Financial 3(B) Updates for 2009 Edition Last Updated March 31, 2009 SECTION A: TEXT, LECTURE & FLASHCARD ERRATA Item A.1 Page F3(B)-4 SFAS 115 - Investments chart This chart indicates that the cash flows from trading securities transactions are classified as operating cash flows on the statement of cash flows. This treatment of trading securities was amended by SFAS 159. SFAS 159 states that trading securities cash flows can be classified as either operating cash flows or investing cash flows based on the nature and purpose for which the securities were acquired. Generally, if trading securities are classified as current assets on the balance sheet, then trading security transactions will be reported as operating cash flows and if trading securities are classified as noncurrent assets on the balance sheet, then trading security transactions will be reported as investing cash flows. Item A.2 Pages F3(B)-24 Item 6. Goodwill (or Gain) is Required Under SFAS 141R, the gain that results when there is a deficiency in the acquisition cost compared to the subsidiary's fair value (a bargain purchase) will only be recorded as extraordinary if it meets the APBO 30 definition of extraordinary (unusual, infrequent and material). Therefore, this paragraph should read: If there in an excess of the acquisition cost (plus any Noncontrolling (Minority) Interest) over the fair value of the subsidiary, then the remaining/excess is debited to create Goodwill. If there is a deficiency in the acquisition cost compared to the subsidiary's fair value, then the shortage/negative amount is credited to Gain - Extraordinary. Item A.3 Flashcard F3(B)-13 Under SFAS 141(R), the gain that results when there is a deficiency in the acquisition cost compared to the subsidiary's fair value (a bargain purchase) will only be recorded as extraordinary if it meets the APBO 30 definition of extraordinary (unusual, infrequent and material). Therefore, this flashcard should read: The acquisition cost is allocated to the fair value of 100% of the balance sheet accounts and the fair value of 100% of the identifiable assets. This creates a negative balance in the acquisition account, which is recorded as an extraordinary gain. Item A.4 Flashcard F3(B)-14 The F3(B) materials reflect the SFAS 141R acquisition method, which replaces the purchase method. This flashcard should read: In a purchase an acquisition, how are acquired identifiable assets amortized. 1
Item A.5 Flashcard F3(B)-19 The F3(B) materials reflect the SFAS 141R acquisition method, which replaces the purchase method. This flashcard should read: In Purchase Acquisition Accounting, state the consolidating workpaper elimination entry. Item A.6 Flashcard F3(B)-20 The F3(B) materials reflect the SFAS 141R acquisition method, which replaces the purchase method. This flashcard should read: How are expenses relating to the combination treated under the purchase acquisition method? SECTION B: PASSMASTER, SIMULATIONS, & QUIZZES ERRATA Item B.1 Online Quiz Question #4 (CPA-05095) Under SFAS 141(R), the gain that results when there is a deficiency in the acquisition cost compared to the subsidiary's fair value (a bargain purchase) will only be recorded as extraordinary if it meets the APBO 30 definition of extraordinary (unusual, infrequent and material). Therefore, the answer options for this question should read: a. An extraordinary gain of $235,000. b. An extraordinary gain of $270,000. c. A deferred credit (negative goodwill) of $235,000. d. A deferred credit (negative goodwill) of $270,000 The explanation should be changed as follows: Choice "b" is correct. When acquiring a subsidiary with an acquisition cost that is less than the fair value of 100% of the underlying assets acquired, adjust all balance sheet accounts to fair value and allocate remaining acquisition costs to the fair value of 100% of identifiable intangible assets. This creates a negative balance in the acquisition cost account, which is allocated to extraordinary gain. Acquisition cost $100,000 = $90,000 purchase price + $10,000 liabilities assumed Less: Assets at FV (370,000) Extraordinary gain (270,000) Choice "a" is incorrect per the above calculation. Choice "c" and "d" are incorrect, since any "bargain purchase" is now credited to extraordinary gain, not to negative goodwill. 2
Item B.2 Simulation #1 - Situation Tab The F3(B) materials reflect the SFAS 141R acquisition method, which replaces the purchase method. The Situation Tab should read: Consolidated Financial Statements for a Business Combination Accounted for as a Purchase an Acquisition On January 1, Year 1, Parent Company acquires a 100% interest in Subsidiary Company by issuing 100,000 shares of $10 par common stock. The market value of the stock at the date of issuance was $17.60 per share. The investment was accounted for internally using the cost method. During Year 1, Subsidiary Company reported net income of $400,000 and declared and paid $10,000 of dividends. Parent uses straight-line depreciation and estimates the remaining life of plant and equipment to be three years. Any excess over fair value is goodwill. Assume goodwill is determined to be impaired by $2,000 for the year. An intercompany receivable and payable of $30,000 was included on the respective financial statements of each company. The acquisition is properly accounted for as a purchase using the acquisition method. Item B.3 Question CPA-00418 This question applies to SFAS 141 (old purchase method accounting), not SFAS 141R (new acquisition method accounting), and should have been removed from the F3(B) materials. Question: In a business combination accounted for as a purchase, the appraised values of the identifiable assets acquired exceeded the acquisition price. How should the excess appraised value be reported? a. As negative goodwill. b. As an extraordinary gain. c. As a reduction of the values assigned to noncurrent assets and an extraordinary gain for any unallocated portion. d. As positive goodwill. Comments: According to Passmaster, the correct answer to this question is Choice "c". However, under SFAS 141(R), the acquisition method), when a subsidiary is acquired with an acquisition cost that is less than the fair value of the underlying assets, the following steps are required: 1. The balance sheet is adjusted to fair value, which creates a negative balance in the acquisition account. 