anthonyIM_12

CHAPTER 12 ACQUISITIONS AND CONSOLIDATED STATEMENTS Changes from Eleventh Edition Updated from Eleventh Edition. Approach The results under the purchase method are of considerable importance, and also of considerable interest to the student. The results are mystifying at first, but something worth learning about. It is probably desirable to go through the illustrative situation in some detail. The material on consolidated statements is brief, but we believe adequate for the objective of this book. Students should be able to grasp the general idea of what is going on without much difficulty and therefore should understand the meaning of consolidated statements when they read them. They should not, of course, be left with the impression that they know all about how to prepare such statements, and reference to the number of pages devoted to this topic in an intermediate or advanced text may be desirable: in some texts, 200 pages. If instructors wish to go further, they can develop worksheets for the asset valuation or minority interest situations. Cases Hardin Tool Company gives a simple set of numbers to illustrate the effect of purchase method accounting, both at the time of acquisition and subsequently. It provides an excellent overview. Carter Corporation is a straightforward problem on the preparation of consolidated statements. Keane’s Acquisition of Metro Information Services is an actual merger that can be used to illustrate the purchase method. Productos Finas a consolidation exercise. This case is new with the Twelfth Edition. Problems Problem 12-1 Company P should use the equity method. It owns more that 20 percent of Company S.

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

Income and Dividends dr. Investment..................................................................................................................................................................... 120,000* cr. Equity Income............................................................................................................................................................ 120,000 * ($300,000 x .4)

dr. Cash.............................................................................................................................................................................. 40,000* cr. Investment.................................................................................................................................................................. 40,000 * ($100,000 x .4) On December 31, the investment in Company P would be reported as $680,000 ($600,000 + $120,000 $40,000). 1

Accounting: Text and Cases 12e – Instructor’s Manual

Anthony/Hawkins/Merchant

Problem 12-2 Company P should use the cost method to account for its investment in Company S. Company P own less than 20 percent of Company S.

Original Investment dr. Investment.................................................................................................................................................................................. 1,000,000 cr. Cash........................................................................................................................................................................................ 1,000,000

Dividend Payment received dr. Cash........................................................................................................................................................................................... 25,000 cr. Dividend Income..................................................................................................................................................................... 25,000

Problem 12-3 Year 1 (1) dr. Investment....................................................................................................................................................................... 700,000 cr. Cash............................................................................................................................................................................. 700,000 (2)

dr. Investment....................................................................................................................................................................... 24,500* cr. Equity Income.............................................................................................................................................................. 24,500 * ($70,000 x .35)

(3)

dr. Cash................................................................................................................................................................................. 21,000* cr. Investment................................................................................................................................................................... 21,000 *($60,000 x .35)

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

No entry.

(3)

dr. Investment....................................................................................................................................................................... 60,000 cr. Equity Income............................................................................................................................................................ 60,000 (150,000 x .4)

(4)

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

Problem 12-4 Goodwill Calculation

Ba Be Current assets.................................................................................................................................................................................. $150,000 (Appraised value) Net fixed assets............................................................................................................................................................................... 555,600 (Appraised value) Other assets..................................................................................................................................................................................... 134,400 (Appraised value) Total Assets............................................................................................................................................................................... 840,000 Liabilities........................................................................................................................................................................................ 192,000 Net Assets................................................................................................................................................................................. 648,000 Purchase price................................................................................................................................................................................. 870,000 Goodwill......................................................................................................................................................................................... $222,000 2

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Chapter 12

Consolidated Balance Sheet Elder BaBe Consolidated Current assets..................................................................................................................................................................... $ 1,104,000 $150,000 $ 1,254,000 Net fixed assets.................................................................................................................................................................. 32,814,000 555,600 33,369,600 Other assets........................................................................................................................................................................ 14,412,000 134,400 14,546,400 Goodwill............................................................................................................................................................................ ----222,000 Total assets................................................................................................................................................................... $49,392,000

Current liabilities................................................................................................................................................................ $ 3,600,000 $ 42,000 $ 3,642,000 Long-term debt................................................................................................................................................................... 15,582,000 150,000 15,732,000 Common stock................................................................................................................................................................... 24,000,000 --24,000,000 Paid-in capital.................................................................................................................................................................... 5,418,000 --5,418,000 Retained earnings............................................................................................................................................................... 600,000 --600,000 Total liabilities and equity............................................................................................................................................ $49,392,000 Problem 12-5 (1)

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

(2)

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

(3)

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

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

Capital Stock (Subsidiary)…………….. X Retained Earnings (Subsidiary).............................................................................................................................. 3.1 million - X Investment in Sandvel (Parent)............................................................................................................................ 3.1 million Problem 12-6 a.

