Chapter Four

CONSOLIDATION OF FINANCIAL STATEMENTS

Introduction
In the previous unit, we have seen a business combination where the investor acquires all the
stocks (the whole assets) of the investee. If the merger is arranged in such a way that the investor
acquires a controlling interest in the investee (ownership level less than 100% but above 50%
just to give power to control the investee) a parent-subsidiary relationship is established. The
investee becomes a subsidiary of the acquiring parent company (investor) but remains a separate
legal entity. A parent company and its subsidiary are a single economic entity. In recognition of
this fact, consolidated financial statements are issued to report the financial position and
operating results of a parent company and its subsidiaries as though they comprised a single
accounting entity.
Consolidated Financial Statements: Nature and Meaning, Use and Limitation
Nature of Consolidated Financial Statements
Consolidated financial statements are somewhat similar to the combined financial statements that
consists a home office and its branches. In a consolidated financial statement, assets, liabilities,
revenue, and expenses of the parent company and its subsidiaries are totaled; intercompany
transactions and balances are eliminated; and the final consolidated amounts are reported in the
consolidated balance sheet, income statement, statement of stockholders' equity, and statement of
cash flows.
The consolidated financial statements are pooled from the separate legal entity status of the
parent and subsidiary corporations which necessitates eliminations that generally are somewhat
complex. It must be made clear that the investor need not consolidate all subsidiaries where it
holds more than 50% of the shares.
Consolidation is normally appropriate where one company (parent) controls another company
(subsidiary). An unconsolidated subsidiary should be reported as an investment on the parent’s
balance sheet. However, unconsolidated subsidiaries are relatively rare. A subsidiary can be
excluded from consolidation in only two situations:

1. Control is likely to be temporary.

2. Control does not rest with the majority owner.

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Use and Limitation of Consolidated Financial Statement
Shareholders of the parent benefit using consolidated financial statements as these statements
provide information that is not included in the separate statements of the parent corporation.
Specifically:

 Consolidated financial statements provide more meaningful information than separate

statements.
 They more fairly present the activities of the consolidated companies.
 Consolidated financial statements are useful to stockholders and prospective investors
of the parent company.
 Users are provided with comprehensive financial information for the economic unit
represented by the parent company subsidiaries without regard for legal separateness
of the individual companies.

Critics on the Use of Consolidated Financial Statements:

 Financial statements of the individual companies composing the larger entity are not always
prepared on a comparable basis.
 Consolidated financial statements do not reveal restrictions on use of cash for individual
companies. Nor do they reveal inter-company cash flows or restrictions placed on those
flows.
 Companies in poor financial condition sometimes combine with financially strong
companies, thus obscuring analysis.
 Extent of inter-company transactions is unknown unless the procedures underlying the
consolidation process are reported.
 Accounting for the consolidation of finance and insurance subsidiaries can pose several
problems for analysis. Aggregation of dissimilar subsidiaries can distort ratios and other
relations.

Methods of Accounting for Investment in Other Firms

Before the consolidation balances can be determined, the parent’s investment account must be
adjusted to reflect application of way investment has been accounted. Accountants can follow
one of the following methods:
 The Equity Method
 The Cost Method
 The Partial Equity Method

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The methods differ in the way/time of accounting and reporting the following facts and events of
the subsidiary:
a) Accounting for the net income/loss reported by the investee
b) Dividend declared and paid
c) Recognition and reporting excess expense due to disparity between carrying
amounts and Fair value of assets/liabilities.
In this section, we will see how the three methods differ in regard to the above issues.

The Equity Method

In applying the equity method, we have to account for the investment in subsidiary by:
1. Recording the Investment in Sub on the acquisition date at cost of consideration given up.
2. Recognizing the receipt of dividends from the subsidiary reducing the investment.
3. Recognizing a share of the sub’s income (loss) as addition to or reduction from the
investment balance.
4. Adjusting the assets and liabilities to reflect the Fair value methods.

The Cost Method

If the cost method is used by the parent company to account for the investment, then the
consolidation entries will change only slightly. The difference between the cost method and the
equity method includes:
1. No adjustments are recorded in the Investment account for current year operations,
dividends paid by the subsidiary, or amortization of purchase price allocations.
2. Dividends received from the subsidiary are recorded as Dividend Revenue.

The Partial Equity Method

The Partial Equity Method slightly differs from the Equity method in that the adjustment to the
Fair value balances of assets and liabilities.

To summarize the above differences in the accounting methods for the investment account and
the income from the investment under the three methods, we have the following table:

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METHOD INVESTMENT ACCOUNT INCOME ACCOUNT

Income Accrued As Earned;

Continually Adjusted to Reflect Ownership of
EQUITY Amortization And Other Adjustments
Acquired Company.
Are Recognized.

Cash Received Recorded As Dividend

COST Remains at Initially Recorded Cost.
Income.

PARTIAL Adjusted Only for Accrued Income and Income Accrued as Earned; No Other
EQUITY Dividends Received from Acquired Company. Adjustments Recognized.

