/1 ...................................................... $14,400

Unrealized Upstream Inventory Gross Profit, 12/31 Inventory being held (given) .................................................... $28,000

Gross profit rate ($40,000 ÷ $80,000) .................................................................................. 50%

Unrealized gross profit, 12/31 ................................................... $14,000 CONSOLIDATION ENTRIES

Entry *G Retained earnings 1/1 (Skyline) ......................... 14,400 Cost of goods sold ........................................ 14,400 To remove impact of beginning unrealized gross profit. Amount

computed above.

Entry S Common stock (Skyline) .................................... 120,000 Additional paid-in capital (Skyline) .................... 30,000 Retained earnings 1/1 (Skyline, adjusted) ......... 277,600 Investment in Skyline ..................................... 427,600 To remove stockholders' equity accounts of subsidiary. Retained

earnings is adjusted for elimination of beginning unrealized gross profit in Entry *G.



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36. (continued) Entry A Trademarks .......................................................... 30,000 Patented technology ........................................... 105,000 Investment in Skyline .................................... 135,000 To recognize excess fair value allocations as of 1/1. Patented

technology is adjusted for one prior year of amortization at $15,000 per year.

Entry I Investment income .............................................. 55,400 Investment in Skyline .................................... 55,400 To remove intra-entity income accrued by parent using the equity

method.

Entry D Investment in Skyline ......................................... 20,000 Dividends declared ........................................ 20,000 To eliminate Intra-entity dividends.

Entry E Other operating expenses ................................... 15,000 Patented technology ...................................... 15,000 To recognize current year amortization expense on patented technology

Entry Tl Revenues ............................................................. 80,000 Cost of goods sold ........................................ 80,000 To eliminate intra-entity inventory transfer for current year. Entry G Cost of goods sold .............................................. 14,000 Inventory .......................................................... 14,000 To defer unrealized inventory gross profit. Amount is computed above. Entry TL Gain on sale of land ............................................ 18,000 Land ................................................................ 18,000 To remove gain from intra-entity transfer of land during current year.

Entry P Accounts payable ............................................... 65,000 Accounts receivable ....................................... 65,000 To remove intra-entity payable and receivable.



36. (continued) PARKWAY AND SKYLINE Consolidation Worksheet


Consolidation Entries Consolidated Accounts Parkway Skyline Debit Credit Totals Revenues (627,000) (358,000) (TI) 80,000 (905,000) Cost of goods sold 289,000 195,000 (G) 14,000 (TI) 80,000 (*G) 14,400 403,600 Other operating expenses 170,000 75,000 (E) 15,000 260,000 Gain on sale of land (18,000) (TL) 18,000 -0- Investment income (55,400) (I) 55,400 -0- Net income (241,400) (88,000) (241,400) Retained earnings 1/1 (314,600) (292,000) (*G) 14,400 (314,600) (S) 277,600 -0- Net income (above) (241,400) (88,000) (241,400) Dividends declared 70,000 20,000 (D) 20,000 70,000 Retained earnings 12/31 (486,000) (360,000) (486,000)

Cash and receivables 134,000 150,000 (P) 65,000 219,000 Inventory 281,000 112,000 (G) 14,000 379,000 Investment in Skyline 598,000 (D) 20,000 (S) 427,600 (A) 135,000 -0- (I) 55,400 Trademarks 50,000 (A) 30,000 80,000 Patented technology 130,000 (A) 105,000 (E) 15,000 220,000 Land, buildings, and equipment (net) 637,000 283,000 (TL) 18,000 902,000 Total assets 1,650,000 725,000 1,800,000 Liabilities (463,000) (215,000) (P) 65,000 (613,000) Common stock (410,000) (120,000) (S) 120,000 (410,000) Additional paid-in capital (291,000) (30,000) (S) 30,000 (291,000) Retained earnings (above) (486,000) (360,000) (486,000) Total liabilities & stockholders’ equity (1,650,000) (725,000) 844,400 844,400 (1,800,000)

Chapter 06 - Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues


Education.

Chapter 5 Excel Case Solution

Excel Case Equity in Shawn Co. Earnings 2014 78,000 Fair Value Allocation Schedule 1/1/2014El profit (34,200) Consideration transferred 1,000,000 Amortization (12,600) C.S. 500,000 Equity earnings 31,200 R.E. 185,000 685,000 Life Amort. 2015 85,000 Tradename 315,000 25 12,600 BI profit 34,200 Inventory El profit (37,800) Shawn sells GPR remaining Amortization (12,600) to Patrick 60% 30% Equity earnings 68,800 Intra-entity Inventory Transfers (upstream) Shawn Co. dividends Sales Inventory Intra. profit 2014 25,000 2014 190,000 57,000 34,200 2015 27,000 2015 210,000 63,000 37,800 Consolidation Adjustments Investment account *G RE-Shawn 34,200 Cost 1,000,000 COGS 34,200 2014 Equity earnings 31,200 dividends (25,000) S Common stock-Shawn 500,000 12/31/14 1,006,200 RE-Shawn 203,800 Investment in Shawn 703,800 2015 Equity earnings 68,800 dividends (27,000) A Tradename 302,400 12/31/15 1,048,000 Investment in Shawn 302,400 I Equity in earnings of Shawn 68,800 Investment in Shawn 68,800 D Investment in Shawn 27,000 Dividends declared 27,000 E Amortization expense 12,600 Tradename 12,600 IT Sales 210,000 COGS 210,000



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G COGS 37,800 Inventory 37,800 Investment account goes to zero? 0



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Analysis and Research—Accounting Information and Salary Negotiations a. With common control over related enterprises, a consolidated income statement better

portrays economic reality. For example, it is likely that the Stadium’s concession and parking revenues would have been less if the team did not play there. Additionally, the $1,400,000 rent expense does not represent an arm’s length transaction—given that the $1,400,000 is the only rent revenue, it appears that the stadium is used exclusively for baseball with its fortunes intertwined with the team.

Searching the FASB ASC for “separate statements” and then “intra-entity” yields the following relevant support:

There is a presumption that consolidated financial statements are more meaningful than separate financial statements and that they are usually necessary for a fair presentation when one of the entities in the consolidated group directly or indirectly has a controlling financial interest in the other entities. FASB ASC (para. 810-10-10-1).

As consolidated financial statements are based on the assumption that they represent the financial position and operating results of a single economic entity, such statements should not include gain or loss on transactions among the entities in the consolidated group. FASB ASC (para. 810-10-45-1).

Granger Eagles Team and Stadium Consolidated Income Statement

Ticket revenues $2,000,000 Concession revenue 800,000 Parking revenue 100,000 $2,900,000 Ticket expense 25,000 Promotion 35,000 COGS 250,000 Depreciation 80,000 Player salaries 400,000 Staff salaries 350,000 1,140,000 Consolidated net income $1,760,000

b. Other pertinent factors include

Any available comparisons for the market values for the players

The market value of any alternative uses for the stadium

The amount the owners have invested in the team

The amount the owners have invested in the stadium

Fair rates of return for the owners’ investments in the team and the stadium



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CHAPTER 6

VARIABLE INTEREST ENTITIES, INTRA-ENTITY DEBT, CONSOLIDATED CASH FLOWS, AND OTHER ISSUES

Chapter Outline

I. Variable interest entities (VIEs)

A. VIEs typically take the form of a trust, partnership, joint venture, or corporation. In most cases a sponsoring firm creates these entities to engage in a limited and well-defined set of business activities. For example, a business may create a VIE to finance the acquisition of a large asset. The VIE purchases the asset using debt and equity financing, and then leases the asset back to the sponsoring firm. If their activities are strictly limited and the asset is pledged as collateral, VIEs are often viewed by lenders as less risky than their sponsoring firms. As a result, such arrangements can allow financing at lower interest rates than would otherwise be available to the sponsor.

B. Control of VIEs, by design, sometimes does not rest with its equity holders. Instead, control is exercised through contractual arrangements with the sponsoring firm who becomes the "primary beneficiary" of the entity. These contracts can take the form of leases, participation rights, guarantees, or other residual interests. Through contracting, the primary beneficiary bears a majority of the risks and receives a majority of the rewards of the entity, often without owning any voting shares.

C. An entity whose control rests with a primary beneficiary is addressed by FASB ASC subtopic 810-10 Variable Interest Entities. The following characteristics indicate a controlling financial interest in a variable interest entity.

1. The power, through voting rights or similar rights, to direct the activities of an entity that most significantly impact the entity’s economic performance.

2. The obligation to absorb the expected losses of the entity if they occur,or

3. The right to receive the expected residual returns of the entity if they occur

The primary beneficiary bears the risks and receives the rewards of a variable interest entity and is considered to have a controlling financial interest.

D. If a reporting entity has a controlling financial interest in a variable interest entity, it should include the assets, liabilities, and results of the activities of the variable interest entity its consolidated financial statements.

Proposed Accounting Standards Update on Variable Interest Entities

In November 2011 (updated January 2013), the FASB issued a proposed change for evaluating whether an entity must consolidate a VIE. The proposed accounting standard update, entitled Principal versus Agent Analysis, would introduce a separate qualitative analysis to determine whether a reporting entity with the authority to make economic decisions for a VIE uses its power in a principal or agent capacity. If the decision making party is a principal (rather than an agent of another party) then it is the controlling party. Alternatively, if the party that exercises decision-making power acts in the capacity of an agent, under the proposed guidance that party would not consolidate the VIE. As this latest FASB proposal demonstrates, the manner in which control is assessed continues to evolve over time.



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II. Intra-entity debt transactions

A. No special difficulty is created when one member of a business combination loans money to another. The resulting receivable/payable accounts as well as the interest income expense balances are identical and can be directly offset in the consolidation process.

B. The acquisition of an affiliate's debt instrument from an outside party does require special handling so that consolidated financial statements can be produced.

1. Because the acquisition price will usually differ from the book value of the liability, a gain or loss has been created by an effective retirement which is not recorded within the individual records of either company.

2. Because of the amortization of any associated discounts and/or premiums, the interest income reported by the buyer will not equal the interest expense of the debtor.

C. In the year of acquisition, the consolidation process eliminates intra-entity accounts (the liability, the receivable, interest income, and interest expense) while the gain or loss (which produced all of the discrepancies because of the initial difference) is recognized.

1. Although several alternatives exist, this textbook assigns all income effects resulting from the retirement to the parent company, the party ultimately responsible for the decision to reacquire the debt.

2. Any noncontrolling interest is, therefore, not affected by the adjustments utilized to consolidate intra-entity debt.

D. After the year of effective retirement, all intra-entity accounts must be eliminated again in each subsequent consolidation. However, when the parent uses the equity method, the parent’s Investment in Subsidiary account is adjusted in consolidation rather than a gain or loss account. If the parent employs an accounting method other than the equity method, then the parent’s Retained Earnings are adjusted for the prior years’ income net effects of the effective gain/loss on retirement.

1. The change in retained earnings is needed because a gain or loss was created in a prior year by the effective retirement of the debt, but only interest income and interest expense were recognized by the two parties.

2. The adjustment to retained earnings at any point in time is the original gain or loss adjusted for the subsequent amortization of discounts or premiums.

III. Subsidiary preferred stock

A. Subsidiary preferred shares not owned by the parent are a part of noncontrolling interest.

B. The fair value of any subsidiary preferred shares not acquired by the parent is added to the consideration transferred along with the fair value of the noncontrolling interest in common shares to compute the acquisition-date fair value of the subsidiary.

IV. Consolidated statement of cash flows

A. Statement is produced from consolidated balance sheet and income statement and not from the separate cash flow statements of the component companies.

B. Consolidated net income is the starting point for the cash flow from operating section—including both the parent and noncontrolling interest share.

C. Intra-entity cash transfers are omitted from this statement because they do not occur with an outside unrelated party.

D. Dividends paid by the subsidiary to the noncontrolling interest are reported as a financing activity.



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V. Consolidated earnings per share A. This computation normally follows the pattern described in intermediate accounting

textbooks. For basic EPS, consolidated net income is divided by the weighted-average number of parent shares outstanding. If convertibles (such as bonds or warrants) exist for the parent shares, their weight must be included in computing diluted EPS but only if earnings per share is reduced.

1. The subsidiary's diluted earnings per share are computed first to arrive at (1) an earnings figure and (2) a shares figure.

2. The portion of the shares figure belonging to the parent is computed. That percentage of the subsidiary's diluted earnings is then added to the parent's net income in order to complete the earnings per share computation.

VI. Subsidiary stock transactions

A. If the subsidiary issues new shares of stock or reacquires its own shares as treasury stock, a change is created in the book value underlying the parent's investment account. The increase or decrease should be reflected by the parent as an adjustment to this balance.

B. The book value of the subsidiary that corresponds to the parent's ownership is measured before and after the transaction with any alteration recorded directly to the investment account. The parent's additional paid-in capital (or retained earnings) account is normally adjusted although the recognition of a gain or loss is an alternate accounting treatment.

C. Treasury stock acquired by the subsidiary may also necessitate a similar adjustment to the parent's investment account. In addition, any subsidiary treasury stock is eliminated within the consolidation process.

Answer to Discussion Question: Who Lost this $300,000?

This case is designed to give life to a theoretical accounting issue: If a subsidiary's debt is retired, should the resulting gain or loss be assigned to the parent or to the subsidiary? The case illustrates that there is no clear-cut solution. This lack of an absolute answer makes financial accounting both intriguing and frustrating. The assignment decision is only necessary in the presence of a noncontrolling interest. Regardless of the ownership level all intra-entity balances are eliminated on the worksheet with a gain or loss recognized. Not until the consolidated net income is allocated across the controlling interest and the noncontrolling interest does the assignment decision have an impact. We assume that financial and operating decisions are made in the best interest of the business entity as a whole. This debt would not have been retired unless corporate officials believed that Penston/Swansan would benefit from the decision. Thus, an argument can be made against any assignment to either separate party. Students should choose and justify one method. Discussion often centers on the following: Parent company officials made the actual choice that created the book loss. Therefore,

assigning the $300,000 to the subsidiary directs the impact of their decision to the wrong party. In effect, the subsidiary had nothing to do with this transaction (as indicated in the case) so that its share of consolidated net income should not be affected by the $300,000 loss.

The debt was that of the subsidiary. Because the subsidiary's debt is being retired, all of the $300,000 should be attributed to that party. Financial records measure the results of transactions and the retirement simply culminates an earlier transaction made by the subsidiary.



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The parent is doing no more than acting as an agent for the subsidiary (as indicated in the case). If the subsidiary had acquired its own debt, for example, no question as to the assignment would have existed. Thus, changing that assignment simply because the parent agreed to be the acquirer is not justified.

Both parties were involved in the transaction so that some allocation of the loss is required. If, at the time of repurchase, a discount existed within the subsidiary's accounts, this figure would have been amortized to interest expense (if the debt had not been retired). Thus, the $300,000 loss was accepted now in place of the later amortization. This reasoning then assigns this portion of the loss to the subsidiary. Because the parent agreed to pay more than face value, that remaining portion is assigned to the buyer.

Answers to Questions 1. A variable interest entity (VIE) is a business structure that is designed to accomplish a specific

purpose. A VIE can take the form of a trust, partnership, joint venture, or corporation although typically it has neither independent management nor employees. The entity is frequently sponsored by another firm to achieve favorable financing rates.

2. Variable interests are contractual, ownership, or other pecuniary interests in an entity that

change with changes in the entity's net asset value. Variable interests will absorb portions of a variable interest entity's expected losses if they occur or receive portions of the entity's expected residual returns if they occur. Variable interests typically are accompanied by contractual arrangements that provide decision making power to the owner of the variable interests. Examples of variable interests include debt guarantees, lease residual value guarantees, participation rights, and other financial interests.

3. The following characteristics are indicative of an enterprise qualifying as a primary beneficiary

with a controlling financial interest in a VIE. The power, through voting rights or similar rights, to direct the activities of an entity that most

significantly impact the entity’s economic performance. The obligation to absorb the expected losses of the entity if they occur, or The right to receive the expected residual returns of the entity if they occur

4. Because the bonds were purchased from an outside party, the acquisition price is likely to differ from the book value of the debt in the subsidiary's records. This difference creates accounting challenges in handling the intra-entity transaction. From a consolidated perspective, the debt is retired; a gain or loss is reported with no further interest being recorded. In reality, each company continues to maintain these bonds on their individual financial records. Also, because discounts and/or premiums are likely to be present, these account balances as well as the interest income/expense will change from period to period because of amortization. For reporting purposes, all individual accounts must be eliminated with the gain or loss being reported so that the events are shown from the vantage point of the consolidated entity.

5. If the bonds are acquired directly from the affiliate company, all reciprocal accounts will be equal

in amount. The debt and the receivable will be in agreement so that no gain or loss is created. Interest income and interest expense should also reflect identical amounts. Therefore, the consolidation process for this type of intra-entity debt requires no more than the offsetting of the various reciprocal balances.



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6. The gain or loss to be reported is the difference between the price paid and the book value of the debt on the date of acquisition. For consolidation purposes, this gain or loss should be recognized immediately on the date of acquisition.

7. Because the bonds are still legally outstanding, they will continue to be found on both sets of

financial records. Thus, each account (Bonds Payable, Investment in Bonds, Interest Expense, and Interest Income) must be eliminated within the consolidation process. Any gain or loss on the effective retirement as well as later effects on interest caused by amortization are also included to arrive at an adjustment to the beginning retained earnings (or the Investment account if the equity method is used) of the parent company.

8. The original gain is never recognized within the financial records of either company. Thus, within

the consolidation process for the year of acquisition, the gain is directly recorded whereas (for each subsequent year) it is entered as an adjustment to beginning retained earnings (or the Investment account if the equity method is used). In addition, because the book value of the debt and the investment are not in agreement, the interest expense and interest income balances being recorded by the two companies will differ each year because of the amortization process. This amortization effectively reduces the difference between the individual retained earnings balances and the total that is appropriate for the consolidated entity. Consequently, a smaller change is needed each period to arrive at the balance to be reported. For this reason, the annual adjustment to beginning retained earnings (or the Investment account if the equity method is used) gradually decreases over the life of the bond.

9. No set rule exists for assigning the income effects from intra-entity debt transactions although several different theories exist and include: (1) assignment of the entire amount to the debtor, (2) assignment of the entire amount to the buyer, and (3) allocation of the gain or loss between the two parties in some manner. This textbook attributes the entire income effect (the $45,000 gain in this case) to the parent company. Assignment to the parent is justified because that party is ultimately responsible for the decision to retire the debt from the public market. The answer to the discussion question included in this chapter analyzes this question in more detail.

10. Subsidiary outstanding preferred shares are part of the noncontrolling interest and are included

in the consolidated financial statements at acquisition-date fair value and subsequently adjusted for their share of subsidiary income and dividends.

11. The consolidated cash flow statement is developed from consolidated balance sheet and

income statement figures. Thus, the cash flows generated by operating, investing, and financing activities are identified only after the consolidation of these other statements.

12. The noncontrolling interest share of the subsidiary’s net income is a component of consolidated

net income. Consolidated net income then is adjusted for noncash and other items to arrive at consolidated cash flows from operations. Any dividends paid by the subsidiary to these outside owners are listed as a financing activity because an actual cash outflow occurs.

13. An alternative to the normal diluted earnings per share calculation is required whenever the

subsidiary has dilutive convertible securities such as bonds or warrants. In this case, the potential impact of the conversion of subsidiary shares must be factored into the overall diluted earnings per share computation.



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14. Basic Earnings per Share. The existence of subsidiary convertible securities does not affect basic EPS. The parent’s basic earnings per share is computed by dividing the parent’s share of consolidated net income by the weighted average number of parent shares outstanding. Diluted Earnings per Share. The subsidiary's diluted earnings per share is computed by including both convertible items. The portion of the parent's controlled shares to the total shares used in this calculation is then determined. Only this percentage (of the income figure used in the subsidiary's computation) is added to the parent's income in arriving at the parent company’s diluted earnings per share.

15. Several reasons could exist for a subsidiary to issue new shares of stock to outside parties. First, additional financing is brought into the company by any such sale. Also, stock issuance may be used to entice new individuals to join the organization. Additional management personnel, as an example, might be attracted to the company in this manner. The company could also be forced to sell shares because of government regulation. Many countries require some degree of local ownership as a prerequisite for operating within that country.

16. Because the new stock was issued at a price above the subsidiary’s assigned consolidation

value, the overall valuation for Metcalf's stock has been increased. Consequently, the Washburn's investment is increased to reflect this change. To measure the effect, the value of Washburn's investment is calculated both before and after the new issue. Because the increment is the result of a stock transaction, an increase is made to additional paid-in capital. Although the subsidiary's shares (both new and old) are eliminated in the consolidation process, the increase in the parent's APIC (or gain or loss) carries into the consolidated figures. Also, the noncontrolling interest percentage of the subsidiary increases.

17. A stock dividend does not alter the assigned consolidated subsidiary value and, thus, creates

no effect on Washburn's investment account or on the consolidated figures. Hence, no entry is recorded by the parent company in connection with the subsidiary's stock dividend.



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Answers to Problems 1. C 2. B 3. D 4. A 5. D 6. D Cash flow from operations: Net income ................................................................. $45,000 Depreciation ............................................................... 10,000 Trademark amortization ............................................ 15,000 Increase in accounts receivable ............................... (17,000) Increase in inventory ................................................. (40,000) Increase in accounts payable ................................... 12,000 (20,000) Cash flow from operations ....................................... $25,000 7. C Cash flow from financing activities: Dividends to parent’s interest .................................. ($12,000)

Dividends to noncontrolling interest (20% $5,000) (1,000) Reduction in long-term notes payable .................... (25,000) Cash flow from financing activities ......................... ($38,000) 8. C 9. C Post-issue subsidiary valuation ($800,000 + $250,000) $1,050,000 Arcola’s new ownership percentage (40,000 ÷ 50,000) 80% Arcola’s share of post-issue subsidiary valuation $ 840,000 Arcola’s pre-issue equity balance 800,000 Increase to Arcola’s investment account $ 40,000 10. C Dane’s income from own operations ....................... $185,000

Carlton’s income ...................................................... 105,000 Eliminate intra-entity interest income ...................... (19,000) Eliminate intra-entity interest expense .................... 18,000 Recognize retirement gain on debt ($209,000 – $196,000) 13,000 Consolidated net income .................................... $302,000

11. B Mattoon’s share of consolidated net income .......... $465,000 Number of Mattoon common shares outstanding .. 100,000

Mattoon’s EPS = ($465,000 ÷ 100,000 shares) ......... $4.65



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12. B Aaron net income ..................................................... $430,000 Less intra-entity dividends (initial value method) .. (8,050) $421,950 Zeese reported net income ...................................... 164,000 Gain on extinguishment of debt ($60,200 – $56,000) 4,200 Eliminate interest expense on "retired" debt ($60,200 × 10%) .................................................... 6,020 Eliminate interest income on "retired" debt ($56,000 × 12%) .................................................... (6,720) Consolidated net income ......................................... $589,450 13. B 30% of $147,000 subsidiary net income; the intra-entity debt effects are attributed solely to the parent company. 30% x $147,000 = $44,100 14. A For 2014, the adjustment to beginning retained earnings should recognize the gain on the retirement of the debt, the elimination of the 2013 interest expense, and the elimination of the 2013 interest income. Gain on Retirement of Bond:

Original book value ............................................................. $10,600,000 2010–2012 amortization ($600,000 ÷ 20 yrs. × 3 yrs.) ....... (90,000) Book value, January 1, 2013 ............................................... $10,510,000 Percentage of bonds retired ............................................... 40% Book value of retired bonds ............................................... $4,204,000 Cash received ($4,000,000 × 96.6%) ................................... 3,864,000 Gain on retirement of bonds ............................................... $ 340,000

Interest Expense on Intra-Entity Debt—2013 Cash interest expense (9% × $4,000,000) .......................... $360,000 Premium amortization ($30,000 per year total × 40% retired portion of bonds) ............................................... (12,000) Interest expense on intra-entity debt ................................. $348,000 Interest Income on Intra-Entity Debt—2013 Cash interest income (9% × $4,000,000) ............................ $360,000 Discount amortization (.034 × $4,000,000 ÷ 17 years) ....... 8,000 Interest income on intra-entity debt ................................... $368,000 Adjustment to 1/1/14 Retained Earnings Recognition of 2013 gain on extinguishment of debt (above) ..... $340,000 Elimination of 2013 intra-entity interest expense (above) ........... 348,000 Elimination of 2013 intra-entity interest income (above) ............. (368,000) Increase in retained earnings, 1/1/14 ....................................... $320,000



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15. D Consideration transferred for preferred stock ............................. $ 424,000 Consideration transferred for common stock .............................. 3,960,000 Noncontrolling interest fair value for preferred ........................... 1,696,000 Noncontrolling interest fair value for common ............................ 440,000 Acquisition-date fair value ............................................................. 6,520,000 Acquisition-date identified net asset fair value ........................... (6,000,000) Goodwill .......................................................................................... $ 520,000 16. B Consideration transferred for preferred stock ............................. $214,000 Consideration transferred for common stock .............................. 1,253,280 Noncontrolling interest fair value for common ............................ 835,520 Acquisition-date fair value ............................................................. $2,302,800 Acquisition-date book value .......................................................... (2,174,000) Excess fair over book value ........................................................... $ 128,800 to building .................................................................................. 63,600 to goodwill .................................................................................. $ 65,200 17. B Parent’s reported sales ............................................ $480,000 Subsidiary's reported sales ..................................... 264,000 Less: intra-entity transfers ...................................... (57,600) Sales to outsiders ............................................... $686,400 Less: increase in receivables ................................... (37,300) Cash generated by sales .................................... $649,100 18. B Subsidiary’s unamortized fair value of prior to new share issue (12,000 × $49) ....................................................... $588,000 Parent's ownership ................................................... 100% Unamortized subsidiary fair value ......................... $588,000 Subsidiary unamortized fair value after issuing new shares (above value plus 3,000 shares at $50 each) $738,000 Parent's ownership 12,000 ÷ 15,000 shares) .......... 80% Unamortized subsidiary fair value after stock issue $590,400 Investment in Veritable increases by $2,400 ($590,400 less $588,000). 19. A Because the parent acquired 80 percent of the new shares, its proportional

ownership remains the same. Because the amount the parent pays will necessarily equal 80 percent of the increase in the subsidiary's book value, no separate adjustment by the parent is required.



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20. C Adjusted acquisition-date sub. fair value at 1/1/14 Consideration transferred ........................................................ $592,000 Noncontrolling interest acquisition-date fair value ................ 148,000 Increase in Stamford book value .............................................. 80,000 Stock issue proceeds ................................................................ 150,000 Subsidiary valuation basis 1/1/14 .................................................. 970,000 New parent ownership (32,000 shs. ÷ 50,000 shs.) ...................... 64% Parent’s post-stock issue ownership balance .............................. $620,800 Parent's investment account ($592,000 + [80% × 80,000]) .......... 656,000 Required adjustment —decrease ............................................ $(35,200) 21. D Adjusted acquisition-date fair value ($820,000 – $192,000) ........ $628,000 New parent ownership (32,000 shs. ÷ 32,000 shs.) ...................... 100% Fair value equivalency of parent's ownership ........................ $628,000 Parent's investment account ($592,000 + [80% × 80,000]) .......... 656,000 Required adjustment—decrease .............................................. $ (28,000) 22. (10 minutes) (Qualification of Primary Beneficiary of a VIE)

Consolidation of a variable interest entity is required if a firm has a variable interest that gives the firm

The power, through voting rights or similar rights, to direct the activities of an entity that most significantly impact the entity’s economic performance.

The obligation to absorb a majority of the entity's expected losses if they occur and/or the right to receive a majority of the entity's expected residual returns if they occur

Because (1) HCO Media’s losses are limited by contract, and (2) Hillsborough

has the right to receive the residual benefits of the sales generated on the HCO Media internet site above $500,000, Hillsborough should consolidate HCO Media.

23. (30 minutes) (VIE Qualifications for Consolidation) a. The purpose of consolidated financial statements is to present the financial

position and results of operations of a group of businesses as if they were a single entity. They are designed to provide information useful for making business and economic decisions—especially assessing amounts, timing, and uncertainty of prospective cash flows. Consolidated statements also provide more complete information about the resources, obligations, risks, and opportunities of an enterprise than separate statements.

b. An entity qualifies as a VIE and is subject to consolidation if either of the

following conditions exist.



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23. (continued)

The total equity at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties. In most cases, if equity at risk is less than 10% of total assets, the risk is deemed insufficient.

The equity investors in the VIE lack any one of the following three characteristics of a controlling financial interest.

1. The power, through voting rights or similar rights, to direct the activities of an entity that most significantly impact the entity’s economic performance.

2. The obligation to absorb the expected losses of the entity if they occur (e.g., another firm may guarantee a return to the equity investors)

3. The right to receive the expected residual returns of the entity (e.g., the investors' return may be capped by the entity's governing documents or other arrangements with variable interest holders).

Consolidation of a variable interest entity is required if a firm has a variable interest that gives the firm

The power, through voting rights or similar rights, to direct the activities of an entity that most significantly impact the entity’s economic performance.

The obligation to absorb a majority of the entity's expected losses if they occur and/or the right to receive a majority of the entity's expected residual returns if they occur

c. Risks of the construction project that has TecPC has effectively shifted to

the owners of the VIE:

At the end of the 1st five-year lease term, if the parent opts to sell the facility, and the proceeds are insufficient to repay the VIE investors, TecPC may be required to pay up to 85% of the project's cost. Thus, a potential 15% risk.

Risks that remain with TecPC

Guarantees of return to VIE investors at market rate, if facility does not perform as expected TecPC is still obligated to pay market rates.

If lease is not renewed, TecPC must either purchase the facility or sell it on behalf of the VIE with a guarantee of Investors' (debt and equity) balances representing a risk of decline in market value of asset

Debt guarantees



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23. (continued) d. TecPC possesses the following characteristics of a primary beneficiary:

Direct decision-making ability (end of five-year lease term).

Absorb a majority of the entity's expected losses if they occur (via debt guarantees and guaranteed lease payments and residual value).

Receive a majority of the entity's expected residual returns if they occur (via use of the facility and potential increase in its market value).

24. (10 minutes) (Consolidation of variable interest entity.)

a. Implied valuation and excess allocation for Softplus. Noncontrolling interest fair value $ 60,000 Consideration transferred by Pantech 20,000 Total business fair value 80,000 Fair value of VIE net assets 100,000 Excess net asset value fair value $20,000

PanTech recognizes the $20,000 excess net asset fair value as a bargain purchase and records all of SoftPlus’ assets and liabilities at their individual fair values.

Cash $20,000 Marketing software 160,000 Computer equipment 40,000 Long-term debt (120,000) Noncontrolling interest (60,000) Pantech equity interest (20,000) Gain on bargain purchase (20,000) -0-

b. Implied valuation and excess allocation for Softplus. Noncontrolling interest fair value 60,000 Consideration transferred by Pantech 20,000 Total business fair value 80,000 Fair value of VIE net identifiable assets 60,000 Goodwill $20,000

When the fair value of a VIE (that is a business) is greater than assessed asset values, all identifiable assets and liabilities are reported at fair values (unless a previously held interest) and the difference is treated as goodwill.

Cash $20,000 Marketing software 120,000 Computer equipment 40,000 Goodwill (excess business fair value) 20,000 Long-term debt (120,000) Noncontrolling interest (60,000) Pantech equity interest (20,000) -0-



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25. (40 minutes) (Acquisition-date consolidated worksheet for a parent and a variable interest entity)

Access Net

Adjust. & Elim.

Consolidated

IT Connect NCI Balances

Cash 61,000 41,000 102,000

Investment in NetConnect 1,000,000 S 65,600

A 934,400

Capitalized software 981,000 156,000 1,137,000

Computer equipment 1,066,000 56,000 1,122,000 Communications equipment 916,000 336,000 1,252,000 Research and development asset A1,960,000 1,960,000

Patent 191,000 191,000

Goodwill A 376,000 376,000

Total assets 4,024,000 780,000 6,140,000

Long-term debt (941,000) (616,000) (1,557,000)

Common stock-Access IT (2,660,000) (2,660,000) Common stock-NetConnect (41,000) S 16,400 (24,600)

Retained earnings (423,000) (123,000) S 49,200 (73,800) (423,000)

Noncontrolling interest A 1,401,600 (1,401,600) (1,500,000)


Consideration transferred $1,000,000

Noncontrolling interest fair value 1,500,000

Acquisition-date fair value $2,500,000

Book value (164,000)

Excess fair over book value $2,336,000

Research and development asset 1,960,000

Goodwill $ 376,000



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26. (25 Minutes) (Consolidation entry for three consecutive years to report effects of intra-entity bond acquisition. Straight-line method used. Parent uses equity method)

a. Book Value of Bonds Payable, January 1, 2013 Book value, January 1, 2011 ................................................. $1,050,000 Amortization—2011–2012 ($5,000 per year [$50,000 premium ÷ 10 years] for two years) .................. 10,000 Book value of bonds payable, January 1, 2013 .................... $1,040,000 Book value of 40% of bonds payable (intra-entity portion), January 1, 2013 ............................. $416,000 Gain on Retirement of Bonds, January 1, 2013 Purchase price ($400,000 × 96%) .......................................... $384,000 Book value of liability (computed above) ............................. 416,000 Gain on retirement of bonds ................................................. $ 32,000 Book Value of Bonds Payable, December 31, 2013 Book value, January 1, 2013 (computed above) .................. $1,040,000 Amortization for 2013 ............................................................. 5,000 Book value of bonds payable, December 31, 2013 .............. $1,035,000 Book value of 40% of bonds payable (intra-entity portion), December 31, 2013 ............................................................ $414,000 Book Value of Investment, December 31, 2013 Book value of investment, January 1, 2013 (purchase price) $384,000 Amortization for 2013 ($16,000 discount ÷ 8-yr. rem. life) .. 2,000 Book value of investment, December 31, 2013 .................... $386,000 Intra-entity Interest Balances for 2013 Interest expense: Cash payment ($400,000 × 9%) ........................................ $36,000 Amortization of premium for 2013 ($5,000 per year × 40% intra-entity portion) .......................................... 2,000 Intra-entity interest expense ............................................ $34,000 Interest income: Cash collection ($400,000 × 9%) ...................................... $36,000 Amortization of discount for 2013 (above) ..................... 2,000 Intra-entity interest income .............................................. $38,000



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26. (continued) CONSOLIDATION ENTRY B (2013) Bonds Payable .......................................................... 400,000 Premium on Bonds Payable ..................................... 14,000 Interest Income .......................................................... 38,000 Investment in Bonds .............................................. 386,000 Interest Expense ................................................... 34,000 Gain on Retirement of Bonds .............................. 32,000 (To eliminate accounts stemming from intra-entity bonds [balances

computed above] and to recognize gain on the effective retirement of this debt.)

b. In 2014, because straight-line amortization is used, the interest accounts

remain unchanged at $38,000 and $34,000. However, the premium associated with the bond payable as well as the discount on the investment are affected by the $2,000 per year amortization. In addition, the gain now has to be removed from the Investment in Hamilton account. Concurrently, the two interest balances recorded by the individual companies in 2013 are removed from the Investment in Hamilton because they occurred after the intra-entity retirement. Gain of $32,000 plus $34,000 expense removal less $38,000 income elimination yields a $28,000 credit to the investment account.

CONSOLIDATION ENTRY *B (2014) Bonds Payable .............................................................. 400,000 Premium on Bonds Payable (net of $2,000 amort.) ........ 12,000 Interest Income .............................................................. 38,000 Investment in Bonds (net of $2,000 amorti.) ............... 388,000 Interest Expense ....................................................... 34,000 Investment in Hamilton ............................................. 28,000 (To remove intra-entity bond accounts that remain on the individual

records of both companies. Both debt and bond investment balances have been adjusted for 2013–13 amortization. Entry to Investment in Hamilton brings the totals reported by the individual companies [interest income and expense] to the balance of the original gain.)

c. As with part b, new premium and discount balances must be determined

and then removed. The adjustment made to the Investment in Hamilton takes into account that another year of interest expense ($34,000) and income ($38,000) have been incorporated into the investment account through application of the equity method.



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26. (continued) CONSOLIDATION ENTRY *B (2015) Bonds Payable .................................................... 400,000 Premium on Bonds Payable ............................... 10,000 Interest Income .................................................... 38,000 Investment in Bonds ...................................... 390,000 Interest Expense ............................................ 34,000 Investment in Hamilton .................................. 24,000

(To remove intra-entity bond accounts that remain on the individual records of both companies. Both debt and bond investment balances have been adjusted for 2013–2015 amortization. Credit to Investment in Hamilton brings the totals reported by the individual companies to the balance of the original gain.)

27. (12 Minutes) (Determine consolidated income statement accounts after

acquisition of intra-entity bonds.)

