Solution Manual For Fundamentals of Advanced Accounting, 8th Edition

Chapter 02 – Consolidation of Financial Information 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 business 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 2A and pushdown accounting in Appendix 2B. 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, the parent company simulates consolidation 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 excess 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.) 2-1 Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 02 – Consolidation of Financial Information II. III. The Acquisition Method A. For business combinations resulting in complete ownership, the acquisition method 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. Convergence between U.S. GAAP and IAS IFRS 3 – nearly identical to U.S. GAAP because of joint efforts APPENDIX 2A: I. 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 (rarely occurred), the acquired company accounts were still measured at fair value except that certain noncurrent asset values were reduced by the excess cost. If these values were not great enough to absorb the entire reduction, an extraordinary gain was recognized. 2-2 Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 02 – Consolidation of Financial Information II. The Pooling of Interest Method (prohibited for combinations after June 2002) A. A pooling of interests reflected united ownership 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 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, an acquisition price was not relevant. a. Since no acquisition price was computed, all direct costs of creating the combination were expensed immediately. b. No new goodwill was recognized from the combination. Similarly, no valuation adjustments were recorded for any of the subsidiary assets or liabilities. 2. The book values of the two companies were simply brought together to produce consolidated financial statements. A pooling was viewed as a uniting of 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. Cost figures indicated by the exchange transaction were ignored. b. Income balances previously reported were combined on a retrospective basis. c. Reported net income was usually higher in subsequent years than in a purchase because the lack of valuation adjustments reduced amortization. APPENDIX 2B: Pushdown Accounting I. Pushdown accounting is the application of the parent’s acquisition-date valuations for the subsidiary’s standalone financial statements. A newly acquired entity may elect the option to apply pushdown accounting in the reporting period immediately following the acquisition. The rationale is that the acquisition-date fair values for the subsidiary’s assets and liabilities are more representationally faithful and relevant to users of the subsidiary’s financial statements. II. When push-down accounting is elected, A. The subsidiary revalues its assets and liabilities based on the acquisition-date fair value allocations. The subsidiary then recognizes periodic amortization expense on those allocations with definite lives. Therefore, the subsidiary’s recorded income equals its impact on consolidated earnings (except in the presence of a bargain purchase gain). B. Any goodwill from the combination is reported in the acquired entity’s separate financial statements. In the case of a bargain purchase gain, pushdown accounting recognize an adjustment to its additional paid-in capital, not as a gain in its income statement. C. the subsidiary’s retained earnings are revalued to zero recognizing the new reporting entity as of the parent’s acquisition date. III. The parent uses no special procedures when push-down accounting is being applied. However, if the equity method is in use, amortization need not be recognized by the parent since that expense is included in the figure reported by the subsidiary. 2-3 Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 02 – Consolidation of Financial Information Answer to Discussion Question What if an acquired entity is not a business? The accounting and reporting implications to this question are included in the discussion followed by an example of an asset acquisition by Celgene Corporation. The question is designed to provide class discussion on the definition of a business and meeting that definition as a requirement for use of the acquisition method. The instructor can point out that the acquisition method can be very complex and costly to implement. Companies that simply are acquiring an asset (even though it may be incorporated) do not need to incur the additional costs of complying with FASB ASC Topic 805, “Business Combinations.” Accounting cost savings in asset acquisitions (vs. a business combination that requires the acquisition method) can result from less effort in determining fair values for contingent consideration, assessing periodic impairment for in-process research and development, assessing periodic impairment for goodwill, etc. Thus, companies that are simply purchasing an asset will avoid many of the complications of ASC 805 compliance. The FASB issued Accounting Standards Update 2017-01 to help companies evaluate whether a set of acquired assets is a business or not by providing a new definition of a business. The new definition replaces a previous one that was considered broad and challenging to apply. ASU 201701 is expected to restrict the number of acquisitions that qualify for the acquisition method. Answers to Questions 1. 2. 3. 4. A business combination is the process of forming a single economic entity by the uniting of two or more organizations under common ownership. The term also refers to the entity that results from this process. Synergy is the concept that through combination, two or more companies will produce more revenue than either one could separately, or eliminate or streamline duplicate efforts, resulting in cost reductions. In a business combination, examples of synergies include utilizing existing distribution channels of one firm for the combined firm to increase revenues. Cost savings may be available through elimination of duplicate facilities. Larger size and scale can also provide additional negotiating power for the combined firm. (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 company’s capital stock. This transaction is labeled a statutory merger if the acquired company transfers its assets and liabilities to the buyer and then legally dissolves as a corporation. (3) A statutory consolidation results when two or more companies transfer all of their assets or capital stock to a newly formed corporation. The original companies are being “consolidated” into the new entity. (4) A business combination is also formed whenever one company gains control over another through the acquisition of outstanding voting stock. Both companies retain their separate legal identities although the common ownership indicates that only a single economic entity exists. Consolidated financial statements represent accounting information gathered from two or more separate companies. This data, although accumulated individually by the organizations, is brought together (or consolidated) to describe the single economic entity created by the business combination. 2-4 Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 02 – Consolidation of Financial Information 5. 