2. Identifiable intangible assets are recognized at fair value, which increases the negative balance in the acquisition account. 3. The total negative balance in the acquisition account is recorded as a gain. 3
SECTION C: TEXT AND LECTURE ADDITIONAL OR ENHANCED INFORMATION Item C.1 Pages F3-16, Item 4 and F3-18, Item II (Goodwill Box at the bottom right) Please note that in both of the above-referenced places in the text, the equity method is being discussed and the goodwill is equity method goodwill. The text indicates such, but it is sometimes hard to remember the context, so we are providing this additional clarification. On Page F3-17, the National Instructor says in the lecture, In this particular case, but it could look a little funny sitting there by itself without his comment. As the National Instructor and the text say, equity method goodwill (by itself) is not amortized (no goodwill is amortized anymore) and it is not (separately) tested for impairment (it is tested for impairment in conjunction with the remainder of the equity method investment, but not separately since it is seldom really isolated as a separate account and remains a part of the equity method investment account). Per Paragraph 40 of SFAS No. 142 is as follows (bold added): The portion of the difference between the cost of an investment and the amount of underlying equity in net assets of an equity method investee that is recognized as goodwill in accordance with paragraph 19(b) of APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock (equity method goodwill) shall not be amortized. However, equity method goodwill shall not be reviewed for impairment in accordance with this Statement. Equity method investments shall continue to be reviewed for impairment in accordance with paragraph 19(h) of Opinion 18. Per Paragraph 19h of APB 18 is as follows: A loss in value of an investment which is other than a temporary decline should be recognized. Evidence of a loss in value might include, but would not necessarily be limited to, absence of an ability to recover the carrying amount of the investment or inability of the investee to sustain an earnings capacity which would justify the carrying amount of the investment. A current fair value of an investment that is less than its carrying amount may indicate a loss in value of the investment. However, a decline in the quoted market price below the carrying amount or the existence of operating losses is not necessarily indicative of a loss in value that is other than temporary. All are factors to be evaluated. Item C.2 Page F3-19, Item III.A, CHANGE FROM COST TO EQUITY METHOD Many have cited that the rationale for the change from the cost method to the equity method not being a change in accounting principle is that the reverse, a change from the equity method to the cost method, is not treated as a change in accounting principle either. Per APB 18 Paragraph 19l: An investment in voting stock of an investee company may fall below the level of ownership described in paragraph 17 from sale of a portion of an investment by the investor, sale of additional stock by an investee, or other transactions and the investor may thereby lose the ability to influence policy, as described in that paragraph. An investor should discontinue accruing its share of the earnings or losses of the investee for an investment that no longer qualifies for the equity method. The earnings or losses that relate to the stock retained by the investor and that were previously accrued should remain as a part of the carrying amount of the investment. The investment account should not be adjusted retroactively under the conditions described in this subparagraph. 4
What all this means is that the investor just stops using the equity method and starts using the cost method (sounds almost like prospective treatment for changes in accounting estimate). The change from the equity method to the cost method is not covered elsewhere in the course, so this is some additional content. It probably will not show up on your exam, but you never know. Item C.3 Page F3-20, Item, III.A.3.b(2): Adjustments to Convert This example has caused some confusion for our students in the past; although, it is correct. It is probably one of the most difficult to understand examples in the course (that does not mean it is a bad example, just difficult). Part of the confusion arises from the facts that the example does not use a valuation account and the ending Journal Entry is a net entry (netting almost always makes things harder to understand). In converting the investment from the cost method to the equity method, the investment has to be converted to what it would have been if the equity method had always been used (in this case, from the beginning of Year 1). That means the $24,450. Unfortunately, because an allowance account was not used, the investment has already been written down to $17,000. The