Consolidation of Wholly Owned Subsidiary on Date of Business Combination

Once you have grasped the basics of how the investment account will be affected with the
passage of time, we will next see the consolidation of financial statements. To begin with, we
consider the consolidation of financial statements from the parent and subsidiary as of the date of
business combination where the parent holds 100% of the subsidiary’s stocks. There is no
question of control of a wholly owned subsidiary.
Thus, to illustrate consolidated financial statements for a parent company and a wholly owned
subsidiary, assume that on December 31, 2005, Palm Corporation issued 10,000 shares of its Br.
10 par common stock (current fair value Br. 45 a share) to stockholders of Starr Company for all
the outstanding Br. 5 par common stock of Starr. There was no contingent consideration. Out-
of-pocket costs of the business combination paid by Palm on December 31, 2005, consisted of
the following:
Finder's and legal fees relating to business combination Br. 50,000
Costs associated with registration 35,000
Total out-of-pocket costs of business combination Br85,000

Assume also that Starr Company was to continue its corporate existence as a wholly owned
subsidiary of Palm Corporation. Both constituent companies had a December 31 fiscal year and
used the same accounting principles and procedures; thus, no adjusting entries were required for
either company prior to the combination.
Financial statements of Palm Corporation and Starr Company for the year ended December 31,
2005, prior to consummation of the business combination, follow:

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 PALM CORPORATION AND STARR COMPANY
Separate Financial Statements (prior to business combination)
For Year Ended December 31, 2005

PALM CORPORATION AND STARR COMPANY

Income Statements (prior to business combination)
For Year Ended December 31, 2005

Palm Corporation Starr Company

Revenue:
Net sales Br. 990,000 Br. 600,000
Interest revenue 10,000 -
Total revenue Br. 1,000,000 Br. 600,000
Costs and expenses:
Cost of goods sold Br. 635,000 Br. 410,000
Operating expenses 158,333 73,333
Interest expense 50,000 30,000
Income taxes expense 62,667 34,667
Total costs and expenses Br. 906,000 Br. 548,000
Net income Br. 94,000 Br. 52,000

PALM CORPORATION AND STARR COMPANY

Statements of Retained Earnings (prior to business combination)
For Year Ended December 31, 2005

Palm Corporation Starr Company

Retained earnings, beginning of year Br. 65,000 Br. 100,000
Add: Net income 94,000 52,000
Subtotals Br. 159,000 Br. 152,000
Less: Dividends 25,000 20,000
Retained earnings, end of year Br. 134,000 Br. 132,000

PALM CORPORATION AND STARR COMPANY

Balance Sheets (prior to business combination)
December 31, 2005

Palm Corporation Starr Company

Assets
Cash Br. 100,000 Br. 40,000
Inventories 150,000 110,000
Other current assets 110,000 70,000
Receivable from Starr Company 25,000 ----
Plant assets (net) 450,000 300,000
Patent (net) ---- 20,000
Total assets Br. 835,000 Br. 540,000

Liabilities and Stockholders' Equity

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 Payables to Palm Corporation ---- Br. 25,000
Income taxes payable Br. 26,000 10,000
Other liabilities 325,000 115,000
Common stock, Br10 par 300,000 ----
Common stock, Br5 par ---- 200,000
Additional paid-in capital 50,000 58,000
Retained earnings 134,000 132,000
Total liabilities and stockholders' equity Br. 835,000 Br. 540,000

The December 31, 2005, current fair values of Starr Company's identifiable assets and
liabilities were the same as their carrying amounts, except for the three assets listed below:

Current Fair
Values,
December 31, 2005
Inventories Br. 135,000
Plant assets (net) 365,000
Patent (net) 25,000

Because Starr was to continue as a separate corporation and current generally accepted
accounting principles do not sanction write-ups of assets of a going concern, Starr did not
prepare journal entries for the business combination. Palm Corporation recorded the
combination on December 31, 2005, with the following journal entries:

PALM CORPORATION (COMBINOR)

Journal Entries
December 31, 2005
Investment in Star Company Common Stock (10,000 x Br. 45) ……………………… 450,000
Common Stock (10,000 x Br. 10)………………………………………………….. 100,000
Paid-in Capital in Excess of par …………………………………………………… 350,000
To record the issuance of 10,000 shares of common stock for all the outstanding common stock
of Starr Company in a business combination.

Investment is star company common stock ……………………………………………… 50,000

Paid-in Capital in Excess Par……………………………………………………………… 35,000
Cash…………………………………………………………………………………… 85,000
To record payment of out-of-pocket costs of business combination with Starr Company.