6. 7. 8. 9. 10. 11. 12. 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 be required for outside shareholders (a noncontrolling interest), the government, debt holders, etc. This information may also be utilized in corporate evaluations and other decision making. However, the business combination must periodically produce consolidated financial statements encompassing all of the companies within the single economic entity. The purpose of a worksheet is to organize and structure this process. The worksheet allows for a simulated consolidation to be carried out on a regular, periodic basis without affecting the financial records of the various component companies. 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; ▪ The number of newly issued shares (especially if the amount is large in comparison to the quantity of previously outstanding shares) may cause the price of the stock to fluctuate widely so that no accurate fair value can be determined during a reasonable period of time; ▪ Jones’ stock may have historically experienced drastic swings in price. Thus, a quoted figure at any specific point in time may not be an adequate or representative value for long-term accounting purposes. For combinations resulting in complete ownership, the acquisition method allocates the fair value of the consideration transferred to the separately recognized assets acquired and liabilities assumed based on their individual fair values. 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 consolidated from the date of the acquisition forward within the worksheet consolidation process. The operations of the subsidiary are only applicable to the business combination if earned subsequent to its creation. Morgan’s additional acquisition value may be attributed to many factors: expected synergies between Morgan’s and Jennings’ assets, favorable earnings projections, competitive bidding to acquire Jennings, etc. In general however, any amount paid by the parent company in excess of the fair values of the subsidiary’s net assets acquired is reported as goodwill. 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 transferred (including any contingent consideration) is less than the total net fair value assigned to the assets acquired and liabilities assumed, then an ordinary gain on bargain purchase is recognized for the difference. Shares issued are recorded at fair value as if the stock had been sold and the money obtained used to acquire the subsidiary. The Common Stock account is recorded at the par value of these shares with any excess amount attributed to additional paid-in capital. 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. 2-5 Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 02 – Consolidation of Financial Information Answers to Problems 1. D 2. B 3. D 4. A 5. A 6. B 7. D 8. A 9. B 10. C 11. C 12. B Consideration transferred (fair value) Cash Accounts receivable Software Research and development asset Liabilities Fair value of net identifiable assets acquired Goodwill 13. C Legal and accounting fees accounts payable Contingent liability Donovan’s liabilities assumed Liabilities assumed or incurred 14. D Consideration transferred (fair value) Current assets Building and equipment Unpatented technology Research and development asset Liabilities Fair value of net identifiable assets acquired Goodwill Current assets Building and equipment Unpatented technology Research and development asset Goodwill Total assets $800,000 $150,000 140,000 320,000 200,000 (130,000) 680,000 $120,000 $15,000 20,000 60,000 $95,000 $420,000 $90,000 250,000 25,000 45,000 (60,000) 350,000 $ 70,000 $ 90,000 250,000 25,000 45,000 70,000 $480,000 2-6 Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 02 – Consolidation of Financial Information 15. C Value of shares issued (51,000 × $3) ……………………………….. $153,000 Par value of shares issued (51,000 × $1) ………………………….. 51,000 Additional paid-in capital (new shares) …………………………… $102,000 Additional paid-in capital (existing shares) …………………….. 90,000 Consolidated additional paid-in capital (fair value)…………… $192,000 At the acquisition date, the parent makes no change to retained earnings. 16. B Consideration transferred (fair value) …………………….. Book value of subsidiary (assets minus liabilities) …. Fair value in excess of book value ……………………… Allocation of excess fair over book value identified with specific accounts: Inventory …………………………………………………………… Patented technology ………………………………………….. Land …………………………………………………………………. Long-term liabilities …………………………………………… Goodwill ……………………………………………………………. $400,000 (300,000) 100,000 17. D TruData patented technology…………………………………. Webstat patented technology (fair value) ……………….. Acquisition-date consolidated balance sheet amount $230,000 200,000 $430,000 18. C TruData common stock before acquisition……………… Common stock issued (par value) ………………………….. Acquisition-date consolidated balance sheet amount $300,000 50,000 $350,000 19. B TruData’s 1/1 retained earnings ……………………………… TruData’s income (1/1 to 7/1) …………………………………. Acquisition-date consolidated balance sheet amount $130,000 80,000 $210,000 30,000 20,000 25,000 10,000 $15,000 20. C Patrick’s assets $1,395,000 Less: investment in Sean ………………………………………. (460,000) Sean’s assets ……………………………………………………….. 415,000 Inventory write-up …………………………………………………. 25,000 Goodwill from the combination (see below) ……………. 145,000 Total consolidated assets ……………………………………… $1,520,000 Consideration transferred ……………………………………… Fair value of net identifiable assets (see below) ……… Goodwill ……………………………………………………………….. $460,000 315,000 $145,000 Sean’s assets (carrying amount) ………………………………….. Sean’s liabilities (carrying amount = $95,000 + $30,000) …… Sean’s net assets (carrying amount) ……………………………. Inventory adjustment to fair value ……………………………… Fair value of Sean’s net identifiable assets…………………. $415,000 125,000 290,000 25,000 $315,000 2-7 Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 02 – Consolidation of Financial Information 21. B Patrick’s stockholders’ equity total. 22. 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 intangible asset does not arise from contractual or other legal rights, it shall be recognized as an asset apart from goodwill only if it is separable, that is, it is capable of being separated or divided from the acquired enterprise and sold, transferred, licensed, rented, or exchanged (regardless of whether there is an intent to do so). An intangible asset that cannot be sold, transferred, licensed, rented, or exchanged individually is considered separable if it can be sold, transferred, licensed, rented, or exchanged with a related contract, asset, or liability. b. ◼ Trademarks—usually meet both the separability and legal/contractual criteria. ◼ Customer list—usually meets the separability criterion. ◼ Copyrights on artistic materials—usually meet both the separability and legal/contractual criteria. ◼ Agreements to receive royalties on leased intellectual property—usually meet the legal/contractual criterion. ◼ Unpatented technology—may meet the separability criterion if capable of being sold even if in conjunction with a related contract, asset, or liability. 