1. Equity investment Cash (to record the purchase of the Equity Investment)

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1 Chapter 1 Accounting for Intercorporate Investments 19 Following are the required journal entries by the investor to record the initial investment and the subsequent recognition of equity income and dividends received: 1. Equity investment Cash (to record the purchase of the Equity Investment) 2. Equity investment Equity income (to record the equity income 2 $30% of $300) 3. Cash Equity investment (to record the receipt of dividends of $30) We have multiplied all of the previous journal entry amounts by 30%, the proportion of the investee that the investor owns in this example. The investor initially records the Equity Investment at its purchase price of $240, and subsequently recognizes the dividends received of $30 as a reduction of that account. For the income recognition, when the investor owns less than 100% of the investee, it can only record equity income equal to the proportion of the investee s income that it owns. Since the investee is reporting $300 of income in this case, the investor recognizes 30% of that amount ($90) in its income statement as Equity Income. The T-account for the Equity Investment illustrates these changes: Equity Investment Beginning balance 240 Equity income Dividends received Ending balance 300 The relation between the Equity Investment account on the investor s balance sheet and the investee s Stockholders Equity still holds. The investee reports Stockholders Equity of $1,000 at the end of the year, and, since the 30% investment was acquired at book value, the investor reports an Equity Investment of $300, representing the 30% of the investee s Stockholders Equity that it owns. One final note: in the previous section we discuss the deferral of unrealized profit on intercompany inventory sales. In that example, the investee sold inventory with a gross profit of $30 that the investor deferred at the end of the year. The deferral of that profit when the investor owns less than 100% of the investee is handled in one of two ways: 1. Investor controls the investee when the investor owns less than 100%, but still controls the investee (say, for ownership levels in excess of 51% of the outstanding common stock), the investor defers all of the intercompany profit as described above, or 2. Investor has a significant interest in the investee when the investor has a significant interest in the investee (say for ownership levels less than or equal to 50%), it defers only the proportion of the gross profit that it owns. For example, if the investor owns 30% of the investee, and the gross profit on the intercompany sale is $30, the investor defers $9 ($ %) in the following journal entry: 16 Equity income Equity investment... 9 (to record the deferral of gross profit on inventory sale in the period of sale) 16 FASB ASC through indicates that proportionate elimination is only allowed if both of the following conditions are met: (1) the investor does not control the investee and (2) the intercompany transactions are considered arm s length. Otherwise, all of the intercompany transaction must be eliminated.

2 Chapter 1 Accounting for Intercorporate Investments 31 Book Values Fair Values Investor Investee Investor Investee Receivables & inventories... $120,000 $ 60,000 $108,000 $ 54,000 Land , , , ,000 Property & equipment , , , ,000 Trademarks & patents ,000 96,000 Total assets.... $630,000 $300,000 $948,000 $486,000 Liabilities.... $180,000 $ 96,000 $216,000 $114,000 Common stock ($1 par)... 36,000 20,000 Additional paid-in capital , ,000 Retained earnings... 90,000 12,000 Total liabilities & equity... $525,000 $250,000 Net assets... $450,000 $204,000 $732,000 $372, Asset acquisition (market value is different from book value) Assume that the investor company issued 18,000 new shares of the investor company s common stock in exchange for all of the individually identifiable assets and liabilities of the investee company, in a transaction that qualifies as a business combination. The financial information presented, above, was prepared immediately before this transaction. Provide the Investor Company s balance (i.e., on the investor s books, before consolidation) for Goodwill immediately following the acquisition of the investee s net assets: a. $0 b. $6,000 c. $78,000 d. $174, Stock acquisition (market value is different from book value) Assume that the investor company issued 18,000 new shares of the investor company s common stock in exchange for 100% of the common stock of the investee company, in a transaction that qualifies as a business combination. The financial information presented, above, was prepared immediately before this transaction. Provide the Investor Company s balance (i.e., on the investor s books, before consolidation) for Investment in Investee immediately following the acquisition of the investee s common stock: a. $20,000 b. $192,000 c. $334,800 d. $378,000 Use the following facts for Multiple Choice problems 19 and 20 (each question is independent of the other): On January 1, 2013, an investor purchases 10,000 common shares of an investee at $9 (cash) per share. The shares represent 20% ownership in the investee. The investee shares are not considered marketable because they do not trade on an active exchange. On January 1, 2013, the book value of the investee s assets and liabilities equals $600,000 and $150,000, respectively. On that date, the appraised fair values of the investee s identifiable net assets approximated the recorded book values. During the year ended December 31, 2013, the investee company reported net income equal to $22,500 and dividends equal to $12, Noncontrolling investment accounting (price equals book value) Assume the investor does not exert significant influence over the investee. Determine the balance in the Investment in Investee account at December 31, a. $2,400 b. $90,000 c. $92,100 d. $460,500 LO1 LO1 LO2,3 AICPA Adapted AICPA Adapted AICPA Adapted AICPA Adapted

