This week, we turn our attention to the consolidation of financial data as an ongoing practice when each party to an acquisition remains a viable entity. Each subsequent period, when a separate subsidiary is maintained, requires consolidation entries prepared on the parent's and sub's accounts.
In last week’s chapter we dealt with the straightforward question of how to consolidate two companies on the date that the acquisition takes place. Eventually the first year is over and we have to consolidate again. This time it is more complicated because there were transactions during the period between the acquisition and the end of the year.
Whatever method we are going to look at is not actually on the external books of the parent. It will only be shown on the internal accounting and worksheets that we will prepare for use in consolidating. The parent has a choice of three methods for how it wishes to handle its internal accounting. These methods are (1) initial value method; (2) equity method; or (3) partial equity method. Note that one method is called the equity method and it incorporates the equity method we learned previously. All three use some of the rules we learned in chapter one. Yes, it does get confusing. At the date of acquisition, all three methods begin with an identical value. It is usually the amount of consideration paid based on fair value. However, each subsequent year will produce a different result for the account balances, especially for the investment in acquired company account and the retained earnings account. Therefore there will be different procedures for consolidating the financial information from the separate organizations.
The initial value method emphasizes the cost of the subsidiary and then uses the cash method instead of the accrual method. The company must use the cash method.
On the other hand, the equity method is based on the accrual method. The company must use the accrual method with the equity method.
The third method is the partial equity method. Under this method the company will accrue any income from the subsidiary. But other than dividends reducing the Investment account, no equity adjustments will be made.
Note that the company is allowed to choose any of these three methods that it wishes.
Regardless of which method is used on an internal basis, the consolidated results do not change.
Consolidation Tutorial
Most of the course deals with corporations that are required to consolidate their financial results. You might know that for federal tax purposes it is only permitted to consolidate when a corporation owns 80% of another, and even then consolidated taxes are optional. However, for financial results, consolidation is mandatory any time a corporation owns 50% or more of another corporation.
Before we work through our journal entries, let us picture what financial statements would be if they were not consolidated.
Assume we have a parent corporation, which we will call General, and that General owns 20 different auto and auto-related corporations. If we were presented with 20 different income statements and balance sheets and some had profits and some had losses and there were intercompany transactions, we could never figure out what General is worth. We might try adding the incomes and subtracting the loss, but that alone would not tell us what we need to know. Therefore, in order to give investors an ability to understand the finances of a company, we are required to consolidate. However, consolidation, again, is not just adding and subtracting numbers. There is a lot that is going on. Each of the entries that we will be making is going to resolve some of our issues. These entries will go in the order of S.A.I.D.E. and sometimes P. Each will be repeated every time, every year we work on consolidating our financial information.
Entry S: Debit the common stock, retained earnings, and additional paid-in-capital of the subsidiary. Credit the investment in subsidiary account that is on the books of the parent. This important entry eliminates the duplication of having the net of the subsidiary and the investment account. If we did not enter this, we would be doubling up on the investment that the parent made. Why? Assume P paid $100,000 for the subsidiary and the subsidiary has $100,000 in net assets. We are leaving those assets on our books, but we cannot leave an account that is essentially just an investment in itself. In other words, this investment account really does not exist when we combine the companies. It belongs on the books of the parent, but in combination it is duplicating the assets.
Entry A: Allocations made in connection with the subsidiary’s acquisition date fair value. It also completes the elimination of the investment in the subsidiary. Assuming we paid more than book value, we accomplish this with a debit to goodwill and any other assets that might have different values from the book value. We credit the investment in subsidiary account. (If we have any equipment that was worth less than book value, we would credit that account.)
Entry I: This entry eliminates the equity income recorded by the parent due to its ownership of the subsidiary. It is logical to remove this income, because it is recorded by the subsidiary itself. We leave the income and expenses of the subsidiary (on the books of the subsidiary) intact and only eliminate the equity income recorded by the parent. We accomplish this by debiting equity in subsidiary earnings (assuming that there was income) and crediting the investment in subsidiary account.
Entry D: We eliminate any intercompany dividends paid and treat them as simply transfers. We accomplish this with a debit to the investment in subsidiary account and a credit to the dividends paid account.
Entry E: Any excess amortization on the acquisition date fair-value adjustment need to be individually recorded.
Entry P: If there are any intercompany payables or receivables, they would need to be eliminated. This is because you can’t owe yourself or have a receivable from yourself, and when we consolidate, we are one company. The entry would be very straightforward, debiting intercompany payable and crediting the intercompany receivable.