Consolidation by Step Acquisition | Business Combinations | Accounting

Control over a subsidiary was assumed to have been achieved through a single transaction. Obviously, Boeing’s takeover of Alsalam shows that a combination also can be the result of a series of stock purchases. These step acquisitions fur­ther complicate the consolidation process. The financial information of the separate companies must still be brought together, but varying amounts of consideration have been transferred to former owners at several different dates. How do the initial acquisitions affect this process?

One area where SFAS 141R and SFAS 160 provide a distinct departure from past reporting practices for business combinations is when control is achieved in a series of equity acquisi­tions, as opposed to a single transaction. Such acquisitions are frequently referred to as step acquisitions or control achieved in stages.

Past practice under the purchase method emphasized cost accumulation and allocation at each date that a parent acquired a block of subsidiary shares. The purchase method treated each acquisition of a firm’s shares as a separate measurement event for reporting each acqui­sition’s percentage of subsidiary assets and liabilities in consolidated financial statements.

Thus, when a parent obtained control through, for example, three separate acquisitions of subsidiary shares, the resulting consolidated balance sheet might combine three different val­uations for individual subsidiary assets acquired and/or liabilities assumed. Moreover, if a noncontrolling interest remained, a portion of each subsidiary asset and liability would remain at its original book value, further compromising the relevance and representational faithfulness of the consolidated financial statements.

Control Achieved in Steps—Acquisition Method:

Attempting to increase both the relevance and representational faithfulness of consolidated reports, the FASB requires the acquisition method when a parent achieves control over another firm in stages. Consistent with the economic unit concept, at the date control is first obtained, the acquisition method measures the acquired firm at fair value, including the non- controlling interest.

The acquisition of a controlling interest is considered an important eco­nomic, and therefore measurement, event. Consequently, the parent utilizes a single uniform valuation basis for all subsidiary assets acquired and liabilities assumed—fair value at the date control is obtained.

If the parent previously held a noncontrolling interest in the acquired firm, the parent remeasures that interest to fair value and recognizes a gain or loss. If after obtaining control, the parent increases its ownership interest in the subsidiary, no further remeasurement takes place.

The parent simply accounts for the additional subsidiary shares acquired as an equity transaction—consistent with any transactions with other owners, as opposed to outsiders. Below we present first an example of consolidated reporting when the parent obtains a con­trolling interest in a series of steps. Then, we present an example of a parent’s post-control acquisition of its subsidiary’s shares.

Example- Step Acquisition Resulting in Control—Acquisition Method:

To illustrate, assume that Art Company obtains control of Zip Company through two cash acqui­sitions. The details of each acquisition are provided in Exhibit 4.9. Assuming that Art has gained the ability to significantly influence Zip’s decision-making process, the first investment, for exter­nal reporting purposes, is accounted for by means of the equity method.

Thus, Art must determine any allocations and amortization associated with its purchase price (Exhibit 4.10). A customer base with a 20-year life represented the initial excess payment.

Application of the equity method requires the accrual of investee income by the parent while any dividends received are recorded as a decrease in the Investment account. Art must also reduce both the income and asset balances in recognition of the annual $2,100 amorti­zation indicated in Exhibit 4.10.

Following the information provided in Exhibits 4.9 and 4.10, over the next two years, Art Company’s investment in Zip account grows to $187,800:

On January 1, 2011, Art’s ownership is raised to 80 percent by the purchase of another 50 percent of Zip Company’s outstanding common stock for $350,000. Although the equity method can still be utilized for internal reporting, this second acquisition necessitates the preparation of consolidated financial statements beginning in 2011. Art now controls Zip; the two companies are viewed as a single economic entity for external reporting purposes.

Once Art gains control over Zip on January 1, 2011, the acquisition method focuses exclu­sively on control-date fair values and considers any previous amounts recorded by the acquirer as irrelevant for future valuations. Thus, in a step acquisition all previous values for the investment, prior to the date control is obtained, are remeasured to fair value on the date control is obtained.

We add the assumption that the $350,000 consideration transferred by Art in its second acquisition of Zip represents the best available evidence for measuring the fair value of Zip Company at January 1, 2011. Therefore, an estimated fair value of $700,000 ($350,000 + 50%) is assigned to Zip Company as of January 1, 2011, and provides the valuation basis for the assets acquired, the liabilities assumed, and the 20 percent noncontrolling interest. Exhibit 4.11 shows Art’s allocation of Zip’s $700,000 acquisition-date fair value.