3 Chapter 3 Consolidated Financial Statements Subsequent to the Date of Acquisition 113 Exhibit 3.3 Consolidation Spreadsheet at the End of the First Year Following Acquisition Consolidation Entries Parent Subsidiary Dr Cr Consolidated Income statement: Sales $10,000,000 $1,500,000 $11,500,000 Cost of goods sold (7,000,000) (900,000) (7,900,000) Gross profit ,000, ,000 3,600,000 Equity income ,500 [C] 182,500 0 Operating expenses (1,900,000) (390,000) [D] 27,500 (2,317,500) Net income $ 1,282,500 $ 210,000 $ 1,282,500 Statement of retained earnings: BOY retained earnings $ 5,024,000 $ 775,000 [E] 775,000 $ 5,024,000 Net income ,282, ,000 1,282,500 Dividends (256,500) (31,500) [C] 31,500 (256,500) Ending retained earnings $ 6,050,000 $ 953,500 $ 6,050,000 Balance sheet: Assets Cash $ 1,134,000 $ 404,500 $ 1,538,500 Accounts receivable ,280, ,000 1,628,000 Inventory ,940, ,000 2,387,000 Equity investment ,651,000 [C] 151,000 0 [E] 1,000,000 [A] 500,000 PPE, net ,332, ,000 [A] 200,000 [D] 10,000 10,349,000 Patent [A] 175,000 [D] 17, ,500 Goodwill [A] 125, ,000 $15,337,000 $2,026,500 $16,185,000 Liabilities and stockholders equity Current liabilities $ 1,437,000 $ 348,000 $ 1,785,000 Long-term liabilities ,000, ,000 5,500,000 Common stock ,635, ,000 [E] 100,000 1,635,000 APIC ,215, ,000 [E] 125,000 1,215,000 Retained earnings ,050, ,500 6,050,000 $15,337,000 $2,026,500 $16,185,000 own financial statements. However, because the parent controls the subsidiary, the parent cannot issue financial statements to the public without first consolidating its subsidiary. 8 The first four of our five C-E-A-D-I entries are designed to eliminate from the Equity Investment Income account the subsidiary s reported net income, eliminate from the Equity Investment account the book value of the subsidiary s Stockholders Equity, reclassify the unamortized AAP from the Equity Investment account into the appropriate individual identifiable net asset accounts and Goodwill, and reclassify the amortized AAP from the Equity Investment Income account into the appropriate income statement accounts (this example did not include the elimination of intercompany transactions and balances; we will include that wrinkle in the next example). As a result of these consolidation entries, the Equity Investment account (on the parent s balance sheet) and the Equity Income account (on the parent s income statement) are both reduced to a zero bal- 8 The parent is allowed to issue supplemental unconsolidated parent-only or subsidiary-only financial statements if (and only if) the parent also publishes consolidated financial statements in the same annual report. General Electric Co. is an example of a company that regularly publishes audited parent and subsidiary financial statements with its audited consolidated statements. You can download its financial statements from the SEC s web site (

4 158 Chapter 3 Consolidated Financial Statements Subsequent to the Date of Acquisition LO4 44. A Consolidation when parent uses the cost method to account for its investment in the subsidiary Assume that your company acquired a subsidiary on January 1, 2012, for $1,000,000. The purchase price was $150,000 in excess of the subsidiary s $850,000 book value of Stockholders Equity on the acquisition date, and that excess was assigned to a Customer List that has a useful life of 10 years. During the two years ending December 31, 2013, the subsidiary reported net income totaling $476,000 and paid dividends to the parent totaling $80,000. The financial statements of the parent and its subsidiary for the year ended December 31, 2013, are as follows: Parent Subsidiary Parent Subsidiary Income statement: Balance sheet: Sales $6,860,000 $1,869,000 Assets Cost of goods sold (4,939,200) (1,121,400) Cash $ 949,931 $ 481,579 Gross profit ,920, ,600 Accounts receivable ,756, ,608 Operating expenses (1,029,000) (485,940) Inventory ,661, ,962 Dividend income ,249 Equity investment ,000,000 Net income $ 931,049 $ 261,660 Property, plant and equipment (PPE), net... 7,315,504 1,030,442 $13,683,275 $2,502,591 Statement of retained earnings: BOY retained earnings $2,587,942 $ 965,650 Liabilities and stockholders equity Net income , ,660 Accounts payable $ 1,004,304 $ 178,178 Dividends (186,210) (39,249) Accrued liabilities ,193, ,002 Ending retained earnings..... $3,332,781 $1,188,061 Long-term liabilities ,000, ,000 Common stock , ,600 APIC , ,750 Retained earnings ,332,781 1,188,061 $13,683,275 $2,502,591 a. Compute the Equity Investment balance January 1, 2013, assuming that the parent had used the equity method instead of the cost method. b. Prepare the [ADJ] entry that is needed in order to bring the Equity Investment from its current balance (using cost method) to the required balance (using the equity method) on January 1, [Hint: you computed this balance in part (a).] c. Prepare the consolidation entries for the year ended December 31, d. Prepare the consolidation spreadsheet for the year ended December 31, e. Explain the function of the [ADJ] consolidation entry proposed in part (b). f. Now, assume that the parent uses a hybrid equity method under which it reports its proportionate share of the subsidiary s net income, but doesn t accrue any depreciation and amortization expense on the [A] assets. Prepare the required [ADJ] consolidation entry.