Interest Expense To Be Eliminated = $84,000 × 11% = $9,240

Interest Income To Be Eliminated = $108,000 × 8% = $8,640

Loss To Be Recognized = $108,000 – $84,000 = $24,000 CONSOLIDATED TOTALS

Revenues and Interest Income = $1,051,360 (add the two book values and eliminate interest income on intra-entity bond)

Operating and Interest Expense = $751,760 (add the two book values and eliminate interest expense on intra-entity bond)

Other Gains and Losses = $152,000 (add the two book values)

Loss on Retirement of Debt = $24,000 (computed above)

Net Income = $427,600 (consolidated revenues, interest income, and gains less consolidated operating and interest expense and losses)



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28. (30 Minutes) (Consolidation entry for two years to report effects of intra-entity bond acquisition. Effective rate method applied.)

a. Loss on Repurchase of Bond Cost of acquisition ......................................... $201,000 Book value ($760,000 × 1/5) .......................... 152,000 Loss on repurchase ....................................... $ 49,000

Interest Balances for 2013 Interest income: $201,000 × 7% ........................................... $14,070 Interest expense: $152,000 (book value [above]) × 12% ..... $18,240 Investment in Bonds Balance, December 31, 2013 Original cost, 1/1/13 ........................................ $201,000 Amortization of premium: Cash interest ($180,000 × 9%) ................. $16,200 Effective interest income (above) ........... 14,070 2,130 Investment in Bonds, 12/31/13 ....................... $198,870

Bonds Payable Balance, December 31, 2013 Book value, 1/1/13 (above) ............................ $152,000 Amortization of discount: Cash interest ($180,000 × 9%) ................. $16,200 Effective interest expense (above) .......... 18,240 2,040 Bonds payable, 12/31/13 ................................ $154,040 Entry B—12/31/13 Bonds Payable ............................................... 154,040 Interest Income .............................................. 14,070 Loss on Retirement of Debt .......................... 49,000 Investment in Bonds ................................ 198,870 Interest Expense ....................................... 18,240

(To eliminate intra-entity debt holdings and recognize loss on retirement.)

b. Interest Balances for 2014 followed by 2015 Interest income: $198,870 (Investment in Bonds balance for the year) × 7% (rounded) ....................... $13,921 Interest expense: $154,040 (liability balance for the year) × 12% (rounded) ................................... $18,485



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28. (continued) Investment in Bonds Balance, December 31, 2014 Book value, January 1, 2014 (part a) ....................... $198,870 Amortization of premium: Cash interest ($180,000 × 9%) ............................ $16,200 Effective interest income (above) ...................... 13,921 2,279 Investment in Bonds balance, December 31, 2014 . $196,591 Bonds Payable Balance, December 31, 2014 Book value, January 1, 2014 (part a) ....................... $154,040 Amortization of discount: Cash interest ($180,000 × 9%) ............................ $16,200 Effective interest expense (above) .................... 18,485 2,285 Bonds payable balance, December 31, 2014 .......... $156,325 Interest Balances for 2015 Interest income: $196,591 (Investment in Bonds .... $13,761 balance for the year [above]) × 7% (rounded) Interest expense: $156,325 (liability balance for the year [above]) × 12% ................................ $18,759 Investment in Bonds Balance, December 31, 2015 Book value, January 1, 2015 (above) ...................... $196,591 Amortization of premium: Cash interest ($180,000 × 9%) ............................ $16,200 Effective interest income (above) ...................... 13,761 2,439 Investment in Bonds balance, December 31, 2015 . $194,152 Bonds Payable Balance, December 31, 2015 Book value, January 1, 2015 (above) ...................... $156,325 Amortization of discount: Cash interest ($180,000 × 9%) ............................ $16,200 Effective interest expense (above) .................... 18,759 2,559 Bonds payable balance, December 31, 2015 .......... $158,884



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28. (continued) Adjustment Needed to Investment in Zack for Bond Retirement Loss: Loss on retirement of debt (part a) ............................................ $49,000 Amounts recognized in previous years: Interest income: 2013 $(14,070) 2014 (13,921) $(27,991) Interest expense: 2013 $18,240 2014 18,485 36,725 8,734 Adjustment needed to Investment in Zack to arrive at consolidated total .................................. $40,266 Entry *B—12/31/15 Bonds Payable .......................................................... 158,884 Interest Income ......................................................... 13,761 Investment in Zack ................................................... 40,266 Investment in Bonds ........................................... 194,152 Interest Expense ................................................. 18,759

(To eliminate intra-entity bond holdings and adjust the Investment in Zack for the unrecognized loss on retirement. Amounts computed above.)

Many of the above amounts can also be determined using amortization tables as shown below. Investment in Bonds Amortization Table: Interest Carrying Cash Revenue Amortization Value 201,000 2013 16,200 14,070 2,130 198,870 2014 16,200 13,921 2,279 196,591 2015 16,200 13,761 2,439 194,152 Intra-Entity Portion of Bonds Payable Amortization Table: Interest Carrying Cash Expense Amortization Value 152,000 2013 16,200 18,240 (2,040) 154,040 2014 16,200 18,485 (2,285) 156,325 2015 16,200 18,759 (2,559) 158,884



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29. (35 Minutes) (Consolidation procedures and balances related to intra-entity bonds. Both straight-line and effective interest rate methods are used.) a. Acquisition price of bonds ............................................................... $283,550 Book value of bonds payable (see Schedule 1) ($443,497 × 50%) .......................................................................... (221,749) Loss on retirement ............................................................................ $61,801 SCHEDULE 1—Book Value of Bonds Payable Effective Book Interest Cash Year-End Date Value (12% Rate) Interest Amortization Book Value 2011 $435,763 $52,292 $50,000 $2,292 $438,055 2012 $438,055 $52,567 $50,000 $2,567 $440,622 2013 $440,622 $52,875 $50,000 $2,875 $443,497 b. Investment in Bloom Bonds Purchase price—12/31/13 ......................................... $283,550 Cash interest ($250,000 × 10%) ............................... $25,000 Effective interest income ($283,550 × 8%) .............. 22,684 Amortization ........................................................ 2,316 Investment in Bloom bonds, 12/31/14 ..................... $281,234 Bonds Payable Book value—12/31/13 (computed above) ............... $443,497 Cash interest ($500,000 × 10%) ............................... $50,000 Effective interest expense ($443,497 × 12%) .......... 53,220 Amortization ........................................................ 3,220 Bonds payable, 12/31/14 .......................................... $446,717

Although not required, the consolidation entry as of 12/31/14 is as follows. The reduction in retained earnings represents the loss only; no intra-entity interest was recognized in the previous year because the purchase was made on December 31.

Entry *B (2014) Bonds Payable ($446,717 × 50%) ............................ 223,359 Interest Income ......................................................... 22,684 Retained Earnings, 1/1/14 ........................................ 61,801



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Interest Expense ($53,220 × 50%) ...................... 26,610 Investment in Bloom Bonds ............................... 281,234



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29.(continued) c. Loss on Retirement of Bond

Because Bloom uses the straight-line method of amortization, the loss on retirement must be computed again.

Original issue price—1/1/11 ......................................................... $435,763 Discount amortization (2011–2013) ([$64,237 ÷ 11] × 3 years) .. 17,519 Book value 12/31/13 .................................................................... $453,282

Intra-entity portion of bonds payable (50%) .............................. $226,641 Purchase price ............................................................................. 283,550 Loss on retirement ...................................................................... $ 56,909

Investment in Bloom Bonds Purchase price—12/31/13 ........................................................... $283,550 Premium amortization (2014) ($33,550 ÷ 8) ............................... (4,194) Book value 12/31/14 ............................................................... $279,356 Interest Income

Cash interest ($250,000 × 10%) .................................................. $25,000 Premium amortization (above) ................................................... (4,194) Intra-entity interest income—2014 ........................................ $20,806

Bonds Payable

Original issue price 1/1/11 ........................................................... $435,763 Discount amortization (2011–2014) [($64,237 ÷ 11) × 4 years] . 23,359 Book value 12/31/14 ............................................................... $459,122 Opus ownership ..................................................................... 50% Intra-entity portion—12/31/14 .......................................... $229,561

Interest Expense Cash interest ($250,000 × 10%) .................................................. $25,000 Discount amortization ([$64,237 ÷ 11] × 1/2) ............................. 2,920 Intra-entity interest expense—2014 ...................................... $27,920

The reduction in retained earnings represents the loss only; no intra-entity interest was recognized in the previous year because the purchase was made on December 31.

Entry *B (2014) Bonds Payable .......................................................... 229,561 Interest Income ......................................................... 20,806 Retained Earnings, 1/1/14 ....................................... 56,909 Interest Expense ................................................ 27,920 Investment in Bloom Bonds ............................... 279,356



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30. (8 Minutes) (Determine goodwill for an acquisition in which subsidiary has both common stock and preferred stock)

Consideration transferred for common stock $1,600,000 Consideration transferred for preferred stock 630,000 Noncontrolling interest in common stock 400,000 Noncontrolling interest in preferred stock 270,000 Hepner’s acquisition-date fair value $2,900,000 Book value of Hepner 2,500,000 Goodwill $400,000

31. (30 Minutes) (Consolidation entries with subsidiary cumulative preferred stock.) a. The preferred shares are entitled to the specified cumulative dividend. Thus, the

noncontrolling interest's share of the subsidiary's income equals $160,000 or 8 percent of the preferred stock's par value.

b. Acquisition-Date Fair Value Allocation and Amortization Consideration transferred ........................................................... $14,040,000 Noncontrolling interest fair value (preferred shares) ................ 2,000,000 Acquisition-date fair value of Smith ........................................... 16,040,000 Book value ................................................................................... (16,000,000) Franchises .................................................................................... $ 40,000 Period of amortization ................................................................. 40 years Annual amortization .................................................................... $1,000 Investment in Smith Account, December 31, 2014 Consideration transferred, January 1, 2014 .............................. $14,040,000 Equity accrual (income remaining for common stock after preferred stock dividend) ............................................. 290,000 Dividends collected ($360,000 total less $160,000 paid to preferred shareholders) ............................................ (200,000) Amortization for 2014 (above) .................................................... (1,000) Investment in Smith account, December 31, 2014 ..................... $14,129,000 c. Consolidation Entries Entry S and A combined Preferred Stock (Smith) ........................................... 2,000,000 Common Stock (Smith) ............................................ 4,000,000 Retained Earnings, 1/1/14 (Smith) ........................... 10,000,000 Franchises ................................................................. 40,000 Investment in Smith ........................................ 14,040,000 Noncontrolling Interest in Smith, Inc ............ 2,000,000

(To eliminate subsidiary stockholders’ equity, record excess fair values, and record outside ownership of subsidiary's preferred stock at fair value)



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31. c. (continued) Entry I Equity Income of Subsidiary .............................. 289,000 Investment in Smith ....................................... 289,000

(To eliminate equity accrual made in connection with common stock [$290,000] along with excess amortization recorded by parent.)

Entry D Investment in Smith ............................................ 200,000 Dividends Declared ........................................ 200,000

(To remove intra-entity dividend declarations made on common stock [see computation above].)

Entry E Amortization Expense ......................................... 1,000 Franchises ...................................................... 1,000

(To recognize amortization of franchises for current year [see computation above].)

32. (30 Minutes) (Prepare consolidation entries for an acquisition where subsidiary has outstanding preferred stock)

Consideration transferred for common stock $ 7,368,000 Consideration transferred for preferred stock 3,100,000 Noncontrolling interest in common stock 4,912,000 Acquisition-date fair value for Young $15,380,000 Young’s book value 15,000,000 Excess fair over book value 380,000 to building (5-year life) $200,000 to equipment (10-year life) (100,000) 100,000 to brand name (20-year life) $280,000

CONSOLIDATION ENTRIES Entries S and A combined Preferred Stock (Young) .......................................... 1,000,000 Common Stock (Young) ........................................... 4,000,000 Retained Earnings (Young) ...................................... 10,000,000 Brand Name ............................................................... 280,000 Building .................................................................... 200,000 Equipment ............................................................ 100,000 Investment in Young's preferred stock (100%) . 3,100,000 Investment in Young's common stock (60%) ... 7,368,000 Noncontrolling Interest ....................................... 4,912,000

(To eliminate subsidiary stockholders’ equity, record excess acquisition-date fair values, and record outside ownership of subsidiary's preferred stock at acquisition-date fair value)



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32. (continued)

Entry I1 Dividend Income ....................................................... 80,000 Dividends Declared ............................................. 80,000

(To offset intra-entity preferred stock dividends recognized as income by parent— $1,000,000 par value × 8% dividend rate.)

Entry I2 Dividend Income ....................................................... 192,000 Dividends Declared ............................................. 192,000

(To eliminate intra-entity dividends [60% of $320,000] on common stock. Because the $320,000 in dividends remaining after Entry I1 equals exactly 8 percent of the common stock par value, the participation factor does not affect the distribution.)

Entry E Amortization Expense .............................................. 44,000 Equipment ................................................................. 10,000 Building ................................................................ 40,000 Brand Name ......................................................... 14,000 (To record 2014 amortization of specific accounts recognized within acquisition price of preferred stock.)



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33. (15 Minutes) (The effect that various events have on a consolidated statement of cash flows.)

Sale of building. The $44,000 in cash received from the sale is listed as a

cash inflow within the company's investing activities. If the company is using the direct method in presenting cash flows from operating activities, the $12,000 gain is not presented. However, if the indirect method is used, the gain (a positive) must be eliminated from net income by a subtraction.

Intra-entity inventory transfers. Because these transactions do not occur with any parties outside of the business combination, they are not reflected in the consolidated statement of cash flows.

Dividend paid by the subsidiary. The $27,000 payment to the parent is eliminated in consolidated statements and is not a cash outflow from the consolidated entity. The remaining $3,000 payment to the noncontrolling interest is reported as a cash outflow from a financing activity.

Amortization of intangible asset. This $16,000 noncash expense appears in the consolidated income statement. If the combined companies are using the direct method to present cash flows from operating activities, this expense not presented. If the indirect method is used, the expense must be removed by adding it back to consolidated net income.

Decrease in accounts payable. Cash payments have reduced this liability balance during the period. If the direct method is used to present cash flows from operating activities, the change is added to cost of goods sold as one step in deriving the cash paid during the period for inventory (an outflow). If the indirect method is applied, the decrease is subtracted from net income in arriving at the net cash generated from operating activities during the period.



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34. (20 Minutes) (Determine cash flows from operations for a consolidated entity.)

DIRECT METHOD Cash revenues (add book values, eliminate intra-entity transfers, and add decrease in accounts receivable) ................................... $648,000 Cash inventory purchases (add book values, eliminate intra-entity transfers, eliminate unrealized gains, add increase in inventory, and add decrease in accounts payable) ...................... (370,000) Depreciation and amortization (omit as noncash expenses) ............ -0- Other expenses (add book values) ..................................................... (40,000) Gain on sale of equipment (omit because this is an investing activity) -0- Equity in earnings of Knight (intra-entity so not included) .............. -0- Net cash flow from operating activities ................................... $238,000

INDIRECT METHOD Consolidated net income (computed below) ..................................... $216,000 Adjustments:

Depreciation and amortization ................................................. 61,000 Gain on sale of equipment ....................................................... (30,000) Increase in inventory ................................................................ (11,000) Decrease in accounts receivable ............................................. 8,000 Decrease in accounts payable ................................................. (6,000)

Net cash flow from operating activities ............................. $238,000 Consolidated Net Income = $206,200 + 9,800 = $216,000 or computation below: Revenues (add book values and subtract intra-entity transfers) $640,000 Cost of goods sold (add book values, less intra-entity transfers and beginning unrealized gain, plus ending unrealized gain) ......................................................................... (353,000) Depreciation and amortization (add book values plus amortization from excess fair value allocations) ................... (61,000) Other expenses (add book value) ................................................. (40,000) Gain on sale of equipment ............................................................. 30,000 Consolidated net income .......................................................... $216,000



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35. (30 Minutes) (Compute basic and diluted earnings per share for a parent and its 100 percent owned subsidiary, both with convertible bonds.)

Basic EPS—Porter Company: Porter's reported net income ................................... $150,000 Street's reported net income ................................... 130,000 Amortization expense .............................................. (10,000) Consolidated net income (all to Porter) ............. $270,000 Porter shares outstanding .................................. 60,000 Basic earnings per share ($270,000 ÷ 60,000) ........ $4.50

Diluted EPS—Street Company Street earnings after amortization ........................... $120,000 Shares outstanding .................................................. 30,000 Basic earnings per share (120,000 ÷ 30,000) .......... $4.00 Street's earnings assuming conversion of its bonds ($120,000 + $24,000 interest saved net of tax) .. $144,000 Street's shares assuming conversion of its bonds (30,000 + 10,000) .................................................. 40,000 Diluted earnings per share (144,000 ÷ 40,000) ....... $3.60

Because diluted earnings per share is less than basic earnings per share, the convertible bonds are dilutive and should be included.

Porter’s share of Street’s diluted earnings: Total shares assuming Street bond conversion .... 40,000 Shares owned by Porter ........................................... 30,000 Porter's ownership percentage (30,000 ÷ 40,000) .. 75% Street's earnings for diluted EPS (above) .............. $144,000 Porter's ownership percentage ................................ 75% Earnings attributed to Porter company .................. $108,000 Porter’s earnings and shares for diluted EPS:

Porter's separate net income .................................. $150,000 Street’s income applicable to Porter (above) .......... 108,000 Interest saved (net of tax) on assumed

conversion of Porter's bonds ............................. 32,000 Diluted earnings to Porter......................................... $290,000

Porter shares outstanding ....................................... 60,000 Additional shares from assumed bond conversion 8,000

Diluted shares ........................................................... 68,000 Consolidated income statement EPS amounts for Porter Company: Basic earnings per share (above) ............................ $4.50

Diluted earnings per share ($290,000 ÷ 68,000) ..... $4.26



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36. (15 Minutes) (Compute diluted EPS. Subsidiary has stock warrants outstanding) Figures For Sonston's Diluted EPS Net Income .................................................................... $200,000 Shares outstanding ...................................... .................... 40,000 Assumed conversion of stock warrants ..... 10,000 Repurchase of treasury stock with proceeds of stock Warrants (10,000 × $10 = $100,000 ÷ $20) ..... (5,000) 5,000 Shares for diluted earnings per share computation 45,000 Shares controlled by Primus: 40,000 + (20% of 5,000) =41,000 Percentage of total held by Primus: 41,000 ÷ 45,000 = 91% (rounded) Income to be included in parent’s diluted EPS = $200,000 × 91% = $182,000 Parent’s Diluted Earnings Per Share: Net income – Primus ........ $600,000 Net income included from Sonston ........ 182,000 Earnings for diluted EPS ........ $782,000 Outstanding shares of Primus .................... 100,000 PARENT’S DILUTED EARNINGS PER SHARE = $782,000 ÷ 100,000 = $7.82 37. (15 Minutes) (Compute diluted EPS. Subsidiary has convertible bonds.) Figures for Simon's diluted EPS: Net income ....................................................................................... $290,000 Interest (net of tax) saved from assumed conversion ................... 56,000 Earnings for diluted earnings per share ......................................... $346,000 Shares outstanding .......................................................................... 80,000 Assumed conversion of bonds ........................................................ 30,000 Subsidiary shares for parent’s share of diluted earnings .............. 110,000 Shares controlled by Garfun = 80,000 ÷ 110,000 = 73% (rounded) Income to be included in parent’s diluted EPS = $346,000 × 73% = $252,580 Earnings for parent’s diluted earnings per share: Net income—Garfun ............................................................. $480,000 Dividends to Garfun's preferred stock ................................. (15,000) Net Income included from Simon (above) ........................... 252,580 Earnings for diluted EPS ................................................. $717,580 PARENT’S DILUTED EARNINGS PER SHARE = $717,580 ÷ 80,000 = $8.97 (rounded)



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38. (35 Minutes) (Compute basic and diluted earnings per share for parent company. Subsidiary has stock warrants and convertible bonds.)

Basic EPS—Parent Company (Burks): Reported net income (separate)—Burks ........................ $150,000 Foreman net income: 80% × ($120,000 – $40,000 amort.) ........ 64,000 Preferred stock dividends (8,000 × $4) ............................. (32,000) Burks’ earnings applicable to basic EPS ....................... $182,000

Burks' outstanding shares .............................................. 65,000 Basic earnings per share ($182,000 ÷ 65,000) ................... $ 2.80

Diluted EPS—Parent Company (Burks) Subsidiary income for Burks’ EPS: Net income after amortization ($120,000 – 40,000) ............ $80,000 Interest (net of tax) saved assuming bond conversion .. 45,000 Income applicable to diluted EPS .............................. $125,000

Shares outstanding .......................................................... 40,000 Assumed conversion of warrants ................................... 20,000 Assumed acquisition of treasury stock with proceeds of conversion [(20,000 × $15) ÷ $20] ............ (15,000) Assumed conversion of bonds ....................................... 10,000 Shares applicable to diluted EPS .............................. 55,000 Shares controlled by parent: (40,000 × 80%) plus (10% × 10,000) ............................ 33,000

Income used in diluted EPS computation ...................... $125,000 Portion owned by parent (33,000 ÷ 55,000) ....................... 60%

Subsidiary income applicable to parent—diluted EPS . $ 75,000 Earnings applicable to Burks’ diluted EPS: Reported net income (separate)— Burks ........................ $150,000 Less: 10% intra-entity interest revenue (net of tax) ........ (4,500) Burks’ income for diluted EPS ......................................... $145,500 Burks’ share of Foreman income (above) ...................... $ 75,000 Because of assumed conversion, preferred stock dividends would not be paid ...................................... -0- Earnings applicable to diluted EPS ................................ $220,500 Burks' outstanding shares .............................................. 65,000 Assumed conversion of preferred stock (8,000 × 4) ....... 32,000

Shares applicable to diluted EPS .................................... 97,000

Diluted earnings per share ($220,500 ÷ 97,000)(rounded) = $ 2.27



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38. (continued)

Alternative derivation of Burks’ diluted EPS: Consolidated net income $150,000 + ($120,000 - $40,000) $(230,000) Consolidated interest saved (net of 10% intra-entity interest) (40,500) Consolidated net income assuming bond conversion (270,500) Subsidiary net income $(120,000) Excess fair value amortization 40,000 Subsidiary interest saved (100%) (45,000) Income applicable to diluted EPS $(125,000) Noncontrolling interest share (22,000 ÷ 55,000) 40% (50,000) Parent's net income applicable to diluted EPS $(220,500)

Shares for diluted EPS 97,000

Diluted EPS ($220,500 ÷ 97,000 shares) $ 2.27 39. (8 Minutes) (Effect of subsidiary stock issuance to public at a price above

reported value per share) Equity method investment prior to Ricardo share issue $490,000 Parent's ownership percentage ..................................... 100% Fair value ownership equivalency ................................. $490,000 Adjusted subsidiary fair value after new share issue (above value plus 10,000 shares at $15.75 each) ... $647,500 Parent's ownership (40,000 ÷ 50,000 shares) .............. 80% New ownership adjusted fair value ............................... $518,000 Investment in Ricardo should be increased by $28,000 ($518,000 less $490,000) 40. (20 Minutes) (Effects of two different stock issuances by subsidiary.) a. Prior to the issuance of the new shares, Albuquerque owns an 80% interest in

Marmon (16,000 shares out of 20,000 shares). The adjusted acquisition-date fair value is $840,000 ($600,000 + $150,000 + $90,000). After the stock issue, the adjusted acquisition-date fair value of the subsidiary will increase by $235,000 (the price of the stock) to $1,075,000. Albuquerque' ownership, however, will only be 64% (16,000 ÷ 25,000). The investment’s equity method balance before stock issue is $672,000 (600,000 + [$90,000 × 80%]). The book value underlying Albuquerque' investment is now $688,000 (64% of $1,075,000) so that a $16,000 increase is recorded by the parent.

Investment in Marmon ............................................. 16,000 Additional Paid-In Capital ................................... 16,000



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40.(continued) b. Albuquerque's adjusted acquisition-date fair value is $840,000 (see above) prior

to the issuance of the new shares. The 4,000 additional shares increase subsidiary's total value by $132,000 (the price of the stock) to $972,000. Albuquerque' ownership decreases to 2/3 (16,000 shares out of a total of 24,000) for a fair value equivalency of $648,000. Reducing the $672,000 (see a.) to $648,000 requires a $24,000 decrease to the parent’s APIC.

Additional Paid-In Capital ........................................ 24,000 Investment in Marmon ........................................ 24,000

41. (55 Minutes) (Prepare consolidation entries following a subsidiary stock issue to

outside parties.) Initially, Aronsen owns 18,000 shares (or 90%) of Siedel's outstanding shares

(the total number of shares can be determined by dividing the subsidiary's common stock account by the $10 per share par value). After issuing 4,000 additional shares, the parent must prepare an adjustment to reflect the change in its share of the subsidiary’s unamortized acquisition-date fair value. Because that entry has not been recorded, it is included on the consolidation worksheet as Entry C1 (labeled in this manner as a correction). Other consolidation procedures follow as described in previous chapters.

Excess Acquisition-Date Fair Value Allocation and Amortization Fair value (consideration transferred plus NCI fair value) .......... $649,000 Acquisition-date book value ........................................................... (480,000) Fair value in excess of book value ................................................ $169,000 Allocated to land based on fair value ............................................ 89,000 Allocated to copyrights based on fair value ................................. $ 80,000 Life of copyrights ........................................................................... 16 yrs Annual amortization ....................................................................... $ 5,000 Adjustment for Stock Transaction Adjusted acquisition-date fair value of subsidiary on new issue date ($649,000 + $90,000 + $152,000) ............... $891,000 Adjusted parent ownership (18,000 shares ÷ 24,000 shares) ..... 75% Parent’s post-issue equity method value at 1/1/14 ................ $668,250 Equity method balance before new subsidiary stock issue Consideration transferred .......................................... 584,100 Increase in book value (90% × $100,000) .................. 90,000 Copyright amortization ($5,000 × 2 years × 90%) ..... (9,000) 665,100 Required increase (Entry C1) ........................................................ $ 3,150



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41. (continued) Consolidation worksheet entries: Entry *C Investment in Siedel ................................................. 81,000 Retained Earnings, 1/1/14 (Aronsen) ................. 81,000

(To convert 1/1/14 balance to full accrual [$100,000 less two year’s amortization expense $5,000 × 2] × 90%)

Entry C1 Investment in Siedel ................................................. 3,150 Additional Paid-In Capital (Aronsen) ................. 3,150

(To record adjustment for subsidiary stock transaction; computation shown above.)

Entry S Common Stock (Siedel) ........................................... 240,000 Additional Paid-In Capital (Siedel) .......................... 112,000 Retained Earnings, 1/1/14 (Siedel) ........ .... 380,000 Investment in Siedel (75%) .................. ................. 549,000 Noncontrolling Interest in Siedel, 1/1/14 (25%) .. 183,000

(To eliminate subsidiary stockholders' equity accounts against Investment account and to recognize noncontrolling interest. Stockholders’equity balances have been adjusted for increase in book value during 2012–2013 and the issuance by the subsidiary of 4,000 shares of stock on 1/1/14.)

Entry A Land 89,000 Copyrights 70,000 Investment in Siedel (75%) 119,250 Noncontrolling Interest (25%) 39,750

(To recognize acquisition price allocated to land and copyrights. Copyrights balance has been reduced for 2012–2013 amortization to arrive at 1/1/14 balance. NCI now reflects 25% of the unamortized 1/1/14 balance.)

Entry I Dividend Income 15,000 Dividends Declared 15,000

(To eliminate intra-entity dividends recorded by parent as income [75% × $20,000].)

Entry E Amortization Expense 5,000 Copyrights 5,000



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(To recognize current year amortization.)



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42. (50 Minutes) (Prepare consolidation worksheet for business combination. Intra-entity bond acquisition is made during the current year.)

Acquisition-date fair-value allocation and amortization: Equipment $30,000 10-year life $3,000 annual amortization Trademarks $40,000 20-year life $2,000 annual amortization

As indicated in the problem, the parent is applying the partial equity method. Hence an Entry *C must be recorded on the worksheet to convert the recorded figures (amortization is needed for the three years prior to 2015) to equity balances: Amortization expense ($5,000 × 3 years) = ............. $15,000 (Entry *C)

Unrealized gain in ending inventory (downstream): Ending balance ......................................................... $10,000 Markup ($20,000 ÷ $100,000) .................................... 20%

Unrealized gain to be eliminated ............................. $ 2,000 (Entry G) Loss on extinguishment of bonds: Book value at date of repurchase ................................. $282,000 Percentage repurchased ............................................... 50% Equivalent book value ................................................... $141,000 Amount paid ................................................................... 145,500 Loss on extinguishment of bonds ................................ $ 4,500 (Entry B)

Amortization during 2015 changed the carrying value of the bond payable from $282,000 to $288,000 (found in the balance sheet) and the investment from $145,500 to $147,000. This amortization also affects interest income and expense accounts.

Entry A reflects remaining values after three years of amortizations.



42.(continued) Pavin and Stabler Consolidation Worksheet

Year Ending December 31, 2015 Consolidation Entries Consolidated Accounts Pavin Stabler Debit Credit Totals Revenues ............................................... (740,000) (505,000) (TI)100,000 (1,145,000) Cost of goods sold ................................ 455,000 240,000 (G) 2,000 (TI) 100,000 597,000 Expenses................................................ 125,000 158,500 (E) 5,000 288,500 Interest expense—bonds .................... 36,000 -0- (B) 18,000 18,000 Interest income—bond investment ..... -0- (16,500) (B) 16,500 -0- Loss on extinguishment of bonds ...... -0- -0- (B) 4,500 4,500 Equity in income of Stabler .................. (123,000) -0- (I) 123,000 -0- Net income .......................................... (247,000) (123,000) (237,000) Retained earnings, 1/1/15 ..................... (345,000) (*C) 15,000 (330,000) Retained earnings, 1/1/15 ..................... (361,000) (S) 361,000 -0- Net income (above) ............................... (247,000) (123,000) (237,000) Dividends declared ............................... 155,000 61,000 (D) 61,000 155,000 Retained earnings, 12/31/15 ................. (437,000) (423,000) (412,000) Cash and receivables ........................... 217,000 35,000 (P) 33,000 219,000 Inventory ................................................ 175,000 87,000 (G) 2,000 260,000 Investment in Stabler ............................ 613,000 -0- (D) 61,000 (*C) 15,000 (S) 481,000 (A) 55,000 -0- (I) 123,000 Investment in Pavin ............................. -0- 147,000 (B) 147,000 -0- Land, buildings, and equipment (net) . 245,000 541,000 (A) 21,000 (E) 3,000 804,000 Trademarks ............................................ -0- -0- (A) 34,000 (E) 2,000 32,000 Total assets ........................................ 1,250,000 810,000 1,315,000 Accounts payable ................................. (225,000) (167,000) (P) 33,000 (359,000) Bonds payable ....................................... (300,000) (100,000) (B) 150,000 (250,000) Discount on bonds ................................ 12,000 -0- (B) 6,000 6,000 Common stock ...................................... (300,000) (120,000) (S) 120,000 (300,000) Retained earnings (above) ................... (437,000) (423,000) (412,000) Total liabilities and stockholders’ equity (1,250,000) (810,000) 1,046,000 1,046,000 (1,315,000)



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43. (45 Minutes) (Prepare consolidation entries after intra-entity bond acquisition.) a. Allocation of Acquisition-date Excess Fair Value

Consideration transferred $312,000 Noncontrolling interest fair value 208,000 Acquisition-date fair value $520,000 Book value acquired 300,000 Fair value in excess of book value $220,000 Annual Excess Excess allocated to patents based Life Amortizations on fair value 90,000 12 years $7,500 Customer list $130,000 10 years 13,000 Total $20,500 CONSOLIDATION ENTRIES Entry *TL Investment in Herman .............................................. 7,000 Land .................................................................... 7,000

(To eliminate unrealized gain created by previous intra-entity transfer. Investment is adjusted here because transfer was downstream and equity method has been applied by parent. Thus, retained earnings have already been corrected.)

Entry *G Retained Earnings 1/1/14 (Herman) ........................ 8,000 Cost of Goods Sold ............................................. 8,000

(To remove unrealized inventory gain from prior year so that it can be properly realized in current year. Amount is computed as shown below.)

Intra-entity profit—2013 ........................................... $25,000 Transfer price—2013 ................................................ $125,000 Markup ($25,000 ÷ $125,000) .................................... 20% Unrealized gain in 1/1/14 inventory ($40,000 × 20%) .................................................... $8,000 Entry S Common Stock (Herman) ......................................... 100,000 Retained Earnings, 1/1/14 (Herman) (adjusted for Entry *G) ........................................ 292,000 Investment in Herman (60%) ......................... 235,200

Noncontrolling Interest in Herman (40%) .... 156,800 (To eliminate Herman's stockholders' equity accounts and to record beginning of year balance for noncontrolling interest.)



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43. a. (continued)

Entry A Patents .................................................................... 75,000 Customer List ............................................................ 104,000 Investment in Herman ......................................... 107,400 Noncontrolling Interest ....................................... 71,600

(To recognize unamortized balances as of 1/1/14 of amounts allocated within original acquisition price. Allocations have been reduced by two years of amortizations.)

Entry I Equity income of Herman ......................................... 3,000 Investment in Herman .................................... 3,000

(To eliminate intra-entity equity income accrual) Herman’s income ............................................................ $25,000 Excess amortizations ..................................................... (20,500) 2013 intra-entity inventory gross profit ......................... 8,000 2014 intra-entity inventory gross profit ......................... (7,500) Accrual-based income .................................................... $5,000 Fred’s ownership percentage ........................................ 60% Equity in earnings of Herman ........................................ $3,000

Entry D Investment in Herman .............................................. 2,400 Dividends Declared ............................................. 2,400 (To eliminate intra-entity dividend declaration.) Entry E Amortization Expense .............................................. 20,500 Patents .................................................................. 7,500 Customer List ....................................................... 13,000 (To recognize current year amortization expense.) Entry P Accounts Payable ..................................................... 60,000 Accounts Receivable .......................................... 60,000

(To remove intra-entity debt created by inventory transfers.)



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43. a. (continued)

Entry B Bonds Payable .......................................................... 20,000 Premium on Bonds Payable .................................... 1,069 Interest Income ......................................................... 1,873 Investment in Parent Bonds ............................... 19,005 Interest Expense ................................................. 1,283 Gain on Retirement of Bonds .............................. 2,654

(To eliminate effect created by bond acquisition and recognize the related retirement gain [$21,386 – $18,732]. Amounts are calculated below.)

Book Cash Year-End Value Effective Interest Excess Book (given) Interest (8%) Amortizations Value

Investment $18,732 $1,873 (10%) $1,600 $273 $19,005 Liability 21,386 1,283 (6%) 1,600 317 21,069

Entry Tl Sales .......................................................................... 120,000 Cost of Goods Sold (or purchases) ................... 120,000 (To eliminate intra-entity transfers made during current year.)

Entry G Cost of Goods Sold .................................................. 7,500 Inventory ............................................................... 7,500

(To defer intra-entity inventory profits until 2014 as calculated below):

Intra-entity profit ....................................................................... $30,000 Transfer price 2014 ................................................................... $120,000 Markup ($30,000 ÷ $120,000) .................................................... 25% Unrealized gain in ending inventory ($30,000 × 25%) ............ $7,500 b. Herman's reported net income for 2014 .................................. $25,000 Excess fair value amortization ................................................. (20,500) 2013 unrealized gain recognized in 2014 (Entry *G) .............. 8,000 2014 unrealized gain (Entry G) ................................................. (7,500) Herman's realized net income for 2014 .................................... $5,000 NCI ownership ........................................................................... 40% NCI’s share of the subsidiary's net income ............................. $2,000 Noncontrolling interest, 1/1/14 (Entries S and A) ................... $228,400 NCI’s share of Herman's net income (above) ......................... 2,000 NCI’s share of Herman's dividends ($4,000 × 40%) ................ (1,600) Noncontrolling interest, 12/31/14 .............................................. $228,800



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43. (continued) c. The balances in the individual records as of December 31, 2015 pertaining to

the Intra-entity bonds are as follows:

Beginning Book Cash Year-End Value Effective Interest Excess Book (see part a.) Interest (8%) Amortizations Value

Investment $19,005 $1,901 (10%) $1,600 $301 $19,306 Liability 21,069 1,264 (6%) 1,600 336 20,733

The adjustment to recognize the original gain by the parent can be computed as follows:

Original gain on retirement (see part a) ....................... $2,654 Interest income recorded on investment in 2014 (see part a) ................................................................ $1,873 Interest expense recorded on liability in 2014 (see part a) ............................................................... 1,283 590 Required increase as of January 1, 2015 ..................... $2,064

Entry *B (as of December 31, 2015) Bonds Payable ........................................................... 20,000 Premium on Bonds Payable .................................... 733 Interest Income ......................................................... 1,901 Investment in Herman ......................................... 2,064 Investment in Fred’s bonds ................................ 19,306 Interest Expense ................................................. 1,264

(To remove accounts pertaining to intra-entity bonds. "Investment in Herman" is adjusted here rather than retained earnings because equity method is being applied and gain is attributed to the parent.)