unrealized loss went to other comprehensive income (loss) in Year 1 and then was closed in that year to accumulated other comprehensive income, just like all items in other comprehensive income. The Dr in the ending Journal Entry gets the investment to $24,450. The first Cr, to retained earnings, is what would have added to Retained Earnings (through net income) in Year 1. The second Cr, to unrealized loss, effectively reverses the Year 1 unrealized loss (it is a Cr so effectively it is an unrealized gain). If an allowance account had been used originally, the investment would never have been written down to the $17,000 (that's what allowance accounts are used for). The Journal Entries for the conversion from the cost method to the equity method would have been as follows: Dr Investment $4,450 Cr Retained earnings $4,450 To adjust the investment and retained earnings to the equity method Dr Allowance $3,000 Cr Unrealized loss $3,000 To reverse the original mark-to-market Journal Entry Using an allowance account makes the ending Journal Entry a little clearer. The whole reason for using allowance accounts is to keep the original cost as isolated as possible in the original account. If, instead, the mark-to-market had been to $21,000 instead of $17,000, and an allowance account had been used originally, the investment would never have been written up to the $21,000. The Journal Entries for the conversion from the cost method to the equity method would have been as follows: Dr Investment $4,450 Cr Retained earnings $4,450 To adjust the investment and retained earnings to the equity method Dr Unrealized gain $1,000 Cr Allowance $1,000 To reverse the original mark-to-market Journal Entry 5
Item C.4 Page F3-24, Item I.A.7: CARINBIG Mnemonic: The CARINBIG mnemonic has generated some confusion among our students; however, the confusion is usually due to people trying to read too much into it, especially considering some of the detailed examples in the text. The CARINBIG mnemonic is merely an excellent way to remember the various accounts in the EJE (and to ensure that all appropriate accounts are eliminated). It really has nothing to do with when that EJE would be made. The EJE is made at the date the consolidated financial statements are prepared and in all subsequent consolidations. Theoretically, some of the amounts in the EJE (goodwill and the fair value of the assets) must be determined at the date of the acquisition, but that was more important in the old days when goodwill was amortized than it is now. To illustrate, assume a very simple purchase transaction with the fair value of the net assets approximating their book values but with some goodwill. On January 1, Year 20X0, Purl Corporation purchased all of the common stock of Scott Corporation for $360,000 in cash. The fair value of the net assets of Scott approximated their book values. The separate condensed balance sheets of Purl and Scott at January 1, 20X0 are as follows: Purl Corporation Scott Corporation Cash $80,000 $30,000 Accounts Receivable $140,000 $25,000 Inventory $90,000 $50,000 Fixed Assets $625,000 $280,000 Investment in Scott $360,000 $0 Total Assets $1,295,000 $385,000 Accounts Payable & Accruals $270,000 $125,000 Common Stock $300,000 $50,000 Additional Paid-in Capital $0 $10,000 Retained Earnings $725,000 $200,000 Total Liabilities and Capital $1,295,000 $385,000 This question was derived from a prior CPA exam question and simplified to meet the facts stated above. We are going to go through this question step by step and will add data as needed. Note that the financial statements in this exercise are as of the beginning of the year. Beginning of the Year Let's start out by verifying the data in the financial statements. The total capital is $260,000. That is the same amount as the net assets ($385,000 - $125,000). Since $360,000 was paid, the total goodwill is $100,000. Since 100% of Scott was purchased, there is no noncontrolling interest. Since the fair value of Scott's net assets approximates their fair values, there is no adjustment for fair value. The eliminating AJE (beginning of year) is as follows: Dr Common stock Scott $50,000 C Dr APIC Scott $10,000 A Dr Retained earnings Scott $200,000 R Cr Investment in Scott $360,000 I Cr Noncontrolling interest $0 N Dr Balance sheet adjusted to fair value $0 B Dr Identifiable intangibles to fair value $0 I Dr Goodwill $100,000 G 6
So, at the date of acquisition (sometimes called the date of purchase in the text), we have just used CARINBIG as a mnemonic for the eliminating EJE; even though, some of the amounts are, of course, zero in this question so far. With the EJE (there are not any others in this question) the consolidated balance sheet is as follows: Consolidated Cash $110,000 Accounts Receivable $165,000 Inventory $140,000 Fixed Assets $905,000 Investment in Scott $0 Goodwill $100,000 Total Assets $1,420,000 Accounts Payable & Accruals $395,000 Common Stock $300,000 Additional Paid-in Capital $0 Retained Earnings $725,000 Total Liabilities and Capital $1,420,000 Note that, other than the investment account and the equity of Scott, the accounts are merely added across because there is nothing else to eliminate. The consolidated equity account is the equity of the parent Purl. End of the Year Let's now advance to the end of the year 20X0. To keep things simple, assume that the income for both companies ends up totally as cash and that all other assets and liabilities are unchanged from their January 1, 20X0 balances. Also assume that no intercompany dividends were declared and/or paid. The income statements for Purl and Scott for the year ended December 31, 20X0 are as follows: Purl Corporation Scott Corporation Sales $2,000,000 $750,000 Cost of goods sole $1,540,000 $500,000 Operating expenses $260,000 $150,000 Equity in earnings of Scott $70,000 $0 Income before income taxes $270,000 $100,000 Provision for income taxes $60,000 $30,000 Net income $210,000 $70,000 Purl accounts for its investment on its books using the equity method. The equity method Journal Entry for the 20X0 equity in net income of Scott is as follows: Dr Investment in Scott $70,000 Cr Equity in earnings of Scott $70,000 7
