Consolidations—Changes in Ownership Interests
1. Explain the terms preacquisition earnings and preacquisition dividends.
Preacquisition earnings and dividends are the earnings and dividends applicable to an investment interest prior to its acquisition during an accounting period. Assume that P purchases an 80 percent interest in S on July 1, 2011 and that S has earnings of $100,000 between January 1 and July 1, 2011 and pays $50,000 dividends on May 1, 2011. In this case, preacquisition earnings and dividends are $100,000and $40,000, respectively. Historically, preacquisition earnings purchased were shown as a deduction on the income statement to arrive at consolidated net income. Under current GAAP, this is no longer the case. Instead, the consolidated income statement should only report revenues, expenses, gains and losses subsequent to the acquisition. For example, in a March 31 acquisition, the consolidated income statement would only include income of the subsidiary from April 1 through December 31. GAAP reasons that acquirers purchase assets and assume liabilities, based on their fair values. Acquirers do not “purchase” preacquisition earnings, although fair values of net assets should reflect earning power of the acquired firm.
2. How are preacquisition earnings accounted for by a parent under the equity method? How are they accounted for in the consolidated income statement?
Preacquisition earnings are not recorded by a parent under the equity method because the investor only recognizes income subsequent to acquisition on the interest acquired. Historically, preacquisition earnings purchased were shown as a deduction on the income statement to arrive at consolidated net income. Under current GAAP, this is no longer the case. Instead, the consolidated income statement should only report revenues, expenses, gains and losses subsequent to the combination date. For example, in a March 31 acquisition, the consolidated income statement would only include income of the subsidiary from April 1 through December 31.
3. Assume that an 80 percent investor of Sub Company acquires an additional 10 percent interest in Sub halfway through the current fiscal period. Explain the effect of the 10 percent acquisition by the parent on noncontrolling interest share for the period and on total noncontrolling interest at the end of the current period.
Noncontrolling stockholders of Sub Company held a 20 percent interest during the first half year and a 10 percent interest during the last half year and at year-end. Since we have a controlling interest all year, noncontrolling interest share for the year is computed as 20% of income for one-half of the year and 10% of income for one-half of the year. Noncontrolling interest at year-end is computed for the 10 percent interest held by noncontrolling stockholders at year end.
4. Isn't preacquisition income really noncontrolling interest share?
Preacquisition income is similar to noncontrolling interest share because it represents the income of a subsidiary attributable to stockholders outside the consolidated entity. But preacquisition income is not income of the noncontrolling stockholders at the date of the financial statements. In fact, preacquisition income relates to a previous controlling stockholder group when the interest acquired exceeds 50 percent. In such a case, it seems improper to report this as a deduction in the consolidated income statement. Rather, the fair value of net assets acquired should reflect the acquiree’s earnings history.
5. How is the gain or loss determined for the sale of part of an investment interest that is accounted for as a one-line consolidation? Is the amount of gain or loss affected by the accounting method used by the investor?
Under GAAP, a gain or loss is only recorded when the sold interest results in deconsolidation of the subsidiary, i.e., the parent no longer holds a controlling interest. The gain or loss on the sale of an equity interest is the difference between the proceeds from the sale (the fair value) and the recorded book value of the interest sold, provided that the investment is accounted for as a one-line consolidation. We must determine the aggregate of (1) the fair value of consideration received, (2) the fair value of any retained noncontrolling investment in the former subsidiary at the date the subsidiary is deconsolidated and (3) the carrying amount of the noncontrolling interest in the former subsidiary at the date the subsidiary is deconsolidated. The aggregate is compared to the carrying amount of the former subsidiary’s assets and liabilities. If another method of accounting has been used, the investment account must be converted to the equity method so that any gain or loss on sale is the same as if a one-line consolidation had been used previously.
When the parent maintains a controlling interest after the sale, the sale is treated as an equity transaction, with no gain or loss recognition. The parent debits cash or other consideration received in the sale, credits the investment account based on percent of carrying value sold, and records the difference as an adjustment to other paid-in capital.
6. When a parent sells a part of its interest in a subsidiary during an accounting period, is the income applicable to the interest sold up to the time of sale included in consolidated net income and parent income under the equity method? Explain.
