Advanced Accounting, 13E by Floyd A Beams Solution Manuals by Ace Test Banks

Advanced Accounting, 13E

By Floyd A. Beams

Email: Richard@qwconsultancy.com

Chapter 1 BUSINESS COMBINATIONS Learning Objectives 1.1 Understand the economic motivations underlying business combinations. 1.2 Learn about alternative forms of business combinations, from both the legal and accounting perspectives. 1.3 Introduce accounting concepts for business combinations, emphasizing the acquisition method. 1.4 See how firms record fair values of assets and liabilities in an acquisition. 1.5 Appendix: Review accounting concepts for a pooling of interests.

Chapter Outline A BUSINESS COMBINATION IS THE UNION OF PREVIOUSLY SEPARATE BUSINESS ENTITIES. A

Horizontal integration is the combination of firms in the same business lines and markets.

Vertical integration is the combination of firms in the same business, but with operations in different, successive, stages of production and/or distribution.

Conglomeration is the combination of firms with unrelated and diverse products and/or service functions.

Reasons for business combinations: (Learning Objective 1.1) 1 2 3 4 5 6

Cost advantage – frequently less expensive to acquire rather than build facilities or develop R&D Lower risk - usually less risky to acquire product lines or markets rather than develop new products, particularly if the goal is diversification Fewer operating delays - facilities are already in place, which shortens the time to market Avoidance of takeovers – some businesses, especially small ones, combine to prevent takeovers Acquisition of intangible assets – acquiring patents, mineral rights, research, databases, or management expertise can be a primary factor Other reasons – combination may offer business tax advantages, such as taxloss carryforwards, or personal income and/or estate-tax advantages

ANTITRUST LAWS PROHIBIT BUSINESS COMBINATIONS THAT RESTRAIN TRADE OR IMPAIR COMPETITION. A

Proposed business combinations are reviewed by federal agencies, and sometimes approval from more than one is required. U.S. federal agencies that may review business combinations include the Department of Justice, the Federal Trade Commission, the Federal Reserve Board, the Department of Transportation, the Federal Communications Commission, and the Securities and Exchange Commission.

State agencies typically review business combinations for possible violations of state regulations. However, some states have antitrust exemption laws to protect hospitals in pursuit of cooperative projects.

Some companies argue that the decreased competition caused by mergers is offset by lower prices and better products.

LEGAL FORM OF BUSINESS COMBINATIONS (Learning Objective 1.2) A

Acquisition: 1 2

One corporation acquires the productive assets of another business entity and integrates those assets into its own operations (see B & C below); or One corporation obtains operating control over the productive facilities of another entity by acquiring a majority of its outstanding voting stock. A+B=A+B

(usually requires consolidated statements)

Merger: One corporation takes over all the operations of another business entity and that entity is dissolved (see Illustration 1-1). A+B=A

Consolidation: A new corporation is formed to take over the assets and operations of two or more separate business entities and all the combining companies are dissolved (see Illustration 1-1).

A+B=C ACCOUNTING CONCEPT OF BUSINESS COMBINATIONS .

Previously separate businesses are brought together into one entity when their business resources and operations come under control of a single management team. That control is established when: 1

One or more corporations becomes a subsidiary (i.e., when another corporation acquires a majority of its outstanding voting stock);

One company transfers its net assets to another; or

Each company transfers its net assets to a newly formed corporation.

Merger, consolidation, and acquisition are often used in a generic sense as synonyms for business combinations. The term "consolidation" also refers to the accounting process of combining a parent company’s financial statements with those of its subsidiaries.

A subsidiary is formed when another corporation acquires a majority (more than 50%) of its outstanding voting stock.

BACKGROUND ON BUSINESS COMBINATION ACCOUNTING 1

The pooling of interests method of accounting was eliminated for all transactions initiated after June 30, 2001. All subsequent combinations must use the acquisition method.

2 Prior combinations accounted for by the pooling of interests method were allowed to continue as acceptable financial reporting practice for past business combinations.

Pooling provides less relevant information to statement users, ignores economic value exchanged in the transaction, and makes subsequent performance evaluation impossible.

Problems occur because the pooling method uses historical book values to record combinations instead of fair values of net assets. GAAP prefers fair values in asset acquisitions.

Elimination of pooling makes U. S. GAAP more consistent with international accounting standards. Most major economies prohibit the use of the pooling of interests method.

ACCOUNTING FOR COMBINATIONS AS ACQUISITIONS (Learning Objective 1.3) A

All business combinations initiated after 12/15/08 follow the same GAAP used in recording the purchase of other assets and liabilities, which is the acquisition method. 1

Cost is measured by the cash disbursed, the fair value of other assets distributed, or the fair value of securities issued (fair value principle).

Direct costs of acquisition:

Direct costs of registering and issuing securities are charged against additional paid-in capital.

All other direct costs of combining (accounting, consulting, and legal fees) are expensed.

Indirect costs are also expenses, such as management salaries, depreciation, rent, or closing a duplicate facility.

Recording Fair Values in an Acquisition (Learning Objective 1.4) – steps to record an acquisition: a

Determine the fair values of all identifiable tangible and intangible assets acquired and liabilities assumed. This is often done before the combination by independent appraisers and valuation experts.

GAAP provides specific guidelines for valuing assets and liabilities.

All identifiable assets and liabilities are valued regardless of whether they are recorded on the books of the acquired company (e.g., a patent where all R&D was expensed as incurred).

Assets and liabilities that arise from contingencies should be recognized at fair value if fair value can be reasonably estimated.

Exceptions to fair value include deferred tax assets and liabilities, pensions and other benefits, and leases. These items should be accounted for pursuant to specific accounting principles governing these items.

No value is assigned to goodwill recorded on the books of the acquired company. Goodwill is an unidentifiable asset, and any goodwill will be determined by the combination itself, not historical transactions.

The acquiring company records the assets received and liabilities assumed at their fair values. a

First, fair values are assigned to all identifiable tangible and intangible assets acquired and liabilities assumed. (1) See text Exhibit 1-2 for a list of intangible assets that meet the criteria for recognition. Recognizable intangible assets must meet either a separability criterion or a contractual-legal criterion. (2) Separability means that the asset can be separated/divided from the acquiree and sold or transferred.

If cost is greater than fair value of the identifiable net assets acquired, the excess cost is assigned to goodwill.

If fair value is greater than cost, the excess fair value is recorded as an ordinary gain by the acquirer.

Contingent Consideration in an Acquisition a

Contingent consideration is an additional payment made to the previous stockholders of the acquired company contingent on future events or transactions. The contingent consideration may include the distribution of cash, other assets, or the issuance of debt or equity securities.

Contingent consideration must be measured and recorded at fair value as of the acquisition date as part of the consideration transferred in the acquisition.

If the contingent consideration is to be paid in additional shares to the acquiree, it is in the form of equity, and the Investment and Paid-inCapital accounts are increased by the fair value of the contingent consideration.

If the contingent consideration is to be paid in cash to the acquiree, the Investment and Liability accounts are increased by the fair value of the contingent consideration.

Subsequent changes in fair value of contingent consideration: If equity, then do not remeasure fair value at each reporting date until contingency is resolved. If liability, acquirer measures fair value at each reporting date until resolved.

6 .

Changes in the fair value of the contingent consideration are reported as a gain or loss in earnings, with corresponding adjustments to the liability. Cost and Fair Value Compared 5

After fair values are assigned to all identifiable assets and assumed liabilities, compare the investment cost with the total fair value of identifiable assets less liabilities.

If investment cost > net fair value, then assign the excess to identifiable net assets according to their fair value and the rest to goodwill.

If investment cost < total fair value of assets less liabilities, then the gain is a bargain purchase and is recognized as an ordinary gain by acquirer.

THE GOODWILL CONTROVERSY A

Goodwill is defined as the excess of the investment cost over the fair value of net assets received.

The theory behind goodwill is that it represents a measure of the present value of the combined company’s future excess earnings over the normal earnings of a similar business.

Goodwill is no longer amortized for financial reporting purposes. In certain cases, it can be amortized and deducted over 15 years.

Firms must periodically assess goodwill for value impairment. Impairment occurs when the recorded value of goodwill is greater than its fair value.

When impairment occurs, firms must write down goodwill to a new estimated amount and record a loss in calculating net income of a period.

The treatment of goodwill has not retroactively changed, but firms will cease amortizing all previously recorded goodwill.

Goodwill and all other intangibles that have indefinite useful lives will be periodically reviewed (at least annually) and adjusted for value impairment but no longer amortized.

GAAP also defines the reporting entity in accounting for intangible assets. 1 Firms will treat goodwill and other intangible assets as assets of the business reporting unit. 2 These intangible assets will be reported based on their fair value at acquisition date.

Costs for internally developing, maintaining, or restoring intangible assets that are not specifically identifiable, have indeterminate lives or are inherent in a continuing business and relate to the entity as a whole, are expensed as incurred.

Recognizing and measuring impairment losses related to goodwill is a two-step process. 1 The first step compares carrying (book) values to fair values at the business reporting unit level. If fair value is less than book value, impairment has occurred.

The second step measures the impairment. The carrying value of goodwill is compared to its implied fair value. The excess book value over implied fair value is the impairment loss. The loss cannot exceed the book value of the goodwill. Previously recognized impairment losses cannot be reversed.

The impairment test is conducted at least annually, and more frequently if certain conditions warrant.

Amortization versus non-amortization 1

Amortization is required for intangible assets with a definite useful life.

The method of amortization should reflect the expected pattern of consumption of the economic benefits of the intangible asset.

If a pattern is not determinable, straight-line amortization is acceptable.

Firms will not amortize intangibles with an indefinite life that cannot be estimated. Like goodwill, these assets should be periodically evaluated for possible impairments.

DISCLOSURE REQUIREMENTS A

Financial statement disclosures for a business combination should include the following: 1 The name and a brief description of the acquired company, acquisition date, the portion of voting stock acquired, reason for the acquisition, and the manner in which acquirer obtained control; 2 Information about goodwill or a gain from a bargain purchase; 3 Nature, terms, and fair value of consideration transferred; 4 Details about assets acquired, liabilities assumed, and any noncontrolling interests;

5 Reduction in acquirer’s pre-existing deferred tax asset valuation allowance due to the business combination; 6 Information about transactions with the acquiree accounted for separately from the business combination; 7 Details about step acquisitions; 8 In the case of a public company acquirer, pro-forma information. B

In addition, GAAP requires the following: 1 Material aggregate amounts of goodwill must be reported as a separate balance sheet item. 2

Goodwill impairment losses must be shown separately on the income statement as a component of income from continuing operations.

GAAP also provides increased disclosure requirements for intangibles (see text Exhibit 1-3).

SARBANES-OXLEY ACT OF 2002 A

After the high-profile collapses of WorldCom, Enron, and other companies, Congress enacted the Sarbanes-Oxley Act of 2002 (SOX) to prevent future financial reporting and auditing abuses.

The rules focus primarily on corporate governance, auditing, and internal control issues.

SOX has far-reaching implications:

Establishing the independent Public Company Accounting Oversight Board (PCAOB) to regulate the accounting and auditing professions

Requiring greater independence of auditors to their audit clients, including restrictions on consulting and advisory services

Requiring greater independence and oversight responsibilities for corporate boards of directors

Requiring the CEO and CFO to certify an entity’s financial statements and internal controls

Requiring independent auditors to review and attest to management’s internal control assessments

Increasing disclosures relating to off-balance sheet arrangements and contractual obligations

Increasing the types of items that require disclosure on Form 8-K and shortening the filing period

Text Exhibit 1-5 provides an example of management’s responsibility for financial results and report on internal control.

APPENDIX: POOLING OF INTERESTS ACCOUNTING (Learning Objective 1.5) A B C

Pooling of interests accounting for business combinations is a thing of the past under U.S. GAAP (ASC 805). No new pooling combinations may be recorded after 2001. Earlier pooling combinations have been grandfathered in. There are five conditions for pooling: 1

3 4 5

The pooling of interests concept was based on the assumption that it was possible to unite ownership interests through the exchange of equity securities without an acquisition of one company combining with another. This method was limited to those business combinations in which the combining entities exchanged equity securities and the ownership interests continued in the new accounting entity. None of the combining companies changed the equity interest of the voting common stock within two years before initiation of the combination. Combining companies reacquired shares of voting common stock only for purposes other than business combination. Proportionate interest of each individual common stockholder is required to remain the same as a result of the exchange of stock to affect the combination.

Description of assignment material

Minutes

Questions (5) Exercises (5) El-1 4 MC general El-2 AICPA 2 MC problem-type El-3 Prepare stockholders’ equity section El-4 Journal entries to record an acquisition El-5 Journal entries to record an acquisition with direct costs and fair value/book value differences EI-6* Journal entries to record business combinations EI-7* Journal entries to record a pooling Problems (5) Pl-1 Prepare balance sheet after acquisition Pl-2 Prepare balance sheet after an acquisition Pl-3 Journal entries and balance sheet for an acquisition Pl-4 Allocation schedule and balance sheet Pl-5 Journal entries and balance sheet for an acquisition Pl-6* Prepare balance sheets of pooled companies P1-7* Journal entries to record pooling business combinations P1-8* Journal entries and balance sheet for a pooling of interests

5 10 15 20 15 20 20

20 20 20 30 35 35 35 45

PROFESSIONAL RESEARCH ASSIGNMENTS Answer the following questions by reference to the FASB Codification of Accounting Standards. Include the appropriate reference in your response. PR 1-1 What are the required disclosures related to goodwill included in the consolidated balance sheet? PR 1-2 Does current GAAP provide any exceptions to the fair-value measurement principle for business combinations?

Illustration 1-1

DIAGRAM OF BASIC TYPES OF BUSINESS COMBINATIONS MERGER

Company A (Surviving Entity)

Net Assets of B

Company B (Dissolved Entity)

Company A may acquire the net assets of Company B by issuing debt or equity securities or assets directly to Company B for B's net assets or to B's stockholders for all of B's outstanding stock. In either case, Company B is dissolved, and Company A takes over the net assets of Company B. A+B=A CONSOLIDATION Net Assets of B

Company B (Dissolved Entity)

Company A (New Entity) Net Assets of C

Company C (Dissolved Entity)

Company A may acquire the net assets of Company B and Company C by issuing stock directly to Companies B and C for their net assets or to the stockholders of Companies B and C for all of their stock. In either case, Companies B and C are dissolved, and Company A takes over their assets. A+B=C ACQUISITION OF NET ASSETS WITHOUT DISSOLUTION .

Company A (Acquiring Entity)

All or a major portion of B's operating assets Company B

Same as for a merger or consolidation except that Company A issues debt or equity securities or assets directly to Company B, and Company B continues to exist as a separate legal entity.

ACQUISITION OF OUTSTANDING STOCK

(Parent-subsidiary operations and consolidated financial statements)

Over 50% of Stock of B

Company A (Parent)

Company B (Subsidiary)

Similar to a merger or consolidation except that Company A receives a majority of the outstanding voting stock of Company B by issuing debt or equity securities or assets to the stockholders of Company B. Company B continues to exist as a separate legal entity and to operate in a parentsubsidiary relationship with Company A. A+B=A+B

Chapter 2 STOCK INVESTMENTS - INVESTOR ACCOUNTING AND REPORTING Learning Objectives 2.1 Recognize investors’ varying levels of influence or control, based on the level of stock ownership. 2.2 Understand how accounting adjusts to reflect the economics underlying varying levels of investor influence. 2.3 Identify factors beyond stock ownership that affect an investor’s ability to exert influence or control over an investee. 2.4 Apply the fair value/cost and equity methods of accounting for stock investments. 2.5 Apply the equity method to stock investments. 2.6 Learn how to test goodwill for impairment.

Chapter Outline ACCOUNTING FOR STOCK INVESTMENTS – ALL STOCK INVESTMENTS MUST BE RECORDED AT THE INVESTOR’S COST (FAIR VALUE AT ACQUISITION). (Learning Objectives 2.1 and 2.2) A

There are two basic methods of accounting for common stock investments: the fair value (cost) method and the equity method. GAAP PRESCRIBED METHODS 1 Fair value (cost) method for up to 20% ownership 2 Equity method for 20% to 50% ownership 3 GAAP presumes 20% or more of ownership demonstrates the company has an ability to exercise significant influence over an investee. 4 In both methods, there are exceptions to the ownership percentage test, depending on whether or not the company has significant influence over the investee.

In the absence of evidence to the contrary, an investment of 20% or more is presumed to give the investor an ability to exercise significant influence. The equity method requires that the investment be recorded at cost and the investment account adjusted for earnings, losses, and dividends each subsequent period. 1

The equity method should not be used if the ability to exercise significant influence is temporary or if the investee is a foreign company operating under severe exchange restrictions or controls.

GAAP provides indicators of the inability to exercise significant influence: 13

(Learning Objective 2.3) a

Opposition by the investee that challenges the investor’s influence

Surrender of significant stockholder rights by agreement between investor and investee

Concentration of majority ownership

Inadequate or untimely information to apply the equity method

Failure to obtain representation on the investee’s board of directors

ACCOUNTING FOR NONCURRENT COMMON STOCK INVESTMENTS UNDER THE FAIR VALUE/COST METHOD: A

The fair value/cost method is used for common stock investments of less than 20% unless it can be demonstrated that the investor company has the ability to exercise significant influence over the investee company.

GAAP classifies equity securities that have a readily determinable market value as either trading securities or available-for-sale securities.

Investment is initially recorded at cost.

The investment is adjusted to fair value at the end of the fiscal period.

Unrealized gains or losses are reported either in income or as an equity adjustment to the balance sheet (other comprehensive income), depending on the company’s intention for holding the stock.

Unrealized gains and losses associated with ‘trading’ securities are recorded as part of income. Trading securities are very short-term holdings; continued relationships are not expected.

Unrealized gains and losses associated with available-for-sale securities are considered “other comprehensive income” and are reported either on the income statement, a separate statement of comprehensive income, or a statement of changes in equity. Only dividend income and realized gains and losses impact income and EPS for available-for-sale securities.

Procedures for the fair value/cost method (Learning Objective 2.4) 14

Investment is initially recorded at cost.

Dividends received are recorded as dividend income. a

An exception: Liquidating dividends are deducted from the investment account. Liquidating dividends are those dividends received in excess of the investor’s share of earnings after the stock is acquired and are considered a return of capital.

ACCOUNTING FOR NONCURRENT COMMON STOCK INVESTMENTS UNDER THE EQUITY METHOD: (Learning Objective 2.5) A Application of the equity method 1

The investment is initially recorded at cost.

Subsequently, the investor records its share of the investee’s income as an increase to the investment account (losses will decrease the investment account).

Dividends received from the investee are recorded as a decrease to the investment account. a

The investment account moves in the same direction as the investee’s net assets (for example, income increases assets for both).

Additional adjustments are required. a

Intercompany profits and losses are eliminated until realized.

Cost-book value differentials are accounted for as if the investee were a consolidated subsidiary. (1) The difference between the investment cost and the underlying equity is assigned to identifiable assets and liabilities based on their fair values with any remaining difference allocated to goodwill. (2) The difference between investment cost and book value acquired will disappear over the remaining lives of identifiable assets and liabilities, except for amounts assigned to land, goodwill, and intangible assets having an indeterminate life, which are not amortized.

(3) If the book value acquired is greater than the investment cost, the difference should be allocated against non-current assets other than marketable securities with any remaining amount treated as an extraordinary gain (negative goodwill). c

The investment is reported on one line of the investor’s balance sheet and income on one line of the investor’s income statement, a one-line consolidation. (1) Except extraordinary and other below-the-line items

Accounting for an interim investment 1

Absent evidence to the contrary, income of the investee is assumed to be earned proportionately throughout the year.

The investee’s book value at an interim date is determined by adding income earned from the last statement date to beginning stockholders’ equity and deducting dividends declared to the date of purchase.

Investment in a step-by-step acquisition 1

An investor may acquire significant influence through a series of purchases.

Prior to obtaining significant influence, the fair value/cost method is used. When an investment qualifies for the equity method, the investment account is adjusted to the equity method, and the investor’s retained earnings are adjusted retroactively. a

Sale of an equity interest 1

This is a change in reporting entity, and it requires retroactive restatement if the effect is material.

When an investor reduces its equity interest in an investee to below 20%, the retained investment is accounted for under the fair value/cost method. a

Gain or loss from the equity interest sold is the difference between the selling price and the book value of the equity interest immediately before the sale.

Immediately after the sale, the balance of the investment account becomes the new cost basis.

If the stock is purchased directly from the investee (rather than its shareholders), the investor’s interest is determined by dividing shares acquired by shares outstanding 16

immediately after the issuance of the additional shares. G

Investee corporation with preferred stock 1

Special adjustments are necessary when investees have both common and preferred stock outstanding.

The investee’s stockholders’ equity must be allocated into its common and preferred stock components to determine the book value of the common stock investment.

The investee’s net income must also be allocated into common and preferred stock components.

Call or liquidating premiums and dividends in arrears must also be considered in determining the investor’s share of earnings.

The one-line consolidation does not apply when the investee’s income includes discontinued operations. Investment income must be separated into ordinary and discontinued operations components.

DISCLOSURES FOR EQUITY INVESTEES A

Material investments accounted for by the equity method require disclosure of the following: 1

The investee’s name and percent of ownership in common stock, the investor’s accounting policies with respect to investments in common stock, the cost/book value differentials and accounting treatment

The aggregate value of each identified investment for which quoted market prices are available

Summarized information about the investee’s assets, liabilities, and results of operations

Related-party transactions 1

Related-party transactions arise when one of the transacting parties has the ability to significantly influence the operations of the other.

There is no presumption of arms-length bargaining between the related parties.

Required disclosures include the nature of the relationship, a description of the transaction, the dollar amount of the transaction (and any change in the method used to establish the terms of the transaction), and amounts due to or due from related parties at the balance sheet date for each balance sheet presented.

TESTING GOODWILL FOR IMPAIRMENT (Learning Objective 2.6) A

GAAP eliminates former requirements to amortize goodwill, but goodwill must be periodically tested for impairment. 1

Firms may find this valuable for two reasons. a

Firms may recognize significant impairment losses on initial adoption which are treated as a “cumulative effect of an accounting change” (appears after “income from operations”).

Firms will no longer report annual goodwill expense charges.

Recognizing and measuring impairment losses is a two-step process. 1

First, carrying values and fair values of net assets are compared at the businessreporting-unit level. a

If fair value is greater than carrying value, goodwill is deemed unimpaired, and no further action is necessary.

If carrying value is greater than fair value, the firm proceeds to step 2.

Step 2, when necessary, requires a comparison of the carrying value of goodwill with its implied fair value.

The implied fair value of goodwill is determined in the same manner used to originally record the goodwill at the business combination date. a

The fair value of the reporting unit is the amount for which it could be purchased or sold in a current, arm’s-length transaction. a

Allocate the fair value of the reporting unit to all identifiable assets and liabilities as if they had made the purchase on the measurement date. Any excess is the implied fair value of goodwill.

Current market prices (in an active market) are considered the most reliable indicator of fair value.

Goodwill impairment testing must be conducted at least annually. 1

More frequent testing may be required if certain events occur such as adverse changes in the legal or business climate, new and unanticipated competition, loss of key personnel, and other similar events.

Reporting and disclosures 1

Material aggregate amounts of goodwill must be reported as a separate line item on the balance sheet.

Goodwill impairment losses are shown separately in the income statement.

Equity method investments 1

Many of the rules regarding goodwill impairment apply only to goodwill arising from business combinations (parent acquiring a controlling interest in a sub). Impairment testing also applies to goodwill arising from use of the equity method.

One notable exception is the rule regarding goodwill impairments; impairment tests are performed based on fair value versus book value of the investment taken as a whole.

Description of assignment material

Minutes

Questions (14) Exercises (16) E2-1 5 MC general E2-2 AICPA 8 MC general and problem-type E2-3 [Son/Pop] Calculate percentage ownership and goodwill on investment acquired directly from investee E2-4 [Pam/Sun] Calculate income for midyear investment E2-5 [Pop/Son] Calculate income and investment balance allocation of excess to undervalued assets .

10 35 12 15 15

E2-6 E2-7 E2-8 E2-9 E2-10 E2-11 E2-12 E2-13 E2-14 E2-15 E2-16

[Pam/Sun] Journal entry to record income from investee with loss from discontinued operations 4 MC problem-type [Pam/Sun] Calculate investment balance four years after acquisition [Son/Pop] Calculate income and investment balance when investee capital structure includes preferred stock [Pam/Sun] Calculate income and investment balance for midyear investment [Pop/Sun] Adjust investment account and determine income when additional investment qualifies for equity method of accounting [Sun/Pam] Journal entries (investment in previously unissued stock) [Pop/Sun] Prepare journal entries and income statement, and determine investment account balance [Pam/Sun] Calculate income and investment account balance (investee has preferred stock) [Pop/Sun] Goodwill impairment [Pam/Alpha/Beta] Goodwill impairment

Problems (12) P2-1 [Pop/Sun] Computations for a midyear purchase (investee has a discontinued operations gain) P2-2 [Pam/Sun] Journal entries for midyear investment (cost and equity methods) P2-3 [Pop/Sun] Computations for investee when excess allocated to inventories, building, and goodwill P2-4 [Pam/Sun] Journal entries for midyear investment (excess allocated to land, equipment, and goodwill) P2-5 [Pop/Sun] Prepare an allocation schedule; compute income and the investment balance P2-6 [Pam/Son] Computations for a midyear acquisition P2-7 [Pop/Son] Partial income statement with a discontinued operations P2-8 [Sun/Pam] Computations and journal entries with excess of book value over fair value Description of assignment material (cont’d) P2-9 P2-10 P2-11 P2-12

[Pop/Sun] Prepare allocation schedules under different stock price assumptions (bargain purchase) [Pam/Sun] Computations for a piecemeal acquisition [Pam/Sun] Computations and a correcting entry (errors) [Pop/Sun] Allocation schedule and computations (excess cost over fair value)

PROFESSIONAL RESEARCH ASSIGNMENTS

10 20 15 20 15 25 15 20 20 10 10

25 20 20 20 15 20 10 25 Minutes

20 25 25 25

Answer the following questions by reference to the FASB Codification of Accounting Standards. Include the appropriate reference in your response. PR 2-1 The equity method of accounting is often referred to as a one-line consolidation. Since the net impact on the balance sheet and income statement is the same under both consolidation and the equity method, is it acceptable to report a noncontrolling investment using the simpler equity method? PR 2-2 A firm sells a part of its investment interest, reducing its holding from 30% to 10%. The firm decides, correctly, that the equity method is no longer appropriate. What is the basis for the investment in applying the new accounting method?

Chapter 3 AN INTRODUCTION TO CONSOLIDATED FINANCIAL STATEMENTS Learning Objectives 3.1 Recognize the benefits and limitations of consolidated financial statements. 3.2 Understand the requirements for including a subsidiary in consolidated financial statements. 3.3 Apply consolidation concepts to parent company recording of an investment in a subsidiary company at the date of acquisition. 3.4 Record the fair value of a subsidiary at the date of acquisition 3.5 Learn the concept of noncontrolling interest when a parent company acquires less than 100 percent of a subsidiary’s outstanding common stock. 3.6 Prepare consolidated balance sheets subsequent to the acquisition date, including preparation of eliminating entries. 3.7 Amortize the excess of the fair value over the book value in periods subsequent to the acquisition. 3.8 Apply the concepts underlying preparation of a consolidated income statement. 3.9 Introduce the concept of push-down accounting. 3.10 For the Students: Create an electronic spreadsheet to prepare a consolidated balance sheet. Chapter Outline A BUSINESS COMBINATION UNDER GAAP INCLUDES COMBINATIONS IN WHICH ONE OR MORE COMPANIES BECOME SUBSIDIARIES OF A PARENT CORPORATION. (Learning Objectives 3.1 and 3.2) A A corporation that holds a majority interest (over 50%) of the voting stock of another corporation is referred to as the parent company. B

The interest not held by the parent company is referred to as the noncontrolling interest.

A corporation whose outstanding voting stock is over 50% owned by another corporation is a subsidiary of that corporation.

GAAP states that the acquisition of additional shares of a subsidiary is recorded by an increase in the investment account and a reduction of the noncontrolling interest, based on the carrying amount of the noncontrolling interest at the additional acquisition date. APIC is adjusted for any difference between the price and the carrying amount.

The parent company and subsidiary exist as separate legal entities and maintain separate accounting records. However, each reporting period their separate accounting records are combined into one set of consolidated financial statements for reporting the financial position and results of operations of a consolidated reporting entity.

Consolidated financial statements are prepared for all the companies under the control of a single management team to reflect a single reporting entity with multiple divisions.

The purpose of consolidated financial statements is to present fairly, primarily for the benefit of the owners and creditors of the parent company, the results of operations and the financial position of a parent and all its subsidiaries as if the consolidated group were a single entity.

The subsidiary will continue to report the results of its separate operations to its noncontrolling stockholders.

The consolidated entity (the reporting entity) has no transactions and it does not maintain a ledger. The financial statements of the separate legal entities are combined only for external reporting purposes.

CONSOLIDATION POLICY A

Under current GAAP, consolidation is required for all corporations that are over 50% owned except in some situations: 1

Where control does not rest with the majority ownership

Formation of joint ventures

The acquisition of an asset or group of assets that does not constitute a business

A combination of entities under common control

A combination between not-for-profit entities or the acquisition of a for-profit business by a not-for-profit entity

DISCLOSURE OF CONSOLIDATION POLICIES A

Disclosures are required for the following: 1

The reporting period that includes a business combination

2 3

A business combination that occurs after the reporting period but before the financial statements are issued Provisional amounts related to business combinations

Adjustments related to business combinations 23

PARENT AND SUBSIDIARY WITH DIFFERENT FISCAL PERIODS A

Consolidated statements are prepared for and as of the end of the parent company’s fiscal period.

CONSOLIDATED FINANCIAL STATEMENTS A

A set of consolidated financial statements includes a consolidated balance sheet, a consolidated income statement and retained earnings statement, and a consolidated statement of cash flows.

The consolidated balance sheet, income statement, and retained earnings statement are prepared by combining the separate financial statements of the parent company and the subsidiary.

The consolidated cash flow statement, however, is prepared from the consolidated financial statements for two consecutive years.

THE CONSOLIDATED BALANCE SHEET (Learning Objective 3.3) A

The investment in a subsidiary account on the parent company balance sheet and the stockholders’ equity accounts on the subsidiary’s balance sheet are reciprocal, both representing the net assets of the subsidiary. 1

The reciprocal investment in a subsidiary on the parent’s balance sheet and subsidiary stockholders’ equity accounts are eliminated in consolidation (and are replaced by the individual assets and liabilities of the subsidiary). a

A one-line consolidation (the investment account) as discussed in Chapter 2 is replaced by details about individual assets and liabilities controlled by a single management group.

Non-reciprocal accounts are combined.

Reciprocal accounts are often eliminated.

The capital stock and retained earnings amounts that appear in the consolidated balance sheet are those of the parent company.

Unimpared cost-book value differentials are added to (or subtracted from) the asset and liability accounts that will appear in the consolidated balance sheet. Goodwill from the

investment, which does not appear in the separate company statements, is added to the asset listing. D

Intercompany balances are eliminated.

One-hundred percent of the assets and liabilities of the parent company and subsidiary are shown in the consolidated balance sheet, and any noncontrolling interest in the subsidiary’s net assets is reported separately in the liability or the stockholders’ equity section. (Learning Objectives 3.4 and 3.5) 1

Noncontrolling interest is computed as the noncontrolling interest ownership percentage multiplied by the subsidiary equity at the balance sheet date.

Classification of noncontrolling interest: a

GAAP requires that noncontrolling interest appear as a separate component of stockholders’ equity.

Income attributable to the noncontrolling interest is deducted from consolidated net income.

ASSIGNING EXCESS TO IDENTIFIABLE NET ASSETS AND GOODWILL (Learning Objectives 3.6 and 3.7) A

Before the balance sheets of the parent and subsidiary can be combined, differences between the book values and fair values must be assigned to over-valued or undervalued identifiable assets.

Fair value/book value differentials are not recorded on the books of the parent company or its subsidiary, so they must be entered in the working papers to adjust the subsidiary’s book values to the new cost basis for consolidated statement purposes. 1

The amounts assigned to identifiable assets and liabilities are for the fair value and book value difference because the price paid by the parent company/investor, which implies an investment price for 100% of the investment. The noncontrolling interest's share of the subsidiary’s assets and liabilities are adjusted based on the price paid by the parent for the percentage owned by the parent. The asset and liability amounts that appear in the consolidated balance sheet are determined by combining the separate parent company and subsidiary financial statement amounts (book value) with the debit and credit amounts entered in the adjustment and elimination columns. 25

If several asset and liability accounts are affected by cost-book value differentials, the use of an “unamortized excess” account simplifies the process of entering the cost-book value differentials in the working papers. The unamortized excess account does not affect the consolidated financial statements because it has equal debit and credit entries in the adjustment and elimination columns.

CONSOLIDATED INCOME STATEMENT (Learning Objective 3.8) A

Under GAAP, consolidated net income is the net income of the consolidated group. The consolidated income statement must clearly separate income attributable to the controlling and noncontrolling interests.

Under the equity method, the parent company’s income statement shows revenues and expenses of the parent company and investment income from the subsidiary.

In contrast, the consolidated income statement shows the total revenues and expenses of the parent company and subsidiary (adjusted for amortization of the fair value/book value differentials) and an allocation as noted above.

The objective of a consolidated income statement is to show the income of a parent company and its subsidiaries as if there were a single entity.

PUSH-DOWN ACCOUNTING (Learning Objective 3.9) A

Push-down accounting is the process of recording the effects of the purchase price assignment directly on the books of the subsidiary.

Push-down accounting affects the subsidiary’s separate books and financial statements, but it does not alter consolidated financial statement amounts. 1

Cost-book value differentials are recorded on the books of the subsidiary (i.e., pushed down to the subsidiary’s accounts). At the acquisition date, the following occurs: a The parent company records its investment as usual. b

The subsidiary makes an entry on its own books to record the new asset bases, including goodwill, and reclassifies retained earnings to pushdown capital.

The balance sheets of the parent company and subsidiary are consolidated by eliminating the investment in subsidiary account against the subsidiary’s capital stock and push-down capital.

The SEC requires push-down accounting for SEC filings when a subsidiary is substantially wholly owned (90%) and has no public debt or preferred stock outstanding.

PREPARING A CONSOLIDATED BALANCE SHEET WORKSHET (Learning Objective 3.10) A B C

First two columns are record balance sheet information for a parent company and a 90 percent-owned subsidiary company. Next two columns record debit and credit consolidation adjustments and eliminations. Final column provides calculations of the correct consolidated balance sheet totals.

Description of assignment material

Minutes

Questions (18) Exercises (10) E3-1 5 MC general questions E3-2 7 MC general questions E3-3 AICPA 3 MC problem-type questions E3-4 [Pop/Son] Correction of consolidated net income E3-5 [Pam/Sun] Disclosure of consolidated dividends E3-6 [Pop/Son] Prepare journal entries and balance sheet under pushdown accounting E3-7 [Pam/Sun] Prepare consolidated income statements with and without fairvalue/book value differentials E3-8 [Pop/Son] Calculate consolidated balance sheet amounts with goodwill and noncontrolling interest E3-9 [Pam/Sun] Prepare stockholders’ equity section of consolidated balance sheet one year after acquisition Description of assignment material (cont'd) E3-10

20 15 18

Minutes

[Pop/Son] Prepare consolidated income statement three years after acquisition

Problems (12) P3-1 [Pam/Sun] Prepare a consolidated balance sheet at acquisition and compute consolidated net income one year later P3-2 [Pop/Son] Allocation schedule for fair value/book value differential and consolidated balance sheet at acquisition .

12 15 30 15 10 20

22 25

P3-3 P3-4 P3-5 P3-6 P3-7 P3-8

P3-9 P3-10 P3-11 P3-12

[Pam/Sun] Prepare assignment schedule with book value greater than fair value [Pam/Sun] Given separate and consolidated balance sheets, reconstruct the schedule to allocate the fair value/book value differential [Pop/Son] Prepare a consolidated balance sheet one year after acquisition [Pam/Sun] Consolidated balance sheet workpapers with goodwill and dividends [Pop/Son] Calculate items that may appear in consolidated financial statements two years after acquisition Based on AICPA [Pop/Son/Sam] Prepare journal entries to account for investments, and compute noncontrolling interest, consolidated retained earnings, and investment balances [Pam/Sun] Consolidated balance sheet workpapers (excess allocated to equipment and goodwill) [Pam/Sun] Calculate investment cost and account balances from a consolidated balance sheet five years after acquisition [Pop/Son] Consolidated balance sheet workpapers (fair value/book value differentials and noncontrolling interest) [Pam/Sun] Calculate separate company and consolidated statement items given investment account for three years

PROFESSIONAL RESEARCH ASSIGNMENTS Answer the following questions by reference to the FASB Codification of Accounting Standards. Include the appropriate reference in your response. PR 3-1 Throughout this chapter we typically indicate that acquisitions take place on January 2. At what date should a business combination be recorded? PR 3-2 What disclosures are required for a parent company with a less than wholly owned subsidiary?

