CHAPTER 2
CONSOLIDATION OF FINANCIAL INFORMATION
Accounting standards for business combination are found in FASB ASC Topic 805, “Business
Combinations” and Topic 810, “Consolidation.” These standards require the acquisition method
which emphasizes acquisition-date fair values for recording all combinations.
In this chapter, we first provide coverage of expansion through corporate takeovers and an
overview of the consolidation process. Then we present the acquisition method of accounting
for business combinations followed by limited coverage of the purchase method and pooling of
interests provided in the Appendix to this chapter.
Chapter Outline
I. Business combinations and the consolidation process
A. A business combination is the formation of a single economic entity, an event that
occurs whenever one company gains control over another
B. Business combinations can be created in several different ways
1. Statutory merger—only one of the original companies remains in business as a
legally incorporated enterprise.
a. Assets and liabilities can be acquired with the seller then dissolving itself as a
corporation.
b. All of the capital stock of a company can be acquired with the assets and
liabilities then transferred to the buyer followed by the seller’s dissolution.
2. Statutory consolidation—assets or capital stock of two or more companies are
transferred to a newly formed corporation
3. Acquisition by one company of a controlling interest in the voting stock of a
second. Dissolution does not take place; both parties retain their separate legal
incorporation.
C. Financial information from the members of a business combination must be
consolidated into a single set of financial statements representing the entire
economic entity.
1. If the acquired company is legally dissolved, a permanent consolidation is
produced on the date of acquisition by entering all account balances into the
financial records of the surviving company.
2. If separate incorporation is maintained, consolidation is periodically simulated
whenever financial statements are to be prepared. This process is carried out
through the use of worksheets and consolidation entries. Consolidation
worksheet entries are used to adjust and eliminate subsidiary company accounts.
Entry “S” eliminates the equity accounts of the subsidiary. Entry “A” allocates
exess payment amounts to identifiable assets and liabilities based on the fair
value of the subsidiary accounts. (Consolidation journal entries are never
recorded in the books of either company, they are worksheet entries only.)
II. The Acquisition Method
A. The acquisition method replaced the purchase method. For combinations resulting
in complete ownership, it is distinguished by four characteristics.
1. All assets acquired and liabilities assumed in the combination are recognized and
measured at their individual fair values (with few exceptions).
2. The fair value of the consideration transferred provides a starting point for valuing
and recording a business combination.
a. The consideration transferred includes cash, securities, and contingent
performance obligations.
b. Direct combination costs are expensed as incurred.
c. Stock issuance costs are recorded as a reduction in paid-in capital.
d. The fair value of any noncontrolling interest also adds to the valuation of the
acquired firm and is covered beginning in Chapter 4 of the text.
3. Any excess of the fair value of the consideration transferred over the net amount
assigned to the individual assets acquired and liabilities assumed is recognized
by the acquirer as goodwill.
4. Any excess of the net amount assigned to the individual assets acquired and
liabilities assumed over the fair value of the consideration transferred is
recognized by the acquirer as a “gain on bargain purchase.”
B. In-process research and development acquired in a business combination is
recognized as an asset at its acquisition-date fair value.
III. Convergence between U.S. GAAP and IAS
A. IFRS 3 – nearly identical to U.S. GAAP because of joint efforts
B. IFRS 10 – Consolidated Finanical Statements and IFRS 12 – Disclosure of Interests
in Other Entities both become effective in 2013. Some differences between these
and GAAP
APPENDIX:
The Purchase Method
A. The purchase method was applicable for business combinations occurring for fiscal
years beginning prior to December 15, 2008. It was distinguished by three
characteristics.
1. One company was clearly in a dominant role as the purchasing party
2. A bargained exchange transaction took place to obtain control over the second
company.
3. A historical cost figure was determined based on the acquisition price paid.
a. The cost of the acquisition included any direct combination costs.
b. Stock issuance costs were recorded as a reduction in paid-in capital and are
not considered to be a component of the acquisition price.
B. Purchase method procedures
1. The assets and liabilities acquired were measured by the buyer at fair value as of
the date of acquisition.
2. Any portion of the payment made in excess of the fair value of these assets and
liabilities was attributed to an intangible asset commonly referred to as goodwill.
3. If the price paid was below the fair value of the assets and liabilities, the accounts
of the acquired company were still measured at fair value except that the values
of certain noncurrent assets were reduced in total by the excess cost. If these
values were not great enough to absorb the entire reduction, an extraordinary
gain was recognized.
The Pooling of Interest Method (prohibited for combinations after June 2002)
A. A pooling of interests was formed by the uniting of the ownership interests of two
companies through the exchange of equity securities. The characteristics of a
pooling are fundamentally different from either the purchase or acquisition methods.
1. Neither party was truly viewed as an acquiring company.
2. Precise cost figures stemming from the exchange of securities were difficult to
ascertain.
3. The transaction affected the stockholders rather than the companies.
B. Pooling of interests accounting
1. Because of the nature of a pooling, determination of an acquisition price was not
relevant.
a. Since no acquisition price was computed, all direct costs of creating the
combination were expensed immediately.
b. In addition, new goodwill arising from the combination was never recognized
in a pooling of interests. Similarly, no valuation adjustments were recorded for
any of the assets or liabilities combined.
2. The book values of the two companies were simply brought together to produce
a set of consolidated financial records. A pooling was viewed as affecting the
owners rather than the two companies.
3. The results of operations reported by both parties were combined on a
retroactive basis as if the companies had always been together.
