After studying this chapter, you should be able to do the following:

1. Perform impairment tests on property, plant, equipment, intangible assets, and goodwill.
2. Prepare schedules to allocate and amortize the acquisition differential on both an annual and a cumulative basis.
3. Prepare consolidated financial statements using the entity theory subsequent to the date of acquisition.
4. Prepare consolidated financial statements using the parent company extension theory subsequent to the date of acquisition.
5. Prepare journal entries and calculate balance in the investment account under the equity method.
6. Analyze and interpret financial statements involving consolidations subsequent to the date of acquisition.
7. Identify some of the differences between IFRS and ASPE involving consolidations subsequent to the date of acquisition.

While a parent company can account for its investment by either the equity method or the cost method, the consolidated statements are the same regardless of the method used. The method of presentation is quite different between the separate-entity financial statements and the consolidated financial statements.

The cost method is a method of accounting for investments whereby the investment is initially recorded at cost; income from the subsidiary is recognized in net income when the investor’s right to receive a dividend is established. This usually occurs when the dividend is declared.

IAS 28 defines the equity method as a method of accounting whereby the investment is initially recognized at cost and adjusted thereafter for the post-acquisition change in the investor’s share of net assets of the investee. The profit or loss of the investor includes the investor’s share of the profit or loss of the investee. Distributions received from an investee reduce the carrying amount of the investment. Adjustments to the carrying amount may also be necessary for changes in the investor’s proportionate interest in the investee’s other comprehensive income. Such changes include those arising from the revaluation of property, plant, and equipment and from foreign-exchange translation differences. The investor’s share of those changes is recognized in other comprehensive income.

The cost method is the simplest of the two methods for the parent to use in its separate-entity records because typically the only entry made by the parent each year is to record, as revenue, its pro rata share of the dividends declared by the subsidiary. However, when it comes time to prepare the consolidated financial statements, if the parent uses the equity method to record the investment in the subsidiary, then consolidation process is much simpler since the equity method of accounting for a subsidiary will produce the same net income and retained earnings on the internal records of the parent as reported on the parent’s consolidated financial statement. The only difference is that the consolidated financial statements incorporate the subsidiary’s values on a line-by-line basis, whereas the equity method incorporates the net amount of the subsidiary’s values on one line (investment in the subsidiary) on the balance sheet and typically on one line (investment income from the subsidiary) on the income statement. For this reason, the equity method is often referred to as the "one-line consolidation". Consolidated net income will be the same regardless of whether the parent used the cost method or the equity method for its internal accounting records. The method of presentation is quite different between the separate-entity financial statements and the consolidated financial statements.

The amortization of the acquisition differential is reflected on the consolidated financial statements—not on the subsidiary’s financial statements. The acquisition differential is amortized or written off on consolidation as if the parent had purchased these net assets directly. For instance, the acquisition differential related to inventory is expensed when the inventory is sold.

Starting in 2001, goodwill and certain intangible assets were no longer amortized but tested for impairment on an annual basis. An asset is impaired if its carrying amount exceeds its recoverable amount. Recoverable amount is the higher of fair value less costs of disposal and value in use. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (i.e., an exit price). It would reflect the highest and best use for nonfinancial assets. It can be determined by using quoted market prices, if available, or by making comparisons with the prices of other similar assets. Value in use is the present value of the future cash flows expected to be derived from the asset or group of assets.

Internal and external factors are considered when assessing if there is an indication that the asset may be impaired. Cash-generating units that have goodwill assigned to them must be assessed for impairment on an annual basis and whenever there is an indication that the unit may be impaired. Individual assets should be tested for impairment before each cash-generating unit is tested for impairment. If an impairment loss for the cash-generating unit exists, any impairment loss is applied first to goodwill and then to other assets. Impairment losses on intangible assets other than goodwill can be reversed under certain conditions. For instance, the asset cannot be written up to an amount higher than it would have been if impairment losses had not been recognized. The reversal of an impairment loss is reported in net income unless the asset is carried at a revalued amount in accordance with another standard (e.g., in accordance with the revaluation model in IAS 16). Substantial information relating to impairment losses and reversals of impairment losses must be disclosed. The impairment tests are complex and often require considerable professional judgment.

