Akuntansi Keuangan Lanjutan - Baker (10 E)

Chapter 1
Intercorporate
Acquisitions and
Investments in
Other Entities
McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objective 1-1
Understand and explain

different methods of
business expansion, the
types of organizational
structures, and the types of
acquisitions.
1-2
Development of Complex Business Structures
 Reasons for Enterprise expansion

 Size often allows economies of scale
 New earning potential
 Earnings stability through diversification
 Management rewards for bigger company size
 Prestige associated with company size
1-3
Business Objectives
 A subsidiary is a corporation that is

controlled by another corporation,
referred to as a parent company.
 Control is usually through majority
ownership of its common stock. P
 Because a subsidiary is a separate
legal entity, the parent’s risk
associated with the subsidiary’s
activities is limited.
S
1-4
Ethical Considerations
 Manipulation of financial reporting

 The use of subsidiaries or other entities to
borrow money without reporting the debt on
their balance sheets
 Using special entities to manipulate profits
 Manipulation of accounting for mergers and
acquisitions
 Pooling-of-interests allowed for manipulation
 The FASB did away with it and modified acquisition
accounting
1-5
Business Expansion: The Big Picture
 Two Types of Expansion

 Internal Expansion
 Investment account (Parent) = BV of net assets (Sub)
 External Expansion
 Acquisition price usually is not the same as BV, carrying value, or
even FMV of net assets
$
P
P
Sub
Shareholders
External Stock Internal Stock $
Expansion Expansion
S S
1-6
Business Expansion for Within
 New entities are created

 subsidiaries
 partnerships
 joint ventures
 special entities
 Motivating factors:
 Helps establish clear lines of control and facilitate the
evaluation of operating results
 Special tax incentives
 Regulatory reasons
 Protection from legal liability
 Disposing of a portion of existing operations
1-7
Business Expansion
 A spin-off
 Occurs when the ownership of a newly created or existing
subsidiary is distributed to the parent’s stockholders
without the stockholders surrendering any of their stock
in the parent company.
 A split-off
 Occurs when the subsidiary’s shares are exchanged for
shares of the parent, thereby leading to a reduction in the
outstanding shares of the parent company.
1-8
Control: How?
 The Usual Way

 Owning more than 50% of the subsidiary’s outstanding
voting stock (50% plus only 1 share will do it)
 The Unusual Way
 Having contractual agreements or financial arrangements
that effectively achieve control
 Informal arrangements
 Formal agreements
 Consummation of a written agreement requires recognition on
the books of one or more of the companies that are a party to
the combination.
1-9
Forms of Organizational Structure
 Expansion through business combinations

 Entry into new product areas or geographic
regions by acquiring or combining with other
companies.
 A business combination occurs when “. . . an
acquirer obtains control of one or more
businesses.”
 The concept of control relates to the ability to
direct policies and management.
1-10
Frequency of Business Combinations
 1960s  Merger boom
 Conglomerates
 1980s  Increase in the number of business
combinations
 Leveraged buyouts and the resulting debt
 1990s  All previous records for merger activity
shattered
 Downturn of the early 2000s, and decline in mergers
 Increased activity toward the middle of 2003 that
accelerated through the middle of the decade
 Role of private equity
 Effect of the credit crunch of 2007-2008
1-11
Organizational Structure and Reporting
 Merger
 A business combination in which the acquired
company’s assets and liabilities are combined
with those of the acquiring company, resulting in
no additional organizational components.
 Financial reporting is based on the original
organizational structure.
1-12
 Controlling ownership
 A business combination in which the acquired
company remains as a separate legal entity with a
majority of its common stock owned by the
purchasing company leading to a parent–
subsidiary relationship.
 Accounting standards normally require
consolidated financial statements.
1-13
 Noncontrolling ownership
 The purchase of a less-than-majority interest in another
corporation does not usually result in a business
combination or a controlling situation.
 Other beneficial interest

 One company may have a beneficial interest in another
entity even without a direct ownership interest.
 The beneficial interest may be defined by the agreement
establishing the entity or by an operating or financing
agreement.
1-14
Practice Quiz Question #1
A common way to obtain corporate

control is
a. by purchasing more than 50% of an
entity’s non-voting preferred stock.
b. by bribing the CEO.
c. by playing a video game about that
company.
d. by purchasing more than 50% of an
entity’s common stock.
e. none of the above.
1-15
Practice Quiz Question #1 Solution
A common way to obtain corporate

control is
a. by purchasing more than 50% of an
entity’s non-voting preferred stock.
b. by bribing the CEO.
c. by playing a video game about that
company.
d. by purchasing more than 50% of an
entity’s common stock.
1-16
Understand the history of

how standards related to
acquisition accounting have
developed over time.
1-17
Accounting for Business Combinations
 Big Picture: Valuation of the acquired company
 In the past, there were two methods:
 Pooling of Interests Method (Investment = BV of Sub)
 Purchase Method (Investment in Sub = FV given)
 SFAS 141 (ASC 805)(Effective July 2001) required the
purchase method.
 SFAS 141R (ASC 805) (Effective December 2008) modified
rules—“Acquisition Method”
 FASB 141R (ASC 805) may not be applied retroactively
1-18
Acquisition Accounting
 The acquirer recognizes all assets acquired and
liabilities assumed in a business combination and
measures them at their acquisition-date fair values.
 If less than 100 percent of the acquiree is acquired, the
noncontrolling interest also is measured at its acquisition-
date fair value.
 Fair value measurement
 The FASB decided in FASB 141R (ASC 805) to focus
directly on the value of the consideration given.
1-19
Goodwill
 Components used in determining goodwill:
1. The fair value of the consideration given by the acquirer
2. The fair value of any interest in the acquiree already held
by the acquirer
3. The fair value of the noncontrolling interest in the
acquiree, if any
 The total of these three amounts, all measured at
the acquisition date, is compared with the
acquisition-date fair value of the acquiree’s net
identifiable assets, and the difference is goodwill.
1-20
The Acquisition Method
 Establishes A New Basis of Accounting
 The new basis of accounting depends on the
acquirer’s purchase price (FMV) + the NCI’s (FMV).
 The depreciation cycle for fixed assets starts over
based on current values and estimates.
 If acquisition price > FMV, goodwill exists.
 Recognize as an asset.
 Do not amortize.
 Evaluate periodically for possible impairment.
 If acquisition price < FMV, a bargain purchase
element exists.
1-21
The Pooling of Interests Method
 No longer allowed!
 The target company’s basis of accounting in its
assets was used by the consolidated group.
 The depreciation cycle merely continued along as
if no business combination had occurred.
 Goodwill was never recognized; thus, future
income statements did not have goodwill
amortization expense.
 Managers loved it!
1-22
Methods of Effecting Business Combinations
 Acquisition of assets
 Statutory Merger
 Statutory Consolidation
 Acquisition of stock
 A majority of the outstanding voting shares usually is
required unless other factors lead to the acquirer gaining
control.
 Noncontrolling interest: the total of the shares of an
acquired company not held by the controlling
shareholder.
 Acquisition by other means
1-23
Valuation of Business Entities
 Value of individual assets and liabilities

 Value determined by appraisal
 Value of potential earnings
 “Going-concern value” based on:
 A multiple of current earnings.
 Present value of the anticipated future net cash flows
generated by the company.
 Valuation of consideration exchanged
1-24
Acquiring Assets vs. Stock
 Major Decision Factors

 Legal considerations—Buyer must be extremely
careful NOT to assume responsibility for (and
thus “inherit”) the target company’s
 Unrecorded liabilities.
 Contingent liabilities (lawsuits).
vs.
1-25
Acquiring Assets vs. Stock
 Major Decision Factors (continued)

 Tax considerations—Often requires major
negotiations involving resolution of
 Seller’s tax desires.
 Buyer’s tax desires.
 Ease of consummation—acquiring common stock
is simple compared with acquiring assets.
vs.
1-26
Acquiring Assets
 Major Advantages of Acquiring Assets

 Will not inherit a target’s contingent liabilities
(excluding environmental).
 Will not inherit a target’s unwanted labor union.
 Major Disadvantages of Acquiring Assets
 Transfer of titles on real estate and other assets
can be time consuming.
 Transfer of contracts may not be possible.
1-27
Acquiring Common Stock
 Advantages of Acquiring Common Stock

 Easy transfer
 May inherit nontransferable contracts
 Disadvantages of Acquiring Common Stock
 May inherit contingent liabilities or unwanted
labor union connection.
 May acquire unwanted facilities/units.
 Will likely be hard to access target’s cash.
1-28
Organizational Forms—What acquired?
Common Stock—Results Target’s Assets—Results in a

in a parent-subsidiary home office-branch/division
relationship. relationship.
P Home Office
P controls S
Branch/Division
S One legal entity
1-29
To qualify for acquisition accounting

treatment,
a. one company must acquire common
stock of the other combining company.
b. a statutory consolidation must occur.
c. each company must be approximately
the same size.
d. a stock-for-stock exchange must occur.
1-30
To qualify for acquisition accounting

treatment,
a. one company must acquire common
stock of the other combining company.
b. a statutory consolidation must occur.
c. each company must be approximately
the same size.
d. a stock-for-stock exchange must occur.
1-31
In acquisition accounting,
a. common stock must be the
consideration given.
b. goodwill is not reported.
c. a statutory merger occurs.
d. a change of basis in accounting occurs.
1-32
In acquisition accounting,
a. common stock must be the
b. goodwill is not reported.
c. a statutory merger occurs.
d. a change of basis in accounting occurs.
1-33
Make calculations and

prepare journal entries for
the creation and purchase of
a business entity.
1-34
Creating Business Entities
 The company transfers assets, and perhaps

liabilities, to an entity that the company has
created and controls and in which it holds
majority ownership.
 The company transfers assets and liabilities to
the created entity at book value, and the
transferring company recognizes an ownership
interest in the newly created entity equal to the
book value of the net assets transferred.
1-35
 Recognition of fair values of the assets

transferred in excess of their carrying values
on the books of the transferring company is
not appropriate in the absence of an arm’s-
length transaction.
 No gains or losses are recognized on the
transfer by the transferring company.
1-36
 If the value of an asset transferred to a newly

created entity has been impaired prior to the
transfer and its fair value is less than the
carrying value on the transferring company’s
books, the transferring company should
recognize an impairment loss and transfer the
asset to the new entity at the lower fair value.
1-37
Internal Expansion: Creating a subsidiary
 Parent sets up the new legal entity.
 Based on state laws
 Parent transfers assets to the new company.
 Subsidiary begins to operate.
 Example: Parent sets up Sub and transfers
P
$1,000 for no-par stock.
Stock $
Parent:
Investment in Sub 1,000
Cash 1,000
Sub: S
Cash 1,000
Common Stock 1,000
1-38
When a parent company creates a

subsidiary through internal expansion,
the parent’s journal entry to transfer
assets to the newly created entity will
include a debit to
a. Acquisition Expense.
b. Cash.
c. Investment in Subsidiary.
d. Common Stock.
1-39
When a parent company creates a

subsidiary through internal expansion,
the parent’s journal entry to transfer
assets to the newly created entity will
include a debit to
a. Acquisition Expense.
b. Cash.
c. Investment in Subsidiary.
d. Common Stock.
1-40

the differences between
different forms of
business
combinations.
1-41
Forms of Business Combinations
 A statutory merger
 The acquired company’s assets and liabilities are
transferred to the acquiring company, and the acquired
company is dissolved, or liquidated.
 The operations of the previously separate companies are
carried on in a single legal entity.
 A statutory consolidation
 Both combining companies are dissolved and the assets
and liabilities of both companies are transferred to a
newly created corporation.
1-42
 A stock acquisition
 One company acquires the voting shares of another
company and the two companies continue to operate as
separate, but related, legal entities.
 The acquiring company accounts for its ownership
interest in the other company as an investment.
 Parent–subsidiary relationship
 For general-purpose financial reporting, a parent
company and its subsidiaries present consolidated
financial statements that appear largely as if the
companies had actually merged into one.
1-43
AA Company
AA Company
BB Company
(a) Statutory Merger
AA Company
CC Company
BB Company
(b) Statutory Consolidation
AA Company AA Company
BB Company BB Company
(c) Stock Acquisition

1-44
Determining the Type of Business Combination
AA Company invests in BB Company
Acquires
Acquires net
net
assets Acquires stock
assets
Yes Acquired
Acquired company
company
liquidated?
liquidated?
No
Record
Record as
as statutory
statutory Record
Record as
as stock
stock
merger
merger or statutory
or statutory acquisition
acquisition and
and
consolidation
consolidation operate as subsidiary
operate as subsidiary
1-45
Forms of Business Combination—Details
 Option #1: Statutory Merger

 Peaceful Merger:
 One entity transfers assets to another in exchange for stock
and/or cash.
 It liquidates pursuant to state laws.
 Hostile Takeover:
 One company buys the stock of another, creating a temporary
parent-subsidiary relationship.
 The parent then liquidates the subsidiary into the parent pursuant
to state laws.
 The result: one legal entity survives.
1-46
Statutory Merger: Peaceful Merger
A Shareholders T Shareholders
A stock + up
to 50% boot
A stock
A Corp. T Corp.
+ boot
T assets
• Need SH approval from both corporations.

1-47
Statutory Merger: The Result
A and T Shareholders
A Corp.
(A & T Assets)
1-48
Statutory Merger: Hostile Takeover
A Shareholders T Shareholders
A Corp. T Corp.
1-49
Statutory Merger: Hostile Takeover
 A takes all of T’s assets and liquidates the

corporate shell.
A & T Shareholders
A
T T Assets
1-50
Statutory Merger: The (Same) Result
A and T Shareholders
A Corp.
(A & T Assets)
1-51
 Option #2: Statutory Consolidation

 New corporation (Newco) is created.
 Newco issues stock to both combining companies in
exchange for their stock.
 Each combining company becomes a temporary
subsidiary of Newco.
 Both subs are liquidated into Newco and become
divisions.
 Result: One legal entity survives.
1-52
Statutory Consolidation: The Process
X Shareholders Y Shareholders
N Stock N Stock
X Corp. Y Corp.
N Stock N Stock
Newco
Corp.
• Need SH approval from both corporations.

1-53
Statutory Consolidation: The Result
X and Y Shareholders
Newco Corp.
(X & Y Assets)
1-54
 Option #3: HOLDING COMPANY:

 Similar to a statutory consolidation except that the two
subsidiaries are NOT liquidated into newly formed parent
corporation.
 Instead, the new company issues its stock to the
shareholders of the two existing corporations in exchange
for their stock in the two new subsidiary corporations.
1-55
Holding Company: The Starting Point
Newco
Corp.
X Shareholders Y Shareholders
X Y
Corp. Corp.
1-56
Holding Company: The Result
X & Y Shareholders
N Stock X & Y Stock
Newco
Corp.
X Y
Corp. Corp.
1-57
A way to force out a target company’s

dissenting shareholders is to use
a. acquisition accounting.
b. pooling of interests accounting.
c. a statutory merger.
d. a statutory consolidation.
1-58
A way to force out a target company’s

dissenting shareholders is to use
a. acquisition accounting.
b. pooling of interests accounting.
c. a statutory merger.
d. a statutory consolidation.
1-59

business combination
journal entries in the
presence of a differential,
goodwill, or a bargain
purchase element.
1-60
The Acquisition Method: Items Included in the
Acquirer’s Cost
 Category #1: The fair value of the consideration

given
 Category #2: Certain out-of-pocket direct costs
 In the past, these were included in acquisition.
 Now expense!
 Category #3: Contingent consideration

 Paid subsequent to the acquisition date
1-61
Acquirer’s Cost: Category 1
 Types of Consideration: Practically any

type
 Cash
 Common stock
 Preferred stock
 Notes receivable or Bonds
 Used trucks
1-62
 General Rule
 Use the FMV of the consideration given.
 Exception
 Use the FMV of the property received . . . if it is
more readily determinable.
stock
P
Sub
Shareholders
stock
S 1-63
Group Exercise 1: Basic Acquisition
Pete Inc. acquired 100% of the outstanding

common stock of Sake Inc. for $2,500,000 cash and
20,000 shares of its own common stock ($1 par
value), which was trading at $50 per share at the
acquisition date.
$+
Stock
Sake
Pete Stock
Shareholders
Sake
Required: Prepare the journal entry to record the acquisition.
1-64
Group Exercise 1: Basic Acquisition
Pete Inc. acquired 100% of the outstanding

common stock of Sake Inc. for $2,500,000 cash and
20,000 shares of its own common stock ($1 par
value), which was trading at $50 per share at the
acquisition date.
$+
Stock
Acquisition Cost: Sake
Cash $2,500,000 Pete Stock
Shareholders
Stock 1,000,000
Total $3,500,000
Investment in Sake 3,500,000 Sake

Cash 2,500,000
Common Stock 20,000
Additional Paid-in Cap. 980,000
1-65
 In the past, costs traceable to the acquisition were

capitalized:
 Legal fees—the acquisition agreement
 Purchase investigation fees
 Finder’s fees
 Travel costs
 Professional consulting fees
 ASC 805 requires that they be expensed in the

acquisition period.
 Do not expense direct costs of issuing stock
 Charge to Additional Paid-In Capital
1-66
Group Exercise 2: Recording Direct Costs
Assume the same information provided in Exercise 1. In addition, assume

that Pete incurred the following direct costs:
Legal fees (acquisition) $ 52,000
Accounting fees 27,000 $+
Travel expenses 11,000 Stock
Sake
Legal fees (stock issue) 31,000
Accounting fees (review) 14,000
Pete Stock
Shareholders
SEC filing fees 9,000

Total $144,000
Sake
Prior to the consummation date, $117,000 had been
paid and charged to a deferred charges account pending
consummation of the acquisition. The remaining
$27,000 has not been paid or accrued.
Required: Prepare the journal entry to record the direct costs.

1-67
Group Exercise 2: Solution
Charge To
Acquisition Additional
Expense Paid-in Capital
Legal fees $ 52,000
Accounting fees 27,000
Travel expenses 11,000
Legal fees—SEC $ 31,000
Accounting fees—SEC 14,000
Filing fees—SEC 9,000
Totals $ 90,000 $ 54,000
Acquisition Expense 90,000

Additional Paid-in Capital 54,000
Deferred Charges 117,000
Accrued Liabilities 27,000
1-68
 Contingent Consideration
 Contingent payments depending on some
unresolved future event.
 Example: agree to issue additional shares in 6 months
if shares given lose value.
 Record at fair value as of the acquisition date.
 Mark to market each subsequent period until the
contingent event is resolved.
1-69
Goodwill vs. Bargain Purchase Element
 FMV Given > FMV of Net Assets  Goodwill
Bargain
 FMV Given < FMV of Net Assets  Purchase
Element
 FMV Given = FMV of Net Assets  Neither GW

nor BPE
1-70
Goodwill: How to calculate it?
 Goodwill is calculated as the residual

amount.
 First, estimate the FMV of identifiable net assets.
 Includes both tangible AND intangible assets
 Second, subtract the total FMV of all identifiable
net assets from the total FMV given by owners.
 The residual is deemed to be goodwill.
GW = Total FMV Given – FMV of Identifiable Net Assets
1-71
Goodwill Example
Assume Bigco Corp. pays $400,000 for Littleco Inc. and

that the estimated fair market values of assets, liabilities,
and equity accounts are as follows:
Accounts Receivable $ 100,000 Liabilities $200,000
Inventory 100,000
LT Marketable sec. 60,000 Retained Earnings 100,000
PP&E 140,000 Common Stock 100,000
Total Assets $ 400,000 Total Liab/Equity $ 400,000
Net Assets = Total Assets – Total Liabilities

Net Assets = $ 400,000 – $200,000 = $200,000
Goodwill = Acquisition price – FMV Net Assets

= $400,000 – $200,000 = $200,000
1-72
Goodwill Example Continued
Journal Entry:
Accounts Receivable $ 100,000

Inventory 100,000
Marketable Securities 60,000
PP&E 140,000
Goodwill 200,000
Cash $ 400,000
Liabilities 200,000
1-73
Goodwill: What to Do With It?
 Goodwill
 Must capitalize as an asset
 Cannot amortize to earnings
 Must periodically (at least annually) assess for
impairment
 If impaired, must write it down—charge to
earnings
1-74
Bargain Purchase Element: What to Do With It?
 Bargain Purchase Element

 Still record assets and liabilities assumed at their
fair values.
 The amount by which consideration given
exceeds the fair value of net assets is a gain to the
acquirer.
1-75
Bargain Purchase Example
Assume Bigco Corp. pays $150,000 for Littleco Inc. and

that the estimated fair market values of assets, liabilities,
and equity accounts are as follows:
Accounts Receivable $ 100,000 Liabilities $200,000
Inventory 100,000
LT Marketable sec. 60,000 Retained Earnings 100,000
PP&E 140,000 Common Stock 100,000
Total Assets $ 400,000 Total Liab/Equity $ 400,000
Net Assets = Total Assets – Total Liabilities

Net Assets = $ 400,000 – $200,000 = $200,000
Goodwill = Acquisition price – Net Assets

= $150,000 – $200,000 = $(50,000)
1-76
Goodwill Example Continued
Journal Entry:
Accounts Receivable $ 100,000

Inventory 100,000
Marketable Securities 60,000
PP&E 140,000
Gain $ 50,000
Cash 150,000
Liabilities 200,000
1-77
Acquisition of Intangibles
 ASC 805
 An intangible asset should be recognized
separately from goodwill only if its benefits can
be separately identified.
 Finite intangible assets should be amortized over
their useful life with no arbitrary cap (i.e., no 40-
year limit).
 Some intangible assets (such as goodwill) may
have an indefinite or infinite life. They should not
be amortized, but tested for impairment at least
annually.
1-78
Intangible Assets
 More are recognized under ASC 805

 Record at fair value but only if either of the
following two criteria are met:
1. Intangible arises from a legal or contractual
right.
2. Intangible does not arise from a legal or
contractual right but is separable.
1-79
Separately Recognized Intangibles
 ASC 805 specifies that the
following should be recognized
separately from goodwill: Key:
 Marketing-related intangibles
Purpose is to
 trademarks and internet domains
get companies
 Customer-related intangibles
to recognize
 customer lists, order backlogs, etc.
intangibles
 Artistic-related intangibles
separately from
 normally items protected by copyrights
goodwill.
 Contract-based intangibles
 licenses, franchises, broadcast rights
 Technology-based intangible assets
 both patented and unpatented
technologies 1-80
Group Exercise 3: Acquisition of Intangibles
On January 1, 2009, Buyer Company acquired 100-percent ownership of
Target Company’s assets for $9,400 cash and assumed its liabilities.
Current Assets $2,400
Property, Plant, and Equipment 1,500 3,900 Total Assets
Current Liabilities 500
Separately Long-term Debt 1,100 1,600 Total Liabilities
Identifiable: 2,300 Net Assets
In addition, Target Company had the following intangible items on the
acquisition date (not included in Target’s balance sheet):
1,400 a. Trademarks (not recognized on Target’s books) because they were
internally developed. The trademarks have a value of $1,400. The useful
life of these trademarks is indefinite.
1,000 b. Ongoing research projects that have an estimated value of $1,000.
1,500 c. Internally-developed computer software with a value of $1,500. This
software has a useful life of three years.
800 d. Internally-developed patents with a value of $800. The patents have a
useful life of seven years.
200 e. Other separately-identifiable intangibles with a value of $200. These
assets have an average useful life of five years.
4,900
REQUIRED: Make Buyer’s journal entry to record the acquisition of Target.
1-81
Purchase Net Separately
Price  Assets  Identified Int. = G.W.
$9,400 $2,300 $4,900 $2,200
Current Assets 2,400

Property, Plant, and Equipment 1,500
Trademarks 1,400
In-Process Research and Development 1,000
Computer Software 1,500
Patents 800
Other Intangible Assets 200
Goodwill 2,200
Current Liabilities 500
Long-term Debt 1,100
Cash 9,400
1-82
Acquisition Method – Comprehensive Example
Entries Recorded by Acquiring Company Entries Recorded by Acquired Company
Merger Expense 40,000 Investment in Point Stock 610,000

Cash 40,000 Current Liabilities 100,000
Record costs related to acquisition of Sharp Company. Accumulated Depreciation 150,000
Cash and Receivables 45,000
Deferred Stock Issue Costs 25,000 Inventory 65,000
Cash 25,000 Land 40,000
Record costs related to issuance of common stock. Buildings and Equipment 400,000
Gain on Sale of Net Assets 310,000
On the date of combination, Point records the acquisition Record transfer of assets to Point Corporation.
of Sharp with the following entry:
Cash and Receivables 45,000 Common Stock 100,000
Inventory 75,000 Additional Paid-In Capital 50,000
Land 70,000 Retained Earnings 150,000
Buildings and Equipment 350,000 Gain on Sale of Net Assets 310,000
Patent 80,000 Investment in Point Stock 610,000
Goodwill 100,000 Record distribution of Point Corporation stock.
Current Liabilities 110,000
Common Stock 100,000
Additional Paid-In Capital 485,000
Deferred Stock Issue Costs 25,000
Record acquisition of Sharp Company.
1-83
 Testing for goodwill impairment

 When goodwill arises in a business combination,
it must be assigned to cash generating units
(CGU).
 To test for impairment, the recoverable amount
of the CGU is compared with its carrying amount.
 If the recoverable amount of the CGU exceeds its
carrying amount, the goodwill of that reporting
unit is considered unimpaired.
 If the carrying amount of the CGU exceeds its
recoverable amount, an impairment of the
reporting unit’s goodwill is implied.
1-84
An impairment loss
– is recognised for a CGU
if, and only if, the recoverable amount of the CGU (group
of CGUs) is less than the carrying amount of the CGU
(group of CGUs).
– is allocated to reduce the carrying amount of the assets of
the CGU (group of CGUs) in the following order:
a) first, to reduce the carrying amount of any goodwill
allocated to the CGU (group of CGUs); and
b) then, to the other assets of the CGU (group of CGUs)
pro rata on the basis of the carrying amount of each
asset in the CGU (group of CGUs).
These reductions in carrying amounts shall be treated
as impairment losses on individual assets
Source : Lam, and Peter Lau (2008), Intermediate Financial Reporting: An IFRS Perspective
1-85
Acquisition Accounting Example
Bear Bull performed an impairment review on the CGU X, which has the following
assets on hand:
Carrying amount
Goodwill $ 1,000
Property, plant and equipment, at depreciated cost 3,000
Intangible assets, at amortised cost 2,000
Investment property, at depreciated cost 2,500
Financial assets, at fair value 1,070
Inventory, at cost 500
Trade receivables 1,300
Total 11,370
After an impairment review, Bear Bull found that the recoverable amount of CGU X
is $8,000 and of the investment property is $2,000
Calculate the impairment loss and allocate to the individual asset.

1-86
Example
Carrying Carrying
amount after Allocated amount after
impairment loss impairment loss impairment loss
Goodwill $ 1,000 $ (1,000) $ 0

Property, plant and equipment 3,000 *(1,122) 1,878
Intangible assets 2,000 (748) 1,252
Investment property ($2,500 – $500) 2,000 - 2,000
Financial assets 1,070 - 1,070
Inventory 500 - 500
Trade receivables 1,300 - 1,300
Total 10,870 (2,870) 8,000
Firstly, the impairment loss reduces any amount of goodwill *3/5 x (10870-8000-1000)
Then, the residual loss is allocated to other non-current assets pro rata
based on the carrying amounts of those non-current asset.
1-87
 Financial reporting subsequent to a

business combination
 Financial statements prepared subsequent to a
business combination reflect the combined entity
only from the date of combination.
 When a combination occurs during a fiscal period,
income earned by the acquiree prior to the
combination is not reported in the income of the
combined enterprise.
1-88
A form of consideration that is not

allowed in acquisition accounting is
a. Cash.
b. Bonds.
c. Preferred stock.
d. Common stock.
1-89
A form of consideration that is not

allowed in acquisition accounting is
a. Cash.
b. Bonds.
c. Preferred stock.
d. Common stock.
1-90
Which of the following costs can be

added to the cost of an acquisition?
a. Legal fees.
b. Accounting fees.
c. Costs of issuing common stock.
d. A pro rata portion of the CEO’s salary.
e. Travel costs.
f. Costs of the M&A department.
g. None of the above.
1-91
Which of the following costs can be

added to the cost of an acquisition?
a. Legal fees.
b. Accounting fees.
c. Costs of issuing common stock.
d. A pro rata portion of the CEO’s salary.
e. Travel costs.
f. Costs of the M&A department.
g. None of the above.
1-92
Understand additional
considerations associated
with business combinations.
1-93
Additional Considerations
 Uncertainty in business combinations

 Measurement Period
 ASC 805 allows for this period of time to
properly ascertain fair values.
 The period ends once the acquirer obtains the
necessary information about the facts as of the
acquisition date.
 May not exceed one year.
1-94
 Contingent consideration
 Sometimes the consideration exchanged is not fixed in amount,
but rather is contingent on future events; e.g., a contingent-
share agreement
 ASC 805 requires contingent consideration to be valued at fair
value as of the acquisition date and classified as either a
liability or equity.
 Acquiree contingencies
 Under ASC 805, the acquirer must recognize all contingencies
that arise from contractual rights or obligations and other
contingencies if it is more likely than not that they meet the
definition of an asset/liability at the acquisition date.
 Recorded by the acquirer at acquisition-date fair value.
1-95
 In-process research and development

 The FASB concluded that valuable ongoing
research and development projects of an acquiree
are assets and should be recorded at their
acquisition-date fair values, even if they have no
alternative use.
 These projects should be classified as indefinite-
lived and, therefore, should not be amortized until
completed or abandoned.
 They should be tested for impairment.
1-96
 Noncontrolling equity held prior to combination

 An acquirer that held an equity position in an acquiree
immediately prior to the acquisition date must revalue
that equity position to its fair value at the acquisition date
and recognize a gain or loss on the revaluation.
 Acquisitions by contract alone
 The amount of the acquiree’s net assets at the date of
acquisition is attributed to the noncontrolling interest and
included in the noncontrolling interest reported in
subsequent consolidated financial statements.
1-97
Consolidation: The Concept
 Parent creates or gains control of the subsidiary.

 The result: a single reporting entity.
P
S
1-98
Consolidation– The Big Picture
How do we report the results of subsidiaries?
Parent
Company
80% 51% 21%
Sub A Sub B Sub C
Consolidation Equity Method

(plus the Equity Method)
1-99
 Two or more separate entities under

common control
 Present “as if ” they were one company.
 Two or more sets of books are merged
together into one set of financial statements
1-100
Consolidation: Basic Idea
 Presentation:
 Sum the parent’s and subsidiary’s accounts.
 We’ll start covering this in detail in Chapter 2.
“One-line” consolidation Replace with…

Parent Sub Consolidated
Cash $ 200 $100 $ 300
Investment in Sub 500
“The Detail”
PP&E 900 600 1,500
Total Assets $1,600 $700 $1,800
Liabilities $ 300 $200 $ 500

Equity 1,300 500 1,300
Total Liabilities & Equity $1,600 $700 $1,800
1-101
Consolidation Entries
 Just a quick introduction…

 Two examples of eliminating entries:
 The “Basic” eliminating entry
 Removes the “investment” account from the parent’s balance
sheet and the subsidiary’s equity accounts.
 An intercompany loan (from Parent to Sub)
Equity 500
Worksheet Investment in Sub 500
Entry
Only! Payable to Parent 100
Receivable from Sub 100
1-102
Simple Consolidation Example
Parent Sub DR CR Cons.

Cash $ 200 $100 $ 300
Receivable from Sub 100 100 0
Investment in Sub 500 500 0
PP&E 800 600 1,400
Total Assets $1,600 $700 $1,700
Liabilities $ 300 $100 $ 400

Payable to Parent 100 100 0
Equity 1,300 500 500 1,300
Total Liabilities & Equity $1,600 $700 $1,700
1-103
Conclusion
The End
1-104
Chapter 2
Reporting Intercorporate
Investments and
Consolidation of Wholly
Owned Subsidiaries with
No Differential
Understand and explain how

ownership and control can
influence the accounting
for investments in common
stock.
2-106
Accounting for Investments in Common Stock
The method used to account for investments in

common stock depends on:
 the level of influence or control that the investor
is able to exercise over the investee.
 choices made by the investor because of options
available.
2-107
Financial Reporting Basis by Ownership Level
2-108
Investment vs. Ownership
 Consolidation eliminates the investment account and
replaces it with “the detail.”
Account for as
trading, AFS, or
Cost Investments
Usually equity method
and consolidation
Ownership Percentage (but cost method is
Equity method also okay here)
or Fair Value
Option
No
significant Control
Significant
influence
influence
Why is the cost
0% 20% 50% method okay? 100%
2-109
If Company A purchases 45% of the

outstanding common stock of Company B,
the investment in Company B should be
accounted for
a. as an available-for-sale investment.
b. as a consolidated subsidiary.
c. as a trading investment.
d. as an equity method investment.
2-110
If Company A purchases 45% of the

outstanding common stock of Company B,
the investment in Company B should be
accounted for
a. as an available-for-sale investment.
b. as a consolidated subsidiary.
c. as a trading investment.
d. as an equity method investment.
2-111
 The Cost Method
 Used for reporting investments in equity securities
when both consolidation and equity-method reporting
are inappropriate
 The Equity Method
 Used when the investor exercises significant influence
over the operating and financial policies of the investee
and consolidation is not appropriate
 May not be used in place of consolidation if
consolidation is appropriate
 Its primary use is in reporting nonsubsidiary
investments
2-112
 Consolidation
 Involves combining for financial reporting the individual
assets, liabilities, revenues, and expenses of two or more
related companies as if they were part of a single company
 Normally is appropriate when one company, referred to
as the parent, controls another company, referred to as a
subsidiary
 A subsidiary that is not consolidated with the parent is
referred to as an unconsolidated subsidiary and is shown
as an investment on the parent’s balance sheet.
2-113
Prepare journal entries

using the cost method for
accounting for investments
2-114
The Cost Method: How It Works
 Record the investment at “cost.”

 General Rule:
 Leave it on the books at cost.
S
2-115
 Review
 Assume P Corp creates a subsidiary, S Corp, and invests $100,000
cash in exchange for all of the $1 par common stock (1,000 shares).
 What journal entries would P and S make at the time of the
investment?
P Corp:
P Investment in S Corp 100,000
Cash 100,000
S Corp:
S Cash 100,000
Common Stock 1,000
Additional PIC—CS 99,000
2-116
 General Rule
 The investment remains on parent’s books at cost
 Record income at the parent level ONLY when
sub declares a dividend.

 Generally, the sub’s income does not affect
parent’s investment account balance.
 However, the parent cannot ignore the sub’s
losses.
 Parent writes-down investment ONLY IF value
has been impaired.

 Write-downs result in a NEW cost basis.
2-117
 The cost method is a one-way street!

 The investment can be written down—but never
written up.
Investment Account
Cost
Impairment
Loss
New Cost
Basis
2-118
The Cost Method: Pros & Cons
 Pros
 Minimal G/L bookkeeping by parent
 Simple consolidation procedures
 Cons
 Overly conservative valuation
 Parent can manipulate its reported income.
 Why?
 Parent controls when sub pays dividends!
 PCO statements—if used internally or issued—
may be misleading.
2-119
The Cost Method: Key Concept
Although the parent can manipulate its

own reported net income, it can never
manipulate consolidated net income.
2-120
The Cost Method
 Used when the investor lacks the ability

either to control or to exercise significant
influence over the investee.
 Accounting Procedures
 The cost method is consistent with the treatment
normally accorded noncurrent assets.
2-121
The Cost Method
 At the time of purchase, the investor records its

investment in common stock at the total cost
incurred in making the purchase.
 The investment continues to be carried at its
original cost until the time of sale.
 Income from the investment is recognized as
dividends are declared by the investee.
 Recognition of investment income before a dividend
declaration is inappropriate.
2-122
Example: The Cost Method
ABC Company acquires 20 percent of XYZ Company’s
common stock for $100,000 at the beginning of the year but
does not gain significant influence over XYZ. During the year,
XYZ has net income of $60,000 and pays dividends of
$20,000. ABC Company records the following entries:
Investment in XYZ Company Stock 100,000

Cash 100,000
Record purchase of XYZ Company stock.
Cash 4,000
Dividend Income 4,000
Record dividend income from XYZ Company stock: $20,000 x 0.20.
2-123
The Cost Method
 Declaration of dividends in excess of earnings since
acquisition
 Liquidating dividends: Dividends declared by the investee in excess of
its earnings since acquisition by the investor from the investor’s
viewpoint
 The investor’s share of these liquidating dividends is treated as a
return of capital, and the investment account balance is reduced by
that amount.
 These dividends usually are not liquidating dividends from the
investee’s point of view.
 Acquisition at interim date
 Does not create any major problems when the cost method is used.
 Potential difficulty: liquidating dividend determination
2-124
The Cost Method
 Changes in the number of shares held

 Changes resulting from stock dividends, stock splits, or
reverse splits receive no formal recognition in the
accounts of the investor
 Purchases of additional shares
 Recorded at cost similar to initial purchase
 New percentage ownership is calculated to determine
whether switch to the equity method is required
 Sales of shares
 Accounted for in the same manner as the sale of any other
noncurrent asset
2-125
Under the cost method, a sub’s dividends

would:
a. NOT be eliminated in consolidation.
b. be the parent’s income from investment.
c. decrease the parent’s investment account.
d. increase the parent’s investment account.
2-126
Under the cost method, a sub’s dividends

would:
2-127

using the equity method
for accounting for
investments.
2-128
The Equity Method: How It Works
 The equity method is accrual basis driven:

 Record income at the parent level based on sub’s earnings
and losses—a built in valuation technique.
 It isn’t the same as fair value accounting.
 Nevertheless, the investment generally goes up and down based
on the operations of the investee company.
 Sub’s dividends reduce the parent’s investment (the
parent has less invested).
Investment in Sub Income from Sub
Cost
Income Losses Losses Income
Dividends
Adj. Bal. 2-129
The Equity Method: How It Works
The equity method is a two-way street!

The investment can be:
1. written up based on the sub’s income AND
2. written down based on sub losses and dividends
2-130
The Equity Method: Pros and Cons
 Pros
 Based on economic activity—not the parent-
controlled dividend policy.
 Has two built-in checking figures:
 Consolidated NI = Parent’s NI
 Consolidated RE = Parent’s RE
 Cons
 Requires continual bookkeeping.
 Unnecessary work if PCO statements are not
used internally or issued to outsiders.
2-131
The Equity Method
 The equity method is intended to reflect the

investor’s changing equity or interest in the
investee.
 The investment is recorded at the initial
purchase price and adjusted each period for
the investor’s share of the investee’s profits
or losses and the dividends declared by the
investee.
2-132
The Equity Method
 ASC 323-10-30 requires that the equity method be

used for:
1. Corporate joint ventures
2. Companies in which the investor’s voting stock interest
gives the investor the “ability to exercise significant
influence over operating and financial policies” of that
company
 “Significant influence” criterion – 20 percent rule
 In the absence of evidence to the contrary, an investor
holding 20 percent or more of an investee’s voting stock
is presumed to have the ability to exercise significant
influence over the investee.
2-133
The Equity Method
 Investor’s equity in the investee

 The investor records its investment at the
original cost
 This amount is adjusted periodically:
Reported by Investee Effect on Investor’s Accounts

Net income Record income from investment
Increase investment account
Net loss Record loss from investment
Decrease investment account
Dividend declaration Record asset (cash or receivable)
Decrease investment account
2-134
Example: The Equity Method
ABC Company acquires significant influence over XYZ
Company by purchasing 20 percent of the common stock of
the XYZ Company for $100,000, XYZ earns income of $60,000
and pays dividends of $20,000.
 Recognition of income
 This entry (equity accrual) is normally made as an adjusting
entry at the end of the period
 If the investee reports a loss, the investor recognizes its
share of the loss and reduces the carrying amount of the
investment by that amount

Income from XYZ Company 12,000
Record income from investment in XYZ Company ($60,000 x 0.20).
2-135
Example: The Equity Method
 Recognition of dividends
Cash 4,000
Record receipt of dividend from XYZ Company ($20,000 x 0.20).
 Carrying amount of the investment
Investment in XYZ Common Stock

Original Cost 100,000
Equity Accrual Dividends
(60,000 x 0.20) 12,000 ($20,000 x 0.20) 4,000
Ending Balance 108,000
2-136
The Equity Method
 Acquisition at Interim Date

 No income earned by the investee before the
date of acquisition may be accrued by the
investor
 Acquisition between balance sheet dates
 The amount of income earned by the investee from
the date of acquisition to the end of the fiscal period
may need to be estimated by the investor in
recording the equity accrual
2-137
The Equity Method
 Purchases of additional shares

 If the equity method was being used to account
for shares already held, the acquisition involves
adding the cost of the new shares to the
investment account and applying the equity
method from the date of acquisition forward.
 New and old investments in the same stock are
combined for financial reporting purposes.
2-138
The Equity Method
 Sale of shares
 Treated the same as the sale of any noncurrent asset
 First, the investment account is adjusted to the date of
sale for the investor’s share of the investee’s current
earnings
 Then, a gain or loss is recognized for the difference
between the proceeds received and the carrying amount
of the shares sold
 If only part of the investment is sold, the investor must
decide whether to continue using the equity method or
to change to the cost method
2-139
Under the equity method, a sub’s

dividends would:
2-140
Under the equity method, a sub’s

dividends would:
2-141
Under the equity method, a sub’s losses

would:
a. never reduce the parent’s income.
b. normally reduce the parent’s income.
c. always reduce the parent’s income.
d. always be eliminated in consolidation.
2-142
Under the equity method, a sub’s losses

would:
a. never reduce the parent’s income.
b. normally reduce the parent’s income.
c. always reduce the parent’s income.
d. always be eliminated in consolidation.
2-143

differences between the
cost and equity methods.
2-144
The Cost and Equity Methods Compared
Item Cost Method Equity Method

Recorded amount of Original cost Original Cost
investment at date of
acquisition
Usual carrying amount of Original cost Original cost increased
investment subsequent to (decreased) by investor’s share
acquisition of investee’s income (loss) and
decreased by investor’s share of
investee’s dividends
Income recognition by Investor’s share of Investor’s share of investee’s
investor investee’s dividends earnings since acquisition,
declared from earnings whether distributed or not
since acquisition
Investee dividends from Income Reduction of investment
earnings since acquisition by
investor
Investee dividends in excess Reduction of investment Reduction of investment
of earnings since acquisition
by investor
2-145
Example: Equity Method versus Cost Method
Pea Corporation created Soup Corporation with a transfer of $500 cash.
During Soup Corp.’s first year of operations, it generated a net loss of $100
and paid no dividends. During Soup Corp.’s second year of operations, it
generated net income of $200 and paid dividends of $50. What is the
balance in the Investment in Sub account on Parent’s books at the end of
year 2 using the equity method?
Investment in Sub
Beginning balance 500
Net Loss 100
Ending balance 400
Net income 200 Dividends 50
Ending balance 550
 What if Parent uses the cost method? $500 COST!!!

 What journal entries would Parent make under each method?
2-146
Summary of Year 1 Equity Method Entries
Investment in Soup Corp. 500

Cash 500
Record the initial investment in Soup Corp.
Income from Soup Corp. 100

Investment in Soup. Corp. 100
Record Pea Corp.’s 100% share of Soup Corp.’s Year 1 net loss.
Investment in Soup Corp. Income from Soup Corp.