Unlike the journal entries for a merger illustrated in the previous unit the foregoing journal
entries do not include any debits or credits to record individual assets and liabilities of Starr
Company in the accounting records of Palm Corporation. The reason is that Starr was not
liquidated as in a merger; it remains a separate legal entity.
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After the foregoing journal entries have been posted, the affected ledger accounts of Palm
Corporation (the combinor) are as follows:

Cash
Date Explanation Debit Credit Balance
2005
Dec. 31 Balance forward 100,000 dr
31 Out-of-pocket costs of business combination 85,000 15,000 dr

Investment in Starr Company Common Stock

Date Explanation Debit Credit Balance
2005
Dec. 31 Issuance of common stock in business combination 450,000 450,000 dr
31 Direct out-of-pocket costs of business combination 50,000 500,000 dr

Common Stock, Br10 Par

Date Explanation Debit Credit Balance
2005
Dec. 31 Balance forward 300,000 cr
31 Issuance of common stock in business combination 100,000 400,000 cr

Paid-in Capital in Excess of Par

Date Explanation Debit Credit Balance
2005
Dec. 31 Balance forward 50,000 cr
31 Issuance of common stock in business combination 350,000 400,000 cr
31 Costs of issuing common stock in business combination 35,000 365,000 cr

Preparation of Consolidated Balance Sheet without a Working Paper

Accounting for the business combination of Palm Corporation and Starr Company requires a
fresh start for the consolidated entity. This reflects the theory that a business combination that
involves a parent company-subsidiary relationship is an acquisition of the combinee net assets

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(assets less liabilities) by the combinor. The operating results of Palm and Starr prior to the date
of their business combination are those of two separate economic - as well as legal - entities.
Accordingly, a consolidated balance sheet is the only consolidated financial statement issued by
Palm on December 31, 2005, the date of the business combination of Palm and Starr.
The preparation of a consolidated balance sheet for a parent company and its wholly owned
subsidiary may be accomplished without the use of a supporting working paper. The parent
company's investment account and the subsidiary's stockholder's equity accounts do not appear
in the consolidated balance sheet because they are essentially reciprocal (intercompany)
accounts. The parent company (combinor) assets and liabilities (other than intercompany ones)
are reflected at carrying amounts, and the subsidiary (combinee) assets and liabilities (other than
intercompany ones) are reflected at current fair values, in the consolidated balance sheet.
Goodwill is recognized to the extent t cost of the parent's investment in 100% of the subsidiary's
outstanding common stock exceeds the current fair value of the subsidiary's identifiable net
assets, both tangible intangible.
Applying the foregoing principles to the Palm Corporation and Starr Company parent-
subsidiary relationship, the following consolidated balance sheet is produced:

PALM CORPORATION AND SUBSIDIARY

Consolidated Balance Sheet
December 31, 2005

Assets
Current assets:
Cash (Br. 15,000 + Br. 40,000) Br. 55,000
Inventories (Br. 150,000 + Br. 135,000) 285,000
Other (Br. 110,000 + Br. 70,000) 180,000
Total current assets Br. 520,000
Plant assets (net) (Br. 450,000 + Br. 365,000) 815,000
Intangible assets:
Patent (net) (Br. 0 + Br. 25,000) Br. 25,000
Goodwill 15,000 40,000
Total assets Br. 1,375,000

Liabilities and Stockholders' Equity

Liabilities:
Income taxes payable (Br. 26,000 + Br. 10,000) Br. 36,000
Other current liabilities (Br. 325,000+ Br. 115,000) 440,000
Total liabilities Br. 476,000
Stockholders' equity:

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 Common stock, Br. 10 par Br. 400,000
Additional paid-in capital 365,000
Retained earnings 134,000 899,000
Total liabilities and stockholders' equity Br. 1,375,000

The following are significant aspects of the consolidated balance sheet:

1. The first amounts in the computations of consolidated assets and liabilities (except
goodwill) are the parent company’s carrying amounts; the second amounts are the
subsidiary’s current fair values.
2. Intercompany accounts (parent's investment, subsidiary's stockholders' equity, and
intercompany receivable/payable) are excluded from the consolidated balance sheet.
3. Goodwill in the consolidated balance sheet is the cost of the parent company's investment
(Br. 500,000) less the current fair value of the subsidiary's identifiable net assets (Br.
485,000), or Br. 15,000. The Br. 485,000 current fair value of the subsidiary's identifiable
assets is computed as follows: Br. 40,000 + Br. 135,000 + Br. 70,000 + Br. 365,000 +
Br. 25,000 –Br. 25,000 –Br. 10,000 – Br. 115,000 = Br. 485,000.

Working Paper for Consolidated Balance Sheet

The preparation of a consolidated balance sheet on the date of a business combination usually ad
the subsidiary requires the use of a working paper for consolidated balance sheet, even for a
parent company and a wholly owned subsidiary. The format of the working paper, with the
individual balance sheet amounts included for both Palm Corporation and Starr Company, is
shown as follows:

Format of Working Paper for Consolidated Balance Sheet for Wholly

Owned Subsidiary on Date of Business Combination
PALM CORPORATION AND SUBSIDIARY
Working Paper for Consolidated Balance Sheet
December 31, 2005

Eliminations
Palm Starr Increase
Corporation Company (Decrease) Consolidated
Assets
Cash 15,000 40,000
Inventories 150,000 110,000
Other current assets 110,000 70,000

Intercompany receivable (payable) 25,000 (25,000)

Investment in Starr Company Common Stock 500,000
Plant assets (net) 450,000 300,000
Patent (net) 20 000
Goodwill