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44. (50 Minutes) (Prepare consolidation entries for intra-entity preferred stock and bonds. Determine specified account balances. Preferred stock is a debt instrument.)

a. Consideration transferred for common stock .................. $552,800

Consideration transferred for preferred stock ................. 65,000 Noncontrolling interest in common stock ........................ 138,200 Noncontrolling interest in preferred stock ....................... 34,000 Lisa’s acquisition-date fair value ....................................... $790,000 Book value of Lisa .............................................................. 750,000 Excess assigned to franchises .......................................... $ 40,000

CONSOLIDATION ENTRIES 1/1/13

Entry S and A combined: Preferred Stock (Lisa) .............................................. 100,000 Common Stock (Lisa) ............................................... 200,000 Retained Earnings, 1/1/13 (Lisa) .............................. 450,000 Franchises ................................................................. 40,000 Investment in Lisa-Common Stock ............... 552,800 Investment in Lisa-Preferred Stock ............... 65,000 Noncontrolling Interest in Lisa, Inc ............... 172,200

(To eliminate subsidiary stockholders’ equity, record excess acquisition-date fair values, and record outside ownership of subsidiary's preferred and common stock at acquisition-date fair values.)

b. Acquisition price of bonds, 1/2/13 ... $53,310 Book value of bonds payable (one-half acquired) . (44,175) Loss on extinguishment of debt . $9,135 Interest income—Mona ($53,310 × 8%) (rounded)$4,265 Interest expense—Lisa ($44,175 × 14%) (rounded)$6,185

Investment in bonds of Lisa (book value): Book value—date of acquisition, 1/2/13 . $53,310 Cash interest ($50,000 × 10%) ..... $5,000 Effective interest (above) ............. 4,265 735 Investment in Bonds of Lisa (book value as of 12/31/13) .... $52,575



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44. b. (continued) Bonds payable (book value) Book value—date of acquisition, 1/2/13 ............ $44,175 Cash interest ($50,000 × 10%) ............................ $5,000 Effective interest (above) .................................... 6,185 1,185 Bonds payable (book value as of 12/31/13) .. $45,360 CONSOLIDATION ENTRY B—December 31, 2013 (all figures computed above) Bonds Payable .......................................................... 50,000 Interest Income (or other revenues) ....................... 4,265 Loss on Retirement of Bonds .................................. 9,135 Discount on Bonds Payable ($50,000 – $45,360) 4,640 Interest Expense .................................................. 6,185 Investment in Bonds of Lisa .............................. 52,575 c. December 31, 2013 book values based on historical cost figures: Cost of fixed assets .................................................. $100,000 Depreciation expense ($40,000 book value over a 10-year life) ....................................................... 4,000 Accumulated depreciation (including current expense) ............................................................... 64,000 December 31, 2013 book values based on transfer price: Cost of fixed assets .................................................. $120,000 Depreciation expense (10-year life) ........................ 12,000 Accumulated depreciation ....................................... 12,000 Gain on transfer of fixed assets ($120,000 – $40,000) book value ........................ 80,000 CONSOLIDATION ENTRY TA—December 31, 2013 Gain on Transfer of Fixed Assets (to remove) ....... 80,000 Accumulated Depreciation ($64,000 – $12,000) . 52,000 Depreciation Expense ($12,000 – $4,000) ......... 8,000 Fixed Assets ($120,000 – $100,000) ................... 20,000



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44. (continued) d. Original allocation to franchises (given) ...................... $40,000 Amortization at $1,000/year (2013–2014) ................ (2,000) Consolidated franchises—12/31/14 ........................ $38,000 Fixed assets (book values): Mona, Inc. .................................................................. $1,100,000 Lisa Co. .................................................................... 800,000 Reduction necessitated by intra-entity sale ($120,000 transfer price reduced to $100,000 original cost) (see part c) .................................... (20,000) Consolidated fixed assets—12/31/14 ...................... $1,880,000 Accumulated depreciation (book values): Mona, Inc .................................................................... $300,000 Lisa Co. .................................................................... 200,000 Increase needed to eliminate intra-entity sale ($60,000 accumulated depreciation at time of transfer less excess depreciation expense [$12,000 - $4,000] for 2013 and 2014) ...................... 44,000 Consolidated Acc. Depr.—12/31/14 .......................... $544,000 Expenses (book values): Mona, Inc ............................................................... $220,000 Lisa Co. ................................................................ 120,000 Recognition of amortization on franchises ............ 1,000 Elimination of interest expense on intercom- pany debt ($45,360 [see part b] × 14%) (rounded) (6,350) Elimination of excess depreciation from intra-entity transfer of fixed assets ($12,000– $4,000) ................................................. (8,000) Consolidated expenses ........................................... $326,650



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45. (35 Minutes) (Prepare statement of cash flows for a business combination.)

(Note: before working this problem, students may wish to review the statement of cash flows in an intermediate accounting textbook.)

BOLERO COMPANY AND CONSOLIDATED SUBSIDIARY RIVERA

Consolidated Statement of Cash Flows Year Ending December 31, 2015

CASH FROM OPERATING ACTIVTIES Consolidated net income .......................................... $250,000 Adjustment from accrual to cash: Depreciation and amortization ........................... 120,000 Gain on sale of building ...................................... (30,000) Decrease in accounts receivable ....................... 20,000 Increase in inventory .......................................... (150,000) Decrease in accounts payable ........................... (50,000) Net cash flow from operating activities .................. $160,000 CASH FLOWS FROM INVESTING ACTIVITIES Sale of building ......................................................... $70,000 Purchase of equipment (given) ................................ (205,000) Net cash flow from investing activities .............. (135,000) CASH FLOWS FROM FINANCING ACTIVITIES Dividends paid .......................................................... $(112,000) Issuance of bonds .................................................... 110,000 Issuance of common stock ...................................... 67,000 Net cash flow from financing activities ............. 65,000

Net increase in cash during 2015 ................................. 90,000 Cash, January 1, 2015 ................................................... 90,000 Cash, December 31, 2015 .............................................. $180,000

The above statement uses the indirect method for computing cash flows from operations.



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45. (continued) Development of Cash Flow Balances via Direct Method OPERATING ACTIVITIES Cash collected from customers (consolidated revenues plus the decrease in accounts receivable) $1,050,000 Cash Purchases (consolidated COGS plus increase in inventory plus decrease in accounts payable) (850,000) Interest expense (the consolidated balance) (40,000) Cash flows from operating activities ...... ............................ $ 160,000 INVESTING ACTIVITIES Sale of building ($40,000 book value sold at a $30,000 gain) ............ $ 70,000 Purchase of equipment (given in problem) ......................................... (205,000) Cash flows from investing activities ....... ........................... $(135,000) FINANCING ACTIVITIES Dividends paid by parent (the consolidated balance) .......................... $(110,000) Dividends paid by subsidiary (amount paid to noncontrolling interest—20%) (2,000) Issuance of bonds 110,000 Issuance of common stock by the parent (increase in common stock and additional paid-in capital) 67,000 Cash flows from financing activities ...... ............................ $ 65,000



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46. (40 Minutes) (Compute basic and diluted earnings per share. Subsidiary has stock warrants outstanding and convertible debt.)

Basic EPS—Austin, Inc. Consolidated net income to parent ............................... $284,000 Austin’s preferred dividends ........................................ (40,000) Earnings applicable to Austin’s basic EPS ............ $244,000 Austin's outstanding common shares ......................... 50,000

Basic earnings per share ($244,000 ÷ 50,000) .................. $4.88 Diluted EPS—Austin, Inc. Subsidiary earnings and shares for Austin’s diluted EPS calculation: Rio Grande net income after amortization .................... $105,000 Interest saved assuming conversion of bonds (net of tax) ................................................................. 22,000 Net income applicable to diluted EPS .......................... $127,000 Shares outstanding ....................................................... 30,000 Assumed conversion of warrants ................................ 5,000 Assumed treasury stock acquisition using proceeds from warrant conversion ([5,000 × $10] ÷ $20) ....... (2,500) Assumed conversion of bonds ..................................... 10,000 Subsidiary shares applicable to diluted EPS .............. 42,500 Shares controlled by parent (24,000 plus 50% of increment created by warrants [or 1,250]) ...................... 25,250 Portion owned by parent (25,250 ÷ 42,500) .................. 59.4% (rounded) Net income applicable to parent—diluted EPS (59.4% × $127,000) .................................................... $75,438 Austin’s income and shares for diluted EPS calculation: Austin’s separate net income ................................... $200,000 Net income of Rio Grande to parent (computed above) 75,438 Preferred dividends (assumed converted) ...................... -0- Earnings applicable to diluted EPS ................................. $275,438 Austin's outstanding common shares ....... .......... 50,000 Assumed conversion of preferred stock (10,000 × 2 shares) ...................................... .......... 20,000 Shares applicable to diluted EPS ............... .......... 70,000

Diluted earnings per share ($275,438 ÷ 70,000) ................ $3.93 (rounded)



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47. (50 Minutes) (Determine consolidated totals. Subsidiary has preferred shares outstanding that are equity instruments.)

Consideration transferred for common and preferred stock $560,000 Skyler’s book value 450,000 Excess fair value assigned to intangible asset (10-year life) $110,000 Annual amortization $11,000

Ending Unrealized Gain Ending inventory (at transfer price) ............................. $18,000 Markup ($30,000 ÷ $90,000) ...................................... 33⅓% Ending unrealized gain (increase made to cost of goods sold to defer gain) ............................... $6,000

Effect of Intra-Entity Equipment Transfer:

Transfer price: Recorded value ................................................................................ $20,000 Depreciation expense ($20,000 ÷ 4) ............................................... $5,000 Accumulated depreciation .............................................................. $5,000 Gain on sale ($20,000 – $12,000) .................................................... $8,000 Historical cost: Recorded value ................................................................................ $30,000 Depreciation expense ($12,000 ÷ 4) ............................................... $3,000 Accumulated depreciation ($18,000 + $3,000) .............................. $21,000



47. (continued) Paisley, Inc. and Skyler Corp.

Consolidation Worksheet Year Ending December 31, 2014

Consolidation Entries Consolidated Accounts Paisley, Inc. Skyler Corp. Debit Credit Totals Sales ................................................. (800,000) (400,000) (TI) 90,000 (1,110,000) Cost of goods sold ......................... 528,000 260,000 (G) 6,000 (TI) 90,000 704,000 Expenses ......................................... 180,000 130,000 (E) 11,000 (ED) 2,000 319,000 Gain on sale of equipment ............. (8,000) -0- (TA) 8,000 -0- Net income .................................... (100,000) (10,000) (87,000)

Retained earnings, 1/1 .................... (400,000) (150,000) (S) 150,000 (400,000) Net income ....................................... (100,000) (10,000) (87,000) Dividends declared ......................... 60,000 -0- 60,000 Retained earnings, 12/31 ............. (440,000) (160,000) (427,000)

Cash ................................................. 30,000 40,000 70,000 Accounts receivable ....................... 300,000 100,000 (P) 28,000 372,000 Inventory .......................................... 260,000 180,000 (G) 6,000 434,000 Investment in Skyler Corp. ............. 560,000 -0- (S) 450,000 -0- (A) 110,000 Land, buildings, and equipment .... 680,000 500,000 (TA) 10,000 1,190,000 Accumulated depreciation ............. (180,000) (90,000) (ED) 2,000 (TA) 18,000 (286,000) Intangible Asset .............................. -0- -0- (A) 110,000 (E) 11,000 99,000 Total assets .................................. 1,650,000 730,000 1,879,000

Accounts payable ........................... (140,000) (90,000) (P) 28,000 (202,000) Long-term liabilities ........................ (240,000) (180,000) (420,000) Preferred stock ................................ -0- (100,000) (S) 100,000 -0- Common stock ................................ (620,000) (200,000) (S) 200,000 (620,000) Additional paid-in capital ............... (210,000) -0- (210,000) Retained earnings, 12/31 ................ (440,000) (160,000) (427,000) Total liab. and stockholders’ equity (1,650,000) (730,000) 715,000 715,000 (1,879,000)

Chapter 11 - Worldwide Accounting Diversity and International Standards


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47. (continued) CONSOLIDATED TOTALS Sales = $1,110,000 (add book values and eliminate intra-entity transfers)

Cost of Goods Sold = $704,000 (add book values, eliminate intra-entity transfers, and eliminate ending unrealized gain [computed above])

Expenses = $319,000 (add book values and include amortization of intangibles and eliminate $2,000 excess equipment depreciation)

Gain on Sale of Equipment = $0 (intra-entity balance is eliminated)

Net Income = $87,000 (consolidated revenues less consolidated expenses)

Retained Earnings, 1/1 = $400,000 (parent company figure only because subsidiary was not acquired until current year)

Dividends Declared = $60,000 (parent balance only)

Retained Earnings, 12/31 = $427,000 (consolidated beginning retained earnings plus net income less dividends declared)

Cash = $70,000 (add book values)

Accounts Receivable = $372,000 (add book values after eliminating intra-entity balance)

Inventory = $434,000 (add book values after eliminating unrealized gain)

Investment in Skyler Corporation = 0 (intra-entity account is eliminated because individual asset and liability accounts of subsidiary are included)

Land, Buildings, and Equipment = $1,190,000 (add book values and increase transferred asset from transfer price to historical cost [see above])

Accumulated Depreciation = $286,000 (add book values and adjust balance for transferred asset from transfer price figure to historical cost (see above])

Intangible Asset = $99,000 (original allocations less one year amortization)

Total Assets = $1,879,000 (summation of consolidated accounts)

Accounts Payable = $202,000 (add book values and remove intra-entity balance)

Long-Term Liabilities = $420,000 (add book values)

Preferred Stock = $0 (subsidiary outstanding shares are eliminated)


Additional Paid-in Capital = $210,000 (parent balance only)

Retained Earnings, 12/31 = $427,000 (computed above)

Total Liabilities and Equities = $1,879,000 (summation of consolidated accounts)



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47. (continued): Consolidation entries and explanations:

Entry S Preferred Stock (Skyler) .................................................... 100,000 Common Stock (Skyler) ..................................................... 200,000 Retained Earnings, 1/1 ....................................................... 150,000 Investment in Skyler Corp. .......................................... 450,000

(To eliminate subsidiary stockholder’s equity accounts.)

Entry A Intangible Asset ................................................................ 110,000 Investment in Skyler Corp. .......................................... 110,000

(To recognize excess fair value attributed to intangible asset.)

Entry E Amortization Expense ....................................................... 11,000 Intangible Asset ............................................................ 11,000 (To record current year’s amortization of intangible asset.)

Entry P Accounts Payable .............................................................. 28,000 Accounts Receivable ................................................... 28,000 (To eliminate intra-entity debt.)

Entry TA Equipment ........................................................................... 10,000 Gain on Sale of Equipment ............................................... 8,000 Accumulated Depreciation .......................................... 18,000

(To eliminate effects as of 1/1 created by intra-entity transfer of equipment.)

Entry TI Sales ................................................................................. 90,000 Cost of Goods Sold ...................................................... 90,000 (To eliminate intra-entity inventory transfers for the current year.) Entry G Cost of Goods Sold ............................................................ 6,000 Inventory ....................................................................... 6,000

......................................................................................................... (To defer unrealized intra-entity gain remaining at the end of the current year. Markup is 33⅓% [30,000 gross profit ÷ 90,000 transfer price] indicating that the ending inventory of 18,000 contains an unrealized profit of 6,000 [18,000 × 33⅓%].)

Entry ED Accumulated Depreciation ................................................ 2,000 Depreciation Expense .................................................. 2,000

(To eliminate excess depreciation resulting from intra-entity gain of 8,000 on transfer of equipment [see Entry TA]. Equipment is being depreciated over a remaining life of four years.)



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48. (30 minutes) (Consolidated Cash Flow Statement with current year business combination)

Plaster Inc. and Subsidiary Stucco Company Consolidated Statement of Cash Flows

For the year ended 12/31/14

CASH FLOW FROM OPERATING ACTIVITIES Consolidated net income $274,000 Depreciation expense 187,500 Amortization expense 8,750 Decrease in accounts receivable (net of acquisition) 3,600 Increase in inventory (net of acquisition) (102,000) Decrease in accounts payable (net of acquisition) (8,000) 89,850 Net cash flow provided by operating activities $363,850 CASH FLOW FROM INVESTING ACTIVITIES Purchase of Stucco Company assets (net of cash acquired) Net cash flow used in investing activities (856,000) CASH FLOW FROM FINANCING ACTIVITIES Issue long-term debt 800,000 Dividends (108,000) Net cash flow provided by financing activities $692,000 Increase in cash 1/1/14 to 12/31/14 $199,850 Beginning cash, 1/1/14 43,000 Ending cash, 12/31/14 $242,850



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Excel Case–Intra-entity Bonds Bonds with a stated rate of 11% sold to yield 12% Eff. Yield 12% 1,000,000.00 0.32197 321,973.24 110,000.00 5.65022 621,524.53 943,497.77 56,502.23 2012 943,497.77 113,219.73 110,000.00 3,219.73 2013 946,717.50 113,606.10 110,000.00 3,606.10 2014 950,323.60 114,038.83 110,000.00 4,038.83 2015 954,362.43 114,523.49 110,000.00 4,523.49 2016 958,885.93 115,066.31 110,000.00 5,066.31 2017 963,952.24 115,674.27 110,000.00 5,674.27 2018 969,626.51 116,355.18 110,000.00 6,355.18 2019 975,981.69 117,117.80 110,000.00 7,117.80 2020 983,099.49 117,971.94 110,000.00 7,971.94 2021 991,071.43 118,928.57 110,000.00 8,928.57 1,000,000.00 56,502.23 Consolidated Worksheet Entry 12/31/14 Bonds Payable 954,362.43 Interest Income 117,523.20 Loss on Retirement 0.00 Gain on Retirement 46,299.01

Investment in Bonds 911,547.79 Interest Expense 114,038.83 Bonds retired by affiliate on 1/1/14 at 904,024.59 Eff. Yield 13% 1,000,000.00 0.37616 376,159.86 110,000.00 4.79877 527,864.73 904,024.59 95,975.41 2014 904,024.59 117,523.20 110,000.00 7,523.20

2015 911,547.79 118,501.21 110,000.00 8,501.21 2016 920,049.00 119,606.37 110,000.00 9,606.37 2017 929,655.37 120,855.20 110,000.00 10,855.20 2018 940,510.57 122,266.37 110,000.00 12,266.37 2019 952,776.95 123,861.00 110,000.00 13,861.00 2020 966,637.95 125,662.93 110,000.00 15,662.93 2021 982,300.88 127,699.12 110,000.00 17,699.12 1,000,000.00 95,975.41



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Financial Reporting Research and Analysis Case The number of potential solutions is large. Searches in Lexis-Nexis, Edgar, etc. will produce numerous examples of consolidations of VIEs. For example, Walt Disney Company prepares a before and after disclosure of its consolidated VIEs Euro Disney, Hong Kong Disneyland, and Shanghai Disney Resort as follows (9-29-12): Before International International Theme Parks Theme Parks Consolidation and Adjustments Total Cash and cash equivalents $2,839 $548 $ 3,387 Other current assets 10,066 256 10,322 Total current assets 12,905 804 13,709 Investments/Advances 6,065 (3,342) 2,723 Fixed assets 17,005 4,507 21,512 Other assets 36,949 5 36,954 Total assets $72,924 $1,974 $74,898 Current portion of borrowings 3,614 -0- 3,614 Other current liabilities 8,742 457 9,199 Total current liabilities 12,356 457 12,813 Borrowings 10,430 267 10,697 Deferred income tax and other liabilities 9,325 105 9,430 Equity 40,813 1,145 41,958 Total liabilities and equity $72,924 $1,974 $74,898



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Education.

CHAPTER 11 WORLDWIDE ACCOUNTING DIVERSITY

AND INTERNATIONAL STANDARDS Chapter Outline I. Accounting and financial reporting rules differ across countries. There are a variety of factors

influencing a country’s accounting system.

A. Legal system—primarily relates to how accounting principles are established; code law countries generally having legislated accounting principles and common law countries having principles established by non-legislative means.

B. Taxation—financial statements serve as the basis for taxation in many countries. In those countries with a close linkage between accounting and taxation, accounting practice tends to be more conservative so as to reduce the amount of income subject to taxation.

C. Financing system—where shareholders are a major provider of financing, the demand for information made available outside the company becomes greater. In those countries in which family members, banks, and the government are the major providers of business finance, there is less demand for public accountability and information disclosure.

D. Inflation—historically, caused some countries, especially in Latin America, to develop accounting principles in which traditional historical cost accounting is abandoned in favor of inflation adjusted figures. As inflation has been brought under control in most countries, this factor is no longer of significant influence.

E. Political and economic ties—can explain the usage of a British style of accounting throughout most of the former British Empire. They also help to explain similarities between the U.S. and Canada, and increasingly, the U.S. and Mexico.

F. Culture—affects a country’s accounting system in two ways: (1) through its influence on a country’s institutions, such as its legal system and system of financing, and (2) through its influence on the accounting values shared by members of the accounting sub-culture.

II. Nobes developed a general model of the reasons for international differences in financial reporting that has only two explanatory factors: (1) national culture, including institutional structures, and (2) the nature of a country’s financing system.

A. A self-sufficient Type I culture will have a strong equity-outsider financing system which results in a Class A accounting system oriented toward providing information for outside shareholders.

B. A self-sufficient Type II culture will have a weak equity-outsider financing system which results in a Class B accounting system oriented toward protecting creditors and providing a basis for taxation.

C. Countries dominated by a country with a Type I culture will use a Class A accounting system even though they do not have strong equity-outsider financing systems.

D. Companies with strong equity-outsider financing located in countries with a Class B accounting system will voluntarily attempt to use a Class A accounting system to compete in international capital markets.

III. Differences in accounting across countries cause several problems.

A. Consolidating foreign subsidiaries requires that the financial statements prepared in accordance with foreign GAAP must be converted into the parent company’s GAAP.



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B. Companies interested in obtaining capital in foreign countries often are required to provide financial statements prepared in accordance with accounting rules in that country, which are likely to differ from rules in the home country.

C. Investors interested in investing in foreign companies may have a difficult time in making comparisons across potential investments because of differences in accounting rules across countries.

IV. The International Accounting Standards Committee (IASC) was formed in 1973 in hopes of improving and promoting the worldwide harmonization of accounting principles. It was superseded by the International Accounting Standards Board (IASB) in 2001.

A. The IASC issued 41 International Accounting Standards (IAS) covering a broad range of accounting issues. Ten IASs have been superseded or withdrawn, leaving 31 in effect.

B. The membership of the IASC was composed of over 140 accountancy bodies from more than 100 nations.

C. The IASC was not in a position to enforce its standards. Instead, member accountancy bodies pledged to work toward acceptance of IASs in the respective countries.

D. Because of criticism that too many options were allowed in its standards and therefore true comparability was not being achieved, the IASC undertook a Comparability Project in the 1990s, revising 10 of its standards to eliminate alternatives.

E. The IASC derived much of its legitimacy as an international standard setter through endorsement of its activities by the International Organization of Securities Commissions. IOSCO and the IASC agreed that, if the IASC could develop a set of core standards, IOSCO would recommend that stock exchanges allow foreign companies to use IASs in preparing financial statements. The IASC completed the set of core standards in 1998, IOSCO endorsed their usage by foreign companies in 2000, and many members of IOSCO adopted this recommendation.

V. The International Accounting Standards Board (IASB) replaced the IASC in 2001.

A. The IASB originally consisted of 14 members – 12 full-time and 2 part-time. The number of board members was increased to 16 members in 2012, at least 13 of whom must be full-time. Full-time IASB members are required to sever their relationships with former employers to ensure independence. To ensure a broad international diversity, there normally are four members from Europe; four from North America; four from the Asia/Oceania region; one from Africa; one from South America; and two from any area to achieve geographic balance.

B. IASB GAAP is referred to as International Financial Reporting Standards (IFRS) and consists of (a) IASs issued by the IASC (and adopted by the IASB), (b) individual International Financial Reporting Standards developed by the IASB, and (c) Interpretations issued by the Standing Interpretations Committee (SIC) (until 2001) and International Financial Reporting Interpretations Committee (IFRIC).

C. In addition to 31 IASs and 13 IFRSs (as of January 2013), the IASB also has a Framework for the Preparation and Presentation of Financial Statements, which serves as a guide to determine the proper accounting in those areas not covered by IFRS.

D. As of June 2012, more than 90 countries required the use of IFRS by all domestic publicly traded companies, and several important countries were to begin using IFRS in the near future. Other countries allow the use of IFRS by domestic companies. Many countries also allow foreign companies that are listed on their securities markets to use IFRS.

E. There are two primary methods used by countries to incorporate IFRS into their financial reporting requirements for listed companies: (1) full adoption of IFRS as issued by the IASB, without any intervening review or approval by a local body, and (2) adoption of IFRS after some form of national or multinational review and approval process.

Chapter 12 - Financial Reporting and the Securities and Exchange Commission


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VI. The U.S. FASB has adopted a strategy of convergence with IASB standards.

A. In 2002, the IASB and FASB signed the so-called “Norwalk Agreement” to “use their best efforts to (a) make their existing financial reporting standards fully compatible as soon as is practicable and (b) coordinate their work program to ensure that once achieved, compatibility is maintained.”

B. The FASB-IASB convergence process has resulted in changes made to U.S. GAAP, IFRS, or both in a number of areas including: Business combinations, Non-controlling interests, Acquired in-process research costs, Share-based payment, Borrowing costs, Segment reporting, and Presentation of other comprehensive income.

C. At the beginning of 2013, the FASB listed joint convergence projects with either an Exposure Draft or final standard expected to be issued in 2013 in the following areas: Leases, Insurance contracts, Financial instruments, Revenue recognition, Investment companies, and Consolidation: Policy and Procedures

VII. The U.S. SEC’s early interest in IFRS stemmed from IOSCO’s endorsement of IFRS for cross-listing purposes.

A. After considering this issue for several years, in 2007 the SEC amended its rules to allow foreign registrants to prepare financial statements in accordance with IFRS without reconciliation to U.S. GAAP. Since 2007, foreign companies using IFRS have been able to list securities on U.S. securities markets without providing any U.S. GAAP information in their annual reports.

B. To level the playing field for U.S. companies, in July 2007, the SEC issued a concept release to determine public interest in allowing U.S. companies to choose between IFRS and U.S. GAAP in preparing financial statements. Many comment letter writers were not in favor of allowing U.S. companies to choose between IFRS and U.S. GAAP instead recommending that U.S. companies be required to use IFRS.

C. In November 2008, the SEC issued the so-called “IFRS Roadmap.” The SEC indicated it would monitor several milestones until 2011 at which time it decide whether to require U.S. companies to follow IFRS over a three-year phase-in period. The Roadmap indicated 2014 as the first year of IFRS adoption, but a subsequent SEC Release in February 2010 pushed that date back to “approximately 2015 or 2016.”

D. In 2011, the SEC Staff published a discussion paper that suggests an alternative framework for incorporating IFRS into the U.S. financial reporting system. This framework combines the existing FASB-IASB convergence project with the endorsement process followed in many countries and the EU. Some refer to this method as “condorsement.” The framework would retain both U.S. GAAP and the FASB as the U.S. accounting standard setter. At the end of a transition period, a U.S. company following U.S. GAAP also would be able to represent that its financial statements are in compliance with IFRS.

E. The 2011 deadline established by the SEC in its IFRS Roadmap came and went without the Commission making a decision whether to require the use of IFRS in the U.S. In July 2012, the SEC staff issued a Final Staff Report that summarized analysis conducted by the SEC Staff on the possible use of IFRS by U.S. companies, but it did not include conclusions or recommendation for action by the Commission and did not provide insight into the nature or timetable for next steps. Thus, at the time this book went to press, the SEC had not signaled when it might make a decision about whether and, if so, how IFRS should be incorporated into the U.S. financial reporting system.

VIII. IFRS 1, First-time Adoption of IFRS, established guidelines that a company must use in transitioning from previously-used GAAP to IFRS.



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A. Companies transitioning to IFRS must prepare an opening balance sheet at the “date of transition.” The transition date is the beginning of the earliest period for which an entity presents full comparative information under IFRS. For example, for a company preparing its first set of financial statements for the calendar year 2017, the date of transition is January 1, 2015.

B. An entity must complete the following steps to prepare the opening IFRS balance sheet:

1. Determine applicable IFRS accounting policies based on standards in force on the reporting date.

2. Recognize assets and liabilities required to be recognized under IFRS that were not recognized under previous GAAP and derecognize assets and liabilities previously recognized that are not allowed to be recognized under IFRS.

3. Measure assets and liabilities recognized on the opening balance sheet in accordance with IFRS.

4. Reclassify items previously classified in a different manner from what is acceptable under IFRS.

IX. IAS 8, “Accounting Policies, Changes in Accounting Estimates and Errors,” establishes guidelines for determining appropriate IFRS accounting polices.

A. Companies must use the following hierarchy to determine accounting polices that will be used in preparing IFRS financial statements. 1. Apply specifically relevant standards (IASs, IFRSs, or Interpretations) dealing with

an accounting issue. 2. Refer to other IASB standards dealing with similar or related issues. 3. Refer to the definitions, recognition criteria, and measurement concepts in the

IASB Framework. 4. Consider the most recent pronouncements of other standard-setting bodies that

use a similar conceptual framework, other accounting literature, and accepted industry practice to the extent that these do not conflict with sources in 2. and 3. above.

B. Because the FASB and IASB conceptual frameworks are similar, step 4 provides an opportunity for entities to adopt FASB standards in dealing with accounting issues where steps 1 through 3 are not helpful.

X. Numerous differences exist between IFRS and U.S. GAAP.

A. Differences exist with respect to recognition, measurement, presentation, and disclosure. Exhibit 11.8 lists several key differences.

B. IAS 1, “Presentation of Financial Statements,” provides guidance with respect to the purpose of financial statements, components of financial statements, basic principles and assumptions, and the overriding principle of fair presentation. There is no equivalent to IAS 1 in U.S. GAAP.

C. The IASB follows a principles-based approach to standard setting, rather than the so-called rules-based approach used by the FASB. The IASB tends to avoid the use of bright line tests and provides a limited amount of implementation guidance in its standards.

XI. Even if all countries adopt a similar set of accounting standards, two obstacles remain in

achieving the goal of worldwide comparability of financial statements.

A. IFRS must be translated into languages other than English to be usable by non-English speaking preparers of financial statements. It is difficult to translate some words and phrases into other languages without a distortion of meaning.



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B. Culture can affect the manner in which an accountant interprets and applies an accounting standard. Differences in culture can lead to differences in application of the same standard across countries.



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Answer to Discussion Question: Which Accounting Method Really is Appropriate?

Students in the United States often assume that U.S. GAAP is superior and that all reporting issues can (or should) be resolved by following U.S. rules. However, the reporting of research and development costs is a good example of a rule where different approaches can be justified and the U.S. rule might be nothing more than an easy method to apply. In the United States, all such costs are expensed as incurred because of the difficulty of assessing the future value of these projects. International Financial Reporting Standards require capitalization of development costs when certain criteria are met. The issue is not whether costs that will have future benefits should be capitalized. Most accountants around the world would recommend capitalizing a cost that leads to future revenues that are in excess of that cost. The real issue is whether criteria can be developed for identifying projects that will lead to the recovery of those costs. In the U.S., the FASB felt that such decisions were too subjective and open to manipulation. Conversely, under IFRS, development costs must be recognized as an intangible asset when an enterprise can demonstrate all of the following: (a) the technical feasibility of completing the intangible asset so that it will be available for use or

sale; (b) its intention to complete the intangible asset and use or sell it; (c) its ability to use or sell the intangible asset; (d) how the intangible asset will generate probable future economic benefits. Among other things,

the enterprise should demonstrate the existence of a market for the output of the intangible asset or the existence of the intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset;

(e) the availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset; and

(f) its ability to measure the expenditure attributable to the intangible asset during its development reliably.

The IFRS treatment of development costs begs the question: How easy is it for an accountant to determine whether the development project will result in an intangible asset, such as a patent, that will generate future economic benefits? In the U.S., a conservative approach has been taken because of the difficulty of determining whether an asset has been or will be created. To ensure comparability, all companies are required to expense all R&D costs. As a result, costs related to development costs that prove to be very valuable to a company for years to come are expensed immediately. Do the benefits of consistency and comparability (each company expenses all costs each year) outweigh the cost of producing financial statements that might omit valuable assets from the balance sheet? No definitive answer exists for that question. However, the reader of financial statements needs to be aware of the fundamental differences in approach that exist in accounting for development costs before making comparisons between companies from different countries.



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1. The five factors most often cited as affecting a country's accounting system are: (1) legal

system, (2) taxation, (3) providers of financing, (4) inflation, and (5) political and economic ties. The legal system is primarily related to how accounting principles are established; code law countries generally having legislated accounting principles and common law countries having principles established by non-legislative means. In some countries, financial statements serve as the basis for taxation and in other countries they do not. In those countries with a close linkage between accounting and taxation, accounting practice tends to be more conservative so as to reduce the amount of income subject to taxation. Shareholders are a major provider of financing in some countries. As shareholder financing increases in importance, the demand for information made available outside the company becomes greater. In those countries in which family members, banks, and the government are the major providers of business finance, there tends to be less demand for public accountability and information disclosure. Historically, chronic high inflation caused some countries, especially in Latin America, to develop accounting principles in which traditional historical cost accounting is abandoned in favor of inflation adjusted figures. Because inflation has been brought under control in most countries of the world, this factor is no longer of much significance. Political and economic ties can explain the usage of a British style of accounting throughout most of the former British empire. They also help to explain similarities between the U.S. and Canada, and increasingly, the U.S. and Mexico.

Culture also is viewed as a factor that has significant influence on the development of a country’s accounting system. This influence is described in more detail in the answer to question 3.

2. Problems caused by accounting diversity for a company like Nestle include: (a) the additional

cost associated with converting foreign GAAP financial statements of foreign subsidiaries to parent company GAAP to prepare consolidated financial statements, (b) the additional cost associated with preparing Nestle financial statements in foreign GAAP (or reconciling to foreign GAAP) to gain access to foreign capital markets, and (c) difficulty in understanding and comparing financial statements of potential foreign acquisition targets.

3. Gray developed a model that hypothesizes that societal values, i.e., culture, affect the

development of accounting systems in two ways: (1) societal values help shape a country’s institutions, such as legal system and financing system, which in turn influences the development of accounting, and (2) societal values influence accounting values held by members of the accounting sub-culture, which in turn influences the development of the accounting system. Gray provides specific hypotheses with respect to the manner in which specific cultural dimensions will influence specific accounting values. For example, he hypothesizes that in countries in which avoiding uncertainty is important, accountants will have a preference for more conservative measurement of profit.

4. According to Nobes, the purpose for financial reporting determines the nature of a country’s

financial reporting system. The most relevant factor for determining the purpose of financial reporting is the nature of the financing system. Some countries have a culture, and accompanying institutional structure, that leads to a strong equity financing system with large numbers of outside shareholders.

A country with a self-sufficient Type I culture will have a strong equity-outsider financing system which in turn will lead that country developing a Class A accounting system oriented toward providing information for outside shareholders. A self-sufficient Type II culture will have a weak equity-outsider financing system which results in a Class B accounting system oriented toward protecting creditors and providing a basis for taxation.



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5. Several of the IASC’s original standards were criticized for allowing too many alternative methods of accounting for a particular item. As a result, through the selection of different acceptable options, the financial statements of two companies following International Accounting Standards still might not have been comparable. To enhance the comparability of financial statements prepared in accordance with International Accounting Standards, and at the urging of the International Organization of Securities Commissions, the IASC systematically reviewed its existing standards (in the so-called Comparability Project) and revised ten of them by eliminating previously acceptable alternatives.

6. A major difference between the IASB and the IASC is the composition of the Board and the

manner in which Board members are selected. IASB has at least 12 and as many as 14 full-time members, the IASC had zero. Full-time IASB members must sever their employment relationships with former employers and must maintain their independence. Seven of the full-time members have a liaison relationship with a national standard setter. At least five members must have been auditors, three must have been financial statement preparers, three must have been users of financial statements, and at least one must come from academia. The most important criterion for appointment to the IASB is technical competence. (Although not stated in the body of the chapter, there was a perception that some appointments to the IASC were based on politic connections and not competence.)

[Some of the common features of the IASC and IASB are that both (a) issue/d “international standards,” (b) have/had their headquarters in London, and (c) use/d English as the working language.]

7. This statement is true in that EU publicly traded companies are required to use IFRS in

preparing consolidated financial statements. It is false in that non-public companies are not required to use IFRS and publicly traded companies do not use IFRS in preparing their parent company only financial statements.

8. The bottom section of Exhibit 11.6 shows the countries as of June 2012 that do not allow

domestic companies to use IFRS in preparing consolidated financial statements. The two most economically important countries in this group are China and the United States.

9. The IASB and FASB have agreed to “use their best efforts to (a) make their existing financial

reporting standards fully compatible as soon as is practicable and (b) coordinate their work program to ensure that once achieved, compatibility is maintained.”

10. Convergence implies a joint effort between two standard setters to reduce differences in the

sets of standards for which they are responsible. Convergence could result in one standard setter adopting an existing standard developed by the other standard setter or by the two standard setters jointly developing a new standard. Convergence does not necessarily mean the two sets of standards that result from the convergence process will be the same. Indeed, the FASB and IASB acknowledge that differences between IFRS and U.S. GAAP will continue to exist even after convergence.

In contrast to the approach taken by the FASB to influence future IASB standards, the European Union simply adopted IFRS as the national GAAP in member nations.



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11. Since 2007, foreign companies listed on U.S. stock exchanges may file IFRS financial statements with the U.S. SEC without providing any reconciliation to U.S. GAAP. Domestic companies listed on U.S. stock exchanges must file financial statements prepared in accordance with U.S. GAAP.

The SEC’s proposed condorsement framework combines the FASB–IASB convergence process with the IFRS endorsement process followed in many countries and in the EU. The framework would retain both U.S. GAAP and the FASB as the U.S. accounting standard setter. At the end of a transition period, a U.S. company following U.S. GAAP also would be able to represent that its financial statements are in compliance with IFRS. The two components of the framework are:

The FASB continues to participate in the process of developing new IFRSs and incorporates those standards into U.S. GAAP by means of an endorsement process.

The FASB would incorporate existing IFRSs into U.S. GAAP over a defined period of time, for example, five to seven years, with a focus on minimizing transition costs for U.S. companies.

At the time this book went to press in the third quarter of 2013, the SEC still had not yet made a decision on the issue of incorporating IFRS into the U.S. financial reporting system.

12. When adopting IFRS, a company must prepare an “IFRS opening balance sheet” at the

date of transition. The date of transition is the beginning of the earliest period for which comparative information must be presented, i.e., two years prior to the “reporting date.” A company must follow five steps in preparing its IFRS opening balance sheet:

1. Determine applicable IFRS accounting policies based on standards that will be in force on the reporting date.

2. Recognize assets and liabilities required to be recognized under IFRS that were not recognized under prior GAAP, and derecognize assets and liabilities recognized under prior GAAP that are not allowed to be recognized under IFRS.

3. Measure assets and liabilities recognized on the IFRS opening balance sheet in accordance with IFRS (that will be in force on the reporting date).

4. Reclassify items previously classified in a different manner from what is acceptable under IFRS.

5. Comply with all disclosure and presentation requirements. 13. The extreme approaches that a company might follow in determining appropriate

accounting policies for preparing its initial set of IFRS financial statements are: 1. Adopt accounting policies acceptable under IFRS that minimize change from existing

accounting policies used under current GAAP. 2. Take a fresh start, clean slate approach and develop accounting policies acceptable

under IFRS that will result in financial statements that reflect the economic substance of transactions and present the most economically meaningful information possible.