23. (12 minutes) (Journal entries to record a merger—acquired company dissolved) Inventory Land Buildings Customer Relationships Goodwill Accounts Payable Common Stock Additional Paid-In Capital Cash 600,000 990,000 2,000,000 800,000 690,000 Professional Services Expense Cash 42,000 Additional Paid-In Capital Cash 25,000 80,000 40,000 960,000 4,000,000 42,000 25,000 2-8 Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 02 – Consolidation of Financial Information 24. (12 minutes) (Journal entries to record a bargain purchase—acquired company dissolved) Inventory Land Buildings Customer Relationships Accounts Payable Cash Gain on Bargain Purchase 600,000 990,000 2,000,000 800,000 Professional Services Expense Cash 42,000 80,000 4,200,000 110,000 42,000 25. (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) ▪ Franchise agreements = $440,000 (Padre’s book value plus Sol’s fair value) ▪ Goodwill = $80,000 (calculated above) ▪ Revenues = $960,000 (only parent company operational figures are reported at date of acquisition) ▪ Additional paid-in capital = $265,000 (Padre’s book value adjusted for stock issue less stock issuance costs) ▪ Expenses = $940,000 (only parent company operational figures plus acquisition-related costs are reported at date of acquisition) ▪ Retained earnings, 1/1 = $390,000 (Padre’s book value only) ▪ Retained earnings, 12/31 = $410,000 (beginning retained earnings plus revenues minus expenses, of Padre only) 2-9 Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 02 – Consolidation of Financial Information 26. (20 minutes) Journal entries for a merger using alternative values. a. Acquisition date fair values: Cash paid Contingent performance liability Consideration transferred Fair values of net assets acquired Gain on bargain purchase $700,000 35,000 $735,000 750,000 $ 15,000 Receivables 90,000 Inventory 75,000 Copyrights 480,000 Patented Technology 700,000 Research and Development Asset 200,000 Current liabilities 160,000 Long-Term Liabilities 635,000 Cash 700,000 Contingent Performance Liability 35,000 Gain on Bargain Purchase 15,000 Professional Services Expense Cash 100,000 100,000 b. Acquisition date fair values: Cash paid Contingent performance liability Consideration transferred Fair values of net assets acquired Goodwill $800,000 35,000 $835,000 750,000 $ 85,000 Receivables 90,000 Inventory 75,000 Copyrights 480,000 Patented Technology 700,000 Research and Development Asset 200,000 Goodwill 85,000 Current Liabilities 160,000 Long-Term Liabilities 635,000 Cash 800,000 Contingent Performance Liability 35,000 Professional Services Expense Cash 100,000 100,000 2-10 Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 02 – Consolidation of Financial Information 27. (20 Minutes) (Determine selected consolidated balances) Under the acquisition method, the shares issued by Wisconsin are recorded at fair value using the following journal entry: Investment in Badger (value of debt and shares issued) 900,000 Common Stock (par value) …………………………………….. 150,000 Additional Paid-In Capital (excess over par value) ….. 450,000 Liabilities………………………………………………………………. 300,000 The payment to the broker is accounted for as an expense. The stock issue cost is a reduction in additional paid-in capital. Professional Services Expense…………………………………… Additional Paid-In Capital …………………………………………… Cash …………………………………………………………………… 30,000 40,000 70,000 Allocation of Acquisition-Date Excess Fair Value: Consideration transferred (fair value) for Badger Stock Book Value of Badger, 6/30 ………………………………………… Fair Value in Excess of Book Value ………………………… Excess fair value (undervalued equipment) …………………. Excess fair value (overvalued patented technology) ……. Goodwill ……………………………………………………………….. $900,000 770,000 $130,000 100,000 (20,000) $ 50,000 CONSOLIDATED BALANCES: a. Net income (adjusted for professional services expense. The figures earned by the subsidiary prior to the takeover are not included) ……………………………………………………………. $ 210,000 b. Retained earnings, 1/1 (the figures earned by the subsidiary prior to the takeover are not included) …………………………….. 800,000 c. Patented technology (the parent’s book value plus the fair value of the subsidiary) ………………………………………………….. 1,180,000 d. Goodwill (computed above) ……………………………………………. 50,000 e. Liabilities (the parent’s book value plus the fair value of the subsidiary’s debt plus the debt issued by the parent in acquiring the subsidiary) ……………………………………………. 1,210,000 f. Common stock (the parent’s book value after recording the newly-issued shares)………………………………………………… 510,000 g. Additional Paid-in Capital (the parent’s book value after recording the two entries above) …………………………….. 680,000 2-11 Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 02 – Consolidation of Financial Information 28. (20 minutes) (Preparation of a consolidated balance sheet)* CASEY CORPORATION AND CONSOLIDATED SUBSIDIARY KENNEDY Worksheet for a Consolidated Balance Sheet January 1, 2021 Cash Accounts receivable Inventory Investment in Kennedy Casey 457,000 1,655,000 1,310,000 3,300,000 Kennedy 172,500 347,000 263,500 -0- Buildings (net) Licensing agreements Goodwill Total assets 6,315,000 -0347,000 13,384,000 2,090,000 3,070,000 -05,943,000 Accounts payable Long-term debt Common stock Additional paid-in cap. Retained earnings Total liab. & equities (394,000) (3,990,000) (3,000,000) -0(6,000,000) (13,384,000) (393,000) (2,950,000) (1,000,000) (500,000) (1,100,000) (5,943,000) Adjust. & Elim. (A) 382,000 (A) 426,000 (S) 1,000,000 (S) 500,000 (S) 1,100,000 3,408,000 Consolidated 629,500 2,002,000 1,573,500 (S) 2,600,000 (A) 700,000 -08,787,000 (A) 108,000 2,962,000 773,000 16,727,000 (787,000) (6,940,000) (3,000,000) -0(6,000,000) 3,408,000 (16,727,000) *Although this solution uses a worksheet to compute the consolidated amounts, the problem does not require it. 29. (50 Minutes) (Determine consolidated balances for a bargain purchase.) a. Marshall’s acquisition of Tucker represents a bargain purchase because the fair value of the net assets acquired exceeds the fair value of the consideration transferred as follows: Fair value of net assets acquired $515,000 Fair value of consideration transferred 400,000 Gain on bargain purchase $115,000 In a bargain purchase, the acquisition is recorded at the fair value of the net assets acquired instead of the fair value of the consideration transferred (an exception to the general rule). Prior to preparing a consolidation worksheet, Marshall records the three transactions that occurred to create the business combination. Investment in Tucker ……………………………………….. 515,000 Long-term Liabilities ……………………………………………………… 200,000 Common Stock (par value) …………………………………………….. 20,000 Additional Paid-In Capital ………………………………………………. 180,000 Gain on Bargain Purchase …………………………………………….. 115,000 (To record liabilities and stock issued for Tucker acquisition fair value) 2-12 Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 02 – Consolidation of Financial Information 29. (continued) Professional Services Expense…………………….. Cash …………………………………………………….. (to record payment of professional fees) 30,000 Additional Paid-In Capital …………………………….. Cash …………………………………………………….. (To record payment of stock issuance costs) 12,000 30,000 12,000 Marshall’s trial balance is adjusted for these transactions (as shown in the worksheet that follows). Next, the $400,000 fair value of the investment is allocated: Consideration transferred at fair value …………………………….. $400,000 Book value (assets minus liabilities or total stockholders’ equity) ………………………………………….. 