20 15 20 20 30 30

30 25 30 30

Chapter 4 CONSOLIDATION TECHNIQUES AND PROCEDURES Learning Objectives 4.1 Prepare a consolidation workpaper for the year of acquisition when the parent uses the complete equity method to account for its investment in a subsidiary. 4.2 Prepare a consolidation workpaper for the years subsequent to an acquisition. 4.3 Locate errors in a consolidation workpaper. 4.4 Record fair values of identifiable net assets acquired. 4.5 Prepare a consolidated statement of cash flows. 4.6 For the Students: Create an electronic spreadsheet to prepare a consolidation workpaper. 4.7 Appendix A: Understand the alternative trial balance workpaper format. 4.8 Appendix B: Prepare a consolidation workpaper when parent company uses either the cost method or incomplete equity method. Chapter Outline CONSOLIDATION WORKPAPERS A

Consolidation workpapers are a tool used to assemble and organize the information required to prepare consolidated financial statements.

All data presented in the consolidated financial statements can be determined independently from the working papers.

Workpaper entries do not affect the general ledger accounts of either the parent company or its subsidiaries.

CONSOLIDATED FINANCIAL STATEMENTS (Learning Objectives 4.1, 4.2, and 4.4) A

Subsequent to acquisition, a consolidated income statement, balance sheet, retained earnings statement, and statement of cash flows must be prepared.

Steps in the process include the following: (more detail below) 1 Determine the method the parent is using to account for its investment (cost or equity method) 2 Set up the worksheet (financial statement, trial balance, or other approach): a 1st column is parent information b 2nd column is subsidiary information

c Middle columns include adjustment and elimination entries d Final column is for the consolidated information 3

Prepare elimination/adjustment entries and post to worksheet: a Intercompany profits and losses and subsidiary income and dividends b Noncontrolling share of subsidiary income and dividends c Elimination of reciprocal accounts d Allocation and elimination of fair value differentials

Calculate noncontrolling interest in net income and allocate/record

Complete worksheet

Prepare statements

WORKPAPER TECHNIQUES – additional notes A

The financial statements of the parent company and subsidiary appear in the first two columns of the working papers, followed by debit and credit columns for the adjusting and eliminating entries. The final column shows the consolidated financial statements.

Some accounts are adjusted or eliminated, and other accounts are added before the separate financial statement columns are combined into consolidated amounts.

Only account balances may be adjusted or eliminated.

Parent company and subsidiary net income (income statement) and ending retained earnings (retained earnings statement) balances are not accounts and are not subject to adjustment or elimination. 1

Consolidated net income consists of consolidated revenues less consolidated expenses.

Consolidated retained earnings consist of beginning consolidated retained earnings plus consolidated net income less parent company dividends.

E All nominal accounts are assumed to be open and to permit adjustment. CONSOLIDATION WORKPAPER PROCEDURE – additional notes

Determine the parent company’s method of accounting for its subsidiary.

Copy the separate company financial statements of the parent and subsidiary in the first two columns of the workpapers.

Enter consolidation workpaper entries in the adjustments and eliminations columns in the following sequence: 1

Adjust for errors or omissions in the separate company financial statements.

Eliminate intercompany profits and losses.

Eliminate income and dividends from the subsidiary and adjust the Investment in Subsidiary account to its beginning-of-the-period balance.

Make an adjustment to record the noncontrolling interest in subsidiary’s earnings (noncontrolling interest expense) and dividends.

Eliminate reciprocal investment in subsidiary and subsidiary equity balances, enter beginning of the period noncontrolling interest, and enter unamortized cost-book value differentials.

Amortize cost-book value differentials.

Eliminate other reciprocal balances (intercompany receivables and payables, for example).

Add the separate company accounts plus or minus any related amounts from the adjustments and eliminations column and enter the sum in the consolidated statement column.

Calculate consolidated net income as consolidated revenues less consolidated expenses and less noncontrolling interest expense and carry consolidated net income to the consolidated retained earnings statement.

Calculate consolidated retained earnings and carry that amount to the consolidated balance sheet.

Calculate the consolidated balance sheet total assets and total liabilities.

LOCATING ERRORS (Learning Objective 4.3)

Most errors made in consolidating financial statements will show up when the consolidated balance sheet does not balance. If this happens, check individual items to make sure that they have been included.

Recheck the debits and credits in the workpaper entries by totaling the adjustment and elimination columns.

EXCESS ASSIGNED TO IDENTIFIABLE ASSETS (Learning Objective 4.4) A

GAAP requires firms to provide a minimum of summary disclosures regarding the allocation of the purchased price of an acquired subsidiary, particularly for acquired goodwill and intangible assets.

In the year of acquisition, firms are required to disclose the following: 1

Fair value of the acquired enterprise

A condensed balance sheet showing major classes of assets and liabilities

Amount of R&D in process acquired

Total amounts assigned to major intangible asset categories

Goodwill is shown as a separate balance sheet line item.

Material noncontrolling interests must be disclosed on the balance sheet, and noncontrolling interests’ share of consolidated net income must also be reported.

CONSOLIDATED STATEMENT OF CASH FLOWS (Learning Objective 4.5) A

A consolidated statement of cash flows (SCF) is prepared from consolidated balance sheets and consolidated income statements using the same procedure used for the SCF for separate company entities. The consolidated SCF is not prepared by combining the separate parent and subsidiary statements.

Both the direct and indirect methods for preparing the cash flows from operating activities section of the statement are permitted. 1

The cash flows from investing activities and the cash flows from financing activities sections are the same under the direct and indirect methods.

The direct method is the preferred method under GAAP, but most companies present the statement of cash flows using the indirect method.

Items not involving cash are explained in notes or schedules to the cash flow statement.

The indirect method begins with consolidated net income (controlling share). Items not providing or using cash are adjusted to arrive at net cash flows from operations. 1

Noncontrolling interest share is an increase in the cash flow from operating activities.

Noncontrolling interest dividends decrease cash flow from financing activities.

Special attention is needed for investments accounted for using the equity method. 1

If the indirect method is used, the net amount of income less dividends received from equity investees (i.e., the change in the investment account) is deducted when computing the cash flow from the operating activities section. (If dividends received are greater than income from equity investees, the net amount is an addition to net income.) a

Use of the equity method results in the parent recording this excess of income over dividends as income. However, there is no cash flow related to the entry.

Dividends received from equity investees increase cash without affecting income because the dividends are reflected in the investment account.

The direct method begins with cash received from customers and investment income. Cash paid to suppliers, employees, and so on is offset against cash received to arrive at net cash flows from operating activities. 1

Consolidated income statement items involving cash flows are converted from the accrual to the cash basis.

Dividends received from equity investees are reported directly as cash flows from operating activities. (Since net income isn’t used to compute cash flows from operating activities, no adjustment is needed as described in “D” above.)

A schedule reconciling consolidated net income to operating cash flows is required (this is essentially the indirect method). 33

PREPARING A CONSOLIDATION WORKSHEET (Learning Objective 4.6) A

The consolidation worksheet is a three-part worksheet to prepare a consolidated income statement, retained earnings statement, and balance sheet. 1

The first part contains two columns with trial balance information for the parent company and subsidiary.

The second part contains two columns to record the debits and credits for consolidation adjustments and eliminations.

The last part contains one column with the corrected calculations of consolidated financial statement balances.

Vertically, the worksheet is also divided into three sections containing the following items: 1

Controlling share of net income

Retained earnings (ending)

Total assets and total equities

UNDERSTAND THE ALTERNATIVE TRIAL BALANCE FORMAT (Learning Objective 4.7) A

The trial balance approach brings together the adjusted trial balances for affiliated companies. Both the financial statement approach and the trial balance approach generate the same information, so the selection is based on user preference. 1

The first part contains two columns with trial balance information for the parent company and subsidiary.

The second part contains two columns to record the debits and credits for consolidation adjustments and eliminations.

The last part contains one column with the corrected calculations of consolidated financial statement balances.

Columns for the trial balance approach are as follows: 1

Account information in format of debits, credits, NCI and controlling shares of consolidated net income, and retained earnings

One column each for parent and subsidiary

Two columns for adjustments and eliminations

One column each for income statement, retained earnings, and balance sheet

ELECTRONIC SPREADSHEET (Learning Objective 4.8) A

Consolidation under an incomplete equity method (the absence of the equality of parent-company net income and the controlling share of net income, and parentcompany retained earnings and consolidated retained earnings) 1

Results from an incorrect application of the equity method or use of the cost method of subsidiary accounting

Not considered a violation of GAAP as long as the consolidated financial statements prepared for stockholders are correct

Approach to preparing consolidation working papers under an incomplete equity method – convert parent company’s accounts to the equity method as the first working paper entry

Consolidation under the cost method (subsidiary income only recognized when dividends are declared) 1

Convert to the equity approach (see above).

Use traditional workpaper entries to consolidate parent and subsidiary under the cost method. This method is easier to use for consolidations in the year of acquisition, but becomes more complicated in years after acquisition, especially if there are intercompany transactions.

Description of assignment material

Minutes

Questions (11) Exercises (7) E4-1 10 MC general questions E4-2 [Pop/Son] Consolidated statement items with equity method E4-3 [Pam/Sun] 3 general problems E4-4 [Pop/Son] Equity method E4-5 5 MC general questions on statement of cash flows E4-6 [Pam] Prepare cash flows from operating activities section E4-7 [Pop] Prepare cash flows from operating activities section E4-8 (Appendix B) Journal entries and computations Problems (19) P4-1 [Pam/Sun] Calculations five years after acquisition P4-2 [Pop/Son] Workpapers and financial statements in year of acquisition P4-3 [Pam/Sun] Workpapers in year of acquisition (goodwill and intercompany transactions) P4-4 [Pop/Sun] Consolidation workpapers from separate financial statements P4-5 [Pam/Sun] Workpapers in year of acquisition (excess recorded for inventory, building, equipment, trademarks, and goodwill) P4-6 [Pop/Son] Workpapers (determine ownership interest, year after acquisition, excess assigned to land and patents) P4-7 [Pam/Sun] Workpapers (year of acquisition, excess recorded for inventory, building equipment, and goodwill, intercompany balances) P4-8 [Pop/Son] Workpapers (excess due to undervalued land and goodwill) P4-9 [Pam/Sun] Workpapers (year of acquisition, excess recorded for inventory, equipment and patents, intercompany transactions) P4-10 [Pop/Son] Workpapers (year of acquisition, fair/book value differentials, intercompany balances) P4-11 [Pam/Sun] Balance sheet (four years after acquisition, fair value/book value differentials) P4-12 [Pop/Son] Workpapers (two years after acquisition, fair value/book differentials, adjustments) P4-13 [Pam/Sun] [Appendix A] Workpapers for two successive years (equity method misapplied in second year) P4-14 [Pam/Sun] [Appendix A] Investment account analysis and trial balance workpapers P4-15 [Pam/Sun/Ell] [Appendix A] Trial balance workpapers and financial statements in year of acquisition P4-16 [Pop] Prepare cash flows from operating activities section (direct method) P4-17 [Pam] Prepare consolidated statement of cash flows using the direct method or indirect method

10 20 15 20 15 15 15 20

35 50 50 40 50 50 45 40 40 50 35 50 50 50 80 20 30

Description of assignment material (cont’d) P4-18 P4-19 P4-20

Minutes

AICPA [Pop/Son] Prepare consolidated statement of cash flows [Pam] Prepare consolidated statement of cash flows using either the direct or indirect method [Pop/Son] [Appendix B] Consolidated financial statements (cost method)

PROFESSIONAL RESEARCH ASSIGNMENTS Answer the following questions by reference to FASB Codification of Accounting Standards. Include the appropriate reference in your response. PR 4-1 In preparing a consolidated statement of cash flows, is a firm required to disclose cash flow per share? PR 4-2 Firms adopting the direct method to prepare the statement of cash flows often include a reconciliation of net income to net cash flows from operating activities. Is this required, and, if so, how should it be presented?

50 40 45

Chapter 5 INTERCOMPANY PROFIT TRANSACTIONS─INVENTORIES Learning Objectives 5.1 Understand the impact of intercompany inventory profit on consolidation workpapers. 5.2 Apply the concepts of upstream versus downstream inventory transfers. 5.3 Defer unrealized inventory profits remaining in the ending inventory. 5.4 Recognize realized, previously deferred inventory profits in the beginning inventory. 5.5 Adjust noncontrolling interest amounts in the presence of intercompany inventory profits. Chapter Outline TRANSACTIONS BETWEEN AFFILIATED COMPANIES A

Transactions between affiliated companies (intercompany transactions) must be eliminated during the consolidation process.

Reciprocal account balances are eliminated. For example, intercompany sales transactions create reciprocal sales and purchases accounts as well as reciprocal accounts receivable and accounts payable.

Gains and losses from intercompany transactions are eliminated until realized through use or through sale to an outside entity. 1

The total amount of the intercompany profit is eliminated, whether or not there is a noncontrolling interest.

The objective is to show the income and financial position of the consolidated entity as they would have appeared if the intercompany transaction had never taken place.

ELIMINATION OF INTERCOMPANY PURCHASES AND SALES (Learning Objective 5.1) A

The elimination of intercompany sales and purchases (or cost of goods sold) does not affect consolidated net income. 1

However, consolidated sales, cost of goods sold, and purchases will be reduced.

Since an equal amount of sales and cost of sales is eliminated, neither gross profit nor net income is affected. 38

Under a periodic inventory system, the workpaper entry is a debit to sales and a credit to purchases.

Under a perpetual inventory system (discussed in the text), the workpaper entry is a debit to sales and a credit to cost of goods sold.

DOWNSTREAM AND UPSTREAM SALES (Illustration 5-1) (Learning Objective 5.2) A

Downstream sales are those sales from a parent to its subsidiary. 1

The consolidation process eliminates the full amount of intercompany sales and cost of sales, regardless of whether the sales are downstream or upstream.

In a downstream sale, the parent company’s separate income includes the unrealized profit (in its sales and cost of sales accounts).

The subsidiary’s net income is not affected; therefore, the noncontrolling interest is computed as the subsidiary’s reported net income multiplied by the noncontrolling interest percentage.

The subsidiary’s ending inventory includes the unrealized profit until the merchandise is sold to outside entities.

The subsidiary’s ending inventory reflects the transfer price, rather than the cost to the consolidated entity.

In the consolidation workpapers, the inventory is reduced to its cost basis by a debit to cost of goods sold and a credit to ending inventory.

Under the equity method, the full amount of unrealized profit from intercompany downstream sales is charged against the income from subsidiary (i.e., not allocated to the noncontrolling interest).

Upstream sales are those sales from a subsidiary to its parent. 1

Again, the consolidation process eliminates the full amount of intercompany sales and cost of sales, regardless of whether the sales are downstream or upstream.

The subsidiary’s net income includes the full amount of the unrealized profits (included in its sales and cost of goods sold accounts). a

The unrealized profit in the subsidiary’s net income is allocated proportionately to the controlling and noncontrolling interests in our text.

Consolidated net income and noncontrolling interest are computed on the basis of income that is realized from the viewpoint of the consolidated entity.

A subsidiary’s realized income is its reported net income, adjusted for intercompany profits from upstream sales.

The parent company’s separate income is not affected by unrealized profits from upstream sales, but its net income, which includes investment income, is affected.

The parent company’s ending inventory includes the unrealized inventory profit until the merchandise is sold to outside entities.

Under the equity method, only the parent’s proportionate share of unrealized profits from intercompany upstream sales is charged against income from the subsidiary.

ACCOUNTING FOR UNREALIZED PROFITS FROM DOWNSTREAM SALES (Learning Objective 5.3) A

In the consolidation workpapers, the full amount of the intercompany sales is eliminated from sales and cost of goods sold.

The unrealized profit is deferred until it is realized when sold to an outside entity.

Deferral is accomplished with a workpaper entry that increases cost of goods sold for the unrealized profit and reduces ending inventory to its cost basis (to the consolidated entity).

From the consolidated entity viewpoint, unrealized profits in the ending inventory understate cost of goods sold and overstate consolidated net income.

Under the equity method, the full amount of the unrealized profit in the subsidiary’s inventory is eliminated from investment income and from the investment in subsidiary account on the parent company books.

When the inventory items acquired by the subsidiary from the parent company are sold to outside entities, the intercompany profit is realized. (Learning Objective 5.4) 1

The unrealized profits in the ending inventory of one period are the unrealized profits in the beginning inventory in the next period.

The effect of unrealized profits in the beginning inventory is the opposite of the effect of unrealized profits in the ending inventory. a

Unrealized profits in the ending inventory (year of intercompany sale) have a direct relationship to consolidated net income.

Unrealized profits in the beginning inventory (year of sale to outside entities) have an inverse relationship to consolidated net income.

Under the equity method, the investment in subsidiary and income from subsidiary amounts are increased for the realization of the intercompany profits from the preceding period.

Realization of deferred profits in the subsidiary’s beginning inventory overstates cost of goods sold from the consolidated viewpoint.

The workpaper entry to record the realization of deferred profits is a debit to the investment in subsidiary account and a credit to cost of goods sold.

The beginning inventory account cannot be adjusted directly because it has already been closed to the cost of goods sold account.

The debit to the investment account reestablishes reciprocity between the investment balance at the beginning of the period and the subsidiary’s equity accounts at the same date.

Unrealized inventory profits in consolidated financial statements are selfcorrecting over any two accounting periods.

ACCOUNTING FOR UNREALIZED PROFITS FROM UPSTREAM SALES (Learning Objective 5.5) A

As in the case of downstream sales, the full amount of intercompany sales is eliminated from sales and cost of sales in the consolidation workpapers.

Intercompany sales from the subsidiary to the parent company increase the subsidiary’s sales, cost of goods sold, gross profit, and net income.

The unrealized profit remains in the parent company’s inventory until the items are sold to outside entities. 1

If the selling subsidiary is 100% owned, the parent company defers 100% of any unrealized profits in the year of the intercompany sale.

If the selling subsidiary is partially owned, the parent company defers only its proportionate share of the unrealized profits in the year of the intercompany sale.

The noncontrolling interest share is reduced for its proportionate share of any unrealized subsidiary profits. To compute noncontrolling interest, the unrealized profit is subtracted from the subsidiary’s reported net income, and the resulting subsidiary realized income is multiplied by the noncontrolling interest percentage.

Intercompany profit is recognized and realized when the inventory items are sold to outside entities. 1

Unrealized profits in beginning inventory overstate cost of goods sold. a

In the consolidation workpapers, a workpaper entry reduces cost of goods sold to its cost basis (credit) and adjusts the investment account and beginning minority interest (debits) for the previously deferred unrealized profits in the beginning inventory.

Recall that the effect of unrealized profits in a beginning inventory on parent company and consolidated net income are opposite the effect of unrealized profits in an ending inventory.

Under the equity method, realization of previously deferred intercompany profits increases investment income and the investment in subsidiary account for the parent company’s proportionate share.

Description of assignment material

Minutes

Questions (14) Exercises (12) E5-1 8 MC general questions E5-2 AICPA 3 MC problem type E5-3 3 MC problem type (downstream sales) E5-4 [Pop/Son] 3 MC problem-type questions (upstream sales) E5-5 [Pam/Sun] 3 MC problem-type questions (upstream sales) E5-6 [Pam/Sun] 3 MC problem-type questions (upstream and downstream sales) E5-7 [[Pam/Sun] Determine consolidated net income with downstream intercompany sales E5-8 [Pop/Son] Consolidated income statement with downstream sales E5-9 [Pam/Sun] Compute noncontrolling interest and consolidated cost of sales (upstream sales) E5-10 [Pop/Son] Consolidated income statement (upstream sales) E5-11 [Pam/Sun] 3 MC problem-type questions (upstream sales) E5-12 [Pop/Son] Consolidated income statement (intercompany sales correction)

16 15 15 15 15 15 12 15 12 15 15 20

Problems (9) P5-1 [Pam/Sun] Consolidated income and retained earnings 20 (upstream sales, noncontrolling interest) P5-2 [Pop/Son] Computations (upstream sales) 20 P5-3 [Pam/Sun/Toy] Computations (parent buys from one subsidiary and sells to 50 the other) P5-4 [Son/Pop] Computations (upstream and downstream sales) 45 P5-5 [Pam/Sun] Workpapers (100 percent owned, downstream sales, 45 year after acquisition) P5-6 [Pop/Son] Workpapers (noncontrolling interest, downstream sales, 60 year after acquisition) P5-7 [Pam/Sun] Consolidation workpapers (upstream sales, noncontrolling interest) 60 P5-8 [Pop/Son] Consolidated workpapers (downstream sales) 50 P5-9 [Pop/Son] Consolidated workpapers (noncontrolling interest, upstream sales, 50 intercompany receivables/payables)

APPENDIX A .

The SEC influence on accounting is discussed. 1) Securities Act of 1933 regulates initial issuances. 2) Securities Exchange Act of 1934 regulates subsequent trading. 3) Sarbanes-Oxley Act is a response to the “scandals.” 4) Registration Statement for Security Issues 5) Integrated Disclosure System 6) SEC Developments

PROFESSIONAL RESEARCH ASSIGNMENTS Answer the following questions by reference to the FASB Codification of Standards. Include the appropriate reference in your response. PR 5-1 Should the consolidated financial statements include the subsidiary’s retained earnings at the acquisition date? PR 5-2 Does noncontrolling interest represent a liability or an equity in the consolidated balance sheet?

Illustration 5-1 INTERCOMPANY INVENTORY PROFITS

Pop owns a 90% interest in Son acquired at book value equal to fair value at the beginning of 20Xl. Separate incomes 20X1 Pop

Son

Combined

Sales

$500,000

$300,000

$800,000

Cost of sales

(300,000)

(200,000)

(500,000)

Expenses

(100,000)

(50,000)

(150,000)

$100,000

$ 50,000

$150,000

Separate incomes

Additional information: 1 2

Intercompany sales in 20Xl were $50,000. Cost of inventory items sold intercompany was $40,000 and the intercompany profit was $10,000. Unrealized profit at year-end 20Xl was $5,000.

Separate incomes 20X2 Sales

Pop $550,000

Son $350,000

Combined $900,000

Cost of Sales

(300,000)

(200,000)

(500,000)

Expenses

(140,000)

( 90,000)

(230,000)

$110,000

$ 60,000

$170,000

Separate incomes

Additional information: 1 2 3 4

Intercompany sales in 20X2 were $80,000. Cost of inventory items sold intercompany was $50,000 and the intercompany profit was $30,000. Unrealized profit at year-end 20X2 was $10,000. All intercompany profit deferred in 20Xl was realized in 20X2.

DOWNSTREAM SALES - 20XI .

($5,000 unrealized profit deferred] 45

One-line consolidation entry: Investment in Son Income from Son

$40,000 $40,000

To take up income from Son computed as ($50,000 x 90%) – $5,000 unrealized profit deferred.

Consolidation working paper entries: a Sales

$50,000

Cost of sales To eliminate intercompany purchases and sales amounts. b

Cost of sales $ 5,000 Inventory To defer unrealized profit in ending inventory. Income from Son $40,000 Investment in Son To eliminate income from Son and return investment account to its beginning of the period balance.

DOWNSTREAM SALES - 20X2

$50,000

$ 5,000

$40,000

($5,000 realized profit; $10,000 profit deferred]

One-line consolidation entry: Investment in Son $49,000 Income from Son $49,000 To take up income from Son computed as: ($60,000 x 90%) + realization of $5,000 in beginning inventory – deferral of $10,000 unrealized profit in ending inventory.

Consolidation working paper entries: a

Sales

$80,000 Cost of sales To eliminate intercompany purchases and sales.

Investment in Son $ 5,000 Cost of sales $ 5,000 To recognize previously deferred profit from beginning inventory.

c Cost of sales $10,000 Inventory To defer unrealized profit in ending inventory. d

Income from Son $49,000 Investment in Son To eliminate investment income and return investment account to its beginning of the period balance.

UPSTREAM SALES - 20XI

($5,000 unrealized profit deferred]

One-line consolidation entry: .

$80,000

$10,000

$49,000

Investment in Son $40,500 Income from Son $40,500 To take up income from Son computed as ($50,000 - $5,000) x 90%.

Consolidation working paper entries: a Sales

$50,000

Cost of sales To eliminate intercompany purchases and sales amounts. b

Cost of sales $ 5,000 Inventory To defer unrealized profit in ending inventory. Income from Son $40,500 Investment in Son To eliminate income from Son and return investment balance to its beginning of the period balance.

$50,000

$ 5,000

$40,500

UPSTREAM SALES - 20X2

[$5,000 realized profit; $10,000 profit deferred]

One-line consolidation entry: Investment in Son $49,500 Income from Son To take up income from Son computed as: ($60,000 + $5,000 in beginning inventory - $10,000 unrealized profit in ending inventory) x 90%.

$49,500

Consolidation working paper entries: a

Sales

$80,000

Cost of sales To eliminate intercompany purchases and sales. b

Investment in Son $ 4,500 Noncontrolling interest 500 Cost of sales $5,000 To recognize previously deferred profit from beginning inventory allocated to investment account and noncontrolling interest.

Cost of sales $10,000 Inventory To defer unrealized profit in ending inventory and return cost of sales to a cost basis.

$80,000

Income from Son $49,500 Investment from Son To eliminate investment income and return investment account to its beginning of the period balance.

$10,000

$49,500

Chapter 6 INTERCOMPANY PROFIT TRANSACTIONS─PLANT ASSETS Learning Objectives 6.1 Assess the impact of intercompany profit on transfers of plant assets on consolidated financial statements. 6.2 Defer unrealized profits on plant asset transfers by either the parent or subsidiary. 6.3 Recognize realized, previously deferred profits on plant asset transfers. 6.4 Adjust the calculations of noncontrolling interest share in the presence of intercompany profits on plant asset transfers. Chapter Outline SALE OF PLANT ASSETS TO AFFILIATED COMPANIES (Learning Objective 6.1) A

The sale of plant assets to affiliated companies at a price other than book value creates an unrealized gain or loss to the consolidated entity.

Gain or loss from the intercompany sale appears in the income statement of the selling affiliate in the year of sale.

The gain or loss is unrealized from the viewpoint of the consolidated entity until:

The plant asset is sold to an outside entity; or

The asset is fully depreciated through use within the consolidated entity.

The effects of unrealized gains and losses are: 1

Eliminated from investment income in a one-line consolidation (use of equity method); and

Eliminated from consolidated financial statements through workpaper entries.

DOWNSTREAM INTERCOMPANY SALE OF LAND (Illustration 6-1) (Learning Objective 6.2) A

In the year of an intercompany sale of land, an entry is made in the consolidation working papers to eliminate the full amount of the gain on the sale and reduce the land account to its cost to the consolidated entity. 1

This entry is the same for downstream and upstream intercompany land sales.

The parent company reduces its investment income and investment account for the unrealized intercompany profit.

While the land is held within the consolidated entity in years subsequent to the year of sale, a consolidation workpaper entry is required each year to reduce the land account to its cost basis (credit) and increase the investment account to establish reciprocity with the subsidiary’s equity accounts at the beginning of the period.

When the land is sold to an outside entity, the parent company recognizes the previously deferred gain from the intercompany sale. 1

A consolidation workpaper entry converts the gain on the sale of land to the gain to the consolidated entity and establishes reciprocity between beginning investment and subsidiary equity accounts.

The consolidated gain is the difference between the cost of the land and the final selling price to an outside entity.

UPSTREAM INTERCOMPANY SALE OF LAND (Illustration 6-1) A

In the year of the intercompany sale of land, the full amount of the gain on the sale is eliminated from the consolidated financial statements, and the land is reported at its cost to the consolidated entity.

The parent company reduces its investment income for only its proportionate share of the unrealized gain because the noncontrolling interest is also charged with its share of the unrealized gain.

In the consolidation workpaper, the noncontrolling interest expense is computed as the subsidiary’s realized income multiplied by the noncontrolling interest percentage. Realized income is the subsidiary’s reported income less unrealized gains plus unrealized losses.

While the land is held within the consolidated entity in years subsequent to the year of sale, a consolidation workpaper is required each year to:

Reduce the land account to its cost basis;

Increase the investment account for its share of the unrealized gain (this entry establishes reciprocity with the subsidiary’s equity accounts at the beginning of the period); and

Decrease the beginning noncontrolling interest to its balance at the end of the previous year. In other words, compute noncontrolling interest on the basis of realized income rather than on the basis of reported income. 51

When the parent company sells the land to an outside entity, the gain or loss to the parent is converted to a gain or loss to the consolidated entity for reporting in the consolidated financial statements. 1

The amount of the gain or loss is the difference between the cost of the land and the final selling price to the outside entity.

A workpaper entry includes the gain from the intercompany sale, increases the investment account to establish reciprocity with beginning subsidiary equity accounts, and decreases the beginning noncontrolling interest to its balance at the end of the previous year.

Only the credit to the gain on land is different from the entries in the previous year in which the land was held within the consolidated entity.

On the parent company’s books, the parent’s share of the previously deferred gain from the intercompany sale is recognized and realized with an entry that increases investment income and the investment account.

DOWNSTREAM SALES OF DEPRECIABLE PLANT ASSETS (Illustration 6-2) (Learning Objective 6.3) A

In the year of sale, the unrealized gain from a downstream sale of plant assets is reflected in the parent company’s accounts. 1

The unrealized gain is eliminated in determining investment income under the equity method.

The unrealized gain does not appear in the consolidated income statement. The unrealized gain is removed from consolidated financial statements by a workpaper entry that eliminates the gain and returns the plant asset to its depreciated cost to the consolidated entity at the time of sale.

Next, depreciation expense and accumulated depreciation are reduced in the consolidation workpaper. a

These items are adjusted to the depreciated cost basis to the consolidated entity at the end of the year.

Depreciation expense is adjusted to the amount it would have been had the intercompany sale not taken place.

By reducing depreciation expense, the gain is recognized on a piecemeal basis as the asset is used by the consolidated entity.

4 B

The noncontrolling interest calculation is not affected.

In years subsequent to the year of intercompany sale, as the overstated plant asset is depreciated, the parent company adjusts it investment income for the piecemeal recognition of the previously unrecognized gain. 1

The full amount of the gain from the intercompany sale will be recognized through investment income by the end of the useful life of the plant asset.

Also at the end of the plant asset’s useful life, the investment account will reflect the parent’s proportionate share of the subsidiary’s underlying equity, assuming there are no other unrealized profits or cost-book value differentials.

UPSTREAM SALES OF DEPRECIABLE PLANT ASSETS (Illustration 6-2) A

In the year of an upstream sale at other than book value, the gain or loss is reflected in the subsidiary accounts. 1

Investment income for the year of sale is adjusted for the parent’s share of the unrealized gain or loss and the parent’s share of any piecemeal recognition of the gain or loss through depreciation.

Noncontrolling interest share is computed as the noncontrolling interest ownership percentage multiplied by the subsidiary’s realized income. Realized income is the subsidiary’s reported net income less the realized gain plus piecemeal recognition of the gain through depreciation.

The unrealized gain does not appear in the consolidated statements.

Consolidation workpaper entries are required to eliminate the effects of the intercompany upstream sale. a

The unrealized gain is eliminated, and the plant asset is returned to its depreciated cost to the consolidated entity at the time of sale.

Excess depreciation for the current year (depreciation in excess of the amount that would have been recorded had the intercompany sale not taken place) is eliminated from the depreciation accounts. This is the piecemeal recognition of the gain.

In years subsequent to the year of the upstream intercompany sale, workpaper entries will allocate the unrealized gain between the investment account and beginning noncontrolling interest and return the plant asset and accumulated depreciation accounts to a cost basis to the consolidated entity. (Learning Objective 6.4)

The debit to noncontrolling interest adjusts the beginning noncontrolling interest balance of the current year to the ending balance of the previous year.

The debit to the investment account establishes reciprocity between the investment account balance and the subsidiary’s equity accounts at the beginning of the period.

When the full amount of the unrealized gain has been realized through depreciation, no further adjustments are necessary.

PLANT ASSETS SOLD AT OTHER THAN FAIR VALUE A

An intercompany sale of plant assets at a loss requires special evaluation to ensure the loss should not have been recognized by the selling affiliate prior to the intercompany sale.

The sale of assets above fair value also creates problems for the parties involved.

While the process for consolidation does not change, questions regarding inappropriate recognition of gains or losses could lead to charges of improper stewardship on the part of corporate directors.

INVENTORY PURCHASED FOR USE AS AN OPERATING ASSET A

The unrealized gain (gross profit) on the sale is recognized through depreciation by the purchasing affiliate.

Workpaper entries in the year of the intercompany sale will:

Reduce sales for the intercompany sale, reduce cost of sales for the cost of the inventory item, and reduce the plant asset to its cost basis to the consolidated entity; and

Eliminate depreciation expense (piecemeal recognition of the gross profit on the sale occurs as the depreciation expense is eliminated).

Workpaper entries in subsequent years will: 1

Reduce the plant asset to its cost basis;

Eliminate depreciation expense (piecemeal recognition of the gross profit on the sale occurs as the depreciation expense is eliminated); and

Establish reciprocity between beginning-of-the-period equity and investment amounts. 54

Description of assignment material

Minutes

Questions (10) Exercises (11) E6-1 4 MC general questions E6-2 [Sun/Pam] Discuss effect of intercompany sale of land E6-3 [Son/Pop] Computations for downstream and upstream sales of land E6-4 [Sun/Pam] Journal entries and consolidated income statement (downstream sale of building) E6-5 AICPA 4 MC general questions E6-6 6 MC problem type questions E6-7 [Pam/Sun] Consolidated income statement (sale of asset sold upstream 2 years earlier) E6-8 [Pop/Son] Investment income from 40 percent investee (upstream and downstream sales) E6-9 [Pam/Sun] Upstream sale of equipment, noncontrolling interest E6-10 [Pop/Son] Inventory items of parent capitalized by subsidiary E6-11 [Pam/Sun] Consolidated net income (upstream and downstream sales) Problems (11) P6-1 [Pop/Son] Consolidated workpaper (downstream sales, intercompany receivable/payable) P6-2 [Pam/Sun] Consolidated workpaper (downstream sales, intercompany receivable/payable) P6-3 [Pop/Son] Workpaper in year of acquisition (downstream and upstream sales) P6-4 [Pam/Sun] Workpaper (downstream sales, two years) P6-5 [Pop/Son] Workpaper (fair value/book value differential, upstream sales) P6-6 [Pam/Sun] Workpaper (downstream and upstream sales) P6-7 [Pam/Sun] Workpaper (upstream sales current and previous years) Description of assignment material (cont’d) P6-8 P6-9

12 30 25 15 20 20 35

25 50 50 50 50 50 70 Minutes

[Pam/Sun] Consolidation workpaper (upstream sales) [Pop/Son] Analyze provided separate company and consolidated statements

PROFESSIONAL RESEARCH ASSIGNMENTS Answer the following questions by reference to the FASB Codification of Accounting Standards. Include the appropriate reference in your response. .

12 15 20 15

90 90

PR 6-1 How should a company treat intercompany sales of assets in the consolidated financial statements? PR 6-2 What information should be disclosed about property, plant, and equipment in the consolidated financial statements?

Illustration 6-1 INTERCOMPANY PROFITS ON LAND Pam owns a 90% interest in Sun, acquired at fair value at the beginning of 20Xl. During 20X1 land that cost $1,500 is sold intercompany for $2,500. The land is sold to an outside entity in 20X3 for $3,000. Separate Incomes 20Xl:

Sales Expenses and cost of sales .

Pam Sells Land to Sun Downstream P S $50,000 $30,000

Sun Sells Land to Pam Upstream P S $50,000 $30,000

(40,000)

(25,000) 56

(25,000)

Gain on sale of land Separate incomes

1,000 $11,000

Separate Incomes 20X2: Sales $55,000 Expenses and cost of sales (44,000) Separate incomes $11,000 Separate Incomes 20X3: Sales $60,000 Expenses and cost of sales (50,000) Gain on sale of land Separate incomes $10,000

$ 5,000

$10,000

1,000 $ 6,000

$35,000

$55,000

$35,000

(29,000) $ 6,000

(44,000) $11,000

(29,000) $ 6,000

$38,000

$60,000

$38,000

(30,000)

(50,000)

(30,000)

500 $ 8,500

500 $10,500

$ 8,000

DOWNSTREAM SALE - 20XI:

$1,000 unrealized gain deferred

One-line consolidation entry: Investment in Sun $3,500 Income from Sun $3, 500 To record 90% of Sun's reported income and eliminate unrealized profit on land. [Computation: ($5,000 x 90%) - $1,000]

Consolidation working paper entries: a

Gain on sale of land Land

$1,000 $1,000 57

To eliminate unrealized profit on sale of land to Sun and reduce land to its cost basis. b

Income from Sun $3,500 Investment in Sun $3,500 To eliminate investment income and return investment account to its beginning of the period balance.

