Chapter 6 in your text discusses consolidation working papers when the parent

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1 C H A P T E R 6 ELECTRONIC SUPPLEMENT TO CHAPTER 6 Chapter 6 in your text discusses consolidation working papers when the parent company uses the equity method of accounting. This supplement repeats those illustrations for the incomplete equity and cost methods of parent company accounting. As in the supplements to Chapters 4 and 5, this supplement departs from the normal numerical sequencing to make it easier to compare the alternative working paper formats. Exhibit I6-4 presents incomplete equity method accounting. Exhibit T6-4 presents the traditional approach to cost method accounting (i.e., no initial conversion to equity method accounting). These exhibits correspond to equity method Exhibit 6-4 in the textbook chapter. CONSOLIDATION EXAMPLE UPSTREAM AND DOWNSTREAM SALES OF PLANT ASSETS Plank Corporation acquired a 90% interest in Sharp Corporation at its underlying book value of $450,000 on January 3, Since Plank Corporation acquired its interest in Sharp, the two corporations have participated in the following transactions involving plant assets: 1. On July 1, 2005, Plank sold land to Sharp at a gain of $5,000. Sharp resold the land to outside entities during 2007 at a loss to Sharp of $1, On January 2, 2006, Sharp sold equipment with a five-year remaining useful life to Plank at a gain of $20,000. This equipment was still in use by Plank at December 31, On January 5, 2007, Plank sold a building to Sharp at a gain of $32,000. The remaining useful life of the building on this date was eight years, and Sharp still owned the building at December 31, Incomplete Equity Method If Plank Corporation had used an incomplete equity method and failed to consider intercompany transactions in accounting for its investment in Sharp, its separate financial statements would show overstated amounts for beginning and ending retained earnings, investment income, net income, and the investment in Sharp. CONVERSION TO EQUITY METHOD APPROACH The following incomplete equity-to-equity conversion schedule shows computations to support the working paper entry to convert Plank s separate accounts to the equity method. Electronic Supplement to Chapter 6 1

2 Plank s Beginning Retained Investment Income from Earnings in Sharp Sharp Prior Year s Effect Sale of land to Sharp in 2005 $ 5,000 $ 5,000 Purchase of equipment from Sharp on January 1, 2006 ($20,000 gain 90%) 18,000 18,000 Piecemeal recognition through 2006 depreciation of equipment [($20,000 gain 5 years) 90%] +3,600 +3,600 Current Year s Effect Sharp s sale of land to outside entity +5,000 $ +5,000 Sale of building to Sharp on January 5, ,000 32,000 Piecemeal recognition of gain on equipment ,600 +3,600 Piecemeal recognition of gain on building through depreciation ($32,000 gain 8 years) +4,000 +4,000 Working paper adjustment to convert to the equity method $ 19,400 $ 38,800 $ 19,400 The working paper entry prepared from the schedule is as follows: Retained earnings Plank January 1 ( SE) 19,400 Income from Sharp ( R, SE) 19,400 Investment in Sharp ( A) 38,800 The equality of these numbers is coincidental, because the retained earnings adjustment consists of overstatements from prior sales of land and equipment, and the income adjustment consists of recognition of previously deferred gain on land, piecemeal recognition of the gain on equipment, and the gain on buildings less related piecemeal recognition. After entering the conversion to equity entry in the consolidation working papers, all other working paper entries should be the same as those in Exhibit 6-4 under the equity method. TRADITIONAL WORKING PAPER SOLUTION FOR INCOMPLETE EQUITY METHOD Exhibit I6-4 illustrates working paper procedures to consolidate the financial statements of Plank and Sharp when Plank uses an incomplete equity method of accounting and consolidates without converting to the equity method. Notice that the entries are similar to those in Exhibit 6-4, except that the debit amounts in entries a and b are to the parent s beginning retained earnings instead of the investment account. This is because the parent did not eliminate intercompany unrealized profits in prior years through a oneline consolidation of its investment in Sharp. The working paper entries from Exhibit I6-4 are reproduced for convenient reference as follows: a Retained earnings Plank January 1 ( SE) 5,000 Gain on land (R, +SE) 5,000 To recognize previously deferred gain on land. b Retained earnings Plank January 1 ( SE) 14,400 Accumulated depreciation equipment (+A) 8,000 Minority interest January 1 ( L) 1,600 Equipment ( A) 20,000 Depreciation expense ( E, +SE) 4,000 To eliminate unrealized profit on upstream sale of equipment. c Gain on building ( R, SE) 32,000 Accumulated depreciation (+A) 4,000 Buildings ( A) 32,000 2 ADVANCED ACCOUNTING