14. According to the accounting policy hierarchy in IAS 8, if a company is faced with an

accounting issue for which (a) there is no specific IASB standard that applies, (b) there are no IASB standards on related issues, and (c) reference to the IASB’s Framework does not help in determining an appropriate accounting treatment, then the company should consider the most recent pronouncements of other standard-setting bodies that use a similar conceptual framework. The FASB’s conceptual framework is similar to the IASB’s, so reference to FASB pronouncements would be acceptable under IAS 8 when conditions (a), (b), and (c) exist.



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15. Potentially significant differences between IFRS and U.S. GAAP related to asset recognition and measurement are:

Acceptable use of LIFO under U.S. GAAP, but not IFRS. Definition of “market” in the lower of cost or market rule for inventory – replacement cost

under U.S. GAAP; net realizable value under IFRS. Reversal of inventory writedowns allowed under IFRS, but not under U.S. GAAP. Possible revaluation of property, plant, and equipment under IFRS (allowed alternative),

but not under U.S. GAAP. Capitalization of development costs as an intangible asset under IFRS, which is not

acceptable under U.S. GAAP (except for computer software development costs). Difference in the determination of whether an asset is impaired. Subsequent reversal of impairment losses allowed by IFRS, but not U.S. GAAP.

16. Even if all countries adopt a similar set of accounting standards, two obstacles remain in

achieving the goal of worldwide comparability of financial statements. First, IFRS must be translated into languages other than English to be usable by non-English speaking preparers of financial statements. It is difficult to translate some words and phrases found in IFRS into non-English languages without a distortion of meaning. Second, culture can affect the manner in which accountants interpret and apply accounting standards. Differences in culture can lead to differences in how the same standard is applied across countries.



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Answers to Problems 1. B 2. C 3. D 4. C 5. D 6. D 7. D 8. A 9. A 10. C 11. B 12. D 13. A 14. C



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Problems 15-19 are based on the comprehensive illustration. 15. (15 minutes) (Carrying inventory at the lower of cost or “market”) Historical cost $120,000 Replacement cost $111,900 Net realizable value $117,000 Normal profit margin 20% Net realizable value less normal profit [$117,000 – (20% x$117,000)] $93,600 a. 1. Under U.S. GAAP, the company reports inventory on the balance sheet at the lower

of historical cost or market, where market is defined as replacement cost (with net realizable value as a ceiling and net realizable value less a normal profit as a floor). In this case, inventory will be written down to replacement cost and reported on the December 31, 2015 balance sheet at $111,900. A $8,100 loss will be included in 2015 income.

2. In accordance with IAS 2, the company reports inventory on the balance sheet at the

lower of historical cost and net realizable value. As a result, inventory will be reported on the December 31, 2015 balance sheet at its net realizable value of $117,000 and a loss on writedown of inventory of $3,000 will be reflected in 2015 net income.

b. As a result of the differing amounts of inventory loss recognized under U.S. GAAP and

IFRS, Lisali will add $5,100 to U.S. GAAP income to reconcile to IFRS income, and will add $5,100 to U.S. GAAP stockholders’ equity to reconcile to IFRS stockholders’ equity.



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16. (25 minutes) (Measurement of property, plant, and equipment subsequent to acquisition)

Cost $78,400 Residual value $10,000 Useful life 6 years Straight-line depreciation $11,400 per year a. 1. Under U.S. GAAP, the company would report the equipment at its depreciated

historical cost. Straight-line depreciation expense is $11,400 per year. The equipment would be reported at $67,000, $55,600, and $44,200, respectively, on the December 31, 2015, 2016, and 2017 balance sheets.

2. Under IFRS, the equipment would be depreciated by $11,400 in 2015, resulting in a

book value of $67,000 at December 31, 2015. Under IAS 16’s allowed alternative treatment, the equipment would be revalued on January 1, 2016 to its fair value of $74,500.

The journal entry to record the revaluation on January 1, 2016 would be: Dr. Equipment $7,500 Cr. Revaluation Surplus (stockholders’ equity) $7,500 (To revalue equipment from carrying value of $67,000 to appraisal value of $74,500.) Depreciation expense on a straight-line basis in 2016, 2017, and beyond would be

$12,900 per year [($74,500 – $10,000) / 5 years]. The equipment would be reported on the December 31, 2016 balance sheet at $61,600 [$74,500 – $12,900], and on the December 31, 2017 balance sheet at $48,700 [$61,600 – $12,900].

The differences can be summarized as follows: Depreciation expense 2015 2016 2017 IFRS $11,400 $12,900 $12,900 U.S. GAAP $11,400 $11,400 $11,400 Difference $0 $1,500 $1,500 Book value of equipment 12/31/15 12/31/16 12/31/17 IFRS $67,000 $61,600 $48,700 U.S. GAAP $67,000 $55,600 $44,200 Difference $0 $ 6,000 $ 4,500



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16. (continued)

b. There is no difference in net income between IFRS and U.S. GAAP in 2015, so no reconciliation adjustments are necessary in 2015.

In 2016, the additional amount of depreciation expense of $1,500 related to the revaluation

surplus under IFRS must be subtracted from U.S. GAAP income to reconcile to IFRS net income. The additional depreciation taken under IFRS causes IFRS retained earnings to be $1,500 less than U.S. GAAP retained earnings at December 31, 2016. Under IFRS, the revaluation surplus causes IFRS stockholders’ equity to be $7,500 larger than U.S. GAAP stockholders’ equity. The adjustment to reconcile U.S. GAAP stockholders’ equity to IFRS is $6,000, the difference between the original amount of the revaluation surplus ($7,500) and the accumulated depreciation on that surplus ($1,500). $6,000 would be added to U.S. GAAP stockholders’ equity to reconcile to IFRS.

In 2017, $1,500 again is added to IFRS net income to reconcile to U.S. GAAP net income,

and $4,500 is subtracted from IFRS stockholders’ equity to reconcile to U.S. GAAP stockholders’ equity. $4,500 is the amount of revaluation surplus ($7,500) less accumulated depreciation on that surplus for two years ($3,000).

17. (15 minutes) (Research and development costs) Research and development costs $650,000 (30% related to development) Useful life 10 years a. 1. Under U.S. GAAP, $650,000 of research and development costs would be expensed

in 2015. 2. In accordance with IAS 38, $455,000 [$650,000 x 70%] of research and development

costs would be expensed in 2015, and $195,000 [$650,000 x 30%] of development costs would be capitalized as an intangible asset. The intangible asset would be amortized over its useful life of ten years, but only beginning in 2016 when the newly developed product is brought to market.

b. In 2015, $195,000 would be added to U.S. GAAP net income to reconcile to IFRS and the

same amount would be added to U.S. GAAP stockholders’ equity. In 2016, the company would recognize $19,500 [$195,000 / 10 years] of amortization

expense on the deferred development costs under IFRS that would not be recognized under U.S. GAAP. In 2016, $19,500 would be subtracted from U.S. GAAP net income to reconcile to IFRS net income. The net adjustment to reconcile from U.S. GAAP stockholders equity to IFRS at December 31, 2016 would be $175,500, the sum of the $195,000 smaller expense under IFRS in 2015 and the $19,500 larger expense under IFRS in 2016. $175,500 would be added to U.S. GAAP stockholders’ equity at December 31, 2016 to reconcile to IFRS.

18. (15 minutes) (Gain on sale and leaseback transaction) Gain on sale of asset $76,000 Life of leaseback 4 years



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a. 1. Under U.S. GAAP, the gain of $76,000 on the sale and leaseback transaction is deferred and amortized to income over the life of the lease. With a lease period of four years, $19,000 [$76,000 / 4 years] of the gain would be recognized in 2015.

2. In accordance with IAS 17, the entire gain of $76,000 on the sale and leaseback would be recognized in income in the year of the sale when the lease is an operating lease.

b. In 2015, IFRS net income exceeds U.S. GAAP net income by $57,000, the difference

($76,000 vs. $19,000) in the amount of gain recognized on the sale and leaseback transaction. A positive adjustment of $57,000 would be made to reconcile U.S. GAAP net income and U.S. GAAP stockholders’ equity to IFRS.

In 2016, a gain of $19,000 would be recognized under U.S. GAAP that would not exist

under IFRS. As a result, $19,000 would be subtracted from U.S. GAAP net income to reconcile to IFRS. By December 31, 2016, $38,000 of the gain would have been recognized under U.S. GAAP and included in retained earnings, whereas retained earnings under IFRS includes the entire $76,000 gain. Thus, $38,000 would be added to U.S. GAAP stockholders’ equity at 12/31/16 to reconcile to IFRS.



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19. (20 minutes) (Impairment of property, plant, and equipment) Cost of equipment $135,000 Salvage value zero Useful life 5 years Depreciation expense, 2015 $27,000 Carrying value, 12/31/15 $108,000 Expected future cash flows, 12/31/15 116,000 PV of expected future cash flows, 12/31/15 100,000 Fair value (net selling price) less costs to dispose, 12/31/15 96,600 a. 1. Under U.S. GAAP, an asset is impaired when its carrying value exceeds the expected

future cash flows (undiscounted) to be derived from use of the asset. Expected future cash flows are $116,000, which exceeds the carrying value of $108,000, so the asset is not impaired. Depreciation expense for the year is $27,000 [$135,000 / 5 years], and the equipment will be carried on the December 31, 2015 balance sheet at $108,000.

2. In accordance with IAS 36, an asset is impaired when its carrying value exceeds its

recoverable amount, which is the greater of (a) value in use (present value of expected future cash flows), and (b) net selling price, less costs to dispose. The carrying value of the equipment at December 31, 2015 is $108,000; original cost of $135,000 less accumulated depreciation of $27,000 [$135,000 / 5 years]. The asset’s recoverable amount is $100,000 (the higher of value in use of $100,000 and fair value of $96,600), so the asset is impaired. An impairment loss of $8,000 [$108,000 - $100,000] would be recognized at the end of 2015, in addition to depreciation expense for the year of $27,000. The equipment will be carried on the December 31, 2015 balance sheet at $100,000.

b. An impairment loss of $8,000 was recognized in 2015 under IFRS but not under U.S.

GAAP. Therefore, $8,000 must be subtracted from U.S. GAAP net income to reconcile to IFRS net income in 2015. The same amount would be subtracted from U.S. GAAP stockholders’ equity at December 31, 2015 to reconcile to IFRS stockholders’ equity.

In 2016, depreciation under IFRS will be $25,000 [$100,000 / 4 years], whereas

depreciation under U.S. GAAP is $27,000. $2,000 would be added to U.S. GAAP net income to reconcile to IFRS net income in 2016. To reconcile stockholders’ equity to IFRS at December 31, 2016, $6,000 must be subtracted from U.S. GAAP stockholders’ equity. This is the difference between the impairment loss of $8,000 in 2015 taken under IFRS and the difference in depreciation expense recognized under the two sets of standards in 2016. It also is equal to the difference in the carrying value of the equipment at December 31, 2016 under the two sets of accounting rules:

IFRS U.S. GAAP Cost $135,000 $135,000 Depreciation, 2015 (27,000) (27,000) Impairment loss, 2015 (8,000) 0 Carrying value, 12/31/15 $100,000 $108,000 Depreciation, 2016 (25,000) (27,000) Carrying value, 12/31/16 $75,000 $81,000



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Chapter 11 Develop Your Skills

Analysis Case 1—Application of IAS 16

This assignment demonstrates the effect one difference between IFRS and U.S. GAAP would have on a company's net income and stockholders' equity over a 20-year period.

Depreciation expense in Years 1 and 2 under both sets of rules: $10,000,000 / 20 years = $500,000 per year

The building has a book value of $9,000,000 on January 1, Year 3. On that date, under IFRS, Abacab would revalue the building through the following journal entry:

Dr. Building $3,000,000 Cr. Accumulated Other Comprehensive Income (AOCI) $3,000,000

Under IFRS, the revalued amount of the building will be depreciated over the remaining useful life of 18 years at the rate of $666,667 per year [$12,000,000 / 18 years].

a. Depreciation Expense Year 2 Year 3 Year 4 IFRS $500,000 $666,667 $666,667 U.S. GAAP $500,000 $500,000 $500,000 b. Book Value of Building 1/2/Y3 12/31/Y3 12/31/Y4 IFRS $12,000,000 $11,333,333 $10,666,666 U.S. GAAP $9,000,000 $8,500,000 $8,000,000 Difference $3,000,000 $2,833,333 $2,666,666

c. Pre-tax income will be $166,667 smaller in each year (Year 3 -Year 20) under IFRS. Cumulatively, IFRS-pretax income will be $3,000,000 smaller than U.S. GAAP pretax income over this 18-year period. Stockholders' equity will be $3,000,000 greater under IFRS at January 1, Year 3. This difference will decrease by $166,667 each year (due to greater IFRS depreciation expense), such that stockholders' equity will be the same under both sets of rules at December 31, Year 20. The difference in stockholders' equity each year is equal to the difference in the book value of the building.



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Analysis Case 2— Reconciliation of IFRS to U.S. GAAP

Quantacc Ltd. Schedule to Reconcile IFRS Net Income and Stockholders’ Equity

to U.S. GAAP

2015

Income under IFRS $ 100,000

Adjustments:

Add depreciation on revaluation amount in current year under IFRS 3,500

Add gain on sale and leaseback recognized in current year under U.S. GAAP 10,000

Add current year’s amortization of deferred development costs 16,000

Income under U.S. GAAP $ 129,500

12/31/2015

Stockholders’ equity under IFRS $ 1,000,000

Adjustments:

Subtract revaluation surplus (35,000)

Add accumulated depreciation on revaluation amount under IFRS (2015 only) 3,500

Subtract total amount of gain on sale and leaseback recognized under IFRS in 2014 (200,000)

Add cumulative amount of gain on sale and leaseback that would have been recognized under U.S. GAAP in 2014 and 2015 20,000

Subtract total amount of development costs capitalized under IFRS in 2014 (80,000)

Add cumulative amount of amortization expense on development costs recognized under IFRS (2015 only) 16,000

Stockholders’ equity under U.S. GAAP $ 724,500

Explanation for adjustments: 1. Under IFRS – Quantacc recorded a Revaluation Surplus (stock equity account) of $35,000

on 1/1/2015. In 2015, $3,500 of depreciation expense was taken on the revaluation amount ($35,000 / 10 years).

Under U.S. GAAP – neither of these would have been recognized. To reconcile from IFRS to GAAP – add $3,500 to IFRS 2015 net income; subtract a total of

$31,500 from IFRS 12/31/2015 stockholders’ equity (subtract $35,000 Revaluation Surplus and add $3,500 of accumulated depreciation on the revaluation amount).



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2. Under IFRS – Quantacc recognized a gain on sale/leaseback of $200,000 in 2014. No gain was recognized in 2015.

Under GAAP – Quantacc would recognize a gain on sale/leaseback of $10,000 in both

2014 and 2015. To reconcile from IFRS to GAAP – add $10,000 to IFRS 2015 net income. At the end of 2015, the increase in retained earnings related to the gain on sale/leaseback

under IFRS is $200,000, but would only be $20,000 under GAAP. To reconcile from IFRS to GAAP – subtract a total of $180,000 from IFRS 12/31/2015

stockholders’ equity. 3. Under IFRS – Quantacc recognized a development cost asset of $80,000 in 2014. In 2015,

amortization expense related to this asset was $16,000 ($80,000 / 5 years). Under GAAP – Quantacc would have expensed development costs of $80,000 in 2014. In 2015, there is $16,000 more expense under IFRS than under GAAP. To reconcile from

IFRS to GAAP – add $16,000 to IFRS 2015 net income. At 12/31/2015, the decrease in retained earnings is $64,000 larger under IFRS than under GAAP. To reconcile from IFRS to GAAP, subtract a total of $64,000 from IFRS 12/31/2015 stockholders’ equity.

Research Case—Reconciliation to U.S. GAAP Note to instructors: The SEC no longer requires a U.S. GAAP reconciliation from

foreign companies using IFRS. As more foreign companies adopt IFRS over time, it will become increasingly more difficult for students to find foreign companies that provide a U.S. GAAP reconciliation in their Form 20-F. Exhibit 11.6 can help in identifying countries not using IFRS.

In addition, students may find EDGAR to be of limited use in accessing foreign

company annual reports because few foreign companies file electronically with the SEC. Instructors might want to emphasize to their students that they might have more luck accessing the annual report of their selected company from the company's website.

This assignment requires students to find the note in Form 20-F in which foreign companies

reconcile net income and stockholders' equity from foreign GAAP to U.S. GAAP. The responses to this assignment will depend upon the company selected by the student to research. Examining the reconciliation from foreign GAAP to U.S. GAAP in Form 20-F is a good way to learn some of the major differences between foreign and U.S. GAAP. Students may be surprised to learn how few adjustments most foreign companies make in reconciling to U.S. GAAP.



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Communication Case—Voluntary Adoption of IFRS The response to the requirement in this case will vary by student. Potential benefits and potential risks from the voluntary adoption of IFRS that students might discuss in their memo include the following: Potential benefits. Preparing IFRS financial statements would make it easier for analysts to compare the

company with foreign competitors that use IFRS. This could result in a lower cost of capital for the company. It also would make it easier for the company to benchmark against foreign competitors.

For multinational companies with subsidiaries primarily using IFRS as their local GAAP, the

use of IFRS would allow the parent company to avoid IFRS to U.S. GAAP conversions in preparing consolidated financial statements.

Potential risks. The major risk of voluntary adoption of IFRS is that the SEC might ultimately decide not to

require the use of IFRS in the United States. In that case, the company would probably be required to switch back to U.S. GAAP. The company would have incurred substantial costs in changing its systems to IFRS, without being able to reap the potential benefits over a long period of time, and it would have to incur the cost of switching back to U.S. GAAP.

Internet Case—Foreign Company Annual Report

The responses to this assignment will depend on the company selected by the student. A

comparison of the findings across companies selected by students can lead to a lively

classroom discussion.

The instructor might wish to complete this assignment for a non-U S. company of his/her

choice to lead the discussion.



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CHAPTER 12 FINANCIAL REPORTING AND THE SECURITIES AND

EXCHANGE COMMISSION Chapter Outline

I. In the United States, the Securities and Exchange Commission (SEC), created by Act of Congress, is responsible for ensuring that complete and reliable information concerning publicly traded securities is available to investors.

A. Although the SEC regulates requirements created by many legislative acts, the most

significant are the Securities Act of 1933, the Securities Exchange Act of 1934, and the Sarbanes-Oxley Act of 2002.

B. The SEC has sought to accomplish its objectives by working to achieve several goals

that include:

1. Assuring adequate disclosure of data before securities can be bought and sold,

2. Preventing the misuse of information by inside parties,

3. Regulating the operation of stock exchanges and other securities markets, and

4. Prohibiting the dissemination of materially misstated information.

C. Disclosure requirements of the SEC are contained primarily in two sets of regulations:

1. Regulation S-K establishes rules for all nonfinancial information, such as management’s discussion of the issuer’s business activities.

2. Regulation S-X prescribes the form and content of the financial statements that are included in the various SEC filings.

D. The ability to establish disclosure requirements gives the SEC the ultimate authority for accounting principles in this country, although it has generally allowed the FASB to set official guidance.

E. The SEC's integrated disclosure system requires that most information that is reported to the SEC must also go to the company's stockholders at various times throughout the year.

II. As a direct result of the corporate accounting scandals exposed in 2001 and 2002,

Congress passed the Sarbanes-Oxley Act of 2002. This legislation has had a wide-



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ranging impact on corporate financial reporting and the accounting profession as a whole.

A. One of the most important results of this act is the creation of the Public Company Accounting Oversight Board.

1. This five-member board is appointed by the SEC and funded by fees assessed

against publicly traded companies. 2. The board has been given the authority to enforce auditing, quality control, and

independence standards. Such power reduces the accounting profession’s ability to regulate itself as it has done in the past seven decades.

B. All accounting firms that audit companies with securities that are publicly traded must

register with the Public Company Accounting Oversight Board.

1. This registration process allows the new board to gather considerable information from the public accounting firms.

2. All registered firms are subject to inspection by the Public Company Accounting

Oversight Board as often as each year.

C. The Sarbanes-Oxley Act eliminates a number of consulting services that an accounting firm can perform for an audit client. The goal of this approach is to strengthen the independence of the auditing profession.

D. The Sarbanes-Oxley Act also requires the audit committee of a company’s Board of Directors to

be made up of individuals who are independent of the management. The audit committee is now responsible for the appointment and compensation of the independent auditors.

E. Due to additional financial scandals, Congress supplemented Sarbanes-Oxley with The Wall Street Reform and Consumer Protection Act of 2010 to expand the federal government’s role in regulating corporate governance.

III. Several methods can be used by the SEC to affect generally accepted accounting principles in the United States.

A. Additional disclosure requirements.

B. Moratorium on specific accounting practices.

C. Challenging individual statements and other reporting by companies filing with the SEC.

D. Overruling the FASB (as shown by the rejection of SFAS 19).

IV. Companies that offer securities for sale to the public must meet a number of filing requirements monitored by the SEC.

A. Registration statements are required prior to the issuance of any new security.



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1. Depending on specific circumstances, specified forms are required for this purpose (including Forms S-1 and S-3).

2. After completing the appropriate registration form, a company will normally receive a letter of comments from the SEC requesting changes and/or additional disclosures that the SEC deems necessary.

3. Unless exempt from registration, securities cannot be sold until the registration statement is made effective by the SEC.

B. Companies that have their securities publicly traded on an exchange must also make regular periodic filings with the SEC. Some of the most common of these disclosure documents are:

1. Form 10-K is an annual report presenting the company's activities and financial position.

2. Form 10-Q contains condensed interim financial statements.

3. Form 8-K discloses the occurrence of a unique or significant happening.

4. A proxy statement (Form 14A) solicits voting power to be used at stockholders' meetings.

V. The SEC has developed a system that allows investors to gain access to filed information

electronically over the Internet. This system is known as EDGAR and contains extensive information and documentation relating to practically every publicly traded security.

Answer to Discussion Question Is the Disclosure Worth the Cost? No ultimate answer exists to the question of how the SEC should weigh the costs of disclosure versus the need for adequate information. Students often feel that the importance of the work of the SEC is unquestioned. That is far from reality, as many business owners and investors will advise. Businesses often resist all demands for additional disclosure as being unimportant and not worth the cost of gathering the data. This is also far from reality. This discussion question is intended to show the high cost to the American economy of ensuring that adequate and fair information is available. The $400 million estimation that was made in 1975 (nearly forty (40) years ago) is a staggering figure. It shows this concern has existed for decades. Could investors have been appropriately protected for a smaller amount? This question becomes especially relevant when coupled with the quotation from George Bentson that "I found that there was little evidence of fraud related to financial statements in the period prior to the enactment of the Securities Acts." The question is even more interesting considering the accounting scandals that were discovered in 2001 and 2002. These problems took place



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despite the presence of the SEC. On the other hand, perhaps the disclosure and compliance is still inadequate and the cost of additional compliance will result in future unknown benefits. One method of approaching this question is to ask students to envision what would result if the SEC was simply to be dissolved. How would companies entice investors into contributing funds? What methods would companies invent to provide assurance to investors? Would more or less money be invested? Would the allocation of resources to the various companies throughout the country be changed? Would investors be adequately protected? How would a new ‘start up’ company attract investors? In other words, does the work of the SEC have an actual impact on the amount of investments that are made and the distribution of these funds to the companies in the country? Once the benefits of having an authority like the SEC are established, how should these benefits be weighed against the cost of disclosure? Although $400 million (which was the estimated cost forty (40) years ago, is an extremely large amount, it is a very small number in comparison to the dollars that are invested each year in the United States. Is this just the price that must be paid to provide comfort to the investing public? Although no resolution can be made of this question, it should provide for a good deal of class discussion. Answers to Questions 1. Many of the federal securities laws were passed initially in hopes of putting an end to abuses

that were present in securities trading. These problems were first brought to the public's attention by the stock market crash in 1929. Two special concerns were the manipulation of stock market prices in part through the dissemination of inaccurate financial data and the misuse of information by insiders, such as corporate officers and directors. However, the passage of legislative actions also was intended to help restore public confidence in the capital market system that was and is so essential to the American economy.

2. The corporate accounting scandals of this period took several forms. Some were based on

manipulating loopholes in generally accepted accounting principles to allow companies to avoid adequately disclosing risky ventures. Others were simply fraudulent reporting of transactions; expenses, for example, were recorded as assets to make the company’s balance sheet(s) look better. Even others were based on the use of corporate funds for personal benefit. The reasons for such behavior can be many and varied. Personal greed is always a motivator. However, the need of a company to report ever-increasing profits in a stock market that was rising at an amazing speed during the mid and late 1990s put significant pressure on many executives. In hindsight, the lack of adequate safeguards in place at corporations, at accounting firms, and even at the SEC must also be considered as playing a role in creating an environment where such practices were allowed to take place.

3. The Sarbanes-Oxley Act has numerous provisions, almost all of which are designed in one way or another to restore public confidence. Several of those provisions include: A Public Company Accounting Oversight Board has been created to enforce and regulate

auditing, quality control, and independence standards. All accounting firms that audit publicly-held issuers of securities must register with the

Oversight Board and provide detailed information about their operations. All registered firms must be inspected by the Oversight Board to ensure adequate quality

control in their audit work. Registered firms are prohibited from providing certain consulting services to audit clients. Corporate audit committees must be composed of members of the Board of Directors who

are independent of management.



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Audit committees must have authority to employ and compensate the independent auditors.

4. The Sarbanes-Oxley Act gives the SEC the power and responsibility to oversee the work of

the Public Company Accounting Oversight Board. For example, the five board members are appointed by the SEC.

5. According to the Sarbanes-Oxley Act, accounting firms are only required to register with the Public Company Accounting Oversight Board if they prepare, issue, or participate in the preparation of an audit report for an “issuer.” An issuer is defined by the Act but normally refers to any organization issuing securities to the public.

6. Registration with the PCAOB forces the accounting firm to (a) provide a significant amount of

information about its operations, (b) have its activities open to inspection by the Public Company Accounting Oversight Board, and (c) be subject to the rulings and authority of this Board.

7. The Sarbanes-Oxley Act gives the Public Company Accounting Oversight Board authority over auditing independence rules. Therefore, all future changes made by this body will be an indirect result of the legislation. Moreover, the Sarbanes-Oxley Act specifically eliminated the accounting firms’ ability to provide certain non-attestation services to their audit clients. It further required that audit committees be made up of members of an organization’s Board of Directors who are independent of management. The audit committee must then be responsible for the appointment and compensation of the independent auditors.

8. Prior to the Sarbanes-Oxley Act, most accounting firms were required to undergo periodic

peer reviews of their audit documentation and their quality control procedures. However, those reviews were largely done by one firm on another and, given the accounting scandals discovered during 2001 and 2002, apparently did not do enough to ensure the quality of audit work. The new inspection process will be carried out under the authority of the Public Company Accounting Oversight Board. That inspection process will attempt to create a process that goes further in making certain that every firm does quality work on every engagement.

9. "Regulation S-K" establishes disclosure and other reporting requirements for the nonfinancial

information that is contained in filings with the SEC. 10. "Regulation S-X" prescribes the form and content of the financial statements, notes, related

schedules, and any other financial information included in the various reports filed with the SEC.

11. The Securities and Exchange Commission is composed of more than two dozen divisions and

major offices. Some of these include the following: — Division of Corporation Finance—ensures that standards for reporting and disclosure are

followed. — Division of Market Regulation—regulates national securities exchanges and investment

brokers and dealers. — Division of Enforcement—supervises investigations and directs enforcement activities. — Office of the Chief Accountant—responsible for accounting and auditing matters in

connection with the securities laws.



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— Office of Compliance Inspections and Examinations—verifies compliance by brokers, dealers, and investment companies.

12. The Securities Act of 1933 regulates the initial offering of securities by a company or its

underwriters. This Act is often referred to as the “truth in securities act” and it is the statute that now governs the issuers’ registration statements.

13. The Securities Exchange Act of 1934 regulates the subsequent buying and selling of

securities through brokers and exchanges. This regulation extends to virtually all aspects of the resale of non-exempt securities.

14. The goals of the SEC are many. However, several prominent goals are as follows: — Ensuring that full and fair information is disclosed to all investors before securities can be

exchanged. — Prohibiting the use of materially misstated information. — Preventing the misuse of information, especially by parties inside of the company. — Regulating the operation of securities markets. 15. Information to be included in proxy solicitation material includes the following data:

— Five-year summary of operations including sales, total assets, income from continuing operations, and cash dividends per share.

— Description of business activities. — Three-year summary of industry segments, export sales, and foreign and domestic

operations. — A list of the directors of the company and its executive officers. — Market price of the company's common stock for each quarterly period within the two most

recent years. — Restrictions on the company's ability to continue dividend payments. — Management's discussion and analysis of financial conditions, changes in financial

condition, and results of operations. — All nonaudit services provided by the company's independent auditors. — Statement as to whether the board of directors approved all nonaudit work of the

independent auditors. — Percentage of nonaudit fees paid to the independent auditors in relation to total annual

audit fees. — Individual nonaudit fees that are larger than 3 percent of the annual audit fee.

16. A proxy statement is a request made to stockholders for the right to cast their votes at

stockholders' meetings. Obviously, the control of the entire company will rest with any group that is able to get a majority of votes through proxy agreements. Thus, the proxy statements are important because they are used in determining the control and direction of the company.

17. Any change made by the SEC in its Regulation S-X, the financial reporting regulation, will

have a direct impact on the form and content of the financial reporting of the publicly-held companies in this country. Thus, the Commission has the ability to dictate generally accepted accounting principles. In addition, Financial Reporting Releases are issued by the SEC to explain changes to be made in accounting. Staff Accounting Bulletins are also prepared to explain views on current reporting matters.

The SEC has historically limited the use of its authority over generally accepted accounting principles to (1) disclosure issues and (2) areas of accounting where authoritative guidance was thought to be lacking. For example, additional disclosure of specified matters may be



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required in areas deemed important by the SEC. The Commission can also prohibit practices that are not thought to be appropriate, especially where official guidance is not available.

18. Financial Reporting Releases are issued by the SEC to explain desired changes in reporting

requirements. FRRs are used to supplement Regulations S-X and S-K. Staff Accounting Bulletins inform the financial community of views on current matters relating to accounting and disclosure issues.

19. Prior to 1977, the SEC had restricted the use of its accounting authority primarily to disclosure

requirements and areas of financial reporting where authoritative guidance was not available. The FASB (and its predecessors in the private sector) had been allowed to establish generally accepted accounting principles in the U.S. The setting of accounting standards was viewed as a process that should be based on theory and research rather than being subjected to government edict. However, when the SEC overruled the FASB's method of reporting unsuccessful exploration costs incurred by gas and oil producing companies, several important precedents were set. The government (through the SEC) showed that it was willing to become a more active participant in setting rules for the accounting profession. The FASB (and other authoritative bodies) then had to be more concerned about pleasing the government prior to establishing standards. Many concerns were raised at the time (as well as since then) as to whether the development of generally accepted accounting principles should be at the mercy of the federal government.

20. Registration statements are designed to disclose and make available adequate relevant data

about both a company and its new stock or bond (security) before the security can be issued to the public.

21. Disclosure of sufficient information – Registration Statement disclosure - is required by the

Securities Act of 1933. 22. Part I of a registration statement is called a prospectus and must be furnished to every

potential buyer of the securities to be issued. It contains information such as financial statements and supplementary data, an explanation of the intended use of the money being raised, a description of the capital structure of the company, and a description of the business and the properties that it holds.

Part II of the registration statement provides information that is needed by the SEC staff. Part

II includes data such as marketing arrangements for the new securities, the expenses of the issuance, sales to special parties, and the like.

23. Revenues are raised by the SEC, in part, through a registration fee for shares being initially

issued. In 2013, this fee was $136.40 for each $1 million of security offering. 24. In the filing of registration statements, a number of different forms are available depending

upon the circumstances. Of these forms, these two are especially common: — Form S-1 which is used by new registrants or by companies that have filed with the SEC

for less than 36 months; — Form S-3 which is completed by larger companies, including foreign issuers that have filed

with the SEC for a considerable length of time and have a significant following in the stock market. Form S-3 permits incorporation of other documents by reference. This permits inclusion of significant data concerning the Issuer, where the data has appeared in other filings.

25. Incorporation by reference is a process allowed when preparing filings with the SEC, and often

other governmental agencies. It is intended to reduce the quantity of redundant information



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that must be processed. When data is required that has already appeared in a previous filing, the company need only refer to the earlier disclosure rather than repeat the information.

26. A pre-filing conference is a meeting between a prospective registrant and the staff of the SEC

in hopes of resolving potential problems that may be expected to arise in an upcoming filing. The reporting and disclosure of complicated financial transactions may be discussed by the parties. The conference may also be used to determine the appropriate handling of unusual problems.

27. A letter of comments (which is also known as a "deficiency letter") is issued by the SEC to a

filing company after a registration statement has been reviewed. The letter lists changes and additional disclosures that the SEC feels are necessary before the registration statement can be made effective.

28. A prospectus is the first part of a registration statement, the portion that has to be furnished

to every potential buyer of a new security. The prospectus discloses a significant amount of specified information about the issuing company as well as about the new security. For example, the financial statements of the company must be included along with a description of current business operations. The prospectus also informs potential buyers of the intended use of the new funds and the capital structure of the company.

29. Certain new security issues are exempt from the registration requirements monitored by the

SEC. For example, securities sold within a single state are normally not subject to these federal laws. In addition, the securities of banks, savings and loan associations, and governments do not come under the Securities Act of 1933. Several other offerings are also exempt from completing formal registration statements although other legal filings may be required:

Private placements to a limited number of sophisticated investors; Securities issued to current stockholders without a commission being paid (usually a

stock dividend or stock split); Securities issued by nonprofit organizations; Small offerings of no more than $5 million; Offerings of no more than $5 million made to 35 or fewer purchasers

30. Private placements of securities have become extremely popular in recent years because

they are exempt from the registration requirements of the SEC. The securities are issued to no more than 35 sophisticated investors (identified as having knowledge and experience in financial matters) who already have sufficient information available to them about the issuing company. General solicitation is not permitted.

31. Blue sky laws are securities laws enforced by individual states. In contrast to federal securities

laws, blue sky laws usually apply only to sales that are restricted to a particular state. 32. A wraparound filing is one in which a company uses its annual report to shareholders to fulfill

reporting requirements of the SEC in a Form 10-K. Rather than repeat the information within the Form 10-K, incorporation by reference is used to direct the SEC to the location of the required data in the annual report.

33. Form 8-K is not issued on a regular basis but only when disclosure of a unique or significant

occurrence is to be made. Thus, a company has some choice as to the necessity of issuing a Form 8-K. The SEC does, however, list several events that require disclosure in this manner:

—resignation of a director; —change in control of the company; —acquisition or disposition of assets; —changes in independent accountants;



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—bankruptcy or receivership. 34. The Management's Discussion and Analysis (MD&A) is a narrative description of the

company's past, its present, and its future. The management describes its priorities, accomplishments, and concerns. In many cases, the MD&A allows the management to share information with owners and other interested parties that would not otherwise be conveyed.

35. The Form 10-K is an annual report (financial statements and related information) whereas the

Form 10-Q contains condensed interim financial statements and is filed quarterly. 36. The EDGAR system is intended to allow companies to file information with the SEC in an

electronic format and then make that information available on-line to all interested parties.

Answers to Problems 1. D – A is false because intrastate offerings are typically exempt from registration; B is false because the 1934 Securities Act regulates post-issuance trading of securities; and C is false because blue sky legislation is state law.

2. B – Remember that regulation S-X is the regulation that focuses upon financial information disclosure.

3. C – Regulation S-K addresses non-financial information filed with the SEC while Regulation S-X addresses the form and content of financial documentation filed with the SEC.

4. A – Remember that the 1933 Act deals with Registration and the 1934 Act deals with Regulation.

5. C – Not all auditing firms are required to register with the PCAOB, only those firms that prepare, issue, or participate in the preparation of an audit report for an issuer. Issuers do incur additional fees as a result of SOX.

6. C – The SEC appoints the five (5) PCAOB members.

7. B – Selection of the auditor and approval of the related contract, including the fees, is done by the firm’s audit committee. This committee must be composed of members of the client’s board who are independent of management.

8. A – The 1933 Act deals with the requirements for registration of a security prior to its initial offering.

9. D – S-3 is the form for registering securities if / when the issuer already has a significant public market following. The issuer will likely also file forms 8-K and 10-K, but those are not registration statements.

10. D – The SEC’s 1977 stand vis-à-vis oil and gas accounting principles was a unique situation wherein the SEC overruled the FASB as far as proper accounting treatment.

11. C – Recall that the letter of comments / deficiency letter relate to the SEC’s response subsequent to an issuer’s filing of a Registration Statement.

12. B – This is a useful approach to referencing data which has already been provided to the SEC, or other agency, so that the data is not redundantly produced.

13. A - Recall that the letter of comments / deficiency letter relate to the SEC’s response subsequent to an issuer’s filing of a Registration Statement.



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14. D – The prospectus must be furnished to all potential new security buyers and is provided to the SEC as part of the registration statement filing.

15. C – Smaller public offerings of less than $5 million made within a 12-month period may be exempt from registration, however, $5.9 million exceeds this threshold.

16. B – A prospectus is filed only in connection with the initial offering of a security. Therefore it is not ‘regularly’ filed with the SEC, unless the issuer is ‘regularly’ issuing new securities.

17. C – Shelf registrations consist of registering securities in advance so that a large issuer may subsequently offer the securities without the need of additional SEC approval.

