Advanced financial accounting. In this presentation we’re going to take a look at a consolidation process when there is a book and fair value difference. In other words, we’ll have a consolidation. We have two companies, we have a parent subsidiary type of relationship, and the parent has a controlling interest of the subsidiary. Therefore consolidation is what we’re going to be doing. That means we’re going to take two separate sets of books combine them together as if they were one. And we had some complications with the fact that when the purchase took place, there was a difference between the book value and the fair value, what will be the effect of that difference on the consolidation process, elimination entry example. So when we consider this difference, we want to think about what’s going on with the parents books and the subsidiaries books and then what would be the process to consolidate them and what type of problems would be caused if there was a difference between the book and fair value of the net assets so the parents books investment accounts starts out containing the acquisition costs at the fair market value of net assets and goodwill, so we have, that’s basically what’s going to be on the parents books, right. And we’re thinking here typically have an equity method being used. So we have the parents books, we have the subsidiary books that we’re gonna have to consolidate together, and then do our elimination entries. And on the parents books, you’re accounting for the subsidiaries.
01:21
The subsidiary, the investment in the subsidiary, typically with the in the equity method, but that first journal entry is going to be looking at that investment for the fair market value of the net assets and goodwill. In essence, you can think about the amount that was paid by the parent for it, then the fair market value of net assets if there’s a bargain purchase gain. Now, obviously, if there wasn’t, if, for example, there was less paid than the book value of the subsidiary, then you have a bargain purchase type of situation. Note that that’s more unusual, that’s a lot more unusual. So you would think that normally the purchase would be for at least the book value of the subsidiary typically more in which case you would have a fair market value difference book and fair market value and or goodwill that would be the case. So this first one would be by far the most likely scenario. Then we have the subsidiaries book. So, if we look at the subsidiaries books, the assets and liabilities are recorded at book value. So, obviously, when you when you think about the subsidiary if the parent company purchased the stocks of the subsidiary, then there’s no change to the subsidiaries books. Even though the parent is paying for the fair market value of the net assets plus the goodwill, the subsidiaries books is still gonna be there as the subsidiaries books at the book value and just carrying forward expenses like depreciation are calculated based on the book values. So if you change something, if you think about some kind of change happening to like a depreciable asset, something that has an effect on the calculation and estimates of the income statement for depreciation expense, then you’re also going to see a problem Here, if you have this difference between the parents books and the subsidiaries, resulting from a fair value calculation over here and a book value calculation on the subsidiary side of things. So when we have the consolidation process, what’s going to happen? Well, the parent will need to make adjustments for the balance sheet and income statement accounts, we’re gonna have to make adjustments for them.
03:20
Note these adjustments are not needed when it parent creates a subsidiary subsidiary, because there would be no goodwill and no undervalued assets at the time of creation to adjust for. So in other words, now that we have the consolidation process, we’re going to put the consolidation process together, we’re going to have to do some adjustments within that consolidation process to account for this difference, right because you’re going to have the parents books being reflected and investment in the subsidiary at the fair value and the subsidiaries books reflecting on the book value. Therefore, you’ll have to do within the adjustment process within the consolidation entries. And adjustments for the balance sheet and income statement accounts that were affected. Now this would happen if the parent subsidiary relationship took place because the parent purchased the outstanding stock of the subsidiary, because you have kind of like a market type of transaction that happened there, but they didn’t buy the net assets, they bought the common stock. Therefore, the subsidiaries books didn’t change, even though the parent is holding their investment, basically, at the amount, the amount that they paid and tracking typically with the use of the equity method. If, on the other hand, the parent had simply created the subsidiary, you’re talking about a situation where the parent, I had wanted to just create another subsidiary, that’s that type of situation where there’s no, like market negotiation. There’s not really two people involved, that’s more of a restructuring, that is happening. So when that type of situation involved happens, you end up with a parent subsidiary relationship, but the consolidation process is going to be far easier because you’re not going to have this difference between The subsidiaries still tracking their information on their original book value in the parent have any different reflected value in their investment account because of that difference in the fair value in the book value. So in that situation where a parent company creates a subsidiary, there’s no other kind of negotiating process that took place. They just basically restructured, you wind up with the same parent subsidiary relationship. But you don’t have this kind of information or this problem, where you’re dealing with goodwill, because there was no goodwill resulting from that creation of the subsidiary. Because goodwill can only really happen when there’s a negotiation process with two separate people because that’s when the market can tell you whether there is goodwill.