DOWNSTREAM SALES - l9X2

One-line consolidation entry: Investment in Sun $5,400 Income from Sun To record 90% of Sun's reported income. Computation: $6,000 x 90%

$5,400

Consolidation working paper entries: a

Investment in Sun $1,000 Land To reduce land to its cost basis and adjust investment account to establish reciprocity with Sun's beginning of 58

$1,000

the period equity accounts. b

Income from Sun $5,400 Investment in Sun To eliminate investment income and return investment account to its beginning of the period balance.

DOWNSTREAM SALES - 20X3:

$5,400

Land is sold to outside entity

One-line consolidation entry: Investment in Sun $8,650 Income from Sun To record 90% of Sun's reported income and recognize the previously deferred profit on the sale of land to Sun. Computation: $8,500 x 90% + $1,000

$8,650

Consolidation working paper entries: a

Investment in Sun $1,000 Gain on sale of land To adjust gain on sale of land to the $1,500 gain to the consolidated entity.

$1,000

Income from Sun $8,650 Investment in Sun To eliminate investment income and return investment account to its beginning of the period balance.

UPSTREAM SALES - 20XI:

$8,650

$1,000 unrealized gain deferred

One-line consolidation entry: Investment in Sun $4,500 Income from Sun To record 90% of Sun's realized income. Computation: ($6,000 - $1,000 unrealized profit) x 90%

$4,500

Consolidation working paper entries: a

Gain on sale of land $1,000 Land To eliminate unrealized profit on sale of land to Pam and reduce land to its cost basis. Income from Sun Investment in Sun

$1,000

$4,500 $4,500 60

To eliminate investment income and return investment account to its beginning of the period balance.

UPSTREAM SALES - 20X2

One-line consolidation entry: Investment in Sun $5,400 Income from Sun To record 90% of Sun's reported income. Computation: $6,000 x 90%

$5,400

Consolidation working paper entries: a

Investment in Sun $ 900 Noncontrolling interest-beginning 100 Land To reduce land to its cost basis and adjust investment and beginning noncontrolling interest amounts to establish reciprocity with the beginning of the period equity accounts of Sun.

$1,000

Income from Sun Investment in Sun

$5,400 $5,400

To eliminate investment income and return investment account to its beginning of the period balance.

UPSTREAM SALE - 20X3: Sale to outside entity.

One-line consolidation entry: Investment in Sun $8,100 Income from Sun To record 90% of Sun's reported income and recognize the previously deferred profit on the sale of land to Sun. Computation: $8,000 x 90% + $900

$8,100

Consolidation working paper entries: a

Investment in Sun $ 900 Noncontrolling interest 100 Gain on sale of land To adjust gain on sale of land to the $1,500 gain to the consolidated entity. Income from Sun Investment in Sun

$1,000

$8,100 $8,100 62

To eliminate investment income and return investment account to its beginning of the period balance.

Illustration 6-2 INTERCOMPANY SALE OF MACHINERY P owns a 90% interest in Sun, acquired at book value equal to fair value at the beginning of 20XI. Part A

On January 1, 20Xl Pam sells machinery with a book value of $4,000 and a 10year remaining useful life to Sun for $5,000. 20X1 20X2 Separate Incomes Separate Incomes Pam

Sun

Pam

Sun

$50,000

$30,000

$55,000

$35,000

Gain on sale of machinery 1,000 Depreciation expense (10,000) Other expenses (30,000) Separate incomes $11,000

( 5,500) (20,000) $ 4,500

(10,000) (34,000) $11,000

( 5,500) (24,000) $ 5,500

Sales

Part B

On January 1, 20X1 Sun sells machinery with a book value of $4,000 and a 10year remaining useful life to Pam for $5,000. 20X1 Separate Incomes

20X2 Separate Incomes

Pam

Sun

Pam

Sun

Sales $50,000 Gain on sale of machinery Depreciation expense (10,500) Other expenses (30,000) Separate incomes $ 9,500

$30,000

$55,000

$35,000

1,000 (5,000) (20,000) $ 6,000

(10,500) (34,000) $10,500

( 5,000) (24,000) $ 6,000

Part A: DOWNSTREAM SALE OF MACHINERY - 20XI ($1,000 gain - $100 unrealized gain deferred)

One-line consolidation entry: Investment in Sun $3,150 Income from Sun To record 90% share of Sun's net income less gain on sale of machinery plus piecemeal recognition of gain through depreciation. Computation: ($4,500 x 90%) - $1,000 + $100

$3,150

Consolidation working paper entries: a

Gain on machinery $1,000 Machinery To eliminate unrealized gain and reduce machinery to a cost basis. Accumulated depreciation-machinery Depreciation expense To eliminate the current year's effect of the unrealized gain from depreciation accounts.

100

Income from Sun $3,150 Investment in Sun To eliminate investment income and adjust investment account to its beginning of the period balance.

$1,000

$ 100

$3,150

Part A: DOWNSTREAM SALE OF MACHINERY - 20X2 ($100 of $900 deferred gain is recognized in 20X2)

One-line consolidation entry: Investment in Sun Income from Sun Computation: ($5,500 x 90%) + $100

$5,050 $5,050

Consolidation working paper entries: a

Accumulated depreciation-machinery $ 100 Depreciation expense To eliminate current year's effect of unrealized profit from depreciation accounts. Investment in Sun $ 900 Accumulated depreciation 100 Machinery To eliminate unrealized profit from machinery and accumulated depreciation as of the beginning of the year and to adjust the investment account for the difference. Income from Sun $5,050 Investment in Sun To eliminate investment income and adjust the investment account to the beginning of the period balance.

Part B: UPSTREAM SALE OF MACHINERY - 20XI ($1,000 - $100 unrealized gain deferred) .

100

$1,000

$5,050

One-line consolidation entry: Investment in Sun Income from Sun Computation: ($6,000 - $1,000 + $100) x 90%

$4,590 $4,590

Consolidation working paper entries: a

Gain on sale of machinery $1,000 Machinery To eliminate unrealized gain and reduce machinery to a cost basis. Accumulated depreciation-machinery $ 100 Depreciation expense To eliminate the current year's effect of unrealized gain from depreciation accounts. Income from Sun $4,590 Investment in Sun To eliminate investment income and adjust investment account to its beginning of the period balance.

$1,000

$ 100

$4,590

PART B: UPSTREAM SALE OF MACHINERY - 20X2 ($100 of $900 deferred gain is recognized in 20X2)

One-line consolidation entry: Investment in Sun $5,490 Income from Sun To record 90% of Sun's realized income. Computation: ($6,000 + $100) x 90% Consolidation working paper entries: a Accumulated depreciation-machinery Depreciation expense To eliminate 20Xl unrealized gain from current depreciation accounts. b

100

Investment in Sun $ 810 Noncontrolling interest-beginning 90 Accumulated depreciation 100 Machinery To eliminate unrealized profit from machinery and accumulated depreciation and to establish reciprocity between the majority and noncontrolling interests and subsidiary equity accounts as of the beginning of the period. Income from Sun $5,490 Investment in Sun To eliminate investment income and adjust the investment account to the beginning of the period balance.

$5,490

$ 100

$1,000

$5,490

Chapter 7 INTERCOMPANY PROFIT TRANSACTIONS─BONDS Learning Objectives 7.1 Differentiate between intercompany receivables and payables, and assets or liabilities of the consolidated reporting entity. 7.2 Demonstrate how a consolidated reporting entity constructively retires debt. 7.3 Defer unrealized gains/losses and later recognize realized gains/losses on bond transfers between parent and subsidiary. 7.4 Calculate noncontrolling interest share in the presence of intercompany gains/losses on debt transfers. Chapter Outline INTERCOMPANY BOND TRANSACTIONS (Learning Objective 7.1) A

When one affiliate purchases the bonds of another affiliated company on the open market, the bonds are no longer outstanding from the viewpoint of the consolidated entity.

However, the purchasing affiliate accounts for the bond investment as if the bonds were those of an unaffiliated entity, and the issuing affiliate continues to account for the bonds as if they were debt obligations held by unaffiliated entities.

Consolidated statements are prepared to show the financial position and results of operations as if the issuing affiliate had purchased and retired its own bonds. 1

The bonds are constructively retired in the consolidation process. Payables and receivables related to the intercompany bond holdings are reciprocals that must be eliminated.

The difference between the book value of the bond liability and the purchase price of the investment is a constructive gain or loss of the consolidated entity.

3 4

The gain or loss is realized and recognized by the consolidated entity.

The gain or loss is not recognized on the books of the issuing affiliate.

Constructive gains and losses are assigned to the issuing affiliate. This is supported by the concept of agency theory.

The constructive gain or loss appears on the consolidated income statement in the year in which the affiliate’s bonds are purchased. Only the bond liability and related premium or discount held outside the consolidated entity appear on the consolidated balance sheet. 69

No gains or losses result from the purchase of an affiliate’s bonds at book value or from direct borrowing and lending between affiliates.

Straight-line amortization of premiums and discounts is used in the examples in this textbook for simplicity. The effective interest method is superior, but it is not required by GAAP for transactions between parent and subsidiary companies and between subsidiaries of a common parent.

SUBSIDIARY ACQUISITION OF PARENT BONDS (Illustrations 7-1, 1, and 2) (Learning Objective 7.2) A

When the bonds of a parent company are acquired by a subsidiary on the open market, the transaction is similar to the accounting for downstream intercompany transactions.

The parent company is the issuing affiliate and constructive gains and losses are assigned to the parent. 1

At the time of purchase, the subsidiary records the investment in parent company bonds at the amount paid. No other entry is made. a

The constructive gain or loss is not recorded on the books of the parent or subsidiary.

The constructive gain or loss is the difference between the bond liability accounts (parent’s books) and the bond investment account (subsidiary’s books).

During the year, the parent amortizes the premium or discount on bonds payable on its separate books, and the subsidiary amortizes the premium or discount on the bond investment on its separate books. 1

This amortization results in a piecemeal realization and recognition of the constructive gain or loss on the respective books of parent and subsidiary. This piecemeal recognition is reflected in the interest income and interest expense accounts relating to the constructively retired bonds.

The amount of piecemeal recognition of a constructive gain or loss is always the difference between the intercompany interest expense and interest income amounts that are eliminated. At year end, the parent company adjusts its income from subsidiary and investment account for the entire constructive gain or loss and any piecemeal recognition of that gain or loss under the equity method of accounting.

The full amount of the constructive gain or loss is charged to investment income because the parent is the issuing affiliate.

When the bonds mature, the difference between the bond liability and bond investment will be fully amortized, and the parent company’s investment in subsidiary account will be equal to the subsidiary’s underlying equity.

Consolidation procedures relating to the bonds in the year of the intercompany bond purchase include the following: 1

The constructive gain or loss is recorded in the consolidation workpapers because it is a gain or loss to the consolidated entity.

The reciprocal bonds payable and bond investment amounts and the related premium or discount are eliminated.

Reciprocal amounts of interest expense and interest income are eliminated.

Reciprocal amounts of interest payable and interest receivable are eliminated.

In years subsequent to the intercompany bond purchase, the parent and subsidiary continue to account for their respective bonds payable and investment in bonds as if the bonds were held by unaffiliated entities. (Learning Objective 7.3) 1

The difference between the parent’s interest expense on the intercompany bonds and the subsidiary’s interest income on the bonds is the piecemeal recognition of the gain or loss. However, this piecemeal gain or loss must be eliminated since the entire gain or loss to the consolidated entity was recognized in the year the bonds were purchased by the affiliate.

This difference is recognized on the parent’s books as an adjustment of investment income.

A consolidation workpaper entry eliminates reciprocal interest income and expense amounts, reciprocal bond investment and liability amounts, and reciprocal interest receivable and payable amounts. The difference is a debit or credit to the investment account, which establishes reciprocity between the investment in subsidiary and the subsidiary equity accounts at the beginning of the period.

PARENT PURCHASES SUBSIDIARY BONDS (Illustrations 7-1, 7-3, and 7-4) A

When the bonds of a subsidiary company are acquired by a parent on the open market, the transaction is similar to the accounting for upstream intercompany transactions.

The subsidiary company is the issuing affiliate, and constructive gains and losses are allocated between the majority and noncontrolling interests. 1

At the time of purchase, the parent records the investment in subsidiary bonds at the amount paid. No other entry is made. a

The constructive gain or loss is not recorded on the books of the parent or subsidiary.

The constructive gain or loss is the difference between the bond liability accounts (subsidiary’s books) and the bond investment account (parent’s books).

During the year, the subsidiary amortizes the premium or discount on bonds payable on its separate books, and the parent amortizes the premium or discount on the bond investment on its separate books. 1

The amount of piecemeal recognition of a constructive gain or loss is always the difference between the intercompany interest expense and interest income amounts that are eliminated.

The constructive gain or loss is allocated between the controlling and noncontrolling interests. (Learning Objective 7.4) a

Only the parent company's proportionate share of the constructive gain or loss is included in consolidated net income.

The noncontrolling interest’s share of the constructive gain or loss is reflected in the consolidated income statement as noncontrolling interest expense.

Noncontrolling interest expense is computed as the minority interest percentage multiplied by the subsidiary’s realized income.

In years subsequent to the year of purchase of intercompany bonds, the portion of the constructive gain or loss that has not been recognized through premium and discount amortization on the separate books of parent and subsidiary must be allocated between the investment account and noncontrolling interest in the consolidation workpapers.

Description of assignment material

Minutes

Questions (11) Exercises (13) E7-1 4 MC general questions E7-2 [Pop/Son] 2 MC problems E7-3 [Pam/Sun] 5 MC problem-type questions (constructive gain on purchase of parent bonds) E7-4 [Pop/Son] Subsidiary purchases parent bonds E7-5 [Pam/Sun] Consolidated income statement (constructive gain on purchase of parent’s bonds) E7-6 [Pop/Son] Parent purchases subsidiary bonds E7-7 [Pam/Sun] 3 MC problem-type questions (constructive gain purchase of subsidiary’s bonds) E7-8 [Pop/Son] Midyear purchase of parent’s bonds E7-9 [Pam/Sun] Different assumptions for purchase of parent’s bonds and subsidiary’s bonds E7-10 [Pop/Son] Constructive retirement of parent’s bonds E7-11 [Pam/Sun] Consolidated income statement (constructive retirement of all subsidiary bonds) E7-12 [Pop/Son] Computations and entries (parent purchases subsidiary bonds) E7-13 [Pop/Son] Computations and entries (constructive gain on purchase of parent bonds) Problems (6) P7-1 [Pam/Sun] Computations and entries (constructive retirement of parent’s bonds) P7-2 [Pop/Son] Four-year income schedule (several intercompany transactions) P7-3 [Pam/Sun] Workpapers (constructive retirement of bonds, intercompany sales) P7-4 [Pop/Son] Computations of separate and consolidated statements given P7-5 AICPA [Pam/Sun] Computations (constructive retirement of subsidiary bonds) P7-6 [Pop/Son] Workpapers (constructive retirement of bonds, intercompany sales) PROFESSIONAL RESEARCH ASSIGNMENTS Answer the following questions by reference to the FASB Codification of Accounting Standards. Include the appropriate reference in your response. PR 7-1 How should a company determine the fair value of long-term debt? PR 7-2 A firm issues mandatorily redeemable preferred stock. Should this be classified as debt or equity in the consolidated financial statements? .

12 10 20 10 15 15 15 20 25 25 20 30 25

25 30 70 50 30 60

Illustration 7-1 INTERCOMPANY BOND TRANSACTIONS Son Acquires Pop Bonds Son is a 90% owned subsidiary of Pop, acquired at book value equal to fair value in 20X1. Pop has a $50,000, 10% bond issue outstanding that was issued at par and matures on January 1, 20X7. Son acquires $10,000 of these bonds for $10,500 on January 1, 20X2. Separate incomes for 20X2 and 20X3 follow: 20X2 Sales Interest income Interest expense Other expenses Separate incomes

Pop $50,000

20X3 Sales Interest income Interest expense Other expenses Separate incomes

Pop $60,000

Son $30,000 900

(5,000) (35,000) $10,000

(25,900) $ 5,000 Son $40,000 900

(5,000) (45,000) $10,000

(35,900) $ 5,000

Pop Acquires Son's Bonds Son is a 90% owned subsidiary of Pop, acquired at book value equal to fair value in 20X1. Son has a $50,000, 10% bond issue outstanding that was issued at par and matures on January 1, 20X7. Pop acquires $10,000 of these bonds for $10,500 on January 1, 20X2. Separate incomes for 20X2 and 20X3 are as follows: 20X2 Sales

Pop $50,000

Son $30,000

Interest income Interest expense Other expenses Separate incomes 20X3 Sales Interest income Interest expense Other expenses Separate incomes

900 (5,000) (20,000) $ 5,000

(40,900) $10,000 Pop $60,000 900

Son $40,000 (5,000) (30,000) $ 5,000

(50,900) $10,000

Son Acquires Pop Bonds [$500 constructive loss - $100 piecemeal recognition]

One-line consolidation entry: Investment in Son $4,100 Income from Son To take up income from Son computed as ($5,000 x 90%) $500 constructive loss + $100 piecemeal recognition of constructive loss Consolidation workpaper entries: a Constructive loss $ 500 Interest income 900 Bonds payable 10,000 Investment in Pop bonds Interest expense To enter constructive loss and eliminate reciprocal bond investment and liability amounts and bond interest income and expense amounts

Income from Son $ 4,100 Investment in Son To establish reciprocity Interest payable $ 500 Interest receivable To eliminate reciprocal interest payable and receivable amounts (assumes six month's interest is accrued on December 31)

$4,100

$10,400 1,000

$ 4,100

500

Son Acquires Pop Bonds [$100 piecemeal recognition of 20X2 loss]

One-line consolidation entry: Investment in Son $4,600 Income from Son To take up income from Son computed as ($5,000 x 90%) + $100 piecemeal recognition from constructive loss in 20X2

$4,600

Consolidation workpaper entries: a

Investment in Son $ 400 Interest income 900 Bonds payable 10,000 Investment in Pop bonds Interest expense To eliminate reciprocal bond investment and liability amounts, bond interest income and expense amounts, and adjust the investment in Son account for the unamortized constructive loss Income from Son Investment in Son To establish reciprocity

$10,300 1,000

$ 4,600 $ 4,600

Interest payable $ 500 Interest receivable To eliminate reciprocal interest payable and receivable amounts (assumes six month's interest is accrued on December 31)

500

Pop Acquires Son Bonds [$500 constructive loss - $100 piecemeal recognition]

One-line consolidation entry: Investment in Son $ 4,140 Income from Son $ 4,140 To take up income from Son computed as: ($5,000 - $500 constructive loss + $100 piecemeal recognition) x 90% Consolidation workpaper entries: .

Constructive loss $ 500 Interest income 900 Bonds payable 10,000 Investment in Son bonds $10,400 Interest expense To enter constructive loss, eliminate reciprocal bond investment and liability amounts, and bond interest income and expense amounts Income from Son Investment in Son To establish reciprocity

1,000

$ 4,140 $ 4,140

Interest payable $ 500 Interest receivable To eliminate reciprocal interest payable and receivable amounts (assumes six month's interest is accrued on December 31)

500

Pop Acquires Son Bonds [$100 piecemeal recognition of 20X2 loss]

One-line consolidation entry: Investment in Son $ 4,590 Income from Son To take up income from Son computed as ($5,000 + $100 piecemeal recognition of constructive loss) x 90%

$ 4,590

Consolidation workpaper entries: a

Investment in Son $ 360 Noncontrolling interest-beginning 40 Interest income 900 Bonds payable 10,000 Investment in Pop bonds Interest expense To eliminate reciprocal bond investment and liability amounts, bond interest income and expense amounts, and adjust the investment in Son and noncontrolling interest for the unamortized constructive loss

$10,300 1,000

Income from Son Investment in Son To establish reciprocity

$ 4,590

Interest payable $ 500 Interest receivable To eliminate reciprocal interest payable and receivable amounts (assumes six month's interest is accrued on December 31)

500

Chapter 8 CONSOLIDATIONS - CHANGES IN OWNERSHIP INTERESTS Learning Objectives 8.1 Apply consolidation procedures to interim (midyear) acquisitions. 8.2 Prepare consolidated statements when the parent company’s ownership percentage increases or decreases during the reporting period. 8.3 Record subsidiary/investee stock issuances and treasury stock transactions. Chapter Outline ACQUISITION OF A SUBSIDIARY DURING AN ACCOUNTING PERIOD (Learning Objective 8.1) A

When a subsidiary is acquired during an accounting period, the subsidiary’s sales and expenses are included in the consolidated income statement for the full year.

The income of a subsidiary earned prior to acquisition is included in the acquisition’s purchase price negotiated by the parent. 1

This purchased income (or preacquisition earnings) must be eliminated from consolidated income.

In theory, the elimination could be made by either eliminating the preacquisition sales and cost of goods sold or by eliminating the preacquisition income.

Earlier GAAP recommended the latter method. That is, include the detailed sales and cost of goods sold information, but deduct preacquisition income to arrive at consolidated net income.

GAAP changed in 2007 and now states that consolidated net income should only reflect subsidiary earnings subsequent to the acquisition date. Preacquisition earnings should not appear as a reduction of consolidated net income. Essentially the books of the subsidiary are closed at acquisition date.

Dividends paid on the purchased company’s stock before the stock is acquired by the parent company during an accounting period are referred to as preacquisition dividends. Preacquisition dividends are eliminated because they are not part of the equity acquired.

Changes in consolidation workpaper procedures for acquisitions during an accounting period are as follows: 1

In the workpaper entry that eliminates the reciprocal investment in subsidiary and subsidiary equity accounts: 79

Preacquisition income is eliminated in the consolidation working papers as a debit, and

Preacquisition dividends are eliminated.

The reason for including the above items in the workpaper entry is that subsidiary equity balances are eliminated as of the beginning of the period, and the investment balance is eliminated as of the acquisition date within the period (and thus reflects the purchased income and preacquisition dividends).

Preacquisition income, like noncontrolling interest income, is deducted from total consolidated income as a separate item in the consolidated income statement.

When the parent company’s interest increases during the year, noncontrolling interest is computed on the basis of the noncontrolling shares outstanding at year-end.

PIECEMEAL ACQUISITIONS (Learning Objective 8.2) A

When a corporation acquires a controlling interest through a series of stock purchases over a period of time, a cost/book value differential is determined for each investment.

If these piecemeal acquisitions are made within an accounting period, preacquisition income and dividends are determined for each investment.

Income, dividends, and amortization of cost-book value differentials are determined for each investment.

The noncontrolling interest income is based on the noncontrolling interest ownership at year-end as long as the parent company’s ownership interest did not decrease.

SALE OF OWNERSHIP INTERESTS A

When a parent company sells an ownership interest, the gain or loss on the sale is the difference between the sales proceeds and the book (carrying) value of the investment interest sold.

Under GAAP, when a consolidated group of firms is involved, we only record gain/loss when the interest sold leads to deconsolidation of a former subsidiary. Otherwise it is treated as an equity transaction.

If the investment was acquired through piecemeal acquisitions, the shares sold must be identified with particular acquisitions.

At the beginning of the period, the sale of an interest at a price in excess of book value reduces the investment account and creates a gain on the sale that is both a gain for the parent company and the consolidated entity. 1

In the consolidation workpapers, the gain is carried to the consolidated income statement column.

Noncontrolling interest is computed on the basis of the ending noncontrolling interest percentage when an investment interest is sold at the beginning of the period.

The sale of an interest during an accounting period may be recorded as of the actual sale date, or, as an expedient, as of the beginning of the period. Use of the beginning-of-theperiod assumption is more efficient and practical because current retained earnings information is usually not available during the period. 1

Beginning-of-the-period sale assumption: a b c d e

Actual sale date: a

The gain on the sale is the difference between the proceeds and the book value of the interest sold at the beginning of the period. Noncontrolling interest is computed as if the ending noncontrolling interest had been outstanding throughout the year. Any dividends received on the interest sold prior to the sale must be included in the calculation of the gain or loss on sale. Parent company and consolidated net income are not affected by the beginning of the period assumption. Any difference in the gain or loss on sale is exactly offset by differences in computing the income from subsidiary, amortization of cost-book value differentials, and noncontrolling interest amounts.

The parent company makes an entry to bring the investment account to its book value on the date of sale (i.e., the parent records income from subsidiary, including amortization of cost book value differentials, from the beginning of the period to the sale date). The proceeds from the sale of the investment are recorded, the investment account is credited for the book value of the interest sold, and a gain or loss is recognized for the difference. At the end of the period, the parent company records investment income on the investment interest retained from the date of sale to the end of the period. Investment income for the year is the total of the investment income on the interest held at the beginning of the period to the date of sale plus

investment income on the percentage interest retained from the sale date to the end of the period. Noncontrolling interest income is calculated as the noncontrolling interest’s beginning-of-the-period percentage times the subsidiary’s income to the date of sale plus the noncontrolling interest’s ending percentage times the subsidiary’s income from the date of sale to the end of the period. Comparison of the actual sale date and the beginning of the year sale date assumption: (1)

The year-end investment account balance and ending noncontrolling interest are the same under the two assumptions.

(2)

Cash flow from the proceeds of the sale and dividends received are the same under the two assumptions.

(3)

The difference in the gain on the sale of an interest under the two assumptions is offset by differences in (a) noncontrolling interest income, (b) the parent company’s share of subsidiary income, and (c) amortization of cost book value differentials.

SALE OR REPURCHASE OF SUBSIDIARY CAPITAL STOCK (Learning Objective 8.3) A

Subsidiary operations may be expanded through the issuance of additional shares of stock, or operations may be contracted through repurchase of the shares. The parent company, through its controlling interest, makes the decisions for the subsidiary.

The noncontrolling interest shareholders may exercise their preemptive right to subscribe to additional stock issuances in proportion to their holdings.

The parent company’s investment in the subsidiary may be impacted by subsidiary sales and purchases of its own shares depending on the purchase or sales price of the shares. GAAP requires that capital transactions of an investee that affect the investor’s share of stockholders’ equity of the investee should be accounted for as if the investee were a consolidated subsidiary. The parent company’s percentage ownership in the subsidiary is determined by dividing the number of shares held by the parent by the total number of subsidiary shares outstanding after the sale or purchase.

Sales of stock by a subsidiary to its parent company result in cost/book value differentials equal to the parent company’s share of the difference in the subsidiary’s stockholders’ equity immediately before and immediately after the sale of stock. 1

The book value of the investment interest acquired from the subsidiary is calculated as the underlying book value of the parent company’s interest after 82

the purchase of the additional shares less the underlying book value of the parent company’s interest before the purchase. 2

If the parent company acquires the additional shares at book value, the parent’s investment account increases by the amount of the purchase, but there is no costbook value differential on the new investment.

If the parent company acquires the additional shares at a price above book value, the parent’s investment account increases by the amount of the purchase and a cost-book value differential is computed on the new investment. a b

If the parent company acquires the additional shares at a price less than book value, the parent’s investment account increases by the amount of the purchase price. As an expedient, the excess book value over cost is charged to any goodwill from the parent’s earlier investments in the subsidiary.

Sales of stock by a subsidiary to outside entities are considered capital transactions. 1

The effect on the parent company’s investment in subsidiary account depends on the selling price of the subsidiary’s shares.

The increase or decrease in the parent company’s underlying book value in the subsidiary is computed as the parent company’s equity in the subsidiary after the stock issuance less the parent company’s equity in the subsidiary before the stock issuance. a b c

If the subsidiary shares are sold at book value, the parent company’s equity in the subsidiary is not affected. If the subsidiary shares are sold above book value, the parent company’s equity in the subsidiary increases. If the subsidiary shares are sold below book value, the parent company’s equity in the subsidiary decreases.

GAAP requires that a parent company accounts for its decreased ownership percentage as an equity transaction a b

The excess cost over book value acquired is assigned to identifiable assets or goodwill and amortized over the life of the assets. The amortization of the cost-book value differentials remaining from the original investment does not change.

The parent’s additional paid-in capital account and investment account are adjusted for change in the underlying equity. Unamortized cost-book value differentials are not adjusted for the decreased ownership interest.

If the parent company and noncontrolling interests (outside investors) purchase the shares relative to their existing stock ownership, there will be no adjustment to additional paid-in capital, regardless of the price paid for the stock. Similarly, the parent company will have no excess cost over book value acquired.

Treasury stock transactions by a subsidiary: 1

Insignificant treasury stock transactions do not require adjustments because they tend to be offsetting.

Acquisition of treasury shares by a subsidiary decreases subsidiary stockholders’ equity and subsidiary shares outstanding. a

If the subsidiary buys the shares from the noncontrolling shareholders at book value, the parent company’s percentage ownership increases, but its share of the subsidiary equity is unchanged. No adjustment is required.

If the subsidiary buys the shares from noncontrolling shareholders at a price above book value, the parent company’s percentage ownership increases, but its share of the subsidiary’s book value decreases. (1) (2)

The parent company records the decrease by a debit to additional paid-in capital and a credit to the investment account. The amount of the decrease is the parent’s share of the subsidiary’s book value before the treasury stock transaction less the parent’s share of the subsidiary’s book value after the treasury stock transaction.

If the subsidiary buys the shares from noncontrolling shareholders at a price below book value, the parent company’s percentage ownership increases and its share of the subsidiary’s book value increases.

(1)

The investment account is increased and additional paid-in capital is increased.

(2)

The increase is the parent’s share of subsidiary’s book value immediately after the treasury stock transaction less the book value immediately before the treasury stock transaction.

STOCK DIVIDENDS AND STOCK SPLITS

Subsidiary stock splits increase the number of outstanding shares, but do not affect subsidiary net assets or the parent company and noncontrolling interest ownership percentages.

Stock dividends lead to some changes in the subsidiary’s equity accounts. 1

An amount of retained earnings equal to the par or stated value or the market price of the additional shares issued is transferred to paid-in capital. Thus, the subsidiary equity accounts in the consolidation workpapers are affected.

Stock dividends do not affect parent company accounting.

Description of Assignment Material

Minutes

Questions (11) Exercises (13) E8-1 [Pop/Son] Allocate income and dividends to controlling, noncontrolling, and preacquisition interests E8-2 [Pam/Sun] Piecemeal acquisition of controlling interest with preacquisition income and dividends E8-3 [Pop/Son] Journal entries (sale of an interest – beginning-of-year assumption) E8-4 [Pam/Sun] Sale of equity interest – beginning-of-year or actual sale date assumption) E8-5 [Pop/Son] Computations and workpaper entries (midyear acquisition) E8-6 [Pam/Sun] Additional stock issued by subsidiary directly to parent) E8-7 [Pop/Son] Additional stock issued by subsidiary under different assumptions Description of Assignment Material (cont’d) E8-8 E8-9 E8-10 E8-11 E8-12 E8-13

10 15 15 20 25 15 20

Minutes

[Pam/Sun] Subsidiary issues additional stock under different assumptions [Pop/Son] Midyear piecemeal acquisitions with goodwill [Pam/Sun] Computations for sale of an interest [Pop/Son] Changes in subsidiary’s outstanding shares [Pam/Sun] Journal entries when subsidiary issues additional shares directly to parent [Pop/Son] Computations and entries (subsidiary issues additional shares to outside entities) 85

20 30 25 20 20 15

Problems (12) P8-1 [Pam/Sun] Midyear acquisition and purchase of additional shares P8-2 [Pop/Son] Computations and entries (subsidiary issues additional shares to public) P8-3 [Pam/Sun] Journal entries for sale of an interest P8-4 [Pam/Son] Reduction of interest owned under three options P8-5 [Pam/Sun] Subsidiary issues additional shares P8-6 [Pop/Son] Midyear purchase of additional interest, preacquisition income P8-7 [Pam/Sun] Consolidated income statement (midyear purchase of 30 additional interest) P8-8 [Pop/Son] Workpaper (midyear acquisition of 80% interest, downstream inventory sales) P8-9 [Pam/Sun] Workpaper (noncontrolling interest, preacquisition income, downstream sale of equipment, upstream sale of land, subsidiary holds parent’s bonds) P8-10 [Pop/Son] Workpaper (midyear purchase of 10% interest, downstream sales) P8-11 [Pam/Sun] Workpaper (midyear acquisition, preacquisition income and dividends, upstream sale of inventory, downstream sale of inventory item used by subsidiary as plant asset) P8-12 [Pop/Son] Consolidated statement of cash flows−indirect method (sale of an interest)

20 15 15 35 25 30

40 40

50 50

PROFESSIONAL RESEARCH ASSIGNMENTS Answer the following questions by reference to FASB Codification of Standards. Include the appropriate reference in your response. PR 8-1 Pop Corporation has owned a 30 percent interest in Son Corporation for ten years, and has properly recorded this investment using the equity method of accounting. On July 1 of the current year Pop purchased an additional 40 percent interest in Son. Is it permissible for Pop to include all current year earnings of Son in the consolidated income statement for the current year?

PR 8-2 Again, consider the facts presented in PR 8-1 above. Is it acceptable for Pop to continue to account for its investment in Son for the current year, using the equity method of accounting and delaying consolidation until the following year?

Chapter 9 INDIRECT AND MUTUAL HOLDINGS Learning Objectives 9.1 Prepare consolidated statements when a parent company controls a subsidiary company through indirect holdings. 9.2 Apply consolidation procedures to the special case of mutual holdings. Chapter Outline AFFILIATION STRUCTURES FOR INDIRECT HOLDINGS (Learning Objective 9.1) A

Indirect holdings are investments that enable the investor to control or significantly influence the decisions of an investee not directly owned through its investment in an investee that is directly owned. 1

Father-son-grandson affiliation structure: a

P 70% A 80% B P directly owns 70% of A. P indirectly owns 56% of B (70% x 80%). Noncontrolling interest in A is 30%. Noncontrolling interest in B is 44% [(30% x 80%) + 20%]. Consolidate P, A, and B.

P 70% A 60% B P directly owns 70% of A. P indirectly owns 42% of B (70% x 60%). Noncontrolling interest in A is 30%. Noncontrolling interest in B is 58% [(30% x 60%) + 40%]. Consolidate P, A, and B. Over 50% of B’s stock is held within the consolidated entity.

P 70% A 40% B P directly owns 70% of A. P indirectly owns 28% of B (70% x 40%). Noncontrolling interest in A is 30%. Noncontrolling interest in B is 72% [(30% x 40%) + 60%]. Consolidate P and A. Include B as equity investee.

Connecting affiliates: a

P 60%

40%

B 30%

P directly owns 60% of A. P directly owns 40% of B. P indirectly owns 18% of B (60% x 30%). P’s total ownership in B is 58% (40% + 18%) Noncontrolling interest in A is 40%. Noncontrolling interest in B is 42% [30% + (40% x 30%)] Consolidate P, A, and B. b

P 70%

20%

B 25%

P directly owns 70% of A. P directly owns 20% of B. P indirectly owns 17.5% of B (70% x 25%). P’s total ownership in B is 37.5% (20% + 17.5%). Noncontrolling interest in A is 30%. Noncontrolling interest in B is 62.5% [55% + (30% x 25%)]. Consolidate P and A. Include B as an equity investee.

The computation of parent company and consolidated net income for indirect holding situations can be easily determined by reference to ownership interests in each affiliate

or by a schedule approach. Assume that P, A, and B companies from the illustrative affiliation structures have separate earnings as follows: P A B 1

Parent company net income and consolidated net income can be determined on the basis of the parent’s percentage ownership in the separate realized earnings of the subsidiaries. a

Refer to the first affiliation structure diagram in which P owns 70% of A and A owns 80% of B. (1)

(2)

P’s net income consists of P’s $50,000 separate income + 60% of A’s separate income + 58% of B’s separate income. Thus, P’s net income (and consolidated net income) is $91,400 ($50,000 + $24,000 + $17,400). Noncontrolling interest income consists of 40% of A’s $40,000 separate income + 42% of B’s $30,000 separate income for a total noncontrolling interest income of $28,600.

Parent company net income and noncontrolling interest income can also be computed using a schedule approach. Schedules are especially useful when the affiliates have cost/book value differentials and unrealized profits. a

P’s net income consists of P’s $50,000 separate income + 70% of A’s $40,000 separate income + 56% of B’s $30,000 separate income. P’s net income (and consolidated net income) is $94,800 ($50,000 + $28,000 + $16,800). Noncontrolling interest income consists of 30% of A’s $40,000 separate income + 44% of B’s $30,000 separate income for a total noncontrolling interest income of $25,200.

