I'm Larry Walther.
This is principlesofaccounting.com, Chapter 9.
In this module, we will look at consolidated financial statements.
So recognize that a consolidation occurs coincident with a purchase or
an acquisition where one business buys another.
Acquisitions generally involve the acquirer buying a majority of the stock of
the target company.
By buying a majority of the stock,
that position enables the acquirer to exercise control over the other company.
That control is ordinarily established when ownership exceeds 50%, but
can occur at lesser levels than at 50% when there's other contractual or
interlocking directorates or things of that nature.
So once one entity controls another, the accountants say,
rather than having two separate economic entities, they are essentially married or
become one economic entity.
And we move on to the preparation of consolidated financial statements that
show the parent company and subsidiary as one consolidated unit.
A controlled company may continue to operate and
maintain its own legal existence, but merely be under new ownership.
Nevertheless, we'll prepare consolidated statements.
That is, legally, you may have a separate parent company,
legally you may have a separate subsidiary company.
For reporting purposes, we'll show a consolidated picture.
So let's look at an example here.
Premier Tools, they're gonna be the parent.
P as in parent, or P in Premier.
Premier Tools bought 100% of the stock of Sledge Hammer, the subsidiary.
S for Sledge or S for subsidiary, Sledge Hammer Company.
So Sledge is now a subsidiary of Premier, the parent.
And even though Sledge is going to continue to operate as a separate
legal entity and prepare its own separate financial statements,
from the accountant's point of view, there's one economic entity here.
And we're going to present a consolidated financial statement.
And so here's Premier's, the parent's,
balance sheet immediately prior to consolidating.
And notice among the typical assets there,
there is a unique one here in the long-term investments category.
Investment in Sledge, $400,000.
So on Premier's balance sheet, we have our all of the assets and
liabilities that belong to Premier.
Premier's total equity of $800,000, but among its assets is a $400,000 investment.
That's what Premier paid for all of the stock of the subsidiary company.
That money was paid to the former shareholders of S Company.
It was not paid to S Company directly.
Premiere paid money to the former shareholders to become the sole
shareholder of the subsidiary company.
And here's Sledge Hammer's balance sheet on the same date.
Notice here we've got the assets and liabilities of Sledge.
But I would call your attention the the fact that Sledge only has $300,000 of
Stockholders' equity.
So we have an interesting thing to observe here.
The parent paid 400,000, but the subsidiary only had 300,000 of equity.
The parent company paid a $100,000 premium, paid 400,000, for
an entity that has equity of 300,000.
That could have been due to undervalued assets or just the intangible value
associated with Sledge Hammer as an ongoing business concern.
And so part of the accounting issue here is to consider that purchase differential,
that premium that was paid.
So Premier paid $400,000 for
Sledge Hammer, obtained Sledge's assets that were carried at $450,000,
and assumed all of Sledge's liabilities that were carried at $150,000.
That is, the equity or net book value of Sledge was $300,000.
We paid 400, so we have 100,000 difference to explain or account for.
That's our purchase differential or premium.
And we have to do an evaluation, a business analysis, and
a business valuation to determine what the difference is due to.
Now, recognize that the assets and liabilities are not
necessarily reported at fair value on the books of either company.
For example, we're going to assume that Sledge Hammer's land is worth $110,000.
On its balance sheet, however,
it was only reported at its historical cost of $75,000.
So, in reality,
there's $35,000 of embedded value that's not on the balance sheet there.
And Premier knew that when they decided to pay $100,000 premium.
But they also paid another $65,000 for goodwill.
Goodwill is the excess of the purchase price of an acquired company
over the fair value of the identifiable net assets acquired.
It's the premium we're willing to pay beyond the value attributable
to the tangible pieces.
It only arises, or I should say,
it only is reported when there's been a business acquisition.
Companies may have implicit goodwill, but that's not recorded
on the books unless there is an actual acquisition transaction.
The goodwill arises because many businesses are worth more than their
identifiable pieces.
For example, a retail store with a favorable business location and
established customer base is perhaps worth far more than its real estate
facilities and equipment.
So here's the consolidated balance sheet now for Premier and
its consolidated subsidiary, Sledge Hammer.
And I'd call your attention to certain things are simply additive.
The $150,000 for cash represents the $100,000 held by the parent and
the $50,000 held by the subsidiary.
Likewise, for the trading securities, the accounts receivable, the inventories.
If you want to look in the textbook online,
you'll be able to do the math to add across on these.
I'm not going to repeat each of these, but let's look at land here.
The parent carried their land at $25,000.
The subsidiary carried their land at $75,000.
But we also know there was $35,000 of undervaluation.
So the land here is reported at $135,000, the book value from the parent,
the book value from the sub, plus the markup to
fair value that was implicit in the price the parent was willing to pay for the sub.
Here's another unique asset.
Here's the goodwill,
there's the other $65,000.00 of the $100,000.00 purchase differential.
It's not attributable to any specific asset or liability.
It's simply reported as the balancing amount here on the consolidated
balance sheet.
So the consolidated balance sheet reflecting the investment in Sledge
account is absent from the consolidated balance.
It was effectively replaced with the assets and liabilities of the subsidiary.
The assets and liabilities acquired from Sledge, including its goodwill,
had been pulled into the consolidated balance sheet at their fair value.
The consolidated stockholders equity matches that of the parent.
That implicitly incorporated its investment activity.
There's also the need for a consolidated income statement.
The income statements of the parent and sub are consolidated from the date of
acquisition forward or post-acquistion, in other words.
Revenues and expenses are generally added together.
There are certain issues to consider, however.
For example, the parent may have paid a premium for depreciable assets and
inventory.
So the consolidated depreciation expense and
the consolidated cost of goods sold may need to be adjusted to reflect
the basis that was implicit in the business acquisition.
If the parent and sub have done business with one another,
we would also want to adjust for intercompany transactions.
So, in closing, let me say this is a very introductory coverage of consolidated
financial statements to give you an appreciation of the issues and
the basic measurement considerations.
Obviously, this can become very complex, indeed.
There are entire advanced accounting courses and
entire textbooks that are devoted just to the subject of preparing consolidated
financial statements.
[BLANK
AUDIO]