05:43
So there’s no revaluing of the assets either. Because again, that revalue and you think is the triggering process to revalue something like buildings and depreciable assets is typically some type of negotiation of markets transaction, which means two parties would be involved. If one company is simply breaking off a subsidiary, then there’s no real market transactions. If one company is buying the stock of the other company, then then you do see basically, if there’s some kind of negotiation happening, there’s a market transaction, resulting in what you would think a need for an increase in recognition of the fair market value of the transaction taking place, revaluation in other words and recognition of any goodwill at that time. Okay, so what’s this process going to look like? Well, how are we going to deal with this difference? Basically, the subsidiaries books will basically be converted from a book value to a fair value at the point of purchase during the consolidation process. So in other words, we’re going to say that we have the parents books, we have the subsidiaries, books, the parents books is reflecting and obviously we will do practice problems. The way to really understand this is to run practice problems. So I highly recommend taking a look at the practice problems but you’ll have the parents books that are reflecting the subsidiary using typically the equity method, but they did the purchase on the fair value basis and the subsidiaries books that’s still just pushing forward, just like they always have been because there hasn’t really been a change, they’re using their book value bases, then when you do the consolidation, when you do the entries for the consolidation process, you’re you are in essence going to be recording the subsidiaries books to meet the the fair value basis of recording. So it’s reflected basically on the fair value basis with regards to the consolidation. So again, when I say the fair value basis, I mean, the fair value basis at the point that the purchase took place. So if we’re doing a consolidation five years later, for example, then the fair value at the point in time, we could imagine a situation where like the depreciation or the depreciable assets at the point of time of the consolidation five years ago, was higher than the book value of the subsidiary. So we’re going to have to account for that for that difference in the fair value at that point in time. The next year. Of course, that We do the consolidation, we’re not going to revalue the fair value of the property, plant and equipment again, because no market transaction took place at that time, there’s no negotiation, we don’t really know what the value of a building is until it’s actually purchased on the market because it’s unique in nature.
08:16
So that means so we’re going to basically revalue everything to the fair value that’s being reflected, in essence by the parent company, which was the fair value at the point in time that the purchase take place. And then we’re going to deal with all the consequences that result from that, such as added depreciation calculations and whatnot, depending on the types of assets that are involved and the related, you know, expense calculations and estimates to them. So, for example, if we have the depreciable assets that are changed, so this is going to be our typical type of scenario that they like that we like to use, because what will happen is, if you change the depreciable assets, well then you have a change for the depreciable assets, you will have to record and record back Every time you do the consolidation entry, but it’s more complicated than just that, because if it was just like land, then land wouldn’t have any kind of effect on the expense accounts typically, but depreciable assets do if you say the depreciable asset is now higher in value will now that that affects the calculation of depreciation for the life of the depreciable asset that you have now, put on the book. So, now, you got to not only adjust the depreciable asset at the point in time that the purchase took place to the fair value, but you got to deal with the fact that the depreciation calculation will now be adjusted basically every time into the future. And note these are complicated journal entries in part as well, because these type of journal entries unlike normal adjusting entries for depreciation will not be recorded on either the parents books or the subsidiaries books, but will have to basically be brought forward and redone every year you did a consolidation So, it’s so you’re gonna have to rethink You know what, you know, re enter basically the prior year’s depreciation, the accumulated depreciation for that difference as you move forward. So we’ll take a look at problems, mainly focusing and looking at that depreciation one, because that’s the one.