460,000 Book value in excess of consideration transferred …….. (60,000) Allocation to specific accounts based on fair value: Inventory …………………………………………………………. 5,000 Land ……………………………………………………………… 20,000 Buildings …………………………………………………………. 30,000 55,000 Gain on bargain purchase (excess net asset fair value over consideration transferred) ………………………………….. $(115,000) CONSOLIDATED TOTALS ▪ Cash = $38,000. Add the two book values less acquisition and stock issue costs ▪ Receivables = $360,000. Add the two book values. ▪ Inventory = $505,000. Add the two book values plus the fair value adjustment ▪ Land = $400,000. Add the two book values plus the fair value adjustment. ▪ Buildings = $670,000. Add the two book values plus the fair value adjustment. ▪ Equipment = $210,000. Add the two book values. ▪ Total assets = $2,183,000. Summation of the above individual figures. ▪ Accounts payable = $190,000. Add the two book values. ▪ Long-term liabilities = $830,000. Add the two book values plus the debt incurred by the parent in acquiring the subsidiary. ▪ Common stock = $130,000.The parent’s book value after stock issue to acquire the subsidiary. ▪ Additional paid-in capital = $528,000.The parent’s book value after the stock issue to acquire the subsidiary less the stock issue costs. ▪ Retained earnings = $505,000. Parent company balance less $30,000 in professional services expense plus $115,000 gain on bargain purchase. ▪ Total liabilities and equity = $2,183,000. Summation of the above figures. 2-13 Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 02 – Consolidation of Financial Information 29. (continued) b. MARSHALL COMPANY AND CONSOLIDATED SUBSIDIARY Worksheet January 1, 2021 Accounts Cash …………………………………….. Receivables …………………………. Inventory …………………………….. Land ……………………………………. Buildings (net) …………………….. Equipment (net) …………………… Investment in Tucker ……………. Marshall Company* 18,000 270,000 360,000 200,000 420,000 160,000 515,000 Tucker Company 20,000 90,000 140,000 180,000 220,000 50,000 Total assets …………………………. 1,943,000 700,000 Accounts payable …………………. Long-term liabilities …………….. Common stock …………………….. Additional paid-in capital ……… Retained earnings, 1/1/21 ……… Total liab. and owners’ equity .. (150,000) (630,000) (130,000) (528,000) (505,000) (1,943,000) (40,000) (200,000) (120,000) -0(340,000) (700,000) Consolidation Entries Consolidated Debit Credit Totals 38,000 360,000 (A) 5,000 505,000 (A) 20,000 400,000 (A) 30,000 670,000 210,000 (S) 460,000 (A) 55,000 -02,183,000 (S) 120,000 (S) 340,000 515,000 (190,000) (830,000) (130,000) (528,000) (505,000) 515,000 (2,183,000) Marshall’s accounts have been adjusted for acquisition entries (see part a.). 2-14 Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 30. (Prepare a consolidated balance sheet) Consideration transferred at fair value ………….. Book value ………………………………………………….. Excess fair over book value …………………………. Allocation of excess fair value to specific assets and liabilities: to computer software ………………………………. to equipment…………………………………………… to client contracts …………………………………… to in-process research and development … to notes payable ……………………………………… Goodwill ……………………………………………………… Cash Receivables Inventory Investment in Spider Pratt Spider 36,000 116,000 140,000 495,000 18,000 52,000 90,000 -0- $495,000 265,000 230,000 $50,000 (10,000) 100,000 40,000 (5,000) Debit Credit 175,000 $ 55,000 Consolidated 54,000 168,000 230,000 (S) 265,000 (A) 230,000 -0280,000 725,000 338,000 100,000 Computer software 210,000 Buildings (net) 595,000 Equipment (net) 308,000 Client contracts -0Research and development asset -0Goodwill -0Total assets 1,900,000 20,000 (A) 50,000 130,000 40,000 (A) 10,000 -0- (A) 100,000 -0- (A) 40,000 -0- (A) 55,000 350,000 40,000 55,000 1,990,000 Accounts payable Notes payable Common stock Additional paid-in capital Retained earnings Total liabilities and equities (88,000) (510,000) (380,000) (25,000) (60,000) (A) 5,000 (100,000) (S)100,000 (113,000) (575,000) (380,000) (170,000) (752,000) (25,000) (S) 25,000 (140,000) (S)140,000 (170,000) (752,000) (1,900,000) (350,000) 510,000 510,000 (1,990,000) Chapter 02 – Consolidation of Financial Information 30. (continued) Pratt Company and Subsidiary Consolidated Balance Sheet December 31, 2021 Assets Liabilities and Owners’ Equity Cash $ 54,000 Accounts payable $ 113,000 Receivables 168,000 Notes payable 575,000 Inventory 230,000 Computer software 280,000 Buildings (net) 725,000 Equipment (net) 338,000 Client contracts 100,000 Research and Common stock 380,000 development asset 40,000 Additional paid in capital 170,000 Goodwill 55,000 Retained earnings 752,000 Total assets $1,990,000 Total liabilities and equities $1,990,000 31. (15 minutes) (Acquisition method entries for a merger) Case 1: Fair value of consideration transferred Fair value of net identifiable assets Excess to goodwill $145,000 120,000 $25,000 Case 1 journal entry on Allerton’s books: Current Assets Building Land Trademark Goodwill Liabilities Cash 60,000 50,000 20,000 30,000 25,000 40,000 145,000 Case 2: Bargain Purchase under acquisition method Fair value of consideration transferred Fair value of net identifiable assets Gain on bargain purchase $110,000 120,000 $ 10,000 Case 2 journal entry on Allerton’s books: Current Assets Building Land Trademark Gain on Bargain Purchase Liabilities Cash 60,000 50,000 20,000 30,000 10,000 40,000 110,000 2-16 Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 02 – Consolidation of Financial Information Problem 31. (continued) In a bargain purchase, the acquisition method employs the fair value of the net identifiable assets acquired as the basis for recording the acquisition. Because this basis exceeds the amount paid, Allerton recognizes a gain on bargain purchase. This is an exception to the general rule of using the fair value of the consideration transferred as the basis for recording the combination. 32. (25 minutes) (Combination entries—acquired entity dissolved) Cash consideration transferred Contingent performance obligation Consideration transferred (fair value) Fair value of net identifiable assets* Goodwill $310,800 17,900 328,700 294,700 $ 34,000 * Acquisition date Streeter book value Excess building fair value Unrecorded customer list In-process research and development Acquisition date Streeter fair value of net identifiable assets $190,000 43,100 25,200 36,400 $294,700 Journal entries: Receivables 83,900 Inventory 70,250 Buildings 122,000 Equipment 24,100 Customer List 25,200 Research and Development Asset 36,400 Goodwill 34,000 Current Liabilities Long-Term Liabilities Contingent Performance Liability Cash 12,900 54,250 17,900 310,800 Professional Services Expense Cash 15,100 15,100 2-17 Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 02 – Consolidation of Financial Information 33. (30 Minutes) (Overview of the steps in applying the acquisition method when shares have been issued to create a combination. Part h. includes a bargain purchase.) a. The fair value of the consideration includes Fair value of stock issued Contingent performance obligation Fair value of consideration transferred $1,500,000 30,000 $1,530,000 b. Stock issue costs reduce additional paid-in capital. c. In