18. C – EDGAR = Electronic Data Gathering Analysis and Retrieval system.

19. (25 Minutes) (Series of questions about securities regulations).

a. Blue Sky Laws—Individual state laws that regulate the issuance of securities when the transactions are limited to the residents of the state in which the issuing company is organized and principally doing business. Such securities are exempted from regulation by federal securities laws.

b. S-8 Statement—A registration statement that must be filed with the SEC and made effective by that body before a company can issue securities in connection with employee stock plans.

c. Letter of Deficiencies (also known as Deficiency Letters)—A request by the SEC for changes, explanations, or more information before a registration statement is made effective. The Division of Corporation Finance of the SEC reviews the registration statement and provides the company with a letter of deficiencies so that the company will be able to furnish the additional data needed or make the appropriate changes. This is also referred to as a Letter of Comment or Comment Letter.

d. Public Company Accounting Oversight Board—This five (5) member Board was created by the Sarbanes-Oxley Act of 2002 as a result of the corporate accounting scandals that rocked the stock market and the investing community during 2001 and 2002. This Board falls under the jurisdiction of the SEC and has wide-ranging responsibilities from the registration of accounting firms and the inspection of these same firms to the establishment of auditing, quality control, and independence standards.

e. Prospectus— The prospectus is the first part of a registration statement that contains financial statements for the company and indicates the use to be made of the money received from the sale of the securities, the capital structure of the company, and a description of the business and its properties. Every potential buyer of the new security must be furnished with a prospectus.



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20. (25 Minutes) (Discussion of the Securities Act of 1933 and the Securities Exchange Act of 1934)

The Securities Act of 1933 and the Securities Exchange Act of 1934 were passed to help rebuild confidence in the capital market system of the United States. Economic development in this country is based on generating large amounts of monetary capital through the issuance of stocks and bonds. To entice sufficient investment, public trust in the integrity of the system must be maintained. Following the stock market crash of 1929, public confidence reached a low level. Federal securities laws were subsequently passed in hopes of achieving several objectives designed to restore trust in the capital markets. Several aspects of these laws should be noted: — Companies were required to supply adequate information to potential buyers before

a new security could be issued. — Companies having publicly traded securities were required to maintain an adequate

and continual flow of information to the public. — Stock markets were to be regulated. — Manipulation of stock market prices was to be eliminated. — The use of inside information by corporate officials and directors was made Illegal.

To help achieve these goals, the Securities and Exchange Commission (SEC) was created to monitor the capital market system. For example, registration statements had to be filed with the SEC before new stocks or bonds could be issued to the public. These statements were reviewed and could not become effective until all necessary disclosures and financial information were properly presented. Periodic filings (such as Form 10-K and Form 10-Q) were also required of companies having securities that were publicly traded. Because of its ability to require specific types of financial information, the SEC has the ultimate authority to develop generally accepted accounting principles in this country. The SEC also has the power to investigate possible misconduct in connection with corporate reporting and to seek prosecution where necessary.

21. (20 Minutes) (Description of the registration process)

In filing a registration statement for a new security, a company must first select the appropriate SEC Registration form. For example, Form S-1 is used by new registrants while Form S-3 is filed by large companies that already have a significant following in the securities markets. Appropriate disclosures and other required data are then prepared in accordance with Regulation S-K and Regulation S-X. When the SEC receives the completed form, it is put through a review. All nonfinancial and financial information are verified against various standards. Legal aspects of the document are also checked along with the report of the independent auditor. A letter of comments (commonly referred to as a "deficiency letter") is prepared by the SEC to indicate changes and added disclosures that are considered necessary. The registrant has the right to discuss these issues with the SEC staff if company officials disagree with any part of the letter of comments. After the SEC is satisfied that the registration statement fulfills all rules, it is made effective. The first part of this document, the prospectus, must be made available to any potential buyer of the new security.

22. (15 Minutes) (Discussion of the SEC's influence on generally accepted accounting

principles)

The SEC has far-ranging authority over the accounting principles in this country. Through its ability to modify Regulation S-X, the SEC holds the power to alter the



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financial reporting of publicly-traded companies. The SEC has historically chosen to limit such changes to disclosure requirements with the creation of accounting principles being left to the FASB (and its predecessors) Thus, the private sector of the accounting profession had been given de facto responsibility for developing generally accepted accounting principles. Although occasionally the object of criticism, this system (theoretically) allows accounting standards to be the result of research and study rather than government edict. However, the SEC has often acted in accounting areas where clear authoritative guidance was not available. In such cases, additional disclosure may be required or the Commission can decide to restrict or even prohibit a particular accounting procedure. The SEC did overrule in 1977 the FASB's method of accounting for unsuccessful exploration and drilling costs incurred by gas and oil producing companies. This action set several important precedents. First, it reaffirmed the SEC's ability to be involved in the standards-setting process. Second, notice was served to the FASB that the private sector needed to make certain that the SEC was satisfied prior to issuing new pronouncements.

23. (20 Minutes) (Listing of forms that are filed with the SEC on a regular periodic basis)

Numerous forms may have to be filed regularly with the SEC by a publicly-held company. Four of these forms (Form 10-K, Form 10-Q, Form 8-K, and proxy statements) are frequently encountered.

— Form 10-K is an annual report filed shortly after a company's year-end. — Form 10-Q contains condensed interim financial statements and must be filed after

the end of each quarter, other than the year-end quarter – because the 10-K is filed after the year-end quarter.

— Form 8-K is only filed when needed to disclose the occurrence of a unique or significant event such as the resignation of a director, changes in control, acquisition or disposition of assets, changes in independent accountants, and bankruptcy. Depending upon the frequency of these ‘unique’ events, the Form 8-K may not actually be filed regularly or periodically.

— Proxy statements, called “Schedule 14A” are requests for the right to case a stockholder's votes at annual (or other) meetings. Included in the information that must be provided are financial statements, disclosure of matters that are to be voted on, and an identification of the party making the solicitation.

24. (10 Minutes) (Describe the forms used to file with SEC for registration purposes)

Some of the most commonly used forms for registering securities to be offered to the public are as follows: — Form S-1—for new registrants or companies that have been filing with the SEC for

less than 36 months. This form is used when no other form is prescribed. — Form S-3—for larger companies that already have a significant following in the

stock market. — Form S-4—for securities issued in connection with business combinations. — Form S-8—for securities issued in connection with employee stock plans. — Form S-11—for securities issued by various real estate companies.

— Form F-3—for a foreign issuer. 25. (20 Minutes) (Discussions of the Form 8-K and proxy statements)



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The Form 8-K is designed to ensure the immediate disclosure by a company of any unique or significant event. Thus, any interested parties are able to obtain needed information without having to wait for a quarterly or annual statement. The filing of the Form 8-K must generally be made within 15 days of the occurrence. Events that necessitate the filing of a Form 8-K are left to the discretion of the company and its management. However, the SEC does list several circumstances that require such disclosure including the resignation of a director, change in control of the company, acquisition or disposition of assets, change in independent auditors, and bankruptcy. A proxy statement is the package of information that must accompany the request made to a stockholder for the right to cast that owner's votes at a stockholders' meeting. Since obtaining a significant number of proxies would allow an individual or company to influence or control an organization, the request for proxy rights is closely monitored by the SEC. The proxy statement has to be filed with the SEC before being distributed and must include specified information such as: —an annual report, —a disclosure of all matters that will be voted upon at the meeting, and —an identification of the party or parties making the solicitation.

26. (20 Minutes) (Describe responsibilities of the Public Company Accounting Oversight

Board)

The Sarbanes-Oxley Act of 2002 is a wide-ranging piece of legislation that covers a large number of different areas of corporate financial reporting. Much of this Act deals with the establishment of the Public Company Accounting Oversight Board (PCAOB). The PCAOB is created / addressed in Title I of the Act. The PCAOB is in charge of all auditing, independence, and quality control standards for the accounting profession. PCAOB has the legal authority to write such rules and / or to simply oversee the work done by the profession (through the Auditing Standards Board and the AICPA). The ultimate authority for such rules now lies clearly with the PCAOB as illustrated at Title I, Sec. 103(a)(1) of the Act. All accounting firms that prepare, issue, or participate in the preparation of an audit report for an issuing organization will now have to register with the PCAOB in order to continue providing such services. This registration provides the PCAOB with the ability to gather an almost unlimited amount of information about the firms such as disagreements with audit clients, annual fees from both audit and nonaudit services, and the like. The PCAOB must periodically inspect the work of each of the registered accounting firms. The depth and breadth of this inspection will ultimately encompass both audit documentation and compliance with quality control standards. Large firms may undergo annual inspection whereas smaller firms will only be inspected every three years.

27. (30 Minutes) (Discussion of financial reporting and the SEC)

a. Staff Accounting Bulletins—According to the website (www.sec.gov) of the Securities and Exchange Commission, “Staff Accounting Bulletins reflect the Commission staff’s views regarding accounting-related disclosure practices. They represent interpretations and policies followed by the Division of Corporation

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Finance and the Office of the Chief Accountant in administering the disclosure requirements of the federal securities laws.”

b. Wraparound filing—the process of using the annual report furnished to shareholders to fulfill many of the requirements of the Form 10-K to be filed with SEC. The company simply indicates the location of the required information (a process known as incorporation by reference) within the annual report.

c. Incorporation by reference—using information in one document filed with the SEC to fulfill other reporting requirements. In this manner, the amount of redundant information being reported is reduced. This process is usually part and parcel of a wrap around filing.

d. Division of Corporation Finance—a division of the SEC that establishes standards of reporting and disclosure. This division also reviews the registration statements that are filed with the SEC and issues any needed letters of comments.

e. Integrated disclosure system—the use of information that is being given to stockholders to meet the filing requirements of the SEC.

f. Management's discussion and analysis—an inclusion in the Form 10-K that serves as the management's description of its priorities, accomplishments, and concerns. The narrative describes the company's past performance, present condition, and future direction.

g. Chief accountant of the SEC—the office of the SEC that is ultimately responsible for all accounting and auditing matters that involve the securities laws.

28. (10 Minutes) (Listing of organizations that are exempt from the registration requirements of the SEC)

— Governments — Banks — Savings and loan associations — Companies that restrict the exchange of their securities to within one state — Companies that restrict an issuance to its own stockholders where no commission

is paid to solicit the exchange — Nonprofit organizations — Companies that make small offerings of no more than $5 million (although a

Regulation A offering circular must still be filed) — Companies that make offerings of no more than $1 million to any number of

investors within a 12-month period. — Companies that make small offerings of no more than $5 million to 35 or fewer

purchasers and an unlimited number of accredited investors. — Companies making private placements to no more than 35 sophisticated investors.

Develop Your Skills RESEARCH CASE 1 (45 Minutes) The purpose of this question is to allow the student the opportunity of working with the actual regulations posted on the SEC web site. The URL given in the problem will take the student to the entire set of rules set out under Regulation A – for Conditional Small Issue(s) Exemptions. This information covers topics such as offering statements, offering circulars, and the filing of sales material. The student can literally read through the entirety of Regulation A in about fifteen (15) minutes. For this assignment, the student should probably focus on the heading “Scope of Exemption.” This reference provides several pages of information on the exemption from



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filing a registration statement that is provided to companies by Regulation A. There are a number of issues that the student might want to address in connection with this question: — Where does the company have to be legally incorporated? (The U.S., Canada, or one

of the territories or possessions of the U.S.) — What is the total amount that can be received for the securities being issued? (Not

more than $5 million) — When both cash and non-cash consideration are received, how is the total amount of

consideration determined? (It is based on the cash price). — What filing must be made with the SEC? (In most cases, a Form 1-A. — Can

advertisements of the securities be made? (Yes, published ads as well as radio and television ads are allowed as long as only specified information is included).

If Domer Corporation is a development stage company, the exempt provisions of Regulation A may not apply. Specifically, Reg. Sec. 230.251 (a) (3) provides that the exemption is not available to “a development stage company that either has no specific business plan or purpose, or has indicated that its business plan is to merge with an unidentified company or companies”. Thus Domer’s status as a development stage company, depending upon the status of its business plan, may preclude its use of the Regulation A exemption. RESEARCH CASE 2 (30 Minutes) The SEC v. Calvo case involves a situation similar to the fact pattern in this research case. The student is directed to this case because of the many similarities. Use of legal / case research is a very valuable skill for accounting students and practitioners as courts ultimately interpret vague rules, regulations, statutes, and definitions. As was suggested in the text, the definition of ‘security’ is very broad. The 1933 Securities Act defines ‘security’ very broadly to include investment contracts. Investment contracts involve: (i) an investment of money or other consideration; (ii) for a common enterprise or undertaking; and (iii) with the expectation of profits to be derived from the efforts of others. In the instant example, the Tasch Corporation will ‘manage’ the customer’s enterprise, the customers are investing money, and the customers are expecting a profit – ie: the guaranteed return. A court would very likely conclude that the “service agreements” constitute an investment contract and thus a security. The next issue / question to address is whether the Tasch Corporation can / will be able to structure the issuance of these securities in a manner to avoid the registration requirements. ANALYSIS CASE 1 (45 Minutes)



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This assignment requires the student to utilize the EDGAR database to find recent company filings by any publicly-held company. The results that a student gets will depend on the company name that is entered and the time frame for when the student accesses the database. The student may actually be overwhelmed by the amount of filings that a company must make with the SEC. For example, a search for Dell would display more than thirty-eight (38) filings in just the first three (3) months of 2013. 1. A number of 8-K forms can be found for most companies. Companies now tend to err on the side of over-disclosure with regard to 8-K filings, many of which merely incorporate by reference various press releases or other publicity-related filings. The specific content of the 8-K each student locates will depend on when the student completes the case analysis. 2. A further investigation of the Dell filings leads to a Form 10-K issued on March 12, 2013 (or later depending on when the student utilizes the database), that contains many attachments including the annual report for 2012. This Form 10-K provides extensive information to supplement the data normally reported to shareholders. 3. Finally, a definitive proxy statement can be located for Dell (DEFA 14A), as of April 1, 2013.

This is the kind of information that students often have not had the opportunity to access unless they have explored the SEC web site.

Communication Case 1 Here, the student is asked to investigate and review that actual statutory components of the Sarbanes-Oxley Act of 2002. This Act encompasses approximately seventy (70) pages and contains an extensive list of requirements for auditors covered by the Statute. The first issue to consider for the Wojtysiak firm is whether it is presently required to register with the Public Company Accounting Oversight Board (PCAOB). It is not, however, if the Wojtysiak firm becomes the audit firm for the new publicly traded client (and ‘issuer’) then the firm will likely be required to register and then be subjected to additional disclosures and inspections, most likely on a triennial basis. Additionally, the Wojtysiak firm will need to carefully consider what services it can offer to the new client in light of the Sarbanes-Oxley independence requirements. The student will most likely wish to consider and incorporate the following provisions of the Act.

Section 102 – Registration with the Board. Section 103 – Auditing, quality control, and independence standards and rules. Section 104 – Inspections of registered public accounting firms. Section 108 – Accounting standards. Section 201 – Services outside the scope of practice of auditors. Section 203 – Audit partner rotation.

The student should be able to write an extensive report on the impact of Sarbanes-Oxley on the Wojtysiak firm, based on these and other provisions of the Act.

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Chapter 14 - Partnerships: Formation and Operation


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CHAPTER 14 PARTNERSHIPS: FORMATION AND OPERATION

Chapter Outline I. Business organizations that are formed legally as partnerships, although they are not always

as visible as corporations, still proliferate throughout this country especially in the legal, medical, and accounting professions.

A. Advantages of the partnership format include ease of creation and the absence of the double taxation effect inherent to the income earned by a corporation and distributed to its owners.

B. Partnerships, however, rarely grow to a significant size (when compared with large corporate organizations) primarily because of the unlimited liability being assumed by each general partner.

C. Alternative legal formats have been created over the years to combine the benefits of corporations and partnerships such as S corporations, limited liability partnerships, and limited liability companies.

II. Partnership accounting and the capital accounts

A. The distinctive aspects of partnership accounting center on the capital accounts maintained for each individual partner.

B. The basis of accounting for these capital balances is the Articles of Partnership agreement which establishes provisions for initial investments, withdrawals, admission of a new partner, retirement of a partner, etc.

C. The actual contribution made by the partners to the business should be recorded at fair market value. A problem arises, however, when a contribution is truly intangible such as a particular expertise or an established client base.

1. In the bonus method, only identifiable assets are valued and recorded. The capital account balances are then aligned to indicate the percentage of the actual contributions being made by each partner.

2. In the goodwill method, the amount being contributed and the corresponding percentage of the initial capital balance are used to calculate the value of the business and the presence of goodwill, a figure which is physically recorded as an intangible asset.

III. Partnership income allocation

A. At the end of each fiscal period, the revenue and expense accounts must be closed out with the resulting income figure being assigned to the individual capital accounts.

B. The method of allocating income to the capital accounts should be established within the Articles of Partnership.



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1. The partners can simply assume an equal division of profits and losses.

2. The partners, however, can select any method that is designed to arrive at an equitable allocation. Such factors as the amounts of capital invested, the time worked in the business, and the degree of business expertise may all serve to influence the assignment of income.

IV. Accounting for partnership dissolution

A. Over time, the identity of the individuals within a partnership can change through admission of a new partner or the death, retirement, or withdrawal of a present partner.

B. Each change in composition serves to dissolve the original partnership usually so that a new partnership can be formed to continue the business. Thus, dissolution does not necessarily affect the operations of the business.

C. Admission of a new partner.

1. A new partner will often buy all (or a portion) of the interest owned by one or more of the present partners.

a. The capital account balances can simply be reclassified to reflect the identity of the new ownership.

b. As an alternative, all accounts may be adjusted to fair market value with the price paid being used as the basis for calculating any goodwill.

2. A new partner can also be admitted by a direct contribution to the partnership business.

a. The bonus (or no revaluation) method records the identifiable assets being contributed at fair market value. The new partner’s capital is set equal to a prearranged percentage or amount. The remaining capital balances are then aligned based on profit and loss percentages.

b. The goodwill (or revaluation) approach initially adjusts all assets and liabilities of the partnership to fair market value and records goodwill based on the amount being paid (which is used to calculate the implied value of the business).

D. Withdrawal of a partner

1. The final asset distribution to an individual should be based on the agreement established in the Articles of Partnership and will often vary in amount from that partner's ending capital balance.

2. The difference between the amount paid and the final capital balance can simply be recorded as an adjustment to the remaining partners' capital accounts in the same manner as the bonus method.

3. As an alternative, all accounts can be adjusted to fair value with the amount of payment being used as the basis for computing goodwill.

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What kind of business is this? The owners of this business face a common problem: they began operations without seriously considering the company’s legal form. The accountant now needs to specify the advantages and disadvantages of the partnership versus corporate or some other legal form. Eventually, the owners must make this decision but should consider all relevant factors in their choice. The accountant should discuss the following issues with the two owners: —Ease of formation. A formal partnership can be created by the writing of an Articles of

Partnership. If income allocation and partners’ contributions are already determined, the document preparation should be relatively simple. Forming a corporation is a usually a more difficult task depending on individual state laws. The accountant should explain the specific procedures that apply to partnerships in the state where the business is organized and conducts its operations.

—Business liabilities. In a partnership, any partner may be held liable for all business debts. Thus,

if liabilities escalate and the business fails, each partner risks a large possible loss. The same problem does not exist in a corporation where owners and the business are separate entities. For the owners, potential losses are, in corporations, normally limited to the amount being invested. However, in many small, newly created, corporations, the owners are required to personally guarantee any loans. Therefore, to an extent, the concept of unlimited liability may actually be present in either case. The partners should forecast the amount of debts that will be incurred and the possible outcome if the business would happen to fail.

—Lawsuits. Some businesses are more susceptible to lawsuits than others. A florist, for example,

would likely have less risk than a pharmaceutical company. The concept of personal liability for business debts becomes especially important when litigation risk is high. To reduce such risk, creating a corporation to protect the personal property of the stockholders may be a wise move. The owners of a partnership may become personally responsible for losses created by a business mistake or accident. The need for this responsibility is recognized in states that prohibit doctors, lawyers, accountants, and the like from incorporating. Such states, however, allow licensed professionals to operate LLPs.

—Taxation. In a partnership, all income is allocated to the owners immediately and they are taxed

on this amount. Double-taxation is avoided. A corporation pays an income tax and any dividends are then taxed again when collected by the owners. Therefore, traditionally, partnerships are viewed as having a tax advantage. The accountant should also mention to the partners other possible tax factors that may affect their decision. For example, in small corporations, double taxation may not be a problem. If salaries paid to the owners are reasonable and approximate the company's profits so that no dividends are distributed, only one tax is paid in either case. As another issue, if a partnership suffers a loss (which often happens when companies begin operations), that loss is passed to the partners and can be used to reduce other taxable income. However, in a corporation, losses are carried back and forward to reduce other taxable income that is earned by the business, possibly delaying the benefits of the loss. As mentioned in the textbook, the owners should consider forming an S Corporation—a business that is incorporated but still taxed as a partnership.



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—Bankruptcy. If the business should ever fail and have to be liquidated, losses of a partnership are passed directly to the owners to reduce taxable income immediately. For a corporation, the loss is a capital loss to the stockholders which can only offset their own capital gains or be deducted at the rate of $3,000 per year. Thus, if a large loss is incurred, the tax benefits may not be realized for years into the future.

—Growth potential. Traditionally, corporations have more growth potential than do partnerships.

Ownership interests can be easily transferred. The limitation on liability encourages ownership by individuals who cannot participate in the management of the company. Partnerships are more restricted in adding new owners. Partnerships usually have to entice individuals who are willing to work in the business in order to obtain additional capital.

Therefore, the accountant may want to address the following questions in advising these

clients: What amount of time and energy is involved in becoming incorporated? How much profit or loss is anticipated from the operations of this business in the

foreseeable future? How much debt will the new business incur? Will this debt be guaranteed by the owners? How much salary do the owners anticipate withdrawing from the business? What are the chances of incurring lawsuits? What is the possibility that the business will fail? How large do the owners expect this business to grow? Do they anticipate the need

for new owners and new capital? Does the creation of an S Corporation apply to this particular business?

How Will the Profits Be Split? This case is designed to point up the difficulty of designing a profit-sharing arrangement that is fair to all parties. Currently, these three individuals have incomes totaling an amount in excess of the first year income that is expected. Thus, the adopted plan will have an immediate impact on them. The reduction of income must be absorbed by the partners in some equitable manner. In addition, the income is projected to increase relatively fast so that the agreed-upon method needs to reward all participants properly over time. Dewars has built up the firm and still handles the bigger clients although he plans to reduce his workload over the next few years. Thus, one method of compensation would be to credit him with interest on the capital built up in the business. However, if that number alone is used, it will tend to escalate even if his work hours are reduced. For this reason, Dewars' share of the profits could also be based in some way on the number of hours that he works. According to the information presented, this number will probably shrink over the years, reducing the profits allocated to Dewars. Thus, this partner might be given interest equal to 10 percent of his capital balance and $50 for each hour worked. Huffman is contributing a significant number of hours to the firm but tends to work on the smaller jobs. A possible allocation technique would be to give this partner a per hour allocation but one that is somewhat smaller than Dewars. For example, Huffman could receive an income allocation of $30 per hour to begin. That number could then be programmed to escalate over the years as Huffman starts to take over the bigger jobs.

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Scriba's role is to develop a tax practice within the firm. Consequently, one suggestion would be to credit her capital account with a percentage of the tax revenues (20 percent, for example) each year. In that way, she benefits by the amount of business that she is able to bring to the organization. During the first years, though, she may have trouble getting the new part of this business to generate significant revenues. Thus, the partners may want to set a minimum figure for her income allocation. She could be credited, as an example, with 20 percent of tax revenues but not less than $50,000. Many answers to this question are possible. The above is just a simple suggestion based on the facts presented in the case. Income allocation techniques are usually designed to reward the partners for the attributes that they bring to the organization. Even with the above system, percentages would still be necessary to assign any remaining profit or loss. If the partners are not totally satisfied with the system as designed, the percentages could be weighted or adjusted to reward any partner not being properly compensated.



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Answers to Questions 1. The advantages of operating a business as a partnership include the ease of formation and

the avoidance of the double taxation effect that inherently reduces the profits distributed to the owners of a corporation. In addition, because the losses of a partnership pass, for tax purposes, directly through to the owners, partnerships have historically been used (especially in certain industries) to reduce or defer income taxes.

Several disadvantages also accrue from the partnership format. Each general partner, for

example, has unlimited liability for all debts of the business. This potential liability can be especially significant in light of the concept of mutual agency, the right that each partner has to create liabilities in the name of the partnership. Because of the risks created by unlimited liability and mutual agency, the growth potential of most partnerships is severely limited. Few people are willing to become general partners in an organization unless they can maintain some day-to-day contact and control over the business.

Further discussion of these issues can be found in the Answer to the first Discussion Question

that appears above. 2. Specific partnership accounting problems center in the equity (or capital) section of the

balance sheet. In a corporation, stockholders' equity is divided between earned capital and contributed capital. Conversely, for a partnership, each partner has an individual capital account that is not differentiated according to its sources. Virtually all accounting issues encountered purely in connection with the partnership format are related to recording and maintaining these capital balances.

3. The balance in each partner's capital account measures that partner's interest in the book

value of the business’ net assets. This figure arises from contributions, earnings, drawings, and other capital transactions.

4. A Subchapter S corporation is formed legally as a corporation so that its owners enjoy limited

legal liability and easy transferability of ownership. However, if a company qualifies and becomes a Subchapter S Corporation, it will be taxed in virtually the same manner as a partnership. Hence, income will be taxed only once and that is to the owners at the time that it is earned by the corporation.

Use of this designation is quite restricted. To qualify as a Subchapter S Corporation, a

company can only have one class of stock and must have no more than 100 owners. These owners can only be individuals, estates, certain tax-exempt entities, and certain types of trusts. Most corporations that do not qualify as Subchapter S Corporations are automatically Subchapter C Corporations. These entities are also corporations but they pay income taxes when the income is earned. Additionally, the owners are liable for a second income tax when dividends are distributed to them. Thus, the income earned by a Subchapter C Corporation faces the double taxation effect commonly associated with corporations.

5. In a general partnership, each partner can have unlimited liability for the debts of the business.

Therefore, a partner may face a significant risk, especially in connection with the actions and activities of other partners. However, general partnerships are easy to form and often serve well in smaller businesses where all partners know each other. The major advantage of a

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general partnership is that all income earned by the business is only taxed once when earned by the business so that no second tax is incurred when distributions are made to owners.

A limited liability partnership (LLP) is very similar to a general partnership except in the method

by which a partner’s liability is measured. In an LLP, the partners can still lose their entire investment and be held responsible for all contractual debts of the business such as loans. However, partners cannot be held responsible for damages caused by other partners. For example, if one partner carelessly causes damage and is sued, the other partners are not held responsible.

A limited liability company can now be created in certain situations. This type of organization

is classified as a partnership for tax purposes so that the double-taxation effect is avoided. However, the liability of the owners is limited to their individual investments like a Subchapter C Corporation. Depending on state law, the number of owners is not restricted in the same manner as a Subchapter S Corporation so that there is a greater potential for growth.

6. The Articles of Partnership is a legal agreement that should be created as a prerequisite for

the formation of a partnership. This document defines the rights and responsibilities of the partners in relation to the business and in relation to each other. Thus, it serves as a governing document for the partnership. The Articles of Partnership may contain any number of provisions but should normally specify each of the following:

a. Name and address of each partner b. Business location c. Description of the nature of the business d. Rights and responsibilities of each partner e. Initial investment to be made by each partner along with the method to be used for

valuation f. Specific method by which profits and losses are to be allocated g. Periodic withdrawals to be allowed each partner h. Procedure for admitting new partners i. Method for arbitrating partnership disputes j. Method for settling a partner's share in the business upon withdrawal, retirement, or death

7. To give fair recognition to noncash contributions, all assets donated by the partners (such as

land or inventory) should be recorded by the partnership at their fair values at the date of investment. However, for taxation purposes, the partner’s book value is retained.

8. In forming a partnership, one or more of the partners may be contributing some factor (such

as an established clientele or an expertise) which is not viewed normally as an asset in the traditional accounting sense. In effect, the partner will be receiving a larger capital balance than the identifiable contributions would warrant.

The bonus method of recording this transaction is to value and record only the identifiable

assets such as land and buildings. The capital accounts are then aligned to recognize the proportionate interest being assigned to each partner's investment. If, for example, the capital balances are to be equal, they are set at identical amounts that correspond in total to the value of the identifiable assets.

As an alternative, the amounts contributed along with the established capital percentages can

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of any goodwill brought into the business. This goodwill is recognized at the time that the partnership is created so that the amount can be credited to the appropriate partner.

9. The Drawing account measures the amount of assets that a particular partner takes from the

business during the current period. Often, only regularly allowed distributions are recorded in the Drawing account with larger, more sporadic withdrawals being recorded as direct reductions to the partner's capital balance.

10. At the end of each fiscal year, when revenues and expenses are closed out, some assignment

must be made of the resulting income figure Because a partnership will have two or more capital accounts rather than a single retained earnings balance. This allocation to the capital accounts is based on the agreement established by the partners preferably as a part of the Articles of Partnership.

11. The allocation process can be based on any number of factors. The actual assignment of

income should be designed to give fair and equitable treatment to each of the partners. Often, an interest factor is used to reward the capital investment of the partners. A salary allowance is utilized as a means of recognizing the amount of time worked by an individual or a certain degree of business expertise. The allocation process can be further refined by a ratio that is either divided evenly among the partners or weighted in favor of one or more members.

12. If agreement as to the allocation of income has not been specified, an equal division among

all partners is presumed. If an agreement has been reached for assigning profits but no mention is made concerning losses, the assumption is made that the same method is intended in either case.

13. The dissolution of a partnership is the breakup or cessation of the partnership. Many reasons

can exist for a partnership to dissolve. One partner may withdraw, retire, or die. A new partner may be admitted to the partnership. The original partnership terminates whenever the identity of the individuals serving as partners has changed.

Dissolution, however, does not necessarily lead to the liquidation of the business. In most

cases, but not all, a new partnership is formed which takes over the business. Such dissolutions are no more than changes in the composition of the ownership and should not affect operations.

14. A new partner can join a partnership by acquiring part or all of the interest of one or more of

the present partners. This transaction is carried out with the individual partners directly and not with the partnership. A new partner may also enter through a contribution to the business. In such cases, the investment is made to the partnership rather than to the individuals.

15. In selling an interest in a partnership, three rights are conveyed to the new owner:

a. The right of co-ownership of the business property; b. The right to a specified allocation of profits and losses generated by the partnership's

business; and c. The right to participate in the management of the business.

No problem exists in selling or assigning the first two of these rights. However, the right to

participate in management decisions can only be transferred with the consent of all partners.

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16. Goodwill recognized in a capital transaction is allocated to the original partners based on the

profit and loss ratio. The amount is assumed to represent unrealized gains in the value of the business. To determine the amount of goodwill, the implied value of the business as a whole must be calculated based on the price being paid for a portion by the new partner. The difference between this implied value and the total capital is assumed to be goodwill or some other adjustment to asset value.

17. Allocating goodwill to an entering partner may be necessary for several reasons. One of the

most common is that the partner is bringing to the partnership an attribute that is not an asset in the traditional accounting sense. For example, a new partner with an excellent business reputation might be credited with goodwill at the time of entrance. Other factors such as an established clientele or a professional expertise can justify attributing goodwill to the new partner. The partnership might make this same concession to an entering partner if cash is urgently needed by the business and a larger share of the capital has to be offered as an enticement to generate the new investment.

18. Book values in most cases measure historical cost expenditures which often have undergone

years of allocation and changes in value. For this reason, book value will frequently fail to mirror or even resemble the actual worth of a business. In addition, the goodwill that is assumed to be present in a business as a going concern is not a factor that is always reflected within book values. Therefore, distributing partnership property to a withdrawing partner based on book value would not necessarily be fair. Hence, the Articles of Partnership should spell out a method by which an equitable settlement can be achieved.



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Answers to Problems 1. B 2. C 3. D 4. C Mary Ann's investment equals 1/3 of total capital ($50,000 ÷ $150,000).

However, she receives only a 1/4 interest capital balance. One explanation for the difference is that the business assets are worth more than book value. To achieve agreement, the net assets could be valued upward to fair value with the adjustment credited to the original partners’ capital accounts. Alternatively, a bonus could be credited to the original partners.

5. D Based on the new contribution, the company’s implied value is $350,000

($105,000 ÷ 30%) which is less than the capital balances ($315,000 in original capital plus $105,000 to be invested). Thus, either the assets are overvalued or the new partner is contributing goodwill in addition to a cash investment. Because the problem indicates that goodwill is recognized, goodwill must be computed. Note that the $105,000 is going into the business and, thus, increases capital.

David's investment = 30% (Original capital plus David's investment)

$105,000 + Goodwill = .30 ($315,000 + $105,000 + Goodwill) $105,000 + Goodwill = $126,000 + .30 Goodwill .70 Goodwill=$21,000 Goodwill =$30,000 David's investment (Capital) = $105,000 + $30,000 = $135,000 6. B The implied value of the company is $960,000 ($240,000 ÷ 25%). Because the

current capital total is only $760,000, goodwill of $200,000 must be recognized. Krystal's investment is paid directly to the partners and does not affect the capital total. Of the $200,000 in goodwill, 30 percent or $60,000 is attributed to Dane which brings that capital balance to $340,000. Because a 25% interest is conveyed to the new partner, Dane's balance decreases by 25% or $85,000—resulting in a new balance of $255,000.

7. B Total capital is $200,000 ($110,000 + $40,000 + $50,000) after the new

investment. As Kansas's portion is 30 percent, the capital balance becomes $60,000 ($200,000 × 30%). Because only $50,000 was paid, a bonus of $10,000 is taken from the two original partners based on their profit and loss ratios: Bolcar – $7,000 (70%) and Neary – $3,000 (30%). The reduction drops Neary's capital balance from $40,000 to $37,000.

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8. B Total capital is $270,000 ($120,000 + $90,000 + $60,000) after the new investment. However, the implied value of the business based on the new investment is $300,000 ($60,000 ÷ 20%). Thus, goodwill of $30,000 must be recognized with the offsetting allocation to the original partners based on their profit and loss ratio: Bishop – $18,000 (60%) and Cotton $12,000 (40%). The increase raises Cotton's capital from $90,000 to $102,000.

9. A Total capital is $450,000 ($210,000 + $140,000 + $100,000) after the new

investment. As Claudius' portion is to be 20 percent, the new capital balance would be $90,000 ($450,000 × 20%). Because $100,000 was paid, a bonus of $10,000 is being given to the two original partners based on their profit and loss ratio: Messalina – $6,000 (60%) and Romulus – $4,000 (40%). The increase raises Messalina's capital balance from $210,000 to $216,000 and Romulus's capital balance from $140,000 to $144,000.

10. D ASSIGNMENT OF INCOME ALFRED BERNARD COLLINSTOTAL

Interest—5% of beginning capital ................ $ 2,500 $ 3,000 $ 3,500 . $ 9,000 Salary ...................................... 18,000 18,000 Allocation of remaining income ($33,000 divided on a 3:3:4 basis) 9,900 9,900 13,200 . 33,000 Totals ........................... $12,400 $30,900 $16,700 . $60,000 STATEMENT OF CAPITAL ALFRED BERNARD COLLINS TOTAL

Beginning capital ................... $50,000 $60,000$70,000 $180,000 Net income (above) ................ 12,400 30,90016,700 60,000 Drawings (given) .................... (5,000) (5,000) (5,000) (15,000) Ending capital ........................ $57,400 $85,900$81,700 $225,000 11. A ASSIGNMENT OF INCOME—YEAR ONE WINSTON DURHAM SALEM TOTAL

Interest—10% of beginning capital .............. $11,000 $ 8,000 $11,000 $30,000 Salary 20,000 .................... -0- 10,000 30,000 Allocation of remaining loss ($80,000 divided on a 5:2:3 basis) (40,000) (16,000) (24,000) (80,000) Totals ........................... $(9,000) $ (8,000) $ (3,000) $(20,000) STATEMENT OF CAPITAL—YEAR ONE WINSTON DURHAM ...... SALEM TOTAL

Beginning capital ................... $110,000 $80,000 $110,000 $300,000 Net loss (above) ..................... (9,000) (8,000) (3,000) (20,000) Drawings (given) .................... (10,000) (10,000) (10,000) (30,000) Ending capital ................... $ 91,000 $62,000 $ 97,000 $250,000



Education.

11. (continued) ASSIGNMENT OF INCOME—YEAR TWO WINSTON DURHAM SALEM TOTAL

Interest—10% of beginning capital .............. $ 9,100 $ 6,200 $ 9,700 $25,000 Salary ............................ 20,000 -0- 10,000 30,000 Allocation of remaining loss ($15,000 divided on a 5:2:3 basis) (7,500) (3,000) (4,500) (15,000) Totals ........................... $21,600 $3,200 $15,200 $ 40,000 STATEMENT OF CAPITAL—YEAR TWO WINSTON DURHAM SALEM TOTAL

Beginning capital (above) ..... $ 91,000 $62,000 $ 97,000 $250,000 Net income (above) ................ 21,600 3,200 15,200 40,000 Drawings (given) .................... (10,000) (10,000) (10,000) (30,000) Ending capital ................... $102,600 $55,200 $102,200 $260,000 12. A Costello receives a $10,000 bonus ($100,000 less $90,000 capital balance).

This bonus is deducted from the two remaining partners according to their profit and loss ratio (2:3). A 60 percent (3/5) reduction is assigned to Burns which decreases that partner’s capital balance from $30,000 to $24,000.