With these assumptions, the separate condensed balance sheets at December 31, 20X0 are as follows: Purl Corporation Scott Corporation Cash $220,000 1 $100,000 Accounts Receivable $140,000 $25,000 Inventory $90,000 $50,000 Fixed Assets $625,000 $280,000 Investment in Scott $430,000 2 $0 Total Assets $1,505,000 $455,000 Accounts Payable & Accruals $270,000 $125,000 Common Stock $300,000 $50,000 Additional Paid-in Capital $0 $10,000 Retained Earnings $935,000 $270,000 Total Liabilities and Capital $1,505,000 $455,000 1 - Purl s year-end cash balance is equal to beginning cash + net income equity in earnings of scott (which is a non-cash item) = $80,000 + 210,000 70,000 = $220,000. 2 The year-end investment in Scott calculated using the equity method for internal accounting purposes is the Investment in Scott + Share of Subsidiary Earnings Dividends Received = $360,000 + 70,000 0 = $430,000. The eliminating AJE (end of the year) is as follows: Dr Common stock Scott $50,000 C Dr APIC Scott $10,000 A Dr Retained earnings Scott $270,000 R Cr Investment in Scott $430,000 I Cr Noncontrolling interest $0 N Dr Balance sheet adjusted to fair value $0 B Dr Identifiable intangibles to fair value $0 I Dr Goodwill $100,000 G So, at the end of the first year, we have just used CARINBIG at the end of the year as a mnemonic for the EJE, even though some of the amounts are again zero. Consolidated Balance Sheet With the EJE the consolidated balance sheet is as follows: Consolidated Cash $320,000 Accounts Receivable $165,000 Inventory $140,000 Fixed Assets $905,000 Investment in Scott $0 Goodwill $100,000 Total Assets $1,630,000 Accounts Payable & Accruals $395,000 Common Stock $300,000 Additional Paid-in Capital $0 Retained Earnings $935,000 Total Liabilities and Capital $1,630,000 8
Note how the change in accounting for goodwill has helped. If we are to use CARINBIG at the end of the first year, the various accounts must all be stated as of the end of the year. In the old days, that meant the amortized amount of goodwill. Now, however, goodwill is not amortized and, ignoring impairment for the moment, the value of the goodwill does not change. Thus, at any point, the goodwill is a plug. In the old days, we probably would have had to go back to the date of acquisition to determine what the original goodwill was so that we could amortize it. Now, we no longer have to do that. Less work is good. In the Purl/Scott question that we have just discussed, we also assumed that the fair values approximated market values. This determination was, of course, an evaluation at the date of acquisition. If we relax that assumption, and there are fair value increments, these fair value increments normally have to be amortized. We would again have to go back to the date of acquisition to determine what the original amounts were. That is the same process that we used to have to do for goodwill also. So, depending on the facts of the question and depending on what is asked, the "backwards" or "lookback" analysis discussed on the Page F3-40 Concept Exercise might be necessary. However, note that this analysis really has nothing to do with CARINBIG per se, but rather with determining the amounts that are used in CARINBIG. Consolidated Income Statement The consolidated income statement for Purl and Scott for the year ended December 31, 20X0, is as follows (we really don't cover the eliminating Journal Entries for the income statement in the text although there are several questions in Passmaster): Consolidated Sales $2,750,000 Cost of goods sold $2,040,000 Operating expenses $410,000 Equity in earnings of Scott $0 Income before income taxes $300,000 Provision for income taxes $90,000 Net income $210,000 Note that the equity in earnings of Scott has effectively been eliminated. The consolidated net income is the separate income of the parent ($210,000 - $70,000) plus the parent's share (100%) of the subsidiary's net income ($70,000). For a formal eliminating AJE, however, the date of acquisition financial statements is the starting point. To examine that EJE, note that the only difference in this question between the beginning of year investment account and the ending of year investment account is the equity in income of the subsidiary. The beginning of year eliminating AJE is as follows: Dr Common stock Scott $50,000 C Dr APIC Scott $10,000 A Dr Retained earnings Scott $200,000 R Cr Investment in Scott $360,000 I Cr Noncontrolling interest $0 N Dr Balance sheet adjusted to fair value $0 B Dr Identifiable intangibles to fair value $0 I Dr Goodwill $100,000 G Dr Equity in income of Scott $70,000 New Cr Investment in Scott $70,000 New Note that this eliminating AJE is the same that we used previously, with an extra two lines to eliminate the equity in income of Scott. So, in the end, it is the same. 9