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 Total assets 1,250,000 515,000

Liabilities and Stockholders' Equity

Income taxes payable 26,000 10,000
Other liabilities 325,000 115,000
Common stock, Br10 par 400,000
Common stock, Br5 par 200,000
Additional paid-in capital 365,000 58,000
Retained earnings 134,000 132,000
Total liabilities and stockholders' equity 1,250,000 515,000

Common Stock - Starr 200,000

Elimination Additional Paid-in Capital - Starr 58,000
of Retained Earnings - Starr 132,000
Intercompany 390,000
Accounts Investment in Starr Company 500,000

The footing of Br. 390,000 of the debit items of the foregoing partial elimination represents the
carrying amount of the net assets of Starr Company and is Br. 110,000 less than the Office
reciprocal account credit item of Br. 500,000, which represents the cost of Palm Corporation's
investment in company accounts of Starr. As indicated on earlier, part of the Br. 110,000
difference is attributable to the excess of current fair values over carrying amounts of certain
identifiable tangible and intangible assets of Starr. This excess is summarized as follows (the
current fair values of all other assets and liabilities are equal to their carrying amounts):
Differences between Identifiable Assets Current Fair Values and
Carrying Amounts of Combinee’s Identifiable Assets
Current Fair Carrying
Values Amounts Difference
Inventories Br. 135,000 Br. 110,000 Br. 25,000
Plant assets (net) 365,000 300,000 65,000
Patent (net) 25,000 20 000 5,000
Total Br. 525,000 Br. 430,000 Br. 95,000

Generally accepted accounting principles do not presently permit the write-up of a going
concern's assets to their current fair values. Thus, to conform to the requirements of purchase
accounting for business combinations, the foregoing excess of current fair values over carrying
amounts must be incorporated in the consolidated balance sheet of Palm Corporation and
subsidiary by means of the elimination.

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 Increases in assets are recorded by debits; thus, the elimination for Palm Corporation
and subsidiary begun above is continued as follows (in journal entry format):

Common Stock - Starr 200,000

Use of Additional Paid-in Capital - Starr 58,000
Elimination to Retained Earnings – Starr 132,000
Reflect Current Inventories - Starr (Br. 135,000 – Br. 110,000) 25,000
Fair Values of Plant Assets (net) - Starr (Br. 365,000 – Br. 300,000) 65,000
Combinee’s Patent (net) - Starr (Br. 25,000 – Br. 20,000) 5,000
Identifiable
Assets 485,000
Investment in Starr Company Common Stock-Palm 500,000

The revised footing of Br. 485,000 of the debit items of the foregoing partial elimination is equal
to the current fair value of the identifiable tangible and intangible net assets of Starr Company.
Thus, the Br. 15,000 difference (Br. 500,000 – Br. 485,000 = Br. 15,000) between the cost of
Palm Corporation's investment in Starr and the current fair value of Starr's identifiable net
assets represents goodwill of Starr, in accordance with purchase accounting theory for business
combinations. Consequently, the December 31, 2005, elimination for Palm Corporation and
subsidiary is completed with a Br. 15,000 debit to Goodwill-Starr.

Completed Elimination and Working Paper for Consolidated Balance Sheet

The completed elimination for Palm Corporation and subsidiary (in journal entry format) and
the related working paper for consolidated balance sheet are as follows:
PALM CORPORATION AND SUBSIDIARY
Working Paper Elimination
December 31, 2005
(a) Common Stock - Starr 200,000
Completed Working Additional Paid-in Capital - Starr 58,000
Paper Elimination for Retained Earnings – Starr 132,000
Wholly Owned Inventories - Starr (Br. 135,000 – Br. 110,000) 25,000
Purchased Subsidiary Plant Assets (net) - Starr (Br. 365,000 – Br. 300,000) 65,000
on date of Business Patent (net) - Starr (Br. 25,000 – Br. 20,000) 5,000
Combination Goodwill-star (Br. 500,000 – Br. 485,000) 15,000
Investment in Starr Company Common Stock-Palm 500,000
To eliminate intercompany investment and equity accounts of subsidiary on date of business combination; and to
allocate excess of cost over carrying amount of identifiable assets acquired, with remainder to goodwill. (Income
tax effects are disregarded.)

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 PALM CORPORATION AND SUBSIDIARY
Working Paper for Consolidated Balance Sheet
December 31, 2005

Eliminations
Palm Starr Increase
Corporation Company (Decrease) Consolidated
Assets
Cash 15,000 40,000 ----- 55,000
Inventories 150,000 110,000 (a) 25,000 285,000
Other current assets 110,000 70,000 ---- 180,000
Intercompany receivable (payable) 25,000 (25,000) -- -0-
Investment in Starr Company Common Stock 500,000 (a) (500,000) -0-
Plant assets (net) 450,000 300,000 (a) 65,000 815,000
Patent (net) 20 000 (a) 5,000 25,000
Goodwill (a) 15,000 15,000
Total assets 1,250,000 515,000 ( 390,000) 1,375,000