Now refer to the first connecting affiliation structure diagram in which P owns 60% of A and 40% of B. A owns 30% of B. (1)

$50,000 $40,000 $30,000

The computation of net income is accomplished from the bottom of the affiliation structure to the top. In other words, realized income of the lowest affiliate is computed and allocated first, and so on.

Refer to the second father-son-grandson affiliation diagram in which P owns 70% of A and A owns 60% of B. A’s separate income of $40,000 includes a $3,000 unrealized profit on land sold to B. A schedule approach to the computation of consolidated net income and noncontrolling interest income is as follows:

Separate earnings Less: Unrealized profit on sale of land Separate realized earnings Allocate B’s income to A Allocate A’s income to P Consolidated net income Noncontrolling interest

P $50,000

50,000 38,500

A $40,000

B $30,000

(3,000) 37,000 18,000 (38,500)

30,000 (18,000)

$88,500 $16,500

_______ $12,000

AFFILIATION STRUCTURES FOR MUTUAL HOLDINGS (Learning Objectives 9.2) A

Mutual holdings are a special type of indirect holdings in which an affiliated company indirectly owns itself.

The parent company is mutually owned: P 70% 10% S P owns 70% of S. S owns 10% of P. Outside entities hold 30% of S’s stock and 90% of P’s stock.

Parent company stock that is mutually held may be accounted for by either the treasury stock approach or the conventional approach.

Under the treasury stock approach, the parent company stock held by the subsidiary is considered treasury stock of the consolidated entity. a

The investment in parent company stock is maintained on a cost basis.

The cost of the investment is deducted from stockholders’ equity in the consolidated balance sheet.

Under the conventional approach parent company stock held by a subsidiary is considered constructively retired. a

Capital stock and retained earnings applicable to the mutually held stock do not appear in the consolidated statements.

Parent company capital stock and retained earnings will not equal consolidated capital stock and retained earnings unless the parent company makes an entry on its separate books to record the constructive retirement of stock as an actual retirement.

The incomes of the parent and subsidiary are mutually related and should be determined simultaneously. The use of simultaneous equations is one approach. It involves two steps: (1)

Income of the parent and subsidiary are computed on a consolidated basis that includes the mutual income.

(2)

The parent’s income on a consolidated basis is then multiplied by the ownership percentage held outside the affiliated group to determine the parent’s net income (and consolidated net income). Likewise, the subsidiary’s income on a consolidated basis is multiplied by the noncontrolling interest percentage to determine the noncontrolling interest income on an equity basis.

(3)

Refer to the diagram for mutually held parent company stock in which the parent company owns 70% of the stock of the subsidiary, and the subsidiary owns 10% of the stock of the parent. Separate earnings for P and A are $76,600 and $50,000, respectively, and there are no cost/book value differentials or unrealized profits. Computations are as follows:

P = P’s income on a consolidated basis A = A’s income on a consolidated basis P = P’s separate earnings of $76,600 + 70% of A A = A’s separate earnings of $50,000 + 10% of P P = $76,600 + .7($50,000 + .lP) P = $76,600 + $35,000 + .07P .93P = $111,600 P = $120,000 (income on a consolidated basis) P’s net income = $120,000 x 90% = $108,000 A = $50,000 + ($120,000 x 10%) A = $62,000 (income on a consolidated basis) Noncontrolling interest income = $62,000 x 30% = $18,600 C

Subsidiary stock mutually owned: P

70% A 60%

20%

B When the mutual holdings involve subsidiaries holding the stock of each other, the treasury stock approach is not applicable, and the separate incomes of the affiliates should be allocated using the conventional approach.

Description of assignment material

Minutes

Questions (15) Exercises (13) E9-1 [Pop/Son] Calculate consolidated net income E9-2 [Pam/Sun] Allocate investment income and loss E9-3 [Place] Prepare an income allocation schedule (includes unrealized profit on land) E9-4 [Pin] 3 MC problems (Determine equation to compute income from subsidiary, noncontrolling interest share, and controlling interest share of consolidated net income) E9-5 [Pal, etc] Prepare income allocation schedule (5 affiliates and unrealized inventory profit) E9-6 [Pet, etc] Calculate controlling interest share and noncontrolling interest share of consolidated net income E9-7 [Pan, etc] 5 MC problem-type questions (No intercompany profits) E9-8 [Pat/Sam/Ten] 4 MC problem-type questions (Correcting net income for unrealized profits) E9-9 [Pan/Sol] Calculate consolidated net income (conventional method, no complications) E9-10 [Pad/Sad/Two] Prepare computations (subsidiary stock mutually held, no unrealized profits) E9-11 [Pin/Son/Tin] AICPA 4 MC problem-type questions (Mutually held parent-company stock) E9-12 [Pet/Sod] 2 MC problem-type questions (Mutually held parent stock) E9-13 [Pug/Sat] Computations (treasury stock and conventional)

Description of Assignment Material (cont’d) .

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Minutes

Problems (7) P9-1 [Pad] Schedule for allocating income (unrealized profits and goodwill) P9-2 [Pot/Sea] Prepare journal entries, computations, and a financial position summary (unrealized profits) P9-3 [Pen etc] Financial statement workpaper (goodwill and unrealized profits) P9-4 [Par/Sit/Tot] Computations for mutually held subsidiaries P9-5 [Pin/Sun] Financial statement workpaper (treasury stock approach) P9-6 [Par/Sip] Consolidation workpaper second year (conventional approach) P9-7 [Pop/Son] Computations and entries (parent stock mutually held)

35 50 80 40 50 80 60

PROFESSIONAL RESEARCH ASSIGNMENT Answer the following questions by reference to the FASB Codification of Accounting Standards. Include the appropriate reference in your response. PR 9-1 Par Corporation owns a 30 percent interest in Sox Corporation, which Par properly accounts for using the equity method. Sox is in need of capital and decides to issue an additional 10,000 shares of common stock to the public. After issuance, Par’s ownership interest will decline to 25 percent. How will the share issuance impact Par’s financial statements? PR 9-2 Pop Corporation owns 80 percent of Son Corporation, and properly included Son as a subsidiary in preparing consolidated financial statements for the year ended December 31, 2016. Pop issued the financial statements on March 1, 2017. In May of 2017, Son had an explosion that severely damaged one of its major manufacturing operations. The cost of replacement will require Son to issue additional shares of stock, which will reduce Pop’s ownership to 60 percent. Will Pop be required to restate the December 31, 2016 financial statements for this subsequent event?

Chapter 10 SUBSIDIARY PREFERRED STOCK, CONSOLIDATED EARNINGS PER SHARE, AND CONSOLIDATED INCOME TAXATION Learning Objectives 10.1 Modify consolidation procedures for subsidiaries with outstanding preferred stock. 10.2 Calculate basic and diluted earnings per share for a consolidated entity. 10.3 Understand the complexities of accounting for income taxes by consolidated entities. Chapter Outline SUBSIDIARIES WITH PREFERRED STOCK OUTSTANDING (Illustration 10-1) (Learning Objective 10.1) A

The stockholders’ equity of a subsidiary with preferred stock outstanding is allocated to the preferred stockholders, based on the preferred contract, and the remainder is common stockholders’ equity. 1

The preferred stockholders’ equity is based on the call or redemption price.

If the preferred stock has no redemption provision, the preferred equity is based on par value plus any liquidation premium.

If the preferred stock is cumulative, the preferred stockholders’ equity includes any dividends in arrears.

Net income of an investee or subsidiary with preferred stock outstanding is allocated to the preferred stockholders, based on the preferred contract, and the remainder is allocated to common stockholders. 1

If the preferred stock is nonparticipating, income is assigned to preferred stockholders based on the preference rate or amount.

If the preferred stock is cumulative and nonparticipating, the current year dividend requirement is assigned to preferred stock, regardless of whether the directors declare any dividend.

If the preferred stock is noncumulative and nonparticipating, only dividends declared and in the amount declared are assigned to preferred stockholders.

A parent company buys common stock of a subsidiary that has cumulative, nonparticipating preferred stock in its capital structure. 1

Preferred equity is deducted from total stockholders’ equity to determine common stockholders’ equity.

The price paid for the investment in common equity is compared to the fair value the common equity interest acquired to determine goodwill.

The parent’s share of subsidiary reported income is its ownership interest times the subsidiary’s income allocated to the common stock.

Noncontrolling interest that appears in the consolidated balance sheet consists of the preferred stockholders’ equity plus the noncontrolling interest in the subsidiary’s common stockholders’ equity.

Noncontrolling interest income in the consolidated income statement consists of the income to preferred stockholders plus the noncontrolling interest’s share of the subsidiary’s income to common stock.

In the consolidation workpapers, an entry is necessary to reclassify the preferred stock as noncontrolling interest.

A parent company acquires the preferred stock of a subsidiary. 1

From the viewpoint of the consolidated entity, the preferred stock is retired and no longer a noncontrolling interest. The retirement of the preferred stock is really a constructive retirement because the stock will be reported as outstanding in the separate financial statements of the subsidiary.

In the consolidation workpapers, the equity related to the preferred stock held by the parent and the investment in preferred stock are eliminated. Any difference is charged or credited to additional paid-in capital. If additional paid-in capital is insufficient to absorb the excess of purchase price over book value, the parent’s retained earnings is charged.

In the parent company’s separate books, the investment in subsidiary preferred stock is adjusted to its book value at acquisition, and the parent’s additional paid-in capital is charged or credited for the difference between the cost of the investment and its underlying book value. a

The investment in preferred stock is accounted for on the basis of its book value, and not on the basis of the cost or equity methods.

Without this adjustment on the parent company books, parent company net income and stockholders’ equity would not equal consolidated net income and stockholders’ equity. 96

If the constructive retirement is not recorded on the parent’s books, the investment is maintained on a cost basis. In this case, a workpaper adjustment to additional paid-in capital is required for each year the statements are consolidated. The consolidated financial statements are not affected by the parent company’s accounting for its investment.

PARENT AND CONSOLIDATED EARNINGS PER SHARE (Illustration 10-2) (Learning Objective 10.2) A

Parent company and consolidated earnings per share are identical. Basic earnings per share are always identical when the parent company uses the complete equity method. 1

When a subsidiary has no potentially dilutive securities, the procedures for computing consolidated EPS are the same as for separate entities.

When a subsidiary has potentially dilutive securities, the potential dilution must be considered in computing the parent’s diluted EPS. a

If the subsidiary’s potentially dilutive securities are convertible into subsidiary common stock, the potential dilution is reflected in subsidiary EPS computations, which are then used in determining parent company EPS.

If the subsidiary’s potentially dilutive securities are convertible into parent company common stock, they are treated as parent company dilutive securities and are included directly in computing the parent company's EPS. In this case, subsidiary EPS computations are not used in parent company EPS computations.

Dilutive securities of the subsidiary are convertible into subsidiary shares. The diluted earnings of the parent company are adjusted to replace the parent’s equity in subsidiary realized income with the parent’s share of the diluted earnings of the subsidiary. 1

The “parent’s equity in subsidiary realized income” is the parent’s percentage interest in the reported income of the subsidiary adjusted for the effects of intercompany profits from upstream sales and constructive gains or losses of the subsidiary.

The amortization of cost/book value differentials, unrealized profits for downstream sales, and constructive gains and losses assigned to the parent company that are excluded from the computation of income from subsidiary are not considered in the computation of the parent’s equity in subsidiary realized income. This is because these items do not affect the subsidiary’s equity.

EPS computations a

This computation of the subsidiary’s EPS is made only for calculating the parent’s EPS, and it may not be the same as one prepared by the subsidiary for its own external reporting.

Subsidiary EPS computations are based on subsidiary realized income. For this purpose, unrealized profits of the subsidiary are eliminated, and constructive gains and losses of the subsidiary are included.

The “parent’s equity in the subsidiary’s diluted earnings” is computed by multiplying the subsidiary shares owned by the parent by the subsidiary’s diluted EPS.

Diluted securities of a subsidiary convertible into parent company shares 1

The parent company common shares are adjusted when potentially dilutive securities of the subsidiary are convertible into parent company stock.

Income attributable to the potentially dilutive securities of the subsidiary under the “if converted” method is added to the parent’s earnings in calculating the parent’s diluted earnings.

INCOME TAXES OF CONSOLIDATED ENTITIES (Learning Objective 10.3) A

A consolidated entity may elect to file a consolidated tax return if it is classified as an affiliated group under Sections 1501 through 1504 of the IRC. 1

An affiliated group exists when a common parent corporation owns at least 80% of the voting power of all classes of stock and 80% or more of the total value of all outstanding stock of each of the includable corporations. The common parent must meet the 80% requirements directly for at least one includable corporation.

All consolidated entities that are not an affiliated group must file separate returns for each affiliated company.

Consolidated tax returns of consolidated entities: 1

Intercompany dividends are excluded from taxable income. This 100% exclusion of dividends from members of the affiliated group applies even if the companies file separate tax returns.

Losses of one affiliate can be offset against income of other affiliates. Loss carryforwards existing at the time an affiliate is acquired can be offset only against taxable income of that affiliate.

Intercompany profits and losses are deferred until realized.

Each subsidiary included in the consolidated tax return must use the parent’s tax year.

Separate tax returns of consolidated entities: 1

Dividends from members of the same affiliated group are 100% excludable from income even when separate returns are filed.

Corporate taxpayers can deduct 80% of the dividends received from domestic corporations that are 20 to 80% owned and can deduct 70% of the dividends received from domestic corporations that are less than 20% owned.

Income taxes are payable on unrealized intercompany profits, but taxes otherwise payable are reduced for unrealized intercompany losses.

INCOME TAX ALLOCATION (Illustration 10-3) A

Under GAAP, the objectives of accounting for income taxes are as follows: 1

Recognize the amount of taxes payable or refundable for the current year; and

Recognize deferred tax liabilities and assets for the future tax consequences of events that have been recognized in the financial statements or tax returns.

Events that have future tax consequences are temporary differences. 1

Some accounting/income tax differences are temporary differences when separate tax returns are filed, but not when consolidated tax returns are filed. a

Unrealized and constructive gains and losses from intercompany transactions are temporary differences when separate tax returns are filed. This is because the gains and losses are not included in accounting income until realized, but the individual companies are taxed on the income included in their separate statements.

Unrealized and constructive gains and losses from intercompany transactions are not temporary differences when consolidated returns are filed. This is because the gains and losses are deferred until realized in both the consolidation workpapers and the consolidated tax return.

Temporary differences 1

Temporary differences from undistributed earnings of a subsidiary (or equity investee): a

Investors pay income taxes on dividends currently received (distributed income) from equity investees and subsidiaries that are not members of the affiliated group.

The investor provides for deferred income taxes on its share of the investee’s undistributed income (i.e., the investee’s net income less dividends).

Temporary differences from unrealized gains and losses from intercompany transactions in separate tax returns: a

The selling entity includes the gain or loss from the intercompany sale in its separate tax return and pays the tax or receives the tax benefit currently.

The tax effect of the temporary difference from the unrealized gain or loss is included in measuring the income tax expense of the selling affiliate. Under this approach: (1)

Intercompany profits are eliminated on a gross basis.

(2)

Consolidated income tax expense is equal to the combined income tax expense of the consolidated entities.

When consolidated tax returns are filed, the tax liability is allocated among the affiliated companies. There are four methods currently used to allocate income taxes among affiliates: 1

Separate return method: Each subsidiary computes its income taxes as if it were filing a separate return.

Agreement method: The tax expense is allocated by agreement between the parent and subsidiaries.

With-or-without method: The income tax provision is computed for the group with and without the pretax income of the subsidiary, and the subsidiary’s income tax expense is the difference.

Percentage allocation method: The consolidated income tax expense is allocated to a subsidiary on the basis of its pretax income as a percentage of consolidated pretax income. This method is used in the textbook.

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BUSINESS COMBINATIONS (Illustration 10-4) A

Business combinations may be taxable or tax free under the IRC. Any of the following combinations is possible. 1

In a taxable purchase business combination, the assets and liabilities of the acquired corporation are revalued to reflect the acquisition values for both accounting and tax purposes.

In a tax-free purchase business combination, the assets and liabilities are carried forward at their book values for tax purposes but are revalued for accounting purposes.

When assets and liabilities are revalued for tax purposes, the seller recognizes gain or loss equal to the fair value of the consideration received minus the tax bases of the assets or stock sold.

Accounting for a taxable purchase business combination:

Assets and liabilities acquired are recorded at their gross amount.

Since the tax basis and the book basis are the same, no deferred tax assets or liabilities are recorded.

Goodwill is tax deductible for purchases after August 1993 based on the Revenue Reconciliation Act of 1993 (section 197). The amortization period for tax purposes is 15 years. Goodwill is no longer amortized for financial reporting purposes.

Accounting for a tax-free purchase business combination: 1

Assets and liabilities are recorded at their gross amount.

The difference between the tax basis (book values) and the assigned values of assets and liabilities acquired times the tax rate is recorded as a deferred tax liability or deferred tax asset. Goodwill is excluded—no deferred tax liability is set up for goodwill.

Goodwill is not tax deductible.

FINANCIAL STATEMENT DISCLOSURES FOR INCOME TAXES A

Deferred tax assets or liabilities are disclosed on the balance sheet in two categories, a current and a non-current amount based on the related asset or liability. If the deferred 101

item is not related to a specific item, its classification depends on the reversal date of the temporary difference. B

Significant components of income tax expense or benefit should be disclosed on the income statement, or in the notes to the financial statements. Amounts allocated to continuing operations, discontinued operations, extraordinary items, and prior-period adjustments should be separately disclosed.

Description of Assignment Material

Minutes

Questions (17) Exercises (19) E10-1 AICPA [Pop/Son] 4 MC problem type questions (Preferred stock and income tax) E10-2 [Sun/Pam] [Preferred stock] Subsidiary preferred stock with dividends in arrears E10-3 [Pop/Son] [Preferred stock] Goodwill and investment income− subsidiary preferred stock E10-4 [Pam/Sun] [Preferred stock] Investment cost and net income− subsidiary preferred stock E10-5 [Son/Pop] [Preferred stock] Journal entries−parent owns both common and preferred stock of subsidiary E10-6 [Pam/Sun] [Preferred stock] Fair value/book value differentials for preferred and common stock E10-7 [EPS] 3 MC General questions E10-8 [Pop/Son] [EPS] 4 MC problem-type questions (Consolidated EPS with goodwill, noncontrolling interest, and warrants) E10-9 [Pam/Sun] [EPS] Consolidated basic and diluted EPS Description of Assignment Material (cont’d) E10-10 E10-11 E10-12 E10-13 E10-14 E10-15

20 20 25 20 25 20 10 20 20

Minutes

[Pop/Son] [EPS] Consolidated EPS with unrealized profit from upstream sale [Pow/Soy] [EPS] Subsidiary EPS and consolidated EPS with goodwill and warrants [Tax] 4 MC General questions [Tax] 5 MC problem-type questions (Asset allocation in business combination, tax effect from equity investees) [Pam/Sun] [Tax] Compare separate and consolidated tax filings [Pop/Son] [Tax] Consolidated income statement (downstream gain on sale of equipment) 102

25 25 15 25 15 30

E10-16 E10-17 E10-18 E10-19

[Sun/Pam] [Tax] Journal entries for unrealized profit with separate and consolidated tax returns [Son/Pop] [Tax] Journal entries for unrealized profit from upstream sale and separate tax returns [Pam/Sun] [Tax] Valuation Allowance [Pop/Son] [Tax] Valuation Allowance

20 20 20 20

Problems (16) P10-1 [Pam/Sun] [Preferred stock] Investment in common stock 20 (subsidiary preferred stock) P10-2 [Pop/Son] [Preferred stock] Consolidation entries−investments 40 in preferred and common stock−midyear purchases P10-3 [Pam/Sun] [Preferred stock] Consolidation workpaper 60 (subsidiary preferred stock, equity method, midyear purchase) P10-4 [Pop/Son] [Preferred stock] Consolidation workpaper 70 (subsidiary preferred stock, downstream inventory sales, upstream sale of land, subsidiary bonds) P10-5 [Pam/Sun] [EPS] Computing EPS with convertible debentures 35 P10-6 [Pop/Son] [EPS] Compute basic and diluted EPS 30 (options; preferred stock) P10-7 [Pam/Sun] [EPS] Convertible preferred stock and 40 amortization of excess P10-8 [Pop/Son] [EPS] Compute consolidated EPS; subsidiary diluted 20 P10-9 [Pam/Sun] [EPS] Computations (subsidiary with preferred stock and 40 warrants) P10-10 [Pop/Son] [Tax] Comparative income statements (consolidated and 25 separate tax returns) P10-11 [Pam/Sun] [Tax] Computations and income statement 30 (upstream sales) P10-12 [Pop/Son] Consolidated income statement (downstream sales) 40 P10-13 [Pam/Sun] [Tax] Reconstruct workpaper (separate and 20 consolidated income statements) Description of Assignment Material Minutes (cont’d) P10-14 P10-15 P10-16

[Pop/Son] [Tax] Allocate fair value/book value differentials in a taxable purchase combination [Pop/Son] [Tax] Consolidated income statement (separate returns and intercompany equipment) [Pam/Sun] Computations (separate tax returns with goodwill, downstream inventory sales, and upstream land sale)

PROFESSIONAL RESEARCH ASSIGNMENTS

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Answer the following questions by reference to the FASB Codification of Accounting Standards. Include the appropriate reference in your response. PR 10-1 Your CEO called you into his office to discuss an article he had read over the weekend. The article stated that the FASB had changed accounting for deferred taxes such that all deferred tax assets and liabilities would be treated as noncurrent items. The article continued noting that this would save companies money and would be required for years beginning after December 15, 2016. Your CEO doesn’t know much about accounting or deferred taxes, but he does like saving money. He asks if it would be possible to adopt the new rules immediately. Is this permitted? PR 10-2 What are the required disclosures related to EPS calculations when preparing consolidated financial statements?

Illustration 10-1 Preferred Stock SUBSIDIARY WITH PREFERRED STOCK OUTSTANDING Assumptions 1

Pop owns 90% of Son’s outstanding common stock.

Son has $100,000 par of cumulative 10% preferred stock outstanding.

Pop’s separate income for 20Xl is $100,000.

Son’s separate income for 20Xl is $40,000.

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Outside Stockholders Hold All of Son’s Preferred Stock

P Holds 30% of Son’s Preferred Stock

$100,000

27,000

$127,000

3,000 $130,000

$140,000

3,000 7,000 3,000 $l27,000

3,000 7,000

Pop’s net income for 20XI Pop's separate income Pop's income from Son Income from Son -- common 90% x ($40,000 - $10,000) Income from Son -- preferred 30% x $10,000 Pop’s net income

Consolidated net income for 20XI Combined separate incomes of Pop and Son Less: Noncontrolling interest Common 10% x ($40,000 - $10,000) Preferred 70% x $10,000 30% x $10,000 Consolidated net income Note:

$130,000

Since the preferred stock of Son is cumulative, Pop's net income and consolidated net income are the same regardless of whether Son declares dividends during the year.

Illustration 10-2 Earnings per Share BASIC COMPUTATIONS FOR CONSOLIDATED EARNINGS PER SHARE

EPS =

Subsidiary has no potentially dilutive securities (PDS) outstanding: Parent’s income to common + parent’s adjustment for PDS ____________________ Parent’s common shares outstanding + shares represented by parent’s PDS

Subsidiary has potentially dilutive securities (PDS) outstanding convertible into subsidiary common stock:

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EPS =

Subsidiary has potentially dilutive securities (PDS) outstanding and convertible into parent common stock:

EPS =

Parent’s income to common + parent’s adjustment for PDS + replacement calculation for subsidiary’s PDS Parent’s common shares outstanding + shares represented by parent’s PDS

Parent’s income to common + parent’s adjustment for its PDS + adjustment for subsidiary’s PDS convertible into parent common stock__________ Parent’s common shares outstanding + shares represented by parent’s PDS and subsidiary’s PDS

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Illustration 10-3 Accounting for Income Taxes ACCOUNTING FOR DISTRIBUTED AND UNDISTRIBUTED INCOME Assumptions 1

Pop owns 60% of Son, a domestic corporation.

Son reports net income of $250,000 and pays $150,000 dividends.

A flat 34% tax rate is applicable.

Pop's share of Son's distributed income: 60% x $150,000 dividends

$90,000

Pop's tax liability on the $90,000 dividends received: $90,000 dividends x 20% taxable x 34% tax rate

$ 6,120

Pop's share of Son's undistributed income: ($250,000 - $150,000) x 60%

$60,000

Pop provides for income taxes on undistributed earnings: $60,000 x 20% taxable x 34% tax rate

$ 4,080

Income taxes currently payable Deferred income taxes Income tax expense

$6,120 4,080 $10,200

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Illustration 10-4 SEPARATE TAX RETURNS AND INTERCOMPANY GAIN Assumptions 1 2 3 4 5

Pop owns a 60% interest in Son. Pop sells land that cost $12,000 to Son for $18,000. A 34% tax rate is applicable. Son pays $10,000 dividends during the year. Income statements for Pop and Son are as follows:

Sales Gain on sale of land Income from Son Cost of sales Operating expenses Income tax expense Net Income

Pop

Son

$200,000 6,000 5,880 (120,000) (60,000) (7,608) $ 24,272

$150,000

(90,000) (30,000) (10,200) $ 19,800

Pop's income from Son: $19,800 x 60% owned - $6,000 unrealized gain from sale of land Pop's share of Son's undistributed income: ($19,800 income - $10,000 dividends) x 60% x 20% taxable = $1,176 Pop's income tax expense is computed as follows: Tax on operating income ($200,000 sales - $120,000 cost of sales - $60,000 operating expense) x 34% Tax on gain from sale of land ($6,000 x 34%) Tax on dividends received ($10,000 x 60% x 20% taxable x 34%) Taxes currently payable Less: Change in deferred income taxes: (Unrealized gain on land $6,000 less the $1,176 taxable share of Son's undistributed earnings) x 34% Income tax expense

$6,800 2,040 408 9,248

(1,640) $7,608

Pop will increase a deferred tax asset or decrease a deferred tax liability by $1,640.

ELECTRONIC SUPPLEMENT .

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Describes accounting for sales agencies and branches: 1. Sales agencies display merchandise and take orders, but do not stock merchandise to fill customer orders. 2. Branch operations stock merchandise, make sales to customers, pass on customer credit, collect receivables, incur expenses, and perform functions associated with the operations of a separate business enterprise.

Sales agencies usually only require cash receipt and disbursement records, which are maintained in the central accounting system of the controlling enterprise.

Branch accounting involves segmenting the accounting system of an enterprise into separate accounting systems for home office and branch operations. Home office and branch financial statements are combined in a manner similar to consolidating parent and subsidiary financial statements.

The home office and branch accounts should be reconciled at year-end to ensure that errors have not been made and that there are reciprocal balances between the two.

Financial statements for the enterprise as a whole are developed by combining the separate statements of the home office and its branches.

ASSIGNMENT MATERIAL W10-1 W10-2 W10-3 W10-4 W10-5 W10-6 W10-7 W10-8 W10-9 W10-10 W10-11 W10-12 W10-13 W10-14 W10-15

Minutes

Branch accounting question Sales agency question Sales agency question Branch account function question Home office/branch question Reciprocal balance question Transfer price question Allocation of home office expense question Home office and branch journal entries Adjusting entries on home office books to eliminate unrealized profits Determine cost of goods sold with outside purchases Prepare a reconciliation of home office and branch accounts Cost of sales schedule and comparative home office, branch, and combined income statements Closing entries, combined balance sheet, and income statement Prepare a schedule of cost of sales and combining working papers

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5 5 5 5 5 5 5 5 30 10 15 20 30 45 45

Chapter 11 CONSOLIDATION THEORIES, PUSH-DOWN ACCOUNTING, AND CORPORATE JOINT VENTURES Learning Objectives 11.1 Compare and contrast the elements of consolidation approaches under parentcompany and contemporary/entity theories. 11.2 Adjust subsidiary assets and liabilities to fair values using push-down accounting. 11.3 Account for corporate and unincorporated joint ventures. 11.4 Identify variable interest entities. 11.5 Consolidate a variable interest entity Chapter Outline CONSOLIDATION UNDER PARENT-COMPANY AND ENTITY THEORIES (Illustration 11-1) (Learning Objective 11.1) A

Contemporary theory evolved from practice and is essentially an entity approach to the preparation of consolidated financial statements.

Traditional theory reflected parts of both the parent-company theory and the entity theory.

Underlying assumptions of the parent-company theory are summarized as follows:

The viewpoint is that consolidated financial statements are an extension of parent statements and are prepared from the viewpoint of parent stockholders.

Consolidated net income is a measure of income to the parent stockholders.

Noncontrolling interest is a liability from the viewpoint of parent shareholders.

Similarly, noncontrolling interest share is considered an expense from the viewpoint of the majority stockholders.

Subsidiary assets are initially consolidated at their book values plus the parent’s share of any excess of fair value over book value. Subsidiary net assets are revalued only to the extent acquired by the parent company.

The noncontrolling interest in subsidiary assets and liabilities is consolidated at book value.

All unrealized gains and losses from downstream intercompany sales are eliminated until realized. 110

Unrealized gains and losses from upstream intercompany sales are eliminated to the extent of the parent company ownership interest. The amount not eliminated is considered realized for noncontrolling shareholders.

Underlying assumptions of the entity theory are summarized as follows: 1

The viewpoint is that of the consolidated entity as a whole. The consolidated statements should provide information for all interest holders.

Total consolidated net income is a measurement of income to all equity stockholders, and it is allocated in the financial statements to majority and noncontrolling interests.

Noncontrolling interest is an equity interest shown in the stockholders’ equity section of the consolidated balance sheet.

Subsidiary assets and liabilities are consolidated at their fair values.

A total subsidiary value is imputed from the price paid by the parent company for its majority interest.

All unrealized gains and losses from downstream intercompany sales are eliminated until realized.

Unrealized gains and losses on upstream intercompany sales are eliminated by allocating them proportionately to majority and noncontrolling interests.

See Exhibit 11-1 in the text for a comparison of consolidation theories.

Current GAAP differs from pure equity theory in reporting consolidated stockholder’s equity. 1

Under entity theory, both controlling and noncontrolling interests are components of consolidated equity.

Entity theory would show the components of each interest, i.e., breaking the controlling and noncontrolling interests into their respective shares of contributed capital and retained earnings.

Under GAAP, the noncontrolling interest is shown as a single, combined amount under consolidated stockholders’ equity. PARENT-COMPANY ACCOUNTING UNDER THE EQUITY METHOD

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Parent-company and entity theories do not affect parent accounting under the equity method because the extra values under entity theory were reflected in the noncontrolling interest, not the majority interest.

The separate company statements will be the same for the parent and subsidiary under both theories.

However, consolidated statements are affected, and different amounts are likely for consolidated assets, liabilities, and noncontrolling interests.

PUSH-DOWN ACCOUNTING (Illustration 11-2) (Learning Objective 11.2) A

Under push-down accounting, the fair values of an acquired subsidiary’s assets and liabilities are recorded in the separate financial statements of the purchased subsidiary (values “pushed down” to subsidiary’s statements). 1

The SEC requires push-down accounting in its filings when a subsidiary is substantially wholly owned (usually 90%) with no substantial publicly held debt or preferred stock outstanding.

Push-down accounting affects only the subsidiary’s separate financial statements. a

Without push-down accounting, the allocation of the purchase price to identifiable assets and goodwill is done in the consolidation workpaper.

Under push-down accounting, the allocation is done on the books of the subsidiary.

Consolidated financial statements are exactly the same under either procedure.

Supporters of push-down accounting are not in agreement regarding: 1

The percentage ownership necessary for push-down accounting, and

Whether the allocation should reflect 100% of the fair values of the subsidiary’s assets and liabilities if less than a 100% change in ownership has occurred.

Push-down accounting can be applied under either parent-company theory or entity theory. 1 Push-down accounting under parent-company theory: a

Cost/book value differentials are allocated in the usual manner.

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The values from the allocation schedule are pushed down to the subsidiary records. (1)

For example, if a 90% interest is purchased, 90% of the difference between cost and fair value is pushed down to the subsidiary’s books.

The subsidiary makes a journal entry to revalue assets and liabilities, eliminate retained earnings, and enter push-down capital.

Push-down accounting under entity theory: a

A total value of the subsidiary is imputed from the price paid by the parent for the interest acquired. (1)

The excess implied value over the book value of the subsidiary’s net assets is assigned to the individual assets and liabilities on the basis of 100% of the fair value/book value differentials and the remainder to goodwill.

(2)

For example, if a 90% interest is purchased, 100% of the implied value (difference between cost and fair value) is pushed down to the subsidiary’s books.

The subsidiary makes a journal entry to revalue assets and liabilities, eliminate retained earnings, and record push-down capital.

JOINT VENTURES (Learning Objective 11.3) A

Joint ventures are business entities that are owned, operated, and jointly controlled by a small group of investors (venturers) for the conduct of specific business undertakings that provide mutual benefit for each of the venturers. No single venturer controls the operations.

Joint ventures may be organized as corporations, partnerships, or undivided interests. The AICPA’s SOP 78-9 defines the following forms of joint ventures: 1

A corporate joint venture is a corporation owned and operated by a small group of venturers to accomplish a mutually beneficial venture or project. a

Venturers that participate in the management of the corporate joint venture and hold no more than 50% interest in the venture account for their interest by the equity method. 113

A corporation that is a subsidiary of another corporation is not a corporate joint venture. (1)

The subsidiary is consolidated in the financial statements of the majority owner. The other investors account for their investments under the equity method.

Unincorporated joint ventures include the following: a

A general partnership is an association in which each partner has unlimited liability. A limited partnership is an association in which one or more general partners have unlimited liability, and one or more partners have limited liability. (1)

GAAP explains that many of the provisions of the equity method should be applied to investments in unincorporated joint ventures.

(2)

Partnership profits and losses accrued by the venturers are generally reflected in the partners’ financial statements.

(3)

The elimination of intercompany profits and losses is generally appropriate.

An undivided interest is an ownership arrangement in which two or more parties jointly own property, and title is held individually to the extent of each party’s interest. Each venturer is proportionately liable for the venturer’s share of each liability. (1)

Some undivided interests are accounted for in the same manner as partnership joint ventures.

(2)

Others follow specialized industry practices in which each venturer accounts for its pro rata share of the assets, liabilities, revenues, and expenses of the joint venture in its own financial statements. This is called pro rata or proportionate consolidation.

VARIABLE INTEREST ENTITIES (Learning Objectives 11.4 and 11.5) A

The FASB coined the term variable interest entity (VIE) to define special-purpose entities that require consolidation due to contractual or financial arrangements other than voting interests.

114

A VIE can take the form of a corporation, partnership, limited liability company, or trust-type arrangement. 1

A potential VIE must be a separate entity, not a subset, branch, or division of another entity.

Pensions and certain other entities are specifically excluded.

GAAP’s definition of VIEs requiring consolidation encompasses situations where a company may only own a minimal voting equity interest, but be contractually required to provide additional financial support in the event of future operating losses.

Primary beneficiaries are required to consolidate VIEs.

An enterprise shall consolidate a VIE if it has a variable interest that will absorb a majority of the VIE’s expected losses, receive a majority of the VIE’s expected returns, or both.

If one entity will receive the majority of a VIE’s losses, and another the majority of residual returns, the one absorbing the losses consolidates the VIE.

All enterprises holding a significant interest in a VIE must provide certain disclosures. 1

The primary beneficiaries of a VIE must provide more extensive disclosures than the other enterprises not deemed the primary beneficiary.

The primary beneficiary consolidates based on fair value on the date it becomes the primary beneficiary. 1

If the primary beneficiary has transferred assets to the VIE, the assets are transferred at book value and no gain or loss is recorded on the transfer.

Goodwill may be recorded only if the VIE is a business (as defined in FIN 46(R)). Otherwise, any excess of consideration paid over fair value of assets is treated as an extraordinary loss.

Estimating fair value may be challenging if the VIE invests in unique assets; firms may need to use expected future cash flows as a means of estimating fair value.

Description of assignment material

Minutes

Questions (8) .