a business combination, direct acquisition costs (such as fees paid to investment banks for arranging the transaction) are recognized as expenses. d. The par value of the 20,000 shares issued is recorded as an increase of $20,000 in the Common Stock account. The $74 fair value in excess of par value ($75 – $1) is an increase to additional paid-in capital of $1,480,000 ($74 × 20,000 shares). e. Fair value of consideration transferred (above) Receivables $ 80,000 Patented technology 700,000 Customer relationships 500,000 In-process research and development 300,000 Liabilities (400,000) Goodwill $1,530,000 1,180,000 $ 350,000 f. Revenues and expenses of the subsidiary from the period prior to the combination are omitted from the consolidated totals. Only the operational figures for the subsidiary after the purchase are applicable to the business combination. The previous owners earned any previous profits. g. The subsidiary’s Common Stock and Additional Paid-in Capital accounts have no impact on the consolidated totals. h. The fair value of the consideration transferred is now $1,030,000. This amount indicates a bargain purchase calculated as follows: Fair value of consideration transferred Receivables Patented technology Customer relationships Research and development asset Liabilities Gain on bargain purchase $1,030,000 $ 80,000 700,000 500,000 300,000 (400,000) 1,180,000 $ 150,000 The values of SafeData’s assets and liabilities would be recorded at fair value, but there would be no goodwill recognized and a gain on bargain purchase would be reported. 2-18 Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 02 – Consolidation of Financial Information 34. (50 Minutes) (Prepare balance sheet for a statutory merger using the acquisition method. Also, use worksheet to derive consolidated totals.) a. In accounting for the combination of NewTune and On-the-Go, the fair value of the acquisition is allocated to each identifiable asset and liability acquired with any remaining excess attributed to goodwill. Fair value of consideration transferred (shares issued) $750,000 Fair value of net assets acquired: Cash $ 29,000 Receivables 63,000 Trademarks 225,000 Record music catalog 180,000 In-process research and development 200,000 Equipment 105,000 Accounts payable (34,000) Notes payable (45,000) 723,000 Goodwill $ 27,000 Journal entries by NewTune to record combination with On-the-Go: Cash 29,000 Receivables 63,000 Trademarks 225,000 Record Music Catalog 180,000 Research and Development Asset 200,000 Equipment 105,000 Goodwill 27,000 Accounts Payable Notes Payable Common Stock (NewTune par value) Additional Paid-In Capital (To record merger with On-the-Go at fair value) Additional Paid-In Capital Cash (Stock issue costs incurred) 34,000 45,000 60,000 690,000 25,000 25,000 2-19 Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 02 – Consolidation of Financial Information Problem 34 (continued): Post-Combination Balance Sheet: Assets Cash Receivables Trademarks Record music catalog Research and development asset Equipment Goodwill Total $ 64,000 213,000 625,000 1,020,000 200,000 425,000 27,000 $2,574,000 Liabilities and Owners’ Equity Accounts payable $ 144,000 Notes payable 415,000 Common stock Additional paid-in capital Retained earnings Total 460,000 695,000 860,000 $2,574,000 b. Because On-the-Go continues as a separate legal entity, NewTune first records the acquisition as an investment in the shares of On-the-Go. Journal entries: Investment in On-the-Go Common Stock (NewTune, Inc., par value) Additional Paid-In Capital (To record acquisition of On-the-Go’s shares) 750,000 Additional Paid-In Capital Cash (Stock issue costs incurred) 25,000 60,000 690,000 25,000 Next, NewTune’s accounts are adjusted for the two immediately preceding entries to facilitate the worksheet preparation of the consolidated financial statements. 2-20 Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 02 – Consolidation of Financial Information 34. (continued) b. NEWTUNE, INC., AND ON-THE-GO CO. Consolidation Worksheet January 1, 2021 Consolidation Entries Accounts NewTune, Inc. On-the-Go Co. Debit Credit Cash 35,000 29,000 Receivables 150,000 65,000 (A) 2,000 Investment in On-the-Go 750,000 -0(S) 270,000 (A) 480,000 Trademarks 400,000 95,000 (A) 130,000 Record music catalog 840,000 60,000 (A) 120,000 Research and development asset -0-0(A) 200,000 Equipment 320,000 105,000 Goodwill -0-0(A) 27,000 Totals 2,495,000 354,000 Accounts payable 110,000 34,000 Notes payable 370,000 50,000 (A) 5,000 Common stock 460,000 50,000 (S) 50,000 Additional paid-in capital 695,000 30,000 (S) 30,000 Retained earnings 860,000 190,000 (S) 190,000 Totals 2,495,000 354,000 752,000 752,000 Consolidated Totals 64,000 213,000 -0625,000 1,020,000 200,000 425,000 27,000 2,574,000 144,000 415,000 460,000 695,000 860,000 2,574,000 Note: The accounts of NewTune have already been adjusted for the first three journal entries indicated in the answer to Part b. to record the acquisition fair value and the stock issuance costs. The consolidation entries are designed to: ▪ Eliminate the stockholders’ equity accounts of the subsidiary (S) ▪ Record all subsidiary assets and liabilities at fair value (A) ▪ Recognize the goodwill indicated by the acquisition fair value (A) ▪ Eliminate the Investment in On-the-Go account (S, A) c. The consolidated balance sheets in parts a. and b. above are identical. The financial reporting consequences for a 100% stock acquisition vs. a merger are the same. The economic substances of the two forms of the transaction are identical and, therefore, so are the resulting financial statements. The difference is in the journal entry to record the acquisition in the parent company books. 2-21 Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 02 – Consolidation of Financial Information 35. (40 minutes) (Prepare a consolidated balance sheet using the acquisition method). a. Journal entries to record the acquisition on Pacifica’s records. Investment in Seguros 1,062,500 Common Stock (50,000 × $5) 250,000 Additional Paid-In Capital (50,000 × $15) 750,000 Contingent Performance Obligation 62,500 The contingent consideration is computed as: $130,000 payment × 50% probability × 0.961538 present value factor Professional Services Expense Cash Additional Paid-In Capital Cash 15,000 15,000 9,000 9,000 b. and c. Revenues Expenses Net income (1,200,000) 890,000 (310,000) Consolidated Balance Sheet (1,200,000) 890,000 (310,000) Retained earnings, 1/1 Net income Dividends declared Retained earnings, 12/31 (950,000) (310,000) 90,000 (1,170,000) (950,000) (310,000) 90,000 (1,170,000) Cash Receivables and inventory Property, plant and equipment Investment in Seguros 86,000 750,000 1,400,000 1,062,500 Pacifica Seguros 85,000 190,000 450,000 Consolidation Entries (A) 10,000 (A)150,000 (S) 705,000 (A) 357,500 Research and development asset Goodwill Trademarks Total assets (A)100,000 (A) 77,500 (A) 40,000 300,000 3,598,500 160,000 885,000 Liabilities Contingent performance obligation Common stock Additional paid-in capital (500,000) (62,500) (650,000) (1,216,000) (180,000) (200,000) (70,000) (S) 200,000 (S) 70,000 Retained earnings Total liabilities and equities (1,170,000) (3,598,500) (435,000) (885,000) (S) 435,000 1,072,500 171,000 930,000 2,000,000 0 100,000 77,500 500,000 