Pooling of Interests Company Company Pooling of A B Interests Current assets.......................................................................................................................................................... $ 500,000 $150,000 $ 650,000 Fixed assets............................................................................................................................................................. 700,000 250,000 950,000 Totals................................................................................................................................................................. $1,200,000 $400,000 $1,600,000

Current liabilities.................................................................................................................................................... $ 250,000 $ 75,000 $ 325,000 Long-term liabilities............................................................................................................................................... 175,000 50,000 225,000 Capital stock, $20 per............................................................................................................................................. 400,000 --660,000* Capital stock, $10, per............................................................................................................................................ --170,000 --Additional paid-in capital....................................................................................................................................... 175,000 60,000 145,000+ Retained earnings.................................................................................................................................................... 200,000 45,000 245,000 Totals................................................................................................................................................................. $1,200,000 $400,000 $1,600,000 * $400,000 + ($650,000 / $50) x $20) + Plug figure (= $175,000 + $60,000 + $170,000 - $260,000) 3

Accounting: Text and Cases 12e – Instructor’s Manual

Anthony/Hawkins/Merchant

Purchase Accounting Company B (Market Company A Value) Purchase Current assets....................................................................................................................................................................... $ 500,000 $175,000 $ 575,000* Fixed assets.......................................................................................................................................................................... 700,000 325,000 1,025,000 Goodwill.............................................................................................................................................................................. ----275,000+ Totals.............................................................................................................................................................................. $1,200,000 $500,000 $1,875,000

Current liabilities................................................................................................................................................................. $ 250,000 $ 75,000 $ 325,000 Long-term liabilities............................................................................................................................................................ 175,000 50,000 775,000^ Capital stock, $20 per.......................................................................................................................................................... 400,000 --400,000 Capital stock, $10 per.......................................................................................................................................................... ------Additional paid-in capital.................................................................................................................................................... 175,000 --175,000 Retained earnings................................................................................................................................................................ 200,000 --200,000 Totals.............................................................................................................................................................................. $1,200,000 $125,000 $1,875,000 * ($500,000 - $100,000) + $175,000 + Plug ($650,000 – ($500,000 - $125,000) ^ ($175,000 + $550,000) + $50,000

Cases Case 12-1: Hardin Tool Company

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Note: This case is unchanged from the Eleventh Edition. Approach This is a straightforward exercise to give the student practice in applying the pooling of interests and purchase methods of accounting for a business combination. The case purposely avoids the complications of intercompany transactions, which are dealt with in Case 12-2. Question 1

HARDIN TOOL COMPANY Consolidated Balance Sheets As of the Proposed Acquisition Date (thousands of dollars) Assets Pooling Purchase Current assets.................................................................................................................................................................................. $ 678 $ 678 Plant and equipment........................................................................................................................................................................ 1,002 1,1611 Goodwill......................................................................................................................................................................................... --2002 Total assets................................................................................................................................................................................. $1,680 $2,039 Liabilities and Equity Current liabilities............................................................................................................................................................................. $ 370 $ 370 Long-term debt................................................................................................................................................................................ 205 205 Common stock ($1 par)................................................................................................................................................................... 200 200 3 Additional paid-in capital................................................................................................................................................................ 252 9183 *

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

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©2007 McGraw-Hill/Irwin

Chapter 12

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

Difference between Hardin’s appraisal value ($600,000) and book value ($441,000) is attributable to fixed assets; hence Pratt’s fixed assets are shown at $312,000 + $159,000 = $471,000 with purchase accounting, giving consolidated fixed assets of $690,000 (Hardin) + $471,000 (Pratt) = $1,161,000. 2 Excess of purchase price (100,000 * $8 = $800,000) over fair value of net assets of Hardin ($600,000). 3 “Plug” figure. Students should note that with pooling treatment, owners’ equity equals $1,105,000, which is the sum of the preacquisition owners’ equities of the two firms ($100,000 + $218,000 + $346,000 for Hardin + $40,000 + $94,000 + $307,000 for Pratt = $1,105,000). With purchase treatment consolidated owners’ equity reflects both the $159,000 write-up of Pratt’s fixed assets and the $200,000 goodwill (excess of purchase pace over fair value of acquired net assets). With purchase accounting, the substance of the transaction is that Hardin issued 100,000 shares for cash (cr. Cash, $800,000; cr. Stock at par, $100,000; cr. Additional paid-in capital, $700,000); then the $800,000 cash was used to acquire $917,000 of assets ($558,000 book value + $159,000 write-up + $200,000 goodwill) and Hardin assumed $117,000 of liabilities. The $918,000 consolidated additional paid-in capital is thus this “new” $700,000 plus the $218,000 already on Hardin’s balance sheet.