115

Exercises (13) E11-1 4 MC general questions (Parent-company and entity theories) E11-2 5 MC general questions (Joint ventures) E11-3 4 MC problem-type questions (Parent-company and entity theories) E11-4 [Pop/Son] Computations (parent-company and entity theories) E11-5 [Pam/Sun] Computations under parent-company and entity theories (fair value/book value differentials) E11-6 [Son/Pop] Computations under parent-company and entity theories (midyear acquisition) E11-7 [Pam/Sun] Computations under parent-company and entity theories (upstream sales) E11-8 [Pop/Son] Compute consolidated net income under the two theories (upstream and downstream sales) E11-9 [Pam/Sun] Journal entries for push-down accounting E11-10 [Sun] Determine investment income for corporate joint venturers E11-11 [Pop] Accounting for a VIE beyond the initial measurement date E11-12 [Pam/Sun] VIE reporting and disclosure requirements E11-13 [Pop/Son] Determining the primary beneficiary in a VIE

15 10 20 20 20 20 15 15 20 12 15 15 10

Problems (11) P11-1 [Pop/Son] Consolidated balance sheets (parent-company and entity theories) P11-2 [Pam/Sun] Consolidated balance sheet and income statement under entity theory P11-3 [Pop/Son] Computations (parent-company and entity theories) P11-4 [Sun/Pam] Comparative consolidated statements under alternative theories P11-5 [Pop/Son] Comparative balance sheets under entity theory P11-6 AICPA [P/S] Separate and consolidate financial statements – entity theory P11-7 [Pam/Sun] Journal entry to record push-down, subsidiary balance sheet, and investment income P11-8 [Pop/Son] Journal entries and calculations for push-down accounting

Description of assignment material (cont’d) P11-9 P11-10 P11-11

30 50 40 70 30 30

Minutes

[Pam/Sun] Journal entries and comparative balance sheets at acquisition for push-down [Pam/Sun] Consolidation workpaper one year after acquisition under push-down accounting (both 90%- and 100%-ownership assumptions) [Pop/Son] Workpaper for proportionate consolidation (joint venture)

PROFESSIONAL RESEARCH ASSIGNMENTS .

30 30

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25 70 50

Answer the following questions by reference to the FASB Codification of Accounting Standards. Include the appropriate reference in your response. PR 11-1 This chapter noted that an acquired firm may elect push-down accounting. If the transaction results in recognition of goodwill, should that goodwill also be reflected on the acquiree’s financial statements? PR 11-2 What disclosures are required for a variable interest entity? Are the disclosures only required for VIEs that will be consolidated?

Illustration 11-1 COMPARISON OF PARENT COMPANY THEORY AND ENTITY THEORY ASSET VALUATION Pam Company acquires a 90% interest in Sun Company for $63,000 on January 1, 20X2. Book values and fair values of Sun’s assets and equities are summarized as follows:

Other current assets Inventories Plant assets-net .

Book Value $40,000 15,000 30,000 117

Fair Value $40,000 20,000 38,000

Difference $5,000 8,000

Total assets Liabilities Capital stock $10 par Retained earnings Total equities

$85,000

$98,000

$38,000 25,000 22,000 $85,000

$38,000

Allocation of Purchase Price under Parent Company Theory: The parent’s share of subsidiary assets and liabilities are revalued. Cost Book value acquired ($47,000 x 90%) Excess cost over book value acquired Excess allocated to: Inventories ($5,000 x 90%) Plant assets-net ($8,000 x 90%) Remainder to goodwill Excess cost over book value acquired

$63,000 42,300 $20,700 $ 4,500 7,200 9,000 $20,700

Allocation of Purchase Price under Entity Theory: A total implied value for the subsidiary's assets and liabilities is computed based on the price paid for the parent’s 90% share. Implied value of Sun ($63,000/90%) Book value of Sun’s net assets Excess implied value over book value Excess allocated to: Inventory (100% of difference) Plant assets-net (100% of difference) Remainder to goodwill Excess implied value over book value

$70,000 47,000 $23,000 $ 5,000 8,000 10,000 $23,000

Consolidated Balance Sheets at Acquisition Parent Company Theory Pam 90% Adjustments and Sun Eliminations Other current assets $ 55,000 $40,000 Inventory 25,000 15,000 a 4,500 Plant assets—net 70,000 30,000 a 7,200 Investment in Sam 63,000 a 63,000 Goodwill a 9,000 Total assets $213,000 $85,000 Liabilities .

$120,000

$38,000 118

Consolidated Balance Sheet $ 95,000 44,500 107,200 9,000 $255,700 $158,000

Capital stock 60,000 25,000 a 25,000 Retained earnings 33,000 22,000 a 22,000 Noncontrolling a 4,700 interest Total equities $213,000 $85,000 *Noncontrolling interest equals 10% of the book value of Sun's net assets.

60,000 33,000 4,700 $255,700

Entity Theory Pam Other current assets Inventory Plant assets—net Investment in Sam Goodwill Total assets

$ 55,000 25,000 70,000 63,000 $213,000

90% Adjustments and Sun Eliminations $40,000 15,000 a 5,000 30,000 a 8,000 a 63,000 a 10,000 $85,000

Consolidated Balance Sheet $ 95,000 45,000 108,000 10,000 $258,000

Liabilities $120,000 $38,000 $158,000 Capital stock 60,000 25,000 a 25,000 60,000 Retained earnings 33,000 22,000 a 22,000 33,000 Noncontrolling a 7,000 7,000 interest Total equities $213,000 $85,000 $258,000 *Noncontrolling interest equals 10% of the value implied by Pam's purchase price for its 90% interest ($63,000 / 90%) x 10% = $7,000.

Important points from the illustration: 1

Goodwill. Goodwill can be determined independently. Under entity theory, goodwill is the difference between the total implied value of Sam’s net assets ($70,000) and the fair value of Sam’s net assets ($60,000). Under parent company theory, goodwill is the difference between the investment cost ($63,000) and the fair value acquired ($60,000 x 90%).

Asset and liability valuations. Consolidated net assets are $2,300 greater under entity theory ($100,000) than under parent company theory ($97,700).

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Consolidated net assets under parent company theory consist of the combined book values of Pet and Sam’s net assets plus 90% of the excess of fair value of Sam’s net assets over the book value of those assets.

Consolidated net assets under entity theory consist of the book value of Pet’s net assets plus the fair value of Sam’s net assets.

Stockholders’ equity. On the consolidated balance sheet, capital stock and retained earnings (the majority interest in consolidated net assets) are the same under parent company and entity theories.

Noncontrolling interest. The $2,300 difference in the value of consolidated net assets under parent company and entity theories lies in the measurement of noncontrolling interest ($7,000 under entity theory and $4,700 under parent company theory). If there is no noncontrolling interest, there are no differences in the value of consolidated net assets among the three theories.

Under parent company theory, the purchase price is allocated to the fair values of the identifiable assets and goodwill acquired. Under entity theory, the total fair value of the entity implied by the purchase price is allocated to the fair values of the identifiable net assets and to goodwill.

Illustration 11-2 PUSH-DOWN ACCOUNTING UNDER PARENT COMPANY AND ENTITY THEORIES

Assumptions 1

Pop Company acquires a 90% interest in Son Company for $585,000 on January 1, 20X2.

Book values and fair values of Son’s assets and liabilities are summarized as follows:

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Book Value

Fair Value

Difference

Current assets Land Buildings-net Equipment-net Total assets

$240,000 100,000 250,000 300,000 $890,000

$240,000 120,000 300,000 270,000 $930,000

$20,000 50,000 (30,000)

Liabilities Capital stock $10 par Retained earnings Total equities

$380,000 300,000 210,000 $890,000

$380,000

Goodwill can be computed independently as follows: Parent company theory Cost of 90% interest Fair value of interest acquired ($550,000 x 90%) Goodwill

$585,000 495,000 $ 90,000

Entity theory Implied value of Son ($585,000 / 90%) Fair value of Son Goodwill

$650,000 550,000 $100,000

Parent company theory allocation schedule: Cost Book value acquired ($510,000 x 90%) Excess cost over book value acquired Excess allocated to: Land ($20,000 x 90%) Buildings-net ($50,000 x 90%) Equipment-net (-$30,000 x 90%) Goodwill Excess cost over book value acquired

$585,000 459,000 $126,000 $ 18,000 45,000 (27,000) 90,000 $126,000

Push-down entry under parent company theory is recorded on Son’s books: .

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Land Buildings-net Goodwill Retained earnings Equipment Push-down capital

18,000 45,000 90,000 210,000 $ 27,000 336,000

Entity theory allocation schedule: Implied value of Son ($585,000 / 90%) Book value of Son’s net assets Excess implied value over book value acquired Excess allocated to: Land Buildings-net Equipment-net Goodwill Excess implied value over book value acquired

$650,000 510,000 $140,000 $ 20,000 50,000 (30,000) 100,000 $140,000

Push-down entry under entity theory is recorded on Son’s books: Land Buildings-net Goodwill Retained earnings Equipment-net Push-down capital

$ 20,000 50,000 100,000 210,000 $ 30,000 350,000

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Chapter 12 DERIVATIVES AND FOREIGN CURRENCY: CONCEPTS AND COMMON TRANSACTIONS Learning Objectives – 12.1 Understand the definition of a derivative and the types of risks that derivatives can manage. 12.2 Understand the structure, benefits, and costs of options, futures contracts, forward contracts, and swaps. 12.3 Understand key concepts related to foreign currency exchange rates, such as indirect and direct quotes; floating, fixed, and multiple exchange rates; and spot, current, and historical exchange rates. 12.4 Explain the difference between receivable or payable measurement and denomination. 12.5 Record foreign currency-denominated sales/receivables and purchases/payables at the initial transaction date, period-end, and the receivable or payable settlement date.

Chapter Outline DERIVATIVES (Learning Objective 12.1) A

A derivative is the name given to a broad range of financial securities whose common characteristic is that the derivative contract’s value to the investor is related to fluctuations in price, rate, or some other variable that underlies it.

A hedge is a combined transaction of an existing position and a derivative contract that is designed to manage risk to the firm. Hedge transactions are accomplished using a type of derivative.

(Learning Objective 12.2) C A forward contract is an agreement between two parties to exchange different currencies or a commodity at a specified future date and at a pre-agreed price and quantity. The agreement may require actual delivery or may allow a net settlement, which allows the payment of money so that the parties are in the same economic position as they would have been if delivery had occurred. D

A futures contract shares essentially the same characteristics as a forward contract, but is standardized, allowing it to be easily traded in markets.

Options are a common hedging instrument in which only one of the contracting parties is required to perform while the other party has the ability, but not the obligation, to perform. Option types are either calls (right to buy) or puts (right to sell).

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Swaps are contracts to exchange an ongoing stream of cash flows and are commonly negotiated on an individual basis.

FOREIGN EXCHANGE CONCEPTS AND DEFINITIONS (Learning Objective 12.3) A

A transaction is measured in a particular currency when it is recorded in the financial records in that currency. 1

Assets and liabilities are denominated in a currency if their amounts are fixed in terms of that currency and will be settled in that currency. a

For example, a U.S. company buys merchandise from a Mexican firm for 500,000 pesos, payable in 10 days. The transaction is denominated in pesos; however, the U.S. company must measure the purchase in U.S. dollars before it can be recorded. This is done through the use of exchange rates.

An exchange rate is the ratio between a unit of one currency and the amount of another currency for which that unit can be exchanged at a particular time. The exchange rate can be computed directly or indirectly. 1

A direct quotation is expressed in U.S. dollars. It is the U.S. dollar equivalent of one unit of a foreign currency. For example, a direct quotation for Mexican pesos might be $.08. The purchase denominated at 500,000 pesos is measured at $40,000 U.S. (500,000 pesos x $.08).

An indirect quotation is expressed in the foreign currency. It is the foreign currency units per U.S. dollar. For example, an indirect quotation for Mexican pesos is expressed as 12.5 pesos. The 500,000 pesos purchase is measured at $40,000 (500,000 pesos / 12.5 pesos).

Floating, Fixed, and Multiple Exchange Rates 1

Floating exchange rates reflect fluctuating market prices for a currency based on supply and demand and other factors in world currency markets. a

Theoretically, a currency’s value should reflect its buying power in world markets. If a country’s inflation rate goes up, its currency’s purchasing power goes down, and vice versa.

If the currency’s value falls in relation to other countries, then its value is weakening. However, if the exporting country’s currency becomes more valuable relative to other currencies, then it strengthens.

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Fixed and multiple exchange rates are set by a government and do not change as a result of changes in world currency markets. a

When exchange rates are fixed, the issuing government is able to set (fix) different rates for different kinds of transactions.

When these rates are fixed, the issuing government is able to assign different rates for different kinds of transactions. These rates are referred to as multiple exchange rates.

Spot, Current, and Historical Exchange Rates 1

A spot rate is the exchange rate for immediate delivery of currencies exchanged.

The current rate is the rate at which one unit of currency can be exchanged for another currency at the balance sheet date or the transaction date.

The historical rate is the rate in effect at the date a specific transaction or event occurred.

Foreign Exchange Quotations 1

Major U.S. banks facilitate international trade by maintaining departments that provide bank transfer serviced between U.S. and non-U.S. companies, including currency exchange services.

U.S. bankers that provide foreign exchange services are paid for their services. Their payment comes in the form of the difference between the amount they receive from U.S. corporations and the amount that is paid out in foreign currencies.

FOREIGN CURRENCY TRANSACTIONS OTHER THAN FORWARD CONTRACTS (Learning Objective 12.4) A

Transactions within a country that are measured and recorded in the currency of that country are local transactions.

Foreign transactions are transactions between countries or enterprises in different countries 1

A foreign currency transaction is a transaction whose terms are stated (denominated) in a currency other than an entity’s functional currency.

From a U.S. firm’s perspective, a transaction is a foreign currency transaction only if it is denominated in a foreign currency (a currency other than U.S. Dollar).

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Conversely, international transactions denominated in U.S. dollars are not foreign currency transactions from a U.S. firm’s viewpoint. C

FASB Requirements: 1

GAAP (ASC 830) applies only to foreign currency transactions and to foreign currency financial statements. GAAP states the following requirements for foreign currency transactions other than derivatives: a

At the date the transaction is recognized, each asset, liability, revenue, expense, gain, or loss arising from the transaction shall be measured and recorded in the functional currency of the recording entity by use of the exchange rate in effect at that date.

At each balance sheet date, recorded balances that are denominated in a currency other than the functional currency of the recording entity shall be adjusted to reflect the current exchange rate.

Foreign currency transactions must be translated into U.S. dollars at the spot rate in effect at the transaction date. a

An exchange gain or loss results when the exchange rate changes between the transaction date and the settlement date.

An exchange gain or loss occurs only when the transaction is denominated in a foreign currency.

At the balance sheet date, recorded balances that are denominated in a foreign currency are adjusted to the current exchange rate. a

The difference between the recorded balance and the adjusted balance at the balance sheet date is the exchange gain or loss to be included in current income.

PURCHASES DENOMINATED IN FOREIGN CURRENCY (Learning Objective 12.5) A

Foreign currency denominated purchases must be measured in the functional currency of the reporting entity at the purchase date using the foreign currency spot rate on that date. For example, a U.S. company that purchases a vehicle in Italy would recognize and record the transaction in U.S. dollars at the purchase date, based on the exchange rate between dollars and euros on that day.

Similarly, foreign currency-denominated sales must be measured in dollars at the sales date using the foreign currency spot rate on that date.

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Description of assignment material

Minutes

Questions (13) Exercises (11) E12-1 4 multiple-choice questions E12-2 4 multiple-choice questions E12-3 3 multiple-choice questions E12-4 [Zip] Accounting for foreign currency-denominated purchases E12-5 [Ava] Accounting for foreign currency-denominated purchases settled in subsequent year E12-6 [Wik] Accounting for foreign currency-denominated sales settled in subsequent year E12-7 [Dot] Accounting for foreign currency-denominated sales E12-8 AICPA 4 short problem-type questions E12-9 [Moe] Various foreign currency-denominated transactions settled in subsequent year E12-10 [ATV] Various foreign currency-denominated transactions settled in subsequent year Problems (5) P12-1 [TCO] The economics of derivatives P12-2 [Sue] The economics of derivatives P12-3 [Sue] The economics of derivatives P12-4 [Lin] Accounting for foreign currency- denominated receivables and payables – multiple years P12-5 [Sho] Foreign currency-denominated receivables and payables – multiple years

20 20 15 15 15 10 10 20 15 15

15 30 30 30 30

PROFESSIONAL RESEARCH ASSIGNMENTS Answer the following questions by reference to the FASB Codification of Accounting Standards. Include the appropriate reference in your response. PR 12-1 What are the primary characteristics that define a derivative? How many paragraphs does it take the ASC to define a derivative completely?

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Chapter 13 ACCOUNTING FOR DERIVATIVES AND HEDGING ACTIVITIES Learning Objectives 13.1 Account for derivative instruments that are not designed as a hedge. 13.2 Understand the definition of a cash-flow hedge and the circumstances in which a derivative is accounted for as a cash-flow hedge. 13.3 Understand the definition of a fair-value hedge and the circumstances in which a derivative is accounted for as a fair-value hedge. 13.4 Account for a cash-flow-hedge situation from inception through settlement and for a fair-value-hedge situation from inception through settlement. 13.5 Understand the special derivative accounting related to hedges of existing foreign currency-denominated receivables and payables. 13.6 Comprehend the footnote disclosure requirements for derivatives. 13.7 Understand the International Accounting Standards Board accounting for derivatives. Chapter Outline HEDGE ACCOUNTING (Learning Objective 13.1) A

A hedge contract is a form of derivative. ASC Topic 815 establishes three defining characteristics for a derivative. 1

It has one or more underlyings and one or more notional amounts or payment provisions, or both.

It requires no initial net investment or one that is smaller than required for other similar contracts.

It requires or permits net settlement, so it can readily be settled net outside the contract, or it provides for asset delivery that puts the recipient in a position not substantially different from net settlement.

For hedged items and the derivative instruments designated to hedge them to qualify for hedge accounting, formal documentation must be prepared at the inception of the hedge. Among other things, this documentation describes the relationship between the hedged item and the derivative, and the risk management objective and strategy the company is achieving through the hedging relationship.

Once a type of risk is identified that qualifies for hedge accounting, the effectiveness of the hedge is assessed both at the inception of the hedge and during the hedge’s existence.

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One of three types of hedge accounting must be used to account for the derivative and the related hedge item. (Learning Objectives 13.2 and 13.3) 1

Fair-value hedge accounting is used when the item being hedged is an existing asset or liability position or firm purchase or sale commitment. Both the item being hedged and the derivative are marked to fair value, and the gain or loss is immediately recognized in earnings.

Cash-flow hedge accounting hedges the exposure to variability in expected future cash flows associated with that risk. The effective portion of the related gain or loss recognition is deferred until the forecasted transaction affects income. The gain or loss is included as a component of Accumulated Other Comprehensive Income (AOCI).

Hedge of a net investment in a foreign subsidiary is covered in Chapter 14.

EXAMPLES OF HEDGES (Learning Objective 13.4) A

A cash-flow hedge attempts to control the impact of price fluctuations on its future cash flows of a financial asset or liability. 1

Option contracts are designed to limit a company’s exposure to price changes in forecasted purchases of assets. a

The option must be recorded at fair value on the financial statement date (computed as the present value of the option payment).

The gain or loss is deferred by including it in other comprehensive income.

Futures contracts are cash-flow hedges of forecasted transactions. a

The futures contract has an observable market and must be market-tomarket at year end.

Gains and losses are included in other comprehensive income.

A fair-value hedge is a highly effective hedge for either existing assets, liabilities, or firm sales/purchase commitments. a

The owner of an asset enters into a forward contract to sell the asset at an agreed-upon price at a later date. The accounting for this situation 129

requires writing the derivative to market at each financial statement date and increase or decrease the value of the asset by the change in fair value from the date the contract is signed to the financial statement date. b

The asset is not marked to fair value unless the fair value equals original cost on the date the contract is signed. If the values are different, the asset will only be changed by the difference between its fair value and the fair value at the derivative signing date. This is known as the mixedattribute model.

Interest rate swaps and cash-flow hedge accounting reduce the risk of variable interest rate loans. When treated as cash-flow hedges, these instruments reduce the variability in cash flows related to the debt.

Interest rate swaps and fair-value hedge accounting reduce the risk of the fair value of fixed-rate loan fluctuation due to changes in market interest rates.

FOREIGN CURRENCY DERIVATIVES AND HEDGING ACTIVITES (Learning Objective 13.5) GAAP requires marking to fair value (the current spot rate) foreign-currency denominated receivables and payables at year end. The resulting gain or loss is recognized immediately in income. The forward premium or discount is the difference between the contracted forward rate and the spot rate on the date the contract is entered into. A

For a forward contract to qualify for cash-flow hedge accounting, it must have the following characteristics: 1

Cash-flow hedges can be used in recognized foreign currency-denominated asset and liability situations if the variability of the cash flows is completely eliminated by the hedge.

The transaction gain or loss arising from the remeasurement of the foreign currency-denominated asset or liability is offset by a related amount reclassified from other comprehensive income to earnings each period.

The premium or discount related to the hedge is amortized into income using the effective interest rate.

Fair-value hedge of an identifiable foreign currency commitment 1

A foreign currency commitment is a contract or agreement denominated in foreign currency that will result in a foreign currency transaction at a future date.

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It differs from an exposed asset or liability position because it does not meet the accounting tests for recording the related asset or liability on the books.

If the forward contract is designated as a hedge of an identifiable foreign currency commitment, the purchase is recorded as a contract receivable and contract payable.

Both must be adjusted on the balance sheet date using the forward rate of the currency.

The recorded gain or loss on the hedge needs to be offset by a corresponding gain or loss on the underlying firm commitment.

Cash-flow hedge of an anticipated foreign currency commitment 1

Anticipated commitments don’t create hedged items on the balance sheet that must be marked to fair value until the actual sale occurs.

The forward contract, however, must be recorded at estimated fair value at year end.

Resulting gains or losses on cash flow hedges are recorded in other comprehensive income.

A derivative instrument that speculates in foreign currency price movements is valued at forward rates throughout the life of the contract. All gains and losses on the contract are included in current income.

FOOTNOTE-DISCLOSURE REQUIREMENTS (Learning Objective 13.6) A

Disclosure requirements focus on how derivatives fit into a company’s overall riskmanagement objectives and strategy.

Disclosures for fair-value hedges include reporting the net gain or loss included in earnings during the period and where in the financial statements the gain or loss is reported.

Disclosures for cash-flow hedges have multiple requirements.

Disclosures include reporting the amount of any hedge ineffectiveness gain or loss from the derivative excluded from the assessment of hedge effectiveness

Also include a description of the situations in which the gain/loss included in Accumulated Other Income is reclassified to income. 131

3 4

For forecasted transactions, report the maximum length of time that the entity is hedging its exposure to these forecasted transactions. Lastly, report the amount of gains or losses that could be reclassified to income if the cash-flow hedges were discontinued.

INTERNATIONAL ACCOUNTING STANDARDS (Learning Objective 13.7) A

International standards are controlled by two companion standards: IAS No.32 (Financial Instruments: Disclosure and Presentation) and IAS No.39 (Financial Instruments: Recognition and Measurement).

IAS No.39 addresses many of the same issues as ASC Topic 815, including defining and providing examples of derivatives as well as hedge accounting.

IAS and U.S. GAAP differ on how firm sale or purchase commitments are accounted for as fair-value hedges, but under IFRS they can be either fair-value or cash-flow hedges.

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Description of assignment material

Minutes

Questions (10) Exercises (7) E13-1 [Jol] Hedge of an anticipated purchase E13-2 [Jol] Hedge of a firm purchase commitment E13-3 [Brk] Firm sales commitment E13-4 [Wil] Hedging of an existing asset E13-5 [AICPA] Various foreign currency hedge situations E13-6 [Win] Firm sales commitment, foreign currency hedge E13-7 [Baz] Firm purchase commitment, foreign currency hedge

15 15 15 15 12 12 12

Problems (8) P13-1 [NGW] Cash-flow hedge, futures contract P13-2 [Ins] Fair-value hedge, option P13-3 [Cam] Cash-flow hedges, interest rate swap P13-4 [Cam] Fair-value hedge, interest rate swap P13-5 [Bay] Foreign currency hedge, existing receivable P13-6 [Fix] Foreign currency hedge, firm purchase commitment P13-7 [Bat] Foreign currency hedge, anticipated sale P13-8 [Mar] Foreign currency hedge, existing payable

25 30 30 30 20 30 20 22

PROFESSIONAL RESEARCH ASSIGNMENTS Answer the following questions by reference to the FASB Codification of Accounting Standards. Include the appropriate reference in your response. PR 13-1 What criteria are required for a hedged item to qualify for special accounting as a fair-value hedge? PR 13-2 What criteria are required for a hedged item to qualify for special accounting as a cash-flow hedge?

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Chapter 14 FOREIGN CURRENCY FINANCIAL STATEMENTS Learning Objectives 14.1 Identify the factors that should be considered when determining an entity’s functional currency. 14.2 Understand how functional currency assignment determines the way the foreign entity’s financial statements are converted. 14.3 Understand how a foreign subsidiary’s economy is determined to be highly inflationary and how this affects the conversion of its financial statements. 14.4 Understand how the investment in a foreign subsidiary is accounted for at acquisition. 14.5 Understand which rates are used to translate balance sheet and income statement accounts under the current rate method and the temporal method on a translation/remeasurement worksheet. 14.6 Know how a parent accounts for its investment in a subsidiary using the equity method depending on the subsidiary’s functional currency determination. 14.7 Know how the translation gain or loss, or remeasurement gain or loss, is reported under the current rate and temporal methods. 14.8 Understand consolidation under the temporal and current rate methods. 14.9 Understand how a hedge of the net investment in a subsidiary is accounted for under the current rate and temporal methods. Chapter Outline THE FUNCTIONAL CURRENCY CONCEPT (Learning Objective 14.1) A

U.S. corporations convert the foreign currency financial statements of their foreign subsidiaries into U.S. dollars under GAAP.

Foreign currency statements are statements prepared in a currency other than the reporting currency (the U.S. dollar) of the U.S. parent-investor. Statements of operations located outside the U.S. that are prepared in U.S. dollars are not foreign currency statements.

The method for converting the foreign currency statements into U.S. dollars and the classification of the resulting gain or loss depends on the foreign entity’s functional currency (currency of the primary economic environment in which the entity operates).

APPLICATION OF THE FUNCTIONAL CURRENCY CONCEPT (Learning Objective 14.2) A

Foreign currency statements must be in conformity with generally accepted accounting principles before they can be translated.

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Account balances on the foreign currency statements that are denominated in a foreign currency from the viewpoint of the foreign entity must be adjusted to reflect current exchange rates. For example, a German subsidiary must adjust a yen-dominated accounts receivable balance to reflect the yen to euro current exchange rate.

An objective of the functional currency concept is to measure a foreign entity’s assets, liabilities, and operations in its functional currency. Subsequently, the foreign entity’s financial statements are consolidated with those of the parent company in the reporting enterprise’s currency.

Converting the foreign entity’s financial statements into the currency of the parent may require translation, remeasurement, or both.

The method selected depends on whether the foreign subsidiary’s books are maintained in its functional currency, or a currency different from its functional currency.

The functional currency is normally the currency with which a foreign entity collects its receivables and pays its liabilities.

Other factors, including management’s judgment, impact the selection of a subsidiary’s functional currency.

If a subsidiary’s functional currency is the U.S. dollar, the foreign financial statements are remeasured into U.S. dollars using the temporal method.

If a subsidiary’s functional currency is the local currency of the foreign entity, its financial statements are translated into U.S. dollars using the current rate method.

When the foreign entity’s books are maintained in its functional currency (that is, functional = local), the statements are translated into the currency of the reporting entity using the current rate method. 1

Translation involves expressing functional currency measurements in the reporting currency.

All elements of financial statements (except stockholders’ equity) are translated using a current exchange rate (the current rate method.)

As an expedient, revenues and expenses are usually translated at a weighted average exchange rate for the period.

The effects of the exchange rate changes are reported as stockholders’ equity adjustments, in Other Comprehensive Income, because they are not expected to impact the cash flows of the parent-investor.

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The equity adjustments from translation are accumulated until the investment is sold or liquidated, at which time they are treated as adjustments to the gain or loss on sale.

When the foreign entity’s books are not maintained in its functional currency (that is, functional does NOT= local), the statements are remeasured in the functional currency using the temporal method 1

If the functional currency is the reporting currency (functional = U.S. dollar) the conversion is complete.

If the functional currency is not the U.S. dollar, the remeasured statements must then be translated into U.S. dollars using the current rate method.

Under the temporal method, monetary assets and liabilities are remeasured at current exchange rates, and other assets and equities are remeasured at historical rates.

Gains or losses from remeasuring the foreign currency statements are included in income because they are expected to impact cash flows of the parent-investor.

Intercompany transactions between a U.S. parent and its foreign subsidiary may be a foreign currency transaction to one affiliate, neither affiliate, or both affiliates. 1

The transaction is a foreign currency transaction of a particular affiliate if it results in a receivable or payable balance denominated in a currency other than that entity’s functional currency.

Intercompany account balances denominated in a foreign currency are adjusted at the balance sheet date to the current exchange rate. a

If the intercompany balances are not of a long-term investment nature, the exchange gain or loss is included in income for the period.

An exchange gain or loss on settlement is also included in income for the period.

If the intercompany balances are of a long-term investment nature (settlement is not expected in the foreseeable future), the exchange gain or loss is reported in stockholders’ equity (in Other Comprehensive Income) as an equity adjustment from translation.

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FOREIGN ENTITIES OPERATING IN HIGHLY INFLATIONARY ECONOMIES (Learning Objective 14.3) A

According to GAAP, a highly inflationary economy is one with a cumulative three-year inflation rate of approximately 100 percent or more.

Foreign currency financial statements of entities operating in highly inflationary economies are remeasured using the U.S. dollar reporting currency as the functional currency.

Exchange gains and losses are recognized in the income for the period.

BUSINESS COMBINATIONS (Learning Objective 14.4) A

The assets and liabilities are translated into U.S. dollars using the current exchange rate in effect at the date of the business combination.

The identifiable assets and liabilities are adjusted to their fair values in local currency and translated at the exchange rate on the date of the business combination. Any difference between the investment fair value and translated net assets acquired is goodwill or a bargain purchase. 1

When the foreign entity’s functional currency is its local currency, the excess cost over book value acquired is assigned to assets, liabilities, and goodwill in local currency units and subsequently translated at current exchange rates.

When the foreign entity’s functional currency is the U.S. dollar, remeasurement is required. The excess allocated to identifiable net assets is amortized at the historical exchange rate in effect at the time of the business combination.

The non-controlling interest in a foreign subsidiary is computed after the foreign currency financial statements have been translated or remeasured into U.S. dollars.

Similarly, the equity method is applied after the foreign entity’s financial statements have been translated or remeasured into U.S. dollars.

TRANSLATION OF A FOREIGN SUBSIDIARY (Illustration 14-1) (Learning Objective 14.5) A

Any intercompany account balances denominated in a foreign currency are adjusted at the balance sheet date to the current exchange rate.

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If the intercompany transaction is of a long-term investment nature, the gain or loss is included in other comprehensive income.

Otherwise, the gain or loss is included in income of the period.

When the foreign subsidiary’s adjusted trial balance is translated using the current rate method: 1

Assets and liabilities are translated at the current rate at the balance sheet date.

Revenues and expenses are usually translated at an average rate.

Dividends are translated at the rate in effect when the dividends are paid.

Retained earnings (RE) is not translated after the acquisition date. In years subsequent to the year of acquisition, RE equals RE at acquisition, plus net income, less dividends after acquisition, all in translated dollar amounts.

Capital stock and other paid-in capital accounts are translated at the exchange rate in effect when the subsidiary (or investee) was acquired.

The difference between the translated debits and the translated credits is an equity adjustment from translation and is reported in Other Comprehensive Income. a

An inequality results from translating some accounts using the current rate (assets) and other accounts using the historical rate (capital stock).

The translated financial statements are used in applying the equity method.

Non-controlling interest is computed as a percentage of the subsidiary’s translated stockholders’ equity; in other words, the equity adjustment from translation is included in the computation.

The elimination of intercompany profits should be based on the exchange rates in effect when the intercompany transaction took place; however, reasonable approximations or averages are permitted by GAAP.

REMEASUREMENT OF A FOREIGN SUBSIDIARY A

When the functional currency is the U.S. dollar, the foreign entity’s accounts are remeasured into U.S. dollars.

The objective of remeasurement is to produce the same results as if the books of the subsidiary had been maintained in U.S. dollars.

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When the adjusted trial balance of a foreign subsidiary is remeasured: 1

Monetary assets are remeasured at the current rate (the same as they are in translated statements).

Dividends paid are translated at reciprocal amounts in dollars recorded by the parent company on its own books.

Inventories are remeasured at historical rates.

Purchases are remeasured at average rates.

Expenses are remeasured at average rates during the period if they relate to monetary items and at historical exchange rates if they relate to nonmonetary items, such as plant assets or intangibles. a

If a single expense account relates to both monetary and nonmonetary items, the remeasurement involves more computations than the application of a single average rate.

Capital stock and other paid-in capital are remeasured at historical exchange rates (the same as in translated amounts).

The retained earnings (RE) balance is computed, but not remeasured. a

Ending RE = Beginning RE + remeasured net income – remeasured dividends.

Total debits in the remeasured trial balance are subtracted from total credits, and the resulting exchange gain or loss is included in income for the period. a

Again, an inequality results from translating some accounts using different rates from other accounts.

The equity method is applied to the remeasured financial statements. Since all remeasurement gains and losses are recognized in current income, the equity method is the same as for domestic subsidiaries. (Learning Objectives 14.6, 14.7, and 14.8)

Because inventory and cost of sales accounts are remeasured at historical exchange rates, intercompany profits in consolidation workpapers are eliminated in the same manner as for domestic subsidiaries.

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HEDGING A NET INVESTMENT IN A FOREIGN ENTITY (Learning Objective 14.9) A

A U.S. firm may enter into a forward contract to hedge a net investment in a foreign entity whose functional currency is other than the U.S. dollar. 1

Procedures to hedge an investment in a foreign subsidiary are not applicable to investees with a U.S. dollar functional currency (accounted for as speculation). a

This is because conversion of the investee’s financial statements into U.S. dollars results in a gain or loss that is included in net income.

The gain or loss from the related hedge is also included in net income.

Translation of the financial statements of a foreign entity whose functional currency is not the U.S. dollar produces a gain or loss that is excluded from net income and is reported in Other Comprehensive Income.

A gain and loss on a hedge of a net investment in a foreign investee is also excluded from net income, and is reported in Other Comprehensive Income.

The investee’s assets and liabilities hedge each other, so only the net assets are exposed to exchange rate gains and losses.

To hedge the foreign currency exposure, the translation adjustment from the hedge must move in the opposite direction of the translation adjustment from the net assets of the investee.

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Description of Assignment Material

Minutes

Questions (12) Exercises (8) E14-1 9 MC general questions – Translation/remeasurement differences E14-2 AICPA 5 MC general questions E14-3 [Pai/Sta] Acquisition date effects E14-4 [Port/Stadt] Inventory remeasurement effect E14-5 [Pana/Sim] Acquisition – Excess allocation and amortization effect E14-6 [Pal/Sta] Acquisition - Excess allocation and amortization effect E14-7 [Pac/Swi] Acquisition - Excess allocation E14-8 AICPA 7 MC problem-type questions

20 15 20 10 15 20 15 30

Problems (9) P14-1 [Pak/Sco] Parent accounting under the equity method P14-2 [Pla/Sorr] Parent accounting under the equity method P14-3 [Pyl/Soo] Translation worksheet, parent accounting P14-4 [Pet/Sul] Translation worksheet, parent accounting P14-5 [Par/Sar] Remeasurement worksheet P14-6 [Phi/Stu] Remeasurement worksheet P14-7 [Pel/Sar] Translation worksheet, parent accounting P14-8 [PWA/SAA] Parent accounting and consolidation under translation P14-9 [Par/San] Translation worksheet, parent accounting, consolidation

25 25 25 25 20 30 35 60 70

PROFESSIONAL RESEARCH ASSIGNMENTS Answer the following questions by reference to the FASB Codification of Accounting Standards. Include the appropriate reference in your response. PR 14-1 What is required to disclose concerning the changes in a firm’s cumulative translation adjustment? PR 14-2 Should a firm readjust after the fiscal period end if before the release of their statements the exchange rate is materially different?

141

Illustration 14-1 TRANSLATION AND CONSOLIDATION OF A FOREIGN SUBSIDIARY Pam Corporation is a foreign firm whose local currency is designated VOL (local currency units.) The exchange rate on December 31, 20Xl is 2 Vol for $1 U.S., and the December 31, 20Xl balance sheet of Pam in Vol and U.S. dollars is as follows:

Vol

Exchange Rate

U.S. Dollars

Cash Plant assets-net Total assets

5,000 20,000 25,000

$.50 .50

$ 2,500 10,000 $12,500

Capital stock Retained earnings Total equities

20,000 5,000 25,000

.50

$10,000 2,500 $12,500

On January 1, 20X2 Sun Corporation, a U.S. firm, acquires all the capital stock of Pam for $15,000. Sun's management determines that the functional currency of its subsidiary, Pam Corporation, is the Vol. Any excess of cost over book value is attributable to a patent and is to be amortized over 5 years. Cost of investment in Pam at January 1, 20X2

$15,000

Book value of interest acquired

12,500

Patent (in $)

$ 2,500

Patent in Vol $2,500/$.50 = 5,000 Vol January 1, 20X2 purchase of Pam Corporation Sun records its investment in Pam as follows: Investment in Pam $15,000 Cash To record acquisition of Pam equal to book value plus $2,500 patent (5,000 Vol patent) with a 5-year amortization period.