3 EXHIBIT I6-4 Intercompany Sales of Plant Assets Incomplete Equity Method, Traditional Approach PLANK CORPORATION AND SUBSIDIARY CONSOLIDATION WORKING PAPERS FOR THE YEAR ENDED DECEMBER 31, 2007 (IN THOUSANDS) 90% Adjustments and Consolidated Plank Sharp Eliminations Statements Income Statement Sales $2,000 $700 $2,700 Gain on building 32 c 32 Loss (or gain) on land (1) a 5 4 Income from Sharp 72 d 72 Cost of goods sold (1,000) (320) (1,320) Depreciation expense (108) (50) b 4 c 4 (150) Other expenses (676.6) (249) (925.6) Minority interest expense e 8.4 (8.4) Net Income $ 80 $ 300 Retained Earnings a 5 Retained earnings Plank $ b 14.4 $ 400 Retained earnings Sharp $200 f 200 Net income Dividends (200) (30) d 27 e 3 (200) Retained earnings December 31, 2007 $ $250 $ 500 Balance Sheet Cash $ $ 32 $ Other current assets Land Buildings c Accumulated depreciation buildings (200) (54) c 4 (250) Equipment b 20 1,000 Accumulated depreciation equipment (258) (100) b 8 (350) Investment in Sharp 585 d 45 f 540 $1,738.8 $700 $1,813.8 Current liabilities $ 200 $ 50 $ 250 Capital stock 1, f 400 1,000 Retained earnings $1,738.8 $700 Minority interest b 1.6 e 5.4 f $1,813.8 Electronic Supplement to Chapter 6 3

4 Depreciation expense ( E, +SE) 4,000 To eliminate unrealized gain on downstream sale of building. d Income from Sharp ( R, SE) 72,000 Dividends (+SE) 27,000 Investment in Sharp ( A) 45,000 To eliminate investment income (as recorded by Plank) and dividends, and return investment account to its beginningof-the-period balance under an incomplete equity method. e Minority interest expense (E, SE) 8,400 Dividends Sharp (+SE) 3,000 Minority interest (+L) 5,400 To enter minority interest share of subsidiary income and dividends. f Retained earnings Sharp ( SE) 200,000 Capital stock Sharp ( SE) 400,000 Investment in Sharp ( A) 540,000 Minority interest (+L) 60,000 To eliminate reciprocal equity and investment balances and enter beginning minority interest. Cost Method Now assume that Plank has used the cost method in accounting for its investment in Sharp. Under the cost method. Plank s investment in Sharp account remains at the $450,000 original investment. Net income and retained earnings are understated by Plank s share of Sharp s undistributed income plus or minus any unrealized intercompany profits. CONVERSION TO EQUITY METHOD APPROACH The working paper entry to convert Plank s costbased accounting records from the cost to the equity method in journal form is: Investment in Sharp (+A) 96,200 Dividend income ( R, SE) 27,000 Income from Sharp (R, +SE) 52,600 Retained earnings Plank January 1 (+SE) 70,600 To adjust Plank s account balances to an equity basis as a first step in consolidating its subsidiary. The following cost-to-equity conversion schedule provides data to support the working paper entry. Plank s Beginning Investment Income Retained in from Dividend Earnings Sharp Sharp Income Prior Year s Effect 90% of Sharp s increase in undistributed income for 2005 and 2006 [($600,000 $500,000) 90%] $+90,000 $+90,000 Gain on sale of land to Sharp 5,000 5,000 Gain on purchase of equipment from Sharp 18,000 18,000 Piecemeal recognition of gain on equipment through depreciation ($4,000 90%) +3,600 +3,600 Current Year s Effect Reclassify dividend income as decrease in investment 27,000 $ 27,000 (Continued) 4 ADVANCED ACCOUNTING