Note that the acquisition method views a multiple step acquisition as essentially the same as a single step acquisition. In the Art Company and Zip Company example, once control is evident, the only relevant values in consolidating the accounts of Zip are fair values at January 1, 2011. A new basis of accountability arises for Zip Company on that single date because obtaining con­trol of another firm is considered a significant remeasurement event. Previously owned noncon­trolling blocks of stock are consequently revalued to fair value on the date control is obtained.

In revaluing a previous stock ownership in the acquired firm, the acquirer recognizes any resulting gain or loss in income.

Therefore, on January 1, 2011, Art increases the Investment in Zip account to $210,000 (30% × $700,000 fair value) and records the revaluation gain as follows:

Worksheet Consolidation for a Step Acquisition (Acquisition Method):

To continue the example, the amount in the Art Company’s 80 percent Investment in Zip account is updated for 2011:

The worksheet for consolidating Art Company and Zip Company is Shown in Exhibit 4.12. Observe that:

i. The consolidation worksheet entries are essentially the same as if Art had acquired its entire 80 percent ownership on January 1, 2011.

ii. The noncontrolling interest is allocated 20 percent of the excess fair-value allocation from the customer base.

iii. The noncontrolling interest is allocated 20 percent of Zip’s 2011 income less its share of the excess amortization attributable to the customer base.

iv. The gain on revaluation of Art’s initial investment in Zip is recognized as income of the current period.

Example- Step Acquisition Resulting after Control is Obtained:

The previous example demonstrates a step acquisition with control achieved with the most recent purchase. Post-control acquisitions by a parent of a subsidiary’s stock, however, often continue as well. Recall that the acquisition method measures an acquired firm at its fair value on the date control is obtained.

A parent’s subsequent subsidiary stock acquisitions do not affect these initially recognized fair values. Once the valuation basis for the acquired firm has been established, as long as control is maintained, this valuation basis remains the same. Any further purchases (or sales) of the subsidiary’s stock are treated as equity transactions.

To illustrate a post-control step acquisition, assume that on January 1, 2009, Amanda Co. obtains 70 percent of Zoe, Inc., for $350,000 cash. We also assume that the $350,000 consideration paid by Amanda also represents the best available evidence for measuring the fair value of the noncontrolling interest in Zoe Company.

Therefore, Zoe Company’s total fair value is assessed at $500,000 ($350,000 70%). Because Zoe’s net assets’ book values equal their collective fair values of $400,000, Amanda recognizes goodwill of $100,000. Then, on January 1, 2010, when Zoe’s book value has increased to $420,000, Amanda buys another 20 percent of Zoe for $95,000, bringing its total ownership to 90 percent.

Under the acquisi­tion method, the valuation basis for Zoe’s net assets was established on January 1, 2009, the date Amanda obtained control. Subsequent transactions in the subsidiary’s stock (purchases or sales) are now viewed as transactions in the combined entity’s own stock. Therefore, when Amanda acquires Zoe’s shares post-control, it recognizes the difference between the fair value of the consideration transferred and the underlying subsidiary valuation as an adjustment to Additional Paid-in Capital.

The difference between the $95,000 price and the underlying consolidated subsidiary value is computed as follows:

Amanda then prepares the following journal entry to record the acquisition of the 20 percent noncontrolling interest:

By purchasing 20 percent of Zoe for $95,000, the consolidated entity’s owners have acquired a portion of their own firm at a price $9,000 less than consolidated book value. From a worksheet perspective, the $104,000 increase in the investment account simply replaces the 20 percent allocation to the noncontrolling interest.

Importantly, the $95,000 exchanged for the 20 percent interest in Zoe’s net assets does not affect consolidated asset valuation. From an economic unit perspective, the basis for the reported values in the con­solidated financial statements was established on the date control was obtained.

Parent Company Sales of Subsidiary Stock—Acquisition Method:

Frequently, a parent company will sell a portion or all of shares it owns of a subsidiary.

For example, Monster Worldwide, Inc. (Monster(dot)com), reported the sale of one of its business units in its 2006 financial statements:

On May 10, 2006, the Company sold its remaining TMP Worldwide Advertising & Communica­tions businesses in Europe. The sale includes all of the Company’s Advertising & Communications businesses. On August 31, 2006, the Company sold its TMP Worldwide Advertising & Commu­nications business in the United States and Canada. The purchase price of the transaction was $45,000,000. The sale completes the global divestiture of the Advertising & Communications unit.

SFAS 160 adopts the economic unit concept to account for sales of a parent’s shares of its sub­sidiary stock. Under the economic unit concept, transactions in the stock of a subsidiary, whether purchases or sales, are considered to be transactions in the equity of the consolidated entity.