3,778,500 (680,000) (62,500) (650,000) (1,216,000) 1,072,500 2-22 Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. (1,170,000) (3,778,500) Chapter 02 – Consolidation of Financial Information 36. (30 minutes) Prepare an acquisition date consolidated balance sheet. Subsidiary has pre-existing goodwill. James Johnson Cash Accounts receivable Inventory Investment in Johnson 245,000 1,830,000 3,500,000 3,050,000 110,000 360,000 280,000 0 Patents Trademarks Goodwill Total assets 7,000,000 -0150,000 15,775,000 1,000,000 3,200,000 75,000 5,025,000 Accounts payable Long-term debt Common stock Additional paid-in capital Retained earnings Total liabilities and equities (100,000) (4,300,000) (5,000,000) -0(6,375,000) (15,775,000) (515,000) (2,210,000) (1,000,000) (200,000) (1,100,000) (5,025,000) Consolidation Entries Consolidated* 355,000 2,190,000 3,780,000 (S) 2,300,000 (A) 750,000 (A) 800,000 (A) 25,000 (S)1,000,000 (S) 200,000 (S)1,100,000 3,125,000 (A) 75,000 3,125,000 -08,800,000 3,200,000 175,000 18,500,000 (615,000) (6,510,000) (5,000,000) -0(6,375,000) (18,500,000) Consolidation Worksheet Entry (S) Common stock-Johnson Additional paid-in capital-Johnson Retained earnings-Johnson Investment in Johnson 1,000,000 200,000 1,100,000 2,300,000 Consolidation Worksheet Entry (A) Patents 800,000 Goodwill (new) 25,000 Goodwill (pre-existing subsidiary) Investment in Johnson 75,000 750,000 *Although this solution uses a worksheet to compute the consolidated amounts, the problem does not require it. 2-23 Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGrawHill Education. Chapter 02 – Consolidation of Financial Information Answers to Appendix 2A Problems 37. (25 minutes) Journal entries for a merger using legacy purchase method. Also compare to acquisition method. a. Purchase Method 1. Purchase price (including acquisition costs) Fair values of net assets acquired Goodwill $635,000 525,000 $110,000 Journal entry: Current Assets Equipment Trademark Goodwill Liabilities Cash 80,000 180,000 320,000 110,000 55,000 635,000 2. Acquisition date fair values: Purchase price (including acquisition costs) $450,000 Fair values of net assets acquired 525,000 Bargain purchase ($ 75,000) Allocation of bargain purchase to long-term assets acquired: Equipment Trademark Fair value Prop. Total reduction Asset reduction $180,000 320,000 $500,000 36% x $75,000 = 64% x 75,000 = $27,000 48,000 $75,000 Journal entry: Current Assets Equipment ($180,000 – $27,000) Trademark ($320,000 – $48,000) Liabilities Cash 80,000 153,000 272,000 55,000 450,000 2-24 Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 02 – Consolidation of Financial Information 37. continued b. Acquisition Method 1. Consideration transferred Fair values of net assets acquired Goodwill $ 610,000 525,000 $ 85,000 Journal entry: Current Assets Equipment Trademark Goodwill Liabilities Cash 80,000 180,000 320,000 85,000 Professional Services Expense Cash 25,000 55,000 610,000 25,000 2. Consideration transferred Fair values of net assets acquired Gain on bargain purchase $425,000 525,000 ($100,000) Journal entry: Current Assets Equipment Trademark Liabilities Gain on Bargain Purchase Cash 80,000 180,000 320,000 Professional Services Expense Cash 25,000 55,000 100,000 425,000 25,000 2-25 Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGrawHill Education. Chapter 02 – Consolidation of Financial Information 38. (25 minutes) (Pooling vs. purchase involving an unrecorded intangible) a. Inventory Land Buildings Unpatented technology Goodwill Total Purchase Pooling $ 650,000 $ 600,000 750,000 450,000 1,000,000 900,000 1,500,000 -0600,000 -0$4,500,000 $1,950,000 b. The purchase method excluded pre-acquisition revenues and expenses from consolidated results, but the pooling method included them. c. Poolings typically produced higher rates of return on assets than purchase accounting because the denominator was often much lower. The Swimwear acquisition pooling produced an increment to total assets of $1,950,000 compared to $4,500,000 under purchase accounting. Future EPS under poolings were also higher because of lower future amortization of the smaller asset base. Managers whose compensation contracts involved accounting performance measures clearly had incentives to use pooling of interest accounting whenever possible. Answers to Appendix 2B Problems 39. C 40. (12 minutes) (Pushdown Accounting Application) Quigley Corporation Balance Sheet May 1 Cash Receivables Inventory Land Building and equipment (net) Patented technology Goodwill Total assets $ 95,000 200,000 260,000 110,000 330,000 220,000 125,000 $1,340,000 Accounts payable Long-term liabilities Common stock—5 par value Additional paid-in capital APIC from pushdown accounting Retained earnings, 1/1 Total liabilities and stockholders’ equity $ 120,000 510,000 210,000 90,000 410,000 -0$1,340,000 2-26 Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 02 – Consolidation of Financial Information Chapter 2 Develop Your Skills CONSIDERATION OR COMPENSATION CASE (estimated time 50 minutes) According to FASB ASC (805-10-55-25): If it is not clear whether an arrangement for payments to employees or selling shareholders is part of the exchange for the acquiree or is a transaction separate from the business combination, the acquirer should consider the following indicators: a. Continuing employment. The terms of continuing employment by the selling shareholders who become key employees may be an indicator of the substance of a contingent consideration arrangement. The relevant terms of continuing employment may be included in an employment agreement, acquisition agreement, or some other document. A contingent consideration arrangement in which the payments are automatically forfeited if employment terminates is compensation for post combination services. Arrangements in which the contingent payments are not affected by employment termination may indicate that the contingent payments are additional consideration rather than compensation. b. Duration of continuing employment. If the period of required employment coincides with or is longer than the contingent payment period, that fact may indicate that the contingent payments are, in substance, compensation. c. Level of compensation. Situations in which employee compensation other than the contingent payments is at a reasonable level in comparison to that of other key employees in the combined entity may indicate that the contingent payments are additional consideration rather than compensation. d. Incremental payments to employees. If selling shareholders who do not become employees receive lower contingent payments on a per-share basis than the selling shareholders who become employees of the combined entity, that fact may indicate that the incremental amount of contingent payments to the selling shareholders who become employees is compensation. e. Number of shares owned. The relative number of shares owned by the selling shareholders who remain as key employees may be an indicator of the substance of the contingent consideration arrangement. For example, if the selling shareholders who owned substantially all of the shares in the acquiree continue as key employees, that fact may indicate that the arrangement is, in substance, a profit-sharing arrangement intended to provide compensation for post combination services. Alternatively, if selling shareholders who continue as key employees owned only a small number of shares of the acquiree and all selling shareholders receive the same amount of contingent consideration on a per-share basis, that fact may indicate that the contingent payments are additional consideration. The preacquisition ownership interests held by parties related to selling shareholders who continue as key employees, such as family members, also should be considered. f. Linkage to the valuation. If the initial consideration transferred at the acquisition date is based on the low end of a range established in the valuation of the acquiree and the contingent formula relates to that valuation approach, that fact may suggest that the contingent payments are additional consideration. Alternatively, if the contingent payment formula is consistent with prior profitsharing arrangements, that fact may suggest that the substance of the arrangement is to provide compensation. 