Liabilities and Stockholders' Equity

Income taxes payable 26,000 10,000 36,000
Other liabilities 325,000 115,000 440,000
Common stock, Br10 par 400,000 400,000
Common stock, Br5 par 200,000 (a) (200,000)
Additional paid-in capital 365,000 58,000 (a) (58,000) 365,000
Retained earnings 134,000 132,000 (a) (132,000) 134,000
Total liabilities and stockholders' equity 1,250,000 515,000 (390,000) 1,375,000

Dear student, you do not have to be worried by the complexity of the working paper. All
you need to emphasize are the following points:

1. The elimination is not entered in either the parent company's or the subsidiary's
accounting records; it is only a part of the working paper for preparation of the
consolidated balance sheet.
2. The elimination is used to reflect differences between current fair values and
carrying amounts of the subsidiary's identifiable net assets because the subsidiary did not
write up its assets to current fair values on the date of the business combination.
3. The Eliminations column in the working paper for consolidated balance sheet
reflects increases and decreases, rather than debits and credits. Debits and credits are
not appropriate in a working paper dealing with financial statements rather than trial
balances.

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 4. Intercompany receivables and payables are placed on the same line of the working pa-
per for consolidated balance sheet and are combined to produce a consolidated amount of
zero.
5. The respective corporations are identified in the working paper elimination.
6. The consolidated paid-in capital amounts are those of the parent company
only. Subsidiaries' paid-in capital amounts always are eliminated in the process of
consolidation.
7. Consolidated retained earnings on the date of a business combination include only
the retained earnings of the parent company. This treatment is consistent with the theory
that purchase accounting reflects a fresh start in an acquisition of net assets (assets
less liabilities).
8. The amounts in the consolidated column of the working paper for consolidated balance
sheet reflect the financial position of a single economic entity comprising two legal entities,
with all intercompany balances of the two entities eliminated.
Consolidated Balance Sheet
The amounts in the ‘Consolidated’ column of the working paper for consolidated balance sheet
are presented in the customary fashion in the Consolidated Balance Sheet of Palm Corporation
and subsidiary that follows:

PALM CORPORATION AND SUBSIDIARY

Consolidated Balance Sheet
December 31, 2005

Assets
Current assets:
Cash Br. 55,000
Inventories 285,000
Other 180,000
Total current assets Br. 520,000
Plant assets (net) 815,000
Intangible assets:
Patent (net) Br. 25,000
Goodwill 15,000 40,000
Total assets Br. 1,375,000

Liabilities and Stockholders' Equity

Liabilities:
Income taxes payable Br. 36,000
Other current liabilities 440,000

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 Total liabilities Br. 476,000
Stockholders' equity:
Common stock, Br. 10 par Br. 400,000
Additional paid-in capital 365,000
Retained earnings 134,000 899,000
Total liabilities and stockholders' equity Br. 1,375,000

The above illustration we have seen a case where the parent is the exclusive owner of a
subsidiary. It is also possible for the parent to own just part of the shares and still control the
subsidiary which requires consolidation by the parent. The consolidation of a parent company
and its partially owned subsidiary differs from the consolidation of a wholly owned subsidiary in
one major respect-the recognition of minority interest. Minority interest, or non-controlling
interest, is a term applied to the claims of stockholders other than the parent company (the
controlling interest) to the net income or losses and net assets of the subsidiary. The minority
interest in the subsidiary's net in- come or losses is displayed in the consolidated income
statement, and the minority interest in the subsidiary's net assets is displayed in the consolidated
balance sheet.
Nature of Minority Interest
The appropriate classification and presentation of minority interest in consolidated finanrcia1
statements has been a perplexing problem for accountants, especially because it is recognized
only in the consolidation process and does not result from a business transaction or event of
either the parent company or the subsidiary. Two concepts for consolidated financial statements
have been developed to account for minority interest-the parent company concept and the
economic unit concept. The FASB has described these two concepts as follows:
The parent company concept emphasizes the interests of the parent's shareholders. As a
result, the consolidated financial statements reflect those stockholders' interests in the
parent itself, plus their undivided interests in the net assets of the parent's subsidiaries.
The consolidated balance sheet is essentially a modification of the parent's balance sheet
with the assets and liabilities of all subsidiaries substituted for the parent's investment in
subsidiaries.
… [T]he stockholders' equity of the parent company is also the stockholders'
equity of the consolidated entity. Similarly, the consolidated income statement is
essentially a modification of the parent's income statement with the revenues, expenses,
gains, and losses of subsidiaries substituted for the parent's income from investment in
the subsidiaries.
The economic unit concept emphasizes control of the whole by a single
management. As a result, under this concept (sometimes called the entity theory in the