Acquisition Price 500 Net Loss 100 Net Loss 100
Dividends 0
Ending Balance 400 Ending Balance 100
2-147
Summary of Year 2 Equity Method Entries

Record Pea Corp.’s 100% share of Soup Corp.’s Year 2 income.
Cash 50
Investment in Soup. Corp. 50
Record Pea Corp.’s 100% share of Soup Corp.’s Year 2 dividends

Beginning Balance 400
Net Income 200 Net Income 200
Dividends 50
2-148
Example: Equity versus Cost Method
Equity Method Cost Method
Investment in Soup Corp. 500 Investment in Soup Corp. 500

Cash 500 Cash 500
Income from Soup Corp. 100 No Entry

Investment in Soup Corp. 200 No Entry

Cash 50 Cash 50
Investment in Soup Corp. 50 Dividend Income 50
2-149
On 1/1/X4, Phillip invested $650,000 in Sleeper (100%

owned). For 20X4, Sleeper:
(1) earned $90,000,
(2) declared dividends of $60,000, and
(3) paid dividends of $40,000.
What amounts does Phillip report?
Cost Equity
Investment income for 20X4
Investment in Sleeper at year-end
Retained earnings increase
2-150
On 1/1/X4, Phillip invested $650,000 in Sleeper (100%

owned). For 20X4, Sleeper:
(1) earned $90,000,
What amounts does Phillip report?
Cost Equity
Investment income for 20X4 $60,000 $90,000
Investment in Sleeper at year-end $650,000 $680,000
Retained earnings increase $60,000 $90,000
2-151

using the fair value
option.
2-152
The Fair Value Option
 ASC 825-10-45 permits but does not require
companies to make fair value measurements
 Option available only for investments that are not
required to be consolidated
 Rather than using the cost or equity method to report
nonsubsidiary investments in common stock, investors
may report those investments at fair value
 The investor remeasures the investment to its fair value at
the end of each period
 The change in value is then recognized in income for the
period
 Normally the investor recognizes dividend income in the
same manner as under the cost method
2-153
Example: The Fair Value Option
Ajax Corporation purchases 40 percent of Barclay Company’s common stock on
January 1, 20X1, for $200,000. Barclay has net assets on that date with a book
value of $400,000 and fair value of $465,000. On March 1, 20X1, Ajax receives a
cash dividend of $1,500 from Barclay. On March 31, 20X1, Ajax determines the fair
value of its investment in Barclay to be $207,000. During the first quarter of 20X1,
Ajax records the following entries:
January 1, 20X1
Investment in Barclay Stock 200,000
Cash 200,000
Record purchase of Barclay Company stock.
March1, 20X1
Cash 1,500
Record dividend income from Barclay Company.
March 31, 20X1

Investment in Barclay Stock 7,000
Unrealized Gain on Increase in Value of Barclay Stock 7,000
Record increase in value of Barclay stock. 2-154

prepare basic elimination
entries for a simple
consolidation.
2-155
Overview of the Consolidation Process
 Chapter 2 introduces the most simple setting for a

consolidation.
 The subsidiary is wholly owned.
 It is either a created subsidiary or we assume it is
purchased for an amount equal to the book value of net
assets.
Wholly Owned Partially Owned

Subsidiary Subsidiary
Investment = Book Value Chapter 2 Chapter 3
Investment > Book Value Chapter 4 Chapter 5
2-156
 The objective is to combine the financial statements

of two or more entities as if they are a single
corporation.
 The consolidation worksheet facilitates the

combining of the two companies.
 Certain accounts need to be eliminated in the

consolidation process to avoid “double counting.”
 Replaces “one-line” consolidation with the “detail.”
2-157
The Consolidation Worksheet (Fig. 2-3, p. 61)
Elimination Entries
Parent Subsidiary DR CR Consolidated
Income Statement
Revenues
Expense
Expense
Net Income
Statement of Retained Earnings

Retained Earnings (1/1)
Add: Net Income
Less: Dividends
Retained Earnings (12/31)
Balance Sheet
Assets
Total Assets
Liabilities
Equity
Common Stock
Retained Earnings
Total Liabilities and Equity
2-158
 In the consolidation worksheet, the three

financial statements need to articulate.
 Net income from the income statement carries down to
the statement of retained earnings.
 The ending balance in retained earnings carries down to
the balance sheet.
 Elimination entries are entered into the

“Elimination Entries” column (debit or credit)
to eliminate any amounts that would result in
“double counting.”
2-159
The Basic Elimination Entry: The Equity Method
 What needs to be eliminated?

 The parent’s investment account
 It represents the initial investment adjusted
for the parent’s cumulative share of the
subsidiary’s income and dividends.
 The parent’s income from sub account
 The subsidiary’s equity accounts
2-160
Example: Equity Method
Pea Corporation created Soup Corporation with a transfer of $500 cash.
During Soup Corp.’s first year of operations, it generated a net loss of $100
and paid no dividends. During Soup Corp.’s second year of operations, it
generated net income of $200 and paid dividends of $50. What is the
balance in the Investment in Sub account on Parent’s books at the end of
year 2 using the equity method?
Investment in Sub
Beginning balance 500
Net Loss 100
Ending balance 400
Net income 200 Dividends 50
Ending balance 550
 What accounts need to be eliminated?

 How are they eliminated? 2-161
The Basic Elimination Entry: Equity Method
 The investment account represents the initial investment
adjusted for the parents cumulative share of the subsidiary’s
income and dividends.
 Therefore, the elimination entry eliminates:
 The subsidiary’s paid-in capital accounts (original investment)
 Beginning retained earnings (past earnings / dividends)
 The subsidiary’s current year earnings and dividends
 Generically, it looks like this:
Common Stock XXX
Additional Paid-in Capital XXX
Retained Earnings (Beginning Balance) XXX
Income from Sub XXX
Dividends Declared XXX
Investment in Sub XXX
2-162
Additional
Total = Common + Paid-In + Retained
Book Value Stock Capital Earnings
Original Book Value 400) 50 450 (100)
+ Net Income 200 200)
 Dividends (50) (50)
Ending Book Value 550 50 450 50)
Note that the “blue” numbers appear Note that this is a

in the basic elimination entry. deficit balance!
Basic Elimination Entry
Common Stock  Original amount invested (100%)
Additional Paid-in Capital  Original amount invested (100%)
Income from Soup Corp.  Soup Corp.’s reported income
Retained Earnings (BB)  Beginning balance in retained earnings
Dividends Declared  100% of Soup Corp.’s dividends
Investment in Soup Corp.  Net book value in2-163
investment account
Additional
Total = Common + Paid-In + Retained
Book Value Stock Capital Earnings
Original Book Value 400) 50 450 (100)
+ Net Income 200 200)
 Dividends (50) (50)
Ending Book Value 550 50 450 50)
Note that the “blue” numbers appear Note that this is a

in the basic elimination entry. deficit balance!
Common Stock 50  Original amount invested (100%)
Additional Paid-in Capital 450  Original amount invested (100%)
Income from Soup Corp. 200  Soup Corp.’s reported income
Retained Earnings (BB) 100  Beginning balance in retained earnings
Dividends Declared 50  100% of Soup Corp.’s dividends
Investment in Soup Corp. 550  Net book value in2-164
investment account
Basic Elimination Entry: The Equity Method
Common Stock 50
Additional Paid-in Capital 450
Retained Earnings (BB) 100
Dividends Declared 50

Beginning Balance 400
Net Income 200 Net Income 200
Dividends 50

550 Basic 200
0 0
2-165
Prepare a
consolidation
worksheet.
2-166
Worksheet: Pre-Consolidation Balances
Elimination Entries
Pea Corp. Soup Corp. DR CR Consolidated
Income Statement
Sales 1,200 600
Less: COGS (600) (300)
Less: Other Expenses (450) (100)
Net Income 350 200

Beginning Balance 150 (100)
Net Income 350 200
Less: Dividends Declared (100) (50)
Ending Balance 400 50
Balance Sheet
Cash 250 100
PP&E (net) 900 600
Total Assets 1,700 700
Liabilities 300 150

Common Stock 200 50
Additional Paid-in Capital 800 450
Retained Earnings 400 50
Total Liabilities & Equity 1,700 700
2-167
Worksheet: Draw lines
Elimination Entries
Income Statement
Sales 1,200 600
Less: COGS (600) (300)
Net Income 350 200

Beginning Balance 150 (100)
Net Income 350 200
Less: Dividends Declared (100) (50)
Balance Sheet
Cash 250 100
PP&E (net) 900 600
Liabilities 300 150

Common Stock 200 50
2-168
Worksheet: Eliminations, Sub-totals, Carry down
Elimination Entries
Income Statement
Sales 1,200 600
Less: COGS (600) (300)
Income from Soup Corp. 200 200
Net Income 350 200

Beginning Balance 150 (100) 100
Net Income 350 200
Less: Dividends Declared (100) (50) 50
Balance Sheet
Cash 250 100
Investment in Soup Corp. 550 550
PP&E (net) 900 600
Liabilities 300 150

Common Stock 200 50 50
Additional Paid-in Capital 800 450 450
2-169
Worksheet: Eliminations, Sub-totals, Carry down
Elimination Entries
Income Statement
Sales 1,200 600
Less: COGS (600) (300)
Net Income 350 200 200 0

Net Income 350 200 200 0
Ending Balance 400 50 200 150
Balance Sheet
Cash 250 100
PP&E (net) 900 600
Total Assets 1,700 700 0 550
Liabilities 300 150

Retained Earnings 400 50 200 150
Total Liabilities & Equity 1,700 700 700 150
2-170
Worksheet: Add across
Elimination Entries
Income Statement
Sales 1,200 600
Less: COGS (600) (300)
Net Income 350 200 200 0

Net Income 350 200 200 0
Balance Sheet
Cash 250 100
PP&E (net) 900 600
Total Assets 1,700 700 0 550
Liabilities 300 150

2-171
Elimination Entries
Income Statement
Sales 1,200 600 1,800
Less: COGS (600) (300) (900)
Less: Other Expenses (450) (100) (550)
Income from Soup Corp. 200 200 0
Net Income 350 200 200 0 350

Net Income 350 200 200 0
Balance Sheet
Cash 250 100
PP&E (net) 900 600
Total Assets 1,700 700 0 550
Liabilities 300 150

2-172
Elimination Entries
Income Statement
Sales 1,200 600 1,800
Less: COGS (600) (300) (900)
Net Income 350 200 200 0 350

Beginning Balance 150 (100) 100 150
Net Income 350 200 200 0 350
Less: Dividends Declared (100) (50) 50 (100)
Ending Balance 400 50 200 150 400
Balance Sheet
Cash 250 100
PP&E (net) 900 600
Total Assets 1,700 700 0 550
Liabilities 300 150

2-173
Elimination Entries
Income Statement
Sales 1,200 600 1,800
Less: COGS (600) (300) (900)
Net Income 350 200 200 0 350

Net Income 350 200 200 0 350
Ending Balance 400 50 200 150 400
Balance Sheet
Cash 250 100 350
Investment in Soup Corp. 550 550 0
PP&E (net) 900 600 1,500
Total Assets 1,700 700 0 550 1,850
Liabilities 300 150

2-174
Worksheet: Completed
Elimination Entries
Income Statement
Sales 1,200 600 1,800
Less: COGS (600) (300) (900)
Net Income 350 200 200 0 350

Net Income 350 200 200 0 350
Ending Balance 400 50 200 150 400
Balance Sheet
Cash 250 100 350
Investment in Soup Corp. 550 550 0
PP&E (net) 900 600 1,500
Total Assets 1,700 700 0 550 1,850
Liabilities 300 150 450

Common Stock 200 50 50 200
Additional Paid-in Capital 800 450 450 800
Retained Earnings 400 50 200 150 400
Total Liabilities & Equity 1,700 700 700 150 1,850
2-175
The Equity Method: Things to Remember in
Consolidation
 Consolidated net income EQUALS the
parent’s net income.
Parent Consolidated
$350 = $350
 Consolidated retained earnings EQUALS

the parent’s retained earnings.
Parent Consolidated
$400 = $400
2-176
Group Exercise 1
Elimination Entries
Pinkett, Inc. Smith, Inc. DR CR Consolidated
Income Statement
Sales 840,000 300,000 REQUIRED
Less: COGS (516,000) (156,000)
Less: Depreciation Expense (12,000) (10,000) • Assume Pinkett
Less: Other Expenses (192,000) (98,000) acquired Smith on
Income from Smith, Inc. 36,000 1/1/11
Net Income 156,000 36,000
• Prepare all
Statement of Retained Earnings elimination
Beginning Balance 132,000 72,000 entries as of
Net Income 156,000 36,000
12/31/11.
Less: Dividends Declared (108,000) (12,000)
Ending Balance 180,000 96,000
• Prepare a
consolidation
Balance Sheet
Cash 54,000 48,000 worksheet at
Accounts Receivable 114,000 66,000 12/31/11.
Inventory 204,000 90,000
Investment in Smith, Inc. 156,000 • Assume Smith’s
Property, Plant, & Equipment 336,000 210,000 accumulated
Less: Accumulated Depreciation (144,000) (30,000) depreciation on
Total Assets 720,000 384,000 1/1/11 was
$20,000.
Accounts Payable 168,000 84,000
Long-term Debt 360,000 144,000
Common Stock 12,000 60,000
Retained Earnings 180,000 96,000
Total Liabilities & Equity 720,000 384,000
2-177
Group Exercise 1
Objective:
 Eliminate equity accounts of Sub
 Eliminate equity method accounts of Parent.
Book Value Calculations
Total Common Retained
= +
Book Value Stock Earnings
Original Book Value
+ Net Income
 Dividends
Ending Book Value

Common Stock
Retained Earnings (BB)
Income from Smith, Inc.
Dividends Declared
Investment in Smith, Inc.
2-178
Objective:
 Eliminate equity accounts of Sub Note that the “blue”
 Eliminate equity method accounts of Parent. numbers appear in the
basic elimination entry.
= +
Original Book Value 132,000) 60,000 72,000
+ Net Income 36,000 36,000)
 Dividends (12,000) (12,000)
Ending Book Value 156,000 60,000 96,000)

Common Stock
Retained Earnings (BB)
Income from Smith, Inc.
Dividends Declared
Investment in Smith, Inc.
2-179
Objective:
 Eliminate equity accounts of Sub
 Eliminate equity method accounts of Parent.
= +
Original Book Value 132,000) 60,000 72,000
+ Net Income 36,000 36,000)
 Dividends (12,000) (12,000)
Ending Book Value 156,000 60,000 96,000)

Common Stock 60,000
Retained Earnings (BB) 72,000
Income from Smith, Inc. 36,000
Dividends Declared 12,000
Investment in Smith, Inc. 156,000
2-180
The optional accumulated depreciation elimination entry:
Accumulated Depreciation 20,000

Buildings and Equipment 20,000
Property, Plant & Equipment Accumulated Depreciation

210,000 20,000
2-181
The optional accumulated depreciation elimination entry:


210,000 20,000
20,000 20,000
190,000 0
Shows the Buildings and Equipment “as if” they have been
recorded on the Sub’s books as new assets at book value.
2-182
Pinkett, Smith, Elimination Entries
Inc. Inc. DR CR Consolidated
Income Statement
Sales 840,000 300,000
Less: COGS (516,000) (156,000)
Less: Depreciation Expense (12,000) (10,000)
Less: Other Expenses (192,000) (98,000)
Income from Smith, Inc. 36,000 36,000
Net Income 156,000 36,000 36,000 0

Beginning Balance 132,000 72,000 72,000
Net Income 156,000 36,000 36,000 0
Less: Dividends Declared (108,000) (12,000) 12,000
Ending Balance 180,000 96,000 108,000 12,000
Balance Sheet
Cash 54,000 48,000
Accounts Receivable 114,000 66,000
Inventory 204,000 90,000
Investment in Smith, Inc. 156,000 156,000
Property, Plant, & Equipment 336,000 210,000 20,000
Less: Accumulated Depreciation (144,000) (30,000) 20,000
Total Assets 720,000 384,000 20,000 176,000
Accounts Payable 168,000 84,000

Common Stock 12,000 60,000 60,000
Retained Earnings 180,000 96,000 108,000 12,000
Total Liabilities & Equity 720,000 384,000 168,000 12,000
2-183
Pinkett, Smith, Elimination Entries
Inc. Inc. DR CR Consolidated
Income Statement
Sales 840,000 300,000 1,140,000
Less: COGS (516,000) (156,000) (672,000)
Less: Depreciation Expense (12,000) (10,000) (22,000)
Less: Other Expenses (192,000) (98,000) (290,000)
Income from Smith, Inc. 36,000 36,000 0
Net Income 156,000 36,000 36,000 0 156,000

Beginning Balance 132,000 72,000 72,000 132,000
Net Income 156,000 36,000 36,000 0 156,000
Less: Dividends Declared (108,000) (12,000) 12,000 (108,000)
Ending Balance 180,000 96,000 108,000 12,000 180,000
Balance Sheet
Cash 54,000 48,000 102,000
Accounts Receivable 114,000 66,000 180,000
Inventory 204,000 90,000 294,000
Investment in Smith, Inc. 156,000 156,000 0
Property, Plant, & Equipment 336,000 210,000 20,000 526,000
Less: Accumulated Depreciation (144,000) (30,000) 20,000 (154,000)
Total Assets 720,000 384,000 20,000 176,000 948,000
Accounts Payable 168,000 84,000 252,000

Long-term Debt 360,000 144,000 504,000
Common Stock 12,000 60,000 60,000 12,000
Retained Earnings 180,000 96,000 108,000 12,000 180,000
Total Liabilities & Equity 720,000 384,000 168,000 12,000 948,000
2-184
Appendix 2B
Consolidation and
the Cost Method.
2-185
Consolidation Entries: Cost Method —
Pre-Consolidation Balances
Elimination Entries
Income Statement
Sales $ 1,200 $ 600
Less: COGS 600 300
Less: Expenses 450 100
Dividend Income 50
Net Income $ 200 $ 200

Beginning Balance $ 250 $ (100)
Net Income 200 200
Less: Dividends Declared 100 50
Ending Balance $ 350 $ 50
Balance Sheet
Cash $ 250 $ 100
Property, Plant, & Equipment 900 600
Total Assets $ 1,650 $ 700
Liabilities $ 300 150

Common Stock 200 50
Total Liabilities & Equity $ 1,650 700
2-186
The Basic Elimination Entry: The Cost Method
 Cost Method
 The investment account is generally exactly equal to the
sum of the subsidiary’s paid-in capital accounts.
 Unless the parent records an impairment loss.
Common Stock 50
Additional Paid-in Capital 450
 Under the cost method, we also eliminate dividends from

sub to parent.
Dividend Income 50
Dividends Declared 50
2-187
Eliminations, Sub-totals, Carry down
Elimination Entries
Income Statement
Sales $ 1,200 $ 600
Less: COGS 600 300
Dividend Income 50 50
Net Income $ 200 $ 200 50

Net Income 200 200 50
Less: Dividends Declared 100 50 50
Ending Balance $ 350 $ 50 50 50
Balance Sheet
Cash $ 250 $ 100
Investment in Sub 500 500
Property, Plant, & Equipment 900 600 0
Total Assets $ 1,650 $ 700 0 500

Total Liabilities & Equity $ 1,650 700 550 50
2-188
Complete the Worksheet
Elimination Entries
Income Statement
Sales $ 1,200 $ 600
Less: COGS 600 300
Net Income $ 200 $ 200 50

Balance Sheet
Cash $ 250 $ 100
Total Assets $ 1,650 $ 700 0 500

2-189
Elimination Entries
Income Statement
Sales $ 1,200 $ 600 $ 1,800
Less: COGS 600 300 900
Less: Expenses 450 100 550
Net Income $ 200 $ 200 50 $ 350

Balance Sheet
Cash $ 250 $ 100
Total Assets $ 1,650 $ 700 0 500

2-190
Elimination Entries
Income Statement
Sales $ 1,200 $ 600 $ 1,800
Less: COGS 600 300 900
Net Income $ 200 $ 200 50 $ 350

Beginning Balance $ 250 $ (100) $ 150
Net Income 200 200 50 350
Less: Dividends Declared 100 50 50 100
Ending Balance $ 350 $ 50 50 50 $ 400
Balance Sheet
Cash $ 250 $ 100
Total Assets $ 1,650 $ 700 0 500

2-191
Elimination Entries
Income Statement
Sales $ 1,200 $ 600 $ 1,800
Less: COGS 600 300 900
Net Income $ 200 $ 200 50 $ 350

Net Income 200 200 50 350
Ending Balance $ 350 $ 50 50 50 $ 400
Balance Sheet
Cash $ 250 $ 100 $ 350
Property, Plant, & Equipment 900 600 0 1,500
Total Assets $ 1,650 $ 700 0 500 $ 1,850

2-192
Worksheet Complete
Elimination Entries
Income Statement
Sales $ 1,200 $ 600 $ 1,800
Less: COGS 600 300 900
Net Income $ 200 $ 200 50 $ 350

Net Income 200 200 50 350
Ending Balance $ 350 $ 50 50 50 $ 400
Balance Sheet
Cash $ 250 $ 100 $ 350
Property, Plant, & Equipment 900 600 0 1,500
Total Assets $ 1,650 $ 700 0 500 $ 1,850
Liabilities $ 300 150 $ 450

Common Stock 200 50 50 200
Additional Paid-in Capital 800 450 450 800
Retained Earnings 350 50 50 50 400
Total Liabilities & Equity $ 1,650 700 550 50 $ 1,850
2-193
Group Exercise 1: Cost Method Consolidation
Elimination Entries
Income Statement
Sales $ 840,000 $ 300,000
Less: COGS (516,000) (156,000)
Less: Expenses (204,000) (108,000)
Net Income $ 132,000 $ 36,000 REQUIRED
• Prepare all consolidation
Balances, 1/1/X3 $ 60,000 $ 72,000
Add: Net Income 132,000 36,000 entries as of 12/31/X3.
Less: Dividends (108,000) (12,000)
Balances, 12/31/X3 $ 84,000 $ 96,000 • Prepare a consolidation
worksheet at 12/31/X3.
Balance Sheet
Cash $ 54,000 $ 48,000
• What is the maximum
Inventory 204,000 90,000 dividend the parent could
Investment in Sub 60,000 declare ($84,000 or
Property & Equipment 336,000 210,000
Accumulated Depreciation (144,000) (30,000) $180,000) if cash were
Total Assets $ 624,000 $ 384,000 available?
Payables & Accruals $ 168,000 84,000
Total Liabilities & Equity $ 624,000 384,000
2-194
Elimination Entries
Income Statement
Sales $ 840,000 $ 300,000
Less: COGS (516,000) (156,000)
Less: Expenses (204,000) (108,000)
Net Income $ 132,000 $ 36,000 Basic Elimination Entry
Investment elimination entry
Balances, 1/1/X3 $ 60,000 $ 72,000 Common Stock 60,000
Add: Net Income 132,000 36,000
Less: Dividends (108,000) (12,000)
Investment in
Balances, 12/31/X3 $ 84,000 $ 96,000 Sub 60,00
0
Balance Sheet
Cash $ 54,000 $ 48,000
Accounts Receivable 114,000 66,000 Dividend elimination entry
Inventory 204,000 90,000 Dividend Income 12,000
Dividend
Accumulated Depreciation (144,000) (30,000) Declared 12,00
Total Assets $ 624,000 $ 384,000 0
2-195
Solution
Elimination Entries
Income Statement
Sales $ 840,000 $ 300,000 $ 1,140,000
Less: COGS (516,000) (156,000) (672,000)
Less: Expenses (204,000) (108,000) (312,000)
Dividend Income 12,000 12,000
Net Income $ 132,000 $ 36,000 12,000 $ 156,000

Balances, 1/1/X3 $ 60,000 $ 72,000 $ 132,000
Add: Net Income 132,000 36,000 12,000 156,000
Less: Dividends (108,000) (12,000) 12,000 (108,000)
Balances, 12/31/X3 $ 84,000 $ 96,000 12,000 12,000 $ 180,000
Balance Sheet
Cash $ 54,000 $ 48,000 $ 102,000
Inventory 204,000 90,000 294,000
Investment in Sub 60,000 60,000
Property & Equipment 336,000 210,000 546,000
Accumulated Depreciation (144,000) (30,000) (174,000)
Total Assets $ 624,000 $ 384,000 60,000 $ 948,000
Payables & Accruals $ 168,000 84,000 $ 252,000

Long-term Debt 360,000 144,000 504,000
Common Stock 12,000 60,000 60,000 12,000
Total Liabilities & Equity $ 624,000 384,000 72,000 12,000 $ 948,000
2-196
The Cost Method: Things to Remember in
Consolidation
 Consolidated net income does NOT equal the parent’s net
income.
P S Sub’s Div CONS

$200 + $200  $50 = $350
 Consolidated retained earnings does NOT equal the parent’s

retained earnings.
P S CONS
$350 + $50 = $400
2-197
Consolidation: The Most Important Point of
All on Investment Basis
The consolidated statement amounts are

identical whether the parent uses the cost
method or the equity method—this holds
true for all three statements.
Equity Cost
Method Method
Consolidated = Consolidated
Statements Statements
2-198
PCO Statements: Presented in Notes to the
Consolidated Statements
 Retained Earnings Available for
Dividends:
 Based on the parent’s G/L amount—not on the
consolidated retained earnings amount.
 Use of the equity method in PCO statements
produces identical retained earnings amounts.
 Use of the cost method in PCO statements
creates confusion.
2-199
Conclusion
The End
2-200
Chapter 3
The Reporting Entity and

Consolidation of
Less-than-Wholly-Owned
Subsidiaries with No
Differential
Learning Objective 1
Understand and explain the

usefulness and limitations of
consolidated
financial statements.
3-202
 Parent creates or gains control of the subsidiary.

 The result: a single reporting entity.
P
S
3-203
Review
How do we report the results of subsidiaries?
Parent
Company
80% 51% 21%
Sub A Sub B Sub C
Consolidation Equity Method

(plus the Equity Method)
3-204
Consolidated Financial Statements
Consolidated financial statements present the

financial position and results of operations for:
 a parent (controlling entity) and
 one or more subsidiaries (controlled entities)
 as if the individual entities actually were a single
company or entity.
3-205
Benefits of Consolidated Financial Statements
 Presented primarily for those parties having a

long-run interest in the parent company:
 shareholders,
 long-term creditors, or
 other resource providers.
 Provide a means of obtaining a clear picture of the
total resources of the combined entity that are
under the parent's control.
3-206
Limitations of Consolidated Financial Statements
 Results of individual companies not

disclosed (hides poor performance).
 Financial ratios are not necessarily
representative of any single company in the
consolidation.
 Similar accounts of different companies may
not be entirely comparable.
 Information is lost any time data sets are
aggregated.
3-207
Subsidiary Financial Statements
 Creditors, preferred stockholders, and

noncontrolling common stockholders of subsidiaries
are most interested in the separate financial
statements of the subsidiaries in which they have an
interest.
 Because subsidiaries are legally separate from their
parents,
 the creditors and stockholders of a subsidiary generally
have no claim on the parent, and
 the stockholders of the subsidiary do not share in the
profits of the parent.
3-208
A primary benefit of consolidated

financial statements is that they:
a. provide information directly applicable
to the needs of regulators.
b. obscure data of individual companies.
c. present data of two or more entities that
clearly reports their individual
performance.
d. give a picture of the use of resources
under the parent’s control.
3-209

direct and indirect control
influence the
consolidation of a
subsidiary.
3-210
Concepts and Standards
 Traditional view of control includes:

 Direct control that occurs when one company
owns a majority of another company’s common
stock.
 Indirect control or pyramiding that occurs when
a company’s common stock is owned by one or
more other companies that are all under common
control.
3-211
 Ability to Exercise Control

 Sometimes, majority stockholders may not
be able to exercise control even though
they hold more than 50 percent of
outstanding voting stock.
 Subsidiary is in legal reorganization or bankruptcy
 Foreign country restricts remittance of subsidiary
profits to domestic parent company
 The unconsolidated subsidiary is reported

as an intercorporate investment.
3-212
 Differences in Fiscal Periods

 Difference in the fiscal periods of a parent and
subsidiary should not preclude consolidation.
 Often the fiscal period of the subsidiary is
changed to coincide with that of the parent.
 Another alternative is to adjust the financial
statement data of the subsidiary each period to
place the data on a basis consistent with the
fiscal period of the parent.
3-213
 Changing Concept of the Reporting Entity

 FASB 94, requiring consolidation of all majority-
owned subsidiaries, was issued to eliminate the
inconsistencies found in practice until a more
comprehensive standard could be issued.
 Completion of the FASB’s consolidation project has
been hampered by, among other things, issues
related to:
 Control
 Reporting entity
3-214
 The FASB has been attempting to move

toward a consolidation requirement for
entities under effective control.
 Ability to direct the policies of another entity
even though majority ownership is lacking.
 Even though FASB 141R indicates that
control can be achieved without majority
ownership, a comprehensive consolidation
policy has yet to be achieved.
3-215
 Defining the accounting entity would help

resolve the issue of when to prepare
consolidated financial statements and what
entities should be included.
 FASB 160 deals only with selected issues
related to consolidated financial statements,
leaving a comprehensive consolidation policy
until a later time.
3-216
P owns 60% of X and 75% of Y. If X

and Y jointly own 100% of Z, under
what circumstance would P not be
deemed to control Z?
a. Z is a bank.
b. Z’s products are largely sold overseas.
c. Z is currently in Chapter 11 bankruptcy.
d. Z has a CEO known to have a bad temper
and a serious gambling habit.
3-217

rules related to the
consolidation of variable
interest entities.
3-218
The Rise and FALL of Enron
Press Release Tuesday, October 16, 2001
ENRON REPORTS NON-RECURRING CHARGES OF $1.01

BILLION AFTER-TAX.
3-219
Special Purpose Entities
 Corporations, trusts, or partnerships created

for a single specified purpose.
 Usually have no substantive operations and
are used only for financing purposes.
 Used for several decades for asset
securitization, risk sharing, and taking
advantage of tax statutes.
3-220
Variable Interest Entities
 A legal structure used for business purposes,

usually a corporation, trust, or partnership,
that either:
 does not have equity investors that have voting
rights and share in all profits and losses of the
entity.
 has equity investors that do not provide sufficient
financial resources to support the entity’s
activities.
3-221
Enron’s Accounting “Sleight of Hand”
Special Purpose Entities (SPEs)

 What is normally the business purpose?
 Bundle peripheral activities and have them
done by an independent, but close, friend.
 Examples:
 Acquire financing for a project
 Package receivables and sell them to third parties
 What was Enron’s purpose?

 Move liabilities off the balance sheet
 Provide favorable terms for some transactions
3-222
“Raptors”
 Established by Enron CFO to provide a quick

buyer for Enron assets.
 Option 1: Find a bona fide third party.
 Can’t find anyone?
 Option 2: Establish a SPE to take the other side
of the transaction.
 Where does the financing come from?
 97% sponsoring institution
 3% third party
3-223
Example: The Chewco Raptor
A diagram of the Chewco transaction is set forth below:
3-224
Raptor’s Impact on Earnings
Raptor’s
Quarter Earnings Raptors
Impact
3Q 2000 $364 $295 $69
4Q 2000 286 (176) 462
1Q 2001 536 281 255
2Q 2001 530 490 40
3Q 2001 (210) (461) 251
Total $1,506 $429 $1,077
3-225
Variable Interest Entities (VIEs)
 As a result of the Enron collapse and other notable
scandals related to SPEs, the FASB issued Interpretation
No. 46 (FIN46) [the revised version is FIN46R].
 What is a VIE?
 An entity that either
 does not have equity investors with voting rights and a
percentage of profits and losses, OR
 has equity investors that do not provide sufficient
financial resources to support the entity’s activities.
 What is a variable interest?
 an interest that changes with changes in the VIE’s net
assets.
3-226
Variable Interest Entities
 FIN 46 (an interpretation of ARB 51) uses the

term variable interest entities to encompass SPEs
and other entities falling within its conditions.
 Does not apply to entities that are considered SPEs
under FASB 140.
 FIN 46R defines a variable interest in a VIE as a
contractual, ownership (with or without voting
rights), or other money-related interest in an
entity that changes with changes in the fair value
of the entity’s net assets exclusive of variable
interests.
3-227
Purpose of FIN46R
The main effect of Fin46R is to

capture those investment
relationships in which a
controlling financial interest is
not indicated by voting rights,
but is indicated by residual
interests in risks and benefits,
which is the conceptual
definition of ownership in CON6.
3-228
Example: Variable Interest Entities
Senior Debt Junior Debt

($85k) ($12k)
Lease Pmts. $100k

ABC Corp. Leasing Corp. Building Owner
Use of Building Building
Investor ($3k)
How would ABC Corp. typically determine whether to consolidate Leasing Corp.?
 A controlling financial interest through voting rights.
What if ABC Corp. were a related party to Investor?
What if ABC Corp. guaranteed the value of the building at the end of the lease?
What if ABC Corp. received any residual value above $100k when building sold?
3-229
Variable Interest Entities (VIEs)
Variable Interest Relationships

 Situations in which an entity receives benefits
and/or is exposed to risks similar to those
received from having a majority ownership
interest.
 Results from contractual arrangements.
3-230
VIEs: “Contractual Arrangements”
 Contractual Arrangement Types:

 Options
 Leases
 Guarantees of asset recovery values
 Guarantees of debt repayment
 Contractual arrangements may exist
simultaneously with a less than majority
ownership in a VIE.
3-231
VIEs: Most are “SPEs”
 Special Purpose Entities

 Legally structured entities to serve a specific,
predetermined, limited purpose.
 May be a corporation, partnership, trust, or some
other legal entity.
 Creator is called the “sponsor.”
 Usually thinly capitalized.
 Most commonly used for securitizations (of
receivables).
3-232
VIEs: Potential Variable Interests
 Potential Variable Interests

 Subordinated loans to a VIE.
 Equity interests in a VIE (50% or less).
 Guarantees to a VIE’s lenders or equity
holders (that reduce the true risk of these
parties).
 Written put options on a VIE’s assets held
by a VIE or its lenders or equity holders.
 Forward contracts on purchases and sales.
3-233
VIEs: The Primary Beneficiary
 The primary beneficiary of a VIE must consolidate

the VIE.
 The primary beneficiary is the entity that:
 Will absorb a majority (more than 50%) of the VIE’s
expected losses and/or
 Will receive a majority (more than 50%) of the VIE’s
expected residual returns.
 Expected losses are given more weight than expected
residual returns in certain situations.
 Only one primary beneficiary can exist for a VIE
(by definition).
3-234
Group Exercise 1: To Consolidate (or not)?
Parch Inc. and Rees Urch, Parch’s former head of R&D, formed
Sede Inc., which will perform research and development.
Sede issued 10,000 shares of common stock to Urch, who is
now Sede’s president. Parch lent $800,000 to Sede for initial
working capital in return for a note receivable that can be
converted at will into 100,000 shares of Sede’s common stock.
Parch also granted Sede a line of credit of $1,000,000.
REQUIRED
1. Is consolidation appropriate?
2. What would Parch accomplish with this arrangement?
3. If consolidation were not appropriate, what serious
reporting issue exists regarding Parch’s separate
financial statements?
3-235
On 1/1/X2, Pocahontas, Inc. invested $480,000 in

Smith (80% owned). For 20X2, Smith:
(1) earned $70,000,
What amounts does Pocahontas report?
Cost Equity
Investment income for 20X2
Investment in Smith at year-end
Retained earnings increase
3-236
On 1/1/X2, Pocahontas, Inc. invested $480,000 in

Smith (80% owned) and NCI shareholders invested
$120,000. For 20X2, Smith:
(1) earned $70,000,
What amounts does Pocahontas report for the
following items?
NCI in net income for 20X2
NCI in net assets at 12/31/X2
Parent’s retained earnings increase
3-237

differences in consolidation
rules under U.S. GAAP
and IFRS.
3-238
IFRS Differences Related to VIEs and SPEs
 U.S. GAAP and International Financial

Reporting Standards (IFRS) are rapidly
converging.
 The FASB and the IASB are working together to
remove differences in existing standards.
 They are also working jointly on all new
standards so that agreed-upon standards can be
adopted.
 Despite convergence efforts, there are still
some differences related to VIEs and SPEs.
 See Fig. 3-1 on p. 117 3-239
Key Differences between U.S. GAAP and IFRS
Topic U.S. GAAP IFRS
Determination  Normally, control is  Normally, control is determined
of Control determined by majority by majority ownership of voting
ownership of voting shares. shares.
 However, majority  In addition to voting shares,
ownership may not indicate convertible instruments and
control of a VIE. other contractual rights that
 Thus, VIE rules must be could affect control are
evaluated first in all considered.
situations.  A parent with less than 50
 The primary beneficiary percent of the voting shares
must consolidate a VIE. could have control through
 The majority shareholder contractual arrangements
consolidates most non-VIEs. allowing control of votes of the
 Control is based on direct or board of directors.
indirect voting interests.  Control over SPEs is determined
 An entity with less than 50 based on judgment and relevant
percent ownership may facts.
have “effective control”  Substance over form considered
through other contractual in determining whether an SPE
arrangements. should be consolidated.
3-240

Related Parties  Interests held by related  There is no specific provision for
parties and “de facto” agents related parties or de facto agents.
may be considered in
determining control of a VIE.
Definitions of  SPEs can be VIEs.  Considers specific indicators of
VIEs versus  Consolidation rules focus on whether an entity has control of
SPEs whether an entity is a VIE an SPE: (1) whether the SPE
(regardless of whether or conducts activities for the entity,
not it is an SPE). (2) whether the entity has
 This guidance applies only to decision-making power to obtain
legal entities. majority of benefits from the SPE,
(3) whether the entity has the
right to majority of benefits from
the SPE, and (4) whether the
entity has majority of the SPE’s
residual or risks.
 This guidance applies whether or
not conducted by a legal entity.
3-241
Disclosure  Disclosures required for  No SPE-specific disclosure
determining control of a VIE. requirements.
 Entities must disclose  There are specific disclosure
whether or not they are the requirements related to
primary beneficiary of consolidation in general.
related VIEs.
Accounting for  Owners typically share  Joint ventures can be accounted
Joint Ventures control (often with 50-50 for using either proportionate
ownership). consolidation or the equity
 If the joint venture is a VIE, method.
contracts must be  Proportionate consolidation
considered to determine reports the venturer’s share of
whether consolidation is the assets, liabilities, income, and
required. expenses on a line-by-line basis
 If the joint venture is not a based on the venturer’s financial
VIE, venturers use the equity statement line items.
method.
 Proportional consolidation
generally not permitted.
3-242
Which of the following differs

between U.S. GAAP and IFRS in the
determination of control?
a. In U.S. GAAP, control is solely based on
ownership but IFRS considers other
factors.
b. U.S. GAAP ignores direct stock
ownership, while IFRS considers it.
c. In U.S. GAAP, rules related to VIEs must
be followed, but IFRS has not specifically
addressed VIEs (only SPEs).
e. The determination of control is identical
under U.S. GAAP and IFRS..
3-243

differences in the
consolidation process when
the subsidiary is not wholly
owned.
3-244
Noncontrolling Interest
 Only a controlling interest is needed for the parent

to consolidate the subsidiary—not 100% interest.
 Shareholders of the subsidiary other than the parent
are referred to as “noncontrolling” shareholders.
 Noncontrolling interest or refers to the claim of
these shareholders on the income and net assets of
the subsidiary.
NCI Parent
<50% >50%
Sub
3-245
Noncontrolling Interest (NCI)
 What is a noncontrolling interest (NCI)?