2-27 Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGrawHill Education. Chapter 02 – Consolidation of Financial Information g. Formula for determining consideration. The formula used to determine the contingent payment may be helpful in assessing the substance of the arrangement. For example, if a contingent payment is determined based on a multiple of earnings, that might suggest that the obligation is contingent consideration in the business combination. Thus, the formula is intended to establish or verify the fair value of the acquiree. In contrast, a contingent payment that is a specified percentage of earnings might suggest that the obligation to employees is a profit-sharing arrangement to compensate employees for services rendered. Suggested answer: Note: This case was designed to have conflicting indicators across the various criteria identified in the FASB ASC for determining the issue of compensation vs. consideration. Thus, the solution is subject to alternative explanations and students can be encouraged to use their own judgment and interpretations in supporting their answers. In the author’s judgment, the $8 million contingent payment (fair value = $4 million) is contingent consideration to be included in the overall fair value AutoNav records for its acquisition of Easy-C. This contingency is not dependent on continuing employment (criteria a.), and uses a formula based on a component of earnings (criteria g.). Even though the four former owners of Easy-C owned 100% of the shares (criteria e.), which suggests the $8 million is compensation, the overall fact pattern indicates consideration because no services are required for the payment. The profit-sharing component of the employment contract appears to be compensation. Criteria g. specifically identifies profit-sharing arrangements as indicative of compensation for services rendered. Criteria a. also applies given that the employees would be unable to participate in profit-sharing if they terminate employment. Although the employees receive non-profit sharing compensation similar to other employees (criteria c.), the overall pattern of evidence suggests that any payments made under the profit-sharing arrangement should be recognized as compensation expense when incurred and not contingent consideration for the acquisition. 2-28 Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 02 – Consolidation of Financial Information ASC RESEARCH CASE—DEFENSIVE INTANGIBLE ASSET (45 MINUTES) a. The ASC Glossary defines a defensive intangible asset as “An acquired intangible asset in a situation in which an entity does not intend to actively use the asset but intends to hold (lock up) the asset to prevent others from obtaining access to the asset.” ASC 820-10-35-10D also observes that To protect its competitive position, or for other reasons, a reporting entity may intend not to use an acquired nonfinancial asset actively, or it may intend not to use the asset according to its highest and best use. For example, that might be the case for an acquired intangible asset that the reporting entity plans to use defensively by preventing others from using it. Nevertheless, the reporting entity shall measure the fair value of a nonfinancial asset assuming its highest and best use by market participants. According to ASC 350-30-25-5 a defensive intangible asset should be accounted for as a separate unit of accounting (i.e., an asset separate from other assets of the acquirer). It should not be included as part of the cost of an entity’s existing intangible asset(s) presumably because the defensive intangible asset is separately identifiable. b. The identifiable assets acquired in a business combination should be measured at their acquisition-date fair values (ASC 805-20-30-1). c. A fair value measurement assumes the highest and best use of an asset by market participants. Highest and best use is determined based on the use of the asset by market participants, even if the intended use of the asset by the reporting entity is different (ASC 820-10-35-10). Importantly, highest and best use provides maximum value to market participants. The highest and best use of the asset establishes the valuation premise used to measure the fair value of the asset—in this case an in-exchange premise maximizes the value of the asset at $2 million. d. A defensive intangible asset shall be assigned a useful life that reflects the entity’s consumption of the expected benefits related to that asset. The benefit a reporting entity receives from holding a defensive intangible asset is the direct and indirect cash flows resulting from the entity preventing others from realizing any value from the intangible asset (defensively or otherwise). An entity shall determine a defensive intangible asset’s useful life, that is, the period over which an entity consumes the expected benefits of the asset, by estimating the period over which the defensive intangible asset will diminish in fair value. The period over which a defensive intangible asset diminishes in fair value is a proxy for the period over which the reporting entity expects a defensive intangible asset to contribute directly or indirectly to the future cash flows of the entity. (ASC 350-30-35A) It would be rare for a defensive intangible asset to have an indefinite life because the fair value of the defensive intangible asset will generally diminish over time as a result of a lack of market exposure or as a result of competitive or other factors. Additionally, if an acquired intangible asset meets the definition of a defensive intangible asset, it shall not be considered immediately abandoned. (ASC 350-30-35B) 2-29 Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGrawHill Education. Chapter 02 – Consolidation of Financial Information RESEARCH CASE—HERSHEY’S ACQUISITION OF AMPLIFY SNACK BRANDS (35 Minutes) 1. From Hershey’s December 18, 2017 conference call announcing the acquisition: The Amplify acquisition is “a strategic, financially compelling transaction that is an important step in our journey to becoming an innovative snacking powerhouse. This will enable us to bring scale and category management capabilities to a key subsegment of the warehouse snack aisle.” “This deal, The Hershey Company’s largest acquisition to date, is expected to create value for Hershey and Amplify’s shareholders and also for consumers, who will soon be able to find these wonderful brands available in more outlets.” “Hershey’s snack mix and meat snack products, combined with Amplify’s Skinny Pop, Tyrrells, Oatmega and Paqui and other international brands will allow us to capture more consumers snacking occasions by expanding our breadth across the snacking spectrum, especially in the warehouse snacks aisle.” …”we plan to expand Amplify’s existing SKUs into mainstream channels using Hershey’s comprehensive distribution network…” 2. Hershey accounted for its acquisition of Amplify using the acquisition method. Accordingly, Hershey recorded the acquisition at $915,457,000. 