14
 accounting literature), consolidated financial statements are intended to provide
information about a group of legal entities-a parent company and its subsidiaries--
operating as a single unit. The asset, liabilities, revenues, expenses, gains, and losses of
the various component entities are the assets, liabilities, revenues, expenses, gains, and
losses of the consolidated entity Unless all subsidiaries are wholly owned, the business
enterprise's proprietary interest (its residual owners' equity-assets less liabilities) is
divided into the controlling interest (stockholders or other owners of the parent
company) and one or more non-controlling interests in subsidiaries. Both the controlling
and the non-controlling interests are part of the proprietary group of the consolidated
entity, even though the non-controlling stockholders' ownership interests relate only to
the affiliates whose shares they own.
The major difference in the two concepts could be summarized as follows:
The parent company concept of consolidated financial statements apparently treats the minority
interest in net assets of a subsidiary as a liability. This liability is increased each accounting
period subsequent to the date of a business combination by an expense representing the
minority's share of the subsidiary's net income (or decreased by the minority's share of the
subsidiary's net loss). Dividends declared by the subsidiary to minority stockholders decrease the
liability to them. Consolidated net income is net of the minority's share of the subsidiary's net
income.
In the economic unit concept, the minority interest in the subsidiary's net assets is
displayed in the stockholders' equity section of the consolidated balance sheet. The consolidated
income statement displays the minority interest in the subsidiary's net income as a subdivision of
total consolidated net income, similar to the division of net income of a partnership.

Consolidated Financial Statements:Subsequent to Date of Business Combination

In this final section of the unit, we will briefly discuss the answers to these questions. To start
with one important aspect of the consolidated financial statements is the impact of passage of
time since the date of business combination, i.e. we have to address the impact of operating
results on consolidation process.
Dear student recall what we have discussed in section 5.2, we have seen the methods as
to how investment in other companies be accounted using the Equity, Cost and Partial Equity
method. Here, we will revisit the methods to refresh your memory so as to help you understand
consolidation techniques on subsequent dates.
In the equity method of accounting, the parent company recognizes its share of the
subsidiary's net income or net loss, adjusted for depreciation and amortization of differences

15
between current fair values and carrying amounts of a subsidiary's identifiable net assets on the
date of the business combination, as well as its share of dividends declared by the subsidiary.
In the cost method of accounting, the parent company accounts for the operations of a
subsidiary only to the extent that dividends are declared by the subsidiary. Dividends declared by
the subsidiary from net income subsequent to the business combination are recognized as
revenue by the parent company; dividends declared by the subsidiary in excess of post
combination net income constitute a reduction of the carrying amount of the parent company's
investment in the subsidiary.
Net income or net loss of the subsidiary is not recognized by the parent company when the cost
method of accounting is used.
Dear student at this point you have to appreciate how complex the consolidation process can get
as we add on cases and assumptions about the methods. To make life easier and give you the
basics of the process, we will limit the illustration of the subsequent date of purchase choosing
one method of accounting for the investment - The Equity method and where the subsidiary is a
wholly owned one. To make ends meet, we will continue to use the example seen above.
Assume that Palm Corporation had appropriately accounted for the December 31, 2005,
business combination with its wholly owned subsidiary, Starr Company and that Starr had a net
income of Br. 60,000 for the year ended December 31, 2006. Assume further that on December
20, 2006, Starr's board of directors declared a cash dividend of Br. 0.60 a share on the 40,000
outstanding shares of common stock owned by Palm. The dividend was payable January 8,
2007, to stockholders of record December 29, 2006.
Starr's December 20, 2006, journal entry to record the dividend declaration is as follows:

2006 20 Dividends Declared (40,000 x Br. 0.60) 24,000

December Intercompany Dividends Payable 24,000
To record declaration of dividend payable January 8, 2007, to stock- holders of record December 29, 2006.

Starr's credit to the Intercompany Dividends Payable ledger account indicates that the liability
for dividends payable to the parent company must be eliminated in the preparation of
consolidated financial statements for the year ended December 31, 2006.
Under the equity method of accounting, Palm Corporation prepares the following journal entries
to record the dividend and net income of Starr for the year ended December 31, 2006:

16
 2006
December 20 Intercompany Dividends Receivable 24,000
Investment in Starr Company Stock 24,000
To record dividend declared by Starr company, payable January 8, 2007, to stockholders of
record Dec, 29, 2006.
31 Investment in Starr Company Common Stock 60,000
Intercompany Investment Income 60,000
To record 100% of Starr Company’s net income for the year ended Dec. 31, 2006.

The parent's first journal entry records the dividend declared by the subsidiary in the
Intercompany Dividends Receivable account and is the counterpart of the subsidiary's journal
entry to record the declaration of the dividend. The credit to the Investment in Starr Company
Common Stock account in the first journal entry reflects an underlying premise of the equity
method of accounting: dividends declared by a subsidiary represent a return of a portion of the
parent company's investment in the subsidiary.
The parent's second journal entry records the parent's 100% share of the subsidiary's net income
for 2006. The subsidiary's net income accrues to the parent company under the equity method of
accounting, similar to the accrual of interest on a note receivable or an investment in bonds.
In addition to the two foregoing journal entries, Palm must prepare a third equity-method journal
entry on December 31, 2006, to adjust Starr's net income for depreciation and amortization
attributable to the differences between the current fair values and carrying amounts of Starr's
identifiable net assets on December 31, 2005, the date of the Palm-Starr business combination.
Because such differences were not recorded by the subsidiary, the subsidiary's 2006 net income
is overstated from the point of view of the consolidated entity.