Many accounting textbooks utilize a kind of "backwards" approach almost as a matter of course for accounting after the acquisition date because they often need to prepare consolidated balance sheets and income statements together. Also, the more assumptions that are relaxed (intercompany transactions, intercompany dividends, etc.), the more you might need to look backwards. On the CPA exam, it often depends on what is asked. Cost Method What about other variations on the same basic concept? Let's go all the way back to the very beginning and assume that the books are kept using the cost method instead of the equity method (and still assume that there are no intercompany dividends). Given these assumptions, the separate condensed balance sheets at December 31, 20X0, are as follows: Purl Corporation Scott Corporation Cash $220,000 $100,000 Accounts Receivable $140,000 $25,000 Inventory $90,000 $50,000 Fixed Assets $625,000 $280,000 Investment in Scott $360,000 $0 Total Assets $1,435,000 $455,000 Accounts Payable & Accruals $270,000 $125,000 Common Stock $300,000 $50,000 Additional Paid-in Capital $0 $10,000 Retained Earnings $865,000 $270,000 Total Liabilities and Capital $1,435,000 $455,000 There is no Journal Entry on Purl's books for the subsidiary because there were no dividends. The eliminating AJE (end of the year) is as follows: Dr Common stock Scott $50,000 C Dr APIC Scott $10,000 A Dr Retained earnings Scott $270,000 R Cr Investment in Scott $360,000 I Cr Noncontrolling interest $0 N Dr Balance sheet adjusted to fair value $0 B Dr Identifiable intangibles to fair value $0 I Dr Goodwill $100,000 G Cr Retained earnings $70,000 New So, at the end of the first year, even with the cost method, we have used CARINBIG at the end of the year as a mnemonic for the eliminating AJE, even though some of the amounts are again zero. The new line is to adjust the net income and the consolidated retained earnings to the parent's separate income plus the parent's share of the subsidiary's income. 10
With the AJE (there are no others for the balance sheet only), the consolidated balance sheet is as follows: Consolidated Cash $320,000 Accounts Receivable $165,000 Inventory $140,000 Fixed Assets $905,000 Investment in Scott $0 Goodwill $100,000 Total Assets $1,630,000 Accounts Payable & Accruals $395,000 Common Stock $300,000 Additional Paid-in Capital $0 Retained Earnings $935,000 Total Liabilities and Capital $1,630,000 This is the same consolidated balance sheet as under the equity method. The eliminating AJE takes care of the difference between the cost method and the equity method. The consolidated income statement would also be the same. Simulation Example The only place where there is enough time on the CPA exam for a full consolidation (including an income statement and a balance sheet) is on a simulation, like the F3 Simulation 1. With this question, the cost method is used on the books (internally). Fair values at acquisition date approximate book values again, except for the plant and equipment, and there is some impairment of goodwill. And there are intercompany dividends and an intercompany payable/receivable. So there are a couple of new factors that were not addressed previously and that can be addressed now. BE SURE TO WORK THE QUESTION BEFORE YOU LOOK AT THE REST OF THIS ANALYSIS. THE MAXIMUM BENEFIT IS GAINED FROM WORKING QUESTIONS RATHER THAN JUST READING QUESTIONS AND ANSWERS. The answer says to eliminate the common stock, the additional paid-in capital, and the retained earnings of the subsidiary at the date of acquisition. That is not the way it was done above. So let's take a look at the subsidiary's data. The common stock and the additional paid-in capital did not change during the year so the only amount that we have to be concerned about is the retained earnings. From the Situation tab, the beginning-of-year retained earnings is $50,000 and the end-of-year retained earnings is $440,000. What accounts for the difference? From the income part of the consolidated worksheet, the subsidiary's net income was $400,000. From the retained earnings part of the consolidated worksheet, the subsidiary's dividends are $10,000. So, $50,000 + $400,000 - $10,000 = $440,000, and everything works out fine. Life is good. The reason why the beginning balances are eliminated is that the worksheet for this question contains the beginning retained earnings in the statement of retained earnings. We have to get rid of that. Effectively, we start with the top of the worksheet and work our way down. So let's look at the answer to the worksheet from the top down. Print it if you need to. The dividends from the subsidiary are eliminated on the income statement. They have to be eliminated because they are intercompany dividends. The depreciation expense is adjusted for the additional depreciation on the plant assets (that was addressed in the text on Page F3-51). The impairment expense is added to the income statement. No problems so far. On the retained earnings part of the consolidated worksheet, the beginning-of-year retained earnings is eliminated. The net income is carried down from the income part of the consolidated worksheet, and the intercompany dividends are eliminated. The accounts with no eliminating entries, in the income statement and retained earnings part of the consolidated worksheet, are merely added across. 11