To account for such sales of subsidiary shares, the acquisition method maintains its valua­tion basis of acquisition-date fair value adjusted for subsequent changes in the subsidiary’s net assets. The income effect of the sale of subsidiary shares depends on whether the parent con­tinues to maintain control after the sale. If the parent maintains control, it recognizes no gains or losses when it sells a portion of its stock in the subsidiary. If the sale of the parent’s owner­ship interest results in the loss of control of a subsidiary, it recognizes any resulting gain or loss in consolidated net income.

Sale of Subsidiary Shares with Control Maintained:

To illustrate, assume Adams Company owns 100% of Smith Company’s 25,000 voting shares and appropriately carries the investment on its books at January 1, 2009, at $750,000 using the equity method.

Assuming Adams sells 5,000 shares to outside interests for $165,000 on January 1, 2009, the transaction is recorded as follows:

The $15,000 “gain” on sale of the subsidiary shares is not recognized in income, but is reported as an increase in owner’s equity. This equity treatment for the “gain” is consistent with the eco­nomic unit notion that as long as control is maintained, payments received from owners of the firm are considered contributions of capital. The ownership group of the consolidated entity specifically includes the noncontrolling interest. Therefore, the above treatment of sales to an ownership group is consistent with accounting for other stock transactions with owners.

Sale of Subsidiary Shares with Control Lost:

SFAS 160 considers the loss of control of a subsidiary as a remeasurement event that can result in gain or loss recognition. The gain or loss is computed as the difference between the sale pro­ceeds and the carrying amount of the shares sold. Using the Adams and Smith example above, assume now that instead of selling 5,000 shares, Adams sells 20,000 of its shares in Smith to outside interests on January 1, 2009, and keeps the remaining 5,000 shares.

Assuming sale proceeds of $675,000, we record the transaction as follows:

SFAS 160 also requires that if the former parent retains any of its former subsidiary’s -shares, the retained investment should be remeasured to fair value on the date control is lost. Any resulting gain or loss from this remeasurement should be recognized in the parent’s net income.

In our Adams and Smith example, Adams still retains 5,000 shares of Smith Company (25,000 original investment less 20,000 shares sold). Assuming further that the $675,000 sale price for the 20,000 shares sold represents a reasonable value for the remaining shares of $33.75, Adams’s shares now have a fair value of $168,750 ($33.75 × 5,000 shares).

Adams would thus record the revaluation of its retained 5,000 shares of Smith as follows:

The above revaluation of retained shares reflects the view that the loss of control of a sub­sidiary is a significant economic event that changes the fundamental relationship between the former parent and subsidiary. Also, the fair value of the retained investment provides the users of the parent’s financial statements with more relevant information about the investment.

Cost-Flow Assumptions:

If it sells less than an entire investment, the parent must select an appropriate cost-flow assumption when it has made more than one purchase. In the sale of securities, the use of spe­cific identification based on serial numbers is acceptable, although averaging or FIFO assump­tions often are applied. Use of the averaging method is especially appealing because all shares are truly identical, creating little justification for identifying different cost figures with indi­vidual shares.

Accounting for Shares that Remain:

If Adams sells only a portion of the investment, it also must determine the proper method of accounting for the shares that remain.

Three possible scenarios can be envisioned:

1. Adams could have so drastically reduced its interest that the parent no longer controls the subsidiary or even has the ability to significantly influence its decision making. For exam­ple, assume that Adams’s ownership drops from 80 to 5 percent. In the current period prior to the sale, the 80 percent investment is reported by means of the equity method with the market-value method used for the 5 percent that remains thereafter. Consolidated financial statements are no longer applicable.

2. Adams could still apply significant influence over Smith’s operations although it no longer maintains control. A drop in the level of ownership from 80 to 30 percent normally meets this condition. In this case, the parent utilizes the equity method for the entire year. Application is based on 80 percent until the time of sale and then on 30 percent for the remainder of the year. Again, consolidated statements cease to be appropriate because control has been lost.

3. The decrease in ownership could be relatively small so that the parent continues to maintain control over the subsidiary even after the sale. Adams’s reduction of its ownership in Smith from 80 to 60 percent is an example of this situation. After the disposal, consolidated finan­cial statements are still required, but the process is based on the end-of-year ownership per­centage.

Because only the retained shares (60 percent in this case) are consolidated, the parent must separately recognize any current year income accruing to it from its terminated interest. Thus, Adams shows earnings on this portion of the investment (a 20 percent interest in Smith for the time during the year that it is held) in the consolidated income statement as a single- line item computed by means of the equity method.