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$15,000

ACTIVITIES – 20X2: The exchange rates for Vol for 20X2 are $.475 average for the year, $.47 when the dividends are paid, and $.45 at December 31, 20X2. A translation worksheet to convert Pam's accounts in Vol into U.S. dollars under the current rate method is as follows: Translation Worksheet December 31, 20X2

Cash Plant assets-net Expenses Dividends Equity adjustment, 20X2 change

Vol 17,000 18,000 8,000 2,000

45,000 Capital stock Retained earnings Revenue

20,000 5,000 20,000 45,000

Exchange Rate $.45 C .45 C .475 A .47 H

U.S. Dollars $ 7,650 8,100 3,800 940

1,510 $22,000 .50 H measured .475 A

$10,000 2,500 9,500 $22,000

One-line Consolidation - 20X2 Sun records its income and dividends from Pam for 20X2 as follows: Cash

$ 940 Investment in Pam $ To record dividends received (2,000 VOL x $.47 exchange rate).

Investment in Pam $4,190 Equity adjustment from translation 1,510 Income from Pam To record equity in Pam's income ($9,500 - $3,800). Income from Pam $ 475 Equity adjustment from translation 225 Investment in Pam To record amortization of patent computed as follows: 5,000 Vol / 5 years x $.475 exchange rate = $475 4,000 Vol ending balance x $.45 current rate = $1,800 Patent change: $2,500 - $1,800 = $700

143

940

$5,700

$ 700

Consolidation - 20X2: Working papers to consolidate the financial statements of Sun and Pam for the year ended December 31, 20X2 are illustrated as follows: Sun Corporation and Subsidiary Consolidation Working Papers for the year ended December 31, 20X2 Sun Pam Adjustment and Eliminations Income Statement Revenue Income from Pam Expenses Net income Retained Earnings Statement Retained earnings-Sun Retained earnings-Pam Net income Dividends Retained earnings 12/31/20X2 Balance Sheet Cash Plant assets-net Investment in Pam

$30,000 5,225 (25,000) $10,225

$9,500

$39,500

a. 5,225 (3,800) c. 475 $5,700

(29,275) $10,225

$10,000 10,225 (6,000) $14,225 $ 2,940 12,000 17,550

$10,000 $2,500 b. 2,500 5,700 (940) $7,260

$32,490

940

4,285

$15,750 $10,000 b. 10,000 7,260 (1,510) b. 1,510 $15,750

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10,225 (6,000) $14,255 $10,590 20,100

b. 2,275 $32,490 $20,000 14,225 (1,735)

$ 7,650 8,100

Patent Capital stock Retained earnings Equity adjustment-Sun Equity adjustment-Pam

Consolidate d Statements

b. 13,265 c. 475

1,800 $32,490 $20,000 14,225 (1,735) $32,490

ACTIVITIES - 20X3: The exchange rates for Vol for 20X3 are $.425 average for the year, $.42 when the dividends are paid, and $.40 at December 31, 20X3. A translation worksheet to convert Pam's accounts in Vol into U.S. dollars under the current rate method is as follows: Translation Worksheet December 31, 20X3

Cash Plant assets-net Expenses Dividends Equity adjustment, 20X3 change

Exchange Rate $.40 C .40 C .425 A .42 H

Vol 10,000 36,000 12,000 2,000

2,035 $26,375

60,000 Capital stock Retained earnings, Jan. 1 Equity adjustment balance on January 1 Revenue

U.S. Dollars $ 4,000 14,400 5,100 840

20,000 15,000

25,000 60,000

.50 H measured

$10,000 7,260

measured .425 A

(1,510) 10,265 $26,375

One-line Consolidation - 20X3 Sun records its income and dividends from Pam for 20X3 as follows: Cash

$ 840 Investment in Pam To record dividends received (2,000 VOL x $.42 exchange rate).

Investment in Pam $3,490 Equity adjustment from translation 2,035 Income from Pam To record equity in Pam 's income ($10,625 - $5,100). Income from Pam $ 425 Equity adjustment from translation 175 Investment in Pam To record amortization of patent computed as follows: 5,000 Vol / 5 years x $.425 exchange rate = $425 3,000 Vol ending balance x $.40 current rate = $1,200 Patent change: $1,800 - $1,200 = $600 .

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$ 840

$5,525

600

Consolidation – 20X3: Working papers to consolidate the financial statements of Sun and Pam for the year ended December 31, 20X3 are illustrated as follows: Sun Corporation and Subsidiary Consolidation Working Papers for the year ended December 31, 20X3 Sun Pam Adjustment and Eliminations Income Statement Revenue Income from Pam Expenses Net income Retained Earnings Statement Retained earnings-Sun Retained earnings-Pam Net income Dividends Retained earnings 12/31/20X2 Balance Sheet Cash Plant assets-net Investment in Pam

$31,000 5,100 (26,000) $10,100

$10,625

$41,625

a. 5,100 (5,100) c. 425 $5,525

(31,525) $10,100

$14,225 10,100 (6,000) $18,325 $ 2,780 12,000 19,600

$14,225 $7,260 b. 7,260 5,525 (840) $11,945

$34,380 $20,000 18,325 (3,945) $34,380

840

$ 4,000 14,400

$18,400 $10,000 b. 10,000 11,945 (3,545) b. 3,545 $18,400

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10,100 (6,000) $18,355 $6,780 26,400

a. 4,260 b. 15,340 b. 1,625

Patent Capital stock Retained earnings Equity adjustment-Sun Equity adjustment-Pam

Consolidate d Statements

425

1,200 $34,380 $20,000 18,325 (3,945) $34,380

Reconciliation of Sun’s Investment Account and Pam’s Equity at December 31, 20X3

Equity in Pam

Patent Amortization and Adjustments

Investment in Pam

$12,500

$2,500

$15,000

Income 20X2

5,700

(475)

5,225

Equity adjustment20X2 change

(1,510)

(225)

(1,735)

Balance January 1, 20X2

Dividends

(940)

Balance Dec. 31, 20X2

15,750

17,550

Income 20X3

5,525

(425)

5,100

Equity adjustment, 20X3 change

(2,035)

(175)

(2,210)

Dividends Balance Dec. 31, 20X3

(840) $18,400

147

(840) $1,200

$19,600

Chapter 15 SEGMENT AND INTERIM FINANCIAL REPORTING Learning Objective 15.1 Understand how firms use the management approach to identify potentially reportable operating segments. 15.2 Apply the threshold tests to identify reportable operating segments: the revenue test, the asset test, and the operating-profit test. 15.3 Determine the reporting of any additional segments using the 75 percent externalrevenue test. 15.4 Understand the types of disclosure information for segments and the reasons that the levels of disclosure may vary across companies. 15.5 Understand what segment disclosures are reconciled to the consolidated amounts. 15.6 Know the required enterprise-wide disclosures with respect to products and services, geographic areas of operation, and major customers. 15.7 Understand the similarities and differences in the reporting of operations in an interim versus an annual reporting period. 15.8 Compute interim-period income tax expense.

Chapter Outline DISAGGREGATION A

A company’s financial information can be disaggregated to provide information useful to financial statement users in assessing management’s effectiveness. 1

Segment reporting discloses information in the same way management organizes the enterprise into units for internal decision making.

Interim reporting provides timely information to financial statement users on a quarterly basis.

SEGMENT REPORTING (Learning Objective 15.1) A

Segment reporting under GAAP applies to all public business entities that have issued debt or equity securities and are required to file financial statements with the SEC. 1

Segments based on a management approach are called operating segments. Pension and other postretirement benefit plans, and corporate headquarters or other functional departments are not operating segments.

148

Segments may be either geographical or industry related, based on internal company segmentation.

Amounts reported in the financial statements are the amounts reported to the chief operating decision maker. Internal allocations made to the operating segment are included in the segment reports.

Segment reporting is required for interim reports as well as annual reports.

Disclosures may appear within the body of the financial statements, in statement notes, or in separate schedules that are an integral part of the financial statements.

IDENTIFYING REPORTABLE SEGMENTS (Learning Objective 15.2) A

An operating segment engages in business activity, has operating results regularly reviewed by the enterprise’s chief operating decision maker, and has discrete financial information available.

Similar segments can be combined if they have similar economic characteristics and are similar in each of the following areas: (1) the nature of the products/services; (2) the nature of the production process; (3) the type/class of customer; (4) the distribution method for products/services; and (5) if applicable, the nature of the regulatory environment.

Operating segments are reportable if they meet certain materiality thresholds.

10% revenue test: The segment’s revenue is 10% or more of the combined revenue (including intersegment sales and transfers) of all operating segments.

10% asset test: The segment’s identifiable assets (those assets that are reviewed by the chief operating decision maker) are 10% or more of the combined identifiable assets of all operating segments.

10% operating profit test: The segment’s operating profit or operating loss (in absolute amounts) is 10% or more of the greater (in absolute amounts) of (a) the combined operating profits of all industry segments that did not incur an operating loss, or (b) the combined operating loss of all industry segments that did incur an operating loss.

Reportable operating segments determined under the above tests must represent a substantial portion of the enterprise’s operations. (Learning Objective 15.3)

149

Reported segments must include 75% of all external revenue, excluding intersegment revenue.

If not, additional segments must be identified as reportable. This can be done by aggregating smaller segments that meet most of the aggregation criteria.

Required disclosures for each reportable operating segment include the following: (Learning Objective 15.4) 1

A measure of profit or loss

Total assets

Amount of revenue from external customers

Amount of revenue from other operating segments of the same entity

Interest revenue

Interest expense (If a segment’s revenues are primarily interest and the chief operating decision maker relies on net interest revenue to evaluate performance, the segment may report interest revenue net of interest expense.)

Depreciation, depletion, and amortization expense

Unusual items

Equity in the net income of investees accounted for by the equity method

Income tax expense or benefit

Significant noncash items other than depreciation, depletion, and amortization expense

If reviewed by the chief operating decision maker, other items are required that may include: amount of investment in equity investments, the total expenditures for additions to long-lived assets other than financial instruments and certain other items, and deferred tax assets.

RECONCILIATION OF SEGMENT INFORMATION (Learning Objective 15.5) A

A reconciliation between the segment data and consolidated information must be provided for the following items:

150

The total of reportable segments’ revenues and reported consolidated revenues

The total reportable segments’ profit or loss and consolidated income before taxes (however, if items like taxes are included in segment profit or loss, segment profit or loss can be reconciled to consolidated income after these items are included)

Total reportable segments’ assets to consolidated assets

The total reportable segments’ amounts for every other significant item of information disclosed, with their corresponding consolidated amount

ENTERPRISE-WIDE DISCLOSURES (Learning Objective 15.6) A

Enterprises also report limited information (if not otherwise reported as part of segment information). 1

Products and Services: If practical, revenue from each product or service (or group of similar products or services) should be disclosed.

Geographic Information: If practical, geographical information should include revenues from external customers in the enterprise’s home country and outside the home country. If the revenue from any one country is material (over 10%), this information should also be disclosed separately. Similar treatment is accorded long-lived assets.

Major Customers: Disclosure of the existence of major customers (a single customer who accounts for 10% or more of the revenue) must be disclosed, including the amount of the revenue but not necessarily the identity of the customer. Groups under common control count as a single customer. However, different levels of government count as different entities.

INTERIM FINANCIAL REPORTING (Learning Objective 15.7) A

Interim financial reports provide information about firm operations for less than a full year. 1

Guidelines apply to any publicly traded company that issues interim financial information to its security holders.

151

Interim reports are usually unaudited, but the quarterly information in the annual report is “reviewed” by the CPA. Interim reports do not constitute fair presentations of financial information in conformity with GAAP.

Each interim period is considered an integral part of each annual period (integral theory), rather than a basic accounting period unto itself (discrete theory).

Revenue is recognized when earned following the same principles as used for the annual period.

Product costs

The gross profit method can be used for pricing interim inventories when a company does not use the perpetual inventory method and is too costly to perform an inventory count. The method must yield a reasonable estimate of inventory and cost of goods sold.

Inventory market declines are not deferred unless considered temporary.

If LIFO inventories are liquidated at an interim date but are expected to be replaced by year end, cost of sales should include the cost of replacing the LIFO base. The amount of current cost in excess of historical cost may be shown as a current liability on an interim balance sheet.

Planned variances under a standard cost system that are expected to be absorbed by year-end are usually deferred at the interim date.

Expenses other than product costs 1

Annual expenses are usually allocated to the interim periods that are expected to be benefited. However, expenses of an interim period that would not be deferred at year-end are not deferred.

Advertising costs are expensed in the interim period unless they clearly benefit subsequent interim periods.

Income taxes for interim reporting are divided into

Taxes applicable to income from continuing operations before income taxes, excluding unusual or infrequently occurring items, and

Taxes applicable to significant, unusual, or infrequently occurring items, and discontinued items.

Computation for income taxes in an interim period: (Learning Objective 15.8) 152

The estimated effective annual tax rate is applied to taxable income from continuing operations excluding unusual and infrequently occurring items.

The year-to-date tax expense less the tax expense recognized in earlier interim periods is the tax expense for the current interim period.

Tax effects of unusual and infrequently occurring items are calculated separately and added to the tax expense of the interim period in which the items are reported.

Gains and losses on discontinued operations are reported on a net-of-tax basis.

The minimum financial information to be disclosed in interim reports of publicly traded companies includes the following: 1

Sales or gross revenues, provisions for income taxes, net income, and comprehensive income

Basic and diluted earnings per share

Seasonal revenue, costs, or expenses

Significant changes in estimates or provisions for income taxes

Disposal of a component of an entity and unusual or infrequently occurring items

Contingent items

Changes in accounting principles or estimates

Significant changes in financial position

For each reportable operating segment the following information is needed: a

Revenues from external customers

Intersegment revenues

A measure of segment profit or loss

Total assets if there has been a material change since the last annual report

A description of a change in segmentation since the last annual report 153

A reconciliation of total of reportable segments’ measure of profit or loss to the entity’s income before taxes and discontinued operations.

Information about defined benefit pension plans and other defined benefit postretirement benefits: a

Amount of net periodic benefit cost recognized for each period for which a statement of income is presented

Total amount of contributions paid, and expected to be paid, during the fiscal year if significantly different from amounts previously disclosed

Information about the following: the use of fair value to measure assets and liabilities; derivative instruments; fair value of financial instruments; certain investments in debt and equity securities; and other-than-temporary impairments

When an enterprise regularly reports interim data, it must also report for the current year-to-date or the last 12 months to date, with comparable information for the preceding year.

SEC requires quarterly reports on Form 10-Q to be filed within 45 days after the end of the quarter. Additional information required by the SEC includes:

Comparative consolidated balance sheets as of the end of the current quarter and at the prior year-end

Comparative consolidated income statements for the current quarter and the same quarter of the prior year, and the current year to date and the prior year-todate

Comparative consolidated statements of cash flows for the current year to date and the prior year-to-date

154

Description of assignment material

Minutes

Questions (15) Exercises (10) E15-1 6 MC general questions (Segment disclosures) E15-2 [Vic] Apply threshold tests – disclosure E15-3 [Sur] Apply threshold tests E15-4 [Wow] Segment and enterprise-wide disclosures E15-5 [Coy] 8 MC problem-type questions (Threshold tests) E15-6 [Nog] 3 MC problem-type questions (Threshold tests) E15-7 4 MC Interim accounting for various situations - tax E15-8 [Ent] Interim tax E15-9 5 MC problem-type questions E15-10 [Tap] Interim accounting under LIFO

16 25 25 15 35 20 15 15 25 10

Problems (8) P15-1 [Wod] Apply threshold tests P15-2 [Hay] Apply threshold tests P15-3 [DaP] Apply threshold tests – Disclosure P15-4 [Mer] Apply threshold tests – Segment and enterprise-wide disclosure P15-5 [Rad] Apply threshold tests – Disclosure P15-6 [Tut] Apply threshold tests – Disclosure P15-7 [Cob] Apply threshold tests – Disclosure P15-8 [Tor] Interim reporting – tax

15 25 30 45 50 40 40 35

PROFESSIONAL RESEARCH ASSIGNMENTS Answer the following questions by reference to the FASB Codification of Accounting Standards. Include the appropriate reference in your response. PR 15-1 Does an entity need to disclose segment level information about depreciation and amortization (D&A) if the chief decision maker does not consider D&A in their assessment of the segments? PR 15-2 When preparing interim reports, does an entity need to use the same method to value inventory that they use at the annual report date? What options are accepted?

155

Illustration 15-1 TESTS FOR REPORTABLE INDUSTRY SEGMENTS REVENUE TEST Solar

Hydro

Wind

Sales to unaffiliated customers

$ 8,000

$51,000

$50,000

Sales to affiliates

2,000

Test values: Solar Hydro Wind Finance Total

$10,000

$51,000

$55,000

$ 5,000

$ 3,000

$ 5,000

$ 3,000

$ 10,000 51,000 55,000 5,000 $121,000 x 10% = $12,100 test value

Reportable industry segments: Hydro and Wind

Corporate

5,000

Interest from nonaffiliates Total revenues

Finance

156

IDENTIFIABLE ASSETS TEST Solar

Hydro

Wind

Finance

Corporate

$ 9,000

$34,000

$32,000

$15,000

$30,000

Goodwill

6,000

9,000

Intersegment loans

10,000

Tangible assets excluding intersegment loans

Total assets Test values: Solar Hydro Wind Finance Total

$ 9,000

25,000

$ 50,000

$ 41,000

$ 9,000 50,000 41,000 40,000 $140,000 x 10% = $14,000 test value

Reportable segments: Hydro, Wind, Finance

$40,000

157

$30,000

OPERATING PROFITS TEST Solar

Hydro

Wind

Finance

Corporate

Revenue (see revenue test)

$10,000

$ 51,000

$ 55,000

$ 5,000

$3,000

Cost of sales: To unaffiliated customers

(5,000)

(25,000)

(29,000)

To affiliated customers

(2,000)

Allocated Expenses

(1,000)

(5,000)

(7,000)

Other expenses

(4,500)

(10,000)

(9,000)

Interest expense to outsiders

(1,000)

Income from equity investee

1,000

Extraordinary Gain

6,000

Income (loss)

$(2,500)

(1,000)

$10,000

$17,000

(1,000) 20,000

$3,000

$22,000

Test values: Solar (only one with negative income) – absolute value is $2,500, and the test value would be $250. Use the higher test value generated by segments with profits. Hydro Wind ($17,000 - $6,000 extraordinary gain) Finance Totals Test Value is

$10,000 11,000 3,000 $24,000 x .10 $2,400

Reportable industry segments: All segments

158

Illustration 15-2 ACCOUNTING FOR INCOME TAXES FROM CONTINUING OPERATIONS IN INTERIM STATEMENTS

Estimate an annual effective tax rate at the end of each quarter.

Apply the annual effective tax rate to the income earned for the year to date.

Deduct the income tax reported in the previous interim reports from the income tax on the year-to-date income to determine the current quarter’s income tax. A company estimates a 30% effective income tax rate at the end of the first and second quarters.

Actual income Estimated income Income taxes reported on interim statement

First Quarter $119,000

Second Quarter $129,000

Third Quarter $155,000

Fourth Quarter $160,000

(35,700) $ 83,300

(38,700) $ 90,300

At the end of the third quarter, the company revises its effective income tax rate to 31.5%. Tax in the third interim report will be computed: Tax on year-to-date income ($403,000 x .315 effective tax rate) Less: Income taxes from first 2 quarters ($35,700 + $38,700)

$126,945 (74,400)

Income taxes reported in third quarter

$ 52,545

159

Chapter 16 PARTNERSHIPS -- FORMATION, OPERATIONS, AND CHANGES IN OWNERSHIP INTERESTS Learning Objectives 16.1 Comprehend the legal characteristics of partnerships. 16.2 Understand initial investment valuation and record keeping. 16.3 Grasp the diverse nature of profit- and loss-sharing agreements and their computation. 16.4 Value a new partner’s investment in an existing partnership. 16.5 Value a partner’s share on retirement or death. 16.6 Understand limited liability partnership characteristics. Chapter Outline NATURE OF PARTNERSHIPS A

A partnership is an association of two or more persons to carry on as co-owners of a business for profit.

Partnerships Characteristics (Learning Objective 16.1)

Limited life: The legal life of a partnership terminates with the admission of a new partner, withdrawal or death of an old partner, voluntary dissolution by the partners, or involuntary dissolution.

Mutual agency: Each partner is assumed to be an agent for the partnership with the power to bind all the other partners by his/her actions on behalf of the partnership.

Unlimited liability: Each partner is liable for all partnership debts.

Articles of partnership (the partnership agreement) should be written, but oral agreements may be legal and binding. 1

The agreement should specify the following: a

The types of products/services to be provided and other business details

Each partner’s rights and responsibilities in conducting the business

Initial investments and provisions for additional investments

Asset drawing provisions

160

Profit- and loss-sharing formulas

Procedures for dissolving the partnership

Profits and losses are divided equally if there is no specific partnership agreement.

Partnerships do not pay federal income taxes, but the IRS requires filing of a financial information return.

Partners own their share of the partnership but do not have ownership shares in the individual assets of the entity.

INVESTMENTS AND DISINVESTMENTS (Illustration 16-1) (Learning Objective 16.2) A

Initial investments 1

All property brought into the partnership or acquired by the partnership is partnership property.

Initial investments are recorded in the partners’ capital accounts at the fair value at the time of transfer to the partnership.

Unidentifiable assets in initial investment arise when partners agree on relative capital interests not aligned with investments of identifiable assets. a

Under the bonus approach, the unidentifiable asset is not recorded on the partnership books, and the capital accounts are adjusted to meet the conditions of the partnership agreement. That is, the other partners give a “bonus” to the incoming partner whose share of capital exceeds his/her investment.

Under the goodwill approach, the unidentifiable asset is measured and recorded by reference to the total partnership capital implied by the other partners’ investment divided by the other partners’ interest. The goodwill the incoming partner brings to the partnership allowed him/her to receive capital in excess of his/her investment.

The same valuation rules apply for additional investments as apply for initial investments.

Withdrawals are large and irregular disinvestments charged directly to partners’ capital accounts.

Drawings, drawing allowances, and salary allowances are:

161

Regular amounts that are withdrawn in anticipation of profits and charged to individual partner drawings accounts.

Closed to the capital accounts at the end of each accounting period before preparation of the partnership balance sheet.

Loans and advances 1

Loans made to the partnership by a partner earn interest and are considered liabilities of the partnership.

Loans made to a partner by the partnership are partnership assets.

PARTNERSHIP OPERATIONS (Learning Objective 16.3) A

The financial statements of a partnership include a balance sheet, an income statement, a statement of partnership capital, and a statement of cash flows.

Profit and loss sharing agreements provide for the division of profits. 1

Salaries and bonuses to partners and interest on capital accounts are not expenses and do not affect the measurement of partnership income.

The order of the partnership agreement is followed regardless of the income or loss experienced by the partnership.

Absent a specific agreement, losses are divided the same as profits.

Capital to be considered in profit- and loss-sharing agreements may be beginning, ending, or average capital balances. Average capital means weighted average unless otherwise specified in the partnership agreement.

CHANGES IN PARTNERSHIP INTERESTS A

Assignment of an interest to a third party: 1

The partnership is not dissolved.

An assignee does not become a partner.

The assignee is entitled to the assigning partner’s share of profits and losses and a share of partnership assets in the event of liquidation.

162

Admission of a new partner, either by purchasing an interest from old partners or investing in an existing partnership: 1

Admission of a new partner requires consent of all existing partners

The old partnership is dissolved.

A new partnership agreement is developed.

Absent a new agreement, profits and losses are divided equally among the partners.

Purchase of an interest from existing partners: (Learning Objective 16.4) 1

The partnership receives no new capital.

Revaluation/goodwill approach:

The only accounting necessary is to record the capital transfer from the assignor to the assignee.

The revaluation should be completed before the admission of the new partner.

Since the partnership receives no money, the amount paid to the old partners provides little evidence for revaluation and appraisals must be relied on for an equitable distribution of total partners’ capital.

Identifiable assets and liabilities are revalued before goodwill is recorded, and existing partner capital accounts are increased at the same time.

An entry is made to transfer capital from the selling partner(s) to the new partner.

Nonrevaluation/bonus approach: a

The bonus procedure requires an entry be made to transfer capital of old partners to the new partner’s capital account.

Without revaluation, the new partner’s capital account may not equal his/her payments to the old partners.

163

INVESTING IN AN EXISTING PARTNERSHIP A

The old partnership is legally dissolved.

Noncash investments are valued using the same valuation techniques as used for initial investments.

Investment of the new partner is recorded under the provisions of the new partnership agreement.

Basis for revaluation of the partnership: 1

If the new partner’s capital interest in the total of the old capital plus new investment is less than the new partner’s investment, there is an implication that the old partnership had unrecorded asset value. (Illustration 15-2) a

Revaluation is determined by dividing the new partner’s capital investment by his/her interest in the new partnership.

The unrecorded asset value may be recognized by either the goodwill or the bonus approach. (1)

(2)

(a)

The difference between the implied value and the total of the old capital plus the new investment is goodwill.

(b)

The goodwill is divided among the old partners in their old profit- and loss-sharing ratios before the admittance of the new partners.

Under the bonus approach, the assets are not revalued, but the difference between the new partner’s investment and his/her capital credit is divided among the old partners in their old profitsharing ratios.

If the new partner’s capital interest in the total of the old capital plus new investment is greater than the new partner’s investment, there is an implication that the new partner is bringing unidentifiable assets into the partnership. (Illustration 16-3) a

Goodwill approach:

The total capital of the new partnership is determined by dividing the old partners’ capital by the old partners’ interest retained in the new partnership.

164

The unidentifiable asset value from the incoming partner can be recognized by either the goodwill or the bonus approach. (1)

Under the goodwill approach, assets are revalued to their fair values and goodwill to the new partner is recorded.

(2)

Bonus approach: (a)

Assets are not revalued.

(b)

Capital balances of the old partners are reduced for the bonus to the new partner, and the new partner’s capital account is recorded according to the partnership agreement.

DISSOCIATION OF A CONTINUING PARTNERSHIP THROUGH DEATH OR RETIREMENT (Learning Objective 16.5) A

The old partnership is dissolved and the retiring partner (or estate of a deceased partner) receives a settlement. A partner can dissociate at any time.

If the partnership agreement does not specify a settlement:

Buyout price = amount that would have been distributable to the dissociating partner if assets were sold equal to the greater of liquidation value or value based on sale of entire business.

The retiring partner, or estate of the deceased partner, receives that amount plus interest as an ordinary creditor. If there is a time lapse between the dissolution and settlement dates, the capital balance is reclassified as a liability.

Any interest on the liability up to the settlement date is an expense of the partnership.

Recording the settlement with a retiring or deceased partner: 1

If the retiring partner receives an amount equal to his/her final capital balance, the only entry is a debit to the capital account and a credit to cash.

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If the retiring partner receives more than the balance in his/her capital account, an undervaluation of the partnership on the partnership books is implied. The excess payment can be recorded in one of three ways. a

If a bonus is paid to the retiring partner, the excess payment to the retiring partner is charged to the remaining partners in their relative profit sharing ratios.

If goodwill is to be recorded, and only goodwill equal to the excess payment to the retiring partner is to be recorded, then only the retiring partner’s share of partnership assets is revalued.

If total implied goodwill is to be recorded, a revaluation of total partnership capital is based on the excess payment to the retiring partner. (1)

A total undervaluation of the partnership is determined by dividing the excess payment to the retiring partner by the retiring partner’s profit-sharing ratio.

(2)

The goodwill is recorded and credited to all partners’ capital accounts before settlement with the retiring partner.

If the retiring partner receives less than the balance of his/her account, the partners may agree that the partnership is worth less than its book value. a

Overvalued assets should be written down to fair values in the partners’ profit-sharing ratios before settlement with the retiring partner.

If a bonus to continuing partners is to be recorded, a bonus equal to the excess of the retiring partner’s capital account over the cash paid by the partnership in settlement of the retiring partner’s interest is credited to the continuing partners’ capital account balances in their relative profitsharing ratios.

LIMITED PARTNERSHIPS (Learning Objective 16.6) A

The unlimited liability characteristic of general partnerships is circumvented by creating a limited partnership. 1

The limited partnership consists of at least one general partner, who has unlimited liability, and one or more limited partners whose risk is limited to their equity interest in the venture.

The limited partner is excluded from the management of the entity.

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The partnership agreement must be written, signed by the partners, and filed with the appropriate state agency.

Description of assignment material

Minutes

Questions (15) Exercises (21) E16-1 [Car/Lam] Computing initial partner investments E16-2 [Arn/Bev/Car] Partnership income allocation – Bonus E16-3 [Mel/Dav] Partnership income allocation – Salary allowance E16-4 [Dan/Hen/Bai] Partnership income allocation - Salary allowance and interest E16-5 [Bir/Cag/Den] Partnership income allocation – Partnership capital statement E16-6 [Ben/Irv/Geo] Partnership income allocation – Assignment of interest to a third party E16-7 [Fax/Bel/Rob] Recording new partner investment E16-8 [Bow/Mon/Joh] Recording new partner investment – Revaluation case E16-9 [Sip/Jog/Run] Recording new partner investment – Revaluation cases E16-10 [Man/Eme/Fot/Box] Recording new partner investment - Nonrevaluation case E16-11 [Nix/Man/Per] Partner retirement entries E16-12 [Bec/Dee/Lyn] Partner retirement entries – Fair value adjustment E16-13 [Kat/Edd] Partnership income allocation - Salary allowance, bonus, and additional contributions during the year E16-14 [Byd/Box/Dan/Fus] Partnership retirement – Revaluation and bonus approaches E16-15 5 MC problem-type questions E16-16 5 MC problem-type questions E16-17 5 MC problem-type questions E16-18 7 MC problem-type questions E16-19 [Kra/Lam/Man] Partnership income allocation – Salary allowance and interest E16-20 [Gro/Ham/Lot] Recording new partner investment E16-21 [Cas/Don/Ear] Partnership retirement - Various situations Problems (14) P16-1 [Ell/Far/Gar] Partnership income allocation - Statement of partnership capital P16-2 [Mor/Osc/Tre] Recording new partner investment – Revaluation and nonrevaluation cases P16-3 [Ash/Bar/] Partnership income allocation .

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10 15 10 15 20 10 15 16 20 20 15 15 10 20 25 25 25 35 25 15 20

25 20 15

Description of assignment material (cont’d) P16-4 P16-5 P16-6 P16-7 P16-8 P16-9 P16-10 P16-11 P16-12 P16-13 P16-14

Minutes

[Ale/Car/Eri] Partnership income allocation – Complex, net loss [Kat/Lyn/Mol] Partnership income allocation – Profit-sharing based on beginning, ending, and average capital balances [Jon/Kel/Gla] Partnership income allocation – Correction of error [Add/Bal/Cat] Recording new partner investment and subsequent balance sheet [Ann/Bob/Car/Dar] Recording new partner investment – Various situations [Pat/Mik/Hay/Con] Recording new partner investment – Various situations [Aid/Tha/Car] Recording new partner investment – Various situations [Har/Ion/Jer] Partnership income allocation – Multiple years [Par/Boo] Partnership income allocation [Pet/Qua/She] Recording new partner investment – Complex non-revaluation and revaluation cases [Tim/Las] Partnership income allocation

40 35 60 20 30 35 25 40 50 45 20

PROFESSIONAL RESEARCH ASSIGNMENTS Answer the following questions by reference to the Uniform Partnership Act of 1997. Include the appropriate reference in your response. PR 16-1 What defines a business as a partnership? What factors need to be examined to determine if an individual is a partner, and not some other type of participant in the business? PR 16-2 Under what circumstances can a partnership expel a partner?

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Illustration 16-1 SUMMARY OF PARTNERSHIP ORGANIZATION AND OPERATIONS Partnership formation * Noncash assets invested in a partnership are recorded at their fair values (i.e. present values for receivables and current cost for inventories and other assets). *

Partner liabilities assumed in a partnership formation should be recorded at their present values as indicators of their fair market values.

Failure to record assets invested and liabilities assumed at the fair values results in individual partner inequities.

Partnership income (loss) * Income or loss should be distributed in accordance with the partnership agreement. In the absence of an agreement, income or loss is shared equally. *

Partnership profit-and loss-sharing agreements frequently specify allocations for partner salaries, interest on capital account balances, and bonuses. Such items do not constitute expenses of the partnership.

Residual income or loss of a partnership should be allocated according to the residual profit and loss sharing ratios.

Partnership dissolution * A partnership entity is dissolved in a legal sense whenever there is an ownership change in the partnership. *

Dissolution of a partnership entity in a legal sense does not necessarily mean liquidation of the partnership business.

The admission or withdrawal of a partner is recorded under the bonus or the goodwill procedure.

An individual may become a partner by purchasing an interest from an existing partner, or by investing cash or other resources in the partnership. o All existing partners must agree to the admission of a new partner. o Partnership assets may or may not be revalued upon the admission or withdrawal of a partner.

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Illustration 16-2 INVESTMENT IN AN EXISTING PARTNERSHIP Jay and Paul are partners with capital balances of $50,000 and $40,000, respectively, and they share profits and losses equally. They admit Kip for a 30% interest for a cash investment of $60,000.

Bonus procedure (Assets not revalued) Journal entry to record Kip's admission: Cash

$60,000

Jay capital $ 7,500 Paul capital 7,500 Kip capital 45,000 Old capital of $90,000 + $60,000 investment = $150,000 new capital. New balances: Jay $57,500; Paul $47,500; Kip $45,000 = $150,000.

Goodwill procedure Journal entry to record revaluation: Goodwill $50,000 Jay capital $25,000 Paul capital 25,000 Investment of $60,000/30% interest = $200,000 implied total capital. Total capital $200,000 - ($90,000 old capital + $60,000 new investment) = $50,000 goodwill. Journal entry to record admission of Kip: Cash

$60,000 Kip capital $60,000 New balances: Jay $75,000; Paul $65,000; Kip $60,000 = $200,000.

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Illustration 16-3 INVESTMENT IN AN EXISTING PARTNERSHIP Jay and Paul are partners with capital balances of $50,000 and $40,000, respectively. They share profits and losses equally. They admit Kip to a 30% interest for a cash investment of $30,000.

Bonus procedure (Assets not revalued) Journal entry to record Kip's admission: Cash Jay capital Paul capital

$30,000 3,000 3,000

Kip capital $36,000 Old capital of $90,000 + $30,000 investment = $120,000 new capital. Kip capital = $120,000 new capital x 30% interest = $36,000. Kip’s capital credit $36,000 - $30,000 cash payment = $6,000 bonus to new partner. New balances: Jay $47,000; Paul $37,000; Kip $36,000 = $120,000 total capital.

Goodwill procedure (Assets revalued) Journal entry to record admission of Kip and revaluation: Cash Goodwill

$30,000 8,571

Kip capital $38,571 Old capital $90,000/70% interest retained by old partners = $128,571 (rounded) new capital. New capital $128,571 - ($90,000 old capital + $30,000 investment) = $8,571. New balances: Jay $50,000; Paul $40,000; Kip $38,571 = $128,571.

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Chapter 17 PARTNERSHIP LIQUIDATION Learning Objectives 17.1 Understand the legal aspects of partnership liquidation. 17.2 Apply simple partnership liquidation computations and accounting. 17.3 Perform safe payment computations. 17.4 Understand installment liquidations. 17.5 Learn about cash distribution plans for installment liquidations. 17.6 Comprehend liquidations when either the partnership or the partners are insolvent. Chapter Outline PARTNERSHIP LIQUIDATION (Learning Objectives 17.1 and 17.2) A

Partnership liquidation is the termination of a partnership as a business entity.

Overview of the liquidation process for a solvent partnership (partnership assets are greater than partnership liabilities)

Noncash assets are converted into cash.

Gains and losses and expenses incurred during the liquidation period are recognized.

Liabilities are settled.

Cash is distributed to the partners according to the final balances in their capital accounts.

Order of distribution of assets in a liquidation of a partnership 1

Amounts owed to creditors other than partners and amounts owed to partners other than for capital and profits

Amounts due to partners liquidating their capital balances upon conclusion of the liquidation of partnership assets and liabilities a

All profits, losses, and drawing balances are closed to capital accounts before any distributions are made.

A partnership liquidation statement is a summary of transactions and balances during the liquidation stage.

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Debit capital balances in a solvent partnership may result from recognizing losses during the liquidation process. 1

The partners with debit balances are normally obligated to use their personal assets to settle their partnership obligations.

If the partners with debit capital balances have inadequate personal assets, the partners with credit balances normally assume losses equal to the debit capital balances and share the losses in their relative profit and loss sharing ratios.