 Voting shares not owned by the parent company
 NCI was formerly called the “Minority Interest”
Two Issues:
NCI Parent (1)Should 100% of
the financial
<50% >50% statements be
consolidated?
Sub (2) Where to report
NCI in the financial
statements?
3-246
Issue 1: Should 100% be Consolidated?
Proportional Full
Consolidation Consolidation
Percent
Consolidated?
Reports NCI
Amounts?
Complies with
US GAAP?
Relative
Complexity?
3-247
Issue 1: Should 100% be Consolidated?
 Full consolidation required by US GAAP

(100%)
 This means two special accounts appear in
consolidated statements:
 NCI in Net Income of Sub
 Like an “expense” in the consolidated income
statement
 “Reported income that doesn’t belong to us.”
 NCI in Net Assets of Sub
 Equity of unrelated owners
 “Net assets on our balance sheet not belonging to us.”
3-248
Issue 2: Where to report NCI in Net Assets?
 Old rules: Could report in in equity,

liabilities, or “no man’s land” between
liabilities and equity.
 New rules: Must report in equity
 FASB 160 makes clear that the noncontrolling
interest’s claim on net assets is an element of
equity, not a liability.
3-249
Noncontrolling Interest
 Computation of income to the

noncontrolling interest
 In uncomplicated situations, it is a simple
proportionate share of the subsidiary’s net
income
 Presentation
 FASB 160 requires that
 the term “consolidated net income” be applied to the
income available to all stockholders,
 with the allocation of that income between the
controlling and noncontrolling stockholders shown.
3-250
The noncontrolling interest in a

corporation can best be describe as:
a. a group of disinterested shareholders
who rarely vote on company issues.
b. all employees below the manager level.
c. all shareholders other than the parent
company.
d. a group of investors who plan to sell
their stock within the next twelve
months .
3-251

differences in theories of
consolidation.
3-252
Different Approaches to Consolidation
 Theories that might serve as a basis for

preparing consolidated financial statements:
 Proprietary theory
 Parent company theory
 Entity theory
 With the issuance of FASB 141R, the FASB’s
approach to consolidation now focuses on the
entity theory.
3-253
Proprietary Theory
 Views the firm as an extension of its

owners.
 Assets and liabilities of the firm are
considered to be those of the owners.
 Results in a pro rata consolidation where
the parent consolidates only its
proportionate share of a less-than-wholly
owned subsidiary’s assets, liabilities,
revenues and expenses.
3-254
Parent Company Theory
 Recognizes that though the parent does not

have direct ownership or responsibility, it
has the ability to exercise effective control
over all of the subsidiary’s assets and
liabilities, not simply a proportionate share.
 Separate recognition is given, in the
consolidated financial statements, to the
noncontrolling interest’s claim on the net
assets and earnings of the subsidiary.
3-255
Entity Theory
 Focuses on the firm as a separate economic

entity, rather than on the ownership rights
of the shareholders.
 Emphasis is on the consolidated entity itself,
with the controlling and noncontrolling
shareholders viewed as two separate
groups, each having an equity in the
consolidated entity.
3-256
Recognition of Subsidiary Income
3-257
Entity Theory
 All of the assets, liabilities, revenues, and

expenses of a less-than-wholly owned
subsidiary are included in the consolidated
financial statements, with no special
treatment accorded either the controlling or
noncontrolling interest.
3-258
Reporting Net Assets of the Subsidiary
3-259
Current Practice
 FASB 141R has significantly changed the

preparation of consolidated financial
statements subsequent to the acquisition of
less-than-wholly owned subsidiaries.
 Under FASB 141R, consolidation follows largely
an entity-theory approach.
 Accordingly, the full entity fair value increment
and the full amount of goodwill are recognized.
3-260
Current Practice
 Current approach clearly follows the entity

theory with minor modifications aimed at the
practical reality that consolidated financial
statements are used primarily by those
having a long-run interest in the parent
company.
3-261
Current consolidation practice in the

U.S. adopts the:
a. Proprietary theory.
b. Parent company theory.
c. Equity theory.
d. Entity theory.
3-262

prepare basic elimination
entries for the consolidation
of a less-than-wholly-owned
subsidiary.
3-263
Summary of differences in consolidation

Investment = No
Book Value Chapter 2 Chapter 3 Differential
Investment >
No NCI NCI
Shareholders Shareholders
3-264
Consolidation of Less-than-wholly-owned Subs
 The entity theory requires that the entity’s

entire income and value be reported.
 The subsidiary’s income is divided between the parent
(controlling interest) and the NCI shareholders.
 The subsidiary’s net assets are divided between the
parent (controlling interest) and the NCI shareholders.
 Basic elimination entry is modified to split both:
Sub Equity Accounts 100%
Income from Sub XXX
NCI in Net Income of Sub XXX
Dividends Declared by Sub 100%
Investment in Sub XXX
NCI in Net Assets of Sub XXX
3-265
The primary difference in

consolidating a less than wholly
owned subsidiary relative to a wholly
owned subsidiary is:
a. Income and net assets of the subsidiary
must be divided between the parent and
the NCI shareholders.
b. The title of the worksheet must specify
“Less than wholly owned.”
c. You only consolidate the parent’s %
ownership.
d. There is no difference.
3-266
Group Exercise 2: Basic Elimination Entry
Given the following information:
1) Photo owns 70% of Snap Photo
2) Snap’s net income for 20X4 is $160,000
3) Photo’s net income for 20X4 from its own separate operations is
70%
$500,000.
4) Snap’s declares dividends of $12,000 during 20X4.
5) Snap has 10,000 shares of $4 par stock outstanding that were Snap
originally issued at $14 per share.
6) Snap’s beginning balance in Retained Earnings for 20X4 is $120,000.
Investment Additional
Account Common Paid-in Retained
NCI (30%) (70%) = Stock Capital Earnings
Beginning Balance
+ Net Income
 Dividends
Ending Balance
3-267
3-268
Group Exercise 2: Basic Elimination Entry
Investment Additional
Account = Common Paid-in Retained
NCI (30%) (70%) Stock Capital Earnings
Beginning Balance
+ Net Income
Dividends
Ending Balance

Common Stock
Investment in Snap Add PIC – CS
Retained Earnings, BB
Income from Snap
NCI in Net Income
Dividends Declared
Investment in Snap
NCI in Net Assets
3-269
3-270
Prepare a consolidation
worksheet for a less-than-
wholly-owned
consolidation.
3-271
Consolidation of < Wholly Owned Subs
 The worksheet is modified when the parent

owns less than 100% of the subsidiary.
 The total “Net Income” is divided between:
 the noncontrolling interest (NCI shareholders) and
 the controlling interest (the parent company)
Elimination Entries
Income Statement
Sales $ 840,000 $ 300,000
Less: COGS (516,000) (156,000)
Less: Depreciation Expense (12,000) (10,000)
Income from Smith, Inc. 32,400 32,400
Net Income $ 152,400 $ 36,000 32,400
NCI in Net Income 3,600
CI In Net Income $ 152,400 $ 36,000 36,000
3-272
The primary difference in the

worksheet when consolidating a less
than wholly owned subsidiary is:
a. only the parent’s % is consolidated.
b. extra columns are added to split the
subsidiary into two or more pieces.
c. extra rows are added to divide the net
income and net assets of the sub
between the parent and NCI
shareholders xxxxx
d. there is no difference.
3-273
Group Exercise 3: Consolidation < 100%
Elimination Entries
Income Statement
Sales $ 840,000 $ 300,000
Less: COGS (516,000) (156,000)
Less: Depreciation expense (12,000) (10,000)
Net Income $ 152,400 $ 36,000
NCI in Net Income
CI in Net Income $ 152,400 $ 36,000 Assume Pinkett only purchases
90% of Smith.
Balances, 1/1/X8 $ 124,800 $ 72,000
Less: Dividends (108,000) (12,000) REQUIRED
Balances, 12/31/X8 $ 169,200 $ 96,000
Balance Sheet • Prepare an analysis of the

Cash
Accounts Receivable
$ 58,800
114,000
$ 48,000
66,000
investment for 20X8.
Inventory 204,000 90,000
• Prepare all consolidation
Property & Equipment 336,000 210,000 entries as of 12/31/X8.
Accumulated Depreciation (144,000) (30,000)
Total Assets $ 709,200 $ 384,000 • Prepare a consolidation
Payables & Accruals $ 168,000 84,000 worksheet at 12/31/X8.
NCI in Net Assets
3-274
3-275
Parent’s Subsidiary’s Equity Accounts
NCI Investment = Common Retained
(10%) Account (90%) Stock Earnings
Balances, 1/1/X8 NCI (10%) (90%) Stock Earnings
+ Net Income
 Dividends
Balances, 12/31/X8

Common Stock
Retained Earnings, BB
Income from Smith
NCI in Net Income
Dividends Declared
Investment in Smith
NCI in Net Assets
3-276
3-277
Don’t forget the accumulated depreciation elimination entry:


210,000 20,000
3-278
3-279
Elimination Entries
Income Statement
Sales $ 840,000 $ 300,000
Less: COGS (516,000) (156,000)
Less: Depreciation expense (12,000) (10,000)
Net Income $ 152,400 $ 36,000
NCI in Net Income
CI in Net Income $ 152,400 $ 36,000

Balances, 1/1/X8 $ 124,800 $ 72,000
Less: Dividends (108,000) (12,000)
Balances, 12/31/X8 $ 169,200 $ 96,000
Balance Sheet
Cash $ 58,800 $ 48,000
Inventory 204,000 90,000
Accumulated Depreciation (144,000) (30,000)
Total Assets $ 709,200 $ 384,000

NCI in Net Assets
3-280
3-281
3-282
Conclusion
The End
3-283
Chapter 4
Consolidation of
Wholly Owned
Subsidiaries Acquired at
More than Book Value
Understand and make

equity-method journal
entries related to the
differential.
4-285
Basic Concepts: Parent and Subsidiary
 Parent’s books
 Investment account initially contains the acquisition
cost
 FMV of net assets,
 Plus goodwill, or
 Minus bargain purchase price
 Parent can use the cost or equity method
 Subsidiary’s books
 Balance sheet: Assets and Liabilities are recorded at
BOOK values.
 Income statement: Expenses calculated based on
BOOK values
4-286
Basic Concepts: Parent and Subsidiary
 What happens when you consolidate the parent’s

and subsidiary’s books?
 Remember:
 The parent’s investment account is based on the actual
acquisition price.
 The sub’s books contain only historical book values.
 The parent needs to make adjustments for both
 Balance Sheet, and
 Income Statement accounts.
 Why wasn’t this a problem with created subs?
 No goodwill
 No undervalued assets at the time of creation
4-287
Basic Concepts: Income Statement Impacts
 Big Picture: Essentially, we switch the sub’s books

from BV to FMV in the consolidation process.
 Income Statement effects
Related Expense
Asset (as the asset expires)
Equipment Depreciation Expense
Inventory Cost of Goods Sold
Patent Amortization Expense
Goodwill Impairment Loss
4-288
Basic Concepts: Income Statement Impacts
 Income Statement Effects

 When Acquisition Price > Book Value
Related Expense Income Statement

Asset (as the asset expires) Effect
Inventory Cost of Goods Sold Too Low
Patent Amortization Expense (understated)
If expenses are UNDERSTATED, then income is too high (OVERSTATED).

To fix the problem, Parent needs to INCREASE expenses.
4-289
Example: Acquisition Price > Book Value
Pepper Inc., a calendar-year reporting company, acquired
100% of Salt Inc.’s outstanding common stock at a cost of
$442,500 on 12/31/X8. The analysis of the parent’s
Investment account as of the acquisition date shows:
Book value element Life remaining

Common Stock $130,000
Retained Earnings 117,000
Under- or Over-valuation
Inventory (6,500) 2 months
Land 39,000 Indefinite
Equipment 85,000 10 years
Covenant-not-to-compete 52,000 4 years
Goodwill element 26,000 Indefinite
Total Cost $442,500 4-290
Example: Acquisition Price > Book Value
Acquisition
Price = BV + Identifiable Excess + GW
442,500 = 247,000 + 169,500 + 26,000
Results for 20X9 (based on Book Values):

Reported Income $78,000
What would the Sub’s income be based on Fair

Values? $63,000
Lower COGS (because inventory is worth less) $ (6,500)
Extra depreciation on equipment 8,500
Extra amortization of contract 13,000
Total increase in expenses / decrease in income $ 15,000
4-291
Consolidation: Equity Method
The Parent’s initial investment in a sub is based

on the FMV of the sub’s net assets (+/- GW).
 Equity method entries:
 Recording share of sub’s income
 Recording share of sub’s dividends
 They should be based on the same FMV basis.
 Problem: Sub reports income based on BOOK VALUES
 Solution: Parent has to record an adjustment to the
income and investment “Equity Method” accounts.
4-292
Example: Equity Method
Results for 20X9 (based on Book Values):
Reported Income $78,000

Adjustment to Salt’s 20X9 income on Parent’s books:
Lower COGS (because inventory is worth less) $ (6,500)

Extra depreciation on equipment 8,500
Extra amortization of contract 13,000
Total increase in expenses / decrease in income $ 15,000
What entries would Pepper record in its general ledger

related to Salt’s income and dividends for 20X9 under the
equity method?
4-293
Example: Equity Method Journal Entries
1. To record 100% share of Salt’s reported income:

Investment in Salt 78,000
Income from Salt 78,000
2. To record 100% of Salt’s dividends declared:

Dividend Receivable 45,500
3. To record additional expenses (based on FMV):

4-294
Example: Equity Method Investment Adjustment
Calculate the correct ending balance in Pepper’s Investment

in Salt account using the equity method:
Called “amortization
of excess value”
Investment in Salt
Beginning Balance 442,500
Net Income 78,000
Dividend 45,500
Income Adjustment 15,000
Ending Balance 460,000
4-295
A parent charges the amortization of

its cost in excess of book value to
a. Goodwill expense.
b. Excess cost expense.
c. Excess cost & goodwill expense.
d. Income from subsidiary.
e. None of the above.
4-296
A parent charges the amortization of

its cost in excess of book value to
a. Goodwill expense.
b. Excess cost expense.
c. Excess cost & goodwill expense.
d. Income from subsidiary.
4-297

consolidation procedures
differ when there is a
differential.
4-298
Consolidation Concepts by Chapter

Investment = No
Investment >
No NCI NCI
4-299
Simple Example
Assume the BV of Sub’s net assets is $800 and that the

FMV of the net assets is $1,000. Finally, assume that the
acquisition price was $1,500. The acquisition price
consists of three parts:
Goodwill = $500 $
P
Sub
Excess value of Shareholders
Stock
identifiable
assets = $200
Book value of
net assets = $800
S
4-300
Understanding Components of Acquisition Cost
Acquisition FMV of
Price = Assets + Goodwill
FMV of Extra
Assets = BV + Value
Acquisition Extra
Price = BV + Value + Goodwill
Key: We need to keep track of each element of the

purchase price separately! Why??
4-301
The Consolidation Process
 When a subsidiary is acquired (instead of

created), the consolidation process is more
complicated:
 Must eliminate intercompany items (same).
 Must update Sub’s assets and liabilities to FMV.
 Must recognize goodwill.
4-302
Summary of Consolidation Entries
1. The basic elimination entry:

Common Stock (S) XX
Additional Paid-in Capital (S) XX
Retained Earnings, Beginning Balance (S) XX
Income from Sub XX
Investment in Sub BV
Dividends Declared XX
2. The excess value reclassification entry:
Asset 1 XX
Asset 2 XX
Goodwill XX
Investment in Sub Excess
4-303
Summary of Consolidation Entries
3. The amortized excess value reclassification entry:
Cost of Sales XX
Other Expenses XX
Income from Sub XX
This entry reclassifies the equity method amortization of

cost in excess of book from Income from Sub to the
appropriate expense accounts where the costs would have
been had the sub used FMV instead of BV.
4. The accumulated depreciation elimination entry:

Accumulated Depreciation XX
Buildings and Equipment XX
4-304
When P company pays more than the

book value of net assets of the
acquired company (S), how does the
consolidation process differ?
a. P hires an outside accountant to do the
work.
b. P tracks the excess value and records it
in the consolidation worksheet.
c. S notifies P of the excess value.
d. P and S ignore the excess amount paid.
4-305
When P company pays more than the

book value of net assets of the
acquired company (S), how does the
consolidation process differ?
a. P hires an outside accountant to do the
work.
b. P tracks the excess value and records it
in the consolidation worksheet.
c. S notifies P of the excess value.
d. P and S ignore the excess amount paid.
4-306
Make calculations and prepare

elimination entries for the
consolidation of a
wholly owned subsidiary when
there is a complex positive
differential at the
acquisition date.
4-307
Group Exercise 1: Analyzing Acquisition Costs
Prince Inc. acquired 100% of She-Ra Inc.’s outstanding common stock for
$1,600,000 cash. Divide the cost into its major elements and prepare the
consolidation entries as of the acquisition date.
Book Value Current Value Difference
Cash 60,000 60,000 -
Accounts Receivable 160,000 160,000 -
Inventory 300,000 350,000 50,000
Notes Receivable 100,000 40,000 (60,000)
Land 500,000 630,000 130,000
Buildings & Equipment 610,000 720,000 110,000
Patent 50,000 140,000 90,000
Goodwill 110,000 - (110,000)
Total Assets 1,890,000 2,100,000
Payables & Accruals 160,000 160,000 -

Long-term Debt 750,000 680,000 70,000
Total Liabilities 910,000 840,000
Common Stock 120,000 Buildings and equipment net

Additional PIC 480,000 of $98,000 accumulated
Retained Earnings 380,000 depreciation. Goodwill is from
a prior acquisition.
Total Equity 980,000 4-308
Splitting of the Investment account:
Total Cost 1,600,000
Less: BV element (CS + Add PIC + RE) (980,000)
Total Excess Cost 620,000
Analysis of the Investment account -- excess cost elements:

Under- or (over-) valuation of identifiable net assets
Inventory 50,000
Notes Receivable (60,000)
Land 130,000
Buildings & Equipment 110,000
Patent 90,000
Goodwill (110,000)
280,000
Goodwill 340,000
How would this affect your worksheet elimination
4-309 entries?
Group Exercise 1: Solution Acquisition Costs
What did we pay for? Investment in Sub
Goodwill 1,600,000
340,000
Excess value
of identifiable 280,000
1,600,000 assets
Book value of
net assets of 980,000
the acquired
firm
4-310
Group Exercise 1: Solution Investment Account
Investment in Sub
1,600,000
1. The basic elimination entry: 980,000
Additional Paid-in Capital 480,000 620,000
Investment in Sub 980,000 0
Inventory 50,000
Land 130,000
Patent 90,000
Goodwill (new) 340,000
Notes Receivable 60,000
Goodwill (old) 110,000
4-311
Group Exercise 1: Solution Worksheet Entries
Inventory 50,000
Land 130,000
Patent 90,000
Goodwill (new) 340,000
Notes Receivable 60,000
Goodwill (old) 110,000
Building and Equipment 98,000
4-312
Group Exercise 1: Solution Depreciation Entry
3. The accumulated depreciation elimination entry: The book
values at acquisition – remember the 610,000 was net of
98,000 in accumulated depreciation.
Buildings & Accumulated

Equipment Depreciation
708,000 98,000
4-313
Group Exercise 1: Solution Depreciation Entry

708,000 98,000
98,000 98,000
610,000 0
Shows the Buildings and Equipment “as if” they have been
recorded on the sub’s books as new assets at book value.
4-314
Group Exercise 1: Solution Reclass Entry

708,000 98,000
98,000 98,000
BV 610,000 0
Excess Value Reclass 110,000
FMV 720,000
The excess value reclassification elimination entry

brings the Buildings and Equipment up to fair value.
4-315
Group Exercise 2: Worksheet at Acquisition
Pepper acquired 100% of Salt’s outstanding stock for $442,500.
Required: Prepare the consolidation entries and worksheet.
Pepper, Inc. and Salt, Inc.
Consolidated Worksheet as of December 31, 20X8
Elimination Entries Consoli-
Pepper Salt DR CR dated Book Value Element:
Balance Sheet Common Stock 130,000
Cash 38,500 26,000 Retained Earnings 117,000
Inventory 136,500 104,000
Under-valuation Element:
Investment in Sub:
Book Value 247,000 Inventory (6,500)
Excess Value 195,500 Land 39,000
Land 130,000 91,000 Equipment 85,000
Build & Equipment 325,000 265,200 Covenant N-T-C 52,000
Acc Depreciation (195,000) (57,200) Goodwill 26,000
Covenant N-T-C
Goodwill
Total Assets 975,000 520,000
Payables & Accruals 104,000 78,000
Common Stock 390,000 130,000
Additional PIC
Total Liab. & Equity 975,000 520,000 4-316
Group Exercise 2: Worksheet Entries
Book Value Analysis: Investment in Salt
Pepper’s Salt’s Equity Accounts, BV
Investment = Common + Retained EB 442,500
Account, BV Stock Earnings
Balances, 12/31/X8
The Basic Elimination Entry:

Common Stock
Retained Earnings
Investment in Salt
Excess Value Analysis:

Pepper’s Salt’s Under- or (Over-) Valuation of Net Assets Element
Investment = Inventory Land Equipment Covenant Goodwill
Balances, 12/31/X8
The Excess Value Reclassification Entry:
Land The Accumulated Depreciation
Building & Equipment Elimination Entry:
Covenant N-T-C Accumulated Depreciation
Goodwill Building & Equipment
Inventory
Investment in Salt 4-317
Balances, 12/31/X8 247,000 130,000 117,000

Common Stock
Retained Earnings
Investment in Salt

Balances, 12/31/X8
Inventory
Balances, 12/31/X8 247,000 130,000 117,000

Common Stock
Retained Earnings
Investment in Salt

Balances, 12/31/X8
Inventory
Investment = Common + Retained EB 442,500 247,000 Basic
Balances, 12/31/X8 247,000 130,000 117,000


Balances, 12/31/X8
Inventory
Balances, 12/31/X8 247,000 130,000 117,000


Balances, 12/31/X8 195,500 (6,500) 39,000 85,000 52,000 26,000
Inventory
Balances, 12/31/X8 247,000 130,000 117,000


Balances, 12/31/X8 195,500 (6,500) 39,000 85,000 52,000 26,000
Inventory
195,500 Excess
Balances, 12/31/X8 247,000 130,000 117,000 Value
Reclass
Common Stock 130,000 Cons. 0

Balances, 12/31/X8 195,500 (6,500) 39,000 85,000 52,000 26,000
Land 39,000 The Accumulated Depreciation
Building & Equipment 85,000 Elimination Entry:
Covenant N-T-C 52,000 Accumulated Depreciation
Goodwill 26,000 Building & Equipment
Inventory 6,500
Investment in Salt 195,500 4-323
195,500 Excess
Balances, 12/31/X8 247,000 130,000 117,000 Value
Reclass
Common Stock 130,000 Cons. 0

Balances, 12/31/X8 195,500 (6,500) 39,000 85,000 52,000 26,000
Land 39,000 The Accumulated Depreciation
Building & Equipment 85,000 Elimination Entry:
Covenant N-T-C 52,000 Accumulated Depreciation 57,200
Goodwill 26,000 Building & Equipment 57,200
Inventory 6,500
Investment in Salt 195,500 4-324
Group Exercise 2: Worksheet at Acquisition
Pepper Salt DR CR dated
Balance Sheet
Cash 38,500 26,000
Inventory 136,500 104,000 6,500
Investment in Sub:
Book Value 247,000 247,000
Excess Value 195,500 195,500
Land 130,000 91,000 39,000
Build & Equipment 325,000 265,200 85,000 57,200
Acc Depreciation (195,000) (57,200) 57,200
Covenant N-T-C 52,000
Goodwill 26,000
Total Assets 975,000 520,000 259,200 506,200

Common Stock 390,000 130,000 130,000
Additional PIC
Retained Earnings 455,000 117,000 117,000
Total Liab. & Equity 975,000 520,000 247,000 04-325
Group Exercise 2: Worksheet at Year End
Balance Sheet
Cash 38,500 26,000 64,500
Inventory 136,500 104,000 6,500 234,000
Investment in Sub:
Book Value 247,000 247,000
Excess Value 195,500 195,500
Land 130,000 91,000 39,000 260,000
Build & Equipment 325,000 265,200 85,000 57,200 618,000
Acc Depreciation (195,000) (57,200) 57,200 (195,000)
Covenant N-T-C 52,000 52,000
Goodwill 26,000 26,000
Total Assets 975,000 520,000 259,200 506,200 1,248,000
Payables & Accruals 104,000 78,000 182,000

Long-term Debt 26,000 195,000 221,000
Common Stock 390,000 130,000 130,000 390,000
Additional PIC
4-326
Total Liab. & Equity 975,000 520,000 247,000 0 1,248,000
An account of the acquired company

that cannot be revalued to its current
value under acquisition accounting is
a. Notes receivable.
b. Bonds payable.
c. Investment in marketable securities.
d. Patents.
4-327
An account of the acquired company

that cannot be revalued to its current
value under acquisition accounting is:
a. Notes receivable.
b. Bonds payable.
c. Investment in marketable securities.
d. Patents.
4-328

consolidation
of a wholly owned subsidiary
when there is a complex
bargain-purchase
differential.
4-329
Acquired at Less than Fair Value of Net Assets
 Bargain purchase
 A business combination where the sum of
 the acquisition-date fair values of the
consideration given,
 any equity interest already held by the acquirer,
and
 any noncontrolling interest
is less than the amounts at which the identifiable
net assets must be valued at the acquisition date
as specified by ASC 805-10-20.
 The acquirer recognizes a gain for the difference.
4-330
Basic Concepts
 Income Statement Effects

 When Acquisition Price < BV
Related Expense Income Statement

Asset (as the asset expires) Effect
Inventory Cost of Goods Sold Too High
Patent Amortization Expense (overstated)
If expenses are OVERSTATED, then income is too low (UNDERSTATED).

To fix the problem, Parent needs to DECREASE expenses.
4-331
How do the elimination entries differ in a

bargain purchase scenario from an acquisition
at an amount greater than book value?
a. The differential is ignored in a bargain purchase
scenario.
b. The parent company multiplies all numbers by −1.
c. The elimination entry to reclassify expenses related
to the differential increases reported expenses.
d. The elimination entry to reclassify expenses related
to the differential decreases reported expenses.
4-332
How do the elimination entries differ in a

bargain purchase scenario from an acquisition
at an amount greater than book value?
a. The differential is ignored in a bargain purchase
scenario.
b. The parent company multiplies all numbers by −1.
c. The elimination entry to reclassify expenses related
to the differential increases reported expenses.
d. The elimination entry to reclassify expenses related
to the differential decreases reported expenses.
4-333
Prepare equity-method journal

entries, elimination entries, and
the consolidation
worksheet for a wholly owned
subsidiary when there is a
complex positive
differential.
4-334
Group Exercise 3
Pepper Inc., a calendar-year reporting company, acquired
100% of Salt Inc.’s outstanding common stock at a cost of
$442,500 on 12/31/X8. The analysis of the parent’s
Investment account as of the acquisition date shows:

Total Cost $442,500 4-335
Group Exercise 3
1. Update the Pepper Salt
Elimination Entries
DR DR
Consoli-
dated
analyses of the Income Statement
Investment Sales 1,235,000 780,000
Cost of Sales (598,000) (370,500)
account through Depreciation Expense (78,000) (19,500)
12/31/X9. S&A Expense (481,000) (312,000)
Net Income 141,000 78,000
2. Prepare all Statement of Retained Earnings
consolidation Balance, 1/1/X9
Add: Net Income
455,000
141,000
117,000
78,000
entries as of Less: Dividends (104,000) (45,500)
12/31/X9. Balance, 12/31/X9 492,000 149,500
Balance Sheet
Cash 77,500 32,500
3. Prepare a Accounts Receivable 123,500 78,000
consolidation Inventory
Investment in Salt:
149,500 156,000
worksheet at Book Value 279,500

12/31/X9. (The Excess Cost
Land
180,500
130,000 91,000
parent’s retained Build & Equip 325,000 291,200
earnings as of Acc Depreciation
Covenant N-T-C
(273,000) (76,700)
1/1/X9 were Goodwill

$455,000. Total Assets 992,500 572,000
Common Stock 390,000 130,000
Total Liab & Equity 992,500 572,000 4-336
Book Value Calculations:

Investment = Common + + Retained
Account, BV Stock Add PIC Earnings
Balances, 1/1/X9
Add: Net Income
Less Dividends
Balances, 12/31/X9
Common Stock
Retained Earnings, 1/1/X9
Income from Salt
Dividends Declared
Investment in Salt
4-337

Balances, 1/1/X9 247,000 130,000 0 117,000
Less Dividends (45,500) (45,500)
Balances, 12/31/X9 279,500 130,000 0 149,500
Common Stock
Income from Salt
Dividends Declared
Investment in Salt
4-338

Balances, 1/1/X9 247,000 130,000 0 117,000
Balances, 12/31/X9 279,500 130,000 0 149,500
Common Stock
Income from Salt
Dividends Declared
Investment in Salt
4-339

Balances, 1/1/X9 247,000 130,000 0 117,000
Balances, 12/31/X9 279,500 130,000 0 149,500

Retained Earnings, 1/1/X9 117,000
4-340
Excess Value Calculations:
Pepper’s
Investment Salt’s Under- or (Over-) Valuation of Net Assets Element
Account = Inventory Land Equipment Acc Dep Covenant Goodwill
Remaining Life Excess Cost 2 months Indefinite 10 years 4 years
Balances, 1/1/X9
Less: Amortization
Balances, 12/31/X9
The Excess Value Reclassification Entry: The Amortized Excess Value

Reclassification Entry:
Land
Building & Equipment Depreciation Expense
Covenant N-T-C S&A Expense
Goodwill Cost of Sales
Accumulated Depreciation Income from Salt
Investment in Salt
The Accumulated Depreciation
Elimination Entry:
Accumulated Depreciation
Building & Equipment
4-341
Pepper’s
Balances, 1/1/X9 195,500 (6,500) 39,000 85,000 52,000 26,000
Less: Amortization
Balances, 12/31/X9

Land
Investment in Salt
Elimination Entry:
4-342
Pepper’s
Balances, 1/1/X9 195,500 (6,500) 39,000 85,000 52,000 26,000
Less: Amortization (15,000) 6,500 0 (8,500) (13,000)
Balances, 12/31/X9

Land
Investment in Salt
Elimination Entry:
4-343
Pepper’s
Balances, 1/1/X9 195,500 (6,500) 39,000 85,000 52,000 26,000
Balances, 12/31/X9 180,500 0 39,000 85,000 (8,500) 39,000 26,000

Land
Investment in Salt
Elimination Entry:
4-344
Pepper’s
Balances, 1/1/X9 195,500 (6,500) 39,000 85,000 52,000 26,000
Balances, 12/31/X9 180,500 0 39,000 85,000 (8,500) 39,000 26,000

Land
Investment in Salt
Elimination Entry:
4-345
Pepper’s
Balances, 1/1/X9 195,500 (6,500) 39,000 85,000 52,000 26,000
Balances, 12/31/X9 180,500 0 39,000 85,000 (8,500) 39,000 26,000

Land 39,000
Building & Equipment 85,000 Depreciation Expense
Covenant N-T-C 39,000 S&A Expense
Goodwill 26,000 Cost of Sales
Accumulated Depreciation 8,500 Income from Salt
Elimination Entry:
4-346
Pepper’s
Balances, 1/1/X9 195,500 (6,500) 39,000 85,000 52,000 26,000
Balances, 12/31/X9 180,500 0 39,000 85,000 (8,500) 39,000 26,000

Land 39,000
Elimination Entry:
4-347
Pepper’s
Balances, 1/1/X9 195,500 (6,500) 39,000 85,000 52,000 26,000
Balances, 12/31/X9 180,500 0 39,000 85,000 (8,500) 39,000 26,000

Land 39,000
Building & Equipment 85,000 Depreciation Expense 8,500
Covenant N-T-C 39,000 S&A Expense 13,000
Goodwill 26,000 Cost of Sales 6,500
Accumulated Depreciation 8,500 Income from Salt 15,000
Elimination Entry:
4-348
Pepper’s
Balances, 1/1/X9 195,500 (6,500) 39,000 85,000 52,000 26,000
Balances, 12/31/X9 180,500 0 39,000 85,000 (8,500) 39,000 26,000

Land 39,000
Elimination Entry:
Building & Equipment 57,200
4-349
Group Exercise 3: Solution Investment Account
Beginning Balance:
Goodwill =
26,000 Investment in Salt
Identifiable Excess = BB 442,500
169,500 NI 78,000
45,500 Dividend
Book value = 15,000 Excess Amort.
247,000
EB 460,000
Ending Balance:
Goodwill =
26,000
Look back at the beginning and
Identifiable Excess = ending balances in the two
154,500 charts you just prepared to
Book value = find the numbers!
279,500
4-350
Notice how the worksheet entries “eliminate” Pepper’s equity method

accounts:
Investment in Salt Income from Salt

BB 442,500
NI 78,000 78,000 NI
45,500 Dividend
15,000 Excess Amort. 15,000
EB 460,000 63,000 Adj. Balance
279,500 Basic 78,000
180,500 Excess Reclass 15,000 Excess Amort.
0 0
4-351
Group Exercise 3: Completed Worksheet
Pepper Salt DR DR dated
Income Statement
Sales 1,235,000 780,000 2,015,000
Cost of Sales (598,000) (370,500) 6,500 (962,000)
Depreciation Expense (78,000) (19,500) 8,500 (106,000)
S&A Expense (481,000) (312,000) 13,000 (806,000)
Income from Salt 63,000 78,000 15,000 0
Net Income 141,000 78,000 99,500 21,500 141,000
Balance, 1/1/X9 455,000 117,000 117,000 455,000
Add: Net Income 141,000 78,000 99,500 21,500 141,000
Less: Dividends (104,000) (45,500) 45,500 (104,000)
Balance, 12/31/X9 492,000 149,500 216,500 67,000 492,000
Balance Sheet
Cash 77,500 32,500 110,000
Inventory 149,500 156,000 305,500
Investment in Salt:
Book Value 279,500 279,500 0
Excess Cost 180,500 180,500 0
Land 130,000 91,000 39,000 260,000
Build & Equip 325,000 291,200 85,000 57,200 644,000
Acc Depreciation (273,000) (76,700) 57,200 8,500 (301,000)
Covenant N-T-C 39,000 39,000
Goodwill 26,000 26,000
Total Assets 992,500 572,000 246,200 525,700 1,285,000
Long-term Debt 26,000 195,000 221,000
Common Stock 390,000 130,000 130,000 390,000
Total Liab & Equity 992,500 572,000 346,500 67,000 4-352
1,285,000

elimination of basic
intercompany transactions.
4-353
Road Map: Intercompany Transactions
 Typical intercompany transactions

 Intercompany reciprocal accounts (Chapter 4)
 Inventory transfers (Chapter 6)
 Fixed asset transfers (Chapter 7)
 Intercompany Indebtedness (Chapter 8)
4-354
Intercompany Transactions
 Questions
 Can a company pay money to itself?
 Can a company receive funds from itself?
 Answers
 All forms of intercompany receivables and payables need to be
eliminated when consolidated financial statements are prepared.
 From a single-company viewpoint, a company cannot owe itself
money.
If intercompany payables and receivables are not

eliminated, both the consolidated assets and
liabilities are overstated
by an equal amount.
4-355
Three things to think about:

1. Note receivable / payable
How would you
2. Interest revenue / expense
eliminate each item?
3. Interest receivable / payable
1. Note Payable (sub) XXX

Note Receivable (parent) XXX
2. Interest Revenue (parent) XXX

Interest Expense (sub) XXX
3. Interest Payable (sub) XXX

Interest Receivable (parent) XXX
4-356
Group Exercise 4: Intercompany Loan &
Interest
Princess Inc. owns 100% of Solo Inc.’s common stock. On
11/1/X8, Princess lent $150,000 to Solo. The loan is to be
repaid on 1/30/X9 along with $6,000 of interest. All aspects
of the intercompany transaction were properly recorded by
each company in its separate books.
Required:
1. What amounts should be reported in each company’s
separate 20X8 income statement and 12/31/X8 balance
sheet (asset and liability sections only)?
2. Prepare and post to your format the consolidation
entries as of 12/31/X8, relating only to these accounts.
4-357
Intercompany income statement

accounts are eliminated in consolidation
because they are deemed to be
a. artificial transactions.
b. potentially manipulative transactions.
c. internal transactions.
d. at amounts that are not determined
on arms-length basis.
4-358
Intercompany income statement

accounts are eliminated in consolidation
because they are deemed to be
a. artificial transactions.
b. potentially manipulative transactions.
c. internal transactions.
d. at amounts that are not determined
on arms-length basis.
4-359
In 20X8, Scott incurred $90,000 of inter-

company interest charges. Of this amount,
Scott paid $70,000 cash to its parent and
capitalized $40,000 to a discrete
construction project. The unrealized
intercompany profit at 12/31/X8 is
a. $0.
b. $10,000.
c. $20,000.
d. $30,000.
e. $40,000.
4-360
In 20X8, Scott incurred $90,000 of inter-

company interest charges. Of this amount,
Scott paid $70,000 cash to its parent and
capitalized $40,000 to a discrete
construction project. The unrealized
intercompany profit at 12/31/X8 is
a. $0.
b. $10,000.
c. $20,000.
d. $30,000.
e. $40,000.
4-361

basics of push-down
accounting.
4-362
Purchase Price > Book Value
 What happens if you pay more

than the book value of the
subsidiary’s assets?
 This is the case MOST of the time! Parent
 Parent has two options:

 Push-Down Accounting
 Force Sub to revalue to FMV Sub
 Non-Push-Down Accounting
 Account for the “extra” value
separately.
4-363
Push-Down Accounting: The EASIER Way
 Push-Down Accounting (an absolute gem)

 In the subsidiary’s general ledger:
 Adjust assets and liabilities to FV
based on the parent’s acquisition price.
 This establishes a new basis of accounting.
 Record goodwill.
 Record “Revaluation Capital” for the difference
A = L + E Revaluation Capital
X
4-364
Nonpush-Down Accounting: The HARDER Way
 Non-Push-Down Accounting:
 Don’t touch the subsidiary’s general ledger
(treat like a “sacred cow”).
 Make fair value adjustments and record
goodwill in consolidation (on the
worksheets).
4-365
Consolidation Consequences: Push-Down vs.
Non-Push-Down
 Push-down accounting:
 Consolidation effort is minimal (has received the
“Better Bookkeeping” stamp of approval).
 Non-push-down accounting:
 Consolidation effort is cumbersome (often a
headache).
 The consolidated financial statement amounts
are the SAME either way!
 ONLY the accounting procedures differ
 Who does the work– parent or sub?
4-366
Parent’s Amortization of Cost in Excess of
Book Value: How Handled?
 Non-push-down accounting
 Equity Method
 Recorded in parent’s general ledger
 Maintains built-in checking features
 Cost Method
 Recorded on consolidation worksheets
 Push-down accounting
 Parent has no amortization – sub records
the amortization
4-367
Actually, these numbers are only part of

the consolidated financial statements.
Non-push-down Accounting Push-down Accounting
Sub’s
Income Statement
(Based on
+ Parent’s
= Sub’s
Income Statement
(Based on
Book Values) Adjustments Fair Values)
For
Excess
Value
Sub’s (Consolidation Sub’s
Balance Sheet Process) Balance Sheet
(Based on
Book Values)
+ = (Based on
Fair Values)
4-368
Postacquisition Subsidiary Earnings: Reportable
Earnings Under Acquisition Method
 ONLY the subsidiary’s postacquisition earnings

are reported in the consolidated financial
statements.
 For a mid-year acquisition, only consolidate earnings
after the acquisition date.
 The same is true for dividends declared.
 The subsidiary’s preacquisition earnings
(included in its retained earnings account) are
always eliminated against the parent’s
Investment account in consolidation.
4-369
A parent records amortization of

excess value under which method?
a. Push-down basis of accounting.
b. Non-push down basis of accounting.
c. Both A and B.
d. None of the above.
4-370
A parent records amortization of

excess value under which method?
a. Push-down basis of accounting.
b. Non-push down basis of accounting.
c. Both A and B.
4-371
Push-down-accounting can be used

a. only in a goodwill situation.
b. only in a bargain purchase situation.
c. in either a goodwill situation or a
bargain purchase situation.
d. only in a cost = book value situation.
4-372
Push-down-accounting can be used

a. only in a goodwill situation.
b. only in a bargain purchase situation.
c. in either a goodwill situation or a
bargain purchase situation.
d. only in a cost = book value situation.
4-373
The consolidated financial statements are

identical regardless of whether the parent
a. uses push-down or non-push-down
accounting.
b. acquires 100% of the common stock or
100% of the assets.
c. Both A and B.
d. Neither A or B.
4-374
The consolidated financial statements are

identical regardless of whether the parent
a. uses push-down or non-push-down
accounting.
b. acquires 100% of the common stock or
100% of the assets.
c. Both A and B.
d. Neither A or B.
4-375
Conclusion
The End
4-376
Chapter 5
Consolidation of
Less-than-Wholly-Owen
Subsidiaries Acquired at
More than Book Value

the consolidation process
differs when the subsidiary
is less-than-wholly owned
and there is a differential.
5-378
Differences in Consolidation in Chapter 5

Investment = No
Investment >
No NCI NCI
5-379
Partial Ownership Example
Assume Parent owns land with a book value of $400,000.
Parent’s 80%-owned subsidiary also owns land. At the time of
the acquisition, Sub’s land has a FMV of $100,000 and a book
value of $61,000. Thus, the land has excess value of $39,000.
Issue
Should Parent revalue NCI Parent
the land by the full
20% 80%
$39,000 in
consolidation or only
its share of the excess Sub
value ($31,200)?
5-380
Partial Ownerships: Partial or Full Valuation?
 We learned earlier that full consolidation is

required, as opposed to partial consolidation.
 Thus, we consolidate 100% of the sub.
 This, however, refers to the BV of the subsidiary.
 What about revaluation of assets to FMV?
 The extent of revaluation of undervalued assets
and goodwill can vary.
 Parent Company Concept: Partial valuation
 Entity Concept: Full valuation
5-381
Partial Ownership Example
Parent Company Entity
Concept Concept
Parent Sub DR CR Consolidated
Land $400,000 $61,000 $31,200 $492,200
Parent Sub DR CR Consolidated
Land $400,000 $61,000 $39,000 $500,000
 Both were used in the NCI Parent

past.
20% 80%
 ASC 805 requires the
Entity Concept.
Sub
5-382
Partial Ownership: Undervalued Assets & GW
 How much to revalue the Subsidiary’s

undervalued assets and goodwill?
 Parent company concept: < 100% of FMV
 Revalued only to the extent of the parent’s
percent ownership
 Entity concept: 100% of FMV
 The offsetting credit for the additional
valuation increases the NCI in net assets
5-383
Under which concept is goodwill

assigned to the noncontrolling
interest for consolidated financial
reporting purposes?
a. The entity concept.
b. The parent company concept.
c. Both a and b.
5-384
Under which concept is goodwill

assigned to the noncontrolling
interest for consolidated financial
reporting purposes?
a. The entity concept.
b. The parent company concept.
c. Both a and b.
5-385

prepare elimination entries
for the consolidation of a
partially owned subsidiary
when there is a complex
positive differential.
5-386
Group Exercise 1: 80% Acquisition
Pepper Inc., a calendar-year reporting company, acquired 80%
of Salt Inc.’s outstanding common stock for $354,000 on
12/31/X8 when the fair value of Salt’s net assets was $422,500.
The following data summarize the fair value calculation:

Total Cost $442,500 5-387
Group Exercise 1: 80% Acquisition
1. Prepare an Pepper, Inc. and Salt, Inc.
analysis of the Elimination Entries Consoli-
Investment Pepper Salt DR CR dated
account through Balance Sheet
12/31/X8. Cash 127,000 26,000
2. Prepare all Inventory 136,500 104,000
Investment in Salt:
consolidation Book Value 197,600
entries as of Excess Cost 156,400
12/31/X8. Land 130,000 91,000
Building & Equipment 325,000 265,200
3. Prepare a Acc Depreciation (195,000) (57,200)
consolidation Covenant N-T-C
Goodwill
worksheet at Total Assets 975,000 520,000
12/31/X8. Payables & Accruals 104,000 78,000
4. What amount of Common Stock 390,000 130,000
income does Retained Earnings 455,000 117,000
Pepper report for NCI in NA of Salt
20X8? Total Liab & Equity 975,000 520,000
5-388

Salt’s Equity Accounts, BV
NCI’s 20% Pepper’s 80% = Common + Retained
Share of BV Share of BV Stock Earnings
Balances, 12/31/X8

Common Stock
Retained Earnings
Investment in Salt
NCI in NA in Salt
5-389

Balances, 12/31/X8 49,400 197,600 130,000 117,000

Common Stock
Retained Earnings
Investment in Salt
NCI in NA in Salt
5-390

Balances, 12/31/X8 49,400 197,600 130,000 117,000

Common Stock
Retained Earnings
Investment in Salt
NCI in NA in Salt
5-391

Balances, 12/31/X8 49,400 197,600 130,000 117,000

NCI in NA in Salt 49,400
5-392
NCI’s 20% Pepper’s 80% Salt’s Under- or (Over-) Valuation of Net Assets
Share of Share of =
Excess Value Excess Value Inventory Land Equipment Covenant Goodwill
Balances, 12/31/X8

The Excess Value Reclassification Entry: Elimination Entry:
Land Accumulated Depreciation
Building & Equipment Building & Equipment
Covenant N-T-C
Goodwill
Inventory
Investment in Salt
NCI in NA of Salt
5-393
Share of Share of =
Balances, 12/31/X8 39,100 156,400 (6,500) 39,000 85,000 52,000 26,000

Covenant N-T-C
Goodwill
Inventory
Investment in Salt
NCI in NA of Salt
5-394
Share of Share of =
Balances, 12/31/X8 39,100 156,400 (6,500) 39,000 85,000 52,000 26,000

Covenant N-T-C
Goodwill
Inventory
Investment in Salt
NCI in NA of Salt
5-395
Share of Share of =
Balances, 12/31/X8 39,100 156,400 (6,500) 39,000 85,000 52,000 26,000

Land 39,000 Accumulated Depreciation
Building & Equipment 85,000 Building & Equipment
Goodwill 26,000
Inventory 6,500
NCI in NA of Salt 39,100
5-396
Share of Share of =
Balances, 12/31/X8 39,100 156,400 (6,500) 39,000 85,000 52,000 26,000

Land 39,000 Accumulated Depreciation 57,200
Building & Equipment 85,000 Building & Equipment 57,200
Goodwill 26,000
Inventory 6,500
5-397
Balance Sheet
Cash 127,000 26,000
Inventory 136,500 104,000 6,500
Investment in Salt:
Book Value 197,600 197,600
Excess Cost 156,400 156,400
Land 130,000 91,000 39,000
Building & Equipment 325,000 265,200 85,000 57,200
Acc Depreciation (195,000) (57,200) 57,200
Goodwill 26,000
Total Assets 975,000 520,000 259,200 417,700
Common Stock 390,000 130,000 130,000
Retained Earnings 455,000 117,000 117,000
39,100
Total Liab & Equity 975,000 520,000 247,000 88,500
5-398
Balance Sheet
Cash 127,000 26,000 153,000
Inventory 136,500 104,000 6,500 234,000
Investment in Salt:
Book Value 197,600 197,600
Excess Cost 156,400 156,400
Land 130,000 91,000 39,000 260,000
Building & Equipment 325,000 265,200 85,000 57,200 618,000
Acc Depreciation (195,000) (57,200) 57,200 (195,000)
Covenant N-T-C 52,000 52,000
Goodwill 26,000 26,000
Total Assets 975,000 520,000 259,200 417,700 1,336,500
Long-term Debt 26,000 195,000 221,000
Common Stock 390,000 130,000 130,000 390,000
NCI in NA of Salt 49,400 88,500
39,100
Total Liab & Equity 975,000 520,000 247,000 88,500 1,336,500
5-399
How Do the Elimination Entries Change?
Common Stock (S) XXX
Additional Paid-in Capital (S) XXX
Retained Earnings, Beginning Balance (S) XXX
Income from Sub % NI
NCI in NI of Sub % NI
Investment in Sub % BV
NCI in NA of Sub % BV
Asset 1 XXX
Asset 2 XXX
Goodwill XXX
Investment in Sub % Excess
NCI in NA of Sub % Excess
5-400
How Do the Elimination Entries Change?
3. The amortized excess value reclassification entry:
Cost of Sales XXX

Other Expenses XXX
Income from Sub % Adj.
NCI in NI of Sub % Adj.
This entry reclassifies the equity method amortization of cost in
excess of book from Income from Sub to the appropriate expense
accounts where the costs would have been had the Sub used FMV
instead of BV.
Accumulated Depreciation XXX

Building & Equipment XXX
Acquisition
Date
5-401
Group Exercise 2: 80% End of First Year
Continuation of Income Statement
Exercise 1 Sales
Cost of Sales
1,235,000
(598,000)
780,000
(370,500)
Depreciation Expense (78,000) (19,500)
1. Update the S&A Expense
Income from Salt
(481,000)
50,400
(312,000)
analysis of Net Income 128,400 78,000
the NCI in Net Income

