Mergers and Acquisitions Paper 7

(a) When preparing consolidated financial statements, the objective is to restate the accounts as if the intercompany transactions had not occurred. Therefore, the year 1 gain on sale of machine of $50,000 [$900,000 – ($1,100,000 – $250,000)] must be eliminated, since the consolidated entity has not realized a gain. In effect, the machine must be reflected on the consolidated balance sheet at 1/1/Y1 at Poe’s cost of $1,100,000, and accumulated depreciation of $250,000, instead of at a new “cost” of $900,000. For consolidated statement purposes, year 1 depreciation is based on the original amounts [($1,100,000 – $100,000) × 1/20 = $50,000]. Therefore, in the 12/31/Y1 consolidated balance sheet, the machine is shown at a cost of $1,100,000 less accumulated depreciation of $300,000 ($250,000 + $50,000).

(a) When Seal purchased the bonds from Wagner, the bonds were viewed as retired from a consolidated viewpoint since there is no longer any obligation to an outside party. Therefore, the consolidated entity would recognize a $100,000 gain ($1,075,000 carrying amount – $975,000 cash paid), which would increase consolidated retained earnings. This transaction has no effect on noncontrolling interest, since the subsidiary (Seal) has merely exchanged one asset for another (cash for investment in bonds).

(a) The requirement is to determine the amount of gain to be reported on the consolidated income statement when a wholly owned subsidiary purchases parent company stock. A parent company reports no gain or loss when a wholly owned subsidiary purchases its common stock. In effect, the consolidated entity is purchasing treasury stock when the purchase is made, and gains are not recognized on treasury stock transactions. The dividends paid by the parent to the subsidiary also do not affect income because such intercompany transactions are eliminated when consolidated financial statements are prepared. Therefore, $0 gain should be reported by the consolidated entity.

(a) When computing consolidated income, the objective is to restate the accounts as if the intercompany transactions had not occurred. As a result of the intercompany sales, sales and cost of goods sold are overstated and an eliminating entry is needed to reduce these accounts by the entire amount of the intercompany sales. Therefore, answer (a) is correct. Answer (b) is incorrect because sales and cost of goods sold need to be reduced by the entire amount of the intercompany sales in order to arrive at their proper consolidated amounts. Answer (c) is incorrect because net income is not affected by the intercompany sale. Sales and cost of goods sold are overstated by the same amount; thus, net income is correct for consolidated purposes. Answer (d) is incorrect because an adjustment is necessary.

(c) The key to this problem is that the equipment must be revalued at Winston’s carrying amount (Winston’s original cost less accumulated depreciation) in the consolidation process. Assume the following potential scenario: Winston buys a piece of equipment on 1/1/ Y2 for $1,000. At 12/31/Y2, the equipment was depreciated $200, and Winston’s carrying value is $800 ($1,000 – $200). On 12/31/Y2, Winston sells the equipment to Foster for $900. Foster’s original cost is therefore $900, and Winston will record a $100 gain that must be eliminated. After consolidation, the equipment is reported at $800, Winston’s carrying value. Winston’s carrying value is also equal to Foster’s original cost ($900) less Winston’s recorded gain ($100). Answer (a) is incorrect because Foster’s original cost includes an unrealized gain that must be eliminated. Answer (b) is incorrect because revaluing the equipment at Winston’s original cost would not take into consideration the depreciation already recorded by Winston. Answer (d) is incorrect because the entire gain, not 80% of the gain, must be eliminated because this is a downstream sale from the parent to the subsidiary.

(b) The requirement is to determine by how much depreciation will be reduced. Use the solutions approach and set up a simple numerical example. Port’s original cost = $1,000 Depreciation per yr = $200 Selling price = $810 If Port sells equipment for $810, it recognizes a $210 gain on the sale (selling price of $810 – carrying value of the equipment $600). Salem, Inc. will now depreciate the equipment on their books at $810, the price that they paid. Because the gain was not realized with an entity outside of the consolidated entity, it must be eliminated. In the consolidated financial statements, equipment will be reported at its original carrying value, the gain on the sale will be removed and depreciation expense must be recorded at Port, Inc. original amount ($200), not the amount of depreciation that Salem, Inc. records. Salem would record depreciation of $270 ($810/3). Therefore, depreciation must be reduced by $70 on the consolidated financial statements to reflect the original depreciation recorded by Port. Depreciation is reduced by $70, which as shown by the example, is 33 1/3% of the gain ($70/$210).

(a) This question is silent as to which year consolidated financial statements are being prepared. However, answer (a) is correct for either the year of acquisition or a subsequent year. If financial statements were being prepared for the current year the loss would be reported as an ordinary loss on the income statement. P Co. acquired the 20% interest in S Company bonds and incurred a loss on them. This loss would be carried through to the consolidated balance sheet as a decrease in retained earnings. In subsequent years, the unamortized portion of the loss would also decrease retained earnings.

(b) Because Planet owns 70% interest in Star, the noncontrolling interest in star is 30%. Therefore, the noncontrolling interest’s share in Star’s net income of $80,000 is 30% × $80,000 = $24,000. Planet’s sale of merchandise to Star for $10,000 will be eliminated on the consolidated worksheet, and Planet’s income will be reduced by the intercompany profit of $2,000. This will not affect the noncontrolling interest’s share of income because it was a downstream sale from the parent to the subsidiary and is eliminated by the parent.

(d) The cost of acquisition is $975,000. The fair value of Shaw’s assets is equal to their book values plus the amount of the write-up, or $1,100,000 ($1,000,000 + 100,000). Goodwill is calculated as follows: Consideration transferred $ 975,000 Plus: Fair value of noncontrolling interest 250,000 Less: Fair value of net identifiable assets $(1,100,000) Amount of goodwill $ 125,000

(d) The percentage of the subsidiary’s stockholders’ equity not owned by the parent represents the noncontrolling interest’s share of the fair value of net assets of the subsidiary. The fair value of the noncontrolling interest is measured at the acquisition date, and adjusted in future periods for the portion of the acquiree’s income and dividends attributable to the noncontrolling interest. Therefore, the noncontrolling interest at 12/31/Y1 is calculated as follows: Fair value of noncontrolling interests $250,000 Plus: Share of net income ($190,000 × 20%) 38,000 Less: Share of dividends ($125,000 × 20%) (25,000) Noncontrolling interest 12/31/Y1 $263,000