If the partnership has a loan balance from an insolvent partner a

No cash should be distributed for the loan without agreement from all partners.

A partner’s personal creditors have a prior claim on personal assets.

SAFE PAYMENTS TO PARTNERS (Illustration 17-1) (Learning Objective 17.3) A

Safe payments are distributions to partners that can be made with the assurance that any resources distributed will not have to be returned to the partnership at some later date (assumes a worst-case scenario).

In calculating safe payments, the following assumptions are made:

All partners are considered personally insolvent.

All noncash assets are considered possible losses.

Some cash may be withheld to cover liquidation expenses, unrecorded liabilities, and general contingencies. The cash withheld is considered a loss in determining safe payments.

The safe payments schedule for determining advance distributions to partners is prepared after non-partner liabilities have been paid. 1

The schedule begins with each partner’s equity (each partner’s capital account plus loans to the partnership and less loans from the partnership).

Possible losses (from noncash assets and cash withheld balances) are allocated to the partners in the profit-and loss-sharing ratios and deducted from the equity balances.

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Any negative partner equity is allocated to partners with equity in their relative profit-and loss-sharing ratios.

Step 3 is repeated until no remaining partner shows negative equity.

The amount shown for partners with equity will equal the cash available for distribution.

Advance distributions require approval from all partners.

INSTALLMENT LIQUIDATIONS (Learning Objective 17.4) A

Installment liquidations involve the distribution of cash to partners as it becomes available during the liquidation period and before all liquidation gains and losses have been realized. 1

Payments to partners can be determined by a safe payment schedule for each installment distribution.

When the partners’ capital accounts are aligned in the profit- and loss-sharing ratios, safe payment schedules will not be necessary.

Once all the partners are included in an installment distribution, future installment payments to the partners will be in the profit-sharing ratios. Thus, additional safe payment schedules are not necessary.

CASH DISTRIBUTION PLANS (Learning Objective 17.5) A

Cash distribution plans involve ranking partners in terms of their vulnerability to possible losses, preparing a schedule of assumed loss absorption, and preparing a cash distribution plan.

How vulnerable a partner is to possible losses (vulnerability ranking) is determined by dividing each partner’s equity by his/her profit-sharing ratio. 1

This amount is the maximum loss that the partner could absorb without reducing his/her equity below zero.

A schedule of assumed loss absorption is prepared using the vulnerability rankings.

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The schedule begins with pre-liquidation equities and charges each partner’s equity with its share of the partnership loss that would exactly eliminate the equity of the most vulnerable partner.

Each remaining partner’s equity is charged with its share of the loss that would exactly eliminate the equity of the next most vulnerable partner.

This process is repeated until the equities of all but the least vulnerable partner have been reduced to zero.

A cash distribution plan is prepared from the schedule of assumed loss absorption. 1

Under the plan, the first cash available for distribution goes to pay nonpartner liabilities.

Next, the least vulnerable partner will receive an amount of cash that will align that partner’s equity in the relative profit- and loss-sharing ratio with the next least vulnerable partner.

This process is continued until all partners’ capital balances are aligned.

Remaining distributions are in the profit- and loss-sharing ratio.

A cash distribution schedule can be prepared from the cash distribution plan. The schedule shows how cash is distributed as it becomes available.

INSOLVENT PARTNERS AND PARTNERSHIPS (Learning Objective 17.6) A

The UPA specifies priorities for the distribution of partnership assets in liquidation and for the distribution of the personal assets.

Partnership creditors must first seek recovery of their claims from partnership property. 1

Creditors of individual partners must first seek recovery of their claims from individual property.

Often with a solvent partnership, but an insolvent partner: 1

Partnership creditors recover their claims from partnership property.

An insolvent partner’s personal creditors have a claim against partnership assets to the extent of the insolvent partner’s equity in such assets.

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Creditors of an insolvent partner with a credit capital balance may have a claim against the personal assets of a solvent partner with a debit capital balance to the extent of the debit capital balance.

Partners with debit capital balances are obligated to the partnership for the amount of the debit balance; however, if the partner with the debit balance is insolvent, that partner’s personal assets will go to his personal creditors.

Description of assignment material

Minutes

Questions (12) Exercises (12) E17-1 [Flo/Fay] Simple liquidation – Schedule of cash available E17-2 [Mac/Nan/Obe] Liquidation – Journal entries E17-3 [Fed/Ela/Luc] Liquidation – Cash distribution computation, safe payments schedule E17-4 [Jan/Kim/Lee] Liquidation – Cash distribution computation, safe payments schedule E17-5 [Ali/Bob/Kia] Liquidation – capital balance computation correcting an error E17-6 [Eve/Fae/Gia] Safe payments schedule E17-7 [Ali/Bev/Cal] Statement of partnership liquidation E17-8 [Dan/Edd/Fed] Statement of partnership liquidation – Partner insolvency case E17-9 [Ace/Ben/Cid/Don] Statement of partnership liquidation – Partner insolvency case E17-10 [Dee/Ema/Lyn/Geo] Safe payments schedule E17-11 [Sam/Red/Sal] 3 MC problem-type questions E17-12 6 MC general and problem-type questions Problems (12) P17-1 [Ben/Bev/Ron] Cash distribution plan and entries – Installment P17-2 [Cam/Doc/Guy] Cash distribution plan P17-3 [Fred/Flo/Wil] Cash distribution plan P17-4 [Gil/Hal/Ian/Joe] Installment liquidation P17-5 [Eli/Joe/Ned] Statement of partnership liquidation P17-6 [Jon/Sam/Tad] Installment liquidation P17-7 [Lin/Mae//Nel] Installment liquidation P17-8 [Jax/Kya/Bud] Installment liquidation – Safe payments schedule P17-9 [Ron/Sue/Tom] Installment liquidation – Safe payments schedule P17-10 [Rob/Tom/Val] Installment liquidation P17-11 [Jee/Moe/Ole] Installment liquidation P17-12 [Bea/Pat/Tim] Installment liquidation .

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PROFESSIONAL RESEARCH ASSIGNMENTS Answer the following question by reference to the Uniform Partnership Act of 1997. Include the appropriate reference in your response. PR 17-1 What events would require partnership liquidation?

Illustration 17-1 PARTNERSHIP DISSOLUTION AND LIQUIDATION Jacob, Kalen, and Louie decide to dissolve their partnership on May 1, 20X7 and to liquidate their partnership as soon as possible after May 1. A condensed balance sheet with profit sharing percentages is as follows: Condensed Balance Sheet as of May 1, 20X7 Assets Cash Inventory (per books) Other assets (per books) Goodwill

$ 50,000 100,000 130,000 20,000 $300,000

Equities Accounts payable Jas capital 20% Kal capital 40% Lou capital 40%

$120,000 40,000 80,000 60,000 $300,000

Additional information *

The inventory was sold for $70,000 during May.

Other assets with a book value of $90,000 were sold for $50,000.

On June 1 the partners agree to distribute available cash immediately except for a $10,000 contingency fund.

Appropriate distributions are based on a Statement of Partnership Liquidation and a Safe Payments Schedule.

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Balances: May 1 Goodwill write-off Sale of inventory Sale of other assets Predistribution balances Cash distribution: Priority claims Partners Balances

Partner equities Loss on noncash assets Contingency fund Safe payments to partners

Jacob, Kalen, and Louie Partnership Statement of Partnership Liquidation from May 1 to June 1, 20X7 Cash Noncash Priority Jas Capital Kal Capital Assets Claims 20% 40% $50,000 $250,000 $120,000 $40,000 $80,000 (20,000) (4,000) (8,000) 70,000 (100,000) (6,000) (12,000) 50,000 (90,000) (8,000) (16,000) 170,000 (120,000) (40,000) $10,000

40,000

120,000

22,000

44,000

24,000

(12,000) $10,000

(24,000) $20,000

(4,000) $20,000

(120,000) $40,000

Jacob, Kalen, and Louie Partnership Safe Payments Schedule from May 1 to June 1, 20X7 Jas Capital-20% Kal Capital-40% Lou Capital-40% $22,000 $44,000 $24,000 (8,000) (16,000) (16,000) (2,000) (4,000) (4,000) $12,000 $24,000 $4,000

Note the safe payment schedule's assumption that all remaining noncash assets are losses.

Lou Capital 40% $60,000 (8,000) (12,000) (16,000)

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Total $90,000 (40,000) (10,000) $40,000

Chapter 18 CORPORATE LIQUIDATIONS AND REORGANIZATIONS Learning Objectives 18.1 Understand differences among different types of bankruptcy filings. 18.2 Comprehend trustee responsibilities and accounting during liquidation. 18.3 Understand financial reporting during reorganization. 18.4 Understand financial reporting after emerging from reorganization, including fresh-start accounting. Chapter Outline BANKRUPTCY LAW (Learning Objective 18.1) A

Bankruptcy law is contained in Title 11 of the United States Code (USC), referred to as the Bankruptcy Act.

The Bankruptcy Reform Act was passed in 1978 and has been amended several times.

The Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) of 2005 received attention for its provisions.

BAPCPA made it more difficult for debtors to abuse the spirit behind bankruptcy provisions.

A debtor company is given 120 days initially to submit a plan of reorganization. The exclusivity period is limited to a maximum of 18 months.

Retail debtors now have only 120 days to assume or reject non-residential real property unexpired leases with a maximum 90-day extension.

Provisions of the Act and its amendments 1

The Bankruptcy Act created bankruptcy courts. a

The jurisdiction of the bankruptcy court covers all cases under Title 11 of U.S.C.

Congress attempted to speed up bankruptcy cases with amendments to the Act in 1994. The court was given the authority to set dates by which certain parties to a bankruptcy case must complete their duties.

The Bankruptcy Act created the Office of U.S. Trustee. (Learning Objective 18.2) 179

U.S. trustees are appointed by the attorney general.

U.S. trustees are responsible for the administration of bankruptcy cases.

U.S. trustees maintain and supervise a panel of private trustees to serve in liquidation cases.

A U.S. trustee serves as trustee or interim trustee in some cases where a private trustee is not available.

The U.S. trustee monitors appointed creditor committees and presides over creditor meetings.

The Bankruptcy Act also provides for bankruptcy judges. a

Bankruptcy judges are appointed by Federal Appeals Court judges for a 14-year period.

Bankruptcy judges settle disputes that occur during the case and approve all payments of debts incurred before the bankruptcy filing, as well as other payments that are considered extraordinary.

Corporate bankruptcy cases 1

A case begins when a petition is filed under which the debtor is initially brought into bankruptcy court.

The petition may be filed by the debtor (a voluntary bankruptcy proceeding) or by creditors (an involuntary bankruptcy proceeding).

The petition may be filed under Chapter 7 or Chapter 11 of the Bankruptcy Act.

Chapter 11 petitions anticipate the reorganization of the debtor.

Chapter 7 cases anticipate the debtor’s liquidation.

A bankruptcy court has the power to a

Enter the order for relief (accept the petition),

Dismiss the case,

Convert a Chapter 7 case to a Chapter 11 case, or

Convert a Chapter 11 case to a Chapter 7 case

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CHAPTER 7 LIQUIDATION CASES A

Commencing a Chapter 7 case 1

A Chapter 7 case is commenced voluntarily when the debtor corporation files a petition with the bankruptcy court.

A Chapter 7 case is commenced involuntarily when a filing is made by: a

Three or more creditors holding unsecured claims totaling at least $15,775; or

A single creditor with an unsecured claim of at least $15,775 if there are fewer than 12 unsecured creditors.

The court will accept the petition under Chapter 7 if the creditors prove their claims or if the debtor does not contest the petition on a timely basis

The debtor may respond by filing for protection under Chapter 11.

The filing of a case creates an estate.

The U.S. trustee (or the bankruptcy judge in non U.S. trustee districts) appoints an interim trustee to take possession of the debtor corporation’s estate until a trustee is elected.

Unsecured creditors with undisputed claims vote for a trustee. 1

A trustee is elected if creditors holding a minimum of 20% of the dollar amount of claims request an election, and one candidate obtains the votes of creditors holding a majority in the dollar amount of claims actually voting.

If a trustee is not elected, the interim trustee serves as trustee.

Unsecured creditors that can vote also elect a creditors’ committee of 3 to 11 members.

The trustee takes possession of the estate, converts the estate assets into cash, and distributes the proceeds according to priority of claims, as directed by the bankruptcy court. The trustee also has the following duties:

To investigate the financial affairs of the debtor

To provide information about the debtor’s estate and its administration to interested parties

To examine creditor claims and object to claims that appear improper 181

To provide operation reports, a statement of receipts and disbursements, and other information as the court specifies, if they are authorized to operate the debtor’s business

To file reports on trusteeship as required by the court

Claims in a Chapter 7 case are paid according to Exhibit 18-2 in the text. 1

Claims secured by valid liens are paid to the extent of the proceeds from the sale of the property pledged as security. Any amount of remaining debt left unpaid becomes an unsecured nonpriority claim.

Unsecured priority claims are divided into 6 classes.

4 G

The first class, administrative expenses of the liquidation case, is paid in full before the next class (claims incurred between the date of filing an involuntary petition and the date an interim trustee was appointed) receives any distribution.

The second class is paid in full before the third class, and so on.

If cash is insufficient to pay all claims in a given class, distributions are made on a pro rata basis.

Unsecured nonpriority claims are divided into 4 classes. a

Again, the first class is paid in full before cash is distributed to the second class and so on.

If there is insufficient cash for a class, distributions within the class are made on a pro rata basis.

Stockholders receive remaining assets after all claims are paid.

The statement of affairs is a financial statement that emphasizes liquidation values. 1

The statement shows balance sheet information with assets measured at expected net realizable values and is classified on the basis of availability for fully secured, partially secured, priority, and unsecured creditors.

Liabilities are classified as priority, fully secured, partially secured, and unsecured.

The statement is prepared as of a specific date.

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The statement of realization and liquidation is an activity statement that shows progress toward the liquidation of a debtor’s estate. 1

It informs the bankruptcy court and interested creditors of the trustee’s accomplishments.

The Bankruptcy Act does not require this statement but allows the judge to prescribe the form in which the information is presented in court.

Basic financial statements with supporting schedules can also meet this information need.

The bankruptcy case is closed when the estate is fully administered, and the trustee is dismissed.

CHAPTER 11 REORGANIZATION CASES A

Commencing a Chapter 11 case 1

A case is initiated voluntarily when a debtor corporation files a petition with the bankruptcy court.

A case is initiated involuntarily when creditors file a petition (in accordance with the same $15,775 claim limitations applicable to Chapter 7 filings).

If the court grants the petition for protection from creditors, it enters an order for relief under Chapter 11. Alternatively, the court may dismiss the petition or convert the case to a Chapter 7 case.

When the order for relief is granted, the bankruptcy judge appoints a U.S. trustee to administer the case.

A private trustee may be appointed for cause, but otherwise the debtor corporation is continued in possession of the estate and is referred to as a debtor in possession. If the court appoints a private trustee for cause, a party in interest may request that a trustee be elected. 1

The duties of the trustee or debtor in possession include the following: a

Being accountable for the debtor’s property, including operations of the debtor’s business

Filing a list of creditors, schedules of assets and liabilities, and a statement of financial affairs

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Furnishing information and reports requested by the court about the estate and its administration

Examining creditor claims and objecting to claims that appear improper

Filing a reorganization plan or reporting why one will not be filed

Filing final reports as required by the court.

Negotiating with creditors and stockholders through creditors’ committees and equity holders’ committees

Creditors’ committees are responsible for protecting the interests of the creditors they represent. 1

A creditors’ committee is appointed by the U.S. trustee as soon as practicable after the order for relief is granted.

All negotiations between the debtor and the pre-petition creditors are carried out through creditors’ committees.

Generally, governmental units cannot serve on creditors’ committees; however, in some cases, the PBGC can be a voting member.

While operating under Chapter 11, the debtor corporation may be able to do the following: 1

Reduce labor costs through layoffs, wage reductions, or termination of pension plans

Reject executory contracts and unexpired leases

Reduce interest expense because interest accrued on unsecured debt stops at the time the petition is filed

Prevent foreclosure on the debtor’s assets (except as permitted by the bankruptcy court)

Force a debt restructuring

The reorganization plan must be fair and equitable to all interests concerned. 1

During the first 120 days after the order of relief is filed, only the debtor corporation can file a reorganization plan. Once the exclusivity period has expired, any party of interest may file a plan.

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Chapter 11 of the Bankruptcy Act requires that the reorganization plan must a

Identify classes of claims (with some exceptions)

Specify any class of claims that is not impaired

Specify any class of claims that is impaired

Treat all claims within a particular class alike

Provide adequate means for the plan’s execution

Prohibit the issuance of nonvoting equity securities

Contain provisions for the selection of officers and directors that are consistent with the interests of creditors, equity holders, and public policy

For the bankruptcy court to confirm a plan, each class of claims must have accepted the plan or not be impaired under it. a

Within each class, each holder of a claim must either have accepted the plan or receive not less than that holder would receive if the debtor corporation were liquidated.

Classes of claims that are unimpaired are assumed to have accepted the plan.

Classes that receive nothing are assumed to have rejected it without the necessity of a vote.

Acceptance of a plan by a class of claims requires approval of at least two-thirds in amount and over half in number of claims.

After the plan has been approved, the court holds a confirmation hearing. a

Confirmation by the court constitutes discharge of the debtor except for claims provided for in the reorganization plan.

FINANCIAL REPORTING DURING REORGANIZATION (Learning Objectives 18.3) A

The balance sheet should present pre-petition liabilities subject to compromise separately from those not subject to compromise.

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Prepetition liabilities subject to compromise are the unsecured and undersecured liabilities incurred before the Chapter 11 filing.

Liabilities not subject to compromise include fully secured liabilities incurred before the Chapter 11 filing and all post-petition liabilities.

Effects of reorganization on income and cash flow statements 1

Expenses directly related to the Chapter 11 proceedings are expensed as incurred.

Revenues, expenses, gains, and losses related to the reorganization are reported separately in the income statement as reorganization items except those required to be reported as discontinued operations.

The amount of interest that will be paid during the bankruptcy proceedings, or the probable amount to be allowed, should be reported as interest expense. The difference between this amount and contractual interest should be disclosed in a financial statement note.

Earnings per share are reported as usual. Probable issuances of common stock under a reorganization plan should be disclosed.

Cash flow items relating to the reorganization should be disclosed separately from other cash flows.

Consolidated financial statements do not provide enough information about bankruptcy proceedings. a

GAAP requires condensed combined financial statements for all entities in reorganization proceedings be presented as supplementary information.

Consolidation may be inappropriate for some subsidiaries in bankruptcy. Control may not be present if a trustee is appointed to operate the company.

FINANCIAL REPORTING FOR THE EMERGING COMPANY (Learning Objective 18.4) A

The reorganization value of a company approximates the fair value of the entity without considering liabilities and determines how much creditors will recover on their claims.

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Financial reporting depends on whether the company emerging from bankruptcy is essentially a new company. An emerging company qualifies for fresh start reporting if both of the following conditions are met: 1

The reorganization value immediately before the date of confirmation of the reorganization plan is less than the total of all postpetition liabilities and allowed claims; and

Holders of existing voting shares immediately before confirmation of the reorganization plan receive less than 50% of the emerging entity. The loss of control must be substantive and not temporary.

Fresh-start reporting results in a new reporting entity with no retained earnings or deficit balance. 1

The reorganization value of the company is allocated to tangible and intangible assets according to the acquisition method of accounting.

Any excess of reorganization value over tangible and identifiable intangible assets is an unidentifiable intangible asset, “reorganization value in excess of the amount allocable to identifiable assets.”

Liabilities, other than deferred income taxes, should be reported at their current value at the confirmation date.

The final statements of the old entity should disclose the effects of the adjustments on the asset and liability accounts resulting from fresh-start reporting and the effects of debt forgiveness. The ending balance sheet of the old entity should be the same as the beginning balance sheet of the new entity, including a zero retained earnings balance.

Disclosures in the new balance sheet include those listed above for inclusion in the old balance sheet, plus significant factors relating to the determination of reorganization value.

Companies that do not qualify for fresh-start reporting should report liabilities compromised at their present values under the provisions of GAAP. 1

Debt forgiveness should be reported as an extraordinary item.

Quasi-reorganization accounting should not be used.

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Description of assignment material

Minutes

Questions (17) Exercises (5) E18-1 4 MC general questions E18-2 [Hal] 4 MC general questions (Financial reporting during bankruptcy) E18-3 [Ram/Pat] Financial reporting during bankruptcy – Distributions to creditors E18-4 [Bax] Fresh-start reporting requirements E18-5 [Hol] Financial reporting during bankruptcy – Distributions to creditors

25 10 10 15 16

Problems (7) P18-1 [Sco] Financial reporting during bankruptcy P18-2 [Jut] Financial reporting during bankruptcy P18-3 [Fab] Claims rankings and cash distribution upon liquidation P18-4 [Han] Financial reporting during bankruptcy - Statement of affairs P18-5 [Dan] Financial reporting during bankruptcy P18-6 [Val] Financial reporting during bankruptcy P18-7 [Lop] Installment liquidation

45 30 30 60 80 60 40

PROFESSIONAL RESEARCH ASSIGNMENTS Answer the following questions by reference to the Uniform Partnership Act of 1997. Include the appropriate reference in your response. PR 18-1 What are the special requirements for the presentation of financial statements for a firm that is operating under Chapter 11 Bankruptcy protection? PR 18-2 Under what circumstances does a firm emerging from bankruptcy qualify for freshstart reporting? Can you find an example of how a firm should report in a fresh-start reporting situation?

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Chapter 19 AN INTRODUCTION TO ACCOUNTING FOR STATE AND LOCAL GOVERNMENTAL UNITS Learning Objectives 19.1 Learn about the historical development of accounting principles for state and local governmental units. 19.2 Understand the purposes of fund accounting and its basic premises. 19.3 Perform transaction analysis using proprietary and governmental accounting models. 19.4 Recognize various fund categories, as well as their measurement focus and basis of accounting. 19.5 Review basic governmental accounting principles. 19.6 Learn about the contents of a governmental entity’s comprehensive annual financial report. Chapter Outline HISTORICAL DEVELOPMENT OF ACCOUNTING PRINCIPLES FOR STATE AND LOCAL GOVERNMENTAL UNITS (Learning Objective 19.1) A

A governmental unit is generally created for the administration of public affairs and has one or more of the following characteristics: 1

Popular election of officers or appointment (or approval) of a controlling majority of the members of the governing body by officials of one or more state or local governments

The potential for unilateral dissolution by a government with the net assets reverting to a government

The power to enact or enforce a tax

The ability to issue debt exempt from federal taxation

Prior to 1984 the National Committee on Governmental Accounting (NCGA), a committee of the Government Finance Officers Association, provided much of the guidance for state and local governmental accounting.

The Governmental Accounting Standards Board (GASB) was formed in 1984. Its first pronouncement, GASB Statement No. 1, Authoritative Status of NCGA Pronouncements and AICPA Industry Audit Guide, designated all NCGA Statements and Interpretations as “generally accepted accounting principles” until changed or superseded by the GASB.

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In 1985, the GASB integrated all effective accounting and reporting standards into one publication called Codification of Governmental Accounting and Financial Reporting Standards. 1

The Codification is revised annually with all official GASB pronouncements.

It constitutes GAAP for governmental units.

GAAP hierarchy for state and local governmental entities 1

GASB issued Statement No.76, The Hierarchy of Generally Accepted Accounting Principles for State and Local Governments, which reduces GAAP hierarchy to two categories of accounting principles: a

Officially established accounting principles – GASB Statements and GASB Interpretations

GASB Technical Bulletins; GASB Implementation Guides; and literature of the AICPA cleared by the GASB

OVERVIEW OF BASIC GOVERNMENTAL ACCOUNTING MODELS AND PRINCIPLES (Learning Objectives 19.2 and 19.3) A

The focus of governmental accounting and financial reporting is on accountability to the public and governmental authorities.

State and local governmental units engage in both business-type and general governmental activities. 1

Business-type activities provide services to users for a fee that are intended to recover all, or at least the primary portion, of the costs of providing the services. General governmental activities provide goods and services to citizens without regard to their ability to pay and are usually financed by taxes or intergovernmental grants and subsidies.

Fund accounting is the use of multiple accounting entities to account for resources segregated according to purpose. 1

A fund is an accounting entity.

Each fund is used to account for only a portion of a government's activities, assets, liabilities, and equities.

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Each fund has a self -balancing set of accounts.

There are three broad categories of funds: a

Proprietary funds, which are similar to business accounting entities, are used to account for business-type activities.

Governmental funds, which are essentially working capital entities, are used to account for governmental-type activities.

Fiduciary or trust and agency funds

The proprietary fund accounting model is very similar to the business accounting model. 1

Proprietary funds are used to account for activities of government that are financed primarily from user charges – similar to a business activity.

Proprietary fund accounting and reporting are very similar to business accounting and reporting.

The proprietary fund accounting equation is the same as that for a business except that the term “net assets” is used to represent fund equity. Current Assets + Non-Current Assets – Current Liabilities – Non-Current Liabilities = Net Assets

Most proprietary fund transactions are accounted for in the same way that they would be for a similar business operation.

Proprietary funds are accounted for using the accrual basis of accounting for revenues and expenses.

The general government accounting model is used to account for most general government functions such as public safety, education, and the judicial system. 1

Governmental funds, in their simplest form, are simply working capital accounting entities.

The basic governmental fund accounting equation is: Current assets – Current liabilities = Fund balance

Fixed assets and unmatured long-term debt are not accounted for in these funds. Records are maintained for both types of accounts and reflected in the government-wide financial statements.

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The following types of funds are identified for use by state and local governments. (Learning Objective 19.4) 1

The modified accrual basis of accounting is used in governmental funds. Revenues and expenditures are reported.

Governments use two types of proprietary funds. a

Internal service funds are used to account for departments that provide goods and services to other departments of a government on a costreimbursement basis.

Enterprise funds are used to account for providing goods and services to the public that are financed by user charges.

Five types of governmental funds are used to account for general governmental activities. a

The general fund is used to account for all financial resources except those required to be accounted for in another fund.

Special revenue funds are used to account for the proceeds of specific revenue sources (other than permanent funds or for major capital projects or debt service) that are legally restricted to expenditures for specified purposes.

Capital projects funds are used to account for financial resources to be used for the acquisition or construction of major capital facilities (other than those financed by proprietary funds and trust funds).

Debt service funds are used to account for the accumulation of resources for, and payment of, general long-term debt principal and interest.

Permanent funds are used to account for resources that are permanently restricted, but whose earnings are expendable for the benefit of the government or its citizenry.

Fiduciary funds include the following: a

Pension trust funds account for governmental pension plans if the trustee is the government.

Investment trust funds account for the external portion of investment trust pools reported by the sponsoring government.

Private-purpose trust funds report all other trust arrangements. 192

Agency funds account for resources a government is holding as an agent on behalf of third parties outside the government.

Different bases of accounting are used for the general governmental fund model and the proprietary fund model. 1

The basis of accounting used for proprietary funds, the accrual basis, is essentially the same as for business entities.

The basis of accounting for governmental funds is the modified accrual basis, and is unique to governments.

Under the modified accrual basis of accounting 1

Revenues are recognized when they become available and measurable to meet current obligations.

Expenditures are recognized in the accounting period in which the liability is incurred (except for unmatured interest on general long-term debt which is recognized when due).

Revenue recognition is determined by the nature of the underlying transaction. (Learning Objective 19.5) 1

Exchange transactions are those in which each party receives and gives up essentially equal values.

Nonexchange transactions are those in which a government gives or receives value without directly receiving or giving equal value in exchange. a

Nonexchange transactions include derived tax revenues like sales and income taxes assessed on the value a taxpayer spends or earns.

Imposed nonexchange revenues include property taxes assessed on the property value.

Government-mandated and voluntary nonexchange transactions, which include grants and donations, do not require an equal exchange by the government entity.

In general, the transaction should be substantially complete prior to revenue recognition.

The available criterion means that the revenue must be legally available for expenditure in the period and collected within a specified period (of not more than 60 days) after the end of the fiscal year. 193

The net revenue approach is used.

Many investments are accounted for at fair value under GASB Statement No. 31. Therefore, investment income includes changes in the fair value of these investments without regard to the 60-day rule.

Expenses of a government unit are like those of a business enterprise while expenditures in a government fund reflect the use of working capital. 1

Expenses are recognized in proprietary funds statements and recognized in the period incurred.

Expenditures are recognized in governmental funds statements to reflect the cost of goods acquired during a period, whether or not consumed, and with limited exception, government funds recognize expenditures in the period that the fund liability is incurred under the modified accrual basis.

In government-wide statements, all funds report expenses under the accrual basis.

In governmental funds, the purchase of a fixed asset results in a capital outlay expenditure in the year of acquisition and no additional expenditures in the future. a

Proceeds from general long-term debt issuances increase current assets and the fund balance, but the liability is not recorded in the governmental funds statements. a

The same purchase within a proprietary fund results in a capitalized asset with annual depreciation expense.

The liability will appear within the government-wide statement of net assets for the same item.

Transactions between two funds must be classified into various categories of interfund transactions. 1

Each of these transaction types is accounted for and reported differently.

The categories are interfund loans, interfund transfers, interfund services provided and used, and interfund reimbursements.

An annual budget must be adopted by every governmental unit. Only the general fund and special revenue funds are required to use formal budgetary accounting practices.

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A budget is a plan of financial operations consisting of an estimate of proposed expenditures for a given period and the proposed means of financing them.

Appropriations are approved or authorized expenditures. If an appropriation is allocated to a specific time period, it is termed an allotment.

A comparison of actual and budgetary amounts is required to be included in the annual operating statement of each governmental fund for which an annual budget has been legally adopted.

THE FINANCIAL REPORTING ENTITY A

GASB Statement No. 14, The Financial Reporting Entity, explains that the financial reporting unit is made up of the primary government and its component units. 1

The primary government has a separately elected governing body, is legally separate, and is fiscally independent of other state and local government units.

Component units are legally separate organizations for which the government is financially accountable or maintains a significant relationship.

Component units may be blended with the primary government only if a voting majority of the primary government governing body serves on the component unit governing board and constitutes a voting majority of that board.

GASB Statement No. 39, Determining Whether Certain Organizations are Component Units, provides criteria for deciding whether organizations should be reported as component units of the primary government.

COMPREHENSIVE ANNUAL FINANCIAL REPORT (CAFR) (Learning Objective 19.6) A

A comprehensive annual financial report (CAFR) should be prepared and published by every governmental entity. The reporting requirements for the CAFR include the preparation of government-wide financial statements using accrual accounting.

The CAFR is the entity’s official annual report and has three major sections: introductory, financial, and statistical.

The introductory section of a CAFR includes a table of contents, a letter of transmittal, a list of principal officers, and an organization chart.

The financial section includes the MD&A, the auditor’s report, the governmentwide financial statements, and the fund financial statements. 195

The auditor’s report of a CAFR indicates the statements are the responsibility of management and expresses an opinion on whether they are presented in conformity with generally accepted accounting principles.

The MD&A is a descriptive presentation of the government’s financial activities based on currently known facts, decisions, and conditions. This is similar to a corporate MD&A.

Government-wide financial statements provide consolidated information for the government as a whole. Operational accountability measures the extent of a government’s success at meeting operating objectives efficiently and effectively. 1

These statements report governmental activities, business-type activities, and discretely presented components units.

All data is reported on the accrual basis.

Financial statements include the statement of net assets and the statement of activities.

Individual fund financial statements are presented to focus on fiscal responsibility. Fund financial statements must include a separate column for each major governmental fund. The general fund is always a major fund.

Budgetary comparisons for the general fund and special revenue funds must be presented for each fund with a legally adopted budget. These may be presented as a comparison statement within the financial statements or, as a schedule with the CAFR required supplementary information.

Governments are required to supply supplementary information on pension plans, budgetary comparisons, and infrastructure assets if applicable.

The financial statements include notes and required disclosures essential to the fair presentation of the statements.

Under GASB 34, capital assets including infrastructure, are capitalized and depreciated on the government-wide financial statements.

Combining financial statements that combine individual funds into an aggregate set of totals by classification or activity are a required part of the CAFR. 196

The statistical section of the CAFR contains statistical tables with comparative data from several time periods. Fifteen specific tables should be included unless inapplicable.

GASB suggests governments supplement the CAFR with additional information about its service efforts and accomplishments (SEA) deemed important to its citizens. SEA is a type of performance measurement, enabling citizens and managers to evaluate the manner and effectiveness of the government’s operations.

Description of assignment material

Minutes

Questions (23) Exercises (13) E19-1 5 MC general questions E19-2 AICPA 5 MC general questions E19-3 5 MC general questions E19-4 5 MC general questions E19-5 5 MC general questions E19-6 Identification of fund type E19-7 Transaction analysis - governmental funds E19-8 Transaction analysis – proprietary funds E19-9 Identification of fund type E19-10 Identification of fund type E19-11 Identification of fund type E19-12 [Sioux Falls] Identification of fund type and transaction analysis E19-13 [Perez] Identification of fund type and transaction analysis

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Internet assignment 1. Visit the GASB’s Web site and answer questions regarding GASB standards. Click on Standards & Guidance menu and select Pronouncements. What is the title of the most recently issued GASB standard? When was it issued? What is its effective date? 2. Locate the Web site for a municipality (city, county, town, parish, etc.) in which your college or university is located. Is the municipality’s financial report available on the Web site? If so, review the CAFR and answer the following questions: a. How many governmental funds does the government have? List the name of one special revenue fund. b. Does the government have a capital projects fund? For what purpose was it created? c. How many enterprise funds does the government have? List the name of one enterprise fund. d. How many trust and agency funds does the government have? List the name of one such fund.

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Chapter 20 ACCOUNTING FOR STATE AND LOCAL GOVERNMENTAL UNITS – GOVERNMENTAL FUNDS Learning Objectives 20.1 Prepare journal entries to record transactions in governmental funds, including the new fund balance classifications. 20.2 Learn about accounting methods unique to government accounting: budgetary issues, encumbrance accounting, and interfund transactions. 20.3 Determine the appropriate governmental fund to be used. 20.4 Prepare governmental fund financial statements. 20.5 Convert governmental fund financial statements to government-wide financial statements. Chapter Outline RECENT CHANGES TO GOVERNMENTAL FUND ACCOUNTING (Learning Objectives 20.1 and 20.2) A

GASB statement No. 54 (2009) established five classifications of governmental fund balance listed in decreasing order in spending constraints: 1

Nonspendable fund balance

Restricted fund balance

Committed fund balance

Assigned fund balance

Unassigned fund balance

THE GENERAL FUND A

The general fund (GF) is the entity that a government uses to account for all unrestricted resources except those to be accounted for in a specific fund. There is only one general fund.

Formal budgetary accounting is required. 1

The GASB Codification requires that governments classify revenues by source (taxes, licenses) and expenditures by character class (current services, capital outlays) and purpose (general government, public safety).

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The approved budget is recorded in the accounts of the general ledger as follows: Estimated revenues xxx Appropriations Estimated other financing uses Unreserved fund balance

xxx xxx xxx

Details of planned revenues are recorded in a subsidiary revenue ledger, and appropriation details are recorded in a subsidiary expenditure ledger.

Compliance with the approved budget is required. A statement of revenues, expenditures, and changes in fund balance – budget and actual is required to demonstrate compliance with the budget.

Some governments require that revenues exceed appropriations, resulting in a balanced budget.

Revenue transactions follow the modified accrual basis of accounting and are recognized in the period they become measurable and available. 1

The 60-day rule helps establish availability.

Uncollectible taxes are recorded as revenue adjustments, not expenditures.

Derived tax revenues, such as sales and income taxes, are recognized when the underlying transaction (e.g., the sale) takes place.

Revenues from other sources, such as licenses, permits, and fines, are typically recorded when cash is received.

Expenditures are recorded when the related liability is incurred.

The law limits expenditures to those for which appropriations have been made. Encumbrance accounting recognizes commitments made for goods on order and for unperformed contracts to help prevent overspending.

Fixed assets do not appear as assets in the governmental fund statements. Instead they are capitalized and included in the government-wide financial statement. Thus, fixed assets are one of the reconciling items between the two statements.

Supply acquisitions may be treated as expenditures either when purchased or when used as long as significant amounts of inventory are reported on the balance sheet.

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Lease agreements fall under the provisions of FASB Statement No. 13. A capital lease is recorded as an expenditure and another financing source, as if long-term debt had been issued.

Intrafund transfers are classified as reciprocal if the fund expects repayment or nonreciprocal if the flow of assets does not require repayment.

SPECIAL REVENUE FUNDS (Learning Objectives 20.3) A

A special revenue fund (SRF) is the fund entity that a government uses to account for specific revenue sources (other than resources from permanent funds, major capital projects, or debt service on general long-term debt) that are restricted by law or administrative action to expenditures for a specific purpose. 1

This demonstrates compliance with legal or administrative requirements.