CI in Net Income 128,400 78,000
Investment Statement of Retained Earnings
Balance, 1/1/X9 455,000 117,000
account Add: Net Income 128,400 78,000
through Less: Dividends
Balance, 12/31/X9
(104,000)
479,400
(45,500)
149,500
12/31/X9. Balance Sheet
Cash 156,900 32,500
2. Prepare the Inventory 149,500 156,000
consolidation Investment in Salt:
Book Value 223,600
entries as of Excess Cost 144,400
12/31/X9. Land
130,000
325,000
91,000
291,200
Acc Depreciation (273,000) (76,700)
Covenant N-T-C
3. Prepare a Goodwill
consolidation Total Assets
Payables & Accruals
979,900
84,500
572,000
97,500
worksheet at Long-term Debt 26,000 195,000
12/31/X9. Common Stock
Retained Earnings
390,000
479,400
130,000
149,500
NCI in Net Assets
Total Liab & Equity 979,900 572,000 5-402

NCI’s Pepper’s Salt’s Equity Accounts, BV
20% Share 80% Share = Common + Retained
of BV of BV Stock Earnings
Balances, 1/1/X9
Add: NI from Salt
Less Dividends
Balances, 12/31/X9
Common Stock
Income from Salt
NCI in NI of Salt
Dividends Declared
Investment in Salt
NCI in NA of Salt
5-403

Balances, 1/1/X9 49,400 197,600 130,000 117,000
Add: NI from Salt 15,600 62,400 78,000
Less Dividends (9,100) ( 36,400) ( 45,500)
Balances, 12/31/X9 55,900 223,600 130,000 149,500
Common Stock
Income from Salt
NCI in NI of Salt
Dividends Declared
Investment in Salt
NCI in NA of Salt
5-404

Balances, 1/1/X9 49,400 197,600 130,000 117,000
Add: NI from Salt 15,600 62,400 78,000
Less Dividends (9,100) ( 36,400) ( 45,500)
Balances, 12/31/X9 55,900 223,600 130,000 149,500
Common Stock
Income from Salt
NCI in NI of Salt
Dividends Declared
Investment in Salt
NCI in NA of Salt
5-405

Balances, 1/1/X9 49,400 197,600 130,000 117,000
Add: NI from Salt 15,600 62,400 78,000
Less Dividends (9,100) ( 36,400) ( 45,500)
Balances, 12/31/X9 55,900 223,600 130,000 149,500

Retained Earnings, 1/1/X9 117,000
NCI in NI of Salt 15,600
5-406
NCI’s Pepper’s
20% 80% Salt’s Under- or (Over-) Valuation of Net Assets Element
Share of Share of = Inventory Land Equipment Acc Dep Covenant Goodwill
Remaining Life Excess Value Excess Value 2 months Indefinite 10 years 4 years
Balances, 1/1/X9
Less: Amortization
Balances, 12/31/X9

Land
Investment in Salt NCI in NI of Salt
NCI in NA of Salt The Accumulated Depreciation
Elimination Entry:
5-407
NCI’s Pepper’s
Balances, 1/1/X9 39,100 156,400 (6,500) 39,000 85,000 52,000 26,000
Less: Amortization ( 3,000) ( 12,000) 6,500 0 (8,500) (13,000)
Balances, 12/31/X9 36,100 144,400 0 39,000 85,000 (8,500) 39,000 26,000

Land
Elimination Entry:
5-408
NCI’s Pepper’s
Balances, 1/1/X9 39,100 156,400 (6,500) 39,000 85,000 52,000 26,000
Balances, 12/31/X9 36,100 144,400 0 39,000 85,000 (8,500) 39,000 26,000

Land
Elimination Entry:
5-409
NCI’s Pepper’s
Balances, 1/1/X9 39,100 156,400 (6,500) 39,000 85,000 52,000 26,000
Balances, 12/31/X9 36,100 144,400 0 39,000 85,000 (8,500) 39,000 26,000

Land 39,000
Investment in Salt 144,400 NCI in NI of Salt
NCI in NA of Salt 36,100 The Accumulated Depreciation
Elimination Entry:
5-410
NCI’s Pepper’s
Balances, 1/1/X9 39,100 156,400 (6,500) 39,000 85,000 52,000 26,000
Balances, 12/31/X9 36,100 144,400 0 39,000 85,000 (8,500) 39,000 26,000

Land 39,000
Investment in Salt 144,400 NCI in NI of Salt
Elimination Entry:
5-411
NCI’s Pepper’s
Balances, 1/1/X9 39,100 156,400 (6,500) 39,000 85,000 52,000 26,000
Balances, 12/31/X9 36,100 144,400 0 39,000 85,000 (8,500) 39,000 26,000

Land 39,000
Investment in Salt 144,400 NCI in NI of Salt 3,000
Elimination Entry:
5-412
NCI’s Pepper’s
Balances, 1/1/X9 39,100 156,400 (6,500) 39,000 85,000 52,000 26,000
Balances, 12/31/X9 36,100 144,400 0 39,000 85,000 (8,500) 39,000 26,000

Land 39,000
Investment in Salt 144,400 NCI in NI of Salt 3,000
Elimination Entry:
Building & Equipment 57,200
5-413
Beginning Balance:
Goodwill =
20,800 Investment in Salt
Identifiable Excess = BB 354,000
135,600 80%
NI 62,400 36,400 80% Dividend
Book value = 12,000 Excess Amort.
197,600 80%
EB 368,000
Ending Balance:
Goodwill =
20,800
Identifiable Excess =
123,600
Book value =
223,600
5-414
Notice how the worksheet entries “eliminate” Pepper’s equity method

accounts:
Investment in Salt Income from Salt

BB 354,000
80% NI 62,400 62,400 80% NI
36,400 80% Dividend
12,000 Excess Amort. 12,000
EB 368,000 80% 50,400 Adj. Balance
223,600 Basic 62,400
144,400 Excess Reclass 12,000 Excess Amort.
0 0
5-415
Income Statement
Sales 1,235,000 780,000
Cost of Sales (598,000) (370,500)
Depreciation Expense (78,000) (19,500)
S&A Expense (481,000) (312,000)
Net Income 128,400 78,000
NCI in Net Income
CI in Net Income 128,400 78,000
Balance, 1/1/X9 455,000 117,000
Less: Dividends (104,000) (45,500)
Balance, 12/31/X9 479,400 149,500
Balance Sheet
Cash 156,900 32,500
Inventory 149,500 156,000
Investment in Salt:
Book Value 223,600
Excess Cost 144,400
Land 130,000 91,000
Covenant N-T-C
Goodwill
Total Assets 979,900 572,000
Common Stock 390,000 130,000
NCI in Net Assets
Total Liab & Equity 979,900 572,000

5-416

Income Statement
Sales 1,235,000 780,000 2,015,000
Cost of Sales (598,000) (370,500) 6,500 (962,000)
S&A Expense (481,000) (312,000) 13,000 (806,000)
Income from Salt 50,400 62,400 12,000
Net Income 128,400 78,000 83,900 18,500 141,000
NCI in Net Income 15,600 3,000 (12,600)
CI in Net Income 128,400 78,000 99,500 21,500 128,400
5-417
Income Statement
Sales 1,235,000 780,000
Cost of Sales (598,000) (370,500) 6,500
Depreciation Expense (78,000) (19,500) 8,500
S&A Expense (481,000) (312,000) 13,000
Income from Salt 50,400 62,400 12,000
Net Income 128,400 78,000 83,900 18,500
NCI in Net Income 15,600 3,000
CI in Net Income 128,400 78,000 99,500 21,500
Balance, 1/1/X9 455,000 117,000 117,000
Add: Net Income 128,400 78,000 99,500 21,500
Less: Dividends (104,000) (45,500) 45,500
Balance, 12/31/X9 479,400 149,500 216,500 67,000
Balance Sheet
Cash 156,900 32,500
Inventory 149,500 156,000
Investment in Salt:
Book Value 223,600 223,600
Excess Cost 144,400 144,400
Land 130,000 91,000 39,000
Building & Equipment 325,000 291,200 85,000 57,200
Acc Depreciation (273,000) (76,700) 57,200 8,500
Goodwill 26,000
Total Assets 979,900 572,000 246,200 433,700
Common Stock 390,000 130,000 130,000
NCI in Net Assets 55,900
36,100
Total Liab & Equity 979,900 572,000 346,500 5-418
Income Statement
Sales 1,235,000 780,000 2,015,000
Cost of Sales (598,000) (370,500) 6,500 (962,000)
S&A Expense (481,000) (312,000) 13,000 (806,000)
Income from Salt 50,400 62,400 12,000
Net Income 128,400 78,000 83,900 18,500 141,000
NCI in Net Income 15,600 3,000 (12,600)
CI in Net Income 128,400 78,000 99,500 21,500 128,400
Balance, 1/1/X9 455,000 117,000 117,000 455,000
Add: Net Income 128,400 78,000 99,500 21,500 128,400
Less: Dividends (104,000) (45,500) 45,500 (140,000)
Balance, 12/31/X9 479,400 149,500 216,500 67,000 479,400
Balance Sheet
Cash 156,900 32,500 189,400
Inventory 149,500 156,000 305,500
Investment in Salt:
Book Value 223,600 223,600
Excess Cost 144,400 144,400
Land 130,000 91,000 39,000 260,000
Covenant N-T-C 39,000 39,000
Goodwill 26,000 26,000
Total Assets 979,900 572,000 246,200 433,700 1,364,400
Long-term Debt 26,000 195,000 221,000
Common Stock 390,000 130,000 130,000 390,000
NCI in Net Assets 55,900 92,000
36,100
Total Liab & Equity 979,900 572,000 346,500 1,364,400 5-419
Understand and explain what

happens when a parent
company ceases to consolidate
a subsidiary.
5-420
Discontinuance of Consolidation
 A parent should stop consolidating a

subsidiary if it can no longer exercise
control.
 Two possible scenarios:
 The parent loses control of a subsidiary and
no longer holds an equity interest.
 The parent loses control but still holds an
equity interest.
5-421
Parent No Longer Holds an Equity Interest
 If a parent loses control of a subsidiary

and no longer holds an equity interest in
the former subsidiary,
 Parent recognizes a gain or loss for the
difference between
 any proceeds received from the event leading
to loss of control, and
 the carrying amount of the parent’s equity
interest.
5-422
Example: Parent No Longer Holds an Equity
Interest
Assume that on December 31, 20X9, Pepper’s Investment in
Salt account has a balance of $368,000. Also assume that
Pepper’s 80% interest in Salt has a fair value of $410,000. On
January 1, 20X0, Pepper sells all of its Salt shares for
$400,000. How should Pepper account for this transaction?
Sale proceeds $400,000

Less: Carrying value of the investment (368,000)
Gain on sale $32,000
Cash 400,000
Gain on sale 32,000
5-423
Parent Maintains an Equity Interest
 If the parent loses control but maintains a

noncontrolling equity interest in the former
subsidiary,
 Parent must recognize a gain or loss for the
difference, at the date control is lost, between:
 the sum of any proceeds received by the parent and
the fair value of its remaining equity interest in the
former subsidiary, and
 the carrying amount of the parent’s total interest in
the subsidiary.
5-424
Example: Parent Maintains an Equity Interest
Assume that on December 31, 20X9, Pepper’s Investment in Salt
account has a balance of $368,000. Also assume that Pepper’s
80% interest in Salt has a fair value of $410,000. On January 1,
20X0, Pepper sells half (remaining 40%) of Salt’s shares for
$200,000. How should Pepper account for this transaction?
Investment in Salt
Sale proceeds $200,000 368,000
Plus: Fair value of remaining investment 205,000 163,000
$405,000
Less: Entire carrying value of investment (368,000) 205,000
Gain on Sale $37,000
Remaining
interest
revalued at
Cash 200,000 fair value
Gain on Sale 37,000
5-425
Paul Corp. owns 90% of Sam Inc.’s

outstanding common stock. The
carrying value of the investment in
Sam is $170,000 and the fair value of
this investment is $250,000. Paul sells
all of its Sam Inc. shares for $200,000
and records a gain of
a. $30,000.
b. $50,000.
c. $70,000.
d. $170,000.
5-426

all of its Sam Inc. shares for $200,000
and records a gain of
a. $30,000 ($200,000 - $170,000).
b. $50,000.
c. $70,000.
d. $170,000.
5-427

half of its Sam Inc. shares for
$130,000 and records a gain of
a. $30,000.
b. $50,000.
c. $85,000.
d. $170,000.
5-428

half of its Sam Inc. shares for
$130,000 and records a gain of
a. $30,000.
b. $50,000.
c. $85,000.
d. $170,000.
5-429

outstanding common stock. The carrying
value of the investment in Sam is $170,000
and the fair value of this investment is
$250,000. Paul sells half of its Sam Inc.
shares for $130,000. What is the carrying
amount of the remaining shares?
a. $85,000
b. $125,000
c. $170,000
d. $250,000
5-430

outstanding common stock. The carrying
value of the investment in Sam is $170,000
and the fair value of this investment is
$250,000. Paul sells half of its Sam Inc.
shares for $130,000. What is the carrying
amount of the remaining shares?
a. $85,000
b. $125,000
c. $170,000
d. $250,000
5-431
Practice Quiz Question #s 3-4 Solutions
Paul Corp. Owns 90% of Sam Inc.’s outstanding common
stock. The carrying value of the investment in Sam is
$170,000, and the fair value of this investment is $250,000.
Paul sells half of its Sam Inc. shares for $130,000.
Investment in Sam
Sale proceeds $130,000 170,000
Plus: Fair value of remaining investment 125,000 45,000
$255,000
Less: Entire carrying value of investment (170,000) 125,000
Gain on Sale $85,000
Remaining
interest
revalued at
Cash 130,000 fair value
Investment in Sam 45,000
Gain on Sale 85,000
5-432

consolidation of a
when there is a complex positive
differential and other
comprehensive income.
5-433
Treatment of Other Comprehensive Income
 ASC 220-10-55 requires that companies

separately report other comprehensive
income.
 Includes revenues, expenses, gains, and losses that
under GAAP are excluded from net income.
 Other comprehensive income accounts are temporary
accounts that are closed at the end of each period to a
special stockholders’ equity account, Accumulated
Other Comprehensive Income.
 The consolidation worksheet normally includes an
additional section at the bottom for other
5-434
Group Exercise 3: 80% with OCI
Assume that during 20X9, Salt purchases $10,000 of
investments classified as available-for-sale. By December 31,
20X9, the fair value of the securities increases to $30,000. Other
than the effects of accounting for Salt’s investment in securities,
the financial information reported at December 31, 20X9, is
identical to that presented in the previous examples.
Adjusting entry recorded by Salt:
Investment in Available-for-Sale Securities 20,000

Unrealized Gain on Investments (OCI) 20,000
Adjusting entry recorded by Pepper:

Other Comprehensive Income from Salt—
Unrealized Gain on Investments (OCI) 16,000
5-435
Group Exercise 3: 80% with OCI
Other comprehensive income entry:

OCI from Salt 16,000
OCI to NCI 4,000
5-436
Balance Sheet
Cash 156,900 22,500
Inventory 149,500 156,000
Investment in AFS Securities 30,000
Investment in Salt:
Book Value 239,600
Excess Cost 144,400
Land 130,000 91,000

Covenant N-T-C
Goodwill
Total Assets 995,900 592,000
Common Stock 390,000 130,000
Accumulated OCI, 12/31/X9 16,000 20,000
NCI in NA of Salt
Other Comprehensive Income

Accumulated OCI, 1/1/X9 0 0
OCI from Salt 16,000
Unrealized Gain on Investments 20,000
Other Comprehensive Income to NCI
Accumulated OCI, 12/31/X9 16,000 20,000 5-437
Balance Sheet
Cash 156,900 22,500 179,400
Inventory 149,500 156,000 305,500
Investment in AFS Securities 30,000 30,000
Investment in Salt:
Book Value 239,600 223,600
Excess Cost 144,400 144,400
16,000
Land 130,000 91,000 39,000 260,000
Covenant N-T-C 39,000 39,000
Goodwill 26,000 26,000
Total Assets 995,900 592,000 246,200 449,700 1,384,400
Long-term Debt 26,000 195,000 221,000
Common Stock 390,000 130,000 130,000 390,000
Accumulated OCI, 12/31/X9 16,000 20,000 20,000 0 16,000
NCI in NA of Salt 55,900 96,000
36,100
4,000
Total Liab & Equity 995,900 592,000 366,500 159,000 1,384,400

Accumulated OCI, 1/1/X9 0 0 0
OCI from Salt 16,000 16,000 0
Unrealized Gain on Investments 20,000 20,000
Other Comprehensive Income to NCI 4,000 (4,000)
Accumulated OCI, 12/31/X9 16,000 20,000 20,000 0 16,000 5-438
Appendix 5A
Additional Consolidation Details
5-439
 Subsidiary valuation accounts at

acquisition
 ASC 805-20-30 indicates that all assets and
liabilities acquired in a business combination
should be valued at their acquisition-date fair
values and no valuation accounts are to be
carried over.
 Its application in consolidation following a stock
acquisition is less clear.
5-440
Additional Considerations—Deficit in RE
 Negative retained earnings of subsidiary

at acquisition
 A parent company may acquire a subsidiary
with a negative in its retained earnings
account.
 The basic elimination entry will have a credit
rather than a debit to Retained Earnings.
5-441
Additional Considerations—Deficit in RE
The basic elimination entry:

Common Stock (S) XXX
Additional Paid-in Capital (S) XXX
Income from Sub % NI
NCI in NI of Sub % NI
Retained Earnings, Beginning Balance (S) XXX
Investment in Sub % BV
NCI in NA of Sub % BV
5-442
 Other stockholders’ equity accounts

 In general, all stockholders’ equity accounts
accruing to the common shareholders
receive the same treatment as common
stock and are eliminated at the time
common stock is eliminated.
5-443
 Subsidiary’s disposal of differential-related

assets
 Both the parent’s equity-method income and consolidated
net income are affected.
 Parent’s books: The portion of the differential included in
the subsidiary investment account that relates to the asset
sold must be written off by the parent under the equity
method as a reduction in both the income from the
subsidiary and the investment account.
 In consolidation, the portion of the differential related to
the asset sold is treated as an adjustment to consolidated
income.
5-444
 Inventory
 Any inventory-related differential is assigned to inventory
for as long as the subsidiary holds the units.
 In the period in which the inventory units are sold, the
inventory-related differential is assigned to Cost of Goods
Sold.
 The inventory costing method used by the subsidiary
determines the period in which the differential cost of
goods sold is recognized.
 FIFO: The inventory units on hand on the date of
combination are viewed as being the first units sold
after the combination .
 LIFO: The inventory units on the date of combination
are viewed as remaining in the subsidiary’s inventory.
5-445
 Fixed Assets
 A differential related to land held by a subsidiary is
added to the Land balance in the consolidation
workpaper each time a consolidated balance sheet is
prepared.
 If the subsidiary sells the land to which the
differential relates, the differential is treated in the
consolidation workpaper as an adjustment to the gain
or loss on the sale of the land in the period of the sale.
 The sale of differential-related equipment is treated in
the same manner as land except that the amortization for
the current and previous periods must be considered.
5-446
Conclusion
The End
5-447
Chapter 6
Intercompany
Inventory
Transactions

intercompany transfers and
why they must be
eliminated.
6-449
Road Map: Intercompany Transactions
 Typical intercompany transactions

 Intercompany reciprocal accounts (Chapter 4)
 Inventory transfers (Chapter 6)
 Fixed asset transfers (Chapter 7)
 Intercompany Indebtedness (Chapter 8)
6-450
Arm’s-Length Transactions
Q: What are “Arm’s-length” Transactions?

A: “Transactions that take place between
completely independent parties.”
6-451
Categories of Transactions
 Arm’s Length Transactions

 The only transactions that can be reported in the
consolidated statements.
 We want to report the results of our interactions
with outside parties!
 Non-Arm’s Length Transactions
 Usually referred to as “related party
transactions.”
 Include all intercompany transactions.
6-452
Types of “Related Party” Transactions
 Involving only Individuals

 Transactions among family members
 Involving Corporations
 With management and other employees
 With directors and stockholders
 With affiliates (controlled entities)
 Probably constitutes at least 99% of all corporate

related-party transactions
6-453
Necessity of Eliminating Intercompany
Transactions
 Eliminate all intercompany transactions in
consolidation:
 Because they are internal transactions from a
consolidated perspective.
 Not because they are related-party transactions.
 Only transactions with outside unrelated parties

can be reported in the consolidated statements.
6-454
Intercompany Transactions: Additional
Opportunities for Fraud
 Intercompany transactions sometimes

occur to
 conceal embezzlements.
 overstate reported profits.
2 + 2 = 5
6-455
Example 1: Intercompany Loan
 A 12-year old girl lends $5 to her 17-year old

brother.
 From the standpoint of individuals, this
represents a receivable and a payable.
 If the family prepares a “consolidated balance
sheet,” what is the effect?
 No net change to the family’s wealth.
 Not a transaction with a non-family person.
6-456
Example 2:
Sale from Parent to Sub to Outsider
 Parent has 19 subsidiaries.
 Parent has received a $1 order from an
outsider.
 Parent sells inventory to Sub 1 for $1.
 Sub 1 sells the inventory to Sub 2 for $1.
 Sub 2 sells the inventory to Sub 3 for $1.
 The inventory is sold from one sub to another until Sub 19
sells it to the outsider for $1.
 The parent and each sub reports sales of $1.
 From a consolidated standpoint, what is the
total amount of sales?
6-457
Example 3: Sale from Parent to Sub, But Not
Yet to an Outsider
 Sleazy Parent Company has one sub.
 Sleazy Parent is preparing for an IPO.
 Sleazy Parent owns lots of obsolete inventory
which it cannot sell.
 Sleazy Parent sells the obsolete inventory (costing
$1,000) to its sub for $100,000.
 Sleazy Sub now holds the inventory.
 Without any adjustment, what items in Sleazy’s
consolidated financial statements will be
misstated?
6-458
Correcting Entries
 Conceptually, how would you correct each of these three
problems?
Easy! To eliminate intercompany loans:

Just Loan Payable xxx
reverse Loan Receivable xxx
To eliminate sale from Parent to Sub to Outsider:

More
Sales xxx
difficult Cost of Goods Sold xxx
Easy! To eliminate sale from Parent to Sub, not yet to Outsider:

Sales xxx
Just
Cost of Goods Sold xxx
reverse Inventory Unrealized GP
6-459
Let’s work through an example:
 Assume Parent Co. owns 100% of Sub Co.
 The following intercompany transactions occurred during
the year:
 Parent loaned $500 to Sub. To keep things simple, assume that
there is no interest revenue or interest expense associated with this
loan.
 Parent made a sale to Sub for $400 cash. The inventory had
originally cost Parent $250. Sub then sold that same inventory to an
outsider for $500.
 Parent made a sale to Sub for $300 cash. The inventory had
originally cost Parent $200. Sub has not yet sold that same
inventory to an outsider.
 What consolidation worksheet entries would you make?
6-460
(a) Loan from Parent to Sub
Does this transaction include outsiders?
Parent:
Receivable 500
Parent $500 Sub Cash 500
Sub:
Cash 500
Reverse the entries made by Payable 500
the parent and the sub.
To eliminate intercompany loans:

Loan Payable 500
Loan Receivable 500
6-461
(b) Sale from Parent to Sub to Outsider
Arm’s Keep Parent’s COGS Keep Sub’s Sale
Length
Are these legitimate transactions?
$250 Parent $400 Sub $500
Keep Eliminate effect Keep

This of this internal This
Purchase Transaction Sale
Get rid of Parent’s Sale Get rid of Sub’s COGS
Internal (fake) 6-462

(b) Sale from Parent to Sub to Outsider
Which transactions are legitimate?
Parent’s sale to Sub: Sub’s sale to Outsider:
Parent: Sub:
Cash 400 Cash 500
Sales 400 Sales 500
COGS 250 COGS 400
Inventory 250 Inventory 400
Sub:
Inventory 400 Reverse the rest!
Cash 400

Sales (parent to sub) 400
Cost of Goods Sold (to outsider) 400
6-463
(c) Sale From Parent to Sub (Not Outside)
Is this a legitimate arm’s length transaction?
Parent:
Cash 300
Sales 300
$200 Parent $300 Sub
COGS 200
Inventory 200
Sub:
Keep Eliminate effect
this of this internal Inventory 300
purchase transaction Cash 300
Summary of the Transaction:

 Parent purchased inventory for $200.
 Parent sold the inventory to a Sub for $300.
Reverse the entries made by the parent and sub.
6-464
(c) Sale From Parent to Sub (Not Outside)
Reverse the entries made by the parent and sub.
Parent:
Cash 300
Sales 300
COGS 200 Parent $300 Sub
Inventory 200
Sub:
Inventory 300
Cash 300
To eliminate sale from Parent to Sub, not yet to Outsider:
Sales 300
Cost of Goods Sold 200
Inventory (net) 100
6-465
Summary of Consolidation Entries:

Loan Payable 500
Loan Receivable 500

Sales 400

Sales 300
Inventory 100
6-466
Fully-adjusted Equity Method Adjustment
 Parent companies have to adjust their equity

method investment accounts for certain
transactions.
 At this point, let’s just consider one:
 Sale from parent to sub, but not yet sold to an outsider.
 It represents “fake profit” that hasn’t really been realized
in an arm’s-length transaction.
 Both the balance sheet and income statement
accounts need to be adjusted.
 This is a REAL journal entry, not a consolidation
worksheet entry!
6-467
Equity Method Adjustment Example
Sales $ 600
$500 Parent $600 Sub COGS 500
GP $ 100
Summary of the Transaction:

 Parent purchased inventory for $500.
 Parent sold the inventory to a Sub for $600.
Equity Method Entry:

Income from Sub 100
 The Parent recognized $100 of “fake” gross profit!

 The Parent should have transferred the inventory at cost.
 This profit is not from a transaction with an arm’s-length
independent party.
6-468
Group Practice
 Assume Parent Co. owns 100% of Sub Co.
 The following intercompany transactions occurred during
the year:
 Parent loaned $100 to Sub. To keep things simple, assume that there
is no interest revenue or interest expense associated with this loan.
 Parent made a sale to Sub for $200 cash. The inventory had originally
cost Parent $120. Sub then sold that same inventory to an outsider for
$300.
 Parent made a sale to Sub for $300 cash. The inventory had originally
cost Parent $180. Sub has not yet sold that same inventory to an
outsider. (Don’t forget equity method entry!)
 Based on our “conceptual discussion,” what consolidation
worksheet entries would you make?
6-469
Loan Payable 100
Loan Receivable 100

Sales 200

Sales 300
Inventory 120
To correct inventory value

Income from Sub 120
6-470
Why must intercompany transactions

be eliminated?
a. They portray the consolidated
company’s results too
conservatively.
b. They understate the results of the
consolidated group.
c. They are arm’s-length transactions.
d. They are not arm’s-length
transactions.
6-471
Why must intercompany transactions

be eliminated?
a. They portray the consolidated
company’s results too
conservatively.
b. They understate the results of the
consolidated group.
c. They are arm’s-length transactions.
d. They are not arm’s-length
transactions.
6-472

concepts associated with
inventory transfers and
transfer pricing.
6-473
Issue #1: Eliminate Intercompany Transfers?
 Whether to Eliminate Intercompany

Transactions in Consolidation:
 No controversy—they must be eliminated.
 Not eliminating them would cause two problems:

 Meaningless double-counting of
1. sales, and
2. expenses
 Potential to manipulate income.
6-474
The Substance of Inventory Transfers
 The CONSOLIDATED Perspective:

 Merely the physical movement of inventory
from one location to another location.
 Similar to the movement of inventory from one
division to another division.
 Not a bona fide transaction.
6-475
Issue #2: Which Measure of Profit To Use?
 Possible theoretical profit measures:

 Gross profit
 Operating profit
 Net income
 Profit measure required under GAAP:
 Gross profit (of the selling entity):
Sales $1,000
Cost of sales 600
Gross profit $ 400
6-476
Issue #3: Eliminate Income Tax Effects?
 Income taxes play a major role in

intercompany sales and transfer pricing
decisions.
 Income taxes on the selling entity’s unrealized
gross profit must also be eliminated.
 In this chapter:
 No income tax entries are required.
 Because we assume that the tax effects have
already been recorded in the parent’s or the
subsidiary’s general ledger.
6-477
Issue #4: Whether To Eliminate All or Some?
 Downstream sales to a
partially-owned subsidiary:
 Eliminate 100% of unrealized
profit.
 Fractional elimination is
prohibited.
 Upstream sales from a
partially-owned subsidiary:
 Eliminate 100% of unrealized
profit.
 Fractional elimination is
prohibited.
6-478
Issue #4: Whether To Eliminate All or Some?
 Downstream sales to a partially-
owned subsidiary:
 Entire profit accrues to the parent;
thus, sharing is not appropriate.
NCI
P
 Upstream sales from a partially-
owned subsidiary:
 Must share deferral with the NCI
shareholders (if amount is material). S
 Because S profits are shared with the
NCI shareholders.
6-479
Inventory Transfers: What is “Realization”?
 Realization for consolidated reporting

purposes:
 Does not focus on whether the seller has
 delivered the product,

 collected on the sale, or
 reduced to an acceptable level the
uncertainty about the net cash flow effect
of an earnings activity.
6-480
Inventory Transfers: What is “Realization”?
 Realization for consolidated reporting

purposes:
 Depends on whether the BUYER has resold the
inventory to an outside unaffiliated customer.
Parent Sub
6-481
Review: Two Types of Transfers
 Parent-to-sub-to-outsider
$750 Parent $1,000 Sub For $1,200
 Parent-to-sub-not-yet-to-outsider
Assume both
transactions
$300 Parent $400 Sub took place
during the
same year.
6-482
Understanding Inventory Transfers: Map it out
Ending Inventory = $400
Resold = $1,000
$1,400
Split
$1,050 Parent $1,400 Sub Unknown
What happened to it?

Total Interco Sales Resold On hand
Sales 1,400 1,000 400
 COGS 1,050 750 300
Gross Profit 350 250 100
Gross Profit % 25%
Splits out parent’s numbers.

6-483
Calculating Unrealized Gross Profit
 Amounts that will always be known (given):
Total Resold On hand

Sales (NEW basis) 1,000 200
 Cost of sales (OLD basis) 600
Gross Profit 400
Gross Profit % 40%
CRITICAL ASSUMPTION:
 The gross profit percentage derivable from the total column
applies to both (1) the inventory that has been resold AND
(2) the inventory that is still on hand.
6-484
Calculating Unrealized Gross Profit
 Completed Analysis:
Total Resold On hand

Sales (NEW basis) 1,000 800 200
 Cost of sales (OLD basis) 600 480 120
Gross Profit 400 320 80
Gross Profit % 40%
Realized Unrealized
 The Inventory/COGS Change in Basis Elimination Entry

is derived from this analysis.
 Unrealized profit = Inventory on hand x GP%
= $200 x 40% = $80
6-485
Inventory Transfers: Terminology

Total Interco
Resold On hand
Sales
Transfer Price Sales 1,400 1,000 400
Cost  COGS 1,050 750 300

Markup Gross Profit 350 250 100
Markup on
Transfer Price Gross Profit % 25%
Watch out for terminology like

“mark-up based on cost”!
6-486
For 20X8, Pete reported intercompany

cost of sales of $800,000 (markup is 20%
of transfer price) to Sampras, which
reported $300,000 of intercompany
acquired inventory at 12/31/X8. The
unrealized profit at 12/31/X8 is
a. $40,000.
b. $48,000.
c. $60,000.
d. $75,000.
6-487
Ending Inventory = $300,000
$???
Split
$800,000 Parent ? Sub ?

Sales 300,000
 COGS 800,000
Gross Profit ?
Gross Profit % 20%
6-488
$???
Split
$800,000 Parent ? Sub ?

Sales 300,000
 COGS 800,000
Gross Profit 60,000
Gross Profit % 20%
6-489
$???
Split
$800,000 Parent ? Sub ?

Sales S 300,000
 COGS 800,000
Gross Profit .2 S 60,000
Gross Profit % 20%
6-490
$???
Split
$800,000 Parent ? Sub ?
S  800,000 = .2 S
.8 S = 800,000
S = 800,000 / .8 = 1,000,000
6-491
$???
Split
$800,000 Parent ? Sub ?

Sales 1,000,000 300,000
 COGS 800,000
Gross Profit 200,000 60,000
Gross Profit % 20%
6-492
Resold = $700,000
$1,000,000
Split
$800,000 Parent 1,000,000 Sub Unknown

Sales 1,000,000 700,000 300,000
 COGS 800,000 560,000 240,000
Gross Profit 200,000 140,000 60,000
Gross Profit % 20%
6-493
For 20X8, Pete reported intercompany

cost of sales of $800,000 (markup is 20%
of transfer price) to Sampras, which
reported $300,000 of intercompany
a. $40,000.
b. $48,000.
c. $60,000 ($300,000 EI x 0.20 GP%).
d. $75,000.
6-494
For 20X8, Post reported $90,000 of

intercompany sales (25% markup on cost
and fully paid for by year end) to Script,
which reported $30,000 of intercompany
a. $0.
b. $6,000.
c. $7,500.
d. $30,000.
6-495
$90,000
Split
? Parent 90,000 Sub ?

Sales 90,000 30,000
 COGS C
Gross Profit 0.25 C ?
Gross Profit % ?
6-496
$90,000
Split
? Parent 90,000 Sub ?
90,000  C = 0.25 C
1.25 C = 90,000
C = 90,000 / 1.25 = 72,000
6-497
$90,000
Split
72,000 Parent 90,000 Sub ?

Sales 90,000 30,000
 COGS 72,000
Gross Profit 18,000 ?
Gross Profit % 20%
6-498
$90,000
Split
72,000 Parent 90,000 Sub ?

Sales 90,000 30,000
 COGS 72,000
Gross Profit % 20%
6-499
Resold = $60,000
$90,000
Split
72,000 Parent 90,000 Sub Unknown

Sales 90,000 60,000 30,000
 COGS 72,000 48,000 24,000
Gross Profit 18,000 12,000 6,000
Gross Profit % 20%
6-500
For 20X8, Post reported $90,000 of

intercompany sales (25% markup on cost
and fully paid for by year end) to Script,
which reported $30,000 of intercompany
a. $0.
b. $6,000 ($30,000 EI x 0.20 GP%).
c. $7,500.
d. $30,000.
6-501
For 20X8, Sempre (80% owned by Para)

reported $1,600,000 of intercompany
sales (1/3 markup on cost) to Para, which
resold $1,400,000 of this inventory by
12/31/X8. The unrealized profit at
12/31/X8 is
a. $40,000.
b. $50,000.
c. $53,333.
d. $66,667.
6-502
Ending Inventory = 200,000
Resold = $1,400,000
$1,600,000
Split
? Parent 1,600,000 Sub unknown

Sales 1,600,000 1,400,000
 COGS
Gross Profit ?
Gross Profit % ?
6-503
Resold = $1,400,000
$1,600,000
Split

Sales 1,600,000 1,400,000
 COGS C
Gross Profit 1/3 C ?
Gross Profit % ?
6-504
Resold = $1,400,000
$1,600,000
Split
1,600,000  C = 1/3 C
4/3 C = 1,600,000
C = 1,600,000 / (4/3) = 1,200,000
6-505
Resold = $1,400,000
$1,600,000
Split
1,200,000 Parent 1,600,000 Sub unknown

Sales 1,600,000 1,400,000
 COGS 1,200,000
Gross Profit % 25%
6-506
Resold = $1,400,000
$1,600,000
Split

Sales 1,600,000 1,400,000 200,000
 COGS 1,200,000
Gross Profit % 25%
6-507
Resold = $1,400,000
$1,600,000
Split

Sales 1,600,000 1,400,000 200,000
 COGS 1,200,000
Gross Profit % 25%
6-508
Resold = $1,400,000
$1,600,000
Split

Sales 1,600,000 1,400,000 200,000
 COGS 1,200,000 1,050,000 150,000
Gross Profit 400,000 350,000 50,000
Gross Profit % 25%
6-509
For 20X8, Sempre (80% owned by Para)

reported $1,600,000 of intercompany
sales (1/3 markup on cost) to Para, which
resold $1,400,000 of this inventory by
12/31/X8. The unrealized profit at
12/31/X8 is
a. $40,000.
b. $50,000 ($200,000 EI x 0.25 GP%).
c. $53,333.
d. $66,667.
6-510

entries and elimination entries
for the consolidation
of a subsidiary following
downstream inventory
transfers.
6-511
Agreement between Parent Company and
 Under the fully adjusted equity method,
 the parent company’s financial statements should
report the same net income and retained earnings
amounts as appear in the consolidated statements.
 Therefore, we
 record and equity method adjustment on the
parent’s books to defer unrealized gross profit,
and
 prepare consolidation worksheet elimination
entries to avoid double counting in the income
statement and overstating inventory.
6-512
Big Picture—Elimination entry: Sale From
Parent to Sub to Outsider

Sales (Parent) 400
Cost of Goods Sold (Sub) 400
Get rid of the non-arm’s-length transaction!
$250 Parent $400 Sub $500
6-513
Big Picture—Elimination entry: Sale From
Parent to Sub (not yet sold outside)
Reverse the entire transaction!
Sales 400
Inventory 150
Income from Sub 150
Sales $400 Parent’s gross profit is overstated by $150

Cost of sales 250 Sub’s inventory is overstated by $150
Gross profit $ 150
$250 Parent $400 Sub

6-514
What to Look For
 Most problems will contain

 Inventory transferred from parent to sub (downstream),
or
 Inventory transferred from sub to parent (upstream).
 Often part of the inventory is sold to an
outsider, but part remains in the buyer’s
ending inventory.
 Key: Any problem can be split into two parts
 The portion of the inventory that is sold
 The portion of the inventory that is still on hand
6-515
A Comprehensive Downstream Example
During 20X8, Parent sold inventory originally costing
$60,000 to its 100% owned Sub for $75,000. Sub sold most
of the inventory purchased from Parent (all but $10,000)
for $70,000 to outsiders during the year.
Income Statements What happened to it?

Parent Sub Sold On-hand
Sales $75,000 $70,000 $65,000 $10,000 x 20% = $2,000
Cost of sales 60,000 65,000 Unrealized GP
Gross profit $15,000 $ 5,000
Ending inventory = $10,000
$75,000
Split
60,000 Parent 75,000 Sub 70,000
6-516
One Approach: Split into Two Transactions
 This transaction can be broken into two pieces:

 Parent sells Sub inventory with a cost of $52,000 for
$65,000. Sub then sells this inventory to outsiders for
$70,000.
 Parent sells Sub inventory with a cost of $8,000 for
$10,000, which remains on hand in Sub’s ending
inventory.
Total Sold On hand

Sales $75,000 $65,000 $10,000
 COGS 60,000 52,000 8,000
Gross Profit $15,000 $13,000 $ 2,000
6-517
Part 1: Sale from Parent to Sub to Outsider

Sales (Parent) 65,000
Cost of Goods Sold (Sub) 65,000
Get rid of the non-arm’s-length transaction!
$52,000 Parent $65,000 Sub $70,000
6-518
Part 2: Sale from Parent to Sub (Not Outside)

Cost of Goods Sold (Parent) 8,000
Inventory (basis correction) 2,000
Sales $10,000 Parent’s gross profit is overstated

Cost of sales 8,000 by $2,000
Gross profit $ 2,000 Sub’s inventory is overstated by $2,000
$8,000 Parent $10,000 Sub

6-519
Summary
To eliminate sale from Parent to Sub to Outsider :


Can combine the two entries:

Sales 75,000
Cost of Goods Sold 73,000
Inventory 2,000
6-520
Partial Consolidated Worksheet
Consol-
Parent Sub DR CR idated
Income Statement
Sales 75,000 70,000 75,000 70,000
COGS 60,000 65,000 73,000 52,000
Gross Profit 15,000 5,000 75,000 73,000 18,000
Balance Sheet
Inventory 0 10,000 2,000 8,000
6-521
Second Approach: Short Cut Method
Total Sold On hand
Sales $75,000 $65,000 $10,000
 COGS 60,000 52,000 8,000
Gross Profit $15,000 $13,000 $ 2,000
COGS Credit = $65,000 + $8,000
The numbers come right off the chart!
Sales 75,000
Inventory 2,000
6-522
 Don’t forget that one of the desirable properties

of using the equity method is that the parent’s
net income should be equal to the consolidated
net income.
 If you only adjust for unrealized deferred profit
in the consolidation, the consolidated net income
will be different from the parent’s income!
6-523
Consol-
Income Statement
Sales 75,000 70,000 75,000 70,000
COGS 60,000 65,000 73,000 52,000
Inc from Sub 5,000 5,000
Net Income 20,000 5,000 80,000 73,000 18,000
Balance Sheet Not the same!
Inventory 0 10,000 2,000 8,000
6-524
 Don’t forget that one of the desirable properties

of using the equity method is that the parent’s
net income should be equal to the consolidated
net income.
 If you only adjust for unrealized deferred profit
in the consolidation, the consolidated net income
will be different from the parent’s income!
 Thus, an actual adjustment on the parent’s books in
addition to the worksheet entries above.
 Like we did for the excess fair value amortization.
6-525
 After calculating the unrealized Parent NI =
deferred profit, simply make an extra Consolidated NI
adjustment to back it out. Sales $75,000
 Do this at the same time you record COGS 60,000
Gross profit $15,000
the parent’s share of the sub’s Inc. from Sub 3,000
income. NI $18,000

NI 5,000 5,000 NI
2,000 Unreal GP 2,000
3,000
Reverse next year when this inventory is sold!

6-526
Consol
Parent Sub DR CR -idated
Income Statement
Sales 75,000 70,000 75,000 70,000
COGS 60,000 65,000 73,000 52,000
Inc from Sub 3,000 3,000
Net Income 18,000 5,000 78,000 73,000 18,000
Balance Sheet Now they’re the same!
Inventory 0 10,000 2,000 8,000
6-527
Under the fully adjusted equity method,

what is one benefit of making an equity
method adjustment to defer unrealized
gross profit on inventory transfers?
a. Consolidated net income always
increases.
b. Parent company net income always
increases.
c. Parent company net income is not equal
to consolidated net income.
d. Parent company net income equals
consolidated net income.
6-528
Under the fully adjusted equity method,

what is one benefit of making an equity
method adjustment to defer unrealized
gross profit on inventory transfers?
a. Consolidated net income always
increases.
b. Parent company net income always
increases.
c. Parent company net income is not equal
to consolidated net income.
d. Parent company net income equals
6-529
Review Exercise Part 1: Downstream
 Para sold inventory costing $100,000 to its
75%-owned subsidiary, Shute, for $125,000
in 20X8. NCI
P
 Shute resold most of this inventory for
25% 75%
$230,000 in 20X8.
 At 12/31/X8, Shute’s balance sheet showed
intercompany-acquired inventory on hand of
$20,000.
S
Required:
 Prepare the consolidation entry and/or entries required
at 12/31/X8 under the equity method.
 Since this is a DOWNSTREAM transaction, we don’t
share the GP deferral with the NCI.
6-530
Review Exercise Part 1: Big Picture
Total Sold On hand

Sales 125,000 20,000
 COGS 100,000
Gross Profit 25,000
Gross Profit %
Resold = $105,000
$125,000
split
$100,000 Parent $125,000 Sub $230,000
6-531
Total Sold On hand

Sales 125,000 20,000
 COGS 100,000
Gross Profit 25,000
Gross Profit % = 25,000 / 125,000 = 1/5 = 20%
Resold = $105,000
$125,000
split
$100,000 Parent $125,000 Sub $230,000
6-532
Total Sold On hand

Sales 125,000 105,000 20,000
 COGS 100,000 84,000 16,000
Gross Profit 25,000 21,000 4,000
Gross Profit % = 25,000 ÷ 125,000 = 1/5 = 20%
Unrealized GP
Resold = $105,000
$125,000
split
$100,000 Parent $125,000 Sub $230,000
6-533
Review Exercise 1: Sale from Parent to Sub
to Outsider

Get rid of the internal non-arm’s-length transaction!
$84,000 Parent $105,000 Sub $230,000
6-534
Review Exercise 1: Sale from Parent to Sub
(Not Yet Outside)

Sales $20,000 Parent’s gross profit is overstated by $4,000

Cost of sales 16,000
Sub’s inventory is overstated by $4,000
Gross profit $ 4,000
$16,000 Parent $20,000 Sub

6-535
Review Exercise 1: Summary

Combine both entries:
Sales 125,000
Inventory 4,000
Fully-adjusted Equity Method Entry on Parent’s books:

Income from Sub 4,000
6-536
Review Exercise Part 1: Short Cut
Total Sold On hand

Sales 125,000 105,000 20,000
 COGS 100,000 84,000 16,000
Gross Profit 25,000 21,000 4,000
COGS Credit = 105,000 + 16,000 = 121,000
Unrealized GP
Worksheet Elimination Entry:

Sales 125,000
Inventory 4,000
6-537
Review Exercise 1: Equity Method Entry

75% NI 93,750 93,750 75% NI
4,000 Defer GP 4,000
Reverse next year!
6-538
Review Exercise 1: Equity Method Reversal
Next Year
Equity Method Adjustment on Parent’s books in 20X7:

Reversal of 20X7 Deferral on Parent’s books in 20X8:

6-539
Review Exercise Part 1
Worksheet Elimination Entry in Year 1:

Sales 125,000
Inventory 4,000
FYI, this year’s deferral is REVERSED next year to recognize

when sold!
6-540
Review Exercise 1: Equity Method Entry

75% NI 93,750 93,750 75% NI
4,000 Defer GP 4,000
Low 4,000 89,750
Downstream, so don’t split

the deferral with the NCI.
6-541

Sales 125,000
Inventory 4,000
FYI, this year’s deferral is REVERSED next year to recognize

when sold!