On the balance sheet, the intercompany receivables are eliminated. The investment in the subsidiary account is eliminated. The goodwill is generated and then reduced for the impairment. The plant assets are adjusted for their fair values and then adjusted for the excess depreciation. The common stock of the subsidiary and the additional paid-in capital are eliminated and the total adjustments for retained earnings are carried down from above. Everything seems reasonable, but it will be helpful to see what happens if the approach discussed above would work, just for the balance sheet. The separate condensed balance sheets at December 31, Year 1 (20X3), are as follows (derived from the worksheet tab): Parent Corporation Subsidiary Corporation Cash $800,000 $400,000 Accounts Receivable (Interco) $30,000 $0 Inventory $40,000 $20,000 Other Current Assets $60,000 $40,000 Investment in Subsidiary $1,760,000 $0 Plant Assets (Net) $1,200,000 $3,700,000 Total Assets $3,890,000 $4,160,000 Accounts Payable (Interco) $0 $30,000 Other Liabilities $1,250,000 $2,990,000 Common Stock $1,200,000 $600,000 Additional Paid-in Capital $300,000 $100,000 Retained Earnings $1,140,000 $440,000 Total Liabilities and Capital $3,890,000 $4,160,000 The eliminating AJE (end of the year) is as follows: Dr Common stock Subsidiary $600,000 C Dr APIC Subsidiary $100,000 A Dr Retained earnings Subsidiary $440,000 R Cr Investment in Subsidiary $1,760,000 I Cr Noncontrolling interest $0 N Dr Balance sheet adjusted to fair value $633,333 B Dr Identifiable intangibles to fair value $0 I Dr Goodwill $58,000 G Cr Retained earnings $81,333 New Dr Dividend income $10,000 New Dr Accounts payable (interco) $30,000 Cr Accounts receivable (interco) $30,000 Remember that, in the Purl/Scott example, the "New" line items in the eliminating AJE adjusted the consolidated net income and the consolidated retained earnings to the parent's separate income plus the parent's share of the subsidiary's income, i.e., from the cost method recording on the books to the equity method. The new line items do the same thing here, although it is not as obvious. The retained earnings adjustment is as follows: Subsidiary income $400,000 Extra depreciation (316,667) Impairment of goodwill ( 2,000) Equity method income $ 81,333 The Dr to dividend income eliminates the cost method income. There were no dividends in the Purl/Scott example. So, again, either the beginning-of-year or end-of-year amounts can be used in CARINBIG. Note, however, that, in either case, the beginning-of-year, or better the acquisition, amounts for the fair value increments must be available so that the amortization of these amounts can be determined. 12
SECTION D: PASSMASTER, SIMULATIONS, & QUIZZES ADDITIONAL OR ENHANCED INFORMATION Item D.1 Question CPA-00467 This question has caused some confusion; although, it is correct. Comments have been added (they follow the question and explanation). The question and answer are as follows: Question A 70%-owned subsidiary company declares and pays a cash dividend. What effect does the dividend have on the retained earnings and minority interest balances in the parent company's consolidated balance sheet? a. No effect on either retained earnings or minority interest. b. No effect on retained earnings and a decrease in minority interest. c. Decreases in both retained earnings and minority interest. d. A decrease in retained earnings and no effect on minority interest. Explanation Choice "b" is correct, no effect on retained earnings and a decrease in minority interest. The parent's balance sheet would reflect 70% of the sub's earnings. Receipt of 70% of the dividends would simply transfer cash from one company to another. The dividend would be eliminated in consolidation. However, 30% of the dividend would be paid to the minority shareholders and would reduce minority interest on the consolidated balance sheet. Choice "a" is incorrect. The dividend affects minority interest but not retained earnings. Choice "c" is incorrect. The dividend does not affect retained earnings. Choice "d" is incorrect. The dividend reduces minority interest. Comments Assuming a $100 dividend from the subsidiary, the Journal Entry for the subsidiary is as follows: Dr Retained earnings $100 Cr Cash $100 Assuming that the parent accounts for the subsidiary on its books with the cost method (for simplicity), the Journal Entry for the parent is as follows: Dr Cash $70 Cr Dividend revenue $70 The eliminating Journal Entry for the intercompany transaction for consolidation purposes is as follows: Dr Dividend revenue $70 (the parent's piece) Cr Retained earnings $100 Dr Minority interest $30 (the minority's piece) Retained earnings is unaffected (the Dr and Cr offset). Because minority interest entry is a Dr, it is reduced (minority interest is a Cr account normally). 13
Item D.2 Question CPA-00478 This question has generated some confusion; although, it is correct. Part or all of the confusion is that the explanation for the answer is quite brief. The question and answer are as follows: Question Wagner, a holder of a $1,000,000 Palmer, Inc. bond, collected the interest due on March 31, 1992, and then sold the bond to Seal, Inc. for $975,000. On that date, Palmer, a 75% owner of Seal, had a $1,075,000 carrying amount for this bond. What was the effect of Seal's purchase of Palmer's bond on the retained earnings and minority interest amounts reported in Palmer's March 31, 1992, consolidated balance sheet? Retained earnings Minority interest a. $100,000 increase $0 b. $75,000 increase $25,000 increase c. $0 $25,000 increase d. $0 $100,000 increase Explanation Choice "a" is correct, $100,000 increase in consolidated earnings. $0 effect on minority interest. Journal entry on consolidated worksheet Dr Bond payable (Palmer's books) $1,075,000 Cr Bond investment (Seal's books) $975,000 Cr Retained earnings - consolidated $100,000 Cr Minority interest $0 Comments This question is an exact parallel to the Intercompany Bond Transactions Example on Page F3-37, Item I.E. In this question, Seal bought the bond from Wagner, the original purchaser. In the Example, the subsidiary bought the bonds from unnamed original purchasers. In