Assume that the December 31, 2005 (date of business combination), differences between the
current fair values and carrying amounts of Starr Company's net assets were as follows:

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 Difference Inventories (first-in, first-out cost) Br. 25,000
between Current Plant assets (net):
Fair Values and Land Br. 15,000
Carrying Amounts Building (economic File 15 years) 30,000
of Wholly Owned Machinery (economic life 10 years) 20,000 65,000
Subsidiary’s Patent (economic life 5 years) 5,000
Assets on Date of
Goodwill (not impaired as of December 31, 2006) 15,000
Business
Combination Total Br. 110,000

Palm Corporation prepares the following additional equity-method journal entry to reflect
the effects of depreciation and amortization of the differences between the current fair values and
carrying amounts of Starr Company's identifiable net assets on Starr's net income for the year
ended December 31, 2006:

2006
December 31 Intercompany Investment Income 30,000
Investment in Starr Company Stock 30,000

To amortize differences between current fair values and carrying amounts

of Starr Company’s net assets on Dec. 31, 2005, as follows:
Inventories-to cost of goods sold Br. 25,000
31
Building-depreciation (Br30,000 ÷ 15) 2,000
Machinery-depreciation (Br20,000 ÷ 10) 2,000
Patent-amortization (Br5,000 ÷ 5) 1,000
Total amortization applicable to 2006 Br. 30,000
(Income tax effects are disregarded.)

Dear student after been introduced to how the investment account be affected with passage of as
a result of events of the Investee and facts that prevail on the date of business combination , we
will next show you what must be done to facilitate the consolidation. The first step to be done is
preparing the elimination entries.
In our Illustration, the investor, Palm Corporation's use of the equity method of
accounting for its Investment in Starr Company results in a balance in the Investment account
that is a mixture of two components:
1) The carrying amount of Starr's identifiable net assets, and

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 2) The excess on the date of business combination of the current fair values of
the subsidiary's net assets (including goodwill) over their carrying amounts, net
of depreciation and amortization.
Working Paper for Consolidated Financial Statements
We continue to apply the equity method to illustrate the preparation of consolidated
financial statements using a work paper. The work paper follows the discussion of the
components and their computation.
We start with the balance sheet of a year ago that we used form Palm Corporation and Starr
Company.
The intercompany receivable and payable is the Br. 24,000 dividend payable by Starr to Palm
on December 31, 2006. (The advances by Palm to Starr that were outstanding on December 31,
2005, were repaid by Starr on January 2, 2006.)
The following aspects of the working paper for consolidated financial statements of Palm
Corporation and subsidiary should be emphasized:

1. The intercompany receivable and payable, placed in adjacent columns on the same line, are
offset without a formal elimination.
2. The elimination cancels all intercompany transactions and balances not dealt with by the
offset described in 1 above.
3. The elimination cancels the subsidiary's retained earnings balance at the beginning of the
year (the date of the business combination), so that each of the three basic financial
statements may be consolidated in turn. (All financial statements of a parent company and a
subsidiary are consolidated for accounting periods subsequent to the business combination.)
4. The first-in, first-out method is used by Starr Company to account for inventories; thus, the
Br. 25,000 difference attributable to Starr's beginning inventories is allocated to cost of
goods sold for the year ended December 31, 2006.
5. Income tax effects are ignored in the process.
6. One of the effects of the elimination is to reduce the differences between the current fair
values and the carrying amounts of the subsidiary's net assets, excepting land and goodwill,
on the business combination date. The effect of the reduction is as follows:

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 Total difference on date of business combination (Dec. 31, 2005) Br. 110,000
Less: Reduction in elimination (a) (Br. 29,000 + Br. 1,000) 30,000
Unamortized difference, Dec, 31, 2006 (Br. 61,000 + Br. 4,000 + Br. 15,000) Br. 80,000

The joint effect of Palm Corporation's use of the equity method of accounting and
the annual elimination will be to extinguish Br. 50,000 of the Br. 80,000 difference
above through Palm's Investment in Starr Company Common Stock ledger account.
Remember that the Br. 15,000 balance applicable to Starr's land will not be extinguished;
the Br. 15,000 balance applicable to Starr's goodwill will be reduced only if the goodwill
in subsequently impaired. [Refer SFAS142 on Amortization of Goodwill]

7. The parent company's use of the equity method of accounting results in the equalities
described below:
Parent company net income = consolidated net income
Parent company retained earnings = consolidated retained earnings
8. The equalities exist when the equity method of accounting is used and intercompany profits
and sales are ignored. Despite the equalities indicated above, consolidated financial
statements are superior to parent company financial statements for the presentation of
financial position and operating results of parent and subsidiary companies. The effect of the
consolidation process for Palm Corporation and subsidiary is to reclassify Palm's Br.
30,000 share of its subsidiary's adjusted net income to the revenue and expense
components of that net income. Similarly, Palm's Br. 506,000 investment in the subsidiary is
replaced by the assets and liabilities comprising the subsidiary's net assets.
9. Purchase accounting theory requires the exclusion from consolidated retained earnings of a
subsidiary's retained earnings on the date of a business combination. Palm Corporation's use
of the equity method of accounting meets this requirement. Palm's ending retained earnings
amount in the working paper, which is equal to consolidated retained earnings, includes only
Palm's Br. 30,000 share of the subsidiary's adjusted net income for the year ended December
31, 2006, the first year of the parent- subsidiary relationship.