INCREASES income!
6-542
Review Exercise 1: Partial Consolidated
Worksheet
Consol-
Income Statement
Sales 125,000 230,000 125,000 230,000)
COGS 100,000 105,000 121,000 84,000)
Inc from Sub 89,750 89,750 Basic
Gross Profit 114,750 125,000 214,750 121,000 146,000)
NCI in NI 31,250 Basic (31,250)
CI in NI 114,750 125,000 246,000 121,000 114,750)
Balance Sheet
Inventory 20,000 4,000 16,000)
6-543

for the consolidation
of a subsidiary following
upstream inventory transfers.
6-544
Partially Owned Upstream Sales
 Must share deferral with the NCI shareholders.
 Simply split up the adjustment for unrealized
gross profit proportionately.
Equity Method
Adjustments
NCI
P
10% 90%
NI 4,500 4,500 NI
1,800 Defer GP 1,800
2,700
NCI in NA of Sub
S
Unreal GP 200 Worksheet
Entry Only
6-545
 In 20X7, Sensei, a 90%-owned subsidiary of Padawan,
sold inventory to Padawan for $600,000, which includes a
markup of 25% on Sensei’s cost.
 Padawan resold most of this inventory in 20X7 for NCI
P
$588,000.
10% 90%
 At 12/31/X7, Padawan reported $110,000 of this
inventory in its balance sheet. (This ending inventory was
resold in 20X8 by Padawan.)
 In 20X8, Sensei sold Padawan inventory for $900,000 that
had a cost of $675,000, of which Padawan resold $700,000
by12/31/X8 for $840,000.
S
Required:
 Since this is an UPSTREAM transaction, we do share the
GP deferral with the NCI.
6-546
Review Exercise Part 2: The Big Picture—20X7
Total Sold On hand

Sales 600,000 110,000
 COGS C
Gross Profit 0.25C
? Sub $600,000 Parent ?
6-547
Total Sold On hand

Sales 600,000 110,000
 COGS
Gross Profit
$600,000 – C = 0.25C
C = $600,000/1.25
= $480,000
? Sub $600,000 Parent ?
6-548
Total Sold On hand

Sales 600,000 110,000
 COGS 480,000
Gross Profit 120,000
Gross Profit % = 120,000 / 600,000 = 1/5 = 20%
Unrealized GP
$600,000 – C = 0.25C
C = $600,000/1.25
= $480,000
? Sub $600,000 Parent ?
6-549
Total Sold On hand

Sales 600,000 110,000
 COGS 480,000
Gross Profit % = 120,000 / 600,000 = 1/5 = 20%
Unrealized GP
$600,000 – C = 0.25C
C = $600,000/1.25
= $480,000
? Sub $600,000 Parent ?
6-550
Total Sold On hand

Sales 600,000 490,000 110,000
 COGS 480,000 392,000 88,000
Gross Profit 120,000 98,000 22,000
Gross Profit % = 120,000 / 600,000 = 1/5 = 20%
Unrealized GP
$600,000 – C = 0.25C
C = $600,000/1.25
= $480,000
? Sub $600,000 Parent ?
6-551
20X7 Upstream Sales: Elimination Entries—
20X7 & 20X8
20X7 Worksheet Elimination Entry:

Sales 600,000
Inventory 22,000
Deferred GP this year “reversed”

to recognize in the financial
NCI
P
statements next year when sold. 10% 90%
S
6-552
20X7 Upstream Sales: Equity Method
Adjustments — 20X7 & 20X8
20X7 Equity Method Adjustment on Parent’s books:

Deferral of GP in 20X7 NCI

P
because not yet sold this year.
10% 90%
20X8 Equity Method Reversal of 20X7 Deferral (on

Parent’s books):
Investment in Sub
Income from Sub
19,800
19,800
S
6-553
20X7 Upstream Sales: 20X7 Equity Accounts

90% NI 108,000 108,000 90% NI
19,800 X7 Deferral 19,800
Low 19,800 88,200
6-554
20X7 Upstream Sales: Elimination Entries—
20X7 & 20X8

Sales 600,000
Inventory 22,000
Deferred GP this year “reversed”

to recognize in the financial
NCI
P
statements next year when sold. 10% 90%

NCI in NA of Sub
Cost of Goods Sold
2,200
22,000
S
6-555
20X7 Upstream Sales: 20X7 Partial Worksheet
Consol-
Income Statement
Sales 588,000 600,000 600,000 588,000)
COGS 490,000 480,000 578,000 392,000)
Inc from Sub 88,200 88,200 Basic
Gross Profit 186,200 120,000 688,200 578,000 196,000)
NCI in NI 9,800 Basic (9,800)
CI in NI 186,200 120,000 698,000 578,000 186,200)
Balance Sheet
Inventory 110,000 22,000 88,000)
6-556
 In 20X7, Sensei, a 90%-owned subsidiary of Padawan,
sold inventory to Padawan for $600,000, which includes a
markup of 25% on Sensei’s cost.
 Padawan resold most of this inventory in 20X7 for NCI
P
$588,000.
10% 90%
 At 12/31/X7, Padawan reported $110,000 of this
inventory in its balance sheet. (This ending inventory was
resold in 20X8 by Padawan.)
 In 20X8, Sensei sold Padawan inventory for $900,000 that
had a cost of $675,000, of which Padawan resold $700,000
by12/31/X8 for $840,000.
S
Required:
 Since this is an UPSTREAM transaction, we do share the
GP deferral with the NCI.
6-557
Total Sold On hand

Sales 900,000 700,000
 COGS 675,000
Gross Profit
675,000 Sub $900,000 Parent ?
6-558
Total Sold On hand

Sales 900,000 700,000 200,000
 COGS 675,000
Gross Profit % = 225,000 / 900,000 = 0.25
675,000 Sub $900,000 Parent ?
6-559
Total Sold On hand

Sales 900,000 700,000 200,000
 COGS 675,000
Gross Profit % = 225,000 / 900,000 = 0.25
Unrealized GP
675,000 Sub $900,000 Parent ?
6-560
Total Sold On hand

Sales 900,000 700,000 200,000
 COGS 675,000
Gross Profit % = 225,000 / 900,000 = 0.25
Unrealized GP
675,000 Sub $900,000 Parent ?
6-561
Total Sold On hand

Sales 900,000 700,000 200,000
 COGS 675,000 525,000 150,000
Gross Profit 225,000 175,000 50,000
Gross Profit % = 225,000 / 900,000 = 0.25
Unrealized GP
675,000 Sub $900,000 Parent ?
6-562
Review Exercise 2: Summary
To eliminate sale from Sub to Parent to Outsider:
Sales (Sub) 700,000
To eliminate sale from Sub to Parent, not yet to Outsider:

Sales (Sub) 200,000
Combine both entries:
Sales 900,000
Inventory 50,000
Fully-adjusted Equity Method Entry on Parent’s books:

6-563
Review Exercise 2: Short Cut
Total Sold On hand

Sales 900,000 700,000 200,000
 COGS 675,000 525,000 150,000
Gross Profit 225,000 175,000 50,000
COGS CR = 700,000 + 150,000 = 850,000
The Elimination Entry:

Sales 900,000
Inventory 50,000
6-564
20X8 Upstream Sales: 20X8 Equity Accounts

Low 19,800
19,800 X7 Reversal 19,800
90% NI 202,500 202,500 90% NI
45,000 X8 Deferral 45,000
Low 45,000 177,300
6-565
20X7 & 20X8 Upstream Sales: 20X8 Partial
Worksheet
Consol-
Income Statement
Sales 840,000 900,000 900,000 840,000)
COGS 700,000 675,000 850,000 503,000)
22,000
Income from Sub 177,300 177,300 Basic
Gross Profit 317,300 225,000 1,077,300 872,000 337,000)

NCI in NI 19,700 Basic (19,700)
CI in NI 317,300 225,000 1,097,000 872,000 317,300)
Balance Sheet
Inventory 200,000 50,000 150,000)
Low by
Investment in Sub 19,800 Basic X
45,000
NCI in NA of Sub 2,200 2,200)

6-566

additional considerations
associated with consolidation.
6-567
 Sale from one subsidiary to another

 Transfers of inventory often occur between
companies that are under common control or
ownership.
 The eliminating entries are identical to those
presented earlier for sales from a subsidiary to its
parent.
 The full amount of any unrealized intercompany
profit is eliminated, with the profit elimination
allocated proportionately against the ownership
interests of the selling subsidiary.
6-568
 Costs associated with transfers

 When one affiliate transfers inventory to
another, some additional cost is often
incurred.
 Such costs should be treated in the same
way as if the affiliates were operating
divisions of a single company.
6-569
 Lower-of-cost-or-market
 A company might write down inventory
purchased from an affiliate under this rule
if the market value at the end of the period
is less than the intercompany transfer
price.
6-570
Lower-of-Cost-or-Market Example
Assume that a parent company purchases inventory for $20,000 and
sells it to its subsidiary for $35,000. The subsidiary still holds the
inventory at year-end and determines that its market value
(replacement cost) is $25,000 at that time. The subsidiary writes the
inventory down from $35,000 to its lower market value of $25,000 at
the end of the year and records the following entry:
Write-down Inventory to Market Value:

Loss on Decline in Value of Inventory 10,000
Inventory 10,000
Make the following worksheet eliminating entry:
Sales 35,000
Cost of Goods sold 20,000
Inventory 5,000
Loss on Decline in Value of Inventory 10,000
6-571
 Sales and purchases before affiliation

 The consolidation treatment of profits on
inventory transfers that occurred before the
business combination depends on whether the
companies were at that time independent and the
sale transaction was the result of arm’s-length
bargaining.
 As a general rule, the effects of transactions that
are not the result of arm’s-length bargaining must
be eliminated.
6-572
 In the absence of evidence to the contrary,

companies that have joined together in a business
combination are viewed as having been separate
and independent prior to the combination.
 If the prior sales were the result of arm’s-length
bargaining, they are viewed as transactions between
unrelated parties.
 No elimination or adjustment is needed in preparing
consolidated statements subsequent to the combination,
even if an affiliate still holds the inventory.
6-573
Peanut Co. regularly purchased inventory

from Snack Inc. in 20X3 when Peanut did
not own any Snack stock. On March 31,
20X4, Peanut purchased 90% of Snack
Inc.’s outstanding common stock.
a. Peanut should eliminate 90% of Snack’s
first quarter 20X4 gross profit.
b. Peanut should eliminate 100% of
Snack’s first quarter 20X4 gross profit.
c. Peanut should not eliminate any of
d. Peanut should eliminate 100% of
Snack’s 20X4 gross profit.
6-574
Peanut Co. regularly purchased inventory

from Snack Inc. in 20X3 when Peanut did
not own any Snack stock. On March 31,
20X4, Peanut purchased 90% of Snack
Inc.’s outstanding common stock.
a. Peanut should eliminate 90% of Snack’s
first quarter 20X4 gross profit.
b. Peanut should eliminate 100% of
c. Peanut should not eliminate any of
d. Peanut should eliminate 100% of
Snack’s 20X4 gross profit.
6-575
Conclusion
The End
6-576
Chapter 7
Intercompany Transfers
of Services and
Noncurrent Assets

transfers of long-term assets
and services.
Summary of GAAP Requirements for
Preparing Consolidated Statements
 All intercompany transactions must be
eliminated in consolidation.
 The full amount of unrealized intercompany
profit or gain must be eliminated.
 The deferral is shared with NCI shareholders in
upstream transactions.
Big Picture: The Consolidated Perspective
 From a consolidated viewpoint,

the reported amount for a fixed
asset cannot change merely
because the asset has been
moved to a different location
within the consolidated group.
P
Long-term
 Objective: Asset

Undo the transfer.
Make it appear as if we only
S
changed the estimated useful
life of asset.
Different Asset Types
 Non-depreciable Assets
 The transfer of non-depreciable assets is very
similar to the transfer of inventory
 Eliminate gains like unrealized gross profit
 Depreciable Assets
 Eliminate the seller’s gain
 Adjust transferred asset back to old basis
 Adjust depreciation back to what it would have
otherwise been if the original owner had
depreciated the asset based on the revised
estimate of useful life
Intercompany Transfers of Services
 When one company purchases services from a

related company, the purchaser typically records an
expense and the seller records a revenue.
 In the consolidation worksheet, an eliminating entry
would be needed to reduce both revenue (debit) and
expense (credit).
 Because the revenue and expense are equal and both
are eliminated, income is unaffected by the
elimination.
 The elimination is still important because otherwise
both revenues and expenses are overstated.
The goal in preparing eliminating entries

related to asset transfers among affiliated
companies is to:
a. Emphasize gains and losses in the
b. Eliminate gains and losses and re-adjust
the basis of the transferred asset to what
it would have been on the original
owner’s books.
c. Augment consolidated income.
d. Decrease consolidated income.
The goal in preparing eliminating entries

related to asset transfers among affiliated
companies is to:
a. Emphasize gains and losses in the
b. Eliminate gains and losses and re-adjust
the basis of the transferred asset to what
it would have been on the original
owner’s books.
c. Augment consolidated income.
d. Decrease consolidated income.
Prepare equity-method
journal entries and
consolidation of a subsidiary
following an intercompany
land transfer.
Example 1: 100% Ownership Land Transfer
(Non-Depreciable)
 On 3/31/X5, Parker Inc. sold land costing $40,000 to its
100% owned subsidiary, Stubben Inc., for $100,000.
 In this example, we’ll do consolidation worksheet entries
without adjusting the equity method accounts.
 This is the modified equity method.
 This is meant to be a conceptual exercise only. (We will
switch to the fully adjusted equity method next.)
Required:
1. Prepare the consolidation entry(ies) as of 12/31/X5 and
12/31/X6.
2. Prepare the consolidation entry at 12/31/X7, assuming that
Stubben sold the land in 20X7 for $120,000.
(Non-Depreciable)
On 3/31/X5, Parker Inc. sold land costing $40,000 to its
In 20X7
$40 Parker $100 Stubben $120
“Fake” Gain = $60 Gain = $20
Total Gain = $80

Example 1: Consolidation Entry at 12/31/X5
Requirement 1:
Parker Stubben
Assets = Liabilities + Equity Assets = Liabilities + Equity
Gain +60 Land +60
Consolidation Entry at 12/31/X5

Gain on Sale of Land 60,000
Land 60,000
What happens to the gain?
RE +60 Land +60

Requirement 1:
Parker Stubben
Gain +60 Land +60
Consolidation Entry at 12/31/X6 (and all years until land is sold)

Land 60,000
Requirement 2:
Parker Stubben
RE +60 Gain +20
What gain should Stubben report in 20X7 when the land is sold?
Consolidation Entry at 12/31/X7 (Stubben resold the land in 20X7)
Gain on Sale 60,000
• Thus, the consolidated gain is $80,000!

• What’s the only problem with the partial equity method?
• THE PARENT’S FINANCIAL STATEMENTS ARE NOT CORRECT!
Solution: Parker Company Equity Method
Journal Entries
Requirement 1
Land 60,000
Land 60,000
Requirement 2
Equity Method Adjustment
 After calculating the unrealized gain, simply make an

extra adjustment to back it out.
 Do this at the same time you record the parent’s
share of the sub’s income.

NI XXX XXX NI
60,000 Unreal. Gain 60,000
This ensures that
the parent income
Reverse later when the is equal to the
asset is sold! consolidated
income.
 On 3/31/X5, Parker Inc. sold land costing $40,000 to its

 Now assume Parker adjusts for this transaction in the
equity accounts.
 This is the fully adjusted equity method!
 How would your answers change?
Required:
1. Prepare the consolidation entry(ies) as of 12/31/X5 and
12/31/X6.
2. Prepare the consolidation entry at 12/31/X7, assuming that
Stubben sold the land in 20X7 for $120,000.
On 3/31/X5, Parker Inc. sold land costing $40,000 to its

In 20X7
$40 Parker $100 Stubben $120
“Fake” Gain = $60 Gain = $20
Total Gain = $80

ONE EXTRA STEP! Equity Method Adjustment
NI XXX XXX NI
60,000 Unreal. 60,000
Gain
This defers the

gain until later
Requirement 1:
Parker Stubben
Invest 60 Gain +60 Land +60
Income from Sub 60
• The equity method adjustment “fixes” parent’s books!
What happens to the equity method accounts?
• Eliminated in the consolidation. But we still need to fix the problem!
Same!
Land 60,000
What happens to the gain AND Income from Sub?
Invest 60 RE correct Land +60
They cancel out!
Requirement 1:
Parker Stubben
Invest 60 Land +60
• The normal basic elimination entry will still eliminate BV of equity.
• The investment account will be “over eliminated” and left with a 60,000
credit!
• We can’t leave a “balance” in that account in the consolidated B/S!
Consolidation Entry at 12/31/X6 (and all years until land is sold)

Investment 60,000
Land 60,000
• This entry eliminates the investment account and fixes the land balance.
Requirement 1:
Parker Stubben
Invest 60 Gain +20
What gain should Stubben report in 20X7 when the land is resold?

Investment 60,000
Gain on Sale 60,000
• Thus, the consolidated gain is $80,000!

• We also reverse out the equity method deferral this year.
• THE PARENT’S FINANCIAL STATEMENTS ARE ALWAYS CORRECT!
Example 2: Solution Summary
Requirement 1
Land 60,000
Investment in Stubben 60,000
Land 60,000
Requirement 2
Consolidation Worksheet—20X5
Adjustments
Consol-
Income Statement
Gain 60,000 60,000 0
(60,000)
Income from Sub 0
Lower Basic
Balance Sheet
(60,000)
Investment in Sub 0
Lower Basic
Land 100,000 60,000 40,000
Adjustments
Consol-
Income Statement
Balance Sheet
(60,000) 60,000
Investment in Sub 0
Lower Basic
Land 100,000 60,000 40,000
Adjustments
Consol-
Income Statement
Gain 20,000 60,000 80,000
Balance Sheet
(60,000) 60,000
Investment in Sub 0
Lower Basic
Land 0 0
The major difference between the modified

and fully adjusted equity methods of
accounting for fixed asset transfers is:
a. The parent’s income is always lower under
the modified equity method.
b. The parent’s income is always higher
under the modified equity method.
c. The parent’s income equals consolidated
income under both methods.
d. The parent’s income equals consolidated
income under the fully adjusted method.
The major difference between the modified

and fully adjusted equity methods of
accounting for fixed asset transfers is:
a. The parent’s income is always lower under
the modified equity method.
b. The parent’s income is always higher
under the modified equity method.
c. The parent’s income equals consolidated
income under both methods.
d. The parent’s income equals consolidated
income under the fully adjusted method.

subsidiary following a
downstream land transfer.
Group Exercise 1: Partial Ownership Land Transfer
 Stubben Corporation is a 90%-owned subsidiary of Parker

Corporation, acquired for $270,000 on 1/1/X5.
 Investment cost was equal to book value and fair value.
 Stubben’s net income in 20X5 was $70,000, and Parker’s
income, excluding its income from Stubben, was $90,000.
 Parker’s income includes a $10,000 unrealized gain on
land that cost $40,000 and was sold to Stubben for
$50,000.
NCI P
90%
 Assume that Stubben sold the land in 20X7 for $65,000. 10%
Assume Parker adjusts for this transaction in the equity
accounts.
NOTE: This is a downstream transaction. S
Required:
1. What entry(ies) would Parker make in 20X5 and 20X7?
2. Prepare the consolidation entries at 12/31/X5,
12/31/X6, and 12/31/X7.
Requirement 1
20X5 Equity Method Entries

Income from Stubben 63,000

20X7 Equity Method Entry (after Stubben resold the land)

Requirement 2

Land 10,000

Land 10,000

Adjustments
Consol-
Income Statement
Gain 10,000 10,000 0
53,000 53,000
Income from Sub 0
Basic
Balance Sheet
323,000 323,000
Investment in Sub 0
Basic
Land 50,000 10,000 40,000
Adjustments
Consol-
Income Statement
Balance Sheet
(10,000)
Lower Basic
Land 50,000 10,000 40,000
Adjustments
Consol-
Income Statement
15,000 10,000 25,000
Balance Sheet
(10,000)
Lower Basic
Land 0 0

subsidiary following an
upstream land transfer.
Group Exercise 2: Partial Ownership Land Transfer
 Stubben Corporation is a 90%-owned subsidiary of Parker
Corporation, acquired for $270,000 on 1/1/X5.
 Investment cost was equal to book value and fair value.
 Stubben’s net income in 20X5 was $70,000, and Parker’s
income, excluding its income from Stubben, was $90,000.
 Stubben’s income includes a $10,000 unrealized gain on
land that cost $40,000 and was sold to Parker for $50,000.
NCI P
90%
 Assume that Parker sold the land in 20X7 for $65,000. 10%
 Assume Parker adjusts for this transaction in the equity
accounts.
 Assume that Stubben sold the land in 20X7 for $65,000.
 Assume Parker adjusts for this transaction in the equity
S
accounts.
Required:
1. What entry(ies) would Parker make in 20X5 and 20X7?
2. Prepare the consolidation entries at 12/31/X5, 12/31/X6,
and 12/31/X7.
Partially Owned Upstream Sales Equity Method Adjustment
 Similar to what we did with inventory transfers:

we must share deferral with the NCI shareholders
 Simply split up the adjustment for unrealized
gains proportionately.
Equity
NCI P
90%
Method
Adjustments 10%
Investment in Income from
S
Stubben Stubben
NI 63,000 63,000 NI
9,000 Unreal. Gain 9,000
54,000
Unreal. 1,000 Gain To NCI Shareholders

Solution: Parker Company Equity Method Journal Entries
Requirement 1
20X5 Equity Method Entries


Investment in Stubben 9000
20X7 Equity Method Entry (after Stubben resold the land)

Solution: Parker Company Equity Method Journal Entries
Requirement 2
Land 10,000
NCI in NA of Stubben 1,000
Land 10,000
Requirement 3
NCI in NA of Stubben 1,000
Adjustments
Consol-
Income Statement
Gain 10,000 10,000 0
54,000 54,000
Income from Sub 0
Basic
Balance Sheet
324,000 324,000
Investment in Sub 0
Basic
Land 50,000 10,000 40,000
Adjustments
Consol-
Income Statement
Income from Sub Basic 0

Balance Sheet
(9,000) 9,000
Investment in Sub 0
Lower Basic
1,000 1,000
NCI in NA
Lower
Land 50,000 10,000 40,000
Adjustments
Consol-
Income Statement
15,000 10,000 25,000
Income from Sub Basic 0
Balance Sheet
(9,000) 9,000
Investment in Sub 0
Lower Basic
1,000 1,000
NCI in NA
Lower
Land 0

subsidiary following a
downstream depreciable asset
transfer.
Transfers of Depreciable Assets
 What is the major difference between depreciable and
non-depreciable assets?
 Depreciation—DUH!
 Adds complexity because you have a “moving target” instead of a
stationary target. However, the concepts are the same!
 Adjust for:
 Unrealized gain (same as with land)
 Differences in depreciation expense
 The goal is to get back to the asset’s old basis “as if ” it were
still on the books of the original owner.
 One difference—depreciated going forward based on the new
estimated new life.
 Same as a change of depreciation estimates on any company’s books
Developing Fixed Asset Elimination Entries
 Compare “Actual” with “As if ”

 “Actual” = How the transferred asset and
related accounts actually appear on the
companies’ books
 “ As if ” = How the transferred asset and
related accounts would have appeared if the
asset had stayed on the original owner’s books
 The difference between the two gives

the elimination entry or entries.
Choosing the Right Depreciable Life
 What’s not relevant?

 The original owner’s remaining useful life
at the transfer date.
 What’s relevant?
 The acquirer’s estimated remaining useful
life (if different from the original remaining
life).
Example 3—End of Year Transfer
Assume Padre Corp. purchased a machine on 1/1/20X1 for
$100,000 and estimated that the machine would have a useful
life of 10 years with no salvage value. After two years, on
12/31/20X2, Padre Corp. sold the machine to its 100% owned
subsidiary, Sonny Co., for $90,000. Sonny Co. estimated that the
asset had a remaining useful life of five years.
What is the amount of the gain or loss recorded by Padre at
the time of the fixed asset transfer?
Accumulated
Machine Depreciation
Sale:
100,000 20,000
Proceeds $90,000
 Book Value 80,000
Book Value = 80,000 Gain $ 10,000
What accounts and balances actually exist after the fixed
asset transfer?
Accumulated
Machine Depreciation Gain on Sale
100,000 20,000 10,000

What balances would have existed if the transfer had not
taken place?
Accumulated
90,000 “Actual” 0 10,000
100,000 “As if” 20,000 0

The worksheet entry on 12/31/X2 to eliminate the asset
transfer is simply the “adjustment” to change from “actual”
to “as if” the asset hadn’t been transferred.
Gain on Sale 10,000

Machine 10,000
Accumulated
90,000 “Actual” 0 10,000

10,000 20,000 10,000
100,000 “As if” 20,000 0

Example 4: Beginning of Year Transfer
How much depreciation expense will Sonny record in 20X3?
Depreciation Expense = (C – SV) / # years
= (90,000 – 0) / 5 years = $18,000
How much depreciation expense would Padre have recorded in 20X3
if it had retained the machine and simply changed the estimated life to
five years?
Depreciation Expense = (BV – SV) / # years left
= (80,000 – 0) / 5 years = $16,000
Sonny’s 20X3 expense can be separated into two parts:

 The portion associated with the original book value from Padre’s books.
 The portion associated with the extra amount paid above Padre’s book
value (the gain).
Gain = 10,000  5 = 2,000 Extra Depreciation

Book Value = 80,000  5 = 16,000 Padre Depreciation
18,000 Total Sonny Depreciation
How do we “fix” the depreciation expense so that it will
appear “as if” the asset had not been transferred?
In other words, how do eliminate the “extra” depreciation
expense?

Depreciation Accumulated
Expense Depreciation
18,000 “Actual” 18,000
16,000 “As if” 16,000

Depreciation Accumulated
Expense Depreciation
18,000 “Actual” 18,000
2,000 2,000
16,000 “As if” 16,000

Depreciation Expense 2,000
In addition to the depreciation adjustment, the asset’s basis needs to be
adjusted and the gain eliminated. What accounts and balances actually
exist after the fixed asset transfer?
Accumulated
90,000 “Actual” 18,000 10,000
What balances would have existed if the transfer hadn’t taken
place?
Accumulated
90,000 “Actual” 18,000 10,000
100,000 “As if” 36,000 0

There are two worksheet entries on 12/31/X3 to compare
“actual” to “as if” to make it appear like the asset hadn’t been
transferred. What is the second elimination entry?
Gain on Sale 10,000
Equipment 10,000
Accumulated
90,000 “Actual” 18,000 10,000
10,000 2,000 20,000 10,000
100,000 “As if” 36,000 0

On 7/1/X8, Pale, Inc. reported a $30,000

gain on equipment sold to Sunny, Inc.
(100% owned), which extended the then
remaining life of 3 yrs. to 5 yrs. The
adjustment to depreciation expense in
consolidation at 12/31/X8 is :
a. $3,000.
b. $5,000.
c. $6,000.
d. $10,000.
On 7/1/X8, Pale, Inc. reported a $30,000

gain on equipment sold to Sunny, Inc.
(100% owned), which extended the then
remaining life of 3 yrs. to 5 yrs. The
adjustment to depreciation expense in
consolidation at 12/31/X8 is :
a. $3,000. ($30,000 / 5) x ½ year
b. $5,000.
c. $6,000.
d. $10,000.
On 5/1/X8, Pastor, Inc. had a $30,000 gain

on equipment sold to Sermon, Inc. (100%
owned) for $150,000. Sermon extended the
then remaining life of 2 yr. (original life was
10 yrs.) to 4 yrs. What is the consolidated
accumulated depreciation at 12/31/X8?
a. $500,000.
b. $505,000.
c. $510,000.
d. $520,000.
e. $540,000.
On 5/1/X8, Pastor, Inc. had a $30,000 gain

on equipment sold to Sermon, Inc. (100%
owned) for $150,000. Sermon extended the
then remaining life of 2 yr. (original life was
10 yrs.) to 4 yrs. What is the consolidated
accumulated depreciation at 12/31/X8?
a. $500,000. ($480,000 + [$120,000/4 x 2/3 yr.])
b. $505,000.
c. $510,000.
d. $520,000.
e. $540,000.
This is a difficult question! Solve it in several steps.
Example 5: Partial Ownership Depreciable
Asset Transfer at the End of the Year
On Pericles Corporation sells machinery to its 80%-owned
subsidiary, Sophocles Corporation, on 12/31/20X4. The
machinery has a book value of $60,000 on this date (cost
$120,000 and accumulated depreciation $60,000), and it is
sold to Sophocles for $90,000. Thus, this transaction produces
an unrealized gain of $30,000. Assume that Pericles adjusts its
equity method accounts accordingly.
Note: Transfer is on last day of the year.
Required:
NCI
80%
P
1. What journal entry would Pericles make on its 20%
books to adjust for the unrealized gain from this
transaction?
2. What worksheet entry would Pericles make to
consolidate on this date?
S
Accumulated
120,000 60,000
Sale:
Proceeds $90,000
Book Value = 60,000
Unrealized Gain $ 30,000
Income from
Investment in Sub Sub
30,000 Defer Gain 30,000
Requirement 1: Equity Method

Accumulated
Sub 90,000 “Actual” 0
30,000 60,000
Parent 120,000 “As if” 60,000
Requirement 2: Worksheet Entry

Gain on Sale 30,000
Equipment 30,000
Example 6: Depreciable Asset Transfer at
Beginning of Year
Given all other information from the previous example,
assume that the transfer takes place on 1/1/20X4. Also,
assume that as of the date of transfer, the machinery has a
five-year remaining useful life (with no residual value) and
that Sophocles uses straight-line depreciation. In addition to
the journal entries to record the transfer of the asset,
Sophocles also records depreciation expense of $18,000 for
20X4 ($90,000 / 5 years).
Note: Transfer is on first day of the year.
Required:
1. What journal entry(ies) would Pericles make on its books
to adjust for the unrealized gain from this transaction?
2. What worksheet entry(ies) would Pericles make to
consolidate on this date?
Beginning of Year
Book Value = 60,000  5 = 12,000 Parent Depreciation
18,000 Total Depreciation
Requirement 1:
Of the $18,000 of depreciation recorded, $12,000 is based
on the BV at the time of transfer and $6,000 is based on the
unrealized gain component. We can think of the $6,000 as
the cancelation of 1/5 of the unrealized gain.
Beginning of Year

30,000 Defer Gain 30,000
6,000 Extra Depreciation 6,000


Beginning of Year
Accumulated
Sub 90,000 “Actual” 18,000
30,000 6,000 60,000
Parent 120,000 “As if” 72,000
Requirement 2: Worksheet Entries

Gain on Sale 30,000
Equipment 30,000

Adjustments
Consol-
Income Statement
Gain 30,000 30,000 0
Depreciation Expense 18,000 6,000 12,000
Balance Sheet
Equipment 90,000 30,000 120,000
Accumulated
18,000 6,000 60,000 72,000
Depreciation
Example 6: Subsequent Years
Given all other information from the previous examples,
consider what happens in the last 5 years of the asset’s
useful life. Think about both the equity method entry
Pericles would have to make each year and what
elimination entry would be made each year.

Required:
1. What journal entry would Pericles make on its books to
adjust for the unrealized gain from this transaction on
12/31/X5?
2. What worksheet entry(ies) would Pericles make to
consolidate on this date on 12/31/X5?
Solution 6: Subsequent Years
Requirement 1:
Pericles will continue to extinguish $6,000 (1/5) of
the unrealized gain each year to its equity accounts.
Equity Method Entry for all Subsequent Years:

Accumulated
Sub 90,000 “Actual” 36,000
30,000 6,000 54,000
Parent 120,000 “As if” 84,000
20X5 Worksheet Entries:

Equipment 30,000

Adjustments
Consol-
Income Statement
Balance Sheet
Equipment 90,000 30,000 120,000
Accumulated
36,000 6,000 54,000 84,000
Depreciation
Investment in Sub XXX 24,000 Basic 0

Accumulated
20X6 Worksheet Entries: Equipment Depreciation
Equipment 30,000 Sub 90,000 “Actual” 54,000
Accumulated Depreciation 48,000 30,000 6,000 48,000
Accumulated Depreciation 6,000 Parent 120,000 “As if” 96,000

Accumulated
20X7 Worksheet Entries: Equipment Depreciation
Accumulated Depreciation 42,000 30,000 6,000 42,000
Depreciation Expense 6,000 Parent 120,000 “As if” 108,000
20X8 Worksheet Entries: Accumulated

30,000 6,000 36,000
Depreciation Expense 6,000 Parent 120,000 “As if” 120,000
Adjustments
Consol-
Income Statement
Balance Sheet
Equipment 90,000 30,000 120,000
Accumulated
54,000 6,000 48,000 96,000
Depreciation

Adjustments
Consol-
Income Statement
Balance Sheet
Equipment 90,000 30,000 120,000
Accumulated
72,000 6,000 42,000 108,000
Depreciation

Adjustments
Consol-
Income Statement
Balance Sheet
Equipment 90,000 30,000 120,000
Accumulated
90,000 6,000 36,000 120,000
Depreciation


subsidiary following an
upstream depreciable asset
transfer.
Example 7: Upstream with Partial Ownership
Depreciable Asset Transfer
On 1/3/X6, Snoopy (an 85%-owned subsidiary of Peanut)
sold equipment costing $150,000 to Peanut for $90,000. At the
time of the sale, the equipment had accumulated depreciation
of $110,000. Peanut continued depreciating the equipment
using the straight-line method and assigned a remaining
useful life of five years.
Required:
1. What journal entry would Peanut make on its
NCI P
85%
books each year to adjust for the unrealized 15%
gain from this transaction?
2. What worksheet entry would Peanut make each
year to consolidate on this date? S
Example 5 Computations
Equipment Accumulated Depreciation

150,000 110,000
Book Value = 40,000
Sale:
Proceeds $90,000
Example 7 Computations
Peanut
NCI
Sale:
15% 85%
Proceeds $90,000
Snoopy

Book Value = 40,000  5 = 8,000 Sub Depreciation
18,000 Total Depreciation
Solution: Peanut Company Equity Method
Journal Entries
Investment in Snoopy Income from Snoopy

42,500 Defer Gain 42,500
85%
8,500 Extra Depr. 8,500
Income from Snoopy 42,500

Year 1
Investment in Snoopy 42,500

Solution: Peanut Company Equity Method
Journal Entries

Year 2

Year 3

Year 4

Year 5
Worksheet Entries
Year 1 Gain on Sale 50,000
Equipment 60,000


Peanut 90,000 “Actual” 18,000
60,000 10,000 110,000
Snoopy 150,000 “As if” 118,000

Worksheet Entries
Year 2 Investment in Snoopy 34,000
NCI in NA of Snoopy 6,000
Equipment 60,000

60,000 10,000 100,000
Snoopy 150,000 “As if” 126,000

Worksheet Entries
Equipment 60,000

60,000 10,000 90,000
Snoopy 150,000 “As if” 134,000

Worksheet Entries
Equipment 60,000

60,000 10,000 80,000
Snoopy 150,000 “As if” 142,000

Worksheet Entries
Equipment 60,000

60,000 10,000 70,000
Snoopy 150,000 “As if” 150,000

Consolidation Worksheet—Year 1
Adjustments
Consol-
Income Statement
Gain 50,000 50,000 0
Balance Sheet
Equipment 90,000 60,000 150,000
Accumulated
18,000 10,000 110,000 118,000
Depreciation
Adjustments
Consol-
Income Statement
Balance Sheet
Equipment 90,000 60,000 150,000
Accumulated
36,000 10,000 100,000 126,000
Depreciation
Investment in Snoopy XXX 34,000 Basic 0
NCI in NA of Snoopy 6,000 XXX

Adjustments
Consol-
Income Statement
Balance Sheet
Equipment 90,000 60,000 150,000
Accumulated
54,000 10,000 90,000 134,000
Depreciation

Adjustments
Consol-
Income Statement
Balance Sheet
Equipment 90,000 60,000 150,000
Accumulated
72,000 10,000 80,000 142,000
Depreciation

Adjustments
Consol-
Income Statement
Balance Sheet
Equipment 90,000 60,000 150,000
Accumulated
90,000 10,000 70,000 150,000
Depreciation

Intercompany Transfers of Amortizable Assets
 Accounting for intangible assets usually differs

from accounting for tangible assets in that
amortizable intangibles normally are reported
at the remaining unamortized balance without
the use of a contra account.
 Other than netting the accumulated
amortization on an intangible asset against the
asset cost, the intercompany sale of intangibles
is treated the same in consolidation as the
intercompany sale of tangible assets.
Conclusion
The End
7-673
Chapter 8
Intercompany
Indebtedness

intercompany debt
transfers.
Consolidation Overview
 A direct intercompany debt transfer involves a loan from one
affiliate to another without the participation of an unrelated
party.
 An indirect intercompany debt transfer involves the issuance
of debt to an unrelated party and the subsequent purchase of
the debt instrument by an affiliate of the issuer.
Direct Intercompany Debt Transfer
Indirect Intercompany Debt Transfer
Which of the following statements is true?

a. A direct intercompany debt transfer
always involves an unrelated party.
b. An indirect intercompany debt transfer
always involves a transfer directly to a
related party.
c. A direct intercompany debt transfer
never involves an unrelated party.
d. An indirect intercompany debt transfer
is first transferred to an affiliated
company with a subsequent transfer to
an unrelated party.

related party.
an unrelated party.

and elimination entries
related to direct
intercompany debt
transfers.
Bond Sale Directly to an Affiliate
 When one company sells bonds directly to an affiliate, all
effects of the intercompany indebtedness must be eliminated
in preparing consolidated financial statements.
 Transfer at par value
(example continues on next slide).
Assume that on January 1, 20X1, Special Foods borrows $100,000 from
Peerless Products by issuing $100,000 par value, 12 percent, 10-year
bonds. During 20X1, Special Foods records interest expense on the
bonds of $12,000 ($100,000 x .12), and Peerless records an equal
amount of interest income.
In the preparation of consolidated financial statements for 20X1, two
elimination entries are needed in the consolidation worksheet to
remove the effects of the intercompany indebtedness:
Eliminate intercorporate bond holding:
Bonds Payable 100,000
Investment in Special Foods Bonds 100,000
Eliminate intercompany interest:

Interest Income 12,000
Interest Expense 12,000
These entries have no effect on consolidated net income because they

reduce interest income and interest expense by the same amount.
 Transfer at a discount or premium
 Bond interest income or expense recorded do not equal cash interest
payments.
 Interest income/expense amounts are adjusted for the amortization
of the discount or premium.
On January 1, 20X1, Peerless Products purchases $100,000 par value, 12
percent, 10-year bonds from Special Foods for $90,000. Interest on the
bonds is payable on January 1 and July 1. The interest expense recognized by
Special Foods and the interest income recognized by Peerless each year
include straight-line amortization of the discount, as follows:
Cash interest ($100,000 x .12) $12,000

Amortization of discount
($10,000 / 20 semiannual interest periods) x 2 periods 1,000
Interest expense or income $13,000
 Entries by the debtor
January 1, 20X1
Cash 90,000
Discount on Bonds Payable 10,000
Issue bonds to Peerless Products.
July 1, 20X1
Discount on Bonds Payable 500
Cash 6,000
Semiannual payment of interest.
December 31, 20X1

Interest Payable 6,000
Accrue interest expense at year-end.
 Entries by the bond investor
January 1, 20X1
Cash 90,000
Purchase of bonds from Special Foods.
July 1, 20X1
Cash 6,000
Investment in Special Foods Bonds 500
Receive interest on bond investment
December 31, 20X1

Interest Receivable 6,000
Accrue interest income at year-end.
Elimination Entries at Year-End—20X1:
Eliminates the bonds payable and associated discount against the investment in
bonds:

Eliminates the bond interest income recognized by Peerless during 20X1 against
the bond interest expense recognized by Special Foods:

Eliminates the interest receivable against the interest payable.

Eliminates intercorporate bond holding.
Eliminates intercompany interest:

Eliminates intercompany interest receivable/payable.

Consolidation at the end of 20X2 requires elimination entries similar to

those at the end of 20X1.
Because $1,000 of the discount is amortized each year, the bond investment
balance on Peerless’ books increases to $92,000.
Bonds of Affiliate Purchased from a
Nonaffiliate
 Scenario: Bonds that were issued to an unrelated
party are acquired later by an affiliate of the issuer.
 From the viewpoint of the consolidated entity, an
acquisition of an affiliate’s bonds retires the bonds at the
time they are purchased.
 Acquisition of the bonds of an affiliate by another
company within the consolidated entity is referred
to as constructive retirement.
 Although the bonds actually are not retired, they are
treated as if they were retired in preparing consolidated
Nonaffiliate
 When a constructive retirement occurs:
 The consolidated income statement for the period reports a gain or
loss on debt retirement based on the difference between the carrying
value of the bonds on the books of the debtor and the purchase price
paid by the affiliate.
 Neither the bonds payable nor the purchaser’s investment in the
bonds is reported in the consolidated balance sheet because the
bonds are no longer considered outstanding.
A constructive debt retirement is

a. an acquisition of the bonds of an affiliate
by another company within the
b. an acquisition of the bonds of an non-
affiliate by a company within a
c. a sale of the bonds of a non-affiliate by a
company within a consolidated entity.
d. a sale of the bonds of an affiliate to a


related to debt purchased
from a nonaffiliate to an
amount less than book
value.
Nonaffiliate
 Purchase at an amount less than book value:
 When the price paid to acquire the bonds of an affiliate
differs from the liability reported by the debtor, a gain or
loss is reported in the consolidated income statement in
the period of constructive retirement.
 The bond interest income and interest expense reported
by the two affiliates subsequent to the purchase must be
eliminated in preparing consolidated statements.
 Interest income reported by the investing affiliate and
interest expense reported by the debtor are not equal in
this case because of the different bond carrying amounts
on the books of the two companies.
Nonaffiliate: Illustration
Peerless Products Corporation acquires 80 percent of the common stock of Special
Foods Inc. on December 31, 20X0, for its underlying book value of $240,000.
At that date, the fair value of the noncontrolling interest is equal to its book value of
$60,000.
Additionally:
1. On January 1, 20X1, Special Foods issues 10-year, 12 percent bonds payable with
a par value of $100,000; the bonds are issued at 102. Nonaffiliated Corporation
purchases the bonds from Special Foods.
2. The bonds pay interest on June 30 and December 31.
3. Both Peerless and Special amortize bond discount and premium using the
straight-line method.
4. On December 31, 20X1, Peerless purchases the bonds from Nonaffiliated for
$91,000.
5. Special Foods reports net income of $50,000 for 20X1 and $75,000 for 20X2 and
declares dividends of $30,000 in 20X1 and $40,000 in 20X2.
6. Peerless earns $140,000 in 20X1 and $160,000 in 20X2 from its own separate
operations. Peerless declares dividends of $60,000 in both 20X1 and 20X2.
Nonaffiliate: Illustration—YEAR 1
Bond Liability Entries—20X1 (Special Foods)
January 1, 20X1
Cash 102,000
Premium on Bonds Payable 2,000
Sale of bonds to Nonaffiliated.
June 30, 20X1

Premium on Bonds Payable 100
Cash 6,000
December 31, 20X1

Cash 6,000
Total interest expense for 20X1 is $11,800 ($5,900 x 2), and the book
value of the bonds on December 31, 20X1, is as follows:
Book value of bonds at issuance $102,000)

Amortization of premium, 20X1 (200)
Book value of bonds, December 31, 20X1 $101,800)
Bond Investment Entry—20X1 (Peerless)

December 13, 20X1
Cash 91,000
Purchase of Special Foods bonds from Nonaffiliated Corporation.
Computation of Gain on Constructive Retirement of Bonds
Book value of Special Foods’ bonds, December 31, 20X1 $101,800 )

Price paid by Peerless to purchase bonds (91,000)
Gain on constructive retirement of bonds $10,800 )
This gain is included in the consolidated income statement as a gain

on the retirement of bonds.
 Assignment of gain: constructive retirement
 Four approaches have been used:
1. The affiliate issuing the bonds
2. The affiliate purchasing the bonds
3. The parent company
4. The issuing and purchasing companies, based on the difference
between the carrying amounts of the bonds on their books at the date
of purchase and the par value of the bonds
Fully Adjusted Equity-Method Entries—20X1: In addition to recording the

bond investment, Peerless records the following equity-method entries during
20X1 to account for its investment in Special Foods stock:
Investment in Special Foods Stock 40,000

Income from Special Foods 40,000
Record equity-method income: $50,000 x 0.80.
Cash 24,000
Record dividends from Special Foods: $30,000 x 0.80.