Some general tips for the consolidation process follow:

• The acquisition differential related to inventory is expensed when the inventory is sold.
• Under the cost method, the investment account remains at the original cost in the parent’s separate-entity balance sheet.
• The amortization and impairment of the various components of the acquisition differential will be recorded on the consolidated financial statements.
• Consolidated net income is the same regardless of whether the parent used the cost method or the equity method in its separate-entity records.
• The consolidated income statement combines the income statements of the separate legal entities and incorporates consolidation adjustments for the amortization of the acquisition differential.
• The consolidated balance sheet accounts are the same regardless of whether the parent used the cost method or the equity method in its separate-entity records.
• Dividends on the consolidated statement of retained earnings are the dividends of the parent.
• The underlying assets and liabilities of the subsidiary plus the unamortized acquisition differential replace the investment account.
• Only the Year 2 amortization of the acquisition differential is deducted when calculating consolidated net income for Year 2. Retained earnings reflect the cumulative effect of all adjustments to a point in time.
• The consolidated financial statements present the combined position of the parent and the subsidiary as if the parent had acquired the subsidiary’s assets and liabilities directly.
• Consolidated net income is attributed to the controlling shareholders and non-controlling interest. Non-controlling interest is shown as a component of shareholders’ equity. Non-controlling interest on the balance sheet increases when the subsidiary earns income and decreases when the subsidiary pays a dividend.
• When the acquisition differential is assigned to financial assets and liabilities, the effective interest method should be used to account for financial assets and liabilities. The subsidiary amortizes the original issue bond premium/discount for its separate-entity financial statements. However, the bond premium/discount arising as part of the acquisition differential is amortized at the consolidated financial statement level as a consolidation adjustment. The straight-line and effective interest methods produce the same results in total over the life of the bond.
• The consolidated financial statements should reflect only the result of transactions with outsiders. Thus, any intercompany receivables and payables should be eliminated during the consolidation process. Similarly, and intercompany revenues and expenses should be eliminated. Failure to eliminate intercompany receivables/payables and intercompany revenues/expenses would result in the amounts being overstated from a single-entity point of view.
• When a subsidiary is acquired during the year, the consolidated financial statements should include the subsidiary’s income only from the date of acquisition.

ASPE Differences

• As mentioned in Chapter 3, private companies could either consolidate their subsidiaries or report their investments in subsidiaries under the cost method, equity method, or at fair value if the market value is quoted in an active market.
• The investments in and income from non-consolidated subsidiaries should be presented separately from other investments.
• All intangible assets and goodwill should be tested for impairment whenever events or changes in circumstances indicate that the carrying amount may exceed the fair value.
• The impairment test for property, plant, and equipment and for intangible assets with definite useful lives has three steps. In step 1, consider whether there are any indicators; that is, events or circumstances that indicate that the asset may be impaired. If not, no further testing is required. In step 2, determine if the carrying amount exceeds its recoverable amount (i.e., the sum of the undiscounted cash flows expected to result from its use and eventual disposition). If so, no further testing is required. In step 3, determine if the carrying amount exceeds its fair value. If so, an impairment loss should be recognized. If not, there is no impairment.
• For intangible assets with indefinite useful lives and goodwill, an impairment loss should be recognized when the carrying amount exceeds its fair value.
• In all cases, the impairment loss is equal to the excess of carrying amount over the fair value, and impairment losses cannot be reversed.

This chapter has illustrated the preparation of consolidated financial statements covering a two-year period after the date of acquisition when the parent has used the cost method to account for its investment. Additional calculations were performed to convert the income and retained earnings from the amounts shown on the separate-entity financial statements to the consolidated financial statements.

The basic steps in the consolidation process when the parent has used the equity and cost methods are outlined in Exhibit 5.17. It is important to have a good grasp of the procedures under both methods because these procedures are the foundation for the consolidation issues we will introduce in the chapters that follow.