13. D Clark receives an additional $10,000. Because Clark receives 20 percent of

profits and losses, this allocation indicates total goodwill of $50,000. 20% of Goodwill = $10,000 Goodwill = $10,000 ÷ .20 = $50,000 Goodwill 50,000 Manning, capital (30%) 15,000 Gonzalez, capital (30%) 15,000 Clark, capital (20%) 10,000 Freeney, capital (20%) 10,000

The above entry raises Manning’s capital from $130,000 to $145,000. 14. B Under the bonus method, Clark’s excess payment is deducted from the remaining partners’ capital accounts according to their relative profit and loss ratios, 3:3:2. Manning’s balance is then $126,250 = $130,000 – $3,750.

Manning, capital 3,750 Gonzalez, capital 3,750 Freeney, capital 2,500 Clark, capital 80,000 Cash 90,000

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15. A The implied value of the company is $900,000 ($270,000 ÷ 30%). Because the

money is going to the partners rather than into the business, the capital total is $490,000 before realigning the balances. Hence, goodwill of $410,000 is recognized based on the implied value ($900,000 – $490,000). This goodwill is assumed to represent unrealized business gains and is attributed to the original partners according to their profit and loss ratio. They will then each convey 30 percent ownership of the $900,000 partnership to Darrow for a capital balance of $270,000.

16. D Because the money goes into the business, total capital becomes $740,000

($490,000 + $250,000). Darrow is allotted 30 percent of this total or $222,000. Because Darrow invested $250,000, the extra $28,000 is assumed to be a bonus to the original partners. Jennings will be assigned 40 percent of this extra amount or $11,200. This bonus increases Jennings’ capital from $160,000 to $171,200.

17. (10 Minutes) (Compute capital balances under both goodwill and bonus

methods) a. Goodwill Method Implied value of partnership ($80,000 ÷ 40%) .................. $200,000 Total capital after investment ($70,000 + $40,000 + $80,000) 190,000 Goodwill .......................................................................... $ 10,000

Goodwill to Hamlet (7/10) ................................................. $ 7,000

Goodwill to MacBeth (3/10) .............................................. $ 3,000

Hamlet, capital (original balance plus goodwill) ......... $ 77,000

MacBeth, capital (original balance plus goodwill) ...... $ 43,000

Lear, capital (payment) (40% of total capital) .............. $ 80,000 b. Bonus Method Total capital after investment ($70,000 + 40,000 + $80,000) $190,000 Ownership portion—Lear .............................................. 40% Lear, capital .................................................................... $ 76,000

Bonus payment made by Lear ($80,000 – $76,000) ...... $ 4,000

Bonus to Hamlet (7/10) .................................................. $ 2,800

Bonus to MacBeth (3/10) ............................................... $ 1,200

Hamlet, capital (original balance plus bonus) ............. $ 72,800

MacBeth, capital (original balance plus bonus) .......... $ 41,200

Lear, capital (40% of total capital) ................................ $ 76,000



Education.

18. (15 Minutes) (Prepare journal entries to record admission of new partner under both the goodwill and the bonus methods)

Part a.

Total capital is $300,000 ($85,000 + $60,000 + $55,000 + $100,000) after the new investment. As Sergio's portion is 25 percent, this partner's capital balance would be $75,000. Because $100,000 was paid, a bonus of $25,000 is given to the three original partners based on their profit and loss ratio: Tiger—$12,500 (50%), Phil—$7,500 (30%), and Ernie—$5,000 (20%).

Cash .......................................................................... 100,000

Sergio, capital ...................................................... 75,000 Tiger, capital ........................................................ 12,500 Phil, capital .......................................................... 7,500 Ernie, capital ........................................................ 5,000

Part b.

Total capital is $260,000 ($85,000 + $60,000 + $55,000 + $60,000) after the new investment. As Sergio's portion is 25 percent, this partner's capital balance is $65,000. Because only $60,000 was paid, a bonus of $5,000 is taken from the three original partners based on their profit and loss ratio: Tiger—$2,500 (50%), Phil—$1,500 (30%), and Ernie—$1,000 (20%).

Cash .......................................................................... 60,000

Tiger, capital ............................................................. 2,500 Phil, capital ................................................................ 1,500 Ernie, capital ............................................................. 1,000 Sergio, capital ...................................................... 65,000 Part c.

Total capital is $272,000 ($85,000 + $60,000 + $55,000 + $72,000) after the new investment. However, the implied value of the business based on the new investment is $288,000 ($72,000 ÷ 25%). Consequently, goodwill of $16,000 must be recognized with the offsetting allocation to the original partners based on their profit and loss ratio: Tiger—$8,000 (50%), Phil— $4,800 (30%), and Ernie—$3,200 (20%).

Goodwill ................................................................... 16,000

Tiger, capital ........................................................ 8,000 Phil, capital .......................................................... 4,800 Ernie, capital ........................................................ 3,200

Cash ........................................................................... 72,000 Sergio, capital ...................................................... 72,000

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19. (16 Minutes) (Determine capital balances after admission of new partner using both goodwill and bonus methods)

Part a.

Total capital is $490,000 ($200,000 + $120,000 + $90,000 + $80,000) after the new investment. However, the implied value of the business based on the new investment is only $444,444 ($80,000 ÷ 18%). According to the goodwill method, this situation indicates that the new partner must be bringing some intangible attribute to the partnership other than just cash. This contribution must be computed algebraically and is recorded as goodwill to the new partner.

G's Investment = .18 ($200,000 + $120,000 + $90,000 + G's Investment) $80,000 + Goodwill = .18 ($410,000 + $80,000 + Goodwill) $80,000 + Goodwill = $88,200 + .18 Goodwill .82 Goodwill = $8,200

Goodwill = $10,000 The above goodwill balance indicates that Grant's total investment is $90,000 (cash of $80,000 and goodwill of $10,000). A $90,000 contribution raises the total capital to $500,000 so that Grant does, indeed, have an 18 percent interest ($90,000 ÷ $500,000).

CAPITAL BALANCES:

Nixon ................................................................. $200,000 Hoover ................................................................. 120,000 Polk ................................................................. 90,000 Grant ................................................................. 90,000

Part b.

Total capital is $510,000 ($200,000 + $120,000 + $90,000 + $100,000) after the new investment. As Grant's portion is to be 20 percent, this partner's capital balance will be $102,000. Because only $100,000 was paid, a bonus of $2,000 is taken from the three original partners based on their profit and loss ratio: Nixon—$1,000 (50%), Hoover—$400 (20%), and Polk—$600 (30%).

CAPITAL BALANCES Original Investment Bonus Total

Nixon .................... $200,000 $(1,000) $199,000 Hoover .................. 120,000 (400) 119,600 Polk ....................... 90,000 (600) 89,400 Grant ..................... -0- 100,000 2,000 102,000 Total ................ $510,000



Education.

20. (10 Minutes) (Record admission of new partner and allocation of new income) Part a.

Total capital is $167,000 ($70,000 + $60,000 + $37,000) after the new investment. However, the implied value of the business based on the new investment is $185,000 ($37,000 ÷ 20%). Consequently, goodwill of $18,000 must be recognized with the offsetting allocation to the original two partners based on their profit and loss ratio: Prince—$14,400 (80%) and Robbins—$3,600 (20%).

Goodwill .. 18,000 Prince, capital .. 14,400 Robbins, capital .. 3,600 Cash 37,000 Jeffrey, capital ................................................ 37,000

Part b. Prince Robbins Jeffrey Total Interest .................................. $8,440 $6,360 $3,700 $18,500 Remaining loss ..................... (1,750) (1,050) (700) (3,500) Income allocation ........... $6,690 $5,310 $3,000 $15,000 21. (5 Minutes) (Allocation of income to partners) Jones King Lane Total Bonus (20%) ......................... $18,000 $ -0- $ -0- $18,000 Interest (15% of average capital) 15,000 30,000 45,000 90,000 Remaining loss ($18,000) ... (6,000) (6,000) (6,000) (18,000) Income assignment ............. $27,000 $24,000 $39,000 $90,000

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22. (15 Minutes) (Allocate income and determine capital balances) ALLOCATION OF INCOME Purkerson Smith Traynor Totals Interest (10%) $ 6,600 (below) $ 4,000 $ 2,000 $12,600 Salary 18,000 25,000 8,000 51,000 Remaining income (loss):

$ 23,600 (12,600) (51,000) $(40,000) (16,000) (8,000) (16,000) (40,000)

Totals $ 8,600 $21,000 $(6,000) $23,600 CALCULATION OF PURKERSON'S INTEREST ALLOCATION Balance, January 1—April 1 ($60,000 × 3) $180,000 Balance, April 1—December 31 ($68,000 × 9) 612,000 Total ................................................................................ $792,000

Months ............................................................................. 12 Average monthly capital balance ................................. $ 66,000 Interest rate .................................................................... × 10% Interest allocation (above) ............................................ $ 6,600

STATEMENT OF PARTNERS' CAPITAL Purkerson Smith Traynor Totals

Beginning balances .............. $60,000 $40,000 $20,000 $120,000 Additional contribution ........ 8,000 -0- -0- 8,000 Income (above) ...................... 8,600 21,000 (6,000) 23,600 Drawings ($1,000 per month) (12,000) (12,000) (12,000) (36,000) Ending capital balances ........ $64,600 $49,000 $ 2,000 $115,600



Education.

23. (30 Minutes) (Allocate income for several years and determine ending capital balances)

INCOME ALLOCATION—2014

Left CenterRight Total Interest (12% of beginning capital) $2,400$ 7,200$ 6,000 $ 15,600 Salary 12,000 8,000 -0- 20,000 Remaining income/loss:

$(30,000) (15,600) (20,000) $(65,600) (19,680) (32,800)(13,120) (65,600)

Totals $(5,280) $(17,600) $(7,120)$(30,000)

STATEMENT OF PARTNERS' CAPITAL—DECEMBER 31, 2014 Left Center Right Total Beginning balances ........... $20,000$60,000 $50,000 $130,000 Income allocation ............... (5,280)(17,600) (7,120) (30,000) Drawings ........................ (10,000)(10,000) (10,000) (30,000) Ending balances ........... $ 4,720$32,400 $32,880 $ 70,000

INCOME ALLOCATION—2015 Left Center Right Total Interest(12% of beginning capital above) *$566 $3,888 $3,946 $ 8,400 Salary ................................. 12,000 8,000 -0- 20,000 Remaining income/loss:

$20,000 (8,400) (20,000) $(8,400) (2,520) (4,200) (1,680) (8,400)

Totals .................. $10,046 $7,688 $2,266 $20,000 *Rounded

STATEMENT OF PARTNERS' CAPITAL—DECEMBER 31, 2015 Left Center Right Total Beginning balances (above) $ 4,720 $32,400 $32,880 $70,000 Additional investment ....... -0- -0- 12,000 12,000 Income allocation ............... 10,046 7,688 2,266 20,000 Drawings ............................. (10,000) (10,000) (10,000) (30,000) Ending balances ........... $ 4,766 $30,088 $37,146 $72,000

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23. (continued) INCOME ALLOCATION—2016

Left Center Right Total Interest (12% of beginning capital above)* ................... $ 572 $ 3,611 $4,457 $ 8,640 Salary ................... 12,000 8,000 -0- 20,000 Remaining income:

$40,000 (8,640) (20,000) $11,360 ....................... 2,272 4,544 4,544 11,360

Totals ....................... $14,844$16,155 $9,001 $40,000 *Rounded

STATEMENT OF PARTNERS' CAPITAL—DECEMBER 31, 2016 Left Center Right Total Beginning balances (above) $ 4,766 $30,088 $37,146 $72,000 Income allocation 14,844 16,155 9,001 40,000 Drawings (10,000) (10,000) (10,000) (30,000) Ending balances $ 9,610 $36,243 $36,147 $82,000



Education.

24. (12 Minutes) (Determine capital balances after retirement of a partner using both the goodwill and the bonus approaches)

a. Fergie receives $30,000 more than her capital balance. Because Fergie is

assigned 20 percent of all profits and losses, this extra allocation indicates total goodwill of $150,000, which must be split among all partners.

20% of Goodwill = $30,000 .20 G = $30,000 G = $150,000

CAPITAL BALANCES AFTER WITHDRAWAL

Original Balance Goodwill Withdrawal Final Balance

Pineda $230,000$45,000 $275,000 Adams 190,00045,000 235,000 Fergie 160,00030,000 $(190,000) -0- Gomez 140,00030,000 170,000 Total $680,000

b. A $50,000 bonus is paid to Pineda ($280,000 is paid rather than the $230,000

capital balance). This bonus is deducted from the three remaining partners according to their relative profit and loss ratio (3:2:1). A reduction of 50 percent (3/6) is assigned to Adams or a decrease of $25,000 which drops this partner's capital balance from $190,000 to $165,000. A reduction of 33.3 percent (2/6) is assigned to Fergie or a decrease of $16,667 which drops this partner's capital balance from $160,000 to $143,333. A reduction of 16.7 percent (1/6) is assigned to Gomez or a decrease of $8,333 which drops this partner's capital balance from $140,000 to $131,667.

25. (10 minutes) (Hybrid method for recording a partner withdrawal) Because the continuing partners do not wish to record goodwill, a hybrid approach records identifiable asset fair value changes and corresponding capital adjustments, but no goodwill. The remaining excess payment to the withdrawing partner after the revaluation is then treated as a bonus. Building 40,000 Matteson, capital 12,000 Richton, capital 20,000 O’Toole, capital 8,000 O’Toole, capital 108,000 Matteson, capital 4,500 Richton, capital 7,500 Cash 120,000

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26. (45 Minutes) (P&L allocations and admission of a new partner)

a. The interest factor was probably inserted to reward Hugh for contributing $50,000 more to the partnership than Jacobs. The salary allowance gives an additional $20,000 to Jacobs in recognition of the full-time (rather than part-time) employment. The 40:60 split of the remaining income was probably negotiated by the partners based on other factors such as business experience, reputation, etc.

b. The drawings show the assets removed by a partner during a period of

time. A salary allowance is added to each partner's capital for the year (usually in recognition of work done) and is a component of net income allocation. The two numbers are often designed to be equal but agreement is not necessary. For example, a salary allowance might be high to recognize work contributed by one partner. The allowance increases the appropriate capital balance. The partner might, though, remove little or no money so that the partnership could maintain its liquidity.

c. Hugh, drawings ......................................................... 7,500 Repair expense .................................................... 7,500 (To reclassify payment made to repair personal residence.)

Hugh, capital 16,500 Jacobs, capital 14,000 Hugh, drawings (adjusted for home repairs) .... 16,500 Jacobs, drawings ............... 14,000 (To close drawings accounts for 2014.)

Revenues 175,000 Expenses (adjusted by first entry) ............... 138,500 Income summary ............... 36,500 (To close revenue and expense accounts for 2014.) Income summary 36,500 Hugh, capital ............... 12,600 Jacobs, capital ............... 23,900 (To close net income to partners' capital–see allocation plan shown below.) Allocation of Income Hugh Jacobs

Interest (10% of beginning balance) $ 15,000 $ 10,000 Salary allowances 5,000 25,000 Remaining income (loss):

Net income $ 36,500 Interest (25,000) Salary (30,000) Remainder $ (18,500) (7,400) (40%) (11,100) (60%)

Profit allocation $12,600 $23,900



Education.

26. (continued) d. Total capital (original balances of $250,000 plus 2014 net income less drawings) ................................. $256,000

Investment by Thomas ............................................. 64,000 Total capital after investment .................................. $320,000 Ownership portion acquired by Thomas ................ 15% Thomas, capital ........................................................ $ 48,000 Amount paid .............................................................. 64,000

Bonus paid by Thomas—assigned to original partners $ 16,000

Bonus to Hugh (40%) ............................................... $6,400 Bonus to Jacobs (60%) ............................................ $9,600 Cash 64,000

Thomas, capital (20% of total capital) ............... 48,000 Hugh, capital ........................................................ 6,400 Jacobs, capital .................................................... 9,600

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27. (40 Minutes) (Reporting a change in the composition of a partnership) a. Exact amount of investment can only be computed algebraically:

E Investment = 25% (Original Capital + E Investment) El = .25 ($270,000 + El) El = $67,500 + .25 El .75 El = $67,500 E Investment = $90,000

b. Implied value of partnership ($36,000 ÷ 10%) ......... $360,000 Total capital after investment by E ($270,000 + $36,000) 306,000 Goodwill .................................................................... $ 54,000 Allocation of Goodwill:

A (30%) ............................................................... $16,200 B (10%) ............................................................... 5,400 C (40%) ............................................................... 21,600 D (20%) ............................................................... 10,800

Total ................................................................ $54,000 CAPITAL BALANCES A B C D E Original balances $20,000 $40,000 $ 90,000 $120,000 $-0- Goodwill (above) 16,200 5,400 21,600 10,800 -0- Investment -0- -0- -0- -0- 36,000 Capital balances $ 36,200 $45,400 $111,600 $130,800 $36,000 c. Because E's investment of $42,000 is less than 20% of the resulting capital

($312,000). E is apparently bringing some other attribute to the partnership (goodwill) that must be computed:

E Investment = 20% (Original Capital + E Investment) $42,000 + Goodwill = .20 ($270,000 + $42,000 + Goodwill) $42,000 + Goodwill = $62,400 + .20 Goodwill .80 Goodwill = $20,400 Goodwill = $25,500

E's investment is, therefore, $42,000 in cash and $25,500 in goodwill for a total capital balance of $67,500; the other capital accounts remain unchanged. Note that E's capital of $67,500 is 20% of the new total capital $337,500 ($270,000 + $67,500).



Education.

27. (continued) d. Total capital after investment ($270,000 + $55,000) $325,000 Amount acquired by E ............................................. 20% E's capital balance .................................................... $ 65,000 E's payment .............................................................. 55,000 Bonus being given to E ............................................ $ 10,000 Bonus from: A (10%) ............................................................... $1,000 B (30%) ............................................................... 3,000 C (20%) ............................................................... 2,000 D (40%) ............................................................... 4,000 $10,000

CAPITAL BALANCES A B C D E Original balances $20,000 $40,000 $90,000 $120,000 $-0- Investment -0- -0- -0- -0- 55,000 Bonus (above) (1,000) (3,000) (2,000) (4,000) 10,000 Capital balances $19,000 $37,000 $88,000 $116,000 $65,000 e. C's capital balance $ 90,000 C's collection (125%) 112,500 Bonus being paid to C $ 22,500 Bonus from:

A (1/3) $7,500 B (1/3) 7,500 D (1/3) 7,500 $22,500

CAPITAL BALANCES

A B C D Original balances ................. $20,000 $40,000 $ 90,000 $120,000 Bonus (above) ...................... (7,500) (7,500) 22,500 (7,500) Payment ................................ -0- -0- (112,500) -0- Capital balances ................... $12,500 $32,500 $ -0- $112,500

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28. (55 Minutes) (Allocation of income to the partners and determination of capital balances)

ALLOCATION OF INCOME—2013

BoswellJohnson Total Salary (8 months) ................. $8,000 $-0- .. $ 8,000 Remaining $3,000 ................. 1,200 (40%) 1,800 (60%) 3,000 Totals .......................$9,200 $1,800 $11,000

STATEMENT OF PARTNERS' CAPITAL—DECEMBER 31, 2013 Boswell Johnson Total Beginning Balances ($114,000 Invested capital split evenly— market value used for assets) $57,000 $57,000 $114,000 Income allocation (above) ... ................... 9,200 1,800 11,000 Drawings .............................. -0- -0- -0- Ending balances ............. $66,200 $58,800$125,000 WALPOLE INVESTMENT JANUARY 1, 2014

Walpole's $54,000 investment increases total capital to $179,000. Walpole is credited with a 40% interest or $71,600. According to the problem, the excess $17,600 is a bonus from the original partners. Of this amount, $10,560 is allocated from Johnson (60%) and $7,040 from Boswell (40%).

ALLOCATION OF INCOME—2014 Boswell Johnson Walpole Total Salary $12,000 .................$-0- $24,000 $36,000 Remaining $8,000 loss ($28,000 – $36,000) ........................... (960) (3,840) (3,200) (8,000) Totals ......................... $11,040 $(3,840) $20,800 $28,000 STATEMENT OF PARTNERS' CAPITAL—DECEMBER 31, 2014 Boswell Johnson ................... Walpole Total Beginning balances .............$66,200$58,800 $ -0- $125,000 Walpole's contribution ........(7,040)(10,560) 71,600 54,000 Income allocation (above) ...11,040 (3,840) 20,800 28,000 Drawings ............................... (5,000) (5,000) (10,000) (20,000) Ending balances .............$65,200$39,400 $82,400 $187,000



Education.

28. (continued) ADMISSION OF POPE—JANUARY 1, 2015

Pope's payment was made directly to the partners. Therefore, neither goodwill nor a bonus need be recognized. Instead, 10% of each capital balance shown above will be reclassified to Pope. The journal entry would be as follows:

Boswell, capital .............................................................. 6,520 Johnson, capital ............................................................. 3,940 Walpole, capital. .............................................................. 8,240 Pope, capital ............................................................. . 18,700

ALLOCATION OF INCOME—2015 Boswell Johnson Walpole Pope Total

Salary $12,000 $-0- $24,000 $9,600 $45,600 Remaining $400 income 54 162 144 40 400 Totals $12,054 $162 $24,144 $9,640 $46,000

STATEMENT OF PARTNERSHIP CAPITAL—DECEMBER 31, 2015 Boswell Johnson Walpole Pope Total Beginning balances $65,200 $39,400 $82,400 $-0- $187,000 Admission of Pope (6,520) (3,940) (8,240) 18,700 -0- Allocation of income (above) 12,054 162 24,144 9,640 46,000 Drawings (5,000) (5,000) (10,000) (4,000) (24,000) Ending balances $65,734 $30,622 $88,304 $24,340 $209,000

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29. (60 Minutes) (Allocate income and prepare a statement of partners' capital) a. Income Allocation—2013 Gray Stone Lawson Totals Salary allowance ($8 per billable hour) $13,680 $11,520 $10,400 $35,600 Interest (see Note A) 25,928 21,600 10,800 58,328 Bonus (not applicable because salary and interest would necessitate a negative bonus) -0- -0- -0- -0- Remaining loss (split evenly):

$ 65,000 (35,600) (58,328) $(28,928) (9,643) (9,643) (9,642) (28,928)

Profit allocation $29,965 $23,477 $11,558 $65,000

Note A: Interest for Stone and Lawson is calculated at 12% of their beginning capital balances ($180,000 and $90,000, respectively) while for Gray the computation is based on a $210,000 balance for 4/12 of the year and $219,100 for the remaining 8/12.

Capital Account Balances—1/1/13 – 12/31/13 Gray Stone Lawson Totals Beginning contributions $210,000 $180,000 $90,000 $480,000 Added Investment 9,100 -0- -0- 9,100 Profit allocation (from above) 29,965 23,477 11,558 65,000 Drawing (10% of beginning balances) (21,000) (18,000) (9,000) (48,000) Ending balances $228,065 $185,477 $92,558 $506,100

Prior to developing the information for 2014, a computation of Monet's investment must be made:

Monet's Investment = 25% ($506,100 + Monet's Investment)

Ml = $126,525 + .25 Ml .75 Ml = $126,525

Ml = $168,700



Education.

29. a. (continued) Income Allocation—2014 Gray Stone Lawson Monet Totals Salary allowance ($8

per billable hour) $14,400 $ 12,000 $ 11,040 $ 9,520 $ 46,960 Interest (12% of beginning capital balances for the year) 27,368 22,257 11,107 20,244 80,976 Bonus (not applicable) -0- -0- -0- -0- -0- Remaining loss (split evenly): $ (20,400) (46,960) (80,976) $(148,336) (37,084) (37,084) (37,084) (37,084) (148,336) Loss allocation $ 4,684 $(2,827) $(14,937) $ (7,320) $(20,400) Capital Account Balances 1/1/14 – 12/31/14 Gray Stone Lawson Monet Totals Beginning balances $228,065 $185,477 $92,558 $168,700 $674,800 Loss allocation (from above) 4,684 (2,827) (14,937) (7,320) (20,400) Drawings (10% of beginning balances) (22,806) (18,548) (9,256) (16,870) (67,480) Ending balances $209,943 $164,102 $68,365 $144,510 $586,920 Income Allocation—2015 Gray Stone Lawson Monet Totals Salary allowance ($8

per billable hour) $15,040 $12,960 $10,480 $12,640 $ 51,120 Interest (12% of beginning capital balances for the year) 25,193 19,692 8,204 17,341 70,430 Bonus (see Note B) 2,604 2,604 -0- -0- 5,208 Remaining profit split evenly:

$152,800 (51,120) (70,430) (5,208)

$ 26,042 6,510 6,510 6,511 6,511 26,042 Profit allocation $49,347 $41,766 $25,195 $36,492 $152,800

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29. a. (continued)

Note B: The bonus to Gray and Stone can only be derived algebraically. Because each of the two partners is entitled to 10% of net income as defined, the total bonus is 20% and can be computed as follows: Bonus = 20% (Net income – Salary – Interest – Bonus)

B = .2 ($152,800 – $51,120 – $70,430 – B) B = .2 ($31,250 – B) B = $6,250 – .2B

1.2 B = $6,250 B = $5,208 (or $2,604 per person)

Capital Account Balances 1/1/15 – 12/31/15 Gray Stone Lawson Monet Totals Beginning balances $209,943 $164,102 $68,365 $144,510 $586,920 Profit allocation (from above) 49,347 41,766 25,195 36,492 152,800 Drawings (10% of beginning balances) (20,994) (16,410) (6,837) (14,451) (58,692) Ending balances $238,296 $189,458 $86,723 $166,551 $681,028 b.

GRAY, STONE, LAWSON, and MONET Statement of Partners' Capital


Gray Stone Lawson Monet Totals Beginning balances $209,943 $164,102 $68,365 $144,510 $586,920 Profit allocation (from above) 49,347 41,766 25,195 36,492 152,800 Drawings (10% of beginning balances) (20,994) (16,410) (6,837) (14,451) (58,692) Ending balances $238,296 $189,458 $86,723 $166,551 $681,028



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30. (40 Minutes) (Recording admission and retirement of partners using both the bonus and goodwill methods)

a. Porthos, capital ......................................................... 35,000 D'Artagnan, capital .............................................. 35,000

(To reclassify Porthos's capital balance to reflect transfer of interest to D'Artagnan.)

b. Goodwill .................................................... 50,000 Athos, capital (50%) ................................................ 25,000 Porthos, capital (30%) ............................................ 15,000 Aramis, capital (20%) .............................................. 10,000

(To record goodwill based on $250,000 implied value of partnership [$25,000 ÷ 10%]. Because current capital is only $200,000 [the $25,000 goes directly to the partners], goodwill of $50,000 has to be recorded and allocated using profit and loss ratio.)

Athos, capital (10% of balance) ............................... 10,500 Porthos, capital (10% of balance) ........................... 8,500 Aramis, capital (10% of balance) ............................. 6,000 D'Artagnan, capital ................................................... 25,000

(To reclassify 10% of each partner's capital to reflect transfer of interest to D'Artagnan.)

c. Cash .......................................................................... 30,000 D'Artagnan, capital (10% of total capital) ............. 23,000 Athos, capital (50% of excess payment) ............. 3,500 Porthos, capital (30% of excess payment) .......... 2,100 Aramis, capital (20% of excess payment) ........... 1,400

(To record $30,000 payment by D'Artagnan which increases total capital to $230,000. D'Artagnan is credited for only 10% of that balance with the extra $7,000 payment being recorded as a bonus to the original partners.)

d. Cash .......................................................................... 30,000 Goodwill .................................................................... 70,000 D'Artagnan, capital ................................................ ............ 30,000 Athos, capital (50% of goodwill) .......................... 35,000 Porthos, capital (30% of goodwill) ...................... 21,000 Aramis, capital (20% of goodwill) ......................... ............ 14,000

(To record D'Artagnan's contribution to the partnership. The $30,000 payment for 10% interest indicates a $300,000 value for the business although the capital balances would only increase to $230,000. The $70,000

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difference is recorded as goodwill, an amount assigned to the original partners.)



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30. (continued) e. Cash ........................................................................... 12,222 Goodwill . .................................................................. 10,000 D'Artagnan, capital ................................................. 22,222

To record investment by D'Artagnan. The implied value of the investment as a whole would be only $122,220 ($12,222 ÷ 10%). Because the capital balances are well in excess of this figure, D'Artagnan is apparently bringing some other factor (goodwill) into the partnership. This goodwill can be computed as follows:

$12,222 + Goodwill = 10% (Original Capital + $12,222 + Goodwill) $12,222 + Goodwill = 10% ($200,000 + $12,222 + Goodwill) $12,222 + Goodwill = $21,222 + .10 Goodwill .90 Goodwill = $9,000 Goodwill = $10,000

f. Goodwill .................................................................... 80,000 Athos, capital (50%) ............................................ 40,000 Porthos, capital (30%) ......................................... 24,000 Aramis, capital (20%) .......................................... 16,000 (To record goodwill of $80,000 based on $280,000 appraisal of business.) Aramis, capital .......................................................... 66,000 Cash .................................................................... 66,000 (To distribute cash to retiring partner based on final capital balance.)

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31. (75 Minutes) (Recording of changes in the composition of a partnership including allocation of income)

a. 1/1/13 Building .......................................................... 52,000 Equipment ....................................................... 16,000 Cash .................................................... 12,000 O'Donnell, capital ......................................... 40,000 Reese, capital ................................................ 40,000 (To record initial investment. Assets recorded at fair value with two

equal capital balances.) 12/31/13 Reese, capital ........................................... 22,000 O'Donnell, capital ..................................... 12,000 Income summary ...................................... 10,000

(The allocation plan specifies that O'Donnell receives 20% in interest [or $8,000 based on $40,000 capital balance] plus $4,000 more [Because that amount exceeds 15% of the profits from the period]. The remaining $22,000 loss is assigned to Reese.)

1/1/14 Cash ........................................................... 15,000 O'Donnell, capital (15%) ........................... 300 Reese, capital (85%) ................................. 1,700 Dunn, capital ........................................ 17,000

(New investment by Dunn brings total capital to $85,000 after 2013 loss [$80,000 – $10,000 + $15,000]. Dunn's 20% interest is $17,000 [$85,000 × 20%] with the extra $2,000 coming from the two original partners [allocated between them according to their profit and loss ratio].)

12/31/14 O'Donnell, capital ..................................... 10,340 Reese, capital ........................................... 5,000 Dunn, capital ............................................. 5,000 O'Donnell, drawings ............................. 10,340 Reese, drawings .................................. 5,000 Dunn, drawings ................................... 5,000

(To close out drawings accounts for the year based on distributing 20% of each partner's beginning capital balances [after adjustment for Dunn's investment] or $5,000 whichever is greater. O'Donnell's capital is $51,700 [$40,000 + $12,000 – $300])

12/31/14 Income summary ...................................... 44,000 O'Donnell, capital ................................ 16,940 Reese, capital ...................................... 16,236 Dunn, capital ........................................ 10,824 (To allocate $44,000 income figure for 2014 as determined below.)



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31. a. (continued) O'Donnell Reese Dunn Interest (20% of $51,700 beginning capital balance) ........ $10,340 15% of $44,000 income ..................... .......... 6,600 60:40 split of remaining $27,060 income .......................................... .......... $16,236$10,824 Total .......................................... $16,940 $16,236 $10,824 Capital Balances as of December 31, 2014: O'Donnell Reese Dunn Initial 2013 investment ...................... $40,000 $40,000 2013 profit allocation ......................... 12,000 (22,000) Dunn's investment ............................ (300)(1,700) $17,000 2014 drawings .................................... (10,340) (5,000) (5,000) 2014 profit allocation ......................... 16,940 16,236 10,824 12/31/14 balances .............................. $58,300 $27,536 $22,824 1/1/15 Dunn, capital ............................. 22,824 Postner, capital ......................... 22,824

(To reclassify balance to reflect acquisition of Dunn's interest.)

12/31/15 O'Donnell, capital ....................... 11,660 Reese, capital ............................. 5,507 Postner, capital .......................... 5,000 O'Donnell, drawings ............. 11,660 Reese, drawings ................... 5,507 Postner, drawings ................ 5,000

(To close out drawings accounts for the year based on 20% of beginning capital balances [above] or $5,000 [whichever is greater].)

12/31/15 Income summary ....................................... 61,000 O'Donnell, capital ...................... 20,810 Reese, capital ............................ 24,114 Postner, capital ......................... 16,076 (To allocate profit for 2015 determined as follows) O'Donnell Reese . Postner

Interest (20% of $58,300 beg. capital) .$11,660 15% of $61,000 income ............ ..........9,150 60:40 split of remaining $40,190 .........______$24,114$16,076 Totals ............................... $20,810$24,114$16,076

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31. a. (continued) 1/1/16 Postner, capital 33,900 O'Donnell, capital (15%) . 509 Reese, capital (85%) 2,881 Cash ....... 37,290

(Postner's capital is $33,900 [$22,824 – $5,000 + $16,076]. Extra 10% payment is deducted from the two remaining partners' capital accounts.)

b. 1/1/13 Building ...................................................... 52,000 Equipment ................................................. 16,000 Cash ........................................................... 12,000 Goodwill .................................................... 80,000 O'Donnell, capital ................................ 80,000 Reese, capital ...................................... 80,000

(To record initial capital investments. Reese is credited with goodwill of $80,000 to match O'Donnell's investment.)

12/31/13 Reese, capital ........................................... 30,000 O'Donnell, capital ................................ 20,000 Income summary ................................. 10,000

(Interest of $16,000 is credited to O'Donnell [$80,000 × 20%] along with a base of $4,000. The remaining amount is now a $30,000 loss that is attributed entirely to Reese.)

1/1/14 Cash ........................................................... 15,000 Goodwill .................................................... 22,500 Dunn, capital ........................................ 37,500

(Cash and goodwill being contributed by Dunn are recorded. Goodwill must be calculated algebraically.)

$15,000 + Goodwill = 20% (Current Capital + $15,000 + Goodwill) $15,000 + Goodwill = 20% ($150,000 + $15,000 + Goodwill) $15,000 + Goodwill = $33,000 + .2 Goodwill

.8 Goodwill = $18,000 Goodwill = $22,500 31. b. (continued) 12/31/14 O'Donnell, capital ..................................... 20,000 Reese, capital ........................................... 10,000

Chapter 18 - Accounting and Reporting for Private Not-for-Profit Entities


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Dunn, capital ............................................. 7,500 O'Donnell, drawings ............................. 20,000 Reese, drawings .................................. 10,000 Dunn, drawings ................................... 7,500

(To close out drawings accounts for the year based on 20 % of beginning capital balances: O'Donnell—$100,000, Reese—$50,000, and Dunn—$37,500.)

12/31/14 Income summary ...................................... 44,000 O'Donnell, capital ................................ 26,600 Reese, capital ...................................... 10,440 Dunn, capital ........................................ 6,960 (To allocate $44,000 income figure as follows) O'Donnell Reese Dunn

Interest (20% of $100,000 beginning capital balance) $20,000 15% of $44,000 income 6,600 60:40 split of remaining $17,400 $10,440 $6,960 Totals $26,600 $10,440 $6,960 Capital balances as of December 31, 2014: O'Donnell Reese Dunn Initial 2013 investment ... $ 80,000 $80,000 2013 profit allocation ..... 20,000 (30,000) Additional investment ... $37,500 2014 drawings ................ (20,000) (10,000) (7,500) 2014 profit allocation ..... 26,600 10,440 6,960 12/31/14 balances .......... $106,600 $50,440 $36,960

1/1/15 Goodwill .................................................... 26,588 O'Donnell, capital (15%) ..................... 3,988 Reese, capital (51%) ............................ 13,560 Dunn, capital (34%) ............................. 9,040 (To record goodwill indicated by purchase of Dunn's interest.)

In effect, profits are shared 15% to O'Donnell, 51% to Reese – (60% of the 85% remaining after O'Donnell's income), and 34% to Dunn (40% of the 85% remaining after O'Donnell's income). Postner is paying $46,000, an amount $9,040 in excess of Dunn's capital ($36,960). The additional payment for this 34% income interest indicates total goodwill of $26,588 ($9,040 ÷ 34%). Because Dunn is entitled to 34% of the profits but only holds 19% of the total capital, an implied value for the company as a whole cannot be determined directly from the payment of $46,000. Thus, goodwill can only be computed based on the excess payment. 31. b. (continued)

1/1/15 Dunn, capital .................................................... 46,000



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Postner, capital ............................................... 46,000 (To reclassify capital balance to new partner.)

12/31/15 O'Donnell, capital ............................................ 22,118 Reese, capital ................................................... 12,800 Postner, capital ................................................ 9,200 O'Donnell, drawings ...................................... 22,118 Reese, drawings ............................................ 12,800 Postner, drawings .......................................... 9,200

(To close out drawings accounts for the year based on 20% of beginning capital balances [after adjustment for goodwill].)

12/31/15 Income summary ............................................. 61,000 O'Donnell, capital ........................................... 31,268 Reese, capital ................................................. 17,839 Postner, capital .............................................. 11,893 To allocate profit for 2015 as follows:

O'Donnell Reese Postner Interest (20% of $110,588 beginning capital balance) $22,118 15% of $61,000 income ....... 9,150 60:40 split of remaining $29,732 ............................ $17,839 $11,893 Totals ............................... $31,268 $17,839 $11,893

Capital Balances as of December 31, 2015: O'Donnell Reese Postner

12/31/14 balances ................ $106,600 $50,440 $36,960 Adjustment for goodwill ..... 3,988 13,560 9,040 Drawings ............................... (22,118) (12,800) (9,200) Profit allocation .................... 31,268 17,839 11,893 12/31/15 balances ................. $119,738 $69,039 $48,693

Postner will be paid $53,562 (110% of the capital balance) for her interest. This amount exceeds her capital balance by $4,869. Because Postner is only entitled to a 34% share of profits and losses, the additional $4,869 indicates that the partnership as a whole is undervalued by $14,321 (4,869 ÷ 34%). Only in that circumstance is the extra payment to Postner justified:

31. b. (continued) 1/1/16 Goodwill ............................................................... 14,321 O'Donnell, capital (15%) ................................ 2,148



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Reese, capital (51%) ...................................... 7,304 Postner, capital (34%) .................................... 4,869 (To recognize implied goodwill.)