Record Peerless’ 80% share of the gain on the constructive retirement
of Special Foods’ bonds.
These entries result in a $264,640 balance in the investment account

at the end of 20X1 as shown:
Investment in Special Foods Income from Special Foods
Acq. 240,000
80% NI 40,000 40,000 80% NI
24,000 80% Dividends
8,640 80% of Bond 8,640
Retirement Gain
EB 264,640 48,640 EB
In preparing a consolidation worksheet prepared at the end of 20X1, the first two elimination
entries are the same as we prepared in Chapter 3 with one minor exception. While the analysis of
the “book value” portion of the investment account is the same, in preparing the basic elimination
entry, we increase the amounts in Peerless’ Income from Special Foods and Investment in Special
Foods Stock accounts by Peerless’ share of the gain on bond retirement, $8,640 ($10,800 x 0.80).
We also increase the NCI in Net Income of Special Foods and NCI in Net Assets of Special Foods by
the NCI share of the deferral, $2,160 ($10,800 x 0.20).
NCI Peerless Common Retained
+ = +
20% 80% Stock Earnings
Original Book Value 60,000) 240,000) 200,000 100,000)
+ Net Income 10,000) 40,000) 50,000)
 Dividends (6,000) (24,000) (30,000)
Ending Book Value 64,000) 256,000) 200,000 120,000)
Basic Investment Account Elimination Entry:
Common Stock 200,000  Common Stock Balance
Retained Earnings 100,000  Beg. RE from trial balance
Income from Special Foods 48,640  Peerless’ % of NI + 80% Ret. Gain
NCI in NI of Special Foods 12,160  NCI share of NI + 20% Ret. Gain
Dividends Declared 30,000  100% of Sub’s dividends
Investment in Special Foods Stock 264,640  Net BV + 80% Ret. Gain
NCI in NA of Special Foods 66,160  NCI share of BV + 20% Ret. Gain
The amounts related to the bonds from the books of Peerless and Special
Foods and the appropriate consolidated amounts are shown below along
with entry to eliminate intercompany bond holdings:
Peerless Special Unadjusted Consolidated
Item Products Foods Totals Amounts
Bonds Payable 0) $(100,000) $(100,000) 0)
Premium on Bonds Payable 0) (1,800) (1,800) 0)
Investment in Bonds $91,000) 0) 91,000) 0)
Interest Expense 0) $11,800) $11,800) $11,800)
Interest Income 0) 0) 0) 0)
Gain on Bond Retirement 0) 0) 0) (10,800)
Worksheet entry to eliminate intercompany bond holdings:

Gain on Bond Retirement 10,800
 The impact of the constructive gain on the beginning
noncontrolling interest balance and on the beginning
consolidated retained earnings balance is reflected in
the entry to eliminate intercompany bond holdings.
 The entry to eliminate intercompany bond holdings
also eliminates all aspects of the intercorporate bond
holdings, including:
 Peerless’ investment in bonds
 Special Foods’ bonds payable and the associated premium
 Peerless’ bond interest income
 Special Foods’ bond interest expense
 The optional accumulated depreciation entry can be made by netting
the accumulated depreciation at the time of acquisition against the
cost as shown:
Optional accumulated depreciation elimination entry:

 Original depreciation
 The consolidation worksheet prepared for December 31, 20X1, is at the
Accumulated Depreciation 300,000 time of the acquisition netted
presented
Building on the next slide (Figure300,000
and Equipment 8–2 in the text).
against cost
Consolidation Worksheet at December 31,
20X2
Peerless Special Elimination Entries
Products Foods DR CR Consolidated
Income Statement
Sales 400,000 200,000 600,000
Less: COGS (170,000) (115,000) (285,000)
Less: Interest Expense (20,000) (11,800) (31,800)
Income from Special Foods 48,640 48,640 0
Gain from Bond Retirement 10,800 10,800
Consolidated Net Income 188,640 50,000 48,640 10,800 200,800
NCI in Net Income 12,160 (12,160)
Controlling Interest Net Income 188,640 50,000 60,800 10,800 188,640

Net Income 188,640 50,000 60,800 10,800 188,640
Ending Balance 428,640 120,000 160,800 40,800 428,640
Balance Sheet
Cash 173,000 76,800 246,800
Inventory 100,000 75,000 175,000
Investment in Special Foods Stock 264,640 264,640 0
Investment in Special Foods Bonds 91,000 91,000 0
Land 175,000 40,000 215,000
Building and Equipment 800,000 600,000 300,000 1,100,000
Total Assets 1,228,640 521,800 300,000 655,640 1,394,800

Bonds Payable 200,000 100,000 100,000 200,000
Premium on Bonds Payable 1,800 1,800 0
Common Stock 500,000 200,000 200,000 500,000
NCI in NA of Special Foods 66,160 66,160
Total Liabilities & Equity 1,228,640 521,800 462,600 106,960 1,394,800
 Consolidated Net Income—20X1
 Noncontrolling Interest—December 31, 20X1

June 30, 20X2
Cash 6,000
December 31, 20X2

Cash 6,000
Bond Investment Entries—20X2 (Peerless)

June 30, 20X2
Cash 6,000
Record receipt of bond interest.
December 31, 20X2

Cash 6,000
 Subsequent recognition of gain on constructive retirement
 In 20X1, the entire $10,800 gain on the retirement was recognized in
the consolidated income statement but not on the books of either
Peerless or Special Foods.
Peerless’ discount on bond investment $9,000

Special Foods’ premium on bond liability 1,800
Total gain on constructive retirement of bonds $10,800
 This can be visualized as in the following figure:
In each year subsequent to 20X1, both Peerless and Special Foods recognize
a portion of the constructive gain as they amortize the discount on the bond
investment and the premium on the bond liability:
Peerless’ amortization of discount on bond investment

($9,000  9 years) $1,000
Special Foods’ amortization of premium on bonds payable
($1,800  9 years) 200
Annual increase in combined incomes of separate companies $1,200
Fully Adjusted Equity-Method Entries—20X2
Cash 32,000
Income from Special Foods 960

Investment in Special Foods Stock 960
Record 1/9 of constructive gain: $10,800 x 1/9 x 0.80.
Whereas neither Peerless nor Special Foods recognized any of the gain from the constructive bond
retirement on its separate books in 20X1, Peerless adjusts its equity method income from Special Foods for
its 80 percent share of the $10,800 gain, $8,640. Therefore, as Peerless and Special Foods recognize the gain
over the remaining term of the bonds, Peerless must reverse its 20X1 equity-method entry for its share of
the gain amortization each year. Thus, the original adjustment of $8,640 is reversed by $960 ($8,640 ÷ 9
years) each year.
+ = +
Beginning Book Value 64,000) 256,000) 200,000 120,000)
+ Net Income 15,000) 60,000) 75,000)
 Dividends (8,000) (32,000) (40,000)

Common Stock 200,000  Common stock balance
Income from Special Foods 59,040  % of NI  80% Gain Rec.
NCI in NI of Special Foods 14,760  NCI % of NI  20% 20X2 Gain Rec.
Investment in Special Foods Stock 283,040  Net BV  80% 20X2 Gain Rec.
NCI in NA of Special Foods 70,760  NCI % of BV  20% Gain Rec.
The amounts related to the bonds from the books of Peerless and Special Foods and the
appropriate consolidated amounts are shown below along with entry to eliminate intercompany
bond holdings:
Bonds Payable 0) $(100,000) $(100,000) 0)
Interest Expense 0) $11,800) $11,800) 0)
Interest Income $(13,000) 0) (13,000)) 0)
This analysis leads to the following worksheet entry to eliminate intercompany bond holdings.

NCI in NA of Special Foods 2,160
cost as shown:

 The consolidation worksheet prepared for December Original depreciation
31, 20X2, is at the
Accumulated Depreciation 300,000 time of the acquisition netted
presented on the
Building and Equipment
next slide (Figure300,000
8–3 in the text).
against cost
20X2
Income Statement
Sales 450,000 300,000 750,000
Less: COGS (180,000) (160,000) (340,000)
Less: Interest Expense (20,000) (11,800) 11,800 (20,000)
Interest Income 13,000 13,000 0

Net Income 232,040 75,000 86,800 11,800 232,040
Ending Balance 600,680 155,000 206,800 51,800 600,680
Balance Sheet
Cash 212,000 86,600 298,600
Inventory 180,000 90,000 270,000
8,640
Land 175,000 40,000 215,000
Total Assets 1,400,680 556,600 300,000 683,680 1,573,600

Bonds Payable 200,000 100,000 100,000 200,000
Premium on Bonds Payable 1,600 1,600
Common Stock 500,000 200,000 200,000 500,000
2,160
 Bond elimination entry in subsequent years
 In years after 20X2, the worksheet entry to eliminate the
intercompany bonds and to adjust for the gain on constructive
retirement of the bonds is similar to the entry to eliminate
intercompany bond holdings.
 The unamortized bond discount and premium decrease each year by
$1,000 and $200, respectively.
 As of the beginning of 20X3, $9,600 of the gain on the constructive
retirement of the bonds remains unrecognized by the affiliates:
In the bond elimination entry in the consolidation worksheet
prepared at the end of 20X3, this amount is allocated
between beginning retained earnings and the noncontrolling
interest.
Eliminate intercompany bond holdings:

Which of the following statements is NOT true when
affiliate bonds are purchased at an amount less than
book value?
a. When the price paid to acquire the bonds differs
from the liability reported by the debtor, a gain or
loss is reported.
b. Bond interest income and interest expense
reported by the two affiliates subsequent to the
purchase must be eliminated.
c. Interest income and interest expense reported
affiliates are not equal because of the different
bond carrying amounts on the companies’ books.
d. Interest income and interest expense reported
affiliates are always equal.
book value?
loss is reported.

amount more than book
value.
Nonaffiliate
 Purchase at an amount greater than book value
 The consolidation procedures are virtually the same except that a loss
is recognized on the constructive retirement of the debt
Nonaffiliate
Special Foods issues 10-year 12 percent bonds on January 1, 20X1, at par of
$100,000. The bonds are purchased from Special Foods by Nonaffiliated
Corporation, which sells the bonds to Peerless on December 31, 20X1, for
$104,500. Special Foods recognizes $12,000 ($100,000 x .12) of interest
expense each year. Peerless recognizes interest income of $11,500 in each
year after 20X1:
Annual cash interest payment ($100,000 x .12) $12,000)

Less: Amortization of premium on bond investment
($4,500  9 years) (500)
Interest income $11,500)
Nonaffiliate
Because the bonds were issued at par, the carrying amount on
Special Foods’ books remains at $100,000. Thus, once Peerless
purchases the bonds from Nonaffiliated Corporation for
$104,500, a loss on the constructive retirement must be
recognized in the consolidated income statement for $4,500.
The bond elimination entry in the consolidation worksheet
prepared at the end of 20X1 removes the bonds payable and the
bond investment and recognizes the loss on the constructive
retirement:
Eliminate intercorporate bond holdings:

Loss on Bond Retirement 4,500
Nonaffiliate
The bond elimination entry needed in the consolidation
worksheet prepared at the end of 20X2 is as follows:

NCI in NA of Special Foods 900
$11,500 = ($100,000 x 0.12)  $500

$3,600 = $4,500 x 0.80
$900 = $4,500 x 0.20
$104,000 = $104,500  $500
$12,000 = $10,000 x 0.12
Nonaffiliate
Similarly, the following entry is needed in the consolidation
worksheet at the end of 20X3:

$3,200 = ($4,500  $500) x 0.80

$900 = ($4,500  $500) x 0.80
$103,500 = $104,500  $500  $500
How do consolidation procedures when

affiliate bonds are purchased at an amount
greater than book value differ from when
they are purchased at an amount less than
book value?
a. A constructive loss is reported instead
of a constructive gain.
b. The entries are identical.
c. No consolidation entries are necessary.
d. The constructive gain is ignored.

book value?
Conclusion
The End
8-734
Chapter 8
Intercompany
Indebtedness

intercompany debt
transfers.
Consolidation Overview
 A direct intercompany debt transfer involves a loan from one
affiliate to another without the participation of an unrelated
party.
 An indirect intercompany debt transfer involves the issuance
of debt to an unrelated party and the subsequent purchase of
the debt instrument by an affiliate of the issuer.
Direct Intercompany Debt Transfer
Indirect Intercompany Debt Transfer

related party.
an unrelated party.

related party.
an unrelated party.

related to direct
intercompany debt
transfers.
 When one company sells bonds directly to an affiliate, all
effects of the intercompany indebtedness must be eliminated
in preparing consolidated financial statements.
 Transfer at par value
(example continues on next slide).
Assume that on January 1, 20X1, Special Foods borrows $100,000 from
Peerless Products by issuing $100,000 par value, 12 percent, 10-year
bonds. During 20X1, Special Foods records interest expense on the
bonds of $12,000 ($100,000 x .12), and Peerless records an equal
amount of interest income.
In the preparation of consolidated financial statements for 20X1, two
elimination entries are needed in the consolidation worksheet to
remove the effects of the intercompany indebtedness:
Eliminate intercorporate bond holding:
Eliminate intercompany interest:

These entries have no effect on consolidated net income because they

reduce interest income and interest expense by the same amount.
 Transfer at a discount or premium
 Bond interest income or expense recorded do not equal cash interest
payments.
 Interest income/expense amounts are adjusted for the amortization
of the discount or premium.
On January 1, 20X1, Peerless Products purchases $100,000 par value, 12
percent, 10-year bonds from Special Foods when the market interest rate is
13 percent. In order to yield a 13 percent return, Special Foods issues the
bonds at a discount for $94,490.75. Interest on the bonds is payable on
January 1 and July 1. The interest expense recognized by Special Foods and
the interest income recognized by Peerless each period based on effective
interest amortization of the discount over the life of the bonds can be
summarized as follows:
Bond Discount Amortization Table
Interest Bonds
Payment Interest Expense Payable Carrying
Payment Period (Face x 0.12 (Carrying Value Amortization Face Value of
Number End x 6/12) x 0.13 x 6/12) of Discount Discount Value Bonds
(5,509.25) 100,000 94,490.75
1 7/1/20X1 6,000 6,141.90 141.90 (5,367.36) 100,000 94,632.64
2 1/1/20X2 6,000 6,151.12 151.12 (5,216.23) 100,000 94,783.77
3 7/1/20X2 6,000 6,160.94 160.94 (5,055.29) 100,000 94,944.71
4 1/1/20X3 6,000 6,171.41 171.41 (4,883.88) 100,000 95,116.12
5 7/1/20X3 6,000 6,182.55 182.55 (4,701.33) 100,000 95,298.67
6 1/1/20X4 6,000 6,194.41 194.41 (4,506.92) 100,000 95,493.08
7 7/1/20X4 6,000 6,207.05 207.05 (4,299.87) 100,000 95,700.13
8 1/1/20X5 6,000 6,220.51 220.51 (4,079.36) 100,000 95,920.64
 Entries by the debtor
January 1, 20X1
Cash 94,491
Issue bonds to Peerless Products.
July 1, 20X1
Cash 6,000
December 31, 20X1

Accrue interest expense at year-end.
 Entries by the bond investor
January 1, 20X1
Cash 94,491
Purchase of bonds from Special Foods.
July 1, 20X1
Cash 6,000
Receive interest on bond investment
December 31, 20X1

Accrue interest income at year-end.
Eliminates the bonds payable and associated discount against the investment in
bonds:

Eliminates the bond interest income recognized by Peerless during 20X1 against
the bond interest expense recognized by Special Foods:

Eliminates the interest receivable against the interest payable.

Eliminates intercorporate bond holding.
Eliminates intercompany interest:

Eliminates intercompany interest receivable/payable.

Consolidation at the end of 20X2 requires elimination entries similar to those at the
end of 20X1. By the end of the second year (i.e., the fourth interest payment), the carrying
value of the bond investment on Peerless’ books increases to $95,116 ($94,491 issue price +
discount amortization of $142 + $151 + $161 + 171). Similarly, the bond discount on
Special Foods’ books decreases to $4,884, resulting in an effective bond liability of
$95,116.
Nonaffiliate
 Scenario: Bonds that were issued to an unrelated
party are acquired later by an affiliate of the issuer.
 From the viewpoint of the consolidated entity, an
acquisition of an affiliate’s bonds retires the bonds at the
time they are purchased.
 Acquisition of the bonds of an affiliate by another
company within the consolidated entity is referred
to as constructive retirement.
 Although the bonds actually are not retired, they are
treated as if they were retired in preparing consolidated
Nonaffiliate
 When a constructive retirement occurs:
 The consolidated income statement for the period reports a gain or
loss on debt retirement based on the difference between the carrying
value of the bonds on the books of the debtor and the purchase price
paid by the affiliate.
 Neither the bonds payable nor the purchaser’s investment in the
bonds is reported in the consolidated balance sheet because the
bonds are no longer considered outstanding.



amount less than book
value.
Nonaffiliate
 Purchase at an amount less than book value:
 When the price paid to acquire the bonds of an affiliate
differs from the liability reported by the debtor, a gain or
loss is reported in the consolidated income statement in
the period of constructive retirement.
 The bond interest income and interest expense reported
by the two affiliates subsequent to the purchase must be
eliminated in preparing consolidated statements.
 Interest income reported by the investing affiliate and
interest expense reported by the debtor are not equal in
this case because of the different bond carrying amounts
on the books of the two companies.
Peerless Products Corporation acquires 80 percent of the common stock of Special Foods
Inc. on December 31, 20X0, for its underlying book value of $240,000. At that date, the fair
value of the noncontrolling interest is equal to its book value of $60,000. Additionally:
1. On January 1, 20X1, Special Foods issues 10-year, 12 percent bonds payable with a par
value of $100,000; the bonds are issued at a premium, $105,975.19, to yield the
current market interest rate of 11%. Nonaffiliated Corporation purchases the bonds
from Special Foods.
2. The bonds pay interest on June 30 and December 31.
3. Both Peerless and Special amortize bond discounts and premia using the effective
interest method.
4. On December 31, 20X1, Peerless purchases the bonds from Nonaffiliated for
$94,823.04 when the bonds’ carrying value on Special’s books is $105,623.04,
resulting in a gain of $10,800 on the constructive retirement of the bonds. Note that
Peerless’ purchase price reflects the current market interest rate of 12.992186%
when the bonds have 18 payments left to maturity.
5. Special Foods reports net income of $50,152 for 20X1 and $75,192 for 20X2 and
declares dividends of $30,000 in 20X1 and $40,000 in 20X2.
6. Peerless earns $140,000 in 20X1 and $160,000 in 20X2 from its own separate
operations. Peerless declares dividends of $60,000 in both 20X1 and 20X2.
In addition, the interest expense recognized by Special Foods each period
based on the effective interest amortization of the premium over the life of
the bonds can be summarized as follows:
Bond Premium Amortization Table

Interest
Payment Bonds
(Face x Interest Expense Payable Carrying
Payment Period 0.12 (Carrying Value Amortization Face Value of
Number End x 6/12) x 0.11 x 6/12) of Premium Premium Value Bonds
1/1/20X1 105,975.19
1 6/30/20X1 6,000.00 5,828.64 (171.36) 5,975.19
5,803.83 100,000.00
100,000.00 105,803.83
2 12/31/20X1 6,000.00 5,819.21 (180.79) 5,623.04 100,000.00 105,623.04
3 6/30/20X2 6,000.00 5,809.27 (190.73) 5,432.30 100,000.00 105,432.30
4 12/31/20X2 6,000.00 5,798.78 (201.22) 5,231.08 100,000.00 105,231.08
5 6/30/20X3 6,000.00 5,787.71 (212.29) 5,018.79 100,000.00 105,018.79
6 12/31/20X3 6,000.00 5,776.03 (223.97) 4,794.82 100,000.00 104,794.82
7 6/30/20X4 6,000.00 5,763.72 (236.28) 4,558.54 100,000.00 104,558.54
8 12/31/20X4 6,000.00 5,750.72 (249.28) 4,309.26 100,000.00 104,309.26
9 6/30/20X5 6,000.00 5,737.01 (262.99) 4,046.27 100,000.00 104,046.27
10 12/31/20X5 6,000.00 5,722.54 (277.46) 3,768.81 100,000.00 103,768.81
11 6/30/20X6 6,000.00 5,707.28 (292.72) 3,476.10 100,000.00 103,476.10
12 12/31/20X6 6,000.00 5,691.19 (308.81) 3,167.28 100,000.00 103,167.28
13 6/30/20X7 6,000.00 5,674.20 (325.80) 2,841.48 100,000.00 102,841.48
January 1, 20X1
Cash 105,975
Sale of bonds to Nonaffiliated.
June 30, 20X1

Cash 6,000
December 31, 20X1

Cash 6,500
Total interest expense for 20X1 is $11,648 ($5,829 + $5,819), and the
book value of the bonds on December 31, 20X1, is $105, 623 as shown
in the amortization table. Bond Premium Amortization Table
Interest
Payment Bonds
(Face x Interest Expense Payable Carrying
Payment Period 0.12 (Carrying Value Amortization Face Value of
Number End x 6/12) x 0.11 x 6/12) of Premium Premium Value Bonds
1/1/20X1 105,975.19
1 6/30/20X1 6,000.00 5,828.64 (171.36) 5,975.19
5,803.83 100,000.00
100,000.00 105,803.83
2 12/31/20X1 6,000.00 5,819.21 (180.79) 5,623.04 100,000.00 105,623.04
3 6/30/20X2 6,000.00 5,809.27 (190.73) 5,432.30 100,000.00 105,432.30
Bond Investment Entry—20X1 (Peerless)4 12/31/20X2 6,000.00 5,798.78 (201.22) 5,231.08 100,000.00 105,231.08
5 6/30/20X3 6,000.00 5,787.71 (212.29) 5,018.79 100,000.00 105,018.79
December 13, 20X1 6 12/31/20X3 6,000.00 5,776.03 (223.97) 4,794.82 100,000.00 104,794.82
7 6/30/20X4 6,000.00 5,763.72 (236.28) 4,558.54 100,000.00 104,558.54
Investment in Special Foods Bonds 8 12/31/20X4 6,000.00 5,750.72 94,823
(249.28) 4,309.26 100,000.00 104,309.26
Cash 9
10
6/30/20X5
12/31/20X5
6,000.00
6,000.00
5,737.01
5,722.54
(262.99)
(277.46)
4,046.27
3,768.81
94,823
100,000.00
100,000.00
104,046.27
103,768.81
Purchase of Special Foods bonds from Nonaffiliated Corporation.
11
12
6/30/20X6
12/31/20X6
6,000.00
6,000.00
5,707.28
5,691.19
(292.72)
(308.81)
3,476.10
3,167.28
100,000.00
100,000.00
103,476.10
103,167.28
13 6/30/20X7 6,000.00 5,674.20 (325.80) 2,841.48 100,000.00 102,841.48
Computation of Gain on Constructive Retirement of Bonds
14 12/31/20X7 6,000.00 5,656.28 (343.72) 2,497.77 100,000.00 102,497.77
15 6/30/20X8 6,000.00 5,637.38 (362.62) 2,135.14 100,000.00 102,135.14
16 12/31/20X8 6,000.00 5,617.43 (382.57) 1,752.58 100,000.00 101,752.58
Book value of Special Foods’ bonds, December 31, 20X1

17
18
6/30/20X9
12/31/20X9
6,000.00
6,000.00
5,596.39
5,574.19
(403.61)
(425.81)
$105,623 )
1,348.97
923.16
100,000.00
100,000.00
101,348.97
100,923.16
Price paid by Peerless to purchase bonds
19 6/30/20Y0 6,000.00 5,550.77 (449.23) (94,823)
473.93 100,000.00 100,473.93
20 12/31/20Y0 6,000.00 5,526.07 (473.93) 0.00 100,000.00 100,000.00
Gain on constructive retirement of bonds 120,000.00 114,024.81 (5,975.19) $10,800 )
This gain is included in the consolidated income statement as a gain

on the retirement of bonds.
 Assignment of gain: constructive retirement
 Four approaches have been used:
1. The affiliate issuing the bonds
2. The affiliate purchasing the bonds
3. The parent company
4. The issuing and purchasing companies, based on the difference
between the carrying amounts of the bonds on their books at the date
of purchase and the par value of the bonds
Fully Adjusted Equity-Method Entries—20X1: In addition to recording the

bond investment, Peerless records the following equity-method entries during
20X1 to account for its investment in Special Foods stock:

Cash 24,000

Record Peerless’ 80% share of the gain on the constructive retirement
of Special Foods’ bonds.
These entries result in a $264,640 balance in the investment account

at the end of 20X1 as shown:
Investment in Special Foods Income from Special Foods
Acq. 240,000
80% NI 40,122 40,122 80% NI
8,640 80% of Bond 8,640
Retirement Gain
EB 264,762 48,762 EB
In preparing a consolidation worksheet prepared at the end of 20X1, the first two elimination
entries are the same as we prepared in Chapter 3 with one minor exception. While the analysis of
the “book value” portion of the investment account is the same, in preparing the basic elimination
entry, we increase the amounts in Peerless’ Income from Special Foods and Investment in Special
Foods Stock accounts by Peerless’ share of the gain on bond retirement, $8,640 ($10,800 x 0.80).
We also increase the NCI in Net Income of Special Foods and NCI in Net Assets of Special Foods by
the NCI share of the deferral, $2,160 ($10,800 x 0.20).
+ = +
+ Net Income 10,030) 40,122) 50,152)
 Dividends (6,000) (24,000) (30,000)
Basic Investment Account Elimination Entry:
Common Stock 200,000  Common Stock Balance
Income from Special Foods 48,762  Peerless’ % of NI + 80% Ret. Gain
NCI in NI of Special Foods 12,190  NCI share of NI + 20% Ret. Gain
Investment in Special Foods Stock 264,762  Net BV + 80% Ret. Gain
NCI in NA of Special Foods 66,190  NCI share of BV + 20% Ret. Gain
The amounts related to the bonds from the books of Peerless and Special
Foods and the appropriate consolidated amounts are shown below along
with entry to eliminate intercompany bond holdings:
Bonds Payable 0) $(100,000) $(100,000) 0)
Interest Expense 0) $11,648) $11,648) $11,648)
Interest Income 0) 0) 0) 0)
Gain on Bond Retirement 0) 0) 0) (10,800)
Worksheet entry to eliminate intercompany bond holdings:

Gain on Bond Retirement 10,800
cost as shown:

 Accumulated
 The consolidation worksheet prepared for December depreciation
31, 20X1, is at
Accumulated Depreciation 300,000 the time of the acquisition
presented
Building on the next slide (Figure300,000
and Equipment 8–2 in the text).
netted against cost
20X2
Income Statement
Sales 400,000 200,000 600,000
Less: COGS (170,000) (115,000) (285,000)
Less: Interest Expense (20,000) (11,648) (31,648)
Gain from Bond Retirement 10,800 10,800

Net Income 188,762 50,152 60,952 10,800 188,762
Ending Balance 428,762 120,152 160,952 40,800 428,762
Balance Sheet
Cash 169,177 80,775 249,952
Inventory 100,000 75,000 175,000
Land 175,000 40,000 215,000
Total Assets 1,228,762 525,775 300,000 659,585 1,394,952

Bonds Payable 200,000 100,000 100,000 200,000
Premium on Bonds Payable 5,623 5,623 0
Common Stock 500,000 200,000 200,000 500,000
Peerless’ separate income $140,000
Special Foods’ net income $50,152
Gain on constructive retirement of bonds 10,800
Special Foods’ realized net income 60,952
Consolidated net income, 20X1 $200,952
Income to noncontrolling interest ($60,800  0.20) (12,190)
Income to controlling interest $188,762
Book value of Special Foods’ net assets, December 31, 20X1:

Common stock $200,000
Retained earnings 120,152
Total reported book value $320,152
Gain on constructive retirement of bonds 10,800
Realized book value of Special Foods’ net assets $330,952
Noncontrolling stockholders’ share  0.20
Noncontrolling interest in net assets, December 31, 20X1 $ 66,190
June 30, 20X2
Cash 6,000
December 31, 20X2

Cash 6,000
Bond Investment Entries—20X2 (Peerless)

June 30, 20X2
Cash 6,000
December 31, 20X2

Cash 6,000
 Subsequent recognition of gain on constructive retirement
 In 20X1, the entire $10,800 gain on the retirement was recognized in
the consolidated income statement but not on the books of either
Peerless or Special Foods.
Peerless’ discount on bond investment $5,177

Special Foods’ premium on bond liability 5,623
Total gain on constructive retirement of bonds $10,800
 This can be visualized as in the following figure:
$5,975
$5,623
$5,177
In each year subsequent to 20X1, both Peerless and Special Foods recognize
a portion of the constructive gain as they amortize the discount on the bond
investment and the premium on the bond liability (based on their respective
amortization tables). Thus, the $10,800 gain on constructive bond
retirement, previously recognized in the consolidated income statement, is
recognized on the books of Peerless and Special Foods over the remaining
nine-year term of the bonds.
Fully Adjusted Equity-Method Entries—20X2
Record Peerless’ 80% share of Special Foods’ 20X2 income.
Cash 32,000
Record Peerless’ 80% share of Special Foods’ 20X2 dividend.
Income from Special Foods 578

Investment in Special Foods Stock 578
Recognize 80% share of amortization of premium and discount [0.80 x (191 + 201 + 160 + 170)]
Whereas neither Peerless nor Special Foods recognized any of the gain from the constructive bond
retirement on its separate books in 20X1, Peerless adjusts its equity method income from Special Foods for
its 80 percent share of the $10,800 gain, $8,640. Therefore, as Peerless and Special Foods recognize the gain
over the remaining term of the bonds, Peerless must reverse its 20X1 equity-method entry for its share of
the gain. This adjustment is needed to avoid double-counting Peerless’ share of the gain. Thus, the original
adjustment of $8,640 is reversed by the 80% portion of the combined amortization of Special Foods’
premium and Peerless’ discount each year.
+ = +
Beginning Book Value 64,030) 256,122) 200,000 120,152)
+ Net Income 15,038) 60,154) 75,192)
 Dividends (8,000) (32,000) (40,000)

Common Stock 200,000  Common stock balance
Income from Special Foods 59,576  % of NI  80% Gain Rec.
NCI in NI of Special Foods 14,894  NCI % of NI  20% 20X2 Gain Rec.
Investment in Special Foods Stock 283,698*  Net BV  80% 20X2 Gain Rec.
NCI in NA of Special Foods 70,924*  NCI % of BV  20% Gain Rec.
* Rounding difference
The amounts related to the bonds from the books of Peerless and Special Foods and the
appropriate consolidated amounts are shown below along with entry to eliminate intercompany
bond holdings:
Bonds Payable 0) $(100,000) $(100,000) 0)
Interest Expense 0) $11,608) $11,608) 0)
Interest Income $(12,330) 0) (12,330)) 0)
This analysis leads to the following worksheet entry to eliminate intercompany bond holdings.

cost as shown:

 The consolidation worksheet prepared for December Accumulated
31, 20X2, is at
depreciation
Accumulated Depreciation 300,000 the time of the acquisition
presented on the
Building and Equipment
next slide (Figure300,000
8–3 in the text).
netted against cost
20X2
Income Statement
Sales 450,000 300,000 750,000
Less: COGS (180,000) (160,000) (340,000)
Less: Interest Expense (20,000) (11,608) 11,608 (20,000)
Interest Income 12,330 12,330 0
NCI in Net Income 14,894 14,894

Net Income 231,906 75,192 86,800 11,608 231,906
Ending Balance 600,668 155,344 206,952 51,608 600,668
Balance Sheet
Cash 208,177 90,575 298,752
Inventory 180,000 90,000 270,000
8,640
Land 175,000 40,000 215,000
Total Assets 1,400,668 560,575 300,000 687,491 1,573,752

Bonds Payable 200,000 100,000 100,000 200,000
Premium on Bonds Payable 5,231 5,231
Common Stock 500,000 200,000 200,000 500,000
2,160
Peerless’ separate income $172,330

Special Foods’ net income $75,192
Peerless’ amortization of bond discount (330)
Special Foods’ amortization of bond premium (392)
Special Foods’ realized net income 74,470
Consolidated net income, 20X1 $246,800
Income to noncontrolling interest ($74,470  0.20) (14,894)
Income to controlling interest $231,906
Book value of Special Foods’ net assets, December 31, 20X2:

Common stock $200,000
Retained earnings 155,344
Total book value of net assets $355,344
Gain on constructive retirement of bonds $10,800
Less: Portion recognized by affiliates during 20X2 (722)
Constructive gain not yet recognized by affiliates 10,078
Realized book value of Special Foods net assets $365,422
Noncontrolling stockholders’ share  0.20
Noncontrolling interest in net assets, December 31, 20X2 $ 73,084
 Bond elimination entry in subsequent years
 In years after 20X2, the worksheet entry to eliminate the
intercompany bonds and to adjust for the gain on constructive
retirement of the bonds is similar to the entry to eliminate
intercompany bond holdings.
 The unamortized bond discount and premium decrease each year
based on the amortization table.
 As of the beginning of 20X3, $10,078 of the gain on the constructive
retirement of the bonds remains unrecognized by the affiliates:
Gain on constructive retirement of bonds $10,800

Less: Portion recognized by affiliates during 20X2:
Peerless’ amortization of bond discount $330
Special Foods’ amortization of bond premium 392
Total gain recognized by affiliates (722)
Unrecognized gain on constructive retirement of
bonds, January 1, 20X3 $10,078
In the bond elimination entry in the consolidation worksheet
prepared at the end of 20X3, this amount is allocated
between beginning retained earnings and the noncontrolling
interest.
Eliminate intercompany bond holdings:

book value?
loss is reported.
book value?
loss is reported.

amount more than book
value.
Nonaffiliate
 Purchase at an amount greater than book value
 The consolidation procedures are virtually the same except that a loss
is recognized on the constructive retirement of the debt
Nonaffiliate
Special Foods issues 10-year 12 percent bonds on January 1, 20X1, at par of
$100,000. The bonds are purchased from Special Foods by Nonaffiliated
Corporation, which sells the bonds to Peerless on December 31, 20X1, for
$104,500. Special Foods recognizes $12,000 ($100,000 x .12) of interest
expense each year. Peerless recognizes interest income based on the
following amortization table:
Bond Premium Amortization Table

Interest Interest Income Bonds
Payment (Carrying Value Payable Carrying
Payment (Face x 0.12 x 0.112393897 Amortization Face Value of
Number Period End x 6/12) x 6/12) of Premium Premium Value Bonds
12/31/20X1 4,500.00 100,000.00 104,500.00
1 6/30/20X2 6,000 5,848.75 (151.25) 4,348.75 100,000.00 104,348.75
2 12/31/20X2 6,000 5,840.28 (159.72) 4,189.03 100,000.00 104,189.03
3 6/30/20X3 6,000 5,831.34 (168.66) 4,020.37 100,000.00 104,020.37
4 12/31/20X3 6,000 5,821.90 (178.10) 3,842.27 100,000.00 103,842.27
Nonaffiliate
Because the bonds were issued at par, the carrying amount on
Special Foods’ books remains at $100,000. Thus, once Peerless
purchases the bonds from Nonaffiliated Corporation for
$104,500, a loss on the constructive retirement must be
recognized in the consolidated income statement for $4,500.
The bond elimination entry in the consolidation worksheet
prepared at the end of 20X1 removes the bonds payable and the
bond investment and recognizes the loss on the constructive
retirement:

Loss on Bond Retirement 4,500
Nonaffiliate
The bond elimination entry needed in the consolidation
worksheet prepared at the end of 20X2 is as follows:

$11,689 = $5,849 + $5,840

$3,600 = $4,500 x 0.80
$900 = $4,500 x 0.20
$104,189 = $104,500  $160
$12,000 = $10,000 x 0.12
Nonaffiliate
Similarly, the following entry is needed in the consolidation
worksheet at the end of 20X3:

$11,653 = $5,831 + $5,822

$3,451 = $4,189 x 0.80
$838 = $4,189 x 0.20
$103,842 = $104,189 - $169 - $178
$12,000 = $100,000 x 0.12

book value?

book value?
Conclusion
The End
8-796
Chapter 9
Consolidation
Ownership
Issues
General Overview
 The following topics are discussed in this

chapter:
1.Subsidiary preferred stock outstanding
2.Changes in the parent’s ownership interest in
the subsidiary
3.Multiple ownership levels
4.Reciprocal or mutual ownership
5.Subsidiary stock dividends
6. Ownership interests other than common stock

how the consolidation
process differs when the
subsidiary has preferred
stock outstanding.
Subsidiary Preferred Stock Outstanding
 Preferred stockholders normally have

preference over common shareholders with
respect to dividends and the distribution of
assets in a liquidation.
 The right to vote usually is withheld.
 Special attention must be given to the claim of a
subsidiary’s preferred shareholders on the net
assets of the subsidiary.
 Consolidation with subsidiary preferred stock outstanding
 The amount of subsidiary stockholders’ equity accruing to preferred
shareholders must be considered with the elimination of the
intercompany common stock ownership.
 If the parent holds some of the subsidiary’s preferred stock, its
portion of the preferred stock interest must be eliminated.
 Any portion of the subsidiary’s preferred stock interest not held by
the parent is assigned to the noncontrolling interest.

a. If a parent company owns both common
and preferred stock, only the common
stock of the subsidiary is eliminated.
b. If a parent company owns both common
and preferred stock, only the preferred
c. The parent’s portion of the subsidiary’s
preferred stock must be eliminated.
d. The NCI’s portion of the subsidiary’s

a. If a parent company owns both common
and preferred stock, only the common
b. If a parent company owns both common
and preferred stock, only the preferred
c. The parent’s portion of the subsidiary’s
d. The NCI’s portion of the subsidiary’s

when the subsidiary has
preferred stock outstanding.
Example 1: Preferred Stock Owned by the NCI
Assume Peanut acquired 75% of Snoopy’s voting

stock for $300,000 (an amount equal to 75% of the
book value of net assets). At the time of the
acquisition, Snoopy had common stock of $150,000,
retained earnings of $250,000, and $80,000 of par
value, 10% preferred stock. During 20X1, the first
fiscal year after the acquisition, Snoopy reported net
income of $60,000 and declared dividends of
$20,000. Assume the NCI shareholders own all of the
preferred stock. Also assume $200,000 of
accumulated depreciation on the acquisition date.
Allocation of Snoopy’s net income
Of the total $60,000 of net income reported by Snoopy for 20X1, $8,000
($80,000 x 0.10) is assigned to the preferred shareholders as their current
dividend. Peanut records its share of the remaining amount:
Snoopy’s net income, 20X1 $60,000)

Less: Preferred dividends ($80,000 x 0.10) (8,000)
Snoopy’s income accruing to common shareholders 52,000)
Peanut's proportionate share x 0.75)
Peanut's income from Snoopy $39,000)
Income assigned to the noncontrolling interest for 20X1:
Preferred dividends of Snoopy $8,000)

Income assigned to Snoopy's noncontrolling common
shareholders ($52,000 x 0.25) 13,000)
Income to noncontrolling interest $21,000)
Subsidiary Preferred Stock Outstanding: Preferred
Stock owned by the NCI
Preparing the worksheet:

 In order to prepare the consolidation worksheet, we first
analyze the book value of common equity in order to
prepare the basic elimination entry.
 Since Snoopy was purchased for an amount equal to the
book value of net assets, there is no differential in this
example.
 In consolidation, the $8,000 preferred dividend is
treated as income assigned to the noncontrolling
interest.
 Because Peanut holds none of Snoopy's preferred stock,
the entire $8,000 is allocated to the noncontrolling
interest.
An analysis of these book value calculations leads to the following basic elimination entry. Note
that the numbers highlighted in blue are the figures that appear in the basic elimination entry.
NCI Investment Preferred Common Retained
25% + 75% = Stock + Stock + Earnings
Original Book Value 180,000) 300,000) 80,000 150,000 250,000)

+ Net Income 21,000) 39,000) 60,000)
 Preferred Dividends (8,000) 0) (8,000)
 Common Dividends (5,000) (15,000) (20,000)
Ending Book Value 188,000) 324,000) 80,000 150,000) 282,000

Preferred Stock 80,000  Balance in PS account
Common Stock 150,000  Balance in CS account
Retained Earnings 250,000  Beginning balance in RE
Income from Snoopy 39,000  Peanut's share of NI
NCI in NI of Snoopy 21,000  NCI share of NI
Dividends Declared, Preferred 8,000  100% of Sub’s preferred dividends
Dividends Declared, Common 20,000  100% of Common dividends
Investment in Snoopy 324,000  Net BV left in investment account
NCI in NA of Snoopy 188,000  NCI share of net book value
In addition to closing out Snoopy's equity accounts, this elimination entry also eliminates
Peanut's Investment in Snoopy and Income from Snoopy accounts:
Acq. 300,000
75% NI 39,000 39,000 75% NI
15,000 75% of
Common Dividends
EB 324,000 39,000 EB
324,000 Basic 39,000
0 0
The only other elimination entry is the optional accumulated depreciation elimination entry:

Subsidiary Preferred Stock Outstanding: Preferred
Stock Owned by the Parent
 Subsidiary preferred stock held by parent

 Because the preferred stock held by the parent is within the
consolidated entity, it must be eliminated when consolidated financial
statements are prepared.
 Any income from the preferred stock recorded by the parent also
must be eliminated.
Example 2: Parent Owns 50 Percent of
Preferred Stock

retained earnings of $250,000, and $80,000 of par
value, 10% preferred stock. During 20X1, the first
fiscal year after the acquisition, Snoopy reported net
income of $60,000 and declared dividends of
$20,000. Assume Peanut also purchased 50% of
Snoopy’s preferred stock.
Example 2: Parent Owns 50 Percent of
Preferred Stock
In order to prepare the basic eliminating entry, we first analyze the book value of equity and the
related investment accounts in Peanut's common and preferred stock, the noncontrolling
interest, and preferred dividend income accounts at the end of 20X1 as follows:
NCI Inv. PS Pref. Div. Inv. CS Preferred Common Retained
50%/25% + 50% + Income 50% + 75% = Stock + Stock + Earnings
Original Book Value 140,000) 40,000 300,000) 80,000 150,000 250,000)