5 Chapter 3 Consolidated Financial Statements Subsequent to the Date of Acquisition A Consolidation when parent uses the cost method to account for its investment in the subsidiary Assume that your company acquired a subsidiary on January 1, 2011, for $590,000. The purchase price was $300,000 in excess of the subsidiary s $290,000 book value of Stockholders Equity on the acquisition date, and that excess was assigned to a Patent that has a useful life of 10 years. During the three years ending December 31, 2013, the subsidiary reported net income of $160,000 and paid dividends to the parent totaling $20,000. The financial statements of the parent and its subsidiary for the year ended December 31, 2013, are as follows: LO4 Parent Subsidiary Parent Subsidiary Income statement: Balance sheet: Sales $4,290,000 $645,000 Assets Cost of goods sold (3,088,800) (387,000) Cash $ 694,756 $166,195 Gross profit ,201, ,000 Accounts receivable ,098, ,640 Operating expenses (643,500) (167,700) Inventory ,664, ,210 Dividend income ,545 Equity investment ,000 Net income $ 571,245 $ 90,300 Property, plant and equipment (PPE), net... 4,574, ,610 $8,622,372 $863,655 Statement of retained earnings: BOY retained earnings $ 893,110 $333,250 Liabilities and stockholders equity Net income ,245 90,300 Accounts payable $ 628,056 $ 61,490 Dividends (114,249) (13,545) Accrued liabilities ,460 80,410 Ending retained earnings.... $1,350,106 $410,005 Long-term liabilities ,500, ,000 Common stock ,000 43,000 APIC ,750 53,750 Retained earnings ,350, ,005 $8,622,372 $863,655 a. Compute the Equity Investment balance as of January 1, 2013, assuming that the parent used the equity method instead of the cost method. b. Prepare the [ADJ] entry that is needed in order to bring the Equity Investment from its current balance (using cost method) to the required balance (using the equity method) on January 1, [Hint: you computed this balance in part (a).] c. Prepare the consolidation entries for the year ended December 31, d. Prepare the consolidation spreadsheet for the year ended December 31, e. Explain the function of the [ADJ] consolidation entry proposed in part (b). f. Now, assume that the parent uses a hybrid equity method under which it reports its proportionate share of the subsidiary s net income, but doesn t accrue any depreciation and amortization expense on the [A] assets. Prepare the required [ADJ] consolidation entry. 46. C Consolidation subsequent to date of acquisition: pooling-of-interests method Assume that on January 1, 2010, the parent company acquires a 100% interest in its subsidiary by issuing common stock with a fair value that is $600,000 over the book value of the subsidiary s Stockholders Equity. The parent accounted for the acquisition under the pooling-of-interest method. (Note: pooling of interests is no longer acceptable for new acquisitions, except in the case of common control acquisitions.) The financial statements of the parent and its subsidiary for the year ended December 31, 2013, follow: LO5

6 162 Chapter 3 Consolidated Financial Statements Subsequent to the Date of Acquisition Solution 3 The $700,000 fair value of the subsidiary is less than the $1,000,000 book value of the Equity Investment (i.e., the carrying value of the reporting unit); therefore, Goodwill is potentially impaired. Fair value of the subsidiary $ 900,000 Fair value of the net assets exclusive of Goodwill ,000 Implied fair value of Goodwill $ 200,000 Book value of Goodwill ,000 Goodwill impairment $(100,000) Goodwill is found to be impaired and must, therefore, be written off in part with the following journal entry: Loss on write-down of Goodwill ,000 Equity investment* ,000 (to write down the book value of Goodwill) *In the consolidated financial statements, this reduction in the Equity Investment account will appear as a reduction in the balance of Goodwill. Comprehensive Review Solution Consolidation Entries Parent Subsidiary Dr Cr Consolidated Income statement: Sales $5,700,000 $480,000 $6,180,000 Cost of goods sold (3,990,000) (288,000) (4,278,000) Gross profit ,710, ,000 1,902,000 Equity income ,200 [C] 47,200 0 Operating expenses (1,083,000) (124,800) [D] 20,000 (1,227,800) Net income $ 674,200 $ 67,200 $ 674,200 Statement of retained earnings: BOY retained earnings $2,863,680 $248,000 [E] 248,000 $2,863,680 Net income ,200 67, ,200 Dividends (134,840) (10,080) [C] 10,080 (134,840) Ending retained earnings $3,403,040 $305,120 $3,403,040 Balance sheet: Assets Cash $ 354,870 $129,440 $ 484,310 Accounts receivable , , ,960 Inventory ,105, ,040 1,248,840 Equity investment ,120 [C] 37,120 0 [E] 320,000 [A] 480,000 Property, plant and equipment (PPE), net ,319, ,640 [A] 150,000 [D] 15,000 5,718,880 Customer list [A] 50,000 [D] 5,000 45,000 Goodwill [A] 280, ,000 $8,346,630 $648,480 $8,617,990 Liabilities and stockholders equity Current liabilities $ 819,090 $111,360 $ 930,450 Long-term liabilities ,500, ,000 2,660,000 Common stock ,950 32,000 [E] 32, ,950 APIC ,550 40,000 [E] 40, ,550 Retained earnings ,403, ,120 3,403,040 $8,346,630 $648,480 $8,617,990