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

Question 2

HARDIN TOOL COMPANY Condensed Consolidated Income Statement For the First Year after Combination (In thousands, except per share amounts)

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

Earnings per share.................................................................................................................................................. $2.80 Purchase Treatment Unadjusted income (as above)............................................................................................................................... $ 860 Additional depreciation.......................................................................................................................................... 161 Taxable income...................................................................................................................................................... 844 Income tax expense................................................................................................................................................ 295 Net income............................................................................................................................................................. $ 549

Earnings per share.................................................................................................................................................. $2.75 1

$159,000 + 10 years = $16.000

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Accounting: Text and Cases 12e – Instructor’s Manual

Anthony/Hawkins/Merchant

Question 3 This question turns the case into an introductory finance case, with the opportunity to discuss financial leverage. Both of these new alternatives would have to be accounted for as a purchase. Assuming the common stock is still valued at $8 per share, the income statements would be as follows:

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

Earnings per share (150,000 shares)................................................................................................................................................ $3.39 $3.49 The debenture alternative provides more leverage than the preferred stock alternative. In this simplified problem, this occurs solely because the interest cost on debt is tax deductible, making the net interest cost $26 versus the nondeductible preferred dividend of $40. If the company has the debt capacity to issue debentures rather than preferred stock, then they should do so. However, calculation of long-term debt/equity ratios for the four alternatives suggests that the debt capacity probably does exist. (Return on common equity figures are shown to quantify the effect of leverage; these can be omitted if the instructor wishes since they arc not formally covered until the next chapter.)

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

Case 12-2: Carter Corporation* Note: This case is unchanged from the Eleventh Edition. Approach This case gives practice in construction of consolidated statements and is constructed in such a way that it progresses by stages from straightforward adjustments to the more difficult and intricate adjustments. Answers to Questions Exhibit A is a consolidation worksheet for the problem as originally presented. The resulting financial statements are shown in the first column of Exhibit B. It may be useful to reconcile with the beginning retained earnings before consolidation, as follows:

*

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

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©2007 McGraw-Hill/Irwin

Chapter 12

Carter’s ending retained earnings were................................................................................................................ $396,100 Carter added to retained earnings during 20xl..................................................................................................... -27,200 Therefore, Carter retained earnings on January 1, 20xl were.............................................................................. 368,900 Consolidated addition to retained earnings in 20xl.............................................................................................. 44,200 Consolidated retained earnings, December 31,20x1............................................................................................ $413,100 Corrections (Question 2) 1. Diroff shareholders’ equity at acquisition was $142,800 ($159,800 - $17,000). Carter paid $142,800 for 75 percent of this equity, which had a book value of 75 percent of $142,800, or $107,100. Therefore, the initial consolidated balance sheet must show Goodwill of $35,700 (unless the assets are restated, and we have no evidence of this). The offset, at the time of acquisition, is to Minority interest. Amortization of goodwill disallowed by FAS 1 and 2. Minority interest would have increased by 25 percent of the increase in Diroff’s retained earnings since acquisition with a corresponding reduction in consolidated retained earnings. In summary, minority interest would be:

At time of acquisition................................................................................................................................ $35,700 25 percent of $17,000 increase to retained earnings.................................................................................. 4,250 $39,950 2. The entire $37,400 listed as other income constitutes income to the consolidated entity, so the $30,600 erroneously subtracted from it should be added back. This increases net income and retained earnings by $30,600. However, the assumed dividend was also subtracted erroneously from retained earnings, so this adjustment must be reversed, leaving no net effect on consolidated retained earnings. Since Diroff has not paid the dividend, it must appear as one of its current liabilities. The $22,950(75 percent) owed to Carter must be eliminated as an intercompany transaction, by decreasing current liabilities and increasing retained earnings. EXHIBIT A Consolidation Worksheet Separate Statements Carter Diroff Adjustments Balance Sheets Dr. Cr.