4. Controversy historically surrounded the pooling of interests method.
a. Any cost figures indicated by the exchange transaction that created the
combination were ignored.
b. Income balances previously reported were altered since operations were
combined on a retroactive basis.
c. Reported net income was usually higher in subsequent years than in a
purchase since no goodwill or valuation adjustments were recognized which
require amortization.
Answers to Questions
1. A business combination is the process of forming a single economic entity by the uniting
2. (1) A statutory merger is created whenever two or more companies come together to
form a business combination and only one remains in existence as an identifiable entity.
This arrangement is often instituted by the acquisition of substantially all of an
enterprise’s assets. (2) A statutory merger can also be produced by the acquisition of a
3. Consolidated financial statements represent accounting information gathered from two
4. Companies that form a business combination will often retain their separate legal
identities as well as their individual accounting systems. In such cases, internal financial
data continues to be accumulated by each organization. Separate financial reports may
5. Several situations can occur in which the fair value of the 50,000 shares being issued
might be difficult to ascertain. These examples include:
The shares may be newly issued (if Jones has just been created) so that no accurate
value has yet been established;
Jones may be a closely held corporation so that no fair value is available for its
shares;
value for long-term accounting purposes.
6. For combinations resulting in complete ownership, the acquisition method allocates the
7. The revenues and expenses (both current and past) of the parent are included within
reported figures. However, the revenues and expenses of the subsidiary are
8. Morgan’s additional acquisition value may be attributed to many factors: expected
synergies between Morgan’s and Jennings’ assets, favorable earnings projections,
9. In the vast majority of cases the assets acquired and liabilities assumed in a business
combination are recorded at their fair values. If the fair value of the consideration
10. Shares issued are recorded at fair value as if the stock had been sold and the money
11. The direct combination costs of $98,000 are allocated to expense in the period in which
they occur. Stock issue costs of $56,000 are treated as a reduction of APIC.
Answers to Problems
1. D
2. B
11. B Consideration transferred (fair value) $800,000
Cash $150,000
Accounts receivable 140,000
Software 320,000
Goodwill $120 ,000
12. C Legal and accounting fees accounts payable $15,000
Contingent liabilility 20,000
13. D Consideration transferred (fair value) $420,000
Current assets $90,000
Building and equipment 250,000
Fair value of net identifiable assets acquired 350 ,000
Goodwill $ 70 ,000
Current assets $ 90,000
Building and equipment 250,000
14. C Value of shares issued (51,000 × $3)……………………………..….. $153,000
Par value of shares issued (51,000 × $1)…………………..…….... 51,000
Consolidated additional paid-in capital (fair value)………….… $192,000
At the acquisition date, the parent makes no change to retained earnings.
15. B Consideration transferred (fair value)…………………..…. $400,000
Book value of subsidiary (assets minus liabilities)….. (300 ,000)
Fair value in excess of book value……………….……… 100,000
Allocation of excess fair over book value
identified with specific accounts:
Inventory……………………………..……….……..…………….. 30,000
Patented technology……………………..…………..……..… 20,000
16. D TruData patented technology…………….………..………..… $230,000
Webstat patented technology (fair value)………………… 200 ,000
Acquisition-date consolidated balance sheet amount $430 ,000
17. C TruData common stock before acquisition……..………. $300,000
18. B TruData’s 1/1 retained earnings………………….…………… $130,000
Acquisition-date consolidated balance sheet amount $210 ,000
19. a. An intangible asset acquired in a business combination is recognized as
an asset apart from goodwill if it arises from contractual or other legal
rights (regardless of whether those rights are transferable or separable
from the acquired enterprise or from other rights and obligations). If an
b. Trademarks—usually meet both the separability and legal/contractual
criteria.
Customer list—usually meets the separability criterion.
liability.
20. (12 minutes) (Journal entries to record a merger—acquired company
dissolved)
Inventory 600,000
Land 990,000
Buildings 2,000,000
Customer Relationships 800,000
Goodwill 690,000
Cash 4,000,000
Professional Services Expense 42,000
Cash 42,000
21. (12 minutes) (Journal entries to record a bargain purchase—acquired
company dissolved)
Inventory 600,000
Land 990,000
Buildings 2,000,000
Customer Relationships 800,000
Professional Services Expense 42,000
Cash 42,000
22. (15 Minutes) (Consolidated balances)
In acquisitions, the fair values of the subsidiary’s assets and liabilities are
consolidated (there are a limited number of exceptions). Goodwill is reported
at $80,000, the amount that the $760,000 consideration transferred exceeds
the $680,000 fair value of Sol’s net assets acquired.
Inventory = $670,000 (Padre’s book value plus Sol’s fair value)
Land = $710,000 (Padre’s book value plus Sol’s fair value)
Buildings and equipment = $930,000 (Padre’s book value plus Sol’s fair
value)
23. (20 minutes) Journal entries for a merger using alternative values.
a. Acquisition date fair values:
Cash paid $700,000
Contingent performance liability 35,000
Consideration transferred $735,000
Receivables 90,000
Inventory 75,000
Patented Technology 700,000
Research and Development Asset 200,000
Current liabilities 160,000
Long-Term Liabilities 635,000
Professional Services Expense 100,000
Cash 100,000
b. Acquisition date fair values:
Cash paid $800,000
Contingent performance liability 35,000
Receivables 90,000
Inventory 75,000
Patented Technology 700,000
Research and Development Asset 200,000
Goodwill 85,000
Contingent Performance Liability 35,000
Professional Services Expense 100,000
Cash 100,000