7 Chapter 4 Consolidated Financial Statements and Intercompany Transactions 189 Equity investment Equity income (to record the equity method adjustment for equipment-gain-related income recognized by the subsidiary) Equity investment Equity income (to recognize the remaining deferred intercompany profit in income and remove the previously deferred profit from the Equity Investment account) When the parent uses the full equity method, the consolidating [C] entry will eliminate the gain that corresponds to the income recognized in the subsidiary s income statement and the consolidating [I] entry will reclassify the $30 of Income from Subsidiary into the consolidated Gain on Sale of Equipment account. These consolidating entries for the year ended December 31, 2010 (i.e., the financial statements that include the January 1, 2010 date of sale) are as follows: [C] Consolidation entries to eliminate changes in the Equity Investment account during the year [I] Consolidation entry in the year of sale to an unaffiliated company [C] Equity income Equity investment [I gain ] Equity income Gain on sale of equipment (to increase the Equity Investment account for the remaining unconfirmed profit and recognize the deferred gain on the sale) Again, the total gain reported in the consolidated income statement is $80 (i.e., $50 by the subsidiary in its income statement and the recognition of the $30 deferred profit balance remaining on January 1, 2010). One final point: if the sale to an unaffiliated party occurred after December 31, 2013, no consolidating adjustment would have been necessary. That is, if the equipment is held by the subsidiary until it is fully depreciated, the deferred gain will be fully amortized. Thus, the gain on sale reported on the books of the subsidiary will be the only gain recognized in the consolidated income statement. Upstream Intercompany Sale of Depreciable Assets In the case of wholly owned subsidiaries, there is no difference in the [I] eliminating entries for upstream versus downstream transactions involving intercompany (i.e., affiliated) transfers of depreciable assets among commonly controlled companies (assuming we hold constant the parent company s pre-consolidation bookkeeping for the Equity Investment account). This is because all of the deferred profit must be removed from the combined financial statements, regardless of the direction of the transaction. If we consider the accounts affected and the amounts in the preceding example, the account relationships, [I] consolidating journal entries, and consolidated balances in Exhibits 4.14 and 4.16 are the same in the upstream case. The only difference in the entries will relate to the [C] adjustment because in the case of the upstream sale, the subsidiary would have recorded the gain in its income statement. Thus the parent company would have recorded its equity method interest in the income of the subsidiary. In addition, the parent would make the same equity method adjustments to eliminate the deferred intercompany profits that result from the sale. 19 The following full-equity-method entries are recorded by the parent company assuming an upstream sale instead of a downstream sale: 19 Again, we made some fairly big simplifying assumptions in this example. In particular, we assumed that there were no other transactions or balances, except for the equipment-related items. Thus, the subsidiary s only income would have been derived from the upstream sale.

8 194 Chapter 4 Consolidated Financial Statements and Intercompany Transactions Comprehensive Review A parent company acquired 100 percent of the stock of a subsidiary company on January 1, 2009, for $555,000. On this date, the balances of the subsidiary s stockholders equity accounts were Common Stock, $292,500, and Retained Earnings, $67,500. On January 1, 2009, the subsidiary s recorded book values were equal to fair values for all items except four: (1) accounts receivable had a book value of $82,500 and a fair value of $72,000, (2) property, plant & equipment, net had a book value of $225,000 and a fair value of $252,000, (3) a previously unrecorded patent had a book value of $0 and a fair value of $45,000, and (4) notes payable had a book value of $45,000 and a fair value of $37,500. Both companies use the FIFO inventory method and sell all of their inventories at least once per year. The year-end net balance of trade receivables are collected in the following year. On the acquisition date, the subsidiary s property, plant & equipment, net had a remaining useful life of 10 years, the patent had a remaining useful life of 4 years, and notes payable had a remaining term of 5 years. On January 1, 2012, the parent sold a building to the subsidiary for $120,000. On this date, the building was carried on the parent s books (net of accumulated depreciation) at $82,500. Both companies estimated that the building has a remaining life of 10 years on the intercompany sale date, with no salvage value. Each company routinely sells merchandise to the other company, with a profit margin of 40 percent of selling price (regardless of the direction of the sale). During 2013, intercompany sales amount to $75,000, of which $20,000 of merchandise remains in the ending inventory of the subsidiary. On December 31, 2013, $15,000 of these intercompany sales remained unpaid. Additionally, the parent s December 31, 2012 inventory includes $15,000 of merchandise purchased in the preceding year from the subsidiary. During 2012, intercompany sales amount to $60,000, and on December 31, 2012, $10,000 of these intercompany sales remained unpaid. The parent accounts for its investment in the subsidiary using the full equity method. Unconfirmed profits are allocated pro rata. The pre-closing trial balances (and additional information) for the two companies for the year ended December 31, 2013, are provided below: Parent Subsidiary Debits Cash... $ 87,120 $ 63,750 Accounts receivable ,500 90,000 Inventories , ,250 Property, plant & equipment, net , ,500 Other assets , ,000 Equity investment ,000 Cost of goods sold , ,000 Depreciation & amortization expense ,000 21,600 Operating expenses ,000 81,150 Interest expense ,000 5,250 Dividends declared ,000 31,500 Total debits... $2,733,870 $1,101,000 Credits Accounts payable... $ 252,000 $ 52,500 Notes payable ,470 45,000 Other liabilities... 49,500 58,500 Common stock , ,500 Retained earnings (Jan. 1, 2013) , ,500 Sales... 1,080, ,000 Equity income ,550 Total credits.... $2,733,870 $1,101,000 Additional Information Retained earnings (Dec. 31, 2013)... $ 609,900 $ 270,000 Net income... $ 104,550 $ 54,000