Consolidated Assets Cash................................................................................................................................................................................... 57,800 20,400 78,200 Accounts receivable........................................................................................................................................................... 110,500 35,700 5,100 141,100 Inventory............................................................................................................................................................................ 120,700 54,400 175,100 Investment in subsidiary..................................................................................................................................................... 142,800 --142,800 --Plant (net)........................................................................................................................................................................... 477,700 134,300 612,000 Loans receivable................................................................................................................................................................ --32,300 32,300 --Total.............................................................................................................................................................................. 909,500 277,100 1,006,400 Liabilities and Equity Current liabilities................................................................................................................................................................ 88,400 62,900 5,100 146,200 Noncurrent liabilities.......................................................................................................................................................... 170,000 54,400 32,300 192,100 Capital stock....................................................................................................................................................................... 255,000 102,000 102,000 255,000 Retained earnings............................................................................................................................................................... 396,100 57,800 40,800 ______ 413,100 Total.............................................................................................................................................................................. 909,500 277,100 180,200 180,800 1,006,400 Income Statement Data 7

Accounting: Text and Cases 12e – Instructor’s Manual

Anthony/Hawkins/Merchant

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

The net effect on consolidated retained earnings is: As stated in Exhibit A.................................................................................................................................................................. $413,100 Deduct minority interest in earnings............................................................................................................................................ (4,250) Add elimination of dividend to Carter......................................................................................................................................... 22,950 Revised retained earnings......................................................................................................................................................... $431,800 The financial statements after these revisions are shown in the second column of Exhibit B. Unsold Merchandise The financial statements report $13,600 of Carter inventory that contains a 25 percent (8,500 / 34,000) unrealized profit, $3,400. This profit must be eliminated from the consolidated inventory, minority interest, and consolidated retained earnings. Minority interest is reduced by one-fourth of the unrealized profit, or $850, and consolidated retained earnings is reduced by $2,550. Dividend The big change between the original and revised consolidated statements came from the mishandling of dividend revenue. Correction of this change increased net income by 67 percent, net profit margin percentage from 3.1 percent to 5.2 percent, and owners’ equity by 8.1 percent. The current redo was also affected by this correction, increasing from 2.70 to 3.17. (Return on investment ratios also changed, but these are not covered until the next chapter.) Correction for the omission of minority interest had no impact in terms of ratio analysis, unless an analyst were to eliminate minority interest from owners’ equity in doing an analysis (as is the case with some analysts). Correction for unrealized profit on intracompany sales has a relatively minor impact on the current ratio and on inventory turnover (from 6.17 to 6.30). Exhibit B CARTER CORPORATION Consolidated Financial Statements Balance Sheet As of December 31, 20x1 As Originally Assets Prepared

As Revised Current Assets: Cash............................................................................................................................................................................................. $ 78,200 $ 78,200 Accounts receivable..................................................................................................................................................................... 141,100 141,100 Inventory...................................................................................................................................................................................... 175,100 175,100 Total current assets 394,400 394,400 Plant (net)........................................................................................................................................................................................ 612,000 612,000 Goodwill......................................................................................................................................................................................... _________ 35,700 Total assets................................................................................................................................................................................ $1,006,400 $1,042,100

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Chapter 12

Liabilities and Equity Current liabilities................................................................................................................................................................ $ 146,200 $ 123,250 Noncurrent liabilities.......................................................................................................................................................... 192,100 192,100 Minority interest................................................................................................................................................................. 39,9501 Capital stock....................................................................................................................................................................... 255,000 255,000 Retained earnings............................................................................................................................................................... 413,100 431,8001 Total liabilities and equity............................................................................................................................................ $1,006,400 $1,042,100

Income Statement For the year ended December 31, 20x1 Sales................................................................................................................................................................................... $1,414,400 $1,414,400 Cost of sales....................................................................................................................................................................... 1,081,200 1,081,200 Gross margin................................................................................................................................................................ 333,200 333,200 Expenses............................................................................................................................................................................ (295,800) (295,800) Other income...................................................................................................................................................................... 6,800 37,400 Net income................................................................................................................................................................... $ 44,200 $ 74,800 1

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

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