Conceptually, the income applicable to an equity interest sold during an accounting period should be included in investment income and consolidated net income. In this case, the gain or loss on sale is computed on the basis of the book value of the interest at the time of sale, and income is assigned to the increased noncontrolling interest only after the date of sale. As a practical expedient, a beginning-of-the-period sale date can be used such that no income is recognized on the interest sold up to the time of sale, and the gain or loss is computed on the book value at the beginning of the period. When this expedient is used, income must be assigned to the increased noncontrolling interest for the entire year of sale. The combined investment income and gain or loss on sale are the same under both approaches provided that the assumptions (beginning of the year and time of sale) are followed consistently. As noted in question 5, gain or loss on the sale of the equity interest is only recognized when the subsidiary is deconsolidated. Other wise, the gain or loss is an adjustment to other paid-in capital.
7. Assume that a subsidiary has 10,000 shares of stock outstanding, of which 8,000 shares are owned by the parent. What equity method adjustment will be necessary on the parent books if the subsidiary sells 2,000 additional shares of its own stock to outside interests at book value? At an amount in excess of book value?
Assuming that no gain or loss is recognized, no adjustment of the parent’s investment account is necessary when the subsidiary sells additional shares to outside parties at book value because the parent’s share of underlying book value does not change. If additional shares are sold above book values, the parent’s share of the underlying equity of the subsidiary increases. This increase is recorded by the parent as follows:
Investment in subsidiary XX
Additional paid-in capital XX
If the subsidiary sells additional shares below book value, the parent’s interest is decreased and the parent records decreases in its investment and additional paid-in capital accounts. In all three cases (at book value, above book value, or below book value), the parent’s ownership percentage decreases from 80 percent (8,000 of 10,000 shares) to percent (8,000 of 12,000 shares).
No gain or loss is recognized, the change in underlying book value, adjusted for one-sixth [(80% – %) * 80%] of any unamortized cost book value differential is reported as adjustment to additional paid-in capital, since the parent maintains its controlling interest. An alternative computation is to assume that the parent sold one-sixth of its interest for percent of the proceeds, the difference being the amount of adjustment to additional paid-in capital.
8. Assume that a subsidiary has 10,000 shares of stock outstanding, of which 8,000 shares are owned by the parent. If the parent purchases an additional 2,000 shares of stock directly from the subsidiary at book value, how should the parent record its additional investment? Would your answer have been different if the purchase of the 2,000 shares had been made above book value? Explain.
The acquisition of the 2,000 shares directly from the subsidiary increases the parent’s percentage interest from 80 percent (8,000 of 10,000 shares) to 5/6 (10,000 of 12,000 shares, or 83 1/3%). The change in the interest held does not affect the way in which the parent records its additional investment. The parent in all cases increases its investment account by the amount of cash paid or other consideration given for the additional investment. It makes no difference if the purchase price is above or below book value.
9. How do the treasury stock transactions of a subsidiary affect the parent's accounting for its investment under the equity method?
Treasury stock transactions by a subsidiary change the parent’s proportionate interest in the subsidiary. Any changes in the parent’s share of the underlying book value of the subsidiary require adjustments in the parent’s investment in subsidiary and additional paid-in capital accounts.
10. Can gains or losses to a parent/investor result from a subsidiary's/investee's treasury stock transactions? Explain.
Gains and losses to a parent (or equity investor) do not result from the treasury stock transactions of its subsidiaries (or equity investees). Although the parent's investment interest may increase or decrease from such transactions, the predominate view is that such changes are of a capital nature and should be accounted for by additional paid-in capital adjustments rather than by recorded gains and losses.
11. Do common stock dividends and stock splits by a subsidiary affect the amounts that appear in the consolidated financial statements? Explain, indicating the items, if any, that would be affected.
Stock splits and stock dividends by a subsidiary do not affect the amounts that appear in the consolidated financial statements. But stock dividends by a subsidiary result in capitalization of subsidiary retained earnings and the amounts involved in eliminations for the subsidiary’s stockholders’ equity accounts are affected.
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