+ Net Income 17,000) 4,000) 39,000) 60,000)
 Preferred Dividends (4,000) (4,000) ) (8,000)
 Common Dividends (5,000) (15,000) (20,000)
Ending Book Value 148,000) 40,000 0) 324,000) 80,000 150,000 282,000

Income from Snoopy 39,000  Peanut's 75% of NI to common interest
Dividends Income—Preferred 4,000  Peanut's share of preferred dividends
NCI in NI of Snoopy 17,000  NCI share of NI
Dividends Declared, Preferred 8,000  100% of Sub’s preferred dividends
Dividends Declared, Common 20,000  100% of Common dividends
Investment in Snoopy CS 324,000  Net BV left in investment CS account
Investment in Snoopy PS 40,000  Net BV left in investment PS account
 Subsidiary preferred stock with special provisions
 The provisions of the preferred stock agreement must be examined to
determine the portion of the subsidiary’s stockholders’ equity to be
assigned to the preferred stock interest.
 Cumulative dividend provision
 Noncumulative preferred stock
 Preferred stock participation features
 Preferred stocks that are callable
Example 3: Subsidiary Preferred Stock with Special
Features
To examine the consolidation treatment of subsidiary preferred stock with the most
common special features, assume the following:
1. Snoopy issues $80,000 par value 10 percent preferred stock on January 1, 20X0. It is
cumulative, nonparticipating, and callable at 102.
2. No dividends are declared on the preferred stock during 20X0.
3. On January 1, 20X1, Peanut Products acquires 75 percent of Snoopy’s common stock for
$300,000, when the fair value of the noncontrolling interest in Snoopy’s common stock is
$150,000.
4. On January 1, 20X1, Peanut acquires 50 percent of the preferred stock for $42,000.
Stockholders’ equity accounts of Snoopy on January 1, 20X1 follow:
Preferred Stock $80,000

Total Stockholders’ Equity $480,000
Features
Peanut acquires 50 percent of Snoopy’s $80,000 par value, 10 percent preferred stock
for $40,000 when issued on January 1, 20X1. During 20X1 dividends of $8,000 are
declared on the preferred stock. Peanut recognizes $7,200 of dividend income from
its investment in preferred stock, and the remaining $4,800 is paid to the holders of
the other preferred shares.
Par value of Snoopy’s preferred stock $80,000)

Call premium 1,600) 9,600
Dividends in arrears for 20X0 8,000) Extra
Total preferred stock interest, January 1, 20X1 $89,600)
This amount is apportioned between Peanut and the noncontrolling shareholders:
Peanut's share of preferred stock interest

($89,600 x 0.50) $44,800)
Noncontrolling stockholders’ share of
preferred stock interest ($89,600 x 0.50) 44,800)
Total preferred stock interest, January 1, 20X1 $89,600)
Features
Because the preferred stock interest exceeds the par value by $9,600, the portion of
Snoopy’s retained earnings accruing to the common shareholders is reduced by that
amount. Therefore, Snoopy’s common stockholders have a total claim on the
company’s net assets as follows:
Common Stock $150,000)

Retained Earnings ($250,000  $9,600) 240,400)
Total common stock interest, January 1, 20X1 $390,400)
Features
NCI Inv. PS Inv. CS Preferred Common Retained
50%/25% + 50% + 75% = Stock + Stock + Earnings
Original Book Value 140,000 40,000 300,000 80,000 150,000 250,000
This analysis leads to the following basic elimination entry:

Investment in Snoopy CS 300,000  Net BV left in inv. in CS
Investment in Snoopy PS 40,000  Net BV left in inv. in PS
The next elimination entry allocates the $9,600 reduction in retained earnings to the
preferred interest:
Retained Earnings 9,600  RE to preferred shareholders

Investment in Snoopy PS 2,000  Excess value in inv. in PS
Additional Paid-In Capital 2,800  “Loss” to NCI on sale of PS
NCI in NA of Snoopy 4,800  50% of RE to common equity
Features
Because the book value of Snoopy's common stock is only $390,400 on
January 1, 20X1, Peanut's acquisition of 75 percent of Snoopy's common
stock for $300,000 results in a differential:
Consideration given by Peanut Products $300,000)

Fair value of noncontrolling interest in
Snoopy's common stock 100,000)
$400,000)
Book value of Snoopy's common stock (390,400)
Differential $9,600)
Stated differently, because of the combination date the sum of the fair values of the
consideration exchanged ($300,000) and the noncontrolling interest in Snoopy's
common stock ($100,000) exceeds the book value of the common shares ($390,400),
a differential arises. This $9,600 differential is assigned to the appropriate assets and
liabilities in the worksheet.
Differential 9,600

explain how consolidation
procedures differ when the
parent’s ownership interest
changes during the
accounting period.
Example 4: Parent Buys Additional Shares
 Parent’s purchase of additional shares from non-

affiliate:
 Effects of multiple purchases of a subsidiary’s stock on the
consolidation process are illustrated in the following
example:
Assume that on January 1, 20X1, Snoopy has $150,000 of common stock

outstanding and retained earnings of $250,000. During 20X0, 20X1, and
20X2, Snoopy reports the following information:
Period Net Income Dividends Ending Book Value

20X0 $150,000
20X1 60,000 $10,000 300,000
20X2 35,000 20,000 320,000
Peanut Products purchases its 75 percent interest in Snoopy in several
blocks, as follows:
Ownership
Purchase Date Cost Book Value Differential
Percentage Acquired
January 1, 20X1 25% $ 105,000 $ 100,000 $5,000
January 1, 20X2 50% 240,000 225,000 15,000
75%
All of the differential relates to land held by Snoopy. Note that Peanut does
not gain control of Snoopy until January 1, 20X2.
The investment account on Peanut's books includes the
following amounts through 20X1:
20X0
Purchase shares (January 1) $105,000)
Equity-method income ($60,000 x 0.25) 15,000)
Dividends ($10,000 x 0.25) (2,500)
Balance in investment account (December 31) $117,500)
Under ASC 805, Peanut must remeasure the equity interest it already held in
Snoopy to its fair value at the date of combination and recognize a gain or
loss for the difference between the fair value and its carrying amount:
Fair value of equity interest already held $120,000)

Carrying amount of investment, December 31, 20X1 (117,500)
Gain on increase in value of investment in Snoopy $ 2,500)
The total balance of the investment account on Peanut's books immediately

after the combination is:
Carrying amount of investment, December 31, 20X1 $117,500)

Increase in value of investment in Snoopy 2,500)
Cost of January 1, 20X2, shares acquired 240,000)
Peanut's total recorded amount of investment $360,000)
Because Peanut Products gains control of Snoopy on January 1, 20X2,
consolidated statements are prepared for the year 20X2. The ending balance
in the Investment in Snoopy account at the end of 20X2 is calculated as
follows:
Investment in Snoopy
12/31/X1 Balance 117,500
Fair Value Adjustment 2,500
Purchase 50% CS 240,000
1/1/X2 Balance 360,000
75% Net Income 26,250
15,000 75% of Dividend
12/31/X2 Balance 371,250
The investment account on Peanut's books includes the following amounts
through 20X1:
20X0
Purchase shares (January 1) $105,000)
Dividends ($10,000 x 0.25) (2,500)
20X1
Fair value adjustment 2,500)
Purchase of shares (January 1) 240,000)
Dividends ($20,000 x 0.75) (15,000)
In order to prepare the consolidation worksheet at the end of the year, we first
analyze the book value component to construct the basic elimination entry:
NCI Peanut Common Retained
25% + 75% = Stock + Earnings
+ Net Income 8,750) 26,250) 35,000)
 Preferred Dividends (5,000) (15,000) (20,000)

Common Stock 150,000  Original amount invested (100%)
Income from Snoopy 26,250  Peanut's share of reported NI
NCI in NI of Snoopy 8,750  NCI share of reported NI
Dividends Declared 20,000  100% of dividends
Investment in Snoopy 348,750  Net amount of BV left in inv. acct.
NCI in NA of Snoopy 116,250  NCI’s share of net book value
When Peanut gains control of Snoopy on January 1, 20X2, assume that the
fair value of the 25 percent equity interest it already holds in Snoopy is
$120,000, and the fair value of Snoopy's 25 percent remaining noncontrolling
interest after the additional purchase is also $120,000. The book value of
Snoopy as a whole on that date is $450,000. Under ASC 805, the differential
at the date of combination is computed as follows:
Fair value of consideration exchanged $240,000)

Fair value of equity interest already held 120,000)
Fair value of noncontrolling interest 120,000)
$480,000)
Book value of Snoopy (450,000)
Differential $ 30,000)
Because all of the differential relates to land, it is not amortized or written off
either on Peanut's books or for consolidation.
We then analyze the differential and its changes during the
period:
Excess Value (Differential) Calculations:

NCI 25% + Peanut 25% = Land
Beginning Balance 7,500 22,500 30,000
Amortization 0 0 0
Ending Balance 7,500 22,500 30,000
Land 30,000  Excess value from undervalued land

Investment in Snoopy 22,500  Peanut's share of excess value
NCI in NA of Snoopy 7,500  NCI’s share of excess value
Changes in Parent Company Ownership
 A parent’s sale of subsidiary shares to a non-affiliate:
 When a parent sells some shares of a subsidiary but continues to hold
a controlling interest, ASC 810 makes clear that this is considered to
be an equity transaction and no gain or loss may be recognized in
 An adjustment is required to the amount assigned to the
noncontrolling interest to reflect its change in ownership of the
subsidiary.
 A parent’s sale of subsidiary shares to a non-affiliate:
 The difference between the fair value of the consideration exchanged
and the adjustment to the noncontrolling interest results in an
adjustment to the stockholders’ equity attributable to the controlling
interest.
 Some parent companies might choose to recognize a gain on their
separate books.
 A better alternative is to avoid recognizing a gain that later will have to be
eliminated and instead recognize an increase in additional paid-in capital.
 A subsidiary’s sale of additional shares to a non-affiliate:
 increases the total stockholders’ equity of the consolidated entity by
the amount received by the subsidiary from the sale.
 increases the subsidiary’s total shares outstanding and reduces the
percentage ownership held by the parent.
 increases the dollar amount assigned to the noncontrolling interest in
the consolidated financial statements.
 The resulting amounts of the controlling and noncontrolling
interests are affected by two factors:
1. The number of shares sold to non-affiliates, and
2. The price at which the shares are sold to non-affiliates.
 Difference between book value and sale price of subsidiary
shares:
 If the sale price of new shares equals the book value of outstanding
shares, there is no change in the existing shareholders’ claim.
 The consolidation eliminating entries are changed to recognize the
increase in the claim of the noncontrolling shareholders and the
corresponding increase in the stockholders’ equity balances of the
subsidiary.
 When the sale price and book value are not the same:
 all common shareholders are assigned a pro rata portion of the
difference.
 the book value of the subsidiary’s shares held by the parent changes.
 this change is recognized by the parent by adjusting the carrying
amount of its investment in the subsidiary and additional paid-in
capital.
 the parent’s additional paid-in capital is then carried to the
workpaper in consolidation.
Example 5: Parent Sells Stock to Non-Affiliate
retained earnings of $250,000. During 20X1, the
first fiscal year after the acquisition, Snoopy
reported net income of $60,000 and declared
dividends of $20,000. Assume Peanut sold some of
its shares to a non-affiliated party for $25,000 cash,
recording a gain of $3,000. Peanut’s new post-sale
ownership percentage was 70%. In 20X2, Snoopy
had income of $70,000 and paid dividends of
$30,000.
Acquisition 300,000
75% of 20X1 NI 45,000
15,000 75% of 20X1 Div.
12/31/X1 Balance 330,000
22,000 Shares sold to NCI
70% of 20X2 NI 49,000
21,000 70% of 20X2 Div.
12/31/X2 Balance 336,000
Cash 25,000
Gain on Sale of Snoopy Stock 3,000
+ Net Income 21,000) 49,000) 70,000)

Dividends Declared 30,000  100% of dividends
In 20X2, the gain on the sale of the shares is reclassified to
additional paid-in capital with an elimination entry:
Gain on the Sale of Stock 3,000

In subsequent years, an additional elimination entry must be

made to continue to reclassify the gain from retained earnings
to additional paid-in capital:

 A subsidiary’s sale of additional shares to the parent at a
price equal to the book value of the existing shares.
 A sale of additional shares directly from a less-than-
wholly owned subsidiary to its parent increases the

parent’s ownership percentage.
 The increase in the parent’s investment account equals
the increase in the stockholders’ equity of the subsidiary.

 The net book value assigned to the noncontrolling interest
remains unchanged.
 Normal elimination entries are made based on the
parent’s new ownership percentage.

 A subsidiary’s sale of additional shares to the parent at an
amount other than book value.
 It increases the carrying amount of its investment by the
fair value of the consideration given.

 In consolidation, the amount of the noncontrolling
interest must be adjusted to reflect the change in its

interest in the subsidiary.
 ASC 810 then requires an adjustment to consolidated
additional paid-in capital for the difference between any

consideration given or received by the consolidated entity
and the amount of the adjustment to the noncontrolling
interest.
 A subsidiary’s sale of additional shares to the parent at an
amount other than book value.
 If the shares are sold at an amount equal to the book
value of common equity, the value of the NCI in net assets

will not change.
 If the shares are sold at an amount greater than the book

will increase.
 If the shares are sold at an amount less than the book

will decrease.
Example 6a: Sub Sells Parent Additional
Shares
Assume Peanut acquired 75% of Snoopy’s no par

voting stock (7,500 shares) on 1/1 20X1 for
$300,000 (an amount equal to 75% of the book value
of net assets). At the time of the acquisition, Snoopy
had common stock of $150,000, retained earnings of
$250,000. During 20X1, the first fiscal year after the
acquisition, Snoopy reported net income of $60,000
and declared dividends of $20,000. Assume Snoopy
sold Peanut 2,500 additional shares for $130,000 on
1/1/20X2, increasing Peanut’s ownership
percentage to 80%.
Shares
The book value per share of common equity prior to
the issuance of the new shares is:
Total BV of Equity $440,000
BV per share = $440,000 ÷ 10,000 = $44/share
Since the new shares are issued at $52/share
($130,000 ÷ 2,500), which is greater than the $44
BV per share, the value of the NCI in NA will
INCREASE by $4,000:
Shares
Before Sale Following Sale

Common stock $150,000) $280,000
Retained earnings 290,000) 290,000

Total Stockholders' Equity $440,000) $570,000

Snoopy's total stockholders' equity $440,000) $570,000
Peanut's proportionate share 75%) 80%
Book value of Peanut's investment $330,000) $456,000
NCI after sale ($570,000 x 0.20) $114,000)

NCI before sale ($440,000 x 0.25) (110,000)
Increase in book value of NCI $4,000)
Shares
Although Peanut pays $130,000 for the additional 2,500 shares,
the NCI increases by $4,000, reducing the value of Peanut’s
investment in these shares to $126,000 (130,000 – 4,000):
Acquisition 300,000
75% of 20X1 NI 45,000
15,000 75% of 20X1 Div.
12/31/X1 Balance 330,000
Value of the
shares purchased 126,000
1/1/X2 Balance 456,000

Shares
In order to prepare the consolidation worksheet on the date the additional shares are
purchased, we first analyze the book value component to construct the basic
elimination entry:

25%/20% + 75%/80% = Stock + Earnings
Before Purchase Book Value 110,000) 330,000) 150,000 290,000
New Shares Issued 4,000) 126,000) 130,000
Ending Book Value 114,000) 456,000) 280,000 290,000

Example 6b: Sub Sells Parent Additional
Shares
Assume Peanut acquired 75% of Snoopy’s no par

voting stock (7,500 shares) on 1/1 20X1 for
$300,000 (an amount equal to 75% of the book value
of net assets). At the time of the acquisition, Snoopy
had common stock of $150,000, retained earnings of
sold Peanut 2,500 additional shares for $80,000 on
1/1/20X2, increasing Peanut’s ownership
percentage to 80%.
Shares
The book value per share of common equity prior to
the issuance of the new shares is:
Total BV of Equity $440,000
BV per share = $440,000 ÷ 10,000 = $44/share
Since the new shares are issued at $32/share ($80,000
÷ 2,500 ), which is less than the $44 BV per share, the
value of the NCI in NA will DECREASE by $6,000:
Shares

Common stock $150,000) $230,000
Retained earnings 290,000) 290,000

Total Stockholders' Equity $440,000) $520,000

Snoopy's total stockholders' equity $440,000) $520,000
Peanut's proportionate share 75%) 80%
Book value of Peanut's investment $330,000) $416,000
NCI after sale ($520,000 x 0.20) $104,000)

NCI before sale ($440,000 x 0.25) (110,000)
Decrease in book value of NCI ($6,000)
Shares
Although Peanut pays $80,000 for the additional 2,500 shares,
the NCI decreases by $6,000, increasing the value of Peanut’s
investment in these shares to $86,000 (80,000 + 6,000):
Acquisition 300,000
75% of 20X1 NI 45,000
15,000 75% of 20X1 Div.
12/31/X1 Balance 330,000
Value of the
shares purchased 86,000
1/1/X2 Balance 416,000

Shares
elimination entry:

25%/20% + 75%/80% = Stock + Earnings
Before Purchase Book Value 110,000) 330,000) 150,000 290,000
New Shares Issued (6,000) 86,000) 80,000
Ending Book Value 104,000) 416,000) 230,000 290,000

 A subsidiary’s purchase of shares from a non-affiliate.
 Sometimes a subsidiary purchases treasury shares from
noncontrolling shareholders, who may be willing sellers.
 The parent’s equity in the net assets of the subsidiary may change as a
result of the transaction.
 When this occurs, the amount of the change must be recognized in
preparing the consolidated statements.
Example 7: Sub Buys Shares from Non-
Affiliate

stock (7,500 shares) on 1/1 20X1 for $300,000 (an
amount equal to 75% of the book value of net
assets). At the time of the acquisition, Snoopy had
common stock of $150,000, retained earnings of
repurchased 625 shares for $40,000 on 1/1/20X2
from a non-affiliate.
Affiliate
Acquisition 300,000
75% of 20X1 NI 45,000
15,000 75% of 20X1 Div.
12/31/X1 Balance 330,000
10,000 Shares Purchased
from NCI
1/1/X2 Balance 320,000

Affiliate
Before After
Repurchase Repurchase
Peanut’s Shares 7,500 7,500
NCI’s Shares 2,500 1,875
Total Shares 10,000 9,375
75% 80%
Affiliate
Before After
Common stock $250,000) $250,000)
Retained earnings 190,000) 190,000)
Total Stockholders' Equity 440,000) 440,000)
Less: Treasury stock ___________ (40,000)
Total Stockholders’ Equity $440,000) $400,000)
Before After
Snoopy's total stockholders' equity $440,000) $400,000)
Peanut's proportionate share 75% 80%)
Book value of Peanut's investment $330,000) $320,000)
NCI after sale ($400,000 x 0.20) $80,000)

NCI before sale ($440,000 x 0.25) (110,000)
Decrease in book value of NCI ($30,000)
Affiliate
elimination entry:

NCI Peanut Common Treasury Retained
25%/20% + 75%/80% = Stock + +
StockEarnings
BV Before Repurchase 110,000) 330,000)) 250,000 190,000

Shares Repurchased (30,000) (10,000)) (40,000)
Ending Book Value 80,000) 320,000)) 250,000 (40,000) 190,000

Treasury Stock 40,000  Treasury stock
 A subsidiary’s purchase of shares from the parent.
 When this happens, the parent has traditionally recognized a gain or
loss on the difference between the selling price and the change in the
carrying amount of its investment.
 From a consolidated viewpoint, the transaction represents an internal
transfer and does not give rise to a gain or loss.
 A better approach is for the parent to adjust additional paid-in capital.
Example 8: Sub Buys Shares from Parent

stock (7,500 shares) on 1/1 20X1 for $300,000 (an
amount equal to 75% of the book value of net
assets). At the time of the acquisition, Snoopy had
common stock of $150,000, retained earnings of
repurchased 3,750 shares for $40,000 on 1/1/20X2
from Peanut.
Acquisition 300,000
75% of 20X1 NI 45,000
15,000 75% of 20X1 Div.
12/31/X1 Balance 330,000
90,000 Shares Purchased
from Peanut
1/1/X2 Balance 240,000

Before After
Peanut’s Shares 7,500 3,750
NCI’s Shares 2,500 2,500
Total Shares 10,000 6,250
75% 60%
Before After
Common stock $250,000) $250,000)
Retained earnings 190,000) 190,000)
Total Stockholders' Equity 440,000) 440,000)
Less: Treasury stock ___________) (40,000)
Total Stockholders’ Equity $440,000) $400,000)
Before After
Snoopy's total stockholders' equity $440,000) $400,000)
Peanut's proportionate share 75%) 60%)
Book value of Peanut's investment $330,000) $240,000)
NCI after sale ($400,000 x 0.20) $160,000)

NCI before sale ($440,000 x 0.25) (110,000)
Decrease in book value of NCI $50,000)
elimination entry:

NCI
+ Peanut = Common
+ Treasury
+
Retained
40% 60% Stock Stock Earnings
BV Before Repurchase 110,000) 330,000)) 250,000 190,000

Shares Repurchased 50,000) (90,000)) (40,000)
Ending Book Value 160,000) 240,000)) 250,000 (40,000) 190,000

Treasury Stock 40,000  Treasury stock
Which of the following statements is false?

a. When a parent sells some subsidiary
shares to a non-affiliate but maintains
control, no gain or loss is recognized.
b. A subsidiary’s sale of additional shares to
the parent at book value results in a gain.
c. A sale of additional shares to the parent at
an amount other than book value increases
the investment by the fair value of the
d. A subsidiary’s purchases of shares from
the parent may result in an adjustment to
additional paid-in capital .

a. When a parent sells some subsidiary
shares to a non-affiliate but maintains
control, no gain or loss is recognized.
b. A subsidiary’s sale of additional shares to
the parent at book value results in a gain.
c. A sale of additional shares to the parent at
an amount other than book value increases
the investment by the fair value of the
d. A subsidiary’s purchases of shares from
the parent may result in an adjustment to
additional paid-in capital .

when the subsidiary has a
complex ownership structure.
Complex Ownership Structures
(b) Multi-Level (c) Reciprocal

(a) Direct Ownership Ownership Ownership
A Company A Company A Company
B Company C Company B Company B Company
C Company
 Direct ownership: The parent has controlling interest in
each of the subsidiaries.
 Multilevel ownership: The parent has only indirect control
over the company controlled by its subsidiary.
 The eliminating entries used are similar to those used in a simple
ownership situation, but careful attention must be given to the
sequence in which the data are brought together.
 Reciprocal ownership or mutual holdings
 The parent owns a majority of the subsidiary’s common stock and the
subsidiary holds some of the parent’s common shares.
 If mutual shareholdings are ignored in consolidation, some reported
amounts may be materially overstated.
 Multilevel ownership and control
 When consolidated statements are prepared, they include
companies in which the parent has only an indirect

investment along with those in which it holds direct
ownership.
 The complexity of the consolidation process increases as
additional ownership levels are included.

 The amount of income and net assets to be assigned to the
controlling and noncontrolling shareholders, and the

amount of unrealized profits and losses to be eliminated,
must be determined at each level of ownership.
 Multilevel ownership and control
 When a number of different levels of ownership exist, the
first step normally is to consolidate the bottom, or most

remote, subsidiaries with the companies at the next
higher level.
 This sequence is continued up through the ownership
structure until the subsidiaries owned directly by the

parent company are consolidated with it.
 Income is apportioned between the controlling and
noncontrolling shareholders of the companies at each

level.
 Reciprocal or Mutual Ownership
 The treasury stock method is used to deal with reciprocal
relationships.
 Purchases of a parent’s stock by a subsidiary are treated in the same way
as if the parent had repurchased its own stock and was holding it in the
treasury.
 The subsidiary normally accounts for the investment in the parent’s stock
using the cost method.
What method is used to deal with

reciprocal or mutual ownership?
a. The retained earnings method.
b. The common stock method.
c. The treasury stock method.
d. The preferred stock method.
e. None of the above
What method is used to deal with

reciprocal or mutual ownership?
a. The retained earnings method.
b. The common stock method.
c. The treasury stock method.
d. The preferred stock method.
e. None of the above

consolidation procedures
differ when the subsidiary
pays stock dividends.
Subsidiary Stock Dividends
 Stock dividends are issued proportionally to all common
stockholders
 The relative interests of the controlling and noncontrolling
stockholders do not change.
 The investment’s carrying amount on the parent’s books also is
unaffected.
 The stockholders’ equity accounts of the subsidiary do change,
although total stockholders’ equity does not.
 The stock dividend represents a permanent capitalization of
retained earnings, thus:
 Decreasing retained earnings and increasing capital stock and,
perhaps, additional paid-in capital.
 Effect on the preparation of consolidated financial statements for the
period:
 The stock dividend declaration must be eliminated along with the
increased common stock and increased additional paid-in capital, if any.
 The stock dividend represents a permanent capitalization of
retained earnings, thus:
 In subsequent years, the balances in the subsidiary’s stockholders’
equity accounts are eliminated in the normal manner.
 The full balances of all the subsidiary’s stockholders’ equity accounts
must be eliminated in consolidation, even though amounts have been
shifted from one account to another.
Example 9: Subsidiary stock dividend

stock on 1/1 20X1 for $300,000 (an amount equal to
75% of the book value of net assets). At the time of
the acquisition, Snoopy had common stock of
$250,000, retained earnings of $150,000. During
20X1, the first fiscal year after the acquisition,
Snoopy reported net income of $60,000 and declared
dividends of $20,000. Assume Snoopy declared a
25% stock dividend on 12/31/20X1.
Common Stock $250,000 x 25% = $62,500 stock div.

Example 9: Subsidiary Stock Dividend
+ Net Income 15,000) 45,000) 60,000)
 Stock Dividend 62,500 (62,500)

Dividends Declared 20,000  100% of sub’s dividends declared
Stock dividends declared 62,500  100% of sub’s stock dividends

a. Since stock dividends are issued
proportionately, the relative interests of
the controlling and NCI stockholders do
not change.
b. Stock dividends do not change the
carrying amount of the investment
account.
c. Stock dividends represent a permanent
capitalization of retained earnings.
d. Stock dividends increase retained
earnings.

a. Since stock dividends are issued
proportionately, the relative interests of
the controlling and NCI stockholders do
not change.
b. Stock dividends do not change the
carrying amount of the investment
account.
c. Stock dividends represent a permanent
capitalization of retained earnings.
d. Stock dividends increase retained
earnings.
Conclusion
The End
9-883
Chapter 10
Additional
Consolidation
Reporting Issues
General Overview
 This chapter discusses the following general financial
reporting topics as they relate to consolidated financial
statements:
1. The consolidated statement of cash flows
2. Consolidation following an interim acquisition
3. Consolidation tax considerations
4. Consolidated earnings per share
Prepare a consolidated
statement of cash flows.
Consolidated Statement of Cash Flows
 A consolidated statement of cash flows is similar to a
statement of cash flows prepared for a single-corporate
entity and is prepared in basically the same manner.
 Preparation
 Typically prepared after the consolidated income statement, retained
earnings statement, and balance sheet.
 Prepared from the information in the other three statements.
 Preparation
 Requires only a few adjustments (such as those for depreciation and
amortization resulting from the write-off of a differential) beyond
those used in preparing a cash flow statement for an individual
company.
 All transfers between affiliates should be eliminated.
 Noncontrolling interest typically does not cause any special problems.
Consolidated Statement of Cash Flows for the Year
Ended December 31, 20X2 (Figure10–2)
 Consolidated cash flow statement—direct method
 Nearly all major companies use the indirect method.
 Critics have argued that the direct method is less confusing and more
useful.
 The only section affected by the difference in approaches is
the operating activities section.
 Under the indirect approach, the operating activities section starts
with net income and, to derive cash provided by operating activities,
adjusts for all items affecting cash and net income differently.
 Under the direct approach, the operating activities section of the
statement shows the actual cash flows.
 Direct approach: As an example, the only cash flows related to
operations are
Cash Flows from Operating Activities:

Cash Received from Customers $615,000)

Cash Paid toofSuppliers
The remainder (510,000)
the cash flow statement is the same under both
Net Cashexcept
approaches Provided
that by Operating
a separate Activities of operating
reconciliation $105,000)
cash
flows and net income is required under the direct approach.
a. After the consolidated income statement
and balance sheet have been prepared, the
statement of cash flows is calculated in the
same way as for a single company.
b. The preparation of a consolidated
statement of cash flows requires
procedures that are unique to consolidated
companies.
c. A consolidated statement of cash flows is
not required under U.S. GAAP.
d. The consolidated statement of cash flows is
calculated from the subsidiary’s financial
statements alone.
a. After the consolidated income statement
and balance sheet have been prepared, the
statement of cash flows is calculated in the
same way as for a single company.
b. The preparation of a consolidated
statement of cash flows requires
procedures that are unique to consolidated
companies.
c. A consolidated statement of cash flows is
not required under U.S. GAAP.
d. The consolidated statement of cash flows is
calculated from the subsidiary’s financial
statements alone.

record journal and
worksheet entries related to
an interim acquisition.
Consolidation Following an Interim Acquisition
 When a subsidiary is acquired during a fiscal period, the

results of the subsidiary’s operations are included in the
consolidated statements only for the portion of the year that
the stock is owned by the parent.
Consolidation Following an Interim Acquisition:
Illustration
Peanut purchases 75% of Snoopy’s outstanding common stock on July 1,
20X1 for an amount equal to 75% of the book value of Snoopy’s net assets.
Prior to the acquisition, Snoopy had earned net income of $35,000 and
declared $8,000 of dividends. The income and dividends for the year are
summarized in the following table:
1/1 to 6/30 7/1 to 12/31

Sales 125,000 250,000
Less: COGS 50,000 110,000
Less: Depreciation Expense 25,000 50,000
Less: Other Expenses 15,000 30,000
Net Income 35,000 60,000
Dividends 8,000 20,000

Illustration
Parent Company Entries

Peanut records the purchase of Snoopy stock with the following entry:
July 1, 20X1
Investment in Snoopy Stock 320,250
Cash 320,250
Record purchase of Snoopy stock.
During the second half of 20X1, Peanut records its share of Snoopy's income and
dividends under the equity method:
Investment in Snoopy Stock 45, 000

Income from Snoopy 45, 000
Cash 15,000
Investment in Snoopy Stock 15,000
Record dividends from Snoopy: $20,000 x 0.75.
Illustration
Pre-acquisition income and dividend elimination entry:
Sales 125,000  Close pre-acquisition sales to RE
COGS 50,000  Close pre-acquisition COGS to RE
Depreciation Expense 25,000  Close pre-acquisition depr. exp. To RE
Other Expense 15,000  Close pre-acquisition other expenses to RE
Dividends Declared 8,000  Close pre-acquisition dividends to RE
Retained Earnings 27,000  Pre-acquisition net increase in RE
After making this worksheet entry to close the pre-acquisition earnings and
dividends to the Retained Earnings account, the beginning balance in Retained
Earnings as of the date of acquisition is $117,000.
Retained Earnings
90,000 Balance 1/1/20X1
27,000
117,000 Balance 6/30/20X1
Illustration
Based on this acquisition date beginning balance, we calculate the post-acquisition
changes in book value as follows:
July 1, 20X1, balances 106,750) 320,250) 250,000 177,000)
+ Net Income 15,000) 45,000) 60,000)
 Dividends (5,000) (15,000) (20,000)
December 31, 20X1, balances 116,750) 350,250) 250,000 217,000)
This leads to the basic elimination entry, following the normal procedure (but based
on post-acquisition earnings and dividends):
NCI in NI of Snoopy 15,000  NCI’s share of reported NI
Dividends Declared 20,000  100% of Sub’s dividends declared
Illustration
The following T-accounts illustrate how the basic elimination entry zeros out the balances in the
Investment in Snoopy and Income from Snoopy accounts:
Acquisition 320,250
75% Net Income 45,000 45,000 75% Net Income
Balance 12/31/X1 350,250 45,000 Balance 12/31/X1

350,250 Basic 45,000
0 0
Again, we include the normal accumulated depreciation elimination entry based on the balance
in accumulated depreciation on Snoopy’s books on the acquisition date. Assume that this
amount is 65,000 on the acquisition date.

Make basic calculations and

journal entries related to
income taxes in the
consolidated financial
statements.
Consolidation Income Tax Issues
 A parent company and its subsidiaries may file a
consolidated income tax return, or they may choose to file
separate returns.
 For a subsidiary to be eligible to be included in a consolidated tax
return, at least 80 percent of its stock must be held by the parent
company or another company included in the consolidated return.
 Filing a consolidated return: advantages
 The losses of one company may be offset against the profits of
another.
 Dividends and other transfers between the affiliated companies are
not taxed.
 May make it possible to avoid limits on the use of certain items such
as foreign tax credits and charitable contributions.
 Filing a consolidated return: limitations
 Once an election is made to include a subsidiary in the consolidated
return, the company cannot file separate tax returns in the future
unless it receives IRS approval.
 The subsidiary’s tax year also must be brought into conformity with
the parent’s tax year.
 Can become quite difficult when numerous companies are involved
and complex ownership arrangements exist.
 Allocation of tax expense when a consolidated return is filed
 Portrays the companies included in the return as if they were actually
a single legal entity.
 All intercorporate transfers of goods and services and intercompany
dividends are eliminated and a single income tax figure is assessed
 Because only a single income tax amount is determined, income tax
expense must be assigned to the individual companies.
 The method of tax allocation can affect the amounts reported in the
income statements of both the separate companies and the
 When a subsidiary is less than 100 percent owned, tax expense
assigned to the subsidiary reduces proportionately the income
assigned to the parent and the noncontrolling interest.
 The more tax expense assigned to the subsidiary, the less is assigned
to the parent; the income attributed to the controlling interest then
becomes greater.
 Unrealized profits when a consolidated return is filed
 Intercompany transfers are eliminated in computing both
consolidated net income and taxable income.
 Because profits are taxed in the same period they are recognized for
financial reporting purposes, no temporary differences arise, and no
additional tax accruals are needed in preparing the consolidated
 Unrealized profits when separate returns are filed
 The companies are taxed individually on the profits from
intercompany sales.
 No consideration is given to whether the intercompany profits are
realized from a consolidated viewpoint.
 Unrealized profits when separate returns are filed
 The tax expense on the unrealized intercompany profit must be
eliminated when the unrealized intercompany profit is eliminated in
preparing consolidated financial statements.
 This difference in timing of the tax expense recognition results in the
recording of deferred income taxes.
Assume that Peanut acquired 75% of Snoopy’s

common stock. Peanut acquired the stock when the
book value of Snoopy’s common stock was
$250,000 and retained earnings were $150,000.
During the year, Snoopy reports pre-tax income of
$60,000 and declares $20,000 of dividends. In
addition, during 20X1 Snoopy sold inventory
costing $75,000 to Peanut for $100,000. $60,000 of
this inventory was resold by year end. Assume the
two companies file separate a tax returns for 20X1.
Both Peanut and Snoopy are subject to a 40% tax
rate.
Snoopy sells inventory costing $75,000 to Peanut Products for $100,000, and
resold $60,000 of this inventory before year-end. Assume 40 percent tax rate.
Total = Re-sold + Ending Inventory
Sales 100,000 60,000 40,000
COGS 75,000 45,000 30,000
Gross Profit 25,000 15,000 10,000
Gross Profit % 25%
Sales 100,000
Inventory 10,000
Eliminate intercompany upstream sale of inventory.
With a 40 percent income tax rate, the following eliminating entry adjusts income tax expense of
the consolidated entity downward by $4,000 ($10,000 x 0.40) to reflect the reduction of reported
profits:
Deferred Tax Asset 4,000

Income Tax Expense 4,000
Eliminate tax expense on unrealized intercompany profit.
Unrealized Profit in Separate Tax Return
Illustrated
If Peanut accounts for its investment in Snoopy using the fully adjusted equity method, Peanut
would make the following journal entries on its books:

Record Peanut’s 75 percent share of Snoopy’s 20X1 reported income.
Cash 15,000
Record Peanut’s 75 percent share of Snoopy’s 20X1 dividend.
Peanut also defers its 75% share of the unrealized profit on intercompany upstream sales (net of
taxes). Thus, the $10,000 of unrealized profit ($40,000  $30,000) net of 40% taxes is $6,000
($10,000 x 0.60). Thus, the deferral of Peanut's relative share of the unrealized gross profit is
$4,500 ($6,000 x 0.75).

Eliminate unrealized gross profit on inventory purchases from Snoopy.
In order to prepare the basic elimination entry, we first analyze the book value of Snoopy's equity
accounts and the related 75% share belonging to Peanut and the 25% share belonging to the NCI
shareholders:
Unrealized Profit in Separate Tax Return
Illustrated
Original book value 100,000) 300,000) 250,000 150,000)
+ Net Income 9,000) 27,000) 36,000)
 Dividends (5,000) (15,000) (20,000)
Ending book value 104,000) 312,000) 250,000 166,000)
We note that the book value calculations form the basis for the basic elimination entry, but
Peanut's share of income and its investment account must be adjusted for the equity-method
entry previously made for $4,500. In addition, the NCI share of income and net assets is adjusted
for the 25% share of the unrealized gross profit (net of 40 percent taxes).

Income from Snoopy 22,500  Peanut's % of NI – 75% of Def. GP (net of tax)
NCI in NI of Snoopy 7,500  NCI % of NI – 25% of Def. GP (net of tax)
Dividends Declared 20,000  100% of Sub’s dividends declared
Investment in Snoopy 307,500  Net BV – 75% of Def. GP (net of tax)
NCI in NA of Snoopy 102,500  NCI % of BV – 25% of Def. GP (net of tax)
Subsequent Profit Realization When Separate
Returns Are Filed
If income taxes were ignored, the following eliminating entry would be used
in preparing consolidated statements as of December 31, 20X2, assuming
that Snoopy had $10,000 of unrealized inventory profit on its books on
January 1, 20X2, and the inventory was resold in 20X2:

Eliminate beginning inventory profit.
On the other hand, if the 40 percent tax rate is considered, the eliminating
entry would be modified as follows:

Income Tax Expense 4,000
Make calculations related to

consolidated earnings per
share.
Consolidated Earnings Per Share
 Basic consolidated EPS is calculated by deducting

income to the noncontrolling interest and any
preferred dividend requirement of the parent
company from consolidated net income
 The resulting amount is then divided by the weighted-
average number of the parent’s common shares
outstanding during the period.
 While consolidated net income is viewed from an entity
perspective, consolidated earnings per share follows a
parent company approach and clearly is aimed at the
stockholders of the parent company.
 Computation of diluted consolidated earnings per share
 Diluted consolidated earnings per share
 The parent’s share of consolidated net income normally is the starting
point in the computation of diluted consolidated EPS.
 It then is adjusted for the effects of parent and subsidiary dilutive
securities.
Consolidated EPS is calculated:

a. as the sum of the subsidiary’s and the
parent’s individual EPS numbers.
b. by adding the subsidiary’s and the parent’s
net income numbers and dividing by the
subsidiary’s shares owned by the parent.
c. by deducting the NCI in net income and
preferred dividends from consolidated net
income and dividing by the parent’s
weighted-average shares.
d. as the parent’s net income divided by the
combined weighted shares outstanding of
the parent and subsidiary.
Consolidated EPS is calculated:

a. as the sum of the subsidiary’s and the
parent’s individual EPS numbers.
b. by adding the subsidiary’s and the parent’s
net income numbers and dividing by the
subsidiary’s shares owned by the parent.
c. by deducting the NCI in net income and
preferred dividends from consolidated net
income and dividing by the parent’s
weighted-average shares.
d. as the parent’s net income divided by the
combined weighted shares outstanding of
the parent and subsidiary.
Conclusion
The End
10-923
Chapter 11
Multinational
Accounting:
Foreign Currency
Transactions and
Financial Instruments
Understand how to make

calculations using foreign
currency exchange rates.
The Accounting Issues
 Foreign currency transactions of a U.S.

company denominated in other currencies
must be restated to their U.S. dollar
equivalents before they can be recorded in
the U.S. company’s books and included in its
 Translation: The process of restating foreign
currency transactions to their U.S. dollar
equivalent values.
The Accounting Issues
 Many U.S. corporations have

multinational operations
 The foreign subsidiaries prepare
their financial statements in the
currency of their countries.
P U.S.
 The foreign currency amounts in

these financial statements have to
be translated into their U.S. dollar S Foreign
equivalents before they can be

consolidated with the U.S. parent’s
Foreign Currency Exchange Rates
 Foreign currency exchange rates between

currencies are established daily by foreign
exchange brokers who serve as agents for
individuals or countries wishing to deal in
foreign currencies.
 Some countries maintain an official fixed rate of
currency exchange.
 Determination of exchange rates

 Exchange rates change because of a number of
economic factors affecting the supply of and
demand for a nation’s currency.
 Factors causing fluctuations are a nation’s
 Level of inflation
 Balance of payments
 Changes in a country’s interest rate
 Investment levels
 Stability and process of governance
 Direct Exchange Rate (DER) is the number of

local currency units (LCUs) needed to
acquire one foreign currency unit (FCU)
 From the viewpoint of a U.S. entity:
U.S. dollar–equivalent value
DER =
1 FCU
 Example: Assume a U.S. based company can
purchase one Euro for $1.40.
$1.40
DER = = 1.40 $/€
€1
 Indirect Exchange Rate (IER) is the

reciprocal of the direct exchange rate
 From the viewpoint of a U.S. entity:
1 FCU
IER =

U.S. dollar–equivalent value
Example: Assume a U.S. based company can
purchase one Euro for $1.40.
€1
IER = = 0.7143 €/$
$1.40
 DER is identified as American terms

 To indicate that it is U.S. dollar–based and
represents an exchange rate quote from the
perspective of a person in the United States
 IER is identified as European terms
 To indicate the direct exchange rate from the
perspective of a person in Europe, which means
the exchange rate shows the number of units of
the European’s local currency units per one U.S.
dollar
 Changes in exchange rates

 Strengthening of the U.S. dollar—direct exchange
rate decreases, implies:
 Taking less U.S. currency to acquire one FCU
 One U.S. dollar acquiring more FCUs
 Example: DER decreases from $1.40/€ to $1.30/€
 Weakening of the U.S. dollar—direct exchange
rate increases, implies:
 Taking more U.S. currency to acquire one FCU
 One U.S. dollar acquiring fewer FCUs
 Example: DER increases from $1.40/€ to $1.50/€
11-933
Relationships between Currencies and Exchange
Rates
Exchange Rates
11-936
 Spot Rates versus Current Rates

 The spot rate is the exchange rate for immediate
delivery of currencies.
 The current rate is defined simply as the spot rate
on the entity’s balance sheet date.
 Forward Exchange Rates

 The forward rate on a given date is not the same
as the spot rate on the same date.
 Expectations about the relative value of
currencies are built into the forward rate.
 The Spread:
 The difference between the forward rate and the spot
rate on a given date.
 Gives information about the perceived strengths or
weaknesses of currencies.
 Forward Exchange Rates Example:

 Assume a U.S.-based company purchases
inventory for €1,000 on 3/31 and the contract
requires payment on 9/30.
180-day
Forward rate = $1.40/€
Spread = $0.05/€
Spot rate = $1.35/€
3/31 9/30

a. Most currency exchange rates are
determined by brokers on a daily basis.
b. Economic factors rarely affect exchange
rates.
c. Some countries maintain control over
their exchange rates.
d. When the U.S. dollar strengthens, it has
greater buying power overseas and can
buy more units of foreign currencies.
e. A spot rate is the exchange rate for
immediate delivery of a currency.