9 198 Chapter 4 Consolidated Financial Statements and Intercompany Transactions Appendix 4B: consolidation When the Parent Uses the Partial Equity Method to Account for Its Equity Investment Given the tremendous volume of intercompany transactions for most affiliated groups of companies, the most expedient accounting for intercompany transactions and deferred profit involves (1) ignoring intercompany transactions and deferred profit adjustments in the parent s pre-consolidation Equity Investment account and (2) removing intercompany transactions and deferred profit during the consolidation process. Intercompany transactions are generally assumed to create temporary differences between the Equity Investment account and the Stockholders Equity of the subsidiary (i.e., they naturally reverse over time). Because consolidation adjustments represent a process of backing out the parent s investment account prior to summing the parents and subsidiaries financial statement information, adjusting the Equity Investment intercompany profits results in more work that will ultimately be backed out in consolidation. 20 Because it involves fewer steps during the bookkeeping and consolidation process, the partial equity method arguably results in a reduced probability of error in the consolidated financial statements. 21 That is the justification for its use in practice. To illustrate the consolidation process when the parent uses the partial equity method to account for its Equity Investment in the subsidiary in the presence of intercompany sales of inventories, we will use the same basic facts as the example in Appendix 4A. 22 In that example, we assume that the parent acquired its subsidiary on January 1, 2010, and we are preparing consolidated financial statements for the year ending December 31, Assume the following facts (all amounts in $): Original AAP... $100,000 Unamortized AAP balance on January 1, ,000 Annual depreciation/amortization of the AAP... 20,000 In addition, the subsidiary has sold inventories to its parent regularly since the acquisition. The intercompany sales and profit for the prior and current period are as follows: Year Ending Dec. 31, 2012 Dec. 31, 2013 Transfer price for inventory sale... $150,000 $200,000 Cost of goods sold , ,000 Gross profit.... $ 48,000 $ 50,000 Percentage of inventory remaining % 30% Deferred intercompany profit (deferred profit) in ending inventory... $ 12,000 $ 15,000 Intercompany receivable/payable at end of period*.... $ 25,000 $ 30,000 * Paid at beginning of next period. Exhibit 4B.1 presents the consolidation spreadsheet including the [ADJ] and C-E-A-D-I entries. Because the parent, in this example, uses the partial equity method to account for its investment in the subsidiary, the balance of the Equity Investment account at the end of the period is $831,000 as follows: End of year stockholders equity (S).... $811,000 Unamortized AAP at end of year... 20,000 Cumulative understatement of Equity investment account... $831, If the parent company wishes to publish supplementary parent only financial statements in addition to the consolidated statements, then the Equity Investment account (and related Equity Investment Income account) must reflect the fully adjusted equity method (i.e., all intercompany profits must be eliminated). 21 Of course, ignoring deferred profit during the parent s Equity Investment bookkeeping process means that the parent s preconsolidation net income likely won t equal consolidated net income. However, given the potentially high volume of intercompany transactions during a given period, this is a small inconvenience for a more efficient consolidation process. 22 Because the parent is using a different method of investment account bookkeeping, some investment-related accounts will have different balances from those included in Appendix 4A.

10 206 Chapter 4 Consolidated Financial Statements and Intercompany Transactions Exercises LO1 26. Computing the amount of equity income and preparing [I] consolidation journal entries Assume that a wholly owned subsidiary sells inventory to the parent company. The parent company, ultimately, sells the inventory to customers outside of the consolidated group. You have compiled the following data for the years ending 2012 and 2013: Subsidiary Net Income Inventory Sales Gross Profit % % Inventory Remaining at End of Year Receivable (Payable) $500,000 $75,000 32% 10% $25, $400,000 $50,000 30% 9% $20,000 LO1 Assume that inventory not remaining at the end of the year was sold outside of the consolidated group during the year. Assume the parent company uses the full equity method to account for its subsidiary. a. How much Equity Income should the parent report in its pre-consolidation income statement the year ending 2013 assuming that it uses the equity method of accounting for its Equity Investment? b. Prepare the required [I] consolidation journal entries for Computing the amount of equity income and preparing [I] consolidation journal entries Assume that a parent company sells inventory to its wholly owned subsidiary. The subsidiary, ultimately, sells the inventory to customers outside of the consolidated group. You have compiled the following data for the years ending 2012 and 2013: Subsidiary Net Income Inventory Sales Gross Profit on Unsold Inventories Receivable (Payable) $300,000 $50,000 $18,000 $20, $200,000 $40,000 $13,500 $15,000 LO2 LO2 Assume that inventory not remaining at the end of the year was sold outside of the consolidated group. a. How much Equity Income should the parent report in its pre-consolidation income statement the year ending 2013 assuming that it uses the equity method of accounting for its Equity Investment? Assume the parent company uses the full equity method to account for its subsidiary. b. Prepare the required [I] consolidation journal entries for Preparing the [I] consolidation journal entries for sale of land Assume that during 2009 your subsidiary sells land that originally cost $100,000 to its parent for a sale price of $130,000. The parent holds the land until it sells the land to an unaffiliated company on December 31, The parent uses the full equity method to account for its Equity Investment. a. Prepare the required [I] consolidation journal entry in b. Prepare the required [I] consolidation journal entry required at the end of each year 2010 through c. Assume that the parent re-sells the land outside of the consolidated group for $190,000 on December 31, Prepare the required [I] consolidation journal entry for d. What will be the amount of gain reported in the consolidated income statement in 2013? 29. Preparing the [I] consolidation journal entries for sale of land Assume that on June 15, 2006 a parent company sells land that originally cost $80,000 to its whollyowned subsidiary for a sale price of $120,000. The subsidiary holds the land until it sells the land to an unaffiliated company on November 12, The parent uses the full equity method to account for its Equity Investment. a. Prepare the required [I] consolidation journal entry in b. Prepare the required [I] consolidation journal entry required at the end of each year 2007 through c. Assume that the subsidiary resells the land outside of the consolidated group for $175,000 on November 12, Prepare the required [I] consolidation journal entry for d. What will be the amount of gain reported in the consolidated income statement in 2013?