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 Equity Method: Wholly Owned Subsidiary Subsequent to Date of Business Combination

PALM CORPORATION AND SUBSIDIARY

Working Paper for Consolidated Financial Statements
For Year Ended December 31, 2006

Elimination
Palm Starr Increase
Corporation Company (Decrease) Consolidated
Income Statement
Revenue:
Net sales 1,100,000 680,000 ---- 1,780,000
Inter-company Investment Income 30,000 (a) (30,000) ----
Total revenue 1,130,000 680,000 (30,000) 1,780,000
Costs and expenses:
Cost of Goods sold 700,000 450,000 (a) 29,000 1,179,000
Operating expenses 217,667 130,000 (a) 1,000 348,667
Interest expense ---- 49,000 ---- 49,000
Income taxes expense 53,333
Total costs and exp 1, 020,000 620,000 30,000* 1,670,000
Net income 110,000 60,000 (60,000) 110,000

Statement of Retained Earnings

Beginning Retained earnings 134,000 132,000 (a) (132,000) 134,000

Net Income 110,000 60,000 (60,000) 110,000
Sub total 244,000 192,000 (192,000) 244,000
Dividends declared 30,000 24,000 (a) (24,000)** 30,000
Ending Retained earnings 214,000 168,000 (168,000) 214,000

Balance Sheet
Assets
Cash 15,900 72,100 88,000
Intercompany receivable (payable) 24,000 (24,000) ---- ----
Inventories 136,000 115,000 251,000
Other current assets 88,000 131,000 219,000
Investment in Starr Co. Common Stock 506,000 ---- (a) (506,000) ----
Plant assets (net) 440,000 340,000 (a) 61,000 841,000
Patent (net) 16,000 (a) 4,000 20,000
Goodwill (a) 15,000 15,000
Total assets 1,209,900 650,100 (426,000) 1,434,000

Liabilities and Stockholder’s Equity

Income taxes payable 40,000 20,000 ---- 60,000
Other liabilities 190,900 204,100 ---- 395,000
Common stock, Br. 10 par 400,000 400,000
Common stock, Br. 5 par 200,000 (a) (200,000)
Additional Paid-in Capital 365,000 58,000 (a) (58,000) 365,000
Retained earnings 214,000 168,000 (168,000) 214 000
Total Liabilities and Stockholders’ Equity 1,209,900 650,100 (426,000) 1,434,000

* an increase in total costs and expenses and a decrease in net income

**a decrease in dividends and an increase in retained earnings

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Dear student, the above working paper is a tool to facilitating the preparation of consolidated
financial statements.
The consolidated income statement, statement of retained earnings, and balance sheet of Palm
Corporation and subsidiary for the year ended December 31, 2006, are as follow. The amounts
in the consolidated financial statements are taken from the consolidated column of the above
working paper.

PALM CORPORATION AND SUBSIDIARY

Consolidated Income Statement
For Year Ended December 31, 2006

Net sales ……………………………………….................. Br. 1,780,000

Costs and expenses:
Cost of goods sold……………………………………….. Br. 1, 179,000
Operating expenses ……………………………………... 348,667
Interest expense …………………………………………. 49,000
Income taxes expense……………………………………. 93,333
Total costs and expenses ……………………………. 1,670,000
Net income ………………………………………………… Br. 110,000

Basic Earnings per share of common stock (40,000 shares

outstanding) Br. 2.75

PALM CORPORATION AND SUBSIDIARY

Consolidated Statement of Retained Earnings
For Year Ended December 31, 2006

Retained earnings, beginning of year Br. 134,000

Add: Net income 110,000
Subtotal Br. 244,000
Less: Dividends (Br. 0.75 a share) 30,000
Retained earnings, end of year Br. 214,000

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 PALM CORPORATION AND SUBSIDIARY
Consolidated Balance Sheet
December 31, 2006

Assets
Current assets:
Cash Br. 88,000
Inventories 251,000
Other 219,000
Total current assets Br. 558,000
Plant assets (net) 841,000
Intangible assets:
Patent (net) Br. 20,000
Goodwill 15,000 35,000
Total assets Br. 1,434,000

Liabilities and Stockholders' Equity

Liabilities:
Income taxes payable Br. 60,000
Other current liabilities 395,000
Total liabilities Br. 455,000
Stockholders' equity:
Common stock, Br. 10 par Br. 400,000
Additional paid-in capital 365,000
Retained earnings 214,000 979,000
Total liabilities and stockholders' equity Br. 1,434,000

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