5 Plank s Beginning Investment Income Retained in from Dividend Earnings Sharp Sharp Income Share of Sharp s reported income ($80,000 90%) +72,000 $+72,000 Sharp s sale of land to outside entity +5,000 +5,000 Gain from sale of building to Sharp 32,000 32, piecemeal recognition of gain on equipment ($4,000 90%) +3,600 +3, piecemeal recognition of gain on building ($32,000 8 years) +4,000 +4,000 Working paper entry to convert cost to equity method $+70,600 $+96,200 $+52,600 $ 27,000 As in the case of the conversion from incomplete equity to the equity method, after this first correcting entry is made in the working papers to convert Plank s accounting for its investment in Sharp to the equity method, the rest of the working paper entries are the same as those in Exhibit 6-4. TRADITIONAL WORKING PAPER SOLUTION FOR COST METHOD Exhibit T6-4 illustrates working paper procedures to consolidate the financial statements of Plank and Sharp when Plank uses the cost method to account for its investment in Sharp and consolidates without converting to the equity method. Working paper entries a, b, and c under the cost method are identical to those under an incomplete equity method. Entry d eliminates dividend income against dividends. Entry f takes up Plank s share of the increase in Sharp s retained earnings from the date of acquisition to the beginning of In other words, entry f establishes reciprocity between the investment and equity balances to the beginning of the year. Entry g then eliminates the reciprocal investment and equity balances and enters beginning-of-theperiod minority interest. We journalized these last three working paper entries as follows: d Dividend income Sharp ( R, SE) 27,000 Dividends (+SE) 27,000 To eliminate dividend income. e Minority interest expense (E, SE) 8,400 Dividends Sharp (+SE) 3,000 Minority interest (+L) 5,400 To enter minority interest share of subsidiary income and dividends. f Investment in Sharp (+A) 90,000 Retained earnings Plank January 1 (+SE) 90,000 To increase parent s beginning retained earnings for its share of Sharp s retained earnings increase between date of acquisition and beginning of the period. g Retained earnings Sharp ( SE) 200,000 Capital stock Sharp ( SE) 400,000 Investment in Sharp ( A) 540,000 Minority interest (+L) 60,000 To eliminate reciprocal investment and equity balances and enter beginning minority interest. Comparison of Results Under the Three Methods Regardless of the method (equity, incomplete equity, or cost) used by the parent in accounting for its subsidiary, or the approach used in the working papers to consolidate the financial statements of the parent and subsidiary, the final consolidated financial statements will always be the same. Here Electronic Supplement to Chapter 6 5

6 EXHIBIT T6-4 Intercompany Sales of Plant Assets Cost Method, Traditional Approach PLANK CORPORATION AND SUBSIDIARY CONSOLIDATION WORKING PAPERS FOR THE YEAR ENDED DECEMBER 31, 2007 (IN THOUSANDS) 90% Adjustments and Consolidated Plank Sharp Eliminations Statements Income Statement Sales $2,000 $700 $2,700 Gain on building 32 c 32 Loss (or gain) on land (1) a 5 4 Income from Sharp 27 d 27 Cost of goods sold (1,000) (320) (1,320) Depreciation expense (108) (50) b 4 c 4 (150) Other expenses (676.6) (249) (925.6) Minority interest expense e 8.4 (8.4) Net Income $ $ 80 $ 300 Retained Earnings a 5 Retained earnings Plank $ b 14.4 f 90 $ 400 Retained earnings Sharp $200 g 200 Net income Dividends (200) (30) d 27 e 3 (200) Retained earnings December 31, 2007 $ $250 $ 500 Balance Sheet Cash $ $ 32 $ Other current assets Land Buildings c Accumulated depreciation buildings (200) (54) c 4 (250) Equipment b 20 1,000 Accumulated depreciation equipment (258) (100) b 8 (350) Investment in Sharp 450 f 90 g 540 $1,603.8 $700 $1,813.8 Current liabilities $ 200 $ 50 $ 250 Capital stock 1, g 400 1,000 Retained earnings $1,603.8 $700 Minority interest b 1.6 e 5.4 g $1, ADVANCED ACCOUNTING