11 Chapter 4 Consolidated Financial Statements and Intercompany Transactions 225 Year Ended December 31, 100% AAP Amortization Dr (Cr) Accounts receivable... $(10,500) $ $ $ $ Property, plant & equipment, net... 2,700 2,700 2,700 2,700 2,700 Customer list... 11,250 11,250 11,250 11,250 Notes payable... 1,500 1,500 1,500 1,500 1,500 Net amortization... $ 4,950 $15,450 $15,450 $15,450 $4,200 December 31, 100% Unamortized AAP Dr (Cr) Jan. 1, Accounts receivable... $ (10,500) $ $ $ $ $ Property, plant & equipment, net... 27,000 24,300 21,600 18,900 16,200 13,500 Customer list... 45,000 33,750 22,500 11,250 Notes payable... 7,500 6,000 4,500 3,000 1,500 Goodwill , , , , , ,000 Net amortization... $195,000 $190,050 $174,600 $159,150 $143,700 $139,500 c. Intercompany depreciable asset sale: One downstream asset sale. Intercompany profit recognized on January 1, 2012: $120,000 2 $82,500 5 $37,500, 10-year remaining life Profit confirmed each year: $37,500/10 5 $3,750 Downstream Upstream Net intercompany profit deferred at January 1, $33,750 $0 Less: Deferred intercompany profit recognized during ,750 0 Net intercompany profit deferred at December 31, $30,000 $0 Intercompany inventory transactions: Intercompany inventory sales during 2013: $50,000 Downstream (in Sub s inventory) Upstream (in Parent s inventory) Intercompany profit in inventory on January 1, $0 $9,000 Intercompany profit in inventory on December 31, $12,000 $0 Intercompany accounts receivables and payables at December 31, 2013: $15,000 d. The following is the general formula for computing the Equity Investment account (under the full equity method) at any point in time when the parent company owns 100% of a subsidiary: Plus: Less: Less: (1) Book value of the net assets of the subsidiary (2) Unamortized AAP (3) Downstream deferred intercompany profits (4) Upstream deferred intercompany profits Full equity method investment account

12 226 Chapter 4 Consolidated Financial Statements and Intercompany Transactions Equity Investment account balance at January 1, 2013: Jan. 1, 2013 $540,000 (1) $292,500 1 $247,500 Plus: 143,700 (2) $74,350 (from part b.) Less: (33,750) (3) $33,750 (from part c.) Less: (9,000) (4) $9,000 (from part c.) $640,950 Equity Investment account balance at December 31, 2013: Dec. 31, 2013 $562,500 (1) $292,500 1 $270,000 Plus: 139,500 (2) $139,500 (from part b.) Less: (30,000) (3) $30,000 (from part c.) (12,000) (3) $12,000 (from part c.) Less: 0 (4) none $660,000 e. Full equity method investment accounting includes the following routine adjustments during any given period: (1) recognition of p% of the subsidiary s income, (2) amortization of the p% AAP, (3) recognition of p% of the dividends declared by the subsidiary, (4) recognition of prior period deferred intercompany profits that have been confirmed though either transactions with unaffiliated parties or depreciation/amortization, and (5) deferral of intercompany profits newly originating during the current period. With respect to the deferred intercompany profits, when the parent company owns 100% of a subsidiary, then 100% of the profit is deferred for downstream and upstream transactions. Information for items (1) and (2) is available in the initial information, information for item (3) was summarized in part b, and information for items (4) and (5) was summarized in part c. These items are all reflected in the following completed T-account. Equity Investment January 1, ,950 (1) p% 3 net income of Sub % 3 54,000 31,500 (2) p% 3 dividends of Sub % 3 $54,000 $31,500 (4) p% 3 BOY upstream inventory profits recognized during % 3 $9,000 (4) 100% 3 downstream building profits recognized via depreciation during 2013 December 31, ,000 9,000 4,200 (3) p% AAP amortization (see part b) 3,700 12,000 (5) 100% 3 EOY downstream inventory profits deferred until year of sale to unaffiliated party

13 228 Chapter 4 Consolidated Financial Statements and Intercompany Transactions Consolidation Spreadsheet for the Year Ended December 31, 2013 Parent Subsidiary Dr Cr Consolidated Income statement: Sales... $1,080,000 $405,000 [I sales ] $ 75,000 $1,410,000 Cost of goods sold... (648,000) (243,000) [I cogs ] 12,000 [I cogs ] $ 9,000 (819,000) [I sales ] 75,000 Gross profit , , ,000 Deprec. and amort. expense... (27,000) (21,600) [D] 2,700 [I deprec ] 3,7500 (47,550) Operating expenses... (339,000) (81,150) (420,150) Interest expense.... (12,000) (5,250) [D] 1,500 (18,750) Total expenses... (378,000) (108,000) (486,450) Equity income from subsidiary ,550 [C] 50,550 Consolidated net income ,550 54, ,550 Retained earnings statement: Beg. ret. earn. parent.... $640,350 $640,350 Beg. ret. earn. subsidiary.... $247,500 [E] 247,500 Income attrib. to control. int ,550 54, , , , ,900 Dividends declared Parent... (135,000) (135,000) Subsidiary... (31,500) [C] 31,500 Ending retained earnings... $609,900 $270,000 $609,900 Balance sheet: Cash... $ 87,120 $ 63,750 $150,870 Accounts receivable ,500 90,000 [I pay ] 15, ,500 Inventories , ,250 [I cogs ] 12, ,750 Property, plant & equip., net , ,500 [A] 16,200 [D] 2, ,500 [I deprec ] 3,750 [I asset ] 33,750 Other assets , , ,250 Patent... Equity investment ,000 [I cogs ] 9,000 [C] 19,050 [I asset ] 33,750 [E] 540,000 [A] 143,700 Goodwill... [A] 126, ,000 Total assets... $1,572,870 $718,500 $1,713,870 Accounts payable.... $252,000 $ 52,500 [I pay ] 15,000 $289,500 Notes payable ,470 45,000 [A] 1,500 [D] 1, ,470 Other liabilities... 49,500 58, ,000 Common stock Parent , ,000 Subsidiary ,500 [E] 292,500 Retained earnings , , ,900 Total liabilities and equity... $1,572,870 $718,500 $886,950 $886,950 $1,713,870