this question, the bond was acquired for $975,000 when the face value was $1,000,000, with a premium of $75,000, for a total of $1,075,000. In the Example, the bonds were bought for $275,000 when the face value of the bonds was $250,000, with a premium of $50,000, for a total of $300,000. The only differences in the two answers are that the Journal Entry for the Example separates the bond and the premium, while the answer for this question does not (the bond payable and the premium account are lumped together), and the Journal Entry for the example illustrates a gain, while the answer for this question illustrates a Cr to retained earnings. Because the question is asking about the balance sheet, retained earnings would be the only account available. Note that the very last line of the text on Page F3-37 says that "Minority interest would be adjusted if the bonds were originally issued by the subsidiary." In both the Example and this question, the bonds were issued by the parent, so there is no effect on minority interest. The fact that Palmer is a 75% owner of Seal is thus irrelevant and a distractor. 14
Item D.3 F3 Simulation #1, Research Tab The question is What is the general accounting treatment for investments that qualify for application of the equity method? The solution indicates that the answer is found in APB 18, Paragraph 6b. The second part of Paragraph 6 definitely does answer the question, as indicated below: The equity method. An investor initially records an investment in the stock of an investee at cost, and adjusts the carrying amount of the investment to recognize the investor's share of the earnings or losses of the investee after the date of acquisition. The amount of the adjustment is included in the determination of net income by the investor, and such amount reflects adjustments similar to those made in preparing consolidated statements including adjustments to eliminate intercompany gains and losses, and to amortize, if appropriate, any difference between investor cost and underlying equity in net assets of the investee at the date of investment. The investment of an investor is also adjusted to reflect the investor's share of changes in the investee's capital. Dividends received from an investee reduce the carrying amount of the investment. A series of operating losses of an investee or other factors may indicate that a decrease in value of the investment has occurred which is other than temporary and which should be recognized even though the decrease in value is in excess of what would otherwise be recognized by application of the equity method. This answer is in the Original Pronouncements section of the database (called the FASB-OP). If you are not sure how to determine that, click on FASB Literature in the left-hand part of the search screen. FASB-OP is original pronouncements (the original material that was published), FASB-CT is current text (a topical arrangement of the original pronouncements where the information is supposedly updated for any changes from later pronouncements). The service that is used on the CPA exam has more sections but not as many as a full service. So how do you arrive at the answer (the remaining discussion assumes that you are working along in the Research question)? Let s try a key word of equity method. Those words are words that are used extensively in the authoritative literature, so it should give us something. It does. It gives 8 different hits (results) with the Becker database, one of which can be eliminated just by looking at it. Normally, in a Research question, results that say Appendix can be ignored or at least placed way down in priority; appendices provide rationale/justification, examples, history, pronouncements that have been changed, and the like but do provide the rules; the rules are in the body of the statement itself. There aren t any of those here. Normally, in a Research question, results that say Summary can also be ignored (as long as the detail presentation shows up in the list); the summaries at the front of Statements are reasonably short and the detail is in the body of the statement itself. There is one of those here. Take it off the list. Normally, in a Research question, results that say Status can also be ignored. There aren t any of those here. Normally, in a Research question, results that say Introduction can also be ignored (for the same reason as Summary ). There aren't any of those here. One is off the list, and there are still 7 hits left. Let s look at the 7 hits remaining. Three of them are from SFAS No. 148, which, by clicking on one of them and looking at the title, is a transition and disclosure SFAS relating to stock-based compensation. Those are probably not what we want (transition is hardly ever questioned on the CPA exam) so let's take all three of them off the list. But if we look right after those three, there is one hit from APB 18. Now APB 18 is real old, but so is the equity method. So if we look at that one, there is the paragraph we need and we are almost done. Trying the same keyword of equity method in a full service such as RIA produces 80 hits in Original Pronouncements. Nine of the hits are in the APB section, six are in the AICPA Interpretations section, one is in the APB Statements section, forty-nine are in the SFAS section, twelve are in the SFAS Interpretations section, one is in the FASB Technical Bulletins section, and one is in the Financial Accounting Concepts section. With this kind of distribution, the best place to start is in the APB section because APB pronouncements are as high in the hierarchy of GAAP as anything, and APB pronouncements are old. Of the hits in the APB section, one is for APB 18. There are many individual hits inside APB 18. One of them is paragraph 6. 15