7 is a summary of the differences in the financial statement items of Plank under the equity, incomplete equity, and cost methods. Incomplete Equity Equity Cost Method Method Method Income Statement Income from Sharp $ 52,600 $ 72,000 Dividend income from Sharp $ 27,000 Net income 300, , ,400 Retained Earnings Statement Retained earnings January 1, , , ,400 Net income 300, , ,400 Dividends (no difference) (200,000) (200,000) (200,000) Retained earnings December 31, , , ,800 Balance Sheet Investment in Sharp 546, , ,000 Retained earnings December 31, , , ,800 ASSIGNMENT MATERIAL W 6-1 Income information for 2003 taken from the separate company financial statements of Park Corporation and its 75%-owned subsidiary, Skyline Corporation, is presented as follows: Park Skyline Sales $1,000,000 $460,000 Gain on sale of building 20,000 Income from Skyline 75,000 Cost of goods sold (500,000) (260,000) Depreciation expense (100,000) (60,000) Other expenses (200,000) (40,000) Net income $ 295,000 $100,000 Park s gain on sale of building relates to a building with a book value of $40,000 and a 10-year remaining useful life that was sold to Skyline for $60,000 on January 1, REQUIRED 1. At what amount will the gain on sale of building appear on the consolidated income statement of Park and Subsidiary for the year Calculate consolidated depreciation expense for Calculate consolidated net income for Park and Subsidiary for What entry should be made on Park s books on December 31, 2003 (after the books are closed) to correct the accounts to an equity basis? W 6-2 Comparative balance sheets for Pony Corporation and its 90%-owned subsidiary, Sox Corporation, on December 31, 2008, are as follows (in thousands): Pony Sox Corporation Corporation Assets Cash $ 3,200 $ 1,200 Receivables net 4,760 2,000 Inventories 4,040 1,800 Land 4,700 1,000 Building net 8,000 4,000 Equipment net 14,000 6,000 Investment in Sox 11,300 Total assets $50,000 $16,000 (Continued) Electronic Supplement to Chapter 6 7

8 Pony Sox Corporation Corporation Liabilities and Stockholders Equity Accounts payable $ 4,000 $ 2,000 Other liabilities 8,000 2,000 Common stock 30,000 10,000 Retained earnings 8,000 2,000 Total equities $50,000 $16,000 Pony acquired its 90% interest in Sox for cash on December 31, 2005, at a price $500,000 in excess of underlying book value. The excess was due to patents having a 10-year amortization period. Sox Corporation s inventories at December 31, 2008, included merchandise acquired from Pony at a price $50,000 in excess of its cost to Pony. Unrealized profit in Sox s December 31, 2007, inventories acquired from Pony were $40,000. During 2008 Sox sold land to Pony at a gain of $200,000. Pony s land account at December 31, 2008, includes the full $700,000 paid for the land. Pony uses the equity method of accounting for its investment in Sox but has applied the equity method without amortizing patents or adjusting for unrealized profits (an incomplete equity method). REQUIRED: Prepare a consolidated balance sheet for Pony Corporation and Subsidiary at December 31, W 6-3 Prime Corporation owns 80% of the outstanding voting stock of Select Corporation, having acquired its interest at book value when Select Corporation was incorporated on January 2, Comparative income statements for Prime and Select for 2005 and 2006 are as follows (in thousands): Prime Select Prime Select Sales $500 $200 $600 $250 Gain on machinery 10 Gain on land 5 Dividend income Total revenue Inventory January Purchases Goods available for sale Inventory December Cost of goods sold Gross profit Operating expenses Net income $160 $ 50 $160 $ 65 ADDITIONAL INFORMATION 1. Prime Corporation uses the cost method of accounting for its investment in Select. 2. The $10,000 gain relates to machinery sold to Select at the beginning of Select still held the machinery on December 31, 2006, and is depreciating it at the rate of 20% per year. The $5,000 relates to land sold to Prime at the beginning of Intercompany sales and inventory data for 2005 and 2006 are as follows: Sales by Prime to Select $40,000 Sales by Select to Prime $50,000 Unrealized profit in Select s December 31 inventory 8,000 Unrealized profit in Prime s December 31 inventory 10,000 REQUIRED: Prepare comparative 2005 and 2006 consolidated income statements for Prime Corporation and Subsidiary. You may use a single line for cost of sales in your comparative income statements. 8 ADVANCED ACCOUNTING