14 Chapter 5 Consolidated Financial Statements with Less than 100% Ownership 239 ($210, % 5 $42,000), decreases by the amortization of the AAP assets attributable to the noncontrolling shareholders ($40, % 5 $8,000), and decreases by the dividends declared and paid to the noncontrolling interests by the subsidiary ($4,200). The ending balance of Noncontrolling Interests equity in the amount of $409,800 is reported separately in the Stockholders Equity section of the consolidated balance sheet. It is important to note that the noncontrolling shareholders have an interest only in the subsidiary company. As a result, the amount of profit that is attributable to them is equal to the proportion of the shares in the subsidiary that they own. 10 Since the subsidiary reports net income of $210,000 in this case, the profit attributable to the noncontrolling interests is equal to 20% of that amount, or $42,000. In a similar manner, the noncontrolling interests are also allocated 20% of the amortization expense related to the AAP assets, $8,000 ($40, %) in this case. As we discuss above, the $150,000 Goodwill asset was allocated $130,000 to the parent s interest and $20,000 to the noncontrolling interests. Neither the controlling nor the noncontrolling portions of Goodwill are amortized. Instead, Goodwill is tested annually for impairment, and is written down if found to be impaired. That charge, if realized, will be allocated to the parent s shareholders and the noncontrolling interests in proportion to the percentage of the Goodwill that has been allocated to them, not in proportion to their respective ownership interests. In Exhibit 5.3, we present our consolidation spreadsheet at the end of the year in the presence of noncontrolling interests. Our five basic C-E-A-D-I entries are a little more complex because of the noncontrolling interest. However, they are fundamentally the same: [C] Equity income ,000 Eliminates all changes in the Equity Investment Consol. NI attributable to NCI... 34,000 and Noncontrolling Interest accounts during the Dividends ,000 consolidation period. The NCI credit includes Equity investment ,200 the net income attributable to the NCI less the dividends paid to the NCI. Noncontrolling interest ($34,000 2 $4,200) ,800 [E] Common 100,000 Eliminates subsidiary Stockholders Equity BOY. The credit to the Equity Investment Retained 775,000 eliminates the BOY balance recognized in the Equity investment parent s Equity Investment account. The credit ($1,000, %) ,000 to the Noncontrolling Interest equity account Noncontrolling establishes its BOY. ($1,000, %) ,000 [A] PPE, net (100% AAP) ,000 The debits recognize the BOY AAP ($950,000 Patent, (100% AAP)... BOY) on the consolidated balance sheet. The BOY (100% AAP) ,000 credits eliminate the parent s share of the BOY Equity investment ($950, %) ,000 AAP from its Equity Investment account and Noncontrolling interest ($950, %) ,000 recognize the noncontrolling interests share of the AAP in the NCI equity account. [Note that the allocation of the 100% AAP is equal to the split calculated in Exhibit 5.2.] [D] Operating expenses (AAP amort) ,000 The debit to Operating Expenses recognizes PPE, net (for 100% AAP amort) ,000 depreciation/amortization expense relating to Patent, net (for 100% AAP amort)... 30,000 the identifiable AAP assets, and the credits to PPE, net and Patent, net, adjust the balances to reflect their correct end-of-year totals. [I] Not applicable in this example (we cover this topic later in the chapter) 10 If there are contractual arrangements that determine the attribution of earnings, such as a profit-sharing agreement, the attribution specified by the arrangement should be considered. If there are no such contractual arrangements, the relative ownership interests should be used if the parent s ownership and the NCI s ownership in the assets and liabilities are proportional. For example, if the controlling interest owns 80%, and the NCI owns 20%, then 80% of the subsidiary s earnings will be allocated to the controlling interest and 20% to the NCI. If, however, the parties have a contractual arrangement specifying a 50/50 split of the earnings, then 50% of the earnings would be allocated to the controlling interest and 50% to the noncontrolling interest, regardless of the ownership percentage.