Depending on the specific question, there are various approaches to finding the answers to Research questions. We have included these comments in the various online updates to demonstrate most or all of the possible approaches. Item D.4 F3 Simulation #2, Research Tab The question is What is the general financial accounting treatment for goodwill? The solution indicates that the answer is found in SFAS No. 142, Paragraph 18, but is that really correct? The answer depends on what the question really is. SFAS No. 142 governs the accounting treatment for goodwill after acquisition (i.e., the fact that goodwill is no longer amortized and is tested for impairment). SFAS No. 141 governs the accounting treatment for goodwill at acquisition (i.e., how the goodwill is calculated in the first place). The question really does not say and needs to be somewhat a little more specific. Let s assume that the question is What is the general financial accounting treatment for goodwill after the goodwill is determined at acquisition? Paragraph 18 is as follows: Goodwill shall not be amortized. Goodwill shall be tested for impairment at a level of reporting referred to as a reporting unit. (Paragraphs 30 36 provide guidance on determining reporting units.) Impairment is the condition that exists when the carrying amount of goodwill exceeds its implied fair value. The two-step impairment test discussed in paragraphs 19 22 shall be used to identify potential goodwill impairment and measure the amount of a goodwill impairment loss to be recognized (if any). So how do we arrive at the answer (the remaining discussion assumes that you are working along in the Research question)? Let s try a key word of goodwill. That word is a word that is used extensively in the authoritative literature, so it should give us something. It does. It gives 42 different hits (results) with the Becker database. Unless we want to spend several hours on this part of the question, some of these hits will have to be eliminated. Normally, in a Research question, results that say Appendix or Summary or Status or Introduction can be eliminated. But there do not appear to be any of those here, at least on the first page of hits. So let s look at what we do have. Let s go back to the question. It is vitally important to keep the question in mind when working a research question. The question, as revised, is What is the general financial accounting treatment for goodwill after the goodwill is determined at acquisition? We should know, in general, that goodwill is no longer amortized but is now tested for impairment. Even if we do not know or remember the details of the goodwill impairment test (see the F2 online update), we should know that the impairment test exists. Let s just look at some of the titles. The first two titles are FAS 142 Par 20 and G40 Par 118. The FAS 142 title is the original pronouncements version, and the G40 title is the cumulative text version. So these two hits are probably the same thing twice, and, if we look at the detail by clicking on the titles, the detail titles are Accounting for Goodwill/Recognition and Measurement of an Impairment Loss and the text provides the details of the accounting (at least for the measurement of the impairment loss, which is what is covered in Paragraph 20 and Paragraph 118). The next two titles are FAS 142 Par 18 and G40 Par 18. Again, the same thing twice, but the detail titles Accounting for Goodwill sure look good if we are interested in the accounting in general and not just the impairment. We could (and should) stop here and read the actual text, but, for learning purposes, let s look a little bit further down. The next two titles are FAS 142 Par 34 and G40 Par 132. Again, the same thing twice, and again more details of the accounting (assigning goodwill to the reporting units). So we can now go back to the Paragraph 18 hit and read it. When we do, we will realize that it is the right answer. Copy and paste and we are done. 16
Again, it is vitally important to keep the question in mind when working a research question. The original question was too vague to know exactly how to answer it. The revised question is better and leads us quickly to the answer, even without necessarily looking at all of the hits. On the CPA exam, the questions "should" be less vague, but there might be a large number of hits to sort through. Everybody needs to practice extensively so that these questions can be worked efficiently. Depending on the specific question, there are various approaches to finding the answers to Research questions. We have included these comments in the various online updates to demonstrate most or all of the possible approaches. # # # EDITORS' NOTES Note: From time to time, we issue a PassMaster updater that updates your PassMaster questions and answers. Normally, error corrections to at least some of the question are included in the updater. Thus, if you have run the updater, some of the errors discussed above may already have been corrected. We do not update the online documents when a PassMaster updater is available because not everybody runs them (although they should). Some of the Items above have come from our internal review process, some have come from questions and comments from Becker instructors around the world, and some have come from questions asked by various candidates, either from Becker KnowledgeBase or in online or live classes. We wish to thank all of these individuals as a group for their efforts to improve our materials. 17