9 W 6-4 Pike Corporation issued 10,000 of its own $10 par shares for 90% of Shad Corporation s outstanding common shares on January 1, 1999, in a pooling of interests business combination. Shad s stockholders equity consisted of $100,000 capital stock, $50,000 other paid-in capital, and $50,000 retained earnings at the time of the pooling. Pike recorded the pooling as follows: Investment in Shad (90%) (+A) 180,000 Capital stock, $10 par (+SE) 100,000 Other paid-in capital (+SE) 35,000 Retained earnings (+SE) 45,000 Separate company financial statements for Pike and Shad on December 31, 2000, are summarized as follows (in thousands): Pike Shad Income Statement for 2000 Sales $ 600 $200 Income from Shad 63.5 Gain on equipment 18 Cost of sales (270) (100) Operating expenses (121.5) (20) Net income $ 290 $ 80 Retained Earnings for 2000 Retained earnings December 31, 1999 $ 70 $ 90 Add: Net income Deduct: Dividends (150) (40) Retained earnings December 31, 2000 $ 210 $130 Balance Sheet on December 31, 2000 Cash $ $ 23 Accounts receivable Dividends receivable 18 Inventories Land Buildings net Equipment net Investment in Shad Total assets $1,350 $400 Accounts payable $ 225 $ 60 Dividends payable Other liabilities Capital stock, $10 par Other paid-in capital Retained earnings Total equities $1,350 $400 During 1999 and 2000, the intercompany transactions between these affiliated companies were as follows: INVENTORY ITEMS: During 1999, Pike sold inventory items that cost $30,000 to Shad for $50,000. Half of these items were inventoried by Shad at December 31, During 2000, Pike sold inventory items that cost $20,000 to Shad for $40,000, and 40% of these items were inventoried by Shad at December 31, Also, Shad owed Pike $5,000 at December 31, PLANT ASSETS: On January 12, 1999, Shad sold land with a book value of $10,000 to Pike for $15,000 and a building with a book value of $50,000 to Pike for $70,000. The building is being depreciated over a four-year period. On January 1, 2000, Shad purchased equipment with a six-year remaining useful life from Pike at a gain to Pike of $18,000. REQUIRED: Prepare consolidation working papers for Pike Corporation and Subsidiary at and for the year ended December 31, Electronic Supplement to Chapter 6 9

10 W 6-5 [AICPA adapted] Pain Corporation acquired all the outstanding $10 par value voting common stock of Sey Corporation on January 1, 2009, in exchange for 25,000 shares of its $10 par value voting common stock. On December 31, 2008, Pain s common stock had a closing market price of $30 per share on a national stock exchange. The acquisition was appropriately accounted for as a purchase. Both companies continued to operate as separate business entities, maintaining separate accounting records with years ending December 31. On December 31, 2009, the companies had condensed financial statements as follows (in thousands): Pain Sey Income Statement for the Year Ended December 31, 2009 Net sales $3,800 $1,500 Dividends from Sey 40 Gain on sale of warehouse 30 Cost of goods sold (2,360) (870) Operating expenses (including depreciation) (1,100) (440) Net income $ 410 $ 190 Retained Earnings Statement for the Year Ended December 31, 2009 Retained earnings beginning $ 440 $ 156 Add: Net income Less: Dividends paid (40) Retained earnings December 31, 2009 $ 850 $ 306 Balance Sheet at December 31, 2009 Assets Cash $ 570 $ 150 Accounts receivable net Inventories 1, Land, plant, and equipment 1, Accumulated depreciation (370) (210) Investment in Sey (at cost) 750 Total assets $4,190 $1,380 Liabilities and Stockholders Equity Accounts payable and accrued expenses $1,340 $ 594 Common stock, $10 par 1, Additional paid-in capital Retained earnings Total equities $4,190 $1,380 ADDITIONAL INFORMATION 1. There were no changes in the common stock and additional paid-in capital accounts during 2009 except the one necessitated by Pain s acquisition of Sey. 2. At the acquisition date, the fair value of Sey s machinery exceeded its book value by $54,000. The excess cost will be amortized over the estimated average remaining life of six years. The fair values of all of Sey s other assets and liabilities were equal to their book values. Any goodwill resulting from the acquisition is not amortized. 3. On July 1, 2009, Pain sold a warehouse facility to Sey for $129,000 cash. At the time of the sale, Pain s book values were $33,000 for the land and $66,000 for the undepreciated cost of the building. Based on a real estate appraisal, Sey allocated $43,000 of the purchase price to land and $86,000 to building. Sey is depreciating the building over its estimated five-year remaining useful life by the straight-line method with no salvage value. 4. During 2009, Pain purchased merchandise from Sey at an aggregate invoice price of $180,000, which included a 100% markup on Sey s cost. At December 31, 2009, Pain owed Sey $86,000 on these purchases, and $36,000 on this merchandise remained in Pain s inventory. REQUIRED: Prepare working papers to consolidate the financial statements of Pain and Sey for the year (Note: Conversion to equity is an inefficient approach to the solution for this problem because the consolidation is in the year of acquisition.) 10 ADVANCED ACCOUNTING