3. Hershey recognized $939,388,000 goodwill from the Amplify acquisition computed as follows (amounts below in thousands): Consideration transferred Net assets acquired: Accounts receivable Other current assets Plant, property and equipment, net Other intangible assets Other non-current assets Accounts payable Accrued liabilities Current debt Other current liabilities Non-current deferred income taxes Non-current liabilities Total fair value of identifiable net assets $915,457 $ 41,152 35,509 71,093 682,000 1,049 (32,394) (109,565) (610,836) (2,931) (93,859) (5,149) Goodwill (23,931) $939,388 2-30 Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 02 – Consolidation of Financial Information RESEARCH CASE—HERSHEY’S ACQUISITION OF AMPLIFY SNACK BRANDS continued 4. From Hershey’s 2018 10-K report: We used various valuation techniques to determine fair value, with the primary techniques being discounted cash flow analysis, relief-from-royalty, and a form of the multi-period excess earnings valuation approaches, which use significant unobservable inputs, or Level 3 inputs, as defined by the fair value hierarchy. Under these valuation approaches, we are required to make estimates and assumptions about sales, operating margins, growth rates, royalty rates and discount rates based on budgets, business plans, economic projections, anticipated future cash flows and marketplace data. 5. Acquisition-related costs totaled $20,577,000 and consisted of legal fees, consultant fee, valuation fees and other. They were recorded as part of selling, marketing, and administrative costs in Hershey’s consolidated income statement. 6. Hershey reported the Amplify acquisition, net of cash acquired, as an investing activity in its statement of cash flows. RESEARCH CASE—MICROCHIP’S ACQUISITION OF MICROSEMI (40 minutes) 1. Microsemi Corporation is the largest U.S. commercial supplier of military and aerospace semiconductor equipment. Microsemi also supplies integrated circuits and semiconductors to communications (telecom), data centers, and other industrial firms. The deal opens Microchip to the aerospace and defense markets which had accounted for only 2% of its sales in the past. Microsemi also bring high-end chip design capability to the deal. Overall the deal appears to be a response to increased growth and competitiveness in the semiconductor chip market. According to its 3/31/19 10-K, Microchip’s primary reason for this acquisition was to expand the Company’s range of solutions, products and capabilities by extending its served available market. 2. The acquisition was accounted for under the acquisition method of accounting, with Microchip identified as the acquirer for consideration transferred of $8.245 billion. 3. According to its 3/31/19 10-K (page F-22), Microchip included $53.9 million, which represented the pre-acquisition vested service provided by employees to Microsemi, in the total consideration transferred as part of the acquisition. According to ASC 805-30-30-11 The portion of the fair-value-based measure of the replacement award that is part of the consideration transferred in exchange for the acquiree equals the portion of the acquiree award that is attributable to pre-combination service. 2-31 Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGrawHill Education. Chapter 02 – Consolidation of Financial Information RESEARCH CASE—MICROCHIP’S ACQUISITION OF MICROSEMI – continued (amounts in millions as adjusted) 4. Consideration transferred Cash and cash equivalents Accounts receivable Inventories Other current assets Property, plant and equipment Purchased intangible assets Long-term deferred tax assets Other assets Accounts payable Other current liabilities Long-term debt Deferred tax liabilities Long-term income tax payable Other long-term liabilities Total identifiable net asset acquired Goodwill acquired $8,244.5 $ 340.0 215.6 576.2 85.2 201.5 5,634.5 5.9 53.3 (233.8) (149.3) (2,056.9) (565.1) (177.7) (49.8) $3,879.6 $4,364.9 5. $4.569 billion of core and developed technology will be expensed over an amortization period of 15 years. In-process research and development assets recognized in the acquisition will be capitalized until they reach technological feasibility, at which point they will be reclassified as core and developed technology and begin amortization over its useful life. Abandoned in-process research and development will be written off to expense. 2-32 Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 02 – Consolidation of Financial Information RESEARCH CASE—KROGER’S ACQUISITION OF HOME CHEF (40 minutes) 1. Home Chef is the largest meal kit company in the US with annual sales exceeding $250 million. Kroger will begin stocking the Home Chef meal kits in its 2,800 nationwide store and expects to generate revenues beyond the amounts Home Chef could generate by itself. The deal is also a response to the increase competition in the expanding meal kit market from Blue Apron, Walmart, HelloFresh, and Amazon/Whole Foods. Kroger also acquires Home Chef’s on-line technology and preparation and distribution systems. 2. Allocation of consideration transferred to fair values of assets and liabilities of Home Chef: (amounts in millions) Cash paid Fair value of contingent consideration* Consideration transferred Fair values of Home Chef net assets acquired: Total current assets (includes $30 cash acquired) Property, plant and equipment Other assets Identifiable intangibles Total current liabilities Other long-term liabilities* Total identifiable net asset acquired Goodwill $227 91 $318 $ 36 6 1 143 (28) (3) $155 $163 * Kroger’s 11/10/18 10-Q page 10 allocation schedule includes the $91 million of contingent consideration among the liabilities assumed in the acquisition. The above schedule shows the $91 million as part of the consideration transferred and removes the $91 million from the other long-term liabilities. Thus, the above schedule includes only the identifiable asset and liability fair values of Home Chef acquired by Kroger. 3. According to Kroger’s 11/10/18 10-Q (page 9), there are “future earnout payments of up to $500 over five years that are contingent on achieving certain milestones. The contingent consideration is based on future performance of both the online and offline business and the related customer engagement. The fair value of the earnout liability in the amount of $91 recognized on the acquisition date was measured using unobservable (Level 3) inputs and is included in “Other long-term liabilities” within the Consolidated Balance Sheets” 2-33 Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGrawHill Education.