The accounting in an SRF is similar to the accounting in a GF.

Grant funds restricted to a specific purpose are often accounted for in an SRF. 1

Grant revenues can be recognized as such when all eligibility requirements set forth in the grant have been met, if the funds are available to meet current liabilities.

If grant funds are disbursed to the government prior to the eligibility requirements having been met, they must be accounted for as deferred revenues.

PERMANENT FUNDS A

Permanent funds (PF) is a new governmental fund category created by GASB 34 that is used to account for nonexpendable resources set aside for support of a government’s programs or citizenry. 1

Governments use a PF to account for contributions for which the grantor specifies that a principal amount must be maintained but for which the interest accumulation or asset appreciation or both may be used for a specific purpose.

Revenues will come from interest and asset appreciation.

Expenditures will be recorded as incurred.

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CAPITAL PROJECTS FUNDS A

Capital projects funds (CPF) are governmental funds used to account for resources for the acquisition or construction of major capital facilities other than those financed by trust and proprietary funds. 1

A CPF is created when it is legally authorized and it exists for the life of the project.

A CPF uses modified accrual accounting and revenue and expenditure accounts. Formal budgetary accounting need not be used unless several projects are financed through the same fund, or the governmental unit is the primary contractor for the facilities.

A CPF is not required for the acquisition of minor general fixed assets. These acquisitions are accounted for in the general fund or a special revenue fund.

Typical financing sources of a CPF include bond issue proceeds, grants, shared revenues, transfers from other funds, and contributions from property owners (for special assessment projects).

Accounting for a CPF 1

When the fund is created, a memorandum entry is made in the fund for its authorization.

Interfund transfers are not revenues and expenditures of the funds involved. They are nonreciprocal, nonexchange transactions and are classified in the financial statements as “other financing sources or uses.”

Bond issue proceeds are recognized in a CPF when the bonds are sold. Bond proceeds are classified in the financial statements as “other financing sources.” The proceeds from special assessment debt are described as contributions from property owners rather than bond proceeds. a

When bonds are issued at a premium, the full amount of the proceeds is recorded in the CPF, and the premium is transferred to the debt service fund. The premium cannot be used as an addition to the project authorization.

When bonds are issued at a discount, the proceeds are recorded in the CPF, and the discount, in effect, reduces the project authorization unless additional resources are provided for the project from other sources.

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Authorized but unissued bonds at an interim statement date should not be accrued. The unissued bonds are disclosed in notes to the financial statements.

When a contract is awarded, the full amount for the contract is encumbered. Construction contracts often require that a retained percentage be withheld from progress payments until completion of the project and final inspection.

Under modified accrual accounting, intergovernmental revenue may be accrued in some circumstances if the commitment is firm. Restricted grants are recognized as revenues when all grant stipulations, including incurring expenditures for the qualified purpose, are met.

SPECIAL ASSESSMENT ACTIVITIES A

Special assessments are tax levies on a limited group of property owners to finance public improvements that are expected to benefit those property owners. 1

A special assessments project usually originates when property owners petition the governmental unit for an improvement such as constructing a sidewalk or paving a street.

If the project is authorized, the government obtains financing, makes the improvement, and levies the special assessments against the property owners. If the project will also benefit the general citizenry, the government may pay a portion of the cost.

Often special assessment bonds are issued to pay the construction costs, and the special assessments are collected in installments over the term of the special assessment bond issue. The interest charged on the unpaid special assessment balance is used to cover the interest on the bonds.

Capital improvements related to special assessment projects are accounted for in a CPF.

Debt service on special assessment debt for which the governmental unit is obligated in some manner is reported in the governmental activities of the government-wide statement of net position.

Debt service on special assessment debt for which the governmental unit is not obligated in any way is accounted for in an agency fund. The obligation is disclosed only in notes to the financial statements.

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DEBT SERVICE FUNDS A

Debt service funds (DSF) are governmental funds that are used to account for the receipt of resources to be used for debt service and for the use of those resources to make principal and interest payments on general long-term debt obligations. 1

A separate DSF is usually created to account for each major general long-term debt issue. However, a DSF is not required by GAAP unless it is legally or contractually mandated, or a government is accumulating resources to be used to pay future years' debt service payments.

Debt service funds generally use modified accrual accounting to account for revenues and expenditures. a

The GASB Codification identifies a major expenditure recognition exception related to debt service expenditures for general long-term debt.

Principal and interest expenditures on general long-term debt are to be recognized in the period that they are legally due and payable, i.e., the period in which they mature. However, if the payment is due early (within a few weeks) in the next fiscal year, and resources are available in the fund before the end of the current year, a government is permitted, but not required, to accrue the next principal and interest payment.

Debt service funds for term bond issues involve sinking fund operations, as resources are accumulated to retire all of the debt at maturity, as well as regular interest payments on the debt.

Debt service funds for serial bond issues involve receiving resources as needed and distributing those resources for the principal and interest payments. No significant balances would be carried over from one period to the next.

GOVERNMENTAL FUND FINANCIAL STATEMENTS (Learning Objective 20.4) A

Required governmental fund financial statements include a statement of net position or balance sheet, and a statement of revenues, expenditures, and changes in fund balance. 1

Budgetary comparison information must be presented for the GF and each SRF that has a legally adopted budget. This is required supplementary information.

The budgetary basis comparison must be presented on the budgetary basis of accounting, even if it differs from GAAP. A reconciliation of the budget to GAAP statements must appear either on the face of the statements or in the notes to the statements. 204

PREPARING THE GOVERNMENT-WIDE FINANCIAL STATEMENTS (Learning Objective 20.5) A

A government must include governmental fund activities in the government-wide financial statements. 1

These are prepared on the accrual basis rather than the modified accrual basis.

There must be a conversion of governmental fund information for the government-wide financial statements. A conversion worksheet is an optional internal document that may be helpful to meet this requirement.

The government-wide financial statements include a statement of net position and a statement of activities. 1

GASB 34 requires a reconciliation between the total fund balance for governmental funds (reported on the fund financial statements) and the net position for governmental funds (reported on the government-wide financial statements).

GASB 34 requires a reconciliation between the change in fund balance (reported on the fund statement of revenues, expenditures, and change in fund balance) and the change in net position (reported on the statement of activities).

Both reconciliations may appear either on the face of the fund financial statements or in an accompanying schedule.

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Description of assignment material

Minutes

Questions (21) Exercises (15) E20-1 5 MC general questions E20-2 5 MC general questions E20-3 5 MC general questions E20-4 5 MC general questions E20-5 AICPA 5 MC general questions E20-6 AICPA 5 MC general and problem-type questions E20-7 [Jedville] General fund journal entries (property taxes) E20-8 [Any City] Governmental fund closing entries E20-9 [Millar] Preparation of fund balance sheet E20-10 [Madelyn] Preparation of a fund statement of revenues, expenditures, and changes in fund balance E20-11 General fund journal entries E20-12 [Rochester] General fund journal entries E20-13 Governmental fund journal entries E20-14 [Alantown] Governmental fund reconciliation to total net position E20-15 [Boulder] Governmental fund reconciliation to total net position Problems (12) P20-1 [Orchard Park] Preparation of a general fund balance sheet P20-2 [Batavia] Preparation of general fund statements P20-3 [Tyler] Governmental fund journal entries, budgetary comparison, and reconciling items P20-4 [Fort Collins] Governmental fund conversion worksheet P20-5 AICPA [Oslo] Reconstruct general fund journal entries P20-6 AICPA [Lahti] Journal entries from the trial balance P20-7 [Volendam] Preparation of a fund statement of revenues, expenditures, and changes in fund balance P20-8 [Lilehammar] Debt service fund journal entries P20-9 [Stockholm] Capital projects fund journal entries P20-10 [Malmo] Journal entries associated with a capital project P20-11 AICPA [Cerone] Capital projects fund journal entries and balance sheet P20-12 [Catalina] Capital projects fund journal entries and financial statements

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10 10 12 10 10 20 15 20 20 20 25 25 15 20 20

25 30 45 30 30 30 25 20 20 25 40 50

Internet assignment 1. Choose a CAFR from a city, county, or other local government. Review the CAFR and answer the following questions: a. How many governmental funds does the government have? List the name of one special revenue fund. b. Does the government have a capital projects fund? For what purpose was it created? Is it a major fund? c. Does the government use a debt service fund? d. Does the government use encumbrance accounting? How can you tell? e. Has the government implemented GASB Statement No. 54? How can you tell? f. Locate the reconciliations between the fund and government-wide statements. List two reconciling items. g. Locate the budgetary comparison statement or schedule for the general fund. Comment on the extent of the differences between the original and final budgets. 2. Locate the Web site for the municipality in which your college or university is located. List one major event that has occurred recently and will be recorded in the accounting records. What fund or funds will be affected by this event? 3. Locate the Web site for the county in which your college or university is located. Has the county recorded any new debt this year in its governmental funds? How much? How can you tell?

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Chapter 21 ACCOUNTING FOR STATE AND LOCAL GOVERNMENTAL UNITS – PROPRIETARY AND FIDUCIARY FUNDS Learning Objective 21.1 Review the appropriate accounting and financial reporting for proprietary funds. 21.2 Recognize the proper treatment of internal service funds in the government-wide statements. 21.3 Introduce the differences between a proprietary fund statement of cash flows and its commercial business counterpart. 21.4 Prepare journal entries and fund financial statements for fiduciary funds. 21.5 Learn about GASB guidance for pension fund accounting. Chapter Outline PROPRIETARY FUNDS (Learning Objective 21.1) A

Proprietary funds are used to account for business-type activities providing goods and services to users and financing those services primarily from user charges. 1

Proprietary funds are accounted for using the accrual basis of accounting for revenues and expenses. a

Revenues are recognized when earned and measurable.

Expenses are recognized in the period incurred, if measurable.

Fixed assets of the proprietary fund are fund fixed assets. Long-term obligations expected to be serviced by proprietary fund revenues are fund longterm debt.

Lease agreements of proprietary funds are accounted for within the fund under the provisions of FASB Statement No. 13, except for operating leases with scheduled rent increases, which recognize rental revenue as it accrues over the lease term.

Accounting and reporting standards applicable to proprietary activities are provided in GASB Statement No. 20 as follows: 1

Governmental proprietary activities must apply to a

All applicable GASB statements, and

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All FASB and predecessor standards issued before November 30, 1989 that do not conflict with GASB standards.

Governmental proprietary activities may either apply to a

All FASB standards issued after November 30, 1989 as long as they do not conflict with GASB standards, or

No FASB standards issued after November 30, 1989 even if they modify or rescind earlier issued FASB statements.

Proprietary funds include enterprise funds and internal service funds.

INTERNAL SERVICE FUNDS A

Internal service funds (ISF) provide goods and services to other departments or agencies of the governmental unit on a cost reimbursement basis. 1

In some cases, the initial financing for the fund comes from the governmental unit. a

A contribution (nonreciprocal transfer) is classified as a part of fund equity.

The government may provide a loan to the ISF to be recorded as a longterm liability that will be repaid from future operating flows of the fund.

Short-term interfund loans are recorded as “due to GF” and “due from ISF,” etc.

Receivables from the sale of goods and services are recorded as revenues to the ISF with a corresponding “due from GF” or “due from SRF,” etc.

ISFs are reported in a unique manner under GASB 34 because they provide goods and services to government units. (Learning Objective 21.2) 1

In fund financial statements, ISFs are reported with the proprietary funds. a

All ISFs are aggregated into a single column within the proprietary fund financial statements.

Within the government-wide financial statements, ISFs are reported with the government activities.

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ISF balance sheet accounts are included in the statement of net assets.

The statement of activities only includes ISF revenues and expenses resulting from transactions involving entities outside the primary reporting entity.

Thus, interfund transactions are eliminated much like they are in consolidated financial statements.

ENTERPRISE FUNDS A

An enterprise fund (EF) provides goods and services financed through user charges to the general public on a continuing basis. 1

Enterprise funds may be used for any service for which there is a significant potential for financing through user charges.

Enterprise funds must be used for any business activities that

Are financed with debt secured solely by net revenue from fees and charges to external users;

Operate under laws or regulations requiring that the cost of providing the service, including capital costs, be recovered through user charges;

Establish prices to cover the costs, including capital, to cover the cost of providing the service.

The accounting is essentially the same as for the ISF, and the same financial statements are required.

Utilities frequently require customer deposits before service starts and refund those deposits when service is terminated. 1

Deposits from developers are segregated and reported as restricted assets in the EF balance sheet.

Customer deposits remain in current liabilities until they are applied against unpaid bills or refunded to customers.

PROPRIETARY FUND FINANCIAL STATEMENTS A

Required fund financial statements include the following:

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A statement of net assets or balance sheet a

In place of the stockholder’s equity section, a government’s net assets include capital assets, net of related debt, restricted net assets, and unrestricted net assets.

A statement of revenues, expenses, and changes in net assets

A statement of cash flows (Learning Objective 21.3) a

The direct method is required.

GASB’s cash flows statement has 4 separate sections: 1

Cash flows from operating activities

Cash flows from noncapital financing activities

Cash flows from capital and related financing activities

Cash flows from investing activities

FIDUCIARY FUNDS (Learning Objective 21.4) A

Fiduciary funds are used to account for assets held by the government as trustee or agent for another entity and include agency funds, private-purpose trust funds, investment trust funds, and pension trust funds. The accrual basis of accounting is used.

Agency funds (AF) do not have revenues or expenses since their operations are of a custodial nature. 1

Agency funds are used when agency responsibilities involve numerous transactions, include several different governmental units, and/or do not arise from normal and recurring operations of another fund. a

A separate agency fund is not required when regular liability accounting is adequate to show how the local government’s fiduciary responsibilities have been met (collection of state sales taxes, for example).

Agency funds are used for the debt service transactions of a special assessment bond issue when the government is not obligated in any manner.

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Operations of agency funds are custodial. a

Agency funds have asset and liability accounts, but they do not have revenues and expenses.

The accounting equation for an agency fund is simple: Assets = Liabilities

AFs are included in the statement of fiduciary net assets. They are not included in the government-wide financial statements.

Trust funds (TF) 1

Investment trust funds are fiduciary funds used to account for multigovernment external investment pools sponsored by the governmental entity. a

Private-purpose trust funds are used to account for resources (other than investment pools and employee benefits) that are held for the benefit of parties outside the governmental entity. a

GASB Statement No. 31 describes the accounting for investment trust funds. Accounting for investment trust funds is not covered in depth in this chapter.

Financial statements for a private purpose trust fund include a statement of fiduciary net assets, and a statement of changes in fiduciary net assets.

Pension trust funds (PTFs) are reported following specialized guidance for defined benefit pension plans. (Learning Objective 21.5) a

Two financial statements are required: a statement of plan net assets and a statement of changes in plan net assets.

A schedule of funding progress and a schedule of employer contributions reporting actuarial information must be presented as required supplementary information.

Governments account for public retirement systems (PERS) through pension trust funds. There are two types: defined benefit and defined contribution. Pension plans can be single-employer or multipleemployer.

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Accounting and reporting for pension trust funds is governed by GASB Statements No. 25 and 27. Reporting differs for governmental funds and proprietary funds.

GASB Statements No. 43 and No. 45 establish standards for reporting, measuring, recognizing and displaying other post-employment benefits (OPEB) to qualified employees.

PREPARING THE GOVERNMENT-WIDE FINANCIAL STATEMENTS A

The government-wide financial statements include a column for business-type activities that includes enterprise fund amounts only. 1

Since the accrual basis is used for the proprietary funds, the amounts can simply be transferred from the fund statements to the government-wide statements with the following exception: a

Internal balances must be eliminated or shown as interfund balances in the statement of net assets.

Internal service funds are reported with governmental activities with internal balances eliminated.

REQUIRED PROPRIETARY FUND NOTE DISCLOSURES A

EF debt backed by revenue-generating activity must present certain detailed segment information in the notes to the financial statement.

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Description of assignment material

Minutes

Questions (16) Exercises (10) E21-1 5 MC general questions E21-2 AICPA 5 MC general questions E21-3 5 MC general questions E21-4 5 MC general questions E21-5 AICPA 6 MC questions (problems) E21-6 [Laramee] Agency fund statement of net position E21-7 Enterprise fund journal entries and reporting E21-8 Identification of fund type E21-9 Journal entries – various funds E21-10 Net position classification

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Problems (7) P21-1 [Thomasville] Internal service fund entries P21-2 [Fiedler] Enterprise fund journal entries and trial balance P21-3 [Douwe] Preparation of internal service fund statements P21-4 [Monee] Preparation of trust fund statements P21-5 [Duchy] Preparation of trust fund statements P21-6 AICPA [Meringen] Internal service fund journal entries P21-7 [Caleb] Enterprise fund statement of cash flows

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Internet assignment 1.

Choose a CAFR from a city, county, or other local government. Review the CAFR and answer the following questions: a. How many proprietary funds does the government have? List the name of one enterprise fund. b. Does the government have an internal service fund? What product or service does it provide? c. Does the government have an agency fund? What is its title? d. What type of pension fund is reported in the financial statements? Are the required disclosures contained in the CAFR? e. What type of other postemployment benefits are reported in the footnotes? Is the net OPEB liability reported on the face of the financial statements?

Locate the Web site for the municipality in which your college or university is located. Does this municipality provide utilities, sewer, or water to its residents? Are these activities accounted for in the appropriate fund?

Locate the Web site for your hometown. Does this municipality provide local transit service (i.e., bus, subway, etc.)? If so, how is it funded? Did the government receive any capital or operating grants during the year?

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Chapter 22 ACCOUNTING FOR NOT-FOR-PROFIT ORGANIZATIONS Learning Objectives 22.1 Learn about the four main categories of not-for-profit organizations. 22.2 Differentiate between governmental and nongovernmental not-for-profit organizations. 22.3 Introduce FASB not-for-profit accounting principles. 22.4 Apply not-for-profit accounting principles to voluntary health and welfare organizations. 22.5 Apply not-for-profit accounting principles to hospitals and other healthcare organizations. 22.6 Apply not-for-profit accounting principles to private not-for profit colleges and universities. Chapter Outline THE NATURE OF NOT-FOR-PROFIT (NFP) ORGANIZATIONS (Learning Objective 22.1) A

An NFP organization possesses the following characteristics: 1

Receives significant contributions from resource providers who do not expect a commensurate return

Operates for purposes other than to provide goods and services at a profit

Does not possess ownership interests like those of a business

NFP organizations fall into one of the following four categories: 1

Voluntary health and welfare organizations

Other not-for-profit organizations

Health care entities

Colleges and universities

An NFP organization must be designated as governmental or non-governmental to determine if they will follow GASB or FASB standards.

A governmental NFP organization meets the earlier criteria described and also possesses one of the following:

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Officers are elected by popular vote or appointed by a government.

A government can unilaterally dissolve the entity with net assets reverting back to the government.

The entity has the power to enact and enforce a tax levy.

Governmental NFP organizations are considered special purpose governments and are generally required to follow GASB standards, but their reporting requirements may be reduced.

Nongovernmental not-for-profit organizations, colleges and universities, and hospitals are required to follow FASB pronouncements. (Learning Objective 22.2)

NOT-FOR-PROFIT ACCOUNTING PRINCIPLES (Learning Objective 22.3) A

Unique financial accounting and reporting principles applicable to nongovernmental not-for-profit entities are set forth primarily in FASB Statement Nos. 116 (accounting for contributions), 117 (financial statement display), 124 (accounting for investments), 136 (transfers of assets), and 157 and 159 (fair value).

The FASB Accounting Standards Codification (FASB ASC) became the single source of GAAP for interim and annual periods after September 15, 2009. FASB ASC 958 incorporates No.116 (accounting for contributions) and No.117 (financial statement display)

FASB will issue ASU (Accounting Standard Updates) that will be pending until formally incorporated into the Codification.

The AICPA Audit and Accounting Guide, Not-for-Profit Entities provides guidance for accounting and reporting for voluntary health and welfare organizations, private colleges and universities, and other NFP organizations.

Financial statements provided by an NFP organization include a statement of financial position, statement of activities, statement of cash flows, and accompanying notes. 1

Voluntary health and welfare organizations must also provide a statement of functional expenses.

Reporting requirements are based on a division of net assets into three classifications depending on the existence or absence of donor-imposed restrictions.

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Permanently restricted net assets are the portion of net assets whose use is limited by donor-imposed stipulations that do not expire and cannot be removed by action of the not-for-profit entity.

Temporarily restricted net assets are the portion of net assets whose use is limited by donor-imposed stipulations that either expire (time restrictions) or can be removed by the organization fulfilling the stipulations (purpose restrictions).

Unrestricted net assets are the portion of net assets that carry no donorimposed stipulations. Net assets restricted by the governing board of the not-for-profit entity are classified as unrestricted.

NFPs entities use the accrual basis of accounting.

The statement of financial position reports total assets, total liabilities, the three classes of net assets, and total net assets. a

Assets do not need to be disaggregated on the basis of donor restrictions, but assets with donor-imposed restrictions that limit their use to longterm purposes should be separated from assets available for current use.

The statement of activities provides information about the change in amount and nature of net assets. a

Depreciation expense is recognized on all long-lived assets including donated assets. Works of art and historical treasures that meet certain criteria may be treated as collections and need not be capitalized and depreciated.

Revenues, expenses, gains, and losses and other changes should be presented by net asset class. 1

Revenues increase unrestricted net assets unless the use of the assets received is limited by donor-imposed restrictions.

Expenses decrease unrestricted net assets.

Generally, revenues and expenses are reported gross, and gains and losses are reported net. Investment income is reported net of related expenses.

Expenses must be classified by function as either program services or support services.

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Program services are activities that fulfill the purpose of the organization, such as distributing goods and services to recipients.

Supporting services include management and general, fundraising, and membership development activities.

A statement of functional expenses is required for voluntary health and welfare organizations. The statement reports expenses by function and by natural classification in a matrix format.

A statement of cash flows for the NFP uses the same classifications as business entities, except that the definition of financing activities is expanded to include resources that are donor restricted for long-term purposes. Cash restricted for longterm purposes is excluded from cash.

Contributions are defined as an unconditional transfer of assets or settlement of a liability in a voluntary, nonreciprocal transfer by another entity acting other than as an owner. 1

Examples of contributions are cash, long-lived assets, gifts in kind, securities, use of facilities, services, and promises to give. a

Promises to give are verifiable written or oral agreements to contribute cash or other assets. They may be conditional or unconditional. 1

Conditional promises to give are recognized as revenues in the period in which the conditions are substantially met. A conditional gift of cash or other assets may have to be returned to the donor if the condition is not met, and it should be accounted for as refundable advance.

Unconditional promises to give are recognized as revenues in the period in which the promise to give is received.

Other contributions are generally recorded at their fair values and recognized as revenues or gains in the period received.

Contributions may have conditions, be restricted, or be unrestricted by the donor. a

A donor-imposed condition provides that the donor’s money be returned if the condition is not met.

A donor-imposed restriction limits the use of the contributed assets. 219

Expiration of a donor-imposed restriction is recognized in the period the time restriction expires or the purpose restriction is met by a qualifying expenditure. If a contribution has more than one restriction, the effect of the expiration is recognized when the last restriction expires.

Resources in temporarily restricted net assets are reclassified as unrestricted net assets, and net assets released from restrictions are reported in the statement of activity.

Gifts of long-lived assets may be either restricted or unrestricted. a

The assets are reported as restricted support in temporarily restricted net assets if donor restricted or if the organization has a policy of implying a time restriction over the life of the asset. Depreciation is recorded as an expense in unrestricted net assets, and an equal (typically) amount is reclassified from temporarily restricted net assets to unrestricted net assets.

If the organization has no policy of implying a time restriction on gifts of long-lived assets and the gift is not donor restricted, the asset is reported as unrestricted support that increases unrestricted net assets.

Contributions do not include exchange transactions, agency transactions, and certain gifts in kind. 1

Exchange transactions are reciprocal transfers such as the sale of goods and services. Resources received in exchange transactions are unrestricted revenues and net assets, even if the resource provider limits their use.

Agency transactions are transfers of assets to the not-for-profit entity for which it has no discretion on the use or disposition of the resources, and the assets are passed on to a third party. The receipt of assets increases the assets and liabilities of the not-for-profit entity and disbursement of the resources decreases the assets and liabilities.

Gifts in kind are contributions if the not-for-profit entity has discretion over the disposition of the resources and a fair value can be reasonably determined.

GAAP (ASC 958-605-25-16) limits the recognition of contributed services to those which (a) create or enhance nonfinancial assets of the organization or (b) require specialized skills, are provided by people with those skills, and would need to be purchased if not received through donation.

NFP organizations measure contributions at fair value.

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Quoted market prices are the best estimate of fair market value. If a reasonable estimate of fair market value cannot be made, the contribution should not be recognized.

If the fair value of a contributed asset changes significantly between the pledge date and the date received, no additional revenue is recognized for increases in the value. If the value decreases, the difference is reported as a change in the net asset class in which the revenue was originally reported.

Collections of works of art and treasures may be capitalized but are not required to as long as the following conditions are met: 1

The assets are held for public exhibition, education or research rather than financial gain.

They are protected, cared for, and preserved.

The sales of these items must be used to acquire other items for collections.

Many NFP organizations use fund accounting as a convenient method for segregating their accounting records by specific purposes, but fund accounting is not required.

VOLUNTARY HEALTH AND WELFARE ORGANIZATIONS (Learning Objective 22.4) A

Voluntary health and welfare organizations (VHWO) are supported by and provide services to the public. VHWOs follow FASB standards, and the 2016 AICPA Audit and Accounting Guide: Not-for-Profit Entities provides additional, but no longer authoritative guidance.

NONGOVERNMENTAL NOT-FOR-PROFIT HOSPITALS AND OTHER HEALTH CARE ORGANIZATIONS (Learning Objective 22.5) A

Hospitals and other health care providers may be organized as governmental not-forprofit entities, nongovernmental not-for-profit entities, or business enterprises owned by investors and operated for profit. 1

Accounting for a hospital or other health care provider depends on its organization.

The AICPA “audit and accounting guide” provides guidance for accounting and reporting for both governmental and nongovernmental health care organizations. Although the FASB and GASB have responsibility for setting accounting 221

standards, the AICPA guide is likely to continue as a useful resource for both accounting and auditing professionals. B

Hospital operating revenue consists of patient service revenues, premium fees, and other operating revenues. 1

Patient service revenue includes nursing services and other professional services. Patient service revenue is reported net of contractual adjustments, charity services, and courtesy discounts. a

Patient revenues are recorded at full established fees when service has been rendered. For uncollectible amounts, bad debt expense is recorded, and an allowance account is used to reduce net receivables for estimated bad debt.

Charity care is provided free to qualifying patients. Charity care is excluded from gross patient service revenues and from expenses.

Premium fees, also known as subscriber fees or capitation fees, are revenues from agreements to provide services without regard to actual services provided. These are recorded separately from patient service revenue.

The “other operating revenue” classification includes revenue from services to patients other than for health care, and revenues from sales and services provided to nonpatients.

Hospitals record operating expenses on an accrual basis and usually include functional categories for nursing services, other professional services, general services, fiscal services, administrative services, interest, and depreciation provisions.

Nongovernmental health care entities' financial statements include a balance sheet, or statement of financial position, a statement of operations, a statement of changes in net assets, and a statement of cash flows, and they follow essentially the same guidance as other nongovernment, not-for-profit entities.

PRIVATE NOT-FOR-PROFIT COLLEGES AND UNIVERSITIES (Learning Objective 22.6) A

Primary authority over accounting principles comes from the FASB. The AICPA Audit and Accounting Guide: Not-For- Profit Entities incorporates FASB standards.

Colleges and universities use accrual accounting. Revenues are recognized when earned and expenses are recognized when the related materials or services are received.

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Unrestricted expenses are broadly classified as educational and general expenditures or as auxiliary expenditures. Functional classifications include the following: a

Instruction

Research

Public service (activities to provide noninstructional services to external groups)

Academic support (support for instruction, research and publications)

Student services (amounts spent for admissions, registrar, and student well-being)

Institutional support (administration and long-range planning)

Operation and maintenance of plant (does not include auxiliary enterprises and university hospitals)

Scholarships and fellowships

As with other NFP organizations, private colleges and universities classify net assets, and revenues, expenses, gains, and losses based on the existence or absence of donor-imposed restrictions (unrestricted, temporarily restricted, or permanently restricted), in accordance with FASB pronouncements.

The required financial statements of a college or university include a statement of financial position, a statement of activities, and a statement of cash flows (direct or indirect method). There are acceptable alternatives to the statement of activities.

The AICPA model is typically used by colleges and universities in their accounting structure for internal control purposes. Private colleges and universities are now required to report their resources based on restrictions rather than funds. The AICPA fund structure is based on the following fund classifications and as many subgroups as needed.

The current operating funds grouping includes the resources that are expendable for operating purposes. Only current funds have revenues and expenditures. Revenues are classified by source, and expenditures are classified by function. The current operating funds grouping contains two subgroups: restricted current funds and unrestricted current funds.

The loan funds group accounts for resources held to provide loans to students.

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The endowment fund group consists of gifts with specified maintenance and distribution. A separate fund is used for each endowment.

Annuity and income funds account for special types of endowments.

The plant funds group accounts for the financial resources of the physical plant, additions, improvements, replacements, and related indebtedness.

Agency funds are used to account for assets held in trust for students, faculty members, or their organizations.

Description of assignment material

Minutes

Questions (21) Exercises (9) E22-1 5 MC general questions (nongovernmental not-for-profit entities) E22-2 5 MC general questions (nongovernmental not-for-profit entities) E22-3 5 MC general questions (voluntary health and welfare organizations) E22-4 5 MC general questions (colleges and universities) E22-5 5 MC general questions (colleges and universities) E22-6 5 MC general questions (hospitals) E22-7 5 MC general questions (hospitals) E22-8 Not-for-profit expense classifications (voluntary health and welfare organization) E22-9 Journal entries - Various NFP organizations Problems (8) P22-1 Journal entries - Various NFP organizations P22-2 [Share Shop] Journal entries - Voluntary health and welfare organization P22-3 [Hometown Hospital] Statement of operations - Nongovernmental not-for-profit health care organization P22-4 Journal entries and statement of activities – Nongovernmental not-for-profit college P22-5 [Community Society] Statement of activities - Nongovernmental not-for-profit organization P22-6 Journal entries - Nongovernmental not-for-profit university P22-7 [Good Grubb] Journal entries – Voluntary health and welfare organization P22-8 [Fort Collins] Non-governmental not-for-profit health care organization

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Internet assignment 1. Search the Internet for the financial statements of the United Way or a charity of your choice. a. Print a copy of the financial statements and bring them to class for discussion. b. Is the charity a VHWO? How can you tell? c. Are net assets properly classified into three categories? d. Are expenses classified into function categories on the face of the financial statements or in the notes? e. Were any temporarily restricted net assets reclassified as unrestricted? Can you determine the nature of the restrictions that were met? 2. Visit the AICPA’s Web site. Select Publications and then select Journal of Accountancy. Find an article related to not-for-profits. Read the article and prepare a one-page summary. 3. Visit NACUBO’s Web site. Locate the Accounting Advisory Reports. Select Business and Policy Areas and then choose Accounting. Under Accounting select Advisory Reports. View the most recent advisory report related to institutions of higher learning, and prepare a one-paragraph summary of its purpose. 4. Visit the GuideStar Web site and obtain the Form 990 for a local not-for-profit organization. a. Examine Part VIII of the 990 to determine gross receipts of the organization. b. Examine Part IX of the 990. What category contained the majority of the organization’s expenses? c. From Part VII, note the salaries of officers. d. After examining Parts VII–IX, look at the mission in Part III. Do you think spending is in line with the organization’s mission?

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Chapter 23 ESTATES AND TRUSTS Learning Objectives 23.1 Understand basic accounting for the estate of a decedent. 23.2 Understand the principal versus income issues in estate and trust accounting. 23.3 Understand basic accounting for a trust. 23.4 Understand how estates are taxed.

Chapter Outline FIDUCIARY ACCOUNTING A

Estate and trust managers operate in a good-faith custodial relationship with the beneficiaries.

A fiduciary (individual or entity authorized to take possession of the property of others) could be an executor, a trustee, an administrator, and a guardian.

Both estates and trusts are subject to various laws and taxes. 1

Estates are subject to probate laws, which vary among states.

There are potential taxes on the value of estate assets (often referred to as inheritance taxes) at both the federal and state levels.

Estates and trusts may be subject to income taxes at both the state and federal levels.

CREATION OF AN ESTATE A

An estate comes into existence upon the death of an individual.

Testate refers to dying with a will. Intestate refers to dying without a will.

An estate consists of the property owned at the date of death.

Estates Testate Will Executor

Intestate No Will Administrator

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PROBATE PROCEEDINGS A

A petition is filed with probate court to probate a will. A testacy proceeding determines the will’s validity.

A confirmation by a probate court that a will is valid means that the decedent died testate.

A representative is appointed.

Distribution of estate property occurs.

ADMINISTRATION OF THE ESTATE A

Personal representative distributes via will to devisees (heirs) or laws of intestate succession.

Devisees can be specific or general.

Under the Uniform Probate Code (UPC), an intestate estate goes to the spouse if the decedent has no living descendants or if all surviving descendants are also descendants of the surviving spouse. If descendants are from a prior marriage, the surviving spouse gets the first $100,000 and one-half of the rest. The other onehalf goes to the descendants (see state law).

Inventory of estate property is prepared within 3 months including FMV at date of death and any liens.

Exempt property and allowances

A homestead allowance allows the surviving spouse to exempt certain property from claims against the estate.

A reasonable family allowance during administration is permitted.

Claims against the estate 1

Notice is published to present claims within 4 months or be barred.

If insufficient funds, the UPC provides that payments are made as follows: a

Costs and expenses of administration

Reasonable funeral and necessary pre-death medical expenses

Debts and taxes with preferences under federal or state law 227

d 3

All other claims

Secured claims may be paid.

ACCOUNTING FOR THE ESTATE (Learning Objective 23.1) A

Inventory is recorded including assets assumed and liabilities paid.

Fiduciary must distinguish between principal and income (applies to estates and trusts). This process follows the Revised Uniform Principal and Income Act. Principal - Expenses to settle estate - Asset at death including receivables/bonds included at FMV - Gains and losses on disposal of principal assets

Journal entries distinguishing principal from income are made. (Learning Objective 23.2) Examples Assets – prin XXX Est. Prin XXX To open estate

Est. Prin XXX Assets XXX To close estate D

The charge-discharge statement is prepared. Estate Principal I charge myself for … I credit myself for … Assets remaining Estate Income I charge myself for … I credit myself for … Assets remaining

Income - Income earned after death (revenue – expenses)

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Assets – inc XXX Est. Inc

XXX

Est. Inc XXX Assets

XXX

ACCOUNTING FOR TRUSTS (Learning Objective 23.3) A

A testamentary trust is created pursuant to a will and is administered by a trustee.

Accounting generally parallels estate accounting after the trust is created.

ESTATE TAXATION (Learning Objective 23.4) A

The Economic Growth and Tax Relief Reconciliation Act of 2001 proposed a reduction of the estate tax, and a total repeal in 2010 (see Exhibit 23-3 in text for tax rate schedule). The tax was repealed in 2010 but returned in 2011.

Trusts and estates are subject to federal and possibly state income taxes. Federal Form 1041, U.S. Income Tax Return for Estates and Trusts must be filed. Schedule K-1 of Form 1041 is used to report a beneficiary’s share of revenue.

Description of assignment material

Minutes

Questions (11) Exercises (12) E 23-1 [John Seagull] Prepare journal entries for estate E 23-2 [Maribeth Rainey] Prepare journal entries for estate E 23-3 [Matthew Troy] Prepare journal entries for estate E 23-4 [Tim/Triciao] Accounting for an estate E 23-5 [Jeff Carpenter] Journal entries and accounting for an estate E 23-6 [Sooner XXV] Prepare journal entries for a trust E 23-7 [Sooner XXV] Prepare charge and discharge statements E 23-8 [Lisa Wyatt] Prepare journal entries for a trust E 23-9 [Josephine Frederick] Prepare journal entries for a trust E 23-10 [Dogbert] Estate tax calculation E 23-11 [Rainy] Estate tax calculation E 23-12 [Jacki Jerome] Estate tax calculation

15 15 15 15 25 20 15 15 15 10 10 10

Problems (8) P 23-1 [Jimmy Olson] Estate accounting P 23-2 [Jimmy Olson] Creation of a trust P 23-3 [George Wilson] Estate accounting P 23-4 [George Wilson] Charge and discharge statement for an estate P 23-5 [George Wilson] Creation of a trust P 23-6 [Tom Josephson] Estate accounting P 23-7 [Tom Josephson] Charge and discharge statement for an estate P 23-8 [Tom Josephson] Creation of a trust

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