1/1/16 Postner, capital ................................................... 53,562 Cash ............................................................... 53,562 (To record final distribution to Postner.)



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Develop Your Skills Research Case This assignment allows the student to make use of the SEC website and, then, the EDGAR system. It also provides a chance to use actual statements created for a partnership rather than those typically produced for a corporation. Probably the most noticeable characteristic of the statements for Buckeye Partners is that they resemble corporate financial statements in most ways. A casual overview might not bring any differences to mind. However, a close reading will show several differences including the following:

On the income statement, net income is allocated between the general partner and limited partners.

Also, on the income statement earnings per share is replaced with a figure labeled as “earnings per partnership unit.”

The balance sheet does not present a stockholders’ equity section but rather partnership capital. That section is comprised of just two figures: one for the general partner and the other for the limited partners.

The first two paragraphs of Note One to the financial statements describe the partnership organization.

A later paragraph presents a schedule reflecting the changes in partnership capital for both the general partner and the limited partners.

Analysis Case An unlimited number of allocation plans can be developed for any partnership. Here, Wilson will be interested in some reward for investing the capital used to create the business. Higgins will expect to be recognized for the work put into the operation. Poncelet should seek some reward for any new clients that she is able to bring to the business. One possibility would be to accrue interest to Wilson on her capital balance for the year based, perhaps, on the prime rate. Poncelet could be assigned a particularly high share of any revenues generated from new clients. The amount of income left would result from Higgins’s work in the day-to-day operations of the business so a large part of that remainder could be assigned to her. As an alternative, Wilson could be allocated an interest factor but only based on the initial amount invested in the business rather than the capital balance as a whole. Higgins could be assigned some type of allowance for the number of hours of work put in each period. Any remaining income could be divided evenly among the three partners but only up to a certain level. Beyond that, perhaps only Poncelet and Higgins would share in the income Because they are doing the



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work, one in gaining new clients and the other in the day-to-day operations of the business. Communication Cases 1 and 2 These two cases ask the student to identify the types of factors that will lend themselves toward the organization becoming a corporation (in Case 1) or a partnership (in Case 2). Several issues should be considered when looking into a legal format for a business enterprise:

Do state laws play any role in the decision? In some states, particular types of organizations are prohibited from operating as a corporation. Will state law come into play in making this decision? If so, the partnership form of organization will be required.

How big do the owners expect the company to become? If the business will remain small, there may be no need to raise additional capital so that the ability to sell ownership may not be an issue. This favors creation of a partnership. However, if Birmingham and Roberts expect the business to prosper and grow, they should consider which type of business will enable them to attract other capital or debt investments. Usually, it is a corporation that is best set up to enable growth through the issuance of securities.

How risky is the business operation? If the company is operating in a business where liability is not a significant problem, the limited liability of a corporation might not be of much interest. However, if there is some risk involved, the two owners may need the corporate type of organization just for their own financial security.

How well do the owners know and trust each other? As with the previous comment, potential liability can be greatly enhanced if the owners do not know each other well or if additional owners are expected to join at a later point in time. Under that circumstance, everyone may feel more comfortable if the business is created as a corporation or as one of the limited liability organizations. If the owners, though, are comfortable with each other, they may not feel the necessity of creating a formalized corporation.

What changes will occur in the tax laws? At this writing, dividends paid by a corporation to its owners are taxable at 15%. However, from time to time various politicians have proposed the elimination of part or all of that tax. Corporations gain appeal if dividend income is not taxed.

How much money do they have available to create a legal organization? In most states, creation of a partnership can be virtually free whereas the legal formality of a corporation can cost money. If finances are tight, the business could begin as a partnership and then convert to a corporation at a later date as monetary restrictions ease.



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Excel Case: There are a variety of ways to create a spreadsheet to solve this particular problem. Here is one possible approach: In Cell A1, enter text “Net Income” and in Cell B1 enter $200,000. In Cell A2, enter text “Billable Hours–Red”. In Cell B2 enter 2,000. In Cell C2, enter $20 hourly rate. In Cell A3, enter text “Billable Hours–Blue”. In Cell B3 enter 1,500. In Cell C3, enter $30 hourly rate. In Cell A4, enter text “Investment–Red” and in Cell B4 enter $80,000. In Cell C4, enter the rate of return of 10%. In Cell A5, enter text “Investment–Blue” and in Cell B5 enter $50,000. In Cell C5, enter the rate of return of 10%. Perform calculation: In Cell D2, enter formula to multiply number of hours by hourly rate. Formula: =+B2*C2 The formula for the next three line items is identical to this first formula; copy the formula to Cells D3, D4, and D5. (To copy a formula across a range of cells, select the cell containing formula, then drag the fill handle, which is the small square in the lower right corner of this box, over the adjacent cells. Note that the formula will adjust automatically for the different lines.) In Cell A6, enter label text “Subtotal” and SUM the amounts in Cells D2 through D5. Click

in Cell D6, press the symbol on the standard toolbar. Click and drag across the range of cells to be summed (D2 through D5) and press enter. Subtract the subtotal of the partner’s initial allocations (Cell D6) from the Net Income (Cell B1) with the following formula: In Cell A8, enter the label text “Profit to be Split” and in Cell D8, enter the following formula: =+B1-D6. Determine the distribution of Profit between partners: In Cell A10, enter label text “Profit – Red” and in Cell C10 enter “50%”. In Cell A11, enter label text “Profit – Blue” and in Cell C11 enter “50%”. Perform calculations: In Cell D10, enter formula to multiply Profit to be Split (Cell D8) by distribution percentage (Cell C10). Formula: =+D8*C10 Repeat this calculation for the other partner. In Cell D11, enter the formula: =+D8*C11 Once the spreadsheet is created, any variable may be changed and the results will adjust automatically. There are eleven variables that can be changed: B1, B2, B3, B4, B5, C2, C3, C4, and C5, as well as C10 and C11 (which must add up to 100%). Example:

Net Income $200,000 Billable Hours-Red 2,000 $20 $40,000 Billable Hours-Blue 1,500 $30 45,000 Investment-Red $80,000 10% 8,000 Investment-Blue $50,000 10% 5,000



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Subtotal $98,000 Profit to be Split: $102,000 Profit-Red 50% $51,000 Profit-Blue 50% $51,000



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CHAPTER 18 ACCOUNTING AND REPORTING FOR PRIVATE

NOT-FOR-PROFIT ENTITIES

Chapter Outline I. Historically, the financial reporting for private not-for-profit entities has differed significantly

according to the type of organization (such as a health care entity versus a college or university). The reporting of these entities has now been largely standardized by FASB pronouncements that focus on (a) the reporting of financial statements for the entity as a whole and (b) significant events such as the receipt of contributions and the recording of mergers and acquisitions. However, public colleges and universities and similar organizations still must follow the standards issued by GASB.

A. This chapter examines the financial reporting for private not-for-profit entities with special emphasis on private colleges and universities, voluntary health and welfare entities, and health care operations.

B. Reporting for these entities is usually similar to a business enterprise unless critical differences exist that impact the needs of financial statement users. Several of these critical differences can be identified.

1. Many private not-for-profit entities receive a significant amount of their financial resources from contributions rather than from revenues or capital investments.

2. A significant amount of the financial resources given to a private not-for-profit entity include donor-imposed restrictions.

3. No single indicator of success is present in the financial reporting. No number such as net income provides a means for evaluation as it does with a for-profit business.

II. FASB has established the following financial statements for private not-for-profit entities.

A. Statement of Financial Position reports assets, liabilities, and net assets.

B. Statement of Activities reports revenues, expenses, gains, and losses.

C. Statement of Cash Flows

D. A voluntary health and welfare entity is also required to present a Statement of Functional Expenses which indicates the amount of resources spent for program services (to meet the goals of the entity) and supporting services (to operate the entity and raise funds).

III. For reporting purposes, all economic resources held by a private not-for-profit entity are classified within one of three categories.

A. "Unrestricted net assets" indicates the amount of an entity's resources that are not subject to external donor restrictions. Entity officials can make whatever use they wish of these assets.

B. "Temporarily restricted net assets" are restricted by an outside party (often a donor) for a particular purpose or for use in a future period of time. When the restriction is eventually satisfied, the classification of these resources is switched to unrestricted net assets. At that time, on the statement of activities, temporarily restricted net assets are reclassified



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as unrestricted net assets when the appropriate time has passed or the resource is used as stipulated.

C. "Permanently restricted net assets" are expected to remain restricted for as long as the entity exists. Income from these assets is normally unrestricted or temporarily restricted based on the specifications of the donor.

IV. Contributions should be recognized as increases in net assets when received.

A. Restricted contributions are reported either within temporarily restricted net assets or permanently restricted net assets based on stipulations established by the donor.

B. Donated assets are recorded at fair value. Recognition of art works, historical treasures, and the like is not required (although allowed) if three conditions are all met.

1. The items are added to a collection for public exhibition, education, or research.

2. The items are protected and preserved.

3. If sold, receipts must be used to acquire other collection items.

C. Unconditional promises to give that are received by a private not-for-profit entity should be reported immediately as both a receivable and an increase in net assets.

1. If not to be collected within one year, the promise is recorded at the present value of the future cash flows. Subsequent amortization of the discount is recorded as contribution rather than as interest.

2. Uncollectible balances are also estimated and deducted.

3. Conditional promises are not recognized until the conditions are met.

D. Services contributed to a not-for-profit entity are recognized as increases in net assets if the services (1) create or enhance a nonfinancial asset or (2) require a specialized skill possessed by the donor that would have been purchased if not donated. If the donated service comes from an affiliated group, the amount is recognized at the cost paid to the employee by the affiliate. If that cost does not reflect the legitimate value of the services rendered, the charity has the option of reporting fair value.

E. If a not-for-profit entity accepts a donation that must be conveyed to a separate individual or other beneficiary, the entity normally records the asset along with an accompanying liability to reflect the accepted responsibility. However, if the entity is given variance powers to change the beneficiary, an increase in net assets is recognized instead of a liability because the donation falls under the entity’s control.

V. Education institutions (such as private colleges and universities) record tuition revenue at the gross amount billed and then show the revenue net of scholarships and financial aid in the statement of activities

VI. Over the years, mergers and acquisitions have become more common in private not-for-profit entities at least in part because of the economic downturn. The rules for recording these combinations are different than those applied to a for-profit business because the transaction can be either an acquisition or a merger.

A. In an acquisition, one entity gains control over another

1. All identifiable assets and liabilities of the acquired company are combined at fair value on the date of acquisition.



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2. If the acquisition value of the acquired company is greater than the sum of the fair value of all identified assets and liabilities, the difference is often reported as goodwill.

3. However, if the acquisition value of the acquired company is greater than the sum of the fair value of all identified assets and liabilities, the excess is charged off immediately as a reduction in net assets if the acquired company expects to be predominantly supported by contributions and investment income in the future.

B. In a merger, two not-for-profits come together to form a new entity with a new governing board. Identifiable assets and liabilities are not adjusted to fair value but retain their previous carrying amounts.

VII. Health care entities exhibit some unique reporting features that must be addressed in not-for-profit accounting.

A. Third-party payors such as Medicare and insurance companies have a significant impact on the reporting process because of their need for usable financial information

B. A net patient service revenue figure is actually reported by these entities but only after reduction for contractual adjustments. These adjustments are decreases allowed for some third-party payors based on the approved cost for a particular service in that geographic region.

C. Charity care services are not included in receivables or revenues if there is no expectation of collection. The cost of that charity work must be disclosed.

D. FASB requires the inclusion of performance indicators (such as revenues in excess of expenses) to help show operational effectiveness because net income is not viewed as applicable for a not-for-profit entity.

Answers to Discussion Questions Are Two Sets of GAAP Really Needed for Colleges and Universities? Over the years, a number of differences have appeared between the accounting for public colleges and universities and for those that are private. GASB holds authority over the reporting of public schools whereas FASB has authority over private educational institutions. Consequently, GASB statements do not apply to private schools and FASB Statements do not apply to pubic schools unless specifically made applicable by GASB. For this reason, FASB pronouncements on depreciation, pledges, contributions, and financial statement format for not-for-private entities do not affect public schools until and unless so stated by GASB. Because of this division of responsibility, the financial statements for these two types of schools have developed independently. GASB states that public schools must follow the guidelines of GASB 34 which created appropriate financial statements for state and local governments. However, these guidelines are not as radically different from private schools as might be imagined. Public colleges and universities are allowed to identify themselves as solely Enterprise Funds if they meet the required criteria. If this decision is made, the school need report only fund financial statements as would be produced by a proprietary fund. These statements have a definite resemblance to the statements prepared by private schools. However, important distinctions do continue to exist. Students can be asked to address the question of whether a public and a private school need to have comparable financial statements. Net income is not an issue, rather the sources and utilization of resources is usually emphasized. Is the adoption of a single set of generally accepted accounting principles necessarily essential? Will a decision-maker care if the University of North Carolina at Chapel Hill (a public school) has



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one statement format while Duke University (a private school) has another? Should the financial statements for the College of William and Mary (a public school) reflect the same reporting as the University of Richmond (a private school)? This controversy leads to the important question of user needs. Why does a company or individual look at the financial statements of a college or university? Donors might have one answer to that question while creditors could have an entirely different response. Once that question has been addressed, the need for comparability is easier to assess. No ultimate answer for that query currently exists but students can be asked to develop their own list of user needs and then note whether the existence of two different sets of GAAP has an adverse impact on those needs. Is This Really an Asset? In theory, accounting for a pledge is a relatively straightforward process. If unconditional, a receivable is established (at present value if the money is not to be received within the year) along with an adequate allowance for doubtful collections. However, in practice, the reporting process might be much more complicated. In this case, for example, was a pledge actually made or was this just a superfluous statement spoken at a moment of overwhelming emotions? Is this a promise to give or an intention to give? Can the donor change his mind? Does this potential donor really own land in Idaho and can it be sold for $30 million? How can an adequate allowance be determined for this pledge? If the individual's mother should die, might he lose interest in supporting the hospital? If the $10 million is reported as a receivable and then is not collected, what is the impact on the readers of the financial statements? How much time and energy should the hospital invest in attempting to arrive at a proper method of financial reporting for this item? The accountant must address all of these questions (and more) to determine the appropriate accounting treatment. At a minimum, hospital officials need to contact this donor and have a serious discussion. He needs to understand their reasons for attempting to establish a valuation of this promise. In class discussion, students can be asked to identify questions that should be posed to this person. They would probably include the following:

—Does he really plan to give $10 million to the hospital? —When does he project that the land will be sold and the gift conveyed? —How did he establish a $30 million price? Could the land ultimately be sold for less and, if

so, how will that impact on the gift to the hospital? —How does the donor want the $10 million to be used? —Is there any chance that he will change his mind? —What other charities has he supported? Has he previously made such large gifts? —Would he be willing to furnish financial statements as well as a list of references who

could verify his intentions and his ability to carry out those intentions? —Does the hospital have legal recourse to force fulfillment of the promise since it is in

writing and signed? If this individual has supported other charities over the years, is committed to the work of Mercy Hospital, has adequate financial resources, and the land appears to be worth $30 million, the hospital should report the pledge as a receivable. However, a large allowance should probably be established because of the uncertainties involved in collecting this money over an extended period of time. Conversely, if too much uncertainty exists (a value for the land cannot be determined or the donor refuses to provide information about his ability to meet the commitment), the hospital may decide that there is no pledge but merely the promise of a



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possible future pledge. In that case, the information should be spelled out in a disclosure note. Unless clear evidence exists to substantiate the pledge, disclosure is most likely.

Answers to Questions 1. The Financial Accounting Standards Board (FASB) has authority for establishing accounting

standards for private not-for-profit entities. In addition, audit and accounting guides produced by the AICPA provide further guidance for the preparation of financial statements by these entities.

2. If a user of financial statements is a potential donor, that party is interested in assessing

whether a gift to a not-for-profit entity is a wise use of resources. To make that assessment, the individual needs to know whether the entity uses its resources appropriately to achieve stated goals. In this way, donors can decide which entity deserves to receive support and how much will be donated. For this reason, the reported division between the amount spent on program services and supporting services can be helpful.

If a user of financial statements is a creditor, that company or person is primarily interested in whether the entity can generate sufficient cash flows to pay its debts as they come due.

3. According to FASB, three financial statements are required to be produced by private

not-for-profit entities: a statement of financial position, a statement of activities, and a state-ment of cash flows. A voluntary health and welfare entity must also produce a statement of functional expenses.

4. Temporarily restricted net assets have been restricted by an external donor or grantor for a

specified purpose or for use at a future point in time. For example, cash might be given to a charity that had to be spent to buy a bus or that could not be spent for three years. Such restrictions are eventually lifted when the intended usage is fulfilled or when the time limit has been met.

5. Permanently restricted net assets have been restricted by an external donor and grantor.

That restriction is expected to last for as long as the entity continues to function. Normally, any income generated by these assets can be used by the entity although its specific usage may be restricted. For example, investments worth $3 million might be given to a private not-for-profit entity with the stipulation that that could never be sold. However, the income produced by these investments over time could be designated by the donor for the purchase of computer equipment or might be available to the entity’s officials for whatever purpose they deemed necessary.

6. The two general types of expenses are (a) program service expenses and (b) supporting

service expenses. Program service expenses are those that relate to the goals and objectives of the not-for-profit entity. Supporting service expenses encompass the costs of operating the entity (general and administrative) and raising funds.

7. Not-for-profit entities (especially voluntary health and welfare entities) are frequently

evaluated based on the ratio of program service expenses to total expenses. This ratio tells readers of the statements what portion of each dollar of expense can be attributed to achieving the goals identified by the entity.



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8. A statement of functional expense is produced by a voluntary health and welfare entity to assist the reader of its financial statements in measuring the entity’s efficiency in using resources. The assumption is that an entity should use a greater portion of those resources to meet stated goals and a smaller part for administrative costs and fundraising. This statement provides a simple way of evaluating one not-for-profit entity in comparison to another.

9. When a donor conveys a gift to a private not-for-profit entity (such as the United Way) that

must be conveyed to a separate beneficiary, a question arises as to the recording of the expense and the contribution. Under normal circumstances, the original donor records an expense at the time of the conveyance while the charity reports both an asset and a liability until the gift can be conveyed to the beneficiary. At the same time, the eventual beneficiary should record a receivable and an increase in net assets because action has been taken that will lead to the receipt of this gift. In this way, the entity that initially collected and then conveyed the gift recorded neither expense nor an increase in net assets because the resources cannot really be used. They simply pass through to the beneficiary.

Other possibilities do exist if the donor has given the initial charity variance powers that allow for a possible change in beneficiaries.

10. If a donor makes a contribution to a charity for conveyance to a separate beneficiary but can

still revoke or redirect the gift before it is made, the donor records a receivable (rather than an expense) until the gift is actually transferred to the beneficiary. At that point, the receivable is reclassified as an expense. The charity initially receiving the gift shows a liability but, in this situation, the balance is directed back to the donor and not to the beneficiary. Because the beneficiary is not completely certain that the gift will be received, no recording is made until the time of receipt. The donor has retained a significant degree of control which impacts the method by which the gift is reported.

11. If a donor makes a contribution to a charity for conveyance to a separate beneficiary but

grants it variance powers to change the identity of the beneficiary, the donor reports an expense immediately. Because control of the gift now lies with the charity, that party should record contribution revenue instead of a liability. The beneficiary makes no entry until the gift is received because of the uncertainty involved. The identity of the ultimate recipient may still change. Here, the charity initially receiving the gift records both revenue and, eventually, an expense for the contribution even though it was not the original donor.

12. The value of donated services is recognized by a private not-for-profit entity if the service (a)

creates or enhances a nonfinancial asset (such as adding a room to a building) or (b) requires a specialized skill possessed by the donor that would have been purchased by the organization except for the gift. An example of this second criterion is the donation of medical services by a surgeon to a children’s hospital. If the service is donated by an affiliated entity, recognition is still necessary based usually on the cost paid to those workers.

13. Except in specified situations, the costs of a direct mailing that contains a solicitation for

funds is classified entirely as a fundraising (supporting services) expense. However, within certain guidelines, these costs can be allocated in a logical manner between supporting services and program services. Allocation becomes necessary when the mailing has a specific call for action that would have been made even without the fundraising solicitation.



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This call for action must further the mission of the entity and the appeal cannot be made purely to potential donors. For example, assume a mailing was sent out by a private not-for-profit blood service asking all previous blood donors to donate blood during the next six weeks. Assume further that this call for action was accompanied by a request for monetary donations. All of the direct mail costs should probably be allocated between program service costs and supporting service costs.

14. Unconditional promises to give must be recorded immediately by a private not-for-profit

entity at present value (if not to be received within the next year) and net of an allowance for uncollectible amounts. An unconditional promise is one that requires no future service or action by the charity.

15. An unconditional promise to give is recorded immediately by the private not-for-profit entity

that anticipates receiving the gift. Conversely, an intention to give is not recorded. In practice, the difference between the two can be rather subtle. If donors have the ability or the right to change their minds, the assumption is that they have only expressed their intention to make a gift at some time in the future but have not yet made an unconditional promise. If an action is required of the charity in advance of the gift, the promise is not unconditional.

16. A number of private not-for-profit entities collect dues from their membership and also

receive contributions. Dues are considered earned revenues rather than contributions if the member receives a benefit in return. That benefit can take the form of a periodic newsletter or journal or can be the use of the facilities (such as at the YMCA) and services provided by the entity. However, if nothing of value is really being given to the member, the dues are considered to be merely donations. Often, an allocation must be made between the portion of the membership dues that qualifies as revenue and the part that is viewed as a contribution.

17. If a not-for-profit entity gains control over another entity, combined financial statements should be prepared. This type of transaction is viewed as an acquisition. If two not-for-profit entities come together to form a new (third) not-for-profit with a new governing board, combined statements are also needed. However, this event is viewed as a merger.

18. Because one party gained control over the other, this transaction is viewed as an acquisition. Here, the acquisition value is in excess of the fair value of all identifiable assets and liabilities by $200,000 ($2.3 million less $2.1 million). In a for-profit consolidation, this excess is reported as goodwill. The same handling is often true for combined statements created when a not-for-profit entity gains control over another. However, if the acquired entity is expected to be predominantly supported by contributions and investment income, then the extra $200,000 is reported as a reduction in unrestricted net assets on the statement of activities. In that situation, the amount is not capitalized as goodwill.



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19. If Helping Hand acquires Fancy Fingers, then the reported value of the equipment on consolidated statements is $2.3 million. That figure is the net carrying value reported by Helping Hand ($1.1 million) plus the fair value of the property held by Fancy Fingers ($1.2 million). If Fancy Fingers acquires Helping Hand, then the reported value for the equipment will be $2.4 million. That figure is the net carrying value reported by Fancy Fingers ($1.0 million) plus the fair value of the property held by Helping Hand ($1.4 million). If the two companies are brought together to form a new third entity under a new governing board, the equipment is reported at $2.1 million. This transaction is a merger and the carryover method is used. The reported figure is the combination of the net carrying value of these assets from both sets of financial statements ($1.1 million plus $1.0 million).

20. A third-party payor is any outside entity who assumes responsibility for a portion or even all

of a patient's medical charges. The most commonly encountered third-party payors include insurance companies, Medicare, and the like. Because third parties bear a significant portion of the medical costs in this country, they are able to demand extensive as well as accurate financial information. Health care entities have long been required, therefore, to develop and maintain accounting systems that provide this needed data.

21. A contractual adjustment refers to a portion of a patient's charged fee that a health care

entity estimates will not be received because of agreements with third-party payors. These arrangements specify that the provider (the health care entity) is willing to accept an amount that is less than its normal charge if the third-party payor determines that the lesser figure is reasonable for the services rendered. As an example, if a hospital charges $272,000 for a specific service but the third-party payor responsible for payment remits only $195,000 (based on its determination of reasonable costs for this service in this area of the world), the hospital must accept that amount as payment in full. The $77,000 reduction is recorded by the hospital as a contractual adjustment.

These reductions may take an extended period of time to finalize. Thus, the expected amount of these reductions is estimated by the health care entity so that they can be recorded at the time that the original invoice is submitted.

22. Charity care is not recorded by a not-for-profit health care entity because the service was performed for patients with no real ability to pay. However, the financial impact of that decision needs to be disclosed. Therefore, the cost of such charity care must be reported in a disclosure note to the financial statements.

Answers to Problems 1. D (Amounts charged to patients less contractual adjustments and the provision

for bad debts) 2. A



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3. B (Private NFPs report depreciation expense. A public university is normally

reported as an Enterprise Fund. Enterprise Funds also record depreciation expense.)

4. B (Permanently restricted net assets have increased by only $120,000.) 5. B (Because the donor continues to have control, an asset [a receivable] will be

reported until the gift is conveyed to Charity Two. As a result of this uncertainty, Charity Two reports nothing until the money is actually received.)

6. B (For private schools, financial aid is shown as a direct reduction to the

tuition revenue so that revenues and support here should total only $780,000.)

7. C (The work of the librarian does not enhance a nonfinancial asset nor does it

require a specialized skill that would be purchased if not donated.) 8. D (If the other information that is included contains a call for a specific action

that will help accomplish the mission of the charity and if the mailing is not directed solely to potential donors, a portion of the costs can be allocated to program service expenses. Otherwise, all of the cost is assigned to supporting services.)

9. A (In its original standards for not-for-profit entities, FASB wanted to get away

from financial reporting based on fund accounting. The statements were designed to provide information about the private not-for-profit entity as a whole.)

10. C (The money to be used for the building is temporarily restricted for that

purpose whereas the other $2 million is permanently restricted so that only the subsequent income earned can be used.)

11. C (Although an investment was sold to generate this cash, that asset was

received from a donor and was liquidated almost immediately upon receipt. FASB has held that this is an operating activity cash inflow.

12. C (Because the accountant has a specialized skill that would otherwise have

to be acquired, the donated service is reported. The amount paid by the affiliated entity is used for recording purpose since it mirrors fair value here.)

13. A (Patient service revenue is reduced by any charity care services. That

amount is not recorded because the entity does not expect to be paid. In addition, a direct reduction is shown for the provision for doubtful



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accounts. Thus, net patient service revenue is $1 million less $94,000 and $200,000 or $706,000.)

14. C (Charity care is not recorded by a not-for-profit health care entity because

the entity provided services for individuals with no ability to pay. The financial impact of that decision must be disclosed in a note to the financial statements that provides information about the direct and indirect costs of these services.)

15. D (The charity must convey the donation to the designated beneficiary. Unless

the charity was given variance powers that allowed it to change the beneficiary, this donation represents a liability to the Jones family. The gift is simply being passed through the charity [in the form of furniture] to the ultimate beneficiary.)

16. B (In this way, no financial benefit accrues to the charity from the sale of the

artifact.) 17. A (Because of the time restriction, the amount spent for playground

equipment remains in temporarily restricted net assets until depreciated. The equipment was bought at the end of the current year so that no depreciation was recorded and no reclassification was made. The $80,000 was properly spent on the salaries for the teachers and must be reclassified from temporarily restricted net assets to unrestricted net assets when the expense is recognized.)

18. A (The key factor here is that YZ is expected to be predominantly supported

by contributions. Thus, future exchange revenues will likely be minor. The acquisition value ($1 million) in excess of the fair value of all assets and liabilities ($700,000) is $300,000. Because most support comes from contributions and investment income, this $300,000 is charged off against unrestricted net assets on the statement of activities. No goodwill is recognized.)

19. A (When two not-for-profit entities come together to form a new not-for-profit

entity with a new governing board, a merger has occurred. In reporting a merger, the carryover method is used. Thus, book value of individual assets and liabilities is retained. The $300,000 book value for BC’s land plus the $500,000 book value for OP’s land gives a reported land account of $800,000.)

20. B (This transaction is an acquisition and the acquired entity is not supported

predominantly by contributions or investment income. Thus, the difference in the acquisition value of Northeast ($980,000) and the fair value of the two recognized assets ($950,000 or $150,000 plus $800,000) is recognized as goodwill.)



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21. D 22. C 23. C 24. C (The charity care work should not be recorded in any way because the entity

has no expectation of collection. That reduction drops the reported amount for patient service revenue to $600,000. The contractual adjustment is reported as a contra balance to the revenue reducing it to a net amount of $400,000. Likewise, the provision for bad debts reduces the net patient service revenue another $100,000 to $300,000.)

25. B (Use of the money is limited to the donor’s specified purpose.) 26. B (This donated service meets the rules for recognition. The expense and the

contributed support are both reported.) 27. A (Form 990 is the annual informational form that most tax-exempt

organizations are required to file by the IRS.) 28. A (As an educational institution, Belwood University will qualify as a 501(c)(3)

tax-exempt organization.) 29. D (These volunteer services, although important, do not meet the criteria for

recognition. They do not require a specialized skill that would be otherwise purchased. They do not enhance a nonfinancial asset.)

30. B (The gift was not specifically designated for this particular family so the entity

recognizes both the revenue and expense.) 31. A (The work performed requires a specialized skill that would otherwise have to

be acquired by the not-for-profit entity.) 32. B 33. A (The fundraising costs and administrative salaries are supporting service

expenses.) 34. B 35. D 36. (10 minutes) (Reporting of various account balances by a not-for-profit health

care entity)



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Donated medicines = an asset is reported as well as an increase in

unrestricted net assets because of the contribution Donated services (replacing salaried workers) = the fair value of the services

contributed causes an increase in unrestricted net assets along with an accompanying decrease in unrestricted net assets because the expense is also recognized

Donated services (not replacing salaried workers) = not recorded Interest income = revenue is an increase in unrestricted net assets Charges to patients = increase in unrestricted net assets shown as net patient

service revenues Charity care = not recorded if the entity has no intention of seeking collection;

if an amount has been recorded, it must be removed from the receivable and the revenue.

Provision for bad debts = amount is anticipated and this provision for bad debts is reported as a direct reduction in patient service revenues to arrive at net patient service revenues.

37. (15 Minutes) (Series of questions about the reporting of health care entities) a. A third-party payor is an entity (such as Medicare or an insurance company)

that pays a portion, or all, of a patient's medical expenses. They are common due to the extremely high cost of medical care. Because of their need for accurate financial information, such third party payors have exerted pressure on health care entities over the decades to develop adequate accounting principles and reliable accounting systems.

b. A contractual adjustment is a reduction to patient service revenues created

when a lesser amount is paid by a third-party payor than the billed amount but is still accepted as payment in full by a health care entity. These outside parties often establish contractual arrangements whereby the health care entity agrees to accept a lower amount for a service if the third party determines the figure to be reasonable in that particular area. These contractual adjustments create an accounting problem for the health care entity because the amount that eventually will be collected is not always known. Thus, the entity recognizes the full amount of the invoice as patient service revenue at the time the service is performed. The entity then estimates and establishes an offsetting Contractual Adjustment account to reduce the net reported revenue to the amount anticipated as being collected.

c. At the time that materials are donated to a health care entity (or any private

not-for-profit entity), the asset is recorded at fair value. Because of the donation, the contribution is recognized as an increase in unrestricted net assets. If the asset has a finite life, officials can assume a time restriction on the use of the asset so that the contribution is reported initially as an increase



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in temporarily restricted net assets. An amount is also reclassified to unrestricted net assets each period equal to depreciation expense.

Donated services are recorded as a contribution increasing unrestricted net

assets and as salary expense also within unrestricted net assets. FASB requires private not-for-profit entities to recognize donated services but only if they (a) enhance nonfinancial assets or (b) require specialized skills, are provided by individuals possessing those skills, and would need to be purchased if not provided by donation. If the donated service enhances a nonfinancial asset, an increase in the asset’s reported balance is recognized rather than as salary expense.

38. (6 Minutes) (Reporting of various accounts by a not-for-profit entity)

Only $7.6 million is reported as patient service revenues. Charity care of $1.4 million is not recorded because no attempt at collection is anticipated. Then, the $800,000 contractual adjustment is netted with the revenue to leave the hospital with a net patient service revenue figure to report of $6.8 million. The supplies are recorded at their $4,000 value with an offsetting increase in unrestricted net assets as a result of the contribution. As the supplies are used, the $4,000 asset will be reclassified as an expense.

39. a). (8 Minutes) (Recording donations by a voluntary health and welfare entity)

Pledges ................................................................... $600,000 Anticipated Amount Deemed to be Uncollectible (15%) (90,000) Net Pledge Balance ................................................... $510,000 Increase in Unrestricted Net Assets in 2015— Contributed Support (60% of above) ....................... $306,000 Increase in Temporarily Restricted Net Assets in 2015—Contributed Support (40% of above) ............ $204,000

b). Both contributed support and salary expense are recognized as $12,000 ($20 per hour times 600 hours) within unrestricted net assets. No overall effect is created on net assets but impact of the donation is reflected.

40. (65 Minutes) (Preparation of statements for a private not-for-profit entity) a. Statement of Activities Unrestricted

Net Assets Temporarily Restricted

Net Assets Permanently Restricted

Net Assets Public Support a. Contributions $210,000 $78,000 b. Contribution—Interest 3,000



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Revenue c. Membership dues 30,000 d. Investment income 3,900 9,100 e.

Net assets released from restriction

72,000 (72,000) Total Public Support and

Revenue $315,900 $18,100 Expenses Program service expenses —Cure disease f. Salaries (26,500) g. Depreciation (16,000) h. Supplies (93,000) Total (135,500) Supporting service expenses – General and administrative i. Salaries (32,000) j. Depreciation (2,000) Total (34,000) – Fundraising k. Salaries (26,500)



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l. Advertising (2,000) m. Depreciation (2,000) Total (30,500) Total Expenses (200,000) Change in Net Assets $115,900 $18,100 -0- Net Assets - Beginning of

Year 400,000 200,000 $100,000 Net Assets - End of Year $515,900 $218,100 $100,000



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40. (continued) Explanation of Balances a. Contributions. The balances to be reported are the unrestricted gifts ($210,000)

plus present value of unrestricted pledge ($78,000). Pledge is viewed as temporarily restricted because it will not be collected for three years.

b. Contribution-Interest. The pledge is recorded at its present value of $78,000. Interest that is recognized to raise the balance to the pledge amount is reported as a contribution.

c. Membership dues. The amount received is shown as revenue and not as public support because rights are being conveyed to the members equal in value to the amount collected.

d. Investment income. Although this income ($13,000) is earned on permanently restricted net assets, 70 percent is shown as temporarily restricted because the donor has specified that it must be spent on advertising. The remaining 30 percent is unrestricted.

e. Net assets released from restriction. Three restricted amounts were properly spent during the period: $20,000 for salaries, $50,000 for equipment, and $2,000 for advertising. No implied time restriction was assumed for the equipment so the entire reclassification was made immediately.

f. Salaries. During the period, $24,000 in salaries were paid (30 percent of $80,000 was assigned here) and another $2,500 was owed at the end of the year (50 percent of year-end accrual).

g. Depreciation. Of the total expense ($20,000) for the period, 80 percent was allocated to program service expenses because that amount of the equipment was used for that purpose.

h. Supplies. A total of $93,000 was acquired and used during the year. i. Salaries. Administrative salaries amounted to $32,000 for the year (40 percent

of overall total). j. Depreciation. Of the total for the period, 10 percent was allocated to general and

administrative expenses. k. Salaries. During the period, $24,000 was paid in salaries (30 percent of $80,000

was assigned here) and another $2,500 was owed at the end of the year (50 percent of year-end accrual).

l. Advertising. Only $2,000 in advertising costs were incurred during the period. m. Depreciation. Of the total for the period ($20,000), 10 percent was allocated to

fundraising expenses. ---Because it qualifies as a museum piece, recording of the painting is optional. Officials do not want to

report the painting, and they are not required to do so.

---The $10,000 gift must be conveyed to an outside beneficiary and is reported by the not-for-profit entity

as a liability.



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40. (continued) b.

Statement of Financial Position Assets a. Cash $738,000 b. Pledge Receivable 81,000 c. Equipment $300,000 d. Accumulated Depreciation (20,000) 280,000 Total Assets $1,099,000 Liabilities e. Salaries Payable $5,000 f. Notes Payable 250,000 g. Donated Amount Due to Separate

Entity

10,000 $265,000 Net Assets (see Statement of Activities)

Unrestricted $515,900 Temporarily Restricted 218,100 Permanently Restricted 100,000 834,000

Explanation of Balances: a. Cash. The final balance is the beginning cash figure of $700,000 plus $210,000

in contributions, less $80,000 for salaries, less $50,000 for equipment, plus $30,000 in membership dues, plus $10,000 contribution that must be conveyed to a separate entity, plus $13,000 investment income, less $2,000 paid for advertising, and less $93,000 paid for supplies.

b. Pledges receivable. The amount to be reported is the present value as of the end of the year (the original $78,000 plus the $3,000 interest recognized for the period).

c. Equipment. Entity acquired $300,000 of equipment during the year. d. Accumulated Depreciation. The $20,000 amount of depreciation recorded for

this initial year of ownership. e. Salaries Payable. The amount owed to employees as of the end of the year. f. Notes Payable. The liability incurred in acquiring equipment. g. Donated Amount Due to Separate Entity. Amount given by a donor that must be

conveyed to a separate organization. The amount must be shown as a liability since no mention was made that the entity here had variance powers that would allow it to change the beneficiary.