10:14
That’s easy, easiest to see that problem, but you have a similar thing with inventory, because inventory could affect the cost of goods sold. So once again, if you say, Okay, I’m going to revalue the inventory to the firt to the fair value, and it’s different than the book value, then when you consume the inventory to generate revenue that’s going to affect the cost of goods sold, and then you got an effect on the cost of goods sold, you got to consider with the fact that you’ve now you know, sold inventory at two different values based on the sale price that took place, a patent or something like that, which would be amortized or any amortized item. If there’s a different value, same way, just like the depreciation up here, you have something on the books that you’re going to allocate the cost to the future years. So if you say the patent is worth more than it’s on the books for, then it’s gonna, it’s gonna, you’re gonna have to record that difference and you’re gonna have to record the difference in the expense the amortization expense then basically same idea as the depreciation and then you have the goodwill. Now, the goodwill would result from the purchase that took place when the purchase price is greater than even the fair value of the book of the of the book value of the company or the subsidiary. So when that is the case, you got goodwill. goodwill is kind of like an it is an intangible asset doesn’t have physical presence, but it’s something that we recognize as value that value being determined through a market exchange. Now, goodwill is not going to be something that we just amortize However, because we don’t really know the life of goodwill. We can, we can imagine it going on forever. If it’s maintained. Apparently that’s, that’s the current thought generally, and therefore we don’t we don’t allocate the cost unless it’s effective. We have to test for impairment of goodwill. And then if it’s impaired, then we’re gonna have to deal with that. So if when goodwill goes on the books, that’s going to be something we’re going to have to put on the books when we do the consolidation process, because it’s not going to be on either Pease books or SS books, it’s going to be as a result of the consolidation process that we’re going to. We’re going to put the goodwill on the books, and then we’re going to have to test for impairment of the goodwill to see if the goodwill has been impaired. And if so, then we’ll account for that impairment, acquisition price and book value difference. So the purchase price of stock is based on the market value of shares, not on book value. So if you think about this process, what’s going to be happening? You’ve got the parents, you’ve got the subsidiary, the parent is purchasing over 51% of the subsidiary getting a controlling interest of it. So to simplify the situation, just to imagine this point, let’s say the parent is purchasing all of the subsidiary at one time 100% of the outstanding stock of the subsidiary Clearly the parent is basing the purchase price or you’re thinking of the purchase price basically at the value of the stock, but the value of the stock should be reflecting. If they’re purchasing 100% of the value of the stock, you would think the net assets of the company or the net assets at a fair value. So if p was purchasing the subsidiary p companies purchasing s company, they’re purchasing 100% of the common stock, then you would expect then the purchase price to be for the fair value, net assets of s and any any other kind of asset that’s not on the books such as goodwill. But the point is when when you purchase the stocks, however, of course, you’re looking at the market value of the stocks, which you would think would reflect the the equity value of the organization, but it’s going to be different than the book value of s organization resulting in this in this difference we’ll have to be dealing with. So this resulted in the acquisition price being different from In the book value of the investors proportion of the share of the investees net assets, and that’s going to be the differential.
14:07
So in other words, if you have this purchase price and you can imagine purchasing it could be anything over 51%. But to simplify the situation, purchasing 100% of the shares of the subsidiary, if it was a, you know, to simplify the situation, as we have seen in prior presentations, you could imagine a situation where they purchased it simply for the net assets, because of the book value of the organization reflected fair market value, then you would think that assets minus liabilities would equal the equity section, and therefore, the purchase of 100% of the stocks of the organization would be for the amount of equity or assets minus liabilities. But that’s not typically the case. Because one the assets minus the liabilities, the assets and liabilities may not be fair valued things like especially property, plant and equipment which are Not words are on the books at cost and then depreciated are not on the books at fair value. So those things may be valued in, you know, not out of market value. There’s reasons to do that, but they might not be valued at the market value. And there could be something not on the balance sheet such as goodwill, that should be included in the price as well. So that results in the price being different than what is on the net assets. That’s what we’re going to be calling the differential and quotes differential. The differential is usually positive because the amount paid is generally more than its share of the books value of the subsidiaries net assets. So in other words almost all the time, if there’s a purchase taking place, you can imagine p purchasing as 100% of the shares of s are going to purchase 100% of the shares of s almost never is that the case where you’re going to say the assets minus liabilities, the purchase price was less than the assets minus liabilities. It could, you know that can happen but typically If the assets, you know, typically that’s going to be more because if you revalue the assets, then you’d think that the revaluation of the assets could be higher, and you would think there could be some kind of goodwill, possibly involved.
16:14
And if that were the case, then the purchase price would typically be higher than the book value of the net assets. The differential, each component of the differential needs to be treated the same as the investi treats the assets and liabilities, the differential relates to. So in other words, this differential that we have, we got to think about, okay, what is the differential meaning we paid more p paid more for the stock, let’s say 100% of the stock of s than its relative share, which in that case would be 100% of the net assets. Well, then we have to think about how we need to allocate that differential the more payment to something to the to the reason they paid more. Why did they pay more? Well, either when they fare value the assets of the liabilities, something was higher in value, such as buildings such as land, typically. And therefore, you’re going to apply some of the differential to the difference in the value of some of the assets that have been acquired. And or there’s some intangible that wasn’t on the books that the differential is accounting for. And that would be you know, typically goodwill that would be involved. So, once we know that, then we can account for the differential in a similar fashion as to the accounts that we are applying that differential to the reason for that differential. So for example, a portion of the differential related to depreciable assets of the investi needs to be amortized over the remaining time amortized or depreciated of cost allocation by the subsidiary. So in other words, if we’re saying hey, there was more paid for the stock than the net assets, and that’s due to in part the fixed assets being worth more than the book value that’s on company s, then we’re going to increase the you know the fair value. And we’re also going to have to do what we need to do with that added increase and treat it the same as we would as the investi as the as the subsidiary would for that account. And that means we have to depreciate it allocating the cost over the useful life in some way, shape, or form, sale of asset with differential. So then you got to think, Okay, well, that’s fine. We can do that sounds sounds tedious. But yeah, that’s doable.