a. Most currency exchange rates are
determined by brokers on a daily basis.
b. Economic factors rarely affect exchange
rates.
c. Some countries maintain control over
their exchange rates.
d. When the U.S. dollar strengthens, it has
greater buying power overseas and can
buy more units of foreign currencies.
e. A spot rate is the exchange rate for
immediate delivery of a currency.
Understand the accounting

implications of and be able
to make calculations related
to foreign currency
transactions.
Foreign Currency Transactions
 Foreign currency transactions are economic

activities denominated in a currency other
than the entity’s recording currency.
 These include:
1. Purchases or sales of goods or services (imports or
exports), the prices of which are stated in a foreign
currency
2. Loans payable or receivable in a foreign currency
3. Purchase or sale of foreign currency forward exchange
contracts
4. Purchase or sale of foreign currency units
 For financial statement purposes, transactions

denominated in a foreign currency must be
translated into the currency the reporting company
uses.
 At each balance sheet date, account balances
denominated in a currency other than the entity’s
reporting currency must be adjusted to reflect
changes in exchange rates during the period.
 The adjustment in equivalent U.S. dollar values is a foreign
currency transaction gain or loss for the entity when
exchange rates have changed.
Example: Foreign Currency Transactions
Assume that a U.S. company acquires €5,000 from its bank on January 1,
20X1, for use in future purchases from German companies. The direct
exchange rate is $1.20 = €1; thus, the company pays the bank $6,000 for
€5,000, as follows:
U.S. dollar equivalent value = Foreign currency units x Direct exchange rate
$6,000 = €5,000 x $1.20
The following entry records this exchange of currencies:
January 1, 20X1
Foreign Currency Units (€ ) 6,000
Cash 6,000
On July 2, 20X1, the exchange rate is $1.100 = €1. The following adjusting
entry is required in preparing financial statements on July 1:
July 1, 20X1
Foreign Currency Transaction Loss 500
Foreign Currency Units (€ ) 500
 Foreign currency import and export

transactions – required accounting overview
(assuming the company does not use
forward contracts)
 Transaction date:
 Record the purchase or sale transaction at the U.S.
dollar-equivalent value using the spot direct
exchange rate on this date.

forward contracts)
 Balance sheet date:
 Adjust the payable or receivable to its U.S. dollar–
equivalent, end-of-period value using the current
direct exchange rate.
 Recognize any exchange gain or loss for the change in
rates between the transaction and balance sheet
dates.

forward contracts)
 Settlement date:
 Adjust the foreign currency payable or receivable for
any changes in the exchange rate between the
balance sheet date (or transaction date) and the
settlement date, recording any exchange gain or loss
as required.
 Record the settlement of the foreign currency
payable or receivable.
 The two-transaction approach

 Views the purchase or sale of an item as a
separate transaction from the foreign currency
commitment.
 The FASB established that foreign currency
exchange gains or losses resulting from the
revaluation of assets or liabilities denominated in
a foreign currency must be recognized currently
in the income statement of the period in which
the exchange rate changes.
Comparative U.S. Company Journal Entries for Foreign Purchase
Transaction Denominated in Dollars versus Foreign Currency Units

a. Foreign currency transactions of a U.S.
Firm involve the exchange of goods from a
foreign country denominated in $ U.S.
b. The purchase or sale of an item is a
separate transaction from the foreign
currency commitment under the two
transaction approach.
c. Foreign currency exchange gains or losses
from the revaluation of assets or liabilities
denominated in a foreign currency must
be recognized in the period when the
exchange rate changes

a. Foreign currency transactions of a U.S.
Firm involve the exchange of goods from a
foreign country denominated in $ U.S.
b. The purchase or sale of an item is a
separate transaction from the foreign
currency commitment under the two
transaction approach.
c. Foreign currency exchange gains or losses
from the revaluation of assets or liabilities
denominated in a foreign currency must
be recognized in the period when the
exchange rate changes
Understand how to hedge

international currency risk
using foreign currency
forward exchange financial
instruments.
Managing International Currency Risk with Foreign
Currency Forward Exchange Financial Instruments
 A financial instrument is cash, evidence of

ownership, or a contract that both:
1.Imposes on one entity a contractual obligation to
deliver cash or another instrument, and
2.Conveys to the second entity that contractual
right to receive cash or another financial
instrument.
 A derivative is a financial instrument or
other contract whose value is “derived from”
some other item that has a variable value
over time.
11-954
 Characteristics of derivatives:
 The financial instrument must contain one or
more underlyings and one or more notional
amounts, which specify the terms of the financial
instrument.
 The financial instrument/contract requires no
initial net investment or an initial net investment
that is smaller than required for other types of
contracts expected to have a similar response to
changes in market factors.
 Characteristics of derivatives:
 The contract terms:
 Require or permit net settlement
 Provide for the delivery of an asset that puts the
recipient in an economic position not substantially
different from net settlement, or
 Allow for the contract to be readily settled net by a
market or other mechanism outside the contract
Derivatives Designated as Hedges
 Two criteria to be met for a derivative

instrument to qualify as a hedging
instrument:
1. Sufficient documentation must be provided at
the beginning of the hedge term to identify the
objective and strategy of the hedge, the hedging
instrument and the hedged item, and how the
hedge’s effectiveness will be assessed on an
ongoing basis.
 Two criteria to be met for a derivative

instrument to qualify as a hedging
instrument:
2. The hedge must be highly effective throughout
its term
 Effectiveness is measured by evaluating the hedging
instrument’s ability to generate changes in fair value
that offset the changes in value of the hedged item.
 Fair value hedges are designated to hedge

the exposure to potential changes in the fair
value of
a) a recognized asset or liability such as available-
for-sale investments, or
b) an unrecognized firm commitment for which a
binding agreement exists.
 The net gains and losses on the hedged asset
or liability and the hedging instrument are
recognized in current earnings on the
statement of income.
 Cash flow hedges

 Designated to hedge the exposure to potential
changes in the anticipated cash flows, either into
or out of the company, for
 a recognized asset or liability such as future interest
payments on variable-interest debt, or
 a forecasted cash transaction such as a forecasted
purchase or sale.
 Cash flow hedges

 Changes in the fair market value are separated
into an effective portion and an ineffective
portion.
 The net gain or loss on the effective portion of the
hedging instrument should be reported in other
 The gain or loss on the ineffective portion is reported
in current earnings on the income statement.
 Foreign currency hedges are hedges in

which the hedged item is denominated in a
foreign currency
 A fair value hedge of a firm commitment to enter
into a foreign currency transaction
 A cash flow hedge of a forecasted foreign
currency transaction
 A hedge of a net investment in a foreign
operation
Forward Exchange Contracts
 Forward Exchange Contracts

 Contracted through a dealer, usually a bank
 Possibly customized to meet contracting
company’s terms and needs
 Typically no margin deposit required
 Must be completed either with the underlying’s
future delivery or net cash settlement
Forward Exchange Contracts
 ASC 815 establishes a basic rule of fair value

for accounting for forward exchange
contracts.
 Changes in the fair value are recognized in the
accounts, but the specific accounting for the
change depends on the purpose of the hedge.
 For forward exchange contracts, the basic rule is
to use the forward exchange rate to value the
forward contract.
Forward Exchange Volumes
 http://www.newyorkfed.org/FXC/volumesu
rvey/
 http://www.cmegroup.com/trading/fx/files
/2010-Q3-FX-Update.pdf
11-965
Summary of Cases 1-3
Case 1: Forward Exchange Contracts
Managing an Exposed Foreign Currency Net Asset or Liability
Position: Not a Designated Hedging Instrument
 This case presents the most common use of foreign
currency forward contracts, which is to manage a part of
the foreign currency exposure from accounts payable or
accounts receivable denominated in a foreign currency.
 Note that the company has entered into a foreign currency
forward contract but that the contract does not qualify for
or the company does not designate the forward contract as
a hedging instrument.
Case 1 Timeline
Rates Summary
U.S. Dollar-Equivalent of 1 Yen
Date Spot Rate Forward Exchange Rate

October 1, 20X1
(transaction date) 0.0070 0.0075 (180 days)
December 31, 20X1
(balance sheet date) 0.0080 0.0077 (90 days)
April 1, 20X2
(settlement date) 0.0076
Case 1 Entries—October 1, 20X1
Entry to record the Forward Contract
FC Receivable from Exchange Broker (¥) 15,000

Dollars Payable to Exchange Broker ($) 15,000
Purchase forward contract to receive 2,000,000 yen:
$15,000 = ¥2,000,000 x $0.0075 forward rate
Entry to record the Account Payable
Inventory 14,000
Accounts Payable (¥) 14,000
Purchase inventory on account:

$14,000 = ¥2,000,000 x $0.0070 Oct. 1 spot rate
Case 1 Entries—December 31, 20X1
Entry to Revalue the Forward Contract
FC Receivable from Exchange Broker (¥) 400

Foreign Currency Transaction Gain 400
Adjust receivable (in yen) to current U.S. dollar–equivalent value (forward rate):
$400 = ¥2,000,000 x ($0.0077 - $0.0075)
Entry to Revalue the Account Payable
Foreign Currency Transaction loss 2,000

Adjust payable (in yen) to current U.S. dollar–equivalent value (spot rate):
$2,000= ¥2,000,000 x ($0.0080 - $0.0070)
Case 1 Entries—April 1, 20X2

Adjust receivable to the spot rate on the settlement date:
$200= ¥2,000,000 yen x ($0.0076 - $0.0077)
Accounts Payable (¥) 800

$800 = ¥2,000,000 x ($0.0076 - $0.0080)
Case 1 Summary
FC Rec. from Broker (¥) Accounts Payable (¥)
15,000 14,000
400 2,000
200 800
15,200 15,200
Case 1 Entries—April 1, 20X2 (Continued)

Cash 15,000
Deliver U.S. dollars to currency broker as specified in the forward contract
Foreign Currency Units (¥) 15,200

Receive ¥2,000,000 from exchange broker valued at the April 1, 20X2 spot rate.
$15,200 = ¥2,000,000 x $0.0076
Accounts Payable ($) 15,200

Pay account payable using the ¥2,000,000 received from the exchange broker
$15,200 = ¥2,000,000 x $0.0076
Hedging an Unrecognized Foreign Currency Firm
Commitment: A Foreign Currency Fair Value Hedge
 This case presents the accounting for an unrecognized firm
commitment to enter into a foreign currency transaction,
which is accounted for as a fair value hedge.
 A firm commitment exists because of a binding agreement
for the future transaction that meets all requirements for a
firm commitment.
 The hedge is against the possible changes in fair value of
the firm commitment from changes in the foreign currency
exchange rates.
Case 2 Timeline
Rates Summary

October 1, 20X1
(transaction date) 0.0070 0.0075
December 31, 20X1
(balance sheet date) 0.0080 0.0077
April 1, 20X2
Case 2 Entries—August 1, 20X1
Entry to Record the Forward Contract

Sign forward exchange contract for receipt of 2,000,000 yen in 240 days:
$14,600 = ¥2,000,000 X $0.0073 Aug. 1, 240-day forward rate
Entry for the Firm Commitment
No Entry

Dollars Payable to Exchange Broker ($) 400
$400 = ¥2,000,000 x ($0.0075 - $0.0073)
Case 2 Entries—October 1, 20X1 (Continued)
Entry to Record the Firm Commitment

Firm Commitment 400
Record the loss on the financial instrument aspect of the firm commitment:
$400 = ¥2,000,000 x ($0.0075 - $0.0073)
Entry to Record the Account Payable
Inventory 13,600
Firm Commitment 400
Record account payable at the spot rate and record the inventory purchase:
$14,000 = ¥2,000,000 x $0.0070 Oct. 1 spot rate

$400 = ¥2,000,000 x ($0.0077 - $0.0075)
Foreign Currency Transaction Loss 2,000

$2,000= ¥2,000,000 x ($0.0080 - $0.0070)

$200= ¥2,000,000 yen x ($0.0076 - $0.0077)

$800 = ¥2,000,000 x ($0.0076 - $0.0080)
Case 2 Summary
14,600 14,000
400 2,000
400 800
200
15,200 15,200

Cash 14,600

$15,200 = ¥2,000,000 x $0.0076

$15,200 = ¥2,000,000 x $0.0076
Hedging a Forecasted Foreign Currency Transaction: A
Foreign Currency Cash Flow Hedge
 This case presents the accounting for a forecasted foreign
currency-denominated transaction, which is accounted for
as a cash flow hedge of the possible changes in future cash
flows.
 The forecasted transaction is probable but not a firm
commitment. Thus, the transaction has not yet occurred
nor is it assured; the company is anticipating a possible
future foreign currency transaction.
 Because the foreign currency hedge is against the impact of
changes in the foreign currency exchange rates used to
predict the possible future foreign currency-denominated
cash flows, it is accounted for as a cash flow hedge.
Case 3 Timeline
Forecast the
purchase of
goods and enter
into a 240-day
forward contract
to hedge the
foreign currency
purchase.
Forecasted Transaction
Rates Summary

October 1, 20X1
December 31, 20X1
April 1, 20X2
Case 3 Entries—August 1, 20X1
Entry to Record the Forward Contract

Sign forward exchange contract for receipt of 2,000,000 yen in 240 days:
$14,600 = ¥2,000,000 X $0.0073 Aug. 1, 240-day forward rate
Entry for the Forecasted Purchase
No Entry
Entry for the Forward Contract
No Entry
Entry to record the Account Payable
Inventory 14,000
Purchase inventory on account

$14,000 = ¥2,000,000 x $0.0070 Oct. 1 spot rate

Other Comprehensive Income 800
$800 = ¥2,000,000 x ($0.0077 - $0.0075)
Other Comprehensive Income 2,000

$2,000= ¥2,000,000 x ($0.0080 - $0.0070)

$200= ¥2,000,000 yen x ($0.0076 - $0.0077)

$800 = ¥2,000,000 x ($0.0076 - $0.0080)
Case 3 Summary
14,600 14,000
2,000
800 800
200
15,200 15,200

Cash 14,600

$15,200 = ¥2,000,000 x $0.0076

$15,200 = ¥2,000,000 x $0.0076
800
2,000
200
800
600

Inventory 14,000
Assumed sale of the inventory

Close out OCI to income in the period the sale is recognized
Speculation in Foreign Currency Markets
 This case presents the accounting for foreign currency
forward contracts used to speculate in foreign currency
markets. These transactions are not hedging transactions.
 The foreign currency forward contract is revalued
periodically to its fair value using the forward exchange
rate for the remainder of the contract term.
 The gain or loss on the revaluation is recognized currently
in earnings on the income statement.
Case 4 Timeline
Rates Summary
U.S. Dollar-Equivalent of 1 Franc

October 1, 20X1
December 31, 20X1
April 1, 20X2
Case 4 Entry—October 1, 20X1
Entry to record the Forward Contract
Dollars Receivable from Exchange Broker ($) 2,960

FC Payable to Exchange Broker (SFr) 2,960
Enter into speculative forward exchange contract:
$2,960 = SFr 4,000 x $0.74, the 180-day forward rate
Case 4 Entry—December 31, 20X1

FC Payable to Exchange Broker (SFr) 160
Recognize speculation loss on forward contract for difference between initial 180-
day forward rate and forward rate for remaining 90-days to maturity of contract :
$160 = SFr 4,000 x ($0.78 - $0.74)
Case 4 Entry—April 1, 20X2
FC Payable to Exchange Broker (SFr) 40

Revalue foreign currency payable to spot rate at end of term of forward contract:
$40 = SFr 4,000 x ($0.78 - $0.77)
Case 4 Summary
FC Payable to Broker (SFr)
2,960
160
40
3,080
Foreign Currency Units (SFr) 3,080

Cash 3,080
Acquire foreign currency units (SFr) in open market when spot rate is $0.77 = SFr1:
$3,080 = SFr 4,000 x $0.77 spot rate
FC Payable to Exchange Broker (SFr) 3,080

Foreign Currency Units (SFr) 3,080
Deliver foreign currency units to exchange broker in settlement of forward contract:

$3,080 = SFr 4,000 x $0.77 spot rate
Cash 2,960
Dollars Receivable from Exch. Broker ($) 2,960
Receive U.S. dollars from exchange broker as contracted.
Which of the following is NOT one of the

criteria for a hedge to be considered
effective?
a. The hedge is based on an effective
interest rate.
b. Documentation of the objective, strategy,
and effectiveness of the hedge.
c. The hedge must be highly effective
through its term.
d. The effectiveness of the hedge is
assessed on an ongoing basis
Which of the following is NOT one of the

criteria for a hedge to be considered
effective?
a. The hedge is based on an effective
interest rate.
b. Documentation of the objective, strategy,
and effectiveness of the hedge.
c. The hedge must be highly effective
through its term.
d. The effectiveness of the hedge is
assessed on an ongoing basis
Know how to measure hedge

effectiveness, make
interperiod tax allocations for
foreign currency transactions,
and hedge net investments in
a foreign entity.
 Measuring hedge effectiveness

 Effectiveness: There will be an approximate
offset, within the range of 80 to 125 percent, of
the changes in the fair value of the cash flows or
changes in fair value to the risk being hedged.
 Must be assessed at least every three months and
when the company reports financial statements
or earnings.
 Intrinsic value and Time value
 Interperiod tax allocation for foreign

currency gains (losses)
 Temporary differences in the recognition of
foreign currency gains or losses between tax
accounting and GAAP accounting require
interperiod tax allocation.
 The temporary difference is recognized in
accordance with ASC 740.
 Hedges of a net investment in a foreign entity

 A number of balance sheet management tools
are available for a U.S. company to hedge its net
investment in a foreign affiliate.
 ASC 815 specifies that for derivative financial
instruments designated as a hedge of the foreign
currency exposure of a net investment in a
foreign operation, the portion of the change in
fair value equivalent to a foreign currency
transaction gain or loss should be reported in
other comprehensive income.
11-1008
Which of the following is the appropriate test

of hedge effectiveness?
a. The hedge offsets between 80-100% of
the cash flows or risk of the item hedged.
b. The hedge offsets between 100-125% of
c. The hedge offsets between 80-125% of
d. The hedge offsets between 80-150% of
Which of the following is the appropriate test

of hedge effectiveness?
a. The hedge offsets between 80-100% of
b. The hedge offsets between 100-125% of
c. The hedge offsets between 80-125% of
d. The hedge offsets between 80-150% of
Conclusion
The End
11-1011
Chapter 12
Multinational
Accounting:
Issues in Financial
Reporting and
Translation of Foreign
Entity Statements

benefits and ramifications of
convergence to international
financial reporting
standards (IFRS) and the
expected timeline to global
convergence.
General Overview
 Accountants preparing financial statements for
multinationals must consider:
 Differences in accounting standards across countries and jurisdictions
 Differences in currencies used to measure the foreign entity’s
operations
Differences in Accounting Principles
 Methods used to measure economic activity differ around
the world
 Benefits of adoption of a single set of globally accepted
accounting standards
 Expansion of capital markets across borders
 Help investors to better evaluate opportunities across borders
 Reduce reporting costs for companies accessing capital in other
countries
 Increased confidence for users
 International Financial Reporting Standards (IFRS)
 Standards published by the International Accounting Standards Board
(IASB)
 Widely accepted
 Mandated or permitted in over 100 countries
 FASB is working with the IASB to improve the quality of standards
and to “converge” their two sets of standards
 New SEC rules
 Allow foreign private issuers to file statements prepared in
accordance with IFRS as issued by the IASB without reconciliation
to U.S. GAAP (January 4, 2008)
 Next steps:
 Allow U.S. issuers to choose between IFRS and U.S. GAAP
 Require U.S. issuers to use IFRS
What major change did the SEC allow in

2008 with respect to IFRS?
a. U.S. registrants are required to use IFRS.
b. Foreign registrants are now required to
use U.S. GAAP if their shares are traded
in the U.S.
c. U.S. registrants may use IFRS without
reconciliation to U.S. GAAP.
d. Foreign registrants may use IFRS
without reconciliation to U.S. GAAP.
What major change did the SEC allow in

2008 with respect to IFRS?
a. U.S. registrants are required to use IFRS.
b. Foreign registrants are now required to
use U.S. GAAP if their shares are traded
in the U.S.
c. U.S. registrants may use IFRS without
reconciliation to U.S. GAAP.
d. Foreign registrants may use IFRS
without reconciliation to U.S. GAAP.
Determine the functional

currency and understand the
ramifications of different
functional currency
designations.
Determining the Functional Currency
 Two major issues that must be addressed when financial
statements are restated from a foreign currency into U.S.
dollars:
 Which exchange rate should be used to restate foreign currency
balances to domestic currency?
 How should gains and losses be accounted for? Should they be
included in income?
 Exchange rates that may be used in converting foreign
currency values to the U.S. dollar:
 The current rate
 The historical rate
 The average rate for the period
 Functional currency
 “The currency of the primary economic environment in which the
entity operates; normally that is the currency of the environment in
which an entity primarily generates and receives cash”
 Used to differentiate between foreign operations that are self-
contained and integrated into a local environment, and those that are
an extension of the parent and integrated with the parent
Functional Currency Indicators
Functional Currency Indicators
 Functional currency designation in highly inflationary
economies
 The volatility of hyperinflationary currencies distorts the financial
statements if the local currency is used as the foreign entity’s
functional currency
 In such cases, the reporting currency of the U.S. parent—the U.S.
dollar—should be used as the foreign entity’s functional currency
Which of the following is NOT an indicator

that a U.S. parent’s currency should be the
functional currency?
a. Sales contracts denominated in U.S
dollars.
b. Raw materials purchased from vendors
in the U.S.
c. Sales contracts denominated in
subsidiary’s currency.
d. Labor costs of factory workers in the
U.S. producing inventory.
Which of the following is NOT an indicator

that a U.S. parent’s currency should be the
functional currency?
a. Sales contracts denominated in U.S
dollars.
b. Raw materials purchased from vendors
in the U.S.
c. Sales contracts denominated in
subsidiary’s currency.
d. Labor costs of factory workers in the
U.S. producing inventory.

differences between
translation and
remeasurement.
Big Picture: Foreign Currencies
Consolidated Worksheet as of December 31, 2009
Pepper Salt
DR CR
Consoli-
dated
 Assumptions:
Income Statement:
Sales 1,235,000 780,000  Pepper is a U.S.-
Cost of Sales (598,000) (370,500)
Depreciation Expense
S&A Expense
(78,000)
(481,000)
(19,500)
(312,000)
based company
Equity in Net Income
Net Income
63,000
141,000 78,000
 Salt is based in Italy
Statement of RE:
Balance, 1/1/08 455,000 117,000 and the functional
Less: Dividends (104,000) (45,500) currency is the Euro.
Balance, 12/31/08 492,000 149,500
Balance Sheet:
Cash 77,500 32,500  In order to “add them
Inventory
Investment in Salt:
149,500 156,000 up,” they need to be
Book Value
Excess Cost
279,500
180,500 stated in the same
Land 130,000 91,000
Build & Equip
Acc Depreciation
325,000
(273,000)
291,200
(76,700)
currency.
Covenant N-T-C
Goodwill
Total Assets 992,500 572,000
 Objective:
Payables & Accruals
Long-term Debt
84,500
26,000
97,500
195,000
 Convert oranges to
Common Stock
Retained Earnings
390,000
492,000
130,000
149,500 apples.
Translation Versus Remeasurement of Foreign
Financial Statements
 Methods used to restate foreign entity statements to U.S.
dollars:
 The translation of the foreign entity’s functional currency statements
into U.S. dollars
 The remeasurement of the foreign entity’s statements into the
functional currency of the entity
 After remeasurement, the statements must then be translated if the
functional currency is not the U.S. dollar.
 No additional work is needed if the functional currency is the U.S.
dollar
Translation Versus Remeasurement
 Translation is the most common method used

 Applied when the local currency is the foreign entity’s functional
currency
 The current rate is used to convert local currency asset and liability
accounts into U.S. dollars
 Historical rates are used to convert equity accounts into U.S. dollars
 Revenues and expenses are translated using the average rate for the
reporting period
 Any translation adjustment that occurs is a component of
comprehensive income
 This method is called the current rate method
 Remeasurement is the restatement of the foreign entity’s
financial statements from the local currency that the entity
used into the foreign entity’s functional currency
 Required only when the functional currency is different from the
currency used to maintain the books and records of the foreign entity
 The method used is called the temporal method
 Example: A U.S. company owns 100% of the stock of an
Argentinian company. The local currency in Argentina is the
peso.
 Scenario 1: The company pays employees, buys inventory, and
conducts most of its operations in pesos. Thus, its functional currency
is the peso.
 Translate the financial statements to U.S. dollars
 Scenario 2: The company pays buys and sells most of its inventory in
southern Brazil. It also pays many of its employees in Brazilian reias.
Thus, its functional currency is the Brazilian real.
 Remeasure the financial statements to reais.
 Then, translate them back to U.S. dollars.
LC = Local Currency
FC = Functional Currency
 Summary for U.S. Parent Companies:
 If LC = FC  Translate to U.S. Dollars
 If LC ≠ FC  Remeasure to FC
 If FC = U.S. dollars, no further work is needed (this is the case for
subsidiaries in countries with hyperinflationary currencies)
 If FC ≠ U.S. dollars  Translate to U.S. Dollars (this is the case for
Scenario 2 of the Argentinian company in the previous example)
An overview of the methods a U.S. company would use to
restate a foreign affiliate’s financial statements in U.S. dollars.
 Remeasurement
 Monetary balance sheet items are remeasured using the current rate
 Nonmonetary balance sheet items are remeasured using historical
rates
 Revenues and expenses are remeasured using:
 The average rate for items related to monetary items (e.g., the gain on the
sale of a fixed asset)
 Historical rates for income statement items related to nonmonetary items
(e.g., depreciation)
 Any imbalance flows through the income statement as a
remeasurement gain or loss.

a. Translation is always into U.S dollars.
b. Remeasurement results in a change of
accounting principle.
c. After remeasurement into the functional
currency, it is sometimes necessary to
translate to U.S. dollars if the functional
currency is not the U.S. dollar.
d. Translation is more common than
remeasurement.
e. Translation uses the current rate
method.

a. Translation is always into U.S dollars.
b. Remeasurement results in a change of
accounting principle.
c. After remeasurement into the functional
currency, it is sometimes necessary to
translate to U.S. dollars if the functional
currency is not the U.S. dollar.
d. Translation is more common than
remeasurement.
e. Translation uses the current rate
method.

translate financial statements
of a foreign subsidiary.
Translation
 Generally, accounts are translated as follows:
Note: Retained Earnings is unique (with a mixed rates).
Functional
Currency Rate U.S. $
Use Last
Retained Earnings 1/1 Mixed Year’s #
+ Net Income Average
- Dividends Historical

Retained
Net incomeEarnings 12/31
is translated Mixed
using the average exchange rate
 Dividends are translated using the historical rate on the date
of declaration.
Translation
 The outcome of the translation process:
 Because various rates are used, the trial balance debits and credits
after translation generally are not equal
 The balancing item to make the translated trial balance debits equal
the credits is called the translation adjustment
 It by-passes the income statement and as “other comprehensive
income.”
Translation
 Financial statement presentation
 The translation adjustment is part of the entity’s
comprehensive income for the period

 Comprehensive income includes net income and “other
comprehensive income”
Statement of
Income Statement Comprehensive Income
Sales Net Income
- Cost of Goods sold +/- OCI Items
Gross Profit Comprehensive Income
- Operating Expenses
Income from Continuing Operations
- Extraordinary Items
- Discontinued Operations
Net Income
Translation
 Financial statement presentation
 Major items comprising the other comprehensive income:
 Foreign currency translation adjustments (Ch. 12)

 Revaluation of cash flow hedges (Ch. 11)
 Unrealized gains/losses on available-for-sale securities
 Adjustments in the minimum pension liability item
Sales Net Income

- Cost of Goods sold +/- OCI Items
Gross Profit Comprehensive Income
- Operating Expenses
Income from Continuing Operations
- Extraordinary Items
- Discontinued Operations
Net Income
Translation
 Each period’s other comprehensive income (OCI) is closed
to accumulated other comprehensive income (AOCI)
 An appropriate title, such as “Accumulated Other
Comprehensive Income,” is used to describe this
stockholders’ equity item

a. Income statement items are generally
translated at the average rate for the
year.
b. Assets and liabilities are normally
translated at the current rate on the
balance sheet date.
c. Equity accounts are usually translated
at historical rates.
d. After translated all items, the trial
balance must balance by definition.

a. Income statement items are generally
translated at the average rate for the
year.
b. Assets and liabilities are normally
translated at the current rate on the
balance sheet date.
c. Equity accounts are usually translated
at historical rates.
d. After translated all items, the trial
balance must balance by definition.
Prepare consolidated
financial statements including
a foreign subsidiary after
translation.
Group Exercise 1: Translation
 On 1/2/X7, Padre Corp. (a U.S. based company)

formed a new subsidiary in Honduras, Sucursal Inc.,
with an initial investment of 150,000 Honduras
Lempiras (HNL).
 Assume Sucursal:
 Purchases inventory evenly throughout 20X7. The ending inventory
is purchased 11/30/X7.
 Uses straight-line depreciation on fixed assets.
 Declares and pays dividends on 11/30/X7.
 Purchased the fixed assets on 4/1/X7.
 Uses Lempiras as the functional currency.
REQUIRED
Prepare a schedule to translate Sucursal’s financial
statements on 12/31/X7 to U.S. dollars.
Honduras U.S.
Account Rate Exchange Rates
Limpiras Dollars
Cash 25,000 1/2/X7 0.0553
Accounts Receivable 60,000 4/1/X7 0.0550
Inventory 160,000 11/30/X7 0.0535
Note Receivable 25,000 12/31/X7 0.0532
Plant and Equipment 350,000 Average 0.0545
Other Expenses 90,000
Dividends 80,000
Total Debits 960,000

Accounts Payable 60,000
Mortgage Payable 230,000
Sales 330,000
Total Credits 960,000
Honduras U.S. Exchange Rates
Account Rate
Limpiras Dollars 1/2/X7 0.0553
Cash 25,000 0.0532 1,330 4/1/X7 0.0550
Accounts Receivable 60,000 0.0532 3,192 11/30/X7 0.0535
Inventory 160,000 0.0532 8,512 12/31/X7 0.0532
Note Receivable 25,000 0.0532 1,330 Average 0.0545
Plant and Equipment 350,000 0.0532 18,620
Cost of Goods Sold 160,000 0.0545 8,720
Depreciation Expense 10,000 0.0545 545
Other Expenses 90,000 0.0545 4,905
Dividends 80,000 0.0535 4,280
Total Debits 960,000 51,434
Acc. OCI— Translation Adjustment 382

Adjusted Total Debits 51,816
Accumulated Depreciation 10,000 0.0532 532

Accounts Payable 60,000 0.0532 3,192
Bonds Payable 180,000 0.0532 9,576
Mortgage Payable 230,000 0.0532 12,236 Note: Beginning Retained
Common Stock 150,000 0.0553 8,295 Earnings does not appear in
0.0545 the trial balance because it is
Sales 330,000 17,985
zero.
Total Credits 960,000 51,816
The resulting journal entry on Padre’s books:

Investment in Sucursal 382

remeasure financial
statements of a foreign
subsidiary.
Remeasurement
 Remeasurement is similar to translation in that its goal is to
obtain equivalent U.S. dollar values for the foreign affiliate’s
accounts so they may be combined or consolidated with the
U.S. company’s statements
 The exchange rates used are different from those used for
translation
Monetary Accounts
 Monetary  Related to “Money”
 By definition:
 Monetary accounts are those that have their amounts “fixed” in terms
of the units of currency.
 They represent amounts that will be received or paid in a fixed
number of monetary units.
 Generally, they include:
 Cash and cash equivalents
 Receivables (short- and long-term)
 Payables (short- and long-term)
Nonmonetary Accounts
Exception: Trading
and available-for-sale
securities are
MONETARY assets!
Remeasurement Rates
Balance sheet accounts:

Monetary accounts Current rate
Non-monetary accounts Historical rate
Income statement accounts:

Most revenues and expenses Weighted-average rate
Items related to non-monetary accounts Historical rate
 Points to remember:
 PP&E: Use the historical rate on the date the parent acquires the
subsidiary or the actual date an asset is acquired if after the
subsidiary’s acquisition
 Depreciation: Use the same historical rate for depreciation expense
used for each associated asset.
Remeasurement Rates
 COGS: Use historical rates for beginning and ending inventory and the
weighted average rate for purchases.
Functional
Historical
on date
Beginning Inventory purchased
+ Purchases Average
= Goods Available for Sale Mixed
Historical
on date
- Ending Inventory purchased
= Cost of Goods Sold Mixed
Remeasurement Rates
 Retained Earnings
Functional
Use Last
Retained Earnings 1/1 Mixed Year’s #
Average and
+ Net Income Historical
- Dividends Historical
 Retainedto
Similar Earnings 12/31 except that while most
translation Mixedincome items
are remeasured using the weighted average rate, items
related to non-monetary balance sheet items are
remeasured using the corresponding historical rates.
 Dividends are translated using the historical rate on the
date of declaration.
Remeasurement
 The process produces the same end result as if the foreign
entity’s transactions had been initially recorded in dollars
 Debits = credits in the local currency trial balance.
 Because of the variety of rates used to remeasure the accounts, the debits
and credits of the remeasured trial balance will generally not be equal.
 A remeasurement gain or loss balances the remeasured trial balance.
 The remeasurement gain or loss only exists in the subsidiary’s
remeasured trial balance.
 It appears on the subsidiary’s remeasured income statement, but it is not
recorded via a journal entry.
Remeasurement
 Statement presentation
 Remeasurement gain or loss is included in the current period income
statement, usually under “Other Income”
 Upon completion of the remeasurement process, the foreign entity’s
financial statements are presented as they would have been had the
U.S. dollar been used to record the transactions in the local currency
as they occurred
Summary of the Translation and
Remeasurement Processes

a. Exchange rates used for remeasurement
differ from those used in translation.
b. The only difference in exchange rates
between remeasurement and translation
of the balance sheet is for the non-
monetary accounts.
c. The rates used to remeasure the income
statement are all the same as those used
in translation.
d. After remeasuring all items, the trial
balance usually won’t balance.

a. Exchange rates used for remeasurement
differ from those used in translation.
b. The only difference in exchange rates
between remeasurement and translation
of the balance sheet is for the non-
monetary accounts.
c. The rates used to remeasure the income
statement are all the same as those used
in translation.
d. After remeasuring all items, the trial
balance usually won’t balance.
Prepare consolidated
financial statements
including a foreign
subsidiary after
remeasurement.
Group Exercise 2: Remeasurement
 On 1/2/X7, Padre Corp. (a U.S. based company)

formed a new subsidiary in Honduras, Sucursal Inc.,
with an initial investment of 150,000 Honduras
Lempiras (HNL).
 Assume Sucursal:
 Purchases inventory evenly throughout 20X7. The ending inventory
is purchased 11/30/X7.
 Uses straight-line depreciation on fixed assets.
 Declares and pays dividends on 11/30/X7.
 Purchased the fixed assets on 4/1/X7.
 Uses the U.S. dollar as the functional currency.
REQUIRED:
Prepare a schedule to remeasure Sucursal’s financial
statements on 12/31/X7 to U.S. dollars.
Honduras U.S.
Limpiras Dollars
Cash 25,000 1/2/X7 0.0553
Accounts Receivable 60,000 4/1/X7 0.0550
Inventory 160,000 11/30/X7 0.0535
Note Receivable 25,000 12/31/X7 0.0532
Plant and Equipment 350,000 Average 0.0545
Other Expenses 90,000
Dividends 80,000
Total Debits 960,000

Accounts Payable 60,000
Mortgage Payable 230,000
Sales 330,000
Total Credits 960,000
Exchange Rates
1/2/X7 0.0553
4/1/X7 0.0550
11/30/X7 0.0535
12/31/X7 0.0532
Average 0.0545
Honduras U.S.
Rate Rate
Limpiras Dollars
Beginning Inventory 0) 0.0553 0)
Add: Purchases 320,000) 0.0545 17,440)
Goods Available for Sale 320,000) 17,440)
Less: Ending Inventory (160,000) 0.0535 (8,560)
Cost of Goods Sold 160,000) (a) 8,880)
Honduras U.S.
Limpiras Dollars
Cash 25,000 0.0532 1,330 1/2/X7 0.0553
Accounts Receivable 60,000 0.0532 3,192 4/1/X7 0.0550
Inventory 160,000 0.0535 8,560 11/30/X7 0.0535
Note Receivable 25,000 0.0532 1,330 12/31/X7 0.0532
Plant and Equipment 350,000 0.0550 19,250 Average 0.0545
Cost of Goods Sold 160,000 (a) 8,880
Depreciation Expense 10,000 0.0550 550
Other Expenses 90,000 0.0545 4,905
Dividends 80,000 0.0535 4,280 This remeasurement
Total Debits 960,000 52,277 gain appears in
Accumulated Depreciation 10,000 0.0550 550 Sucursal’s income
Accounts Payable 60,000 0.0532 3,192 statement. As a result,
Bonds Payable 180,000 0.0532 9,576 it will flow into
Mortgage Payable 230,000 0.0532 12,236 Padre’s investment
Common Stock 150,000 0.0553 8,295 and income from
Sales 330,000 0.0545 17,985 Sucursal accounts
Total Credits 960,000 51,834 when Padre records
Remeasurement Gain 443 its 100% share of
Adjusted Total Credits 52,277 Sucursal’s income.
• This remeasurement gain appears in Sucursal’s “remeasured”
income statement.
• No entry is required on Sucursal’s books because the gain
only exists on the remeasured trial balance.
Sales 17,985
COGS (8,880)
Depreciation Expense (550)
Other Expenses (4,905)
Remeasurement gain 443
Net Income 4,093
• The effect on Padre’s books would be through the regular
entry to record its share of Sucursal’s remeasured net income.
Investment in Sucursal 4,093
Income from Sucursal 4,093
Understand other issues

related to foreign operations
including the hedging of a
net investment in a foreign
subsidiary.
Foreign Investments and Unconsolidated
Subsidiaries
 A parent company consolidates a foreign subsidiary, except
when it is unable to exercise economic control:
1. Restrictions on foreign exchange in the foreign country
2. Restrictions on transfers of property in the foreign country
3. Other governmentally imposed uncertainties
Subsidiaries
 An unconsolidated foreign subsidiary is reported as an
investment on the U.S. parent company’s balance sheet
 The U.S. company must use the equity method if it has the ability to
exercise “significant influence”
 When the equity method is used, the investee’s financial statements are
either remeasured or translated, depending on the determination of
the functional currency
 If the equity method cannot be applied, the cost method is used
Subsidiaries
 Liquidation of a foreign investment
 The translation adjustment account is directly related to a company’s
investment in a foreign entity
 If the investor sells a substantial portion of its stock investment, ASC
830 requires that the pro rata portion of the accumulated translation
adjustment account attributable to that investment be included in
computing the gain or loss on the disposition of the investment
Hedge of a Net Investment in a Foreign Subsidiary
 ASC 815 permits hedging of a net investment in foreign

subsidiaries
 The gain or loss on the effective portion of a hedge of a net investment
is taken to other comprehensive income as part of the translation
adjustment
 The amount of offset to comprehensive income is limited to the
translation adjustment for the net investment
 Any excess must be recognized currently in earnings
Disclosure Requirements
 ASC 830 requires the aggregate foreign transaction gain or
loss included in income to be separately disclosed in the
income statement or in an accompanying note
 If not disclosed as a one-line item on the income statement,
this disclosure is usually a one-sentence footnote
summarizing the foreign operations
 Proof of remeasurement exchange gain or loss
 The analysis primarily involves the monetary items, because they are
remeasured from the exchange rate at the beginning of the period, or
on the date of the generating transaction to the current exchange rate
at the end of the period
 Statement of Cash Flows
 Accounts reported in the statement of cash flows should be restated in
U.S. dollars using the same rates as used for balance sheet and income
statement purposes
 Lower-of-cost-or-market inventory valuation under
remeasurement
 The historical cost of inventories must be remeasured using historical
exchange rates to determine the functional currency historical cost
value
 These remeasured costs are compared with the inventory market
value translated using the current rate
 The final step is to compare the cost and market and to recognize any
appropriate write-downs to market
 Intercompany transactions
 Assume that a U.S. company has a foreign currency–denominated
receivable from its foreign subsidiary
 The U.S. company would first revalue the receivable to its U.S. dollar
equivalent value as of the date of the financial statements
 After the foreign affiliate’s statements have been translated or
remeasured, the receivable should be at the same U.S. dollar value and
can be eliminated
 Intercompany transactions
 ASC 830 provides an exception when the intercompany foreign
currency transactions will not be settled within the foreseeable future
 These transactions may be considered part of the net investment in
the foreign entity
 The translation adjustments on these are deferred and accumulated
as part of the cumulative translation account
 Income taxes
 Interperiod tax allocation is required whenever
temporary differences exist in the recognition of revenue

and expenses for income statement purposes and for tax
purposes
 Exchange gains and losses from foreign currency
transactions require the recognition of a deferred tax if

they are included in income but not recognized for tax
purposes in the same period
 A deferral is required for the portion of the translation
adjustment related to the subsidiary’s undistributed

earnings that are included in the parent’s income
 Income taxes
 Deferred taxes need not be recognized if the undistributed earnings
will be indefinitely reinvested in the subsidiary
 If the parent expects eventually to receive the presently undistributed
earnings of a foreign subsidiary, deferred tax recognition is required,
and the tax entry would be:
 Translation when a third currency is the functional currency
 If the entity’s books and records are not expressed in its functional
currency, the following two-step process must be used:
 Remeasure the subsidiary’s financial statements into the functional
currency
 The statements expressed in the functional currency are then
translated into U.S. dollars

a. Foreign subsidiaries are always
consolidated.
b. U.S. GAAP does not allow for the complete
liquidation of foreign investments.
c. U.S. GAAP permits the hedging of a net
investment in foreign subsidiaries.
d. The statement of cash flows is always
translated at historical costs.
e. Translated intercompany transactions are
not eliminated like normal intercompany
transactions

a. Foreign subsidiaries are always
consolidated.
b. U.S. GAAP does not allow for the complete
liquidation of foreign investments.
c. U.S. GAAP permits the hedging of a net
investment in foreign subsidiaries.
d. The statement of cash flows is always
translated at historical costs.
e. Translated intercompany transactions are
not eliminated like normal intercompany
transactions
Conclusion
The End
12-1086

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Akuntansi Keuangan Lanjutan - Baker (10 E)

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Chapter 1

Understand and explain

 Reasons for Enterprise expansion

 A subsidiary is a corporation that is

 Manipulation of financial reporting

 Two Types of Expansion

 New entities are created

 The Usual Way

 Expansion through business combinations

 Other beneficial interest

A common way to obtain corporate

A common way to obtain corporate

Understand the history of

 Value of individual assets and liabilities

 Valuation of consideration exchanged

 Major Decision Factors

 Major Decision Factors (continued)

 Major Advantages of Acquiring Assets

 Advantages of Acquiring Common Stock

Common Stock—Results Target’s Assets—Results in a

To qualify for acquisition accounting

To qualify for acquisition accounting

Make calculations and

 The company transfers assets, and perhaps

 Recognition of fair values of the assets

 If the value of an asset transferred to a newly

When a parent company creates a

When a parent company creates a

Understand and explain

(a) Statutory Merger

(b) Statutory Consolidation

(c) Stock Acquisition

AA Company invests in BB Company

 Option #1: Statutory Merger

• Need SH approval from both corporations.

 A takes all of T’s assets and liquidates the

 Option #2: Statutory Consolidation

• Need SH approval from both corporations.

 Option #3: HOLDING COMPANY:

N Stock X & Y Stock

A way to force out a target company’s

A way to force out a target company’s

Make calculations and

 Category #1: The fair value of the consideration

 Category #3: Contingent consideration

 Types of Consideration: Practically any

Pete Inc. acquired 100% of the outstanding

Pete Inc. acquired 100% of the outstanding

Investment in Sake 3,500,000 Sake

 In the past, costs traceable to the acquisition were

 ASC 805 requires that they be expensed in the

Assume the same information provided in Exercise 1. In addition, assume

SEC filing fees 9,000

Required: Prepare the journal entry to record the direct costs.

Acquisition Expense 90,000

 FMV Given > FMV of Net Assets  Goodwill

 FMV Given = FMV of Net Assets  Neither GW

 Goodwill is calculated as the residual

GW = Total FMV Given – FMV of Identifiable Net Assets