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41. (50 Minutes) (Effect of various transactions on unrestricted and restricted net assets)

a. Investments—Internally Restricted .............................. 160,000 Cash .................................................................. 160,000 b. Cash ....................................................... 80,000 Contributed Support— Permanently Restricted Net Assets ................ 80,000 c. Inventory of Medicines ................................................... 25,000 Cash ....................................................... 25,000 Reclassification—Temporarily Restricted Net Assets ............................................... 25,000 Reclassification—Unrestricted Net Assets ....................................................... 25,000 d. Accounts Receivable—Patients .................................... 120,000 Accounts receivable—Third-Party Payors 480,000 Patient service revenues ..................................... 600,000 e. Depreciation Expense .................................................... 38,000 Accumulated Depreciation .................................. 38,000 f. Cash ................................................................................. 15,000 Interest Revenue— Unrestricted Net Assets (internally restricted) 15,000 g. Provision for Bad Debts ................................................. 20,000 Allowance for Uncollectible Accounts ......................................................... 20,000 Contractual Adjustment ................................................. 30,000 Allowance for Reduced Charges ........................ 30,000



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41. (continued) h. Supplies Expense .......................................................... 25,000 Inventory of Medicines ........................................ 25,000 i. Cash ................................................................................ 172,000 Investments—Internally Restricted ........................ 160,000 Gain on Sale of Investments—Unrestricted Net Assets ................................................................ 12,000 Equipment ....................................................................... 212,000 Cash ($172,000 + $15,000 + $25,000) ....................... 212,000 Reclassification—Temporarily Restricted Net Assets 25,000 Reclassification—Unrestricted Net Assets ... 25,000 j. Cash 12,600 Pledges Receivable (present value) 98,000 Allowance for Uncollectible Pledges .................. ........ 9,000 Contributed Support—Unrestricted Net Assets ....................................................... ....... 12,600 Contributed Support—Temporarily Restricted Net Assets ..................................... ....... 89,000



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41. (continued) Calculation of Changes in Net Assets

Unrestricted Temporarily Restricted Permanently Restricted Net AssetsNet Assets Net Assets a. No change b. Donation— Income for Salaries 80,000 c. Stipulation Met—Reclass- ification 25,000(25,000) d. Patient Services 600,000 e. Depreciation (38,000) f. Interest 15,000 g. Bad Debts (20,000) Contractual Adjustment (30,000) h. Supplies Expense (25,000) i. Gain on Investments 12,000 Stipulation Met—Reclas- sification 25,000(25,000) j. Pledges 12,60089,000 Increase (Decrease) In Net Assets 576,60039,000 80,000



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42. (70 minutes) (Produce journal entries for a private university as well as a statement of activities)

a. Tuition Receivable 1,200,000 Tuition Revenues 1,200,000 b. Investments 300,000

Contributions—Permanently Restricted Net Assets 300,000 c. Cash 700,000 Contributions—Temporarily Restricted Net Assets 700,000 d. Scholarships—Financial Aid 100,000 Tuition Receivable 100,000 e. Salary Expenses 310,000 Cash 310,000 f. Salary Expense 80,000 Contributed Support— Unrestricted Net Assets 80,000 g. Equipment 200,000 Cash 200,000 Temporarily Restricted Net Assets— Reclassification 200,000 Unrestricted Net Assets— Reclassification 200,000 h. Investments 30,000 Unrealized Gain on Investments— Permanently Restricted Net Assets 30,000 i. Cash 9,000 Dividend Revenue—Unrestricted Net Assets 9,000 j. Depreciation Expense 32,000 Accumulated Depreciation 32,000 k. Cash—Internally Restricted 100,000 Cash 100,000

42. (continued)



Education.

l. Pledge Receivable 7,000 Contribution—Temporarily Restricted Net Assets 7,000 m. No entry because of choice made by officials n. Utilities and Other Expenses 212,000 Cash 212,000 o. No entry—does not require a specialized skill.



Education.

42. (continued)

University of Danville Statement of Activities

Unrestricted Temporarily Permanently Total

Net Restricted Restricted Assets Net Assets Net Assets

Revenues and Gains -Tuition 1,200,000 -Scholarships (100,000) 1,100,000 1,100,000 -Unrealized Gain on Investments 30,000 30,000 -Dividend Revenue 9,000 9,000 Contributions -Cash and Other Assets 707,000 300,000 1,007,000 -Services 80,000 80,000 Total Revenues, Gains, And Contributions 1,189,000 707,000 330,000 2,226,000 Net Assets Released From Restriction 200,000 (200,000) Totals 1,389,000 507,000 330,000 2,226,000 Operating Expenses -Salaries 390,000 390,000 -Depreciation 32,000 32,000 -Utilities and Other Expenses 212,000 212,000 Total Expenses 634,000 634,000 Increase in Net Assets 755,000 507,000 330,000 1,592,000 Net Assets—Beginning Of Year 400,000 200,000 100,000 700,000 Net Assets—End of Year 1,155,000 707,000 430,000 2,292,000

43. (30 Minutes) (Series of questions about private not-for-profit entities) a. Many private non-for-profit entities depend heavily on gifts and grants from

outside parties. An earning process is not present in connection with such

Chapter 01 - The Equity Method of Accounting for Investments


Education.

conveyances. Asset inflows are simply created by donations. Such amounts are reported as public (or contributed) support. These same entities, however, do sometimes earn (in an accounting sense) some of the funds that are received. Membership dues, for example, are not viewed as gifts if rights that have value are conveyed to the members. A not-for-profit entity might also gain assets from sources such as interest or dividend income. Money derived in this fashion is not a donation and is, thus, recorded as earned revenue.

b. A statement of functional expenses is required to be included in the financial

statements of voluntary health or welfare entities and is permitted for all other private not-for-profits. This statement enables readers to determine the ultimate usage of the money that has been raised. Expenses are separated according to program service expenses (directed towards activities that relate to the entity’s goals and mission) and supporting service expenses (dealing with the cost of running the entity and raising funds). This statement permits interested parties such as potential donors to see the utilization made of the not-for-profit entity’s resources.

c. Some charities (Goodwill Industries and the Salvation Army, for example)

receive a large amount of contributions in the form of donated materials such as clothing and furniture. If the value of these goods has a clearly measurable basis, recording the gifts as contributed support is appropriate.

d. A not-for-profit entity may receive gifts (or unconditional promises to give) from

outside parties that (1) must be expended for a particular purpose or (2) cannot be expended until a particular point in the future. Because the organization does not have free use of these assets, they are included within "Temporarily Restricted Net Assets." At the time that the stipulation is met or the designated time period arrives, the asset is reclassified into the Unrestricted Net Asset category.

Other gifts may be given where the donor specifies that only subsequent income can be expended

(frequently for a designated purpose). Because the assets received in the original gift cannot be

expended, they are included within the “Permanently Restricted Net Assets."

e. Donated services are extremely common in the operation of many not-for-profit

entities. Literally thousands of individuals solicit funds for entities such as the Heart Fund, Salvation Army, and March of Dimes. In addition, individuals often voluntarily fill positions of responsibility throughout many of these not-for-profits. Donated services are formally recognized in the accounting records but only if one of two specific circumstances are met:

1. The service creates or enhances a nonfinancial asset or

2. The service requires a specialized skill possessed by the donor that the

entity would have had to be purchased if not donated.

f. Prior to 1987, the costs of direct mailings and other solicitations for support were recorded by

private not-for-profit entities as fundraising expenses even if educational materials were included. In

that year, this requirement was modified so that an allocation of the joint costs could be made between

educational expenses (a program service cost) and fundraising (a supporting service cost). Some entities

took advantage of this rule. They included educational materials with their fundraising appeals because

they could allocate part of the mailing and other distribution costs to program services which made their

statements look like these entities were spending more to meet their goals. In 1998, the AICPA issued

its Statement of Position 98-2 “Accounting for Costs of Activities of Not-for-Profit Organizations and

State and Local Governmental Entities That Include Fund-Raising” which is now part of the FASB

Accounting Standards Codification. This rule stated that direct mailing costs should be assigned entirely

to fundraising costs unless a specific call for action was being included that was not limited to potential

donors. This call for action had to be one that would further the mission of the not-for-profit. If these

requirements were met, a logical portion of the direct mailing costs could be assigned to program

service expenses. Otherwise, the entire cost is included within fundraising.

g. Donated materials are normally reported as assets at their fair value accompanied by an increase in

unrestricted net assets (see answer [c] above). However, the recording of art works, historical treasures,

museum pieces, and the like is optional. An item qualifies for such treatment if (1) it is part of a

collection for public exhibition, education, or research, (2) it is protected and preserved, and (3) if sold,

the money received must be used to acquire other collection items. If these criteria are all met, no

recording is required (although recording is allowed).

44. (25 Minutes) (Determine impact of various transactions on a private college.)

(1)---False. The January 1, Year 1, restriction is an internal action and, therefore, causes no changes in the

amount of unrestricted net assets. Such changes can only be created by external donors.

(2)---True. The stipulation of the April 1, Year 1, gift is that only subsequent cash income can be used for

the designated purpose. Therefore, changes in value are shown as adjustments to the permanently restricted

net assets. The interest income earned during the year is temporarily restricted

(3)---True. As indicated in (2), the donor has indicated that only cash income can be used for the football

stadium. The change in value increases (or decreases) the amount held as permanently restricted net assets.

(4)---True. The school has properly spent the $500,000 earned on the donated investments. The school has

not set a policy that assumes a time restriction on the use of this stadium. Therefore, the reclassification to

unrestricted net assets is made immediately at the time of proper expenditure. Spending of the board-

designated $1.9 million does not change the amount of net unrestricted assets—just the composition.



Education.

(5)---False. Depreciation expense is appropriate for all long-lived assets with a finite life regardless of the

policy of the school. A time restriction indicates when any related donations for this project are released from

restriction.

(6)---False. This is the same answer as in (5). Depreciation expense is appropriate for all long-lived assets

with a finite life regardless of the policy of the school about use of the property.

(7)---True. The acquisition of the football stadium seat has two effects. Because the value of that seat for

watching football games is $12,000, the school should recognize that amount as revenue. Dr. Johnson paid

an extra $18,000, apparently as a gift to the school.

(8)---True. This answer is the same as in (7). Dr. Johnson paid an extra $18,000, apparently as a gift to the

school.

(9)---True. These donated services meet the requirement for being reported so that contributed service

support as well as a salary expense are recognized for the $14,000 value.

(10)---False. Based on the information given, both the contributed support and the expense must be reported.

“Might” implies an option which is not available for this type of donation. If a donated service meets the

criteria, it is reported.

(11)---False. This answer is the same as in (10). Both the contributed support and the expense must be

reported. Unrestricted net assets both go up (for the contribution support) and go down (for the salary

expense).

(12)---False. If this painting does not qualify as a work of art, the school must record the asset at $30,000

along with a contribution of that same amount. However, if the painting qualifies as a work of art, the school

can either make this entry or simply make no entry. Therefore, under one set of circumstances, recognition

of a contribution is not required.

(13)---False. As in answer (12), the handling depends on whether this painting qualifies as a work of art.

However, if the value of the donated gift is $30,000, no situation can exist where the school is not allowed to

recognize revenue.

45. (30 Minutes) (Determine changes in net asset balances for several different types of transactions)

Part (1)

--Unrestricted Net Assets – No net change. When the $22,000 in designated funds is spent as designated,

a reclassification of that amount is made into Unrestricted Net Assets. At that time, though, a faculty salary

expense of the same amount is also recognized. The two amounts balance out for no net impact on

Unrestricted Net Assets.

--Temporarily Restricted Net Assets – Category increases by $9,000. The $31,000 of investment income

increases this category because its use is restricted. However, it is then reduced by the $22,000 reclassified

into Unrestricted Net Assets because that amount is properly spent.

--Permanently Restricted Net Assets – Category increases by $400,000. The current donation increases this

category. Because subsequent income must be spent for salaries, it increases Temporarily Restricted Net

Assets.

Part (2)

--Unrestricted Net Assets – No net change. Because of the restriction on the use of the machine for this

period of time, the $200,000 gift is initially reported as an increase in Temporarily Restricted Net Assets. At

the end of the year, the asset balance will be reduced by $20,000 in depreciation. Thus, a $20,000

reclassification moves $20,000 from Temporarily Restricted Net Assets to Unrestricted Net Assets. That

$20,000 increase will exactly offset the $20,000 in depreciation expense also recognized within Unrestricted

Net Assets.

--Temporarily Restricted Net Assets – Category Increases by $180,000. Because of the restriction on the

time use of the asset, the $200,000 is initially recorded in Temporarily Restricted Net Assets. The $20,000

reclassification discussed above reduces that net increase to $180,000.

--Operating Expenses – Category increases by the $20,000 in depreciation expense for the year.

Part (3)

--Unrestricted Net Assets – Category increases by $1.6 million. The tuition revenue of $2 milion is reduced

by the $700,000 in financial aid for a net increase of $1.3 million. However, because $300,000 of previously

restricted net assets was used here, a reclassification of that amount from Temporarily Restricted Net Assets

to Unrestricted Net Assets causes the overall increase to be $1.6 million.

--Operating Expenses – There are no operating expenses. Financial aid is a reduction to tuition revenue

and not an operating expense.

--Temporarily Restricted Net Assets – Category decreases by $300,000. Money that had previously been

restricted was properly utilized. Thus, a reclassification of this amount is reported.



Education.

46. (65 Minutes) (Prepare financial statements for a private not-for-profit entity.)

a. Entries for this not-for-profit entity are presented below. The numbers in

parenthesis indicate account totals at that point in time. This method is used as an easy way to monitor account balances.

Contributions receivable ............................................ 20,000 (220,000)

Contributed support—interest--unrestricted net assets ........................................... 20,000 ( 20,000) Cash ...................................................................... 100,000 (200,000)

Allowance for uncollectible pledges ........ 4,000 Contributions receivable ....................... 104,000 (net of 120,000) Cash ...................................................................... 180,000 (380,000)

Contributed support—unrestricted net assets ............................................. 180,000 (180,000) Salary expense ........................................... 90,000 ( 90,000) Cash ..................................................... 90,000 (290,000) Reclassification - temporarily restricted net assets .................................................. 15,000 ( 15,000) Reclassification - unrestricted net assets .................................................... 15,000 ( 15,000) Cash ...................................................................... 12,000 (302,000)

Contributed support—temporarily restricted 12,000 ( 12,000) (To record gift to go to a specified beneficiary. Entity records this contribution because it holds variance powers.) Land, buildings, and equipment .............. 500,000 (700,000) Note payable ........................................... 450,000 (450,000) Cash ..................................................... 50,000 (252,000) Reclassification - temporarily restricted net assets .................................................. 50,000 ( 65,000) Reclassification - unrestricted net assets .................................................... 50,000 ( 65,000) (To record reclassification of restricted amount properly spent.)

46. (continued)

Cash .......................................................................... 30,000 (282,000)

Membership revenue—unrestricted net assets 30,000 ( 30,000) (Membership dues are listed as revenues and not as contributions because members receive substantial benefits.) Cash ........................................................................... 30,000 (312,000)

Investment revenue—unrestricted net assets 30,000 ( 30,000) (Income is earned on permanently restricted net assets but use of the income is unrestricted.) Rent expense .............................................. 12,000 ( 12,000) Advertising expense ................................. 15,000 ( 15,000) Utilities expense ........................................ 16,000 ( 16,000) Cash ..................................................... 43,000 (269,000) Contributions receivable ........................... 149,000 (269,000) Contributed support—temporarily restricted net assets ........................................... 149,000 (161,000) (Although pledge is unrestricted, it will not be collected for five years and, therefore, the proceeds are viewed as temporarily restricted.) Contributions receivable ........................... 6,000 (275,000) Contributed support—interest--temporarily restricted net assets ........................ 6,000 ( 6,000) Depreciation expense ............................... 40,000 ( 40,000) Land, buildings, and equipment ......... 40,000 (660,000) Interest expense ......................................... 15,000 ( 15,000) Cash ..................................................... 15,000 (254,000)



Education.

46. (continued) Based on the final balances computed above, the following statements can be prepared.

WATSON FOUNDATION STATEMENT OF ACTIVITIES


Temporarily Permanently Unrestricted Restricted Restricted Net Assets Net Assets Net Assets Contributed support $ 180,000 $ 161,000 Contributions -- interest 20,000 6,000 Investment revenue 30,000 Membership revenue 30,000 _______ ________ Total support and revenues $ 260,000 $ 167,000 Net assets released from restriction 65,000 ( 65,000) ________ Total support, revenues, and net Assets released from restriction $ 325,000 $ 102,000 ________ Expenses: General and administrative —Rent $ (12,000)

—Salary (90,000) —Advertising (15,000) —Utilities (16,000) —Depreciation (40,000) —Interest (15,000) Total expenses $(188,000) Excess of total support, revenues and net assets released from restriction over expenses $137,000 $102,000 -0- Net assets at beginning of year 400,000 100,000 $300,000 Net assets at end of year $537,000 $202,000 $300,000 46. (continued)

b.

WATSON FOUNDATION STATEMENT OF FINANCIAL POSITION

December 31, 2015 ASSETS Cash $ 254,000 Contributions receivable (net) 275,000 Investments 300,000 Land, buildings, and equipment (net) 660,000 Total assets 1,489,000 LIABILITIES Notes payable 450,000 NET ASSETS - Unrestricted $537,000 - Temporarily restricted 202,000 - Permanently restricted 300,000 $1,039,000 47. (40 minutes) (Accounting for mergers and acquisitions)

a. In an acquisition, the assets and liabilities of the acquired entity are included at fair value. Thus, the buildings and equipment reported by Swim For Safety must be increased by $140,000 from $590,000 to $730,000. Because the acquisition value ($1 million) exceeds the total fair value recognized for the individual assets and liabilities ($1,470,000 plus $140,000 less $690,000 or $920,000), the excess ($80,000 in this case) is reported as goodwill. Goodwill is reported because Swim For Safety is primarily supported by contributions and investment income.

Cash held by Help & Save must be reduced by the $1 million payment as must

the balance shown for its unrestricted net assets. The increases in the buildings & equipment ($140,000) as well as the increase

in goodwill ($80,000) are reflected by increases in unrestricted net assets since no external restriction is in place for these assets.

Balances To Be Reported: --Cash - $1,100,000 ($1,600,000 less $1,000,000 plus $500,000) --Contributions receivable (net) - $280,000 ($70,000 plus $210,000) --Investments - $470,000 ($300,000 plus $170,000) --Buildings & equipment - $1,430,000 ($700,000 plus $730,000) 47. (continued)



Education.

--Goodwill - $80,000 (above) --Total assets - $3,360,000 (summation) --Accounts payable and accrued liabilities - $180,000 ($110,000 plus $70,000) --Notes payable - $1,720,000 ($1,100,000 plus $620,000) --Total liabilities - $1,900,000 (summation) --Unrestricted net assets - $740,000 ($1,100,000 less $1,000,000 payment plus

$140,000 increase in buildings and equipment plus $80,000 in goodwill plus $420,000 from Swim for Safety)

--Temporarily restricted net assets - $440,000 ($250,000 plus $190,000) --Permanently restricted net assets - $280,000 ($110,000 plus $170,000) --Total net assets - $1,460,000 (summation) --Total liabilities and net assets - $3,360,000 ($1,900,000 plus $1,460,000) b. In an acquisition, the assets and liabilities of the acquired entity are

included at fair value. Thus, the buildings and equipment reported by Swim For Safety must be increased by $140,000 from $590,000 to $730,000. Because the acquisition value ($990,000) exceeds the total fair value recognized for the individual assets and liabilities ($1,470,000 plus $140,000 less $690,000 or $920,000), the excess ($70,000 in this case) is normally reported as goodwill. However, one exception is made. If the acquired company is predominantly supported by contributions and investment income (as is the case here), then the excess $70,000 is not recognized as an asset. Instead, the excess $70,000 within the $990,000 payment is reported as an immediate reduction in unrestricted net assets with no accompanying increase in goodwill.

Cash held by Help & Save must be reduced by the $990,000 payment as must

the balance shown for its unrestricted net assets. The increase in the buildings & equipment ($140,000) is reflected by an

increase in unrestricted net assets since no external restriction is in place for these assets. Goodwill is not recognized so that no additional increase in unrestricted net assets is needed.

Balances To Be Reported: --Cash - $1,110,000 ($1,600,000 less $990,000 plus $500,000) --Contributions receivable (net) - $280,000 ($70,000 plus $210,000) --Investments - $470,000 ($300,000 plus $170,000) --Buildings & equipment - $1,430,000 ($700,000 plus $730,000) --Total assets - $3,290,000 (summation) 47. (continued) --Accounts payable and accrued liabilities - $180,000 ($110,000 plus $70,000)

--Notes payable - $1,720,000 ($1,100,000 plus $620,000) --Total liabilities - $1,900,000 (summation) --Unrestricted net assets - $670,000 ($1,100,000 less $990,000 payment plus

$140,000 addition to buildings and equipment plus $420,000 balance for Swim for Safety)

--Temporarily restricted net assets - $440,000 ($250,000 plus $190,000) --Permanently restricted net assets - $280,000 ($110,000 plus $170,000) --Total net assets - $1,390,000 (summation) --Total liabilities and net assets - $3,290,000 ($1,900,000 plus $1,390,000) c. This transaction is a merger: two not-for-profit entities are brought

together to form a new not-for-profit under a newly-formed governing body. As a merger, the carryover method is used. Book values are simply added

together to get new balances to be reported. No cash was spent and no adjustments to fair value are made.

Balances To Be Reported: --Cash - $2,100,000 ($1,600,000 plus $500,000) --Contributions receivable (net) - $280,000 ($70,000 plus $210,000) --Investments - $470,000 ($300,000 plus $170,000) --Buildings & equipment - $1,290,000 ($700,000 plus $590,000) --Total assets - $4,140,000 (summation) --Accounts payable and accrued liabilities - $180,000 ($110,000 plus $70,000) --Notes payable - $1,720,000 ($1,100,000 plus $620,000) --Total liabilities - $1,900,000 (summation) --Unrestricted net assets - $1,520,000 ($1,100,000 plus $420,000) --Temporarily restricted net assets - $440,000 ($250,000 plus $190,000) --Permanently restricted net assets - $280,000 ($110,000 plus $170,000) --Total net assets - $2,240,000 (summation) --Total liabilities and net assets - $4,140,000 ($1,900,000 plus $2,240,000)

48. (10 minutes) (Adjusting totals for incorrectly reported student tuition)

a. The tuition was properly recorded as revenue. However, the financial aid

figure should have been a direct reduction to the tuition revenue rather than



Education.

a separate expense. In either case, the aid reduces unrestricted net assets so the $400,000 total computed at the end of the year is correct.

b. As indicated in (a), the financial aid should not have been an expense but,

rather, a reduction in the tuition revenue. Removing the $140,000 from the recognized amount of expenses reduces that total from $500,000 to $360,000.

49. (15 minutes) (Adjusting totals for incorrectly recorded restricted giving)

a. Because the use of the interest was specified by the donor, both interest

balances should have been recorded initially as increases within Temporarily Restricted Net Assets. Later, when properly spent, these amounts would have been reclassified into Unrestricted Net Assets. Instead, this entity recorded the amounts immediately in Unrestricted Net Assets. Since the amounts have now been properly spent, they did wind up in the category where they were supposed to be reported. The $400,000 shown as unrestricted net assets is correct.

b. Each amount was reported as expenses in unrestricted net assets and that

handling was correct. No change is needed so that the $500,000 reported as expenses is shown properly.

c. As indicated in (a), the $5,000 and the $7,000 should have initially increased

Temporarily Restricted Net Assets and then been removed through a reclassification leaving no net effect. Because nothing was ever recorded by the entity in Temporarily Restricted Net Assets, the total of $300,000 is correct.

50. (15 minutes) (Adjusting the incorrect recording of a donation and subsequent

expenditure) a. Because a time restriction has been assumed, only $5,000 ($50,000/10

years) should have been reclassified from Temporarily Restricted Net Assets into Unrestricted Net Assets. However, the entity increased Unrestricted Net Assets by $50,000. The final balance being reported, therefore, is $45,000 too high. Removing this $45,000 inflation reduces the final Unrestricted Net Asset figure from $400,000 to $355,000.

b. Depreciation expense of $5,000 ($50,000/10 years) was recorded within the

Unrestricted Net Assets. That handling is appropriate so that the $500,000 expense figure that is reported is correct.

c. The problem says that the correct entry was made in Year One. Thus, a

$50,000 balance resides in Temporarily Restricted Net Assets as a result of the gift. Because a time restriction was assumed, only an amount ($5,000)

equal to the depreciation recorded should have been reclassified to Unrestricted Net Assets. That $5,000 amount was never removed. Reclassifying the $5,000 reduces Temporarily Restricted Net Assets from the reported $300,000 to $295,000. The $50,000 reclassification error does not affect this category. Permanently Restricted Net Assets should not have been reduced by $50,000 but that is not relevant to this particular question.

51. (5 minutes) (Incorrect reporting of membership dues)

In this case, because nothing was received in exchange for the members’

dues, these collections should have been recorded as contributed support which would increase Unrestricted Net Assets. Instead, the dues were recorded as membership (or earned) revenue which is incorrect but it does increase Unrestricted Net Assets by the correct amount. Although the source is wrongly reported, the total Unrestricted Net Assets is correctly stated at $400,000.

52. (15 minutes) (Reporting of donated services)

a. The problem here is that an expense of $70,000 was reported when the

donation was a garage that should have been capitalized as an asset. Subsequently, this asset should have been depreciated at the rate of $7,000 per year. For this reason, at the end of Year 2 expenses are overstated by $63,000 ($70,000 minus $7,000) which causes Unrestricted Net Assets to be understated by $63,000. Instead of an Unrestricted Net Assets balance of $400,000, the entity should report $463,000.

b. The entity reported no assets as a result of the contributed garage. The

entity should report a $70,000 garage less $7,000 in accumulated depreciation. If the net balance of $63,000 is added to the reported total for assets of $900,000, a corrected figure of $963,000 is determined.

c. As indicated in (a) above, the expenses were overstated by $63,000.

Removing this $63,000 drops the expense total from $500,000 to $437,000. 53. (10 minutes) (Reporting a gift that must be transferred to another party)

a. Because the donor can take the money back, the gift is still under the

control of the donor. Consequently, the not-for-profit entity should have recorded a liability to the donor until a final resolution takes place. Instead, the charity recorded contributed support which served to increase Unrestricted Net Assets. That $40,000 should be removed so that Unrestricted Net Assets are $360,000 and not $400,000.



Education.

b. The issue in this problem is about whether contributed service or a liability

should be reported by the entity. The total amount reported as assets is not in question and is, thus, correctly stated at $900,000.

54. (15 minutes) (Handling of various events by two different charities)

a. Charity A debits repair expense and credits contributed support. These two changes offset so that unrestricted net assets are not impacted. Charity B makes no entry at all so that unrestricted net assets are not impacted. After this reporting, the two charities report the same amount of unrestricted net assets.

b. Charity A will report the investment income as an increase in unrestricted

net assets and then report salary expense for the same amount. These two changes offset so that unrestricted net assets are not impacted. Charity B records the salary expense and then records an increase in unrestricted net assets because the restricted balance has been released. These two changes cancel out so that unrestricted net assets are not impacted. After this reporting, the two charities report the same amount of unrestricted net assets.

c. The only difference here between Charity A and Charity B is in the handling

of the excess $20,000 acquisition value. Charity A records this amount as goodwill because the acquired charity gains a significant amount of its support from exchange transactions. Charity B records this excess as a reduction in net assets because the acquired charity gets most of its resources from donations. Because of this reduction, total unrestricted net assets will be $20,000 lower for Charity B.

d. Charity A records the $100,000 as patient service revenue and then writes

the amount off as uncollectible. The provision for bad debts is a direct reduction in patient service revenues and not an expense. Charity B simply records the $100,000 from the beginning because of a lack of any intention to collect. In either approach, patient service revenue is reduced by $100,000. The new entities have the same amount of net patient service revenues.

e. Charity A reports the entire $50 per cake as earned revenue. Charity B reports $30 per cake as earned revenue and $20 per cake as contributed support. In both cases, unrestricted net assets are increased by $50 per cake. The two entities will report the same amount of unrestricted net assets.

Develop Your Skills

Research Case 1 This assignment is an excellent way to demonstrate the wealth of information available on the Internet about charities and other not-for-profit entities. Many individuals want to be generous and help entities that deserve assistance. Determining whether a specific entity is truly worthy of support is not necessarily easy. Every charity will claim that it is effectively helping to improve some element of society that is in need. Obviously, the information that a student finds at this website depends on the specific charities that are examined. However, some of the information that is normally available includes:

the entity’s stated purpose, year it was started, website address, the existence of any affiliated organizations, whether this entity has met all of the standards of the group that created the

website and, if not, what was the problem, a discussion of the charity’s programs along with the program expenses, identification of the chief executive officer (along with compensation), number of individuals on the board and the number of staff members

working in the entity, methods used for fundraising, tax status, sources of funding, including dollar amounts

From this type of information, a student should be able to write a detailed overview of the not-for-profit entity and its operations and finances. Research Case 2 Charity Navigator provides a wealth of information about its methodology that should help students understand how a charity can be evaluated. The following outline of information was listed on this website at June 23, 2013, under methodology: “Charity Navigator works to guide intelligent giving. Our goal is to help people give to charity with confidence. At the same time, we aim to help charities by shining lights on truly effective entities. In doing so, we believe we can help ensure that charitable giving keeps pace with the growing need for charitable programs. “Our approach to rating charities is driven by those two objectives: helping givers and celebrating the work of charities. The pages listed below describe how we



Education.

select charities to evaluate, how we classify and rate them, and what givers can conclude based on our ratings. What Kind of Charities Do We Evaluate? How Do We Classify Charities? How Do We Rate Charities? How Do We Rate Charities' Financial Health? Financial Ratings Tables How Do We Rate Charities' Accountability and Transparency? Accountability and Transparency Ratings Tables How Do We Calculate the Overall Score and Star Rating? What Do Our Ratings Mean? What Other Information Do We Present on the Charities We Evaluate? How Current are Our Ratings? How Do We Decide To Post A Donor Advisory? How Do We Decide To Remove A Donor Advisory? How Do We Plan To Evaluate Results Reporting? Glossary of Terms” ** Each of these links provides an extensive amount of information. For example, the link “How Do We Rate Charities' Financial Health?” provides a description of seven different performance metrics. 1 – Program expenses 2 – Administrative expenses 3 – Fundraising expenses 4 – Fundraising efficiency 5 – Primary revenue growth 6 – Program expenses growth 7 – Working capital ratio

http://www.charitynavigator.org/index.cfm?bay=content.view&cpid=32















Based on all of the available information, students should be able to write a memo on how this organization rates various charities. Research Case 3 This case is designed to introduce students to the information that can be found on the Form 990 that must be made public by tax-exempt organizations. Some of this information can be found in the entity’s financial statements but much of it goes beyond what is otherwise available. The filing of Form 990 ensures that such information is made public. Because of the sheer number and visibility, most not-for-profit entities that students might research are likely to qualify as Section 501(c)(3) charities. The available salary information will give students the opportunity to discuss whether officials of these entities are paid too much or too little. Do the amounts seem reasonable in comparison to the amount of revenues generated or the quantity of assets managed? What, for example, would the president of a comparable-sized for-profit business make in salary and other compensation? Throughout the chapter, mention was made of the statement of functional expenses and the amount expended by an entity for program service expenses. One possibility is to make a list in class of a number of well known charities and compare their ratio of program service expenses to total expenses just to see the range present. Another exercise that can be done is to simply list on the classroom board the types of information that the students uncover in the Form 990. What data seems most important and why include each of these items? Research Case 4 Students often have trouble envisioning the amount of evolution that can take place in accounting and financial reporting. By comparing the 1987 financial statements for Georgetown University to the current statements, students should note how much change has taken place. Here are just a few of the more obvious examples that students might list. --The influence of government accounting in 1987 is obvious. These statements resemble fund financial statements for the Governmental Funds of a state or local government more than they resemble the current financial statements of a private not-for-profit entity.



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--Instead of a statement of activities, the university reports a statement of changes in fund balance. --The statements have multiple columns that include Current Funds, Loan Funds, and Plant Funds. --Current funds are separated into “unrestricted” and “restricted” but the type of restriction (temporarily restricted or permanently restricted) is not evident. --Expenditures are listed rather than expenses. --Scholarships and fellowships are listed as expenditures and not as reductions in tuition revenue. --Transfers between funds are listed. --There is no statement of cash flows. Analysis Case 1 Many times a potential donor might be interested in an array of information that can best be found by studying the actual financial statements of a not-for-profit entity. The purpose of financial statements is to provide a complete picture of the financial operations and position of the entity to help outsiders make decisions. Students can observe the construction of financial statements in textbooks but only by actually making use of these statements can they come to appreciate the information that is available. One way to approach this assignment is to ask the students to list the five most interesting pieces of information that they uncover about a particular charity. The web site for many not-for-profit entity’s can be found by going to www.give.org and then clicking on “Charity Reports and Standards” and then clicking on “List of National BBB Wise Giving Reports.” At that spot, a large number of charities are listed. By clicking on a specific organization, the student can get considerable information including the website address. The exact information that is found will, obviously, depend on the not-for-profit entity that is studied. As just one example, the following information comes from recent financial statements for the American Heart Association for June 30, 2012, and the year then ended:

1--This not-for-profit entity has four program services listed in its financial statements: research, public health education, professional education/training, and community services.

2--The charity reported total expenses for the year ended June 30, 2012, in excess of $617 million. Of that total, nearly $130 million was reported in connection with supporting services. Thus, approximately 21 percent of each dollar of expense was incurred in connection with supporting services (management and general and fundraising).

http://www.give.org/

3--In the statement of activities, the American Heart Association recognized $54.3 million in contributed services and materials for the year ended June 30, 2012. The biggest single source of contributed materials was $44.2 million for public health education. The biggest single source of contributed services was $6.1 million for research. Note 1, section j, spells out additional information about these donations as well as other donated services that were not recognized.

4--A question that is raised in connection with virtually any charity has to do with the amount of financial resources that are expended to raise more resources. In the year ended June 30, 2012, the American Heart Association, incurred $80.9 million in fundraising expenses. That amount makes up approximately 13 percent of the total expenses for the period.

5—As of June 30, 2012, the financial statements show that the American Heart Association held $284.3 million in unrestricted net assets, $224.5 million in temporarily restricted net assets, and $165.2 million in permanently restricted net assets.

6—For the year ended June 30, 2012, $147.9 million of temporarily restricted net assets were reclassified as unrestricted. Either the related purpose restriction had been satisfied ($93.4 million) or a time restriction expired ($54.5 million).

Analysis Case 2 Most private colleges and universities now place their latest audited financial statements on their Website. However, in some cases, a bit of searching is needed to locate these statements. The method by which the statements are made available is certainly not standardized. The information that will be uncovered by reading through these financial statements will depend entirely on the school being used. Here are the answers to the posed questions for Baylor University as of May 31, 2012, and the year then ended (http://www.baylor.edu/content/services/document.php/185324.pdf)

1--Tuition and fee revenue for the period totaled $463.5 while the total for the school’s “scholarships” was $184.8 million. Hence, this financial aid covered approximately 39.9 percent of the tuition and fees charged to students. To put this information another way, the “average” student paid 60.1 percent of the school’s tuition and fee charges.

2-- Note five to the financial statements provides the following information about contributions receivable as of May 31, 2012 (all numbers in thousands):

http://www.baylor.edu/content/services/document.php/185324.pdf



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Restricted current funds $ 63 Endowment funds 1,000 Plant Projects: Due in 1 year 6,570 Due in 2 to 5 years 27,780 Due in 6 to 10 years 12,070 Split interest agreements 21,355 Less: Present value adjustments (10,561) Total contributions receivable $ 58,277 In addition, the footnote states that another $26,246,000 has been deemed an intent to give and not yet reported because they are not viewed as unconditional promise.

3--This is an extremely difficult question for any school to answer because the costs of “educating the students” can be included within several different accounts: instruction, academic support, student services & activities, institutional support, and the like. So, no exact comparison between educational costs and research costs is possible here. However, considerable information can be determined about the school’s priorities simply by comparing instruction expenses ($209.6 million) and research and public service expenses ($14.5 million).

4--For the year ended May 31, 2012, Baylor University shows “gifts” of $16.5 million under unrestricted net assets, $56.6 million under temporarily restricted net assets, and $29.2 million under permanently restricted net assets.

5—As of May 31, 2012, Baylor University reported $450.1 million in unrestricted net assets, $298.6 million in temporarily restricted net assets, and $624.7 million in permanently restricted net assets. For these last two figures, the restrictions had to have been put in place by an outside party (probably the donor).

6—Footnote 4 indicates a single figure (a loss of $45.1 million) as the net realized and unrealized gains (and losses).

7--The problem with this computation is determining exactly what is meant by “education expenses.” One way to compute that figure for the Baylor University for the year ended May 31, 2012 is as follows:

Net Tuition and Fees $278,721,000 Education Expenses (one way that term can be defined) —Instruction $209,565,000 —Academic Support 48,520,000 —Student Services and Activities 96,634,000

—Institutional Support 65,732,000 (420,451,000) Net Loss on Educating Students $(141,730,000) Many students feel that, because of the high amounts being charged, colleges and universities should be making a great profit from tuition. Depending on how education costs are defined, most schools will show a monetary loss (and often a considerable loss) from the process of educating students. This is one computation that can really interest a college student. Communication Case Under each principle listed for Strong Financial Oversight, the Core Concepts will include a considerable amount of practical guidance for the accountant of a private not-for-profit entity. Students will already expect some of these recommendations based on their education and experiences but much of it may be new to them. What they focus on will depend on their personal interests. Here are the Core Concepts for financial records:

It is important for the staff to keep complete, accurate, and current financial records and share appropriate records with the board in a timely manner.

The board should review financial statements at least quarterly.

Some organizations are required by law to have an audit. Almost every entity should consider the benefits of having an audit, review, or compilation by an independent CPA.

Separating the audit committee from the finance committee provides a check and balance.

The auditor reports to the board, not to the staff.

chapter 1 the equity method of accounting for

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