18:29
We’ll have examples on that. But I can see how to do that. But what happens if we sell, you know, one of the assets that had this differential on it, so now we got property, plant and equipment, that that has a book value for the subsidiary that they’re tracking it at. And then whenever we consolidate it, we’re going to increase the value because there was a difference. So it’s a differential and then we got to allocate the depreciation based on that differential and then what happens when we sell the assets, the assets, you know, the property, plant and equipment Well, the part of the differential needs needs to be taken off the investment account on the investees books. So obviously, we’re gonna have to account for that, you know, as we sell that particular part of the depreciable assets, so we’re gonna have to track that on the subsidiary, schedule for the property, plant and equipment, and note which asset was sold and all that kind of stuff. The investors share of the gain or loss also needs to be adjusted to represent that the investor paid more for its proportionate share of the asset. So in other words, the book when you when the thing is sold, when the property plant and equipment is sold by the subsidiary, they’re gonna record the sale and the related accumulated depreciation for it and the related gain or loss to that. But when we when we think about the consolidation, when we think about you know, then we got to think well, it was actually the you know, the value of the asset was actually more so then we got to take into consideration that as well as the differential and the accumulated depreciation and then adjust The the the sale so you can imagine this taking place right? You could say okay, what what you might have to do is say I say okay this is what happened this is similar thing that happens for tax preparation when you have to two sets of depreciable tables depreciate in two different ways you might say, this is how the subsidiary recorded the sale, you know, they took the investment off the books, they took the accumulated depreciation off the books and then have the gain, you might just reverse that entirely and then reflect and then just re record the asset as if it was at the cost that that’s being reflected after the fair value and the related depreciation based on that that calculation now and then recalculate you know the gain on it at that point okay. Equity method with differential So, remember the equity method means that the parents company is representing this the subsidiary using the equity method. So they got one line item that basically it represents their equity in interest in the subsidiary. And so they’re tracking their equity interest in the subsidiary meaning. For example, here we go, the parent records their share of the subsidiaries income.
21:12
So what happens first on the on the equity method, they’re going to put the the investment on the books that whatever they paid for it. So that means they’re putting it on the books at a fair value value method. And then the parent records their share of the subsidiary income. So the subsidiary has net income. And what happens is the parent company is going to record their share if they own 100%, for example, they’ll they’ll increase their investment by the subsidiaries net income, so the parent records their share of the subsidiaries dividends, so then the subsidiary gives dividends. You can imagine a situation where the parent owns 100% of the subsidiary, in which case all the dividends would go to the parent and the dividends that the parent then receives would be decreasing the the account record in the subsidiary interest In the assets section of the parents books, that’s normal equity method accounting. But now we have the parents should also record an adjustment for differences in the subsidiary book value and fair market value. So in other words, note that the subsidiary is going to have their net income based on the book values, which will include things like the depreciation expense will be part of that. But now we’re saying hey, if if if we know that the property plant and equipment is now of a higher value, we know that their depreciation is going to be under depreciated because it’s not being based on the full value of the fair value that we’re going to need upon consolidation. Therefore, the parents should take into consideration the added in that example depreciation related to it and then record their equity method, accounting with regards to that to that change that that’s going to take place on consolidation. Now, you might see some problems where that doesn’t happen. Like you could see a parent company basically doing this normal Equity method, which might be kind of kind of an easier thing to do, if you saw that, and then within the consolidation process, then you’d have to account for that you’d have to say,
23:09
Okay, now I’m gonna, you know, account for the fair market value, we’ll see this in practice problems, but take in the equity method with regards to this differential to include it, this should include it, which means a little bit more complication in the calculation of the equity method, meaning you can’t just record the subsidiaries, your portion of the subsidiaries net income, which if you own 100%, you just record 100%, you’d have to then take their net income adjusted for these differentials such as depreciation expense, if that was one of the differentials that took place and the fair value of the book versus fair value at the point of purchase. And you’d have to take that into consideration when you’re recording the equity method. So in other words, again, you could see this like from a from a logistics standpoint, you would think that a company could, you know, basically use the equity method doing this Normal equity method and then wait to do kind of this component at the consolidation process that would be kind of an easier thing you know to do. But but to do the full equity method including this item they should be, they should be taken into consideration that differential value and basically tacking on this adjusting entry to, you know the equity method. journal entry