15 Chapter 5 Consolidated Financial Statements with Less than 100% Ownership 255 Because the long-term-notes-payable-related AAP has a credit balance, its amortization will decrease interest expense by $2,000 (i.e., increase consolidated net income) in the consolidated income statement each year through December 31, 2015 (i.e., the due date of the last payment on the note). The following table summarizes the balances and activity for the 100% AAP through December 31, 2012: 100% AAP Dr (Cr) Unamortized 100% AAP 1/1/2011 Fiscal Year 2011 Amortization Unamortized 100% AAP 12/31/2011 Fiscal Year 2012 Amortization Unamortized 100% AAP 12/31/2012 Fiscal Year 2013 Amortization Unamortized 100% AAP 12/31/2013 Inventories... $(40,000) $40, Land... (90,000) (90,000) (90,000) (90,000) Patents... (60,000) 6,000 (54,000) $6,000 (48,000) $6,000 (42,000) Long-term notes payable... (10,000) 2,000 (8,000) 2,000 (6,000) 2,000 (4,000) Goodwill , , , ,000 Net... $373,000 $48,000 $421,000 $8,000 $429,000 $8,000 $421,000 The 100% AAP is important to understand because it is necessary to determine account balances in the consolidated financial statements. Understanding the AAP allocated to the controlling and noncontrolling interests is also necessary because (1) the controlling interest AAP is included in the parent company s pre-consolidation investment account and (2) the noncontrolling-interest share of the AAP is reflected in the consolidated noncontrolling-interest-related accounts. The controlling interest share of the AAP on January 1, 2011 equals $300,000, and is determined by taking the fair value of the controlling interest on the acquisition date and subtracting the controlling interest share of the book value of net assets of the subsidiary on that same date: $1,400,000 2 (80% 3 $1,375,000) 5 $1,400,000 2 $1,100,000 5 $300,000. On the acquisition date, each of the identifiable net assets is assigned a controlling-interest share of their respective AAP amounts. The controlling-interest goodwill is then calculated as the residual controlling AAP that remains after factoring in the controlling portions of the AAP assigned to the all of the identifiable net assets. In addition, similar to the 100% AAP, the controlling interest AAP is amortized for any of the identifiable net assets subject to depreciation or amortization. The following table summarizes the balances and activity for the controlling interest portion of the AAP from the acquisition date through December 31, 2012: Controlling Interest AAP Dr (Cr) Unamortized 80% AAP 1/1/2011 Fiscal Year 2011 Amortization Unamortized 80% AAP 12/31/2011 Fiscal Year 2012 Amortization Unamortized 80% AAP 12/31/2012 Fiscal Year 2013 Amortization Unamortized 80% AAP 12/31/2013 Inventories... $(32,000) $32, Land... (72,000) (72,000) (42,000) (42,000) Patents... (48,000) 4,800 (43,200) $4,800 (38,400) $4,800 (33,600) Long-term notes payable... (8,000) 1,600 (6,400) 1,600 (4,800) 1,600 (3,200) Goodwill , , , ,000 Net... $300,000 $38,400 $338,400 $6,400 $344,800 $6,400 $351,200 The noncontrolling interest share of the AAP on January 1, 2011 equals $73,000, and is determined by taking the fair value of the noncontrolling interest on the acquisition date and subtracting the noncontrolling interest share of the book value of net assets of the subsidiary on that same date: $348,000 2 (20% 3 $1,375,000) 5 $348,000 2 $275,000 5 $73,000. On the acquisition date, each of the identifiable net assets is assigned a noncontrolling-interest share of their respective AAP amounts. The noncontrolling-interest goodwill is then calculated as the residual noncontrolling AAP that remains after factoring in all of the noncontrolling portions of the AAP assigned to the identifiable net assets. In addition, similar to the 100% AAP and the controlling interest AAP, the noncontrolling interest AAP is amortized for any of the identifiable net assets subject to depreciation or amortization.

16 282 Chapter 5 Consolidated Financial Statements with Less than 100% Ownership AICPA Adapted AICPA Adapted AICPA Adapted AICPA Adapted AICPA Adapted AICPA Adapted AICPA Adapted AICPA Adapted LO3 LO3 LO2, 3 LO3 LO3 LO3 LO2, Intercompany inventory transactions Consolidated Revenues: a. $2,400,000 b. $2,620,000 c. $2,720,000 d. $2,820, Intercompany inventory transactions and Acquisition Accounting Premium Consolidated Expenses: a. $1,600,000 b. $1,687,500 c. $1,760,000 d. $1,787, Noncontrolling interest, upstream deferred intercompany inventory profits and Acquisition Accounting Premium Consolidated net income attributable to noncontrolling interest: a. $26,500 b. $28,000 c. $30,500 d. $32, Intercompany inventory transactions Current Assets: a. $907,500 b. $900,000 c. $892,500 d. $875, Acquisition Accounting Premium Noncurrent Assets: a. $4,380,000 b. $4,360,000 c. $4,300,000 d. $4,280, Full equity method and consolidations Retained Earnings: a. $1,834,000 b. $1,794,000 c. $1,754,000 d. $1,594, Noncontrolling interest, upstream deferred intercompany inventory profits and Acquisition Accounting Premium Noncontrolling Interest: a. $58,500 b. $32,000 c. $24,000 d. $18,500 Use the following facts for Multiple Choice problems Assume that on January 1, 2009, a parent company acquired a 90% interest in a subsidiary s voting common stock. On the date of acquisition, the fair value of the subsidiary s net assets equaled their reported book values. On January 1, 2011, the subsidiary purchased a building for $480,000. The building has a useful life of 10 years and is depreciated on a straight-line basis with no salvage value. On January 1, 2013, the subsidiary sold the building to the parent for $420,000. The parent estimated that the building had an eight year remaining useful life and no salvage value. The parent also uses the straight-0line method of amortization. The parent s stand-alone income (i.e., net income before recording any adjustments related to pre-consolidation investment accounting) is $500,000. The subsidiary s recorded net income is $100,000.